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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Form 10-Q
(Mark One)
X QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the quarterly period ended September 30, 2002
OR
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from ______________________ to ______________________
Commission File Number 1-8865
SIERRA HEALTH SERVICES, INC.
(Exact name of registrant as specified in its charter)
NEVADA 88-0200415
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
2724 NORTH TENAYA WAY
LAS VEGAS, NV 89128
(Address of principal executive offices) (Zip Code)
(702) 242-7000
(Registrant's telephone number, including area code)
N/A
(Former name, former address and former fiscal year, if changed
since last report)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes X No
As of November 11, 2002, there were 29,546,000 shares of common stock
outstanding.
SIERRA HEALTH SERVICES, INC. AND SUBSIDIARIES
FORM 10-Q FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2002
INDEX
Page No.
Part I - FINANCIAL INFORMATION
Item 1. Financial Statements
Condensed Consolidated Balance Sheets -
September 30, 2002 and December 31, 2001.................................................. 3
Condensed Consolidated Statements of Operations -
three and nine months ended September 30, 2002 and 2001................................... 4
Condensed Consolidated Statements of Cash Flows -
nine months ended September 30, 2002 and 2001............................................. 5
Notes to Condensed Consolidated Financial Statements....................................... 6
Item 2. Management's Discussion and Analysis of
Financial Condition and Results of Operations............................................. 16
Item 3. Quantitative and Qualitative Disclosures
about Market Risk......................................................................... 30
Item 4. Controls and Procedures.................................................................... 30
Part II - OTHER INFORMATION
Item 1. Legal Proceedings.......................................................................... 31
Item 2. Changes in Securities and Use Of Proceeds.................................................. 31
Item 3. Defaults Upon Senior Securities............................................................ 31
Item 4. Submission of Matters to a Vote of Security Holders........................................ 31
Item 5. Other Information.......................................................................... 31
Item 6. Exhibits and Reports on Form 8-K........................................................... 31
Signatures................................................................................................... 33
Certifications............................................................................................... 34
PART I - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
SIERRA HEALTH SERVICES, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands, except per share data)
(Unaudited)
ASSETS
September 30, December 31,
2002 2001
Current Assets:
Cash and Cash Equivalents.............................................. $ 93,779 $ 115,754
Investments............................................................ 394,596 260,762
Accounts Receivable(Less Allowance for Doubtful
Accounts; 2002 - $10,912; 2001 - $12,655).......................... 23,099 26,003
Military Accounts Receivable .......................................... 41,702 40,166
Current Portion of Deferred Tax Asset.................................. 49,905 35,869
Current Portion of Reinsurance Recoverable............................. 81,603 96,762
Prepaid Expenses and Other Current Assets.............................. 26,452 31,640
Assets of Discontinued Operations...................................... 20,767 28,404
--------- ---------
Total Current Assets............................................... 731,903 635,360
Property and Equipment, Net................................................. 62,857 141,451
Long-Term Investments....................................................... 2,727 8,434
Restricted Cash and Investments............................................. 34,846 26,011
Reinsurance Recoverable, Net of Current Portion............................. 103,967 123,383
Deferred Tax Asset, Net of Current Portion.................................. 36,076 77,036
Goodwill ................................................................... 14,782 14,782
Other Assets................................................................ 42,419 43,505
--------- ---------
TOTAL ASSETS................................................................ $1,029,577 $1,069,962
========= =========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current Liabilities:
Accrued Liabilities.................................................... $ 72,255 $ 53,546
Trade Accounts Payable................................................. 19,178 21,578
Accrued Payroll and Taxes.............................................. 27,653 14,390
Medical Claims Payable................................................. 101,315 81,662
Current Portion of Reserve for Losses and Loss Adjustment Expense...... 167,281 142,342
Unearned Premium Revenue............................................... 30,138 52,919
Military Health Care Payable........................................... 76,104 77,261
Current Portion of Long-Term Debt...................................... 51,617 1,612
Liabilities of Discontinued Operations................................. 43,895 83,931
--------- ---------
Total Current Liabilities.......................................... 589,436 529,241
Reserve For Losses and
Loss Adjustment Expense, Net of Current Portion........................... 231,495 243,363
Long-Term Debt, Net of Current Portion...................................... 16,235 181,759
Other Liabilities........................................................... 38,900 19,080
--------- ---------
TOTAL LIABILITIES........................................................... 876,066 973,443
--------- ---------
Stockholders' Equity:
Preferred Stock, $.01 Par Value, 1,000
Shares Authorized; None Issued or Outstanding
Common Stock, $.005 Par Value, 60,000 Shares Authorized;
Shares Issued: 30,703 and 29,648 issued as of 2002
and 2001, respectively.............................................. 155 148
Additional Paid-in Capital................................................ 196,636 181,076
Deferred Compensation for Restricted Stock................................ (620) (1,058)
Treasury Stock: 2002 - 1,163; 2001 - 1,523 Common Stock Shares............ (17,148) (22,789)
Accumulated Other Comprehensive Gain (Loss)............................... 2,031 (5,636)
Accumulated Deficit....................................................... (27,543) (55,222)
--------- ---------
Total Stockholders' Equity......................................... 153,511 96,519
--------- ---------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY.................................. $1,029,577 $1,069,962
========= =========
See accompanying notes to condensed consolidated financial statements.
SIERRA HEALTH SERVICES, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share data)
(Unaudited)
Three Months Ended Nine Months Ended
September 30, September 30,
2002 2001 2002 2001
Operating Revenues:
Medical Premiums.................................... $217,995 $184,402 $ 636,047 $522,806
Military Contract Revenues.......................... 100,366 85,499 279,560 255,497
Specialty Product Revenues.......................... 50,057 49,447 140,434 135,774
Professional Fees................................... 7,819 6,981 23,045 22,056
Investment and Other Revenues....................... 5,087 4,525 14,786 16,276
------- ------- --------- -------
Total......................................... 381,324 330,854 1,093,872 952,409
------- ------- --------- -------
Operating Expenses:
Medical Expenses.................................... 178,958 156,307 530,402 443,595
Military Contract Expenses.......................... 96,629 83,561 268,845 250,332
Specialty Product Expenses.......................... 52,843 50,144 147,246 139,570
General, Administrative and Marketing Expenses...... 33,333 30,084 96,065 86,701
------- ------- --------- -------
Total ........................................ 361,763 320,096 1,042,558 920,198
------- ------- --------- -------
Operating Income from Continuing Operations............ 19,561 10,758 51,314 32,211
Interest Expense and Other, Net........................ (1,312) (3,888) (6,142) (14,450)
------- ------- --------- -------
Income from Continuing Operations Before Taxes......... 18,249 6,870 45,172 17,761
Income Tax Provision................................... (6,114) (2,298) (15,133) (5,946)
------- ------- --------- -------
Net Income from Continuing Operations.................. 12,135 4,572 30,039 11,815
Income (Loss) from Discontinued Operations (Note 3).... 1,928 (12,126) 1,928 (13,369)
------- ------- --------- -------
Net Income (Loss)...................................... $ 14,063 $ (7,554) $ 31,967 $ (1,554)
======= ======= ========= =======
Earnings per Common Share:
- -------------------------
Net Income from Continuing Operations.................. $.42 $ .16 $1.05 $ .43
Income (Loss) from Discontinued Operations............. .06 (.43) .07 (.49)
--- ---- ---- ----
Net Income (Loss)................................... $.48 $(.27) $1.12 $(.06)
=== ==== ==== ====
Earnings per Common Share Assuming Dilution:
- -------------------------------------------
Net Income from Continuing Operations.................. $.38 $ .16 $ .97 $ .42
Income (Loss) from Discontinued Operations............. .06 (.42) .06 (.47)
--- ---- ---- ----
Net Income (Loss)................................... $.44 $(.26) $1.03 $(.05)
=== ==== ==== ====
Weighted Average Common Shares Outstanding............. 29,166 27,851 28,489 27,619
Weighted Average Common Shares Outstanding
Assuming Dilution................................... 31,756 29,270 30,994 28,316
See accompanying notes to condensed consolidated financial statements.
SIERRA HEALTH SERVICES, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited)
Nine Months Ended September 30,
2002 2001
Cash Flows From Operating Activities:
Net Income (Loss)....................................................... $ 31,967 $ (1,554)
Adjustments to Reconcile Net Income (Loss) to Net Cash
Provided by Operating Activities:
(Gain) Loss from Discontinued Operations......................... (1,928) 13,369
Depreciation and Amortization.................................... 15,205 18,439
Provision for Doubtful Accounts.................................. 2,321 1,899
Deferred Compensation Expense.................................... 438
(Gain) Loss on Property and Equipment Dispositions............... (80) 2,399
Changes in Assets and Liabilities
Deferred Tax Asset............................................... 29,653 595
Reinsurance Recoverable.......................................... 34,575 (8,259)
Accrued Payroll and Taxes........................................ 12,095 3,001
Medical Claims Payable........................................... 19,653 3,164
Reserve for Losses and Loss Adjustment Expense................... 13,071 36,055
Unearned Premium Revenue......................................... (22,781) 9,648
Other Assets and Liabilities..................................... 5,752 10,291
-------- ---------
Net Cash Provided by Operating Activities .......................... 139,941 89,047
-------- ---------
Cash Flows From Investing Activities:
Capital Expenditures, Net of Dispositions............................... (5,588) (2,454)
Changes in Investments.................................................. (110,281) (839)
-------- -------
Net Cash Used for Investing Activities.............................. (115,869) (3,293)
-------- -------
Cash Flows From Financing Activities:
Payments on Debt and Capital Leases..................................... (42,630) (74,255)
Proceeds on Sale-Leaseback Deposit...................................... 16,862 2,866
Issuance of Stock in Connection with Stock Plans........................ 10,193 2,180
-------- -------
Net Cash Used for Financing Activities.............................. (15,575) (69,209)
-------- -------
Net Cash Used for Discontinued Operations.................................. (30,472) (26,414)
-------- -------
Net Decrease In Cash and Cash Equivalents.................................. (21,975) (9,869)
Cash and Cash Equivalents at Beginning of Period........................... 115,754 157,564
-------- -------
Cash and Cash Equivalents at End Of Period................................. $ 93,779 $147,695
======== =======
Supplemental Condensed Consolidated Continuing Operations Nine Months Ended September 30,
Statements of Cash Flows Information: 2002 2001
- ---------------------------------------------------------------------------
Cash Paid During the Period for Interest
(Net of Amount Capitalized)............................................. $ 5,224 $14,423
Net Cash Received During the Period for Income Taxes....................... 13,019 376
Non-cash Investing and Financing Activities:
Retired Sale-Leaseback Assets, Liabilities
and Financing Obligations (Note 6).................................. 89,751 10,626
Debentures Exchanged.................................................... 19,692
See accompanying notes to condensed consolidated financial statements.
SIERRA HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
1. Basis of Presentation
The accompanying unaudited financial statements include the consolidated
accounts of Sierra Health Services, Inc. ("Sierra", a holding company,
together with its subsidiaries, collectively referred to herein as the
"Company"). All material intercompany balances and transactions have been
eliminated. These statements have been prepared in conformity with
accounting principles generally accepted in the United States of America
and used in preparing the Company's annual audited consolidated financial
statements but do not contain all of the information and disclosures that
would be required in a complete set of audited financial statements. They
should, therefore, be read in conjunction with the Company's annual audited
consolidated financial statements and related notes thereto for the years
ended December 31, 2001 and 2000. In the opinion of management, the
accompanying unaudited condensed consolidated financial statements reflect
all material adjustments, consisting only of normal recurring adjustments,
necessary for a fair presentation of the financial results for the interim
periods presented.
The preparation of financial statements in conformity with accounting
principles generally accepted in the United States of America requires
management to make estimates and assumptions that affect the reported
amounts of assets and liabilities and disclosure of contingent assets and
liabilities at the date of the financial statements and the reported
amounts of revenues and expenses during the reporting period. Such
estimates and assumptions could change in the future as more information
becomes available, which could impact the amounts reported and disclosed
herein. Actual results may materially differ from estimates.
Certain amounts in the Condensed Consolidated Financial Statements for the
three and nine months ended September 30, 2001 have been reclassified to
conform with the current year presentation.
2. Asset Impairment, Restructuring, Reorganization and Other Costs
The table below presents a summary of asset impairment, restructuring,
reorganization and other cost activity for the periods indicated that are
included in general, administrative and marketing expenses. Discontinued
Texas HMO health care operations are excluded from this table and are
discussed in Note 3.
Restructuring
and
Reorganization Other Total
(In thousands)
Balance, January 1, 2001......................... $ 594 $4,447 $5,041
Charges recorded.................................
Cash used........................................ (594) (594)
Noncash activity.................................
Changes in estimate..............................
---- ----- -----
Balance, December 31, 2001....................... - 4,447 4,447
Charges recorded.................................
Cash used........................................
Noncash activity................................. (500) (500)
Changes in estimate..............................
---- ----- -----
Balance, September 30, 2002...................... $ - $3,947 $3,947
==== ===== =====
The remaining other costs of $3.9 million are related to legal claims.
Management believes that the remaining reserves, as of September 30, 2002,
are appropriate and that no revisions to the estimates are necessary at
this time.
3. Discontinued Operations
In conjunction with the Company's plan to exit the Texas healthcare market,
during the third quarter of 2001, the Company recorded charges of $10.6
million for premium deficiency medical costs, $1.6 million to write down
certain Texas furniture and equipment, $2.0 million in lease and other
termination costs, $1.8 million in legal and related costs, $500,000 in
various other exit related costs and $570,000 in premium deficiency
maintenance.
As part of the Company's continual evaluation of its remaining liabilities,
it was determined during the second quarter of 2002, that the medical
claims run out had been favorable compared with the Company's original
projection and that legal and other costs were estimated to be higher than
originally anticipated. As a result, during the second quarter, we reduced
our medical claims payable and medical expenses by $5.0 million and
increased our estimate of accounts payable and other liabilities and
related expenses by $5.0 million. During the third quarter we continued to
have favorable medical claims development and reduced our medical claims
payable estimate by $2.0 million. The adjustment resulted in income, net of
tax, from discontinued operations of $1.3 million. See the discussion below
for a description of the $628,000 gain, net of tax, related to the
Kaiser-Texas mortgage loan.
The following are the unaudited condensed statements of operations of the
discontinued Texas HMO health care operations:
Three Months Ended Nine Months Ended
September 30, September 30,
2002 2001 2002 2001
(In thousands)
Operating Revenues......................................... $ 84 $ 45,474 $ 3,837 $137,744
------ ------- ------ -------
Medical Expenses.......................................... (2,165) 49,042 (5,975) 136,259
General, Administrative and Marketing Expenses............ 705 8,184 4,352 22,766
Asset Impairment, Restructuring, Reorganization
and Other Costs........................................ 6,550 5,000 (1,250)
Interest Expense and Other, Net (including rental income). (1,423) (74) (2,507) 66
------ ------- ------ -------
Income (Loss) from Discontinued Operations Before Taxes... 2,967 (18,228) 2,967 (20,097)
Income Tax (Expense) Benefit.............................. (1,039) 6,102 (1,039) 6,728
------ ------- ------ -------
Net Income (Loss) from Discontinued Operations............ $ 1,928 $(12,126) $ 1,928 $(13,369)
====== ======= ====== =======
The table below presents a summary of discontinued Texas HMO health care
operations' asset impairment, restructuring, reorganization and other cost
activity for the periods indicated.
Restructuring Premium
Asset and Deficiency
Impairment Reorganization Maintenance Other Total
(In thousands)
Balance, January 1, 2001....... - $ 3,755 $ 9,278 $ 800 $13,833
Charges recorded............... $ 1,600 4,380 570 6,550
Cash used...................... (3,716) (1,478) (800) (5,994)
Noncash activity............... (1,600) (125) (1,725)
Changes in estimate............ (7,800) (7,800)
------ ------ ------ ---- ------
Balance, December 31, 2001..... - 4,294 570 - 4,864
Charges recorded...............
Cash used...................... (1,707) (570) (2,277)
Noncash activity...............
Changes in estimate............ 5,000 5,000
------ ------ ------ ---- ------
Balance, September 30, 2002.... $ - $ 7,587 $ - $ - $ 7,587
====== ====== ====== ==== ======
The remaining restructuring and reorganization costs of $7.6 million are
primarily due to legal and related costs, lease and other termination
costs, the cost to provide malpractice insurance on our discontinued
affiliated medical groups and various other exit related costs. Management
believes that the remaining reserves, as of September 30, 2002, are
appropriate and that no further revisions to the estimates are necessary at
this time. Based on the current estimated Texas HMO healthcare run-out
costs and recorded reserves, we believe we have adequate funds available
and the ability to fund the anticipated obligations.
The following are the unaudited assets and liabilities of the discontinued
Texas health care operations:
September 30, December 31,
2002 2001
(In thousands)
ASSETS
Cash and Cash Equivalents.............................. $ - $ -
Accounts Receivable, Net............................... 31 1,402
Other Assets........................................... 4,593 6,895
Property and Equipment, Net............................ 16,143 20,107
------- -------
ASSETS OF DISCONTINUED OPERATIONS....................... 20,767 28,404
------- -------
LIABILITIES
Accounts Payable and Other Liabilities................. 13,846 16,407
Medical Claims Payable................................. 5,411 36,567
Unearned Premium Revenue............................... - 68
Premium Deficiency Reserve............................. - 1,700
Mortgage Loan Payable.................................. 24,638 29,189
------- -------
LIABILITIES OF DISCONTINUED OPERATIONS.................. 43,895 83,931
------- -------
NET LIABILITIES OF DISCONTINUED OPERATIONS.............. $(23,128) $(55,527)
======= =======
The assets and liabilities above do not include an intercompany liability
of $30.5 million from Texas Health Choice, L.C., ("TXHC") to Sierra at
September 30, 2002. The liability is secured by certain of the TXHC land
and buildings and has been eliminated upon consolidation.
Property and equipment consists mainly of real estate properties located in
the Dallas/Fort Worth metroplex areas. TXHC acquired these properties from
Kaiser Foundation Health Plan of Texas ("Kaiser-Texas"), for $44.0 million
as part of the acquisition of certain assets of Kaiser-Texas in October
1998. In June 2000, as part of its restructuring and reorganization of the
Texas HMO health care operations, the Company announced its intention to
sell these properties. The real estate was written down to its estimated
fair value and the Company took an asset impairment charge of $27.0
million. The real estate is encumbered by a mortgage loan to Kaiser-Texas,
which is guaranteed by Sierra.
During 2001, Sierra participated in negotiations with Kaiser-Texas relating
to the real estate properties and associated mortgage loan to Kaiser-Texas
along with other matters. Sierra reached an agreement with Kaiser-Texas,
effective December 31, 2001, whereby Kaiser-Texas forgave $8.5 million of
the outstanding principal balance of the mortgage loan and extended the
maturity from November 1, 2003 to November 1, 2006. In exchange for the
consideration by Kaiser-Texas, Sierra agreed to an unconditional guaranty
of the mortgage loan. In conjunction with the agreement, Sierra applied a
$2.5 million outstanding receivable from Kaiser-Texas to the outstanding
balance of the mortgage loan on December 31, 2001.
In accordance with accounting principles generally accepted in the United
States of America, the agreement was accounted for as a restructuring of
debt. In the transaction, total future cash payments (interest and
principal) were less than the balance of the mortgage loan at the time of
the agreement. Accordingly, a gain on restructuring was recognized for the
difference and the carrying amount of the mortgage loan is equal to the
total future cash payments. Costs incurred in connection with the agreement
were offset against the gain on restructuring. Effective January 1, 2002,
all future cash payments, including interest, related to the mortgage loan
are reductions of the carrying amount; therefore, no future interest
expense will be recognized.
During the third quarter of 2002, TXHC sold two of the real estate
properties for net proceeds of $3.6 million. As required under the terms of
the mortgage loan agreement, the proceeds of the sale went directly to
Kaiser-Texas as payment on the mortgage loan. Since the principal payment
resulted in a reduction of future interest, future accrued interest was
reduced and a gain, net of tax, of $628,000 was recorded. At September 30,
2002, the mortgage loan has a carrying value of $24.6 million, which
consists of a principal balance of $20.1 million and $4.5 million in future
accrued interest.
4. Earnings Per Share:
The following table provides a reconciliation of basic and diluted earnings
per share ("EPS") for continuing operations:
Dilutive
Basic Stock Options Diluted
(In thousands, except per share data)
For the Three Months ended September 30, 2002:
Income from Continuing Operations $12,135 $12,135
Weighted Average Common Shares Outstanding 29,166 2,590 31,756
Per Share Amount $.42 $.38
For the Three Months ended September 30, 2001:
Income from Continuing Operations $ 4,572 $ 4,572
Weighted Average Common Shares Outstanding 27,851 1,419 29,270
Per Share Amount $.16 $.16
For the Nine Months ended September 30, 2002:
Income from Continuing Operations $30,039 $30,039
Weighted Average Common Shares Outstanding 28,489 2,505 30,994
Per Share Amount $1.05 $.97
For the Nine Months ended September 30, 2001:
Income from Continuing Operations $11,815 $11,815
Weighted Average Common Shares Outstanding 27,619 697 28,316
Per Share Amount $.43 $.42
5. The following table presents comprehensive income for the periods
indicated:
Three Months Ended Nine Months Ended
September 30, September 30,
2002 2001 2002 2001
(In thousands)
Net Income (Loss)........................... $14,063 $(7,554) $31,967 $(1,554)
Change in Accumulated Other
Comprehensive Income, Net................. 6,555 4,779 7,667 3,190
------ ------ ------ ------
Comprehensive Income (Loss)................. $20,618 $(2,775) $39,634 $ 1,636
====== ====== ====== ======
The change in accumulated other comprehensive income is all due to
unrealized gains in the available for sale investment portfolio.
6. Sale-Leaseback
On December 28, 2000, the Company sold the majority of its Las Vegas,
Nevada, administrative and medical clinic real estate holdings in a
sale-leaseback transaction. Due to continuing involvement as defined in
Statement of Financial Accounting Standards No. 98, "Accounting for Leases"
("SFAS No. 98"), the transaction did not qualify as a sale. The Company
recorded the transaction as a financing obligation offset by the mortgage
notes receivable.
During 2001, the Company received full payment on the outstanding mortgage
notes receivable associated with three of the medical clinics. During the
first two quarters of 2002, the Company received the deposit back on the
three administrative buildings and full payment of the outstanding mortgage
obligation on one of the remaining medical clinics.
During the third quarter of 2002, the Company received full payment on the
remaining outstanding mortgage obligations on the four remaining clinics.
The payment cured the continuing involvement criteria from SFAS No. 98 and
the transaction then qualified as a sale. To record the sale, the Company
retired the assets and their associated accumulated depreciation and
financing obligation and recorded a deferred gain to be recognized over the
remaining 13 year term of the lease. The impact of the sale of the
buildings recorded during 2002 was a net reduction of $68.8 million in
property and equipment, a net reduction of $89.8 million in the associated
financing obligation and a deferred gain of $21.0 million. As of September
30, 2002, the entire transaction has qualified as a sale. The total
deferred gain recorded on the transaction in 2001 and 2002 was $25.7
million; $1.9 million will be recognized annually over the remaining term
of the lease.
7. Segment Reporting
The Company has three reportable segments based on the products and
services offered: managed care and corporate operations, military health
services operations and workers' compensation operations. The managed care
and corporate segment includes managed health care services provided
through HMOs, managed indemnity plans, third-party administrative services
programs for employer-funded health benefit plans, multi-specialty medical
groups, other ancillary services and corporate operations. Discontinued
Texas health care operations are excluded. The military health services
segment administers a managed care federal contract for the Department of
Defense's TRICARE program in Region 1. The workers' compensation segment
assumes workers' compensation claims risk in return for premium revenues
and also provides third party administrative services.
The Company evaluates each segment's performance based on segment operating
profit. Information concerning reportable segments for continuing operations is
as follows:
Managed Care Military Workers'
and Corporate Health Services Compensation
Operations Operations Operations Total
(In thousands)
Three Months Ended September 30, 2002
Medical Premiums.......................... $217,995 $ 217,995
Military Contract Revenues................ $100,366 100,366
Specialty Product Revenues................ 2,491 $ 47,566 50,057
Professional Fees......................... 7,819 7,819
Investment and Other Revenues............. 744 624 3,719 5,087
------- ------- ------- ---------
Total Revenue.......................... $229,049 $100,990 $ 51,285 $ 381,324
======= ======= ======= ==========
Segment Operating Profit (Loss)........... $ 15,824 $ 4,361 $ (624) $ 19,561
Interest Expense and Other, Net........... (1,080) 91 (323) (1,312)
------- ------- ------- ---------
Income (Loss) Before Income Taxes......... $ 14,744 $ 4,452 $ (947) $ 18,249
======== ======= ======= =========
Three Months Ended September 30, 2001
Medical Premiums.......................... $184,402 $ 184,402
Military Contract Revenues................ $ 85,499 85,499
Specialty Product Revenues................ 1,908 $ 47,539 49,447
Professional Fees......................... 6,981 6,981
Investment and Other Revenues............. 296 659 3,570 4,525
------- ------- ------- ---------
Total Revenue.......................... $193,587 $ 86,158 $ 51,109 $ 330,854
======= ======= ======= =========
Segment Operating Profit.................. $ 6,888 $ 2,597 $ 1,273 $ 10,758
Interest Expense and Other, Net........... (3,412) 31 (507) (3,888)
------- ------- ------- ---------
Income Before Income Taxes................ $ 3,476 $ 2,628 $ 766 $ 6,870
======= ======= ======= =========
Nine Months Ended September 30, 2002
Medical Premiums.......................... $636,047 $ 636,047
Military Contract Revenues................ $279,560 279,560
Specialty Product Revenues................ 6,454 $133,980 140,434
Professional Fees......................... 23,045 23,045
Investment and Other Revenues............. 1,813 1,709 11,264 14,786
------- ------- ------- ---------
Total Revenue.......................... $667,359 $281,269 $145,244 $1,093,872
======= ======= ======= =========
Segment Operating Profit.................. $ 37,758 $ 12,424 $ 1,132 $ 51,314
Interest Expense and Other, Net........... (5,196) 76 (1,022) (6,142)
------- ------- ------- ---------
Income Before Income Taxes................ $ 32,562 $ 12,500 $ 110 $ 45,172
======= ======= ======= =========
Nine Months Ended September 30, 2001
Medical Premiums.......................... $522,806 $ 522,806
Military Contract Revenues................ $255,497 255,497
Specialty Product Revenues................ 5,813 $129,961 135,774
Professional Fees......................... 22,056 22,056
Investment and Other Revenues............. 2,508 1,821 11,947 16,276
------- -------- ------- ---------
Total Revenue.......................... $553,183 $257,318 $141,908 $ 952,409
======= ======= ======= =========
Segment Operating Profit.................. $ 20,249 $ 6,986 $ 4,976 $ 32,211
Interest Expense and Other, Net........... (13,194) 14 (1,270) (14,450)
------- ------- ------- ---------
Income Before Income Taxes................ $ 7,055 $ 7,000 $ 3,706 $ 17,761
======= ======= ======= =========
Goodwill amortization of $201,000 and $606,000 is included as part of the
managed care and corporate operations segment for the three and nine months
ended September 30, 2001, respectively.
8. CII Financial Debentures
In December 2000, CII Financial, our wholly-owned workers' compensation
subsidiary, commenced an offer to exchange its outstanding subordinated
debentures for cash and/or new debentures. On May 7, 2001, CII Financial
closed its exchange offer on $42.1 million of its outstanding subordinated
debentures. CII Financial purchased $27.1 million in principal amount of
subordinated debentures for $20.0 million in cash and issued $15.0 million
in new 9 1/2% senior debentures, due September 15, 2004, in exchange for
$15.0 million in subordinated debentures. The remaining $5.0 million in
subordinated debentures were paid at maturity. Since the time of the
exchange, Sierra has purchased $1.0 million in outstanding 9 1/2% senior
debentures which are eliminated upon consolidation.
The transaction was accounted for as a restructuring of debt, therefore all
future cash payments, including interest, related to the debentures will be
reductions of the carrying amount of the debentures and no future interest
expense will be recognized. Accordingly, the 9 1/2% senior debentures have
a carrying amount of $16.8 million, which consists of principal amount of
$14.0 million and $2.8 million in future accrued interest.
The 9 1/2% senior debentures pay interest, which is due semi-annually on
March 15 and September 15, commencing on September 15, 2001. The 9 1/2%
senior debentures rank senior to outstanding notes payable from CII
Financial to Sierra and CII Financial's guarantee of Sierra's revolving
credit facility. The 9 1/2% senior debentures may be redeemed by CII
Financial at any time at premiums currently at 105% and declining to 100%
for redemptions after April 1, 2004. In the event of a change in control of
CII Financial (as defined), the holders of the 9 1/2% senior debentures may
require that CII Financial repurchase them at the then applicable
redemption price, plus accrued and unpaid interest.
9. Goodwill
On January 1, 2002, the Company adopted Statement of Financial Accounting
Standards No. 142, "Goodwill and Other Intangible Assets" ("SFAS No. 142").
SFAS No. 142 requires, among other things, the discontinuance of goodwill
amortization. In addition, the pronouncement includes provisions for the
reclassification of certain existing recognized intangibles as goodwill,
reassessment of the useful lives of existing recognized intangibles,
reclassification of certain intangibles out of previously reported goodwill
and the identification of reporting units for purposes of assessing
potential future impairments of goodwill. SFAS No. 142 also required the
Company to complete a transitional goodwill impairment test six months from
the date of adoption and at least annually thereafter. The net amortized
goodwill balance at December 31, 2001, was $14.8 million. The Company has
completed its transitional goodwill test and determined that the recorded
goodwill was not impaired under the guidelines of the pronouncement.
SIERRA HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
The following table presents the results of our operations as though the
adoption of SFAS No. 142 occurred as of January 1, 2001:
Three Months Ended September 30, 2001
As Reported Adjustments As Adjusted
(In thousands, except per share data)
Net Income from Continuing Operations................... $ 4,572 $131 $ 4,703
Loss from Discontinued Operations....................... (12,126) - (12,126)
------- --- -------
Net (Loss) Income............................... $ (7,554) $131 $ (7,423)
======= === =======
Earnings per Common Share:
-------------------------
Net Income from Continuing Operations................... $ .16 $.01 $ .17
Loss from Discontinued Operations....................... (.43) - (.43)
---- ---- ----
Net (Loss) Income............................... $(.27) $.01 $(.26)
==== ==== ====
Earnings per Common Share Assuming Dilution:
-------------------------------------------
Net Income from Continuing Operations................... $ .16 - $ .16
Loss from Discontinued Operations....................... (.42) - (.42)
---- ---- ----
Net Loss........................................ $(.26) - $(.26)
==== ==== ====
Nine Months Ended September 30, 2001
As Reported Adjustments As Adjusted
(In thousands, except per share data)
Net Income from Continuing Operations................... $ 11,815 $394 $ 12,209
Loss from Discontinued Operations....................... (13,369) - (13,369)
------- --- -------
Net (Loss) Income............................... $ (1,554) $394 $ (1,160)
======= === =======
Earnings per Common Share:
-------------------------
Net Income from Continuing Operations................... $ .43 $.01 $ .44
Loss from Discontinued Operations....................... (.49) - (.49)
---- ---- ----
Net (Loss) Income............................... $(.06) $.01 $(.05)
==== === ====
Earnings per Common Share Assuming Dilution:
-------------------------------------------
Net Income from Continuing Operations................... $ .42 $.01 $ .43
Loss from Discontinued Operations....................... (.47) - (.47)
---- ---- ----
Net (Loss) Income............................... $(.05) $.01 $(.04)
==== === ====
10. Investments
Investments consist principally of U.S. Government and its agencies' securities
and municipal bonds, as well as corporate and mortgage-backed securities. At
September 30, 2002, over 85% of our portfolio is invested in U.S. Government and
its agencies' securities and municipal bonds. All non-restricted investments
that are designated as available-for-sale are classified as current assets.
These investments are available for use in the current operations regardless of
contractual maturity dates. Non-restricted investments designated as
held-to-maturity are classified as current assets if expected maturity is within
one year of the balance sheet date. Otherwise, they are classified as long-term
investments. Realized gains and losses are calculated using the specific
identification method and are included in net income. Unrealized holding gains
and losses on available-for-sale securities are included as a separate component
of stockholders' equity until realized.
Investments that the Company has the intention and ability to hold to maturity
are stated at amortized cost and categorized as held-to-maturity. The remaining
investments have been categorized as available-for-sale and are stated at their
fair value. Fair value is estimated primarily from published market values as of
the balance sheet date. The Company does not have any other than temporary
investment impairments.
11. Recent Accounting Pronouncements
In April 2002, the FASB issued Statement of Financial Accounting Standard No.
145, "Recission of FASB Statements No. 4, 44, and 64, Amendment of FASB
Statement No. 13, and Technical Corrections" ("SFAS No. 145"). SFAS No. 145
requires that gains and losses from extinguishment of debt be classified as
extraordinary items only if they meet the criteria in Accounting Principles
Board Opinion No. 30 ("Opinion No. 30"). Applying the provisions of Opinion No.
30 will distinguish transactions that are part of an entity's recurring
operations from those that are unusual and infrequent that meet the criteria for
classification as an extraordinary item. SFAS No. 145 is effective for the
Company beginning January 1, 2003, but the Company may adopt the provisions of
SFAS No. 145 prior to this date. The Company has not yet completed is evaluation
of the impact from SFAS No. 145 on its financial position and results of
operations.
In June 2002, the FASB issued Statement of Financial Accounting Standard No.
146, "Accounting for Costs Associated with Exit or Disposal Activities" ("SFAS
No. 146"). SFAS No. 146 addresses financial accounting and reporting for costs
associated with exit or disposal activities and nullifies Emerging Issues Task
Force Issue No. 94-3, "Liability Recognition for Certain Employee Termination
Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred
in a Restructuring)". SFAS No. 146 requires that a liability for a cost
associated with an exit or disposal activity be recognized when the liability is
incurred. A fundamental conclusion reached by the FASB in this statement is that
an entity's commitment to a plan, by itself, does not create a present
obligation to others that meets the definition of a liability. SFAS No. 146 also
establishes that fair value is the objective for initial measurement of the
liability. The provisions of this statement are effective for exit or disposal
activities that are initiated after December 31, 2002, with early adoption
encouraged. The Company has not completed its evaluation of the impact from SFAS
No. 146 on its financial position and results of operations.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATION
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The following discussion and analysis provides information which management
believes is relevant for an assessment and understanding of our consolidated
financial condition and results of operations. The discussion should be read in
conjunction with our audited Consolidated Financial Statements and accompanying
notes for the year ended December 31, 2001, and "Management Discussion and
Analysis of Financial Condition and Results of Operations" included in our 2001
annual report on Form 10-K filed with the Securities and Exchange Commission on
March 29, 2002, and in conjunction with our unaudited Condensed Consolidated
Financial Statements and accompanying notes for the three and nine month periods
ended September 30, 2002 and 2001, included in this Form 10-Q. The information
contained below is subject to risk factors. We urge you to review carefully the
section "Risk Factors" in our 2001 Form 10-K for a more complete discussion of
the risks associated with an investment in our securities. See "Note on
Forward-Looking Statements and Risk Factors" under Item 1 of our 2001 Form 10-K.
This report contains "forward-looking statements" within the meaning of Section
27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act
of 1934, both as amended. All statements other than statements of historical
fact are forward-looking statements for purposes of federal and state securities
laws. The cautionary statements are made pursuant to the "safe harbor"
provisions of the Private Securities Litigation Reform Act of 1995, as amended,
and identify important factors that could cause our actual results to differ
materially from those expressed in any projected, estimated or forward-looking
statements relating to us. These forward-looking statements are identified by
their use of terms and phrases such as "anticipate," "believe," "continue,"
"could," "estimate," "expect," "intend," "may," "plan," "project," "will" and
other similar terms and phrases, including references to assumptions.
Although we believe that the expectations reflected in any of our
forward-looking statements are reasonable, actual results could differ
materially from those projected or assumed in any of our forward-looking
statements. Readers are cautioned not to place undue reliance on these
forward-looking statements that speak only as of the date hereof. We undertake
no obligation to republish revised forward-looking statements to reflect events
or circumstances after the date hereof or to reflect the occurrence of
unanticipated events.
Critical Accounting Policies and Estimates
In preparing our consolidated financial statements, we are required to make
judgments, assumptions and estimates which affect certain of our revenues and
expenses, their related balance sheet accounts and our disclosure of our
contingent assets and liabilities. Our most significant accounting estimates are
the liability for medical claims payable, reserve for losses and loss adjustment
expense, or LAE, and reinsurance recoverables. Due to the inherent uncertainty
in projecting these estimates, it is not only possible but probable that there
will be differences between the projections and the actual results. Claims we
incur in excess of our projections generally are not recovered in the current
contract year. Any subsequent change in an estimate for a prior period would be
reflected in the current period's operating results. For a description of our
other critical accounting policies and estimates, see Item 7 of our 2001 Form
10-K and for a more extensive discussion of our accounting policies, see Note 2,
Summary of Significant Accounting Policies, in the Notes to the Consolidated
Financial Statements in our 2001 Form 10-K filed on March 29, 2002.
Our medical claims payable liability includes an estimate for pending claims and
claims incurred but not reported to us. We use a variety of actuarial projection
methods to make this estimate including historical trends and projected future
trends. Our assumptions could be affected by unanticipated legal and regulatory
changes or disputed contract provisions with either providers or members.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATION
We review the adequacy of our workers' compensation insurance reserves for
losses and LAE with our independent actuary periodically. We consider external
forces such as changes in the rate of inflation, the regulatory environment,
state laws, changes in legal decisions that affect the administration or amount
of payment on claims, medical costs and other factors that could cause actual
losses and LAE to change. The actuarial projections include a range of estimates
reflecting the uncertainty of projections over long periods of time and are
based on the anticipated ultimate cost of losses. We evaluate the reserves in
the aggregate and make adjustments where appropriate.
Reinsurance recoverable primarily represents the estimated amount of unpaid
workers' compensation loss and LAE reserves that would be recovered from our
reinsurers and, to a lesser extent, amounts billed to the reinsurers for their
portion of paid losses and LAE and health care claims. Reinsurance receivable
for ceded paid claims is recorded in accordance with the terms of the agreements
and reinsurance recoverable for unpaid losses and LAE and medical claims payable
is estimated in a manner consistent with the claim liability associated with the
reinsurance policy. Any significant changes in the underlying claim liability
could directly affect the amount of reinsurance recoverable. Reinsurance
recoverable, including amounts related to paid and unpaid losses, are reported
as assets rather than as a reduction of the related liabilities. Reinsurance
contracts do not relieve us from our obligations to enrollees, injured workers
or policyholders. If our reinsurers were to fail to honor their obligations
because of insolvency or disputed contract provisions, we could incur
significant losses. Prior to entering into reinsurance agreements, we evaluate
the financial condition of our reinsurers to minimize our exposure to
significant losses from reinsurer insolvencies.
RESULTS OF OPERATIONS, THREE MONTHS ENDED SEPTEMBER 30, 2002, COMPARED TO THREE
MONTHS ENDED SEPTEMBER 30, 2001.
Total Operating Revenues increased approximately 15.3% to $381.3 million from
$330.9 million for 2001.
Medical Premiums from our HMO and managed indemnity insurance subsidiaries
increased $33.6 million or 18.2%. The $33.6 million increase in premium revenue
reflects a 4.2% increase in Medicare member months (the number of months
individuals are enrolled in a plan), a 49.4% increase in Medicaid member months
and a 21.9% increase in commercial member months. The growth in Medicare member
months contributes significantly to the increase in premium revenues as the
Medicare per member premium rates are more than three times higher than the
average commercial premium rate.
HMO premium rates for renewing commercial groups increased on average 9% to 12%
while the overall rate increase, including continuing business and new members,
resulted in an approximate 7.8% increase. Managed indemnity rates increased
approximately 17.8%. We do not anticipate a rate increase for Medicaid in 2002
or 2003. The basic Medicare rate increase received for the Las Vegas area was
approximately 2%. Our overall Medicare rate increase was approximately 7.4% due
primarily to the following:
o An increase in the Social HMO membership as a percentage of our total
Medicare membership. The Social HMO members have a higher average rate
than our other Medicare members. Over 97% of our Las Vegas, Nevada
Medicare members are enrolled in the Social HMO Medicare program.
o We experienced increased risk factors in our Social HMO membership
which contributes to higher rates and corresponding medical expenses.
o We received rate increases in excess of 2% for membership outside of
the Las Vegas area.
The Centers for Medicare and Medicaid Services, or CMS, formerly known as the
Health Care Financing Administration, or HCFA, may consider adjusting the
reimbursement factor or changing the program for the Social HMO members in the
future. At this time, however, the final reimbursement per member for 2004 has
not been determined and there is no guaranty that the Social HMO contract will
be renewed beyond 2003. It should be noted that Congress has in the past agreed
to extend the contract. If the reimbursement for these members decreases
significantly and related benefit changes are not made timely, there could be a
materially adverse effect on our business. Continued medical premium revenue
growth is principally dependent upon continued enrollment in our products and
upon competitive and regulatory factors.
Military Contract Revenues increased $14.9 million or 17.4%. The increase in
revenue is primarily the result of additive change order work and is
significantly offset by increased military contract expenses associated with
those change orders. The Congressionally approved Department of Defense, or DoD,
fiscal year 2001 budget included several sweeping changes to the TRICARE
program. In April 2001, Sierra Military Health Services, Inc., or SMHS, began
implementation of a prescription drug program for beneficiaries over age 65.
Likewise, in October 2001, SMHS implemented TRICARE for Life which is a
comprehensive health care benefit to those retired military beneficiaries over
age 65. Both of these program modifications resulted from Congressional changes
to the program. SMHS administers the expanded benefits only to the over age 65
retiree military population. SMHS does not directly fund claims payment or bear
any risk on these program modifications for the actual level of health care
service utilization and does not record any claim payments or related revenue on
these program modifications.
In June 2002, SMHS began the fifth year of a five year contract with the DoD. In
October 2002, the DoD extended SMHS's contract. The new contract extension is
renewable annually at the DoD's option for up to four additional years. However,
on August 1, 2002, the DoD released a request for proposal for the procurement
and subsequent award of three TRICARE managed care support contracts in place of
the current seven contracts. SMHS expects to submit a bid proposal for one of
the three new regions within the coming months. An announcement of the awarding
of these new contracts under the TRICARE Next Generation program, or T-Nex, is
not expected until the middle of 2003, with a transition period expected into
mid to late 2004. If the DoD continues with its current plan to reduce the
number of contracts from seven to three and we were not able to obtain one of
the three new contracts, there would be a material adverse effect on our
business.
SMHS incurred $1.3 million in bid proposal costs during the quarter which was
partially offset by a change order adjustment. We expect to incur additional bid
proposal costs in the fourth quarter and in 2003.
Specialty Product Revenues increased $610,000 or 1.2%. The revenue increase was
from administrative services revenue as workers' compensation insurance revenue
remained consistent between the quarters.
Workers' compensation net earned premiums are the end result of direct written
premiums, plus the change in unearned premiums, plus premiums assumed from
mandatory reinsurance pools, less premiums ceded to reinsurers. Direct written
premiums decreased from $47.6 million in 2001 to $46.1 million in 2002 or 3.2%
due primarily to a 30.4% decrease in premium production that was offset by a
37.5% increase in composite premium rates. Ceded reinsurance premiums decreased
by $1.2 million due to the expiration of our low level reinsurance agreement on
June 30, 2000 and a new reinsurance agreement with lower ceded premiums.
Professional Fees increased by $840,000 or 12.0% as a result of increased visits
and activity at our provider subsidiaries.
Investment and Other Revenues increased $560,000 or 12.4% due primarily to an
increase in the average invested balance offset by a decrease in the average
investment yield during the period.
Medical Expenses increased $22.7 million or 14.5% due primarily to our increased
membership. Medical expenses as a percentage of medical premiums and
professional fees decreased to 79.3% from 81.7%. The decrease is primarily due
to premium yields in excess of cost and utilization increases. Our medical
claims payable liability requires us to make significant estimates. See the
discussion of our medical claims payable liability under critical accounting
policies and estimates for a further explanation.
During the third quarter of 2002, the Company entered into a new hospital
contract. With this new contract, which begins October 1, 2002, the Company
holds some form of contracted provider relationship with every hospital in the
Las Vegas area.
Military Contract Expenses increased $13.1 million or 15.6%. The increase is
consistent with the increase in revenues discussed previously and includes $1.3
million in bid proposal costs offset by a change order adjustment. Health care
delivery expense consists primarily of costs to provide managed health care
services to eligible beneficiaries in accordance with Sierra's TRICARE contract.
Under the contract, SMHS provides health care services to approximately 662,000
dependents of active duty military personnel and military retirees under the age
of 65 and their dependents through a network of approximately 50,000 health care
providers and certain other subcontractor partnerships. Also included in
military contract expenses are costs incurred to perform specific administrative
services, such as health care appointment scheduling, enrollment, medical and
network management services as well as health care advice line services, and
other administrative functions of the military health care subsidiary. These
administrative services are performed for active duty personnel and family
members as well as retired military families.
Specialty Product Expenses increased $2.7 million or 5.4%. Expenses increased in
the workers' compensation operations by $2.1 million and by $600,000 in the
administrative services operations.
The increase in workers' compensation insurance segment expenses is primarily
due to the following:
o In 2002, we recorded $5.5 million of net adverse loss development for prior
accident years compared to net adverse loss development of $1.5 million
recorded in 2001. Of the $5.5 million recorded, $1.3 million is related to
our mandatory participation in assumed reinsurance pools. The remaining net
adverse loss development recorded was largely attributable to higher costs
per claim, or claim severity, in California. Higher claim severity has had
a negative impact on the entire California workers' compensation industry
in the past few periods and this trend may continue.
o The loss and LAE ratio for the 2002 accident year was lower due to
significant premium increases offset partly by the termination of the low
level reinsurance agreement. The lower loss and LAE ratio resulted in a
decrease in expense of approximately $2.1 million. The low level
reinsurance agreement terminated on June 30, 2000, which resulted in a
higher risk exposure on policies effective after that date and a higher
amount of net incurred loss and LAE.
o A net increase in underwriting expenses, policyholders' dividends and other
operating expenses of approximately $200,000.
Since 1999, we have experienced adverse loss development on prior accident
years. Loss reserves are evaluated periodically and due to the inherent
uncertainty in projecting loss reserves, it is possible that we may continue to
experience adverse development in the foreseeable future. Our reserve for losses
and LAE requires us to make significant estimates. See the discussion of our
reserves for losses and LAE under critical accounting policies and estimates for
a further explanation.
The net adverse loss development on prior accident years included those years
that were covered by our low level reinsurance agreement. This resulted in an
increase in the reinsurance recoverable balance which is then reduced by amounts
collected from reinsurers. During the quarter, we increased our ceded reserves
by $7.5 million and received payments from our reinsurers totaling $23.6
million. Our net reinsurance recoverable decreased by $16.1 million in the third
quarter of 2002, compared to a $2.0 million decrease in the third quarter of
2001.
In February 2002, California enacted Assembly Bill 749. This new legislation
will increase benefits paid to injured workers starting January 1, 2003.
Increased loss costs, such as benefit increases, are normally built into the
rate making process so that premiums are increased to cover the increase in
costs. On October 18, 2002, the California Insurance Commission approved an
increase of 10.5% in pure premium rates for new and renewal policies effective
in 2003. In addition, the Commission approved a 4.9% increase in pure premium
rates to the unexpired terms of policies in force at January 1, 2003. Although
we intend to increase our premiums, there is no assurance that our increase will
be sufficient enough to cover the ultimate cost increases or that the WCIRB's
estimate is accurate. Assembly Bill 749 is effective for claims occurring on and
after January 1, 2003. However, due to other statutes, certain temporary total
disability claims with dates of injury prior to 2003 will automatically increase
to the new benefit levels effective January 1, 2003.
Reinsurance contracts do not relieve us from our obligations to insured workers
or policyholders. At September 30, 2002, we had over $183 million in reinsurance
recoverable. Prior to entering into reinsurance agreements, we evaluate the
financial condition of our reinsurers to minimize our exposure to significant
losses from reinsurer insolvencies. At September 30, 2002, all of our reinsurers
were rated A+ or better by Fitch Ratings and the A.M. Best Company. Should these
companies be unable to perform their obligations to reimburse us for ceded
losses, we would experience significant losses and it could have a material
adverse effect on our business.
The combined ratio is a measurement of the workers' compensation underwriting
profit or loss and is the sum of the loss and LAE ratio, underwriting expense
ratio and policyholders' dividend ratio. A combined ratio of less than 100%
indicates an underwriting profit. Our combined ratio was 109.4% compared to
105.5% for 2001. The increase was primarily due to increased net adverse loss
development for prior accident years.
General, Administrative and Marketing Expenses, or G&A, increased $3.2
million or 10.8%. The primary increases in G&A expenses were brokers fees
and facility lease expense. The increase in brokers fees is primarily due to the
growth in premium revenues. The increase in facility lease expense is due to the
rent payments associated with the sale-leaseback transaction for our
administrative buildings now being recorded as an operating expense instead of
depreciation and interest expense. As a percentage of revenues, G&A expenses
were 8.7% for 2002, compared to 9.1% in 2001. As a percentage of medical premium
revenue, G&A expenses were 15.3% for 2002, compared to 16.3% for 2001. Our
office buildings associated with the sale-leaseback transaction qualified as a
sale at the end of the first quarter of 2002. This resulted in a quarterly
increase in G&A expenses of approximately $1.1 million and a corresponding
decrease in interest expense. See Note 6 of the Notes to Condensed Consolidated
Financial Statements for a further explanation of the sale-leaseback
transaction.
Interest Expense and Other, Net decreased $2.6 million or 66.3%. Interest
expense related to the revolving credit facility decreased $500,000 due to a
decrease in the average balance of outstanding debt during the period and a
decrease in the weighted average cost of borrowing. Our average interest rate on
the revolving credit facility, excluding the amortization of deferred financing
fees, our interest rate swap agreement and fees on the unused portion of the
credit facility was 4.4% in 2002, compared to 7.7% in 2001. We incur a fee of
0.5% on the unused portion of the revolving credit facility. In addition, we are
amortizing $300,000 per quarter of deferred financing fees.
Interest expense related to the sale-leaseback transaction decreased by $1.5
million as the remaining eight buildings have qualified as a sale since the end
of the third quarter of 2001. The quarterly impact of the entire sale-leaseback
transaction qualifying as a sale compared to the treatment prior to qualifying
for a sale is a decrease in interest expense of $2.4 million and a decrease in
depreciation expense of $900,000 offset by an increase in facility rent on
office buildings of $1.3 million and $1.6 million in facility rent on medical
buildings. See Note 6 of the Notes to Condensed Consolidated Financial
Statements for a further explanation of the sale-leaseback transaction.
In addition, we had a net gain on the sale of assets of $240,000 in 2002.
Provision for Income Taxes was recorded at $6.1 million for 2002 compared to
$2.3 million for 2001. The effective tax rate for both periods was 33.5% and is
expected to increase slightly in 2003. Our ongoing effective tax rate is less
than the statutory rate due primarily to tax preferred investments. The State of
Nevada is considering several alternatives to increase tax revenues for the
state including imposing a gross receipts tax or corporate state income tax that
may begin in 2003. It is not anticipated that our results of operations would be
significantly impacted by this tax.
Discontinued Operations consist entirely of our Texas HMO health care
operations. We elected to adopt early Statement of Financial Accounting
Standards No. 144, "Accounting for the Impairment or Disposal of Long-Lived
Assets", or SFAS No. 144, effective January 1, 2001. In the third quarter of
2001, we decided to exit the Texas HMO health care market and received approval
from the Texas Department of Insurance in mid-October 2001. We ceased providing
HMO health care coverage on April 17, 2002. In accordance with SFAS No. 144, our
Texas HMO health care operations are now reclassified as a discontinued
operation. Net income from discontinued operations in the third quarter of 2002
was $1.9 million compared to a loss of $12.1 million for the third quarter of
2001. The utilization of prior premium deficiency reserves were $124,000 in 2002
and $7.1 million in 2001. The net income from discontinued operations in 2002 of
$1.9 million was the result of a gain on a debt payment to Kaiser-Texas of
$628,000, net of tax, and the reduction of our medical claims payable reserve,
which resulted in a gain of $1.3 million, net of tax. See Note 3 of the Notes to
Condensed Consolidated Financial Statements.
RESULTS OF OPERATIONS, NINE MONTHS ENDED SEPTEMBER 30, 2002, COMPARED TO NINE
MONTHS ENDED SEPTEMBER 30, 2001.
Total Operating Revenues, increased approximately 14.9% to $1.09 billion from
$952.4 million for 2001.
Medical Premiums from our HMO and managed indemnity insurance subsidiaries
increased $113.2 million or 21.7%. The $113.2 million increase in premium
revenue reflects a 5.1% increase in Medicare member months (the number of months
individuals are enrolled in a plan), a 60.5% increase in Medicaid member months
and a 27.1% increase in commercial member months. The growth in Medicare member
months contributes significantly to the increase in premium revenues as the
Medicare per member premium rates are more than three times higher than the
average commercial premium rate.
HMO premium rates for renewing commercial groups increased on average 9% to 12%
while the overall rate increase, including continuing business and new members,
resulted in an approximate 7.5% increase. Managed indemnity rates increased
approximately 13.6%. We do not anticipate a rate increase for Medicaid in 2002
or 2003. The basic Medicare rate increase received for the Las Vegas area was
approximately 2%. Our overall Medicare rate increase was approximately 6.7% due
primarily to the following:
o An increase in the Social HMO membership as a percentage of our total
Medicare membership. The Social HMO members have a higher average rate
than our other Medicare members. Over 97% of our Las Vegas, Nevada
Medicare members are enrolled in the Social HMO Medicare program.
o We experienced increased risk factors in our Social HMO membership
which contributes to higher rates and corresponding medical expenses.
o We received rate increases in excess of 2% for membership outside of
the Las Vegas area.
The Centers for Medicare and Medicaid Services, or CMS, formerly known as the
Health Care Financing Administration, or HCFA, may consider adjusting the
reimbursement factor or changing the program for the Social HMO members in the
future. At this time, however, the final reimbursement per member for 2004 has
not been determined and there is no guaranty that the Social HMO contract will
be renewed beyond 2003. It should be noted that Congress has in the past agreed
to extend the contract. If the reimbursement for these members decreases
significantly and related benefit changes are not made timely, there could be a
materially adverse effect on our business. Continued medical premium revenue
growth is principally dependent upon continued enrollment in our products and
upon competitive and regulatory factors.
Military Contract Revenues increased $24.1 million or 9.4%. The increase in
revenue is primarily the result of additive change order work and is
significantly offset by increased military contract expenses associated with
those change orders. The Congressionally approved Department of Defense, or DoD,
fiscal year 2001 budget included several sweeping changes to the TRICARE
program. In April 2001, SMHS began implementation of a prescription drug program
for beneficiaries over age 65. Likewise, in October 2001, SMHS implemented
TRICARE for Life which is a comprehensive health care benefit to those retired
military beneficiaries over age 65. Both of these modifications resulted from
Congressional changes to the program. SMHS administers the expanded benefits
only to the over age 65 retiree military population. SMHS does not directly fund
claims payment or bear any risk on these program modifications for the actual
level of health care service utilization and does not record any claim payments
or related revenue on these program modifications.
Specialty Product Revenues increased $4.7 million or 3.4%. The revenue increase
was from the workers' compensation insurance segment as administrative services
revenue remained consistent between the periods.
Workers' compensation net earned premiums are the end result of direct written
premiums, plus the change in unearned premiums, plus premiums assumed from
mandatory reinsurance pools, less premiums ceded to reinsurers. Direct written
premiums decreased from $143.0 million in 2001 to $132.4 million in 2002 or 7.4%
due primarily to a 26.7% decrease in premium production that was partially
offset by a 26.3% increase in composite premium rates. Ceded reinsurance
premiums decreased by 107.9% due to the expiration of our low level reinsurance
agreement on June 30, 2000, and a new reinsurance agreement with lower ceded
premiums. In addition, during the second quarter of 2002, we recorded an
adjustment of our estimate of historical ceded premiums related to the low level
agreement which further reduced our ceded reinsurance by $2.0 million.
Professional Fees increased $1.0 million or 4.5% as a result of increased visits
and activity at our provider subsidiaries.
Investment and Other Revenues decreased $1.5 million or 9.2% due primarily to a
decrease in the average investment yield during the period offset by an increase
in the average invested balance.
Medical Expenses increased $86.8 million or 19.6% due primarily to our increased
membership. Medical expenses as a percentage of medical premiums and
professional fees decreased to 80.5% from 81.4%. The decrease is primarily due
to premium yields in excess of cost and utilization increases which were
partially offset by higher bed days in 2002. Our medical claims payable
liability requires us to make significant estimates. See the discussion of our
medical claims payable liability under critical accounting policies and
estimates for a further explanation.
During the third quarter of 2002, the Company entered into a new hospital
contract. With this new contract, which begins October 1, 2002, the Company
holds some form of contracted provider relationship with every hospital in the
Las Vegas area.
Military Contract Expenses increased $18.5 million or 7.4%. The increase is
consistent with the increase in revenues discussed previously. Health care
delivery expense consists primarily of costs to provide managed health care
services to eligible beneficiaries in accordance with Sierra's TRICARE contract.
Under the contract, SMHS provides health care services to approximately 662,000
dependents of active duty military personnel and military retirees under the age
of 65 and their dependents through a network of approximately 50,000 health care
providers and certain other subcontractor partnerships. Also included in
military contract expenses are costs incurred to perform specific administrative
services, such as health care appointment scheduling, enrollment, medical and
network management services as well as health care advice line services, and
other administrative functions of the military health care subsidiary. These
administrative services are performed for active duty personnel and family
members as well as retired military families.
Specialty Product Expenses increased $7.7 million or 5.5%. Expenses increased in
the workers' compensation operations by approximately $7.2 million and by
$500,000 in administrative services operations.
The increase in workers' compensation insurance segment expenses is primarily
due to the following:
o Approximately $3.0 million in additional loss and LAE related to the
increase in net earned premiums in 2002 compared to 2001.
o In 2002, we recorded $10.8 million of net adverse loss development for
prior accident years compared to net adverse loss development of $7.3
million recorded in 2001. Of the $10.8 million recorded, $1.3 million is
related to our mandatory participation in assumed reinsurance pools. The
net adverse loss development recorded was largely attributable to higher
costs per claim, or claim severity, in California. Higher claim severity
has had a negative impact on the entire California workers' compensation
industry in the past few periods and this trend may continue.
o The loss and LAE ratio for the 2002 accident year was lower by 1.6% due to
significant premium increases offset by the termination of the low level
reinsurance agreement. The lower loss and LAE ratio resulted in a decrease
in expense of approximately $2.1 million. The low level reinsurance
agreement terminated on June 30, 2000, which resulted in a higher risk
exposure on policies effective after that date and a higher amount of net
incurred loss and LAE.
o A net increase in underwriting expenses, policyholders' dividends and other
operating expenses of $2.8 million related primarily to the increase in net
earned premiums.
Since 1999, we have experienced adverse loss development on prior accident
years. Loss reserves are evaluated periodically and due to the inherent
uncertainty in projecting loss reserves, it is possible that we may continue to
experience adverse development in the foreseeable future. Our reserve for losses
and LAE requires us to make significant estimates. See the discussion of our
reserves for losses and LAE under critical accounting policies and estimates for
a further explanation.
The net adverse loss development on prior accident years included those years
that were covered by our low level reinsurance agreement. This resulted in an
increase in the reinsurance recoverable balance which is then reduced by amounts
collected from reinsurers. During the nine months ended September 30, 2002, we
increased our ceded reserves by $28.2 million and received payments from our
reinsurers totaling $62.3 million. Our net reinsurance recoverable decreased by
$34.1 million for the nine months ended September 30, 2002, compared to an $8.6
million decrease for the nine months ended September 30, 2001.
The combined ratio is a measurement of the workers' compensation underwriting
profit or loss and is the sum of the loss and LAE ratio, underwriting expense
ratio and policyholders' dividend ratio. A combined ratio of less than 100%
indicates an underwriting profit. Our combined ratio was 107.9% compared to
106.0% for 2001. The increase was primarily due to increased net adverse loss
development for prior accident years. Excluding adverse loss development, the
combined ratio would have been 99.8% for 2002 and 100.3% for 2001.
General, Administrative and Marketing Expenses, or G&A, increased
approximately $9.4 million or 10.8%. The primary increases in G&A expenses
were payroll and benefits, brokers fees, which were primarily due to increased
premium revenues, and facility lease expense. The increase in facility lease
expense is due to the rent payments associated with the sale-leaseback
transaction for our administrative buildings now being recorded as an operating
expense instead of depreciation and interest expense. Our office buildings
associated with the sale-leaseback transaction qualified as a sale at the end of
the first quarter of 2002. This resulted in a quarterly increase in G&A
expenses of approximately $1.1 million and a corresponding decrease in interest
expense. See Note 6 of the Notes to Condensed Consolidated Financial Statements
for a further explanation of the sale-leaseback transaction. As a percentage of
revenues, G&A expenses were 8.8% for 2002, compared to 9.1% in 2001. As a
percentage of medical premium revenue, G&A expenses were 15.1% for 2002,
compared to 16.6% for 2001.
Interest Expense and Other, Net decreased $8.3 million or 57.5%. Interest
expense related to the revolving credit facility decreased $2.6 million due to a
decrease in the average balance of outstanding debt during the period and a
decrease in the weighted average cost of borrowing. Our average interest rate on
the revolving credit facility, excluding the amortization of deferred financing
fees, our interest rate swap agreement and fees on the unused portion of the
credit facility was 6.0% in 2002, compared to 8.8% in 2001. We incur a fee of
0.5% on the unused portion of the revolving credit facility. In addition, we are
amortizing $300,000 per quarter of deferred financing fees.
Interest expense related to the sale-leaseback transaction decreased by $3.1
million as the remaining eight buildings have qualified as a sale since the end
of the third quarter of 2001. See Note 6 of the Notes to Condensed Consolidated
Financial Statements for a further explanation of the sale-leaseback
transaction.
CII Financial debenture interest decreased by $1.2 million in 2002, as a result
of the restructuring of the debentures, which occurred during the second quarter
of 2001 when we recorded a net gain of $700,000 on the transaction.
We had a net gain on sale of assets of $100,000 in 2002, compared to a loss of
$2.4 million in 2001. In addition, we had various other increases in interest
and other expense totaling $400,000.
Provision for Income Taxes was recorded at $15.1 million for 2002, compared to
$5.9 million for 2001. The effective tax rate for both periods was 33.5%. Our
ongoing effective tax rate is less than the statutory rate due primarily to tax
preferred investments. The State of Nevada is considering imposing a gross
receipts tax or corporate state income tax that may begin in 2003. It is not
anticipated that our results of operations would be significantly impacted by
this tax.
Discontinued Operationss consist entirely of our Texas HMO health care
operations. Net income from discontinued operations in 2002 was $1.9 million
compared to a loss of $13.4 million in 2001. The utilization of prior premium
deficiency reserves were $1.7 million in 2002, and $15.6 million in 2001. The
net income from discontinued operations in 2002 was the result of a gain on a
debt payment to Kaiser-Texas of $628,000, net of tax, and the reduction of our
medical claims payable reserve, which resulted in a gain of $1.3 million, net of
tax. See Note 3 of the Notes to Condensed Consolidated Financial Statements.
LIQUIDITY AND CAPITAL RESOURCES
For continuing operations, we had cash in-flows from operating activities of
$139.9 million in 2002, compared to $89.0 million in 2001. After adjusting for
the timing of our Medicare payment received October 1, 2002, cash in-flows for
2002 would have been $168.6 million. The improvement over 2001 is primarily
attributable to increased cash from earnings, reinsurance recoveries, an income
tax refund and an increase in medical premiums.
SMHS receives monthly cash payments equivalent to one-twelfth of its annual
contractual price with the DoD. SMHS accrues health care revenue on a monthly
basis for any monies owed above its monthly cash receipt based on the number of
at-risk eligible beneficiaries and the level of military direct care system
utilization. The contractual bid price adjustment, or BPA, process serves to
adjust the DoD's monthly payments to SMHS, because the payments are based in
part on 1996 DoD estimates for beneficiary population and beneficiary population
baseline health care cost, inflation and military direct care system
utilization. As actual information becomes available for the above items,
quarterly adjustments are made to SMHS' monthly health care payment in addition
to lump sum adjustments for past months. In addition, SMHS accrues change order
revenue for DoD directed contract changes. Our business and cash flows could be
adversely affected if the timing or amount of the BPA and change order
reimbursements vary significantly from our expectations.
To further enhance SMHS' funding resources, on November 16, 2001, SMHS entered
into a securitization arrangement with General Electric Capital Corporation. The
arrangement provides for the sale of SMHS' Federal Government accounts
receivable to SMHS Funding, LLC. SMHS Funding is a special purpose limited
liability company owned by SMHS and was formed for the purpose of purchasing all
receivables of SMHS. This entity is fully consolidated into SMHS. SMHS Funding,
LLC may sell an undivided interest in certain of the receivables to a subsidiary
of General Electric Capital Corporation in the event that additional financing
by SMHS is warranted. This securitization arrangement has not yet been utilized
and we do not anticipate utilizing it in 2002.
For continuing operations, cash used in investing activities during 2002 was
$115.9 million, compared to $3.3 million in 2001. The 2002 amount included $5.6
million in net capital expenditures compared to $2.5 million in 2001. The net
change in investments for the period was an increase in investments of $110.3
million for 2002 and $840,000 for 2001 as investments were purchased with cash
from operations.
For continuing operations, cash used in financing activities during 2002 was
$15.6 million, compared to $69.2 million in 2001. The 2002 amount included net
payments of $39.0 million on the revolving credit facility, compared to net
payments of $41.0 million in 2001. Additional payments of $3.6 million and $6.0
million were made on other outstanding debt and capital leases for 2002 and
2001, respectively. Proceeds from the sale-leaseback notes were $16.9 million
and $2.9 million for 2002 and 2001, respectively. Additionally, $27.3 million
was used in 2001 for the purchase of CII Financial's 7 1/2% convertible
subordinated debentures. In 2001, we have purchased $1.0 million in outstanding
CII Financial 9 1/2% senior debentures. Proceeds from the issuance of stock in
connection with stock plans were $10.2 million in 2002, compared to $2.2 million
in 2001.
Discontinued Texas HMO health care operations used cash of $30.5 million in
2002, compared to $26.4 million in 2001. The cash used in 2002 was primarily for
the run out of claims offset in part by premiums collected. Based on the current
estimated Texas HMO healthcare run-out costs and recorded reserves, we believe
we have adequate funds available and the ability to invest, should we be
required to do so, adequate funds in Texas to meet the anticipated obligations
for our members' claims.
Revolving Credit Facility
Our revolving credit facility balance decreased from $89 million to $50 million
during the nine month period ended September 30, 2002. The balance is reflected
as current since the credit facility matures on September 30, 2003. The
availability under the credit facility has been reduced to $101 million at
September 30, 2002, leaving $51 million available under the credit facility. The
total availability, however, will be reduced by $6.0 million on December 31,
2002 and by $10.0 million on June 30, 2003. Interest under the revolving credit
facility is variable and is based on Bank of America's "prime rate" adjusted by
a margin. The rate as of September 30, 2002, is 4.375%, which is a combination
of the prime rate of 4.75%, less a credit of .375%. We received .5% drop in the
prime rate as of November 7, 2002, which makes our new rate 3.875%. The margin
can fluctuate based on our completing certain transactions or if we fail to
exceed certain financial ratios. The margin was reduced by 1.0% on April 1,
2002, since we exceeded certain ratio requirements as of December 31, 2001. Of
the outstanding balance, $25 million is covered by an interest-rate swap
agreement. In accordance with Statement of Financial Accounting Standards No.
133, "Accounting for Derivative Instruments and Hedging Activities", or SFAS No.
133, we increased our recorded liability of the interest-rate swap agreement
during 2002 by $115,000.
Debentures
In December 2000, CII Financial commenced an offer to exchange its outstanding
subordinated debentures for cash and/or new debentures. On May 7, 2001, CII
Financial closed its exchange offer on $42.1 million of its outstanding
subordinated debentures. CII Financial purchased $27.1 million in principal
amount of subordinated debentures for $20.0 million in cash and issued $15.0
million in new 9 1/2% senior debentures, due September 15, 2004, in exchange for
$15.0 million in subordinated debentures. The remaining $5.0 million in
subordinated debentures were paid at maturity. Since the time of the exchange,
Sierra has purchased $1.0 million in outstanding 9 1/2% senior debentures which
are eliminated upon consolidation.
The transaction was accounted for as a restructuring of debt; therefore, all
future cash payments, including interest, related to the debentures will be
reductions of the carrying amount of the debentures and no future interest
expense will be recognized. Accordingly, the 9 1/2% senior debentures have a
carrying amount of $16.8 million, which consists of principal amount of $14.0
million and $2.8 million in future accrued interest.
The 9 1/2% senior debentures pay interest, which is due semi-annually on March
15 and September 15 of each year, commencing on September 15, 2001. The 9 1/2%
senior debentures rank senior to outstanding notes payable from CII Financial to
Sierra and CII Financial's guarantee of Sierra's revolving credit facility. The
9 1/2% senior debentures may be redeemed by CII Financial at any time at
premiums currently at 105% and declining to 100% for redemptions after April 1,
2004. In the event of a change in control of CII Financial, the holders of the 9
1/2% senior debentures may require that CII Financial repurchase them at the
then applicable redemption price, plus accrued and unpaid interest.
CII Financial is a holding company and its only significant asset is its
investment in California Indemnity. Of the $27.3 million in cash and cash
equivalents held at September 30, 2002, approximately $26.7 million was
designated for use only by the regulated insurance companies. CII Financial has
limited sources of cash and is dependent upon dividends paid by California
Indemnity. California Indemnity may pay a dividend, without the prior approval
of the state insurance commissioner, only to the extent the cumulative amount of
dividends or distributions paid or proposed to be paid in any year does not
exceed the amount shown as unassigned funds (reduced by any unrealized gains or
losses included in any such amount) on its statutory statement as of the
previous December 31. In 2002, California Indemnity can pay dividends of up to
$2.1 million without the prior approval of the state insurance commissioner. In
2002, California Indemnity paid a dividend of $750,000 and in 2001, California
Indemnity received prior approval to pay an aggregate of $10.0 million in
dividends. We are not in a position to assess the likelihood of obtaining future
approval for the payment of dividends other than those specifically allowed by
law without prior approval in each of our subsidiaries' state of domicile.
Statutory Capital and Deposit Requirements
Our HMO and insurance subsidiaries are required by state regulatory agencies to
maintain certain deposits and must also meet certain net worth and reserve
requirements. The HMO and insurance subsidiaries had restricted assets on
deposit in various states totaling $33.3 million at September 30, 2002. The HMO
and insurance subsidiaries must also meet requirements to maintain minimum
stockholders' equity, on a statutory basis, as well as minimum risk-based
capital requirements, which are determined annually. Additionally, in
conjunction with the exit from the Texas HMO health care market, the Texas
Department of Insurance approved a plan of withdrawal and TXHC is now required
to maintain deposits and net worth of at least $3.5 million. We believe we are
in compliance with our regulatory requirements. We are limited by our credit
facility in the amount of funds we can invest in our Texas operations.
Of the $93.8 million in cash and cash equivalents held at September 30, 2002,
$48.8 million was designated for use only by the regulated subsidiaries. Amounts
are available for transfer to the holding company from the HMO and insurance
subsidiaries only to the extent that they can be remitted in accordance with the
terms of existing management agreements and by dividends. The holding company
will not receive dividends from its regulated subsidiaries if such dividend
payment would cause violation of statutory net worth and reserve requirements.
In California, workers' compensation insurers are required to place qualified
securities on deposit with the state to cover potential workers' compensation
claims. The amount of the deposit is calculated annually and is largely based on
the amount of workers' compensation insurance premiums earned during the
preceding three years. A credit for ceded reinsurance to companies authorized as
reinsurers by the California Department of Insurance can reduce the amount of
deposit that a workers' compensation insurer must place. However, any reduction
in the deposit for ceded reinsurance must then be made up by the reinsurer so
that 100% of the deposit requirements are met. Failure of the reinsurer to make
the required deposit can result in a disallowance of the ceded reinsurance
credit by the ceding insurance company. The ceding insurance company will then
either have to place the required deposit or show the ceded reinsurance as
unauthorized reinsurance, which in turn reduces its total statutory surplus.
Sierra's workers' compensation insurance companies were notified by the
California Department of Insurance in August of 2002, that some of its
reinsurers had failed to make the required deposit. We have notified our
reinsurers of this and they are in the process of making the required deposit.
If the reinsurers were to fail to make the required deposit, this could have a
material adverse effect on our workers' compensation insurance subsidiaries'
ability to write business.
Obligations and Commitments
The following schedule represents our obligations and commitments for long-term
debt, capital leases and operating leases at September 30, 2002. With the
exception of our revolving credit facility, the amounts below represent the
entire payment, principal and interest, on our outstanding obligations.
Long-Term Capital Operating
Debt Leases Leases Total
(In thousands)
Continuing Operations
Payments due within 12 months................... $51,541 $121 $ 17,808 $ 69,470
Payments due in 13 to 36 months................. 15,414 130 33,432 48,976
Payments due in 37 to 60 months................. 71 61 32,209 32,341
Payments due in more than 60 months............. 521 187 123,648 124,356
------ --- ------- -------
Total Continuing Operations................ $67,547 $499 $207,097 $275,143
====== === ======= =======
Discontinued Operations
Payments due within 12 months................... $ 1,899 $235 $ 2,134
Payments due in 13 to 36 months................. 5,065 5,065
Payments due in 37 to 60 months................. 17,674 17,674
Payments due in more than 60 months............. -
------ --- -------
Total Discontinued Operations.............. $24,638 $235 $ 24,873
====== === =======
The amount included in long-term debt payments for discontinued operations is
for a mortgage loan secured by certain underlying real estate assets of the
discontinued operations. We are actively seeking a buyer for the real estate
assets and anticipate selling them within the next 12 months. As the real estate
assets are sold, we are required to make reductions on the mortgage note and
completely satisfy the obligation once all of the assets have been sold.
Recent Accounting Pronouncements
In April 2002, the FASB issued Statement of Financial Accounting Standard No.
145, "Recission of FASB Statements No. 4, 44, and 64, Amendment of FASB
Statement No. 13, and Technical Corrections", or SFAS No. 145. SFAS No. 145
requires that gains and losses from extinguishment of debt be classified as
extraordinary items only if they meet the criteria in Accounting Principles
Board Opinion No. 30 ("Opinion No. 30"). Applying the provisions of Opinion No.
30 will distinguish transactions that are part of an entity's recurring
operations from those that are unusual and infrequent that meet the criteria for
classification as an extraordinary item. SFAS No. 145 is effective for us
beginning January 1, 2003, but we may adopt the provisions of SFAS No. 145 prior
to this date. We have not yet completed our evaluation of the impact from SFAS
No. 145 on our financial position and results of operations.
In June 2002, the FASB issued Statement of Financial Accounting Standard No.
146, "Accounting for Costs Associated with Exit or Disposal Activities", or SFAS
No. 146. SFAS No. 146 addresses financial accounting and reporting for costs
associated with exit or disposal activities and nullifies Emerging Issues Task
Force Issue No. 94-3, "Liability Recognition for Certain Employee Termination
Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred
in a Restructuring)". SFAS No. 146 requires that a liability for a cost
associated with an exit or disposal activity be recognized when the liability is
incurred. A fundamental conclusion reached by the FASB in this statement is that
an entity's commitment to a plan, by itself, does not create a present
obligation to others that meets the definition of a liability. SFAS No. 146 also
establishes that fair value is the objective for initial measurement of the
liability. The provisions of this statement are effective for exit or disposal
activities that are initiated after December 31, 2002, with early adoption
encouraged. We have not yet completed our evaluation of the impact from SFAS No.
146 on our financial position and results of operations.
Other
Under our current revolving credit facility, which expires September 30, 2003,
we are limited to $20.2 million in capital expenditures for 2003. Our planned
expenditures include a new provider clinic, digital radiology equipment,
upgrades to our disaster recovery systems, various computer hardware and
software, furniture and equipment and other normal capital requirements. Our
liquidity needs over the next 12 months will primarily be for the capital items
noted above, debt service and funds required to exit the Texas HMO health care
market. We believe that our existing working capital, operating cash flow and,
if necessary, equipment leasing, divestitures of certain non-core assets and
amounts available under our credit facility and securitization arrangement
should be sufficient to fund our capital expenditures and debt service.
Additionally, subject to unanticipated cash requirements, we believe that our
existing working capital and operating cash flow should enable us to meet our
liquidity needs on a long-term basis.
In the second quarter of 1997, our Board of Directors authorized a $3.0 million
loan from us to our Chief Executive Officer, or CEO. In April 2000, our Board of
Directors authorized an additional $2.5 million loan from us to the CEO. In the
second quarter of 2001, our Board of Directors approved a loan amendment which
extended the maturity of the principal balance along with accrued interest to
December 31, 2003. During 2001, the CEO made payments of $898,000. No additional
payments have been made during 2002 and as of September 30, 2002 the aggregate
principal balance outstanding and accrued interest for both instruments was $5.2
million. All amounts borrowed bear interest at a rate equal to our current rate
on our revolving credit facility plus 10 basis points. The amounts outstanding
are collateralized by certain of the CEO's assets and rights to compensation
from us. The loan is pledged as collateral under our revolving credit facility.
We have a $25 million interest-rate swap agreement, which expires on September
29, 2003, that allows us to mitigate the risk of interest rate fluctuation on
our credit facility. The intent of the agreement was to keep our interest rate
on $25 million of the credit facility relatively fixed. In accordance with SFAS
No. 133, we recorded the interest-rate swap agreement to fair market value as of
September 30, 2002. The fair market value indicated that we would need to pay
$800,000 to terminate the swap agreement compared to an indicated fair market
value of $685,000 at December 31, 2001. If the prime rate were to decrease by
1%, we estimate our maximum increase in annual expense associated with the swap
to be approximately $250,000.
Membership
- ----------
Number of Members at September 30,
2002 2001
Continuing Operations:
HMO
Commercial.................................................. 185,800 168,200
Medicare.................................................... 47,100 45,300
Medicaid.................................................... 34,900 23,500
Managed Indemnity............................................. 26,700 29,300
Medicare Supplement........................................... 19,900 25,000
Administrative Services (1)................................... 219,600 206,100
TRICARE Eligibles............................................. 662,300 643,300
--------- ---------
Total Members, Continuing Operations.......................... 1,196,300 1,140,700
========= =========
Discontinued Texas Operations:
- -----------------------------
HMO
Commercial.................................................. - 50,900
Medicare (2) ............................................... - 14,100
--------- ---------
Total Members, Discontinued Operations........................ - 65,000
========= =========
(1) Restated to exclude the workers' compensation ASO membership which was
93,000 at September 30, 2001.
(2) The 2001 Medicare membership does not include 5,400 Houston members that
the Company ceded to AmCare Health Plans of Texas, Inc., under a
reinsurance agreement on December 1, 2000.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
As of September 30, 2002, we had unrealized holding gains on available for sale
investments of $2.0 million compared to unrealized holding losses of $5.6
million at December 31, 2001. This fluctuation is due primarily to a decrease in
the yield on Government obligations and a decrease in mortgage rates. We believe
that changes in market interest rates, resulting in unrealized holding gains or
losses, should not have a material impact on future earnings or cash flows, as
it is unlikely that we would need or choose to substantially liquidate our
investment portfolio.
ITEM 4. CONTROLS AND PROCEDURES
Based on the evaluation by the Chief Executive Officer and Chief Financial
Officer of the Company as of a date within 90 days of the filing date of this
quarterly report, those officers believe that the Company's disclosure controls
and procedures are reasonably effective to ensure that the information required
to be included in this report has been recorded, processed, summarized and
reported on a timely basis. There have not been any significant changes in the
Company's internal controls or in other factors that could significantly affect
these controls and there have been no corrective actions taken with regard to
significant deficiencies and material weaknesses subsequent to the date of such
officers' evaluation.
SIERRA HEALTH SERVICES, INC. AND SUBSIDIARIES
PART II - OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
We are subject to various claims and other litigation in the ordinary course of
business. Such litigation includes, for example, claims of medical malpractice,
claims for coverage or payment for medical services rendered to HMO members and
claims by providers for payment for medical services rendered to HMO and other
members. Some litigation may also include claims for punitive damages that are
not covered by insurance. Also included in such litigation are claims for
workers' compensation and claims by providers for payment for medical services
rendered to injured workers. These actions are in various stages of litigation
and some may ultimately be brought to trial. With respect to certain pending
actions, the Company maintains commercial insurance coverage with varying
deductibles for which the Company maintains reserves for its self-insured
portion based upon its current assessment of such litigation. Due to recent
unfavorable changes in the commercial insurance market, the Company has, for
certain risks, purchased coverage with higher deductibles and lower limits of
coverage. In the opinion of management, based on information presently
available, the ultimate resolution of these pending legal proceedings should not
have a material adverse effect on our financial condition.
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
None
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
None
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None
ITEM 5. OTHER INFORMATION
None
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits
(99.1) Certification pursuant to 18 U.S.C. as adopted pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002 of Principal
Executive Officer dated November 14, 2002.
(99.2) Certification pursuant to 18 U.S.C. as adopted pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002 of Principal
Financial Officer dated November 14, 2002.
(b) Reports on Form 8-K
Current Report on Form 8-K, dated August 14, 2002, with the
Securities and Exchange Commission in connection with the
Company's Principal Executive Officer and Principal Financial
Officer submitting sworn statements pursuant to the Securities
and Exchange Commission Order No. 4-460.
Current Report on Form 8-K, dated September 5, 2002, with the
Securities and Exchange Commission in connection with the
announcement of the Company's participation in a health care
conference on September 18, 2002.
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of
1934, the registrant has duly caused this report to be signed on
its behalf by the undersigned thereunto duly authorized.
SIERRA HEALTH SERVICES, INC.
----------------------------
(Registrant)
Date: November 14, 2002 /s/ Paul H. Palmer
-----------------------------------
Paul H. Palmer
Senior Vice President of Finance,
Chief Financial Officer and Treasurer
(Principal Financial and Accounting Officer)
CERTIFICATION
I, Anthony M. Marlon, M.D., Chief Executive Officer, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Sierra Health Services,
Inc.;
2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to make
the statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this quarterly
report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this quarterly report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a. designed such disclosure controls and procedures to ensure that material
information relating to the registrant, including its consolidated
subsidiaries, is made known to us by others within those entities,
particularly during the period in which this quarterly report is being
prepared;
b. evaluated the effectiveness of the registrant's disclosure controls and
procedures as of a date within 90 days prior to the filing date of this
quarterly report (the "Evaluation Date"); and
c. presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based on our
most recent evaluation, to the registrant's auditors and the audit committee of
registrant's board of directors (or persons performing the equivalent function):
a. all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to record,
process, summarize and report financial data and have identified for the
registrant's auditors any material weaknesses in internal controls; and
b. any fraud, whether or not material, that involves management or other
employees who have significant role in the registrant's internal controls;
and
6. The registrant's other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal controls
subsequent to the date of our most recent evaluation, including my corrective
actions with regard to significant deficiencies and material weaknesses.
Date: November 14, 2002
/s/ Anthony M. Marlon
---------------------
Anthony M. Marlon
Chief Executive Officer
CERTIFICATION
I, Paul H. Palmer, Chief Financial Officer, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Sierra Health Services,
Inc.;
2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to make
the statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this quarterly
report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this quarterly report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a. designed such disclosure controls and procedures to ensure that material
information relating to the registrant, including its consolidated
subsidiaries, is made known to us by others within those entities,
particularly during the period in which this quarterly report is being
prepared;
b. evaluated the effectiveness of the registrant's disclosure controls and
procedures as of a date within 90 days prior to the filing date of this
quarterly report (the "Evaluation Date"); and
c. presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based on our
most recent evaluation, to the registrant's auditors and the audit committee of
registrant's board of directors (or persons performing the equivalent function):
a. all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to record,
process, summarize and report financial data and have identified for the
registrant's auditors any material weaknesses in internal controls; and
b. any fraud, whether or not material, that involves management or other
employees who have significant role in the registrant's internal controls;
and
6. The registrant's other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal controls
subsequent to the date of our most recent evaluation, including my corrective
actions with regard to significant deficiencies and material weaknesses.
Date: November 14, 2002
/s/ Paul H. Palmer
------------------
Paul H. Palmer
Chief Financial Officer