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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
(Mark One) X
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 1998
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
(State or other jurisdiction of
incorporation or organization)
88-0200415
(I.R.S. Employer Identification Number)
2724 NORTH TENAYA WAY
LAS VEGAS, NEVADA 89128
(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code: (702) 242-7000
Securities registered pursuant to Section 12(b) of the Act:
Title of each class
Name of each exchange on
which registered
Common Stock, par value $.005
New York Stock Exchange
Securities Registered Pursuant to Section 12(g) of the Act: None
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. YES X NO
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [ ]
The aggregate market value of the voting stock held by non-affiliates of
the registrant on February 26, 1999 was $353,058,000.
The number of shares of the registrant's common stock outstanding on
February 26, 1999 was 27,141,000.
DOCUMENTS INCORPORATED BY REFERENCE
DOCUMENT WHERE INCORPORATED
Registrant's Current Report on Form 8-K dated Part I
March 17, 1999. Part II, Item 7
Portions of the registrant's definitive proxy statement for Part III
its 1999 annual meeting to be filed with the SEC not later
than 120 days after the end of the fiscal year.
SIERRA HEALTH SERVICES, INC.
1998 FORM 10-K ANNUAL REPORT
TABLE OF CONTENTS
Page
PART I
Item 1. Business ................................................................................. 1
Item 2. Properties................................................................................ 17
Item 3. Legal Proceedings......................................................................... 17
Item 4. Submission of Matters to a Vote of Security Holders....................................... 17
PART II
Item 5. Market for Registrant's Common Stock and
Related Stockholder Matters............................................................ 18
Item 6. Selected Financial Data................................................................... 19
Item 7. Management's Discussion and Analysis of Financial Condition
and Results of Operations ............................................................. 20
Item 7a. Quantitative and Qualitative Disclosures about Market Risk ............................... 32
Item 8. Financial Statements and Supplementary Data............................................... 33
Item 9. Changes in and Disagreements with Accountants on
Accounting and Financial Disclosure.................................................... 62
PART III
Item 10. Directors and Executive Officers of the Registrant........................................ 62
Item 11. Executive Compensation.................................................................... 62
Item 12. Security Ownership of Certain Beneficial Owners and Management............................ 62
Item 13. Certain Relationships and Related Transactions............................................ 62
PART IV
Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K........................... 63
i
PART I
ITEM 1. BUSINESS
GENERAL
Sierra Health Services, Inc. ("Sierra") and its subsidiaries (collectively
referred to as the "Company"), is a managed health care organization that
provides and administers the delivery of comprehensive health care and workers'
compensation programs with an emphasis on quality care and cost management. The
Company's strategy has been to develop and offer a portfolio of managed health
care and workers' compensation products to employer groups and individuals. The
Company's broad range of managed health care services is provided through its
federally qualified and non-qualified health maintenance organizations ("HMOs"),
managed indemnity plans, a third-party administrative services program for
employer-funded health benefit plans, workers' compensation medical management
programs and a subsidiary that administers a managed care federal contact for
the Department of Defense's TRICARE program in Region 1. This contract is
currently structured as five one-year option periods. If all option periods are
exercised by the Department of Defense ("DOD") and no extensions of the
performance period are made, health care delivery will end on May 31, 2003 for
Region 1. Ancillary products and services that complement the Company's managed
health care and workers' compensation product lines are also offered.
On October 31, 1998, Sierra and one of its subsidiaries, Texas Health Choice,
L.C. ("TXHC"), (formerly HMO Texas L.C.) completed the acquisition of certain
assets of Kaiser Foundation Health Plan of Texas ("Kaiser-Texas"), a health plan
operating in Dallas/Ft. Worth with approximately 109,000 members, and Permanente
Medical Association of Texas ("Permanente"), a medical group with approximately
150 physicians. The purchase price was $124 million, which is net $20 million in
operating cost support to be paid to Sierra by Kaiser Foundation Hospitals in
five quarterly installments following the closing of the transaction. The
purchase price includes amounts for real estate and eight medical and office
facilities with approximately 500,000 square feet. In December 1998, certain
accreditation goals were met by the health plan resulting in a purchase price
increase of $3.0 million, to $127 million. The purchase price may increase up to
an additional $27 million over three years if certain growth and member
retention goals are met by the health plan. Sierra assumed no prior liabilities
for malpractice or other litigation, or for any unanticipated future adjustments
to claims expenses for periods prior to closing. The transaction was financed
with a five-year revolving credit facility and a $35.2 million note payable to
Kaiser Foundation Health Plan of Texas. The note is secured by the acquired real
estate. Approximately $110 million of the $200 million revolving credit facility
was used to fund the transaction.
On December 31, 1998, Sierra completed the acquisition of the Nevada health care
business of Exclusive Healthcare, Inc. ("EHI"), United of Omaha Life Insurance
Company and United World Life Insurance Company ("United"), all of which are
subsidiaries of Mutual of Omaha Insurance Company. Sierra retained approximately
9,000 members (approximately 4,400 HMO members) subsequent to the acquisition.
On January 27, 1999, Sierra signed a definitive agreement to purchase the Texas
operations of EHI (6,900 HMO members) and United's related preferred provider
organization ("PPO") that is part of the dual option HMO/PPO plan. The
transaction is expected to be completed no later than April 30, 1999 and is
subject to regulatory approvals. The purchase price of both transactions is
contingent based on how many members are retained through 2000 and 2001. No cash
will be paid until group renewals begin in 2000.
On September 30, 1997, Sierra Military Health Services, Inc. ("SMHS") was
awarded a TRICARE contract to provide managed health care coverage to eligible
beneficiaries in Region 1. In June 1998, the Company began providing health care
benefits to approximately 606,000 individuals in Connecticut, Delaware, Maine,
Maryland, Massachusetts, New Hampshire, New Jersey, New York, Pennsylvania,
Rhode Island, Vermont, Virginia, West Virginia and Washington, D.C. In 1998, the
award resulted in a total of approximately $204.8
1
million of revenue for the final five-months of the implementation phase and
seven months of health care delivery. SMHS was notified on February 13, 1998
that the United States General Accounting Office ("GAO") sustained a
competitor's protest of the contract award for TRICARE Managed Care Support
Region 1 and recommended that the contract be re-bid. In December 1998, the
Company reached an agreement to settle the protest (See Note 14 of Notes to the
Consolidated Financial Statements). As part of the settlement, the competitor
will forego any and all rights it may have to challenge the contract award and
seek a re-bid.
The principal executive offices of the Company are located at 2724 North Tenaya
Way, Las Vegas, Nevada 89128, and its telephone number is (702) 242-7000.
Managed Care Products and Services
The Company's primary types of health care coverage are HMO plans, HMO Point of
Service ("POS") plans, and managed indemnity plans, which include a PPO option.
As of December 31, 1998, the Company provided HMO products to approximately
182,000 members in Nevada, 112,000 in Dallas, 25,000 in Houston and 5,000 in
Arizona. The POS products allow members to choose one of the various coverage
options when medical services are required instead of one plan for the entire
year. The Company also provides managed indemnity products to approximately
41,000 members, Medicare supplement products to approximately 26,000 members,
and administrative services to approximately 318,000 members. Medical premiums
account for approximately 59% of total revenues. Approximately 70% of such
medical premiums were derived from southern Nevada in 1998. With the acquisition
of Kaiser-Texas, medical premiums derived from southern Nevada in November and
December of 1998 were approximately 57% of medical premium revenue.
Health Maintenance Organizations. The Company operates mixed group network model
HMOs in Las Vegas, Nevada and Dallas/Ft. Worth, Texas and a network model HMO in
Reno, Nevada and Houston, Texas. Contracted primary care physicians and
specialists for the HMOs are compensated on a capitation or modified
fee-for-service basis. Contracts with their primary hospitals are on a
capitation or discounted per diem basis. Members receive a wide range of
coverage after paying a nominal co-payment and are eligible for preventive care
coverage. The HMOs do not require deductibles or claim forms.
Most of the Company's managed health care services in Nevada are provided
through its independently contracted network of over 2,200 providers and 13
hospitals. These Nevada networks include the Company's multi-specialty medical
group, which provides medical services to approximately 71% of the Company's
Nevada HMO members and employs over 170 primary care and other providers in
various medical specialties. The Company directly provides home health care,
hospice care and behavioral health care services and operates a company that
provides home infusion, oxygen and durable medical equipment services. In
addition, the Company operates three 24-hour urgent care centers, a radiology
department, a vision department, an occupational medicine department and two
free-standing, state-licensed and Medicare-approved ambulatory surgery centers.
The Company believes that this vertical integration of its health care delivery
system in Nevada provides a competitive advantage as it has helped it to manage
health care costs effectively while delivering quality care.
On October 31, 1998, the Company acquired certain assets of Kaiser-Texas, a
group model HMO with approximately 109,000 members and a 150 physician medical
group in Dallas/Ft. Worth, Texas. The independently contracted medical group
provides professional services from nine health centers; eight of which offer
primary care services while two offer specialty care services. In addition, TXHC
has contracts with 13 hospitals for inpatient care in Dallas/Ft. Worth. Shortly
after the acquisition, the Company changed the provider model in Dallas/Ft.
Worth from a group model to a mixed network model by overlaying individual
practice association ("IPA") delivery systems on top of the existing group model
to provide members with more choice. The first IPA was contracted in November
1998 and added approximately
2
1,500 physicians to the Dallas/Ft. Worth delivery system. The Houston HMO
members are served by approximately 1,600 independent contracted providers and
30 hospitals.
In addition to its commercial HMO plans, which involve traditional HMO benefits
and POS benefits, the Company offers a Medicare risk product for
Medicare-eligible beneficiaries called Senior Dimensions in Nevada and parts of
Arizona and Golden Choice in Texas. Senior Dimensions is marketed directly to
Medicare-eligible beneficiaries in the Company's Nevada service area as well as
contiguous parts of Arizona. The monthly payment received from the Health Care
Financing Administration ("HCFA") is determined by formula established by
Federal law. The Balanced Budget Act of 1997 included legislative changes which
affected the way health plans are compensated for Medicare members by
eliminating over five years amounts paid for graduate medical education and by
increasing the blend of national cost factors applied in determining local
reimbursement rates over a six-year phase-in period. Both changes will have the
effect of reducing reimbursement in high cost metropolitan areas with a large
number of teaching hospitals; however, the legislation includes a provision for
a minimum increase of 2% annually in health plan Medicare reimbursement for the
next five years. Under the authority provided by the 1997 Balanced Budget Act
(see "Government Regulation and Recent Legislation"), HCFA has begun to collect
hospital encounter data from Medicare risk contractors. The data will be used to
implement a new risk adjustment mechanism which will be phased in over a
five-year period beginning January 1, 2000. Given the relatively high Medicare
risk premium levels in certain of the Company's market areas, the Company is in
jeopardy that the new risk adjustment mechanism to be developed could adversely
affect the Company's Medicare premium rates going forward. The Company does not
believe that the risk adjustment mechanism will be applied to Social HMO
capitation payments.
As of December 31, 1998, the Company had 47,000 Medicare members, of which
33,500 were located in Nevada, 8,300 in Texas and 5,200 in Arizona.
Approximately 26,000 of the Nevada Medicare members were enrolled in a Social
Health Maintenance Organization (see "Social Health Maintenance Organization"
following).
Social Health Maintenance Organization. Effective November 1, 1996, the Company
entered into a Social HMO contract pursuant to which a large portion of the
Company's Medicare risk enrollees will receive certain expanded benefits. Sierra
was one of six HMOs nationally to be awarded this contract, and is currently the
only company to have implemented the program as of December 31, 1998. The
Company receives additional revenues for providing these expanded benefits. The
additional revenues are determined based on health risk assessments that have
been, and will continue to be, performed on the Company's eligible Medicare risk
members. The additional benefits include, among other things, assisting the
eligible Medicare risk members with typical daily living functions such as
bathing, dressing and walking. These members, as identified in the health risk
assessments, are those who currently have difficulty performing such daily
living functions because of a health or physical problem. HCFA has expressed the
intention to continue the current reimbursement methodology for the Social HMO
contract through December 31, 2000. HCFA has considered adjusting the
reimbursement factors for the Social HMO members. At this time, however, there
can be no assurance as to what the final per member reimbursement will be or
that the social HMO contract will be renewed.
Preferred Provider Organizations. The Company also offers health insurance
through its PPO. The Company's managed indemnity plans generally offer insureds
the option of receiving their medical care from either non-contracted or
contracted providers. Insureds pay higher deductibles and co-insurance or
co-payments when they receive care from non-contracted providers. Out-of-pocket
costs are lowered by utilizing contracted providers who are part of the
Company's PPO network. As of December 31, 1998, approximately 41,000 members
were enrolled in Sierra's managed indemnity plans.
The Company currently provides managed indemnity and Medicare supplement
services to individuals in Nevada, Arizona, Colorado, Texas, California,
Louisiana, Iowa and South Carolina. The Company is also exploring further
expansion in certain other states and currently provides other insurance
services in Missouri, New Mexico, and Pennsylvania. As of December 31, 1998 the
PPO is licensed in a total of 43 states and the District of Columbia.
3
Ancillary Medical Services. Among the ancillary medical services offered by the
Company are outpatient surgical care, diagnostic tests, medical and surgical
procedures, inpatient and outpatient laboratory tests, x-ray, CAT scans, nuclear
medicine services, and mental health and substance abuse services. In Nevada,
the Company also provides home health care services, a hospice program and
vision services. These services are provided to members of the Company's HMOs,
managed indemnity and administrative services plans. The mental health and
substance abuse services are also provided to approximately 137,000 participants
from non-affiliated employer groups and insurance companies. In addition, the
Company offers home infusion, oxygen and durable medical equipment services.
Administrative Services. The Company's administrative services products provide,
among other things, utilization review and PPO services to large employer groups
that are usually self-insured. As of December 31, 1998, approximately 318,000
members were enrolled in the Company's administrative services plans. The
results of operations for these services are included in specialty product
revenues and expenses in the Consolidated Statements of Operations.
Workers' Compensation Operations
Workers' Compensation Subsidiary. On October 31, 1995, the Company acquired CII
Financial, Inc. ("CII"), for approximately $76.3 million of common stock in a
transaction accounted for as a pooling of interests. CII writes workers'
compensation insurance in the states of California, Colorado, Kansas, Missouri,
Nebraska, New Mexico, Texas and Utah. CII has licenses in 31 states and the
District of Columbia. California, Colorado, and Texas represent approximately
84%, 8%, and 5%, respectively, of CII's fully insured workers' compensation
insurance premiums in 1998. Workers' compensation insurance premiums account for
approximately 13% of the Company's total revenue. The workers' compensation
subsidiary applies the discipline of managed care concepts to its operations.
These concepts include, but are not limited to, the use of specialized preferred
provider networks, utilization reviews by employed board certified occupational
medicine and orthopedic surgeons as well as nurse case managers, medical bill
reviewers and job developers who facilitate early return to work.
Effective September 30, 1997, the Company terminated its workers' compensation
administrative services contract with the state of Nevada. The contract served
approximately 200,000 enrollees and provided approximately $3.2 million in
revenues for the year ended December 31, 1997. The contract was terminated to
allow the Company to participate in the Nevada workers' compensation insurance
market when the state allows private insurance companies to begin offering
products on July 1, 1999.
Military Contract Services
Sierra Military Health Services, Inc. On September 30, 1997, the Company was
awarded a TRICARE contract to provide managed health care coverage to eligible
beneficiaries in Region 1. This region includes approximately 606,000 eligible
individuals in Connecticut, Delaware, Maine, Maryland, Massachusetts, New
Hampshire, New Jersey, New York, Pennsylvania, Rhode Island, Vermont, Virginia,
West Virginia and Washington, D.C. SMHS completed an eight month implementation
phase in May 1998 and began providing health care benefits on June 1, 1998 under
the TRICARE contract.
Under the TRICARE contract, SMHS provides health care services to approximately
606,000 dependents of active duty military personnel and military retirees and
their dependents through subcontractor partnerships and individual providers.
Through such partnerships, SMHS also performs specific administrative services,
such as health care appointment scheduling, enrollment, network management and
health care advice line services. SMHS performs such services using DOD
information systems. If all five option periods are exercised by the DOD and no
extensions of the performance period are made, health care delivery will end on
May 31, 2003, followed by an additional eight month phaseout of the Region 1
managed care support contract.
4
Marketing
The Company's marketing efforts for its commercial managed care products involve
a two-step process. The Company first makes presentations to employers and then
provides information directly to employees once the employer has decided to
offer the Company's products. Once a relationship with a group is established
and a group agreement is negotiated and signed, the Company's marketing efforts
focus on individual employees. During a designated "open enrollment" period each
year, usually the month preceding the annual renewal of the agreement with the
group, employees choose whether to remain with, join or terminate their
membership with a specific health plan offered by the employer. New employees
decide whether to join one of the employers' health insurance options at the
time of their employment. Although contracts with employers are generally
terminable on 60 days notice, changes in membership occur primarily during open
enrollment periods. Medicare risk products are primarily marketed by the HMOs'
sales employees. Retention of employer groups and membership growth is
accomplished through print advertising directed to employers and through
consumer media campaigns. Media communications convey the Company's emphasis on
preventive care, ready access to health care providers and quality service.
Other communications to customers include employer and member newsletters,
member education brochures, prenatal information packets, employer/broker
seminars and direct mail advertising to clients. Members' satisfaction with
Company benefits and services is monitored by customer surveys. Results from
these surveys and other primary and secondary research guide the sales and
advertising efforts throughout the year.
The Company's workers' compensation insurance policies are sold primarily
through independent insurance agents and brokers, who may also represent other
insurance companies. The Company believes that independent insurance agents and
brokers choose to market the Company's insurance policies primarily because of
the price the Company charges. Additional considerations include the quality of
service that the Company provides and the commissions the Company pays. The
Company employs full-time employees as marketing representatives to make
personal contacts with agents and brokers, to maintain regular communication
with them, to advise them of the Company's services and products, and to recruit
additional agents and brokers. In addition, the Company employs full-time field
underwriters who meet with agents and brokers and can provide an immediate quote
on a policy. As of December 31, 1998, the Company had relationships with
approximately 730 agents and 20 brokers and paid its agents and brokers
commissions based on a percentage of the gross written premium produced by such
agents and brokers. The Company also utilizes a number of promotional media,
including advertising in publications and at trade fairs, to support the efforts
of its independent agents.
SMHS administers marketing initiatives in accordance with the TRICARE Region 1
managed care support contract. SMHS' dedicated Marketing Division uses a
multi-faceted marketing approach to ensure that all beneficiaries within Region
1 have the opportunity to learn about the health care benefits under TRICARE and
have the opportunity to make health care choices that best fit their specific
needs. Marketing initiatives include direct beneficiary briefings, direct mail,
newspaper advertising, newsletters and web page briefs.
5
Membership
Period End Membership:
Years Ended December 31,
1998 1997 1996 1995 1994
HMO:
Commercial.............................. 277,000 156,000 147,000 116,000 107,000
Medicare................................ 47,000 36,000 30,000 25,000 20,000
Managed Indemnity........................... 41,000 64,000 46,000 31,000 24,000
Medicare Supplement......................... 26,000 25,000 23,000 15,000 9,000
Administrative Services (1) ................ 318,000 328,000 338,000 117,000 65,000
TRICARE Eligibles........................... 606,000 _______ _______ _______ _______
Total Membership........................ 1,315,000 609,000 584,000 304,000 225,000
(1) For comparability purposes, enrollment information has been restated to
reflect the September 30, 1997 termination of the Company's workers'
compensation administrative services contract with the state of Nevada.
Enrollment in the terminated plan was 163,000, 94,000 and 79,000 members at
December 31, 1996, 1995 and 1994, respectively.
For the years ended December 31, 1998 and 1997, the Company received
approximately 23.0% and 23.7%, respectively, of its total revenues from its
contract with HCFA to provide health care services to Medicare enrollees. The
Company's contract with HCFA is subject to annual renewal at the election of
HCFA, and requires the Company to comply with federal HMO and Medicare laws and
regulations and may be terminated if the Company fails to so comply. The
termination of the Company's contract with HCFA would have a material adverse
effect on the Company's business. In addition, there have been, and the Company
expects that there will continue to be, a number of legislative proposals to
limit Medicare reimbursements and to require additional benefits. Future levels
of funding of the Medicare program by the federal government cannot be predicted
with certainty (See "Government Regulation and Recent Regulation").
The Company's ability to obtain and maintain favorable group benefit agreements
with employer groups affects the Company's profitability. The agreements are
generally renewable on an annual basis but are subject to termination on 60 days
prior notice. For the fiscal year ended December 31, 1998, the Company's ten
largest HMO employer groups were, in the aggregate, responsible for less than
10% of the Company's total revenues. Although none of such employer groups
accounted for more than 2% of total revenues during that period, the loss of one
or more of the larger employer groups would, if not replaced with similar
membership, have a material adverse effect upon the Company's business. The
Company has generally been successful in retaining these employer groups.
However, there can be no assurance that the Company will be able to renew its
agreements with such employer groups in the future or that it will not
experience a decline in enrollment within its employer groups. Additionally,
revenues received under certain government contracts are subject to audit and
retroactive adjustment.
Provider Arrangements and Cost Management
HMO and Managed Indemnity Products. A significant distinction between the
Company's health care delivery system and that of many other managed care
providers is the fact that approximately 71% of the Company's Nevada HMO members
and 80% of its Texas HMO members receive primary health care through the
Company's affiliated multi-specialty medical groups. The Company makes health
care available through independently contracted providers employed by the
multi-specialty medical groups and other independently contracted networks of
physicians, hospitals and other providers.
Under the Company's HMOs, the member selects a primary care physician who
provides or authorizes any non-emergency medical care given to that member.
These primary care physicians and some specialists are compensated to a limited
extent on the basis of how well they coordinate appropriate medical care. The
Company has a system of limited incentive risk arrangements and utilization
management with respect
6
to its independently contracted primary care physicians. The Company compensates
its independently contracted primary care physicians and specialists by using
both capitation and modified fee-for-service payment methods. In Nevada, under
both the capitation and modified fee-for-service methods, an incentive risk
arrangement is established for institutional services. Additional amounts may be
made available to certain capitated physicians if hospital costs are less than
anticipated for the Company's HMO members. For those primary care physicians
receiving payments on a modified fee-for-service basis, portions of the payments
otherwise due the physicians are withheld. The amounts withheld are available
for payment to the physicians if, at year-end, the expenditures for both
institutional and non-institutional medical services are within predetermined,
contractually agreed upon ranges. It is believed that this method of limited
incentive risk payment is advantageous to the physician, the Company and the
members because all share in the benefits of managing health care costs. The
Company has, however, negotiated capitation and reduced fee-for-service
agreements with certain specialists and primary care providers who do not
participate in the incentive risk arrangements. The Company monitors health care
utilization, including evaluation of elective surgical procedures, quality of
care and financial stability of its capitated providers to facilitate access to
service and to ensure member satisfaction.
The Company also believes that it has negotiated favorable rates with its
contracted hospitals. The Company's contracts with its hospital providers
typically renew automatically with both parties granted the right to terminate
after a notice period ranging from between three and twelve months.
Reimbursement arrangements with other health care providers, including
pharmacies, generally renew automatically or are negotiated annually and are
based on several different payment methods, including per diems (where the
reimbursement rate varies and is based on a per day of service charge for
specified types of care), capitation or modified fee-for-service arrangements.
To the extent possible, when negotiating non-physician provider arrangements,
the Company solicits competitive bids.
The Company provides, or negotiates discounted contracts with hospitals for the
provision of, inpatient and outpatient hospital care, including room and board,
diagnostic tests and medical and surgical procedures. The Company believes that
it currently has a favorable contract with its primary southern Nevada
contracted hospital, Columbia Sunrise Hospital. Subject to certain limitations,
the contract provides, among other things, guaranteed contracted per diem rate
increases on an annual basis after December 31, 1997. The per diem rate
increased 1% in 1998 and is scheduled for 2% in 1999. Since a majority of the
Company's southern Nevada hospital days are at Columbia Sunrise Hospital, this
contract assists the Company in managing a significant portion of its medical
costs. The contract expires in the year 2012. In Texas, the Company has
negotiated a capitation arrangement with Columbia Hospital, Inc. for hospital
services provided in Houston and has contracts with 13 hospitals for inpatient
care in Dallas/Ft. Worth.
The Company utilizes two reimbursement methods for health care providers
rendering services under the Company's indemnity plans. For services to members
utilizing a PPO plan, the Company reimburses participating physicians on a
modified fee-for-service basis which incorporates a limited fee schedule and
reimburses hospitals on a per diem or discounted fee-for-service basis. For
services rendered under a standard indemnity plan, pursuant to which a member
may select a non-plan provider, the Company reimburses non-contracted physicians
and hospitals at pre-established rates, less deductibles and co-insurance
amounts.
The Company manages health care costs through its large case management program,
urgent care centers and by educating its members on how and when to use the
services of its plans and how to manage chronic disease conditions. The Company
also audits hospital bills to identify inappropriate charges. Further, in Nevada
the Company utilizes its home health care agency and its hospice which helps to
minimize hospital admissions and lengths of stay.
Military Health Services. Under the TRICARE contract, dependents of active duty
military personnel and military retirees and their dependents choose one of
three option plans available to them for health care services: (1) TRICARE Prime
(an HMO style option with a self-selected primary care manager and no
deductibles), (2) TRICARE Extra (a PPO style option), or (3) TRICARE Standard
(an indemnity style option with deductibles and cost shares). Approximately 30%
of eligible beneficiaries receive their primary care
7
through existing Military Treatment Facilities. SMHS negotiated discounted
contracts with approximately 20,000 individual providers, 1,200 institutions and
5,000 pharmacies to provide supplemental network access for TRICARE Prime and
Extra beneficiaries. SMHS' contracts with providers are primarily on a
discounted fee-for-service basis with renewal and termination terms similar to
Sierra's commercial practice. SMHS is at-risk for and manages the health care
service cost of all TRICARE Extra and Standard beneficiaries as well as a small
percentage of TRICARE Prime beneficiaries.
Risk Management
The Company maintains general and professional liability, property and fidelity
insurance coverage in amounts that it believes are adequate for its operations.
The Company's multi-specialty medical groups maintain excess malpractice
insurance for the providers presently employed by the group. In Nevada and
Arizona, the Company has assumed the risk for the first $250,000 per malpractice
claim, not to exceed $1.5 million in the aggregate per contract year up to its
limits of coverage. In Texas, the Company has assumed no self-insured retention
per claim. The aggregate maximum exposure for each of these policies is $30
million per year. In addition, the Company requires all of its independently
contracted provider physician groups, individual practice physicians,
specialists, dentists, podiatrists and other health care providers (with the
exception of certain hospitals) to maintain professional liability coverage.
Certain of the hospitals with which the Company contracts are self-insured. The
Company also maintains stop-loss insurance that reimburses the Company between
50% and 90% of hospital charges for each individual member of its HMO or managed
indemnity plans whose hospital expenses exceed, depending on the contract,
$100,000 to $200,000, during the contract year and up to $2.0 million per member
per lifetime.
Effective July 1, 1997, the Company also maintains excess catastrophic coverage
for one of the Company's wholly-owned HMOs, Health Plan of Nevada, Inc. ("HPN"),
that reimburses the Company for amounts by which the ultimate net loss exceeds
$400,000, but does not exceed the annual maximum of $19.6 million per accident
and $39.2 million per contract. In the ordinary course of its business, however,
the Company is subject to claims that are not insured, principally claims for
punitive damages.
Effective January 1, 1998, workers' compensation claims are reinsured between
$500,000 and $100 million per occurrence. For claims occurring on and after July
1, 1998, that are below $500,000, the Company obtained quota share and excess of
loss reinsurance. Under this agreement, the Company reinsures 30% of the first
$10,000 of each claim, 75% of the next $40,000 and 100% of the next $450,000.
The Company receives a ceding commission from the reinsurer as a partial
reimbursement of operating expenses.
Information System
The Company has in place certain data systems which assist the Company in, among
other things, pricing its services, monitoring utilization and other cost
factors, providing bills on a timely basis, identifying accounts for collection
and handling various accounting and reporting functions. Its imaging and
workflow systems are used to process and track claims and coordinate customer
service. Where it is cost efficient, the Company's system is connected to large
provider groups, doctors' offices, payors and brokers to enable efficient
transfer of information and communication. The Company views its information
systems capability as critical to the performance of ongoing administrative
functions and integral to quality assurance and to the coordination of patient
care across care sites. The Company is continually modifying or improving its
information systems capabilities in an effort to improve operating efficiencies.
Year 2000
The Year 2000 issue exists because many computer systems and applications
currently use two-digit date fields to designate a year. As the century date
change occurs, date-sensitive systems will recognize the year 2000 as 1900, or
not at all. This inability to recognize or properly treat the Year 2000 may
cause systems to process critical financial and operational information
incorrectly.
8
The Company is currently in the process of modifying or replacing its mission
critical financial and operational computer systems. The Company is also in the
process of testing its non-information system technology for Year 2000
compliance. The Year 2000 project has been broken down into five phases: (1)
inventorying Year 2000 items; (2) assessing the Year 2000 items that are
determined to be material to the Company; (3) renovating or replacing material
items that are determined not to be Year 2000 compliant; (4) testing and
validating material items; and (5) implementing renovated and validated systems.
At December 31, 1998, the inventory and assessment phases are substantially
complete as it relates to all material computer systems and approximately 50%
complete as it relates to non-information system technology. The Company
estimates that the replacement/renovation phases and the testing/validation
phases will be 95% complete by October 31, 1999. The Company estimates that it
is approximately 50% complete with the total project as of December 31, 1998.
Contingency planning for the mission critical business operations is scheduled
to be completed by the end of April 1999. These plans focus on business
operations involving information systems and non-information systems
technologies.
The Company has initiated formal communications with entities with whom it does
business to assess their Year 2000 issues. Evaluations of the most critical
third parties have been initiated, and follow-up reviews will be conducted
through 1999. Contingency plans are being developed based on these evaluations
and are expected to be completed by the middle of 1999. There can be no
assurances that the systems of other companies or governmental agencies, such as
HCFA and the DOD, on which the Company relies will be timely modified for Year
2000, or that the failure to modify by another company would not have a material
adverse effect on the Company. Based upon two separate reports issued by the
United States General Accounting Office it is doubtful that the computer systems
at both HCFA and the DOD will be fully Year 2000 compliant by the end of 1999.
The Company does not currently have available data to predict the impact of such
non-compliance on its business operations. Should there be any material delays
caused by Year 2000 issues, the Company anticipates that the governmental
entities will make estimated payments.
The Company is in the process of implementing three major systems at an
estimated cost of $36 million to $38 million, which includes the implementation
costs related to the recently acquired Kaiser-Texas operations. To date, the
Company has spent approximately $19.0 million on the new computer systems and
other Year 2000 items. The Company is expensing the costs to make modifications
to existing computer systems and non-computer equipment. Management currently
estimates the remaining new computer system costs and other Year 2000 costs to
be $13.0 million to $16.0 million for operations in existence prior to the
Kaiser-Texas transaction and $6.0 million to $8.0 million for the Kaiser-Texas
operations that were acquired on October 31, 1998. While this is a substantial
effort, it will give the Company the benefits of new technology and
functionality for many of its financial and operational computer systems and
applications.
The failure to correct a material Year 2000 problem could result in an
interruption of, or a failure of, certain business activities or operations.
Such failures could materially adversely affect the Company's operations,
liquidity and financial condition. Due to the general uncertainty inherent in
the Year 2000 problem, resulting in part from uncertainty of the Year 2000
readiness of third parties with which the Company does business, the Company is
unable to determine at this time whether the consequences of potential Year 2000
failures will have a material adverse impact on the Company's results of
operations, liquidity or financial condition. The Company's Year 2000 project is
expected to significantly reduce the Company's level of uncertainty about the
Year 2000 problem. The Company believes that, with the implementation of the new
computer systems and completion of the entire project as scheduled, the
possibility of significant interruptions of operations should be reduced.
The above contains forward-looking statements including, without limitation,
statements relating to the Company's plans, strategies, objectives,
expectations, intentions, and adequate resources, that are made pursuant to the
"safe harbor" provisions of the Private Securities Litigation Reform Act of
1995. Readers are cautioned that forward-looking statements contained in the
Year 2000 disclosure should be read in conjunction with the following disclosure
of the Company:
9
The costs of the project and the dates on which the Company plans to complete
the necessary Year 2000 modifications are based on management's best estimates,
which were derived utilizing numerous assumptions of future events including the
continued availability of certain resources and other factors. However, there
can be no guarantee that these estimates will be achieved and actual results
could differ materially from those plans. Specific factors that might cause such
material differences include, but are not limited to, the availability and cost
of personnel trained in this area, the ability to locate and correct all
relevant computer codes, the ability of the Company's significant suppliers,
customers and others with which it conducts business, including federal and
state governmental agencies, to identify and resolve their own Year 2000 issues
and similar uncertainties.
Quality Assurance and Improvement
The Company has developed programs to help ensure that the health care services
provided by its HMO and managed indemnity plans meet the professional standards
of care established by the medical community. The Company believes that its
emphasis on quality allows it to increase and retain its members. The Company
monitors and evaluates the availability and quality of the medical care rendered
by the providers in its HMO and insurance plans and periodically audits selected
diagnoses, problems and referrals to determine adherence to appropriate
standards of medical care. In addition, the Company has medical directors who,
supported by a professional medical staff, monitor the quality and
appropriateness of health care by analyzing a physician's utilization of
diagnostic tests, laboratory and radiology procedures, specialty referrals,
prescriptions and hospitals. Physicians and hospitals selected to provide
services to the Company's members are subject to the Company's quality assurance
programs including a formal credentialing process of all physicians.
The Company also has internal quality assurance and improvement review
committees that meet on a regular basis to review specialist referrals, monitor
the performance of physicians and review practice patterns, complaints and other
patient issues. Staff members regularly visit hospitals to review medical
records, meet with patients and review treatment programs and discharge plans
with attending physicians. In addition, the Company solicits information from
both existing and former members as to their satisfaction with the care
delivered. Complaints and grievances are responded to on both an informal and
formal basis, depending on the nature of the complaint.
Several independent organizations have been formed for the purpose of responding
to external demands for accountability in the health care industry. The Company
has voluntarily elected to be evaluated by these external organizations,
including the National Committee for Quality Assurance ("NCQA") and the Joint
Commission on Accreditation of Healthcare Organizations ("JCAHO").
NCQA is an independent, not-for-profit organization that evaluates managed care
organizations. The NCQA accreditation process includes rigorous evaluations
conducted by a team of physicians and managed care experts. No comparable
evaluation exists for fee-for-service health care. The NCQA evaluates plans on
approximately 50 quality standards that fall into six categories: Quality
Management and Improvement; Physician Credentials; Members' Rights and
Responsibilities; Preventive Health Services; Utilization Management; and,
Medical Records. In 1998, Health Plan of Nevada ("HPN") earned a three-year,
full accreditation from the NCQA for its HMO and Medicare products in the Las
Vegas metropolitan area and Pahrump. TXHC in Dallas/Ft. Worth currently has a
One-Year Accreditation from NCQA, pending a May 1999 acquisition review.
The JCAHO reviews rights, responsibilities and ethics, continuum of care,
education and communication, leadership, management of information, and human
resources and network performance. The Company's home health care and hospice
subsidiaries are JCAHO accredited.
There can be no assurance, however, that the Company will maintain NCQA or other
accreditations in the future and there is no basis to predict what effect, if
any, the lack of NCQA or other accreditations could have on HPN's or TXHC's
competitive positions in southern Nevada and Dallas/Ft. Worth, Texas
respectively.
10
Underwriting
HMO. The Company structures premium rates for its various health plans primarily
through community rating and community rating by class method. Under the
community rating method, all costs of basic benefit plans for the Company's
entire membership population are aggregated. These aggregated costs are
calculated on a "per member per month" basis and converted to premium rates for
various coverage types, such as single or family coverage. The community rating
by class method is based on the same principles as community rating, except that
actuarial adjustments to premium rates are made for demographic variations
specific to each employer group such as the average age and sex of their
employees, group size and industry. All employees of an employer group are
charged the same premium rate if the same coverage is selected.
In addition to those premium charges paid by the employers with whom the
Company's HMOs contract, members also pay co-payments at the time certain
services are provided. The Company believes that such co-payments encourage
appropriate utilization of health care services while allowing the Company to
offer competitive premium rates. The Company also believes that the capitation
method of provider compensation encourages physicians to provide only medically
necessary and appropriate care.
Managed Indemnity. Premium charges for the Company's managed indemnity products
are set in a manner similar to the community rating by class method described
above. This rate calculation utilizes similar demographic adjustment factors
such as age, sex and industry factors to develop group-specific adjustments from
a given per member per month base rate by plan. Actual health claims experience
is used in whole or in part to develop premium rates for larger insurance member
groups. This process includes the use of utilization experience, adjustments for
incurred but not reported claims, inflationary factors, credibility and specific
reinsurance pooling levels for large claims.
Workers' Compensation. Prior to insuring a particular risk, the Company reviews,
among other factors, the employer's prior loss experience and premium payment
history. Additionally, the Company determines whether the employer's employment
classifications are among the classifications that the Company has elected to
insure generally and if the amounts of the premiums for the classifications are
within the Company's guidelines. The Company reviews these classifications
periodically to evaluate whether they are profitable. A member of the Company's
loss control department may conduct an on-site safety inspection before the
Company insures the employer. The Company generally initiates this inspection
for enterprises with manufacturing or construction classifications. The Company
may also initiate inspections if the enterprise previously has had a high loss
ratio or frequent losses. If the on-site inspection reveals hazards that can be
corrected, and an agreement can be reached with the employer that these hazards
will be corrected in a time frame established by the Company's underwriting
department, the Company may issue a policy subject to correction of those
hazards. In the event the Company has issued a policy where no previous
inspection has been conducted, and subsequently learns through an inspection the
employer has hazards that must be corrected, the Company will request that the
employer correct the hazards within a specified period of time. If these hazards
are not corrected, the Company may cancel the policy for non-compliance of the
hazard correction. With regard to new business, the agent or broker will usually
submit the claims history on the prospective account. In those situations where
the claims history is not supplied by the agent or broker, other sources (such
as the prior insurer) are used to obtain the appropriate claims history if
possible.
Competition
HMO and Managed Indemnity. Managed care companies and HMOs operate in a highly
competitive environment. The Company's major competition is from self-funded
employer plans, PPO networks, other HMOs, such as Humana Care Plus, Pacificare,
Inc., Aetna and Harris Methodist and traditional indemnity carriers, such as
Blue Cross/Blue Shield. Many of the Company's competitors have substantially
larger total enrollments, have greater financial resources and offer a broader
range of products than the Company. Additional competitors with greater
financial resources than the Company may enter the Company's markets in the
future. The Company believes that the most important competitive factors are the
delivery of reasonably priced, quality medical benefits to members and the
adequacy and availability of health care delivery services and facilities. The
Company depends on a large PPO network and flexible benefit plans
11
to attract new members. Competitive pressures are expected to limit the
Company's ability to increase premium rates and, to a lesser extent, to result
in declining premium rates. Accordingly, the profitability of the Company will,
to a large extent, depend on the Company's ability to manage the costs of
providing health care benefits to its members. The inability of the Company to
manage these costs would have an adverse impact on the Company's future results
of operations by reducing margins. In addition, competitive pressures may also
result in reduced membership levels. Any such reductions could materially affect
the Company's results of operations.
Workers' Compensation. The Company's workers' compensation business is
concentrated in California, a state where the workers' compensation insurance
industry is extremely competitive. Since open rating became effective for
policyholders in 1995, there have been, and continue to be, substantial
reductions in premiums. The Company believes that there are more than 200
insurance companies writing workers' compensation insurance in California. Many
of the Company's competitors have been in business longer, have a larger volume
of business, offer a more diversified line of insurance coverage, have greater
financial resources and have greater distribution capability than the Company.
The largest writer of workers' compensation insurance in California is the State
Compensation Insurance Fund.
In all states in which the Company is currently writing business, competition
for workers' compensation insurance is primarily driven by price and secondarily
by services provided to insureds and agents. In states other than California and
Texas, the National Council on Compensation Insurance ("NCCI") is usually the
designated rating organization. The NCCI accumulates statistical information and
recommends pure loss costs to the state's Department of Insurance. The Company
then selects loss cost multiplier, expense loads to derive premium rates. Rating
plans in those states are more "standardized" and are usually based on plans
developed by the NCCI.
Losses and Loss Adjustment Expenses
Often, in workers' compensation insurance, several years may elapse between the
occurrence of a loss and the final settlement of the loss. To recognize
liabilities for unpaid losses, the Company establishes reserves, which are
balance sheet liabilities representing estimates of future amounts needed to pay
claims and related expenses for insured events, including reserves for events
that have been incurred but have not yet been reported to the Company ("incurred
by not reported" or "IBNR").
When a claim is reported, the Company's claims personnel initially establish
reserves on a case-by-case basis for the estimated amount of the ultimate
payment. These estimates reflect the judgment of the claims personnel based on
their experience and knowledge of the nature and value of the specific type of
claim and the available facts at the time of reporting as to severity of injury
and initial medical prognosis. Included in these reserves are estimates of the
expenses of settling claims, including legal and other fees, and the general
expenses of administering the claims adjustment process. Claims personnel adjust
the amount of the case reserves as the claim develops and as the facts warrant.
IBNR reserves are established for unreported claims and loss development
relating to current and prior accident years. In the event that a claim that
occurred during a prior accident year was not reported until the current
accident year, the case reserve for such claim typically will be established out
of previously established IBNR reserves for that prior accident year.
The Company reviews the adequacy of its reserves on a monthly basis and
considers external forces such as changes in the rate of inflation, the
regulatory environment, the judicial administration of claims, medical costs and
other factors that could cause actual losses and loss adjustment expenses
("LAE") to change. Reserves are reviewed with the Company's independent actuary
at least annually. The actuarial projections include a range of estimates
reflecting the uncertainty of projections. Management evaluates the reserves in
the aggregate, based upon the actuarial indications, and makes adjustments where
appropriate. The
12
consolidated financial statements of the Company provide for reserves based on
the anticipated ultimate cost of losses.
Once an employer is insured by the Company, the Company's loss control
department may assist the insured in developing and maintaining safety programs
and procedures to minimize on-the-job injuries and industrial health hazards.
The safety programs and procedures vary from insured to insured. The Company's
loss control department may recommend to the employer that a safety committee
consisting of members of the employer's management staff and its general labor
force be established. The Company's loss control department may then assist the
committee members in isolating safety hazards, advising the committee on how to
correct the hazards and assisting the employer in establishing procedures to
enforce the corrections. The Company's loss control department may also revisit
the employer to determine whether the recommended corrections and procedures
have been implemented. Depending upon the size, classifications, and loss
experience of the employer, the Company's loss control department will
periodically inspect the employer's places of business and may recommend changes
that could prevent industrial accidents. In addition, severe or recurring
injuries may also warrant on-site inspections. In certain instances, members of
the Company's loss control department may conduct special educational training
sessions for insureds' employees to assist in the prevention of on-the-job
injuries. For example, employers engaged in manufacturing may be offered a
training session on how to prevent back injuries or employers engaged in
contracting may be offered a training session on general first aid and
prevention of injuries that may result from specific work exposures.
Government Regulation and Recent Legislation
HMOs and Managed Indemnity. Federal and state governments have enacted statutes
extensively regulating the activities of HMOs. In addition, growing government
concerns over increasing health care costs and quality could result in new or
additional state or federal legislation that could affect health care providers,
including HMOs, PPOs and other health insurers. Among the areas regulated by
federal and state law are the scope of benefits available to members, premium
structure, procedures for review of quality assurance, enrollment requirements,
the relationship between an HMO and its health care providers and members,
licensing and financial condition.
Government regulation of health care coverage products and services is a
changing area of law that varies from jurisdiction to jurisdiction. Changes in
applicable laws and regulations are continually being considered and
interpretation of existing laws and rules also may change from time to time.
Regulatory agencies generally have broad discretion in promulgating regulations
and in interpreting and enforcing laws and regulations.
While the Company is unable to predict what regulatory changes may occur or the
impact on the Company of any particular change, the Company's operations and
financial results could be negatively affected by regulatory revisions. For
example, any proposals affecting underwriting practices, limiting rate
increases, requiring new or additional benefits or affecting contracting
arrangements (including proposals to require HMOs and PPOs to accept any health
care providers willing to abide by an HMO's or PPO's contract terms) may have a
material adverse effect on the Company's business. The continued consideration
and enactment of "anti-managed care" laws and regulations by federal and state
bodies may make it more difficult for the Company to control medical costs and
may adversely affect financial results.
In addition to changes in applicable laws and regulations, the Company is
subject to various audits, investigations and enforcement actions. These include
possible government actions relating to the federal Employee Retirement Income
Security Act, which regulates insured and self-insured health coverage plans
offered by employers, the Federal Employees Health Benefit Plan, federal and
state fraud and abuse laws, and laws relating to utilization management and the
delivery of health care and payment or reimbursement therefor. Any such
government action could result in assessment of damages, civil or criminal fines
or
13
penalties, or other sanctions, including exclusion from participation in
government programs. In addition, disclosure of any adverse investigation or
audit results or sanctions could negatively affect the Company's reputation in
various markets and make it more difficult for the Company to sell its products
and services.
The Company has HMO licenses in Nevada, Texas and Arizona. The Company's HMO
operations are subject to regulation by the Nevada Division of Insurance, the
Nevada Division of Health, the Texas Department of Insurance and the Arizona
Department of Insurance. The Company's health insurance subsidiary is domiciled
and incorporated in California and is licensed in 43 states and the District of
Columbia, with current operations primarily in Nevada, Arizona, Colorado, Texas,
California, Louisiana, Iowa and South Carolina. It is subject to licensing and
other regulations of the California Department of Insurance as well as the
insurance departments of other states in which it operates or holds licenses.
The Company's premium rate increases are subject to various state insurance
department approvals. The Company's HMO and insurance subsidiaries are also
required by state regulatory agencies to maintain certain deposits and must also
meet certain net worth and reserve requirements. The Company also has certain
other deposit requirements. The Company has restricted assets on deposit in
various states ranging from $20,000 to $2.0 million and totalling $17.8 million
at December 31, 1998. The Company's HMO and insurance subsidiaries meet
requirements to maintain minimum stockholder's equity ranging from $1.1 million
to $5.2 million. In addition, in conjunction with the Kaiser-Texas acquisition,
TXHC entered into a letter agreement with the Texas Department of Insurance
whereby TXHC agreed to maintain a net worth of $20.0 million. The Company's
Nevada HMO and health insurance subsidiaries currently maintain home offices and
a regional home office, respectively, in Las Vegas and, accordingly, are
eligible for certain premium tax credits in Nevada.
The Company's HMO subsidiaries are also restricted by state law as to the amount
of dividends that can be declared and paid. Moreover, insurance companies and
HMOs domiciled in Texas, Nevada and California generally may not pay
extraordinary dividends without providing the state insurance commissioner with
30 days prior notice, during which period the commissioner may disapprove the
payment. An "extraordinary dividend" is generally defined as a dividend whose
fair market value together with that of other dividends or distributions made
within the preceding 12 months exceeds the greater of (i) ten percent of the
insurer's surplus as of the preceding December 31 or (ii) the net gain from
operations of such insurer for the 12-month period ending on the preceding
December 31. The Company is not in a position to assess the likelihood of
obtaining future approval for the payment of "extraordinary dividends" or
dividends other than those specifically allowed by law in each of its
subsidiaries' states of domicile. No prediction can be made as to whether any
legislative proposals relating to dividend rules in the domiciliary states of
the Company's subsidiaries will be made or adopted in the future, whether the
insurance departments of such states will impose either additional restrictions
in the future or a prohibition on the ability of the Company's regulated
subsidiaries to declare and pay dividends or as to the effect of any such
proposals or restrictions on the Company's regulated subsidiaries.
The Company is subject to the Federal HMO Act and the regulations promulgated
thereunder. Of the Company's three subsidiary HMOs, only MedOne Health Plan,
acquired at the end of 1996, is not federally-qualified under this Act. In
order to obtain federal qualification, an HMO must, among other things,
provide its members certain services on a fixed, prepaid fee basis and set its
premium rates
in accordance with certain rating principles established by federal law and
regulation. The HMO must also have quality assurance programs in place with
respect to its health care providers. Furthermore, an HMO may not refuse to
enroll an employee, in most circumstances, because of such person's health, and
may not expel or refuse to re-enroll individual members because of their health
or their need for health services.
Under the "corporate practice of medicine" doctrine, in most states, business
organizations, other than those authorized to do so, are prohibited from
providing, or holding themselves out as providers of, medical care. Some states,
including Nevada, exempt HMOs from this doctrine. The laws relating to this
doctrine are subject to numerous conflicting interpretations. Although the
Company seeks to structure its operations
14
to comply with corporate practice of medicine laws in all states in which it
operates, there can be no assurance that, given the varying and uncertain
interpretations of those laws, the Company would be found to be in compliance
with those laws in all states. A determination that the Company is not in
compliance with applicable corporate practice of medicine laws in any state in
which it operates could have a material adverse effect on the Company if it were
unable to restructure its operations to comply with the laws of that state.
Medicare and Medicaid antifraud and abuse provisions are codified at 42 U.S.C.
Sections 1320a-7(b) (the "Anti-kickback Statute") and 1395nn (the "Stark
Amendments"). Many states have similar anti-kickback and anti-referral laws.
These statutes prohibit certain business practices and relationships involving
the referral of patients for the provision of health care items or services
under certain circumstances. Sanctions for violations of the Anti-kickback
Statute and the Stark Amendments include criminal penalties and civil sanctions,
including fines and possible exclusion from the Medicare and Medicaid programs.
Similar penalties are provided for violation of state anti-kickback and
anti-referral laws. The Department of Health and Human Services ("HHS") has
issued regulations establishing "safe harbors" with respect to the Antikickback
Statute. The Office of the Inspector General recently proposed new rules to
clarify those safe harbors. HHS has also recently proposed to establish certain
safe harbors under the Stark Amendments. The Company believes that its business
arrangements and operations are in compliance with the Antikickback Statute and
the Stark Amendments and the exceptions set forth therein, regardless of the
availability of regulatory safe harbor protection with respect to those
statutes. There can, however, be no assurance that (i) government officials
charged with responsibility for enforcing the prohibitions of the Antikickback
Statute and the Stark Amendments will not assert that the Company or certain
transactions in which it is involved are in violation of those statutes; and
(ii) such statutes will ultimately be interpreted by the courts in a manner
consistent with the Company's interpretation.
In 1997, Congress passed the Balanced Budget Act ("Act") which revised the
structure of and reimbursement for private health plan options for Medicare
enrollees. The Act seeks to expand the options available to Medicare enrollees
by permitting HCFA to contract with a variety of types of managed care plans,
creating a new Medicare fee-for-service option and establishing a Medicare
Medical Savings Account Demonstration Program. The legislation also encourages
provider sponsored organizations to contract directly with HCFA to provide
coverage for Medicare enrollees. Federal reimbursement was modified so that the
premiums paid by HCFA will be adjusted to take into account, on an increasing
basis, a blend of national and local health care cost factors, rather than only
local costs--starting with a 10% national factor in 1998 and moving to a 50%
national factor by 2003. Congress also provided for gradual removal of a
graduate medical education factor in determining reimbursement. As a result, it
is likely that premiums paid by HCFA will not match the rate of increase for
medical costs.
The legislation includes a provision for a minimum increase of 2% annually in
health plan Medicare reimbursement for the next five years. The legislation also
provides for expedited licensure of provider-sponsored Medicare plans and
a repeal in 1999 of the rule requiring health plans to have one
commercial
enrollee for each Medicare or Medicaid enrollee. These changes could have the
effect of increasing competition in the Medicare market. Further, effective
January 1, 1999, the Company was required to implement new Medicare regulations
including, but not limited to, regulations relating to discharge notices,
additional provider contract language and extensive new quality improvement
programs. These new regulations are likely to increase the burden of
administering the Company's Medicare plans and may adversely impact the
Company's operations.
The Health Insurance Portability and Accountability Act of 1996 (the
"Accountability Act") was passed by Congress and signed into law by President
Clinton on August 21, 1996 and effective beginning July 1, 1997. While the
Accountability Act contains provisions regarding health insurance or health
plans, such as portability and limitations on pre-existing condition exclusions,
guaranteed availability and renewability, it also contains several anti-fraud
measures that significantly change health care fraud and abuse
15
provisions. Some of the provisions include (i) creation of an anti-fraud and
abuse trust fund and coordination of fraud and abuse efforts by federal, state
and local authorities; (ii) extension of the criminal anti-kickback statues to
all federal health programs; (iii) expansion of and increase in the amount of
civil monetary penalties and establishment of a knowledge standard for
individuals or entities potentially subject to civil monetary penalties; and
(iv) revisions to current sanctions for fraud and abuse, including mandatory and
permissive exclusion from participation in the Medicare or Medicaid programs.
Workers' Compensation. The Company is subject to extensive governmental
regulation and supervision in each state in which it conducts workers'
compensation business. The primary purpose of such regulation and supervision is
to provide safeguards for policyholders and injured workers rather than protect
the interests of shareholders. The extent and form of the regulation may vary,
but generally has its source in statutes that establish regulatory agencies and
delegate to the regulatory agencies broad regulatory, supervisory and
administrative authority. Typically, state regulations extend to such matters as
licensing companies; restricting the types or quality of investments; requiring
triennial financial examinations and market conduct surveys of insurance
companies; licensing agents; regulating aspects of a company's relationship with
its agents; restricting use of some underwriting criteria; regulating rates,
forms and advertising; limiting the grounds for cancellation or nonrenewal of
policies, solicitation and replacement practices; and specifying what might
constitute unfair practices. Moreover, the payment of dividends and the making
of other distributions to the Company by its workers' compensation insurance
company subsidiaries are contingent upon the earnings of those subsidiaries and
are subject to various business considerations, applicable state corporate laws
and regulations, the terms of agreements to which they may become a party and
government regulations, which restrict in certain circumstances the payment of
dividends and distributions, and the transfer of assets to the Company.
In the normal course of business, the Company and the various state agencies
that regulate the activities of the Company may disagree on interpretations of
laws and regulations, policy wording and disclosures or other related issues.
These disagreements, if left unresolved, could result in administrative hearings
and/or litigation. The Company attempts to resolve all issues with the
regulatory agencies, but is willing to litigate issues where it believes it has
a strong position. The ultimate outcome of these disagreements could result in
sanctions and/or penalties and fines assessed against the Company. Currently,
there are no litigation matters pending with any department of insurance.
Typically, states mandate participation in insurance guaranty associations,
which assess solvent insurance companies in order to fund claims of
policyholders of insolvent insurance companies. Under this arrangement, insurers
can be assessed up to 1% (or 2% in certain states) of premiums written for
workers' compensation insurance in that state each year to pay losses and LAE on
covered claims of insolvent insurers. In California and certain other states,
insurance companies are allowed to recoup such assessments from policyholders
while several states allow an offset against premium taxes. Potential assessment
expenses, net of recoupment, if any, for insolvencies are not accrued until
after an insolvency has occurred since the likelihood and the amount of the
assessment expense cannot be reasonably determined or estimated. In California,
there have been no new assessments for insolvent workers' compensation insurance
companies since 1990.
California's Insurance Holding Company Act regulates the payment of shareholder
dividends by insurance companies. To date, the workers' compensation insurance
subsidiaries have not paid dividends to the Company.
General. Besides state insurance laws, the Company is subject to general
business and corporation laws, federal and state securities laws, consumer
protection laws, fair credit reporting acts and other laws regulating the
conduct and operation of its subsidiaries.
16
Employees
The Company had approximately 4,700 employees as of December 31, 1998. None of
these employees are covered by a collective bargaining agreement. The Company
believes that its relations with its employees are good.
ITEM 2. PROPERTIES
The Company owns several administrative facilities in southern Nevada totalling
approximately 406,000 square feet. Such facilities include an approximate
134,000 square foot six-story home office building and an approximate 43,000
square foot two-story corporate administrative headquarters. These buildings are
subject to liens securing an $800,000 loan balance from Bank of America. Also
included in this total is a 198,000 square foot six-story administrative
headquarters building which became fully occupied in 1998. This building was
financed in January 1998 and is subject to a $13.4 million loan balance. The
Company also owns several clinical facilities in the southern Nevada area
totalling approximately 396,000 square feet and consisting primarily of nine
medical clinics and two surgery centers. The Company leases additional office
and clinical space in Nevada totalling approximately 145,000 and 86,000 square
feet, respectively.
In conjunction with the Kaiser-Texas acquisition, the Company purchased eight
medical facilities totalling approximately 323,000 square feet and
administrative facilities totalling approximately 175,000 square feet. These
buildings are subject to a deed of trust note securing a $35.2 million note. In
addition, the Company leases additional office and clinical space in Texas
totalling approximately 54,000 square feet and 77,000 square feet, respectively.
The above properties are utilized primarily for the managed care operations. The
workers' compensation subsidiary is headquartered in Nevada and occupies
approximately 25% of the 198,000 square foot administrative building as well as
leases approximately 67,000 square feet of office space in California. The
Company leases approximately 150,000 square feet of office space in other
various states as needed for other regional operations, for TRICARE service
centers and for the military subsidiary's administrative headquarters.
The Company believes that current and planned clinical space will be adequate
for its present needs. Additional clinical space may be required, however, if
membership continues to expand in southern Nevada.
The Company owns real estate and a building in Park City, Utah purchased in 1996
to provide entertainment and a meeting environment for significant current and
prospective clients, brokers and others who assist in the Company's marketing
efforts.
ITEM 3. LEGAL PROCEEDINGS
The Company is subject to various claims and other litigation in the ordinary
course of business. Such litigation includes 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 members.
Also included in such litigation are claims for workers' compensation and claims
by providers for payment for medical services rendered to injured workers. The
litigation with Humana resulting from its acquisition of Physician Corporation
of America that was discussed in previous filings has been settled. In the
opinion of the Company's management, the ultimate resolution of pending legal
proceedings should not have a material adverse effect on the Company's financial
condition.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None
17
PART II
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER
MATTERS
Market Information
The Company's common stock, par value $.005 per share (the "Common Stock"), has
been listed on the New York Stock Exchange under the symbol SIE since April 26,
1994 and, prior to that, was listed on the American Stock Exchange since the
Company's initial public offering on April 11, 1985. The following table sets
forth the high and low sales prices for the Common Stock for each quarter of
1998 and 1997.
Period High Low
1998
First Quarter........................................ $26 7/8 $20 9/16
Second Quarter....................................... 27 37/64 23 1/4
Third Quarter........................................ 26 15 7/8
Fourth Quarter....................................... 24 15/16 17 15/16
1997
First Quarter........................................ $18 1/2 $16 5/12
Second Quarter....................................... 21 5/12 16 1/12
Third Quarter........................................ 24 11/12 20 19/24
Fourth Quarter....................................... 26 2/3 20 19/24
On February 26, 1999, the closing sale price of the common stock was $14 3/8 per
share.
Note: The above stock prices have been adjusted to account for the
three-for-two stock split of the Company's common stock to stockholders
of record as of May 18, 1998.
Holders
The number of record holders of Common Stock at February 26, 1999 was 254. Based
upon information available to it, the Company believes there are several
thousand beneficial holders of the Common Stock.
Dividends
No cash dividends have been paid on the Common Stock since the Company's
inception. The Company currently intends to retain its earnings for use in its
business and does not anticipate paying any cash dividends in the foreseeable
future. As a holding company, the Company's ability to declare and to pay
dividends is dependent upon cash distributions from its operating subsidiaries.
The ability of the Company's health maintenance organization ("HMO") and
insurance subsidiaries to declare and to pay dividends is limited by state
regulations applicable to the maintenance of minimum deposits, reserves and net
worth. (See Management's Discussion and Analysis of Financial Condition and
Results of Operations -- Liquidity and Capital Resources.) The declaration of
any future dividends will be at the discretion of the Company's Board of
Directors and will depend on, among other things, future earnings, debt
covenants, operations, capital requirements and the financial condition of the
Company and upon general business conditions.
18
ITEM 6. SELECTED FINANCIAL DATA
The following selected consolidated financial data of Sierra Health Services,
Inc., and subsidiaries (the "Company"), for each of the fiscal years in the
five-year period ended December 31, 1998 should be read in conjunction with the
Consolidated Financial Statements and the related Notes thereto, "Management's
Discussion and Analysis of Financial Condition and Results of Operations" and
other information which appears elsewhere in this Annual Report on Form 10-K.
The selected consolidated financial data below has been derived from the audited
Consolidated Financial Statements of the Company.
Years Ended December 31,
1998 1997 1996 1995 1994
(Amounts in thousands, except per share data)
Statement of Operations Data:
OPERATING REVENUES:
Medical Premiums............................................. $ 609,404 $513,857 $386,968 $319,475 $269,382
Specialty Product Revenues .................................. 148,368 146,211 133,324 102,807 101,287
Military Contract Revenues .................................. 204,838 4,346
Professional Fees............................................ 45,363 31,238 28,836 19,417 12,331
Investment and Other Revenues................................ 29,230 26,072 26,283 25,310 19,081
Total...................................................... 1,037,203 721,724 575,411 467,009 402,081
OPERATING EXPENSES:
Medical Expenses............................................. 513,209 419,272 315,915 245,135 200,229
Specialty Product Expenses................................... 142,258 143,082 130,758 102,859 96,600
General, Administrative and Marketing Expenses............... 110,687 93,919 72,237 63,562 53,671
Military Contract Expenses ................................. 196,625 4,193
Integration, Settlement and Other Costs (1) ................. 13,851 29,350 12,064 11,614
Total...................................................... 976,630 689,816 530,974 423,170 350,500
OPERATING INCOME ............................................... 60,573 31,908 44,437 43,839 51,581
INTEREST EXPENSE AND OTHER, NET................................. (7,181) (4,433) (2,823) (3,737) (6,401)
INCOME FROM CONTINUING OPERATIONS
BEFORE INCOME TAXES ....................................... 53,392 27,475 41,614 40,102 45,180
PROVISION FOR INCOME TAXES...................................... 13,796 3,234 10,471 12,198 8,236
INCOME FROM CONTINUING OPERATIONS............................... 39,596 24,241 31,143 27,904 36,944
LOSS FROM DISCONTINUED OPERATIONS .............................. (6,600) (2,501)
NET INCOME ..................................................... $ 39,596 $ 24,241 $ 31,143 $ 21,304 $ 34,443
EARNINGS PER COMMON SHARE (2):
Income from Continuing Operations Per Share ................. $1.45 $.90 $1.17 $1.07 $1.57
Loss Per Share from Discontinued Operations ................. (.25) (.11)
Net Income Per Share ........................................ $1.45 $.90 $1.17 $ .82 $1.46
Weighted Average Number of Common
Shares Outstanding ........................................ 27,391 27,013 26,589 26,121 23,517
EARNINGS PER COMMON SHARE ASSUMING
DILUTION (2):
Income from Continuing Operations Per Share ............. $1.43 $.88 $1.15 $1.05 $1.54
Loss Per Share from Discontinued Operations ............. ___ (.25) (.10)
Net Income Per Share .................................... $1.43 $.88 $1.15 $ .80 $1.44
Weighted Average Number of Common
Shares Outstanding Assuming Dilution ...................... 27,747 27,426 27,191 26,601 23,999
19
Years Ended December 31,
1998 1997 1996 1995 1994
(Amounts in thousands)
Balance Sheet Data:
Working Capital ............................................. $ 47,763 $ 88,377 $ 76,530 $ 18,157 $ 71,337
Total Assets................................................. 1,045,120 723,936 629,462 575,146 535,487
Long-term Debt (Net of Current Maturities)................... 242,398 90,841 66,189 71,257 75,209
Cash Dividends Per Common Share.............................. NONE NONE NONE NONE NONE
Stockholders' Equity......................................... 303,714 265,682 234,482 207,715 168,157
(1) The Company recorded certain identifiable integration, settlement and other
costs. See Note 14 of Notes to the Consolidated Financial Statements. (2)
Adjusted to account for three-for-two stock split of the Company's common stock
to stockholders of record as of May 18, 1998.
ITEM 7. 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 the Company's
consolidated financial condition and results of operations. The discussion
should be read in conjunction with the Consolidated Financial Statements and
Related Notes thereto. Any forward-looking information contained in this
Management's Discussion and Analysis of Financial Condition and Results of
Operations and any other sections of this 1998 Annual Report on Form 10-K should
be considered in connection with certain cautionary statements contained in the
Company's Current Report on Form 8-K filing dated March 17, 1999, incorporated
herein by reference. Such cautionary statements are made pursuant to the "safe
harbor" provisions of the Private Securities Litigation Reform Act of 1995 and
identify important risk factors that could cause the Company's actual results to
differ materially from those expressed in any projected, estimated or
forward-looking statements relating to the Company.
Acquisitions
On October 31, 1998, Sierra and one of its subsidiaries, Texas Health Choice,
L.C. (formerly HMO Texas L.C.) completed the acquisition of certain assets of
Kaiser Foundation Health Plan of Texas ("Kaiser- Texas"), a health plan
operating in Dallas/Ft. Worth with approximately 109,000 members, and Permanente
Medical Association of Texas ("Permanente"), a medical group with approximately
150 physicians. The purchase price was $124 million, which is net $20 million in
operating cost support to be paid to Sierra by Kaiser Foundation Hospitals in
five quarterly installments following the closing of the transaction. The
purchase price allocation includes a premium deficiency reserve of $25 million
for estimated losses on the contracts acquired from Kaiser-Texas. Of this
amount, $6.8 million was reversed in 1998 to offset losses on the acquired
contracts. The purchase price includes amounts for real estate and eight medical
and office facilities with approximately 500,000 square feet. In December 1998,
certain accreditation goals were met by the health plan resulting in a purchase
price increase of $3.0 million to $127 million. The purchase price may increase
up to an additional $27 million over three years if certain growth and member
retention goals are met by the health plan. Sierra assumed no prior liabilities
for malpractice or other litigation, or for any unanticipated future adjustments
to claims expenses for periods prior to closing. The transaction was financed
with a five-year revolving credit facility and a $35.2 million note payable to
Kaiser Foundation Health Plan of Texas. The note is secured by the acquired real
estate. Approximately $110 million of the $200 million revolving credit facility
was used to fund the transaction.
20
On December 31, 1998, Sierra completed the acquisition of the Nevada health care
business of Exclusive Healthcare, Inc., United of Omaha Life Insurance Company
and United World Life Insurance Company, all of which are subsidiaries of Mutual
of Omaha Insurance Company. The purchase price is contingent based on how many
members are retained through 2000 and 2001. No cash will be paid until group
renewals begin in 2000. Sierra retained approximately 9,000 members
(approximately 4,400 HMO members) subsequent to the acquisition.
In August 1997, the Company acquired the assets and operations of Total Home
Care, Inc. ("THC") for approximately $3.1 million, net of cash acquired. THC
provides home infusion, oxygen, and durable medical equipment services in Nevada
and Arizona. The Company sold the Arizona operations in the first quarter of
1998 for approximately $1.5 million. Also, in the first quarter of 1998, the
Company purchased three medical clinics in southern Nevada for approximately
$7.3 million.
Effective December 31, 1996, the Company purchased Prime Holdings, Inc.
("Prime") for approximately $32.2 million in cash. At December 31, 1996, Prime
operated MedOne Health Plan, Inc., a 12,800 member HMO, and also served 215,000
people through preferred provider organizations, workers' compensation programs,
and administrative services products for self-insured employers and union
welfare funds, primarily in the state of Nevada.
Overview
The Company derives revenues from its health maintenance organizations, managed
indemnity, military health care services and workers' compensation insurance
subsidiaries. To a lesser extent, the Company also derives additional specialty
product revenues from non-HMO and insurance products (consisting of fees for
workers' compensation administration, utilization management services and
ancillary products), professional fees (consisting primarily of fees for
providing health care services to non-members and co-payment fees received from
members), and investment and other revenue. Medical premium revenues accounted
for approximately 58.8%, 71.2% and 67.3% of the Company's total revenues for
1998, 1997 and 1996, respectively. The decrease in medical premiums as a
percentage of total revenues is primarily due to the addition of military
contract revenues. Continued medical premium revenue growth is principally
dependent upon continued enrollment in the Company's products and upon
competitive and regulatory factors.
The Company's principal expenses consist of medical expenses, military contract
expense, specialty product expenses, and general, administrative and marketing
expenses. Medical expenses represent the aggregate expenses of operating the
Company's multi-specialty medical group and other provider subsidiaries as well
as capitation fees and other fee-for-service payments paid to independently
contracted physicians, hospitals and other health care providers. As a provider
of managed care services, the Company seeks to manage medical expenses by
employing or contracting with physicians, hospitals and other health care
providers at negotiated price levels, by adopting quality assurance programs, by
monitoring and managing utilization of physicians and hospital services and by
providing incentives to use cost-effective providers. Military contract expenses
represent the expenses of delivering health care as agreed to in the TRICARE
contract with the federal government as well as administrative costs to operate
the military health care subsidiary. Specialty product expenses primarily
consist of losses and loss adjustment expenses, and underwriting expenses
associated with the Company's workers' compensation insurance subsidiaries.
General, administrative and marketing expenses generally represent operational
costs other than those associated with the delivery of health care services and
specialty product services.
On September 30, 1997, Sierra Military Health Services, Inc. ("SMHS") was
awarded a TRICARE contract to provide managed health care coverage to eligible
beneficiaries in Region 1. In June 1998, the Company began providing health care
benefits to approximately 606,000 individuals in Connecticut, Delaware, Maine,
Maryland, Massachusetts, New Hampshire, New Jersey, New York, Pennsylvania,
Rhode Island, Vermont,
21
Virginia, West Virginia and Washington, D.C. In 1998, the award resulted in a
total of $204.8 million of revenue for the final five-months of the
implementation phase and seven months of health care delivery. SMHS was notified
on February 13, 1998 that the United States General Accounting Office ("GAO")
sustained a competitor's protest of the contract award for TRICARE Managed Care
Support Region 1 and recommended that the contract be re-bid. In December 1998,
the Company reached an agreement to settle the protest. As part of the
settlement, the competitor will forego any and all rights it may have to
challenge the contract award and seek a re-bid (See Note 14 of Notes to the
Consolidated Financial Statements).
Integration, settlement and other expenses represent identifiable incremental
costs the Company has incurred primarily in connection with various mergers,
acquisitions and planned dispositions as well as expenses associated with the
Company's proposal to serve TRICARE beneficiaries in Region 1 and the ultimate
cost to settle a bid protest. Start-up expenses associated with the proposal to
serve TRICARE beneficiaries were charged to operations upon notification of
award.
Results of Operations
The following table sets forth selected operating data as a percentage of
revenues for the periods indicated:
Years Ended December 31,
1998 1997 1996
OPERATING REVENUES:
Medical Premiums........................................ 58.8% 71.2% 67.3%
Specialty Product Revenues ............................. 14.3 20.3 23.2
Military Contract Revenues 19.7 .6
Professional Fees....................................... 4.4 4.3 5.0
Investment and Other Revenues .......................... 2.8 3.6 4.5
Total................................................ 100.0 100.0 100.0
OPERATING EXPENSES:
Medical Expenses........................................ 49.5 58.1 54.9
Specialty Product Expenses.............................. 13.7 19.8 22.7
General, Administrative and Marketing Expenses.......... 10.7 13.0 12.6
Military Contract Expenses ............................. 19.0 .6
Integration, Settlement and Other Costs................. 1.3 4.1 2.1
Total................................................ 94.2 95.6 92.3
OPERATING INCOME ............................................ 5.8 4.4 7.7
INTEREST EXPENSE AND OTHER, NET.............................. (.7) (.6) (.5)
INCOME FROM CONTINUING OPERATIONS
BEFORE INCOME TAXES .................................... 5.1 3.8 7.2
PROVISION FOR INCOME TAXES................................... 1.3 .4 1.8
NET INCOME .................................................. 3.8% 3.4% 5.4%
22
1998 Compared to 1997
Revenues. The Company's total operating revenues for 1998 increased
approximately 43.7% to $1.04 billion from $721.7 million for 1997. The increase
was primarily due to military contract revenue of $204.8 million and an increase
in premium revenue of $95.5 million. The military contract revenue is a result
of the implementation of the TRICARE contract as well as the first seven months
of health care delivery. Revenue under the TRICARE contract is recorded based on
the contract price as agreed to by the federal government. The contract also
contains provisions which adjust the contract price based on actual experience.
The estimated effects of these adjustments are recognized on a monthly basis.
Medical premium revenue from the Company's HMO and managed indemnity insurance
subsidiaries increased $95.5 million, or 18.6%. Excluding the effect of the
Kaiser-Texas acquisition in the fourth quarter of 1998, premium revenue
increased $66.9 million, or 13.0%. The $66.9 million increase in premium revenue
reflects a 3.4% increase in member months (the number of months of each year
that an individual is enrolled in a plan). Medicare member months increased
20.1% which contributed to the increase in medical premium revenue. Such growth
in Medicare member months contributes significantly to the increase in premium
revenues as the Medicare per member premium rates are over three times higher
than the average commercial premium rate. The Company's premium rates increased
an average of 3% to 4% for its HMO commercial groups and in excess of 10% for
managed indemnity commercial groups. The Company also realized a slight increase
in its capitation rate established by Health Care Financing Administration
("HCFA"). Approximately 78% of the Company's Nevada Medicare members are
enrolled in the Social HMO Medicare program. HCFA is considering adjusting the
reimbursement factor for the Social HMO members in the future. If the
reimbursement for these members decreases significantly and related benefit
changes are not made timely, there could be a material adverse effect on the
Company's business.
Specialty product revenue increased $2.2 million, or 1.5%, for the year ended
December 31, 1998 compared to the prior year. The increase was due to revenue
growth of $5.1 million in the workers' compensation insurance operation offset
in part by a decrease in administrative services and other revenue of $2.9
million due primarily to the termination of the Company's workers' compensation
administrative services contract with the State of Nevada. The Company's
workers' compensation subsidiary signed a reinsurance agreement whereby a
greater portion of premium is ceded thus reducing revenue. The agreement results
in a reduction of specialty product expense as discussed later in this section.
Excluding the effect of the new reinsurance agreement, the workers' compensation
subsidiaries' revenue would have increased $21.2 million compared to the prior
year. Professional fee revenue increased approximately $14.1 million primarily
due to the January 1998 acquisition of the operations of two medical clinics in
southern Nevada and the clinics acquired in the Dallas/Ft. Worth area. In
addition approximately $3.5 million of the increase in professional fees was due
to the operations of Total Home Care, Inc. ("THC") which was acquired in August
1997.
Investment and other revenue increased approximately $3.2 million over the
comparable period in the prior year primarily due to an increase in invested
balances and capital gains realized on the sale of investments.
Medical and Specialty Product Expense. Medical expenses as a percentage of
medical premiums and professional fees ("Medical Care Ratio") increased from
76.9% to 78.4% for the year ended December 31, 1998 compared to the prior
period. The increase in the medical care ratio was due to an increase in
Medicare members as a percentage of fully-insured members, continued expansion
in Texas, northern Nevada and Arizona which have higher medical care ratios,
higher pharmacy costs and the acquisitions of THC and two medical clinics for
which costs of operations are included in medical expenses. The cost of
providing medical care to Medicare members generally requires a greater
percentage of the premiums received. Pharmacy costs increased as the management
of the pharmacy benefit was transitioned from a capitated pharmacy benefits
contract to in-house management in the third quarter of 1998. The costs
23
under such capitation contract were substantially below actual claims
experience. The medical care ratio is expected to further increase in 1999 due
to the changes in member mix and pharmacy costs noted above. Included in medical
expenses is the reversal of $4.4 million of premium deficiency reserve that was
used to offset losses on contracts from the Kaiser-Texas operations that were
acquired on October 31, 1998.
Specialty product expenses decreased approximately $800,000, or less than 1.0%,
due primarily to the implementation of the reinsurance agreement as discussed
previously. Specialty product revenue and expense is primarily related to the
workers' compensation insurance business. Effective January 1, 1998, workers'
compensation claims are reinsured between $500,000 and $100 million per
occurrence. For claims occurring on and after July 1, 1998, that are below
$500,000, the Company obtained quota share and excess of loss reinsurance. Under
this agreement, the Company reinsures 30% of the first $10,000 of each claim,
75% of the next $40,000 and 100% of the next $450,000. The Company receives a
ceding commission from the reinsurer as a partial reimbursement of operating
expenses. Excluding the effect of the reinsurance agreement, specialty product
expense would have increased $19.5 million compared to the prior year.
The combined ratio for the workers' compensation insurance business was 98.7%
compared to 101.9% for the comparable prior year period. The reduction was due
to a 198 basis point decrease in the loss ratio and a 122 basis point decrease
in the expense ratio. The decrease in the loss ratio was largely due to the new
reinsurance agreement for losses occurring on and after July 1, 1998 and as a
result of the Company's ability to overlay and implement managed care techniques
to the workers' compensation claims. The combined ratio excluding the effect of
the new reinsurance agreement was 101.6% for the year ended December 31, 1998.
In addition, favorable loss development on prior accident years totalled $9.6
million for the year ended December 31, 1998, compared to net favorable loss
development of $9.0 million for the comparable prior year period. The favorable
loss development is largely due to actual paid losses being below projected
losses. There can be no assurance that favorable development, or the magnitude
thereof, will continue in the future. The reduction in the expense ratio was
largely due to a reduction in agents' commissions, as a result of a ceding
commission related to the new reinsurance agreement and from lower salaries and
related benefits expenses. The losses and loss adjustment expense ratio for the
year ended December 31, 1998 reflect the Company's current projection of the
ultimate costs of claims occurring in the current as well as prior accident
years. Such projections are subject to change and any change would be reflected
in the income statement. Workers' compensation claims are paid over several
years. Until payment is made, the Company invests the monies, earning a yield on
the invested balance.
Military Contract Expense. The military contract expense is comprised of those
expenses incurred in 1998 for five months of contract implementation and seven
months of health care delivery. This expense consists primarily of costs to
provide managed health care services to eligible beneficiaries in accordance
with the Company's TRICARE contract. Under the contract, SMHS provides health
care services to approximately 606,000 dependents of active duty military
personnel and military retirees and their dependents through subcontractor
partnerships and individual providers. Health care costs are recorded in the
period when services are provided to eligible beneficiaries, including estimates
for provider costs which have been incurred but not reported to the Company.
Also, included in military contract expense are costs incurred to perform
specific administrative services, such as health care appointment scheduling,
enrollment, network management and health care advice line services, and other
administrative functions of the military health care subsidiary.
General, Administrative and Marketing Expenses. General, administrative and
marketing ("G&A") cost increased $16.8 million, or 17.9%, compared to 1997. As a
percentage of revenues, G&A costs for 1998 decreased to 10.7% from 13.0% during
1997. The decrease in the G&A ratio is primarily due to the addition of military
contract revenues offset in part by costs for additional infrastructure needed
to support overall Company growth. Excluding military revenues, G&A as a
percentage of revenues was 13.3% in 1998. Of the $16.8 million increase in G&A,
$3.2 million was due to additional G&A related to the acquired HMO business in
the Dallas/Ft. Worth area. The remaining increase of $13.6 million consisted of
$3.8
24
million increased compensation expense, resulting primarily from additional
employees supporting expanded services and new benefit programs for management.
Broker, third party administration and premium tax expense increased
approximately $900,000 due to increased membership. In addition, depreciation
expense increased $1.7 million.
Integration, Settlement and Other Costs. In the fourth quarter of 1998, the
Company expensed approximately $13.9 million, $10.3 million after tax, of costs
primarily associated with the settlement of the protest pertaining to its
military services contract as well as costs associated with the integration of
the Kaiser-Texas business acquired October 31, 1998 (see Note 14 to the
Consolidated Financial Statements).
On March 18, 1997, the Company announced it had terminated its merger agreement
with Physician Corporation of America, Inc. and recorded expenses of $11.0
million, $8.4 million after tax, for merger- related costs. During the third
quarter of 1997 SMHS was awarded a contract to serve TRICARE eligible
beneficiaries in Region 1. Development expenses of $18.4 million, $10.6 million
net of taxes, were recorded in the third quarter primarily for expenses
associated with the Company's proposal to serve TRICARE Region 1. Such expenses
had been deferred until award notification.
Interest Expense and Other. Interest expense and other increased approximately
$2.7 million for the year ended December 31, 1998, compared to the same period
in the prior year due to an increase in debt as a result of the Kaiser-Texas
acquisition.
Income Taxes. For the period, the Company recorded approximately $13.8 million
of tax expense for an effective tax rate of 25.8% compared to 23.9% in 1997,
excluding the tax effects of identifiable integration, settlement and other
costs. The Company's current low operating tax rate is primarily a result of
tax-preferred investments and the change in the deferred tax valuation
allowance,
which is due primarily to the ability to use a portion of net operating loss
carryovers. The effective tax rate will increase to the 32% to 34% range in 1999
as most of the valuation allowances for net operating loss carryforwards have
been utilized as of December 31, 1998.
1997 Compared to 1996
Revenues. The Company's total operating revenues for 1997 increased 25.4% to
$721.7 million from $575.4 million for 1996. The increase was primarily due to
medical premium revenue increases of approximately $126.9 million, or 32.8%,
from the Company's HMO and managed indemnity insurance subsidiaries. Such
premium growth resulted principally from an approximate 30.3% increase in member
months. The Company's HMO and insurance subsidiaries' premium rates increased
approximately 2.5%, primarily due to an increase in its capitation rate for its
Medicare members as established by HCFA. The increase was due in part to the
Company's participation in HCFA's social HMO program. The Company realized 1% to
3% rate increases for its existing HMO subsidiaries' commercial groups and the
managed indemnity subsidiary. However, these increases were offset in part by
lower premium rates at MedOne Health Plan, an HMO acquired on December 31, 1996.
The Company's specialty product revenue increased $12.9 million, or 9.7%, to
$146.2 million in 1997 from $133.3 million in 1996. The increase was due to
specialty product revenue growth in the workers' compensation insurance market
of approximately $8.3 million and an increase in administrative services and
other of $4.6 million due primarily to the acquisition of Prime Health, Inc., at
the end of 1996. Some of this increase will be offset in the future by the loss
of a portion of the state of Nevada's self-insured medical business. Also,
effective September 30, 1997, the Company terminated its workers' compensation
administrative services contract with the state of Nevada. The contract served
approximately 200,000 enrollees and provided approximately $3.2 million in
revenues for the year ended December 31, 1997. The contract was terminated to
allow the Company to participate in the Nevada workers' compensation insurance
market when the state allows private insurance companies to begin offering
products, which is anticipated for 1999. Professional fees increased $2.4
million, or 8.3%, over 1996 to $31.2 million. This increase is due in part to
the acquisition of the
25
assets and operations of THC during the third quarter of 1997. THC provides home
infusion, oxygen and durable medical equipment services in Nevada and Arizona.
During the fourth quarter of 1997, SMHS began the implementation period of its
TRICARE contract. The military contract revenue of $4.3 million is a result of
this contract. Investment and other revenue was consistent with the prior year.
Medical and Specialty Product Expenses. Total medical expenses increased by
$103.4 million in 1997 compared to 1996. This 32.7% increase resulted from the
consolidated member month growth discussed previously. The Medical Care Ratio
increased from 76.0% to 76.9% due primarily to member growth and expansion in
areas with higher medical expenses, such as northern Nevada and Texas. In
addition, MedOne Health Plan has a higher Medical Care Ratio, which further
contributed to the increase in the Company's overall Medical Care Ratio.
Specialty product expenses increased $12.3 million, or 9.4%, over 1996. This
increase is due primarily to the increase in workers' compensation premiums
noted above. Specialty product revenue and expense is primarily related to the
workers' compensation insurance business.
The combined ratio for the workers' compensation insurance business was 101.9%
for the year ended December 31, 1997, compared to 103.2% for the comparable
prior year period. The reduction was due to a 40 basis point decrease in the
loss ratio along with a 90 basis point decrease in the expense ratio. Compared
to the prior year period, incurred losses for the current accident year were
reduced as a result of the Company's ability to overlay and implement managed
care techniques to the workers' compensation claims. In addition, the Company
had net favorable loss development on prior accident years totaling $9.0 million
compared to net favorable loss development of $15.3 million for the comparable
prior year period. The favorable development is largely due to actual paid
losses being below projected losses. The majority of the favorable loss
development occurred on the 1992 through 1995 accident years. There can be no
assurances that favorable development, or the magnitude thereof, will continue
in the future. The losses and loss adjustment expense ratio for the year ended
December 31, 1997 reflects the Company's current projection of the ultimate
costs of claims occurring in the current as well as prior accident years. Such
projections are subject to change and any change would be reflected in the
income statement. Workers' compensation claims are paid over several years.
Until payment is made, the Company invests the monies, earning a yield on the
invested balance.
General, Administrative and Marketing Expenses. G&A costs increased $21.7
million, or 30.0%, for the twelve months ended December 31, 1997 compared to the
twelve months ended December 31, 1996. As a percentage of revenues, G&A costs
for the twelve months ended December 31, 1997 increased to 13.0% from 12.6%
during the comparable period in 1996. Of the $21.7 million increase in G&A, $8.6
million was in compensation costs primarily resulting from additional employees
supporting expanded services and increased incentive amounts for management.
Broker, third-party administration, and premium tax expenses increased
approximately $8.5 million due to increased membership. Amortization and
depreciation costs increased approximately $1.9 million primarily due to the
amortization of goodwill resulting from the Prime acquisition. The remaining G&A
increase was due to additional expenses in several areas including data
processing maintenance.
Military Contract Expense. During the fourth quarter of 1997, SMHS began
the implementation period of its TRICARE contract. The military contract expense
is a result of this contract.
Integration, Settlement and Other Costs. On March 18, 1997, the Company
announced it had terminated its merger agreement with Physician Corporation of
America, Inc. and recorded and paid expenses of approximately $11.0 million,
$8.4 million after tax, for merger-related costs.
During the third quarter of 1997, SMHS, a wholly owned subsidiary of the
Company, was awarded a contract to serve TRICARE eligible beneficiaries in
Region 1. This region includes approximately 606,000 TRICARE beneficiaries in 13
northeastern states and the District of Columbia. Development expenses of
26
$18.4 million, $10.6 million net of taxes, were recorded in the third quarter
primarily for expenses associated with the Company's proposal to serve eligible
beneficiaries in Region 1.
During 1995, as part of the Company's clinical expansion and growth efforts, the
Company acquired a medical facility in Mohave County, Arizona, across the border
from Laughlin, Nevada. This medical facility included a 12-bed hospital. During
1996, the Company implemented a plan to exit the hospital business and has
actively pursued buyers for this business. As a result of this plan, the Company
recorded a charge of $3.8 million, ($2.9 million after tax) in the fourth
quarter of 1996, primarily to recognize the estimated costs to dispose of the
hospital. As of December 31, 1998, the Company has been unable to reach an
agreement to sell the hospital.
As a result of higher than expected claim and administrative costs relative to
premium rates that can be obtained in certain regional insurance operations and
the Company's inability to negotiate adequate provider contracts due to its
limited presence in some of these markets, the Company adopted a plan to
restructure certain insurance operations during the third quarter of 1996 and
recorded a charge of $8.3 million, ($6.2 million after tax). These restructuring
costs included cancellation of certain contractual obligations of $6.0 million,
lease termination costs of $1.5 million and approximately $750,000 of other
costs.
Interest Expense and Other. Interest expense and other increased approximately
$1.6 million over the prior year primarily due to the $2.1 million benefit for
minority interests recorded in 1996, offset in part by an increase in
capitalized interest related to various construction projects in 1997. In
November 1996, the Company acquired complete ownership of a Texas HMO in which
it had previously held a 50% interest. That HMO began business in March 1995 and
experienced losses in both years. In the prior year, a portion of these losses
resulted in a benefit from minority interests.
Income Taxes. The Company's effective tax rate for the year ended December 31,
1997 was 11.8%, compared to 25.2% in 1996. The difference between the Company's
effective tax rate and the current federal tax rate is due primarily to a $4.7
million tax benefit recorded as a result of a reduction of the deferred tax
valuation allowance and the Company's portfolio of tax preferred investments.
These benefits are more significant as a result of the charges related to the
Physicians Corporation of America acquisition and start-up costs associated with
the TRICARE contract. Excluding these costs, the effective tax rate for 1997 is
23.9%. See Note 9 of Notes to Consolidated Financial Statements.
LIQUIDITY AND CAPITAL RESOURCES
The Company's cash flow from operating activities of $50.1 million during the
twelve months ended December 31, 1998 resulted primarily from $39.6 million of
net income, $19.3 million in depreciation and amortization and $6.4 million in
provision for doubtful accounts offset by a $15.2 million decrease in cash flows
from changes in assets and liabilities. The decrease in cash flow resulting from
the change in assets and liabilities was primarily due to an increase in
reinsurance recoverable and military accounts receivable. The increase in
reinsurance recoverable is primarily due to the new reinsurance agreement
implemented by the Company's workers' compensation subsidiary for claims
occurring on or after July 1, 1998 that are below $500,000 (see Note 6 to the
Consolidated Financial Statements). Military accounts receivable increased due
to the implementation of health care delivery in 1998. Military accounts
receivable consists primarily of one month's contract payment from the
government in arrears, estimates of bid price adjustments ("BPAs") under the
contract based on actual experience and any change orders not originally
specified in the contract. These cash outflows were offset in part by increases
in military health care payable and other current liabilities. The increase in
military health care payable is a result of health care delivery beginning June
1, 1998 for the Region 1 TRICARE contract. Military health care payable includes
the estimated cost for unpaid claims for which health care services have been
provided to TRICARE eligibles and a provision of the estimated costs for claims
that have been incurred but have not been
27
reported. The increase in other current liabilities is primarily due to expenses
related to operations of the military services subsidiary and reinsurance
premiums payable due to the new reinsurance contract.
SMHS receives monthly cash payments equivalent to one-twelfth of its annual
contractual price with the Department of Defense ("DOD") and 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. Approximately $34 million
of the military accounts receivable balance is associated with monies owed to
SMHS as a result of providing health care services for a larger than expected
beneficiary population. SMHS expects to receive this amount at the completion of
the first BPA. The BPA process serves to adjust the DOD's monthly payments to
SMHS, because such payments are based in part on 1996 DOD estimates for:
beneficiary population, beneficiary population baseline health care cost,
inflation and military direct care system utilization. As actual information is
made available for the above items, quarterly adjustments are made to SMHS'
monthly health care payment in addition to a lump sum adjustment for past
months. SMHS accrues for such adjustments on a monthly basis as actual
information is made available. The first such adjustment did not occur as
scheduled on February 28, 1999 (SMHS anticipates additional DOD delays of up to
6 months). If the timing or amount of the BPA reimbursement varies significantly
from the Company's expectations, there could be a material adverse effect on the
Company's business and cash flows.
Net cash used for investing activities during 1998 included $40.7 million in
capital expenditures for construction costs associated with office facilities,
furniture and equipment for the newly constructed six-story administrative
headquarters building, continued implementation of three new computer systems,
computer and medical equipment, other capital needs to support the Company's
growth, and a $24.2 million net increase in investments. In addition,
approximately $111.4 million of cash was used to purchase the Dallas, Texas
operations of Kaiser Foundation Health Plan.
Cash flows from financing activities included net proceeds from long-term
borrowings (proceeds less payments) of $113.1 million. The majority of net
proceeds from long-term borrowings was used to fund the Kaiser-Texas
acquisition. The transaction was financed with a five-year revolving credit
facility. As of December 31, 1998, the Company had $139 million in borrowings on
the $200 million line of credit. Interest under the credit facility is variable
and based on the London Interbank Offering Rate ("LIBOR") plus a margin
determined by reference to the Company's leverage ratio. In addition, $50
million of the outstanding balance is covered by interest-rate swap agreements.
The average cost of borrowing on this line of credit for the fourth quarter of
1998, including the impact of the swap agreements, was approximately 8.0%. The
terms of the credit facility contain a mandatory payment schedule that begins on
June 30, 2001 and ends on September 30, 2003 if the principal balance exceeds
certain thresholds. The terms of the credit facility contain certain covenants
including a minimum fixed charge coverage ratio and a maximum leverage ratio.
The remaining $61 million available balance on the line of credit as of December
31, 1998, may be used for general corporate purposes, including working capital.
During 1998 and 1997, the Company used $9.2 million and $5.5 million,
respectively, to buy back Company stock on the open market.
In the second quarter of 1997, the Company's Board of Directors authorized a
$3.0 million line of credit from the Company to the Company's Chief Executive
Officer ("CEO"). The CEO borrowed a total of $650,000 in 1998 and $2 million in
1997 at an interest rate equal to the LIBOR Offering Rate plus 53 basis points.
During the first quarter of 1999, the CEO repaid approximately $360,000 of the
line of credit. The line of credit is collateralized by certain of the CEO's
rights to compensation from the Company and is due and payable no later than
August 15, 1999.
In September 1991, CII issued convertible subordinated debentures (the
"Debentures") due September 15, 2001. The Debentures bear interest at 7 1/2%
which is due semi-annually on March 15 and September 15.
28
Each $1,000 in principal is convertible into 25.382 shares of the Company's
common stock at a conversion price of $39.40 per share. Unamortized issuance
costs of $500,000 are included in other assets on the balance sheet and are
being amortized over the life of the Debentures. The Debentures are general
unsecured obligations of CII only and are not guaranteed by Sierra Health
Services, Inc. ("Sierra"). During the twelve months ended December 31, 1998, the
Company purchased $3.2 million of the Debentures on the open market.
The holding company may receive dividends from its HMO and insurance
subsidiaries which generally must be approved by certain state insurance
departments. The Company's 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 Company had restricted assets on deposit in
various states totaling $17.8 million as of December 31, 1998. The HMO and
insurance subsidiaries must also meet requirements to maintain minimum
stockholder's equity, on a statutory basis, ranging from $1.1 million to $5.2
million. In addition, in conjunction with the Kaiser-Texas acquisition, Texas
Health Choice, L.C. ("TXHC") entered into a letter agreement with the Texas
Department of Insurance whereby TXHC agreed to maintain a net worth of $20.0
million. Of the cash and cash equivalents held at December 31, 1998, $81.3
million is designated for use only by the regulated subsidiaries. Such 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. Remaining amounts are
generally available on an unrestricted basis.
The National Association of Insurance Commissioners has adopted new minimum
capitalization requirements for HMOs, health care insurance entities and other
risk-bearing health care entities. Depending on the nature and extent of the new
minimum capitalization requirements ultimately adopted by each state, there
could be an increase in the capital required for certain of the Company's
regulated subsidiaries. The Company intends to fund any increase from available
parent company cash reserves; however, there can be no assurance that such cash
reserves will be sufficient to fund these minimum capitalization requirements.
The new requirements are expected to be effective on or before December 31, 1999
upon enactment by each state. The Company does not believe that any such
required increase in the amount of funds to be contributed to the subsidiaries
will be material.
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.
The Company has a 1999 capital budget of approximately $60 million, primarily
for computer hardware and software, furniture and equipment and other
requirements due to the Company's computer system conversion and projected
growth and expansion. The Company's liquidity needs over the next 12 months will
primarily be for the capital items noted above, the Company's stock repurchase
program, debt service and expansion of the Company's operations, including
potential acquisitions. The Company believes that existing working capital,
operating cash flow and, if necessary, mortgage financing, equipment leasing,
and amounts available under its credit facility will be sufficient to fund its
capital expenditures and debt service. Additionally, subject to unanticipated
cash requirements, the Company believes that its existing working capital and
operating cash flow and, if necessary, its access to new credit facilities, will
enable it to meet its liquidity needs on a longer term basis.
Year 2000
The Year 2000 issue exists because many computer systems and applications
currently use two-digit date fields to designate a year. As the century date
change occurs, date-sensitive systems will recognize the year 2000 as 1900, or
not at all. This inability to recognize or properly treat the Year 2000 may
cause systems to process critical financial and operational information
incorrectly.
29
The Company is currently in the process of modifying or replacing its mission
critical financial and operational computer systems. The Company is also in the
process of testing its non-information system technology for Year 2000
compliance. The Year 2000 project has been broken down into five phases: (1)
inventorying Year 2000 items; (2) assessing the Year 2000 items that are
determined to be material to the Company; (3) renovating or replacing material
items that are determined not to be Year 2000 compliant; (4) testing and
validating material items; and (5) implementing renovated and validated systems.
At December 31, 1998, the inventory and assessment phases are substantially
complete as it relates to all material computer systems and approximately 50%
complete as it relates to non-information system technology. The Company
estimates that the replacement/renovation phases and the testing/validation
phases will be 95% complete by October 31, 1999. The Company estimates that it
is approximately 50% complete with the total project as of December 31, 1998.
Contingency planning for the mission critical business operations is scheduled
to be completed by April 1999. These plans focus on business operations
involving information systems and non-information systems technologies.
The Company has initiated formal communications with entities with whom it does
business to assess their Year 2000 issues. Evaluations of the most critical
third parties have been initiated, and follow-up reviews will be conducted
through 1999. Contingency plans are being developed based on these evaluations
and are expected to be completed by the middle of 1999. There can be no
assurances that the systems of other companies or governmental agencies, such as
HCFA and the Department of Defense ("DOD"), on which the Company relies will be
timely modified for Year 2000, or that the failure to modify by another company
would not have a material adverse effect on the Company. Based upon two separate
reports issued by the United States General Accounting Office it is doubtful
that the computer systems at both HCFA and the DOD will be fully Year 2000
compliant by the end of 1999. The Company does not currently have available data
to predict the impact of such non-compliance on its business operations. Should
there be any material delays caused by Year 2000 issues, the Company anticipates
that the governmental entities will make estimated payments.
The Company is in the process of implementing three major systems at an
estimated cost of $36 million to $38 million, which includes the implementation
costs related to the recently acquired Kaiser-Texas operations. To date the
Company has spent approximately $19.0 million on the new computer systems and
other Year 2000 items. The Company is expensing the costs to make modifications
to existing computer systems and non-computer equipment. Management currently
estimates the remaining new computer system costs and other Year 2000 costs to
be $13.0 million to $16.0 million for operations in existence prior to the
Kaiser-Texas transaction and $6.0 million to $8.0 million for the Kaiser-Texas
operations that were acquired on October 31, 1998. While this is a substantial
effort, it will give the Company the benefits of new technology and
functionality for many of its financial and operational computer systems and
applications.
The failure to correct a material Year 2000 problem could result in an
interruption of, or a failure of, certain business activities or operations.
Such failures could materially adversely affect the Company's operations,
liquidity and financial condition. Due to the general uncertainty inherent in
the Year 2000 problem, resulting in part from uncertainty of the Year 2000
readiness of third parties with which the Company does business, the Company is
unable to determine at this time whether the consequences of potential Year 2000
failures will have a material adverse impact on the Company's results of
operations, liquidity or financial condition. The Company's Year 2000 project is
expected to significantly reduce the Company's level of uncertainty about the
Year 2000 problem. The Company believes that, with the implementation of the new
computer systems and completion of the entire project as scheduled, the
possibility of significant interruptions of operations should be reduced.
The above contains forward-looking statements including, without
limitation, statements relating to the Company's plans, strategies, objectives,
expectations, intentions, and adequate resources, that are made pursuant to the
"safe harbor" provisions of the Private Securities Litigation Reform Act of
1995. Readers
30
are cautioned that forward-looking statements contained in the Year 2000
disclosure should be read in conjunction with the following disclosure of the
Company:
The costs of the project and the dates on which the Company plans to complete
the necessary Year 2000 modifications are based on management's best estimates,
which were derived utilizing numerous assumptions of future events including the
continued availability of certain resources and other factors. However, there
can be no guarantee that these estimates will be achieved and actual results
could differ materially from those plans. Specific factors that might cause such
material differences include, but are not limited to, the availability and cost
of personnel trained in this area, the ability to locate and correct all
relevant computer codes, the ability of the Company's significant suppliers,
customers and others with which it conducts business, including federal and
state governmental agencies, to identify and resolve their own Year 2000 issues
and similar uncertainties.
Inflation
Health care costs continue to rise at a faster rate than the Consumer Price
Index. The Company uses various strategies to mitigate the negative effects of
health care cost inflation, including setting commercial premiums based on its
anticipated health care costs, risk-sharing arrangements with the Company's
various health care providers, and other health care cost containment measures.
There can be no assurance, however, that, in the future, the Company's ability
to manage medical costs will not be negatively impacted by items such as
technological advances, competitive pressures, applicable regulations, increases
in pharmacy costs, utilization changes and catastrophic items, which could, in
turn, result in medical cost increases equaling or exceeding premium increases.
Government Regulation
The Company's business, offering health care coverage, health care management
services, workers' compensation programs and, to a lesser extent, the delivery
of medical services, is heavily regulated at both the federal and state levels.
Government regulation of health care coverage products and services is a
changing area of law that varies from jurisdiction to jurisdiction. Changes in
applicable laws and regulations are continually being considered and
interpretation of existing laws and rules also may change from time to time.
Regulatory agencies generally have broad discretion in promulgating regulations
and in interpreting and enforcing laws and regulations.
While the Company is unable to predict what regulatory changes may occur or the
impact on the Company of any particular change, the Company's operations and
financial results could be negatively affected by regulatory revisions. For
example, any proposals affecting underwriting practices, limiting rate
increases, requiring new or additional benefits or affecting contracting
arrangements (including proposals to require HMOs and PPOs to accept any health
care providers willing to abide by an HMO's or PPO's contract terms) may have a
material adverse effect on the Company's business. The continued consideration
and enactment of "anti-managed care" laws and regulations by federal and state
bodies may make it more difficult for the Company to manage medical costs and
may adversely affect financial results.
In addition to changes in applicable laws and regulations, the Company is
subject to various audits, investigations and enforcement actions. These include
possible government actions relating to the federal Employee Retirement Income
Security Act, which regulates insured and self-insured health coverage plans
offered by employers, the Federal Employees Health Benefit Plan, federal and
state fraud and abuse laws, and laws relating to utilization management and the
delivery of health care. Any such government action could result in assessment
of damages, civil or criminal fines or penalties, or other sanctions, including
31
exclusion from participation in government programs. In addition, disclosure of
any adverse investigation or audit results or sanctions could negatively affect
the Company's reputation in various markets and make it more difficult for the
Company to sell its products and services.
Recently Issued Accounting Standards
In March 1998, the Accounting Standards Executive Committee of the American
Institute of Certified Public Accountants ("AcSEC") issued Statement of Position
98-1 ("SOP 98-1"), "Accounting for the Costs of Computer Software Developed For
or Obtained For Internal Use". SOP 98-1 requires certain computer software costs
to be capitalized and amortized over the software's estimated useful life. In
June 1998, the AcSEC issued Statement of Position 98-5 ("SOP 98-5"), "Reporting
on the Costs of Start-Up Activities". This standard requires organization costs
and costs associated with start-up activities to be expensed as incurred. Both
statements are effective for years beginning after December 15, 1998. The
Company will adopt SOP 98-1 and SOP 98-5 for the fiscal year ending December 31,
1999 and does not believe these statements will have a material impact on its
financial statements.
In June 1998, The Financial Accounting Standards Board issued "Accounting for
Derivative Instruments and Hedging Activities" ("FAS 133"). FAS 133 is effective
for fiscal years beginning after June 15, 1999. FAS 133 addresses the accounting
for derivative instruments including certain derivative instruments embedded in
other contracts, and hedging activities. The Company does not believe this
statement will have a material impact on its financial statements.
ITEM 7a. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
As of December 31, 1998, the Company has approximately $392 million in cash and
cash equivalents, and short-term, long-term and restricted investments. Of the
investments, approximately $254.6 million is classified as available-for-sale
investments and $54.0 million is classified as held-to-maturity investments.
These investments are primarily in fixed income, investment grade securities.
The Company's investment policies emphasize return of principal and liquidity
and are focused on fixed returns that limit volatility and risk of principal.
Because of the Company's investment policies, the primary market risk associated
with the Company's portfolio is interest rate risk.
Assuming an immediate 10% increase in interest rates, the net hypothetical loss
in fair value of shareholders' equity related to financial instruments is
estimated to be approximately $7.5 million (after tax) (2.5% of total
shareholders' equity). The Company believes that such an increase in interest
rates would not have a material impact on future earnings or cash flows as it is
unlikely that the Company would need or choose to substantially liquidate its
investment portfolio.
The effect of interest rate risk on potential near-term net income, cash flow
and fair value was determined based on commonly used sensitivity analyses. The
models project the impact of interest rate changes on a wide range of factors,
including duration and prepayment. Fair value was estimated based on the net
present value of cash flows or duration estimates, assuming an immediate 10%
increase in interest rates.
As of December 31, 1998, the Company had approximately $139 million in
borrowings outstanding under a revolving credit facility that was entered into
in October 1998. Interest under the credit facility is variable and based on the
London Interbank Offering Rate plus a margin, except for $50 million of the
outstanding balance that is covered by interest-rate swap agreements. The
average cost of borrowing on this line of credit was approximately 8% for the
fourth quarter of 1998. If the average cost of borrowing on the amount
outstanding as of December 31, 1998, was to increase by 10%, annual income
before tax would decrease by approximately $900,000.
32
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
INDEX TO FINANCIAL STATEMENTS
Page
Management Report on Consolidated Financial Statements.................................................... 34
Independent Auditors' Report.............................................................................. 35
Consolidated Balance Sheets at December 31, 1998 and 1997................................................. 36
Consolidated Statements of Operations for the Years Ended
December 31, 1998, 1997, and 1996...................................................................... 37
Consolidated Statements of Changes in Stockholders' Equity
for the Years Ended December 31, 1998, 1997 and 1996................................................... 38
Consolidated Statements of Cash Flows for the Years Ended
December 31, 1998, 1997, and 1996...................................................................... 39
Notes to Consolidated Financial Statements................................................................ 40
33
MANAGEMENT REPORT ON CONSOLIDATED FINANCIAL STATEMENTS
The management of Sierra Health Services, Inc., is responsible for the integrity
and objectivity of the accompanying Consolidated Financial Statements. The
statements have been prepared in conformity with generally accepted accounting
principles applied on a consistent basis and are not misstated due to fraud or
material error. The statements include some amounts that are based upon the
Company's best estimates and judgment.
The accounting systems and controls of the Company are designed to provide
reasonable assurance that transactions are executed in accordance with
management's authorization, that the financial records are reliable for
preparing financial statements and maintaining accountability for assets, and
that assets are safeguarded against losses from unauthorized use or disposition.
Management believes that for the year ended December 31, 1998, such systems and
controls were adequate to meet the objectives discussed herein.
The accompanying Consolidated Financial Statements have been audited by
independent certified public accountants, whose audits thereof were made in
accordance with generally accepted auditing standards and included a review of
internal accounting controls to the extent necessary to design audit procedures
aimed at gathering sufficient evidence to provide a reasonable basis for their
opinion on the fairness of presentation of the Consolidated Financial Statements
taken as a whole.
The Audit Committee of the Board of Directors, comprised solely of directors
from outside the Company, meets regularly with management and the independent
auditors to review the work procedures of each. The independent auditors have
free access to the Audit Committee, without management being present, to discuss
the results of their opinions on the adequacy of the Company's accounting
controls and the quality of the Company's financial reporting. The Board of
Directors, upon the recommendation of the Audit Committee, appoints the
independent auditors, subject to stockholder ratification.
Anthony M. Marlon, M.D.
Chairman and
Chief Executive Officer
Paul H. Palmer
Vice President, Finance
Chief Financial Officer,
and Treasurer
34
INDEPENDENT AUDITORS' REPORT
Board of Directors
Sierra Health Services, Inc.:
We have audited the accompanying consolidated balance sheets of Sierra Health
Services, Inc., and its subsidiaries as of December 31, 1998 and 1997, and the
related consolidated statements of operations, stockholders' equity, and cash
flows for each of the three years in the period ended December 31, 1998. Our
audits also included the financial statement schedules listed in the index at
Item 14 (a)(2). These financial statements and financial statement schedules are
the responsibility of the Company's management. Our responsibility is to express
an opinion on these financial statements and financial statement schedules based
on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, such consolidated financial statements present fairly, in all
material respects, the financial position of Sierra Health Services, Inc. and
its subsidiaries at December 31, 1998 and 1997, and the results of their
operations and their cash flows for each of the three years in the period ended
December 31, 1998 in conformity with generally accepted accounting principles.
Also, in our opinion, such financial statement schedules when considered in
relation to the basic consolidated financial statements taken as a whole,
present fairly in all material respects the information set forth therein.
DELOITTE & TOUCHE LLP
Las Vegas, Nevada
February 8, 1999
35
SIERRA HEALTH SERVICES, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
December 31, 1998 and 1997
ASSETS
1998 1997
CURRENT ASSETS:
Cash and Cash Equivalents.............................................. $ 83,910,000 $ 96,841,000
Short-term Investments................................................. 110,008,000 115,498,000
Accounts Receivable (Less: Allowance for Doubtful
Accounts 1998 - $10,540,000 ; 1997 - $7,916,000)................... 44,100,000 37,695,000
Military Accounts Receivable........................................... 69,552,000 4,346,000
Current Portion of Deferred Tax Asset ................................. 14,311,000 15,496,000
Reinsurance Recoverable................................................ 32,076,000 5,159,000
Prepaid Expenses and Other Current Assets.............................. 39,974,000 25,571,000
Total Current Assets............................................... 393,931,000 300,606,000
PROPERTY AND EQUIPMENT, NET................................................ 229,164,000 148,831,000
LONG-TERM INVESTMENTS...................................................... 180,816,000 155,153,000
RESTRICTED CASH AND INVESTMENTS............................................ 17,758,000 16,540,000
REINSURANCE RECOVERABLE, Net of Current Portion............................ 34,946,000 20,245,000
GOODWILL (Less: Accumulated Amortization
1998 - $5,213,000; 1997 - $2,898,000)............................. 142,471,000 42,803,000
OTHER ASSETS............................................................... 46,034,000 39,758,000
TOTAL ASSETS............................................................... $1,045,120,000 $723,936,000
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES:
Accounts Payable and Accrued Liabilities.................................. $ 69,284,000 $ 43,601,000
Accrued Payroll and Taxes................................................. 19,942,000 14,838,000
Medical Claims Payable.................................................... 78,022,000 55,943,000
Current Portion of Reserve for
Losses and Loss Adjustment Expense .................................. 79,869,000 63,358,000
Unearned Premium Revenue.................................................. 39,968,000 29,763,000
Military Health Care Payable.............................................. 53,820,000
Current Portion of Long-term Debt......................................... 5,263,000 4,726,000
Total Current Liabilities............................................ 346,168,000 212,229,000
RESERVE FOR LOSSES AND
LOSS ADJUSTMENT EXPENSE (Less Current Portion) ........................... 132,394,000 139,341,000
LONG-TERM DEBT (Less Current Portion) ........................................ 242,398,000 90,841,000
OTHER LIABILITIES ............................................................ 20,446,000 15,843,000
TOTAL LIABILITIES............................................................. 741,406,000 458,254,000
STOCKHOLDERS' EQUITY:
Preferred Stock, $.01 Par Value, 1,000,000
Shares Authorized; None Issued or Outstanding
Common Stock, $.005 Par Value, 40,000,000
Shares Authorized; Shares Issued: 1998 -- 28,236,000;
1997 - 27,709,000.................................................... 141,000 139,000
Additional Paid-in Capital................................................ 173,583,000 164,247,000
Treasury Stock; 1998 - 966,900; 1997 - 426,800
Common Shares........................................................ (14,821,000) (5,601,000)
Accumulated Other Comprehensive Income:
Unrealized Holding (Loss) Gain on Available-for-Sale
Investment...................................................... (1,027,000) 655,000
Retained Earnings......................................................... 145,838,000 106,242,000
Total Stockholders' Equity........................................... 303,714,000 265,682,000
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY.................................... $1,045,120,000 $723,936,000
See the accompanying notes to consolidated
financial statements.
36
SIERRA HEALTH SERVICES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
For the Years Ended December 31, 1998, 1997 and 1996
1998 1997 1996
OPERATING REVENUES:
Medical Premiums............................................. $ 609,404,000 $513,857,000 $386,968,000
Specialty Product Revenues .................................. 148,368,000 146,211,000 133,324,000
Military Contract Revenues .................................. 204,838,000 4,346,000
Professional Fees............................................ 45,363,000 31,238,000 28,836,000
Investment and Other Revenues ............................... 29,230,000 26,072,000 26,283,000
Total..................................................... 1,037,203,000 721,724,000 575,411,000
OPERATING EXPENSES:
Medical Expenses............................................. 513,209,000 419,272,000 315,915,000
Specialty Product Expenses................................... 142,258,000 143,082,000 130,758,000
General, Administrative and Marketing Expenses............... 110,687,000 93,919,000 72,237,000
Military Contract Expenses .................................. 196,625,000 4,193,000
Integration, Settlement and Other Costs...................... 13,851,000 29,350,000 12,064,000
Total..................................................... 976,630,000 689,816,000 530,974,000
OPERATING INCOME.................................................. 60,573,000 31,908,000 44,437,000
INTEREST EXPENSE AND OTHER, NET................................... (7,181,000) (4,433,000) (2,823,000)
INCOME FROM OPERATIONS
BEFORE INCOME TAXES ......................................... 53,392,000 27,475,000 41,614,000
PROVISION FOR INCOME TAXES........................................ 13,796,000 3,234,000 10,471,000
NET INCOME ....................................................... $ 39,596,000 $ 24,241,000 $ 31,143,000
EARNINGS PER COMMON SHARE:
Net Income Per Share .................................... $1.45 $.90 $1.17
EARNINGS PER COMMON SHARE ASSUMING DILUTION:
Net Income Per Share .................................... $1.43 $.88 $1.15
See the accompanying notes to consolidated financial
statements.
37
SIERRA HEALTH SERVICES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS'
EQUITY For the Years Ended December 31, 1998,
1997 and 1996
(Amounts in thousands)
Accumu-
lated
Addi- Other Total
tional Compre- Compre- Stock-
Common Stock Paid-In Treasury hensive hensive Retained holders'
Shares Amount Capital Stock Income Income Earnings Equity
BALANCE, JANUARY 1, 1996.............. 26,516 $133 $147,195 $ (130) $9,659 0 $50,858 $207,715
Comprehensive Income:
Net Income....................... $31,143 31,143 31,143
Other Comprehensive Income, Net of Tax
Unrealized Loss on Available-for-sale-
Investments ................ (9,172) (9,172) (9,172)
Comprehensive Income................. $21,971
Common Stock Issued in Connection
With Stock Plans................. 349 1 3,637 3,638
Income Tax Benefit Realized Upon
Exercise of Stock Options........ 1,158 ______ 1,158
BALANCE, DECEMBER 31, 1996 ........... 26,865 134 151,990 (130) 487 82,001 234,482
Comprehensive Income:
Net Income....................... $24,241 24,241 24,241
Other Comprehensive Income,
Net of Tax
Unrealized Gain on Available-for-sale-
Investments ............ 168 168 168
Comprehensive Income................. $24,409
Common Stock Issued in Connection
with Stock Plans................. 844 5 10,253 10,258
Purchase of Treasury Stock ......... (5,471) (5,471)
Income Tax Benefit Realized Upon
Exercise of Stock Options........ 2,004 2,004
BALANCE, DECEMBER 31, 1997 ........... 27,709 139 164,247 (5,601) 655 106,242 265,682
Comprehensive Income:
Net Income....................... $39,596 39,596 39,596
Other Comprehensive Income,
Net of Tax
Unrealized Holding Loss on Available-
for-sale Investments Arising
During Period. (3,960) (3,960) (3,960)
Reclassification Adjustment for
Gains Included in Net Income 2,278 2,278 2,278
Comprehensive Income................. $37,914
Common Stock Issued in Connection
with Stock Plans................. 527 2 8,052 8,054
Purchase of Treasury Stock ......... (9,220) (9,220)
Income Tax Benefit Realized Upon
Exercise of Stock Options........ 1,284 1,284
BALANCE, DECEMBER 31, 1998 ......... 28,236 $141 $173,583 $(14,821) $(1,027) $145,838 $303,714
See the accompanying notes to
consolidated financial statements.
38
SIERRA HEALTH SERVICES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
For the Years Ended December 31, 1998, 1997 and 1996
1998 1997 1996
CASH FLOWS FROM OPERATING ACTIVITIES:
Net Income ........................................................ $ 39,596,000 $ 24,241,000 $ 31,143,000
Adjustments to Reconcile Net Income to Net Cash
Provided by Operating Activities:
Depreciation and Amortization.................................. 19,263,000 13,510,000 10,499,000
Provision for Doubtful Accounts................................ 6,379,000 4,283,000 3,057,000
Change in Assets and Liabilities, Net of
Effects from Acquisitions:
Other Assets................................................... (5,362,000) (5,851,000) (16,301,000)
Reinsurance Recoverable ....................................... (41,618,000) (5,635,000) 10,164,000
Reserve for Losses and Loss Adjustment Expense ................ 9,564,000 14,923,000 5,458,000
Other Liabilities ............................................. 4,594,000 6,838,000 6,985,000
Minority Interests............................................. 9,000 (12,000) (1,746,000)
Accounts Receivable............................................ (2,870,000) (7,944,000) (12,469,000)
Other Current Assets........................................... (10,674,000) (11,853,000) (4,671,000)
Military Accounts Receivable................................... (69,552,000) (4,346,000)
Military Health Care Payable................................... 53,820,000
Medical Claims Payable......................................... 12,333,000 8,974,000 4,973,000
Other Current Liabilities...................................... 34,606,000 15,692,000 15,354,000
Net Cash Provided by Operating Activities ..................... 50,088,000 52,820,000 52,446,000
CASH FLOWS FROM INVESTING ACTIVITIES:
Capital Expenditures............................................... (40,743,000) (55,642,000) (17,927,000)
Property and Equipment Dispositions, Net........................... 772,000 172,000
Purchase of Available-for-Sale Investments......................... (901,542,000) (1,078,396,000) (712,503,000)
Proceeds from Sales/Maturities of
Available-for-Sale Investments................................. 884,288,000 1,046,523,000 752,279,000
Purchase of Held-to-Maturity Investments........................... (51,887,000) (7,523,000) (25,835,000)
Proceeds from Maturities of Held-to-Maturity Investments........... 44,964,000 10,449,000 39,184,000
Corporate Acquisitions, Net of Cash Acquired....................... (111,408,000) (3,145,000) (36,310,000)
Corporate Disposition, Net of Cash Disposed........................ 1,373,000
Net Cash Used for Investing Activities......................... (174,955,000) (86,962,000) (940,000)
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from Long-term Borrowing.................................. 172,200,000 25,000,000 1,000,000
Payments on Debt and Capital Leases................................ (59,098,000) (2,391,000) (9,601,000)
Purchase of Treasury Stock ........................................ (9,220,000) (5,471,000)
Exercise of Stock in Connection with Stock Plans................... 8,054,000 10,258,000 3,638,000
Net Cash Provided by (Used for) Financing Activities........... 111,936,000 27,396,000 (4,963,000)
NET (DECREASE) INCREASE IN CASH
AND CASH EQUIVALENTS............................................... (12,931,000) (6,746,000) 46,543,000
CASH AND CASH EQUIVALENTS AT BEGINNING
OF YEAR........................................................... 96,841,000 103,587,000 57,044,000
CASH AND CASH EQUIVALENTS AT END OF YEAR................................. $ 83,910,000 $ 96,841,000 $103,587,000
See the accompanying notes to consolidated
financial statements.
39
SIERRA HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
For the Years Ended December 31, 1998, 1997 and 1996
1. BUSINESS
Business. The consolidated financial statements include the accounts of Sierra
Health Services, Inc. ("Sierra") and its subsidiaries (collectively referred to
as the "Company"). The Company is a managed health care organization that
provides and administers the delivery of comprehensive health care and workers'
compensation programs with an emphasis on quality care and cost management. The
Company's broad range of managed health care services is provided through its
health maintenance organizations ("HMOs"), managed indemnity plans, third-party
administrative services programs for employer-funded health benefit plans,
workers' compensation medical management programs and its military health
services programs. Ancillary products and services that complement the Company's
managed health care product lines are also offered.
Acquisitions. On October 31, 1998, Texas Health Choice, L.C. ("TXHC") (formerly
HMO Texas, L.C.), a subsidiary of Sierra, completed the acquisition of certain
assets of Kaiser Foundation Health Plan of Texas ("Kaiser-Texas"), a health plan
operating in Dallas/Ft. Worth with approximately 109,000 members, and Permanente
Medical Association of Texas ("Permanente"), a 150 physician medical group
operating in that area. The purchase price was $124 million, which is net of $20
million in operating cost support to be paid to Sierra by Kaiser Foundation
Hospitals in five quarterly installments following the closing of the
transaction. The purchase price allocation includes a premium deficiency reserve
of approximately $25 million for estimated losses on the contracts acquired from
Kaiser-Texas. The purchase price includes amounts for real estate and eight
medical and office facilities encompassing approximately 500,000 square feet.
During the first quarter of 1999 certain accreditation goals were met by the
health plan resulting in a purchase price increase of $3.0 million, to $127
million. The purchase price may increase an additional $27 million over three
years if certain growth and member retention goals are met by the health plan.
The acquisition has been recorded using purchase accounting and the excess of
the purchase price over the fair value of the assets acquired was recorded as
goodwill. The goodwill, in the amount of $102.0 million, is being amortized on a
straight line basis over 40 years.
The following pro forma information (unaudited) has been prepared assuming that
this acquisition had taken place at the beginning of the respective periods. The
pro forma information includes adjustments for the amortization of goodwill
arising from the transaction and interest expense that would have been incurred
to finance the purchase. The pro forma financial information is not necessarily
indicative of the results of operations had the transaction been effected on the
assumed dates.
1998 1997
Total Revenue ....................................... $1,207,000,000 $923,797,000
Net Income (Loss).................................... (2,818,000) (20,239,000)
Net Income (Loss) Per Common Share................... (.10) (.75)
Net Income (Loss) Per Common Share
Assuming Dilution............................... (.10) (.75)
On December 31, 1998, Sierra completed the acquisition of the Nevada health care
business of Exclusive Healthcare, Inc., United of Omaha Life Insurance Company
and United World Life Insurance Company, all of which are subsidiaries of Mutual
of Omaha Insurance Company. The purchase price is contingent based on how many
members are retained through 2000 and 2001. No cash will be paid until group
renewals begin in 2000. Sierra retained approximately 9,000 members
(approximately 4,400 HMO members) subsequent to the acquisition.
In August 1997, the Company acquired the assets and operations of Total Home
Care, Inc. ("THC") for approximately $3.1 million, net of cash acquired. THC
provides home infusion, oxygen, and durable medical equipment services in Nevada
and Arizona. The Company sold the Arizona operations in the first
40
SIERRA HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
For the Years Ended December 31, 1998, 1997 and 1996
quarter of 1998 for approximately $1.5 million. Also, in the first quarter of
1998, the Company purchased three medical clinics in southern Nevada for
approximately $7.3 million.
Effective December 31, 1996 the Company purchased Prime Holdings, Inc.
("Prime"), for approximately $32 million in cash. At December 31, 1996 Prime
operated MedOne Health Plan, Inc. ("MedOne"), a 12,800 member HMO. Prime also
served 215,000 people through preferred provider organizations, workers'
compensation programs and administrative service products for self-insured
employers and union welfare trust funds, primarily in the state of Nevada. The
acquisition resulted in goodwill of $31 million.
In November 1996, the Company acquired complete ownership of TXHC for
$5,040,000. The Company had previously held a 50 percent interest in the
Houston-based health plan. The purchase resulted in goodwill of $5,040,000.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Principles of Consolidation. All significant intercompany transactions and
balances have been eliminated. Sierra's wholly owned subsidiaries include:
Health Plan of Nevada, Inc. ("HPN"), TXHC and MedOne, all licensed HMOs; Sierra
Health and Life Insurance Company, Inc. ("SHL"), a health and life insurance
company; Southwest Medical Associates, Inc. ("SMA"), and The Medical Group of
Texas ("TMGT"), multi-specialty medical groups; CII Financial, Inc. ("CII"), a
holding company primarily engaged in writing workers' compensation insurance
through its wholly owned subsidiaries; Sierra Military Health Services, Inc.,
("SMHS"), a company that has been contracted to provide and administer managed
care services to certain TRICARE eligible beneficiaries from June 1, 1998 to May
31, 2003; administrative services companies; a home health care agency; a
hospice; a home medical products subsidiary; and a company that provides and
manages mental health and substance abuse services.
Medical Premiums. Non-Medicare member enrollment is represented principally by
employer groups. Medical premiums are billed to each employer group in
accordance with negotiated contracts, and such premium revenue is recognized
when earned. Unearned premium revenue includes payments under prepaid Medicare
contracts with the Health Care Financing Administration ("HCFA") and prepaid
HPN, TXHC and MedOne commercial and SHL indemnity premiums. HPN and TXHC offer a
prepaid health care program to Medicare recipients. Revenues associated with
these Medicare recipients were approximately $238,913,000, $186,105,000 and
$140,611,000 in 1998, 1997 and 1996, respectively.
Specialty Product Revenues. These revenues consist primarily of workers'
compensation premiums. Premiums are calculated by formula such that the premium
written is earned pro rata over the term of the policy. Also included in
specialty product revenues are administrative services and certain ancillary
product revenues. Such revenues are recognized in the period in which the
service is performed or the period that coverage for services is provided.
Premiums written in excess of premiums earned are recorded as an unearned
premium revenue liability. Premiums earned include an estimate for earned but
unbilled premiums. Also included in specialty product revenue are revenues
associated with administrative services and certain ancillary products.
Military Contract Revenues. Revenue under the TRICARE contract is recorded based
on the contract price as agreed to by the federal government. The contract also
contains provisions which adjust the contract price based on actual experience.
The estimated effects of these adjustments are recognized on a monthly basis. In
addition, the Company records revenue based on estimates of the earned portion
of any contract change orders not originally specified in the contract.
41
SIERRA HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
For the Years Ended December 31, 1998, 1997 and 1996
Professional Fees. Revenue for professional medical services is recorded on the
accrual basis in the period in which the services are provided. Such revenue is
recorded at established rates net of provisions for estimated contractual and
charitable allowances.
Medical Expenses. Sierra contracts with hospitals, physicians and other
providers of health care under capitated or discounted fee-for-service
arrangements including hospital per diems to provide medical care services to
enrollees. Capitated providers are at risk for the cost of medical care services
provided to the Company's enrollees in the relevant geographic areas; however,
the Company is ultimately responsible for the provision of services to its
enrollees should the capitated provider be unable to provide the contracted
services. Health care costs are recorded in the period when services are
provided to enrolled members, including estimates for provider costs which have
been incurred as of the balance sheet date but not reported to the Company.
Losses on specific contracts, if any, are accrued when measurable.
Specialty Product Expenses. This expense consists primarily of losses and loss
adjustment expense ("LAE") and policy acquisition costs associated with issued
workers' compensation policies. Losses and LAE is based upon the accumulation of
cost estimates for reported claims occurring during the period as well as an
estimate for losses that have occurred but have not yet been reported. Policy
acquisition costs consist of commissions, premium taxes and other underwriting
costs, which are directly related to the production and retention of new and
renewal business and are deferred and amortized as the related premiums are
earned. Should it be determined that future policy revenues and earnings on
invested funds relating to existing insurance contracts will not be adequate to
cover related costs and expenses, deferred costs are expensed. Also included in
specialty product expense are costs associated with administrative services and
certain ancillary products. These costs are recorded when incurred.
Military Contract Expenses. This expense consists primarily of costs to provide
managed health care services to eligible beneficiaries in accordance with the
Company's TRICARE contract. Under the contract, SMHS provides health care
services to approximately 606,000 dependents of active duty military personnel
and military retirees and their dependents through subcontractor partnerships
and individual providers. Health care costs are recorded in the period when
services are provided to eligible beneficiaries including estimates for provider
costs which have been incurred as of the balance sheet date but not reported to
the Company. Also included in military contract expense are costs incurred to
perform specific administrative services, such as health care appointment
scheduling, enrollment, network management and health care advice line services,
and other administrative functions of the military health care subsidiary.
Cash and Cash Equivalents. The Company considers cash and cash equivalents as
all highly liquid instruments with a maturity of three months or less at time of
purchase. The carrying amount of cash and cash equivalents approximates fair
value because of the short maturity of these instruments.
Investments. Short- and long-term investments consist principally of U.S.
Government securities and municipal bonds, as well as corporate and mortgage
backed securities. Short-term investments have maturities of one year or less.
Long-term investments have maturities in excess of one year.
Restricted Cash and Investments. Certain subsidiaries are required by state
regulatory agencies to maintain certain deposits and must also meet certain net
worth and reserve requirements. The Company and its subsidiaries are in
compliance with the applicable minimum regulatory and capital requirements.
Military Accounts Receivable. Amounts receivable under government contracts are
comprised primarily of one month's contract payment from the government in
arrears, estimates of adjustments under the contract based on actual experience,
and estimates of the earned portion of any change orders not originally
specified in the contract.
42
SIERRA HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
For the Years Ended December 31, 1998, 1997 and 1996
Property and Equipment. Property and equipment are stated at cost. Maintenance
and repairs that do not improve or extend the life of the respective assets are
charged to operations. Depreciation and amortization is computed using the
straight-line method over the estimated service lives of the assets or terms of
leases if shorter. Estimated useful lives are as follows:
Buildings and Improvements 30 years
Leasehold Improvements 3 - 10 years
Furniture, Fixtures and Equipment 3 - 5 years
Data Processing Hardware and Software 3 - 5 years
Goodwill. Goodwill has been recorded primarily as a result of various business
acquisitions by the Company. Amortization is provided on a straight line basis
over periods not exceeding 40 years. The Company evaluates the carrying value of
its intangible assets at each balance sheet date.
Medical Claims Payable and Military Health Care Payable. Medical claims payable
and Military health care payable include the estimated cost for unpaid claims
for which health care services have been provided to enrollees and TRICARE
eligibles and a provision of the estimated costs for claims that have been
incurred but have not been reported.
Reserve for Losses and Loss Adjustment Expense. The reserve for losses and LAE
consists of estimated costs of each unpaid claim reported to the Company prior
to the close of the accounting period, as well as those incurred but not yet
reported. The methods for establishing and reviewing such liabilities are
continually reviewed and adjustments are reflected in current operations.
Income Taxes. The Company accounts for income taxes using the liability method.
Deferred income tax assets and liabilities result from temporary differences
between the tax basis of assets and liabilities and the reported amounts in the
consolidated financial statements that will result in taxable or deductible
amounts in future years. The Company's temporary differences arise principally
from certain net operating losses, accrued expenses, reserves and depreciation.
Concentration of Credit Risk. The Company's financial instruments that are
exposed to credit risk consist primarily of investments and accounts receivable.
The Company maintains cash and cash equivalents, and short- and long-term
investments with various financial institutions. These financial institutions
are located in many different regions, and company policy is designed to limit
exposure with any one institution.
Credit risk with respect to accounts receivable is generally diversified due to
the large number of entities comprising the Company's customer base, other than
gaming, and their dispersion across many different industries. These customers
are primarily located in the states in which the Company operates. Such
operations are principally in California, Nevada and Texas. However, the Company
is licensed and does business in several other states as well. As of December
31, 1998, the Company has receivables outstanding from the federal government
related to its TRICARE contract in the amount of $69.6 million. The Company also
has receivables from certain reinsurers. Reinsurance contracts do not relieve
the Company from its obligations to enrollees or policyholders. Failure of
reinsurers to honor their obligations could result in losses to the Company. The
Company evaluates the financial condition of its reinsurers to minimize its
exposure to significant losses from reinsurer insolvencies. All reinsurers that
the Company has reinsurance contracts with are rated A- or better by the A.M.
Best Company.
Recently Issued Accounting Standards. In March 1998, the Accounting Standards
Executive Committee of the American Institute of Certified Public Accountants
("AcSEC") issued Statement of Position 98-1 ("SOP 98-1"), "Accounting for the
Costs of Computer Software Developed For or Obtained For Internal Use". SOP 98-1
requires certain computer software costs to be capitalized and amortized over
the software's estimated useful life. In June 1998, the AcSEC issued Statement
of Position 98-5 ("SOP 98-5"), "Reporting on the Costs of Start-Up Activities".
This standard requires organization costs and costs
43
SIERRA HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
For the Years Ended December 31, 1998, 1997 and 1996
associated with start-up activities to be expensed as incurred. Both statements
are effective for years beginning after December 15, 1998. The Company will
adopt SOP 98-1 and SOP 98-5 for the fiscal year ending December 31, 1999 and
does not believe these statements will have a material impact on its financial
statements.
In June 1998, The Financial Accounting Standards Board issued "Accounting for
Derivative Instruments and Hedging Activities" ("FAS 133"). FAS 133 is effective
for fiscal years beginning after June 15, 1999. FAS 133 addresses the accounting
for derivative instruments including certain derivative instruments embedded in
other contracts, and hedging activities. The Company does not believe this
statement will have a material impact on its financial statements.
Estimates and Assumptions. The preparation of financial statements in conformity
with generally accepted accounting principles 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. Estimates and assumptions include, but are not
limited to, medical and specialty product expenses and military revenue and
expenses. Actual results may materially differ from estimates.
Reclassifications. Certain amounts in the Consolidated Financial Statements for
the years ended December 31, 1997 and 1996 have been reclassified to conform
with the current year presentation.
3. EARNINGS PER SHARE
The following table provides a reconciliation of basic and diluted earnings
per share ("EPS"):
Dilutive
Basic Stock Options Diluted
For the Year Ended December 31, 1998:
Net Income..................................... $39,596,000 0 $39,596,000
Shares......................................... 27,391,000 356,000 27,747,000
Per Share Amount............................... $1.45 $1.43
For the Year Ended December 31, 1997:
Net Income..................................... $24,241,000 $24,241,000
Shares......................................... 27,013,000 413,000 27,426,000
Per Share Amount............................... $.90 $.88
For the Year Ended December 31, 1996:
Net Income..................................... $31,143,000 $31,143,000
Shares......................................... 26,589,000 602,000 27,191,000
Per Share Amount............................... $1.17 $1.15
Stock Split. On May 5, 1998, the Company announced a three-for-two stock split.
Each stockholder of record of the Company owning one share of common stock, par
value of $.005, as of the close of business on the record date of May 18, 1998,
received an additional one-half share on June 18, 1998. In lieu of any
fractional share resulting from the stock split, a stockholder received a cash
payment based on the closing price of the Company's common stock on the record
date. The par value remains $.005 per share. Common stock and earnings per share
amounts have been retroactively adjusted to account for the split.
44
SIERRA HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
For the Years Ended December 31, 1998, 1997 and 1996
CII issued convertible subordinated debentures (the "Debentures") due September
15, 2001. Each $1,000 in principal is convertible into 25.382 shares of the
Company's common stock at a conversion price of $39.40 per share. The Debentures
were not included in the computation of EPS because their effect would be
anti-dilutive.
4. PROPERTY AND EQUIPMENT
Property and equipment at December 31 consists of the following:
Classification 1998 1997
Land................................................... $ 28,588,000 $ 14,296,000
Buildings and Improvements............................. 145,308,000 109,307,000
Furniture, Fixtures and Equipment...................... 57,261,000 38,692,000
Data Processing Equipment and Software................. 43,643,000 31,452,000
Software in Development and Construction
in Progress......................................... 20,324,000 4,170,000
Less: Accumulated Depreciation ........................ (65,960,000) (49,086,000)
Net Property and Equipment......................... $229,164,000 $148,831,000
The following is an analysis of property and equipment under capital leases by
classification as of December 31:
Classification 1998 1997
Data Processing Equipment and Software ................ $4,736,000 $4,779,000
Furniture, Fixtures and Equipment...................... 3,783,000 728,000
Building............................................... 245,000 245,000
Less: Accumulated Depreciation......................... (2,185,000) (467,000)
Net Property and Equipment.......................... $6,579,000 $5,285,000
The Company capitalizes interest expense as part of the cost of construction of
facilities and the implementation of computer systems. Interest expense
capitalized in 1998, 1997 and 1996 was $1,037,000, $1,621,000 and $245,000,
respectively.
5. CASH AND INVESTMENTS
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 as a result are
stated at their fair value. Unrealized holding gains and losses on
available-for-sale securities are included as a separate component of
stockholders' equity until realized. Gross realized gains and losses on
investments in 1998 were $4.8 million and $2.5 million, respectively. Realized
gains and losses are calculated using the specific identification method and are
included in net income.
45
SIERRA HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
For the Years Ended December 31, 1998, 1997 and 1996
The following table summarizes the Company's short-term, long-term and
restricted investments as of December 31, 1998:
Gross Gross Estimated
Amortized Unrealized Unrealized Fair
Cost Gains Losses Value
Available-for-Sale Investments:
Classified as Short-term:
U.S. Government
and its Agencies..................... $ 19,180,000 $ 52,000 $ 219,000 $ 19,013,000
Municipal Obligations................... 24,974,000 88,000 5,000 25,057,000
Corporate Bonds......................... 31,419,000 45,000 60,000 31,404,000
Other. . . . ........................... 13,795,000 41,000 548,000 13,288,000
Total Short-term..................... 89,368,000 226,000 832,000 88,762,000
Classified as Long-term:
U.S. Government
and its Agencies..................... 61,034,000 608,000 1,357,000 60,285,000
Mortgage Backed......................... 6,209,000 1,000 216,000 5,994,000
Municipal Obligations................... 33,086,000 229,000 408,000 32,907,000
Corporate Bonds......................... 51,198,000 714,000 769,000 51,143,000
Total Long-term...................... 151,527,000 1,552,000 2,750,000 150,329,000
Classified as Restricted:
U.S. Government
and its Agencies..................... 8,549,000 87,000 8,636,000
Municipal Obligations................... 2,594,000 124,000 2,718,000
Corporate Bonds......................... 2,071,000 19,000 2,090,000
Other. . . . . . . . . ................. 2,081,000 2,081,000
Total Restricted .................... 15,295,000 230,000 15,525,000
Total Available-for-Sale ......... $256,190,000 $2,008,000 $3,582,000 $254,616,000
Held-to-Maturity Investments:
Classified as Short-term:
U.S. Government
and its Agencies..................... $ 8,468,000 $ 9,000 $ 432,000 $ 8,045,000
Mortgage Backed......................... 5,936,000 266,000 5,670,000
Municipal Obligations................... 1,570,000 44,000 1,614,000
Corporate Bonds......................... 5,272,000 66,000 5,338,000
Total Short-term..................... 21,246,000 119,000 698,000 20,667,000
Classified as Long-term:
U.S. Government
and its Agencies..................... 6,529,000 29,000 51,000 6,507,000
Mortgage Backed.......................... 14,331,000 672,000 13,659,000
Municipal Obligations.................... 4,154,000 259,000 4,413,000
Corporate Bonds.......................... 5,473,000 441,000 5,914,000
Total Long-term...................... 30,487,000 729,000 723,000 30,493,000
Classified as Restricted:
U.S. Government
and its Agencies..................... 495,000 9,000 504,000
Municipal Obligations................... 574,000 17,000 591,000
Corporate Bonds......................... 1,164,000 50,000 1,214,000
Total Restricted .................... 2,233,000 76,000 2,309,000
Total Held-to-Maturity ........... $ 53,966,000 $ 924,000 $1,421,000 $ 53,469,000
46
SIERRA HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
For the Years Ended December 31, 1998, 1997 and 1996
The following table summarizes the Company's short-term, long-term and
restricted investments as of December 31, 1997:
Gross Gross Estimated
Amortized Unrealized Unrealized Fair
Cost Gains Losses Value
Available-for-Sale Investments:
Classified as Short-term:
U.S. Government
and its Agencies........................... $ 7,577,000 $ 31,000 $ 1,000 $ 7,607,000
Municipal Obligations......................... 41,732,000 88,000 194,000 41,626,000
Corporate Bonds.....................48,945,000 345,000 74,000 49,216,000
Other . . . . . .............................. 6,163,000 9,000 99,000 6,073,000
Total Short-term........................... 104,417,000 473,000 368,000 104,522,000
Classified as Long-term:
U.S. Government
and its Agencies........................... 38,031,000 169,000 59,000 38,141,000
Municipal Obligations......................... 3,160,000 139,000 1,000 3,298,000
Corporate Bonds.....................81,299,000 776,000 43,000 82,032,000
Other . . . . . ............... 63,000 63,000
Total Long-term............................ 122,553,000 1,084,000 103,000 123,534,000
Classified as Restricted:
U.S. Government
and its Agencies........................... 8,639,000 34,000 12,000 8,661,000
Municipal Obligations......................... 3,166,000 104,000 3,270,000
Corporate Bonds........................497,000 1,000 498,000
Other. . . . . . . . . ....................... 2,373,000 2,373,000
Total Restricted .......................... 14,675,000 139,000 12,000 14,802,000
Total Available-for-Sale ............... $241,645,000 $1,696,000 $483,000 $242,858,000
Held-to-Maturity Investments:
Classified as Short-term:
U.S. Government
and its Agencies........................... $ 2,884,000 $ 33,000 $ 2,917,000
Corporate Bonds .............................. 8,092,000 189,000 8,281,000
Total Short-term........................... 10,976,000 222,000 11,198,000
Classified as Long-term:
U.S. Government
and its Agencies........................... 14,313,000 20,000 $ 38,000 14,295,000
Municipal Obligations......................... 6,038,000 372,000 6,410,000
Corporate Bonds.................. 11,268,000 509,000 11,000 11,766,000
Total Long-term............................ 31,619,000 901,000 49,000 32,471,000
Classified as Restricted:
Municipal Obligations......................... 575,000 26,000 601,000
Corporate Bonds.................. 1,163,000 22,000 1,185,000
Total Restricted .......................... 1,738,000 48,000 1,786,000
Total Held-to-Maturity ................. $ 44,333,000 $1,171,000 $ 49,000 $ 45,455,000
47
SIERRA HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
For the Years Ended December 31, 1998, 1997 and 1996
The contractual maturities of available-for-sale short-term, long-term and
restricted investments at December 31, 1998 are shown below. Expected maturities
may differ from contractual maturities because borrowers may have the right to
call or prepay obligations.
Amortized Estimated
Cost Fair Value
Due in one year or less...................................... $ 64,036,000 $ 63,497,000
Due after one year through five years........................ 54,609,000 55,362,000
Due after five years through ten years....................... 16,763,000 17,063,000
Due after ten years.......................................... 120,782,000 118,694,000
Total................................................... $256,190,000 $254,616,000
The contractual maturities of held-to-maturity short-term, long-term and
restricted investments at December 31, 1998 were as follows:
Amortized Estimated
Cost Fair Value
Due in one year or less...................................... $12,563,000 $12,417,000
Due after one year through five years........................ 12,209,000 12,957,000
Due after five years through ten years....................... 2,954,000 2,988,000
Due after ten years.......................................... 26,240,000 25,107,000
Total................................................... $53,966,000 $53,469,000
Of the cash and cash equivalents that total $83,910,000 million in the
accompanying Consolidated Balance Sheet at December 31, 1998, $81,328,000
million is limited for use only by the Company's regulated subsidiaries. Such
amounts are available for transfer to Sierra from the regulated subsidiaries
only to the extent that they can be remitted in accordance with terms of
existing management agreements and by dividends which customarily must be
approved by regulating state insurance departments. The remainder is available
to Sierra on an unrestricted basis.
6. REINSURANCE
In the normal course of business, the Company seeks to reduce potential losses
that may arise from catastrophic events that cause unfavorable underwriting
results by reinsuring certain levels of such risk with other reinsurers. Amounts
recoverable from reinsurers are estimated in a manner consistent with the claim
liability associated with the reinsurance policy.
The Company is covered under medical reinsurance agreements that provide
coverage for 50% - 90% of hospital and other costs in excess of, depending on
the contract, $100,000 to $200,000, per case, up to a maximum of $2,000,000 per
member per lifetime for both the managed indemnity and HMO subsidiaries. In
addition, certain of the Company's HMO members are covered by an excess
catastrophe reinsurance contract. Reinsurance premiums of $2,860,000, $3,156,000
and $3,235,000 net of reinsurance recoveries of $1,185,000, $1,729,000 and
$2,276,000 are included in medical expense for 1998, 1997 and 1996,
respectively. In addition, SHL maintains reinsurance on certain other insurance
products.
CII also has reinsurance treaties in effect. Effective January 1, 1998, workers'
compensation claims between $500,000 and $100,000,000 per occurrence are
reinsured. In 1997 and 1996, workers' compensation claims between $350,000 and
$60,000,000 per occurrence were reinsured. In addition, effective July 1, 1998,
workers' compensation claims below $500,000 per occurrence are reinsured under
quota share and excess reinsurance agreements (referred to as "low level
reinsurance") with an A+ rated carrier. Under this agreement, CII reinsures 30%
of the first $10,000 of each loss, 75% of the next $40,000
48
SIERRA HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
For the Years Ended December 31, 1998, 1997 and 1996
and 100% of the next $450,000. CII receives a ceding commission from the
reinsurer as a partial reimbursement of its operating expenses.
The low level reinsurance agreement contains both retroactive and prospective
reinsurance coverage and CII has bifurcated the low level reinsurance agreement
to account for the different accounting treatments. The amount by which the
estimated ceded liabilities exceed the amount paid for the retroactive coverage
is amortized to income over the estimated remaining settlement period using the
interest method. For the year ended December 31, 1998, CII amortized a deferred
gain of $1,038,000. Any subsequent changes in estimated or actual cash flows are
accounted for by adjusting the previously recorded deferred gain to the balance
that would have existed had the revised estimate been available at the inception
of the reinsurance transactions, with a corresponding charge or credit to
income.
At December 31, 1998 and 1997, the amount of reinsurance recoverable under
prospective reinsurance contracts for unpaid losses and loss adjustment expenses
for CII was $37,797,000 and $21,056,000, respectively. At December 31, 1998, the
amount of reinsurance recoverable under the retroactive reinsurance contract was
$18,710,000. The amount of reinsurance receivable for paid losses and loss
adjustment expenses was $1,917,000 and $358,000, at December 31, 1998 and 1997,
respectively.
Reinsurance contracts do not relieve the Company from its obligations to
enrollees or policyholders. Failure of reinsurers to honor their obligations
could result in losses to the Company. The Company evaluates the financial
condition of its reinsurers to minimize its exposure to significant losses from
reinsurer insolvencies. All reinsurers that the Company has reinsurance
contracts with are rated A- or better by the A.M. Best company.
The following table provides workers' compensation prospective reinsurance
information for the three years ended December 31, 1998:
Change in
Recoveries Recoverable
on Paid on Unpaid Premiums
Losses/LAE Losses/LAE Ceded
1998:
Travelers Indemnity Company
of Illinois............................... $1,379,000 $19,664,000 $16,095,000
General Reinsurance Corporation............... 3,292,000 (2,923,000) 3,533,000
Others ....................................... 202,000
Total ........................................ $4,671,000 $16,741,000 $19,830,000
1997:
General Reinsurance Corporation................. $ 841,000 $ 5,380,000 $ 4,872,000
Others ......................................... 187,000
Total .......................................... $ 841,000 $ 5,380,000 $ 5,059,000
1996:
General Reinsurance Corporation................. $3,076,000 $(10,195,000) $4,713,000
Others ......................................... 456,000
Total .......................................... $3,076,000 $(10,195,000) $5,169,000
49
SIERRA HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
For the Years Ended December 31, 1998, 1997 and 1996
7. LOSSES AND LOSS ADJUSTMENT EXPENSES
The following table provides a reconciliation of the beginning and ending
reserve balances for unpaid losses and LAE. There can be no assurances that
favorable development, or the magnitude of the development, will continue in the
future.
Year ended December 31,
1998 1997 1996
Net Beginning Losses and LAE Reserve ..................... $181,643,000 $172,100,000 $156,447,000
Net Provision for Insured Events Incurred in:
Current Year .......................................... 103,990,000 102,301,000 101,401,000
Prior Years............................................ (9,643,000) (8,970,000) (15,284,000)
Total Net Provision.................................. 94,347,000 93,331,000 86,117,000
Net Payments for Losses and LAE
Attributable to Insured Events Incurred in:
Current Year .......................................... 29,592,000 26,811,000 24,733,000
Prior Years............................................ 71,932,000 56,977,000 45,731,000
Total Net Payments .................................. 101,524,000 83,788,000 70,464,000
Net Ending Losses and LAE Reserve ........................ 174,466,000 181,643,000 172,100,000
Reinsurance Recoverable .................................. 37,797,000 21,056,000 15,676,000
Gross Ending Losses and LAE Reserve ...................... $212,263,000 $202,699,000 $187,776,000
8. LONG-TERM DEBT
Long-term debt at December 31 consists of the following:
1998 1997
Revolving Credit Facility............................................ $139,000,000 $ 25,000,000
7 1/2% Convertible Subordinated Debentures .......................... 51,251,000 54,467,000
6% Mortgage Note..................................................... 35,171,000
7 1/5% Mortgage Note................................................. 13,440,000
7 3/8% Mortgage Note ............................................... 821,000 5,833,000
Adjustable Rate Mortgage Note ....................................... 3,116,000
Other................................................................ 7,978,000 7,151,000
Total.............................................................. 247,661,000 95,567,000
Less Current Portion................................................. (5,263,000) (4,726,000)
Long-term Debt....................................................... $242,398,000 $90,841,000
Revolving Credit Facility. On October 31, 1998, the Company replaced its prior
line of credit with a $200 million credit facility under which it has $139
million in borrowings outstanding as of December 31, 1998. Interest under the
credit facility is variable and based on the London Interbank Offering Rate plus
a margin determined by reference to the Company's leverage ratio. Of the
outstanding balance, $50.0 million is covered by interest-rate swap agreements.
The average cost of borrowing on this line of credit for the fourth quarter of
1998, including the impact of the swap agreements, was approximately 8.0%. The
terms of the credit facility contain a mandatory payment schedule that begins on
June 30, 2001 and ends on September 30, 2003 if the principal balance exceeds
certain thresholds. The terms of the credit facility
50
SIERRA HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
For the Years Ended December 31, 1998, 1997 and 1996
contain certain covenants including a minimum fixed charge coverage ratio and a
maximum leverage ratio. In November 1998, the Company borrowed approximately
$110 million to fund the acquisition of Kaiser- Texas.
7 1/2% Convertible Subordinated Debentures. In September 1991 CII issued
convertible subordinated debentures (the "Debentures") due September 15, 2001.
The Debentures bear interest at 7 1/2% which is due semi-annually on March 15
and September 15. Each $1,000 in principal is convertible into 25.382 shares of
the Company's common stock at a conversion price of $39.40 per share.
Unamortized issuance costs of $509,000 are included in other assets on the
balance sheet and are being amortized over the life of the Debentures. Accrued
interest on the Debentures as of December 31, 1998 and 1997 was $1,117,000 and
$1,191,000, respectively. The Debentures are redeemable by CII, in whole or in
part, at redemption prices of 101.05% in 1999 and 100.75% thereafter, plus
accrued interest. The Debentures are general unsecured obligations of CII only
and were not assumed or guaranteed by Sierra. During the twelve months ended
December 31, 1998 and 1997, the Company purchased $3,216,000 and $30,000,
respectively, of the debentures on the open market.
6.0% Mortgage Note. In conjunction with the acquisition of Kaiser-Texas, TXHC
executed a deed of trust note for $35,200,000. The note is secured by deeds of
trust covering the underlying real estate and fixtures. The terms of the note
include fixed monthly payments of $211,000 for five years at which time the
remaining principal is due.
7 1/5% Mortgage Note. In January 1998, the Company obtained a $15,000,000 loan
from Bank of America, Nevada at an interest rate of 7 1/5%. This loan is secured
by a deed of trust, assignment of rents and leases, and a security agreement and
fixture filing covering the newly constructed portion of the Company's
administrative headquarters complex and underlying real property.
7 3/8% Mortgage Note. In December 1993, the Company obtained a loan from Bank of
America, Nevada. This loan is secured by a deed of trust, assignment of rents
and leases, and a security agreement and fixture filing covering a portion of
the Company's administrative headquarters complex and underlying real property.
Adjustable Rate Mortgage Note. In 1998, the Company repaid a mortgage which had
an adjustable rate with an interest margin of 3% over the Federal Home Loan Bank
Board 11th District Cost of Funds Index, a maximum interest rate of five
percentage points above the initial rate of 11.85% and a minimum interest rate
of 8%.
Other. The Company has obligations under capital leases with interest rates from
6.3% to 13.4%. In addition, the Company has term loans with the City of
Baltimore and the State of Maryland.
51
SIERRA HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
For the Years Ended December 31, 1998, 1997 and 1996
Scheduled maturities of the Company's notes payable and future minimum payments
under capital leases, together with the present value of the net minimum lease
payments at December 31, 1998, are as follows:
Obligations
Notes Under Capital
Year ending December 31, Payable Leases
1999................................................. $ 2,761,000 $2,932,000
2000................................................. 2,310,000 1,967,000
2001................................................. 53,263,000 1,314,000
2002................................................. 2,150,000 1,278,000
2003 ................................................ 173,984,000 105,000
Thereafter........................................... 6,379,000 276,000
Total............................................. $240,847,000 7,872,000
Less: Amounts Representing Interest................. (1,058,000)
Present Value of Minimum Lease Payments.............. $6,814,000
The fair value of the Debentures at December 31, 1998 was $48,176,000 which was
determined based on the market price on January 7, 1999. Excluding the
Debentures, the fair value of long-term debt, including the current portion, is
$195,057,000 based on the borrowing rates currently available to the Company for
bank loans with similar terms and average maturities.
9. INCOME TAXES
A summary of the provision for income taxes for the years ended December 31,
1998, 1997, and 1996 is as follows:
1998 1997 1996
Provision for Income Taxes:
Current..................................... $12,595,000 $5,528,000 $11,860,000
Deferred.................................... 1,201,000 (2,294,000) (1,389,000)
$13,796,000 $3,234,000 $10,471,000
The following reconciles the difference between the 1998, 1997 and 1996 current
and statutory provision for income taxes:
1998 1997 1996
Statutory Rate .................................. 35% 35% 35%
Tax Preferred Investments ....................... (2) (5) (6)
Change in Valuation Allowance ................... (9) (17) (6)
Other ........................................... 2 (1) 2
Provision for Income Taxes ................. 26% 12% 25%
52
SIERRA HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
For the Years Ended December 31, 1998, 1997 and 1996
The tax effects of significant items comprising the Company's net deferred
tax assets are as follows:
1998 1997
Deferred Tax Assets:
Medical and Losses and LAE Reserves ...................... $ 4,398,000 $ 7,428,000
Accruals Not Currently Deductible......................... 4,875,000 7,269,000
Compensation Accruals .................................... 4,569,000 2,344,000
Bad Debt Allowances....................................... 2,189,000 2,041,000
Loss Carryforwards and Credits............................ 9,878,000 11,543,000
Unearned Premiums......................................... 850,000 902,000
Deferred Reinsurance Gains................................ 2,188,000
Other .................................................... 551,000
29,498,000 31,527,000
Deferred Tax Liabilities:
Deferred Policy Acquisition Costs ........................ 586,000 596,000
Depreciation and Amortization ............................ 6,249,000 4,872,000
Other .................................................... 558,000 1,096,000
7,393,000 6,564,000
Net Deferred Tax Asset Before
Valuation Allowance.................................... 22,105,000 24,963,000
Valuation Allowance ...................................... (1,575,000) (6,266,000)
Net Deferred Tax Asset ................................... $20,530,000 $18,697,000
At December 31, 1998, the Company had approximately $20,022,000 of regular tax
net operating loss carryforwards which are limited to use at the rate of
approximately $7,021,000 per year during the carryforward period. The net
operating loss carryforwards can be used to reduce future taxable income until
they expire through the year 2011. In addition to the net operating loss
carryforwards, the Company has alternative minimum tax credits of approximately
$848,000 which can be used to reduce regular tax liabilities in future years.
There is no expiration date for the alternative minimum tax credits. The
majority of the above items are subject to both annual and separate company
limitations required by the Internal Revenue Code.
A valuation allowance has been set up to reflect the Company's inability to use
tax benefits from certain acquisitions currently or in the near future. For the
years ended December 31, 1998 and 1997, the Company was able to realize a
portion of the tax benefits for which a valuation allowance had been previously
established. As a result, the Company reduced its valuation allowance by
$4,691,000 and $4,663,000 for the years ended December 31, 1998 and 1997,
respectively.
53
SIERRA HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
For the Years Ended December 31, 1998, 1997 and 1996
10. COMMITMENTS AND CONTINGENCIES
Leases. The Company is the lessee under several operating leases, most of which
relate to office facilities and equipment. The rentals on these leases are
charged to expense over the lease term as the Company becomes obligated for
payment and, where applicable, provide for rent escalations based on certain
costs and price index factors. The following is a schedule, by year, of the
future minimum lease payments under existing operating leases:
Year Ending December 31,
1999................................................... $ 8,811,000
2000................................................... 6,896,000
2001................................................... 6,060,000
2002................................................... 5,665,000
2003 .................................................. 3,740,000
Thereafter............................................. 5,038,000
Total............................................. $36,210,000
Rent expense totaled $8,763,000, $5,827,000 and $4,945,000 in 1998, 1997 and
1996, respectively.
Litigation and Legal Matters. The Company is subject to various claims and other
litigation in the ordinary course of business. Such litigation includes 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 members. Also included in such litigation are claims for
workers' compensation and claims by providers for payment for medical services
rendered to injured workers. In the opinion of the Company's management, the
ultimate resolution of pending legal proceedings should not have a material
adverse effect on the Company's financial condition.
11. EMPLOYEE BENEFIT PLANS
Defined Contribution Plan. The Company has a defined contribution pension and
401(k) plan (the "Plan") for its employees. The Plan covers all employees who
meet certain age and length of service requirements. The Company contributes a
maximum of 2% of eligible employees' compensation and matches 50% of a
participant's elective deferral up to a maximum of either 10% of an employee's
compensation or the maximum allowable under current IRS statute. Expense under
the plan totaled $4,522,000, $3,929,000 and $3,216,000 in 1998, 1997 and 1996,
respectively.
Supplemental Retirement Plan. The Company has Supplemental Retirement Plans (the
"SRPs") for certain officers, directors and highly compensated employees. The
SRPs are non-qualified deferred compensation plans through which participants
may elect to postpone the receipt and taxation of all or a portion of their
salary and bonuses received from the Company. The Company also matches 50% of
those contributions that participants are restricted from deferring, if any,
under the Company's pension and 401(k) plan. As contracted with the Company, the
participants or their designated beneficiaries may begin to receive benefits
under the SRPs upon participant death, disability, retirement, termination of
employment or certain other circumstances including financial hardship.
Executive Life Insurance Plan. Effective July 1, 1997 the Company has funded and
entered into split dollar life insurance agreements with certain officers and
key executives (selected and approved by the Sierra Board of Directors). The
premiums paid by the Company will be reimbursed upon the occurrence of certain
events as specified in the contract.
Supplemental Executive Retirement Plan (SERP). Effective July 1, 1997, the
Company adopted a defined benefit retirement plan covering certain key
employees. The Company is funding the benefits through the
54
SIERRA HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
For the Years Ended December 31, 1998, 1997 and 1996
purchase of certain life insurance policies. Benefits are based on, among other
things, the employee's average earnings over the five-year period prior to
retirement or termination, and length of service. Benefits attributable to
service prior to the adoption of the plan are amortized over the estimated
remaining service period for those employees participating in the plan. In 1998,
the Company expanded the SERP to include more participants. The effect of adding
these participants is included in plan amendments in the reconciliation below.
A reconciliation of ending year balances is as follows:
For the Year Ended
December 31,
1998 1997
Change in Benefit Obligation:
Projected Benefit Obligation at Beginning of Period
(Inception for 1997) ...................................... $ 9,515,000 $ 9,008,000
Service Cost ................................................. 408,000 132,000
Interest Cost ................................................ 875,000 375,000
Plan Amendments............................................... 995,000
Actuarial Gains/Losses........................................ 1,925,000
Benefits Paid ................................................ (97,000)
Benefit Obligation at End of Period........................... 13,621,000 9,515,000
Change in Plan Assets:
Fair Value of Plan Assets at Beginning of Period.............. 1,872,000
Actual Return on Plan Assets ................................. (58,000) (308,000)
Company Contributions ........................................ 2,679,000 2,180,000
Fair Value of Plan Assets at End of Period.................... 4,493,000 1,872,000
Funded Status of the Plan .................................... (9,128,000) (7,643,000)
Unrecognized Actuarial Change................................. 1,858,000
Unrecognized Prior Service Credit ............................ 8,757,000 8,647,000
Unrecognized Net Loss ........................................ 748,000 394,000
Total Recognized ............................................. $ 2,235,000 $ 1,398,000
Total Recognized Amounts in the Financial
Statements Consist of:
Accrued Benefit Liability .................................... $(3,325,000) $(2,964,000)
Intangible Asset ............................................. 5,560,000 4,362,000
Total ........................................................ $ 2,235,000 $ 1,398,000
Assumptions:
Discount Rate ................................................ 7.0% 7.0%
Expected Return on Plan Assets ............................... 8.0% 8.0%
Rate of Compensation Increase ................................ 5.0% 5.0%
Components of Net Periodic Benefit Cost:
Service Cost.................................................. $ 408,000 $ 132,000
Interest Cost ................................................ 875,000 375,000
Expected Return on Plan Assets................................ (295,000) (87,000)
Amortization of Prior Service Credits......................... 885,000 361,000
Recognized Actuarial Loss..................................... 68,000
Net Periodic Benefit Cost..................................... $1,941,000 $ 781,000
55
SIERRA HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
For the Years Ended December 31, 1998, 1997 and 1996
12. CAPITAL STOCK PLANS
Stockholders' Rights Plan. Each share of Sierra common stock, par value $.005
per share, contains one right (a "Right"). Each Right entitles the registered
holder to purchase from Sierra a unit consisting of one one-hundredth of a share
of the Series A Junior Participating Preferred Shares (a "Unit"), par value $.01
per share, of Sierra, or a combination of securities and assets of equivalent
value, at a purchase price of $100.00 per Unit, subject to adjustment. The
Rights have certain anti-takeover effects. The Rights will cause substantial
dilution to a person or group that attempts to acquire Sierra on terms not
approved by Sierra's Board of Directors, except pursuant to an offer conditioned
on a substantial number of Rights being acquired. The Rights should not
interfere with any merger or other business combination approved by the Board of
Directors since Sierra may redeem the Rights at the price of $.02 per Right
prior to the time that a person or group has acquired beneficial ownership of
20% or more of Sierra common stock.
Stock Option Plans. The Company has several plans that provide common
stock-based awards to employees and to non-employee directors. The plans provide
for the granting of Options, Stock, and other stock-based awards. Awards are
granted by a committee appointed by the Board of Directors. Options become
exercisable at such times and in such installments as set by the committee. The
exercise price of each option equals the market price of the Company's stock on
the date of grant. Stock options generally vest at a rate of 20% - 25% per year.
Options generally expire one year after the end of the vesting period.
The following table reflects the activity of the stock option plans:
Number of Option Weighted
Shares Price Average Price
Outstanding January 1, 1996................. 2,790,000 $ 2.25 - $21.17 $14.36
Granted.................................. 480,000 16.67 - 23.33 17.43
Exercised................................ (249,000) 2.25 - 19.09 8.38
Canceled................................. (23,000) 7.13 - 21.17 14.47
Outstanding December 31, 1996 .............. 2,998,000 5.00 - 23.33 15.34
Granted.................................. 459,000 16.25 - 24.50 23.15
Exercised................................ (705,000) 5.00 - 21.17 11.81
Canceled................................. (97,000) 6.31 - 23.33 17.33
Outstanding December 31, 1997 .............. 2,655,000 6.31 - 24.50 17.53
Granted.................................. 468,000 16.94 - 24.83 22.49
Exercised................................ (386,000) 6.31 - 23.33 14.25
Canceled................................. (7,000) 7.13 - 24.50 17.01
Outstanding December 31, 1998............... 2,730,000 6.31 - 24.83 18.89
Exercisable at December 31, 1998 ........... 1,274,000 $6.31 $24.50 $17.16
Available for Grant at
December 31, 1998 ....................... 3,002,000
56
SIERRA HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
For the Years Ended December 31, 1998, 1997 and 1996
The following table summarizes information about stock options outstanding
at December 31, 1998:
Weighted Average Weighted Average
Range of Exercise Remaining Options Exercise Price
Prices Contractual Life Outstanding Exercisable Outstanding Exercisable
$ 6.31 - 6.311,264 days 16,000 16,000 $ 6.31 $ 6.31
9.91 - 12.083,068 days 189,000 136,000 11.10 11.11
16.25 - 21.171,081 days 1,678,000 1,034,000 17.53 17.52
22.17 - 24.831,986 days 847,000 88,000 23.57 24.30
Employee Stock Purchase Plan. The Company has an employee stock purchase plan
(the "Purchase Plan") whereby employees may purchase newly issued shares of
stock through payroll deductions at 85% of the fair market value of such shares
on specified dates as defined in the Purchase Plan. As of December 31, 1998, the
Company had 353,000 shares reserved for purchase under the Purchase Plan. During
1998, a total of 144,000 shares were purchased at prices of $17.75 and $19.06
per share. During January 1999, 72,000 shares were issued to employees at $17.85
per share in connection with the Purchase Plan.
Accounting for Stock-Based Compensation. The Company uses the intrinsic value
method in accounting for its stock-based compensation plans. Accordingly, no
compensation cost has been recognized for its employee stock option plans nor
the Stock Purchase Plan. Had compensation cost for the Company's stock-based
compensation plans been determined based on the fair value at the grant dates
for awards under those plans, the Company's net income and earnings per share
would have been reduced to the pro forma amounts indicated below:
For the Years Ended
1998 1997 1996
Net Income As reported $39,596,000 $24,241,000 $31,143,000
Proforma 37,106,000 22,177,000 29,703,000
Net Income Per Share As reported $1.45 $.90 $1.17
Proforma 1.35 .82 1.12
Net Income Per Share
Assuming Dilution As reported $1.43 $.88 $1.15
Proforma 1.34 .81 1.09
The fair value of each option grant is estimated on the date of grant using the
Black-Scholes option pricing model with the following weighted average
assumptions used for grants in 1998, 1997 and 1996, respectively: dividend yield
of 0% for all years; expected volatility of 37%, 35% and 29%; risk-free interest
rates of 4.46%, 5.89% and 5.92%; and expected lives of five years for all years.
The weighted fair value of options granted in 1998, 1997 and 1996 was $9.92,
$8.27 and $5.65, respectively.
The fair value of the look-back option implicit in each offering of the Purchase
Plan is estimated on the date of grant using the Black-Scholes option pricing
model with the following weighted average assumptions used for grants in 1998,
1997 and 1996, respectively: dividend yield of 0% for all years; expected
volatility of 32%, 35% and 29%; risk-free interest rates of 5.30%, 5.32% and
5.29%; and expected lives of six months for all years.
57
SIERRA HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
For the Years Ended December 31, 1998, 1997 and 1996
Due to the fact that the Company's stock option programs vest over many years
and additional awards are made each year, the above pro forma numbers are not
indicative of the financial impact had the disclosure provisions of FAS 123 been
applicable to all years of previous option grants. The above numbers do not
include the effect of options granted prior to 1995.
13. STATEMENTS OF CASH FLOWS SUPPLEMENTAL INFORMATION
Supplemental statements of cash flows information for the years ended
December 31, is presented below:
1998 1997 1996
Cash Paid During the Year for Interest
(Net of Amount Capitalized)............................... $ 8,737,000 $4,463,000 $5,275,000
Cash Paid During the Year for Income Taxes.................... 15,003,000 7,943,000 7,966,000
Noncash Investing and Financing Activities:
Liabilities Assumed in Connection with
Corporate Acquisitions................................. 53,461,000 195,000 7,890,000
Reductions to Funds Withheld by Ceding
Insurance Company and Future
Policy Benefits........................................ 8,471,000 773,000
Stock Issued for Exercise of Options
and Related Tax Benefits............................... 1,284,000 2,004,000 1,158,000
Additions to Capital Leases............................... 3,070,000 4,574,000
14. INTEGRATION, SETTLEMENT AND OTHER COSTS
1998
During the fourth quarter of 1998, the Company incurred settlement expenses
totaling $8 million, $5.9 million after tax, related to the settlement of a
competitor's protest for the Region 1 TRICARE contract. All this amount was paid
during fiscal year 1998. On September 30, 1997, SMHS was awarded a five-year,
$1.2 billion contract to administer managed health care services to military
families and retirees in 13 northeastern states and Washington, D.C. A competing
bidder protested the contract award and claimed, among other issues, that the
United States Department of Defense failed to adequately disclose the weights of
the significant factors used to evaluate proposals. In December 1998, SMHS
reached an agreement to settle the protest. As part of the settlement, the
competitor has foregone any and all rights it may have to challenge the contract
award and seek re-bid.
During the fourth quarter of 1998, the Company incurred integration, transition
and other charges totaling $3.1 million, $2.3 million after tax, related
primarily to its acquisition of the Texas operations of Kaiser Foundation Health
Plan. In addition, the Company incurred certain legal expenses totaling $2.7
million, $2.0 million after tax, resulting primarily from the TRICARE settlement
and acquisition and integration activity. As of December 31, 1998, $2.8 million
was included in accrued expenses for these integration, transition and legal
costs incurred through December 31, 1998.
1997
During 1997, the Company recorded and paid expenses of approximately $11.0
million, $8.4 million after tax, for merger-related costs. On March 18, 1997,
the Company announced it had terminated its merger agreement with Physician
Corporation of America. The original agreement had been entered into in November
1996.
58
SIERRA HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
For the Years Ended December 31, 1998, 1997 and 1996
During the third quarter of 1997, SMHS was notified it had been awarded a
TRICARE managed care contract by the Department of Defense to serve eligible
beneficiaries in Region 1. This region includes more than 600,000 beneficiaries
in 13 northeastern states and the District of Columbia. Development expenses of
$18.4 million $10.6 million net of taxes, were recorded in the third quarter,
primarily for expenses associated with the Company's proposal to serve TRICARE
beneficiaries in Region 1. Such expenses had been deferred until award
notification. SMHS began health care delivery on June 1, 1998. SMHS subcontracts
for health care delivery, including some of the risk, for parts of the TRICARE
contract.
1996
During 1995, as part of the Company's clinical expansion and growth efforts, the
Company acquired a medical facility in Mohave County, Arizona, across the border
from Laughlin, Nevada. This medical facility included a 12-bed hospital. During
1996 the Company implemented a plan to exit the hospital business and has
actively pursued buyers for this business. As a result of this plan, the Company
recorded a charge of $3.8 million, $2.9 million after tax, in the fourth quarter
of 1996, primarily to recognize the estimated costs to dispose of the hospital.
As of December 31, 1998, the Company has been unable to reach an agreement to
sell the hospital.
As a result of higher than expected claim and administrative costs relative to
premium rates that can be obtained in certain regional insurance operations and
the Company's inability to negotiate adequate provider contracts due to its
limited presence in some of these markets, the Company adopted a plan to
restructure certain insurance operations during the third quarter of 1996 and
recorded a charge of $8.3 million, $6.2 million after tax. These restructuring
costs included cancellation of certain contractual obligations of $6.0 million,
lease termination costs of $1.5 million and approximately $750,000 of other
costs.
15. UNAUDITED QUARTERLY INFORMATION (Amounts in thousands, except per
share data)
March June September December
31 30 30 31
Year Ended December 31, 1998:
Operating Revenues.................................... $210,409 $244,545 $281,082 $301,167
Operating Income...................................... 17,663 18,550 18,213 6,147
Income Before Income Taxes ........................... 16,382 16,931 17,006 3,073
Net Income .....................................12,187 12,551 12,584 2,274
Earnings Per Share ................................... .44 .46 .46 .08
Earnings Per Share Assuming Dilution ................. .44 .45 .46 .08
Year Ended December 31, 1997:
Operating Revenues.................................... $170,578 $176,321 $183,859 $190,966
Operating Income (Loss) .............................. 3,242 15,103 (2,765) 16,328
Income (Loss) From Continuing Operations
Before Income Taxes ............................... 1,840 13,896 (3,705) 15,444
Net Income............................................ 1,398 10,561 495 11,787
Earnings Per Share ................................... .05 .39 .02 .43
Earnings Per Share Assuming Dilution ................. .05 .39 .02 .43
59
SIERRA HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
For the Years Ended December 31, 1998, 1997 and 1996
16. SEGMENT REPORTING
The Company has three reportable segments based on the products and services
offered: managed care and corporate operations, workers' compensation operations
and military health services operations. The managed care 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. The workers' compensation segment assumes workers' compensation
claims risk in return for premium revenues. The military health services segment
administers a five-year, managed care federal contract for the Department of
Defense's TRICARE program in Region 1.
Sierra evaluates each segment's performance based on segment operating profit.
The accounting policies of the operating segments are the same as those
described in the summary of significant accounting policies.
60
SIERRA HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
For the Years Ended December 31, 1998, 1997 and 1996
Information concerning the operations of the reportable segments is as follows:
(Amounts in thousands)
Managed Care Workers' Military
and Corporate Compensation Health Services
Operations Operations Operations Total
1998
Medical Premiums.................................. $609,404 0 0 $ 609,404
Specialty Product Revenues........................ 12,843 $135,525 148,368
Professional Fees ................................ 45,363 45,363
Military Contract Revenues........................ $204,838 204,838
Investment and Other Revenues..................... 8,594 20,229 407 29,230
Total Revenue.................................. $676,204 $155,754 $205,245 $1,037,203
Depreciation and Amortization..................... $ 15,545 $ 1,551 $ 2,167 $ 19,263
Interest Expense and Other 2,610 3,998 573 7,181
Segment Profit. ....................... $ 40,704 $ 18,492 $ 8,047 $ 67,243
Integration, Settlement and Other Costs........... (4,869) (8,982) (13,851)
Net Income (Loss) Before Income Taxes............. $ 35,835 $ 18,492 $ (935) $ 53,392
Segment Assets. ........................ $ 593,332 $377,911 $ 73,877 $1,045,120
Capital Expenditures.............................. 32,520 3,208 5,015 40,743
1997
Medical Premiums.................................. $513,857 $ 513,857
Specialty Product Revenues........................ 16,297 $129,914 146,211
Professional Fees ................................ 31,238 31,238
Military Contract Revenues........................ $ 4,346 4,346
Investment and Other Revenues..................... 8,711 17,361 26,072
Total Revenue.................................. $570,103 $147,275 $ 4,346 $ 721,724
Depreciation & Amortization....................... $ 12,491 $ 950 $ 69 $ 13,510
Interest Expense and Other 371 4,062 4,433
Segment Profit. ....................... $ 45,662 $ 11,010 153 $ 56,825
Integration, Settlement and Other Costs........... (12,600) (16,750) (29,350)
Net Income (Loss) Before Income Taxes............. $ 33,062 $ 11,010 $(16,597) $ 27,475
Segment Assets. ........................ $373,652 $343,425 $ 6,859 $ 723,936
Capital Expenditures.............................. 43,825 11,178 639 55,642
1996
Medical Premiums.................................. $386,968 $ 386,968
Specialty Product Revenues........................ 11,983 $121,341 133,324
Professional Fees ................................ 28,836 28,836
Investment and Other Revenues..................... 7,595 18,688 26,283
Total Revenue.................................. $435,382 $140,029 $ 575,411
Depreciation & Amortization....................... $ 9,599 $ 900 $ 10,499
Interest Expense and Other (1,247) 4,070 2,823
Segment Profit. ....................... $ 42,930 $ 10,748 $ 53,678
Integration, Settlement and Other Costs........... (12,064) 12,064
Net Income Before Income Taxes.................... $ 30,866 $ 10,748 $ 41,614
Segment Assets. ....................... $313,463 $315,999 $ 629,462
Capital Expenditures.............................. 17,361 566 17,927
61
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
None.
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information set forth under the caption "Election of Directors" in Sierra's
Proxy Statement for its 1999 Annual Meeting of Stockholders, is incorporated
herein by reference.
ITEM 11. EXECUTIVE COMPENSATION
The information set forth under the caption "Compensation of Executive Officers"
in Sierra's Proxy Statement for its 1999 Annual Meeting of Stockholders, is
incorporated herein by reference.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information set forth under the caption "Security Ownership of Certain
Beneficial Owners and Management" in Sierra's Proxy Statement for its 1999
Annual Meeting of Stockholders, is incorporated herein by reference.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information set forth under the caption "Certain Relationships and Related
Transactions" in Sierra's Proxy Statement for its 1999 Annual Meeting of
Stockholders, is incorporated herein by reference.
62
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a)(1) The following consolidated financial statements are included in Part
II, Item 8 of this Report:
Page
Independent Auditors' Report............................................................. 35
Consolidated Balance Sheets at December 31, 1998 and 1997................................ 36
Consolidated Statements of Operations for the Years Ended
December 31, 1998, 1997 and 1996...................................................... 37
Consolidated Statements of Changes in Stockholders' Equity
for the Years Ended December 31, 1998, 1997 and 1996.................................. 38
Consolidated Statements of Cash Flows for the Years Ended
December 31, 1998, 1997 and 1996...................................................... 39
Notes to Consolidated Financial Statements............................................... 40
(a)(2) Financial Statement Schedules:
Schedule I - Condensed Financial Information of Registrant................... S-1
Schedule V - Supplemental Information Concerning
Property-Casualty Insurance .................................. S-4
Section 403.04 b - Reconciliation of Beginning and Ending Loss
and Loss Adjustment Expense Reserves
and Exhibit of Redundancies (Deficiencies) ................... S-5
All other schedules are omitted because they are not applicable, not required,
or because the required information is in the consolidated financial statements
or notes thereto.
(a)(3) and (c) The following exhibits are filed as part of, or incorporated by
reference into, this Report as required by Item 601 of Regulation
S-K:
(3.1) Articles of Incorporation, together with amendments thereto to
date, incorporated by reference to the Registrant's Annual
Report on Form 10-K for the fiscal year ended December 31,
1990.
(3.2) Certificate of Division of Shares into Smaller Denominations
of the Registrant, incorporated by reference to Exhibit 3.3 to
the Registrant's Annual Report on Form 10-K for the fiscal
year ended December 31, 1992.
(3.3) Amended and Restated Bylaws of the Registrant, as amended
through December 12, 1997, incorporated by reference to
Exhibit 3.3 to the Registrant's Annual Report on Form 10-K for
the fiscal year ended December 31, 1997.
(4.1) Rights Agreement, dated as of June 14, 1994, between the
Registrant and Continental Stock Transfer & Trust Company,
incorporated by reference to Exhibit 3.4 to the Registrant's
Registration Statement on Form S-3 effective October 11, 1994
(Reg. No. 33- 83664).
(4.2) Specimen Common Stock Certificate, incorporated by reference to
Exhibit 4(e) to the Registrant's Registration Statement on Form S-8 as filed and
effective on August 5, 1994 (Reg. No. 33-82474).
(4.3) Form of Indenture, of 7 1/2% convertible subordinated
debentures due 2001 from CII Financial, Inc. to Manufacturers
Hanover Trust Company as Trustee dated September 15, 1991,
incorporated by reference to Exhibit 4.2 of Post-Effective
Amendment No. 1 on Form S-3 to Registration Statement on Form
S-4 dated October 6, 1995 (Reg. No. 33-60591).
63
(4.4) First Supplemental Indenture between CII Financial, Inc., Sierra
Health Services, Inc. and Chemical Bank as Trustee, dated as of October 31,
1995, to Indenture dated September 15, 1991, incorporated by reference to
Exhibit 4.3 of Post-Effective Amendment No. 2 on Form S-3 to Registration
Statement on Form S-4 dated October 31, 1995 (Reg. No. 33- 60591).
(10.1) Administrative Services agreement between Health Plan of
Nevada, Inc. and the Registrant dated December 1, 1987,
incorporated by reference to Exhibit 10.17 to Registrant's
Annual Report on Form 10-K for the fiscal year ended December
31, 1991.
(10.2) Administrative Services agreement between Sierra Health and
Life Insurance Company, Inc. and the Registrant dated April 1,
1989, incorporated by reference to Exhibit 10.18 to
Registrant's Annual Report on Form 10-K for the fiscal year
ended December 31, 1991.
(10.3) Agreement between Health Plan of Nevada, Inc. and the United States
Health Care Financing Administration dated July 24, 1992, incorporated by
reference to Exhibit 10.18 to the Registrant's Annual Report on Form 10-K filed
for the fiscal year ended December 31, 1992.
(10.4) Credit Agreement dated as of October 30, 1998, among Sierra
Health Services, Inc. as Borrower, Bank of America National
Trust and Savings Association as Administrative Agent and
Issuing Bank, First Union National Bank as Syndication Agent,
and the Other Financial Institutions Party Thereto, dated as
of October 30, 1998.
(10.5) First Amendment to Credit Agreement among Sierra Health
Services, Inc., as Borrower, Bank of America National Trust
and Savings Association as Administrative Agent and Issuing
Bank and the Other Financial Institutions Party Thereto, dated
as of November 23, 1998.
(10.6) Second Amendment to Credit Agreement among Sierra Health
Services, Inc. as borrower, Bank of America National Trust and
Savings Association as Administrative Agent and the Other
Financial Institutions Party Thereto, dated as of January 15,
1999.
(10.7) Compensatory Plans, Contracts and Arrangements.
(1) Employment Agreement with Jonathon W. Bunker dated
November 15, 1997, incorporated by reference to Exhibit
10.6 to Registrant's Annual Report on Form 10-K for the
fiscal year ended December 31, 1997.
(2) Employment Agreement with Frank E. Collins dated
November 15, 1997, incorporated by reference to Exhibit
10.6 to Registrant's Annual Report on Form 10-K for the
fiscal year ended December 31, 1997.
(3) Employment Agreement with William R. Godfrey dated
November 15, 1997, incorporated by reference to Exhibit
10.6 to Registrant's Annual Report on Form 10-K for the
fiscal year ended December 31, 1997.
(4) Employment Agreement with Laurence S. Howard dated
November 15, 1997, incorporated by reference to Exhibit
10.6 to Registrant's Annual Report on Form 10-K for the
fiscal year ended December 31, 1997.
(5) Employment Agreement with Anthony M. Marlon, M.D. dated
November 15, 1997, incorporated by reference to Exhibit
10.6 to Registrant's Annual Report on Form 10-K for the
fiscal year ended December 31, 1997.
64
(6) Employment Agreement with Erin E. MacDonald dated
November 15, 1997, incorporated by reference to Exhibit
10.6 to Registrant's Annual Report on Form 10-K for the
fiscal year ended December 31, 1997.
(7) Employment Agreement with Michael A. Montalvo dated
November 15, 1997, incorporated by reference to Exhibit
10.6 to Registrant's Annual Report on Form 10-K for the
fiscal year ended December 31, 1997.
(8) Employment Agreement with Marie H. Soldo dated November
15, 1997, incorporated by reference to Exhibit 10.6 to
Registrant's Annual Report on Form 10-K for the fiscal
year ended December 31, 1997.
(9) Employment Agreement with James L. Starr dated November
15, 1997, incorporated by reference to Exhibit 10.6 to
Registrant's Annual Report on Form 10-K for the fiscal
year ended December 31, 1997.
(10) Employment Agreement with Paul H. Palmer dated November
20, 1998.
(11) Draft of Split Dollar Life Insurance Agreement effective as of July 1,
1997, by and between Sierra Health Services, Inc., and Jonathon W. Bunker, Ria
Marie Carlson, Frank E. Collins, William R. Godfrey, Laurence S. Howard, Erin E.
MacDonald, Anthony M. Marlon, M.D., Kathleen M. Marlon, Michael A. Montalvo,
John A. Nanson, M.D., Marie H. Soldo, and James L. Starr, incorporated by
reference to Exhibit 10.2 to the Registrant's Quarterly Report on Form 10-Q for
the fiscal quarter ended June 30, 1997.
(12) Sierra Health Services, Inc. Deferred Compensation
Plan effective May 1, 1996 as Amended and Restated
Effective July 1, 1997, dated as of July 1, 1997,
incorporated by reference to Exhibit 10.3 to the
Registrant's Quarterly Report on Form 10-Q for the
fiscal quarter ended June 30, 1997.
(13) Sierra Health Services, Inc. Supplemental Executive
Retirement Plan effective as of July 1, 1997, dated as
of July 7, 1997, incorporated by reference to Exhibit
10.4 to the Registrant's Quarterly Report on Form 10-Q
for the fiscal quarter ended June 30, 1997.
(14) Sierra Health Services, Inc. Supplemental Executive
Retirement Plan effective as of March 1, 1998,
incorporated by reference to Exhibit 10 to the
Registrant's Quarterly Report on Form 10-Q for the
fiscal quarter ended March 31, 1998.
(15) The Registrant's Second Amended and Restated 1986 Stock
Option Plan as amended to date, incorporated by
reference to Exhibit 10.24 to the Registrant's Annual
Report on Form 10-K for the fiscal year ended December
31, 1992.
(16) The Registrant's Second Restated Capital Accumulation
Plan, as amended to date, incorporated by reference to
Exhibit 10.24 to the Registrant's Annual Report on Form
10-K for the fiscal year ended December 31, 1992.
(17) Protocols for cash bonus awards, incorporated by
reference to Exhibit 10.17 (5) to the Registrant's
Annual Report on Form 10-K for the fiscal year ended
December 31, 1994.
(18) Sierra Health Services, Inc. 1995 Long-Term Incentive
Plan, as amended and restated through May 18, 1998,
incorporated by reference to Exhibit 10.4 to the
Registrant's Quarterly Report on Form 10-Q for the
fiscal quarter ended June 30, 1998.
65
(19) Sierra Health Services, Inc. 1995 Non-Employee
Directors' Stock Plan, as amended and restated through
May 18, 1998, incorporated by reference to Exhibit 10.5
to the Registrant's Quarterly Report on Form 10-Q for
the fiscal quarter ended June 30, 1998.
(10.8) Agreement and Plan of Merger dated as of June 12, 1995 among
the Registrant, Health Acquisition Corp., and CII Financial,
Inc., incorporated by reference to the Report on Form 8-K
dated June 13, 1995, as amended.
(10.9) Loan Agreement dated August 11, 1997 between the Company and
Anthony M. Marlon for a revolving credit facility in the
maximum aggregate amount of $3,000,000, incorporated by
reference to the Registrant's Quarterly Report on Form 10-Q
for the fiscal quarter ended September 30, 1997.
(10.10) Master Purchase and Sale Agreement between Kaiser Foundation
Health Plan of Texas (as Seller) and HMO Texas, L.C. (as
Buyer), dated June 5, 1998, incorporated by reference to
Exhibit 10.1 to the Registrant's Quarterly Report on Form 10-Q
for the fiscal quarter ended June 30, 1998.*
(10.11) Asset Sale and Purchase Agreement between Kaiser Foundation
Health Plan of Texas, A Texas Non-Profit Corporation and HMO
Texas, L.C., a Texas Limited Liability Company, dated June 5,
1998, incorporated by reference to Exhibit 10.2 to the
Registrant's Quarterly Report on Form 10-Q for the fiscal
quarter ended June 30, 1998.*
(10.12) Asset Sale and Purchase Agreement between Permanente Medical
Association of Texas, a Texas Professional Association and HMO
Texas, L.C., a Texas Limited Liability Company, dated June 5,
1998, incorporated by reference to Exhibit 10.3 to the
Registrant's Quarterly Report on Form 10-Q for the fiscal
quarter ended June 30, 1998.*
(10.13) Amendment No. 2 to Asset Sale and Purchase Agreement between Kaiser
Foundation Health Plan of Texas and Texas Health Choice, L.C. (formerly HMO
Texas, L.C.)*
66
(21) Subsidiaries of the Registrant (listed herein):
There is no parent of the Registrant. The following is a
listing of the active subsidiaries of the Registrant:
Jurisdiction of
Incorporation
Sierra Health and Life Insurance Company, Inc. California
Health Plan of Nevada, Inc. Nevada
Sierra Healthcare Options, Inc. and Subsidiary Nevada
Behavioral Healthcare Options, Inc. Nevada
Family Health Care Services Nevada
Family Home Hospice, Inc. Nevada
Southwest Medical Associates, Inc. Nevada
Sierra Medical Management, Inc. and Subsidiaries Nevada
Southwest Realty, Inc. Nevada
Sierra Health Holdings, Inc. (Texas Health Choice, L.C.) Texas
Sierra Texas Systems, Inc. Texas
CII Financial, Inc., and Subsidiaries California
Northern Nevada Health Network, Inc. Nevada
Intermed, Inc. Arizona
Prime Holdings, Inc. and Subsidiaries Nevada
Sierra Military Health Services, Inc. Nevada
Sierra Home Medical Products, Inc. Nevada
Nevada Administrators, Inc. Nevada
MedOne Health Plan, Inc. Nevada
(23.1) Consent of Deloitte & Touche LLP
(27.1) Financial Data Schedule - 1998
(99) Registrant's current report on Form 8-K dated March 17, 1999,
incorporated herein.
All other Exhibits are omitted because they are not applicable.
(b) Reports on Form 8-K
The Company filed a Current Report on Form 8-K, dated November
11, 1998, with the Securities and Exchange Commission to
present pro forma financial information related to the
acquisition of Kaiser-Texas and the required financial
statements.
(d) Financial Statement Schedules
The Exhibits set forth in Item 14 (a)(2) are filed herewith.
*The agreements contain certain schedules and exhibits which were not included
in this filing. The Company will furnish supplementally a copy of any omitted
schedule or exhibit to the Commission upon request.
67
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has caused this report to be signed on its
behalf by the undersigned thereto duly authorized.
SIERRA HEALTH SERVICES, INC.
By: /S/ ANTHONY M. MARLON
Anthony M. Marlon, M.D.
Date: March 17, 1999
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
Registrant and in the capacities and on the dates indicated.
Signature Title Date
/S/ ANTHONY M. MARLON, M.D. Chief Executive Officer March 17, 1999
Anthony M. Marlon, M.D. and Chairman of the Board
(Chief Executive Officer)
/S/ PAUL H. PALMER Vice President of Finance, March 17, 1999
Paul H. Palmer Chief Financial Officer,
and Treasurer
(Chief Accounting Officer)
/S/ ERIN E. MACDONALD President and March 17, 1999
Erin E. MacDonald Chief Operating Officer
Director
/S/ CHARLES L. RUTHE Director March 17, 1999
Charles L. Ruthe
/S/ WILLIAM J. RAGGIO Director March 17, 1999
William J. Raggio
/S/ THOMAS Y. HARTLEY Director March 17, 1999
Thomas Y. Hartley
68
SIERRA HEALTH SERVICES, INC. AND SUBSIDIARIES
SCHEDULE I - CONDENSED FINANCIAL INFORMATION OF REGISTRANT
CONDENSED BALANCE SHEETS - Parent Company Only
December 31,
1998 1997
CURRENT ASSETS:
Cash and Cash Equivalents .......................................... $ 7,945,000 $ 15,115,000
Short-term Investments.............................................. 2,831,000 2,090,000
Prepaid Expenses and Other Current Assets........................... 9,189,000 10,415,000
Total Current Assets.......................................... 19,965,000 27,620,000
PROPERTY AND EQUIPMENT - NET ............................................ 45,699,000 55,251,000
EQUITY IN NET ASSETS OF SUBSIDIARIES .................................... 375,910,000 204,204,000
NOTES RECEIVABLE FROM SUBSIDIARIES ...................................... 9,677,000 9,744,000
LONG-TERM INVESTMENTS ................................................... 1,088,000 86,000
GOODWILL AND OTHER INTANGIBLE ASSETS .................................... 2,275,000 2,362,000
OTHER ................................................................... 30,817,000 24,081,000
TOTAL ASSETS ............................................................ $485,431,000 $323,348,000
CURRENT LIABILITIES:
Accounts Payable and Other Accrued Liabilities ..................... $ 24,422,000 $ 16,757,000
Current Portion of Long-term Debt .................................. 393,000 2,349,000
Total Current Liabilities .................................... 24,815,000 19,106,000
LONG-TERM DEBT (Less Current Portion).................................... 139,429,000 25,858,000
OTHER LIABILITIES ....................................................... 17,473,000 12,702,000
TOTAL LIABILITIES ....................................................... 181,717,000 57,666,000
STOCKHOLDERS' EQUITY:
Capital Stock ...................................................... 141,000 139,000
Additional Paid-in Capital ......................................... 173,583,000 164,247,000
Treasury Stock ..................................................... (14,821,000) (5,601,000)
Accumulated Other Comprehensive Income:
Unrealized Holding (Loss) on Available-for-sale
Investments ............................................. (1,027,000) 655,000
Retained Earnings .................................................. 145,838,000 106,242,000
Total Stockholders' Equity ................................... 303,714,000 265,682,000
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY............................... $485,431,000 $323,348,000
Note:Scheduled maturities of long-term debt, including the principal portion of
obligations under capital leases, are as follows:
Year Ending December 31,
1999........................................................... $ 393,000
2000........................................................... 429,000
2001........................................................... --
2002........................................................... --
2003 .......................................................... 139,000,000
Thereafter..................................................... --
Total...................................................... $139,822,000
S-1
SIERRA HEALTH SERVICES, INC. AND SUBSIDIARIES
SCHEDULE I - CONDENSED FINANCIAL INFORMATION OF REGISTRANT (Continued)
CONDENSED STATEMENT OF OPERATIONS - Parent Company Only
Year Ended December 31,
1998 1997 1996
OPERATING REVENUES:
Management Fees........................................ $52,773,000 $47,303,000 $44,139,000
Subsidiary Dividends................................... 4,085,000 1,700,000 3,733,000
Investment and Other Income............................ 5,564,000 6,688,000 5,145,000
Total Operating Revenues............................ 62,422,000 55,691,000 53,017,000
GENERAL AND ADMINISTRATIVE EXPENSES:
Payroll and Benefits................................... 22,238,000 17,616,000 11,579,000
Depreciation........................................... 5,329,000 3,707,000 3,433,000
Data Processing Maintenance............................ 2,556,000 2,370,000 1,115,000
Rent................................................... 620,000 615,000 649,000
Repairs and Maintenance................................ 879,000 459,000 408,000
Legal.................................................. 691,000 293,000 1,874,000
Consulting............................................. 1,242,000 769,000 827,000
Other.................................................. 6,489,000 4,677,000 4,030,000
Integration, Settlement and Other Costs ..... ......... 4,569,000 29,350,000 12,064,000
Total General and Administrative.................... 44,613,000 59,856,000 35,979,000
INTEREST EXPENSE AND OTHER, NET............................ (2,566,000) (676,000) (503,000)
EQUITY IN UNDISTRIBUTED
EARNINGS OF SUBSIDIARIES............................... 28,364,000 25,615,000 21,991,000
INCOME BEFORE INCOME TAXES................................. 43,607,000 20,774,000 38,526,000
(PROVISION FOR) BENEFIT FROM
INCOME TAXES.......................................... (4,011,000) 3,467,000 (7,383,000)
NET INCOME................................................. $39,596,000 $24,241,000 $31,143,000
S-2
SIERRA HEALTH SERVICES, INC. AND SUBSIDIARIES
SCHEDULE I - CONDENSED FINANCIAL INFORMATION OF REGISTRANT (Continued)
CONDENSED STATEMENTS OF CASH FLOWS - Parent Company Only
Year Ended December 31,
1998 1997 1996
CASH FLOWS FROM OPERATING ACTIVITIES:
Net Income........................................................... $39,596,000 $24,241,000 $31,143,000
Adjustments to Reconcile Net Income to Net Cash
Provided by Operating Activities:
Depreciation and Amortization.................................... 5,416,000 3,885,000 3,611,000
Equity in Undistributed Earnings of Subsidiaries..................... (28,364,000) (25,615,000) (21,991,000)
Change in Assets and Liabilities:
Other Assets..................................................... (6,890,000) (1,177,000) (15,917,000)
Current Assets................................................... 1,192,000 (2,312,000) (5,959,000)
Current Liabilities.............................................. 8,949,000 5,493,000 4,712,000
Other Long-term Liabilities ..................................... 4,770,000 6,634,000 6,069,000
Net Cash Provided by Operating Activities........................ 24,669,000 11,149,000 1,668,000
CASH FLOWS FROM INVESTING ACTIVITIES:
Capital Expenditures, Net ........................................... (22,294,000) (26,453,000) (9,292,000)
(Increase) Decrease in Short-term Securities......................... (606,000) 9,732,000 14,136,000
(Increase) Decrease in Other Assets.................................. (886,000) 5,820,000 6,942,000
Dividends from Subsidiary............................................ 4,085,000 1,700,000 3,733,000
Acquisitions, Net of Cash Acquired .................................. (7,500,000) (3,145,000) (31,270,000)
Dispositions, Net of Cash Disposed .................................. 1,373,000
(Increase) Decrease in Net Assets in Subsidiaries................... (125,488,000) (30,816,000) 14,321,000
Net Cash Used for Investing Activities .......................... (151,316,000) (43,162,000) (1,430,000)
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from Long-term Borrowing ................................... 166,000,000 25,000,000
Reductions in Long-term Obligations and
Payments on Capital Leases....................................... (45,424,000) (480,000) (718,000)
Proceeds from Note Receivable to Subsidiary.......................... 67,000 60,000 2,789,000
Purchase of Treasury Stock .......................................... (9,220,000) (5,471,000)
Exercise of Stock in Connection with Stock Plans..................... 8,054,000 10,258,000 3,638,000
Net Cash Provided by Financing Activities........................ 119,477,000 29,367,000 5,709,000
Net (Decrease) Increase in Cash and Cash Equivalents....................... (7,170,000) (2,646,000) 5,947,000
Cash and Cash Equivalents at Beginning of Year............................. 15,115,000 17,761,000 11,814,000
Cash and Cash Equivalents at End of Year................................... $ 7,945,000 $15,115,000 $17,761,000
Supplemental condensed statements of cash flows information:
Cash Paid During the Year for Interest
(Net of Amount Capitalized).......................................... $ 2,030,000 $ 632,000 $ 443,000
Cash Paid During the Year for Income Taxes................................. 14,788,000 7,916,000 6,423,000
Noncash Investing and Financing Activities:
Stock Issued for Exercise of Options
and Related Tax Benefits......................................... 1,284,000 2,004,000 1,158,000
Liabilities Assumed in Connection
with Corporate Acquisition....................................... 1,233,000
S-3
SIERRA HEALTH SERVICES, INC.
SUPPLEMENTAL INFORMATION
CONCERNING PROPERTY - CASUALTY INSURANCE
(amounts in thousands)
Gross
Reserves
Deferred for Unpaid
Policy Claims and Discount if any Gross Net
Acquisition Adjustment Deducted in Unearned Earned Investment
Affiliation With Costs Expenses Column C Premiums Premiums Income
Registrant Column A Column B Column C Column D Column E Column F Column G
Consolidated Property and
Casualty Entities of CII
Financial, Inc. for
Years Ended:
December 31, 1998........ $1,804 $212,263 -- $11,158 $154,104 $18,241
December 31, 1997........ 1,800 202,699 -- 11,285 134,262 16,780
December 31, 1996........ 1,832 187,776 -- 9,885 126,121 16,422
Table continued on next page
SIERRA HEALTH SERVICES, INC.
SUPPLEMENTAL INFORMATION
CONCERNING PROPERTY - CASUALTY INSURANCE
(amounts in thousands)
Claims & Claim
Adjustment Amortization
Expenses Incurred of Deferred Paid Claims
Related to Policy and Claims Direct
(1) (2) Acquisition Adjustment Premiums
Affiliation With Current Prior Year Costs Expenses Written
Registrant Column A Year Column H Column I Column J Column K
Consolidated Property and
Casualty Entities of CII
Financial, Inc. for
Years Ended:
December 31, 1998........ $103,990 $(9,643) $28,243 $101,524 $153,914
December 31, 1997........ 102,301 (8,970) 26,211 83,788 135,580
December 31, 1996........ 101,401 (15,284) 21,968 70,464 126,497
S-4
SIERRA HEALTH SERVICES, INC. AND SUBSIDIARIES
SECTION 403.04b
RECONCILIATION OF BEGINNING AND ENDING LOSS AND LOSS
ADJUSTMENT EXPENSE RESERVES
AND EXHIBIT OF REDUNDANCIES (DEFICIENCIES)
(in thousands)
Year ended December 31
1998 1997 1996 1995 1994 1993 1992 1991 1990 1989
Losses and LAE
Reserve............... $212,263 $202,699 $187,776 $182,318 $190,962 $200,356 $178,460 $112,749 $ 67,593 $ 37,466
Less Reinsurance
Recoverables (1)...... 37,797 21,056 15,676 25,871 29,342 25,841 20,207
Net Loss and LAE
Reserves ............. 174,466 181,643 172,100 156,447 161,620 174,515 158,253
Cumulative Net Paid
as of:
One Year Later ....... 71,933 56,977 45,731 44,519 50,210 50,360 57,611 39,118 14,820
Two Years Later ...... 91,765 70,854 68,619 79,788 84,465 89,177 65,165 28,657
Three Years Later .... 83,674 80,645 94,865 104,569 108,849 76,988 36,579
Four Years Later ..... 86,381 102,395 114,293 120,539 83,822 39,345
Five Years Later ..... 106,012 119,462 126,100 87,618 41,043
Six Years Later ...... 122,000 129,060 89,607 41,962
Seven Years Later .... 130,649 90,721 42,541
Eight Years Later .... 91,354 42,818
Nine Years Later ..... 43,054
Net Reserve Re-estimated
as of:
One Year Later ....... 172,000 163,130 141,163 139,741 160,562 154,388 140,815 83,841 37,463
Two Years Later ...... 146,987 132,193 125,279 141,100 147,167 142,447 96,011 39,753
Three Years Later .... 113,766 117,792 126,483 134,747 143,433 97,142 43,528
Four Years Later ..... 102,955 122,517 132,193 137,143 97,942 44,404
Five Years Later ..... 114,443 131,112 135,249 94,852 45,027
Six Years Later ...... 127,258 135,299 93,561 44,543
Seven Years Later .... 133,729 93,672 43,741
Eight Years Later .... 92,851 43,682
Nine Years Later ..... 43,682
Cumulative Redundancy
(Deficiency) ......... 9,643 25,113 42,681 58,665 60,072 30,995 (20,980) (25,258) (6,216)
Net Reserve.............. 174,466 181,643 172,100 156,447 161,620 174,515
Reinsurance
Recoverables...... 37,797 21,056 15,676 25,871 29,342 25,841
Gross Reserve ......... $212,263 202,699 187,776 182,318 190,962 200,356
Net Re-estimated Reserve ..... 172,000 146,987 113,766 102,955 114,443
Re-estimated Reinsurance
Recoverables ......... 17,856 14,154 15,000 14,502 12,523
Gross Re-Estimated
Reserve .............. 189,856 161,141 128,766 117,457 126,966
Gross Cumulative
Redundancy............ $ 12,843 $ 26,635 $ 53,552 $ 73,505 $ 73,390
(1) Amounts reflect reinsurance recoverable under prospective reinsurance
contracts only. The Company adopted Financial Accounting Standards Board
Statement No. 113 ("FAS 113"), "Accounting and Reporting for
Short-Duration and Long-Duration Reinsurance Contracts" for the year
ended December 31, 1992. As permitted, prior financial statements have
not been restated. Reinsurance recoverables on unpaid losses and LAE are
shown as an asset on the balance sheets at December 31, 1998 and 1997.
However, for purposes of the reconciliation and development tables, loss
and LAE information are shown net of reinsurance.
See the notes to consolidated financial
statements.
S-5