MID ATLANTIC MEDICAL SERVICES INC - 10-Q Quarterly Report

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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
--------------------

FORM 10-Q

[X] Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange
Act of 1934

For the quarterly period ended MARCH 31, 2003, or

[ ] Transition report pursuant to Section 13 or 15(d) of the Securities Exchange
Act of 1934

For the transition period from to -------- --------

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COMMISSION FILE NUMBER 1-13340
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MID ATLANTIC MEDICAL SERVICES, INC.
(Exact name of registrant as specified in its charter)

DELAWARE
(State or other jurisdiction of
incorporation or organization)

52-1481661
(I.R.S. Employer Identification No.)

4 TAFT COURT, ROCKVILLE, MARYLAND
(Address of principal executive offices)

20850
(Zip code)

(301) 762-8205
(Registrant's telephone number, including area code)

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 whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act).

Yes [X] No [ ]

The number of shares outstanding of each of the issuer's classes of common stock
was 46,654,322 shares of common stock, par value $.01, outstanding as of March
31, 2003.

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PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS

MID ATLANTIC MEDICAL SERVICES, INC.
CONSOLIDATED CONDENSED BALANCE SHEETS (Note 1)
(in thousands except share amounts)

(Unaudited) (Note)
March 31, 2003 December 31, 2002
------------ ------------

ASSETS
Current assets:
Cash and cash equivalents $ 10,458 $ 7,144
Investment securities 580,753 486,740
Accounts receivable, net of allowance of $7,289 and $7,068 145,373 118,050
Prepaid expenses, advances and other 34,695 37,104
Deferred income taxes 4,793 3,419
----------- -----------
Total current assets 776,072 652,457

Property and equipment, net of accumulated
depreciation of $73,168 and $70,123 82,372 82,683
Statutory deposits 21,543 21,541
Other assets 9,266 8,951
Deferred income taxes 8,164 7,396
----------- -----------
Total assets $ 897,417 $ 773,028
=========== ===========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Short-term borrowings $ 3,247 $ 3,219
Accounts payable 59,485 62,434
Claims payable, net 362,484 297,304
Income taxes payable 16,160 12,751
Deferred premium revenue 43,104 33,901
Unearned revenue 33,743 14,592
Deferred income taxes 2,518 2,262
----------- -----------
Total liabilities 520,741 426,463
----------- -----------
Stockholders' equity
Common stock, $.01 par, 100,000,000 shares authorized; 65,772,502 issued and
46,654,322 outstanding at March 31, 2003; 65,772,502 issued
and 46,987,122 outstanding at December 31, 2002 657 657
Additional paid-in capital 526,088 466,154
Stock compensation trust (common stock held in trust) 7,933,766 shares
outstanding at March 31, 2003;
8,311,590 shares outstanding at December 31, 2002 (321,714) (269,296)
Treasury stock, 19,118,180 shares at March 31, 2003;
18,785,380 shares at December 31, 2002 (288,114) (276,205)
Accumulated other comprehensive income 9,628 9,279
Retained earnings 450,131 415,976
----------- -----------
Total stockholders' equity 376,676 346,565
----------- -----------
Total liabilities and stockholders' equity $ 897,417 $ 773,028
=========== ===========

Note: The balance sheet at December 31, 2002 has been extracted from the audited
financial statements at that date.

See accompanying notes to these financial statements.

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MID ATLANTIC MEDICAL SERVICES, INC.
CONSOLIDATED CONDENSED STATEMENTS OF INCOME
(in thousands except share amounts)
(Unaudited)

Three Months Ended
March 31, March 31,
2003 2002
------------ ------------

Revenue
Health premium $ 646,501 $ 534,010
Fee and other 5,873 5,555
Life and short-term disability premium 2,340 2,152
Home health services 5,655 5,244
Investment 4,007 3,202
----------- -----------
Total revenue 664,376 550,163
----------- -----------
Expense
Medical 538,436 455,444
Life and short-term disability claims 1,131 785
Home health patient services 5,654 4,774
Administrative (including interest expense of $189 and $159) 67,289 61,486
----------- -----------
Total expense 612,510 522,489
----------- -----------
Income before income taxes 51,866 27,674

Income tax expense (17,711) (8,821)
----------- -----------

Net income $ 34,155 $ 18,853
=========== ===========

Basic earnings per common share $ .88 $ .48
=========== ===========

Diluted earnings per common share $ .84 $ .45
=========== ===========

See accompanying notes to these financial statements.

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MID ATLANTIC MEDICAL SERVICES, INC.
CONSOLIDATED STATEMENT OF CASH FLOWS
(in thousands)
(Unaudited)

Three Months
Ended
March 31, 2003
------------

Cash flows provided by operating activities:
Net income $ 34,155
Adjustments to reconcile net income to net cash provided by
operating activities:
Depreciation and amortization $ 3,115
Provision for bad debts 221
Provision for deferred income taxes (2,075)
Loss on sale and disposal of assets 5
Stock option tax benefit 3,383
Increase in accounts receivable (27,544)
Decrease in prepaid expenses, advances, and other 2,409
Decrease in accounts payable (2,949)
Increase in income taxes payable 3,409
Increase in claims payable, net 65,180
Increase in deferred premium revenue 9,203
Increase in unearned revenue 19,151
-----------
Total adjustments 73,508
-----------
Net cash provided by operating activities 107,663

Cash flows used in investing activities:
Purchases of investment securities (231,698)
Sales of investment securities 138,209
Purchases of property and equipment (2,796)
Purchase of statutory deposits (1,050)
Maturity of statutory deposit 1,050
Purchases of other assets (357)
Proceeds from sale of assets 41
-----------
Net cash used in investing activities (96,601)

Cash flows used in financing activities:
Increase in short-term borrowings 28
Exercise of stock options 4,133
Purchase of treasury stock (11,909)
-----------
Net cash used in financing activities (7,748)
-----------
Net increase in cash and cash equivalents 3,314

Cash and cash equivalents at beginning of period 7,144
-----------
Cash and cash equivalents at end of period $ 10,458
===========

See accompanying notes to these financial statements.

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MID ATLANTIC MEDICAL SERVICES, INC.
CONSOLIDATED STATEMENT OF CASH FLOWS
(in thousands)
(Unaudited)

Three Months
Ended
March 31, 2002
------------

Cash flows provided by operating activities:
Net income $ 18,853
Adjustments to reconcile net income to net cash provided by
operating activities:
Depreciation and amortization $ 2,857
Provision for bad debts 196
Provision for deferred income taxes 555
Loss on sale and disposal of assets 9
Stock option tax benefit 3,611
Increase in accounts receivable (19,418)
Increase in prepaid expenses, advances, and other (426)
Decrease in accounts payable (300)
Increase in income taxes payable 1,583
Increase in claims payable, net 45,693
Decrease in deferred premium revenue (6,336)
Increase in unearned revenue 2,146
-----------
Total adjustments 30,170
-----------
Net cash provided by operating activities 49,023

Cash flows used in investing activities:
Purchases of investment securities (154,365)
Sales of investment securities 135,398
Purchases of property and equipment (5,826)
Purchase of statutory deposits (144)
Purchases of other assets (349)
Proceeds from sale of assets 71
-----------
Net cash used in investing activities (25,215)

Cash flows used in financing activities:
Increase in short-term borrowings 181
Exercise of stock options 10,807
Purchase of treasury stock (19,848)
-----------
Net cash used in financing activities (8,860)
-----------
Net increase in cash and cash equivalents 14,948

Cash and cash equivalents at beginning of period 4,510
-----------
Cash and cash equivalents at end of period $ 19,458
===========

See accompanying notes to these financial statements

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MID ATLANTIC MEDICAL SERVICES, INC.
NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

INTRODUCTION

Mid Atlantic Medical Services, Inc. is a holding company whose subsidiaries are
active in managed health care and other life and health insurance related
activities. MAMSI's principal markets currently include Maryland, Virginia, the
District of Columbia, Delaware, West Virginia, North Carolina and Pennsylvania.
MAMSI and its subsidiaries (collectively referred to as "MAMSI" or the
"Company") offer a broad range of health care coverage and related ancillary
products and deliver these services through health maintenance organizations
("HMOs"), a preferred provider organization ("PPO"), and a life and health
insurance company. MAMSI also owns a home health care company, a home infusion
services company, a hospice company, a coordination of benefits identification
and collections company and maintains a partnership interest in an outpatient
surgery center.

MAMSI delivers managed health care services principally through HMOs. The HMOs,
MD-Individual Practice Association, Inc. ("M.D. IPA"), Optimum Choice, Inc.
("OCI"), and Optimum Choice of the Carolinas, Inc. ("OCCI") arrange for health
care services to be provided to an enrolled population for a predetermined,
prepaid fee, regardless of the extent or nature of services provided to the
enrollees. The HMOs offer a full complement of health benefits, including
physician, hospital and prescription drug services.

Other MAMSI subsidiaries include Alliance PPO, LLC, which provides a delivery
network of physicians to employers and insurance companies in association with
various health plans, and provides psychiatric services principally to third
party payors or self-insured employer groups. MAMSI Life and Health Insurance
Company develops and markets indemnity health products and group life,
accidental death and short-term disability insurance. HomeCall, Inc., FirstCall,
Inc., and HomeCall Pharmaceutical Services, Inc. provide in-home medical care
including skilled nursing, infusion and therapy to MAMSI's HMO members and other
payors. HomeCall Hospice Services, Inc. provides services to terminally ill
patients and their families. Alliance Recovery Services, LLC provides
coordination of benefits identification and collection services to third party
administrators and insurance companies.

NOTE 1 - FINANCIAL STATEMENTS

The consolidated balance sheet of the Company as of March 31, 2003, the
consolidated statements of operations for the three months ended March 31, 2003
and 2002, and the consolidated statements of cash flows for the three months
ended March 31, 2003 and 2002 have been prepared by MAMSI without audit. In the
opinion of management, all adjustments (consisting of normal recurring accruals)
considered necessary for a fair presentation have been included.

Certain information and disclosures normally included in financial statements
prepared in accordance with generally accepted accounting principles have been
condensed or omitted. These financial statements should be read in conjunction
with the financial statements and notes thereto included in the Company's
December 31, 2002 audited consolidated financial statements included in its
annual report on Form 10-K for the year ended December 31, 2002 ("2002 Form
10-K"). The results of operations for the three month period ended March 31,
2003 are not necessarily indicative of the operating results for the full year.

In June 2001, the Financial Accounting Board issued Statement of Financial
Accounting Standards No. 142, "Goodwill and Other Intangible Assets" ("Statement
No. 142"), which establishes standards for financial accounting and reporting
for intangible assets at acquisition and for goodwill and other intangible
assets subsequent to their acquisition. Statement No. 142 is applied to existing
goodwill and intangible assets for fiscal years beginning after December 15,
2001. Statement No. 142 requires goodwill to be tested for impairment on an
annual basis and between annual tests in certain circumstances, and written down
when impaired, rather than being amortized as previous accounting standards
required.

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The Company adopted this Statement January 1, 2002, at which time amortization
of the remaining book value of goodwill ceased. The unamortized book value of
goodwill was $4.9 million at January 1, 2002. As of December 31, 2002, the
Company's estimated fair value exceeded the carrying value of its goodwill and
therefore, no impairment to its goodwill was identified. As the Company does not
have a material amount of goodwill, the adoption of Statement No. 142 had no
significant effect on the consolidated financial statements.

The Company has entered into certain long-term vendor contracts some of which
include incentives or cost guarantees designed to provide savings to the Company
over several years. The Company typically accounts for the benefit derived from
these incentives or guarantees ratably over the contract period as a reduction
to medical expense. Because of the complexity of the Company's product offerings
as well as obligations imposed under the contracts, and the timing of settlement
of various contractual periods, disputes may arise as to the degree of
satisfaction of the various contractual obligations which could result in
material adjustments to the Company's financial statements. In the case of one
of these contracts, a dispute with the Company's pharmacy benefits manager,
("PBM"), Medco Health Solutions, Inc., (formerly known as Merck-Medco Managed
Care, LLC), ("Merck"), arose over its 2000 guarantee which involved
approximately $41.0 million which had been recorded in the Company's financial
statements as a reduction of medical expense over the three years of the
contract. On April 24, 2002 the Company reached a settlement of its dispute with
Merck over its 2000 cost guarantee. Under the terms of the settlement, the
Company received payment of $41 million. In addition to the 2000 guarantee, the
Company's former PBM contract provided for a risk-sharing arrangement for the
years 2001 and 2002. There is also a risk sharing arrangement with the Company's
new PBM for 2003. The 2001 risk-sharing arrangement is in the process of being
finalized and settled. It is anticipated that the 2002 risk-sharing arrangement
will be settled in July, 2003. As of March 31, 2003, the Company has recorded
what it believes to be a reasonable estimate of the results of these risk-share
arrangements.

NOTE 2 - COMMON STOCK

The following table sets forth the computation of basic and diluted earnings per
share (in thousands except share amounts):

Three Months Ended
March 31, March 31,
2003 2002
---------- ----------
Numerator:
Net income $ 34,155 $ 18,853
Denominator:
Denominator for basic earnings per share
- weighted average shares 38,654,509 39,058,024
Dilutive securities - employee stock options 2,113,668 2,580,864
Denominator for diluted earnings per share
- adjusted weighted average shares 40,768,177 41,638,888

Options to purchase approximately 33,900 shares of common stock at various
prices were outstanding at March 31, 2003, but were not included in the
computation of diluted earnings per share because the option proceeds would
exceed the average market price and, therefore, the effect would be
antidilutive.

During the first quarters of 2003 and 2002, total comprehensive income amounted
to $34,504,000 and $18,256,000, respectively.

The Company maintains a stock compensation trust ("SCT") to fund its obligations
arising from its various stock option plans. Shares held by the SCT are excluded
from the denominator used in calculating basic and diluted earnings per common
share.

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NOTE 3 - FEDERAL EMPLOYEES' HEALTH BENEFIT PROGRAM

M.D. IPA contracts with the Office of Personnel Management ("OPM") to provide or
arrange health services under the Federal Employees Health Benefits Program
("FEHBP"). The contract with OPM and applicable government regulations establish
premium rating requirements for the FEHBP. In the normal course of business, OPM
audits health plans with which it contracts to verify, among other things, that
the premiums calculated and charged to OPM are established in compliance with
the best community rating guidelines established by OPM. OPM typically audits
plans once every five or six years, and each audit covers the prior five or six
year period. While the government's initial on-site audits are usually followed
by a post-audit briefing as well as a preliminary audit report in which the
government indicates its preliminary results, final resolution and settlement of
the audits can take a minimum of two to three years. The results of these audits
could result in material adjustments to the Company's financial statements. The
Company has been audited through 1999. There were no significant findings
related to 1999. OPM has not yet audited 2000-2002.

NOTE 4 - CLAIMS PAYABLE

The following table shows the components of claims payable at March 31, 2003 and
2002 (in thousands):

March 31, March 31,
2003 2002
-------- --------

Reserve for incurred but
not reported claims $287,303 $233,342

Claims received, not yet
paid and other items 75,181 55,585
-------- --------
Subtotal 362,484 288,927
Amortized value of pharmacy cost
guarantee related to the year 2000 - (31,224)
-------- --------
Total claims payable $362,484 $257,703
======== ========

The following tables show the components of the change in claims payable for the
three months ended March 31, 2003 and 2002 for each quarter's Dates of Service
("DOS") (in thousands except for percentages):

For the Quarter Ended
March 31, 2003: Life & 2002 &
Medical STD Total 2003 DOS Prior DOS
----------------------------------------- -----------------------

Beginning of the year $ 295,721 $ 1,583 $ 297,304 $ - $ 297,304

Components of medical expense:
Estimated cost incurred 569,293 1,131 570,424 570,424 -
Estimated redundancy (30,857) - (30,857) - (30,857)
---------- -------- ---------- ---------- ---------
538,436 1,131 539,567 570,424 (30,857)
Payments for medical expense (473,032) (1,355) (474,387) (259,860) (214,527)
---------- -------- ---------- ---------- ---------
End of the quarter $ 361,125 $ 1,359 $ 362,484 $ 310,564 $ 51,920
========== ======== ========== ========== =========
Prior period redundancy as a percentage
of current year medical expense 5.73%

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For the Quarter Ended
March 31, 2002: Life & 2001 &
Medical STD Total 2002 DOS Prior DOS
----------------------------------------- -----------------------

Beginning of the year $ 238,814 $ 1,310 $ 240,124 $ - $ 240,124

Components of medical expense:
Estimated cost incurred 478,993 785 479,778 479,778 -
Estimated redundancy (23,549) - (23,549) - (23,549)
---------- -------- ---------- ---------- ---------
455,444 785 456,229 479,778 (23,549)
Payments for medical expense (406,516) (910) (407,426) (218,950) (188,476)
---------- -------- ---------- ---------- ---------
End of the quarter $ 287,742 $ 1,185 288,927 $ 260,828 $ 28,099
========== ======== ========== =========

Amortized value of pharmacy cost
guarantee related to year 2000 (31,224)
----------
Total claims payable $ 257,703
==========

Prior period redundancy as a percentage
of current period medical expense 5.17%

The Company does not track the redundancy/(deficiency) related to its life and
short-term disability business. Any actual redundancy/(deficiency) would be
immaterial to the tables above and the Company's financial statements.

NOTE 5 - REPORTABLE SEGMENTS

The Company's principal business is providing health insurance products. The
Company has two reportable segments: commercial risk products and preferred
provider organizations. The Company evaluates performance and allocates
resources based on profit or loss from operations before income taxes, not
including gains or losses on the Company's investment portfolio. Management does
not allocate assets in the measurement of segment profit or loss. The accounting
policies of the reportable segments are the same as those described in the
summary of significant accounting policies described in the Company's 2002 Form
10-K.

Three Months Ended
March 31, March 31,
(In thousands) 2003 2002
------------ ------------

Revenues:
Commercial risk $ 646,501 $ 534,010
Preferred provider organizations 5,873 5,555
All other 7,995 7,396
----------- -----------
$ 660,369 $ 546,961
=========== ===========
Income before taxes:
Commercial risk $ 45,827 $ 22,505
Preferred provider organizations 2,467 2,778
All other (315) (715)
----------- -----------
$ 47,979 $ 24,568
=========== ===========

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Reconciliations of segment data to the Company's consolidated data is as
follows:

Three Months Ended March 31,
2003 2002
(In thousands) ---------- ----------

Total profit from reportable segments $ 48,294 $ 25,283
Other loss (315) (715)
Unallocated amounts:
Investment income 3,887 3,106
--------- ---------
Income before taxes $ 51,866 $ 27,674
========= =========

NOTE 6 - STOCK-BASED COMPENSATION

In accordance with Statement of Financial Accounting Standards No. 148,
Accounting for Stock-Based Compensation - Transition and Disclosure ("SFAS No.
148"), the effect on net income and net income per share if the Company had
applied the fair value recognition provisions of SFAS No. 123, Accounting for
Stock-Based Compensation ("SFAS No. 123") to stock-based employee compensation
is as follows:

Three Months Ended March 31,
2003 2002
(In thousands) ---------- ----------

Net income, as reported $ 34,155 $ 18,853
Deduct: Net stock-based employee
compensation expense determined
under fair value based method (2,845) (2,099)
--------- ---------
Pro forma net income $ 31,310 $ 16,754
========= =========

Earnings per share:
Basic - as reported $ .88 $ .48
Basic - pro forma $ .81 $ .43

Diluted - as reported $ .84 $ .45
Diluted - pro forma $ .77 $ .40

The effect of applying SFAS No. 123 on the three month periods ended March 31,
2003 and 2002 pro forma net income and net income per share as stated above, is
not necessarily representative of the effects on reported net income for future
years, due to, among other things, (1) the vesting period of stock options and
(2) the fair value of additional stock options in future years.

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MID ATLANTIC MEDICAL SERVICES, INC.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS

FORWARD-LOOKING INFORMATION

All forward-looking information contained in this Management's Discussion and
Analysis of Financial Condition and Results of Operations is based on
management's current knowledge of factors, all with inherent risks and
uncertainties, affecting MAMSI's business. MAMSI's actual results may differ
materially if these assumptions prove invalid. Significant risk factors, while
not all-inclusive, are:

1. The possibility of increasing price competition in the Company's service
area.

2. The effect of a weak economy on the Company.

3. The effect on the Company due to the acts of terrorism and the threat of
future attacks.

4. The possibility that the Company is not able to increase its market share at
the anticipated premium rates.

5. The possibility of increased litigation, legislation or regulation (such as
the numerous class action lawsuits that have been filed against managed care
companies and the pending initiatives to increase health care regulation)
that might have the potential for increased costs, and/or increased
regulation of rates which might have the potential to decrease revenue.

6. The inability to predict and control medical expenses due to:
- Increased utilization by the Company's membership.
- Increased practitioner and pharmaceutical costs.
- Federal or state mandates that increase benefits or limit the Company's
oversight ability.
- The ultimate accuracy of the Company's estimate of the liability for
incurred but not reported claims.
- The potential for disputes under its risk-sharing arrangements, and the
Company's ability to maintain and renew these arrangements.

7. The possibility that the Company is not able to negotiate new or renewal
contracts with appropriate physicians, other health care practitioners,
hospitals and facilities.

The list of significant risk factors is not intended to be exhaustive. There may
be other risk factors that would preclude the Company from realizing the
predictions made in the forward-looking statements. While the Company may
periodically update this discussion of risk factors, the Company does not
undertake to update any forward-looking statement that may be made by or on
behalf of the Company prior to its next required filing with the Securities and
Exchange Commission.

CRITICAL ACCOUNTING POLICIES

MAMSI, through its 100% owned subsidiary companies, is predominately in the
business of selling various forms of health insurance. In 2003, approximately
97% of revenues were earned from the sale of health insurance products, mostly
to employers who purchase health insurance for their employees. Since premium
rates are generally fixed for a one year period, it is critical to the Company's
continued financial success that premiums are set at levels that will at least
cover the next policy year's medical costs for members plus administrative costs
to pay claims, provide member services, pay taxes, and cover other related
costs.

This means that we have to carefully evaluate data and estimate both future
utilization of medical services by our members and the cost of those services so
that we can set premiums at adequate levels. This is the single most important
factor in our business. Very simply, if our medical expenses are greater than
our premiums, we lose money.

While MAMSI's business is somewhat complex from an insurance regulatory
standpoint, its consolidated balance sheet and income statement are
straightforward and the accounting policies and procedures that we use to
produce them are reasonable and appropriate. MAMSI does not own any special
purpose entities, does not have any complex or extraordinarily

12

risky investments nor does it have any off balance sheet financing arrangements.
In fact, MAMSI has almost no debt outstanding.

The buildings that the Company owns are either used in its operations or are
currently leased to other entities and do not have mortgages; they are owned
free and clear. The Company's funds are held in cash or invested in money market
accounts, tax exempt securities and other debt securities. All of the bonds we
own have investment ratings of "A" or better.

Certain of our accounting policies are extremely important to the fair
presentation of our results and financial position.

We think that the single most important accounting issue we have is the
recording, at the end of each reporting period, of an adequate liability and
corresponding expense for medical services that have been provided to our
members but for which we have not yet received a bill. This lag between date of
service and date of billing is normal in the insurance business and the
liability for these claims is called "liability for incurred, but not reported
claims" ("IBNR"). The IBNR liability is included with claims payable in our
balance sheet.

The determination of the Company's IBNR is a fairly complex process. The Company
employs its own actuary to aid in its determination. The primary method we use
to estimate IBNR is consistent from period to period and uses historical claims
data to develop the historical relationship of how many claims dollars have been
reported in any given month to what was received in total, once all claims were
received. This relationship gives us an indication of how much medical expense
has been incurred in months for which we have not yet received all claims. While
we use a consistent method in developing our IBNR estimate, considerable
judgment is required. Various factors such as timing of the receipt of claims,
seasonal utilization, and underlying cost inflation affect the ultimate
development of claims expense. To the extent that we over or under estimate our
IBNR at the end of any reporting period, the adjustment is included in the next
period's results. The table below indicates how much we believe we have
over-estimated our IBNR liability for the quarters ended and expresses it as a
percentage of the quarter's medical expense:

Over As a % of
Quarter Estimated Medical Expense
------- ----------- ---------------

March 2003 $30,857,000 5.73%
March 2002 23,549,000 5.17%

If medical expense was annualized for 2003, the over-estimation as a percentage
of medical expense would be 1.4% for 2003. The over-estimation for 2002 as a
percentage of actual medical expense for 2002 would be 1.2%. This annualized
medical expense is not necessarily indicative of the medical expense for the
full year.

Another important accounting policy relates to our risk sharing contracts.
Certain of the Company's larger vendors offer various forms of "risk- sharing"
or "guarantees" as a part of their contractual relationship with us. These
arrangements are not significant in relation to the Company's financial
statements with one exception; the Company's risk-sharing arrangement with its
PBM. The Company's PBM is responsible for providing administrative and technical
support as well as providing the ability to process pharmacy transactions on a
real time basis. The Company's PBM through December 31, 2002 was Merck. As a
part of its contract with us, Merck agreed to a pharmacy cost guarantee related
to fiscal year 2000. We recorded the amount due under this guarantee over the
contract term of three years, which expired December 31, 2002. The total value
of the guarantee for financial statement purposes was approximately $41.0
million which has been recorded in our financial statements as a reduction of
medical expense over the three years of the contract. In April 2002, the Company
received payment of $41.0 million from Merck. At December 31, 2002, no amounts
related to the 2000 guarantee remain unrecognized. In addition to the 2000
guarantee, the Company's former PBM contract provided for a risk-sharing
arrangement for the years 2001 and 2002. There is also a risk sharing
arrangement with the Company's new PBM for 2003. The 2001 risk-sharing
arrangement is in the process of being finalized and settled. It is anticipated
that the 2002 risk-sharing arrangement will be settled in July, 2003. As of
March 31, 2003, the Company has recorded what it believes to be a reasonable
estimate of the results of these risk-share arrangements.

13

Another accounting policy that is very important to the fair presentation of our
financial results is the proper valuation of the Company's accounts receivable.
The Company bills the majority of its health insurance customers on a monthly
basis. The premium bill is typically sent out 15 days in advance of the month
being billed for, so that the Company can receive the cash at the start of the
month for which the insurance is being provided. The vast majority of our
customers pay in a timely fashion but some do not. After some communication, we
generally receive payment but we do not always collect what we are due. This can
happen for a variety of reasons such as customers having financial difficulties,
disputes regarding the amount of the bill or a customer failing to notify us
that they have obtained other health insurance. To properly value the accounts
receivable at its net realizable value we must determine an allowance for
doubtful accounts.

The allowance for doubtful accounts reduces the gross amount of accounts
receivable that are recorded, based on the bills sent, to the net amount that we
actually think we will receive. The allowance also reduces premium revenue by
the same amount. To determine how much to record as a reduction of the gross
accounts receivable, we prepare an accounts receivable aging. This aging
segments the total accounts receivable balance by category as to when it was due
to the Company. This allows us to evaluate how old our accounts receivable are.
We then prepare an evaluation based on historical collection percentages applied
to various categories of accounts. We also identify individual accounts that are
unlikely to pay due to financial or other problems and analyze them
individually. The aforementioned analyses are then summarized and an allowance
is developed and recorded. The Company applies this methodology on a consistent
basis from period to period.

RESULTS OF OPERATIONS

THE THREE MONTHS ENDED MARCH 31, 2003 COMPARED WITH THE THREE MONTHS ENDED
MARCH 31, 2002

Consolidated net income of the Company was $34,155,000 and $18,853,000 for the
first quarters of 2003 and 2002, respectively. Diluted earnings per share were
$.84 and $.45 in the first quarters of 2003 and 2002, respectively. This
increase in earnings is attributable to an increase in members, an increase in
premiums per member, a reduction in medical expenses as a percentage of health
premium revenue ("medical care ratio"), and a reduction in administrative
expenses as a percentage of total revenue ("administrative expense ratio"). The
Company has priced its health products competitively in order to increase its
membership base and thereby enhance its strategic position in its market place.
The Company currently has one of the largest HMO and managed care enrollments
and also the largest network of contract providers of medical care in its
service area (which includes the entire states of Maryland and Delaware, the
District of Columbia, most counties and cities in Virginia and certain areas of
West Virginia, North Carolina and Pennsylvania).

Health premium revenue for the three months ended March 31, 2003 increased
approximately $112.5 million or 21.1 percent over the three months ended March
31, 2002. A 7.7 percent increase in net average HMO and indemnity enrollment
resulted in an increase of approximately $41.2 million in health premium
revenue, while a 12.4 percent increase in average monthly premium per enrollee,
combined for all products, resulted in a $71.3 million increase in health
premium revenue. Management believes that commercial health premiums should
continue to increase during 2003 as the Company continues to increase its
commercial membership and as new and renewing groups are charged higher premium
rates due to legislatively mandated benefit enhancements and general price
increases initiated by the Company. This is a forward-looking statement. See
"Forward Looking Information" above for a description of the risk factors that
may effect health premiums per member.

The Company has implemented increased premium rates across essentially all of
its commercial products. As the Company's contracts are generally for a one year
period, increased pricing generally cannot be initiated until a contract reaches
its renewal date. Therefore, price increases are not implemented across the
Company's membership at the same time. Overall, commercial premium rate
increases are expected to continue in 2003 in the range of 12.25% to 12.75%, net
of buy downs. Management believes that these rate increases may have the effect
of slowing the Company's future membership growth.

14

The Company's future membership growth depends on several factors such as
relative premium prices and product availability, future increases or decreases
in the Company's service area, and increased competition in the Company's
service area.

The Company's home health operations contributed approximately $5.7 million in
revenue in the first quarter of 2003 as compared with $5.2 million in the first
quarter of 2002 reflecting an increase in services provided to non-affiliated
companies and office consolidation. Fee and other revenue increased to $5.9
million for the quarter ended March 31, 2003 from $5.6 million for the quarter
ended March 31, 2002, primarily due to an increase in rental income from company
owned facilities. Life and short-term disability products contributed $2.3
million in revenue in the first quarter of 2003 as compared with $2.2 million
for the first quarter of 2002.

Investment income increased from $3.2 million for the first quarter of 2002 to
$4.0 million for the first quarter of 2003, due to higher invested balances
offset by lower interest rates.

The medical care ratio decreased from 85.3% for the first quarter of 2002 to
83.3% or the first quarter of 2003. On a per member per month basis, medical
expenses increased 9.8%. The decrease in the medical care ratio is due to a
combination of factors including continuing efforts by the Company to implement
product specific cost containment controls, continued activity in specialized
subrogation areas and claims review for dual health coverage, and also increased
premiums per member. The ongoing initiatives should help to control the
Company's medical care ratio. The medical expense trend is expected to be
between 11.0% and 11.75% for 2003. The statements in this paragraph and the
preceding paragraphs regarding future utilization rates, cost containment
initiatives, total medical costs and trend and future increases in health
premiums per member are forward-looking statements. See "Forward-Looking
Information" above for a description of risk factors that may affect medical
expenses per member and the medical care ratio.

The administrative expense ratio decreased from 11.2 percent for the first
quarter of 2002 to 10.1 percent for the same period in 2003. The decrease in the
administrative expense ratio is principally due to increases in premium rates
and membership, management's efforts to control costs as the business volume
increases and technology and productivity gains which have allowed headcount to
remain stable. Management believes that the administrative expense ratio will be
approximately 10.3% to 10.7% for 2003. Management's expectation concerning the
administrative expense ratio is a forward-looking statement. The administrative
expense ratio is affected by changes in health premiums and other revenues and
increased administrative activity related to business volume and to price
increases from the Company's vendors.

The net margin rate increased from 3.4 percent in the first quarter of 2002 to
5.1 percent in the current quarter. This increase is consistent with the factors
previously described.

LIQUIDITY AND CAPITAL RESOURCES

The Company's business is not capital intensive and the majority of the
Company's expenses are payments to physicians and health care practitioners,
which generally vary in direct proportion to the health premium revenues
received by the Company. Although medical utilization rates vary by season, the
payments for such expenses lag behind cash inflow from premiums because of the
lag in provider billing procedures. In the past, the Company's cash requirements
have been met principally from operating cash flow and it is anticipated that
this source, coupled with the Company's operating line-of-credit, will continue
to be sufficient to meet the Company's cash requirements in the future.

The Company's cash and investment securities increased $97.3 million from $493.9
million at December 31, 2002 to $591.2 million at March 31, 2003, primarily due
to the timing of medical expense payments which traditionally lag behind the
receipt of increased premiums per member, a $27.2 million contractual payment
received from a vendor in February 2003, cash received from the exercise of
stock options and net income offset by the effect of treasury stock purchases
and other capital expenditures. Accounts receivable increased from $118.1
million at December 31, 2002 to $145.4 million at March 31, 2003, principally
due to increased membership and the reclassification of $10.1 million in amounts
due from a vendor related to the 2002 contract year. Prepaid expenses, advances
and other

15

decreased from $37.1 million at December 31, 2002 to $34.7 million at March 31,
2003 primarily due to the amortization of prepayments for insurance policies
which cover the Company's assets and business operations.

Net property and equipment decreased from $82.7 million at December 31, 2002 to
$82.4 million at March 31, 2003 due to depreciation expense exceeding capital
expenditures in the first quarter of 2003.

Claims payable increased from $297.3 million at December 31, 2002 to $362.5
million at March 31, 2003, primarily due to increased membership and an increase
in medical expenses per member, and the timing of payments to physicians and
health care practitioners. Deferred premium revenue increased from $33.9 million
at December 31, 2002 to $43.1 million at March 31, 2003 due to a increase in
cash payments received in advance of the premium coverage period. Unearned
revenue increased from $14.6 million at December 31, 2002 to $33.7 million at
March 31, 2003 primarily due to the receipt of contractual advances.

Additional paid-in capital increased from $466.2 million at December 31, 2002 to
$526.1 million at March 31, 2003 due to the exercise of employee stock options,
as well as an increase in the market value of the shares of the Company's stock
held in the SCT.

The value of the SCT increased from $269.3 million at December 31, 2002 to
$321.7 million at March 31, 2003 due to the increase in the market value of the
shares of the Company's stock held in the SCT, offset by the exercise of
employee stock options. For financial reporting purposes, the SCT is
consolidated with MAMSI. The fair market value of the shares held by the SCT is
shown as a reduction to stockholders' equity in the Company's consolidated
balance sheets. All transactions between the SCT and MAMSI are eliminated. The
difference between the cost and fair value of common stock held in the SCT is
included in the consolidated financial statements as additional paid-in capital.

Treasury stock increased from $276.2 million at December 31, 2002 to $288.1
million at March 31, 2003, due to the repurchase of 332,800 additional shares of
its common stock by the Company at a total cost of $11.9 million. On March 31,
2003, approximately $40.9 million of unspent authorization was available for
future purchases. During April 2003, the Company repurchased an additional
156,400 shares of its common stock for a total cost of approximately $6.2
million.

The Company currently has access to total revolving credit facilities of $29.0
million which are subject to annual renewal and collateral requirements, and are
used to provide short-term capital resources for routine cash flow fluctuations.
At March 31, 2003, the Company's investment security balances used as
collateral, which are parent company only investments, fell below the minimum
collateral requirements thereby reducing the credit line availability to $25.5
million. In addition, at March 31, 2003, approximately $3.2 million was drawn
against these facilities, and approximately $614,000 in letters of credit were
outstanding. While no amounts have been drawn against these letters of credit,
they reduce the Company's credit line availability.

Following is a schedule of the short-term capital resources available to the
Company:

16

The Company believes that cash generated from operations along with its current
liquidity and borrowing capabilities are adequate for both current and planned
expanded operations.

The Company's major business operations are principally conducted through its
HMOs and its insurance company. HMOs and insurance companies are subject to
state regulations that, among other things, require those companies to maintain
certain levels of equity and Risk Based Capital ("RBC"), and restrict the amount
of dividends and other distributions that may be paid to their parent
corporation. As of March 31, 2003, those subsidiaries of the Company were in
compliance with all minimum capital requirements and exceeded all RBC - Company
Action Level requirements.

CONTRACTUAL OBLIGATIONS

There were no material changes in contractual obligations at March 31, 2003 when
compared with December 31, 2002.

MARKET RISK

The Company is exposed to market risk through its investment in fixed and
variable rate debt securities that are interest rate sensitive. The Company does
not use derivative financial instruments. The Company places its investments in
instruments that meet high credit quality standards, as specified in the
Company's investment policy guidelines; the policy also limits the amount of
credit exposure to any one issue, issuer, or type of instrument. A hypothetical
ten percent change in market interest rates over the next year would not
materially affect the Company's financial position or cash flow. The Company has
no significant market risk with regard to liabilities and does not use special
purpose entities. There are no material changes in market risk exposure at March
31, 2003 when compared with December 31, 2002.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The information required by this Item is contained in Item 2 - "Management's
Discussion and Analysis of Financial Condition and Results of Operations".

ITEM 4. CONTROLS AND PROCEDURES

Based on the evaluation by the Chief Executive Officer and Chief Financial
Officer of the Company as of a date within 90 days of the filing date of this
quarterly report, the Company's disclosure controls and procedures are
adequately designed to ensure that the information required to be included in
this report has been recorded, processed, summarized and reported on a timely
basis. There have not been any significant changes in the Company's internal
controls or in other factors that could significantly affect these controls and
there have been no corrective actions taken with regard to significant
deficiencies and material weaknesses subsequent to the date of such officers'
evaluation.

17

PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS

In September, 2000, the Company and other HMOs operating in Maryland were served
with similar class action lawsuits challenging the constitutionality of the law
which allows the Company to subrogate against other insurance companies. The
action against the Company was filed in the Circuit Court for Montgomery County,
Maryland. The Company filed a motion for removal of the case to federal court
under the Employee Retirement Income Security Act of 1974 ("ERISA") which was
denied on February 4, 2003. In a separate matter unrelated to the Company, but
similar in facts, the Maryland Court of Appeals recently ruled that the
retroactive portion of the law is unconstitutional under the Maryland
constitution. The Company believes that its operations with respect to the law
are valid and is pursuing all available defenses. The Company does not believe,
at this time, the ultimate outcome of this action will be material to the
Company's financial statements.

The Company is involved in other various legal actions arising in the normal
course of business, some of which seek substantial monetary damages. After
review, including consultation with legal counsel, management believes that any
ultimate liability that could arise from these other actions will not materially
effect the Company's consolidated financial position or results of operations.

ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS

None

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

None

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

An annual meeting of the stockholders of MAMSI was held on April 28, 2003. The
following matters were submitted to a vote of the stockholders during the annual
meeting:

(1) The following individuals were elected to the Board of Directors for a three
year term, except for Howard M. Arnold, who was elected for a one year term,
with the indicated votes:

For Against Abstain
----------- ------- ----------

Howard M. Arnold 42,401,577 None 1,282,429
John W. Dillon 42,818,642 None 865,364
Mark D. Groban, M.D. 42,818,675 None 865,331
Charles H. Epps, Jr., M.D. 42,814,682 None 869,324

Board members whose term of office continued after the meeting are as follows:

Thomas P. Barbera
Francis C. Bruno, M.D.
Raymond H. Cypess, D.V.M., Ph.D.
Robert E. Foss
Edward J. Muhl
Janet L. Norwood
John A. Paganelli
Ivan R. Sabel
James A. Wild

(2) The adoption of the 2003 Non-Qualified Stock Option Plan was ratified by a
count of 36,436,006 affirmative votes, 6,401,684 negative votes and 846,316
abstentions.

18

There were no broker non-votes with respect to the election of Directors or the
adoption of the 2003 Non-Qualified Stock Option Plan for Senior Executives.

ITEM 5. OTHER INFORMATION

None

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K

(a) Exhibits

Exhibit Number Description of Document
- -------------- -----------------------

99.2 Certifications of Chief Executive Officer and Chief Financial
Officer Pursuant to Title 18, United States Code, Section 1350,
as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of
2002.

(b) Reports on Form 8-K

None

19
SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by undersigned
thereto duly authorized.

MID ATLANTIC MEDICAL SERVICES, INC.
--------------------------------------------
(Registrant)

Date: May 15, 2003 /s/ Robert E. Foss
---------------------------------
Robert E. Foss
Senior Executive Vice President
and
Chief Financial Officer
(duly authorized officer and
principal financial officer)

20

CERTIFICATION

I, Thomas P. Barbera, Chief Executive Officer, certify that:

1. I have reviewed this quarterly report on Form 10-Q of Mid Atlantic Medical
Services, Inc.;

2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to make
the statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this quarterly
report;

3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this quarterly report;

4. The registrant's other certifying officer and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:

a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its consolidated
subsidiaries, is made known to us by others within those entities, particularly
during the period in which this quarterly report is being prepared;

b) evaluated the effectiveness of the registrant's disclosure controls
and procedures as of a date within 90 days prior to the filing date of this
quarterly report (the "Evaluation Date"); and

c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our evaluation
as of the Evaluation Date.

5. The registrant's other certifying officer and I have disclosed, based on our
most recent evaluation, to the registrant's auditors and to the audit committee
of the registrant's board of directors:

a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to record,
process, summarize and report financial data and have identified for the
registrant's auditors any material weaknesses in internal controls; and

b) any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal controls; and

6. The registrant's other certifying officer and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal controls
subsequent to the date of our most recent evaluation, including any corrective
actions with regard to significant deficiencies and material weaknesses.

Date: May 15, 2003

/s/ Thomas P. Barbera
-----------------
Thomas P. Barbera
President and Chief Executive Officer

21

CERTIFICATION

I, Robert E. Foss, Chief Financial Officer, certify that:

1. I have reviewed this quarterly report on Form 10-Q of Mid Atlantic Medical
Services, Inc.;

2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to make
the statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this quarterly
report;

3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this quarterly report;

4. The registrant's other certifying officer and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:

a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its consolidated
subsidiaries, is made known to us by others within those entities, particularly
during the period in which this quarterly report is being prepared;

b) evaluated the effectiveness of the registrant's disclosure controls
and procedures as of a date within 90 days prior to the filing date of this
quarterly report (the "Evaluation Date"); and

c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our evaluation
as of the Evaluation Date.

5. The registrant's other certifying officer and I have disclosed, based on our
most recent evaluation, to the registrant's auditors and to the audit committee
of the registrant's board of directors:

a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to record,
process, summarize and report financial data and have identified for the
registrant's auditors any material weaknesses in internal controls; and

b) any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal controls; and

6. The registrant's other certifying officer and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal controls
subsequent to the date of our most recent evaluation, including any corrective
actions with regard to significant deficiencies and material weaknesses.

Date: May 15, 2003

/s/ Robert E. Foss
--------------
Robert E. Foss
Senior Executive Vice President and
Chief Financial Officer