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 SEPTEMBER 30, 2004
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 1-13154
AMERICAN MEDICAL SECURITY GROUP, INC.
(Exact name of Registrant as specified in its charter)
WISCONSIN 39-1431799
(State of Incorporation) (I.R.S. Employer Identification No.)
3100 AMS BOULEVARD
GREEN BAY, WISCONSIN 54313
(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code: (920) 661-1111
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 Exchange Act).
Yes __X__ No ____
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practicable date.
Common stock, no par value, outstanding as of October 31, 2004:
13,683,383 shares
AMERICAN MEDICAL SECURITY GROUP, INC.
INDEX
PART I FINANCIAL INFORMATION
Item 1. Financial Statements (Unaudited)
Condensed Consolidated Balance Sheets
September 30, 2004 and December 31, 2003.....................3
Condensed Consolidated Statements of Operations
Three months ended September 30, 2004 and 2003;
Nine months ended September 30, 2004 and 2003................4
Condensed Consolidated Statements of Cash Flows
Nine months ended September 30, 2004 and 2003................5
Notes to Condensed Consolidated Financial Statements
September 30, 2004...........................................6
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations...................................12
Item 3. Quantitative and Qualitative Disclosures About Market Risk..........20
Item 4. Controls and Procedures.............................................20
PART II OTHER INFORMATION
Item 1. Legal Proceedings...................................................21
Item 6. Exhibits............................................................22
Signatures....................................................................23
Exhibit Index...............................................................EX-1
2
PART I FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
AMERICAN MEDICAL SECURITY GROUP, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
September 30, December 31,
(THOUSANDS, EXCEPT SHARE DATA) 2004 2003
- --------------------------------------------------------------------------------------------------------------------
(Unaudited)
ASSETS
Investments:
Fixed maturity securities available for sale, at fair value $ 302,119 $ 302,277
Fixed maturity securities held to maturity, at amortized cost 3,164 3,377
Trading securities, at fair value 1,797 1,424
- --------------------------------------------------------------------------------------------------------------------
Total investments 307,080 307,078
Cash and cash equivalents 20,756 17,289
Property and equipment, net 39,922 37,446
Goodwill 32,138 32,138
Other intangibles, net 1,468 1,957
Other assets 39,323 48,179
- --------------------------------------------------------------------------------------------------------------------
Total assets $ 440,687 $ 444,087
====================================================================================================================
LIABILITIES AND SHAREHOLDERS' EQUITY
Liabilities:
Medical and other benefits payable $ 106,274 $ 129,809
Advance premiums 15,350 15,865
Payables and accrued expenses 23,846 24,099
Notes payable 30,158 30,158
Other liabilities 21,838 26,332
- --------------------------------------------------------------------------------------------------------------------
Total liabilities 197,466 226,263
Shareholders' equity:
Common stock (no par value, $1 stated value, 50,000,000 shares authorized,
16,654,315 issued and 13,683,383 outstanding at September 30, 2004,
16,654,315 issued and 13,511,183 outstanding at December 31, 2003) 16,654 16,654
Paid-in capital 195,610 194,431
Retained earnings 56,164 32,168
Accumulated other comprehensive income (net of taxes of
$2,795 at September 30, 2004 and $3,302 at December 31, 2003) 5,190 6,133
Treasury stock (2,970,932 shares at September 30, 2004
and 3,143,132 shares at December 31, 2003, at cost) (30,397) (31,562)
- --------------------------------------------------------------------------------------------------------------------
Total shareholders' equity 243,221 217,824
- --------------------------------------------------------------------------------------------------------------------
Total liabilities and shareholders' equity $ 440,687 $ 444,087
====================================================================================================================
SEE ACCOMPANYING NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
3
AMERICAN MEDICAL SECURITY GROUP, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited)
Three Months Ended Nine Months Ended
September 30, September 30,
------------------------------------------------------------
(THOUSANDS, EXCEPT PER COMMON SHARE DATA) 2004 2003 2004 2003
- --------------------------------------------------------------------------------------------------------------------
REVENUES
Insurance premiums $ 175,789 $ 176,735 $ 530,039 $ 534,566
Net investment income 3,506 3,211 10,498 9,958
Net realized investment gains (losses) 28 1,416 (24) 1,882
Other revenue 4,076 3,899 12,480 11,784
- --------------------------------------------------------------------------------------------------------------------
Total revenues 183,399 185,261 552,993 558,190
EXPENSES
Medical and other benefits 117,598 119,218 348,156 359,131
Selling, general and administrative 55,539 52,873 164,058 163,178
Interest 255 309 697 972
Amortization of intangibles 163 238 489 715
- --------------------------------------------------------------------------------------------------------------------
Total expenses 173,555 172,638 513,400 523,996
- --------------------------------------------------------------------------------------------------------------------
Income from continuing operations,
before income tax expense 9,844 12,623 39,593 34,194
Income tax expense 4,593 4,735 15,597 12,883
- --------------------------------------------------------------------------------------------------------------------
Income from continuing operations 5,251 7,888 23,996 21,311
Income from discontinued operations - 923 - 732
- --------------------------------------------------------------------------------------------------------------------
Net income $ 5,251 $ 8,811 $ 23,996 $ 22,043
====================================================================================================================
Earnings per common share - basic:
Income from continuing operations $ 0.38 $ 0.59 $ 1.75 $ 1.62
Income from discontinued operations - 0.07 - 0.06
- --------------------------------------------------------------------------------------------------------------------
Net income $ 0.38 $ 0.66 $ 1.75 $ 1.67
====================================================================================================================
Earnings per common share - diluted:
Income from continuing operations $ 0.36 $ 0.55 $ 1.64 $ 1.52
Income from discontinued operations - 0.06 - 0.05
- --------------------------------------------------------------------------------------------------------------------
Net income $ 0.36 $ 0.61 $ 1.64 $ 1.58
====================================================================================================================
SEE ACCOMPANYING NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
4
AMERICAN MEDICAL SECURITY GROUP, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)
Nine Months Ended
September 30,
---------------------------------
(THOUSANDS) 2004 2003
- --------------------------------------------------------------------------------------------------------------------
OPERATING ACTIVITIES
Net income $ 23,996 $ 22,043
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation and amortization 6,372 8,219
Net gain from sale of subsidiary - (950)
Net realized investment losses (gains) 24 (1,882)
Change in trading securities (373) (328)
Deferred income tax expense 6,455 1,165
Changes in operating accounts:
Other assets 3,010 (4,414)
Medical and other benefits payable (23,535) (7,456)
Advance premiums (515) 950
Payables and accrued expenses (253) (5,599)
Other liabilities (3,663) (4,253)
- --------------------------------------------------------------------------------------------------------------------
Net cash provided by operating activities 11,518 7,495
INVESTING ACTIVITIES
Proceeds from sale of subsidiary - 3,500
Purchases of available for sale securities (75,593) (105,380)
Proceeds from sale of available for sale securities 63,162 95,233
Proceeds from maturity of available for sale securities 9,705 2,375
Proceeds from maturity of held to maturity securities 200 500
Purchases of property and equipment (6,937) (7,325)
Proceeds from sale of property and equipment 3 6
- --------------------------------------------------------------------------------------------------------------------
Net cash used in investing activities (9,460) (11,091)
FINANCING ACTIVITIES
Issuance of common stock 1,409 4,719
Purchase of treasury stock - (660)
Repayment of notes payable - (900)
- --------------------------------------------------------------------------------------------------------------------
Net cash provided by financing activities 1,409 3,159
- --------------------------------------------------------------------------------------------------------------------
Cash and cash equivalents:
Net change 3,467 (437)
Balance at beginning of year 17,289 30,620
- --------------------------------------------------------------------------------------------------------------------
Balance at end of period $ 20,756 $ 30,183
====================================================================================================================
SEE ACCOMPANYING NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
5
AMERICAN MEDICAL SECURITY GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
SEPTEMBER 30, 2004
1. BASIS OF PRESENTATION
The accompanying unaudited condensed consolidated financial statements have been
prepared in accordance with accounting principles generally accepted in the
United States for interim financial information and with the instructions to
Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all
of the information and footnotes required by accounting principles generally
accepted in the United States ("GAAP") for complete financial statements. In the
opinion of management, all adjustments (consisting of normal recurring
adjustments) considered necessary for a fair presentation have been included.
Operating results for the three and nine months ended September 30, 2004 are not
necessarily indicative of the results that may be expected for the year ending
December 31, 2004. These condensed consolidated financial statements should be
read in conjunction with the consolidated financial statements and footnotes
thereto included in the American Medical Security Group, Inc. (the "Company")
Annual Report on Form 10-K for the year ended December 31, 2003.
2. STOCK-BASED COMPENSATION
The Company has stock-based compensation plans for the benefit of eligible
employees and directors of the Company, which are described more fully in Note
11 in the Company's 2003 Annual Report on Form 10-K. During the first quarter of
2004, the Company granted 20,700 shares of restricted stock to outside members
of the Company's Board of Directors. As a result, the Company's statements of
operations for the three and nine months ended September 30, 2004 include
compensation expense of $24,000 and $72,000 respectively, net of tax.
The Company follows Accounting Principles Board Opinion No. 25, the intrinsic
value method of accounting for stock-based compensation, under which no
compensation expense is recorded when the exercise price of the Company's
employee stock options equals the market price of the underlying stock on the
date of grant. The following table illustrates the pro forma net income and pro
forma net income per share as if the Company had followed the fair value method
of accounting for stock-based compensation under Statement of Financial
Accounting Standards No. 123, ACCOUNTING FOR STOCK-BASED COMPENSATION
("Statement 123").
Three Months Ended Nine Months Ended
September 30, September 30,
------------------------------------------------------------
(THOUSANDS, EXCEPT PER COMMON SHARE DATA) 2004 2003 2004 2003
- --------------------------------------------------------------------------------------------------------------------
Net income, as reported $ 5,251 $ 8,811 $ 23,996 $ 22,043
Add: Stock-based compensation expense included in
reported net income, net of tax 24 - 72 -
Deduct: Stock-based compensation expense in
accordance with the fair value method of
Statement 123, net of tax (313) (391) (843) (1,202)
- --------------------------------------------------------------------------------------------------------------------
Pro forma net income $ 4,962 $ 8,420 $ 23,225 $ 20,841
====================================================================================================================
Net income per common share, as reported:
Basic $ 0.38 $ 0.66 $ 1.75 $ 1.67
Diluted $ 0.36 $ 0.61 $ 1.64 $ 1.58
Pro forma net income per common share:
Basic $ 0.36 $ 0.63 $ 1.70 $ 1.58
Diluted $ 0.34 $ 0.59 $ 1.58 $ 1.49
6
In determining compensation expense in accordance with Statement 123, the fair
value of options was estimated at the date of grant using the Black-Scholes
option valuation model, which is commonly used in estimating the fair value of
traded options that have no vesting restrictions and are fully transferable.
Option valuation models require the input of highly subjective assumptions
including the expected stock price volatility and the expected life of the
options. Because the Company's employee stock options have characteristics
significantly different from those of traded options, and because changes in the
subjective input assumptions can materially affect the fair value estimates, in
management's opinion, the existing models do not necessarily provide a reliable
single measure of the fair value of its employee stock options.
3. PENDING MERGER WITH PACIFICARE
On September 15, 2004, the Company entered into a definitive agreement and plan
of merger with PacifiCare Health Systems, Inc. ("PacifiCare") whereby PacifiCare
will acquire all of the outstanding shares of common stock of the Company
through a cash merger in which the Company will become a wholly-owned subsidiary
of PacifiCare. Under the terms of the merger agreement, PacifiCare will pay
$32.75 in cash for each share of the Company's common stock outstanding for a
total equity purchase price of approximately $500 million on a fully diluted
basis. It is anticipated that the acquisition will be completed following
approvals by the Company's shareholders, the Wisconsin Office of the
Commissioner of Insurance and the Georgia Department of Insurance, and
compliance with the Hart-Scott-Rodino Antitrust Improvement Act of 1976, as
amended ("Hart-Scott-Rodino Act"), as well as other customary approvals. The
Company's statements of operations for the three and nine months ended September
30, 2004 include merger-related transaction costs of approximately $2.6 million.
4. DISCONTINUED OPERATIONS
During the third quarter of 2003, the Company sold all of the outstanding common
shares of its preferred provider organization network subsidiary, Accountable
Health Plans of America, Inc. ("AHP"). The network contracted with more than 900
hospitals and 100,000 physicians in eight primary states: Arizona, Florida,
Iowa, Nebraska, North Dakota, South Dakota, Texas and Wisconsin. Subject to the
terms of the agreement, AHP will continue to provide network services to the
Company at least until September 2008. At the time of the sale, AHP served
approximately 13% of the Company's members. The three and nine-month periods
ended September 30, 2003 as presented in the Company's statements of operations
have been reclassified to exclude the results of the discontinued networking
business from reported income from continuing operations.
5. PHARMACY BENEFITS MANAGER SETTLEMENT
During the first quarter of 2004, the Company reached an agreement with its
former pharmacy benefits manager settling a dispute related to pricing and
prescription drug fees charged from 1995 through 2002. As a result of the
settlement, the Company received a cash payment of $5.9 million, and the results
for the nine months ended September 30, 2004 include a one-time gain of
approximately $3.4 million or $0.23 per diluted share, net of taxes and other
related expenses. The settlement provided a refund of medical and other benefit
expenses, which resulted in an improvement in the Company's health segment loss
ratio of 1.0% for the nine months ended September 30, 2004.
7
6. EARNINGS PER COMMON SHARE ("EPS")
Basic EPS is computed by dividing earnings by the weighted average number of
common shares outstanding. Diluted EPS is computed by dividing earnings by the
weighted average number of common shares outstanding, adjusted for the effect of
dilutive stock options. The following table illustrates the computation of EPS
for income from continuing operations and provides a reconciliation of the
number of weighted average basic and diluted shares outstanding:
Three Months Ended Nine Months Ended
September 30, September 30,
-----------------------------------------------------------
(THOUSANDS, EXCEPT PER COMMON SHARE DATA) 2004 2003 2004 2003
- -------------------------------------------------------------------------------------------------------------------
Numerator:
Income from continuing operations $ 5,251 $ 7,888 $ 23,996 $ 21,311
===================================================================================================================
Denominator:
Denominator for basic EPS 13,763 13,392 13,694 13,179
Effect of dilutive employee stock options 929 948 954 799
- -------------------------------------------------------------------------------------------------------------------
Denominator for diluted EPS 14,692 14,340 14,648 13,978
===================================================================================================================
Earnings per common share - income from continuing
operations:
Basic $ 0.38 $ 0.59 $ 1.75 $ 1.62
Diluted $ 0.36 $ 0.55 $ 1.64 $ 1.52
===================================================================================================================
Certain options to purchase shares of common stock were not included in the
computation of diluted earnings per common share for the three and nine months
ended September 30, 2003 because the options' exercise prices were greater than
the average market price of the outstanding common shares for the period and,
therefore, the effect would be antidilutive.
7. COMPREHENSIVE INCOME
Under existing accounting standards, comprehensive income for the Company
includes net income and unrealized gains and losses on certain investments in
debt and equity securities, net of tax effects. Comprehensive income for the
Company is calculated as follows:
Three Months Ended Nine Months Ended
September 30, September 30,
------------------------------------------------------------
(THOUSANDS) 2004 2003 2004 2003
- --------------------------------------------------------------------------------------------------------------------
Net income $ 5,251 $ 8,811 $ 23,996 $ 22,043
Unrealized gain (loss) on available for sale securities 3,096 (2,443) (943) (125)
- --------------------------------------------------------------------------------------------------------------------
Comprehensive income $ 8,347 $ 6,368 $ 23,053 $ 21,918
====================================================================================================================
8
8. CONTINGENCIES
In February 2000, a class action lawsuit was filed against the Company in the
state of Florida alleging that the Company failed to follow Florida law when in
1998 it discontinued writing certain health insurance policies and offered new
policies to insureds. Plaintiffs claim that the Company wrongfully terminated
coverage, improperly notified insureds of conversion rights and charged improper
premiums for new coverage. Plaintiffs also allege that the Company's renewal
rating methodology violated Florida law. In 2002, a Circuit Court Judge ruled
against the Company and ordered the question of damages be tried before a jury,
at a later date. In September 2004, the Company entered into an agreement to
settle with the plaintiffs. The settlement has received preliminary approval by
the Circuit Court. If the settlement receives final approval, all claims of
participating class members will be dismissed and the litigation terminated in
exchange for settlement consideration. The Company believes it is adequately
reserved for the anticipated cost of the settlement and related expenses. As a
result, the agreement is not expected to have a material effect on the Company's
earnings or results of operations. The Company expects final approval of the
settlement by the Circuit Court in December 2004.
The Company is a defendant in a number of other lawsuits in various states,
primarily Alabama, alleging misrepresentation of the rating methodology used by
the Company with respect to certain MedOne(R) products purchased by the
plaintiffs. These lawsuits commonly seek unspecified damages for
misrepresentation and emotional distress, in addition to punitive damages. Some
of these cases involve multiple plaintiffs. The cases are in various stages of
litigation. The Company believes that these lawsuits are unfounded because the
Company properly disclosed the nature of the products sold. The Company also
believes the subject matter of the lawsuits falls under the primary jurisdiction
of state insurance departments. The Company has reached an agreement of
settlement regarding a class action lawsuit involving these issues in Alabama
and Georgia. Final approval of the settlement has been received from the Alabama
Circuit Court, although a motion for reconsideration has been filed and the time
for filing an appeal has not yet expired. A Georgia Superior Court, in a
separate matter, enjoined the Company from settling with Georgia residents who
are members of the class. The Company has appealed to the Georgia Supreme Court
and expects the injunction to be overturned. The Company believes it is
adequately reserved for the cost of the settlement and related expenses. The
Company is vigorously defending itself in the other pending actions.
The Company is involved in various other legal and regulatory actions occurring
in the normal course of business. Based on current information, including
consultation with outside counsel, management believes any ultimate liability in
excess of amounts reserved that may arise from the above-mentioned and all other
legal and regulatory actions would not have a material adverse effect on the
Company's consolidated financial position or results of operations. However,
management's evaluation of the likely impact of these actions could change in
the future and an unfavorable outcome could have a material adverse effect on
the Company's consolidated financial position, results of operations or cash
flow of a future period.
9
9. SEGMENT INFORMATION
The Company has two reportable segments: 1) health insurance products; and 2)
life insurance products. The Company's health insurance products consist of the
following coverages related to preferred provider organization products:
MedOne(R) (for individuals and families) and small group medical, self-funded
medical, dental and short-term disability. Life products consist primarily of
group term life insurance. The "All other" category includes operations not
directly related to the business segments and unallocated corporate items (i.e.,
corporate investment income, interest expense on corporate debt, amortization of
intangibles and unallocated overhead expenses). The reportable segments are
managed separately because they differ in the nature of the products offered and
in profit margins.
The Company evaluates segment performance based on income or loss before income
taxes, excluding realized gains and losses on the Company's investment
portfolio. The accounting policies of the reportable segments are the same as
those used to report the Company's consolidated financial statements.
Significant intercompany transactions have been eliminated prior to reporting
reportable segment information.
A reconciliation of segment income (loss) before income taxes to consolidated
income from continuing operations before income taxes is as follows:
Three Months Ended Nine Months Ended
SEGMENT SUMMARY September 30, September 30,
------------------------------------------------------------
(THOUSANDS) 2004 2003 2004 2003
- --------------------------------------------------------------------------------------------------------------------
Health segment $ 10,242 $ 9,833 $ 36,123 $ 28,438
Life segment 1,636 1,518 4,706 4,445
All other (2,034) 1,272 (1,236) 1,311
- --------------------------------------------------------------------------------------------------------------------
Income from continuing operations, before tax $ 9,844 $ 12,623 $ 39,593 $ 34,194
====================================================================================================================
Operating results and statistics for each of the Company's segments are as
follows:
Three Months Ended Nine Months Ended
HEALTH SEGMENT September 30, September 30,
------------------------------------------------------------
(THOUSANDS, EXCEPT MEMBERSHIP DATA) 2004 2003 2004 2003
- --------------------------------------------------------------------------------------------------------------------
REVENUES
Insurance premiums $ 173,003 $ 173,744 $ 521,486 $ 525,371
Net investment income 1,417 1,596 4,481 4,994
Other revenue 4,030 3,828 12,327 11,565
- --------------------------------------------------------------------------------------------------------------------
Total revenues 178,450 179,168 538,294 541,930
EXPENSES
Medical and other benefits 117,178 118,518 346,576 356,938
Selling, general and administrative 51,030 50,817 155,595 156,554
- --------------------------------------------------------------------------------------------------------------------
Total expenses 168,208 169,335 502,171 513,492
- --------------------------------------------------------------------------------------------------------------------
Income from continuing operations, before tax $ 10,242 $ 9,833 $ 36,123 $ 28,438
====================================================================================================================
Loss ratio 67.7% 68.2% 66.5% 67.9%
Expense ratio 27.2% 27.0% 27.5% 27.6%
- --------------------------------------------------------------------------------------------------------------------
Combined ratio 94.9% 95.3% 93.9% 95.5%
====================================================================================================================
Health membership at end of period:
Fully-insured medical 272,140 270,401
Self-funded medical 43,218 43,858
Dental 214,664 226,734
- ------------------------------------------------------------------------------------
Total health membership 530,022 540,993
====================================================================================
10
Three Months Ended Nine Months Ended
LIFE SEGMENT September 30, September 30,
------------------------------------------------------------
(THOUSANDS, EXCEPT MEMBERSHIP DATA) 2004 2003 2004 2003
- --------------------------------------------------------------------------------------------------------------------
REVENUES
Insurance premiums $ 2,786 $ 2,991 $ 8,553 $ 9,195
Net investment income 116 121 351 383
Other revenue 46 71 153 219
- --------------------------------------------------------------------------------------------------------------------
Total revenues 2,948 3,183 9,057 9,797
EXPENSES
Medical and other benefits 420 700 1,580 2,216
Selling, general and administrative 892 965 2,771 3,136
- --------------------------------------------------------------------------------------------------------------------
Total expenses 1,312 1,665 4,351 5,352
- --------------------------------------------------------------------------------------------------------------------
Income from continuing operations, before tax $ 1,636 $ 1,518 $ 4,706 $ 4,445
====================================================================================================================
Loss ratio 15.1% 23.4% 18.5% 24.1%
Expense ratio 30.4% 29.9% 30.6% 31.7%
- --------------------------------------------------------------------------------------------------------------------
Combined ratio 45.4% 53.3% 49.1% 55.8%
====================================================================================================================
Life membership at end of period 127,075 137,395
====================================================================================
11
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
BUSINESS OVERVIEW
American Medical Security Group, Inc., together with its subsidiary companies
(the "Company"), is a provider of individual and small employer group insurance
products. The Company's principal product offerings are medical insurance for
small employer groups and medical insurance marketed to individuals and their
families ("MedOne(R)"). The Company also offers dental, life, prescription drug,
disability and accidental death insurance, and provides self-funded benefit
administration. The Company has two reportable segments: health insurance
products (which accounted for approximately 98% of the Company's total premium
revenues for the nine months ended September 30, 2004 and 2003) and life
insurance products. The Company markets its products in 33 states and the
District of Columbia through independent agents. The Company has approximately
75 sales managers and representatives located in sales offices throughout the
United States to support the independent agents. The Company's products
generally provide discounts to members that utilize preferred provider
organizations with which the Company contracts.
PENDING MERGER WITH PACIFICARE
On September 15, 2004, the Company entered into a definitive agreement with
PacifiCare Health Systems, Inc. ("PacifiCare") whereby PacifiCare will acquire
all of the outstanding shares of common stock of the Company through a cash
merger in which the Company will become a wholly-owned subsidiary of PacifiCare.
Under the terms of the merger agreement, PacifiCare will pay $32.75 in cash for
each share of the Company's common stock outstanding for a total equity purchase
price of approximately $500 million on a fully diluted basis. It is anticipated
that the acquisition will be completed following approvals by the Company's
shareholders, the Wisconsin Office of the Commissioner of Insurance and the
Georgia Department of Insurance, and compliance with the Hart-Scott-Rodino Act,
as well as other customary approvals. The Company's statements of operations for
the three and nine months ended September 30, 2004 include merger-related
transaction costs of approximately $2.6 million.
A special meeting of shareholders will be held December 2, 2004, at which
shareholders will be asked to consider and vote upon the proposal to approve the
agreement and plan of merger with PacifiCare and the transactions contemplated
by the merger agreement. A proxy statement for the special meeting was mailed to
shareholders on or about November 1, 2004.
FINANCIAL RESULTS SUMMARY
The Company reported net income of $5.3 million or $0.36 per diluted share for
the three months ended September 30, 2004, compared to net income of $8.8
million or $0.61 per diluted share for the corresponding quarter in the prior
year. The decrease in quarterly net income resulted primarily from the
following: (1) net income for the third quarter of the prior year included a net
gain of $0.9 million from discontinued operations related to the sale of the
Company's network subsidiary; (2) realized investment gains were higher net of
tax in the third quarter of the prior year by $0.9 million, net of tax resulting
from a realignment of the Company's investment portfolio; and (3) net income for
the third quarter of 2004 includes a charge for merger-related transaction costs
of $2.6 million.
For the nine months ended September 30, 2004, the Company reported net income of
$24.0 million or $1.64 per diluted share compared to net income for the first
nine months of the prior year of $22.0 million or $1.58 per diluted share. Net
income for the year was impacted by the items identified in the preceding
paragraph, in addition to a settlement of a dispute with the Company's former
pharmacy benefits manager related to pricing and prescription drug fees charged
to the Company from 1995 through 2002 (the "PBM settlement") in the first
quarter of 2004. As a result of the PBM settlement, the Company received a cash
payment of $5.9 million and the Company's financial results for the nine months
ended September 30, 2004 include a one-time gain of $3.4 million or $0.23 per
diluted share, net of taxes and other related expenses.
12
INSURANCE PREMIUM REVENUE AND MEMBERSHIP
Insurance premium revenue for the three months ended September 30, 2004
decreased to $175.8 million from $176.7 million for the corresponding period in
2003. For the nine months ended September 30, 2004, insurance premium revenue
declined to $530.0 million from $534.6 million for the same period of the prior
year. The decrease in premium revenue was caused by a decline in membership,
coupled with a trend of members choosing lower priced products with higher
deductibles and copayments, resulting in lower premiums per member per month.
Total health membership, which includes medical and dental members, declined
10,971 members from 540,993 members at September 30, 2003 to 530,022 members at
September 30, 2004. The Company's dental membership declined by 12,070 members
from September 30, 2003. Medical membership increased slightly in the third
quarter of 2004 due to an increase in MedOne membership, partially offset by a
decline in the Company's small group line of business.
The impact of rapidly rising health care costs and the cost of health insurance
coverage continues to be a major challenge faced by individuals and small
business owners, the Company's primary markets. To help alleviate the impact of
rising health care costs, the Company has designed product offerings that
provide insurance consumers with a greater financial stake in their health care
decisions. In exchange for higher deductibles and copayments, the Company's
products attempt to offer more affordable premiums. To mitigate the increasing
cost of healthcare, small employers are offering health insurance plans with
more limited benefits. Management believes this trend is contributing to the
decline in dental membership as fewer small businesses are offering dental
benefits to employees. Also, employee attrition among existing small employer
groups continues to negatively impact the Company's ability to increase
membership in the small employer group market.
INVESTMENT INCOME
Net investment income was $3.5 million for the three months ended September 30,
2004, compared to $3.2 million for the same period in 2003. Net investment
income increased for the nine-month period ended September 30, 2004 to $10.5
million from $10.0 million for the same period of the prior year. The increase
in net investment income is due primarily to an increase in average invested
assets during the period. Realized investment gains from the sale of securities
for the three and nine months ended September 30, 2004 decreased by $1.4 and
$1.9 million, respectively, compared to the prior year. Realized investment
gains and losses fluctuate as the Company takes advantage of market
opportunities and realigns its investment portfolio from time to time.
OTHER REVENUE
Other revenue, which primarily consists of administrative fee income from claims
processing on self-funded business and other administrative services, increased
to $4.1 million for the three months ended September 30, 2004 from $3.9 million
for the three months ended September 30, 2003. For the first nine months of
2004, other revenue increased to $12.5 million from $11.8 million for the same
period of the prior year. The increase in other revenue is due to an increase in
self-funded membership.
LOSS RATIO
The health segment loss ratio improved slightly in the third quarter of 2004 to
67.7%, compared to 68.2% for the third quarter of 2003. For the first nine
months, the health segment loss ratio was 66.5% in 2004, compared to 67.9% in
2003. The improvement from the first nine months of the prior year is due
primarily to the 1.0% impact of the PBM settlement. The health segment loss
ratio is also impacted by a variety of other factors including claims cost
trends, product pricing and the cost of litigation. Management closely monitors
developments in litigation and emerging trends in claims costs to determine the
adequacy and reasonableness of the Company's related reserves, and adjusts such
reserves when necessary. The loss ratio for the life segment was favorable at
15.1% for the three months ended September 30, 2004, compared with 23.4% for the
corresponding period of the prior year. For the nine months ended September 30,
2004 the life segment improved to 18.5% from 24.1% for the same period of the
prior year.
13
SELLING, GENERAL AND ADMINISTRATIVE EXPENSE RATIO
The selling, general and administrative ("SG&A") expense ratio includes
commissions and selling expenses, administrative expenses net of other revenues,
and premium taxes and assessments. The SG&A expense ratio for the health segment
for the three months ended September 30, 2004 was 27.2%. This compares to the
third quarter of 2003 health segment SG&A expense ratio of 27.0%.
EFFECTIVE TAX RATE
The effective tax rate for three and nine months ended September 30, 2004 was
46.7% and 39.4%, respectively compared to 37.5% and 37.7% for the same
respective periods of the prior year. The increase in the effective rate
resulted from non-deductible merger-related transaction costs incurred during
the third quarter of 2004.
LIQUIDITY AND CAPITAL RESOURCES
The Company's sources of cash flow consist primarily of insurance premiums,
administrative fee revenue and investment income. The primary uses of cash
include payment of medical and other benefits and SG&A expenses. Positive cash
flows are invested pending future payments of operating expenses; primarily
medical and other benefits. The Company's investment policies are structured to
provide sufficient liquidity to meet anticipated payment obligations.
The Company's investment portfolio consists almost exclusively of investment
grade bonds and has limited exposure to equity securities. At September 30, 2004
and December 31, 2003, greater than 99% of the Company's investment portfolio
was invested in debt securities. The bond portfolio had an average quality
rating of AA at September 30, 2004 and December 31, 2003, as measured by
Standard & Poor's Corporation, and the Company held no below investment grade
securities. The majority of the bond portfolio was classified as available for
sale. The Company had no investment in mortgage loans, non-publicly traded
securities, real estate held for investment or financial derivatives.
The Company's operating cash flow fluctuates from quarter to quarter due to
variations in the timing of claims, litigation and other operating payments or
recoveries. Cash provided by operations for the third quarter of 2004 was $4.7
million compared to cash provided by operations of $9.1 million in the third
quarter of the prior year. Cash provided by operations in the third quarter of
2004 was reduced by payments of litigation settlements in excess of $10.0
million, as well as payments of merger-related transaction costs. For the nine
months ended September 30, 2004, cash provided by operations was $11.5 million,
compared to cash provided by operations of $7.5 million for the corresponding
period in the prior year. The majority of the improvement in cash flow for the
nine-month period was due to the receipt of a cash payment of $5.9 million in
the first quarter of 2004 resulting from the PBM settlement described above.
The Company maintains a revolving bank line of credit agreement with a maximum
available facility of $50.0 million. At September 30, 2004, the outstanding
balance of advances under the credit agreement was $30.2 million. The credit
agreement requires a lump-sum payment of the outstanding balance at the end of
2005. The credit agreement contains customary covenants which, among other
matters, require the Company to achieve certain minimum financial results,
prohibit the Company from paying future cash dividends and restrict or limit the
Company's ability to incur additional debt and dispose of assets outside the
ordinary course of business. The Company was in compliance with all such
covenants at September 30, 2004. The Company's obligations under the credit
agreement are guaranteed by its subsidiary, American Medical Security Holdings,
Inc. ("AMS Holdings"), and secured by pledges of stock of AMS Holdings and
United Wisconsin Life Insurance Company ("UWLIC"), the Company's principal
insurance subsidiary which is domiciled in Wisconsin.
During the first nine months of 2004, the Company continued its investment in an
enterprise-wide information technology modernization project. The project
involves the purchase of software applications and the utilization of internal
and external technology and resources to support most of the Company's major
business processes. Management believes this software investment will help
support business growth, operational efficiency, service improvements and future
administrative cost savings. The design and development of certain
administrative software applications began during the first quarter of 2003 and
modules were implemented during 2003 and the first
14
nine months of 2004, and the remaining implementation is scheduled to be phased
in over the next few years. Capital expenditures during the first nine months of
2004 were $6.9 million. In June 2004, the Company amended an agreement with a
software vendor resulting in a commitment to purchase software applications and
other services to support the Company's core insurance systems. Management
believes that the Company's existing working capital and operating cash flow
will be sufficient to fund the Company's anticipated future capital expenditures
related to the modernization project.
In January 2003, the Company's Board of Directors approved a share repurchase
program, which provides the Company with the authority to repurchase up to $10.0
million of its outstanding common shares. The plan allows the Company to buy
back its shares, from time to time, in open market or privately negotiated
transactions, subject to price and market conditions. During 2003, the Company
purchased 87,900 shares of its common stock at an average market price of $15.44
per share, and at an aggregate cost of $1.4 million. No share repurchases were
made by the Company during the first nine months of 2004.
Dividends paid by UWLIC to the corporate parent may be limited by Wisconsin
insurance regulations. The insurance regulator may disapprove any dividend
which, together with other dividends paid by UWLIC in the prior 12 months,
exceeds the regulatory maximum, computed as the lesser of 10% of statutory
capital and surplus or total statutory net gain from operations as of the end of
the preceding calendar year. In June 2004, a $6.0 million dividend was paid by
UWLIC to the corporate parent. Based upon the financial statements of the
Company's insurance subsidiaries as of December 31, 2003, as filed with the
insurance regulators, the remaining amount available for dividend without
regulatory approval is $0.3 million until December 2004, when a dividend of
$11.3 million can be paid without regulatory approval.
The National Association of Insurance Commissioners has adopted risk-based
capital ("RBC") standards for life and health insurers designed to evaluate the
adequacy of statutory capital and surplus in relation to various business risks
faced by such insurers. The RBC formula is used by state insurance regulators as
an early warning tool to identify insurance companies that potentially are
inadequately capitalized. At December 31, 2003, each of the Company's insurance
subsidiaries had RBC ratios substantially above the levels that would require
Company or regulatory action.
The Company does not expect to pay any cash dividends in the foreseeable future
and intends to employ its earnings in the continued development of its business.
The Company's future dividend policy will depend on its earnings, capital
requirements, debt covenant restrictions, financial condition and other factors
considered relevant by the Company's Board of Directors.
Upon the successful completion of the pending merger with PacifiCare, the
Company will be obligated to pay a transaction fee for financial advisory
services of approximately $4.0 million. In addition, the Company will incur
additional merger-related administrative expenses in the process of completing
the transaction.
CAUTIONARY FACTORS
This report and other documents or oral presentations prepared or delivered by
and on behalf of the Company contain or may contain "forward-looking statements"
within the meaning of the safe harbor provisions of the United States Private
Securities Litigation Reform Act of 1995. Forward-looking statements are
statements based upon management's expectations at the time such statements are
made. The Company undertakes no obligation to publicly update or revise any
forward-looking statements, whether as a result of new information, future
events or otherwise. Forward-looking statements are subject to risks and
uncertainties that could cause the Company's actual results to differ materially
from those contemplated in the statements. Readers are cautioned not to place
undue reliance on the forward-looking statements. When used in written documents
or oral presentations, the terms "anticipate," "believe," "estimate," "expect,"
"may," "objective," "plan," "possible," "potential," "project," "will" and
similar expressions are intended to identify forward-looking statements. In
addition to the assumptions and other factors referred to specifically in
connection with such statements, factors that could impact the Company's
business and financial prospects include, but are not limited to, those
discussed below and those discussed from time to time in the Company's various
filings with the Securities and Exchange Commission or in other publicly
disseminated written documents:
15
CAUTIONARY FACTORS RELATED TO THE PROPOSED MERGER WITH PACIFICARE
APPROVAL OF THE MERGER. Obtaining regulatory and other approvals may delay or
prevent completion of the merger with PacifiCare. Any significant delay in
completing the merger could adversely affect the Company.
In addition to obtaining shareholder approval of the merger and the transactions
contemplated by the agreement and plan of merger, completion of the merger is
conditioned upon, among other things, the termination or expiration of the
applicable waiting periods under the Hart-Scott-Rodino Act and the receipt of
approval of PacifiCare's acquisition of control of the Company's insurance
subsidiaries from each of the Wisconsin Office of the Commissioner of Insurance
and the Georgia Department of Insurance. It is possible that one or more of the
governmental entities may seek various regulatory concessions or impose
conditions for granting approval of the merger. There can be no assurance that
the Company or PacifiCare will agree to any such concessions or will be able to
satisfy or comply with any such conditions or be able to cause their respective
subsidiaries to agree to any such concessions or satisfy or comply with any such
conditions.
FAILURE TO COMPLETE MERGER. Failure to complete the merger is likely to
negatively impact the Company's stock price and the future business and
financial results of the Company.
If the merger is not completed, the ongoing business of the Company may be
adversely affected and the Company will be subject to several risks, including
(1) being required, under certain circumstances, to pay PacifiCare a termination
fee of $17.5 million, (2) having to pay certain costs relating to the merger,
such as legal, accounting, financial advisor and printing fees, and (3) the
focus of management on the merger instead of on pursuing other opportunities
that could be beneficial to the Company, in each case without realizing any of
the benefits of having the transaction completed. If the merger is not
completed, the Company cannot ensure that these risks will not materialize and
will not materially affect the business, financial results and Company's stock
price.
CAUTIONARY FACTORS RELATED TO THE COMPANY'S BUSINESS
MEDICAL CLAIMS AND HEALTH CARE COSTS. If the Company is unable to accurately
estimate medical claims and control health care costs, its results of operations
may be materially adversely affected.
The Company estimates the costs of future medical claims and other expenses
using actuarial methods based upon historical data, medical inflation, product
mix, seasonality, utilization of health care services and other relevant
factors. The Company establishes premiums based on these methods. The premiums
the Company charges its customers generally are fixed for one-year periods, and
therefore, costs the Company incurs in excess of its medical claim projections
generally are not recovered in the contract year through higher premiums.
Certain factors may and often do cause actual health care costs to vary from
what the Company estimated and reflected in premiums. These factors may include,
but not be limited to: (1) an increase in the rates charged by providers of
health care services and supplies, including pharmaceuticals; (2) higher than
expected use of health care services by members; (3) the occurrence of
bioterrorism, catastrophes or epidemics; (4) changes in the demographics of
members and medical trends affecting them; and (5) new mandated benefits or
other regulatory changes that increase the Company's costs. The occurrence of
any of these factors, which are beyond the Company's control, could result in a
material adverse effect on its business, financial condition and results of
operations.
GOVERNMENT REGULATIONS. The Company conducts business in a heavily regulated
industry and changes in government regulation could increase the costs of
compliance or cause the Company to discontinue marketing its products in certain
states.
The Company's business is extensively regulated by federal and state
authorities. Some of the new federal and state regulations promulgated under the
Health Insurance Portability and Accountability Act of 1996, or HIPAA, relating
to health insurance regulations require the Company to implement changes in its
programs and systems in order to maintain compliance. The Company has incurred
significant expenditures as a result of HIPAA regulations and expects to
continue to incur expenditures as various regulations become effective.
The Company is subject to periodic changes in state laws and regulations
regarding the selection and pricing of risks and other matters. New regulations
regarding these issues could increase the Company's costs and decrease its
premiums. The Company has in the past decided, and may in the future decide, to
discontinue marketing its products
16
in states that have enacted, or are considering, various health insurance
regulations that would impair the Company's ability to market its products
profitably.
Federal and state legislatures also are considering regulatory measures that may
result in higher health insurance costs. Congress is considering legislation
allowing small employers to form association health plans, exempt from state
insurance regulations, which may impact the risk profile of employers willing to
purchase insurance from the Company. Various states occasionally consider
community rating legislation that would restrict risk factors that the Company
could take into consideration when rating its products, which could impact the
profitability of our products and the availability of insurance coverage. In
addition, the implementation of "prompt pay" laws, whereby a claim must be paid
in a certain number of days regardless of whether it is a valid claim or not,
subject to a right of recovery, may have a negative effect on the Company's
results of operations.
REGULATORY COMPLIANCE. The Company's failure to comply with new or existing
government regulation could subject it to significant fines and penalties.
The Company's efforts to measure, monitor and adjust its business practices to
comply with the law are ongoing. Failure to comply with enacted regulations,
including the laws mentioned above, could require the Company to pay refunds or
result in significant fines, penalties, or the loss of one or more of its
licenses. From time to time the Company is subject to inquiries related to its
activities and practices in states in which it operates. The Company has been
subject to regulatory penalties, assessments and restitution orders in a number
of states. Furthermore, federal and state laws and regulations continue to
evolve. The costs of compliance may cause the Company to change its operations
significantly, or adversely impact the health care provider networks with which
the Company does business, which may adversely affect its business and results
of operations.
LITIGATION. The Company is subject to class actions and other forms of
litigation in the ordinary course of its business, including litigation based on
new or evolving legal theories, which could result in significant liabilities
and costs.
For example, the Company recently entered into an agreement to settle a class
action lawsuit in which the Florida Circuit Court previously had found the
Company liable for damages. The settlement agreement is subject to final
approval by the Circuit Court. The Company also recently received final approval
from a Alabama Circuit Court of the certification and settlement of a class
action lawsuit involving the rating methodology formerly used by the Company for
group health benefit plans marketed to individuals in Alabama and Georgia. The
Company is involved in a number of other lawsuits in various states that allege
misrepresentation by the Company of its renewal rating methodology. For
additional information, see Part II, Item 1, "Legal Proceedings."
The nature of the Company's business subjects it to a variety of legal actions
and claims relating but not limited to the following: (1) denial of health care
benefits; (2) disputes over rating methodology and practices or termination of
coverage; (3) disputes with agents over compensation or other matters; (4)
disputes related to claim administration errors and failure to disclose network
rate discounts and other fee and rebate arrangements; (5) disputes related to
managed care or cost containment activities, (6) disputes over co-payment
calculations; and (7) customer audits of compliance with the Company's plan
obligations.
The Company cannot predict with certainty the outcome of lawsuits against the
Company or the potential costs involved.
COMPETITION. Competition in the Company's industry may limit its ability to
attract new members or to maintain its existing membership in force. As
competitors seek to increase market share, they may lower prices and/or enter
the markets in which the Company competes.
The Company operates in a highly competitive environment. The Company competes
primarily on the basis of price, benefit plan design, strength of provider
networks, quality of customer service, reputation and quality of agent
relations. The Company competes for members with other health insurance
providers and managed care companies, many of whom have larger membership in
regional markets and greater financial resources. Consolidations within the
industry may also contribute to the competitive environment. The Company cannot
provide assurance that it will be able to compete effectively in this industry.
As a result, the Company may be unable to attract new members or maintain its
existing membership and its revenues may be adversely affected.
17
BUSINESS GROWTH STRATEGY. The Company's future operating performance is largely
dependent on its ability to execute its growth strategy.
The Company has experienced a decline in membership over the last several years.
The Company's challenge is to increase the number of individuals and small
employer groups purchasing its products and services and to retain existing
members. Also impacting the Company's growth prospects is the affordability of
health insurance premiums as health care costs continue to rise, as well as the
downsizing or restrained hiring among small employers as a result of economic
uncertainty. If the Company's initiatives are not successful and the Company
does not meet its growth goals, the Company's future operating performance may
be adversely affected.
INFORMATION SYSTEMS. A failure of the Company's information system could
adversely affect its business.
Information processing is critical to the Company's business. The Company
depends on its information system for timely and accurate information. The
Company's failure to maintain an effective and efficient information system or
disruptions in its information system could cause disruptions in its business
operations, including any of the following: (1) failure to comply with prompt
pay laws; (2) loss of existing members; (3) difficulty in attracting new
members; (4) disputes with members, providers and agents; (5) regulatory
problems; (6) increases in administrative expenses; and (7) other adverse
consequences.
The Company is investing in an enterprise-wide information technology
modernization project involving the purchase of software applications to support
most of the Company's major processes. The design and development of the
software applications began in early 2003, with a phased implementation
scheduled over the next few years. Although the Company is taking measures to
safeguard against disruptions to its information systems during this process, it
cannot provide assurance that disruptions will not occur or that the project
will be successfully implemented or implemented on schedule.
INDEPENDENT AGENT RELATIONSHIPS. The Company depends on the services of
non-exclusive independent agents and brokers to market its products to potential
customers. These agents and brokers frequently market the health insurance
products of competitors as well as the Company's products. Most of the Company's
contracts with agents and brokers are terminable without cause upon 30-days'
notice by either party. The Company faces intense competition for the services
and allegiance of independent agents and brokers. The Company cannot provide
assurance that they will continue to market the Company's products in the future
or that they will not refer the Company's members to competitors.
In addition, the Company has a relationship with a general agent who, along with
affiliated subagents, generated approximately 10% of the Company's premium
revenue for the nine months ended September 30, 2004. The loss of this
relationship could hamper the Company's growth plans and, as a result, adversely
affect the Company's future operating performance.
NEGATIVE PUBLICITY. Negative publicity regarding the Company's business
practices and about the health insurance industry may harm the Company's
business and operating results.
In 2002, the Company was subject to negative national publicity surrounding its
MedOne(R) rating practices and related legal matters, which management believes
harmed the Company's MedOne(R) new member enrollment during the last half of
2002. The Company changed its rating practices in all MedOne(R) markets
effective January 1, 2003. Adverse publicity about the Company's rating
practices or other matters in the future may affect sales of the Company's
products, which could impede the Company's growth plans.
In addition, the health insurance industry, in general, has received negative
publicity and does not have a positive public perception. This publicity and
perception may lead to increased legislation, regulation, review of industry
practices and private litigation. These factors may adversely affect the
Company's ability to market its products and increase the regulatory burdens
under which the Company operates, further increasing the costs of doing business
and adversely affecting operating results.
INSURANCE RISK MANAGEMENT. If the Company's insurers or reinsurers do not
perform their obligations or offer affordable coverage with reasonable
deductibles or limits, the Company could experience significant losses.
18
The Company's risk management program includes several insurance policies it has
purchased to cover various property, business and other risks of loss. In
addition, the Company carries policies to cover its directors and officers. Many
of the carriers marketing these lines of coverage are experiencing unfavorable
claims experience and loss of, or increased costs for, their own reinsurance
coverage. Several carriers have exited markets and no longer offer certain lines
of coverage. Accordingly, there is no assurance that the Company will be able to
purchase insurance coverages for its own risk management at affordable premiums
or with reasonable deductibles and policy limits.
The Company has entered into and may continue to enter into a variety of
reinsurance arrangements under which it cedes business to other insurance
companies to mitigate large claims risk. Although reinsurance allows for greater
diversification of risk relating to potential losses arising from large claims,
the Company remains liable if these other insurance companies fail to perform
their obligations. As a result, any failure of an insurance company to perform
its obligations under an agreement could expose the Company to significant
losses. Also, there is no assurance that the Company will be able to purchase
reinsurance.
PERSONNEL. Loss of key personnel and the inability to attract and retain
qualified employees could have a material adverse impact on the Company's
operations.
The Company is dependent on the continued services of its management team,
including its key executives. Loss of such personnel could have a material
adverse effect on the Company. Some of the members of the Company's senior
management have developed relationships with some of the Company's independent
agents and brokers. If the Company is unable to retain these employees, the loss
of their services could adversely impact the Company's ability to maintain
relations with certain independent agents and brokers who market the Company's
products. Additionally, the Company needs qualified managers and skilled
employees with insurance industry experience to operate its businesses
successfully. From time to time there may be shortages of skilled labor that may
make it more difficult and expensive for the Company to attract and retain
qualified employees. If the Company is unable to attract and retain qualified
individuals or its costs to do so increase significantly, its operations could
be materially adversely affected.
PROVIDER NETWORK RELATIONSHIPS. The Company's inability to enter into or
maintain satisfactory relationships with provider networks could harm
profitability.
The Company's profitability could be adversely impacted by its inability to
contract on favorable terms with networks of hospitals, physicians, dentists,
pharmacies and other health care providers. The failure to secure cost-effective
health care provider network contracts may result in a loss of membership or
higher medical costs. In addition, the inability to contract with provider
networks, the inability to terminate contracts with existing provider networks
and enter into arrangements with new provider networks to serve the same market,
and/or the inability of providers to provide adequate care, could adversely
affect the Company's results of operations.
A.M. BEST INSURANCE RATING. If the Company's insurance subsidiaries are not able
to maintain their current rating by A.M. Best Company, the Company's results of
operations could be materially adversely affected.
The Company's insurance subsidiaries are assigned a rating by A.M. Best Company,
a nationally recognized rating agency. The rating reflects A.M. Best Company's
opinion of the insurance subsidiaries' financial strength, operating results and
ability to meet their ongoing obligations. Decreases in operating performance
and other financial measures may result in a downward adjustment of A.M. Best
Company's rating of the insurance subsidiaries. In addition, other factors
beyond the Company's control such as general downward economic cycles and
changes implemented by the rating agencies, including changes in the criteria
for the underwriting or the capital adequacy model, may result in a decrease in
the rating. A downward adjustment in A.M. Best's rating of the Company's
insurance subsidiaries could cause the Company's agents or potential customers
to look at the Company with less favor, which could have a material adverse
effect on the Company's results of operations.
REGULATION LIMITING TRANSFER OF FUNDS. Regulations governing the Company's
insurance subsidiaries could affect its ability to satisfy its obligations to
creditors as they become due, including obligations under the Company's credit
facility.
19
The Company's insurance subsidiaries are subject to regulations that limit their
ability to transfer funds to the Company. If the Company is unable to obtain
funds from its insurance subsidiaries, it will experience reduced cash flow,
which could affect the Company's ability to pay its obligations to creditors as
they become due. The Company will be required to make a lump-sum payment of the
outstanding balance under its credit facility at the end of 2005. The Company's
outstanding balance at September 30, 2004 was $30.2 million. If the Company's
insurance subsidiaries are unable to provide these funds, the Company could
default on its obligations under the credit facility.
CAPITAL AND SURPLUS REQUIREMENTS. If the Company's regulated insurance
subsidiaries are not able to comply with state capital standards, state
regulators may require the Company to take certain actions that could have a
material adverse effect on its results of operations and financial condition.
State regulations govern the amount of capital required to be retained in the
Company's regulated insurance subsidiaries and the ability of those regulated
subsidiaries to pay dividends. Those state regulations include the requirement
to maintain minimum levels of statutory capital and surplus, including meeting
the requirements of the risk-based capital standards promulgated by the National
Association of Insurance Commissioners. State regulators have broad authority to
take certain actions in the event those capital requirements are not met. Those
actions could significantly impact the way the Company conducts its business,
reduce its ability to access capital from the operations of its regulated
insurance subsidiaries and have a material adverse effect on its results of
operations and financial condition. Any new minimum capital requirements adopted
in the future through state regulation may increase the Company's capital
requirements.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The Company's market risk has not substantially changed from the year ended
December 31, 2003.
ITEM 4. CONTROLS AND PROCEDURES
The Company's management, with the participation of the Company's Chief
Executive Officer and Chief Financial Officer, has evaluated the effectiveness
of the Company's disclosure controls and procedures as of September 30, 2004.
Based on that evaluation, the Company's Chief Executive Officer and Chief
Financial Officer concluded that the Company's disclosure controls and
procedures were effective as of September 30, 2004. There were no changes in the
Company's internal control over financial reporting during the third quarter of
2004 that have materially affected, or are reasonably likely to materially
affect, the Company's internal control over financial reporting.
20
PART II OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
The following report of recent developments in previously reported legal
proceedings should be read in conjunction with Item 3, Legal Proceedings, in the
Company's annual report on Form 10-K for the year ended December 31, 2003, and
quarterly reports on Form 10-Q for the quarters ended March 31, 2004 and June
30, 2004.
On September 23, 2004, two of the Company's wholly owned subsidiaries, American
Medical Security, Inc. ("AMS") and United Wisconsin Life Insurance Company
("UWLIC") entered into an agreement to settle a class action lawsuit brought by
Evelyn Addison and others, pending in the Circuit Court of Palm Beach County,
Florida. The lawsuit was filed in February 2000 and alleges that the Company
failed to follow Florida law when in 1998 it discontinued writing certain health
insurance policies and offered new policies to insureds. Plaintiffs claim that
the Company wrongfully terminated coverage, improperly notified insureds of
conversion rights and charged improper premiums for new coverage. Plaintiffs
also allege that the Company's renewal rating methodology violated Florida law.
In April 2002, the Circuit Court Judge had ruled against the Company and ordered
that the question of damages be tried before a jury. The settlement has received
preliminary approval by the Circuit Court. If the settlement receives final
approval, all claims of participating class members will be dismissed and the
litigation terminated in exchange for settlement consideration. The Company
believes it is adequately reserved for the anticipated cost of the settlement
and related expenses. As a result, the agreement is expected to have no material
effect on the Company's earnings or results of operations. The Company expects
final approval of the settlement by the Circuit Court in December 2004.
On September 29, 2004, the Circuit Court of Montgomery County, Alabama, granted
final approval of the certification and settlement of a class action lawsuit,
GADSON V. UNITED WISCONSIN LIFE INSURANCE COMPANY, although a motion for
reconsideration has been filed and the time for filing an appeal has not yet
expired. The Circuit Court had granted preliminary approval of the certification
and settlement in March 2004. The lawsuit was filed in 2001 and involves issues
relating to the rating methodology formerly used by the Company for group health
benefit plans marketed to individuals in Alabama and Georgia. All claims of
participating class members have been dismissed in exchange for the settlement
consideration. On June 14, 2004, the Superior Court of Cobb County, Georgia, in
PARKER V. AMERICAN MEDICAL SECURITY GROUP, INC., issued an order enjoining the
Company from settling with Georgia residents who are members of the Gadson
class. On September 2, 2004 the Superior Court certified a class of Georgia
residents. The Company believes this injunction and class certification violates
general principles of comity and the Full Faith and Credit clause of the United
States Constitution and expects the injunction and certification to be
overturned by the Georgia Supreme Court, where the Company's appeal of the order
is currently pending. The Company believes it is adequately reserved for the
cost of the settlement, including related attorneys' fees.
The Company believes a portion of the cost of settlement of the Florida and
Alabama class actions should be covered by insurance. Any potential insurance
recovery is not reflected as an asset on the Company's balance sheet.
The Company's subsidiaries, AMS and UWLIC, are defendants in a number of other
lawsuits in various states, primarily Alabama, alleging misrepresentation of the
rating methodology used by the Company with respect to certain MedOne(R)
products purchased by the plaintiffs. These lawsuits commonly seek unspecified
damages for misrepresentation and emotional distress, in addition to punitive
damages. Some of these cases involve multiple plaintiffs. The cases are in
various stages of litigation. The Company believes that these lawsuits are
unfounded because the Company properly disclosed the nature of the products
sold. The Company also believes the subject matter of the lawsuits falls under
the primary jurisdiction of state insurance departments. The Company is
vigorously defending itself in these actions.
The Company is involved in various other legal and regulatory actions occurring
in the normal course of business. Based on current information, including
consultation with outside counsel, management believes any ultimate liability in
excess of amounts reserved that may arise from the above-mentioned and all other
legal and regulatory actions would not have a material adverse effect on the
Company's consolidated financial position or results of operations. However,
management's evaluation of the likely impact of these actions could change in
the future and an unfavorable outcome could have a material adverse effect on
the Company's consolidated financial position, results of operations or cash
flow of a future period.
21
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) EXHIBITS
See the Exhibit Index following the signature page of this report, which is
incorporated herein by reference.
22
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
DATE: November 4, 2004
AMERICAN MEDICAL SECURITY GROUP, INC.
/s/ John R. Lombardi
John R. Lombardi
Executive Vice President, Chief Financial Officer
and Treasurer (Principal Financial Officer and
Chief Accounting Officer and duly authorized to
sign on behalf of the Registrant)
23
AMERICAN MEDICAL SECURITY GROUP, INC.
(the "Registrant")
(Commission File No. 1-13154)
EXHIBIT INDEX
TO
FORM 10-Q QUARTERLY REPORT
for quarter ended September 30, 2004
EXHIBIT DESCRIPTION INCORPORATED HEREIN FILED
NUMBER BY REFERENCE TO HEREWITH
2 Agreement and Plan of Merger, dated as of Exhibit 2.1 to the Registrant's Form 8-K
September 15, 2004, by and among the filed with the Securities and Exchange
Registrant, PacifiCare Health Systems, Inc. Commission (the "SEC") on September 16,
and Ashland Acquisition Corp. 2004
4.1(a) Rights Agreement, dated as of August 9, 2001 Exhibit 1 to the Registrant's Registration
Registrant's by and between the Registrant Statement on Form 8-A, filed with the SEC
and Firstar Bank, N.A., as rights agent for on August 14, 2001
(the "Rights Agreement")
4.1(b) Appointment and Assumption Agreement dated Exhibit 4.2 to the Registrant's Form 8-K
December 17, 2001 by and between the filed with the SEC on February 5, 2002
Registrant and Firstar Bank, N.A., appointing (the "2/5/02 8-K")
LaSalle Bank, N.A. as rights agent for the
Rights Agreement
4.1(c) Amendment dated as of February 1, 2002 to the Exhibit 4.1 to 2/5/02 8-K
Rights Agreement
4.1(d) Amendment dated as of June 4, 2002 to the Exhibit 4.4(d) to the Registrant's Form
Rights Agreement 8-K filed with the SEC on June 19, 2002
4.1(e) Amendment dated as of September 15, 2004 to Exhibit 4.5 to the Registrant's
the Rights Agreement Registration Statement on Form 8-A
(Amendment No. 1) filed with the SEC on
September 15, 2004
10.1 Description of the Executive Management 2004 X
Interim Performance Award
10.2 Amendment dated September 15, 2004 to X
Employment Agreement between the Registrant
and its Chief Executive Officer
10.3 Amendment dated as of September 15, 2004 to X
Deferred Stock Agreement by and between the
Registrant and its Chief Executive Officer
10.4 Amendment dated September 15, 2004 to the X
Registrant's Change of Control Severance
Benefit Plan
EX-1
EXHIBIT INCORPORATED HEREIN FILED
NUMBER DESCRIPTION BY REFERENCE TO HEREWITH
31.1 Certification of Chief Executive Officer X
pursuant to Rule 13a-14(a) and Rule 15d-14(a)
of the Securities Exchange Act of 1934, as
amended
31.2 Certification of Chief Financial Officer X
pursuant to Rule 13a-14(a) and Rule 15d-14(a)
of the Securities Exchange Act of 1934, as
amended
32 Certification of Chief Executive Officer and X
Chief Financial Officer pursuant to 18 U.S.C.
Section 1350, as adopted pursuant to Section
906 of the Sarbanes-Oxley Act of 2002
EX-2