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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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FORM 10-K
(MARK ONE)
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
FOR THE YEAR ENDED DECEMBER 31, 1998
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM ____________ TO ____________ .
COMMISSION FILE NUMBER 000-21949
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PACIFICARE HEALTH SYSTEMS, INC.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
DELAWARE 95-4591529
(STATE OR OTHER JURISDICTION (IRS EMPLOYER IDENTIFICATION NUMBER)
OF INCORPORATION OR ORGANIZATION)
3120 LAKE CENTER DRIVE, SANTA ANA, CALIFORNIA 92704
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES, INCLUDING ZIP CODE)
(REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE) (714) 825-5200
SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT: NONE
SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:
CLASS A COMMON STOCK, PAR VALUE $0.01
CLASS B COMMON STOCK, PAR VALUE $0.01
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Indicate by check mark whether the Registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes [X] No [ ]
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of Registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [ ]
The aggregate market value of common stock held by non-affiliates of the
Registrant on January 29, 1999 was approximately $2,645,900,000.
The number of shares of Class A Common Stock and Class B Common Stock
outstanding at January 29, 1999 was approximately 14,800,000 and 30,800,000
respectively.
DOCUMENTS INCORPORATED BY REFERENCE
DOCUMENT WHERE INCORPORATED
PORTIONS OF THE REGISTRANT'S DEFINITIVE PROXY PART III
STATEMENT TO BE FILED BY APRIL 30, 1999
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PACIFICARE HEALTH SYSTEMS, INC.
INDEX TO ANNUAL REPORT ON FORM 10-K
FOR THE YEAR ENDED DECEMBER 31, 1998
PAGE
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PART I
Item 1. Business.................................................... 1
Item 2. Properties.................................................. 9
Item 3. Legal Proceedings........................................... 9
Item 4. Submission of Matters to a Vote of Security Holders......... 9
PART II
Item 5. Market for the Company's Common Equity and Related
Stockholders Matters........................................ 10
Item 6. Selected Financial Data..................................... 11
Item 7. Management's Discussion and Analysis of Financial Condition
and Results of Operations................................... 13
Item 7A. Quantitative and Qualitative Disclosures About Market
Risk........................................................ 26
Item 8. Consolidated Financial Statements and Supplementary Data.... 27
Item 9. Changes in and Disagreements with Accountants on Accounting
and Financial Disclosure.................................... 27
PART III
Item 10. Directors and Executive Officers of the Registrant.......... 27
Item 11. Executive Compensation...................................... 27
Item 12. Security Ownership of Certain Beneficial Owners and
Management.................................................. 27
Item 13. Certain Relationships and Related Transactions.............. 27
PART IV
Item 14. Exhibits, Financial Statement Schedules, and Reports on Form
8-K......................................................... 28
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PART I
ITEM 1. BUSINESS
OVERVIEW
PacifiCare Health Systems, Inc. is one of the nation's leading managed health
care services companies, serving approximately 3.5 million members in nine
states and Guam as of December 31, 1998. We operate health maintenance
organizations ("HMOs") and offer HMO related products and services.
HMOS AND HMO RELATED PRODUCTS AND SERVICES. PacifiCare offers HMO and
HMO-related products and services primarily to the Medicare and commercial
markets. An HMO is a health care organization that combines aspects of a health
care insurer with those of a health care provider by arranging for health care
services for its members through a defined provider network at a reduced
deductible or a nominal copayment. Our Medicare programs and commercial plans
are designed to deliver quality health care and customer service to members at
cost-effective prices.
- - SECURE HORIZONS(R). For Medicare beneficiaries, PacifiCare offers health care
services through its Secure Horizons(R) programs. Secure Horizons programs are
the largest Medicare+Choice programs in the United States (as measured by
membership). Secure Horizons membership has grown from approximately 0.3
million members at December 31, 1993 to approximately 1.0 million members at
December 31, 1998.
- - COMMERCIAL. For the commercial employer market, PacifiCare offers a range of
products and benefit plan designs that vary in the amount of member
copayments. These options allow employers flexibility in selecting
cost-effective benefit packages for their employees. PacifiCare's commercial
membership has grown from approximately 0.8 million members at December 31,
1993 to 2.5 million members at December 31, 1998. We also offer a variety of
specialty HMO managed care and HMO related products and services that
employers can purchase as a supplement to our basic commercial plans or as
stand-alone products. These products include behavioral health services, life
and health insurance, dental and vision services and pharmacy benefit
management. We generally provide these specialty services through subcontracts
or referral relationships with other health care providers.
NATURE OF OPERATIONS
PacifiCare's membership at December 31, 1998 was as follows:
SECURE PERCENT
HORIZONS COMMERCIAL TOTAL OF TOTAL
-------- ---------- --------- --------
Arizona........................................ 86,500 107,100 193,600 5.5%
California..................................... 599,800 1,595,000 2,194,800 62.2
Colorado....................................... 58,500 296,600 355,100 10.1
Guam........................................... -- 39,800 39,800 1.1
Nevada......................................... 22,900 38,900 61,800 1.7
Ohio........................................... 16,600 44,000 60,600 1.7
Oklahoma....................................... 26,900 96,300 123,200 3.5
Oregon......................................... 39,300 114,700 154,000 4.4
Texas.......................................... 61,900 127,100 189,000 5.4
Washington..................................... 60,400 94,600 155,000 4.4
------- --------- --------- -----
Total membership............................... 972,800 2,554,100 3,526,900 100.0%
======= ========= ========= =====
SECURE HORIZONS PROGRAMS
GENERAL. We have offered Secure Horizons programs to Medicare beneficiaries
since 1985 through participation in the Medicare risk program with the Health
Care Financing Administration or HCFA. Beginning January 1, 1999, we participate
in the new Medicare+Choice program which replaced the Medicare risk program. To
participate in the Medicare+Choice program, HCFA requires that HMOs be either
federally qualified or meet similar requirements as a competitive medical plan
to be eligible for Medicare+Choice contracts. All of our HMO operations meet
these requirements. Our Medicare+Choice
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contracts entitle us to annual fixed per-member premiums. Under current law, our
premiums are based upon the average cost of providing traditional
fee-for-service Medicare benefits to the Medicare population in each county,
subject to annual limits on the growth of our premiums. Our premium growth is
also limited by an overall cap on the growth of all payments under all
Medicare+Choice contracts. Future premiums from HCFA will be impacted by new
payment methods being developed by HCFA. See Government Regulation -- "HCFA."
Our per-member premium revenue for the Secure Horizons programs usually is, and
will continue to be, more than three times higher than for our commercial plans
primarily because of the higher medical and administrative costs of serving a
Medicare member. As a result of the premium differences, the Secure Horizons
programs accounted for approximately 59 percent of our consolidated premium
revenue for the year ended December 31, 1998, and an even larger percentage of
our operating profit, even though it represented only 28 percent of our total
membership. The Secure Horizons programs are subject to certain risks relative
to our commercial plans, such as higher comparative medical costs, higher levels
of utilization, government and regulatory reporting requirements, the
possibility of reduced or insufficient government reimbursement in the future
and higher marketing and advertising costs associated with selling to
individuals rather than to employer groups. These risks may adversely affect our
operating margins on these programs and our overall profitability. In addition,
each Secure Horizons member enrolls individually in our program, and may
disenroll by providing 30 days notice. We believe that our Secure Horizons
programs have one of the lowest disenrollment rates among Medicare+Choice plans.
HCFA may unilaterally revise our Medicare+Choice contracts based on updated
demographic information relating to the Medicare population and the cost of
providing health care in a particular geographic area. PacifiCare's
Medicare+Choice contracts are automatically renewed every 12 months unless we or
HCFA elect to terminate them. HCFA may also terminate our Medicare+Choice
contracts if we fail to continue to meet compliance and eligibility standards.
Termination of our Medicare+Choice contracts would have an effect on our
financial position, results of operations, cash flows or business prospects. We
have had these contracts in some states for at least 13 years. We have no reason
to believe that these terminations will occur.
COMMERCIAL PROGRAMS
GENERAL. PacifiCare's commercial plans offer a comprehensive range of products
to employer groups, including HMO, Preferred Provider Organization ("PPO") and
Point of Service ("POS") plans. A PPO is a selected group of providers, such as
medical groups, that offers discounted fee-for-service health care. POS plans
combine the features of an HMO with the features of a traditional indemnity
insurance product, allowing members to choose from a network of providers at a
lower cost or from other physicians at a higher deductible or copayment. Our
HMOs also have commercial contracts with the United States Office of Personnel
Management ("OPM") to provide managed health care services to approximately
204,000 members under the Federal Employee Health Benefits Program ("FEHBP") for
federal employees, annuitants and their dependents.
COMMERCIAL RETIREE PRODUCTS. In response to the needs of employers to provide
cost-effective health care coverage to their retired employees who may or may
not be currently entitled to Medicare, we offer the Secure Horizons retiree
product. This product draws on our Medicare expertise by offering provider
networks that are similar to those offered to our Secure Horizons enrollees. We
set our premiums generally based on the same revenue requirements needed to
provide services to Secure Horizons members. The retiree product gives us access
to individuals who, once familiar with our services and delivery system, may
enroll in Secure Horizons programs when they become eligible for Medicare
benefits.
HMO RELATED PRODUCTS AND SERVICES. In addition to our HMO operations, PacifiCare
provides a range of specialty managed care products which supplement our HMO
products and are primarily sold in our commercial programs. These include:
- - Behavioral Health Services. PacifiCare Behavioral Health of California, Inc.
is a California licensed specialized health care service plan that provides
behavioral health care services, including chemical dependency benefit
programs, primarily to our California and other HMO commercial members.
Outside of California, PacifiCare Behavioral Health, Inc. contracts with our
HMOs, other insurers and employers to manage their respective mental health
and chemical dependency benefit programs.
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- - Life and Health Insurance. PacifiCare's life and health insurance
subsidiaries, PacifiCare Life and Health Insurance Company and PacifiCare Life
Assurance Company, offer managed health care insurance products to employer
groups. We integrate these products with our existing HMO products to form
multi-option health benefits programs, including our PPO and POS plans.
Together, our insurance subsidiaries are licensed to operate in 38 states,
including each of the states where our HMOs operate, the District of Columbia,
and Guam.
- - Dental and Vision Services. PacifiCare Dental and Vision is a California
licensed, specialized health care service plan that provides prepaid dental
and optometry benefits directly to individuals and employer groups and
indirectly to our California Secure Horizons and commercial HMO members.
- - Pharmacy Benefit Management. PacifiCare Pharmacy Centers, Inc., dba
Prescription Solutions(R), is one of the industry's largest pharmacy benefit
management companies. Prescription Solutions offers pharmacy benefit
management services to HMOs and employer groups that are self-insured for
prescription drugs. Clients of Prescription Solutions have access to a
pharmacy provider network that features independent and chain pharmacies and a
variety of cost and quality management capabilities. Prescription Solutions
also provides its clients with an array of fully integrated services,
including mail order distribution, an extensive network of retail pharmacies,
claims processing and sophisticated drug utilization reporting.
- - Medicare+Choice Management. Formed to promote our expertise in the Medicare
risk area, Secure Horizons USA, Inc., ("SHUSA") licenses the Secure Horizons
name and provides management services to HMOs and health care delivery systems
that seek participation in the Medicare+Choice program. SHUSA's management
services include, marketing, provider contracting and administrative services.
The fee charged by SHUSA is generally based on a percentage of a licensee's
revenue. SHUSA has agreements in New Mexico with Presbyterian Healthcare
Services, Inc., in New England with Tufts Associated Health Maintenance
Organization, Inc., and in Hawaii with Queens Health Plans. We anticipate that
Queens Health Plan will offer a product similar to Secure Horizons beginning
in the summer of 1999, if HCFA approval is received. We anticipate that with
the repeal of the 50/50 Rule (the requirement that 50 percent of a
Medicare+Choice health plan's enrollment be drawn from commercial contracts)
and the drive to enroll Medicare beneficiaries in HMOs, SHUSA may expand into
new markets by entering into licensing arrangements in a variety of geographic
areas.
BUSINESS STRATEGY
Our current business strategy continues to focus on growing and improving our
operating performance. During 1999 we will seek to increase operating income by:
- - Increasing commercial membership at improved commercial premium prices;
- - Managing health care costs through capitated arrangements with strong provider
organizations that align the interests of our providers with ours and our
members; and
- - Improving our administrative and marketing efficiencies to reduce the
percentage of revenue spent on marketing, general and administrative expenses.
Our ability to increase operating income is subject to various risks and
uncertainties described throughout this document and other documents filed by
PacifiCare with the Securities and Exchange Commission.
We will also focus on improving quality and service in 1999. See Nature of
Operations -- "Quality Improvement." Our goals include:
- - Increasing Medicare and commercial member satisfaction;
- - Improving the quality and service on our basic HMO products;
- - Receiving National Committee for Quality Assurance ("NCQA") accreditation in
Texas, where 1999 is our initial year of application;
- - Maintaining NCQA accreditation in all other states; and
- - Participating in the Coalition for Affordable Quality Healthcare to inform and
educate the public about managed care.
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We are also having continuing discussions with HCFA regarding the
Medicare+Choice changes. See Government Regulation -- "HCFA."
We continue to evaluate opportunities in new and existing geographic markets
that may be available through acquisitions and the development of new products.
We also continuously assess our geographic markets and product lines to
determine if any do not fit within our profitability objectives and current
business strategy. We believe that our ability to offer a comprehensive range of
products and services, combined with long-term relationships with our health
care providers, will enable us to respond effectively to the changing needs of
the health care marketplace.
COMPETITION
The health care industry is highly competitive, both nationally and in
PacifiCare's various markets. Consolidation in the health care industry has
resulted in fewer but larger competitors, including insurance carriers, other
HMOs, employer self-funded programs and PPOs, some of which have substantially
larger enrollments or greater financial resources than PacifiCare. Also, because
of this consolidation, we have become one of the largest HMOs in the country.
Other competitors include hospitals, health care facilities and other health
care providers. These competitors have combined to form their own networks to
contract directly with employer groups, and other prospective customers for the
delivery of health care services. We face competition in all our markets from
national HMOs, insurance carriers, local HMOs, PPOs and other local health care
providers. In this increasingly competitive environment, we believe that we
should continue to provide a comprehensive range of products and services, along
with a strong provider network, to remain competitive. Other factors which give
us some competitive advantages in this environment are:
- - Strong underwriting and pricing practices and staff;
- - Significant market position in certain geographic areas;
- - Financial strength;
- - Experience; and
- - A generally favorable marketplace reputation with providers, members and
employers.
RISK MANAGEMENT
We use underwriting criteria as an integral part of our commercial risk
management efforts. Underwriting is the process by which a health plan assesses
the risk of enrolling employer groups (or individuals) and establishes
appropriate or necessary premium rates. The setting of premium rates directly
affects a health plan's profitability and marketing success. See "Health Care
Costs." We cannot employ underwriting techniques for the Secure Horizons
programs because of regulations that require us to accept nearly all Medicare
beneficiaries. We shift part of our risk of catastrophic losses by maintaining
reinsurance coverage for certain hospital costs incurred in the treatment of
catastrophic illnesses. We require contracting physicians, physician groups and
hospitals to maintain individual malpractice insurance coverage. We also
maintain general liability, property and medical malpractice insurance coverage
in amounts that we believe to be adequate.
HEALTH CARE COSTS AND PROVIDER RELATIONSHIPS
GENERAL. Our profitability and the success of our business strategy depends on
our ability to attract and retain a network of qualified health care providers
in each geographic area we serve. We contract with various providers, including
primary care physicians, specialists, hospitals, and other ancillary service
providers. Our contracts typically have one year terms. However, we have entered
into multiple-year contracts with certain physician groups to ensure the quality
and stability of our provider network.
CAPITATION ARRANGEMENTS. PacifiCare typically contracts with providers on a
capitated basis (a fixed fee per member per month, regardless of the services
provided each member). Capitation payments to providers are often based on a
percentage of the premium we receive; this is especially true for our Secure
Horizons
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contracts. The percentage of premium arrangement causes provider compensation to
fluctuate directly with the amount of premiums we receive. The primary care
physician group influences medical utilization and controls costs through
referrals, hospitalization and other services. With capitation contracts, there
are two possible administration arrangements for network contracting,
utilization management and claims processing:
- - DELEGATED ADMINISTRATION. In the majority of our networks, providers perform
some or all of the administrative functions associated with operating in a
capitated environment. In those situations, we provide support for their
administrative functions to help them achieve greater levels of efficiency and
autonomy while promoting the wellness of our members. We believe one of our
core competencies is our ability to manage delegated provider relationships.
- - DIRECT ADMINISTRATION. Other providers do not have the capability to manage
the administrative functions associated with operating in a capitation
environment. With such providers, we perform the administrative functions on
their behalf. In addition, we work with those providers to assist them in
developing the capability to assume a greater share of the administrative
functions. We continue to develop our own expertise in this area to ensure
that we can continue to build strong provider networks for our members in
existing and new markets where providers may not be capable of performing
these functions.
FEE-FOR-SERVICE ARRANGEMENTS. In some of our markets, some health care providers
are not contracted under capitated arrangements. Non-capitated arrangements may
increase health care costs when utilization is not appropriately managed. To the
extent possible we have renegotiated, or are in the process of renegotiating,
these contracts to move the providers to a capitated payment plan. Our ability
to renegotiate provider contracts in certain markets is limited due to a lack of
provider competition.
INCENTIVE ARRANGEMENTS. Our HMOs share the risk of certain health care costs,
primarily in capitation arrangements. We provide additional incentives to the
physicians or groups for appropriate utilization of hospital inpatient,
outpatient surgery and emergency room services. We may also pay incentives to
providers based on their performance in controlling health care costs while
providing quality health care.
UTILIZATION MANAGEMENT. We operate a utilization review system through which we
review routine hospital admissions and lengths of stay. Our utilization review
committees are composed of several physicians at each physician group. The
committees approve non-emergency hospitalizations in advance of admission.
Together with our medical services utilization staff, the committees carefully
monitor the member's continued stay after admission. Through our medical
services departments, we are actively involved in the utilization review of
chronic and complex cases. These departments also actively monitor catastrophic
cases in the field to ensure that members receive appropriate medical care and
suggest treatment options that may be more appropriate and cost-effective than a
long-term hospital stay.
NETWORK STABILITY. We work closely with our provider partners to ensure the
strength and quality of our network. We track provider stability and solvency on
an ongoing basis to avoid network disruptions for our members and to minimize
our financial risk. Provider assessments focus on solvency indicators, including
liquidity and cash management. Operational information is reviewed periodically
to assess the strength of the provider's financial management. When our
delegated providers require assistance, we provide clinical management tools,
clinical and operational best practices and performance benchmarks.
PacifiCare has multiple year contracts with MedPartners Inc. ("MedPartners").
MedPartners provides services to over 0.1 million members or 10 percent of our
total Medicare membership, and approximately 0.3 million members or 12 percent
of our total commercial membership. In November 1998, MedPartners announced its
intention to sell its physician groups and discontinue its physician practice
management business. We are implementing programs to retain our physician
networks in anticipation of these sales. The loss of physician networks could
have a material effect on our revenues, profitability and business prospects.
PROVIDER INSOLVENCY. When a delegated provider significantly slows or stops
paying claims, we may take on the administrative functions described above. We
may also shift membership to other providers, a step that is taken when a
provider has or is expected to declare bankruptcy. Our 1998 results include
significant provider insolvency costs, primarily related to FPA Medical
Management Inc., ("FPA") who declared bankruptcy in July 1998. See Management's
Discussion and Analysis. Provider insolvency reserves include write-offs of
providers' uncollectable receivables and the estimated cost of unpaid health
care claims covered by our capitation payment.
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In addition to the insolvency costs, shifting membership to other providers
increases our administrative costs and may increase future health care costs.
QUALITY IMPROVEMENT
GENERAL. We believe that providing our members with reasonable access to quality
health care services is an essential ingredient for sustained success. To assure
this, we focus on provider peer review procedures, member quality initiatives
and national industry measures.
PROVIDER PEER REVIEW PROCEDURES. We have established a peer review procedure at
each HMO, governed by a quality improvement committee. The medical director for
each HMO chairs that HMO's committee. Each committee consists of health plan
clinical professionals and physician representatives from the contracted
physician groups of that HMO. When we identify a new physician or physician
group as a potential provider, the quality improvement committee of the HMO
evaluates that provider. The quality assessment includes evaluating the quality
of the providers' medical facilities, medical records, laboratory and x-ray
licenses and its capacity to handle membership demands. We also engage in
ongoing quality reviews of our existing providers to ensure that members are
receiving quality medical care.
MEMBER QUALITY INITIATIVES. To improve the quality of service and clinical
outcomes for our members, we have developed a comprehensive quality improvement
program including:
- - Offering health improvement programs, including several chronic care
management initiatives, preventive health programs, smoking cessation, and
senior health risk assessments;
- - Standardizing and streamlining our specialty provider referral process;
- - Improving our complaint management program to better coordinate problem
resolution; and
- - Monitoring member satisfaction through surveys and internal operational report
cards compared to our current established benchmarks.
In markets where these initiatives have been fully implemented, we have seen
significant improvements in member health outcomes and member satisfaction.
NATIONAL INDUSTRY MEASURES. Our HMOs provide quality and service information
under the Health Plan Employer Data Set ("HEDIS") program. Our membership and
provider quality initiatives described above are designed to improve our scores.
The NCQA is an independent, non-profit organization that reviews and accredits
HMOs. NCQA performs site reviews of standards established for quality
improvement, utilization management, physician credentialing process, a
commitment to members' rights and preventative health services. HMOs that comply
with NCQA's review requirements and quality standards receive NCQA
accreditation. At December 31, 1998, our HMOs in Arizona, California, Colorado,
Nevada, Oklahoma and Oregon (covering approximately 87 percent of our
membership) have received full three year NCQA accreditation. In 1999, we will
complete the NCQA site review in Texas.
MARKETING
Primary marketing responsibility for each of our HMOs and HMO related products
and services resides with a marketing director and direct sales force.
SECURE HORIZONS MARKETING. We market our Secure Horizons programs to Medicare
beneficiaries primarily through direct mail, telemarketing, television, radio
and cooperative advertising with participating medical groups. Most Secure
Horizons members enroll directly in a plan, generally without the involvement of
insurance brokers, except when enrolling as part of an employer group retiree
offering. We anticipate further growth opportunities in the Medicare+Choice
program based on our current marketing strategies, and the growing senior
population in the United States. See "Nature of Operations -- Secure Horizons
Programs" and "Commercial Programs and Medicare+Choice Management."
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COMMERCIAL MARKETING. Commercial marketing is a two-step process where we first
market to employer groups, and then provide information directly to employees
once the employer has selected our HMO. We solicit new employer groups of
various sizes through direct, personal selling efforts and through contacts with
insurance brokers and consultants. Insurance brokers and consultants represent
many employer groups under contract with PacifiCare. These brokers and
consultants work directly with employers to recommend or design employee
benefits packages. We pay insurance brokers commissions over the life of the
contract, while employers generally pay consultants directly. A significant
portion of our commercial membership growth comes from existing employer groups.
With each open enrollment, we identify our specific approach with certain
employer groups to increase our penetration. We use various techniques to
attract commercial members, including work site presentations, direct mail,
medical group tours and local advertising. We also use television, radio,
billboard, and print media to market our programs.
MANAGEMENT INFORMATION SYSTEMS
GENERAL. PacifiCare uses computer-based management information systems for
various purposes, including marketing and sales tracking, underwriting, billing,
claims processing, utilization management, medical cost and utilization
trending, financial and management accounting, reporting, planning, and
analysis. These systems also support member, group and provider service
functions, including on-line access to membership verification, claims and
referral status, and information regarding hospital admissions and lengths of
stay. In addition, these systems support extensive analyses of cost and outcome
data.
We continually enhance and upgrade our computer information systems to preserve
our investment in existing systems, embrace new technologies, improve the cost
effectiveness and quality of our services, and introduce new products. Ongoing
system enhancements include upgrading mainframe computers, enhancing existing
software, implementing purchased software, and migrating to more suitable
software database environments. Simplification, integration, and expansion of
the systems servicing our business is an important component of controlling
health care and administrative expenses and improving member and provider
satisfaction. We have recovery plans in place to mitigate the effect of
information systems outages, if necessary. To the extent that these systems fail
to operate, however our financial results may be adversely affected. We have
also developed a program to address Year 2000 issues. See "Management Discussion
and Analysis -- Forward Looking Information under the Private Securities
Litigation Act of 1995."
GOVERNMENT REGULATION
GENERAL. PacifiCare's HMOs are subject to extensive federal and state regulation
which govern the scope of benefits provided to its members, financial solvency
requirements, quality assurance and utilization review procedures, member
grievance procedures, provider contracts, marketing and advertising. Certain
federal and/or state regulatory agencies also require our HMOs to maintain
restricted cash reserves represented by interest-bearing investments that are
held by trustees or state regulatory agencies. These requirements, which limit
the ability of our subsidiaries to transfer funds to us, may limit our ability
to pay dividends. From time to time, we advance funds, to our subsidiaries to
assist them in satisfying federal or state financial requirements. Our
behavioral health, dental and insurance subsidiaries are also subject to
extensive federal and state regulation.
HCFA. PacifiCare's Secure Horizons programs are subject to regulations by HCFA
and certain state agencies. These agencies govern the benefits provided,
premiums paid, quality assurance procedures, marketing and advertising. See
"Nature of Operations-Secure Horizons Programs." As part of its drive to
encourage Medicare beneficiaries to enroll in private health care plans, the
1997 Balanced Budget Act replaced the Medicare risk contract program with the
Medicare+Choice program. On June 26, 1998, HCFA published interim final
regulations to implement the Medicare+Choice program. The regulations establish
new or expanded requirements for organizations participating in the
Medicare+Choice program. They also establish new or expanded standards for
quality assurance, beneficiary protection, coordinated open enrollment, program
payments, information disclosure and provider participation. While the new
regulations became effective on July 27, 1998, most provisions did not affect us
until we moved to the Medicare+Choice program on January 1, 1999. Compliance
with and implementation of the new Medicare+Choice program regulations will
increase our Medicare administration costs. We continue to evaluate the
operational and financial impact of the new Medicare+Choice program.
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The Balanced Budget Act also revised the formula used by HCFA to calculate
payments to Medicare health plans. It established minimum payment levels,
limiting annual increases and the overall rate of payment growth. Further, the
Balanced Budget Act required HCFA to develop a risk adjusted payment methodology
by March 1, 1999 and to implement the payment process for periods beginning
January 1, 2000. On January 15, 1999, HCFA released the Year 2000 premium
payment rate changes and the risk adjusted payment program. The proposed
methodology relies on retrospective hospital inpatient data to establish risk
premiums for individual Medicare enrollees. The new proposed risk adjusted
program is scheduled to be implemented over a five-year period according to the
following schedule: 10 percent in 2000, 30 percent in 2001, 55 percent in 2002,
80 percent in 2003, and 100 percent in 2004. Phase-in of the risk adjusted
payments will mitigate the near term financial impact on us. However, the
proposed method may have a longer-term adverse impact on us since the proposal
would provide larger premiums to health plans with higher inpatient utilization.
Managed care organizations, such as PacifiCare, have achieved lower inpatient
utilization and have developed programs to avoid unnecessary hospitalizations
through the use of other, less costly sites for providing healthcare. If this
approach is implemented as proposed, we may receive lower premiums because of
our lower inpatient utilization.
We have provided comments to the proposed methodology and are engaged in various
efforts with HCFA and others to modify the proposed process. We believe the
payment formula should not create incentives for increased inpatient utilization
and should not penalize health plans that have developed programs to reduce
unnecessary hospitalizations. However, there can be no assurance that we will be
successful in our efforts to obtain changes to the proposed methodology. The
loss of Medicare contracts or terminations or modification of the HCFA
risk-based Medicare program could have a material effect on our revenue,
profitability and business prospects.
EMPLOYEE RETIREMENT INCOME SECURITY ACT OF 1974 ("ERISA"). ERISA regulates
insured and self-insured health coverage plans offered by employers, FEHBP, and
federal and state fraud and abuse laws and laws relating to health care
management and delivery. ERISA controls how PacifiCare may do business with
employers covered by ERISA, particularly employers that maintain self-funded
plans. The Department of Labor is engaged in an ongoing ERISA enforcement
program which may result in additional constraints on how ERISA-governed benefit
plans conduct their activities. There have been recent legislative attempts to
limit ERISA's preemptive effect on state laws. If such limitations are enacted,
they might increase our exposure under state law claims that relate to employee
health benefits offered by PacifiCare, and may permit greater state regulation
of other aspects of those business operations.
OPM. PacifiCare's HMOs have commercial contracts with OPM to provide managed
care health services to federal employees, annuitants and their dependents under
the FEHBP. In the normal course of business, OPM audits health plans with which
it contracts, among other things, to verify that the premiums calculated and
charged to OPM are established in compliance with the best price 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. OPM
recently completed audits of the majority of our health plans through 1996.
OPM's initial on-site audits are usually followed by post-audit briefings where
OPM indicates preliminary results. However, final resolution and settlement of
the audits have historically taken a minimum of three to five years. In
connection with the sale of our health plans in New Mexico, Illinois and Utah,
we have agreed to indemnify the buyers for potential OPM liabilities that relate
to the years when FHP owned these plans. PacifiCare intends to negotiate with
OPM on all unresolved matters to attain a mutually satisfactory result.
In addition to claims made by the OPM auditors as part of the normal audit
process, OPM may also refer their results to the United States Department of
Justice ("DOJ") for potential legal action under the False Claims Act. The DOJ
has the authority to file a claim under the False Claims Act if it believes that
the health plan knowingly overcharged the government or otherwise submitted
false documentation or certifications. In actions under the False Claims Act,
the DOJ may impose trebled damages and a civil penalty of not less than $5,000
nor more than $10,000 for each separate alleged false claim. In November 1997,
we were notified that the 1990-1995 OPM audit of our Oklahoma HMO had been
referred to the DOJ. In January 1999, we preliminarily agreed to settle the
1990-1995 Oklahoma OPM audits for $9 million, an amount which had previously
been reserved.
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TRADEMARKS
PacifiCare owns the federally registered service marks PacifiCare(R) and
SecureHorizons(R). These service marks are material to our business.
EMPLOYEES
At December 31, 1998, PacifiCare had approximately 8,700 full and part-time
employees. None of our employees are presently covered by a collective
bargaining agreement. We consider relations with our employees to be good and
have never experienced any work stoppage.
ITEM 2. PROPERTIES
As of December 31, 1998, PacifiCare leased approximately 220,000 aggregate
square feet of space for its principal corporate headquarters and executive
offices in Santa Ana and Costa Mesa, California. In connection with our
operations, as of December 31, 1998, we leased approximately 2.2 million
aggregate square feet for office space, subsidiary operations, customer service
centers and space for computer facilities. Such space corresponds to areas in
which our HMOs or specialty managed care products and services operate, or where
we have satellite administrative offices. Our leases expire at various dates
from 1999 through 2009.
We own 32 buildings encompassing approximately 914,000 aggregate square feet of
space. Six of the buildings, representing approximately 348,000 aggregate square
feet of space, are primarily used for administrative operations and are located
in California and Guam. The remaining 26 buildings are medical office buildings
leased under a master lease agreement. All 26 medical buildings are being
marketed for sale. We also own nine parcels of vacant land for a total of 46
acres, all of which are being marketed for sale.
Our facilities are in good working condition, are well maintained and are
adequate for our present and currently anticipated needs. We believe that we can
rent additional space at competitive rates when current leases expire, or if we
need additional space.
ITEM 3. LEGAL PROCEEDINGS
As previously reported, a securities class action lawsuit, Madruga et al. v.
PacifiCare Health Systems, Inc., et al. (No. SAVC-97-974 LHM, Central District
of California) was brought on behalf of all purchasers of PacifiCare stock
between February 14, 1997 and November 24, 1997. The complaint accuses
PacifiCare and certain of its officers and directors of making false and
misleading statements about the cost savings and synergies resulting from the
FHP acquisition. Plaintiffs also claim we made fraudulent earnings forecasts for
1997 and 1998 and misstated financial results for the first, second and third
quarters of 1997. The complaint alleges violations of certain sections of the
Securities Exchange Act of 1934. On May 11, 1998, we filed a motion to dismiss
the entire complaint under the Private Securities Litigation Reform Act of 1995.
No discovery has been taken and all discovery has been stayed pending the
resolution of our motion to dismiss. We believe that we have good defenses to
these claims and are contesting the claims vigorously.
We are involved in legal actions in the normal course of business, some of which
seek monetary damages, including claims for punitive damages which are not
covered by insurance. Based on current information and review, including
consultation with our lawyers, we believe any ultimate liability which may arise
from these actions (including all purported class actions) would not materially
affect our consolidated financial position, results of operations, cash flows or
business prospects. However, our evaluation of the likely impact of these
actions could change in the future and an unfavorable outcome, depending upon
the amount and timing, could have a material effect on the results of operations
or cash flows of a future quarter.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matter was submitted to a vote of security holders during the three months
ended December 31, 1998.
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12
PART II
ITEM 5. MARKET FOR THE COMPANY'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
PacifiCare's Class A and B common stock are listed on the Nasdaq National Market
under the symbols PHSYA and PHSYB, respectively. The following tables indicate
the high and low reported sale prices per share as furnished by Nasdaq.
CLASS A CLASS B
COMMON COMMON
STOCK STOCK
----------- ------------
HIGH LOW HIGH LOW
---- --- ---- ----
YEAR ENDED DECEMBER 31, 1998
First Quarter......................................... 74 46 3/4 75 5/8 49
Second Quarter........................................ 85 7/8 68 3/8 89 3/8 69 7/16
Third Quarter......................................... 88 7/8 53 3/4 93 1/4 55 5/8
Fourth Quarter........................................ 78 7/8 53 3/4 84 3/4 58 1/4
YEAR ENDED DECEMBER 31, 1997
First Quarter......................................... 85 5/8 68 3/4 89 1/2 72 7/8
Second Quarter........................................ 83 55 1/2 87 3/4 58 3/4
Third Quarter......................................... 71 60 1/4 74 3/4 62
Fourth Quarter........................................ 71 1/4 48 1/8 72 1/2 50 7/8
PacifiCare has never paid cash dividends on its common stock. We expect that we
will not declare dividends on our common stock in the future, retaining all
earnings for business development. Any possible future dividends will depend on
our earnings, financial condition, and regulatory requirements. If we decide to
declare common stock dividends in the future, such dividends may only be made in
shares of PacifiCare's common stock, according to the terms of our credit
facility. See Note 6 of the Notes to Consolidated Financial Statements.
As of December 31, 1998 there were 286 shareholders of record of our Class A
common stock and 335 shareholders of record of our Class B common stock. As of
December 31, 1998 there were approximately 21,000 beneficial holders of our
Class A and B common stock.
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13
ITEM 6. SELECTED FINANCIAL DATA
In February 1997, PacifiCare's board of directors approved a change in our
fiscal year end from September 30 to December 31. This resulted in a transition
period for October 1, 1996 through December 31, 1996. The following selected
financial and operating data are derived from our audited consolidated financial
statements, or from our unaudited internal financial data. For clarity of
presentation and comparability, the following selected financial and operating
data includes the unaudited period for the twelve months ended December 31,
1996. The selected financial and operating data should be read in conjunction
with "Item 7. Management's Discussion and Analysis of Financial Condition and
Results of Operations," and also with "Item 8. Consolidated Financial Statements
and Supplementary Data."
INCOME STATEMENT DATA
(TRANSITION
(UNAUDITED) PERIOD)
TWELVE THREE
YEAR ENDED YEAR ENDED MONTHS ENDED MONTHS ENDED
DECEMBER 31, DECEMBER 31, DECEMBER 31, DECEMBER 31,
1998(1) 1997(2) 1996(3) 1996
------------ ------------ ------------ ------------
(IN THOUSANDS, EXCEPT PER SHARE DATA)
Operating revenue..................... $9,521,482 $8,982,680 $4,807,856 $1,234,875
---------- ---------- ---------- ----------
Expenses:
Health care services................ 8,002,260 7,658,879 4,017,383 1,039,345
Other operating expenses............ 1,166,011 1,125,299 605,546 154,996
Impairment, disposition,
restructuring and other charges... 15,644 154,507 75,840 --
Office of Personnel Management
(credits) charges................. (4,624) -- 25,000 --
---------- ---------- ---------- ----------
Operating income...................... 342,191 43,995 84,087 40,534
Net investment income and interest
expense............................. 43,383 16,129 44,696 12,302
---------- ---------- ---------- ----------
Income before income taxes and
cumulative effect of a change in
accounting principle................ 385,574 60,124 128,783 52,836
Provision for income taxes............ 183,147 81,825 53,052 21,079
---------- ---------- ---------- ----------
Income (loss) before cumulative effect
of a change in accounting
principle........................... 202,427 (21,701) 75,731 31,757
Cumulative effect on prior years of a
change in accounting principle...... -- -- -- --
---------- ---------- ---------- ----------
Net income (loss)..................... $ 202,427 $ (21,701) $ 75,731 $ 31,757
========== ========== ========== ==========
Preferred dividends................... (5,259) (8,792) -- --
---------- ---------- ---------- ----------
Net income (loss) available to common
shareholders........................ $ 197,168 $ (30,493) $ 75,731 $ 31,757
========== ========== ========== ==========
Basic earnings (loss) per share(5).... $ 4.50 $ (0.75) $ 2.43 $ 1.01
========== ========== ========== ==========
Diluted earnings (loss) per
share(5)............................ $ 4.40 $ (0.75) $ 2.39 $ 1.00
========== ========== ========== ==========
OPERATING STATISTICS
Medical care ratio (health care
services as a percent of premium
revenue)
Consolidated........................ 85.0% 85.7% 84.5% 85.1%
Government.......................... 86.5% 85.6% 85.6% 85.5%
Commercial.......................... 82.8% 85.8% 82.8% 84.4%
Marketing, general and administrative
expenses as a percent of operating
revenue............................. 11.4% 11.7% 12.4% 12.4%
Operating income...................... 3.6% 0.5% 1.7% 3.3%
Effective tax rate(6)................. 47.5% 136.1% 41.2% 39.9%
Return on average shareholders'
equity.............................. 9.4% (1.5)% 9.3% 3.9%
YEAR ENDED YEAR ENDED YEAR ENDED
SEPTEMBER 30, SEPTEMBER 30, SEPTEMBER 30,
1996(3) 1995 1994(4)
------------- ------------- -------------
(IN THOUSANDS, EXCEPT PER SHARE DATA)
Operating revenue..................... $4,637,305 $3,731,022 $2,893,252
---------- ---------- ----------
Expenses:
Health care services................ 3,872,747 3,077,135 2,374,258
Other operating expenses............ 585,081 505,644 398,064
Impairment, disposition,
restructuring and other charges... 75,840 -- --
Office of Personnel Management
(credits) charges................. 25,000 -- --
---------- ---------- ----------
Operating income...................... 78,637 148,243 120,930
Net investment income and interest
expense............................. 44,143 33,857 24,538
---------- ---------- ----------
Income before income taxes and
cumulative effect of a change in
accounting principle................ 122,780 182,100 145,468
Provision for income taxes............ 50,827 74,005 60,875
---------- ---------- ----------
Income (loss) before cumulative effect
of a change in accounting
principle........................... 71,953 108,095 84,593
Cumulative effect on prior years of a
change in accounting principle...... -- -- 5,658
---------- ---------- ----------
Net income (loss)..................... $ 71,953 $ 108,095 $ 90,251
========== ========== ==========
Preferred dividends................... -- -- --
---------- ---------- ----------
Net income (loss) available to common
shareholders........................ $ 71,953 $ 108,095 $ 90,251
========== ========== ==========
Basic earnings (loss) per share(5).... $ 2.31 $ 3.69 $ 3.30
========== ========== ==========
Diluted earnings (loss) per
share(5)............................ $ 2.27 $ 3.62 $ 3.22
========== ========== ==========
OPERATING STATISTICS
Medical care ratio (health care
services as a percent of premium
revenue)
Consolidated........................ 84.4% 83.6% 83.1%
Government.......................... 85.4% 84.3% 85.2%
Commercial.......................... 83.1% 82.5% 80.5%
Marketing, general and administrative
expenses as a percent of operating
revenue............................. 12.4% 13.4% 13.6%
Operating income...................... 1.7% 4.0% 4.2%
Effective tax rate(6)................. 41.4% 40.6% 41.8%
Return on average shareholders'
equity.............................. 9.3% 18.9% 24.6%
See footnotes following "Balance Sheet Data."
Continued on next page.
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FINANCIAL STATEMENT CHANGE STATISTICS
YEAR ENDED YEAR ENDED YEAR ENDED YEAR ENDED YEAR ENDED
DECEMBER 31, DECEMBER 31, SEPTEMBER 30, SEPTEMBER 30, SEPTEMBER 30,
1998 1997(7) 1996(3) 1995 1994(4)
------------ ------------ ------------- ------------- -------------
Operating revenue............................... 6.0% 86.8% 24.3% 29.0% 30.3%
Net income (loss)............................... 1,032.8% (128.7)% (33.4)% 19.8% 44.0%
Earnings (loss) per share....................... 686.7% (131.4)% (37.3)% 12.4% 43.1%
Total assets.................................... (6.7)% 217.8% (6.2)% 25.3% 59.4%
Total shareholders' equity...................... 8.5% 139.8% 12.5% 77.1% 29.5%
DECEMBER 31, DECEMBER 31, DECEMBER 31, SEPTEMBER 30, SEPTEMBER 30, SEPTEMBER 30,
1998 1997 1996 1996 1995 1994
------------ ------------ ------------ ------------- ------------- -------------
MEMBERSHIP DATA
Government (Medicare & Medicaid)..... 972,800 1,001,100 593,600 596,200 541,000 409,100
Commercial........................... 2,554,100 2,790,000 1,451,500 1,434,500 1,216,100 949,100
---------- ---------- ---------- ---------- ---------- ----------
Total membership..................... 3,526,900 3,791,100 2,045,100 2,030,700 1,757,100 1,358,200
========== ========== ========== ========== ========== ==========
Percent change in membership......... (7.0%) 85.4% 0.7% 15.6% 29.4% 23.8%
========== ========== ========== ========== ========== ==========
BALANCE SHEET DATA
(IN THOUSANDS)
Cash and equivalents and marketable
securities......................... $1,600,189 $1,545,382 $ 962,482 $ 700,093 $ 811,525 $ 710,608
Total assets......................... $4,630,944 $4,963,046 $1,561,472 $1,299,462 $1,385,372 $1,105,548
Medical claims and benefits
payable............................ $ 645,300 $ 721,500 $ 282,500 $ 268,000 $ 288,400 $ 302,900
Long-term debt, due after one year... $ 650,006 $1,011,234 $ 1,370 $ 5,183 $ 11,949 $ 101,137
Shareholders' equity................. $2,238,096 $2,062,187 $ 860,102 $ 823,224 $ 732,024 $ 413,358
- ---------------
(1) The 1998 results include $11 million of net pretax charges ($6 million, or
$0.12 diluted loss per share, net of tax) for the disposal of unprofitable
subsidiaries and potential OPM claims. See Notes 4 and 9 of the Notes to
Consolidated Financial Statements. Operating income as a percentage of
operating revenue before pretax credits and charges was 3.7 percent. Return
on average shareholders' equity before pretax credits and charges was 9.4
percent.
(2) The 1997 results include the results of operations for the FHP International
Corporation ("FHP") acquisition from February 14, 1997. The 1997 results
also include $155 million of pretax charges ($129 million or $3.18 diluted
loss per share, net of tax) for the impairment of long-lived assets,
restructuring and certain other charges. See Notes 4 and 9 of the Notes to
Consolidated Financial Statements. Operating income as a percentage of
operating revenue before pretax charges was 2.2 percent. Return on average
shareholders' equity before pretax charges was 6.9 percent.
(3) The 1996 results include $101 million of pretax charges ($62 million or
$1.96 diluted loss per share, net of tax for the fiscal year ended September
30 and $1.97 diluted loss per share for the twelve months ended December 31)
for the impairment of long-lived assets, potential government claims,
dispositions and certain restructuring charges. See Note 9 of the Notes to
Consolidated Financial Statements. Operating income as a percentage of
operating revenue before pretax charges for 1996 was 3.8 percent for the
fiscal year ended September 30 and 3.9 percent for the twelve months ended
December 31. Return on average shareholders' equity before pretax charges
for the fiscal year ended September 30 was 17.2 percent and 17.0 percent for
the twelve months ended December 31.
(4) The fiscal 1994 results reflect the cumulative effect on prior fiscal years
of a change in accounting principle. Diluted earnings per share before
cumulative effect of a change in accounting principle for fiscal 1994 was
$3.02 per share. The cumulative effect of a change in accounting principle
for fiscal 1994 was $0.20 per share. The fiscal 1994 change in net income
was 34.9 percent and the change in earnings per share was 34.2 percent
before cumulative effect of a change in accounting principle.
(5) Earnings per share were restated to conform with the provisions of Statement
of Financial Accounting Standards No. 128, "Earnings per Share." See Note 2
of the Notes to Consolidated Financial Statements.
(6) Effective income tax rate includes the effect of non-deductible pretax
charges.
(7) Changes as compared to the unaudited period for the twelve months ended
December 31, 1996.
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ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
RESULTS OF OPERATIONS
OVERVIEW. PacifiCare sells HMO and HMO-related products primarily to members in
two groups: the Secure Horizons program for Medicare beneficiaries and the
commercial programs for members of employer groups and individuals. Our
specialty managed care HMOs and HMO related products and services supplement our
commercial programs. These include behavioral health services, life and health
insurance, dental and vision services and pharmacy benefit management.
Events significant to our business that occurred during 1998 included:
- - In November 1997, we announced our intention to sell our Utah HMO and workers'
compensation subsidiaries. We sold our Utah HMO subsidiary on September 30,
1998, and our workers' compensation subsidiary on October 31, 1998.
- - In July 1998, FPA, one of our contracted health care providers, declared
bankruptcy. As a result, we terminated all of our FPA contracts. Significant
provider insolvency reserves were recognized in 1998.
- - In December 1998, we recognized net pretax credits related to preliminary
favorable settlements of OPM claims.
- - During 1998, we borrowed $30 million to repurchase shares of our common stock
and repaid $390 million of the outstanding balance on our credit facility.
- - In January 1998, our board of directors approved a plan to repurchase shares
of our outstanding common stock. During 1998, we repurchased 784,000 shares
for an aggregate amount of $45 million.
- - In June 1998, substantially all of our 10.5 million shares of Series A
preferred stock were converted to 3.9 million shares of Class B common stock.
- - In 1998, with the sale of our Utah HMO, we exited the Medicaid line of
business.
The information below includes both the Medicare and Medicaid line of business
as part of the government program for the 1998 and prior periods presented.
1998 COMPARED WITH 1997
MEMBERSHIP. Total membership decreased seven percent to approximately 3.5
million members at December 31, 1998, from approximately 3.8 million members at
December 31, 1997. The disposition of Utah accounted for 68 percent of the
membership decline. California contributed 23 percent of the decline as we
continue to emphasize renewing commercial contracts with sufficient price
increases to improve gross margin. This decline was consistent with our shift in
strategic focus from rapid growth to improved margin performance. The remaining
nine percent was attributable to our exit of certain rural counties, where
government and commercial premiums were neither sufficient to support the cost
of health care nor our profitability requirements. Government membership
declined three percent year over year. 1998 commercial membership decreased nine
percent from 1997.
PREMIUM REVENUE. During 1998, premium revenue increased five percent from the
prior year, primarily due to six additional weeks of results in 1998 from the
FHP acquisition. Discontinued indemnity and workers' compensation products that
were not meeting profitability expectations partially offset this increase.
Government premiums increased seven percent or $380 million over the prior year
as a result of:
- - Increases of $301 million from the inclusion of six additional weeks of
results in 1998 from the FHP acquisition;
- - Increases of $208 million from premium rate increases that averaged
approximately four percent; offset by
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16
- - Decreases of $129 million from net membership losses caused by our exit of
certain rural geographic areas and Medicaid lines of business primarily in
California, Utah and Texas.
Commercial premiums increased three percent or $95 million over the prior year.
The net increase was due to:
- - Increases of $231 million from the inclusion of six additional weeks of
results in 1998 from the FHP acquisition;
- - Increases of $130 million from premium rate increases that averaged
approximately five percent; offset by
- - Decreases of $224 million from net membership losses caused by our disposition
of Utah and by our premium rate increases primarily in California, Oklahoma
and Ohio; and
- - Decreases of $42 million, primarily from discontinued indemnity and workers'
compensation products.
OTHER INCOME. Other income increased 134 percent in 1998 from the prior year due
primarily to higher revenues from Prescription Solutions and SHUSA.
CONSOLIDATED MEDICAL CARE RATIO AND PROVIDER INSOLVENCY RESERVES. The 1998
consolidated medical care ratio (health care services as a percentage of premium
revenue) declined by 0.7 percent compared to 1997. The improved commercial
product performance was partially offset by increased provider insolvency
reserves. Excluding these reserves, the consolidated medical care ratio was 84
percent. Provider insolvency reserves were immaterial in 1997 and totaled $95
million in 1998 as follows:
QUARTER GOVERNMENT COMMERCIAL TOTAL
------- ---------- ---------- -----
(IN MILLIONS)
First................................. $ 3 $ 3 $ 6
Second................................ 25 10 35
Third................................. 14 6 20
Fourth................................ 20 14 34
--- --- ---
Total....................... $62 $33 $95
=== === ===
Provider insolvency reserves include the write-offs of the providers'
uncollectable receivables and estimated cost of unpaid health care claims
covered by our capitation payment. Depending on state law, we may be held liable
for unpaid health care claims, which were the responsibility of the capitated
provider.
The majority of the insolvency reserves relate to specific provider
bankruptcies. However, the estimate also includes reserves for potentially
insolvent providers, where conditions indicate claims are not being paid or have
slowed considerably.
FPA declared bankruptcy in July 1998. FPA served approximately 200,000
PacifiCare members in Arizona, California, Nevada and Texas. Reserves for the
FPA bankruptcy totaled $57 million, with $41 million attributable to our Nevada
HMO. Nevada law specifically requires that we pay all health care services
claims for our members including those previously covered by capitation
payments. The second quarter FPA insolvency reserves were partially offset by
unrelated favorable provider settlements. We periodically make changes in
estimates as prior year contract issues are resolved. Increases to FPA reserves
were made in the third and fourth quarters as additional claims information was
presented for payment. The remaining FPA reserves of $16 million primarily
relate to non-contracted claims and receivable write-offs in the remaining HMOs.
Unpaid FPA reserves at December 31, 1998 were approximately $20 million.
Reserves for other providers totaled $38 million. Approximately $17 million of
the reserves recognized in the third and fourth quarters related to another
provider that has ceased paying claims in Nevada and Arizona. This provider has
not declared bankruptcy. The membership was transitioned to other providers
between December 1998 and January 1999. The remaining $21 million is the
estimated liability for smaller bankrupt providers and potentially insolvent
providers, primarily in California. Other provider insolvency reserves unpaid at
December 31, 1998 were approximately $38 million.
GOVERNMENT MEDICAL CARE RATIO. The government medical care ratio for the year
ended December 31, 1998 increased 0.9 percent compared to the prior year because
we recognized $62 million of provider insolvency
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reserves. Government insolvency reserves for FPA were $40 million, with the
majority of these charges recognized in the second and third quarters. Other
provider insolvency reserves of $22 million were recorded, primarily in the
fourth quarter. Higher costs incurred for FPA membership shifted into new
provider relationships were offset by the disposition of Utah. Excluding
government provider insolvency reserves, the government medical care ratio was
85.4 percent.
COMMERCIAL MEDICAL CARE RATIO. The commercial medical care ratio includes the
specialty HMOs and indemnity insurance results. The commercial medical care
ratio for the year ended December 31, 1998 decreased due to the following:
- - Improved provider contracts;
- - A favorable pricing environment;
- - Improved performance from the specialty HMOs;
- - Sale of our Utah HMO and workers' compensation subsidiaries; offset by
- - Provider insolvency reserves of $33 million.
Commercial insolvency reserves for FPA totaled $17 million, primarily recognized
in the second and third quarters. Other provider insolvency reserves of $16
million were recognized in the fourth quarter and related to Arizona,
California, Nevada, Texas and Washington. Excluding commercial provider
insolvency reserves, the commercial medical care ratio was 82.0 percent.
MARKETING, GENERAL AND ADMINISTRATIVE EXPENSES. As a percentage of operating
revenue, marketing, general and administrative expenses decreased slightly
compared to the prior year because we realized the benefits of restructuring and
a full year of synergies as a result of the FHP acquisition.
PRETAX CHARGES. The following is a summary of our net pretax charges:
QUARTER PRETAX NET OF TAX DILUTED (LOSS)/
RECOGNIZED (CHARGE)/CREDIT AMOUNT EARNINGS PER SHARE
----------- ---------------- ---------- ------------------
(DOLLARS IN MILLIONS, EXCEPT PER SHARE DATA)
1998
Sale of Utah HMO and workers'
compensation subsidiaries.............. Third $ (15.6) $ (8.2) $(0.18)
OPM charges.............................. Third (3.8) (2.0) (0.04)
------- ------- ------
Total Third (19.4) (10.2) (0.22)
OPM credits.............................. Fourth 8.4 4.4 0.10
------- ------- ------
$ (11.0) $ (5.8) $(0.12)
======= ======= ======
1997
Impairment of long-lived assets:
Utah HMO............................... Fourth $ (62.4) $ (55.7) $(1.37)
Washington health plan................. Fourth (40.5) (36.1) (0.89)
Discontinued workers' compensation
products............................ Fourth (21.1) (18.9) (0.47)
------- ------- ------
Total impairment of long-lived
assets....................... (124.0) (110.7) (2.73)
Loss contracts........................... Fourth (15.4) (9.2) (0.23)
Restructuring............................ Fourth (15.1) (9.0) (0.22)
------- ------- ------
$(154.5) $(128.9) $(3.18)
======= ======= ======
See Note 9 of the Notes to Consolidated Financial Statements.
We recognized $11 million of net pretax charges in 1998, primarily for
dispositions of unprofitable operations. Favorable OPM settlements in the fourth
quarter offset increased reserves recognized in the third quarter. In 1997,
Utah, Washington and the workers' compensation subsidiary charges related to the
impairment of goodwill. Restructuring reserves recognized in 1997 were spent in
1998.
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NET INVESTMENT INCOME. Net investment income increased approximately 29 percent
in 1998 compared to the prior year, due primarily to gains on sales of
marketable securities experienced throughout 1998 and more efficient investment
through account consolidation.
INTEREST EXPENSE. Interest expense decreased approximately six percent in 1998
compared to the prior year, due to continued repayment of our credit facility
and declining interest rates. The decrease was partially offset by interest on
the FHP acquisition borrowings that were outstanding for six weeks longer in
1998.
PROVISION FOR INCOME TAXES. The effective income tax rate was 47.5 percent in
1998, compared with 136.1 percent in 1997. The rate declined significantly for
two reasons:
- - The 1997 effective rate was disproportionately high because most of the pretax
charges recorded in the fourth quarter of 1997 were not deductible for tax
purposes. The 1997 effective income tax rate without the effect of the pretax
charges was approximately 50 percent.
- - Nondeductible goodwill amortization was a smaller percentage of taxable
income.
DILUTED EARNINGS PER SHARE. For the year ended December 31, 1998, income
excluding the pretax charges described above was $208 million or $4.52 diluted
earnings per share. For the year ended December 31, 1997, income excluding the
pretax charges was $107 million or $2.43 diluted earnings per share. The
increase in income was due to:
- - Increased other income;
- - Improved commercial medical care ratio;
- - Efficiency in marketing, general and administrative expenses;
- - Increased investment income; and
- - Decreased interest expense.
1997 COMPARED WITH 1996
OVERVIEW. In 1997, we began reporting on calendar year end. We previously
reported a fiscal year ending September 30. This resulted in an audited
transition period from October 1, 1996 to December 31, 1996. For clarity of
presentation and comparability, the discussion of results of operations compares
the year ended December 31, 1997 to the unaudited twelve months ended December
31, 1996, which is referred to as the prior year.
On February 14, 1997, we finalized the FHP acquisition for a total purchase
price, including transaction costs, of $2.2 billion. The FHP acquisition was
accounted for as a purchase. Our consolidated results of operations include the
results of FHP from the date of the FHP acquisition. See Note 4 of the Notes to
Consolidated Financial Statements.
MEMBERSHIP. Total membership increased 85 percent to approximately 3.8 million
members at December 31, 1997, from approximately 2.0 million members at December
31, 1996. The FHP acquisition increased membership by approximately 0.4 million
government members and 1.5 million commercial members.
PREMIUM REVENUE. During 1997, total premium revenue increased 88 percent from
the prior year, a direct result of the FHP acquisition. Six percent of the
increase in premiums resulted from enrollment gains (net of the FHP acquisition)
in both government and commercial programs. The remainder of the premium
increase was mainly attributable to the government programs, along with our
specialty managed care products and services.
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Government premiums in 1997 increased 85 percent compared to the prior year.
Approximately 81 percent of the total increase was due to the FHP acquisition.
The balance of the net increase was due to the following:
- - HCFA premium rate increases effective January 1, 1997 averaging over six
percent;
- - Increased government per member premium rates due to our exit of Medicaid
lines of business in certain markets that had lower average per member
premiums;
- - Lower member paid supplemental premiums in several of our markets; and
- - Enrollment gains in the government programs, net of acquisition membership.
Commercial premiums increased 97 percent compared to the prior year.
Approximately 92 percent of the total increase related to the FHP acquisition.
The remainder of the net increase was due to the following:
- - Enrollment gains in the commercial programs, net of acquisition membership,
accounted for seven percent, while premium rates remained relatively flat;
offset by
- - Decreased membership growth, excluding the FHP acquisition, due to the sale of
our Florida operations and a shift in focus from one of rapid growth to
improved profit margins through the use of a more disciplined product pricing
strategy.
CONSOLIDATED MEDICAL CARE RATIO. The consolidated medical care ratio increased
1.2 percent from the prior year as a result of higher FHP commercial costs. The
government medical care ratio for the year ended December 31, 1997 remained flat
compared to the prior year. This consistency was largely due to FHP, which had
lower cost provider contracts and generally higher reimbursement for Medicare
membership. Additionally, the wind down of the Medicaid business contributed to
slight decreases in the government medical care ratio. These decreases were
partially offset by enhanced prescription drug benefits provided to enrollees
combined with lower member paid supplemental premiums. The increase in the
commercial medical care ratio included higher cost FHP provider contracts,
increased non-capitated physician costs and increased out of area emergency room
costs compared to the prior year. The commercial medical care ratio includes the
specialty managed care health care costs.
MARKETING, GENERAL AND ADMINISTRATIVE EXPENSES. As a percentage of operating
revenue, marketing, general and administrative expenses decreased slightly
compared to the prior year. These cost savings were caused by lower than
expected staffing, and greater than expected efficiencies resulting from the
integration of the FHP administrative functions and information systems.
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PRETAX CHARGES. The following is a summary of our pretax charges:
QUARTER PRETAX NET OF TAX DILUTED (LOSS)/
RECOGNIZED (CHARGE)/CREDIT AMOUNT EARNINGS PER SHARE
------------ --------------- ---------- ------------------
(DOLLARS IN MILLIONS, EXCEPT PER SHARE DATA)
1997
Impairment of long-lived assets:
Utah HMO.............................. Fourth $ (62.4) $ (55.7) $(1.37)
Washington health plan................ Fourth (40.5) (36.1) (0.89)
Discontinued workers' compensation
products........................... Fourth (21.1) (18.9) (0.47)
------- ------- ------
Total impairment of long-lived
assets...................... (124.0) (110.7) (2.73)
Loss contracts.......................... Fourth (15.4) (9.2) (0.23)
Restructuring........................... Fourth (15.1) (9.0) (0.22)
------- ------- ------
$(154.5) $(128.9) $(3.18)
======= ======= ======
1996
OPM charges............................. Second $ (25.0) $ (14.9) $(0.47)
Florida disposition..................... Second (9.3) (8.3) (0.26)
Restructuring........................... Second (7.8) (4.7) (0.15)
------- ------- ------
Total Second (42.1) (27.9) (0.88)
Impairment of long-lived
assets - Florida...................... Third (58.7) (34.1) (1.08)
------- ------- ------
$(100.8) $ (62.0) $(1.96)
======= ======= ======
See Note 9 of the Notes to Consolidated Financial Statements.
We recognized $155 million of pretax charges in 1997, $124 million related to
the write-off of goodwill for our Utah and Washington HMOs and our workers'
compensation subsidiary. In 1996, we recognized Florida goodwill impairment of
$59 million plus $42 million of OPM, restructuring and Florida disposition
losses. Restructuring reserves recognized in 1996 were spent in 1996 and 1997.
NET INVESTMENT INCOME. Net investment income increased approximately $34 million
for the year ended December 31, 1997 compared to the prior year. The increase
was due primarily to additional investments over the prior year because of the
FHP acquisition.
INTEREST EXPENSE. Interest expense increased approximately $63 million for the
year ended December 31, 1997 compared to the prior year. The increase was due to
increased borrowings on our credit facility to finance the FHP acquisition.
PROVISION FOR INCOME TAXES. The majority of the pretax charges were not
deductible for income tax purposes. Therefore, we did not record an income tax
benefit for most of these charges. The magnitude of these charges, combined with
the inability to record a related income tax benefit, resulted in a
disproportionately high effective income tax rate. The effective income tax
rate, without the effect of the pretax charges, was approximately 50 percent, an
increase over the prior year. This increase reflected the additional goodwill
amortization expense attributed to the FHP acquisition.
DILUTED EARNINGS PER SHARE. For the year ended December 31, 1997, income
excluding the pretax charges described above was $107 million or $2.43 diluted
earnings per share. For the year ended December 31, 1996, income excluding
pretax charges was $138 million or $4.36 diluted earnings per share. The
decrease over the prior year was due to increases in the following:
- - Commercial medical care ratio;
- - Amortization expense;
- - Interest expense related to the FHP acquisition; and
- - Increased shares used to calculate earnings per share.
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The convertible preferred stock and potentially dilutive securities (including
stock options) used to calculate diluted loss per share in the fourth quarter
and for 1997 were anti-dilutive. Anti-dilution results when diluted earnings per
share is a greater value than basic earnings per share. The net loss per share
reported in 1997 was due mainly to the pretax charges recognized in the fourth
quarter and the high effective tax rate. Because the actual diluted loss per
share was less than the basic loss per share, the calculation of the diluted
loss per share reported was equal to the basic loss per share.
LIQUIDITY AND CAPITAL RESOURCES
OPERATING CASH FLOWS IN 1998. PacifiCare's consolidated cash, equivalents and
marketable securities increased to $1.6 billion at December 31, 1998 from $1.5
billion at December 31, 1997. The combined increase in cash, equivalents and
marketable securities was directly related to current-year earnings that were
invested. This increase was partially offset by long-term debt principal
payments.
Cash flows from operations increased by $43 million to $456 million in 1998 from
$413 million in 1997 as follows:
- - Increases of $224 million in net income; offset by
- - Decreases of $138 million in impairment, disposition, restructuring and other
charges; and
- - Net decreases of $43 million, primarily related to changes in deferred income
taxes.
INVESTING ACTIVITIES IN 1998. Net cash used in investing activities was $19
million in 1998. Purchases of property, plant and equipment of $42 million were
offset by $41 million of proceeds from the sale of property, plant and
equipment. In 1998, we sold several medical clinics and related personal
property acquired in the FHP acquisition. Disposition proceeds were
approximately $17 million and were offset by increased investments in all
marketable securities totaling $35 million.
INVESTING ACTIVITIES IN 1997. Net cash used by investing activities in 1997 was
$1.0 billion for the acquisition of FHP. The proceeds from the subsidiary
dispositions and property, plant and equipment in 1997 were $80 million. This
was offset by $69 million of property, plant and equipment purchases and $24
million of marketable securities purchases, including restricted.
FINANCING ACTIVITIES IN 1998. Financing activities used $393 million of cash in
1998, primarily because we paid $391 million on our credit facility and other
notes during the year. We also borrowed $30 million under the credit facility to
repurchase shares of our outstanding common stock. As of December 31, 1998, we
had repurchased 784,000 shares of our Class A and Class B common stock for $45
million. Cash received for the issuance of common and treasury stock was $19
million and was partially offset by $6 million of preferred stock dividends and
cash paid on redemption of preferred stock.
FINANCING ACTIVITIES IN 1997. In 1997, our financing activities provided $912
million of cash. Of the $912 million of cash, $885 million was the net effect of
borrowing $1.1 billion under our credit facility to finance the FHP acquisition,
offset by $235 million of credit facility payments in 1997. Proceeds from the
issuance of common stock provided $43 million of cash in 1997 while preferred
stock dividend payments used $9 million of cash. Finally, in the first quarter
of 1997, we made capital contributions totaling $67 million to Talbert Medical
Management Corporation, a former subsidiary of FHP. In the second quarter of
1997, we received $60 million from the sale of the Talbert stock.
OTHER BALANCE SHEET CHANGE EXPLANATIONS
RECEIVABLES, NET. Receivables, net decreased by $30 million from 1997 as
follows:
- - $31 million increase in provider and pharmacy rebate receivables; offset by
- - $33 million decrease in premiums and reinsurance receivables;
- - $19 million decrease for subsidiary dispositions and discontinued indemnity
products; and
- - $9 million decrease in other receivables, including the timing of net
investment income receivable.
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Provider receivables increased by $19 million. In 1998, we reduced the claims
payable backlog from 33 days at the beginning of the year to 30 days at the end
of the year. Accelerated claims payments often result in provider receivables
that are collected through capitation withhold adjustments and other incentive
settlements. Pharmacy rebate receivables increased by $12 million as 1998
prescription drug utilization increased. Premium receivables decreased $26
million. Improved collection efforts in California and Oregon contributed $17
million of the decrease. Outstanding reinsurance receivables declined by $7
million in 1998.
GOODWILL AND INTANGIBLE ASSETS, NET. Goodwill and intangible assets decreased by
$145 million from 1997 as follows:
- - $76 million of goodwill and intangible amortization expense; and
- - $69 million for FHP acquisition exit costs in excess of original estimates.
See Note 4 of Notes to Consolidated Financial Statements.
MEDICAL CLAIMS AND BENEFITS PAYABLE. Medical claims and benefits payable
decreased by $76 million from 1997 as follows:
- - $55 million increase in provider insolvency reserves;
- - $11 million increase in provider capitation liabilities; offset by
- - $92 million decrease in claims payable, both our risk and claims administered
on behalf of providers; and
- - $50 million decrease for dispositions, including Utah's loss contract
reserves, and discontinued indemnity products.
Claims payable decreased as our claims inventory fell by 47 percent from the
December 1997 level.
ACCOUNTS PAYABLE. We experienced a $73 million decline in accounts payable at
December 31, 1998 compared to the prior year. This decrease was planned and is
related to accounts payable systems changes effective January 1, 1999. We made
an effort to decrease accounts payable inventory to ease the number of items
that would be converted in the reorganization of the accounts payable system.
INCOME TAXES. Income taxes changed from a receivable in the prior year to a
payable in 1998. The change was attributable to the income tax provision on the
1998 income, partially offset by the estimated income tax payments made during
the year.
OTHER LIABILITIES. Other liabilities decreased by $47 million from 1997. The
decrease was primarily attributable to the disposition of our workers'
compensation subsidiary.
FORWARD LOOKING INFORMATION UNDER THE PRIVATE SECURITIES LITIGATION ACT OF 1995
The Private Securities Litigation Reform Act of 1995 provides a "safe harbor"
for forward looking statements. The Act was designed to encourage companies to
provide prospective information about themselves without fear of litigation. The
prospective information must be identified as forward looking and must be
accompanied by meaningful cautionary statements identifying important factors
that could cause actual results to differ materially from those projected in the
statements. The statements about our plans, strategies, intentions, expectations
and prospects contained throughout the document are based on current
expectations. These statements are forward looking and actual results may differ
materially from those predicted as of the date of this report in the forward
looking statements, which involve risks and uncertainties. In addition, past
financial performance is not necessarily a reliable indicator of future
performance and investors should not use historical performance to anticipate
results or future period trends. Stockholders are also directed to the other
risks discussed in other documents filed by PacifiCare with the Securities and
Exchange Commission.
MEMBERSHIP. We expect government membership to increase three to four percent by
December 31, 1999 compared to 1998. For 1999, we plan to expand our membership
retention programs and target group retiree members in our existing markets. We
expect membership increases from enhanced drug benefits and new enrollment as
competitors exit markets in which Secure Horizons will remain. We also
anticipate offering our
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Secure Horizon programs in new geographic markets. These increases will be
partially offset by the exit of rural markets.
We expect commercial membership for the year ended December 31, 1999 to increase
four to five percent compared to 1998. The majority of the growth will be in
California where we plan to:
- - Strengthen our sales fundamentals;
- - Streamline and enhance our product mix;
- - Improve underwriting practices;
- - Increase the efficiency and effectiveness of our distribution channels; and
- - Maximize membership renewal growth opportunities.
MEMBERSHIP RISK FACTORS. An unforeseen loss of profitable membership could have
an effect on our financial position, results of operations and cash flows.
Factors that could contribute to the loss of membership include:
- - Failure to obtain new customers or retain existing customers;
- - The effect of premium increases;
- - Reductions in work force by existing customers;
- - Negative publicity and news coverage;
- - Inability of marketing and sales plans to attract new customers; or
- - The loss of key executives or key employees.
PREMIUMS. Effective January 1, 1999, we received Medicare premium rate increases
of two percent. We expect to continue to improve our gross margin by renewing
commercial employer contracts with price increases. The price increases in our
commercial product line are expected to range from zero to 12 percent depending
upon competition, employer size, benefit design, geographic market and other
factors. We plan to exit markets where our premium revenue does not cover the
cost of providing care. While we expect to increase commercial premiums without
experiencing significant membership losses, we may have to alter our pricing
strategy to avoid such losses. Reduction in Medicare premiums, such as the
proposed risk adjusted payment program, could have an effect on our financial
position as every one percent change in premium represents approximately $56
million dollars of annual revenue. To counteract this impact, we would need to
generate additional revenue or cost savings of approximately $56 per person per
year. We could achieve this by increasing member premiums, office copayments,
hospital deductibles or prescription copayments.
OTHER INCOME. In 1999, we expect other income to be lower than 1998 because of
lower SHUSA revenues. In addition, 1999 rental income is expected to be less
than 1998 because several medical clinics were sold in the last half of 1998.
HEALTH CARE PROVIDER CONTRACTS. Our profitability depends, in part, on our
ability to control health care costs while providing quality care. Maintaining
capitated arrangements with solvent providers, especially in the Nevada market,
will be important to improve 1999 results of operations. Securing cost-effective
contracts with existing and new physician groups has become more difficult due
to increased competition. Failure to secure cost-effective contracts may result
in a loss in membership or a higher medical care ratio. Additionally, the
negotiation of provider contracts, generally as of January 1, may be impacted by
unfavorable state and federal legislation and regulation discussed below. Our
inability to contract with providers, loss of contracts with providers,
inability of providers to provide adequate care, or insolvency of providers
could materially affect us. Based on current information, we believe that our
contingency plans are adequate to cover the potential impact of contract
terminations.
We continue to evaluate the financial stability of our providers, focusing on
providers with significant membership in key geographic areas and providers that
have been identified as a poor risk. We are also seeking to improve our
performance in 1999 by taking steps to minimize our risk associated with
providers. We
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believe that the December 31, 1998 provider insolvency reserves are adequate to
cover the cost of health care services rendered through 1998 that may not be
paid by insolvent or unstable providers. We believe our contingency plans for
shifting the membership or assisting the provider to obtain and maintain
stability are adequate to cover the risk. We have and may continue to incur
additional costs as a result of entering into new contracts, especially for FPA
and potentially for MedPartners. The effect of these risks and the need for
additional provider reserves could have a material effect on our results of
operations or cash flows. We believe, however, that such reserves would not
materially affect our consolidated financial position.
GOVERNMENT MEDICAL CARE RATIO. We expect the government medical care ratio in
1999 to remain flat or slightly increase from 1998. Price increases,
recontracting efforts in Nevada and California, and our exit of rural markets in
four states plus the disposition of Utah are expected to improve the medical
care ratio. However, these improvements will be offset by changes in premium
mix, increases in capitation, decreases in non-capitated contracts and changes
in pharmacy costs. The implementation of the Medicare reform provisions that
limit program spending and allow the entry of new providers and plans that could
increase competitive pressures could also offset any increases. See Legislation
and Regulation below.
COMMERCIAL MEDICAL CARE RATIO. In 1999, we expect the commercial medical care
ratio to be consistent with, or improve slightly from 1998. We expect
improvements as we continue to renegotiate provider contracts and implement
capitated contracts and price increases. Moreover, higher premium rates offered
during renewal periods should continue to result in the elimination of some high
medical care ratio business. We also plan to exit markets where price increases
do not cover the cost of health care.
MEDICAL CARE RISK FACTORS. The government and commercial medical care ratio
expectations discussed above could be affected by various uncertainties,
including:
- - Medical and prescription drug costs that have been rising faster than premium
increases;
- - Increases in utilization and costs of medical services;
- - The effect of actions by competitors or groups of providers; or
- - Termination of provider contracts, provider insolvency or renegotiation of
such contracts at less cost-effective rates or terms of payment.
MARKETING, GENERAL AND ADMINISTRATIVE SUPPORT. In 1999, marketing, general and
administrative expenses as a percentage of operating revenue are expected to
decline slightly because we expect to realize additional efficiencies from the
FHP acquisition. Additionally, California's final conversion from FHP
information systems to PacifiCare systems was completed in June 1998, so 1999
will be the first full year of integrated operations. The need for additional
advertising, marketing, administrative, or management information systems
expenditures, and the inability of marketing and sales plans to attract new
customers, could impact marketing, general and administrative expenses.
1999 DISPOSITIONS. Dispositions could be announced as we continue to evaluate
whether certain subsidiaries or products fit within our core business strategy.
There can be no assurance that the dispositions will not result in additional
pretax charges. We believe, however, that any disposition operating losses would
not materially affect our consolidated financial position. However, the
disposition losses could have a material effect on the results of operations or
cash flows of a future period.
IMPAIRMENT OF LONG-LIVED ASSETS. As circumstances warrant, we determine whether
the realizable value of long-lived assets such as property and equipment, real
estate and goodwill, are less than the value carried on the consolidated
financial statements. We believe that any impairment of such long-lived assets
would not materially affect our consolidated financial position. However,
impairment charges, if material, could have an effect on our results of
operations or cash flows of a future period.
EFFECTIVE TAX RATE. We expect the 1999 effective tax rate to decrease three to
five percent from 1998. Consistent with our integration strategies, we will
complete a legal reorganization of the Company and its subsidiaries. The full
year benefit of certain tax strategies is expected to be realized in 1999. The
tax strategies are expected to reduce the effective tax rate by one to three
percent. The 1998 effective tax rate includes more
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than one percent related to the dispositions of Utah and the workers'
compensation subsidiary that is not expected to recur. Finally, the impact of
nondeductible goodwill on the effective tax rate is expected to decrease by
approximately one percent because 1999 pretax income is projected to increase
from 1998. There can be no assurance that these tax strategies will be
successful or that pre-tax income will increase as projected, for various
reasons set forth in this document and other documents we have filed with the
Securities and Exchange Commission. As a result, there can be no assurance our
tax rate will decrease in 1999.
YEAR 2000. PacifiCare has implemented a Year 2000 compliance program to address
all major computing information systems, including core application systems,
networks, desktop systems, infrastructure, and critical information supply
chains. In addition to all major information systems, we are verifying that all
date fields and calculations used in critical business processes will be Year
2000 compliant. Under the program we are also addressing our external Year 2000
related risks which arise from the year 2000 readiness of third parties with
whom we maintain ongoing relationships.
The Year 2000 Compliance Program includes the following five phases which are
listed in logical order, but are being addressed concurrently as appropriate:
- - Awareness and Communication. There is an on-going company-wide communication
and education effort to ensure that there is a clear understanding of the Year
2000 problem and associated risks.
- - Inventory and Assessment. A company-wide inventory has been taken of all
computer information systems and their components, including infrastructure
equipment and hardware, software applications and information supply chains.
Through the inventory, we are assessing the business risks and Year 2000
compliance status of each system component. For components which are not Year
2000 compliant, a remediation plan is being developed which includes the Year
2000 remediation action required and the time and resources needed to
accomplish it. Priorities are also established based on the relative business
critical function of each system component.
- - Remediation. Based upon the remediation plan developed as part of the
assessment phase, appropriate action is taken to correct or remediate the Year
2000 issues associated with the system and its components to render it Year
2000 compliant. Except for the FHP core system, we expect all affected system
components to be remediated by March 31, 1999. Contingency plans for critical
business functions will be completed as part of this phase as well.
- - Testing and Certification. Following the completion of the remediation phase,
each computer information system and its components are tested. Actual test
results are reviewed and compared to expected test results based on accepted
industry standards and methodologies. If the actual test results are
acceptable, the system and/or component are certified as Year 2000 compliant.
Testing and certification for the PacifiCare core computer system are 90
percent complete. We expect all other systems (except the FHP core system) to
be tested and certified as Year 2000 compliant by June 30, 1999. Testing and
certification of the FHP core computer systems will occur during 1999 and are
expected to be completed in December 1999.
- - Implementation and Close. There will be a final review and confirmation that
the remediated systems and components have met all Year 2000 compliance
objectives.
When our Year 2000 compliance program was first established in 1996, we focused
on existing systems and did not contemplate acquisitions of other companies.
These core computing programs became Year 2000 compliant in 1998. The total cost
to make our pre-FHP core computing information systems Year 2000 compliant was
approximately $6 million.
With the February 1997 FHP acquisition, we originally expected the Arizona,
Colorado, Nevada and Ohio HMOs to shift to our pre-FHP core computing
information systems throughout 1998 and 1999 as providers moved to delegated
capitation arrangements. In the second quarter of 1998, we determined that while
we had successfully moved some of these providers to capitation arrangements,
the provider networks did not have sufficient infrastructure to administer the
claims under a fully delegated capitated arrangement. We concluded that our HMOs
in these states will need to continue to administer claims on behalf of
providers.
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Because the claims-based FHP core systems function more effectively than our
core computing systems for claims administration on behalf of non-delegated
delivery systems, we decided to maintain the FHP systems. As a result, the scope
of our Year 2000 compliance activities was expanded to include the FHP computer
system. We have a detailed project plan for modifying the FHP systems to be Year
2000 compliant in phases during 1999. Based upon an outside consultant's
recommendations and internal analysis, we estimate that the total cost to make
the FHP systems Year 2000 compliant ranges from $5 to $9 million.
Our Year 2000 compliance program establishes priorities to achieve resolution of
the most business critical issues first. The program incorporates a regular
reporting process which helps us to monitor and measure our progress toward Year
2000 compliance against defined goals. Through this reporting process we can
focus resources on, any Year 2000 issue, as necessary.
We are also contacting our third party vendors, provider and hospital networks,
business partners, contractors, and service providers, including HCFA, to assess
their Year 2000 level of readiness. In some cases, we are seeking reasonable
assurances with respect to Year 2000 compliance. Our priority is to assess the
readiness of our providers with delegated responsibility and other third parties
with which we electronically exchange data or interact. Because we do not
control the products, services, or systems of our providers, vendors or
customers, we cannot ensure their Year 2000 compliance. We anticipate developing
business process contingency plans by June 1999 for external sources that appear
to be at risk.
If HCFA or certain other third parties experience significant failures or
erroneous applications, it could have a material effect on our financial
position, results of operations, cash flows, and business prospects. For
example, if HCFA, OPM, or our commercial customers experience system failures,
this could cause a delay in our receipt of payments from these customers,
including a significant HCFA payment due in January 2000. Therefore, we are
developing a cash receipts contingency plan.
We also could have difficulties processing Medicare and other claims within
required periods, collecting accurate claims and other data on which we depend,
or enrolling new members. In preparing contingency plans, we are developing risk
reduction strategies. However, some risks may be beyond our control. Further,
our marketing, general and administrative expenses could increase due to Year
2000 compliance expenditures.
OPM. OPM generally audits health plans which it contracts with every five or six
years. We currently have several audits with OPM that are in various stages. We
intend to negotiate with OPM and DOJ on all unresolved matters to attain a
mutually satisfactory result. We cannot assure that the negotiations will
conclude satisfactorily, or that there will not be additional liability upon
completion of the audits. However, we believe that any ultimate liability in
excess of amounts already set aside would not materially affect our consolidated
financial position. The liability, if material, could have an effect on results
of operations or cash flows of a future quarter. See Note 10 of the Notes to
Consolidated Financial Statements.
LIQUIDITY AND CAPITAL RESOURCES. Additional borrowings on our credit facility
may be necessary if HCFA and OPM are unable to remit funds as a result of Year
2000 compliance issues. We also may continue to repurchase shares of outstanding
stock, resulting in reduced cash or additional borrowings on our credit
facility. Additional borrowings on the credit facility may make us subject to
earlier mandatory reduction of the outstanding balance. Additionally, should the
credit facility be drawn, our ability to repay amounts owed under the credit
facility and other long-term debt will depend on cash receipts from our
subsidiaries' restricted cash reserves. These subsidiary receipts represent fees
for management services rendered by us to the subsidiaries and cash dividends by
the subsidiaries to us. Nearly all of the subsidiaries are subject to HMO
regulations or insurance regulations and may be subject to substantial
supervision by one or more HMO or insurance regulators. Subsidiaries subject to
regulation must meet or exceed various capital standards imposed by HMO or
insurance regulations, which may from time to time impact the amount of funds
the subsidiaries can pay to us. Additionally, from time to time, we advance
funds in the form of a loan or capital contribution to our subsidiaries to
assist them in satisfying federal or state financial requirements. If a federal
or state regulator has concerns about the financial position of a subsidiary, a
regulator may impose additional financial requirements on the subsidiary, which
may require additional funding from us. We believe that
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cash flows from operations, existing cash equivalents, marketable securities and
other financing sources will be sufficient to meet the requirements of the
credit facility.
RISK-BASED CAPITAL REQUIREMENTS. The National Association of Insurance
Commissioners has proposed that states adopt risk-based capital standards that,
if implemented, would require new minimum capitalization limits for health care
coverage provided by HMOs and other risk-bearing health care entities. To date,
Washington is the only state where we have HMO operations that has adopted these
standards. We do not expect this legislation to have a material impact on our
consolidated financial position in the near future if other states where we
operate HMOs adopt these standards. Further, we believe that cash flows from
operations or, if necessary, borrowings under our credit facility, will be
sufficient to fund any additional risk-based capital requirements.
LEGISLATION AND REGULATION. Federal and state legislation and regulation
significantly affect us. During 1998 our government programs, the majority of
which are Medicare business, contribute 59 percent of our revenue and an even
greater percentage of our profits. Changes in state and federal legislation or
regulation could cause actual results to differ materially from the expected
results discussed throughout this document. Changes that could effect us
materially include:
- - Limitations on premium levels;
- - Increases in minimum capital and reserves and other financial viability
requirements;
- - Prohibition or limitation of capitated arrangements or provider financial
incentives;
- - Benefit mandates (including mandatory length of stay and emergency room
coverage, many of which become effective in 1999);
- - Limitations on the ability to manage care and utilization of any willing
provider and direct access laws; and
- - Adoption on the federal and/or state level of a "Patients Bill of Rights."
Legislation and regulation could also include adverse actions of governmental
payors, including reduced Medicare premiums; discontinuance of or limitation on
governmentally funded programs; recovery by governmental payors of previously
paid amounts; the inability to increase premiums or prospective or retroactive
reductions to premium rates for federal employees; and adverse regulatory
actions.
OTHER. Results may differ materially from those projected, forecast, estimated
and budgeted by us due to adverse results in ongoing audits or in other reviews
conducted by federal or state agencies or health care purchasing cooperatives;
adverse results in significant litigation matters; and changes in interest rates
causing changes in interest expense and net investment income.
25
28
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
MARKET RISK
The principal objective of our asset/liability management activities is to
maximize net investment income, while maintaining levels of interest rate risk
and facilitating our funding needs. Our net investment income and interest
expense are subject to the risk of interest rate fluctuations. To mitigate the
impact of fluctuations in interest rates, we manage the structure of the
maturity of debt, investments and derivatives. We use derivative financial
instruments, primarily interest rate swaps, with maturities that correlate to
balance sheet financial instruments. This results in a modification of existing
interest rates to levels deemed appropriate based on our current economic
outlook.
The following table provides information about our financial instruments that
are sensitive to changes in interest rates as of December 31, 1998. For
investment securities and debt obligations, the table presents principal cash
flows and related weighted average interest rates by expected maturity dates.
Additionally, we have assumed our marketable securities and marketable
securities-restricted, comprised primarily of U.S. government, state, municipal,
and corporate debt securities, are similar enough to aggregate into fixed rate
and variable rate securities for presentation purposes. For interest rate swaps,
the table presents notional amounts by contractual maturity dates. Notional
amounts are used to calculate the contractual cash flows to be exchanged under
the contract.
1999 2000 2001 2002 2003 BEYOND TOTAL FAIR VALUE
-------- -------- ------- -------- -------- -------- -------- ----------
(DOLLARS IN THOUSANDS)
Assets:
Marketable securities:
Fixed rate............................. $ 20,719 $119,218 $12,850 $ 36,762 $ 34,797 $588,723 $813,069 $826,296
Average interest rate.................. 5.26% 5.34% 6.22% 6.02% 5.93% 5.57% 5.56% --
Variable rate.......................... $ 999 -- -- -- -- $ 49,590 $ 50,589 $ 49,257
Average interest rate.................. 5.03% -- -- -- -- 5.88% 5.86% --
Marketable securities - restricted:
Fixed rate............................. $ 40,519 $ 27,183 $ 3,826 $ 3,494 $ 214 $ 7,424 $ 82,660 $ 83,539
Average interest rate.................. 5.25% 5.36% 6.13% 5.76% 6.35% 5.98% 5.47% --
Liabilities:
Long term debt, including debt due within
one year:
Variable rate.......................... $ 87 $ 6 -- $550,000 $100,000 -- $650,093 $650,093
Average interest rate.................. 10.00% 11.00% -- 6.00% 7.00% -- -- --
Derivative financial instruments related
to debt:
Interest rate swaps:
Pay variable/receive fixed............. $350,000 -- -- -- -- -- $350,000 $350,000
Average interest rate.................. 6.00% -- -- -- -- -- -- --
26
29
ITEM 8. CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
See the Index included at "Item 14. Exhibits, Financial Statement Schedules, and
Reports on Form 8-K."
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS AND ACCOUNTING AND
FINANCIAL DISCLOSURE
We have not changed our independent auditors, nor have we had disagreements with
such auditors on accounting principles, practices or financial statement
disclosure within the last two years.
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Information about directors and executive officers is incorporated by reference
from our Proxy Statement under the headings Election of Directors and Executive
Officers and Directors Other Than Nominees for the 1999 Annual Meeting of
Shareholders. We expect to file this Proxy Statement with the SEC no later than
April 30, 1999.
ITEM 11. EXECUTIVE COMPENSATION
Information about executive compensation is incorporated by reference from our
Proxy Statement under the heading Compensation of Executive Officers for the
1999 Annual Meeting of Shareholders. We expect to file this Proxy Statement with
the SEC no later than April 30, 1999.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
Information about security ownership of certain beneficial owners and management
is incorporated by reference from our Proxy Statement under the heading Security
Ownership of Certain Beneficial Owners and Management for the 1999 Annual
Meeting of Shareholders. We expect to file this Proxy Statement with the SEC no
later than April 30, 1999.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Information about certain relationships and transactions with related parties is
incorporated by reference from our Proxy Statement under the heading Certain
Transactions for the 1999 Annual Meeting of Shareholders. We expect to file this
Proxy Statement with the SEC no later than April 30, 1999.
27
30
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
The following documents are filed as part of this report:
PAGE
REFERENCE
---------
(a)1. Consolidated Financial Statements:
Consolidated Balance Sheets as of December 31, 1998 and
1997...................................................... F-1
Consolidated Statements of Operations for the years ended
December 31, 1998
and 1997, three months ended December 31, 1996 and the
fiscal year ended September 30, 1996...................... F-2
Consolidated Statements of Shareholders' Equity for the
years ended December 31, 1998 and 1997, three months ended
December 31, 1996 and the fiscal year ended September 30,
1996...................................................... F-3
Consolidated Statements of Cash Flows for the years ended
December 31, 1998 and 1997, three months ended December
31, 1996 and the fiscal year ended September 30, 1996..... F-4
Notes to Consolidated Financial Statements.................. F-6
Report of Ernst & Young LLP Independent Auditors............ F-24
Quarterly Information for 1998 and 1997 (unaudited)......... F-25
2. Financial Statement Schedule:
Schedule II -- Valuation and Qualifying Accounts............ F-26
All other schedules are omitted because they are not
required or the information is included elsewhere in the
consolidated financial statements.
3. Exhibits: An "Exhibit Index" is filed as part of this Form
10-K beginning on page E-1 and is incorporated by
reference.
(b) Reports on Form 8-K:
On November 20, 1998, PacifiCare Health Systems, Inc. filed
a Form 8-K/A in connection with its sale of PacifiCare of
Utah, Inc.
28
31
SIGNATURES
Pursuant to the requirements of the Section 13 or 15(d) 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.
PACIFICARE HEALTH SYSTEMS, INC.
By: /s/ ALAN R. HOOPS
---------------------------------------
Alan R. Hoops
Chairman of the Board and Chief
Executive Officer
Date: February 26, 1999
Pursuant to the requirements of the Securities Act of 1934, this Report has been
signed below by the following persons on behalf of the registrant and in the
capacities and on the dates indicated.
NAME TITLE DATE
---- ----- ----
/s/ ALAN R. HOOPS Chairman of the Board and February 26, 1999
- ----------------------------------------------------- Chief Executive Officer
Alan R. Hoops (Principal Executive Officer)
/s/ ROBERT B. STEARNS Executive Vice President and February 26, 1999
- ----------------------------------------------------- Chief Financial Officer
Robert B. Stearns (Principal Financial Officer)
/s/ MARY C. LANGSDORF Senior Vice President and February 26, 1999
- ----------------------------------------------------- Corporate Controller
Mary C. Langsdorf (Principal Accounting
Officer)
/s/ JACK R. ANDERSON Director February 26, 1999
- -----------------------------------------------------
Jack R. Anderson
/s/ CRAIG T. BEAM Director February 26, 1999
- -----------------------------------------------------
Craig T. Beam
/s/ RICHARD M. BURDGE Director February 26, 1999
- -----------------------------------------------------
Richard M. Burdge
/s/ BRADLEY C. CALL Director February 26, 1999
- -----------------------------------------------------
Bradley C. Call
/s/ DAVID R. CARPENTER Director February 26, 1999
- -----------------------------------------------------
David R. Carpenter
/s/ TERRY O. HARTSHORN Vice Chairman of the Board February 26, 1999
- -----------------------------------------------------
Terry O. Hartshorn
/s/ GARY L. LEARY Director February 26, 1999
- -----------------------------------------------------
Gary L. Leary
29
32
NAME TITLE DATE
---- ----- ----
/s/ WARREN E. PINCKERT II Director February 26, 1999
- -----------------------------------------------------
Warren E. Pinckert II
/s/ DAVID A. REED Director February 26, 1999
- -----------------------------------------------------
David A. Reed
/s/ LLOYD E. ROSS Director February 26, 1999
- -----------------------------------------------------
Lloyd E. Ross
/s/ JEAN BIXBY SMITH Director February 26, 1999
- -----------------------------------------------------
Jean Bixby Smith
30
33
PACIFICARE HEALTH SYSTEMS, INC.
CONSOLIDATED BALANCE SHEETS
DECEMBER 31, DECEMBER 31,
1998 1997
------------ ------------
(IN THOUSANDS, EXCEPT PER
SHARE DATA)
ASSETS
Current assets:
Cash and equivalents...................................... $ 724,636 $ 680,674
Marketable securities..................................... 875,553 864,708
Income tax receivable..................................... -- 95,088
Receivables, net.......................................... 275,955 305,645
Prepaid expenses and other current assets................. 24,979 31,994
Deferred income taxes..................................... 132,452 112,037
---------- ----------
Total current assets.............................. 2,033,575 2,090,146
---------- ----------
Property, plant and equipment at cost, net of accumulated
depreciation and amortization............................. 178,520 235,943
Marketable securities-restricted............................ 82,660 145,989
Goodwill and intangible assets, net......................... 2,313,266 2,458,463
Other assets................................................ 22,923 32,505
---------- ----------
$4,630,944 $4,963,046
========== ==========
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Medical claims and benefits payable....................... $ 645,300 $ 721,500
Accounts payable.......................................... 43,436 116,277
Accrued liabilities....................................... 352,352 323,495
Accrued compensation and employee benefits................ 68,382 71,055
Unearned premium revenue.................................. 509,859 496,183
Long-term debt due within one year........................ 87 154
---------- ----------
Total current liabilities......................... 1,619,416 1,728,664
---------- ----------
Long-term debt due after one year........................... 650,006 1,011,234
Deferred income taxes....................................... 112,056 102,793
Other liabilities........................................... 11,015 57,793
Minority interest........................................... 355 375
Commitments and contingencies
Shareholders' equity:
Capital stock, $0.01 par value per share:
Preferred stock, 40,000 shares authorized: issued
10,517 shares of Series A Convertible Preferred Stock
in 1997............................................... -- 105
Common stock:
Class A, 100,000 shares authorized, voting: issued
14,880 shares in 1998 and 14,794 shares in 1997..... 149 148
Class B, 100,000 shares authorized, non-voting:
issued 31,506 shares in 1998 and 27,201 shares in
1997................................................ 315 272
Additional paid-in capital................................ 1,624,619 1,599,229
Accumulated other comprehensive income.................... 7,359 9,993
Retained earnings......................................... 649,608 452,440
Treasury shares, at cost: Class A Common, 42 shares and
Class B Common, 728 shares in 1998..................... (43,954) --
---------- ----------
Total shareholders' equity........................ 2,238,096 2,062,187
---------- ----------
$4,630,944 $4,963,046
========== ==========
See accompanying notes.
F-1
34
PACIFICARE HEALTH SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
THREE MONTHS
YEAR ENDED YEAR ENDED ENDED YEAR ENDED
DECEMBER 31, DECEMBER 31, DECEMBER 31, SEPTEMBER 30,
1998 1997 1996 1996
------------ ------------ ------------ -------------
(IN THOUSANDS, EXCEPT PER SHARE DATA)
Revenue:
Government premiums (Medicare and
Medicaid)............................... $5,586,592 $5,206,919 $ 722,748 $2,720,698
Commercial premiums........................ 3,823,587 3,728,243 498,832 1,866,830
Other income............................... 111,303 47,518 13,295 49,777
---------- ---------- ---------- ----------
Total operating revenue............ 9,521,482 8,982,680 1,234,875 4,637,305
Expenses:
Health care services:
Government services........................ 4,834,638 4,458,994 618,265 2,322,375
Commercial services........................ 3,167,622 3,199,885 421,080 1,550,372
---------- ---------- ---------- ----------
Total health care services......... 8,002,260 7,658,879 1,039,345 3,872,747
Marketing, general and administrative
expenses................................... 1,089,418 1,055,080 153,135 575,928
Amortization of goodwill and intangible
assets..................................... 76,593 70,219 1,861 9,153
Impairment, disposition, restructuring and
other charges.............................. 15,644 154,507 -- 75,840
Office of Personnel Management (credits)
charges.................................... (4,624) -- -- 25,000
---------- ---------- ---------- ----------
Operating income............................. 342,191 43,995 40,534 78,637
Net investment income........................ 104,306 80,665 12,652 46,237
Interest expense............................. (60,923) (64,536) (350) (2,094)
---------- ---------- ---------- ----------
Income before income taxes................... 385,574 60,124 52,836 122,780
Provision for income taxes................... 183,147 81,825 21,079 50,827
---------- ---------- ---------- ----------
Net income (loss)............................ $ 202,427 $ (21,701) $ 31,757 $ 71,953
========== ========== ========== ==========
Preferred dividends.......................... (5,259) (8,792) -- --
---------- ---------- ---------- ----------
Net income (loss) available to common
shareholders............................... $ 197,168 $ (30,493) $ 31,757 $ 71,953
========== ========== ========== ==========
Basic earnings (loss) per share.............. $ 4.50 $ (0.75) $ 1.01 $ 2.31
========== ========== ========== ==========
Diluted earnings (loss) per share............ $ 4.40 $ (0.75) $ 1.00 $ 2.27
========== ========== ========== ==========
See accompanying notes.
F-2
35
PACIFICARE HEALTH SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
ACCUMULATED
CLASS A CLASS B ADDITIONAL OTHER
PREFERRED COMMON COMMON PAID IN COMPREHENSIVE RETAINED TREASURY
STOCK STOCK STOCK CAPITAL INCOME EARNINGS STOCK TOTAL
--------- ------- ------- ---------- ------------- -------- -------- ----------
(IN THOUSANDS)
BALANCES AT SEPTEMBER 30, 1995.... $ -- $123 $186 $ 347,548 $ 4,944 $379,223 $ -- $ 732,024
----- ---- ---- ---------- ------- -------- -------- ----------
Comprehensive income:
Net income...................... -- -- -- -- -- 71,953 -- 71,953
Other comprehensive loss, net of
tax:
Unrealized losses on
securities, net of
reclassification
adjustment.................. -- -- -- -- (3,651) -- -- (3,651)
----- ---- ---- ---------- ------- -------- -------- ----------
Comprehensive income.............. -- -- -- -- (3,651) 71,953 -- 68,302
----- ---- ---- ---------- ------- -------- -------- ----------
Issuance of capital stock under
employee benefit plans.......... -- 1 3 14,510 -- -- -- 14,514
Tax benefit associated with
exercise of stock options....... -- -- -- 8,384 -- -- -- 8,384
----- ---- ---- ---------- ------- -------- -------- ----------
BALANCES AT SEPTEMBER 30, 1996.... -- 124 189 370,442 1,293 451,176 -- 823,224
----- ---- ---- ---------- ------- -------- -------- ----------
Comprehensive income:
Net income...................... -- -- -- -- -- 31,757 -- 31,757
Other comprehensive income, net
of tax:
Unrealized gains on
securities, net of
reclassification
adjustment.................. -- -- -- -- 2,158 -- -- 2,158
----- ---- ---- ---------- ------- -------- -------- ----------
Comprehensive income.............. -- -- -- -- 2,158 31,757 -- 33,915
----- ---- ---- ---------- ------- -------- -------- ----------
Issuance of capital stock under
employee benefit plans.......... -- -- -- 612 -- -- -- 612
Tax benefit associated with
exercise of stock options....... -- -- -- 2,351 -- -- -- 2,351
----- ---- ---- ---------- ------- -------- -------- ----------
BALANCES AT DECEMBER 31, 1996..... -- 124 189 373,405 3,451 482,933 -- 860,102
----- ---- ---- ---------- ------- -------- -------- ----------
Comprehensive loss:
Net loss........................ -- -- -- -- -- (21,701) -- (21,701)
Other comprehensive income, net
of tax:
Unrealized gains on
securities, net of
reclassification
adjustment.................. -- -- -- -- 6,542 -- -- 6,542
----- ---- ---- ---------- ------- -------- -------- ----------
Comprehensive loss................ -- -- -- -- 6,542 (21,701) -- (15,159)
----- ---- ---- ---------- ------- -------- -------- ----------
Capital stock activity:
FHP acquisition................. 105 23 74 1,163,393 -- -- -- 1,163,595
Employee benefit plans.......... -- 1 9 44,584 -- -- -- 44,594
Tax benefit associated with
exercise of stock options....... -- -- -- 17,847 -- -- -- 17,847
Preferred dividends............... -- -- -- -- -- (8,792) -- (8,792)
----- ---- ---- ---------- ------- -------- -------- ----------
BALANCES AT DECEMBER 31, 1997..... 105 148 272 1,599,229 9,993 452,440 -- 2,062,187
----- ---- ---- ---------- ------- -------- -------- ----------
Comprehensive income:
Net income...................... -- -- -- -- -- 202,427 -- 202,427
Other comprehensive loss, net of
tax:
Unrealized losses on
securities, net of
reclassification
adjustment.................. -- -- -- -- (2,634) -- -- (2,634)
----- ---- ---- ---------- ------- -------- -------- ----------
Comprehensive income.............. -- -- -- -- (2,634) 202,427 -- 199,793
----- ---- ---- ---------- ------- -------- -------- ----------
Capital stock activity:
Conversion of preferred stock to
common stock.................. (105) -- 39 (344) -- -- -- (410)
Employee benefit plans.......... -- 1 4 19,438 -- -- 704 20,147
Purchase of treasury stock...... -- -- -- -- -- -- (44,658) (44,658)
Tax benefit associated with
exercise of stock options....... -- -- -- 6,296 -- -- -- 6,296
Preferred dividends............... -- -- -- -- -- (5,259) -- (5,259)
----- ---- ---- ---------- ------- -------- -------- ----------
BALANCES AT DECEMBER 31, 1998..... $ -- $149 $315 $1,624,619 $ 7,359 $649,608 $(43,954) $2,238,096
===== ==== ==== ========== ======= ======== ======== ==========
See accompanying notes.
F-3
36
PACIFICARE HEALTH SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
THREE MONTHS
YEAR ENDED YEAR ENDED ENDED YEAR ENDED
DECEMBER 31, DECEMBER 31, DECEMBER 31, SEPTEMBER 30,
1998 1997 1996 1996
------------ ------------ ------------ -------------
(IN THOUSANDS)
Operating activities:
Net income (loss)................................... $202,427 $ (21,701) $ 31,757 $ 71,953
Adjustments to reconcile net income (loss) to net
cash provided by (used in) operating activities:
Amortization of goodwill and intangible assets.... 76,593 70,219 1,861 9,153
Depreciation and amortization..................... 44,436 46,658 5,244 22,949
Deferred income taxes............................. (19,299) 25,579 213 (25,783)
Impairment, disposition, restructuring and other
charges......................................... 15,644 154,507 -- 75,840
Loss on disposal of property, plant and equipment
and other....................................... 12,547 6,715 191 750
Office of Personnel Management (credits)
charges......................................... (4,624) -- -- 25,000
Provision for doubtful accounts................... 1,485 5,171 296 999
Changes in assets and liabilities, net of effects
from acquisitions and dispositions:
Receivables, net................................ 24,516 6,321 13,037 (55,971)
Prepaid expenses, income tax receivable and
other current assets......................... 102,696 (112,409) (13,745) (5,038)
Medical claims and benefits payable............. (47,421) (2,504) 10,800 (21,261)
Accounts payable, accrued liabilities, and
accrued compensation and employee benefits... 31,549 (2,340) (7,139) 573
Unearned premium revenue........................ 15,038 237,273 232,357 (172,156)
-------- ----------- -------- ---------
Net cash flows provided by (used in)
operating activities....................... 455,587 413,489 274,872 (72,992)
-------- ----------- -------- ---------
Investing activities:
Purchase of property, plant and equipment........... (41,631) (68,533) (4,614) (22,728)
Proceeds from the sale of property, plant and
equipment......................................... 41,187 3,154 -- --
Purchase of marketable securities-restricted........ (17,980) (15,475) (2,993) (9,298)
Proceeds from dispositions.......................... 16,809 76,500 -- --
Purchase of marketable securities, net.............. (16,546) (8,795) (33,964) (30,623)
Acquisitions, net of cash acquired.................. (750) (999,892) (358) (5,403)
-------- ----------- -------- ---------
Net cash flows used in investing
activities................................. (18,911) (1,013,041) (41,929) (68,052)
-------- ----------- -------- ---------
Financing activities:
Principal payments on long-term debt................ (391,295) (235,166) (8,625) (8,625)
Repurchase of common stock.......................... (44,658) -- -- --
Proceeds from borrowings of long-term debt.......... 30,000 1,120,000 -- --
Proceeds from issuance of common and treasury
stock............................................. 18,908 43,838 612 13,342
Preferred dividends paid............................ (5,259) (8,792) -- --
Redemption of preferred stock....................... (410) -- -- --
Capitalization of Talbert........................... -- (67,000) -- --
Proceeds from sale of Talbert stock................. -- 59,598 -- --
-------- ----------- -------- ---------
Net cash flows provided by (used in)
financing activities....................... (392,714) 912,478 (8,013) 4,717
-------- ----------- -------- ---------
Net increase (decrease) in cash and equivalents....... 43,962 312,926 224,930 (136,327)
Beginning cash and equivalents........................ 680,674 367,748 142,818 279,145
-------- ----------- -------- ---------
Ending cash and equivalents........................... $724,636 $ 680,674 $367,748 $ 142,818
======== =========== ======== =========
See accompanying notes.
Table continued on next page.
F-4
37
PACIFICARE HEALTH SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED)
THREE MONTHS
YEAR ENDED YEAR ENDED ENDED YEAR ENDED
DECEMBER 31, DECEMBER 31, DECEMBER 31, SEPTEMBER 30,
1998 1997 1996 1996
------------ ------------ ------------ -------------
(IN THOUSANDS)
Supplemental cash flow information:
Cash paid during the year for:
Income taxes, net of refunds...................... $ 28,696 $ 100,202 $ 794 $ 74,092
Interest.......................................... $ 55,735 $ 55,282 $ 241 $ 1,230
Supplemental schedule of noncash investing and
financing activities:
Tax benefit associated with exercise of stock
options........................................... $ 6,296 $ 17,847 $ 2,351 $ 8,384
Compensation awarded in Class B common stock........ $ 1,239 $ 756 $ -- $ 1,172
Details of accumulated other comprehensive income:
Change in marketable securities..................... $ (4,652) $ 10,577 $ 3,495 $ (5,955)
Less change in deferred income taxes................ 2,018 (4,035) (1,337) 2,304
-------- ----------- -------- ---------
Change in shareholders' equity...................... $ (2,634) $ 6,542 $ 2,158 $ (3,651)
======== =========== ======== =========
Details of businesses acquired in purchase
transactions:
Fair value of assets acquired....................... $ 750 $ 3,376,241 $ 448 $ 9,906
Less liabilities assumed or created, including notes
to sellers........................................ -- (1,168,236) (90) (3,023)
Less common and preferred stock consideration....... -- (1,163,595) -- --
-------- ----------- -------- ---------
Cash paid for acquisitions.......................... 750 1,044,410 358 6,883
Cash acquired in acquisitions....................... -- (44,518) -- (1,480)
-------- ----------- -------- ---------
Net cash paid for acquisitions............... $ 750 $ 999,892 $ 358 $ 5,403
======== =========== ======== =========
Purchase accounting accrual adjustment:
Reduction of purchase accounting accruals........... $(79,340) $ -- $ -- $ --
Deferred income taxes............................... 10,165 -- -- --
-------- ----------- -------- ---------
Net goodwill adjustment............................... $(69,175) $ -- $ -- $ --
======== =========== ======== =========
See accompanying notes.
Table continued from previous page.
F-5
38
PACIFICARE HEALTH SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. BASIS OF PRESENTATION
ORGANIZATION AND OPERATIONS. PacifiCare Health Systems, Inc. owns and operates
federally qualified health maintenance organizations ("HMOs"), that arrange
health care services principally for a predetermined, prepaid periodic fee to
enrolled subscriber groups through independent health care organizations under
contract. We also offer certain specialty products and services to group
purchasers and to other managed care organizations and their beneficiaries,
including behavioral health services, life and health insurance, dental and
vision services, pharmacy benefit management, and Medicare+Choice management
services. UniHealth, a California non-profit public benefit corporation, owned
approximately 40 percent of our outstanding shares of Class A common stock and
one percent of our Class B common stock at December 31, 1998.
CONSOLIDATION. The accompanying consolidated financial statements include the
accounts of the parent company and all significant subsidiaries that are more
than 50 percent owned and controlled. All significant intercompany transactions
and balances were eliminated in consolidation.
CHANGE OF YEAR END. In 1997 we began reporting on a calendar year end. We
previously reported on a fiscal year ended September 30. Accordingly, the
accompanying consolidated financial statements and notes include results for the
three month transition period ended December 31, 1996, as required by the
Securities and Exchange Commission.
SEGMENT INFORMATION. We have adopted Statement of Financial Accounting Standards
("SFAS") No. 131, "Disclosures about Segments of an Enterprise and Related
Information." SFAS No. 131 establishes new standards for reporting operating
segments of publicly held companies. Its guiding principle is the "management
approach." This approach requires us to present segment information externally
the same way management uses financial data internally to make operating
decisions and assess performance. Because we sell health care packages, in the
form of bundled HMO and supplemental HMO products, to members of all ages we
have one reportable operating segment. These HMO members generally fall within
two product lines. Revenues from our Medicare customers are reported in the
government product line. Revenues from non-Medicare members, generally employees
or early retirees of businesses, are reported in the commercial product line.
Our single largest customer is the federal government. Sources of federal
government revenues include revenues from Medicare beneficiaries and from
federal employees covered by the Federal Employee Health Benefits Program
("FEHBP"). Federal government revenues were $5.9 billion in 1998, $5.5 billion
in 1997, $ 0.7 billion in the 1996 transition period and $2.8 billion in fiscal
1996.
USE OF ESTIMATES. In preparing the consolidated financial statements, we must
use some estimates and assumptions that may affect reported amounts and
disclosures. We use estimates most often when accounting for:
- - Allowances for doubtful accounts receivable;
- - Medical claims and benefits payable, including provider insolvency reserves;
- - Professional and general liability;
- - Reserves relating to the United States Office of Personnel Management ("OPM");
and
- - Certain other reserves.
We are also subject to risks and uncertainties that may cause actual results to
differ from estimated results, such as changes in the health care environment,
competition and legislation.
Footnote references for 1998 represent the year ended December 31, 1998, 1997
represents the year ended December 31, 1997, 1996 transition period represents
the three months ended December 31, 1996, and fiscal 1996 represents the fiscal
year ended September 30, 1996.
F-6
39
PACIFICARE HEALTH SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
1. BASIS OF PRESENTATION (CONTINUED)
RECLASSIFICATIONS. We reclassified certain prior year amounts in the
accompanying consolidated financial statements to conform to the 1998
presentation.
2. SIGNIFICANT ACCOUNTING POLICIES
CASH AND EQUIVALENTS. Cash and equivalents include items such as money market
funds and certificates of deposit, with maturity periods of three months or less
when purchased.
MARKETABLE SECURITIES. All marketable securities (which include municipal bonds,
corporate notes, commercial paper and U.S. government securities), except
marketable securities-restricted, are designated as available-for-sale.
Accordingly, marketable securities are carried at fair value and unrealized
gains or losses, net of applicable income taxes, are recorded in shareholders'
equity. Because marketable securities are available for use in current
operations, they are classified as current assets without regard to the
securities' contractual maturity dates.
We are required by state regulatory agencies to set aside funds for the
protection of our plan members in accordance with the laws of the various states
in which we operate. These funds are classified as marketable
securities-restricted (which includes U.S. government securities and
certificates of deposit held by trustees or state regulatory agencies).
Marketable securities-restricted are designated as held-to-maturity since we
have the intent and ability to hold such securities to maturity.
Held-to-maturity securities are stated at amortized cost, adjusted for
amortization of premiums and accretion of discounts to maturity, and are
classified as noncurrent assets.
CONCENTRATIONS OF CREDIT RISK. Financial instruments that potentially subject us
to concentrations of credit risk consist primarily of investments in marketable
securities and commercial premiums receivable. Our short-term investments in
marketable securities are managed by professional investment managers within
guidelines established by our board of directors, that, as a matter of policy,
limit the amounts that may be invested in any one issuer. Concentrations of
credit risk with respect to commercial premiums receivable are limited due to
the large number of employer groups comprising our customer base. We had no
significant concentrations of credit risk at December 31, 1998.
FAIR VALUE OF FINANCIAL INSTRUMENTS. Our consolidated balance sheets include the
following financial instruments: cash and equivalents, trade accounts and notes
receivable, trade accounts payable and long-term obligations. We consider the
carrying amounts of current assets and liabilities in the consolidated financial
statements to approximate the fair value for these financial instruments because
of the relatively short period of time between origination of the instruments
and their expected realization. The carrying value of all long-term obligations
approximates the fair value of such obligations.
MARKET RISK -- INTEREST-RATE SWAPS. We enter into interest-rate swap agreements
to modify the interest characteristics of our outstanding debt. Each
interest-rate swap agreement is designated with all or a portion of the
principal balance and term of a specific debt obligation. These agreements
involve the exchange of amounts based on a fixed interest rate for amounts based
on variable interest rates over the life of the agreement without an exchange of
the notional amount upon which the payments are based. The differential to be
paid or received as interest rates change is accrued and recognized as an
adjustment of interest expense related to the debt (the accrual accounting
method). The related amount payable to, or receivable from counterparties is
included in other liabilities or assets. The fair value of the swap agreements
and changes in the fair value as a result of changes in market interest rates
are not recognized in the consolidated financial statements. Gains and losses on
terminations of interest-rate swap agreements are deferred as an adjustment to
the carrying amount of the outstanding debt, and amortized as an adjustment to
interest expense related to the debt over the remaining term of the original
contract life of the terminated swap agreement. In the event of the early
extinguishment of a designated debt obligation, any realized or unrealized gain
or loss from
F-7
40
PACIFICARE HEALTH SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
2. SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
the swap would be recognized in income coincident with the extinguishment gain
or loss. See Note 5, "Long-Term Debt."
LONG-LIVED ASSETS.
- - PROPERTY, PLANT AND EQUIPMENT. We record property, plant and equipment at
cost. We capitalize replacements and major improvements. We charge repairs and
maintenance to expense as incurred. We eliminate the costs and related
accumulated depreciation when we sell property, plant and equipment, and any
resulting gains or losses are included in net income. We depreciate property,
plant and equipment, including assets under capital leases, evenly over the
assets' useful lives ranging from five to 25 years. We amortize leasehold
improvements evenly over the shorter of the lease term or 10 years.
Accumulated depreciation totaled $110 million for 1998 and $129 million for
1997.
- - GOODWILL AND INTANGIBLE ASSETS. When we acquire a business, we allocate the
excess of the purchase price over the fair value of the net assets acquired to
goodwill and identifiable intangible assets. Identifiable intangible assets
can include employer group contracts, Medicare contracts, provider networks
and assembled work force. We amortize goodwill and intangible assets evenly
over periods ranging from four to 40 years. Accumulated amortization totaled
$160 million for 1998 and $84 million for 1997.
- - LONG-LIVED ASSET IMPAIRMENT. We review long-lived assets for impairment when
events or changes in business conditions indicate that their full carrying
value may not be recovered. We consider assets to be impaired and write them
down to fair value if expected associated cash flows are less than the
carrying amounts. Fair value is the present value of the expected associated
cash flows. We recorded pretax charges for the impairment of goodwill and
intangible assets totaling $124 million in 1997 and $59 million in fiscal
1996. See Note 9, "Impairment, Disposition, Restructuring and Other Charges."
SOFTWARE COSTS. As of January 1, 1998, we adopted Statement of Position ("SOP")
No. 98-1. This statement requires that certain internal and external costs
associated with the purchase or development of internal-use software be
capitalized rather than expensed. We amortize these costs evenly over estimated
useful lives ranging from three to five years. Total costs capitalized in 1998
were $10 million. Development costs that did not meet SOP No. 98-1
capitalization requirements in 1998 were $24 million. Prior to 1998, we expensed
direct costs associated with the development of computer software as incurred.
These costs totaled $20 million in 1997, $3 million in the 1996 transition
period and $13 million in fiscal 1996.
PREMIUMS AND REVENUE RECOGNITION. We report prepaid health care premiums
received from our HMOs' enrolled groups as revenue in the month that enrollees
are entitled to receive health care. We record premiums received in advance as
unearned premium revenue. Funds received under the federal Medicare program
accounted for approximately 59 percent in 1998, 58 percent in 1997, 59 percent
in the 1996 transition period and 57 percent in fiscal 1996 as a percentage of
total premiums.
HEALTH CARE SERVICES. Our HMOs arrange for comprehensive health care services to
their members principally through capitation. Capitation is a fixed monthly
payment made without regard to the frequency, extent or nature of the health
care services actually furnished. We provide benefits to enrolled members
generally through our contractual relationships with physician groups and
hospitals. Our contracted providers may, in turn, contract with specialists or
referral providers for specific services and are responsible for any related
payments to those referral providers. Our HMOs provide incentives to
participating medical groups through the use of risk-sharing agreements and
other programs. Payments are made to medical groups based on their performance
in controlling health care costs while providing quality health care. Expenses
related to these programs, that are based in part on estimates, are recorded in
the period in which the related services are dispensed. The cost of health care
provided is accrued in the period it is dispensed to the enrolled members, based
in part on estimates for hospital services and other health care costs that have
been incurred but not
F-8
41
PACIFICARE HEALTH SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
2. SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
yet reported. We have also recorded reserves, based in part on estimates, to
indemnify our members against potential referral claims related to insolvent
medical groups. See Note 10 "Commitments and Contingencies." Our HMOs have
stop-loss insurance to cover unusually high costs of care when incurred beyond a
predetermined annual amount per enrollee.
PREMIUM DEFICIENCY RESERVES ON LOSS CONTRACTS. We assess the profitability of
our contracts for providing health care services to our members when current
operating results or forecasts indicate probable future losses. We compare
anticipated premiums to health care related costs, including estimated payments
for providers, commissions and cost of collecting premiums and processing
claims. If the anticipated future costs exceed the premiums, a loss contract
accrual is recognized. See Note 9, "Impairment, Disposition, Restructuring and
Other Charges."
ACCOUNTING FOR STOCK-BASED COMPENSATION. We use Accounting Principles Board
Opinion No. 25 to account for our stock-based compensation plans. Because we
typically set the exercise price of options granted at our stock's market price
on the grant date, there is no associated compensation expense. We have,
however, granted certain options that vest only if target stock prices are met.
Because these options have variable terms, there may be compensation expense
incurred for the difference between the exercise price and the closing market
price on the vesting dates. See Note 8, "Employee Benefit Plans."
TAXES BASED ON PREMIUMS. Certain states in which we do business require the
payment of excise, per capita or premium taxes based on a specified rate for
enrolled members or a percentage of billed premiums. Such taxes may be levied
instead of state income tax. These taxes are recorded in marketing, general and
administrative expenses, and totaled $17 million in 1998, $13 million in 1997,
$2 million in the 1996 transition period and $6 million in fiscal 1996.
INCOME TAXES. We recognize deferred income tax assets and liabilities for the
expected future tax consequences of events that have been included in the
consolidated financial statements or tax returns. Deferred tax assets and
liabilities are determined based on differences between the financial reporting
and tax bases of assets and liabilities. We measure deferred tax assets and
liabilities by applying enacted tax rates and laws to taxable years in which
such differences are expected to reverse. See Note 7, "Income Taxes."
EARNINGS PER SHARE. We calculated the denominators for the computation of basic
and diluted earnings per share as follows:
1996
TRANSITION FISCAL
1998 1997 PERIOD 1996
------ ------ ---------- ------
(AMOUNTS IN THOUSANDS)
Shares outstanding at the beginning of the period........... 41,995 31,301 31,292 30,882
Weighted average number of shares issued:
Conversion of Series A preferred stock.................... 2,067 -- -- --
Treasury stock acquired, net of shares issued............. (543) -- -- --
Stock options exercised................................... 261 724 3 209
FHP acquisition........................................... -- 8,498 -- --
------ ------ ------ ------
Denominator for basic earnings per share.................... 43,780 40,523 31,295 31,091
Assumed conversion of Series A preferred stock.............. 1,862 -- -- --
Employee stock options and other dilutive potential common
shares.................................................... 363 -- 505 580
------ ------ ------ ------
Denominator for diluted earnings per share.................. 46,005 40,523 31,800 31,671
====== ====== ====== ======
F-9
42
PACIFICARE HEALTH SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
2. SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
Since we reported a net loss in 1997, potentially dilutive securities were not
included in the calculation of the 1997 loss per share because they were
anti-dilutive. See Note 6, "Shareholders' Equity" and Note 8, "Employee Benefit
Plans."
DERIVATIVES. In June 1998, the Financial Accounting Standards Board issued SFAS
No. 133, "Accounting for Derivative Instruments and Hedging Activities." This
standard requires companies to record all derivatives on the balance sheet as
either assets or liabilities and measure those instruments at their fair value.
The manner in which companies are to record gains or losses resulting from
changes in the values of those derivatives depends on the use of the derivative
and whether it qualifies for hedge accounting. This standard is effective for
our consolidated financial statements beginning January 1, 2000, although early
adoption is permitted. Based on our current derivatives held, we believe that
the adoption of this statement will not have a material impact to our
consolidated financial position or results of operations.
3. MARKETABLE SECURITIES
The following tables summarize marketable securities as of the dates indicated:
GROSS GROSS
AMORTIZED UNREALIZED UNREALIZED
COST GAINS LOSSES FAIR VALUE
--------- ---------- ---------- ----------
(AMOUNTS IN THOUSANDS)
Marketable securities:
U.S. government and agency........................ $141,072 $ 3,489 $ (173) $ 144,388
State, municipal and state and local agency....... 330,512 6,809 (508) 336,813
Corporate debt and other securities............... 392,074 4,530 (2,252) 394,352
-------- ------- ------- ----------
Total marketable securities............... 863,658 14,828 (2,933) 875,553
-------- ------- ------- ----------
Marketable securities-restricted:
U.S. government and agency........................ 48,961 658 (6) 49,613
Municipal and local agency........................ 3,756 53 (2) 3,807
Corporate debt and other securities............... 29,943 176 -- 30,119
-------- ------- ------- ----------
Total marketable securities-restricted.... 82,660 887 (8) 83,539
-------- ------- ------- ----------
BALANCE AT DECEMBER 31, 1998........................ $946,318 $15,715 $(2,941) $ 959,092
======== ======= ======= ==========
Marketable securities:
U.S. government and agency........................ $427,728 $ 9,936 $ (399) $ 437,265
State, municipal and state and local agency....... 244,130 5,773 (731) 249,172
Corporate debt and other securities............... 176,543 1,941 (213) 178,271
-------- ------- ------- ----------
Total marketable securities............... 848,401 17,650 (1,343) 864,708
-------- ------- ------- ----------
Marketable securities-restricted:
U.S. government and agency........................ 110,555 1,106 (1,021) 110,640
Municipal and local agency........................ 8,898 45 (42) 8,901
Corporate debt and other securities............... 26,536 39 (39) 26,536
-------- ------- ------- ----------
Total marketable securities-restricted.... 145,989 1,190 (1,102) 146,077
-------- ------- ------- ----------
BALANCE AT DECEMBER 31, 1997........................ $994,390 $18,840 $(2,445) $1,010,785
======== ======= ======= ==========
F-10
43
PACIFICARE HEALTH SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
3. MARKETABLE SECURITIES (CONTINUED)
As of December 31, 1998 the contractual maturities of our marketable securities
were as follows:
MARKETABLE SECURITIES --
MARKETABLE SECURITIES RESTRICTED
--------------------------- ---------------------------
AMORTIZED COST FAIR VALUE AMORTIZED COST FAIR VALUE
-------------- ---------- -------------- ----------
(AMOUNTS IN THOUSANDS)
Due in one year or less............. $ 21,718 $ 21,636 $40,519 $40,597
Due after one year through five
years............................. 203,627 204,588 34,717 35,202
Due after five years through ten
years............................. 338,766 347,967 5,682 5,979
Due after ten years................. 299,547 301,362 1,742 1,761
-------- -------- ------- -------
$863,658 $875,553 $82,660 $83,539
======== ======== ======= =======
Proceeds from sales and maturities of marketable securities were $1.4 billion in
1998 and $3.4 billion in 1997. Gross realized gains and gross realized losses
are included in net investment income under the specific identification method.
4. ACQUISITIONS AND DISPOSITIONS
1998 DISPOSITIONS. On September 30, 1998, we sold our Utah HMO subsidiary. We
guaranteed the buyer that the Utah HMO would have a minimum net equity of $10
million, based on the values of the Utah HMO's assets and liabilities as of
September 30, 1998. We also extended a $700,000 subordinated loan to the Utah
HMO to increase its statutory net equity. We sold all of the issued and
outstanding shares of capital stock of the Utah HMO to the buyer for no other
consideration. As of September 30, 1998, the Utah HMO served approximately
102,000 commercial and 19,000 government members. On October 31, 1998, we sold
our workers' compensation subsidiary. The sales price totaled $17 million. We
recognized pretax charges of approximately $15 million ($8 million or $0.18
diluted loss per share, net of tax) for these dispositions.
1997 ACQUISITION. On February 14, 1997 we acquired FHP International Corporation
("FHP"). Each outstanding share of FHP's common stock was exchanged for $17.50
in cash, 0.056 shares of our Class A common stock and 0.176 shares of our Class
B common stock. Each outstanding share of FHP's preferred stock was exchanged
for $14.113 in cash and one-half of one share of our Series A preferred stock.
We paid approximately $1.0 billion in cash to FHP's common and preferred
shareholders.
The terms of the FHP acquisition required FHP to contribute $67 million to
Talbert Medical Management Corporation ("Talbert"), a wholly owned subsidiary of
FHP, increasing Talbert's net worth to approximately $60 million on February 14,
1997. Concurrently, FHP sold its investment in Talbert in exchange for a $60
million non-recourse promissory note and rights to purchase shares of Talbert
common stock. Each former FHP shareholder received Talbert rights. Holders of
Talbert rights were able to purchase one share of Talbert common stock for each
Talbert right, for the subscription price of $21.50 per share. Holders of
Talbert rights were entitled to subscribe for all, or any portion of, the shares
of Talbert common stock underlying their Talbert rights, as well as to subscribe
for any unallocated additional shares. In May 1997, Talbert successfully
completed its rights offering and shares of Talbert common stock were
distributed. Proceeds from the Talbert rights offering were used to repay the
non-recourse promissory note issued to FHP.
We accounted for the FHP acquisition as a purchase. Total consideration of
approximately $2.2 billion, including $18 million of transaction costs, was
allocated to the assets acquired and liabilities assumed based on estimates of
their fair values. The fair value of assets acquired was $0.9 billion. The fair
value of liabilities assumed was $1.1 billion. A total of $2.4 billion, net of
related deferred taxes, representing the excess of the purchase price over the
fair values of the net assets acquired, was allocated to goodwill and other
acquired intangible assets and is being amortized over a four to 40 year period.
Identified intangibles of $365 million include commercial employer group
contracts, Medicare contracts, provider networks and assembled work
F-11
44
PACIFICARE HEALTH SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
4. ACQUISITIONS AND DISPOSITIONS (CONTINUED)
force. We recorded fair value increases and decreases in tangible assets and
liabilities acquired. Fair value decreases included a $76 million decrease to
property, plant and equipment. This decrease included real property write downs
based on appraised values and the abandonment of capitalized software and
equipment. Certain liabilities were recognized in purchase accounting for exit
costs and loss contingencies. We reviewed all exit cost liabilities and
determined that certain amounts exceeded the final expected payments at December
31, 1998. Certain of the items accrued, the related payments, and amounts
reversed as a reduction to the FHP purchase price were as follows:
LIABILITIES LIABILITIES
RECOGNIZED AT LIABILITIES OUTSTANDING AT
DATE OF FHP 1998/1997 REVERSED DECEMBER 31,
ACQUISITION PAYMENTS IN 1998 1998
------------- --------- ----------- --------------
Abandonment of FHP systems.................. $ 62 $(44) $(18) $--
Losses on disposition....................... 34 (8) (25) 1
FHP severance benefits...................... 33 (29) (1) 3
FHP OPM claims accrual...................... 33 -- -- 33
Abandonment of FHP facility leases.......... 14 (3) (7) 4
Other....................................... 11 (3) (8) --
---- ---- ---- ---
Total............................. $187 $(87) $(59) $41
==== ==== ==== ===
During 1998 we successfully settled audits of previously filed FHP federal tax
returns and reversed approximately $20 million of income tax liabilities. Total
purchase accounting accrual reductions were $79 million. The liabilities
reversed in 1998 had the effect of reducing the amount of tax benefits we
expected to realize in the future. As a result, we reduced our deferred tax
assets by $10 million. In total, the purchase price of FHP decreased by $69
million and is reflected as a reduction of goodwill.
At the acquisition, we accrued $62 million of contractual obligations and
commitments to conform all of FHP's multiple information systems to one uniform
system that will be abandoned upon the final conversion to our core computing
information system. These costs were direct, incremental and were not related to
the development of new software systems that would have future economic benefit.
With the 1997 and 1998 dispositions, and other contract negotiations, only $44
million was required.
As described below, we held certain FHP subsidiaries for sale in 1997. These
dispositions were completed in 1997 with certain liabilities not being assumed
by the buyers. Certain liabilities, including uninsured contingencies, were
resolved for amounts significantly lower than estimated.
Our estimates for FHP employee severance are expected to be fully utilized. The
remaining $3 million will be paid over the next two years.
We also accrued $33 million for FHP OPM claims based on FHP's internal review
completed just prior to the acquisition and draft audit findings by the
government. These matters generally take a number of years to resolve. See Note
10, "Commitments and Contingencies."
Finally, property management reserves of $14 million for various real property
leases were not fully utilized as the real estate market improved in late 1997
and early 1998. We were able to negotiate better lease terminations than
estimated and also sublet space at higher rates than originally anticipated.
1997 DISPOSITIONS. In February 1997, we announced our intention to sell the
Illinois and New Mexico HMO subsidiaries of FHP. We classified these
subsidiaries as net assets held for sale and assigned their carrying values at
net realizable value. The Illinois HMO was sold in October 1997, and the New
Mexico HMO was sold in November 1997. Net losses measured from the date of the
FHP acquisition until their dispositions
F-12
45
PACIFICARE HEALTH SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
4. ACQUISITIONS AND DISPOSITIONS (CONTINUED)
were $15 million, and disposition gains totaled $46 million. These net losses
and disposition gains were treated as part of the FHP purchase price allocation.
In February 1997, we sold the outstanding common stock of our Florida
subsidiary, at which time the buyer assumed the daily operations. The sales
price, which approximated net book value, totaled $9 million. The sale was
closed in July 1997 when we received regulatory approval from the state of
Florida.
FISCAL 1996 ACQUISITION. In January 1996, we acquired Psychology Systems, Inc.,
a California-based managed care behavioral health and employee assistance
program company. The acquisition was accounted for as a purchase, and its
operating results were included in our consolidated financial statements from
the purchase date. We amortize the excess purchase price over a period not to
exceed 40 years.
PRO FORMA FINANCIAL STATEMENTS. The pro forma information below presents our
results of operations as if the sales of the Florida and Utah HMOs and the FHP
acquisition occurred on January 1, 1997. This information reflects our actual
operating results before these transactions, plus adjustments for interest
expense, goodwill amortization and income taxes. No adjustment was made to give
effect to synergies realized as a result of the FHP acquisition. Because the
sale of the workers' compensation subsidiary, the sales of the Illinois and New
Mexico HMO subsidiaries, and the fiscal 1996 acquisition were not material to
our results of operations, these transactions were not included in the pro forma
information below.
1998 1997
----------- -----------
(UNAUDITED)
(AMOUNTS IN THOUSANDS,
EXCEPT PER SHARE AMOUNTS)
Total operating revenue..................................... $9,369,487 $9,311,919
Pretax income............................................... $ 415,814 $ 160,943
Net income.................................................. $ 220,511 $ 60,431
========== ==========
Basic earnings per share.................................... $ 4.92 $ 1.22
========== ==========
Diluted earnings per share.................................. $ 4.79 $ 1.22
========== ==========
5. LONG-TERM DEBT
We have a $1.5 billion credit facility under which we had $550 million in
borrowings outstanding as of December 31, 1998. The terms of this facility
require a mandatory step-down payment schedule if the principal balance exceeds
certain thresholds. Because the current balance is $550 million, no step-down
payments are required until the final maturity date on January 1, 2002. Interest
under the credit facility is variable and is presently based on the London
Interbank Offering Rate ("LIBOR") plus a spread, except for $350 million of the
outstanding balance that is covered by interest-rate swap agreements. The
average fixed interest rate we pay on the existing swap agreements is
approximately six percent. The terms of the credit facility contain various
covenants usual for financing of this type, including a minimum net worth
requirement, a minimum fixed charge requirement, leverage ratios and limits on
the amount of treasury stock we may purchase. At December 31, 1998, we were in
compliance with all such covenants. We also have $100 million in senior notes
outstanding that were assumed in the FHP acquisition. These notes carry an
interest rate of seven percent, are payable semiannually and mature on September
15, 2003.
6. SHAREHOLDERS' EQUITY
As of December 31, 1998, we had repurchased 784,000 shares of our Class A and
Class B common stock for $45 million.
In May 1998, we announced the redemption of our 10,517,044 shares of Series A
preferred stock. All but 15,604 shares of this stock were converted into
3,929,503 shares of Class B common stock as of the June 23,
F-13
46
PACIFICARE HEALTH SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
6. SHAREHOLDERS' EQUITY (CONTINUED)
1998 redemption date. The conversion ratio was one share of Series A preferred
stock to 0.37419548 of a share of Class B common stock. The shares not converted
were redeemed in cash for $25.77 per share, including accrued and unpaid
dividends of approximately $0.02 per share, or $0.4 million in the aggregate.
During the year ended December 31, 1998, we paid approximately $5 million in
dividends to our preferred shareholders.
In January 1998, our board of directors approved a plan to repurchase shares of
our outstanding common stock. We have and may continue to repurchase our
outstanding common stock using cash flows from operations and additional
borrowings under the credit facility. The terms of the credit facility permit us
to repurchase up to $500 million of our outstanding common stock. Shares
repurchased have been and will be reissued for our employee benefit plans or for
other corporate purposes.
7. INCOME TAXES
The tax effects of the major items recorded as deferred tax assets and
liabilities were as follows:
1998 1997
--------- ---------
(IN THOUSANDS)
Current deferred tax assets (liabilities):
Accrued health care costs................................. $ 56,299 $ 59,938
Accrued expenses.......................................... 30,487 37,819
Accrued compensation...................................... 21,659 14,939
Provider insolvency....................................... 19,366 --
State franchise taxes..................................... 10,765 3,852
Unrealized gains on marketable securities................. (4,532) (6,550)
Other assets/liabilities.................................. 4,509 14,447
Pharmacy rebate........................................... (4,486) (11,190)
Prepaid expenses.......................................... (1,615) (2,381)
Other..................................................... -- 1,163
--------- ---------
$ 132,452 $ 112,037
========= =========
Non-current deferred tax assets (liabilities):
Identifiable intangibles.................................. $(119,509) $(132,067)
Accrued expenses.......................................... 9,295 22,922
Depreciation.............................................. (8,407) (7,374)
Accrued health care costs................................. 249 6,314
Future benefits from goodwill impairment.................. -- 3,569
Other..................................................... 6,316 3,843
--------- ---------
$(112,056) $(102,793)
========= =========
F-14
47
PACIFICARE HEALTH SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
7. INCOME TAXES (CONTINUED)
The provision for income taxes consisted of the following:
1996 TRANSITION
1998 1997 PERIOD FISCAL 1996
-------- ------- --------------- -----------
(IN THOUSANDS)
Current:
Federal............................ $171,478 $46,810 $17,337 $ 62,781
State.............................. 30,968 9,436 3,529 13,829
-------- ------- ------- --------
Total current.............. 202,446 56,246 20,866 76,610
-------- ------- ------- --------
Deferred:
Federal............................ (13,615) 18,754 163 (22,172)
State.............................. (5,684) 6,825 50 (3,611)
-------- ------- ------- --------
Total deferred............. (19,299) 25,579 213 (25,783)
-------- ------- ------- --------
Provision for income taxes......... $183,147 $81,825 $21,079 $ 50,827
======== ======= ======= ========
Reconciliations of the U.S. statutory income tax rate to our effective tax rate
follow:
1996 TRANSITION
1998 1997 PERIOD FISCAL 1996
---- ----- --------------- -----------
Computed expected provision................ 35.0% 35.0% 35.0% 35.0%
Amortization of intangibles................ 5.1 29.7 0.9 1.5
State taxes, net of federal benefit........ 4.3 16.9 4.4 4.4
Disposition of subsidiaries................ 1.6 -- -- --
Tax exempt interest........................ (1.4) (6.3) (2.0) (3.6)
Impairment of non-deductible goodwill...... -- 54.6 -- 1.8
Other, net................................. 2.9 6.2 1.6 2.3
---- ----- ---- ----
Provision for income taxes................. 47.5% 136.1% 39.9% 41.4%
==== ===== ==== ====
The majority of the goodwill impairment charges recorded in 1997 was not
deductible for income tax purposes. See Note 9, "Impairment, Disposition,
Restructuring and Other Charges." Therefore, we did not record a benefit for
most of these charges. The magnitude of the 1997 charges, combined with the
inability to record a related income tax benefit, resulted in a
disproportionately high effective income tax rate for 1997. The 1997 effective
income tax rate, without the effect of the impairment charges, was approximately
50 percent. Excluding the impact of non-deductible goodwill impairment and
amortization, the impact of state taxes, net of federal benefit would have been
5.3 percent for 1997.
8. EMPLOYEE BENEFIT PLANS
SAVINGS AND PROFIT-SHARING PLANS. Most of our employees may participate in our
savings and profit-sharing plan. Features of the plan in 1998 were as follows:
- - Participants may defer up to 12 percent of annual compensation;
- - We match one-half of the deferral, up to three percent of annual compensation
per employee;
- - We automatically contribute two percent of annual compensation per employee;
- - We may contribute an additional amount to each employee's account, generally
based on a percentage of pretax income; and
- - We may make a cash profit sharing payment.
F-15
48
PACIFICARE HEALTH SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
8. EMPLOYEE BENEFIT PLANS (CONTINUED)
Charges to income for the plan were $20 million in 1998, $7 million in 1997, $3
million in the 1996 transition period and $14 million in fiscal 1996.
FHP had an employee stock ownership plan that covered most FHP employees. This
plan consisted of three separate parts:
- - An employee stock ownership plan (the "ESOP");
- - A 401(k) plan; and
- - A payroll-based tax credit employee stock ownership plan.
In February 1997, the ESOP and 401(k) components were converted to a
profit-sharing plan named the FHP Savings Plan. Our employees from FHP
participated in the FHP Savings Plan until December 31, 1997, at which time they
became eligible to participate in our plan. We expect the FHP Savings Plan to be
merged into our plan during 1999. The payroll-based tax credit employee stock
ownership plan was terminated in 1997.
STOCK OPTION PLANS.
1996 Employee Plan. Officers and key employees may be granted:
- - Options to purchase shares of common stock;
- - Shares of Class B common stock; and
- - Stock appreciation rights.
We grant stock options at exercise prices that equal or exceed the market price
of our common stock on the dates granted. These options typically vest over four
years in 25 percent increments, are generally subject to continuous employment,
and expire 10 years after the grant date. At December 31, 1998, approximately
1.1 million shares were available for awards under the 1996 Employee Plan.
During 1997, we granted options that vest if certain earnings targets are
achieved. These options ultimately vest four years from the grant date. Also
during 1997, the FHP acquisition triggered accelerated vesting provisions of
some stock options. Certain employees agreed to receive additional stock options
in exchange for waiving these accelerated vesting provisions.
1996 Director Plan. We grant options to purchase 5,000 shares of our Class B
common stock annually to each eligible non-employee director and grant options
to purchase 10,000 shares of Class B common stock when a new director is elected
or appointed to the Board. These options vest over four years in 25 percent
increments.
1997 Premium Plan. We granted options to purchase 2.6 million shares (the
maximum available) of our Class B common stock to certain executive officers
under this plan. The first 50 percent vest within three years of the grant date
if the closing market price of our Class B common stock reaches $92.50, and
expire in 2000 if the $92.50 stock price is not reached. The remaining 50
percent vest within five years of the grant date if the closing market price of
our Class B common stock reaches $114.00, and expire in 2002 if the $114.00
stock price is not reached.
F-16
49
PACIFICARE HEALTH SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
8. EMPLOYEE BENEFIT PLANS (CONTINUED)
Non-qualified stock option activity for all plans was as follows:
CLASS A WEIGHTED AVERAGE CLASS B WEIGHTED AVERAGE
STOCK EXERCISE PRICE STOCK EXERCISE PRICE
------- ---------------- --------- ----------------
OUTSTANDING AT SEPTEMBER 30, 1996..... 308,834 $7.49 1,647,121 $ 53.21
Granted at market price............... -- -- 358,300 $ 80.92
Exercised............................. -- -- (9,722) $ 62.91
Canceled.............................. -- -- (210,561) $ 80.25
------- ----- --------- -------
OUTSTANDING AT DECEMBER 31, 1996...... 308,834 $7.49 1,785,138 $ 55.79
Granted at market price............... -- -- 1,948,100 $ 70.98
Granted in excess of market price..... -- -- 1,187,500 $ 92.50
Granted in excess of market price..... -- -- 1,187,500 $114.00
Exchanged for FHP stock options....... -- -- 933,594 $ 51.83
Exercised............................. (74,784) $5.85 (903,029) $ 46.98
Canceled.............................. -- -- (470,347) $ 75.04
------- ----- --------- -------
OUTSTANDING AT DECEMBER 31, 1997...... 234,050 $8.02 5,668,456 $ 75.51
Granted at market price............... -- -- 1,068,810 $ 77.76
Granted in excess of market price..... -- -- 112,500 $ 92.50
Granted in excess of market price..... -- -- 112,500 $114.00
Exercised............................. (94,200) $6.54 (360,551) $ 48.50
Canceled.............................. -- -- (424,707) $ 84.49
------- ----- --------- -------
OUTSTANDING AT DECEMBER 31, 1998...... 139,850 $9.02 6,177,008 $ 82.00
======= ===== ========= =======
Non-qualified options exercisable under all plans were as follows:
CLASS A WEIGHTED AVERAGE CLASS B WEIGHTED AVERAGE
STOCK EXERCISE PRICE STOCK EXERCISE PRICE
------- ---------------- --------- ----------------
September 30, 1996.................... 308,834 $7.49 435,474 $35.57
December 31, 1996..................... 308,834 $7.49 728,316 $45.73
December 31, 1997..................... 234,050 $8.02 1,268,710 $54.62
December 31, 1998..................... 139,850 $9.02 1,392,229 $60.29
F-17
50
PACIFICARE HEALTH SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
8. EMPLOYEE BENEFIT PLANS (CONTINUED)
The following is a summary of information about options outstanding and options
exercisable at December 31, 1998:
OPTIONS OUTSTANDING OPTIONS EXERCISABLE
----------------------------------------- -----------------------------
WEIGHTED WEIGHTED WEIGHTED
NUMBER AVERAGE AVERAGE NUMBER AVERAGE
RANGE OF EXERCISE PRICES OUTSTANDING LIFE(I) EXERCISE PRICE EXERCISABLE EXERCISE PRICE
------------------------ ----------- -------- -------------- ----------- --------------
CLASS A STOCK:
$ 8.38 - $19.75................ 139,850 2 $ 9.02 139,850 $ 9.02
========= =========
CLASS B STOCK:
$ 8.38 - $19.75................ 43,500 2 $ 10.43 43,500 $10.43
$29.75 - $41.30................ 241,930 5 $ 38.69 237,723 $38.69
$44.75 - $67.00................ 1,377,050 8 $ 64.74 727,698 $63.96
$68.88 - $92.50................ 3,307,028 9 $ 81.61 383,308 $72.38
$114.00........................ 1,207,500 9 $114.00 -- --
--------- ---------
6,177,008 1,392,229
========= =========
- ---------------
(i) Weighted average contractual life remaining in years.
PRO FORMA STOCK OPTION DISCLOSURE. We used the Black-Scholes option pricing
model to calculate the fair value of grants in the years presented below. We
applied the following assumptions to determine pro forma compensation expense:
1996 TRANSITION
1998 1997 PERIOD FISCAL 1996
------ ------ --------------- -----------
Expected dividend yield......................... 0% 0% 0% 0%
Risk-free interest rate......................... 6% 6% 6% 6%
Expected stock price volatility................. 45% 43% 43% 43%
Expected term until exercise (years)............ 2 3 3 3
Weighted average fair value of options on grant
date:
Granted at market prices...................... $30.92 $25.40 $29.57 $27.69
Granted in excess of market price............. $29.76 $26.99 -- --
We do not record compensation expense for stock option grants. The following
table summarizes results as if we had recorded compensation expense for the
1998, 1997, 1996 transition period and fiscal 1996 grants:
1996 TRANSITION
1998 1997 PERIOD FISCAL 1996
-------- -------- --------------- -----------
(IN THOUSANDS, EXCEPT PER SHARE DATA)
Net income (loss):
As reported............................... $202,427 $(21,701) $31,757 $71,953
Pro forma................................. $168,382 $(48,359) $30,996 $69,492
Basic earnings (loss) per share:
As reported............................... $ 4.50 $ (0.75) $ 1.01 $ 2.31
Pro forma................................. $ 3.85 $ (1.19) $ 0.99 $ 2.24
Diluted earnings (loss) per share:
As reported............................... $ 4.40 $ (0.75) $ 1.00 $ 2.27
Pro forma................................. $ 3.66 $ (1.19) $ 0.97 $ 2.19
F-18
51
PACIFICARE HEALTH SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
8. EMPLOYEE BENEFIT PLANS (CONTINUED)
These figures reflect only the impact of grants since October 1, 1995, and
reflect only part of the possible compensation expense that we amortize over the
vesting period of the grants (generally up to four years). Therefore, the effect
on net income and earnings per share may differ in future years from the amounts
shown above.
9. IMPAIRMENT, DISPOSITION, RESTRUCTURING AND OTHER CHARGES
We recognized pretax charges in 1998, 1997 and 1996 as follows:
QUARTER PRETAX NET OF TAX DILUTED (LOSS)/
RECOGNIZED (CHARGE)/CREDIT AMOUNT EARNINGS PER SHARE
------------ --------------- ---------- ------------------
(DOLLARS IN MILLIONS, EXCEPT PER SHARE DATA)
1998
Sale of Utah HMO and workers'
compensation subsidiaries....... Third $ (15.6) $ (8.2) $(0.18)
OPM charges....................... Third (3.8) (2.0) (0.04)
------- ------- ------
Total Third (19.4) (10.2) (0.22)
OPM credits....................... Fourth 8.4 4.4 0.10
------- ------- ------
$ (11.0) $ (5.8) $(0.12)
======= ======= ======
1997
Impairment of long-lived assets:
Utah HMO........................ Fourth $ (62.4) $ (55.7) $(1.37)
Washington health plan.......... Fourth (40.5) (36.1) (0.89)
Discontinued workers'
compensation products........ Fourth (21.1) (18.9) (0.47)
------- ------- ------
Total impairment of
long-lived assets..... (124.0) (110.7) (2.73)
Loss contracts.................... Fourth (15.4) (9.2) (0.23)
Restructuring..................... Fourth (15.1) (9.0) (0.22)
------- ------- ------
$(154.5) $(128.9) $(3.18)
======= ======= ======
1996
OPM charges....................... Second $ (25.0) $ (14.9) $(0.47)
Florida disposition............... Second (9.3) (8.3) (0.26)
Restructuring..................... Second (7.8) (4.7) (0.15)
------- ------- ------
Total Second (42.1) (27.9) (.88)
Impairment of long-lived
assets-Florida.................. Third (58.7) (34.1) (1.08)
------- ------- ------
$(100.8) $ (62.0) $(1.96)
======= ======= ======
1998. Pretax charges of $11 million ($6 million or $0.12 diluted loss per share,
net of tax) were recorded in 1998 as follows:
- - Dispositions. We recognized $16 million of disposition charges ($8 million or
$0.18 diluted loss per share, net of tax) with the sales of our Utah HMO and
workers' compensation subsidiaries. See Note 4, "Acquisitions and
Dispositions."
F-19
52
PACIFICARE HEALTH SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
9. IMPAIRMENT, DISPOSITION, RESTRUCTURING AND OTHER CHARGES (CONTINUED)
- - OPM. Partially offsetting the disposition charges were net OPM credits of $5
million ($3 million or $0.06 diluted income per share, net of tax). See Note
10, "Commitments and Contingencies."
1997. Pretax charges of $155 million ($129 million or $3.18 diluted loss per
share, net of tax) were recorded in 1997 as follows:
- - Utah HMO impairment. We recognized a goodwill and other intangible impairment
charge of $62 million ($56 million or $1.37 diluted loss per share, net of
tax) in anticipation of our disposition of the subsidiary. Utah's operating
losses related to lower than expected 1997 premium rate increases, combined
with a shift of membership from capitated to non-capitated health care
providers. This shift of membership resulted from a significant health care
provider contract that switched from capitation to fee-for-service. We entered
into the contract to ensure an adequate infrastructure to service the Utah
membership. At that same time, the Utah information systems migrated to the
standard FHP system in anticipation of the conversion of the FHP system into
our common system. As a result, increased utilization under the new
fee-for-service contract was not visible until the fourth quarter of 1997 when
conversion reconciliations discovered significant unpaid claims, as well as
claims paid inaccurately. Because the 1997 losses and the cash flow analysis
did not support the recoverability of goodwill, we recorded an impairment
charge. We disposed of our Utah operations in September 1998 with the
additional disposition losses noted above. See Note 4, "Acquisitions and
Dispositions."
- - Washington health plan impairment. In 1997 we determined that the Washington
health plan goodwill and intangibles were no longer recoverable, and recorded
an impairment charge of $41 million ($36 Million or $0.89 diluted loss per
share, net of tax). Since its acquisition, the Washington market has incurred
operating losses. 1998 results were break-even.
- - Workers' compensation subsidiary impairment. We recognized $21 million ($19
million or $0.47 diluted loss per share, net of tax) of goodwill impairment
charges, primarily for discontinued workers' compensation products. We
determined that California legislation did not allow workers' compensation
products to be priced at rates that could produce our required return on
investment. See Note 4, "Acquisitions and Dispositions."
- - Loss contracts. We recorded approximately $15 million ($9 million, or $0.23
diluted loss per share, net of tax) for contracts on which the anticipated
future health care costs exceeded the premiums, the majority related to our
Utah HMO and workers' compensation subsidiary. These losses were realized
throughout 1998. Any remaining accrued losses at the disposition of Utah and
our workers' compensation subsidiary offset disposition losses.
- - Restructuring. We recognized restructuring charges of $15 million ($9 million
or $0.22 diluted loss per share, net of tax) in 1997. Work force reduction
costs of $8 million primarily included employee severance for involuntary
terminations. Lease terminations and personal property abandonment of $5
million pretax were associated with the consolidation of administration and
operations office space. Other related charges totaled $2 million, pretax.
Cash flows from operations funded all of the restructuring charges. The
restructuring was substantially complete at December 31, 1998 and actual
expenditures did not differ materially from amounts accrued.
FISCAL 1996. We recognized pretax impairment, disposition, restructuring and OPM
charges for fiscal 1996 totaling $101 million ($62 million or $1.96 diluted loss
per share, net of tax) as follows:
- - OPM. During 1996, we recognized a pretax charge of $25 million ($15 million or
$0.47 diluted loss per share, net of tax) for an increase of reserves in
anticipation of negotiations relating to potential governmental claims for
contracts with OPM. See Note 10, "Commitments and Contingencies."
F-20
53
PACIFICARE HEALTH SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
9. IMPAIRMENT, DISPOSITION, RESTRUCTURING AND OTHER CHARGES (CONTINUED)
- - Florida disposition. Effective June 1, 1996, we sold the assets of our Florida
subsidiary's staff-model medical clinics, resulting in a pretax loss of $9
million ($8 million or $0.26 diluted loss per share, net of tax).
- - Restructuring. We recognized a restructuring charge of $8 million ($5 million
or $0.15 diluted loss per share, net of tax). This charge included employee
severance for an involuntary work force reduction of approximately $4 million,
write-offs of assets designated for sale totaling approximately $3 million,
and other related costs of approximately $1 million. The restructuring was
financed by cash flows from operations. The restructuring was substantially
complete at December 31, 1998 and actual expenditures did not differ
materially from amounts accrued.
- - Florida impairment. We recognized a $59 million impairment charge ($34 million
or $1.08 diluted loss per share, net of tax) in 1996 when we decided to sell
our Florida operations. The sale was completed in early 1997. See Note 4,
"Acquisitions and Dispositions."
10. COMMITMENTS AND CONTINGENCIES
PROVIDER INSTABILITY AND INSOLVENCY. Our 1998 results include significant
provider insolvency costs, primarily related to FPA Medical Management, Inc.
("FPA") who declared bankruptcy in July 1998. Provider insolvency reserves
totaled $95 million in 1998 and were immaterial in 1997. Provider insolvency
reserves include write-offs of providers' uncollectable receivables and the
estimated cost of unpaid health care claims covered by our capitation payment.
Depending on state law, we may be held liable for unpaid health care claims
which were the responsibility of the capitated provider.
The majority of the insolvency reserves relate to specific provider
bankruptcies. However, the estimate also includes reserves for potentially
insolvent providers, where conditions indicate claims are not being paid or have
slowed considerably.
FPA served approximately 200,000 PacifiCare members in Arizona, California,
Nevada and Texas. Reserves for the FPA bankruptcy totaled $57 million, with $41
million attributable to our Nevada HMO. Nevada law specifically requires that we
pay all health care services claims, both non-contracted and contracted.
Reserves for the remaining FPA states of $16 million primarily relate to
reserves for non-contracted claims and receivable write-offs. Unpaid FPA
reserves at December 31, 1998 were approximately $20 million.
In 1998, reserves for other providers totaled $38 million. Approximately $17
million recognized in the third and fourth quarters were attributable to another
provider that has ceased paying claims in Nevada and Arizona. This provider has
not declared bankruptcy. The membership was transitioned to other providers
between December 1998 and January 1999. The remaining $21 million was the
estimated liability for non-contracted health care services rendered through
December 31, 1998 for smaller bankrupt providers and potentially insolvent
providers, primarily in California. Other provider insolvency reserves unpaid at
December 31, 1998 were approximately $38 million.
Based on current information, we believe that any liability in excess of amounts
accrued would not materially affect our consolidated financial position.
However, our evaluation of the likely impact of claims asserted against us could
change in the future and an unfavorable outcome, depending on the amount and
timing, could have a material effect on our results of operations or cash flows
for a future quarter.
OPM. Our HMO subsidiaries have commercial contracts with OPM to provide managed
health care services to federal employees, annuitants and their dependents under
the FEHBP. In the normal course of business, OPM audits health plans with which
it contracts mainly to verify that the premiums calculated and charged to OPM
are established in compliance with the best price 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
F-21
54
PACIFICARE HEALTH SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
10. COMMITMENTS AND CONTINGENCIES (CONTINUED)
year period. While the government's initial on-site audits are usually followed
by a post-audit briefing in which the government indicates its preliminary
results, final resolution and settlement of the audits have historically taken a
minimum of three to five years. In connection with the sales of our health plans
in New Mexico, Illinois and Utah, we have agreed to indemnify the buyers for
potential OPM liabilities that relate to the years in which we owned these
plans.
We intend to negotiate with OPM on all unresolved matters to attain a mutually
satisfactory result. There can be no assurance that these negotiations will be
concluded satisfactorily, that additional audits will not be referred to the
DOJ, or that additional, possibly material, liability will not be incurred. We
believe that any ultimate liability in excess of amounts accrued would not
materially affect our consolidated financial position. However, such liability
could have a material effect on results of operations or cash flows of a future
quarter if resolved unfavorably.
In addition to claims made by the OPM auditors as part of the normal audit
process, OPM may also refer their results to the United States Department of
Justice ("DOJ") for potential legal action under the False Claims Act. The DOJ
has the authority to file a claim under the False Claims Act if it believes that
the health plan knowingly overcharged the government or otherwise submitted
false documentation or certifications. In False Claims Act actions, the
government may impose trebled damages and a civil penalty of not less than
$5,000 nor more than $10,000 for each separate alleged false claim. In November
1997, we were notified that the 1990 through 1995 audit of the operations of our
Oklahoma HMO subsidiary had been referred to the DOJ. In the third quarter of
1998 we recorded approximately $4 million ($2 million, or $0.04 diluted loss per
share, net of tax) for potential OPM claims. In January 1999, we preliminarily
agreed to settle the 1990-1995 Oklahoma OPM audits for $9 million. As a result
of this settlement and other changes in estimate, we recognized a pretax OPM
credit of $8 million ($4 million or $0.10 diluted income per share, net of tax).
LEGAL PROCEEDINGS. In 1997 we were served with several purported class action
suits alleging violations of federal securities laws by PacifiCare and by
certain of our officers and directors. The complaints related to the period from
the date of the FHP acquisition through our November 1997 announcement that
earnings for the fourth quarter of 1997 would be lower than expected. These
complaints primarily alleged that we previously omitted and/or misrepresented
material facts with respect to our costs, earnings and profits. We have filed a
motion to dismiss the entire complaint. No discovery has been taken, and all
discovery has been stayed pending the resolution of our motion to dismiss. We
believe we have good defenses to the claims in these suits and are contesting
them vigorously.
We are also involved in legal actions in the normal course of business, some of
which seek monetary damages, including claims of punitive damages that are not
covered by insurance. Based on current information and review with our lawyers,
management believes any ultimate liability which may arise from these actions
(including the purported class actions), would not materially affect our
consolidated financial position, results of operations or cash flows. However,
management's evaluation of the likely impact of these actions could change in
the future and an unfavorable outcome, depending upon the amount and timing,
could have a material effect on our results of operations or cash flows for a
future quarter.
LEASE COMMITMENTS. We lease office space and equipment under various
non-cancelable operating leases. Rental expense totaled $59 million in 1998, $48
million in 1997, $5 million in the 1996 transition period, and $29 million in
fiscal 1996.
Future minimum lease payments will be $49 million in 1999, $37 million in 2000,
$24 million in 2001, $17 million in 2002 and $13 million in 2003. Minimum lease
payments after 2003 will be $23 million.
In 1997, we entered into a real estate and equipment master transfer agreement
that allows us to lease, sublease or assign facilities and equipment that we own
or lease. The net book value of such facilities and
F-22
55
PACIFICARE HEALTH SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
10. COMMITMENTS AND CONTINGENCIES (CONTINUED)
equipment at December 31, 1998 was approximately $27 million. The leases are
accounted for as operating leases, and subleases are accounted for as rental
income. The agreement includes extensions of the individual leases to December
31, 2005, and two five-year extension options at prevailing market rates. These
options are exercisable solely at the lessee's discretion, and include a right
of first offer for the lessee to purchase the furniture, fixtures and equipment.
The parties terminated a separate lease agreement for furniture, fixtures and
equipment when the assets were sold in 1998.
EMPLOYMENT AGREEMENTS. We have employment agreements with our chief executive
officer and certain other executive officers. The agreements entitle these
officers to receive severance benefits, payable if employment is terminated for
various reasons, including termination following a change of ownership or
control of PacifiCare. The maximum severance amount we would owe these
executives according to their employment agreements (excluding amounts that may
be payable under incentive plans and the value of certain other benefits) was
approximately $11 million at December 31, 1998.
11. COMPREHENSIVE INCOME
The following tables summarize the components of other comprehensive income
(loss) for the periods indicated:
INCOME
TAX NET-OF-
PRETAX EXPENSE TAX
AMOUNT (BENEFIT) AMOUNT
-------- --------- -------
(IN THOUSANDS)
1998:
Unrealized holding gains arising during the period.......... $ 12,766 $ 5,538 $ 7,228
Less: reclassification adjustment for net gains realized in
net income................................................ (17,418) (7,556) (9,862)
-------- ------- -------
Other comprehensive loss.................................... $ (4,652) $(2,018) $(2,634)
======== ======= =======
1997:
Unrealized holding gains arising during the period.......... $ 12,806 $ 4,885 $ 7,921
Less: reclassification adjustment for net gains realized in
net income................................................ (2,229) (850) (1,379)
-------- ------- -------
Other comprehensive income.................................. $ 10,577 $ 4,035 $ 6,542
======== ======= =======
1996 TRANSITION PERIOD:
Unrealized holding gains arising during the period.......... $ 3,891 $ 1,487 $ 2,404
Less: reclassification adjustment for net gains realized in
net income................................................ (396) (150) (246)
-------- ------- -------
Other comprehensive income.................................. $ 3,495 $ 1,337 $ 2,158
======== ======= =======
FISCAL 1996
Unrealized holding gains arising during the period.......... $ 7,111 $ 2,750 $ 4,361
Less: reclassification adjustment for net gains realized in
net income................................................ (13,066) (5,054) (8,012)
-------- ------- -------
Other comprehensive loss.................................... $ (5,955) $(2,304) $(3,651)
======== ======= =======
F-23
56
REPORT OF ERNST & YOUNG LLP INDEPENDENT AUDITORS
The Board of Directors and Shareholders
PacifiCare Health Systems, Inc.
We audited the accompanying consolidated balance sheets of PacifiCare Health
Systems, Inc. as of December 31, 1998 and 1997, and the related consolidated
statements of operations, shareholders' equity and cash flows for the years
ended December 31, 1998 and 1997, the three months ended December 31, 1996 and
the year ended September 30, 1996. Our audits also included the financial
statement schedule listed in the Index at Item 14(a)(2). These consolidated
financial statements and schedule are the responsibility of the Company's
management. Our responsibility is to express an opinion on these consolidated
financial statements and schedule based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the consolidated financial statements are
free of material misstatement. An audit includes examining, on a test basis,
evidence supporting the amounts and disclosures in the consolidated financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the consolidated financial position of
PacifiCare Health Systems, Inc. at December 31, 1998 and 1997, and the
consolidated results of its operations and its cash flows for the years ended
December 31, 1998 and 1997, the three months ended December 31, 1996 and the
year ended September 30, 1996 in conformity with generally accepted accounting
principles. Also in our opinion, the related financial statement schedule, when
considered in relation to the basic consolidated financial statements taken as a
whole, presents fairly in all material respects the information set forth
therein.
ERNST & YOUNG LLP
Los Angeles, California
February 9, 1999
F-24
57
PACIFICARE HEALTH SYSTEMS, INC.
QUARTERLY INFORMATION FOR 1998 AND 1997 (UNAUDITED)
QUARTERS ENDED
-------------------------------------------------------------
MARCH 31 JUNE 30 SEPTEMBER 30(1) DECEMBER 31(1)
---------- ---------- --------------- --------------
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
1998
Operating revenue.................. $2,381,950 $2,396,259 $2,400,897 $2,342,376
Operating expenses................. 2,309,450 2,309,987 2,316,522 2,243,332
Net investment income.............. 25,304 23,850 29,193 25,959
Interest expense................... (17,518) (16,913) (13,828) (12,664)
---------- ---------- ---------- ----------
Income before income taxes......... 80,286 93,209 99,740 112,339
Provision for income taxes......... 38,940 44,338 46,509 53,360
---------- ---------- ---------- ----------
Net income......................... $ 41,346 $ 48,871 $ 53,231 $ 58,979
========== ========== ========== ==========
Preferred dividends................ (2,629) (2,630) -- --
---------- ---------- ---------- ----------
Net income available to common
shareholders..................... $ 38,717 $ 46,241 $ 53,231 $ 58,979
========== ========== ========== ==========
Basic earnings per share........... $ 0.93 $ 1.10 $ 1.17 $ 1.29
========== ========== ========== ==========
Diluted earnings per share......... $ 0.90 $ 1.06 $ 1.16 $ 1.28
========== ========== ========== ==========
Membership (4)..................... 3,689 3,660 3,645 3,527
========== ========== ========== ==========
1997(2)(3)
Operating revenue.................. $1,843,603 $2,381,100 $2,401,355 $2,356,622
Operating expenses................. 1,772,488 2,338,872 2,343,947 2,483,378
Net investment income.............. 17,685 20,368 22,196 20,416
Interest expense................... (9,719) (18,695) (18,069) (18,053)
---------- ---------- ---------- ----------
Income (loss) before income
taxes............................ 79,081 43,901 61,535 (124,393)
Provision for income taxes......... 35,587 25,904 30,767 (10,433)
---------- ---------- ---------- ----------
Net income (loss).................. $ 43,494 $ 17,997 $ 30,768 $ (113,960)
========== ========== ========== ==========
Preferred dividends................ (904) (2,630) (2,629) (2,629)
---------- ---------- ---------- ----------
Net income (loss) available to
common shareholders.............. $ 42,590 $ 15,367 $ 28,139 $ (116,589)
========== ========== ========== ==========
Basic earnings (loss) per share.... $ 1.17 $ 0.37 $ 0.67 $ (2.78)
========== ========== ========== ==========
Diluted earnings (loss) per
share............................ $ 1.12 $ 0.37 $ 0.67 $ (2.78)
========== ========== ========== ==========
Membership (4)..................... 3,849 3,841 3,834 3,792
========== ========== ========== ==========
- ---------------
(1) We recognized pretax charges in the third quarter of 1998 totaling $19
million ($10 million or $0.22 diluted loss per share, net of tax). These
charges included approximately $15 million ($8 million or $0.18 diluted loss
per share, net of tax) for the disposal of the Utah HMO and workers'
compensation subsidiaries. The charges also included approximately $4
million ($2 million, or $0.04 diluted loss per share, net of tax) for
potential OPM claims. The 1998 charges were partially offset by $8 million
($4 million or $0.10 diluted earnings per share, net of tax) for favorable
OPM settlements in the fourth quarter. See Notes 9 and 10 of the Notes to
Consolidated Financial Statements.
(2) The 1997 results include the results of operations for the FHP acquisition
from February 14, 1997. See Note 4 of the Notes to Consolidated Financial
Statements.
(3) The December 31, 1997 results include $155 million of pretax charges ($129
million or $3.18 diluted loss per share, net of tax) for the impairment of
long-lived assets, restructuring and certain other charges. See Note 9 of
the Notes to Consolidated Financial Statements.
(4) Membership as of quarter end.
F-25
58
PACIFICARE HEALTH SYSTEMS, INC. AND SUBSIDIARIES
SCHEDULE II -- VALUATION AND QUALIFYING ACCOUNTS
(AMOUNTS IN THOUSANDS)
YEAR ENDED YEAR ENDED THREE MONTHS ENDED FISCAL YEAR ENDED
DECEMBER 31, 1998 DECEMBER 31, 1997 DECEMBER 31, 1996 SEPTEMBER 30, 1996
----------------- ----------------- ------------------ ------------------
Allowance for doubtful
accounts:
Beginning balance........... $13,598 $ 1,048 $ 890 $690
FHP acquisition............. -- 7,036 -- --
Additions:
Charged to costs and
expenses................. 1,485 5,171 296 999
Charged to other accounts... (4,850) 3,620 (92) (85)
Deductions/write offs......... (1,704) (3,277) (46) (714)
------- ------- ------ ----
Ending balance................ $ 8,529 $13,598 $1,048 $890
======= ======= ====== ====
F-26
59
PACIFICARE HEALTH SYSTEMS, INC.
EXHIBIT INDEX
EXHIBIT
NUMBER DESCRIPTION
- ------- -----------
3.01 Amended and Restated Certificate of Incorporation of the
Registrant [incorporated by reference to Exhibit 3.01 to the
Registrant's Form 10-K for the year ended December 31,
1997].
3.02 Certificate of Amendment of Amended and Restated Certificate
of Incorporation of the Registrant [incorporated by
reference to Exhibit 3.02 to the Registrant's Form 10-K for
the year ended December 31, 1997].
3.03 Bylaws of the Registrant, as amended.
4.01 Form of Specimen Certificate for Registrant's Class A Common
Stock [incorporated by reference to Exhibit 4.01 to the
Registrant's Form 8-K, dated February 21, 1997].
4.02 Form of Specimen Certificate for Registrant's Class B Common
Stock [incorporated by reference to Exhibit 4.02 to the
Registrant's Form 8-K, dated February 21, 1997].
4.03 First Supplemental Indenture, dated as of February 14, 1997,
by and among the Registrant, FHP International Corporation
and The Chase Manhattan Bank, N.A. [incorporated by
reference to Exhibit 4.01 to the Registrant's Form 10-Q for
the quarter ended March 31, 1997].
10.01 Employment Agreement, dated December 1, 1994, between the
Registrant and Alan R. Hoops [incorporated by reference to
Exhibit 10.2 to the Registrant's Form 10-Q for the quarter
ended December 31, 1994].(1)
10.02 Employment Agreement, dated December 12, 1994, between the
Registrant and Jeffrey M. Folick [incorporated by reference
to Exhibit 10.3 to the Registrant's Form 10-Q for the
quarter ended December 31, 1994].(1)
10.03 Employment Agreement, dated June 15, 1998, between the
Registrant and Robert B. Stearns [incorporated by reference
to Exhibit 10.01 to the Registrant's Form 10-Q for the
quarter ended September 30, 1998].(1)
10.04 Employment Agreement, dated October 6, 1997, between the
Registrant and Bradford A. Bowlus.(1)
10.05 Employment Agreement, dated June 10, 1996, between the
Registrant and Linda M. Lyons, MD, as amended January 1,
1998 and February 9, 1998.(1)
10.06 Form of Contract With Eligible Medicare+Choice Organization
for the period January 1, 1999 through December 31, 1999
between PacifiCare of California and the Health Care
Financing Administration.
10.07 1996 Stock Option Plan for Officers and Key Employees of the
Registrant [incorporated by reference to Exhibit 10.05 to
Registrant's Form 8-B, dated January 23, 1997].(1)
10.08 1996 Non-Officer Directors Stock Option Plan of the
Registrant [incorporated by reference to Exhibit 10.06 to
Registrant's Form 8-B, dated January 23, 1997].(1)
10.09 1996 Management Incentive Compensation Plan of the
Registrant [incorporated by reference to Exhibit 10.07 to
Registrant's Form 8-B, dated January 23, 1997].(1)
10.10 1996 Long-Term Performance Incentive Plan of the Registrant
[incorporated by reference to Exhibit 10.08 to Registrant's
form 8-B, dated January 23, 1997].(1)
10.11 Amended 1997 Premium Priced Stock Option Plan of the
Registrant [incorporated by reference to Exhibit A to
Registrant's Definitive Proxy Statement, dated April 28,
1998].(1)
10.12 First Amendment to Amended 1997 Premium Priced Stock Option
Plan, dated as of August 27, 1998.(1)
10.13 PacifiCare Health Systems, Inc. Statutory Restoration Plan
[incorporated by reference to Exhibit 10.15 to the
Registrant's Form 10-K for the year ended December 31,
1997].(1)
E-1
60
PACIFICARE HEALTH SYSTEMS, INC.
EXHIBIT INDEX
EXHIBIT
NUMBER DESCRIPTION
- ------- -----------
10.14 PacifiCare Health Systems, Inc. Non-Qualified Deferred
Compensation Plan [incorporated by reference to Exhibit
10.16 to the Registrant's Form 10-K for the year ended
December 31, 1997].(1)
10.15 PacifiCare Health Systems, Inc. Stock Unit Deferred
Compensation Plan [incorporated by reference to Exhibit
10.17 to the Registrant's Form 10-K for the year ended
December 31, 1997].(1)
10.16 Credit Agreement, dated as of October 31, 1996, among
Registrant, the several financial institution from time to
time party to the Credit Agreement, The Bank of New York,
The Bank of Nova Scotia, Banque Nationale de Paris, Dai-Ichi
Kangyo Bank, Ltd., The Industrial Bank of Japan Limited,
RaboBank Nederland, Sanwa Bank of California, The Sumitomo
Bank, Limited and Wells Fargo Bank, N.A., as co-agents, The
Chase Manhattan Bank and CitiCorp USA, Inc. as managing
agents, and Bank of America National Trust and Savings
Association, as agent for the Banks [incorporated by
reference to Exhibit 10.01 to the Registrant's Registration
Statement on Form S-4 (File No. 333-16271)].
10.17 First Amendment to Credit Agreement, dated as of August 15,
1997, among the Registrant, the Banks party to the Credit
Agreement, dated as of October 31, 1996, and Bank of America
National Trust and Savings Association, as Agent
[incorporated by reference to Exhibit 10.12 to the
Registrant's Form 10-K for the year ended December 31,
1997].
10.18 Second Amendment to Credit Agreement, dated as of December
31, 1997 among the Registrant, the Banks party to the Credit
Agreement, dated as of October 31, 1996, and Bank of America
National Trust and Savings Association, as Agent
[incorporated by reference to Exhibit 10.13 to the
Registrant's Form 10-K for the year ended December 31,
1997].
21 List of Subsidiaries.
23 Consent of Ernst & Young LLP Independent Auditors.
27 Financial Data Schedules (filed electronically).
- ---------------
(1) Management contract or compensatory plan or arrangement required to be filed
as an exhibit to this Form 10-K pursuant to Item 14(c) of Form 10-K.
E-2