UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(MARK ONE)
[X]
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF
THE SECURITIES EXCHANGE ACT OF 1934
For the Quarterly Period ended September 30, 2002
OR
[ ]
TRANSITIONAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF
THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from _________ to ________
COMMISSION FILE NUMBER 001-31513
WELLCHOICE, INC.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
DELAWARE 71-0901607
(State or other jurisdiction of (I.R.S. Employer
Incorporation or organization) Identification Number)
11 WEST 42ND STREET
NEW YORK, NEW YORK 10036
(Address of principal executive offices) (Zip Code)
REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (212) 476-7800
NOT APPLICABLE
(FORMER NAME, FORMER ADDRESS AND FORMER FISCAL YEAR,
IF CHANGED SINCE LAST REPORT)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes [ ] No [X]*
Indicate by check mark whether the registrant is an accelerated filer
(as defined in Rule 12b-2 of the Exchange Act). Yes [ ] No [X]
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practicable date. 83,490,477 shares of common
stock, $0.01 par value, and one share of Class B common stock, $0.01 par value
per share, as of December 17, 2002.
_____________
* See Explanatory Note
1
WELLCHOICE, INC
INDEX TO FORM 10-Q
PAGE
INTRODUCTORY NOTE.............................................................................3
PART I FINANCIAL INFORMATION..........................................................4
ITEM 1. FINANCIAL STATEMENTS...............................................................4
Consolidated Balance Sheets at September 30, 2002 and
December 31, 2001 (Unaudited) ..............................................4
Consolidated Income Statements for the Three Months and
Nine Months Ended September 30, 2002 and 2001
(Unaudited) ................................................................6
Consolidated Statements of Cash Flows for the Nine Months
Ended September 30, 2002 and 2001 (Unaudited)...............................7
Notes to Consolidated Financial Statements (Unaudited)...............................8
Report of Independent Accountants...................................................16
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS...........................................................17
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK........................32
ITEM 4. CONTROLS AND PROCEDURES...........................................................33
PART II OTHER INFORMATION.............................................................33
ITEM 1. LEGAL PROCEEDINGS.................................................................33
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS.........................................34
ITEM 5. OTHER INFORMATION.................................................................35
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K..................................................35
SIGNATURES ..................................................................................36
CERTIFICATIONS...............................................................................37
INDEX TO EXHIBITS............................................................................39
2
INTRODUCTORY NOTE
This quarterly report is filed by WellChoice, Inc. ("WellChoice"), a
Delaware corporation that was incorporated in August 2002 and is our first
quarterly report. As discussed in Part I of this report, the historical
financial statements included in this report reflect Empire HealthChoice, Inc.
("HealthChoice") and its subsidiaries. On November 7, 2002, HealthChoice
converted from a not-for-profit health service corporation to a for-profit
accident and health insurer under the insurance laws of the State of New York
and HealthChoice and its subsidiaries became wholly owned direct and indirect
subsidiaries of WellChoice. Also on November 7, 2002 (and as discussed in detail
in Part II of this report), following the conversion, the Securities and
Exchange Commission declared effective the Registration Statement on Form S-1
(File No. 333-99051) filed by WellChoice with respect to the initial public
offering of its common stock (the "IPO") and, thereafter, WellChoice completed
its IPO. Prior to the completion of the conversion and IPO, WellChoice did not
engage in any operations. We have included certain limited pro forma information
in this report consistent with the presentation of this information in the
aforementioned registration statement in order to provide investors with
information that gives effect to the conversion.
We are filing this quarterly report within 45 days after the effective
date of the IPO registration statement, as required by Rule 13a-13(a) under the
Securities Exchange Act of 1934.
All financial data presented in this report has been prepared in
accordance with generally accepted accounting principles, or GAAP. YOU SHOULD BE
AWARE THAT THE NEW YORK STATE DEPARTMENT OF INSURANCE RECOGNIZES ONLY STATUTORY
ACCOUNTING PRACTICES FOR DETERMINING AND REPORTING THE FINANCIAL CONDITION AND
RESULTS OF OPERATIONS OF AN INSURANCE COMPANY, FOR DETERMINING ITS SOLVENCY
UNDER THE NEW YORK INSURANCE LAWS AND FOR DETERMINING WHETHER ITS FINANCIAL
CONDITION WARRANTS THE PAYMENT OF A DIVIDEND TO ITS STOCKHOLDERS. NO
CONSIDERATION IS GIVEN BY THE NEW YORK STATE DEPARTMENT OF INSURANCE TO
FINANCIAL STATEMENTS PREPARED IN ACCORDANCE WITH GAAP IN MAKING SUCH
DETERMINATIONS.
3
Empire HealthChoice, Inc. and Subsidiaries
Consolidated Balance Sheets
(Unaudited)
SEPTEMBER 30, DECEMBER 31,
2002 2001
----------------------------------------
(In thousands)
ASSETS
Investments:
Fixed maturities, at fair value (amortized cost: $970,259
and $909,497) $ 991,281 $ 919,864
Marketable equity securities, at fair value (cost: $48,482
and $23,482) 40,431 23,418
Short-term investments 231,712 225,298
Other long-term equity investments 29,679 27,157
----------------------------------------
Total investments 1,293,103 1,195,737
Cash and cash equivalents 361,326 408,588
----------------------------------------
Total investments and cash and cash equivalents 1,654,429 1,604,325
Receivables:
Billed premiums, net 128,477 135,965
Accrued premiums 243,594 267,583
Other amounts due from customers, net 85,419 68,453
Notes receivable, net 11,954 10,449
Advances to hospitals, net 326 1,613
Accrued investment income 10,065 9,446
Insurance proceeds receivable - 13,716
Miscellaneous, net 57,024 49,358
----------------------------------------
Total receivables 536,859 556,583
Property, equipment and information systems, net of accumulated
depreciation 104,041 102,949
Prepaid pension expense 43,472 39,253
Deferred taxes, net 338,009 118,904
Other 34,034 27,573
----------------------------------------
Total assets $ 2,710,844 $ 2,449,587
========================================
See notes to consolidated financial statements.
4
SEPTEMBER 30, SEPTEMBER 30, DECEMBER 31,
2002 PRO FORMA 2002 2001
-----------------------------------------------------------
(In thousands, except share and
per share data)
LIABILITIES AND RESERVE FOR POLICYHOLDERS' PROTECTION
Liabilities:
Unpaid claims and claims adjustment expense $ 580,413 $ 634,130
Unearned premium income 97,460 120,182
Managed cash overdrafts 168,730 174,602
Accounts payable and accrued expenses 89,291 114,713
Advance deposits 142,014 211,256
Group and other contract liabilities 109,673 96,554
Postretirement benefits other than pensions 146,314 138,206
Obligations under capital lease 48,270 50,079
Other 104,732 80,620
--------------------------------------
Total liabilities 1,486,897 1,620,342
Reserve for policyholders' protection:
Common stock, $0.01 par value, 225,000,000 shares
authorized; 83,490,477 shares issued and
outstanding $ 835
Class B common stock, $0.01 per share value, one
share authorized; one share issued and outstanding
-
Preferred stock, $0.01 per share value, 25,000,000
shares authorized; none issued and outstanding -
Additional paid-in capital 1,205,604
Retained earnings -
Unassigned reserves - 1,206,439 813,310
Accumulated other comprehensive income 17,508 17,508 15,935
-----------------------------------------------------------
Total reserve for policyholders' protection $ 1,223,947 1,223,947 829,245
=====================--------------------------------------
Total liabilities and reserves for policyholders'
protection $ 2,710,844 $ 2,449,587
======================================
See notes to consolidated financial statements.
5
Empire HealthChoice, Inc. and Subsidiaries
Consolidated Statements of Income
(Unaudited)
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30 SEPTEMBER 30
--------------------------- ---------------------------
2002 2001 2002 2001
--------------------------- ---------------------------
(In thousands)
Revenue:
Premiums earned $ 1,101,502 $ 1,043,151 $ 3,461,319 $ 3,205,353
Administrative service fees 104,255 80,419 298,553 240,673
Investment income, net 15,945 17,681 50,354 54,942
Net realized investment (losses) gains (139) 94 (545) (5,388)
Other (expense) income, net (359) 279 13,265 3,083
----------------------------------------------------------
Total revenue 1,221,204 1,141,624 3,822,946 3,498,663
Expenses:
Cost of benefits provided 916,035 919,922 2,973,041 2,835,194
Administrative expenses 213,367 184,769 614,679 555,661
Conversion and IPO expenses 4,578 303 8,206 1,645
----------------------------------------------------------
Total expenses 1,133,980 1,104,994 3,595,926 3,392,500
----------------------------------------------------------
Income from continuing operations before
income taxes 87,224 36,630 227,020 106,163
Income tax benefit (expense) 167,185 (90) 167,165 (138)
----------------------------------------------------------
Income from continuing operations 254,409 36,540 394,185 106,025
Loss from discontinued operations,
net of taxes of $0 - (5,552) (1,056) (12,563)
----------------------------------------------------------
Net income $ 254,409 $ 30,988 $ 393,129 $ 93,462
==========================================================
PRO FORMA INFORMATION (1)
---------------------------------------------
NINE MONTHS ENDED YEAR ENDED
SEPTEMBER 30, 2002 DECEMBER 31, 2001
---------------------------------------------
(In thousands, except share and
per share data)
Pro forma administrative expenses (2) $ 641,979 $ 784,777
Pro forma income from continuing operations before income taxes $ 199,720 $ 105,565
Pro form income tax expense (3) $ 84,462 $ 45,528
Pro forma net income $ 114,572 $ 49,343
Pro form earnings per common share $ 1.37 $ 0.59
Shares used to compute pro forma earnings per share 83,490,477 83,490,477
(1) Following the conversion, Empire HealthChoice, Inc. ("HealthChoice")
is a for-profit entity and is subject to state and local taxes as well
as federal income taxes at the statutory rate of 35%.
(2) Includes an estimate of premium and sales and use tax expense of
$27,300 and $42,000 for the nine months ended September 30, 2002 and
the year ended December 31, 2001, respectively.
(3) Includes an estimate of state and local income tax expense of $22,400
and $13,200 for the nine months ended September 30, 2002 and the year
ended December 31, 2001, respectively. Federal income tax expense was
computed at the statutory rate of 35%.
See notes to consolidated financial statements.
6
Empire HealthChoice, Inc. and Subsidiaries
Condensed Consolidated Statements of Cash Flows
(Unaudited)
NINE MONTHS ENDED
SEPTEMBER 30
---------------------------------------
2002 2001
---------------------------------------
(In thousands)
NET CASH PROVIDED BY OPERATING ACTIVITIES $ 78,198 $ 176,577
CASH FLOWS FROM INVESTING ACTIVITIES
Purchases of property, equipment and information systems
(27,875) (26,519)
Proceeds from sale of property, equipment and
information systems 1,349 -
Purchases of available-for-sale investments (1,089,374) (361,212)
Proceeds from sales and maturities of available-
for-sale investments 992,250 467,187
---------------------------------------
Net cash (used in) provided by investing activities (123,650) 79,456
---------------------------------------
CASH FLOWS FROM FINANCING ACTIVITIES
Decrease in capital lease obligations (1,810) (1,422)
---------------------------------------
Net cash used in financing activities (1,810) (1,422)
---------------------------------------
Net change in cash and cash equivalents (47,262) 254,611
Cash and cash equivalents at beginning of period 408,588 325,560
---------------------------------------
Cash and cash equivalents at end of period $ 361,326 $ 580,171
=======================================
See notes to consolidated financial statements.
7
EMPIRE HEALTHCHOICE, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
(DOLLARS IN THOUSANDS)
1. FOR-PROFIT CONVERSION AND INITIAL PUBLIC OFFERING
On November 7, 2002, Empire HealthChoice, Inc. ("HealthChoice")
converted from a not-for-profit health service corporation to a for-profit
accident and health insurer under the New York insurance laws and the converted
HealthChoice issued all of its authorized capital stock to the New York Public
Asset Fund (the "Fund") and The New York Charitable Asset Foundation (the
"Foundation"). The Fund and the Foundation then received their respective shares
of WellChoice, Inc. ("WellChoice") common stock in exchange for the transfer of
all the outstanding shares of HealthChoice to a wholly-owned subsidiary of
WellChoice. WellChoice was formed in August 2002 as a Delaware corporation to be
the for-profit parent holding company for HealthChoice and subsidiaries
(collectively, the "Company") after the conversion. Pursuant to the plan of
conversion, WellChoice issued 82,300,000 shares to the Fund and the Foundation
and completed an initial public offering of 19,199,000 shares of common stock,
consisting of 18,008,523 shares that were sold by the Fund and Foundation and
1,190,477 newly issued shares of common stock sold by WellChoice. After
deducting the underwriting discount, net proceeds to WellChoice were
approximately $27,991.
The conversion was accounted for as a reorganization using the
historical carrying values of the Company's assets and liabilities. Immediately
following the conversion, the Company's unassigned reserves were reclassified to
par value of common stock and additional paid-capital. Concurrently,
HealthChoice became a wholly-owned subsidiary of WellChoice. The costs of the
conversion were recognized as an expense.
2. BASIS OF PRESENTATION
The accompanying unaudited consolidated financial statements have been
prepared in accordance with accounting principles generally accepted in the
United States for interim financial information and with the instructions to
Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all
of the information and footnotes required by accounting principles generally
accepted in the United States for complete financial statements. In the opinion
of management, all adjustments (consisting of normal recurring accruals)
considered necessary for fair presentation have been included. Operating results
for the three- and nine-month periods ended September 30, 2002 are not
necessarily indicative of results that may be expected for the year ending
December 31, 2002.
The balance sheet at December 31, 2001 has been derived from the
audited financial statements at that date but does not include all of the
information and footnotes required by accounting principles generally accepted
in the United States for complete financial statements.
For further information refer to the consolidated financial statements
and footnotes thereto included in the WellChoice's Registration Statement on
Form S-1 (File No. 333-99051), declared effective by the Securities and Exchange
Commission on November 7, 2002.
8
EMPIRE HEALTHCHOICE, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED) (CONTINUED)
(DOLLARS IN THOUSANDS)
2. BASIS OF PRESENTATION (CONTINUED)
The changes in value of securities included in other comprehensive
income include unrealized gains of $1,219 and $16,154 for the nine months ended
September 30, 2002 and 2001, respectively, reduced by the tax effects of $656
and $6,834 for the nine months ended September 30, 2002 and 2001, respectively,
and reclassification adjustments for realized losses of $353 and $3,501 for the
nine months ended September 30, 2002 and 2001, respectively, reduced by the tax
effects of $191 and $1,886 for the nine months ended September 30, 2002 and
2001, respectively.
3. INCOME TAXES
Prior to January 1, 1987, HealthChoice was exempt from federal income
taxes. With the enactment of the Tax Reform Act of 1987, HealthChoice and all
other Blue Cross and Blue Shield plans, became subject to federal income tax.
Among other provisions of the Internal Revenue Code (the "IRC"), these plans
were granted a special deduction (the "833(b) deduction") for regular tax
calculation purposes. Various other Blue Cross and Blue Shield plans had
previously been subjected to Internal Revenue Service ("IRS") challenges due to
the ordering of their respective special deductions and their available regular
tax loss carryforwards. Consistent with recent IRS rulings, the Company's
position with regard to tax deduction ordering is that the special deduction
must be taken before any regular tax loss carryforward deduction. The Company
has followed this position and the related tax deduction ordering methodology in
all its federal income tax return filings. As a result of the 833(b) deduction,
HealthChoice currently incurs no regular tax liability but in profitable years,
has paid taxes at the alternative minimum tax rate of 20%.
The 833(b) deduction is calculated as the excess of 25% of the incurred
claim and claim adjustment expenses for the tax year over adjusted surplus, as
defined, limited to taxable income. The amount of 833(b) deductions utilized in
each tax year is accumulated in an adjusted surplus balance. Once the cumulative
adjusted surplus balance exceeds the 833(b) deduction for the current taxable
year, the deduction is eliminated.
The regular operating loss carryforwards (totaling $519,617 at
September 30, 2002 on a pretax basis) cannot be used until the Section 833(b)
deduction is exhausted. Accordingly, the Company estimates future taxable
income, including when the Section 833(b) deduction will be exhausted, and
consider whether it is more likely than not that some or all of the operating
loss carryforwards can be utilized within an appropriate period. Prior to
September 30, 2002, the Company maintained a valuation allowance on its regular
tax net operating loss carryforwards due to uncertainty in the Company's ability
to utilize these assets in the future. The use of these assets was largely
dependent on the conversion and future positive taxable income. On October 8,
2002, the New York State Insurance Department approved the plan of conversion.
With the uncertainty of conversion removed, HealthChoice reevaluated its tax
position for financial statement reporting purposes at September 30, 2002 and
determined that when HealthChoice converted to a for-profit entity, its ability
to continue to utilize the Section 833(b) deduction was uncertain. No authority
directly addresses whether a conversion transaction will render the Section
833(b) deduction unavailable. The Company is aware, however, that the IRS has
taken the position related to other Blue Cross Blue Shield plans that a
conversion could result in the inability of a Blue
9
EMPIRE HEALTHCHOICE, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED) (CONTINUED)
(DOLLARS IN THOUSANDS)
3. INCOME TAXES (CONTINUED)
Cross Blue Shield plan to utilize the Section 833(b) deduction. In light of the
absence of governing authority, while the Company intends to continue to take
the deduction on its tax returns after the conversion, the Company will assume,
for financial statement reporting purposes, that the deduction will be
disallowed. This means that, in projecting future taxable income, it is now more
likely than not that the Company will utilize its tax loss and credit carryovers
within a reasonable period and, accordingly, this portion of the valuation
allowance is no longer necessary. Therefore, at September 30, 2002 the valuation
allowance was reduced, which resulted in the recognition of a $176,952 deferred
tax benefit.
Because the tax law bases the availability of the Section 833(b)
deduction on the status of a company at the end of the year, the Company expects
to incur federal income tax expense of approximately $75,000 in the fourth
quarter of 2002, primarily for the reversal of Section 833(b) deductions taken
in the first three quarters of 2002. The Company believes that subsequent to the
conversion, the effective federal income tax rate will approximate the 35%
statutory rate.
The significant components of the provision for income tax benefit
(expense) are as follows:
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30 SEPTEMBER 30
----------------------------- ---------------------------
2002 2001 2002 2001
----------------------------------------------------------
Current tax expense $ (23,386) $ (9,226) $ (52,786) $ (23,444)
Deferred tax benefit 190,571 9,136 219,951 23,306
----------------------------------------------------------
Income tax benefit (expense) $ 167,185 $ (90) $ 167,165 $ (138)
==========================================================
10
EMPIRE HEALTHCHOICE, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED) (CONTINUED)
(DOLLARS IN THOUSANDS)
3. INCOME TAXES (CONTINUED)
A reconciliation of income tax computed at the federal statutory tax
rate of 35% to total income tax is as follows:
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30 SEPTEMBER 30
------------------------------ -----------------------------
2002 2001 2002 2001
---------------------------------------------------------------
Income tax at prevailing corporate
tax rate applied to pre-tax income $ (30,529) $ (10,877) $ (79,088) $ (32,760)
Increase (decrease):
IRC Sec. 833(b) special deduction 19,205 12,082 73,472 35,092
Change in valuation reserve 176,952 3,646 170,546 2,474
Other 1,557 (4,941) 2,235 (4,944)
---------------------------------------------------------------
Income tax benefit (expense) $ 167,185 $ (90) $ 167,165 $ (138)
===============================================================
The Company's regular tax loss carryforwards of $519,617 at September
30, 2002 expire between the years 2002 and 2022; of this amount, $90,025 expires
in 2002. The Company's alternative minimum tax credit carryforward of $111,744
has no expiration date.
4. INFORMATION TECHNOLOGY OUTSOURCING
In June 2002, the Company entered into a ten-year outsourcing agreement
with International Business Machines Corporation ("IBM"). Under the terms of the
contract, IBM is responsible for operating WellChoice's data center, technical
help desk and applications development. IBM's charges under the contract
included personnel, calculated as a function of IBM's cost for personnel
dedicated to the outsourcing; computer equipment, based on equipment usage
rates; space, based on actual usage rates; and certain other costs.
IBM is expected to charge WellChoice approximately $732,300 over the
term of the agreement for operating WellChoice's data center and technical help
desk.
The agreement provides for IBM to assist WellChoice in developing new
systems. In connection with these services, WellChoice is obligated to purchase
$65,000 in modernization services from IBM.
Additionally, IBM, in coordination with deNovis, Inc. ("deNovis") has
agreed to develop a new claims payment system and to license it to WellChoice.
WellChoice will pay a development and license fee of $50,000 for the license
granted by IBM, with $25,000 due in 2004 and $25,000 due in 2005. However,
WellChoice will have no obligation to pay the development and license fee if the
11
EMPIRE HEALTHCHOICE, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED) (CONTINUED)
(DOLLARS IN THOUSANDS)
4. INFORMATION TECHNOLOGY OUTSOURCING (CONTINUED)
successful completion and delivery of the claims payment system does not occur.
Beginning in 2005, WellChoice will pay an annual maintenance fee of $10,000.
Under the terms of the contract, WellChoice is entitled to 2% of IBM's gross
revenues from licensing the claims payment system to third parties for the term
for the IBM outsourcing contract, including any extensions.
The Company received warrants from deNovis to purchase 2 million shares
of deNovis Series B Preferred Stock. These warrants are exercisable for four
years from when the Company has paid in full for the claims payment system.
Subject to the purchase by IBM of deNovis common stock, the Company was also
assigned IBM's contractual rights to warrants to purchase an additional
4,094,984 shares of deNovis Series B Preferred Stock, which are exercisable
through July 31, 2006. The value of these warrants determined using the
Black-Scholes model was $2,851. This amount is included in the balance sheet as
of September 30, 2002 in both other long-term equity investments and, as a
deferred contract incentive in other liabilities. The deferred contract
incentive will be amortized over the term of the outsourcing agreement.
WellChoice will own all software developed by IBM under the agreement,
other than the claims payment system. All such software in which WellChoice will
have all rights, title and interest will be accounted for in accordance with SOP
98-1, "Accounting for the Costs of Computer Software Developed or Obtained for
Internal Use" ("SOP 98-1").
In connection with the agreement, the Company sold computer equipment
with a net book value of $1,736 to IBM. No gain or loss on the sale of the
computer equipment was recognized. Also in connection with the agreement, the
Company licensed to IBM its Internet portal technology for an upfront initial
license fee of $2,000. In accordance with SOP 98-1, the Company applied the
proceeds from the license of the Internet portal technology to the book value of
the assets and no gain or loss was recorded. Under the agreement, IBM has the
right to sublicense the Internet portal technology to third parties and
WellChoice will receive 4% of IBM's gross revenues from its licensing of the
Internet portal technology for fifteen years.
The agreement can be terminated by either WellChoice or IBM in certain
circumstances for cause without penalty. WellChoice can terminate the contract
without cause after two years or if it experiences a change in control and, in
such instances, would be obligated to pay certain termination costs, which vary
based on the duration of the contract but are significant in the early years, to
IBM.
During the second quarter of 2002, in connection with the IBM
outsourcing, the Company began the implementation of a plan relating to its
information technology personnel. Certain employees were involuntarily
terminated in accordance with a plan of termination, certain employees were
retained by the Company and certain employees were transitioned to IBM.
Severance and other costs accrued at June 30, 2002 relating to the plan of
termination were $5,351. Payments related to these costs of approximately $521
were made during the three months ended September 30, 2002. To help retain its
employees and to help IBM retain its newly transitioned employees, the Company
offered stay bonuses for these individuals. The estimated maximum cost of these
12
EMPIRE HEALTHCHOICE, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED) (CONTINUED)
(DOLLARS IN THOUSANDS)
4. INFORMATION TECHNOLOGY OUTSOURCING (CONTINUED)
bonuses assuming all individuals remain with the Company or IBM through the
required dates, which range from 2003 to 2004 is approximately $8,518. At
September 30, 2002, approximately $1,112 was accrued for these bonuses. The
Company will recognize the cost of these stay bonuses in future periods as these
employees provide service.
5. CONTINGENCIES
The Company is subject to a number of lawsuits, investigations and
claims, some of which are class actions arising out of the conduct of its
business. The Company believes that it has meritorious defenses in all of these
matters and intends to vigorously defend its respective positions. The outcome
of these matters is not currently predictable and the damages, if any, are also
uncertain. The Company is also involved in and is subject to numerous claims,
contractual disputes and uncertainties in the ordinary course of business. In
the opinion of management, after consultation with legal counsel, the ultimate
disposition of these matters will not have a material adverse effect on the
Company's financial condition.
In June 2002, the Company settled a class action lawsuit for an
estimated $23,000 in claims and legal fees. This amount was included as a
liability in June 30, 2002 consolidated balance sheet. During the period from
June 2002 to September 2002, the members of the class were informed of their
right to receive payment, were required to respond, and the payments due to
respondents were determined. Based on the number of respondents to the class
action mailing through August 24, 2002 and the Company's estimate of the number
of late respondents to the mailing, the Company has revised its best estimate of
the ultimate liability for this action to $14,600. This change in estimate has
been recorded in the consolidated financial statements for the three-month
period ending September 30, 2002.
6. SEGMENT INFORMATION
Empire has two reportable segments: commercial managed care and other
insurance products and services. The commercial managed care segment includes
group preferred provider organization, or PPO, health maintenance organization,
or HMO (including Medicare+Choice), exclusive provider organization, or EPO, and
other products (principally dental only coverage) as well as the Company's New
York Cityand New York State PPO business. The New York City and New York State
PPO business accounts for approximately 29% of the Company's earned premium for
the nine months ended September 30, 2002. The other insurance products and
services segment consists of the Company's traditional indemnity products,
Medicare supplemental, individual hospital only, state sponsored individual
plans, government mandated individual plans and government contracts with CMS to
act as a fiscal intermediary for Medicare Part A program beneficiaries and as a
carrier for Medicare Part B program beneficiaries.
The reportable segments follow the Company's method of internal
reporting by products and services. The financial results of the Company's
segments are presented consistent with the accounting policies described in Note
2. Administrative expenses, investment income and other income, but not assets,
are allocated to the segments. There are no intersegment sales or expenses.
13
EMPIRE HEALTHCHOICE, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED) (CONTINUED)
(DOLLARS IN THOUSANDS)
6. SEGMENT INFORMATION (CONTINUED)
OTHER
COMMERCIAL INSURANCE
MANAGED PRODUCTS AND
CARE SERVICES TOTAL
--------------------------------------------
THREE MONTHS ENDED SEPTEMBER 30, 2002 (IN THOUSANDS)
Revenues from external customers $ 966,808 $238,949 $1,205,757
Investment income and net realized gains 13,186 2,620 15,806
Other revenue (297) (62) (359)
Income from continuing operations before income tax expense 72,637 14,587 87,224
THREE MONTHS ENDED SEPTEMBER 30, 2001
Revenues from external customers 845,096 278,474 1,123,570
Investment income and net realized gains 13,397 4,378 17,775
Other revenue 216 63 279
Income from continuing operations before income tax expense 30,112 6,518 36,630
NINE MONTHS ENDED SEPTEMBER 30, 2002
Revenues from external customers 2,929,354 830,518 3,759,872
Investment income and net realized gains 39,791 10,018 49,809
Other revenue 10,626 2,639 13,265
Income from continuing operations before income tax expense 193,278 33,742 227,020
NINE MONTHS ENDED SEPTEMBER 30, 2001
Revenues from external customers 2,560,930 885,096 3,446,026
Investment income and net realized gains 36,314 13,240 49,554
Other revenue 2,353 730 3,083
Income for continuing operations before income tax expense 88,863 17,300 106,163
14
EMPIRE HEALTHCHOICE, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED) (CONTINUED)
(DOLLARS IN THOUSANDS)
6. SEGMENT INFORMATION (CONTINUED)
The following table presents our revenue from external customers by
products and services:
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30 SEPTEMBER 30
-----------------------------------------------------------
2002 2001 2002 2001
-----------------------------------------------------------
(IN THOUSANDS)
Revenues from external customers:
Commercial managed care
Premiums earned:
PPO $ 559,027 $ 488,186 $1,748,852 $1,543,963
HMO 288,525 246,002 849,761 690,088
EPO 62,014 64,306 171,603 186,897
Other 968 9,130 2,423 25,207
Administrative service fees 56,274 37,472 156,715 114,775
-----------------------------------------------------------
Total commercial managed care 966,808 845,096 2,929,354 2,560,930
-----------------------------------------------------------
Other insurance products and services:
Premiums earned:
Indemnity 63,765 109,224 303,895 377,280
Individual 127,203 126,303 384,785 381,918
Administrative service fees 47,981 42,947 141,838 125,898
-----------------------------------------------------------
Total other insurance products and services 238,949 278,474 830,518 885,096
-----------------------------------------------------------
Total revenues from external customers $ 1,205,757 $ 1,123,570 $3,759,872 $3,446,026
===========================================================
7. SUBSEQUENT EVENTS
During the fourth quarter of 2002, the Company approved a restructuring
plan in order to increase overall productivity, and in part as a result of the
implementation of the technology outsourcing strategy. The Company estimates
that it will incur a charge of approximately $17,000 in the fourth quarter of
2002.
On October 17, 2002 WellChoice and the Company entered into a credit
and guaranty agreement with the Bank of New York, as Issuing Bank and
Administrative Agent, and several other financial institutions as agents and
lenders. The credit facility, which cannot exceed $100,000 became effective upon
the completion of the initial public offering.
15
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors of
WellChoice, Inc.
We have reviewed the accompanying consolidated balance sheet of Empire
HealthChoice, Inc. and subsidiaries (the "Company") as of September 30, 2002,
and the related consolidated statements of income for the three-month and
nine-month periods ended September 30, 2002 and 2001, and the consolidated cash
flows for the nine-month periods ended September 30, 2002 and 2001. These
financial statements are the responsibility of the Company's management.
We conducted our review in accordance with the standards established by
the American Institute of Certified Public Accountants. A review of interim
financial information consists principally of applying analytical procedures to
financial data, and making inquiries of persons responsible for financial and
accounting matters. It is substantially less in scope than an audit conducted in
accordance with auditing standards generally accepted in the United States,
which will be performed for the full year with the objective of expressing an
opinion regarding the financial statements taken as a whole. Accordingly, we do
not express such an opinion.
Based on our review, we are not aware of any material modifications
that should be made to the accompanying financial statements referred to above
for them to be in conformity with accounting principles generally accepted in
the United States.
We have previously audited, in accordance with auditing standards
generally accepted in the United States, the consolidated balance sheet of the
Company as of December 31, 2001, and the related consolidated statements of
income, reserves for policyholders' protection and cash flows for the year then
ended (not presented herein); and in our report dated February 8, 2002, we
expressed an unqualified opinion on those financial statements. In our opinion
the information set forth in the accompanying consolidated balance sheet as of
December 31, 2001, is fairly stated, in all material respects, in relation to
the consolidated balance sheet from which it was derived.
/s/ Ernst & Young LLP
New York, New York
November 7, 2002
16
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS.
The following discussion and analysis presents a review of WellChoice,
Inc. and its subsidiaries (collectively, the "Company") for the three and nine
months ended September 30, 2002 and 2001. This review should be read in
conjunction with the consolidated financial statements and other data presented
herein as well as Management's Discussion and Analysis of Financial Condition
and Results of Operations contained in the Company's final prospectus dated
November 7, 2002 on file with the Securities and Exchange Commission.
This report contains forward-looking statements that include
information about possible or assumed future sales, results of operations,
developments, regulatory approvals or other circumstances. Statements that use
the terms "believe," "expect," "plan," "intend," "estimate," "anticipate,"
"project," "may," "will," "shall," "should" and similar expressions, whether in
the positive or negative, are intended to identify forward-looking statements.
All forward-looking statements in this report are based on management's
estimates, assumptions and projections and are subject to significant risks and
uncertainties, many of which are beyond our control. Important risk factors
could cause actual future results and other future events to differ materially
from those estimated by management. Those risks and uncertainties include but
are not limited to: our ability to accurately predict health care costs and to
manage those costs through underwriting criteria, quality initiatives and
medical management, product design and negotiation of favorable provider
reimbursement rates; our ability to maintain or increase our premium rates;
possible reductions in enrollment in our health insurance programs or changes in
membership; the regional concentration of our business; and the impact of health
care reform and other regulatory matters. For a more detailed discussion of
these and other important factors that may materially affect WellChoice, please
see our filings with the Securities and Exchange Commission, including the risk
factors contained in WellChoice's final prospectus dated November 7, 2002, on
file with the Commission. Except as required by applicable law, including the
securities laws of the United States, we do not intend to update or revise any
forward-looking statements.
In this report, "WellChoice," "company," "we," "us," and "our" refer to
WellChoice, Inc., a Delaware corporation, and as the context requires, its
subsidiaries.
OVERVIEW
We are the largest health insurance company in the State of New York
based on total preferred provider organization, or PPO, and health maintenance
organization, or HMO, membership, which includes members under our insured and
administrative services only, or ASO, plans. We offer managed care and
traditional indemnity products to over 4.6 million members. We have licenses
with the Blue Cross Blue Shield Association which entitle us to the exclusive
use of the Blue Cross and Blue Shield names and marks in ten counties in the New
York City metropolitan area and in six counties in upstate New York, the
non-exclusive right to use the Blue Cross and Blue Shield names and marks in one
upstate New York county, the exclusive right to only the Blue Cross name and
mark in seven upstate New York counties and the non-exclusive right to only the
Blue Cross name in four upstate New York counties. We market our products and
services using these names and marks in our New York service areas. We also
market our managed care products in 16 counties in New Jersey under the
WellChoice brand.
We offer our products and services to a broad range of customers,
including large groups of more than 500 employees; middle market groups, ranging
from 51 to 500 employees; small groups, ranging from two to 50 employees and
individuals. Over one million of our members are employees of national accounts,
including Fortune 500 companies.
17
Our revenue primarily consists of premiums earned and administrative
service fees derived from the sale of managed care and traditional indemnity
health benefits products to employer groups and individuals. Premiums are
derived from insured contracts and administrative service fees are derived from
self-funded contracts, under which we provide a range of customer services,
including claims administration and billing and membership services. Revenue
also includes administrative service fees earned under the BlueCard program for
providing members covered by other Blue Cross and Blue Shield plans with access
to our network providers, reimbursements under our government contracts with the
Centers for Medicare and Medicaid Services, or CMS, to act as a fiscal
intermediary for Medicare Part A program beneficiaries and a carrier for
Medicare Part B program beneficiaries, and investment income.
Our cost of benefits provided expense consists primarily of claims paid
and claims in process and pending to physicians, hospital and other healthcare
providers and includes an estimate of amounts incurred but not yet reported.
Administrative expenses consist primarily of compensation expenses, commission
payments to brokers and other overhead business expenses.
We report our operating results as two business segments: commercial
managed care and other insurance products and services. Our commercial managed
care segment accounted for 82.4% of our membership as of September 30, 2002. Our
commercial managed care segment includes group PPO, HMO (including
Medicare+Choice), exclusive provider organization, or EPO, and other products
(principally dental only coverage) as well as our PPO business under our
accounts with New York City and New York State. Our other insurance products and
services segment consists of our indemnity and individual products. Our
indemnity products include traditional indemnity products and government
contracts with CMS to act as a fiscal intermediary and carrier. Our individual
products include Medicare supplemental, state sponsored plans, government
mandated individual plans and individual hospital-only. We allocate
administrative expenses, investment income and other income, but not assets, to
our segments. Except when otherwise specifically stated or where the context
requires, all references in this document to our membership include both our
insured and ASO membership. Our New York City and New York State account members
are covered under insured plans.
Our future results of operations will depend in part on our ability to
predict and control health care costs through underwriting criteria, utilization
management, product design and negotiation of favorable provider and hospital
contracts. Our ability to contain such costs may be adversely affected by
changes in utilization rates, demographic characteristics, the regulatory
environment, health care practices, inflation, new technologies, clusters of
high-cost cases, continued consolidation of physician, hospital and other
provider groups, acts of terrorism and bioterrorism or other catastrophes,
including war, and numerous other factors. The inability to mitigate any or all
of the above-listed or other factors may adversely affect our future
profitability.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
The following is an explanation of our accounting policies considered
most significant by management. These accounting policies require us to make
estimates and assumptions that affect the amounts reported in the financial
statements and accompanying notes. Such estimates and assumptions could change
in the future as more information is known. Actual results could differ
materially from those estimates.
REVENUE RECOGNITION
Our membership contracts generally have one year terms and are subject
to cancellation upon 60 days written notice. Premiums are generally due monthly
and are recognized as revenue during the period in which we are obligated to
provide services to our members. We record premiums received prior to such
18
periods as unearned premiums. We record premiums earned net of an allowance for
doubtful accounts. Premiums recorded for groups with certain funding
arrangements are based upon the actual and estimated claim experience of these
groups. Future adjustments to the claims experience of these groups will result
in changes in premium revenue. Our estimated claim experience is based on a
number of factors, including our prior claims experience. These estimates are
continually reviewed and adjusted based on actual claims experience. Any changes
in these estimates are included in current period results. Funds received from
these groups in excess of premiums recorded are reflected as liabilities on our
balance sheet.
We recognize administrative service fees during the period the related
services are performed. Administrative service fees consist of revenues from the
performance of administrative services for self-funded contracts, reimbursements
from our contracts with CMS under which we serve as an intermediary for the
Medicare Part A program and a carrier for the Medicare Part B program and fees
earned under the BlueCard program. The revenue earned under our contracts with
CMS is recorded net of an allowance for an estimate of disallowed expenses.
COST OF BENEFITS PROVIDED
Cost of benefits provided includes claims paid, claims in process and
pending, and an estimate for unreported claims for charges for healthcare
services for enrolled members during the period. We are required to estimate the
total amount of claims that have not been reported or that have been received,
but not yet adjudicated, during any accounting period. These estimates, referred
to as unpaid claims on our balance sheet, are recorded as liabilities.
We estimate claim reserves in accordance with Actuarial Standards of
Practice promulgated by the Actuarial Standards Board, the committee of the
American Academy of Actuaries that establishes professional guidelines and
standards for actuaries to follow. Factors we consider in estimated future
payments include existing claims data, medical cost trends, the mix of products
and benefits sold, internal processing changes and the amount of time it took to
pay all of the benefits for claims from prior periods. To the extent the actual
amount of these claims is greater than the estimated amount based on our
underlying assumptions, such differences would be recorded as additional cost of
benefits provided in subsequent accounting periods and our future earnings would
be adversely affected. To the extent the claims experience is less than
estimated based on our underlying assumptions, such differences would be
recorded as a reduction in cost of benefits provided in subsequent accounting
periods.
TAXES
We account for income taxes using the liability method. Accordingly,
deferred tax assets and liabilities are recognized for the future tax
consequences attributable to the difference between the financial reporting and
tax basis of assets and liabilities. We record a valuation allowance to reduce
our deferred tax asset to the amount we believe is more likely than not to be
realized. This determination, which requires considerable judgment, is based on
a number of assumptions including an estimate of future taxable income. If
future taxable income or other factors are not consistent with our expectations,
an adjustment to our deferred tax asset may be required in the future. Any such
adjustment would be charged or credited to income in the period such
determination was made.
THE CONVERSION
The historical financial statements included in this report reflect
Empire HealthChoice, Inc., or HealthChoice, which prior to November 7, 2002 had
19
been a not-for-profit corporation and the parent company of all of our
subsidiaries. In the conversion, on November 7, 2002, immediately prior to the
effectiveness of our initial public offering, HealthChoice:
o converted from a not-for-profit health service corporation to a
for-profit accident and health insurer under the New York insurance
laws;
o issued 95% and 5% of its capital stock to The New York Public Asset
Fund and The New York Charitable Asset Foundation, respectively, which
in turn transferred those shares to a direct, wholly owned subsidiary
of WellChoice in exchange for a corresponding amount of shares of
WellChoice common stock; and
o merged with the converted HealthChoice's existing wholly owned
accident and health insurance subsidiary, with HealthChoice surviving
as "Empire HealthChoice Assurance, Inc.," which we refer to as
"Empire".
As a result, immediately prior to the effectiveness of our initial
public offering, the Fund and the Foundation owned all of our capital stock and
WellChoice was the parent holding company of all of its direct and indirect
subsidiaries.
The conversion has been accounted for as a reorganization using the
historical carrying values of HealthChoice's assets and liabilities. Immediately
following the conversion, HealthChoice's unassigned reserves were reclassified
to par value of common stock and additional paid-capital. Concurrently,
HealthChoice became a wholly owned subsidiary of WellChoice. The costs of the
conversion are recognized as an expense as they are incurred. We started
incurring conversion-related expenses in 1998 when HealthChoice first began
paying fees and expenses of advisors to the New York State Superintendent of
Insurance, or Superintendent, in connection with the New York State Department
of Insurance's consideration of our original draft plan of conversion. Through
September 30, 2002, we incurred conversion and offering expenses of $16.8
million. We incurred approximately $7.2 million of additional conversion and
offering expenses from October 1, 2002 through the completion of the initial
public offering.
ADDITIONAL STATE AND LOCAL TAXES
As a result of the conversion, we became a for-profit entity and are
subject to state and local taxes that we were not previously required to pay.
These include premium taxes on most non-HMO insured business and sales and use
taxes (which are recorded as administrative expenses), as well as state and
local income taxes.
If we had been a for-profit company for all of 2001, we would have
incurred approximately $42.0 million in premium and sales and use taxes and
approximately $13.2 million in state and local income taxes for the year ended
December 31, 2001. These estimates do not include recoupment of premium taxes
through premium rate increases or the benefit from any effort to convert
accounts from insured to self-funded arrangements. We intend to maintain our
insurance contracts as competitively priced and, accordingly, the market for our
products will determine the extent to which we can recover these additional
expenses.
20
SELECTED MEMBERSHIP DATA AND RESULTS OF OPERATIONS
The following table sets forth selected membership data as of the dates
set forth below:
SEPTEMBER 30,
-------------
2002 2001
---- ----
(MEMBERS IN
THOUSANDS)
PRODUCTS AND SERVICES:
COMMERCIAL MANAGED CARE:
Group PPO, HMO, EPO and other(1)(2) 2,031 1,730
New York City and New York State PPO(3) 1,787 1,561
----- -----
TOTAL COMMERCIAL MANAGED CARE 3,818 3,291
----- -----
OTHER INSURANCE PRODUCTS AND SERVICES:
Indemnity 573 841
Individual 244 262
----- -----
TOTAL OTHER INSURANCE PRODUCTS AND SERVICES 817 1,103
----- -----
OVERALL TOTAL 4,635 4,394
----- -----
CUSTOMERS:
Large group(3) 2,919 2,704
Small group and middle market 397 356
Individuals 300 321
National accounts 1,019 1,013
----- -----
OVERALL TOTAL 4,635 4,394
----- -----
FUNDING TYPE:
Insured(3) 3,086 3,136
Self-funded 1,549 1,258
----- -----
OVERALL TOTAL 4,635 4,394
----- -----
(1) Our HMO product includes Medicare+Choice. As of September 30, 2002, we had
approximately 56,000 members enrolled in Medicare+Choice.
(2) "Other" principally consists of our members enrolled in dental only
coverage. As of September 30, 2002, we had approximately 69,000 members enrolled
in dental only coverage.
(3) Enrollment as of September 30, 2002 includes 172,000 New York State PPO
account members who reside in New York State but outside of our service areas.
Prior to 2002, these members were enrolled in the New York Blue Cross Blue
Shield plan licensed in the area where the members resided, and, accordingly,
the membership was reported by these plans and not by us. Starting in 2002, in
accordance with a change to the contract with New York State, we began
administering the entire plan, including those members enrolled outside of our
service area, and all members were therefore enrolled in, and reported by,
HealthChoice. New York State PPO account members who reside in New York State
21
but outside of our service areas are excluded from the enrollment total at
September 30, 2001.
As of September 30, 2002, total enrollment was 4.6 million members and
commercial managed care enrollment was 3.8 million members (82.4% of total
enrollment). If we add to the September 30, 2001 enrollment the 166,000 New York
State PPO account members who reside in New York State but outside of our
service areas, total enrollment and commercial managed care enrollment increased
1.7% and 10.5%, respectively, from September 30, 2001 to September 30, 2002.
Membership has continued to increase in each of our commercial managed care
products. Our enrollment growth of 17.5%, or 302,000 members, in group PPO, HMO,
EPO and other was a combination of new membership in small group and middle
market customer accounts, particularly in our PPO, EPO and Direct Connection HMO
(our HMO product which allows members to seek care from in-network specialists
without a referral) products, and the migration of members enrolled in our
indemnity products to our commercial managed care products. Enrollment in other
insurance products and services declined 25.9% to approximately 0.8 million
members due, in part, to the continued migration of members to commercial
managed care products.
As of September 30, 2002, our New York State account covered
approximately 979,000 members, or 21.1% of our total membership and 25.6% of our
commercial managed care membership, and our New York City account covered
approximately 808,000 members, or 17.4% of our total membership and 21.2% of our
commercial managed care membership. Both accounts are subject to annual price
negotiations. The pricing of our PPO products with New York City expires on
December 31, 2002 and is currently under renegotiation based upon a competitive
bid process that is open to us and third parties and involves renegotiation with
respect to rates. The new contract awarded to the winner of this competitive bid
process is expected to commence July 1, 2003. We are currently renegotiating the
pricing of our PPO products with New York City for the first six months of 2003.
The current rates for the New York State account expire on December 31, 2002,
and are in the process of being renegotiated. The loss of one or both of these
accounts would result in reduced membership and revenue and require us to
reduce, reallocate or absorb administrative expenses associated with these
accounts.
22
The following table sets forth results of operations for each of our
segments for the periods set forth below:
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
----------------- ------------------
2002 2001 2002 2001
---- ---- ---- ----
($ IN MILLIONS)
COMMERCIAL MANAGED CARE:
Total revenue $ 979.7 $ 858.7 $ 2,979.8 $ 2,599.6
Income from continuing operations before
income tax expense $ 72.6 $ 30.1 $ 193.3 $ 88.9
Medical loss ratio (1):
Commercial managed care total 84.1% 88.8% 86.2% 89.0%
Commercial managed care, excluding New
York City and New York State PPO(2) 79.8% 86.5% 82.3% 86.1%
Administrative expense ratio (3) 14.7% 13.2% 13.5% 13.0%
OTHER INSURANCE PRODUCTS AND SERVICES:
Total revenue $ 241.5 $ 282.9 $ 843.2 $ 899.1
Income from continuing operations before
income tax expense $ 14.6 $ 6.5 $ 33.7 $ 17.3
Medical loss ratio (1) 78.9% 86.0% 84.5% 86.7%
Administrative expense ratio (3) 31.9% 26.5% 27.4% 25.3%
____________
(1) Medical loss ratio represents cost of benefits provided as a percentage of
premiums earned.
(2) We present commercial managed care medical loss ratio, excluding New York
City and New York State PPO because these accounts differ from our standard
PPO product in that they are hospital-only accounts which have lower
premiums relative to administrative expense and are retrospectively rated
with a guaranteed administrative service fee. In addition, the size of
these accounts distorts our performance when the total medical loss ratios
are presented.
(3) Administrative expense ratio represents administrative and conversion and
IPO expenses as a percentage of premiums earned and administrative service
fees.
THREE MONTHS ENDED SEPTEMBER 30, 2002, COMPARED TO THREE MONTHS ENDED SEPTEMBER
30, 2001
Total revenue increased 7.0%, or $79.6 million, to $1,221.2 million for
the three months ended September 30, 2002, from $1,141.6 million for the three
months ended September 30, 2001 due to an increase in premiums earned and
administrative service fee revenue.
Premium revenue increased $58.3 million, or 5.6%, to $1,101.5 million
for the three months ended September 30, 2002, from $1,043.2 million for the
three months ended September 30, 2001. The increase in premium revenue was
primarily due to growth in our commercial managed care segment. Commercial
managed care premium revenue was $910.5 million for the three months ended
September 30, 2002, a 12.7% increase compared to the three months ended
September 30, 2001. The increase in commercial managed care premium revenue was
attributable to enrollment growth and premium rate increases. Premium revenue
growth was primarily due to increases in membership and premium increases from
our HMO and PPO products. Premium revenue growth was partially offset by the
anticipated decline in our other insurance products and services, the
cancellation of unprofitable EPO contracts and the migration of insured EPO
national and large group indemnity contracts to self-funded contracts. On a per
23
member per month, or PMPM, basis, premium for the three months ended September
30, 2002 increased 13.6%, to $129.79, from $114.22 for the three months ended
September 30, 2001. Commercial managed care PMPM premium increased to $126.94
for the three months ended September 30, 2002, from $113.84 for the three months
ended September 30, 2001.
Administrative service fee revenue increased 29.7%, or $23.9 million,
to $104.3 million for the three months ended September 30, 2002, from $80.4
million for the three months ended September 30, 2001. The increase was
primarily due to growth in self-funded group PPO, HMO, EPO and other membership,
increased BlueCard fees and expanded volume of services provided under our CMS
contracts for Medicare Part A and Part B programs. Approximately $20.9 million
of the increase was driven by the migration of approximately 45,000 members from
insured EPO national contracts and approximately 137,000 insured large group
indemnity contracts to self-funded contracts and increased administrative
service fees revenue from our CMS contracts. Total BlueCard fees increased
36.1%, or $3.0 million, to $11.3 million for the three months ended September
30, 2002, from $8.3 million for the three months ended September 30, 2001 due to
an increase in transaction volume.
Investment income, net of investment expenses, decreased 10.2%, or $1.8
million, to $15.9 million for the three months ended September 30, 2002, from
$17.7 million for the three months ended September 30, 2001 due to lower
interest rates. There were no investment transactions that resulted in
significant gains or losses for the three months ended September 30, 2002 and
2001.
Other expense, net of $0.4 million for the three months ended September
30, 2002 is primarily attributable to miscellaneous non-operating expenses.
Other income, net of $0.3 million for the three months ended September 30, 2001
primarily consists of interest income earned on advances to hospitals and late
payment fee income.
Total cost of benefits provided decreased 0.4%, or $3.9 million, to
$916.0 million for the three months ended September 30, 2002, from $919.9
million for the three months ended September 30, 2001, This reflects a 7.1%
decline in member months due to the migration of membership from fully-insured
to self-insured contracts, offset by a 7.2% increase in costs of benefits
provided on a PMPM basis. The increase in benefit costs was due to increases in
unit costs, offset in part by decreases in utilization. Overall, benefit expense
on a PMPM basis for the three months ended September 30, 2002 increased to
$107.94, from $100.73 for the three months ended September 30, 2001. Commercial
managed care PMPM benefit expense increased 5.5% to $106.69 for the three months
ended September 30, 2002, from $101.12 for the three months ended September 30,
2001. Costs of benefits provided in our other insurance products and services
segment for the three months ended September 30, 2002 was net of $8.4 million of
litigation reserve releases related to the settlement of a large case (see Part
II, Item 1. Legal Proceedings).
The total medical loss ratio decreased to 83.2% for the three months
ended September 30, 2002, from 88.2% for the three months ended September 30,
2001, resulting from a 7.2% increase in PMPM costs, offset by a 13.6% increase
in average premium yield. The medical loss ratio in our commercial managed care
segment decreased to 84.1% for the three months ended September 30, 2002, from
88.8% for the three months ended September 30, 2001. New York City and New York
State PPO includes the results of our contracts with New York City and New York
State to provide hospital-only coverage to their employees and retirees, using
our PPO provider network. Our New York City and New York State accounts differ
from our standard PPO product in that they are hospital-only accounts and are
retrospectively rated with a guaranteed administrative service fee.
Administrative charges included in hospital-only contracts, as a percentage of
premium, are generally significantly lower than the percentage of such fees for
comprehensive hospital and medical policies. This is due to the fact that
hospital utilization is generally much lower than combined hospital and medical
24
utilization. Accordingly, the results of these hospital-only contracts
significantly influences our medical loss ratios. Excluding the New York City
and New York State PPO accounts, the medical loss ratio in our commercial
managed care segment decreased to 79.8% for the three months ended September 30,
2002, from 86.5% for the three months ended September 30, 2001, reflecting a
1.2% increase in PMPM costs, offset by a 9.7% increase in PMPM premiums. The
medical loss ratio for other insurance products and services decreased to 78.9%
for the three months ended September 30, 2002, from 86.0% for the three months
ended September 30, 2001 due to favorable claim experience. The aforementioned
litigation reserve release accounts for 4.4 of the 7.1 point decrease in MLR.
Administrative expenses increased 15.5%, or $28.6 million, to $213.4
million for the three months ended September 30, 2002, from $184.8 million for
the three months ended September 30, 2001. This increase was attributable to
increased employee benefit expense of $6.1 million, increased broker commissions
of $3.8 million due to premium revenue growth in small group and middle market
customers and $1.1 million of transition costs incurred as part of the IBM
outsourcing agreement entered into in June 2002.
As part of our continuing focus on increasing overall productivity, and
in part as a result of the implementation of our technology outsourcing
strategy, we are streamlining certain of our operations and anticipate that we
will incur a charge of approximately $17.0 million in the fourth quarter of 2002
relating to these efforts.
In 2003, we plan to transition several leased properties, which
temporarily replaced our World Trade Center office, to a long-term leased
facility. As a result, we will begin incurring additional facility costs in
2003.
Conversion and IPO expenses increased $4.3 million to $4.6 million for
the three months ended September 30, 2002, from $0.3 million for the three
months ended September 30, 2001, due to the increased conversion and IPO related
activities as we approached the effective date of the conversion and our initial
public offering.
Income from continuing operations before income taxes increased 138.3%,
or $50.6 million, to $87.2 million for the three months ended September 30,
2002, from $36.6 million for the three months ended September 30, 2001. Income
from continuing operations increased $217.9 million, to $254.4 million for three
months ended September 30, 2002, from $36.5 million for the three months ended
September 30, 2001 due to the recognition of a deferred tax benefit and improved
operating results. Taking into account our loss from discontinued operations,
our net income for the three months ended September 30, 2002 was $254.4 million
and for the three months ended September 30, 2001 was $31.0 million.
We had maintained a valuation allowance on our regular tax net
operating loss carryforwards due to uncertainty in our ability to utilize these
assets in the future. The use of these assets is largely dependent on the
conversion and future positive taxable income. On October 8, 2002, the New York
State Superintendent of Insurance, or the Superintendent, issued an Opinion and
Decision approving the plan of conversion. With the uncertainty of conversion
removed, we reevaluated our tax position for financial statement reporting
purposes at September 30, 2002 and determined that if we were to convert to a
for-profit entity, our ability to continue to utilize the Section 833 deduction
was uncertain. No authority directly addresses whether a conversion transaction
of the type we contemplate will render the Section 833 deduction unavailable. We
are aware, however, that the IRS has taken the position related to other Blue
Cross Blue Shield plans that a conversion could result in the inability of a
Blue Cross Blue Shield plan to utilize the Section 833 deduction. In light of
the absence of governing authority, while we intend to continue to take the
deduction on our tax returns after the conversion, we will assume, for financial
25
statement reporting purposes, that the deduction will be disallowed. This means
that, in projecting our future taxable income, it is now more likely than not
that we will utilize our tax loss and credit carryovers within a reasonable
period and, accordingly, this portion of the valuation allowance is no longer
necessary. Therefore, at September 30, 2002 we reduced the valuation allowance,
which resulted in the recognition of a $177.0 million deferred tax benefit.
Because we completed the conversion in November of 2002 and the tax law
bases the availability of the Section 833 deduction on the status of a company
at the end of the year, we would expect to incur for financial statement
reporting purposes federal income tax expense of approximately $75.0 million in
the fourth quarter of 2002, primarily for the reversal of Section 833 deductions
taken in the first three quarters of 2002. We believe that subsequent to the
conversion, our effective federal income tax rate will approximate the 35%
statutory rate.
NINE MONTHS ENDED SEPTEMBER 30, 2002, COMPARED TO NINE MONTHS ENDED SEPTEMBER
30, 2001
Total revenue increased 9.3%, or $324.2 million, to $3,822.9 million
for the nine months ended September 30, 2002, from $3,498.7 million for the nine
months ended September 30, 2001 primarily due to an increase in premium revenue.
Premium revenue increased $255.9 million, or 8.0%, to $3,461.3 million
for the nine months ended September 30, 2002, from $3,205.4 million for the nine
months ended September 30, 2001. The increase in premium revenue was primarily
due to growth in our commercial managed care segment. Commercial managed care
premium revenue was $2,772.6 million for the nine months ended September 30,
2002, a 13.3% increase compared to the nine months ended September 30, 2001. The
increase in commercial managed care premium revenue was attributable to
enrollment growth and premium rate increases. Premium revenue growth was
primarily due to increases in membership and premium increases from our HMO and
PPO products. Premium revenue growth was partially offset by the anticipated
decline in our other insurance products and services, the cancellation of
unprofitable EPO contracts and the migration of insured EPO national and large
group indemnity contracts to self-funded contracts. On PMPM basis, premium for
the nine months ended September 30, 2002 increased 11.2%, to $129.96, from
$116.92 for the nine months ended September 30, 2001. Commercial managed care
PMPM premium increased to $128.49 for the nine months ended September 30, 2002,
from $116.26 for the nine months ended September 30, 2001.
Administrative service fee revenue increased 24.1%, or $57.9 million,
to $298.6 million for the nine months ended September 30, 2002, from $240.7
million for the nine months ended September 30, 2001. The increase was primarily
due to growth in self-funded group PPO, HMO, EPO and other membership, increased
BlueCard fees and expanded volume of services provided under our CMS contract
for Medicare Part A and Part B programs. Approximately $50.7 million of the
increase was driven by the migration of approximately 45,000 members from
insured EPO national contracts and approximately 137,000 insured large group
indemnity contracts to self-funded contracts and increased administrative
service fees revenue from our CMS contract. Total BlueCard fees increased 27.5%,
or $7.1 million, to $32.9 million for the nine months ended September 30, 2002,
from $25.8 million for the nine months ended September 30, 2001 due to an
increase in transaction volume.
Investment income, net of investment expenses, decreased 8.2%, or $4.5
million, to $50.4 million for the nine months ended September 30, 2002, from
$54.9 million for the nine months ended September 30, 2001 due to lower interest
rates. There were no investment transactions that resulted in significant gains
or losses for the nine months ended September 30, 2002. The net realized loss of
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$5.4 million for the nine months ended September 30, 2001 was primarily the
result of an impairment loss on our commercial paper investment in Pacific Gas
and Electric Co., which defaulted in January 2001.
Other income, net of $13.3 million for the nine months ended September
30, 2002 consisted primarily of a gain of $8.0 million resulting from insurance
settlements in excess of estimated recoveries recorded as of December 31, 2001
for property and equipment lost at our World Trade Center headquarters, interest
income earned on advances to hospitals of $2.5 million, a benefit of $1.9
million resulting from the reversal of a hospital advance previously considered
uncollectible and late payment fee income of $0.7 million. Other income, net of
$3.1 million for the nine months ended September 30, 2001 primarily consists of
proceeds of $1.6 million from the demutualization of MetLife, Inc., the life
insurance carrier for our employees, interest income earned on advances to
hospitals of $0.8 million and late payment fee income of $0.6 million.
Total cost of benefits provided increased 4.9%, or $137.8 million, to
$2,973.0 million for the nine months ended September 30, 2002, from $2,835.2
million for the nine months ended September 30, 2001, reflecting a 2.8% drop in
member months, offset by a 7.9% increase in PMPM benefit costs. The increase in
benefit costs was due to increases in unit costs, offset in part by decreases in
utilization. Benefit costs in the nine months ended September 30, 2002 included
a $4.4 million premium deficiency reserve charge related to our New Jersey PPO
business, offset in part by a $15.4 million litigation reserve release. Overall,
benefit expense on a PMPM basis for the nine months ended September 30, 2002
increased to $111.63, from $103.42 for the nine months ended September 30, 2001.
The total medical loss ratio decreased to 85.9% for the nine months
ended September 30, 2002, from 88.5% for the nine months ended September 30,
2001. The medical loss ratio in our commercial managed care segment decreased to
86.2% for the nine months ended September 30, 2002, from 89.0% for the nine
months ended September 30, 2001. Excluding the New York City and New York State
PPO, the medical loss ratio in our commercial managed care segment decreased to
82.3% for the nine months ended September 30, 2002, from 86.1% for the nine
months ended September 30, 2001 due to better than anticipated claim experience.
The medical loss ratio for other insurance products and services decreased to
84.5% for the nine months ended September 30, 2002, from 86.7% for the nine
months ended September 30, 2001. The aforementioned litigation reserve release
accounts for all the MLR decrease.
Administrative expenses increased 10.6%, or $59.0 million, to $614.7
million for the nine months ended September 30, 2002, from $555.7 million for
the nine months ended September 30, 2001. This increase was attributable to
increased broker commissions of $16.1 million due to premium revenue growth in
small group and middle market customers, increased employee benefit expense of
$12.8 million and employee-related transition costs of $6.4 million incurred as
part of our outsourcing agreement with IBM in June 2002. Administrative expenses
for the nine months ended September 30, 2002, also included a $2.4 million
estimate for expenses incurred as a result of the loss of our headquarters
located at the World Trade Center that may not be reimbursed by our property
protection and blanket earnings and expense insurance policy. Conversion and IPO
expenses increased $6.6 million to $8.2 million for the nine months ended
September 30, 2002, from $1.6 million for the nine months ended September 30,
2001 due to the increased conversion and IPO related activities as we approached
the effective date of the conversion and our initial public offering.
Income from continuing operations before income taxes increased 113.7%,
or $120.8 million, to $227.0 million for the nine months ended September 30,
2002, from $106.2 million for the nine months ended September 30, 2001. This
improvement was primarily driven by increased commercial managed care membership
and improved underwriting performance. The tax benefit of $167.2 increased
income from continuing operations to $394.2 million for the nine months ended
September 30, 2002. The tax expense of $0.1 million reduced income from
continuing operations to $106.1 million for the nine months ended September 30,
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2001. Taking into account our loss from discontinued operations, our net income
for the nine months ended September 30, 2002 was $393.1 million and for the nine
months ended September 30, 2001 was $93.5 million.
LIQUIDITY AND CAPITAL RESOURCES
WellChoice is a holding company and depends on its subsidiaries for
cash and working capital to pay expenses. We anticipate that WellChoice will
receive cash from our subsidiaries from administrative and management service
fees, as well as tax sharing payments and dividends. On November 7, 2002, the
Superintendent approved the payment of a dividend to WellChoice from its
subsidiary, Empire, in the amount of $225.0 million, which was paid on November
8, 2002. This dividend has been accounted for as an equity transfer from a
subsidiary to the parent of a consolidated group. On November 20, 2002, we
received net proceeds of approximately $28.0 million, after deducting the
underwriting discount, from the exercise of the underwriters' over-allotment
option in our initial public offering. We expect to use these proceeds from the
exercise of the over-allotment option to pay offering and conversion expenses
and for general corporate purposes. Pending the use of the net proceeds as
described above, we intend to invest the net proceeds in short-term,
interest-bearing, investment grade investments.
Our subsidiaries' primary source of cash is from premiums and fees
received and investment income. The primary uses of cash include healthcare
benefit expenses, brokers' and agents' commissions and administrative expenses.
We generally receive premium revenues in advance of anticipated claims for
related healthcare services.
Our investment policies are designed to provide liquidity to meet
anticipated payment obligations and to preserve principal. We believe the
composition of our marketable investment portfolio is conservative, consisting
primarily of high-rated, fixed income securities with the objective of producing
a consistently growing income stream and maximizing risk-adjusted total return.
The fixed income portfolio is comprised of U.S. government securities, corporate
bonds, asset-backed bonds and mortgage-related securities. The average credit
rating of our fixed income portfolio as of September 30, 2002 was "AA." A
portion of the fixed income portfolio is designated as short-term and is
intended to cover near-term cash flow needs. Our marketable equity portfolio as
of September 30, 2002 consisted of an investment in a mutual fund indexed to the
S&P 500, our common stock investment in WebMD and our investment in
non-redeemable preferred stock of several companies. As of September 30, 2002,
our marketable equity portfolio was 3.2% of the total marketable investment
portfolio, compared to 2.0% as of September 30, 2001.
At September 30, 2002, we maintained letters of credit, including a
$25.0 million unsecured letter of credit from a group of financial institutions
to support our lease obligation for our Brooklyn, New York facility. As of
September 30, 2002, there were no funds drawn against these letters of credit.
On October 17, 2002, we entered into a credit and guaranty agreement, effective
as of November 7, 2002, with The Bank of New York, as Issuing Bank and
Administrative Agent, and several other financial institutions as agents and
lenders, which will provide us with a credit facility. The credit facility
replaced our existing $25.0 million letter of credit agreement and that letter
of credit is now deemed issued under the new credit facility. We are also able
to borrow under the credit facility for general working capital purposes. The
total outstanding amounts (including the amount of the letter of credit) under
the credit facility cannot exceed $100.0 million. The facility has a term of 364
days, subject to extension for additional periods of 364 days with the consent
of the lenders. Borrowings under the facility will bear interest, at our option,
at The Bank of New York's prime commercial rate (or, if greater, 0.50% plus the
federal funds rate) as in effect from time to time plus a margin of between zero
and 1.0%, or LIBOR plus a margin of between 1.125% and 2.250%, with the
applicable margin to be determined based on our financial strength rating.
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The credit facility contains covenants that limit our ability to issue
any equity interest which is not issued on a perpetual basis or in respect of
which we shall become liable to purchase, redeem, retire or otherwise acquire
any such interest, including any class of redeemable preferred stock. However,
the credit facility does not restrict us from paying dividends on our common
stock or repurchasing or redeeming shares of our common stock. Covenants under
the credit facility also impose limitations on the incurrence of secured debt,
creation of liens, mergers, asset sales, transactions with affiliates and
material amendments of material agreements, as defined in the credit facility
without the consent of the lenders. In addition, the credit facility contains
certain financial covenants. Failure to comply with any of these covenants will
result in an event of default which could result in the termination of the
credit facility.
We believe that cash flow from our operations and our cash and
investment balances, including the proceeds of the dividend mentioned above,
will be sufficient to fund continuing operations and capital expenditures for at
least the next twelve months.
Nine Months ended September 30, 2002 compared to Nine Months ended
September 30, 2001
Cash from operating activities decreased $98.4 million to $78.2 million
as of September 30, 2002, from $176.6 million as of September 30, 2001. The
decrease in cash from operating activities is principally due to a $75.8 million
return of advanced premium held related to our New York State account, an
increase of $54.0 million in taxes paid and the delay of payments made for other
liabilities in September 2001, due to the impact of the World Trade Center
attack on our operations. This decrease was partially offset by an increase in
insurance proceeds received of $32.0 million relating to the loss of our World
Trade Center office space.
Net cash used in investing activities was $123.7 million for the nine
months ended September 30, 2002, compared to cash provided by investing
activities of $79.5 million for the nine months ended September 30, 2001. Cash
used in investing activities in 2001 was impacted by a strategic decision to
maintain cash flow generated by operations in cash and cash equivalents to cover
business needs related to the recovery of our World Trade Center operations.
CONTRACTUAL COMMITMENTS TO IBM
In June 2002, we entered into a ten-year agreement with IBM to
modernize our systems applications and operate our data center and technical
help desk. Our payments to IBM for operating our data center and technical help
desk will be based upon actual utilization of services billed at the rates
established in the agreement. We estimate that our payments to IBM for operating
our data center and technical help desk will total approximately $732.3 million
over the term of the agreement, which we anticipate to be less than the costs we
would have otherwise incurred had we continued to operate the data center and
technical help desk ourselves. Under the terms of the contract, we will work
jointly with IBM to modernize our systems applications, centered around a new
state-of-the-art claims payment system being developed by deNovis, Inc., a
privately held startup company, in coordination with IBM and which will be
licensed to us in perpetuity. Subject to the successful completion and delivery
of the claims payment system, we will pay a one-time development and license fee
of $50.0 million for the license granted by IBM. Under the agreement with IBM,
we are scheduled to pay $25.0 million of this fee in installments during 2004.
The remaining $25.0 million will be paid on July 16, 2005, subject to meeting
performance benchmarks. Following the payment of the final $25.0 million, we
will pay IBM an annual fee of $10.0 million for maintenance and support
services.
The agreement also provides for IBM to assist us in modernizing our other
systems. In connection with these services, we have agreed to purchase up to
$65.0 million in modernization services from IBM over the next four years with a
target purchase rate of $7.3 million, $28.3 million, $19.0 million, $7.2 million
29
and $3.2 million during 2002, 2003, 2004, 2005 and 2006, respectively. We may
defer the purchase of services beyond the target date, provided that to the
extent we delay purchases more than one year beyond the target year, we shall
pay a premium to IBM of 10% per annum of the contract price. The amount that we
will actually spend for these integration and modernization services could be
less or greater than the annual target purchase rate, though over the term we
anticipate that the amount we will actually spend for these services could be
significantly greater than those contractual minimums. We will own all software
developed by IBM under the agreement, other than the claims payment system.
We intend to fund the modernization expenses incurred in connection with
this collaboration with IBM in part through the cost savings we expect to
realize as a result of the outsourcing of our applications development
functions, data center and help desk to IBM. Any substantial increase in these
expenses or inability to achieve our anticipated cost savings, could have an
adverse effect on our profitability, financial condition and results of
operations. Also, while we do not expect to realize significant cost savings
from this contract in the early years of the project, we anticipate that we will
incur the substantial majority of the costs and expenses related to the
modernization initiatives in the first four years of the agreement.
Our outsourcing agreement with IBM contains standard indemnification
clauses which reduce the risk associated with a variety of claims and actions,
including certain failures of IBM to perform under the agreement. We have the
right to terminate certain services if IBM fails to meet our quality and
performance benchmarks and we may terminate our relationship with IBM in its
entirety upon the occurrence of material breaches under the agreement, IBM's
entrance into the health insurance business, changes of control and certain
other events which are damaging to us. We can terminate the outsourcing
agreement without cause after June 1, 2004, or at any time within twelve months
following a change of control of WellChoice, provided that we pay IBM a
termination fee. The termination fee includes a lump sum payment which decreases
over the life of the agreement. For any WellChoice termination without cause,
the lump sum decreases from $23.4 million beginning in June 2004 to $0.9 million
in January 2012. We have the right to pay only a portion of this lump sum
payment if we choose not to terminate the entire agreement but only certain
discrete portions of IBM's services. Any termination following a change of
control of WellChoice requires a similar lump sum payment which decreases over
the life of the agreement and which is approximately 80% of the payment
described in the previous sentence, although we do not have the similar right to
terminate only portions of IBM's services, as allowed with a termination without
cause. In addition, upon termination we must reimburse certain of IBM's costs,
subject to reduction to the extent we purchase equipment, assume licenses and
leases and hire employees used by IBM to provide the services. We also have the
right to terminate the agreement at no cost within six months following a change
of control of IBM.
REGULATORY AND OTHER DEVELOPMENTS
Empire is subject to capital and surplus requirements under the New
York insurance laws and the capital and surplus licensure requirements
established by the Blue Cross Blue Shield Association. Each of these standards
is based on the NAIC's RBC Model Act, which provides for four different levels
of regulatory attention depending on the ratio of a company's total adjusted
capital (defined as the total of its statutory capital, surplus, asset valuation
reserve and dividend liability) to its risk-based capital. The capital and
surplus level required to meet the minimum requirements under the New York
insurance laws and Blue Cross Blue Shield Association licensure requirements,
applicable to Empire is 200% of Risk-Based Capital Authorized Control Level.
Empire exceeds the New York minimum capital and surplus requirements and the
Blue Cross Blue Shield Association capital and surplus licensure requirements
that is applicable to it following the conversion.
30
Capital and surplus requirements for Empire HealthChoice HMO, Inc., our
HMO subsidiary which is directly owned by Empire, are regulated under a
different method set forth in the Department of Health's HMO regulations. The
regulations require that Empire HealthChoice HMO currently maintain reserves of
five percent of its annual premium income. Empire HealthChoice HMO, with respect
to its operations in New York, meets the financial reserve standards of the New
York Department of Health. The Department of Health is currently redrafting its
regulations and proposes to increase the required reserves gradually over the
next six years to twelve and one half percent of annual premium income. If that
requirement changes it will affect all HMOs and we expect we will meet those
revised standards. In November 2002, Empire HealthChoice HMO received a $50.0
million capital contribution from Empire, which was made in connection with the
transfer of our New York HMO business from HealthChoice to Empire HealthChoice
HMO during 2002 in order to ensure compliance with New York capital and surplus
requirements. Empire HealthChoice HMO is also licensed in New Jersey and there
are minimum net worth standards established under New Jersey laws and
regulations. Empire HealthChoice HMO, with respect to its operations in New
Jersey, meets the minimum net worth standards established under New Jersey law.
Empire HealthChoice HMO is also subject to the Blue Cross Blue Shield
Association capital and surplus licensure requirement which is applicable to
Empire and satisfies that requirement.
Our New Jersey operations are not subject to the Blue Cross Blue Shield
Association capital and surplus licensure requirement. At September 30, 2002,
WellChoice Insurance of New Jersey met the minimum capital and surplus
requirements of the New Jersey Department of Banking and Insurance.
Regulation of financial reserves for insurers and HMOs is a frequent
topic of legislative and regulatory scrutiny and proposals for change. It is
possible that the method of measuring the adequacy of our financial reserves
could change and that could affect our financial condition. However, any such
change is likely to affect all companies in the state.
The ability of our insurance and HMO subsidiaries to pay dividends to
us is subject to regulatory requirements, including state insurance laws and
health department regulations and regulatory surplus or admitted asset
requirements, respectively. These laws and regulations require the approval of
the applicable state insurance department or health regulators in order to pay
any proposed dividend over a certain amount. For example, any proposed dividend
to WellChoice from Empire, which, together with other dividends paid within the
preceding twelve month period, exceeds the lesser of 10% of its surplus to
policyholders or 100% of adjusted net investment income will be subject to
approval by the New York Department of Insurance. The provisions of our Blue
Cross and Blue Shield licenses also may limit our ability to obtain dividends or
other cash payments from our subsidiaries as they require our licensed
subsidiaries to retain certain levels of minimum surplus.
INVESTMENTS
We classify all of our fixed maturity and marketable equity investments
as available for sale and, accordingly, they are carried at fair value. The fair
value of investments in fixed maturities and marketable equity securities are
based on quoted market prices. Unrealized gains and losses are reported as a
separate component of other comprehensive income, net of deferred income taxes.
The amortized cost of fixed maturities, including certain trust preferred
securities, is adjusted for amortization of premiums and accretion of discounts
to maturity, which is included in investment income. Amortization of premiums
and discounts on collateralized mortgage obligations are adjusted for prepayment
patterns using the retrospective method. Investment income is shown net of
investment expenses. The cost of securities sold is based on the specific
identification method. When the fair value of any investment is lower than its
cost and such a decline is determined to be other than temporary, the cost of
the investment is written down to fair value and the amount of the write down is
charged to net income as a realized loss.
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Short-term investments consist principally of U.S. treasury bills,
commercial paper and money market investments. We consider securities with
maturities greater than three months and less than one year at the date of
purchase as short-term investments. The fair value of short-term investments is
based on quoted market prices.
Other long-term equity investments, which include joint ventures, which
are accounted for under the equity method, and derivative instruments, which are
accounted for at fair value.
We are subject to state laws and regulations that require
diversification of our investment portfolios and limit the amount our insurance
company subsidiaries may invest in certain investment categories, such as
below-investment-grade fixed income securities, mortgage loans, real estate and
equity investments. Failure to comply with these laws and regulations might
cause investments exceeding regulatory limitations to be treated as non-admitted
assets for purposes of measuring statutory surplus and risk-based capital and,
in some instances, require the sale of those investments.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
Our fixed maturity and marketable equity securities are subject to the
risk of potential losses from adverse market conditions. To manage the potential
for economic losses, we regularly evaluate certain risks, as well as the
appropriateness of the investments, to ensure the portfolio is managed within
its risk guidelines. The result is a portfolio that is well diversified. Our
primary risk exposures are changes in market interest rates, credit quality and
changes in equity prices. The market value of our investments varies from time
to time depending on economic and market conditions.
Interest Rate Risk
Interest rate risk is defined as the potential for economic losses on
fixed-rate securities due to an adverse change in market interest rates. Our
fixed maturity portfolio consists exclusively of U.S. dollar-denominated assets,
invested primarily in U.S. government securities, corporate bonds, asset-backed
bonds and mortgage-related securities, all of which represent an exposure to
changes in the level of market interest rates. We manage interest rate risk by
maintaining a duration commensurate with our insurance liabilities and
policyholders' surplus. Further, we do not engage in the use of derivatives to
manage interest rate risk. A hypothetical increase in interest rates of 100
basis points would result in an estimated decrease in the fair value of the
fixed income portfolio at September 30, 2002 of approximately $37.3 million.
Credit Quality Risk
Credit quality risk is defined as the risk of a credit downgrade to an
individual fixed income security and the potential loss attributable to that
downgrade. We manage this risk through our investment policy, which establishes
credit quality limitations on the overall portfolio as well as dollar limits for
individual issuers. The result is a well-diversified portfolio of fixed income
securities, with an average credit rating of approximately "AA."
Equity Price Risk
Equity price risk for stocks is defined as the potential for economic
losses due to an adverse change in equity prices. Equity risk exposure is
managed through our investment in an indexed mutual fund. Specifically, we are
invested in ML S&P 500 Index LLC, which is an S&P 500 index mutual fund,
resulting in a well- diversified and liquid portfolio that replicates the risk
and performance of the broad U.S. stock market. We also hold a direct common
32
stock investment in WebMD and investments in non-redeemable preferred stock of
several companies. Our investment in non-redeemable preferred stock is managed
in conjunction with our fixed maturity portfolio. We estimate our equity price
risk from a hypothetical 10% decline in the S&P 500 and the relative effect of
that decline in the value of our marketable equity portfolio at September 30,
2002 to be a decrease in fair value of $2.5 million.
Fixed Income Securities
Our fixed income strategy is to construct and manage a high quality,
diversified portfolio of securities. Additionally, our investment policy
establishes minimum quality and diversification requirements resulting in an
average credit rating of approximately "AA." The average duration of our
portfolio as of September 30, 2002 is 2.7 years, and is managed to within 20% of
the Lehman Intermediate Aggregate Index.
ITEM 4. CONTROLS AND PROCEDURES.
(a) We maintain disclosure controls and procedures that are designed to
ensure that information required to be disclosed in our filings under the
Securities Exchange Act of 1934 is recorded, processed, summarized and reported
within the periods specified in the rules and forms of the Securities and
Exchange Commission. Such information is accumulated and communicated to our
management, including its principal executive officer and principal financial
officer, as appropriate, to allow timely decisions regarding required
disclosure. Our management, including the principal executive officer and the
principal financial officer, recognizes that any set of controls and procedures,
no matter how well designed and operated, can provide only reasonable assurance
of achieving the desired control objectives.
(b) Within 90 days prior to the filing date of this quarterly report on
Form 10-Q, we have carried out an evaluation, under the supervision and with the
participation of our management, including our Chief Executive Officer and Chief
Financial Officer, of the effectiveness of the design and operation of our
disclosure controls and procedures. Based upon that evaluation, the Chief
Executive Officer and Chief Financial Officer concluded that our disclosure
controls and procedures are effective.
(c) There have been no significant changes in our internal controls or
in other factors, which could significantly affect the internal controls
subsequent to the date of their evaluation in connection with the preparation of
this quarterly report on Form 10-Q.
PART II
OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS.
Cohen v. Empire. On June 21, 2002, we settled Cohen v. Empire, a class
action which commenced on November 6, 1995 in the United States District Court
for the Eastern District of New York. The plaintiffs in the action had alleged
that we engaged in various activities in violation of statute or in breach of
contract, including arbitrarily adjusting customary charges downward, improperly
excluding high and low charges for services, reducing customary charges paid for
non-specialists and failing to properly consider the training and experience of
physicians. The plaintiffs purported to represent a class of individuals and
group policyholders whose claims were reimbursed on the basis of customary
charges between 1988 to the present. Under the court-approved settlement, our
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maximum exposure to liability will not exceed $23.0 million (and, based upon our
current estimates, our liability should be approximately $14.6 million),
including attorneys' fees, which will be covered by a previously established
reserve.
Consumers Union of the U.S., Inc. et. al. On August 21, 2002, Consumers
Union of the U.S., Inc., the New York Statewide Senior Action Council and
several other groups and individuals filed a lawsuit in New York Supreme Court
against the State of New York, the Superintendent, the Fund, HealthChoice and
its board of directors, among others, challenging the Conversion Legislation on
several constitutional grounds, including that it impairs the plaintiffs'
contractual rights, it impairs the plaintiffs' property rights without due
process of law, and constitutes an unreasonable taking of property. In addition,
the lawsuit alleges that HealthChoice has violated Section 510 of the New York
Not-For-Profit Corporation Law and that the directors of HealthChoice breached
their fiduciary duties, among other things, in approving the plan of conversion.
The complaint seeks a permanent injunction against the conversion or portions
thereof, including a redirection of the proceeds received from the sale of
shares by our largest stockholder, The New York Public Asset Fund to uses that
are charitable in nature.
By a motion dated September 20, 2002, we and the State defendants moved
on several grounds to dismiss plaintiffs' complaint in its entirety. In our
motion, we argued first, that plaintiffs' entire complaint should be dismissed
because the issue of how best to use HealthChoice's value to advance the
public's health and welfare raised by the complaint is a non-justiciable
political question that is the sole province of the Legislature and beyond
review by the courts. Second, we argue that plaintiffs' constitutional claims
based upon violations of the contracts, due process, and takings clauses should
be dismissed because plaintiffs fail to allege a state action, a cognizable
property or contractual right, or that the procedures pursuant to which any
conversion would take place do not comport with due process safeguards. We
argued further that plaintiffs' state law claims should be dismissed because the
Conversion Legislation supersedes any state provisions allegedly violated;
plaintiffs fail to plead that our board of directors' decision to pursue the
conversion constitutes a breach of fiduciary duty; plaintiffs have not pled all
of the elements of constructive trust against any defendant; and plaintiffs'
allegation that the Conversion Legislation does not apply to HealthChoice is
contradicted by the statute itself and by the decision of the Superintendent to
approve the plan of conversion, which allegation plaintiffs seek to withdraw. In
addition, on November 6, 2002, pursuant to a motion filed by plaintiffs, the New
York Supreme Court issued a temporary restraining order enjoining and
restraining the transfer of the proceeds of the sale of common stock by the
selling stockholders in our initial public offering to The New York Public Asset
Fund or The New York Charitable Asset Foundation or to the State or any of its
agencies or instrumentalities. The court also ordered that such proceeds be
deposited with The Comptroller of the State of New York pending the outcome of
this action. The court did not enjoin WellChoice, HealthChoice or the other
defendants from completing the conversion or the initial public offering or the
receipt by WellChoice of the net proceeds from its issuance and sale of shares
in the initial public offering. A court conference was held on November 26,
2002, at which time the motion to dismiss and the motion to convert the
temporary restraining order into a preliminary injunction were deemed submitted.
We are awaiting a decision.
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS.
On November 7, 2002, the Securities and Exchange Commission declared
effective the Registration Statement on Form S-1 (Registration No. 333-99051)
filed by WellChoice with respect to the initial public offering, or IPO, of our
common stock, par value $0.01 per share (the "Common Stock"); together with the
Registration Statement on Form S-1 that we filed pursuant to Rule 462(b) of the
Securities Act of 1933 (Registration No. 333-101089) to increase the amount of
the Common Stock being offered in the IPO. The lead managing underwriter and
bookrunner for the IPO was Credit Suisse First Boston. The co-managing
underwriters for the IPO were UBS Warburg, Bear, Stearns & Co. Inc., Morgan
Stanley, Goldman, Sachs & Co., JP Morgan, Salomon Smith Barney, Blaylock &
Partners, L.P. and The Williams Capital Group, L.P. The IPO commenced on
34
November 7, 2002 and terminated upon the sale of all the 19,199,000 shares of
Common Stock offered (including 2,079,158 shares sold pursuant to the
underwriters' over-allotment option).
Two selling stockholders, The New York Public Asset Fund and The New
York Charitable Asset Foundation, sold 17,108,097 and 900,426 shares,
respectively in the IPO (including an aggregate of 1,313,740 shares sold upon
exercise of the underwriters' over-allotment option). We received no proceeds
from the sale of those shares by the selling stockholders. We received proceeds
only from our issuance and sale of 1,190,477 shares of Common Stock as part of
the shares sold in the underwriters' over-allotment option. The closing of the
over-allotment option occurred on November 20, 2002 and resulted in gross
proceeds to the us of approximately $29.8 million before deducting the
underwriting discount of $1.8 million. Immediately after the sale of the
19,199,000 shares in the IPO, the Fund owned 17,108,097 shares of common stock
(and one share of Class B common stock), and the Foundation owned 900,426 shares
of common stock, representing approximately 73.2% and 3.9%, respectively, of the
83,490,477 shares of common stock outstanding.
We are using the net proceeds we received in the IPO to pay conversion
and offering expenses and for general corporate purposes. None of the proceeds
from the IPO were paid by us, directly or indirectly, to any director, officer
or employee of the Company, or to any person owning ten percent or more of any
class of our equity securities, or to any of our affiliates, other than the
payment of approximately $2.375 million relating to legal and investment banking
expenses incurred by The New York Public Asset Fund in connection with the IPO
and conversion.
ITEM 5. OTHER INFORMATION.
On November 8, 2002, Standard & Poor's, or S&P, affirmed Empire's
financial strength and counterparty credit rating of "A-," which represents the
third highest of nine S&P ratings categories and is within the "strong" category
("A+," "A," and "A-"). This rating is not a recommendation to buy, sell or hold
securities and may be revised or withdrawn by S&P at any time.
On November 18, 2002, Jack A. Smith resigned as Senior Vice President,
Chief Marketing Officer and Jason Gorevic was appointed as Acting Chief
Marketing Officer. Mr. Gorevic had served as Vice President, Local Group
Commercial Markets since joining the Company in February 2002.
On November 18, 2002, Deborah Bohren was appointed Vice President,
Communications. Ms. Bohren, who has been with the Company since 1996, will
assume responsibility for establishing the Company's investor relations
department and will be the Company's primary liaison with analysts and
institutional investors. Ms. Bohren will retain her current responsibilities for
all external communications, including the development and implementation of
strategic public relations and government affairs programs.
The Company's Chief Executive Officer, Michael Stocker, is being
treated for prostate cancer. He will continue performing all of his regular
duties and does not expect to take any extended leave of absence in connection
with his condition.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K.
(a) See Index to Exhibits.
(b) Current Reports on Form 8-K. None.
35
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934,
the registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
Date: December 18, 2002 WELLCHOICE, INC.
(Registrant)
By: /s/ John W. Remshard
----------------------------
John W. Remshard
Senior Vice President and
Chief Financial Officer
36
CERTIFICATIONS
CHIEF EXECUTIVE OFFICER'S CERTIFICATION
I, Michael A. Stocker, MD, Chief Executive Officer of WellChoice, Inc., certify
that:
1. I have reviewed this quarterly report on Form 10-Q of WellChoice, Inc.;
2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to
make the statements made, in light of the circumstances under which such
statements were made, not misleading with respect to the period covered by
this quarterly report;
3. Based on my knowledge, the financial statements, and other financial
information included in the quarterly report, fairly present in all
material respects the financial condition, results of operations and cash
flows of the registrant as of, and for, the periods presented in this
quarterly report;
4. The registrant's other certifying officer and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined
in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
(a) Designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within those
entities, particularly during the period in which this quarterly
report is being prepared;
(b) Evaluated the effectiveness of the registrant's disclosure controls
and procedures as of a date within 90 days prior to the filing date of
this quarterly report (the "Evaluation Date"); and
(c) Presented in this quarterly report our conclusions based upon the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;
5. The registrant's other certifying officer and I have disclosed, based on
our most recent evaluation, to the registrant's auditors and the audit
committee of registrant's board of directors (or persons performing the
equivalent function):
(a) All significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to
record, process, summarize and report financial data and have
identified for the registrant's auditors any material weaknesses in
internal controls; and
(b) Any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal
controls; and
6. The registrant's other certifying officer and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal
controls subsequent to the date of our most recent evaluation, including
any corrective actions with regard to significant deficiencies and material
weaknesses.
Date: December 18, 2002 /s/ Michael A. Stocker, MD
---------------------------------
Michael A. Stocker, MD
Chief Executive Officer
37
CHIEF FINANCIAL OFFICER'S CERTIFICATION
I, John W. Remshard, Chief Financial Officer of WellChoice, Inc., certify that:
1. I have reviewed this quarterly report on Form 10-Q on WellChoice, Inc.;
2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to
make the statements made, in light of the circumstances under which such
statements were made, not misleading with respect to the period covered by
this quarterly report;
3. Based on my knowledge, the financial statements, and other financial
information included in the quarterly report, fairly present in all
material respects the financial condition, results of operations and cash
flows of the registrant as of, and for, the periods presented in this
quarterly report;
4. The registrant's other certifying officer and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined
in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
(a) Designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within those
entities, particularly during the period in which this quarterly
report is being prepared;
(b) Evaluated the effectiveness of the registrant's disclosure controls
and procedures as of a date within 90 days prior to the filing date of
this quarterly report (the "Evaluation Date"); and
(c) Presented in this quarterly report our conclusions based upon the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;
5. The registrant's other certifying officer and I have disclosed, based on
our most recent evaluation, to the registrant's auditors and the audit
committee of registrant's board of directors (or persons performing the
equivalent function):
(a) All significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to
record, process, summarize and report financial data and have
identified for the registrant's auditors any material weaknesses in
internal controls; and
(b) Any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal
controls; and
6. The registrant's other certifying officer and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal
controls subsequent to the date of our most recent evaluation, including
any corrective actions with regard to significant deficiencies and material
weaknesses.
Date: December 18, 2002 /s/ John W. Remshard
--------------------------------
John W. Remshard
Chief Financial Officer
38
INDEX TO EXHIBITS
NUMBER DESCRIPTION
------ -----------
3.1 Amended and Restated Certificate of Incorporation of
WellChoice, Inc.
3.2 Amended and Restated Bylaws of WellChoice, Inc., as
amended on December 18, 2002
4.2 Registration Rights Agreement dated as of November 7,
2002, by and among WellChoice, Inc., The New York
Public Asset Fund and The New York Charitable Asset
Foundation
9.1 Voting Trust and Divestiture Agreement dated as of
November 7, 2002 by and among WellChoice, Inc., The
New York Public Asset Fund and The Bank of New York,
as trustee
39