Back to GetFilings.com
1
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
------------------------
FORM 10-K
(MARK ONE)
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE YEAR ENDED DECEMBER 31, 1999
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM __________ TO __________ .
COMMISSION FILE NUMBER 000-21949
------------------------
PACIFICARE HEALTH SYSTEMS, INC.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
DELAWARE 95-4591529
(STATE OR OTHER JURISDICTION OF (IRS EMPLOYER
INCORPORATION OR ORGANIZATION) IDENTIFICATION NUMBER)
3120 LAKE CENTER DRIVE, SANTA ANA, CALIFORNIA 92704
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES, INCLUDING ZIP CODE)
(REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE) (714) 825-5200
SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT: NONE
SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:
COMMON STOCK, PAR VALUE $0.01
------------------------
Indicate by check mark whether the Registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes [X] No [ ]
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of Registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [ ]
The aggregate market value of common stock held by non-affiliates of the
Registrant on February 29, 2000 was approximately $927,600,000.
The number of shares of common stock outstanding at February 29, 2000 was
approximately 35,900,000.
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
2
PACIFICARE HEALTH SYSTEMS, INC.
INDEX TO ANNUAL REPORT ON FORM 10-K
FOR THE YEAR ENDED DECEMBER 31, 1999
PAGE
----
PART I
Item 1. Business.................................................... 1
Item 2. Properties.................................................. 13
Item 3. Legal Proceedings........................................... 13
Item 4. Submission of Matters to a Vote of Security Holders......... 14
PART II
Item 5. Market for the Company's Common Equity and Related
Stockholders Matters........................................ 15
Item 6. Selected Financial Data..................................... 15
Item 7. Management's Discussion and Analysis of Financial Condition
and Results of Operations................................... 18
Item 7A. Quantitative and Qualitative Disclosures About Market
Risk........................................................ 37
Item 8. Consolidated Financial Statements and Supplementary Data.... 37
Item 9. Changes in and Disagreements with Accountants on Accounting
and Financial Disclosure.................................... 37
PART III
Item 10. Directors and Executive Officers of the Registrant.......... 38
Item 11. Executive Compensation...................................... 43
Item 12. Security Ownership of Certain Beneficial Owners and
Management.................................................. 51
Item 13. Certain Relationships and Related Transactions.............. 53
PART IV
Item 14. Exhibits, Financial Statement Schedules, and Reports on Form
8-K......................................................... 54
i
3
PART I
ITEM 1. BUSINESS
HMOS AND HMO-RELATED PRODUCTS AND SERVICES. PacifiCare Health Systems, Inc. is
one of the nation's leading managed health care services companies, serving
approximately 3.7 million members in nine states and Guam as of December 31,
1999. We operate health maintenance organizations ("HMOs") and offer HMO-related
products and services.
Our commercial plans offer a comprehensive range of products to employer groups
and individuals, including HMO, Preferred Provider Organization ("PPO") and
Point of Service ("POS") plans. An HMO is a health care organization that
combines aspects of a health care insurer with those of a health care provider
by arranging health care services for its members through a defined provider
network at a reduced deductible or nominal copayment. A PPO is a selected group
of providers, such as medical groups, that offers discounted fee-for-service
health care. POS plans combine the features of an HMO with the features of a
traditional indemnity insurance product, allowing members to choose from a
network of providers at a lower cost, or from other physicians at a higher
deductible or copayment. Our Medicare program and commercial plans are designed
to deliver quality health care and customer service to members at cost-effective
prices. We also offer a variety of specialty HMO managed care and HMO-related
products and services that employers can purchase as a supplement to our basic
commercial plans or as stand-alone products. These products include life and
health insurance, behavioral health services, dental and vision services and
pharmacy benefit management. We generally provide these specialty services
through subcontracts or referral relationships with other health care providers.
BUSINESS OPERATIONS
In September 1999, we announced that we had organized our company in three
divisions: Health Plans, Specialty Products and a Seniors division. This
realignment, effective in 2000, will allow each division to focus on its
customers, markets and growth opportunities. Our Medicare and commercial HMO
health plans and life and health insurance companies, which operate in nine
states and serve 3.7 million members, fall within the Health Plans division.
This new division integrates services that had been operated through regional
and local offices with the programs operated through the corporate headquarters.
The goal of this integration is to bring cost savings and synergies to our HMO
operations.
Our behavioral health, dental and vision and pharmacy benefit management
subsidiaries operate within the Specialty Products division to focus on growth
opportunities. The third division, a Seniors division, researches and develops
health, lifestyle and ancillary products and services marketed to older adults.
We will take advantage of our experience in this growing market segment through
our 14 years of experience with SecureHorizons(R), our Medicare+Choice HMO
program.
HEALTH PLANS DIVISION
PacifiCare's government and commercial membership at December 31, 1999 was as
follows:
GOVERNMENT(1) COMMERCIAL TOTAL PERCENT OF TOTAL
------------- ---------- --------- ----------------
Arizona................................... 89,300 105,000 194,300 5.3%
California................................ 608,100 1,720,000 2,328,100 63.7
Colorado.................................. 78,200 318,300 396,500 10.9
Guam...................................... -- 41,500 41,500 1.1
Nevada.................................... 28,500 35,100 63,600 1.7
Ohio...................................... 16,500 42,700 59,200 1.6
Oklahoma.................................. 29,000 84,300 113,300 3.1
Oregon.................................... 36,500 109,000 145,500 4.0
Texas..................................... 64,100 112,600 176,700 4.8
Washington................................ 64,400 74,900 139,300 3.8
--------- --------- --------- -----
Total membership................ 1,014,600 2,643,400 3,658,000 100.0%
========= ========= ========= =====
- ---------------
(1) The government program represents the Medicare line of business.
1
4
SECURE HORIZONS PROGRAM
GENERAL. For Medicare beneficiaries, we offer health care services through our
Secure Horizons program. The Secure Horizons program is the largest
Medicare+Choice program in the United States (as measured by membership). Secure
Horizons membership has grown from approximately 0.4 million members at December
31, 1994 to approximately 1.0 million members at December 31, 1999. Beginning
January 1, 1999, the new Medicare+Choice program replaced the Medicare risk
program and all of our Medicare HMO operations qualified and continue to provide
services to Medicare beneficiaries under this program.
PREMIUMS. Our Medicare+Choice contracts entitle us to per-member per-month
payments on behalf of each enrolled Medicare beneficiary. In addition, we, and
all participants in the Medicare+Choice program, are subject to periodic
adjustments to premiums based upon retroactive changes in members' status such
as Medicaid eligibility. These periodic adjustments can be positive or negative.
In 1999, our payments from the Health Care Financing Administration ("HCFA")
were based on a mix of the average annual cost of providing traditional
fee-for-service Medicare benefits to the Medicare population in each county and
nationally. The payment was also adjusted for each individual based upon
demographic factors including the age, gender, zip code, Medicaid status as well
as certain health status information relating to each enrollee. Effective
January 1, 2000, HCFA further began adjusting payments based upon health status.
Under HCFA's new risk-adjusted methodology, plans with enrollees who were
hospitalized for more than one day in the previous year for select disease
conditions including certain cancers, cardiovascular problems, diabetes, and
neurological disorders will be paid more for those enrollees than for enrollees
without those conditions. The higher payments are determined from data that we
and all other Medicare+Choice contracting organizations have supplied to HCFA.
In addition, payments from HCFA are subject to annual limits on the growth of
overall payments to Medicare+Choice contracting organizations. See "Government
Regulation and Proposed Legislation -- HCFA" and "Government Regulation and
Proposed Legislation -- Adjusted Community Rate Filings."
The per-member revenue we receive from the government for enrollees in the
Secure Horizons program has been and will continue to be more than three times
higher than the per-member revenue we receive from enrollees in our commercial
plans primarily because of the higher medical and administrative costs of
serving a Medicare member. As a result, the Secure Horizons program accounted
for approximately 60 percent of our consolidated premium revenue for the year
ended December 31, 1999, even though it represented only 28 percent of our total
membership.
Our Medicare+Choice contracts are renewed every 12 months unless we or HCFA
elect to terminate them. HCFA may also terminate our Medicare+Choice contracts
if we fail to continue to meet compliance standards. Termination of our
Medicare+Choice contracts would have a material effect on our financial
position, results of operations or cash flows of a future period. We have had
these contracts in some states for at least 14 years and we have no reason to
believe that such terminations would occur.
COMMERCIAL PLANS
GENERAL. For the commercial employer market, we offer a range of products and
benefit plan designs that vary in the amount of member copayments. These options
allow employers flexibility in selecting cost-effective benefit packages for
their employees. Our commercial membership has grown from approximately 1.0
million members at December 31, 1994 to 2.7 million members at December 31,
1999. Our commercial plans offer a comprehensive range of products to employer
groups and individuals, including HMO, Preferred Provider Organization ("PPO")
and Point of Service ("POS") plans. A PPO is a selected group of providers, such
as medical groups, that offers discounted fee-for-service health care. POS plans
combine the features of an HMO with the features of a traditional indemnity
insurance product, allowing members to choose from a network of providers at a
lower cost, or from other physicians at a higher deductible or copayment.
PREMIUMS. In our commercial plan pricing, we use underwriting criteria as an
integral part of our commercial risk management efforts. Underwriting is the
process by which a health plan assesses the risk of enrolling employer groups
(or individuals) and establishes appropriate or necessary premium rates. The
setting of
2
5
premium rates directly affects a health plan's profitability and marketing
success. See "Health Care Costs and Provider Relationships." We cannot employ
underwriting techniques for the Secure Horizons program because of regulations
that require us to accept nearly all Medicare beneficiaries.
FEDERAL EMPLOYEES. Our HMOs also have commercial contracts with the United
States Office of Personnel Management ("OPM") to provide managed health care
services to approximately 171,000 members under the Federal Employee Health
Benefits Program ("FEHBP") for federal employees, annuitants and their
dependents as of December 31, 1999. See "Government Regulation and Proposed
Legislation -- OPM" and Note 10 of the Notes to Consolidated Financial
Statements.
COMMERCIAL RETIREE PRODUCTS. In response to the needs of employers to provide
cost-effective health care coverage to their retired employees who may or may
not be currently entitled to Medicare, we offer the Secure Horizons retiree
product. This product draws on our Medicare expertise by offering provider
networks that are similar to those offered to our Secure Horizons enrollees. We
set our premiums generally based on the same revenue requirements needed to
provide services to Secure Horizons members. The retiree product gives us access
to individuals who, once familiar with our services and delivery system, may
enroll in Secure Horizons when they become eligible for Medicare benefits.
LIFE AND HEALTH INSURANCE. We are licensed through our subsidiaries, PacifiCare
Life and Health Insurance Company and PacifiCare Life Assurance Company, to
issue life and health care insurance in 38 states, including each of the states
where our HMOs operate, the District of Columbia and Guam. Under our new
structure, when our sales and marketing representatives promote our HMO
commercial product line, they will offer managed health care insurance products
to employer groups at the same time. This allows us to form multi-option health
benefits programs, including our PPO and POS plans. In addition, other
supplementary insurance products offered to employer groups include group term
life, indemnity dental and indemnity behavioral health benefits.
SPECIALTY PRODUCTS DIVISION
In addition to our HMO operations, we provide a range of specialty managed care
products that supplement our HMO products and are primarily sold in our
commercial plans. These products have been organized as one division and
include:
BEHAVIORAL HEALTH SERVICES. PacifiCare Behavioral Health of California, Inc. is
a California licensed specialized health care service plan that provides
behavioral health care services, including chemical dependency benefit programs,
primarily to our California and other HMO commercial members. Outside of
California, PacifiCare Behavioral Health, Inc. contracts with our HMOs and
employers to manage their respective mental health and chemical dependency
benefit programs.
DENTAL AND VISION SERVICES. PacifiCare Dental, a California licensed HMO dental
plan, and PacifiCare Dental & Vision Administrators, a third-party administrator
of indemnity and PPO dental and vision plans, provide HMO, PPO and
fee-for-service dental and PPO vision benefits directly to individuals and
employer groups and indirectly to seniors through Secure Horizons. We currently
offer these products in five states: California, Colorado, Nevada, Oregon and
Washington.
PHARMACY BENEFIT MANAGEMENT. PacifiCare Pharmacy Centers, Inc., dba Prescription
Solutions(R), is one of the industry's largest pharmacy benefit management
companies. Prescription Solutions offers pharmacy benefit management services to
HMOs, including our HMOs, and employer groups that are self-insured for
prescription drugs. Clients of Prescription Solutions have access to a pharmacy
provider network that features independent and chain pharmacies and a variety of
cost and quality management capabilities. Prescription Solutions also provides
its clients with an array of fully integrated services, including mail order
distribution, an extensive network of retail pharmacies, claims processing and
sophisticated drug utilization reporting. Prescription Solutions launched its
e-commerce initiative this year as a means of improving member services and
moving more medications to its mail service operation. We will continue to
enhance the services available in this area, including the offering of
non-prescription items such as over-the-counter medications and durable medical
equipment supplies.
3
6
SENIORS DIVISION
Our newly formed Seniors division researches and develops health, lifestyle and
ancillary products and services marketed to older adults. As we define our
business opportunities and strategies, we will take advantage of our experience
in this growing market segment through our 14 years of experience through Secure
Horizons. Currently, the division is comprised of:
MEDICARE+CHOICE MANAGEMENT. Formed to promote our expertise in the
Medicare+Choice area, Secure Horizons USA, Inc., ("SHUSA") licenses the Secure
Horizons name and provides management services to HMOs and health care delivery
systems that seek participation in the Medicare+Choice program. SHUSA's
management services include marketing, provider contracting and administrative
services. The fee charged by SHUSA is generally based on a percentage of a
licensee's revenue. SHUSA has agreements in New Mexico with Presbyterian
Healthcare Services, Inc. and in New England with Tufts Associated Health
Maintenance Organization, Inc.
BUSINESS STRATEGY
PacifiCare's objective is to be the leading health plan in the western United
States and to gain new growth opportunities in our specialty products and the
older adult market. To achieve these objectives, we intend to pursue the
following strategies:
PURSUE MARKET LEADERSHIP IN THE WESTERN UNITED STATES TO ACHIEVE OPERATING
EFFICIENCIES AND REDUCE DEPENDENCE ON MEDICARE BUSINESS. Our Health Plans
division intends to pursue primarily commercial membership growth within the
following states that we are targeting as our primary HMO market: Arizona,
California, Colorado, Guam, Nevada, Oklahoma, Oregon, Texas and Washington. We
believe that by gaining market leadership within the western region, we can more
effectively enhance our brand recognition and gain additional operating
efficiencies, including in our provider contracting. By focusing on commercial
membership growth, we intend to reduce our exposure to risks associated with our
Medicare business, including the government's evolving reimbursement policies.
We will target our marketing efforts at large and medium size employers in these
states, focusing on potential growth opportunities. To reduce membership
acquisition costs, we will use the Internet, in addition to our other marketing
efforts, to target individuals and small employers (with fewer than 50
employees) in California. We plan to introduce similar Internet strategies for
individuals and small employers in markets outside of California by the end of
2000.
IMPLEMENT NEW INITIATIVES TO IMPROVE OPERATING PERFORMANCE. Our Health Plans
division has completed an efficiency and effectiveness review of all of its
operations and identified potential savings and synergies. These initiatives
include streamlining provider contracting and reorganizing our sales and
marketing teams and human resources department. We expect to implement the
initial initiatives within the next twelve months. As an ongoing process, we
intend to continue to seek out opportunities for new sources of efficiency and
cost savings.
PURSUE GROWTH THROUGH STRATEGIC ACQUISITIONS. As part of our commercial growth
strategy, we intend to purchase smaller health plans in our target markets. As
of January 1, 1999, there were more than 80 health plans with fewer than 100,000
members operating within the states of our target market. Consistent with this
strategy, in 1999 we acquired 15,000 commercial members in Texas as well as
ANTERO Health Plans in Colorado, which added approximately 32,000 commercial
members and 4,000 Medicare members. In February 2000, we acquired Harris
Methodist Texas Health Plan and Harris Methodist Health Insurance Company in
Texas, adding approximately 250,000 commercial members and 50,000 Medicare
members. During the first quarter of 2000, we will assume from the QualMed Plans
approximately 25,000 to 28,000 commercial members in Colorado and approximately
24,000 commercial members in Washington.
EXPAND OUR SPECIALTY PRODUCTS AND SENIORS DIVISIONS. We intend to expand our
marketing activities for our specialty products to grow the division's revenues.
For example, Prescription Solutions is expanding its mail order capacity so that
it can service more business that is independent of the services we provide to
our HMO businesses. We intend to market these services to other health plans
within the states of our target HMO market. The Specialty Products division will
also continue to develop competencies to better serve
4
7
customers outside of our HMO business, as well as increase the synergies between
our core businesses. The Seniors division will research and develop products and
services that are not HMO-based that can be marketed to older adults.
COMPETITION
The health care industry is highly competitive, both nationally and in
PacifiCare's HMO and specialty product markets. Consolidation in the health care
industry has resulted in fewer but larger competitors, including insurance
carriers, other HMOs, employer self-funded programs and PPOs, some of which have
substantially larger enrollments or greater financial resources than PacifiCare.
As a result of this consolidation, we have become one of the larger HMOs in the
country with a concentration in the western United States.
PacifiCare competes with CIGNA Corporation, Aetna Inc. and UnitedHealth Group
for membership from national employers. We also compete with regional HMOs which
vary depending on the geographic market. Regional competitors include Kaiser
Foundation Health Plan, Foundation Health Care Systems, WellPoint Health
Networks Inc., and Humana, Inc. We also offer a regional alternative for
national employers who are willing to support multiple health plans to maintain
plans that best suit the needs of employees within a specific region. PacifiCare
has the highest Medicare membership in the nation, both in absolute terms and as
a percentage of overall membership, offering significant competitive advantages
and economies of scale in the Medicare+Choice market. Many health plans have
exited the Medicare HMO market due to changes in federal law, beginning with the
Balanced Budget Act of 1997 ("BBA"), that reduced Medicare reimbursement rates.
While we have benefited in certain regions from our competitors' market exits,
the long-term impact of the BBA on enrollment trends in Medicare+Choice HMO
programs is uncertain.
Other competitors include hospitals, health care facilities and other health
care providers. These competitors have combined to form their own networks to
contract directly with employer groups, and other prospective customers for the
delivery of health care services. We face competition in all our markets from
national HMOs, insurance carriers, local HMOs, PPOs and other local health care
providers.
Our behavioral health and dental and vision products supplement our HMO products
and are sold primarily as part of our commercial plans. Our pharmacy benefit
management product, Prescription Solutions, is an integral part of our
commercial and Medicare products; however, Prescription Solutions is also sold
as a stand-alone product. Competitors include Merck-Medco Managed Care,
WellPoint Pharmacy Management, PCS Health Systems, Med Impact, Express Scripts
and Advance Paradigm.
We believe that to retain our health plans' competitive advantages we should
continue to focus on building market share in our existing markets, as well as
develop additional products and services. Other factors that we believe give us
competitive advantages are:
- - Strong underwriting and pricing practices and staff;
- - Significant market position in certain geographic areas;
- - Financial strength;
- - Long-term operating experience in managed care;
- - A generally favorable marketplace reputation with providers, members and
employers;
- - An extensive provider network;
- - A primary reimbursement model that allows physicians, rather than HMO
administrators, to make decisions regarding medical care;
- - A relatively stable cost structure;
- - A focus on the Medicare+Choice market, creating significant purchasing power;
- - A strong brand identity;
- - Emphasis on providing high quality customer service; and
5
8
- - An effort to continually improve the quality of care provided to our members.
HEALTH CARE COSTS AND PROVIDER RELATIONSHIPS
GENERAL. The cost of drugs and medical services have been rising in the past few
years and we expect that they will continue to rise, causing HMO insurance
premiums to increase. The reasons for the increases have been numerous,
including:
- - An aging population, which has greater medical needs;
- - The availability of more costly diagnostic and therapeutic procedures;
- - New laws and regulations specifying covered services;
- - Increased prices for medications and the introduction of more expensive
medications;
- - Defensive medical practices due to physician fear of lawsuits;
- - Significant investments by pharmaceutical companies in advertising campaigns;
- - Growth in the number of hospitals and medical specialists, resulting in
increased use of services; and
- - Consumer demand for easy access to providers, low out-of-pocket costs and
coverage of lifestyle drugs.
Our profitability depends on our ability to successfully implement premium
increases that will keep pace with the rising costs of health care. Also
impacting our profitability is our ability to control health care costs while
providing quality care. Our focus is both securing cost-effective physician,
hospital and other health care provider contracts to maintain our qualified
network of providers in each geographic area we serve, as well as improving the
medical management of health services.
PROVIDER CONTRACTING ARRANGEMENTS. We use contracting processes that include
analysis and modeling of underlying cost and utilization assumptions. Through
these processes, we expect to enhance provider performance under PacifiCare
contracts and identify strategies to increase the likelihood of provider
success. Some of our provider contracts have one-year terms. However, we have
entered into a number of multiple-year contracts with physician groups to ensure
the quality and stability of our provider network. We believe improved business
consultation and management tools, including more thorough data reporting and
financial analysis of expected performance of our contracts, will enable us to
create more financially successful provider networks.
- - Capitation Arrangements. PacifiCare typically contracts with physician
organizations as well as most hospitals and ancillary providers on a prepaid,
capitated fixed-fee per-member-per month, regardless of the services provided
to each member. Capitation payments to providers may be based on a percentage
of the premium we receive, which is especially true for our Secure Horizons
contracts, or a fixed per-member per-month amount that is adjusted to reflect
membership age, sex and benefit variation. Under capitation arrangements, the
physician group influences medical utilization and controls costs through
referrals, hospitalization and other services. At December 31, 1999,
approximately 95 percent of our members were in contracts that are capitated
for professional risk. Medical groups may potentially assume delegated
administration functions, including medical management and claims processing
to support management of health care services under PacifiCare's capitation
contracts:
-- Provider Delegated Administration. Approximately 80 percent of our
capitated provider networks have qualified through our assessment
processes to perform some or all of the delegated, administrative
functions associated with operating in a capitated environment. In those
situations, we provide support for their administrative functions to help
them achieve greater levels of efficiency while promoting the health
status of our members. We believe one of our core competencies is our
ability to manage delegated provider relationships.
-- HMO Direct Administration. Other provider groups do not have the
capability to manage the administrative functions associated with
operating in a capitated environment. With such providers, we perform all
the direct management functions, such as paying claims and providing
medical
6
9
management on their behalf. In addition, we work with those providers to
assist them in developing the capability to assume a greater share of the
administrative functions. We continue to develop our own expertise in
this area to ensure that we can continue to build strong provider
networks for our members in existing and new markets where providers may
not be capable of performing these functions.
- - Fee-for-Service Arrangements. We contract with other hospitals and ancillary
providers, as well as some individual physicians or physician organizations,
to receive payments based on billed charges, often discounted, for the
service provided.
- - Direct Physician Management Model ("DPM"). Where the provider community is
not organized around aggregate physician groups or requires more extensive
medical management and/or administrative service, PacifiCare contracts with
physicians directly through its DPM model. DPM allows individual physicians
to serve our members through a program that generally compensates physicians
on a discounted fee-for-service basis and incorporates some elements of
risk-sharing, while PacifiCare performs all administrative functions required
for effective management of quality, medical costs and claims payment. We
designed the DPM model to be user friendly and efficient in the delivery of
administrative services.
- - Incentive Arrangements. Our HMOs share the risk of certain health care costs
through both capitation and DPM. We provide additional incentives to the
physicians or medical groups for improving quality, as well as the
appropriate utilization of hospital inpatient, outpatient surgery and
emergency room services.
HEALTH CARE COST TRENDS. Since the end of 1998, we have seen a trend of hospital
providers electing not to renew capitated contracts and opting for either
fee-for-service or shared-risk hospital arrangements. As a result of this trend,
the percentage of consolidated members under capitated arrangements for hospital
contracts has decreased from 85 percent at the end of 1998 to 75 percent to 80
percent at the end of 1999. As hospital capitation arrangements decrease, we
bear more risk for higher costs and utilization.
MEDICAL MANAGEMENT REDESIGN. We continue to believe that delegation of certain
functions empowers our providers to provide quality service and care. We are
seeking to reduce our exposure to provider insolvency by using more rigorous
standards to determine whether a provider can have delegated status or maintain
its status. We currently delegate to fewer providers than we have in the past
for medical management and claims payment, a trend we expect to continue through
the next few years. We upgraded our tracking and assessment tools to enable more
proactive identification of potential provider stability and solvency issues.
The tools are deployed on an ongoing basis to detect problems and avoid network
disruptions for our members and to minimize our financial risk. Provider
assessments focus on indicators of solvency problems, including liquidity and
cash management, underlying cost and utilization patterns, and operational and
management deficiencies. When our delegated providers require assistance, we
provide clinical and management tools, clinical and operational best practices
and performance benchmarks.
We are exploring new strategies for improving medical management core
competencies we put in place. Examples of such strategies include automating the
pre-certification and concurrent review process based on objective criteria,
auto-adjudicating claims based on prior authorization, investing in decision
support software, investing in improved training and needs assessment of
internal staff to assure consistent determinations of coverage and management
issues, and re-engineering workflows to maximize efficiencies. To support our
vision of provider success, we will make the tools and best practices we develop
available to all our providers.
NETWORK STABILITY. We believe improved business consultation and management
tools, including more thorough data reporting and financial analysis of expected
performance of our contracts, will enable us to create more financially
successful provider networks. We work closely with our provider partners to
ensure the strength and quality of our network. Under fee-for-service contracts,
PacifiCare has no insolvency risk; however, we do have increased utilization
risk. Under our capitated arrangements, we face the risk of a provider becoming
insolvent. Depending on state law, we may be held liable for unpaid health care
claims that were the responsibility of the capitated provider. Regardless, our
business consultation services, including
7
10
on-site financial and operational audits of medical groups, provider profiles,
and corrective action plans, provide monitors and management tools to maximize
network stability.
QUALITY IMPROVEMENT
GENERAL. We are convinced that providing our members access to continually
improved health care services leads to improved health for our members. To
assure this, we focus on provider peer review procedures, member quality
initiatives and national industry measures.
PROVIDER PEER REVIEW PROCEDURES. We have established a comprehensive peer review
procedure at each HMO, governed by a quality improvement committee. The medical
director for each HMO chairs that HMO's committee. Each committee consists of
health plan clinical professionals and physician representatives from the
contracted physician groups. All physicians are initially credentialed and
approved by that HMO's quality improvement committee. The quality assessment
includes evaluating the performance of that physician, as well as the quality of
the providers' medical facilities, medical records, laboratory and x-ray
licenses and its capacity to handle membership demands. We also engage in
ongoing quality reviews of our existing providers to ensure that members are
receiving quality medical care. A highlight of our physician management program
is our provider profile which measures medical group performance quarterly
across 59 indicators of clinical quality, service quality, utilization
management, and administrative services to assist medical groups in improving
results. In addition, the provider profile serves as the data source for the
Quality Index, which is a public report card of medical groups measured in 28
areas. Our member information materials highlight best performing medical
groups, so that members have credible and relevant information by which to
select physicians. We plan to implement this report in all the PacifiCare
regions by the fall of 2000.
MEMBER QUALITY INITIATIVES. To improve the quality of service and health for our
members, we have developed a comprehensive quality improvement program that
includes:
- - Offering independent external review programs to members in which members can
have a service or treatment denial of coverage decision reviewed by a
physician or panel of physicians outside their health plan;
- - Training our contracting provider groups to decrease inappropriate denials
and improve the appeals process for our members;
- - Standardizing and streamlining our specialty provider referral process;
- - Resolving claims issues more efficiently and reducing turnaround times, with
the goal of improving member satisfaction;
- - Launching our "JustOne/Ready Reply" initiative in California, Oklahoma and
Texas designed to resolve members' issues and answer questions with a single
phone call by the member. PacifiCare handles all necessary contact between
the plan, physicians, hospitals and medical groups through the final
resolution of the issue, and reports the outcome to the member;
- - Monitoring member satisfaction through surveys and internal operational
report cards compared to our current established benchmarks;
- - Offering highly effective health management programs, including chronic care
management initiatives in diabetes, congestive heart failure, cardiovascular
risk reduction, and depression;
- - Conducting preventive health programs, smoking cessation, and senior health
risk assessments; and
- - Providing members free access to in-depth health information on thousands of
topics via the internet at www.pacificare.com.
NATIONAL INDUSTRY MEASURES. The National Committee for Quality Assurance
("NCQA") is an independent, non-profit organization that reviews and accredits
HMOs. Our HMOs provide quality and service information under NCQA's Health Plan
Employer Data Information Set program. NCQA also
8
11
performs site reviews to determine if an HMO complies with standards it has
established for quality improvement, utilization management, provider
credentialing, a commitment to members' rights and preventive health services.
HMOs that comply with NCQA's review requirements and quality standards receive
NCQA accreditation. We have improved our NCQA scores by implementing the
membership and provider quality initiatives described above. At December 31,
1999, our HMOs in Arizona, California, Colorado, Nevada, Oklahoma and Oregon
(covering approximately 89 percent of our membership) have received
"commendable" three-year NCQA accreditation. Our Texas plan will receive its
NCQA accreditation status in March 2000, and the Washington plan will be
reviewed by NCQA in June 2000.
RISK MANAGEMENT
We shift part of our risk of catastrophic losses by maintaining reinsurance
coverage for certain hospital costs incurred in the treatment of catastrophic
illnesses. We require contracting physicians, physician groups and hospitals to
maintain individual malpractice insurance coverage. We also maintain general
liability, property and medical malpractice insurance coverage in amounts that
we believe to be adequate.
MARKETING
We have reorganized our sales and marketing teams by function rather than by
geographic regions. We believe the new structure will allow us to increase sales
growth and add value for our members and providers. We established three
strategic areas for marketing leadership, as follows:
- - Secure Horizons;
- - Commercial national, major, mid-size, group retiree, labor and trust
accounts; and
- - Commercial individual and small group accounts.
We believe this focus will allow us to satisfy customer expectations, create
enterprise-wide solutions, streamline operations, optimize efficiencies and
quality improvements and leverage our growth opportunities.
SECURE HORIZONS MARKETING. We market our Secure Horizons programs to Medicare
beneficiaries primarily through direct mail, telemarketing, our website,
television, radio and community based events with participating medical groups.
Most Secure Horizons members enroll directly in a plan, generally without the
involvement of insurance brokers, except when enrolling as part of an employer
group retiree offering. See "Business Operations -- Secure Horizons Program" and
"Business Operations -- Commercial Plans."
COMMERCIAL NATIONAL, MAJOR, MID-SIZE, GROUP RETIREE, LABOR AND TRUST ACCOUNTS
MARKETING. Commercial marketing is a two-step process in which we first market
to employer groups, then provide information directly to employees once the
employer has selected our HMO. We use various techniques to attract commercial
members, including work site presentations, direct mail, medical group tours and
local advertising. We also use television, radio, billboard and print media to
market our programs. Insurance brokers and consultants represent many employer
groups under contract with PacifiCare. These brokers and consultants work
directly with employers to recommend or design employee benefits packages. We
pay insurance brokers commissions over the life of the contract, while employers
generally pay consultants directly. Our commercial membership growth is a result
of in-market acquisitions as well as greater penetration in existing employer
groups. With each open enrollment, we identify our specific approach with
certain employer groups to increase our penetration.
COMMERCIAL INDIVIDUAL AND SMALL GROUP ACCOUNTS MARKETING. A small group is an
employer with fewer than 50 employees. We now consider small groups as a single
market throughout all of our regions, not as separate markets managed
independently and differently in each state as in the past. Since September
1999, we have had a partnership with InsWeb Corporation which is accessible from
more than 115 sites on the Internet to provide free health insurance quotes. We
currently offer individual health products at InsWeb in California, with plans
to expand to individual and small group offerings in our other states by the end
of 2000. In February 2000, we announced the launch of our Premier plans, a new
line of small group products sold through the Internet. This product's pricing
reflects the reduced distribution costs of doing business online.
9
12
The Premier plans are currently available to our California customers through
electronic brokers via online insurance channels, PacifiCare's website
(www.pacificare.com/need insurance) and through traditional insurance brokers.
We plan to introduce similar Internet strategies for small employers in markets
outside of California by the end of 2000.
MANAGEMENT INFORMATION SYSTEMS
GENERAL. PacifiCare uses computer-based management information systems for
various purposes, including marketing and sales tracking, underwriting, billing,
claims processing, medical management, medical cost and utilization trending,
financial and management accounting, reporting, planning and analysis. These
systems also support member, group and provider service functions, including
on-line access to membership verification, claims and referral status and
information regarding hospital admissions and lengths of stay. In addition,
these systems support extensive analyses of cost and outcome data.
We continually enhance and upgrade our computer information systems to preserve
our investment in existing systems, embrace new technologies, improve the cost
effectiveness and quality of our services and introduce new products. Ongoing
system enhancements include upgrading system platforms, enhancing existing
software, implementing purchased software, selectively outsourcing some
technical functions and migrating to more suitable software database
environments. Simplification, integration and expansion of the systems servicing
our business are important components of controlling health care and
administrative expenses and improving member and provider satisfaction. We have
recovery plans in place to mitigate the effect of information systems outages,
if necessary. To the extent that these systems fail to operate, however, it
could have a material effect on results of operations or cash flows of a future
period.
GOVERNMENT REGULATION AND PROPOSED LEGISLATION
GENERAL. PacifiCare's HMOs are subject to extensive federal and state regulation
that govern the scope of benefits provided to its members, financial solvency
requirements, quality assurance and utilization review procedures, member
grievance procedures, provider contracts, marketing and advertising. Certain
federal and state regulatory agencies also require our HMOs to maintain
restricted cash reserves represented by interest-bearing investments that are
held by trustees or state regulatory agencies. These requirements, which limit
the ability of our subsidiaries to transfer funds, may limit their ability to
pay dividends. From time to time, we advance funds to our subsidiaries to assist
them in satisfying federal or state financial requirements. Our behavioral
health, dental and insurance subsidiaries are also subject to extensive federal
and state regulation.
HCFA. PacifiCare's Secure Horizons program is subject to regulations by HCFA,
the United States Department of Health and Human Services ("HHS") and certain
state agencies. These agencies govern the benefits provided, premiums paid,
quality assurance procedures, marketing and advertising. See "Business
Operations -- Secure Horizons Program." Congress enacted the Balanced Budget Act
of 1997, which required the creation of the Medicare+Choice program as a
replacement to the Medicare Risk program. HCFA has since promulgated
regulations, operational policy letters and contracts implementing
Medicare+Choice, including the Balanced Budget Refinement Act of 1999. These
contracts and regulations establish new and expanded requirements for
Medicare+Choice organizations. They also establish new or expanded standards for
quality assurance, beneficiary protection, coordinated open enrollment, program
payment and audits, information disclosure and provider participation.
Compliance with and implementation of the new Medicare+Choice regulations has
and will continue to increase our Medicare administration costs. We continue to
evaluate the operational and financial impact of the new Medicare+Choice
program.
The Balanced Budget Act also revised the formula used by HCFA to calculate
payments to Medicare health plans. The BBA established minimum payment levels,
limiting annual increases and the overall rate of payment growth. Further, as
authorized by the BBA, HCFA has developed a health risk-adjusted payment
methodology that it began to implement on January 1, 2000. See "Secure Horizons
Program -- Premiums." Effective January 1, 2000, 10 percent of the payment
amount is subject to risk adjustment in 2000. Under the Balanced Budget
Refinement Act of 1999, the phase-in schedule for risk adjusted payments was
modified to 10 percent in 2001 and 20 percent in 2002. It had previously been
set at 30 percent in 2001 and 55 percent in
10
13
2002. Currently, HCFA is basing its assessment of health risk solely on the
prior year's hospital utilization statistics relating to each member. Managed
care organizations, such as PacifiCare, have succeeded in part because of
programs designed to avoid unnecessary, extended and risky hospitalizations. We
have achieved lower inpatient utilization through the use of other, less costly
processes for providing and managing health care. We anticipate that, beginning
in 2004, as much as 100 percent of the payments to Medicare health plans may be
subject to a risk adjustment factor.
It is possible that future legislation may create additional changes in the
payment formula or modify risk adjustment. However, it is not certain that
efforts to revise either will succeed. The loss of Medicare contracts or changes
in the program could have a material effect on our financial position, results
of operations or cash flows of a future period.
ADJUSTED COMMUNITY RATE FILINGS. As a result of the Balanced Budget Act of 1997
and related HCFA rules and regulations, our HMO subsidiaries are required to
submit separate adjusted community rate ("ACR") proposals for every
Medicare+Choice plan they offer to Medicare beneficiaries. These rates are based
upon our average commercial rate (for non-Medicare enrollees) modified by a
factor that represents the difference in utilization characteristics between
Medicare and non-Medicare enrollees within each geographic area. In effect, our
benefits structure for Secure Horizons is established based upon these rates.
Each of our subsidiaries must submit the ACR proposals, generally by county or
service area, to HCFA by July 1st for each Medicare+Choice plan offered in the
subsequent year. In the normal course of business, all information submitted as
part of the ACR process is subject to audit by HCFA or any person or
organization designated by HCFA. Beginning in January 2000, HCFA contracted with
the Office of Inspector General of the United States Department of Health and
Human Services to conduct more comprehensive audits on one-third of all ACR
filings as mandated by law. We cannot be certain that any ongoing and future
audits will be concluded satisfactorily. We may incur additional, possibly
material, liability as a result of these audits. We believe that any ultimate
liability would not materially affect our consolidated financial position.
However, the incurrence of such liability could have a material effect on
results of operations or cash flows of a future period.
EMPLOYEE RETIREMENT INCOME SECURITY ACT OF 1974 ("ERISA"). Pursuant to ERISA,
the federal government regulates insured and self-insured health coverage plans
offered by employers. There have been recent highly publicized legislative
attempts to amend ERISA to remove the current limitation on the ability of
states to regulate employer health plans and the limitations on an employee's
ability to sue a health plan under state law. If such proposals were enacted,
they may permit greater state regulation of other aspects of those business
operations, and they might increase our exposure under state law claims that
relate to employee health benefits.
HEALTH INSURANCE PORTABILITY AND ACCOUNTABILITY ACT OF 1996 ("HIPAA"). HIPAA's
federal standards apply to both the group and individual health insurance
markets. HIPAA includes certain mandates including guarantees of the
availability and renewability of health insurance for certain employers,
employees and individuals, limits on the use of preexisting condition
exclusions, disclosure of prior coverage, prohibitions against discriminating on
the basis of health status, and requirements that make it easier to continue
coverage in cases where an employee is terminated or changes employers.
PacifiCare believes that it is in substantial compliance with the mandates
required by HIPAA. HIPAA also includes administrative simplification provisions
directed at simplifying electronic data interchange through standardizing
transactions, establishing uniform health care provider, payer and employer
identifiers and seeking protections for confidentiality and security of patient
data. Proposed rules under HIPAA administrative simplification are expected to
be released as final rules during 2000 for full implementation within two years
from the date of each release. The administrative simplification portion of
HIPAA as currently proposed would require health plans, health care providers,
health care clearing houses and additional third parties such as business
partners to communicate electronically using standardized formats. We are
proceeding as if the proposed rules will be adopted as currently proposed and
will be assessing where our current systems diverge from the requirements of
administrative simplification. We are unable at this time to assess the cost of
implementation of the administrative simplification requirements of HIPAA.
11
14
Both federal and state regulators have enforcement responsibilities for HIPAA.
As a result, we may encounter different interpretations of HIPAA's provisions in
the different states, as well as varying enforcement philosophies in states
where we operate HMOs. These differences may inhibit our ability to standardize
our products and services across state lines. Ultimately, under HIPAA and other
state laws, cost control through provider contracting and coordinating care may
become more important, and we believe our experience in these areas will allow
us to compete effectively.
OPM. Our HMO subsidiaries have commercial contracts with OPM to provide managed
health care services to federal employees, annuitants and their dependents under
the FEHBP. Rather than negotiating rates with HMOs, OPM requires HMOs to provide
the FEHBP with rates comparable to the rates charged to the two employer groups
with enrollment closest in size to the FEHBP in the applicable state after
adjusting for differences in benefits, enrollment demographics, and coordination
of costs with Medicare. OPM further requires that every HMO certify each year
that its rates meet these requirements. Approximately every three to five years,
OPM's Office of Inspector General ("OIG") audits each HMO to verify that the
premiums charged are calculated and charged in compliance with these rating
regulations and guidelines. Each audit encompasses a period of up to six years.
Following the government's initial on-site audit, OPM will provide the HMO with
a post-audit briefing indicating its preliminary results. Because these are
actuarial calculations, interpretations of the rating regulations and audit
findings often raise complex issues. The final resolution and settlement of
audits have historically taken more than three years and as many as seven years.
During the audit process, OPM may refer its findings to the United States
Department of Justice ("DOJ") if it believes that the health plan knowingly
overcharged the government or otherwise submitted false documentation or
certifications in violation of the False Claims Act. Under the False Claims Act,
an action can be considered knowingly committed if the government contractor
acted with actual knowledge, or with reckless disregard or deliberate ignorance
of the government's rules and regulations. If the government were to win a False
Claims Act lawsuit against an HMO, the government could obtain trebled damages,
a civil penalty of not less than $5,000 nor more than $10,000 for each separate
alleged false claim, and the government could permanently disqualify the HMO
from participating in all federal government programs.
Prior to our acquisition of FHP International Corporation ("FHP"), the FHP HMO
subsidiary, TakeCare of California, was audited by the OIG auditors. The OIG
issued a draft audit report in September 1996 alleging that TakeCare overcharged
the FEHBP by approximately $24 million including lost investment income.
TakeCare responded to this draft audit in January 1997, questioning many of the
auditors' calculations and assumptions. When we purchased FHP in February 1997,
we were aware of the government's claims, and we reserved for potential
liabilities in accordance with our accounting policies. In August 1999, we were
notified that the auditors had referred certain allegations to the DOJ for
review of potential claims under the False Claims Act. We are negotiating with
the DOJ to resolve all outstanding issues relating to the TakeCare of California
audit amicably. We do not agree with the auditors' interpretations of the
applicable rules and guidelines or their method of calculating rates for the
applicable period, and we do not believe there is any evidence that TakeCare of
California ever engaged in intentional wrongdoing or any action that would
violate the False Claims Act.
In July 1999, we received a request from the OIG for documentation regarding all
of the contracts between OPM and any of the HMOs owned by FHP that related to
the contract years 1990 through 1997. The majority of these contract years have
already been audited, but are not yet settled. We have complied with this
request.
OPM has conducted an audit of our Oregon HMO subsidiary for the years 1991
through 1996. We have recently been notified that the auditors had referred
certain allegations to the DOJ for review of potential claims under the False
Claims Act. We intend to negotiate with the DOJ to resolve any potential claims
amicably.
We intend to negotiate with OPM on any existing or future unresolved matters to
attain a mutually satisfactory result. We cannot be certain that any ongoing and
future negotiations will be concluded satisfactorily, that additional audits
will not be referred to the DOJ, or that additional, possibly material,
liabilities will not be incurred. We believe that any ultimate liability,
including any lost investment income, in
12
15
excess of amounts accrued would not materially affect our consolidated financial
position. However, such liability could have a material effect on results of
operations or cash flows of a future period if resolved unfavorably.
In late 1997, we established a formal corporate compliance program to
specifically address potential issues that may arise from the FEHBP rating
process, to work with OPM to understand its interpretation of the rules and
guidelines prior to completion of the rating process, to standardize the FEHBP
rating process among all of our HMOs, and to help reduce the likelihood that
future government audits will result in any significant findings. Based upon the
results of a limited number of audits that have been conducted for contract
years 1998 and later, we believe that this program has been effective.
TRADEMARKS
PacifiCare owns the federally registered service marks PacifiCare and
SecureHorizons(R). These service marks are material to our business.
EMPLOYEES
At February 29, 2000, PacifiCare had approximately 8,800 full and part-time
employees. None of our employees is presently covered by a collective bargaining
agreement. We consider relations with our employees to be good and have never
experienced any work stoppage.
ITEM 2. PROPERTIES
As of December 31, 1999, PacifiCare leased approximately 201,000 aggregate
square feet of space for its principal corporate headquarters and executive
offices in Santa Ana and Costa Mesa, California. In connection with our
operations, as of December 31, 1999, we leased approximately 1.8 million
aggregate square feet for office space, subsidiary operations, customer service
centers and space for computer facilities. Such space corresponds to areas in
which our HMOs or specialty managed care products and services operate, or where
we have satellite administrative offices. Our leases expire at various dates
from 2000 through 2009.
We own 13 buildings encompassing approximately 445,000 aggregate square feet of
space. Three of the buildings, representing approximately 244,000 aggregate
square feet of space, are primarily used for administrative operations and are
located in California and Guam. The remaining 10 buildings are medical office
buildings, of which nine are leased to third parties under a master lease
agreement. All 10 medical buildings are being marketed for sale. We also own
three parcels of vacant land for a total of 18 acres, all of which are being
marketed for sale.
Our facilities are in good working condition, are well maintained and are
adequate for our present and currently anticipated needs. We believe that we can
rent additional space at competitive rates when current leases expire, or if we
need additional space.
ITEM 3. LEGAL PROCEEDINGS
On November 2, 1999, Jose Cruz filed a class action complaint against
PacifiCare, our California subsidiary and FHP in San Francisco Superior Court.
On November 9, 1999, Cruz filed a first amended class action complaint that
omitted FHP as a defendant. The amended complaint relates to the period from
November 2, 1995 to the present and purports to be filed on behalf of all
enrollees in our health care plans other than Medicare and Medicaid enrollees.
The amended complaint alleges that we have engaged in unfair business acts in
violation of California law, engaged in false, deceptive and misleading
advertising in violation of California law and violated the California Consumer
Legal Remedies Act. It also alleges that we have received unjust payments as a
result of our conduct. The amended complaint seeks injunctive and declaratory
relief, an order requiring the defendants to inform and warn all California
consumers regarding our financial compensation programs, unspecified monetary
damages for restitution of premiums and disgorgement of improper profits,
attorneys' fees and interest. On December 2, 1999, we removed the action to the
United
13
16
States District Court for the Northern District of California on the grounds
that the amended complaint was completely preempted by the Employee Retirement
Income Security Act of 1974 or ERISA. We also moved to compel arbitration. The
plaintiff sought to have the case returned to state court. The court held a
hearing on these motions in February 2000 and has not ruled on the motions. We
deny all material allegations in the amended complaint and intend to defend the
action vigorously.
On November 22, 1999, Debbie Hitsman filed a class action complaint against
PacifiCare in the United States District Court for the Southern District of
Mississippi, Hattiesburg Division. The complaint relates to the period from
November 22, 1995 to the present and purports to be on behalf of all enrollees
in our health care plans other than Medicare and Medicaid enrollees. The
complaint alleges causes of action for violations of the Racketeer-Influenced
and Corrupt Organizations Act and ERISA. The complaint seeks an unspecified
amount of compensatory and treble damages, injunctive and restitutionary relief,
attorneys' fees, the imposition of a constructive trust and interest. On January
13, 2000, we filed a motion to compel arbitration and a motion to dismiss or, in
the alternative, to transfer the case for lack of personal jurisdiction and
improper venue. On January 25, 2000, the court stayed the action pending
resolution by the Multi-District Litigation or MDL Panel as to whether to
consolidate and transfer this and other similar actions to the MDL Panel. We
deny all material allegations and intend to defend the action vigorously.
In 1997, Tim Brady and other individuals filed a class action suit against
PacifiCare, several PacifiCare officers and several former officers of FHP in
the United States District Court for the Central District of California. In
addition, in 1997, Brady and other individuals filed class action against
PacifiCare and several PacifiCare officers and several former officers of FHP in
the Orange County Superior Court. Finally, in 1997, William Madruga and another
individual filed a class action suit against PacifiCare and several of its
directors and officers in the United States District Court for the Central
District of California. Each of the complaints related to the period from the
date of proxy statement for the FHP acquisition through our November 1997
announcement that earnings for the fourth quarter of 1997 would be lower than
expected. These complaints primarily alleged that we previously omitted and/or
misrepresented material facts with respect to our costs, earnings and profits.
The trial courts dismissed the Brady cases, brought on behalf of former FHP
shareholders, but the cases are now on appeal. The Madruga case, brought on
behalf of our stockholders, was dismissed with permission for the plaintiffs to
amend the complaint. The plaintiffs filed an amended complaint in November 1999
and we moved to dismiss the amended complaint in February 2000. The court has
scheduled a hearing on April 17, 2000 to consider our motion to dismiss. We deny
all material allegations and intend to defend the actions vigorously.
We are involved in legal actions in the normal course of business, some of which
seek monetary damages, including claims for punitive damages which are not
covered by insurance. Based on current information and review, including
consultation with our lawyers, we believe any ultimate liability that may arise
from these actions (including all purported class actions) would not materially
affect our consolidated financial position, results of operations, cash flows or
business prospects. However, our evaluation of the likely impact of these
actions could change in the future and an unfavorable outcome, depending upon
the amount and timing, could have a material effect on the results of operations
or cash flows of a future period.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matter was submitted to a vote of security holders during the three months
ended December 31, 1999.
14
17
PART II
ITEM 5. MARKET FOR THE COMPANY'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
PacifiCare's common stock is listed on the Nasdaq National Market under the
symbol PHSY. The following table indicates the high and low reported sale prices
per share as furnished by Nasdaq.
HIGH LOW
---- ---
YEAR ENDED DECEMBER 31, 1999
First Quarter(1).......................................... 82 7/8 63 1/2
Second Quarter(1)......................................... 100 3/8 60 1/2
Third Quarter............................................. 72 1/8 42
Fourth Quarter............................................ 59 31 1/8
YEAR ENDED DECEMBER 31, 1998(1)
First Quarter............................................. 75 5/8 49
Second Quarter............................................ 89 3/8 69 7/16
Third Quarter............................................. 93 1/4 55 5/8
Fourth Quarter............................................ 84 3/4 58 1/4
- ---------------
(1) At our June 24, 1999 annual meeting, our Class A and Class B common
stockholders approved an amended and restated certificate of incorporation,
which combined and reclassified our Class A and Class B common stock into a
single class of voting common stock. The 1999 first and second quarter
information and 1998 information listed above indicate the high and low
reported sales price per share for the Class B common stock. See Note 6 of
the Notes to Consolidated Financial Statements.
PacifiCare has never paid cash dividends on its common stock. We do not expect
to declare dividends on our common stock in the future, retaining all earnings
for business development. Any possible future dividends will depend on our
earnings, financial condition, and regulatory requirements. If we decide to
declare common stock dividends in the future, such dividends may only be made in
shares of PacifiCare's common stock, according to the terms of our credit
facility. See Note 6 of the Notes to Consolidated Financial Statements.
As of March 13, 2000 there were 328 stockholders of record of our common stock.
As of March 13, 2000 there were approximately 18,373 beneficial holders of our
common stock.
ITEM 6. SELECTED FINANCIAL DATA
In February 1997, PacifiCare's board of directors approved a change in our
fiscal year end from September 30 to December 31. This resulted in a transition
period for October 1, 1996 through December 31, 1996. The following selected
financial and operating data are derived from our audited consolidated financial
statements, or from our unaudited internal financial data. For clarity of
presentation and comparability, the following selected financial and operating
data includes the unaudited period for the twelve months ended December 31,
1996. The selected financial and operating data should be read in conjunction
with "Item 7. Management's Discussion and Analysis of Financial Condition and
Results of Operations," and also with "Item 8. Consolidated Financial Statements
and Supplementary Data."
15
18
INCOME STATEMENT DATA
(TRANSITION
(UNAUDITED) PERIOD)
TWELVE THREE
YEAR ENDED YEAR ENDED YEAR ENDED MONTHS ENDED MONTHS ENDED YEAR ENDED YEAR ENDED
DECEMBER 31, DECEMBER 31, DECEMBER 31, DECEMBER 31, DECEMBER 31, SEPTEMBER 30, SEPTEMBER 30,
1999(1) 1998(2) 1997(3) 1996(4) 1996 1996(4) 1995
------------ ------------ ------------ ------------ ------------ ------------- -------------
(AMOUNTS IN THOUSANDS, EXCEPT PER SHARE DATA)
Operating revenue......... $9,989,090 $9,521,482 $8,982,680 $4,807,856 $1,234,875 $4,637,305 $3,731,022
---------- ---------- ---------- ---------- ---------- ---------- ----------
Expenses:
Health care services.... 8,368,690 8,002,260 7,658,879 4,017,383 1,039,345 3,872,747 3,077,135
Other operating
expenses.............. 1,181,773 1,166,011 1,125,299 605,546 154,996 585,081 505,644
Impairment, disposition,
restructuring and
other (credits)
charges............... (2,233) 15,644 154,507 75,840 -- 75,840 --
Office of Personnel
Management (credits)
charges............... -- (4,624) -- 25,000 -- 25,000 --
---------- ---------- ---------- ---------- ---------- ---------- ----------
Operating income.......... 440,860 342,191 43,995 84,087 40,534 78,637 148,243
Net investment income and
interest expense........ 41,049 43,383 16,129 44,696 12,302 44,143 33,857
---------- ---------- ---------- ---------- ---------- ---------- ----------
Income before income
taxes................... 481,909 385,574 60,124 128,783 52,836 122,780 182,100
Provision for income
taxes................... 203,365 183,147 81,825 53,052 21,079 50,827 74,005
---------- ---------- ---------- ---------- ---------- ---------- ----------
Net income (loss)......... $ 278,544 $ 202,427 $ (21,701) $ 75,731 $ 31,757 $ 71,953 $ 108,095
========== ========== ========== ========== ========== ========== ==========
Preferred dividends....... -- (5,259) (8,792) -- -- -- --
---------- ---------- ---------- ---------- ---------- ---------- ----------
Net income (loss)
available to common
stockholders............ $ 278,544 $ 197,168 $ (30,493) $ 75,731 $ 31,757 $ 71,953 $ 108,095
========== ========== ========== ========== ========== ========== ==========
Basic earnings (loss) per
share(5)................ $ 6.26 $ 4.50 $ (0.75) $ 2.43 $ 1.01 $ 2.31 $ 3.69
========== ========== ========== ========== ========== ========== ==========
Diluted earnings (loss)
per share(5)............ $ 6.23 $ 4.40 $ (0.75) $ 2.39 $ 1.00 $ 2.27 $ 3.62
========== ========== ========== ========== ========== ========== ==========
OPERATING STATISTICS
Medical care ratio (health
care services as a
percentage of premium
revenue)
Consolidated............ 84.8% 85.0% 85.7% 84.5% 85.1% 84.4% 83.6%
Government.............. 86.9% 86.5% 85.6% 85.6% 85.5% 85.4% 84.3%
Commercial.............. 81.7% 82.8% 85.8% 82.8% 84.4% 83.1% 82.5%
Marketing, general and
administrative expenses
as a percentage of
operating revenue....... 11.1% 11.4% 11.7% 12.4% 12.4% 12.4% 13.4%
Operating income as a
percentage of operating
revenue................. 4.4% 3.6% 0.5% 1.7% 3.3% 1.7% 4.0%
Effective tax rate(6)..... 42.2% 47.5% 136.1% 41.2% 39.9% 41.4% 40.6%
Return on average
stockholders' equity.... 13.2% 9.4% (1.5)% 9.3% 3.9% 9.3% 18.9%
See footnotes following "Balance Sheet Data."
Continued on next page.
16
19
FINANCIAL STATEMENT CHANGE STATISTICS
YEAR ENDED YEAR ENDED YEAR ENDED YEAR ENDED YEAR ENDED
DECEMBER 31, DECEMBER 31, DECEMBER 31, SEPTEMBER 30, SEPTEMBER 30,
1999 1998 1997(7) 1996 1995
------------ ------------ ------------ ------------- -------------
Operating revenue.................................... 4.9% 6.0% 86.8% 24.3% 29.0%
Net income (loss).................................... 37.6% 1,032.8% (128.7)% (33.4)% 19.8%
Earnings (loss) per share............................ 41.6% 686.7% (131.4)% (37.3)% 12.4%
Total assets......................................... 5.5% (6.7)% 217.8% (6.2)% 25.3%
Total stockholders' equity........................... (11.6)% 8.5% 139.8% 12.5% 77.1%
DECEMBER 31, DECEMBER 31, DECEMBER 31, DECEMBER 31, SEPTEMBER 30, SEPTEMBER 30,
1999 1998 1997 1996 1996 1995
------------ ------------ ------------ ------------ ------------- -------------
MEMBERSHIP DATA
Government (Medicare & Medicaid)...... 1,014,600 972,800 1,001,100 593,600 596,200 541,000
Commercial............................ 2,643,400 2,554,100 2,790,000 1,451,500 1,434,500 1,216,100
---------- ---------- ---------- ---------- ---------- ----------
Total membership...................... 3,658,000 3,526,900 3,791,100 2,045,100 2,030,700 1,757,100
========== ========== ========== ========== ========== ==========
Percentage change in membership....... 3.7% (7.0)% 85.4% 0.7% 15.6% 29.4%
========== ========== ========== ========== ========== ==========
BALANCE SHEET DATA
(AMOUNTS IN THOUSANDS)
Cash and equivalents and marketable
securities.......................... $1,848,258 $1,600,189 $1,545,382 $ 962,482 $ 700,093 $ 811,525
Total assets.......................... $4,884,021 $4,630,944 $4,963,046 $1,561,472 $1,299,462 $1,385,372
Medical claims and benefits payable... $ 795,200 $ 645,300 $ 721,500 $ 282,500 $ 268,000 $ 288,400
Long-term debt, due after one year.... $ 975,000 $ 650,006 $1,011,234 $ 1,370 $ 5,183 $ 11,949
Stockholders' equity.................. $1,977,719 $2,238,096 $2,062,187 $ 860,102 $ 823,224 $ 732,024
- ---------------
(1) The 1999 results include impairment, disposition, restructuring and other
net pretax credits totaling $2 million ($2 million or $0.04 diluted loss per
share, net of tax). The after tax and per share amounts were losses because
the goodwill impairment was not deductible for income tax purposes. See Note
9 of the Notes to Consolidated Financial Statements. Operating income before
pretax credits and charges as a percentage of operating revenue was 4.4
percent. Return on average stockholders' equity before pretax credits and
charges was 13.3 percent.
(2) The 1998 results include $11 million of net pretax charges ($6 million or
$0.12 diluted loss per share, net of tax) for the disposal of unprofitable
subsidiaries and potential OPM claims. See Note 9 of the Notes to
Consolidated Financial Statements. Operating income before pretax credits
and charges as a percentage of operating revenue was 3.7 percent. Return on
average stockholders' equity before pretax credits and charges was 9.7
percent.
(3) The 1997 results include the results of operations for the FHP International
Corporation acquisition from February 14, 1997. The 1997 results also
include $155 million of pretax charges ($129 million or $3.18 diluted loss
per share, net of tax) for the impairment of long-lived assets,
restructuring and certain other charges. See Note 9 of the Notes to
Consolidated Financial Statements. Operating income before pretax charges as
a percentage of operating revenue was 2.2 percent. Return on average
stockholders' equity before pretax charges was 6.9 percent.
(4) The 1996 results include $101 million of pretax charges ($62 million or
$1.96 diluted loss per share, net of tax for the fiscal year ended September
30 and $1.97 diluted loss per share for the twelve months ended December 31)
for the impairment of long-lived assets, potential government claims,
dispositions and certain restructuring charges. Operating income before
pretax charges as a percentage of operating revenue for 1996 was 3.8 percent
for the fiscal year ended September 30 and 3.9 percent for the twelve months
ended December 31. Return on average stockholders' equity before pretax
charges for the fiscal year ended September 30 was 17.2 percent and 17.0
percent for the twelve months ended December 31.
(5) Earnings per share were restated to conform with the provisions of Statement
of Financial Accounting Standards No. 128, "Earnings per Share."
(6) Effective income tax rate includes the effect of nondeductible pretax
charges.
(7) Changes compared to the unaudited period for the twelve months ended
December 31, 1996.
17
20
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
RESULTS OF OPERATIONS
OVERVIEW. PacifiCare sells HMO and HMO-related products primarily to members in
two groups: the Secure Horizons program for Medicare beneficiaries and the
commercial plans for members of employer groups and individuals. Our specialty
managed care HMOs and HMO-related products and services supplement our
commercial and Secure Horizons programs. These include life and health
insurance, behavioral health services, dental and vision services, pharmacy
benefit management and Medicare+Choice management services.
Events significant to our business in 1999 include the following:
- - In November 1999, we entered a definitive agreement to purchase Harris
Methodist Texas Health Plan, Inc. and Harris Methodist Health Insurance
Company, Inc., a health plan and insurance company in Texas with
approximately 250,000 commercial and 50,000 Medicare members. We completed
the acquisition effective February 1, 2000 once we had received all necessary
approvals from the regulators. See Note 12 of the Notes to Consolidated
Financial Statements.
- - In October 1999, our board of directors approved a stock repurchase program
that allows us to repurchase up to 12 million shares of our outstanding
common stock, including any shares purchased from UniHealth Foundation. From
November 8, 1999, through December 31, 1999, we repurchased 6.3 million
shares under this authorization. This repurchase program supersedes the stock
repurchase program approved in January 1998, under which we purchased 3.2
million shares. Included in this 3.2 million shares were 2.5 million shares
repurchased in 1999. We also obtained an amendment to our existing credit
facility that increased the maximum allowable amount of share repurchases to
$1 billion from $500 million. See Note 6 of the Notes to Consolidated
Financial Statements.
- - We signed transition agreements with QualMed Washington Health Plans, Inc.,
in October 1999 and with QualMed Plans for Health of Colorado, Inc. in
September 1999, each a subsidiary of Foundation Health Systems, Inc. During
the first quarter of 2000 we will assume approximately 25,000 to 29,000
members in Colorado and approximately 24,000 members in Washington. See Note
12 of the Notes to Consolidated Financial Statements.
- - In September 1999, we acquired ANTERO Health Plans in Colorado and in
February 1999, we acquired 15,000 commercial members in Texas. See Note 4 of
the Notes to Consolidated Financial Statements.
- - In June 1999, we submitted our 2000 proposed Secure Horizons benefit plan
changes to HCFA for approval. These changes were designed to enable us to
maintain our Medicare margins in 2000. The changes, which were effective
January 1, 2000, included increasing our members' monthly premiums and
copayments or reducing benefits where the government provided insufficient
reimbursement. We expect disenrollments as a result of these premium and
benefit adjustments. In addition, we exited Secure Horizons operations in 12
counties in Ohio, Washington, California and Oregon effective January 1,
2000. These county exits did not result in a significant loss of our Secure
Horizons members. See "Forward-Looking Information under the Private
Securities Litigation Act of 1995."
- - In May 1999, we entered into a stock purchase agreement with UniHealth
Foundation to repurchase up to 5.9 million shares of our common stock held by
UniHealth Foundation. At our June 24, 1999 annual meeting, our Class A and
Class B common stockholders approved an amended and restated certificate of
incorporation, which combined and reclassified PacifiCare's Class A and Class
B common stock into a single class of voting common stock. We paid UniHealth
Foundation $60 million when our stockholders approved the amended and
restated certificate of incorporation on June 24, 1999. This payment was
recorded as a reduction of stockholders' equity. To date we have not
repurchased any of the shares held by UniHealth Foundation because our stock
price has been substantially below the $75 per share price at which UniHealth
Foundation may agree to sell the stock. See Note 6 of the Notes to
Consolidated Financial Statements.
18
21
1999 COMPARED WITH 1998
MEMBERSHIP. Total membership increased four percent to approximately 3.7 million
members at December 31, 1999 from approximately 3.5 million members at December
31, 1998.
AT DECEMBER 31, 1999 AT DECEMBER 31, 1998
-------------------------------------- --------------------------------------
MEMBERSHIP DATA GOVERNMENT(1) COMMERCIAL TOTAL GOVERNMENT(1) COMMERCIAL TOTAL
--------------- ------------- ---------- --------- ------------- ---------- ---------
Arizona......................... 89,300 105,000 194,300 86,500 107,100 193,600
California...................... 608,100 1,720,000 2,328,100 599,800 1,595,000 2,194,800
Colorado........................ 78,200 318,300 396,500 58,500 296,600 355,100
Guam............................ -- 41,500 41,500 -- 39,800 39,800
Nevada.......................... 28,500 35,100 63,600 22,900 38,900 61,800
Ohio............................ 16,500 42,700 59,200 16,600 44,000 60,600
Oklahoma........................ 29,000 84,300 113,300 26,900 96,300 123,200
Oregon.......................... 36,500 109,000 145,500 39,300 114,700 154,000
Texas........................... 64,100 112,600 176,700 61,900 127,100 189,000
Washington...................... 64,400 74,900 139,300 60,400 94,600 155,000
--------- --------- --------- ------- --------- ---------
Total membership................ 1,014,600 2,643,400 3,658,000 972,800 2,554,100 3,526,900
========= ========= ========= ======= ========= =========
- ---------------
(1) The government program represents the Medicare line of business.
Government membership increased four percent at December 31, 1999 compared to
membership at December 31, 1998 due to:
- - Competitor exits in markets where Secure Horizons will remain, primarily
Colorado, Nevada, Washington and Arizona; and
- - The positive results of retention programs initiated during 1998 in
California.
Commercial membership increased approximately three percent at December 31, 1999
compared to membership at December 31, 1998 due to:
- - Membership increases in California primarily due to improved sales efforts,
and in Colorado as a result of the acquisition of ANTERO Health Plans;
partially offset by
- - Membership losses attributable to our continued focus on renewing commercial
contracts with sufficient price increases to improve gross margin, primarily
in Washington and Texas.
GOVERNMENT PREMIUMS. Government premiums increased five percent or $289 million
for the year ended December 31, 1999 compared to premiums in the prior year as
follows:
YEAR ENDED
DECEMBER 31, 1999
---------------------
(AMOUNTS IN MILLIONS)
Premium rate increases that averaged approximately three
percent for the year ended December 31, 1999............ $205
Net membership increases (excluding Utah), primarily due
to competitors' exits in markets where Secure Horizons
will remain............................................. 131
Membership losses resulting from the disposition of
Utah.................................................... (47)
----
Increase over prior year.................................. $289
====
Government premium rates on a per member basis increased due to higher HCFA
premiums received, changes in membership demographics and health status, higher
retiree supplemental premiums and the exit of the Utah Medicaid business.
19
22
COMMERCIAL PREMIUMS. Commercial premiums increased four percent or $171 million
for the year ended December 31, 1999 compared to premiums in the prior year as
follows:
YEAR ENDED
DECEMBER 31, 1999
---------------------
(AMOUNTS IN MILLIONS)
Premium rate increases that averaged approximately six
percent for the year ended December 31, 1999............ $ 228
Net membership increases (excluding Utah), primarily in
California.............................................. 62
Membership losses resulting from the disposition of
Utah.................................................... (100)
Discontinued indemnity and workers' compensation
products................................................ (19)
-----
Increase over prior year.................................. $ 171
=====
OTHER INCOME. Other income increased for the year ended December 31, 1999
compared to the prior year. The increase was primarily due to increased
mail-service revenues from our pharmacy benefit management company, where we,
rather than network retail pharmacies, collect the member copayments.
CONSOLIDATED MEDICAL CARE RATIO. The 1999 consolidated medical care ratio
(health care services as a percentage of premium revenue) declined slightly
compared to 1998 primarily because current year provider reserves were
significantly less than in 1998.
YEAR ENDED
DECEMBER 31
------------
1999 1998
---- ----
Medical care ratio:
Consolidated.............................................. 84.8% 85.0%
Government................................................ 86.9% 86.5%
Commercial................................................ 81.7% 82.8%
Excluding 1998 net provider reserves, the increase in the 1999 consolidated
medical care ratio compared to 1998 was primarily due to higher contracted
physician costs, increased pharmacy utilization, pharmacy benefit enhancements
and higher prescription drug costs for our Secure Horizons members. See "1998
Compared with 1997 -- Consolidated Medical Care Ratio and Provider Reserves" for
further discussion of provider reserves.
GOVERNMENT MEDICAL CARE RATIO. The government medical care ratio for the year
ended December 31, 1999 increased compared to the prior year due to:
- - Higher contracted physician costs;
- - Increased pharmacy utilization, pharmacy benefit enhancements and higher
prescription drug costs; partially offset by
- - Higher premiums; and
- - Reduced hospital expenses, primarily because current year provider reserves
were significantly less than in 1998.
COMMERCIAL MEDICAL CARE RATIO. The commercial medical care ratio includes the
specialty HMOs and indemnity insurance results. The commercial medical care
ratio for the year ended December 31, 1999 decreased compared to the prior year
due to the following:
- - Premium rate increases;
- - The sale of our Utah HMO and workers' compensation subsidiaries; partially
offset by
- - Higher contracted physician costs.
20
23
MARKETING, GENERAL AND ADMINISTRATIVE EXPENSES. For the year ended December 31,
1999 compared to 1998, marketing, general and administrative expenses as a
percentage of operating revenue decreased because of:
- - Higher operating revenues;
- - The Utah HMO disposition; and
- - The improved efficiencies of our regional customer service operations.
YEAR ENDED
DECEMBER 31
------------
1999 1998
---- ----
Marketing, general and administrative expenses as a
percentage of operating revenue........................... 11.1% 11.4%
IMPAIRMENT, DISPOSITION, RESTRUCTURING AND OTHER (CREDITS) CHARGES. We
recognized impairment, disposition, restructuring and other pretax credits in
1999 totaling $2 million (after tax charges of $2 million or $0.04 diluted loss
per share). The after tax and per-share amounts were losses because the goodwill
impairment was not deductible for income tax purposes. See Note 9 of the Notes
to Consolidated Financial Statements.
OPERATING INCOME. Factors contributing to the increase in operating income are
discussed above.
YEAR ENDED
DECEMBER 31
------------
1999 1998
---- ----
Operating income as a percentage of operating revenue....... 4.4% 3.6%
NET INVESTMENT INCOME. Net investment income decreased approximately 19 percent
for the year ended December 31, 1999 compared to the prior year due to the
following:
- - Fewer realized gains on sales of marketable securities in the current year;
and
- - The shift of more portfolio holdings to tax-exempt investments that have
lower interest rates.
INTEREST EXPENSE. Interest expense decreased approximately 29 percent for the
year ended December 31, 1999 compared to the prior year due to the reduction in
outstanding borrowings until December 1999, when we borrowed $400 million to
fund our share repurchase program, and lower overall average interest rates paid
on our credit facility.
PROVISION FOR INCOME TAXES. The effective income tax rate was 42.2 percent in
1999, compared with 47.5 percent in 1998. The rate declined significantly
because:
- - Nondeductible goodwill amortization was a smaller percentage of pretax
income;
- - We benefited from certain tax strategies, in particular the legal
reorganization of PacifiCare and its subsidiaries, which resulted in lower
state income taxes;
- - The 1998 effective tax rate included an increase related to nondeductible
losses recognized for the dispositions of the Utah HMO and workers'
compensation subsidiaries; and
- - 1999 investment strategies resulted in increased tax-exempt earnings.
21
24
DILUTED EARNINGS PER SHARE. For the year ended December 31, 1999, net income was
$279 million or $6.23 diluted earnings per share. For the year ended December
31, 1998, net income was $202 million or $4.40 diluted earnings per share. The
change was due to the following:
YEAR ENDED
DECEMBER 31
-----------
Diluted earnings per share -- December 31, 1998............. $ 4.40
Impairment, disposition, restructuring, OPM and other
charges................................................... 0.12
------
Diluted earnings per share before impairment, disposition,
restructuring, OPM and other charges -- December 31,
1998...................................................... 4.52
Change attributable to operations:
Commercial medical care ratio performance................. 0.99
Government medical care ratio performance................. 0.22
Marketing, general and administrative expenses............ (0.21)
Other income performance.................................. 0.10
Amortization of goodwill and intangible assets............ 0.01
------
Total change attributable to operations................ 1.11
Net investment income and interest expense.................. (0.03)
Income tax rate decrease.................................... 0.54
Accretive impact of share repurchases due to 8.8 million
shares repurchased in 1999................................ 0.13
------
Diluted earnings per share before impairment, disposition,
restructuring and other (credits) charges -- December 31,
1999...................................................... 6.27
Impairment, disposition, restructuring, and other (credits)
charges................................................... (0.04)
------
Diluted earnings per share -- December 31, 1999............. $ 6.23
======
1998 COMPARED WITH 1997
MEMBERSHIP. Total membership decreased seven percent to approximately 3.5
million members at December 31, 1998 from approximately 3.8 million members at
December 31, 1997.
AT DECEMBER 31, 1998 AT DECEMBER 31, 1997
-------------------------------------- --------------------------------------
MEMBERSHIP DATA GOVERNMENT(1) COMMERCIAL TOTAL GOVERNMENT(2) COMMERCIAL TOTAL
--------------- ------------- ---------- --------- ------------- ---------- ---------
Arizona......................... 86,500 107,100 193,600 88,700 109,500 198,200
California...................... 599,800 1,595,000 2,194,800 605,300 1,650,000 2,255,300
Colorado........................ 58,500 296,600 355,100 52,600 286,700 339,300
Guam............................ -- 39,800 39,800 -- 42,800 42,800
Nevada.......................... 22,900 38,900 61,800 24,200 40,700 64,900
Ohio............................ 16,600 44,000 60,600 13,200 54,200 67,400
Oklahoma........................ 26,900 96,300 123,200 26,200 108,700 134,900
Oregon.......................... 39,300 114,700 154,000 40,600 116,500 157,100
Texas........................... 61,900 127,100 189,000 68,600 128,400 197,000
Utah............................ -- -- -- 25,000 154,200 179,200
Washington...................... 60,400 94,600 155,000 56,700 98,300 155,000
------- --------- --------- --------- --------- ---------
Total membership............ 972,800 2,554,100 3,526,900 1,001,100 2,790,000 3,791,100
======= ========= ========= ========= ========= =========
- ---------------
(1) The government program represents the Medicare line of business.
(2) The government program represents the Medicare and Medicaid lines of
business.
Government membership decreased approximately three percent at December 31, 1998
compared to the membership at the end of the prior year primarily as a result of
the sale of our Utah HMO and our exit from certain rural counties.
22
25
Commercial membership decreased approximately eight percent at December 31, 1998
compared to the membership at the end of the prior year due to:
- - The sale of our Utah HMO; and
- - Our continued focus on renewing commercial contracts with sufficient price
increases to improve gross margin, primarily in California.
GOVERNMENT PREMIUMS. Government premiums increased seven percent or $380 million
for the year ended December 31, 1998 compared to premiums in the prior year as
follows:
YEAR ENDED
DECEMBER 31, 1998
---------------------
(AMOUNTS IN MILLIONS)
The inclusion of six additional weeks of results in 1998
from the FHP acquisition.............................. $ 301
Premium rate increases that averaged approximately four
percent for the year ended December 31, 1998.......... 208
Net membership losses caused by our exit of certain
rural geographic areas and the Medicaid line of
business, primarily in California, Utah and Texas..... (129)
-----
Increase over prior year................................ $ 380
=====
COMMERCIAL PREMIUMS. Commercial premiums increased three percent or $95 million
for the year ended December 31, 1998 compared to premiums in the prior year as
follows:
YEAR ENDED
DECEMBER 31, 1998
---------------------
(AMOUNTS IN MILLIONS)
The inclusion of six additional weeks of results in 1998
from the FHP acquisition................................ $ 231
Premium rate increases that averaged approximately five
percent for the year ended December 31, 1998............ 130
Net membership losses primarily in California, Oklahoma
and Ohio, and from the disposition of Utah.............. (224)
Discontinued indemnity and workers' compensation
products................................................ (42)
-----
Increase over prior year.................................. $ 95
=====
OTHER INCOME. Other income increased in 1998 from the prior year due primarily
to higher revenues from our pharmacy benefit management company and SHUSA.
CONSOLIDATED MEDICAL CARE RATIO AND PROVIDER RESERVES. The 1998 consolidated
medical care ratio declined 0.7 percent compared to 1997.
YEAR ENDED
DECEMBER 31
------------
1998 1997
---- ----
Medical care ratio:
Consolidated.............................................. 85.0% 85.7%
Government................................................ 86.5% 85.6%
Commercial................................................ 82.8% 85.8%
23
26
The improved commercial product performance was partially offset by increased
provider reserves. Excluding these reserves, the consolidated medical care ratio
was 84.0 percent. Provider reserves were immaterial in 1997 and totaled $95
million in 1998 as follows:
QUARTER GOVERNMENT COMMERCIAL TOTAL
------- ---------- ---------- -----
(AMOUNTS IN MILLIONS)
First................................. $ 3 $ 3 $ 6
Second................................ 25 10 35
Third................................. 14 6 20
Fourth................................ 20 14 34
--- --- ---
Total............................ $62 $33 $95
=== === ===
The majority of the provider reserves related to specific provider bankruptcies.
However, the estimate also included reserves for potentially insolvent
providers, where conditions indicated claims were not being paid or had slowed
considerably. Provider charges include the write-off of uncollectable
receivables from providers and the estimated cost of unpaid health care claims
covered by our capitation payments. Depending on state law, we may be held
liable for unpaid health care claims that were the responsibility of the
capitated provider.
Reserves for the FPA Medical Management, Inc. bankruptcy totaled $57 million,
with $41 million attributable to our Nevada HMO. Reserves for other providers
totaled $38 million. Approximately $17 million of the reserves recognized in the
third and fourth quarters related to Caremark Rx, Inc. (formerly MedPartners,
Inc.), who ceased paying claims in Nevada and Arizona. The membership was
transitioned to other providers between December 1998 and January 1999. The
remaining $21 million was the estimated liability for smaller bankrupt providers
and potentially insolvent providers, primarily in California.
GOVERNMENT MEDICAL CARE RATIO. The government medical care ratio for the year
ended December 31, 1998 increased 0.9 percent compared to the prior year because
we recognized $62 million of provider reserves. Government provider reserves for
FPA were $40 million, with the majority of these charges recognized in the
second and third quarters. Other provider reserves of $22 million were recorded
primarily in the fourth quarter. Higher costs incurred for FPA membership
shifting into new provider relationships were offset by the disposition of Utah
in September 1998. Excluding government provider reserves, the 1998 government
medical care ratio was 85.4 percent.
COMMERCIAL MEDICAL CARE RATIO. The commercial medical care ratio includes the
specialty HMOs and indemnity insurance results. The commercial medical care
ratio for the year ended December 31, 1998 decreased due to the following:
- - Improved provider contracts;
- - Premium rate increases;
- - Improved performance from the specialty HMOs;
- - Sale of our Utah HMO and workers' compensation subsidiaries; offset by
- - Provider reserves of $33 million.
Commercial provider reserves for FPA totaled $17 million, primarily recognized
in the second and third quarters. Other provider reserves of $16 million were
recognized in the fourth quarter and related to Arizona, California, Nevada,
Texas and Washington. Excluding commercial provider reserves, the 1998
commercial medical care ratio was 82.0 percent.
24
27
MARKETING, GENERAL AND ADMINISTRATIVE EXPENSES. For the year ended December 31,
1998 compared to 1997, marketing, general and administrative expenses as a
percentage of operating revenue decreased because we realized the benefits of
restructuring and a full year of synergies as a result of the FHP acquisition.
YEAR ENDED
DECEMBER 31
-------------
1998 1997
----- ----
Marketing, general and administrative expenses as a
percentage of operating revenue........................... 11.4% 11.7%
IMPAIRMENT, DISPOSITION, RESTRUCTURING, OPM AND OTHER CHARGES. We recognized $11
million of net pretax charges in 1998, primarily for dispositions of
unprofitable operations. Favorable OPM settlements in the fourth quarter
partially offset increased reserves recognized in the third quarter. In 1997, we
recognized $155 million of pretax charges primarily related to our impairment of
our Utah and Washington HMOs and our workers' compensation subsidiary.
Restructuring reserves recognized in 1997 were paid in 1998. See Note 9 of the
Notes to Consolidated Financial Statements.
OPERATING INCOME. Factors contributing to the increase in operating income are
discussed above.
YEAR ENDED
DECEMBER 31
------------
1998 1997
---- ----
Operating income as a percentage of operating revenue....... 3.6% 0.5%
NET INVESTMENT INCOME. Net investment income increased approximately 29 percent
in 1998 compared to the prior year, due primarily to gains on sales of
marketable securities experienced throughout 1998 and more efficient investment
through account consolidation.
INTEREST EXPENSE. Interest expense decreased approximately six percent in 1998
compared to the prior year, due to continued repayment of our credit facility
and declining interest rates. The decrease was partially offset by interest on
the FHP acquisition borrowings that were outstanding for six weeks longer in
1998.
PROVISION FOR INCOME TAXES. The effective income tax rate was 47.5 percent in
1998, compared with 136.1 percent in 1997. The rate declined significantly for
two reasons:
- - The 1997 effective rate was disproportionately high because most of the
pretax charges recorded in the fourth quarter of 1997 were not deductible for
tax purposes. The 1997 effective income tax rate without the effect of the
pretax charges was approximately 50 percent.
- - We had a smaller percentage of nondeductible goodwill amortization as part of
our expenses.
DILUTED EARNINGS PER SHARE. For the year ended December 31, 1998, net income was
$202 million or $4.40 diluted earnings per share. For the year ended December
31, 1997, the net loss was $22 million or $0.75 diluted loss per share.
LIQUIDITY AND CAPITAL RESOURCES
OPERATING CASH FLOWS. PacifiCare's consolidated cash, equivalents and marketable
securities increased to $1.8 billion at December 31, 1999 from $1.6 billion at
December 31, 1998. The combined increase in cash, equivalents and marketable
securities occurred primarily due to the large draws on our line of credit to
repurchase shares in the open market. In addition, the Medicare payment received
from HCFA in December 1999 for January 2000 was higher than the amount received
in December 1998 for January 1999.
INVESTING ACTIVITIES. For the year ended December 31, 1999, we used $251 million
of cash for investing activities, compared to $19 million used in 1998. We
purchased more marketable securities and property, plant and equipment in 1999,
resulting in the majority of the net increase over the prior year. Property,
plant and equipment purchases were primarily related to internally developed
software and computer equipment.
25
28
FINANCING ACTIVITIES. For the year ended December 31, 1999, we used $194 million
of cash for financing activities compared to $393 million used for the same
period of the prior year. The decrease was primarily related to fewer credit
facility payments. The changes were as follows:
- - We repurchased 8.8 million shares of our common stock in 1999 for $480
million compared to 0.8 million shares of our common stock in 1998 for $45
million under our stock repurchase programs;
- - We borrowed under the credit facility to repurchase shares of our outstanding
common stock. Borrowings were $400 million in 1999 and $30 million in 1998;
- - We paid $75 million in principal on our credit facility during 1999 in
comparison to $391 million in principal in 1998. Principal payments declined
as we used available cash to fund our stock repurchases;
- - In consideration for UniHealth Foundation's vote for the reclassification of
our stock and in consideration for the agreements and covenants contained in
the stock purchase agreement between PacifiCare and UniHealth Foundation, we
paid UniHealth Foundation $60 million on June 24, 1999, when our stockholders
approved the amended and restated certificate of incorporation. We incurred
$2 million of expenses related to the reclassification of our common stock
and the registration of the shares held by UniHealth Foundation. See Note 4
of the Notes to Consolidated Financial Statements;
- - We received cash for the issuance of common stock totaling $23 million for
the year ended December 31, 1999 compared to $18 million for year ended
December 31, 1998; and
- - We paid $5 million in preferred stock dividends in 1998. No preferred
dividends were paid in 1999 because all of the outstanding preferred stock
was converted or redeemed in 1998.
OTHER BALANCE SHEET CHANGE EXPLANATIONS
RECEIVABLES, NET. Receivables, net increased $31 million from December 31, 1998
primarily due to increases in provider receivables as a result of our higher
proportion of shared-risk hospital contracts. In shared-risk contracts,
PacifiCare shares the risk of certain health care costs not covered by
capitation arrangements and we provide additional incentives to the physicians
or groups for appropriate utilization of hospital inpatient, outpatient surgery
and emergency room services. In some cases, the utilization of the hospital
health care costs is above the budgeted percentage as specified in the contract.
As a result, the hospital or medical group shares the liability for these costs
with PacifiCare.
GOODWILL AND INTANGIBLE ASSETS, NET. Goodwill and intangible assets decreased
$69 million from 1998 as follows:
- - $76 million decrease attributable to goodwill and intangible amortization
expense;
- - $14 million decrease attributable to the impairment of the Ohio HMO's
goodwill; partially offset by
- - $21 million increase attributable to membership acquisitions in Texas and
Colorado.
MEDICAL CLAIMS AND BENEFITS PAYABLE. Medical claims and benefits payable
increased $150 million from December 31, 1998 as follows:
- - $120 million increase in claims incurred but not yet reported for increased
membership and utilization under shared-risk hospital arrangements. Under
capitation arrangements, providers are prepaid based on a fixed-fee
per-member per-month, regardless of the services provided to each member.
Under shared-risk arrangements, claims are payable, once incurred. This
results in a payable for claims incurred, but not yet paid as well as an
estimate of claims incurred but not yet reported to PacifiCare;
- - $35 million increase primarily due to increased amounts withheld from
capitation for claims we administered on behalf of non-delegated providers;
- - $13 million increase in pharmacy claims attributable to a one day lag in
payment to our two largest pharmacy chains. This occurs when the payment date
falls on a weekend; partially offset by
26
29
- - $12 million net decrease in provider insolvency reserves, consisting of $24
million in payments primarily to Nevada providers, other net changes in
estimates totaling $3 million; partially offset by $15 million in additional
provisions; and
- - $6 million net decrease in other provider liabilities.
ACCOUNTS PAYABLE. Accounts payable increased $26 million primarily due to
increased prescription drug inventory purchases from manufacturers that are not
payable until January 2000, higher legal and professional costs and higher
broker commission accruals due to increased membership.
ACCRUED LIABILITIES. Accrued liabilities decreased $81 million from December 31,
1998 primarily due to income taxes payable. The decrease was attributable to
higher estimated tax payments, partially offset by the income tax provision on
1999 income.
MATERIAL COMMITMENTS. See Note 6 of the Notes to Consolidated Financial
Statements for a discussion of our agreement to purchase shares of our common
stock held by UniHealth Foundation.
NEW ACCOUNTING PRONOUNCEMENTS. See Note 2 of the Notes to Consolidated Financial
Statements for a discussion of future application of accounting standards.
THREE MONTHS ENDED DECEMBER 31, 1999 COMPARED WITH THREE MONTHS ENDED SEPTEMBER
30, 1999
The following presents our results of operations for the three months ended
December 31, 1999 in comparison to the results of operations for the three
months ended September 30, 1999. We are presenting this information to assist in
the understanding of our discussions about our operating trends. This includes
our outlook on future performance and the risks affecting our future performance
discussed below in Forward-Looking Information under the Private Securities
Litigation Act of 1995.
MEMBERSHIP. Total membership at December 31, 1999 was comparable to the total
membership at September 30, 1999.
AT DECEMBER 31, 1999 AT SEPTEMBER 30, 1999
--------------------------------------- ---------------------------------------
MEMBERSHIP DATA GOVERNMENT(1) COMMERCIAL TOTAL GOVERNMENT(1) COMMERCIAL TOTAL
--------------- -------------- ---------- --------- -------------- ---------- ---------
Arizona.................. 89,300 105,000 194,300 82,800 102,900 185,700
California............... 608,100 1,720,000 2,328,100 616,800 1,710,000 2,326,800
Colorado................. 78,200 318,300 396,500 76,100 319,300 395,400
Guam..................... -- 41,500 41,500 -- 40,400 40,400
Nevada................... 28,500 35,100 63,600 25,400 34,500 59,900
Ohio..................... 16,500 42,700 59,200 19,600 42,900 62,500
Oklahoma................. 29,000 84,300 113,300 28,800 86,700 115,500
Oregon................... 36,500 109,000 145,500 37,800 115,900 153,700
Texas.................... 64,100 112,600 176,700 59,900 121,100 181,000
Washington............... 64,400 74,900 139,300 64,400 74,900 139,300
--------- --------- --------- --------- --------- ---------
Total membership......... 1,014,600 2,643,400 3,658,000 1,011,600 2,648,600 3,660,200
========= ========= ========= ========= ========= =========
- ---------------
(1) The government program represents the Medicare line of business.
GOVERNMENT PREMIUMS. Government premiums increased approximately two percent or
$26 million for the three months ended December 31, 1999 compared to the three
months ended September 30, 1999. The increase was due to $15 million of
membership increases and $11 million of premium rate increases, primarily for
prior periods related to retroactive adjustments due to changes in members'
status, including Medicaid eligibility and employment status.
27
30
COMMERCIAL PREMIUMS. Commercial premiums increased approximately two percent or
$19 million for the three months ended December 31, 1999 compared to the three
months ended September 30, 1999 due to:
- - Membership increases of $10 million;
- - Premium rate increases of $7 million; and
- - Indemnity product line increases of $2 million due to increased membership
and premium rates.
OTHER INCOME. Other income increased for the three months ended December 31,
1999 compared to the three months ended September 30, 1999 due to increased
mail-service revenues from our pharmacy benefit management company, where we,
rather than the network retail pharmacies, collect the member copayments.
CONSOLIDATED MEDICAL CARE RATIO. The consolidated medical care ratio for the
three months ended December 31, 1999 was comparable to the consolidated medical
care ratio for the three months ended September 30, 1999.
THREE MONTHS ENDED THREE MONTHS ENDED
DECEMBER 31, 1999 SEPTEMBER 30, 1999
------------------ ------------------
Medical care ratio:
Consolidated............................................ 84.7% 84.7%
Government.............................................. 85.9% 87.3%
Commercial.............................................. 82.8% 80.9%
GOVERNMENT MEDICAL CARE RATIO. The government medical care ratio decreased for
the three months ended December 31, 1999 compared to the three months ended
September 30, 1999 due to:
- - Premiums received for prior periods related to retroactive adjustments due to
changes in members' status, including Medicaid eligibility and employment
status; and
- - Decreased hospital costs, primarily settlements and changes in estimates for
risk-sharing arrangements.
COMMERCIAL MEDICAL CARE RATIO. The commercial medical care ratio includes the
specialty HMOs and indemnity insurance results. The commercial medical care
ratio increased for the three months ended December 31, 1999 compared to the
three months ended September 30, 1999 due to:
- - Increases in contracted physician costs, primarily provider reserves;
- - Increased pharmacy utilization and higher prescription drug costs; partially
offset by
- - Premium rate increases.
MARKETING, GENERAL AND ADMINISTRATIVE EXPENSES. Marketing, general and
administrative expenses as a percentage of operating revenue for the three
months ended December 31, 1999 increased compared to the prior quarter due to
higher marketing expenses related to annual open enrollment and charitable
contributions.
THREE MONTHS ENDED
--------------------------------------
DECEMBER 31, 1999 SEPTEMBER 30, 1999
----------------- ------------------
Marketing, general and administrative
expenses as a percentage of operating
revenue.................................... 11.6% 11.2%
OPERATING INCOME. Factors contributing to the increase in operating income are
discussed above.
THREE MONTHS ENDED
--------------------------------------
DECEMBER 31, 1999 SEPTEMBER 30, 1999
----------------- ------------------
Operating income as a percentage of operating
revenue.................................... 4.1% 4.5%
28
31
NET INVESTMENT INCOME. Net investment income increased approximately 15 percent
for the three months ended December 31, 1999 compared to the three months ended
September 30, 1999. The increase was due to higher invested balances and
increases in short-term interest rates.
INTEREST EXPENSE. Interest expense increased approximately 38 percent for the
three months ended December 31, 1999 compared to the three months ended
September 30, 1999 due to increased borrowings on our credit facility to fund
our share repurchase program. In addition, the reduction in our credit rating by
the credit rating agencies combined with a higher interest fee structure in the
credit facility amendment resulted in higher interest rates.
PROVISION FOR INCOME TAXES. The effective income tax rate was 42.1 percent for
the three months ended December 31, 1999 compared with 43.8 percent for the
three months ended September 30, 1999. The sequential decrease was primarily due
to the nondeductible Ohio goodwill impairment charges recognized in the third
quarter. See Note 9 of the Notes to Consolidated Financial Statements.
DILUTED EARNINGS PER SHARE. For the three months ended December 31, 1999, net
income was $66 million or $1.59 diluted earnings per share compared to net
income of $69 million or $1.54 diluted earnings per share for the three months
ended September 30, 1999. The change was due to the following:
THREE MONTHS ENDED
------------------
Diluted earnings per share -- September 30, 1999........... $ 1.54
Impairment, disposition, restructuring, and other (credits)
charges.................................................. 0.04
------
Diluted earnings per share before impairment, disposition,
restructuring and other (credits) charges -- September
30, 1999................................................. 1.58
Change attributable to operations:
Commercial gross margin performance...................... (0.21)
Government gross margin performance...................... 0.34
Marketing, general and administrative expenses........... (0.22)
Other income performance................................. 0.03
Amortization of goodwill and intangible assets........... (0.02)
------
Total change attributable to operations.................... (0.08)
Net investment income and interest expense................. (0.01)
Income tax rate impact(1).................................. (0.02)
Accretive impact of share repurchases...................... 0.12
------
Diluted earnings per share -- December 31, 1999............ $ 1.59
======
- ---------------
(1) This represents the income tax rate impact for the fourth quarter 1999 as a
result of the change in the income tax rate due to the impairment,
disposition, restructuring, and other (credit) charges recognized in the
third quarter 1999.
FORWARD-LOOKING INFORMATION UNDER THE PRIVATE SECURITIES LITIGATION ACT OF 1995
This document contains forward-looking statements that involve risks and
uncertainties. These statements relate to future events or our future financial
performance. In some cases, you can identify forward-looking statements by
terminology including, "may," "will," "could," "should," "intend," "expect,"
"plan," "anticipate," "believe," "estimate," "predict," "potentially,"
"continue," or "opportunity" or the negative of these terms or other comparable
terminology. The statements about our plans, strategies, intentions,
expectations and prospects contained throughout the document are forward-looking
and are based on current expectations. Actual results may differ materially from
those predicted as of the date of this report in the forward-looking statements.
In addition, past financial performance is not necessarily a reliable indicator
of future performance and investors should not use historical performance to
anticipate results or future period trends. In evaluating these statements, you
should specifically consider factors, including the risks described below and in
other parts of this annual report.
The expectations discussed below include QualMed membership assumed during the
first quarter of 2000 and the February 1, 2000 acquisition of Harris. See Note
12 of the Notes to Consolidated Financial Statements.
29
32
MEMBERSHIP. We expect the rate of government membership growth to be up to three
percent for the year ended December 31, 2000. The increase is primarily due to
the Harris acquisition. We expect approximately 40,000 Harris members will
remain enrolled by the end of 2000. In addition, we will continue to focus our
marketing efforts on group retiree members and growing membership as our
competitors exit markets where Secure Horizons will remain. These increases will
be partially offset by membership decreases as a result of reducing benefits,
increasing copayments and instituting or increasing member-paid supplemental
premiums in certain markets. We also experienced a slight membership decrease
due to discontinued Medicare risk contracts in 12 counties in Ohio, Washington,
California and Oregon effective January 1, 2000.
We expect the rate of commercial membership growth to range from 13 percent to
18 percent for the year ended December 31, 2000. The majority of the growth will
be a result of acquisitions. We expect to increase membership by approximately
175,000 by the end of 2000 as a result of the Harris acquisition. We also expect
to assume approximately 25,000 to 29,000 members in Colorado and approximately
24,000 members in Washington by the end of 2000, as a result of the agreements
signed with QualMed. In addition, we expect growth in California, where we plan
to focus our marketing efforts on membership retention and renewal of national
and major employer accounts.
PREMIUMS. HCFA premium rate increases combined with supplemental member premiums
are expected to be approximately three percent to five percent in 2000. We
instituted or increased member-paid supplemental premiums for approximately 45
percent of our Secure Horizons members for the first time in certain markets,
and increased premiums in other markets, to offset lower annual HCFA premium
rate increases. Commercial HMO premium rate increases are expected to range from
seven percent to nine percent in 2000. We expect our commercial premium revenue
to increase 22 percent to 26 percent as a result of these rate increases
combined with our expected commercial membership growth. In addition, in the
second half of the year we plan to implement higher premium rate increases in
California to cover the cost of new mental health coverage mandated under state
and federal laws.
MEMBERSHIP AND PREMIUM RISK FACTORS. An unforeseen loss of profitable membership
or a change in premium expectations could negatively affect our financial
position, results of operations and cash flows. Factors that could contribute to
the loss of membership or lower premiums include:
- - The inability of our marketing and sales plans to attract new customers or
retain existing customers;
- - The effect of premium increases, benefit changes and member-paid supplemental
premiums and copayments;
- - Our exit from certain markets;
- - Reductions in work force by existing customers;
- - Negative publicity and news coverage or threats of litigation;
- - Our failure to successfully complete and/or integrate contemplated
acquisitions; and
- - The loss of our key employees in sales and marketing.
OTHER INCOME. In 2000, we expect other income to increase, primarily related to
increased pharmacy mail-service revenues.
HEALTH CARE COSTS. Our profitability depends, in part, on our ability to control
health care costs while providing quality care. Our primary focus is securing
cost-effective physician, hospital and other health care provider contracts to
maintain our qualified network of providers in each geographic area we serve.
Through December 31, 1999, consolidated medical and hospital costs were trending
between one and five percent higher. Other costs, the majority of which is
prescription drugs, were trending between 12 percent and 16 percent higher.
These health care cost trends are expected to be slightly higher in 2000.
Since the end of 1998, our hospital providers have increasingly not wanted to
renew capitated hospital contracts and have requested fee-for-service and
shared-risk arrangements. As a result of this trend, the percentage of
consolidated members under capitated arrangements for hospital contracts has
decreased from
30
33
85 percent at the end of 1998 to approximately 75 percent to 80 percent at the
end of 1999. We expect the percentage of capitated hospital contracts to
continue to decrease in 2000 to between 70 percent and 75 percent, particularly
in markets where providers face less competition. We expect to increase the
capitation rates we pay some of our medical and hospital providers to improve
the network stability of our capitated providers. To offset these increases, we
have reduced benefits, increased copayments and instituted or increased
member-paid supplemental premiums in certain markets for our Secure Horizons
members. We have also begun to implement initiatives intended to improve
performance of our provider contracts, including our medical management redesign
initiative. See "Health Care Costs and Provider Relationships -- Medical
Management Redesign." Members in contracts that are capitated for professional
risk were approximately 95 percent at December 31, 1999 and are not expected to
change in 2000.
We work closely with our provider partners to ensure the strength and quality of
our network. Under fee-for-service contracts, we have no insolvency risk,
however, we do have increased utilization risk. Under our capitated
arrangements, we face the risk of a provider becoming insolvent. To minimize our
insolvency risk, we have developed contingency plans that include shifting
members to other providers and reviewing operational and financial plans to
increase financial stability. We believe our December 31, 1999 provider
insolvency reserves, intended to pay for December 1999 and prior health care
services that may not be paid by insolvent or unstable providers, are adequate.
PHARMACY. Our prescription drug costs have been rising for the past few years.
The increases are due to the introduction of new drugs costing significantly
more than existing drugs, direct consumer advertising by the pharmaceutical
industry creating consumer demand for particular brand drugs, patients seeking
medications to address lifestyle changes and higher prescribed doses of
medications and enhanced pharmacy benefits for members such as reduced
copayments and higher benefit maximums. Our efforts to mitigate these trends and
ensure appropriate utilization include formulary management, provider education,
successful pharmaceutical contracting and increased utilization of our in-house
mail service pharmacy operated by Prescription Solutions.
Formularies are lists of physician-recommended drugs in different therapeutic
classes that have been reviewed for safety, efficacy and value. These lists help
ensure that members get the right prescription at the right time in the right
dose, avoiding potential adverse effects. Formularies also ensure that the costs
are effectively managed; if two medications have the same effect, the less
expensive option (often a generic alternative) is recommended. Medically
necessary drugs not included in the formulary can be obtained through our
authorization process. We continue to conduct member and physician education
programs to provide information on the appropriate use of generic drugs, over
the counter drugs and antibiotics. Many of our medical groups share the
financial risk for prescription drugs to find the most effective and
cost-efficient treatments for our members. Prescription drug benefit changes for
Secure Horizons members have been implemented in almost all our geographic areas
for 2000 as a way of controlling this health care cost component.
CONSOLIDATED MEDICAL CARE RATIO. We manage premium increases to offset health
care cost increases to maintain long term stability in our medical care ratio.
Our "same store" business is expected to have a consolidated medical care ratio
comparable to 1999. Our acquisition of Harris is expected to slightly increase
the consolidated medical care ratio.
GOVERNMENT MEDICAL CARE RATIO. We expect the 2000 government medical care ratio
to increase compared to the December 31, 1999 medical care ratio. We expect
increases in capitation rates and higher claims under shared-risk arrangements
to cause an increase in the medical care ratio. To partially offset these rising
health care costs, we plan to charge member-paid supplemental premiums, reduce
benefits and increase our hospital utilization management.
COMMERCIAL MEDICAL CARE RATIO. We expect the 2000 commercial medical care ratio
to slightly increase due to the number of fee-for-service provider contracts and
the more extensive drug formulary, both obtained as a result of the Harris
acquisition. In addition, we also expect increases in costs resulting from
higher pharmacy costs and increased utilization under our shared-risk contracts.
These increases will be partially offset by premium rate increases and cost
savings from hospital utilization management.
31
34
MEDICAL CARE RATIO RISK FACTORS. An increase in our consolidated medical care
ratio could have an adverse effect on our profitability. Uncertainties that
could have a negative impact on our medical care ratio include:
- - The mix of our capitated, shared-risk and fee-for-service provider contracts;
- - Medical and prescription drug costs that rise faster than premium increases;
- - Increases in utilization and costs of medical and hospital services;
- - Our inability to successfully implement our new medical management
initiatives including hospital utilization management initiatives;
- - The effect of federal and/or state legislation on our ability to secure
cost-effective contracts with providers;
- - The effect of actions by competitors;
- - Termination of provider contracts, provider instability or renegotiations of
such contracts at less favorable rates or terms of payment; and
- - Legislation that gives physicians collective bargaining power.
We have and may continue to incur additional health care costs. The effect of
these risks and the need for additional provider reserves could have a material
effect on our results of operations or cash flows of a future period. We
believe, however, that such reserves would not materially affect our
consolidated financial position.
MARKETING, GENERAL AND ADMINISTRATIVE EXPENSES. We expect marketing, general and
administrative expenses as a percentage of operating revenue to be comparable or
slightly increase compared to 1999. We expect increases as we invest in our
medical management initiative by hiring additional personnel and as we make
planned investments in technology. We anticipate spending $10 million to $15
million to integrate the Harris acquisition. In addition, we expect to incur
employee severance costs in the first quarter. These increases will be partially
offset by our plan to gain efficiencies in a number of functional areas
including the centralization and consolidation of our sales and marketing and
human resources departments.
MARKETING, GENERAL AND ADMINISTRATIVE RISK FACTORS. The following factors could
have an adverse impact on marketing, general and administrative expenses:
- - Our compliance with the Health Insurance Portability and Accountability Act
of 1996 ("HIPAA");
- - Our need for additional advertising, marketing, administrative or management
information systems expenditures;
- - The success of our marketing and sales plans to attract new customers;
- - Our need for increased claims administration for capitated providers;
- - Our need for additional unanticipated investments in medical management
resources and technology;
- - Integration costs for Harris and other acquisitions that exceed our
expectations;
- - Ineffectiveness of the use of the Internet to originate small group and
individual policies; and
- - Our inability to achieve the anticipated efficiencies and resulting cost
savings.
RESTRUCTURING. In January 2000, we announced a restructuring that will allow us
to develop plans to strengthen our operations through planned productivity
enhancements and technology improvements to further our competitive advantages
and growth opportunities. As a result of these changes, we will record a
restructuring charge of approximately $7 million to $8 million in the first
quarter of 2000. The restructuring charge includes severance and related
employee benefits. In January 2000, we reduced our workforce by 90 employees.
During the twelve months ending December 31, 2000, an additional 160 employees
are in transition, which will result in further reductions in workforce. In
addition, 200 other positions will be eliminated through attrition and
cancellation of certain open positions.
32
35
HEALTH INSURANCE PORTABILITY AND ACCOUNTABILITY ACT OF 1996 ("HIPAA"). HIPAA
includes administrative simplification provisions directed at simplifying
electronic data interchange through standardizing transactions, establishing
uniform health care provider, payer and employer identifiers and seeking
protections for confidentiality and security of patient data. Proposed rules
under HIPAA administrative simplification are expected to be released as final
rules during 2000 for full implementation within two years from the date of each
release. The administrative simplification portion of HIPAA as currently
proposed would require health plans, health care providers, health care clearing
houses and additional third parties such as business partners to communicate
electronically using standardized formats. We are proceeding as if the proposed
rules will be adopted as currently proposed. We will be undertaking an
assessment of our current systems to determine where they diverge from the
requirements of administrative simplification. We expect to begin this analysis
by the end of the first quarter and believe we will be able to determine the
cost of implementation of the administrative simplification requirements of
HIPAA by the beginning of the third quarter. Currently, we are unable to assess
the cost of implementation of the administrative simplification requirements of
HIPAA or predict the results of the system analysis.
FUTURE DISPOSITIONS AND IMPAIRMENTS. We continue to evaluate whether our
subsidiaries or products fit within our Health Plans division's strategy and may
decide to dispose of some of our businesses or products. We review long-lived
assets for impairment when events or changes in business conditions indicate
that their full carrying value may not be recovered. We consider assets to be
impaired and write them down to fair value if we determine that the realizable
value of long-lived assets such as property and equipment, real estate and
goodwill are less than the value carried on the consolidated financial
statements. We cannot be certain that the dispositions and impairments will not
result in additional pretax charges. We believe that any disposition or
impairment losses would not materially affect our consolidated financial
position. However, the disposition or impairment losses could have a material
effect on the results of operations or cash flows of a future period.
OPERATING INCOME. Including first-quarter restructuring charges, we expect the
rate of operating income growth to be up to seven percent for the year ended
December 31, 2000. This growth expectation is based upon our membership growth
and premium growth assumptions and our medical care ratio and marketing, general
and administrative assumptions and is subject to the risks discussed for each of
these assumptions.
NET INVESTMENT INCOME. We expect net investment income for the year ended
December 31, 2000 to increase compared to 1999 due to significant cash balances
acquired in the Harris acquisition and expected increases in short-term interest
rates.
INTEREST EXPENSE. In 2000, we expect interest expense will significantly
increase compared to 1999 primarily due to increased borrowings on our credit
facility to fund our share repurchase program. In addition, the reduction in our
credit rating by the credit rating agencies, combined with a higher interest fee
structure in the credit facility amendment and rising market interest rates,
will result in higher interest rates in 2000.
EFFECTIVE TAX RATE. We expect our effective tax rate for the year ended December
31, 2000 to be approximately 41 percent to 42 percent compared to 42.2 percent
for 1999. During 1999, we recognized $14 million of Ohio HMO goodwill impairment
charges, which will lower nondeductible goodwill amortization and reduce the tax
rate for the year ended December 31, 2000. We cannot be certain that pretax
income will increase as projected or that future business decisions will not
impact the estimated effective tax rate.
WEIGHTED AVERAGE NUMBER OF SHARES. We expect the weighted average number of
shares used to compute diluted earnings per share to be approximately 34 million
to 36 million shares for the year ended December 31, 2000. This range is based
on the assumption that we will repurchase approximately 4.8 million shares
during 2000. The following factors could affect the weighted average number of
shares calculation for 2000:
- - Fluctuations in our stock price that influence the number of shares
repurchased and the options exercised;
- - The magnitude of stock options granted during the year;
33
36
- - Any unanticipated stock for stock acquisitions, equity, convertible preferred
or debt issuances; and
- - Management decisions to use cash from operations or credit facility
borrowings on business initiatives other than share repurchases.
DILUTED EARNINGS PER SHARE. We expect to achieve our long-term diluted earnings
per share growth goal of approximately 15 percent in 2000.
YEAR 2000. PacifiCare implemented a Year 2000 compliance program to address all
major computing information systems, including core application systems,
networks, desktop systems, infrastructure and critical information supply
chains. We also addressed risks relating to the Year 2000 readiness of third
parties with whom we maintain ongoing relationships. We incurred approximately
$12 million to make our core computing systems Year 2000 compliant, including
approximately $9 million that we incurred prior to 1999 and approximately $3
million that we incurred in 1999. The 1999 expenses related primarily to
remedying the claims-based FHP core systems that we acquired with the February
1997 FHP acquisition. We have not experienced any material failures or
disruptions of our operations or internal systems due to Year 2000 problems. We
also have not experienced any material problems relating to Year 2000 problems
of third party vendors, providers or other parties with whom we have
relationships. In January 2000, we received our scheduled payment from HCFA
without delay. The risk of delayed payment was one of the most significant
potential risks we identified and addressed through our contingency plans. We
continue to have contingency plans in place and will continue to monitor Year
2000 matters until we are satisfied that we no longer face any material risks.
OFFICE OF PERSONNEL MANAGEMENT CONTINGENCIES. We intend to negotiate with OPM on
any existing or future unresolved matters to attain a mutually satisfactory
result. We cannot be certain that any ongoing and future negotiations will be
concluded satisfactorily, that additional audits will not be referred to the
Department of Justice, or that additional, possibly material, liability will not
be incurred. We believe that any ultimate liability in excess of amounts accrued
would not materially affect our consolidated financial position. However, such
liability could have a material effect on results of operations or cash flows of
a future period if resolved unfavorably. See Note 10 of the Notes to
Consolidated Financial Statements.
ADJUSTED COMMUNITY RATE FILINGS. We intend to cooperate with HCFA or any person
or organization designated by HCFA in all ACR audits. We cannot be certain that
any ongoing and future audits will be concluded satisfactorily. We may incur
additional, possibly material, liability as a result of these audits. We believe
that any ultimate liability would not materially affect our consolidated
financial position. However, the incurrence of such liability could have a
material effect on results of operations or cash flows of a future period.
LIQUIDITY AND CAPITAL RESOURCES. The terms of our credit facility permit us to
repurchase up to $1 billion of our outstanding common stock. We plan to fund
repurchases through a combination of cash flow and borrowings under our credit
facility. Our ability to repay amounts owed under the credit facility depends on
dividends from our subsidiaries. Nearly all of the subsidiaries are subject to
HMO regulations or insurance regulations and may be subject to substantial
supervision by one or more HMO or insurance regulators. Subsidiaries subject to
regulation must meet or exceed various capital standards imposed by HMO or
insurance regulations, which may from time to time impact the amount of funds
the subsidiaries can pay to us. Our subsidiaries are not obligated to make funds
available to us and creditors of our subsidiaries have superior claim to our
subsidiaries' assets. Additionally, from time to time, we advance funds in the
form of a loan or capital contribution to our subsidiaries to assist them in
satisfying federal or state financial requirements. If a federal or state
regulator has concerns about the financial position of a subsidiary, a regulator
may impose additional financial requirements on the subsidiary, which may
require additional funding from us. We believe that cash flows from operations,
existing cash equivalents, marketable securities and other financing sources
will be sufficient to meet the requirements of the credit facility, stock
repurchases and our business operations during the next twelve months.
RISK-BASED CAPITAL REQUIREMENTS. The National Association of Insurance
Commissioners has proposed that states adopt risk-based capital standards that,
if implemented, would require new minimum capitalization
34
37
limits for health care coverage provided by HMOs and other risk-bearing health
care entities. To date, Colorado and Washington are the only states where we
have HMO operations that have adopted these standards. We do not expect this
legislation to have a material impact on our consolidated financial position in
the near future if other states where we operate HMOs adopt these standards. We
believe that cash flows from operations will be sufficient to fund any
additional 2000 risk-based capital requirements. Further borrowings under the
credit facility could be used for risk-based capital requirements, if necessary.
LEGISLATION AND REGULATION. Recent changes in state and federal legislation have
increased and will continue to increase the costs of regulatory compliance, and
proposed changes in the law may negatively impact our financial and operating
results. These changes may increase our medical care ratios, decrease our
membership or otherwise adversely affect our revenues and our profitability.
Regulation and enforcement is increasing both at the state and federal level.
Increased regulations, mandated benefits and more oversight, audits and
investigations may increase our administrative, litigation and health care
costs. The following recent or proposed legislation, regulation or initiatives
could materially affect our financial position:
- - New and proposed legislation that would hold HMOs liable for medical
malpractice (including proposed federal legislation that would remove the
federal preemption set forth in ERISA that precludes most individuals from
suing their employer based health plan for causes of action based upon state
law). To date, both California and Texas have adopted regulations that may
increase the likelihood of lawsuits against HMOs for malpractice liability;
- - Existing and proposed legislation that would limit our ability to manage care
and utilization such as "any willing provider" and "direct access" laws;
- - New state and proposed federal laws mandating benefits including those that
mandate equal coverage for mental health benefits ("mental health parity");
- - Proposed federal regulations that place new restrictions and administrative
requirements on the use of, the electronic retention of, the transmission of
and the disclosure of personally identifiable health information;
- - New and proposed legislation that permit and would permit independent
physicians to collectively bargain with health plans on a number of issues
including financial compensation;
- - Legislation and regulation could also include adverse actions of governmental
payors, including reduced Medicare premiums; discontinuance of, or limitation
on, governmentally funded programs; recovery by governmental payors of
previously paid amounts; the inability to increase premiums or prospective or
retroactive reductions to premium rates for federal employees; and adverse
regulatory actions;
- - New and increased initiatives at the DOJ, the Office of Inspector General of
the United States Department of Health and Human Services, the Office of
Inspector General of the United States Office of Personnel Management and the
various enforcement divisions of the state regulatory agencies governing
health care programs. These initiatives pursue both civil and criminal
investigations against health care providers, payors, and pharmaceutical
companies for misconduct relating to potential health care fraud and abuse,
false claims, ERISA violations, violations of the Medicare program,
overbilling of government programs, incorrect reporting of data, improper
denial or mismanagement of care;
- - State legislation that may increase the financial capital requirements of
providers who contract with HMOs to accept financial risk for health
services, or legislation that would otherwise limit our ability to capitate
providers or delegate financial risk, utilization review, quality assurance
or other medical decisions to our contracting providers; and
- - Increases in minimum capital, reserves, and other financial liability
requirements.
INDUSTRY RISK. Consumers are currently attacking practices of the HMO industry
through a number of separate class action lawsuits against PacifiCare and
against other national HMOs. These lawsuits, including the ones filed to date
against PacifiCare, may take years to resolve and, depending upon the outcomes
of these cases, may cause or force changes in practices of the HMO industry.
These cases also may cause additional regulation of the industry through new
federal or state laws. These changes ultimately could adversely affect
35
38
the HMO industry and could have a material effect on our financial position,
results of operations or cash flows of a future period and prospects of
PacifiCare.
STOCK MARKET RISK FACTORS. The market prices of the securities of PacifiCare and
certain of the publicly held companies in the industry in which we operate have
shown volatility and sensitivity in response to many factors, including:
- - Variations in our financial results;
- - General market conditions;
- - The investor's perception of our business model and strategy, including the
use of capitation and the mix of commercial and Medicare membership;
- - Changes in earnings estimates by industry research analysts;
- - Public communications regarding managed care;
- - Legislative or regulatory actions;
- - Health care cost trends;
- - Pricing trends;
- - Competition;
- - Earnings or membership reports of particular industry participants;
- - The outcome of class action lawsuits; and
- - Acquisition activity.
We cannot assure the level or stability of our share price at any time, or the
impact of the foregoing or any other factors may have on our share price. The
market price of our common stock may decline significantly if our earnings
results for any quarter are below the expectations of industry research
analysts.
OTHER. Results may differ materially from those projected, forecasted, estimated
and budgeted by us due to adverse results in ongoing audits or in other reviews
conducted by federal or state agencies or health care purchasing cooperatives;
adverse results in significant litigation matters; and changes in interest rates
causing changes in interest expense and net investment income.
36
39
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
MARKET RISK
The principal objective of our asset/liability management activities is to
maximize net investment income, while maintaining acceptable levels of interest
rate risk and facilitating our funding needs. Our net investment income and
interest expense are subject to the risk of interest rate fluctuations. To
mitigate the impact of fluctuations in interest rates, we manage the structure
of the maturity of debt and investments and also use derivatives. We use
derivative financial instruments, primarily interest rate swaps, with maturities
that correlate to balance sheet financial instruments. This results in a
modification of existing interest rates to levels deemed appropriate based on
our current economic outlook.
The following table provides information about our financial instruments that
are sensitive to changes in interest rates as of December 31, 1999. For
investment securities and debt obligations, the table presents principal cash
flows and related weighted average interest rates by expected maturity dates.
Additionally, we have assumed our marketable securities and marketable
securities-restricted, comprised primarily of U.S. government, state, municipal,
and corporate debt securities, are similar enough to aggregate into fixed rate
and variable rate securities for presentation purposes. Our average interest
rate for the year 2000 is lower than future years because of the inclusion of
zero coupon securities in 2000. For terms relating to our long term debt, see
Note 5 of the Notes to Consolidated Financial Statements.
2000 2001 2002 2003 2004 BEYOND TOTAL FAIR VALUE
-------- ------- -------- -------- ------- -------- -------- ----------
(AMOUNTS IN THOUSANDS)
Assets:
Marketable securities:
Fixed rate.................... $144,799 $23,725 $ 38,320 $ 38,528 $39,065 $686,989 $971,426 $932,259
Average interest rate......... 2.56% 6.20% 5.88% 5.69% 5.90% 5.26% 4.94% --
Variable rate................. -- $ 5,010 $ 6,364 -- -- $ 56,231 $ 67,605 $ 66,935
Average interest rate......... -- 6.55% 5.76% -- -- 4.94% 5.14% --
Marketable
securities -- restricted:
Fixed rate.................... $ 56,437 $ 8,457 $ 2,931 -- $ 500 $ 16,784 $ 85,109 $ 84,521
Average interest rate......... 3.09% 5.68% 5.89% -- 5.68% 4.95% 3.82% --
Variable rate................. -- -- -- -- -- $ 1,362 $ 1,362 $ 1,367
Average interest rate......... -- -- -- -- -- 5.91% 5.91% --
Liabilities:
Long term debt, including debt
due within one year:
Variable rate................. -- $75,000 $800,000 $100,000 -- -- $975,000 $975,000
Average interest rate......... -- 6.76% 6.76% 7.00% -- -- -- --
ITEM 8. CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
See the Index included at "Item 14. Exhibits, Financial Statement Schedules, and
Reports on Form 8-K."
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS AND ACCOUNTING AND
FINANCIAL DISCLOSURE
We have not changed our independent auditors, nor have we had disagreements with
our auditors on accounting principles, practices or financial statement
disclosure.
37
40
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
PacifiCare's Directors and Executive Officers are as follows:
DIRECTORS AGE TITLE
--------- --- -----
David A. Reed 67 Chairman of the Board
Terry O. Hartshorn 55 Vice Chairman of the Board
Alan R. Hoops 52 Director, President and Chief Executive
Officer
Jack R. Anderson 75 Director
Craig T. Beam 44 Director
Richard M. Burdge, Sr. 73 Director
Bradley C. Call 57 Director
David R. Carpenter 61 Director
Gary L. Leary 64 Director
Warren E. Pinckert II 56 Director
Lloyd E. Ross 59 Director
Jean Bixby Smith 61 Director
CORPORATE EXECUTIVE OFFICERS
----------------------------
Jeffrey M. Folick 52 Executive Vice President and Interim
President and CEO, PacifiCare Specialty
Products Division
Joseph S. Konowiecki 46 Executive Vice President, General Counsel
and Secretary
Craig S. Schub 44 President, Secure Horizons USA, Inc.
Robert N. Franklin 56 Senior Vice President, Public Affairs
John E. Kao 38 Senior Vice President, Corporate
Development and Chief Financial Officer,
Secure Horizons USA, Inc.
Mary C. Langsdorf 40 Senior Vice President, Finance, Corporate
Controller and Interim Chief Financial
Officer
Wanda A. Lee 58 Senior Vice President, Corporate Human
Resources
HEALTH PLANS DIVISION EXECUTIVE OFFICERS
----------------------------------------
Bradford A. Bowlus 44 President and Chief Executive Officer
Richard E. Badger 50 Regional Vice President, Western Region
and President and Chief Executive Officer,
PacifiCare of California
James W. Cassity 48 Regional Vice President, Southwest Region
and President and Chief Executive Officer,
PacifiCare of Texas, Inc. and PacifiCare
of Oklahoma, Inc.
Ace M. Hodgin Jr., M.D. 44 Regional Vice President, Desert Region and
President and Chief Executive Officer,
PacifiCare of Arizona, Inc.
Eric D. Sipf 51 Regional Vice President, Central Region,
and President and Chief Executive Officer,
PacifiCare of Colorado, Inc.
Christopher P. Wing 42 Regional Vice President, Northwest Region
and President and Chief Executive Officer,
PacifiCare of Washington, Inc.
38
41
HEALTH PLANS DIVISION EXECUTIVE OFFICERS
----------------------------------------
Ronald M. Davis 40 Senior Vice President and Chief
Administrative Officer
W. Joseph Arbanas 55 Senior Vice President, Human Resources
Katherine F. Feeny 47 Senior Vice President, Secure Horizons
Sales and Marketing
Maria Z. Fitzpatrick 42 Interim Chief Information Officer and Vice
President, Information Technology
James A. Frey II 33 Senior Vice President, Operations
Mitchell J. Goodstein 48 Senior Vice President, Health Care
Economics
Richard J. LaBrecque 56 Senior Vice President, Individual, Small
and Mid-Size Account Sales and Marketing
Linda M. Lyons, M.D. 50 Senior Vice President, Health Services and
Chief Medical Officer
David A. Taaffe 47 Senior Vice President, National Account
Sales and Marketing
DAVID A. REED has been Chairman of the Board since November 1999, and a Director
of PacifiCare since 1992. His current term expires in 2002. Mr. Reed currently
is the President of DAR Consulting Group and served as past Chairman of the
American Hospital Association. Mr. Reed has served as a Director of In-Vitro
International since 1996. Mr. Reed is Chairman of the Executive Committee.
TERRY O. HARTSHORN has been a director of PacifiCare since 1985 and is currently
Vice Chairman of the Board. His current term expires in 2001. Mr. Hartshorn
served as Chairman of PacifiCare's Board of Directors from 1993 to 1998. Mr.
Hartshorn was President and Chief Executive Officer of UniHealth, the
predecessor of UniHealth Foundation,* from 1993 to February 1997. Mr. Hartshorn
is a Director of Professional Bancorp Inc., a bank holding company. Mr.
Hartshorn is Chairman of the Governance and Nominating Committee and a member of
the Executive Committee.
ALAN R. HOOPS has been a Director of PacifiCare since 1994. His current term
expires this year. He served as Chairman of the Board from January 1999 through
November 1999, and has been PacifiCare's Chief Executive Officer since 1993. Mr.
Hoops has served as PacifiCare's President since November 1999, and previously
served as President from 1993 to 1998.
JACK R. ANDERSON has been a director of PacifiCare since 1997. His current term
expires in 2001. Mr. Anderson was a Director of FHP from 1994 until February
1997 when FHP was acquired by PacifiCare. He has been President of Calver
Corporation, a health care consulting and investing firm, and a private investor
since 1982. Mr. Anderson currently serves on the Boards of Directors of Horizon
Mental Health Management, Inc. and Genesis Health Ventures, Inc.
CRAIG T. BEAM has been a Director of PacifiCare since 1997. His current term
expires this year. Mr. Beam is President of Beam & Associates, a real estate
development and management company, including health care project management.
Mr. Beam was a Director of UniHealth from 1993 to 1998. Mr. Beam is a member of
the Real Estate Committee.
RICHARD M. BURDGE, SR. has been a Director since 1997. His current term expires
this year. Mr. Burdge was a Director of FHP from 1994 until February 1997 when
FHP was acquired by PacifiCare. Mr. Burdge retired in 1984 as Executive Vice
President of CIGNA Corporation, a position he held from 1982 to 1984. Mr. Burdge
is a member of the Compensation Committee.
BRADLEY C. CALL has been a Director since 1997. His current term expires in
2002. Since 1998, Mr. Call has been a Director, President and Chief Executive
Officer of Stellex Aerospace, Inc., a privately held aerospace component
manufacturing firm with multiple plant operations throughout the U.S. Mr. Call
has been a
- ---------------
*UniHealth Foundation is the single largest holder of PacifiCare's common stock.
39
42
Director of UniHealth Foundation since 1998, and served as Director of UniHealth
from 1995 to 1998. Mr. Call is a member of the Executive and Audit Committees.
DAVID R. CARPENTER has been a Director of PacifiCare since 1989. His current
term expires in 2002. Since 1998, Mr. Carpenter has served as Chairman and CEO
of UniHealth Foundation. From February 1997 through December 1997, Mr. Carpenter
served as Chairman, President and CEO of UniHealth. Since 1997, Mr. Carpenter
has also served as Chairman and CEO of Paradigm Partners International, LLC. Mr.
Carpenter is a Director of Employee Solutions, Inc. and Sales Media, Inc. Mr.
Carpenter is Chairman of the Compensation Committee and a member of the
Executive Committee.
GARY L. LEARY has been a Director of PacifiCare since 1989. His current term
expires this year. On May 1, 1999, Mr. Leary retired from all of his positions
with UniHealth Foundation, except as General Counsel, a position he has held
since 1998 and will continue to hold until April 15, 2000. Mr. Leary served as a
Director of UniHealth Foundation from June through December 1998. Mr. Leary also
served as an Executive Vice President and President of the UniHealth Foundation
from 1998 through May 1999. He continues to be a Director of several
subsidiaries of the UniHealth Foundation. Mr. Leary was an Executive Vice
President and General Counsel of UniHealth, the foundation's predecessor, from
1992 to 1998. Mr. Leary is a member of the Governance and Nominating and Real
Estate Committees.
WARREN E. PINCKERT II has been a Director since 1985. His current term expires
in 2001. Mr. Pinckert has been a Director, President and Chief Executive Officer
of Cholestech Corporation, a medical device manufacturing firm, since 1993. Mr.
Pinckert is a member of the Compensation Committee and is Chairman of the Audit
Committee. Mr. Pinckert is a certified public accountant.
LLOYD E. ROSS has been a Director of PacifiCare since 1985. His current term
expires in 2002. Mr. Ross is Managing Partner of InverMex, L.P. From 1996 to
1997, Mr. Ross served as Vice President/Division Manager of SMI Corporation, a
division of ARB, Inc., a commercial and industrial building company and as
President/CEO of SMI Construction from 1961 to 1996. Mr. Ross is a Director of
the Southern California Water Company. Mr. Ross is a member of the Audit,
Compensation, Real Estate and Governance and Nominating Committees.
JEAN BIXBY SMITH has been a Director since 1995. Her current term expires in
2001. Ms. Smith has been Chairman of Bixby Land Company since 1994 and President
of Alamitos Land Company since 1991, both of which are engaged in the
development and management of commercial and industrial real estate. Ms. Smith
has also been a Director and Vice President of UniHealth Foundation since 1998.
Ms. Smith is a member of PacifiCare's Governance and Nominating Committee and
Chairperson of the Real Estate Committee.
JEFFREY M. FOLICK became Interim President and CEO of the Health Plans Division
in November 1999. Mr. Folick has also served as an Executive Vice President of
PacifiCare from 1993 to the present. Mr. Folick previously served as
PacifiCare's President from July 1998 to November 1999, and Chief Operating
Officer from 1993 through November 1999.
JOSEPH S. KONOWIECKI became an Executive Vice President in November 1999, and
has been General Counsel of PacifiCare since 1989 and Secretary of PacifiCare
since 1993. Mr. Konowiecki has been a partner of Konowiecki & Rank LLP,
including a professional corporation, or its predecessor, since 1980 and has
over 20 years of practice in business, corporate and health care law.
CRAIG S. SCHUB has been President of Secure Horizons USA, Inc. since 1993. Mr.
Schub served as Senior Vice President, Marketing of PacifiCare from 1996 to 1998
and as Senior Vice President, Government Programs from 1995 to 1998. Mr. Schub
serves as a Director of Presbyterian Health Plan.
ROBERT N. FRANKLIN has been Senior Vice President, Public Affairs since February
1997. From 1993 to February 1997, Mr. Franklin was Senior Vice President, Public
Affairs of FHP.
JOHN E. KAO has been Senior Vice President, Corporate Development and Chief
Financial Officer, Secure Horizons USA since 1998, and Vice President, Corporate
Development since February 1997. From 1995 to February 1997, Mr. Kao was Vice
President, Corporate Development for FHP. Prior to joining FHP, Mr. Kao held
numerous positions with Bank of America.
40
43
MARY C. LANGSDORF has served as Interim Chief Financial Officer since September
1999. She has been Senior Vice President, Finance since January 1999 and
PacifiCare's Corporate Controller since 1996. From 1995 to January 1999, Ms.
Langsdorf served as Vice President, Finance.
WANDA A. LEE has been Senior Vice President, Corporate Human Resources of
PacifiCare since 1993. From 1984 to 1993, Ms. Lee was Vice President of Human
Resources of FHP.
BRADFORD A. BOWLUS joined PacifiCare in 1994 and became President and CEO of
PacifiCare's Health Plans Division in October 1999. He served as Regional Vice
President, Western Region and President and CEO of PacifiCare of California or
"PCC" from 1997 through October 1999. From 1994 through 1997, Mr. Bowlus served
in various capacities for PacifiCare, including President and CEO of PacifiCare
of Washington, Inc., President and CEO of PacifiCare Dental and Vision and Vice
President of PCC.
RICHARD E. BADGER has been Regional Vice President, Western Region and President
and CEO of PacifiCare of California since November 1999. Mr. Badger served as
Regional Vice President, Desert Region and President and CEO of PacifiCare of
Arizona, Inc. from 1998 to November 1999. Mr. Badger served as President of
PacifiCare of Northern California from 1993 to 1998.
JAMES W. CASSITY was appointed Regional Vice President, Southwest Region and
President and CEO of PacifiCare of Texas, Inc. and PacifiCare of Oklahoma, Inc.,
on March 20, 2000. From June 1997 through September 1999, Mr. Cassity served as
President Central Division, Prudential HealthCare, a national healthcare
company, and as Vice President, Prudential HealthCare, from August 1996 through
June 1997.
ACE M. HODGIN JR., M.D. has been Regional Vice President, Desert Region and
President and CEO of PacifiCare of Arizona since November 1999. Dr. Hodgin
served as Vice President, Health Serves of PacifiCare of Arizona from 1997 to
November 1999, and Medical Director of PacifiCare of Arizona from 1994 to 1997.
ERIC D. SIPF joined PacifiCare in February 1997 and currently serves as Regional
Vice President, Central Region. Mr. Sipf has been President and CEO of
PacifiCare of Colorado, Inc., formerly FHP of Colorado, Inc., since 1996. Mr.
Sipf joined FHP as a Senior Vice President Eastern Division in 1994 and served
in that capacity until February 1997.
CHRISTOPHER P. WING joined PacifiCare in 1994 and currently serves as Regional
Vice President, Northwest Region and President and CEO of PacifiCare of
Washington, Inc. From 1994 to 1997, Mr. Wing served in various capacities for
PacifiCare, including President and CEO of PacifiCare of Utah, Inc., Senior Vice
President, Health Services of PCC and Vice President, General Manager of PCC.
RONALD M. DAVIS became Senior Vice President and Chief Administrative Officer of
PacifiCare's Health Plans Division in October 1999. He was Senior Vice
President, Corporate Operations from 1995 to October 1999. Mr. Davis served as
Senior Vice President, Operations of PCC from 1993 to 1995.
W. JOSEPH ARBANAS has been Senior Vice President, Human Resources since January
2000. From 1998 through December 1999, Mr. Arbanas served as a Senior Business
Consultant, Organization Development of PacifiCare. He served as Vice President,
Human Resources of PCC from 1997 to 1998 and as Vice President, Organization and
Human Resources of PacifiCare from 1995 to 1997.
KATHERINE F. FEENY has been Senior Vice President, Secure Horizons Sales and
Marketing since January 2000. From August through December 1999, Ms. Feeny
served as Vice President, Sales and Marketing of Secure Horizons of California
and from 1995 to 1997, as Regional Sales Director, Secure Horizons of
California.
MARIA Z. FITZPATRICK has been Interim Chief Information Officer since March 11,
2000. From August 1996 through March 2000, Ms. Fitzpatrick served as Vice
President, Information Technology-Systems Development. Prior to joining
PacifiCare, Ms. Fitzpatrick served in various capacities with Bank of America,
National Trust and Savings Association.
JAMES A. FREY II has been Senior Vice President, Operations since January 2000.
Mr. Frey served as President, PacifiCare of Nevada, Inc. from April through
December 1999, as Vice President of Operations,
41
44
Desert Region from 1997 to April 1999 and as Director of Regulatory Affairs,
Desert Region from 1996 to 1997.
MITCHELL J. GOODSTEIN currently serves as Senior Vice President, Health Care
Economics. Mr. Goodstein was Regional Vice President, Southeast Region and
President of PacifiCare of Florida, Inc. from 1995 to 1997. Prior to joining
PacifiCare, Mr. Goodstein served as the Chief Executive Officer of HMO
California, a licensed health care service plan, from 1992 to 1995.
RICHARD J. LABRECQUE has been Senior Vice President, Individual, Small and
Mid-Size Account Sales and Marketing since January 2000. From September 1999
through December 1999, Mr. LaBrecque served as Vice President, Sales, National
Accounts for PacifiCare. Before joining PacifiCare, Mr. LaBrecque was National
Vice President, Sales for Prudential HealthCare from 1995 through August 1999.
LINDA M. LYONS, M.D. has been Senior Vice President, Health Services since 1996.
Prior to joining PacifiCare, Dr. Lyons served in various capacities for SCRIPPS
Clinic Medical Group, including as Senior Vice President, Managed Care
Operations, from 1986 to 1996.
DAVID A. TAAFFE has been Senior Vice President, National Account Sales and
Marketing since January 2000. Prior to joining PacifiCare, Mr. Taaffe was Vice
President of Sales for the east coast for Prudential HealthCare from 1997
through 1999 and from 1994 through 1997, he served as Vice President of Sales
for Prudential's Southern California operations.
Each Executive Officer of PacifiCare is elected or appointed by the Board of
Directors of PacifiCare and holds office until his successor is elected, or
until the earlier of his death, resignation or removal.
The information given in this Form 10-K concerning the Directors is based upon
statements made or confirmed to PacifiCare by or on behalf of such Directors,
except to the extent that such information appears in its records.
COMPLIANCE WITH SECTION 16(a) OF THE SECURITIES EXCHANGE ACT
PacifiCare believes that during 1999, all filings with the Securities and
Exchange Commission of its officers, directors and 10 percent stockholders
complied with the requirement for reporting ownership and changes in ownership
of PacifiCare's common stock pursuant to Section 16(a) of the Securities and
Exchange Act of 1934, as amended (the "Exchange Act"), except that Jack R.
Anderson, John E. Kao, Mitchell J. Goodstein and Eric D. Sipf each did not file
a report for one transaction on a timely basis. Once discovered, these
oversights were promptly corrected.
42
45
ITEM 11. EXECUTIVE COMPENSATION
The following table shows the compensation paid to Alan Hoops, who served as
Chief Executive Officer of PacifiCare during 1999, and the other most highly
compensated executive officers of PacifiCare (collectively, the Named Executive
Officers, or "NEOs") for the years ended December 31, 1999, 1998 and 1997.
SUMMARY COMPENSATION TABLE
LONG-TERM
ANNUAL COMPENSATION COMPENSATION
------------------------------------ ---------------------
OTHER ANNUAL SECURITIES LTIP ALL OTHER
SALARY BONUS COMPENSATION UNDERLYING PAYOUTS COMPENSATION
NAME AND PRINCIPAL POSITION YEAR (1) (2) (3) OPTIONS (4) (5)
--------------------------- ---- -------- ---------- ------------ ---------- -------- ------------
Alan R. Hoops........................... 1999 $920,000 $1,104,995 $521,998 160,000 $298,996 $ 58,994
CEO, Corporate President 1998 $893,078 $1,161,001 $553,708 15,000 $ -- $ 47,983
1997 $860,000 $ -- $ 80,000 445,000 $ -- $120,497
Jeffrey M. Folick....................... 1999 $600,000 $ 564,957 $225,983 50,000 $176,176 $ 51,794
Executive Vice President, Corporate 1998 $597,115 $ 621,000 $248,400 12,500 $ -- $ 44,762
1997 $575,000 $ -- $ -- 310,000 $ -- $ 93,325
Bradford A. Bowlus...................... 1999 $501,923 $ 449,856 $143,954 140,000 $ 75,504 $ 79,507
President and CEO, Health Plans
Division 1998 $363,463 $ 253,681 $ 40,589 10,000 $ -- $269,037
1997 $235,385 $ -- $ -- 195,000 $ 76,667 $129,166
Richard E. Badger....................... 1999 $318,076 $ 294,261 $ -- 80,000 $ 50,441 $ 65,715
Regional Vice President, 1998 $256,846 $ 178,875 $ 35,775 39,365 $ -- $ 77,670
Western Region, Health Plans Division 1997 $220,000 $ -- $ -- 46,500 $ 99,700 $ 21,306
Linda M. Lyons, M.D..................... 1999 $300,000 $ 349,161 $ -- 45,000 $ 65,613 $ 49,647
Senior Vice President Health Services, 1998 $305,307 $ 190,365 $ 45,688 10,000 $ -- $ 81,965
Health Plans Division 1997 $275,000 $ -- $ -- 164,400 $ -- $ 56,677
Robert B. Stearns(6).................... 1999 $450,000 $ 279,002 $111,601 30,000 $ -- $107,835
Exec. Vice President and CFO 1998 $216,347 $ 245,044 $ 98,018 275,000 $ -- $172,597
1997 $ -- $ -- $ -- -- $ -- $ --
- ---------------
(1) 1998 salaries included one extra pay period because of year-end payroll
timing. Base salaries at December 31, 1998 were as follows:
Alan R. Hoops............. $860,000
Jeffrey M. Folick......... $575,000
Bradford A. Bowlus........ $350,000
Richard E. Badger......... $265,000
Linda M. Lyons, M.D. ..... $294,000
Robert B. Stearns......... $450,000
(2) The amounts shown in this column include payments made pursuant to
PacifiCare's 1996 Management Incentive Compensation Plan, as amended (the
"MICP"), and include amounts awarded and accrued during the fiscal years
earned, but paid in the following fiscal year. Portions of the 1999 and 1998
MICP bonuses were attributable to incentives where executive officers
received bonuses in excess of the maximum payable under the MICP for the
achievement of maximum performance objectives. Bonuses awarded under these
incentives are payable in installments over a three-year period. To receive
each installment, the executive officer must be employed by PacifiCare at
the time of payment and PacifiCare must achieve target earnings per share
for the prior year.
(3) Amounts shown are attributable to a risk premium applied to amounts deferred
under PacifiCare's stock unit deferred compensation plan. Under this
deferred compensation plan, executive officers may defer all or a portion of
their bonus. The Corporate CEO may also defer all or a portion of his
salary. Amounts deferred are converted into units of PacifiCare's common
stock. The number of stock units converted is equal to the amount of bonus
or salary deferred, multiplied by a risk premium, then divided by the price
of PacifiCare's common stock. The common stock price used is determined by
PacifiCare's Compensation Committee based on the closing price of the common
stock on the Nasdaq National Market. Distributions are made in shares of
common stock.
(4) Includes amounts awarded and accrued under PacifiCare's Long-Term
Performance Incentive Plan (the "LTPIP") during the years earned, but paid
in the following year. In 1999 and 1997, 60 percent of the awards were paid
in cash and 40 percent of the awards were paid in shares of common stock.
The shares of common stock distributed were valued at $45.13 per share in
1999 and $72.88 per share in 1997 (the
43
46
fair market values of the common stock at the time the payments were
awarded). No awards were made under the LTPIP to the NEOs for 1998. Payments
under the LTPIP to the NEOs were as follows:
1999 1997
--------------------- ---------------------
NUMBER NUMBER
CASH PAID OF SHARES CASH PAID OF SHARES
--------- --------- --------- ---------
Alan R. Hoops................... $179,398 2,650 $ -- --
Jeffrey M. Folick............... $105,706 1,561 $ -- --
Bradford A. Bowlus.............. $ 45,302 669 $46,060 420
Richard E. Badger............... $ 30,265 447 $59,837 547
Linda M. Lyons, M.D. ........... $ 39,368 581 $ -- --
PacifiCare suspended the LTPIP in 1997. When the LTPIP was suspended in 1997,
three performance cycles remained outstanding. The payment made for the 1997 to
1999 cycle, represented by the "1999" column above, was the last performance
cycle.
(5) Amounts in this column include contributions by PacifiCare to the PacifiCare
Health Systems, Inc. Savings and Profit Sharing Plan (the "Profit Sharing
Plan") and miscellaneous fringe benefits. All PacifiCare employees who have
completed 3 1/2 months of continuous service are eligible to participate in
the Profit Sharing Plan.
(a) PacifiCare contributed amounts equal to three percent of annual
salaries in 1999 and two percent in 1998 and 1997, up to a specified
maximum amount. For the NEOs, these contributions were:
1999 1998 1997
------ ------ ------
Alan R. Hoops................................ $4,800 $3,200 $3,200
Jeffrey M. Folick............................ $4,800 $3,200 $3,200
Bradford A. Bowlus........................... $4,800 $3,200 $3,200
Richard E. Badger............................ $4,800 $3,200 $3,200
Linda M. Lyons, M.D. ........................ $4,800 $3,200 $2,115
Robert B. Stearns............................ $4,800 $ -- $ --
(b) PacifiCare contributed amounts equal to one-half of the compensation
deferred by each employee up to three percent of the employee's annual
compensation up to a specified amount. For the NEOs, these
contributions were:
1999 1998 1997
------ ------ ------
Alan R. Hoops................................ $4,800 $4,800 $4,750
Jeffrey M. Folick............................ $4,800 $4,800 $4,750
Bradford A. Bowlus........................... $4,800 $4,800 $6,409
Richard E. Badger............................ $4,800 $4,800 $4,750
Linda M. Lyons, M.D. ........................ $4,800 $4,800 $3,730
Robert B. Stearns............................ $4,800 $ -- $ --
(c) PacifiCare contributed discretionary amounts, determined solely at the
discretion of the Board of Directors, from PacifiCare's current or
accumulated earnings (generally based upon a percentage of pretax
income). For the NEOs, these contributions were:
1999 1998 1997
------ ------ ------
Alan R. Hoops................................ $3,159 $2,997 $3,494
Jeffrey M. Folick............................ $3,159 $2,997 $3,494
Bradford A. Bowlus........................... $3,159 $2,997 $3,494
Richard E. Badger............................ $3,159 $2,997 $3,494
Linda M. Lyons, M.D. ........................ $3,159 $2,997 $ 423
Robert B. Stearns............................ $3,159 $ -- $ --
44
47
(d) Includes amounts contributed by PacifiCare pursuant to the Statutory
Restoration Plan of PacifiCare (the "Statutory Restoration Plan"). The
Statutory Restoration Plan allows participants to defer the portion of
their pay that otherwise would be deferred under the Profit Sharing
Plan, but for statutory limitations, and to receive excess matching
contributions, profit-sharing contributions and discretionary
contributions in the same percentages as those provided by the Profit
Sharing Plan. Employees in PacifiCare's two highest salary grades are
eligible to participate in the Statutory Restoration Plan. For the
NEOs, these contributions were:
1999 1998 1997
------- ------- -------
Alan R. Hoops............................. $33,600 $25,077 $48,844
Jeffrey M. Folick......................... $26,400 $21,856 $40,766
Bradford A. Bowlus........................ $30,859 $12,642 $ --
Richard E. Badger......................... $14,851 $ 9,558 $ 5,337
Linda M. Lyons, M.D. ..................... $12,398 $ 6,977 $13,192
Robert B. Stearns......................... $17,793 $ -- $ --
(e) Includes premiums paid by PacifiCare for term life insurance for all
employees. For each of the NEOs, these amounts were $290 for 1999, 1998
and 1997. Also includes additional insurance premiums paid by
PacifiCare for Mr. Hoops totaling $2,802 for 1997 and for Mr. Folick
totaling $1,532 for 1997.
(f) Includes amounts paid by PacifiCare for excess sick time and vacation
time accrued. For the NEOs, these amounts were:
1999 1998 1997
------- ------- -------
Alan R. Hoops............................. $ -- $ -- $53,783
Jeffrey M. Folick......................... $ -- $ -- $35,959
Bradford A. Bowlus........................ $20,192 $ -- $ 3,349
Richard E. Badger......................... $ 5,385 $ -- $ --
Linda M. Lyons, M.D. ..................... $ 5,769 $ -- $ --
Robert B. Stearns......................... $30,780 $ -- $ --
(g) Includes amounts paid by PacifiCare for personal financial services.
For the NEOs, these amounts were:
1999 1998 1997
------- ------- -------
Alan R. Hoops............................. $12,345 $11,619 $ 3,334
Jeffrey M. Folick......................... $12,345 $11,619 $ 3,334
Bradford A. Bowlus........................ $15,157 $17,452 $ --
Richard E. Badger......................... $12,930 $ -- $ --
Linda M. Lyons, M.D. ..................... $18,431 $13,701 $ --
(h) Includes amounts paid by PacifiCare for relocation expenses. For the
NEOs, these amounts were:
1999 1998 1997
------- ------- -------
Bradford A. Bowlus........................ $ -- $227,656 $88,249
Richard E. Badger......................... $19,500 $26,825 $ --
Linda M. Lyons, M.D. ..................... $ -- $50,000 $16,927
Robert B. Stearns......................... $14,100 $47,500 $ --
45
48
(i) Includes amounts paid by PacifiCare as sign-on bonuses. For the NEOs,
these amounts were:
1999 1998 1997
---- -------- -------
Bradford A. Bowlus.......................... $-- $ -- $24,175
Richard E. Badger........................... $-- $ 30,000 $ --
Linda M. Lyons, M.D. ....................... $-- $ -- $20,000
Robert B. Stearns........................... $-- $125,000 $ --
(j) In connection with his relocation to California in 1998, PacifiCare
loaned $125,000 to Mr. Stearns. According to the terms of his severance
agreement, Mr. Stearns is not required to repay any outstanding
principal or interest on the loan. Of this total, $25,000 plus accrued
interest was included in All Other Compensation for 1999. The balance
will be forgiven in 2000.
(6) Mr. Stearns resigned as Executive Vice President and Chief Financial Officer
effective September 15, 1999. His effective termination date was December
13, 1999. The options granted to Mr. Stearns in 1999 expired on his
effective termination date.
OPTION GRANTS IN LAST FISCAL YEAR
The following table provides information on stock options granted in 1999 to
PacifiCare's NEOs pursuant to PacifiCare's 1996 Stock Option Plan for Officers
and Key Employees, as amended (the "Employee Plan").
PERCENT
NUMBER OF OPTIONS
SECURITIES GRANTED TO EXERCISE OR
UNDERLYING EMPLOYEES BASE PRICE EXPIRATION GRANT DATE
NAME OPTIONS(1) IN 1999 PER SHARE(2) DATE PRESENT VALUE(3)
---- ---------- ---------- ------------ ---------- ----------------
Alan R. Hoops................. 60,000 2.7 $71.59 4/22/09 $2,519,160
100,000 4.4 $45.31 11/5/09 $2,564,010
Jeffrey M. Folick............. 50,000 2.2 $71.59 4/22/09 $1,756,334
Bradford A. Bowlus............ 40,000 1.8 $71.59 4/22/09 $1,405,067
100,000 4.4 $45.31 11/5/09 $2,223,205
Richard E. Badger............. 15,000 0.7 $75.38 3/8/09 $ 543,482
65,000 2.9 $45.31 11/5/09 $1,445,083
Linda M. Lyons, M.D. ......... 10,000 0.4 $71.59 4/22/09 $ 351,267
35,000 1.5 $45.31 11/5/09 $ 778,122
Robert B. Stearns(4).......... 30,000 1.3 $71.59 4/22/09 $1,053,800
CHANGE IN TOTAL MARKET VALUE OF COMPANY
AT ASSUMED ANNUAL RATES OF STOCK PRICE APPRECIATION FOR 10 YEARS(5) 5% 10%
- ------------------------------------------------------------------- -------------- --------------
37,252,000 shares outstanding, $53.00 per share at 12/31/99.... $1,241,884,000 $3,147,160,000
- ---------------
(1) Only nonqualified stock options were granted in 1999 pursuant to the
Employee Plan. These options generally become exercisable in four cumulative
annual installments of 25 percent on each anniversary of the date of grant.
No incentive stock options or stock appreciation rights were granted in
1999. Options that have been held for six months, and not already
exercisable or expired automatically, become exercisable if there is a
"Change of Control." Under the Employee Plan, a Change of Control is defined
as the occurrence of any of the following:
(a) a business combination effectuated through the merger or consolidation
of PacifiCare with or into another entity where PacifiCare is not the
surviving organization. For purposes hereof, "Surviving Organization"
shall mean any entity where the majority of the members of such
entity's board of directors are persons who were members of
PacifiCare's Board of Directors prior to the merger, consolidation or
other business combination and the senior management of the surviving
entity includes all of the individuals who were PacifiCare's executive
management (PacifiCare's chief executive officer and those individuals
who report directly to PacifiCare's chief executive officer)
46
49
prior to the merger, consolidation or other business combination and
such individuals are in at least comparable positions with such entity;
(b) any business combination effectuated through the merger or
consolidation of PacifiCare with or into another entity where
PacifiCare is the Surviving Organization and such business combination
occurred with an entity whose market capitalization prior to the
transaction was greater than 50 percent of PacifiCare's market
capitalization prior to the transaction;
(c) the sale in a transaction or series of transactions of all or
substantially all of PacifiCare's assets;
(d) any merger, consolidation or sale such that any individual, entity or
group (within the meaning of Section 13(d)(3) or 14(d)(2) of the
Exchange Act) acquires beneficial ownership, within the meaning of Rule
13d-3 of the Exchange Act, of 20 percent or more of the voting common
stock of PacifiCare and the ownership interest of the voting common
stock owned by UniHealth is less than or equal to the ownership
interest of the voting common stock of such individual, entity or
group;
(e) a dissolution or liquidation of PacifiCare; or
(f) PacifiCare becomes a non-publicly held company.
(2) The exercise price may be paid in cash, in shares of common stock valued at
fair market value on the date of exercise or pursuant to a cashless exercise
procedure under which the optionee provides irrevocable instructions to a
brokerage firm to sell the purchased shares and to remit to PacifiCare, out
of the sale proceeds, an amount equal to the exercise price plus all
applicable withholding taxes.
(3) These values were established using the Black-Scholes stock option pricing
model. Assumptions used to calculate the grant date present value of option
shares granted during 1999 were in accordance with Statement of Financial
Accounting Standards ("SFAS") No. 123, as follows:
(a) Expected Volatility -- The standard deviation of the continuously
compounded rates of return calculated on PacifiCare's average daily
common stock price over a period of time immediately preceding the
grant and equal in length to the expected term of the option until
exercise. The volatility was 52 percent.
(b) Risk-Free Interest Rate -- The rate available at the time the grant was
made on zero-coupon U.S. government issues with a remaining term equal
to the expected life. The risk-free interest rate ranged from
approximately five to six percent.
(c) Dividend Yield -- The expected dividend yield was zero percent based on
the historical dividend yield over a period of time immediately
preceding the grant date equal in length to the expected term of the
grant.
(d) Expected Term until Exercise -- The expected term of the option grants
ranged from two to four years. Expected terms were calculated based on
the historical average number of years executive officers exercise
options, after the options vest.
(e) Forfeiture Rate -- Under SFAS No. 123, forfeitures may be estimated or
assumed to be zero. The forfeiture rate was assumed to be zero.
(4) The options granted to Mr. Stearns in 1999 expired on December 13, 1999, his
effective termination date.
(5) These amounts are not intended to forecast possible future appreciation, if
any, of PacifiCare's stock prices. No assurances can be given that the stock
prices will appreciate at these rates or experience any appreciation at all.
47
50
AGGREGATED OPTION EXERCISES IN LAST FISCAL YEAR
AND FISCAL YEAR-END OPTION VALUES
The following table provides information for NEO options exercised during 1999,
and unexercised options held as of December 31, 1999.
NUMBER OF SECURITIES VALUE OF UNEXERCISED
UNDERLYING UNEXERCISED IN-THE-MONEY OPTIONS
SHARES OPTIONS AT FY-END AT FY-END
ACQUIRED ON VALUE --------------------------- ---------------------------
NAME EXERCISE REALIZED EXERCISABLE UNEXERCISABLE EXERCISABLE UNEXERCISABLE
---- ----------- ---------- ----------- ------------- ----------- -------------
Alan R. Hoops.............. 40,000 $3,178,850 390,500 427,500 $2,063,875 $768,750
Jeffrey M. Folick.......... 15,000 $ 513,538 300,375 243,125 $ 96,250 $ --
Bradford A. Bowlus......... -- $ -- 103,500 250,000 $ -- $768,750
Richard E. Badger.......... 21,375 $ 543,000 19,716 132,774 $ -- $499,688
Linda M. Lyons, M.D. ...... 1,100 $ 22,000 91,100 147,200 $ -- $269,063
Robert B. Stearns.......... -- $ -- 125,000 -- $ -- $ --
EMPLOYMENT AGREEMENTS
PacifiCare has entered into employment agreements with Mr. Bowlus, Mr. Badger
and Dr. Lyons. Each agreement continues until the death, disability, misconduct
or written notice of termination by either PacifiCare or the NEO. The agreements
provide that Mr. Bowlus, Mr. Badger and Dr. Lyons are entitled to his or her
base salary, participation in all employee benefit programs, reimbursement for
business expenses and participation in PacifiCare's MICP and Employee Plan. The
agreements also contain provisions that entitle each of the NEOs to receive
severance benefits, payable if the officer's employment with PacifiCare is
terminated for various reasons, including death, disability, termination
following a change of ownership or control of PacifiCare and termination without
cause.
Under the employment agreements, a change of ownership or control would result
from:
(a) any merger, consolidation or sale such that any individual, entity or
group (within the meaning of Section 13(d)(3) or 14(d)(2) of the
Exchange Act) acquires beneficial ownership, within the meaning of Rule
13d-3 of the Exchange Act, of 20 percent or more of the voting common
stock of PacifiCare and the ownership interest of the voting common
stock owned by UniHealth is less than or equal to the ownership
interest of the voting common stock of such individual, entity or
group;
(b) any transaction in which PacifiCare sells substantially all of its
material assets;
(c) a dissolution or liquidation of PacifiCare; or
(d) PacifiCare becomes a non-publicly held company.
In the event Mr. Bowlus, Mr. Badger or Dr. Lyons is terminated by PacifiCare
(other than for incapacity, disability, habitual neglect or gross misconduct)
within 24 months of a change of control or is terminated without cause, the
employment agreements provide for payment of base salary and certain benefits
for 24 months, and payment of benefits under PacifiCare's MICP that will be
deemed to have accrued to the termination date. The contingent liability for
severance payments that PacifiCare would be required to make under the
employment agreements (excluding amounts that may be payable under incentive
plans and the value of certain benefits) would be approximately $1,220,400 to
Mr. Bowlus, $798,000 to Mr. Badger, and $618,000 to Dr. Lyons.
Mr. Folick has entered into an agreement with PacifiCare, that provides
compensation for him upon retirement. Through December 31, 2000, Mr. Folick will
receive salary, will be eligible to participate in certain employee benefit
plans and his stock options will continue to vest in accordance with their
terms. From January 1, 2001 through December 31, 2001, Mr. Folick will be able
to exercise his vested stock options and will receive continued medical, dental
and vision coverage. As of December 31, 2000, all other employee benefits will
cease and he will not receive any additional compensation. Mr. Folick will
receive approximately $487,000 in compensation through December 31, 2000. If Mr.
Folick is employed by a competitor of
48
51
PacifiCare before December 31, 2000, we will reduce his compensation by the
amount he receives from the competitor.
Mr. Hoops has entered into an amended employment agreement, that continues until
the earlier of a change of control or March 31, 2001. Upon termination, Mr.
Hoops will retire as Chief Executive Officer and President of PacifiCare. If a
change of control has not occurred on or before March 31, 2001, Mr. Hoops will
become a consultant to PacifiCare. Through March 31, 2001 or upon a change of
control, Mr. Hoops will receive salary, will be eligible to participate in
PacifiCare's benefit programs, including PacifiCare's MICP and Employee Plan,
and will be reimbursed for business expenses. The agreement also contain
provisions that entitle Mr. Hoops to receive severance benefits, payable if his
employment with PacifiCare is terminated for various reasons, including death,
disability, termination following a change of ownership or control of PacifiCare
and termination without cause.
If Mr. Hoops is terminated for reasons other than incapacity, disability,
habitual neglect or gross misconduct, he will receive an amount equal to: (i) 36
months of his current salary, (ii) three times his average bonus under the MICP,
(iii) continuation of health benefits, (iv) 36 months of his automobile
allowance, (v) outplacement services and (vi) the ability to exercise all vested
stock options for one year. Mr. Hoops will receive the severance benefits over a
period of 36 months. If Mr. Hoops becomes a consultant, he will receive
compensation similar to the benefits he would receive if he were involuntarily
terminated. We estimate that this expense will not exceed approximately $6.3
million. Upon a change of control, Mr. Hoops will receive a lump sum payment
consisting of (i) three times his existing base salary; (ii) three times his
average MICP bonus for the last two years; (iii) a prorated target bonus; (iii)
an amount equal to 36 months of continued medical, dental and vision coverage;
(v) outplacement benefits; and (vi) 36 months of his automobile allowance. Mr.
Hoops will also receive an amount to cover any excise tax penalty. In addition,
Mr. Hoops' stock options will automatically vest upon a change of control and
Mr. Hoops will have one year to exercise his options. We estimate that this
expense will not exceed approximately $6.3 million plus a prorated target bonus.
If, while receiving severance payments following their involuntary termination,
any NEO (except Mr. Folick and Mr. Stearns, as described herein) is employed by
a competitor, their severance payments will be reduced by an amount equal to the
payment received from the competitor.
Mr. Stearns has entered into a separation agreement with PacifiCare that
provides for Mr. Stearns to receive salary and an auto allowance for a period of
24 months, and outplacment services. Mr. Stearns will also be able to exercise
his vested stock options for one year after the effective date of his employment
termination, which was December 13, 1999. In addition, Mr. Stearns received an
award under the MICP for 1999, and the $125,000 loan that we provided him in
connection with his relocation was forgiven. Mr. Stearns is not eligible to
participate in any other employee benefit plans of PacifiCare. If, while
receiving his severance payments, Mr. Stearns is employed by a competitor of
PacifiCare, we may reduce his severance by the amount he receives from the
competitor.
Upon a change of control (as defined in the Employee Plan) and if a minimum per
share consideration is being paid for the transaction, each of the NEOs, except
Mr. Badger, will receive a cash payment for each unexercised premium priced
option equal to the difference between (x) 110 percent of the price per share at
which the PacifiCare common stock is sold in the change of control transaction
and (y) the exercise price of the premium priced option. If the per share
consideration equals or exceeds $115 per share, the executive officers will not
receive a cash payment. The exercise price for one-half of the premium priced
options outstanding is $92.50 per share. The exercise price for the balance is
$114.00 per share. For the NEOs as a group, cash payments under this program may
range from approximately $5,000 to $24 million.
COMPENSATION OF DIRECTORS
CASH COMPENSATION. Directors who are not full-time employees of PacifiCare
receive, as compensation for their services, an annual retainer of $25,000,
$1,200 for each PacifiCare Board of Directors meeting attended, $1,000 for each
Board of Directors committee meeting attended and a telephone meeting fee equal
to one-half the fee paid for a Board of Directors meeting or Board committee
meeting, as the case may be. The
49
52
Chairman of the Board, when not an employee or officer, receives $2,400 for
attendance at meetings of the Board. Chairmen of committees receive $2,000 for
each committee meeting attended. Directors are also reimbursed for usual and
customary travel expenses. In 2000, the Board of Directors suspended the program
that required each Director to own a minimum amount of PacifiCare common stock.
PacifiCare does not have a retirement plan for non-employee directors.
David Reed became Chairman of the Board and a PacifiCare employee on November 1,
1999. We pay Mr. Reed $250,000 annually for his services as Chairman, but do not
compensate him for his participation as a Board member or as a member of a
committee of the Board. Mr. Reed is eligible to participate in our Profit
Sharing Plan and the Employee Plan, but is not eligible for any other benefits.
Mr. Reed received a stock option grant under the Employee Plan on November 5,
1999 for 25,000 shares of PacifiCare common stock, with an exercise price of
$45.31 per share. The options vest 33 1/3 percent per year beginning one year
from the date of grant, or 100 percent upon retirement, whichever occurs
earlier.
STOCK OPTION PLAN. Under PacifiCare's Amended and Restated 1996 Non-Officer
Directors Stock Option Plan (the "Directors Plan"), non-officer Directors of
PacifiCare who are not eligible to receive awards under the Employee Plan are
automatically granted nonqualified stock options to purchase 5,000 shares of
common stock on June 30 of each year; provided that, during the preceding 12
months, the director served on the Board of Directors and was not eligible to
receive awards under the Employee Plan. The Directors Plan also provides for the
automatic grant of nonqualified stock options to purchase 10,000 shares of
common stock upon being elected to the Board of Directors. Currently, no more
than 390,000 shares of common stock are available for nonqualified stock options
under the Directors Plan.
The exercise price of the shares of common stock subject to any nonqualified
stock option granted under the Directors Plan is 100 percent of the fair market
value of the underlying common stock on the date of grant. Nonqualified stock
options granted under the Directors Plan vest immediately on the grant date. The
underlying common stock, however, may not be sold within the first six months of
the grant date.
Nonqualified stock options granted under the Directors Plan may not be exercised
after the earlier of:
(a) the expiration of 10 years and one day from the date the nonqualified
stock option was granted;
(b) the expiration of one year from the time the optionee voluntarily
ceases to serve as a director of PacifiCare; and
(c) the expiration of one year from the date an optionee ceases to serve as
a director of PacifiCare by reason of disability or death.
In addition, the Directors Plan provides for an automatic and immediate
acceleration of the vesting of all nonqualified stock options granted under the
Directors Plan that have been held for at least six months upon the occurrence
of a Change of Control (as defined in the Employee Plan).
50
53
During 1999, the non-officer Directors were granted nonqualified stock options
under the Directors Plan as follows (except as indicated for Mr. Reed and Mr.
Hartshorn):
NUMBER OF SECURITIES EXERCISE OR BASE
NAME GRANT DATE UNDERLYING OPTIONS PRICE PER SHARE
---- ---------- -------------------- ----------------
David A. Reed, Chairman........................ 06/30/99 5,000 $71.94
11/05/99(1) 25,000 $45.31
Terry O. Hartshorn, Vice Chairman.............. 06/30/99(1) 5,000 $71.94
11/05/99 10,000 $45.31
Jack R. Anderson............................... 06/30/99 5,000 $71.94
11/05/99 10,000 $45.31
Craig T. Beam.................................. 06/30/99 5,000 $71.94
11/05/99 10,000 $45.31
Richard M. Burdge.............................. 06/30/99 5,000 $71.94
11/05/99 10,000 $45.31
Bradley C. Call................................ 06/30/99 5,000 $71.94
11/05/99 10,000 $45.31
David R. Carpenter............................. 06/30/99 5,000 $71.94
11/05/99 10,000 $45.31
Gary L. Leary.................................. 06/30/99 5,000 $71.94
11/05/99 10,000 $45.31
Warren E. Pinckert II.......................... 06/30/99 5,000 $71.94
11/05/99 10,000 $45.31
Lloyd E. Ross.................................. 06/30/99 5,000 $71.94
11/05/99 10,000 $45.31
Jean Bixby Smith............................... 01/28/99 5,000 $70.38
06/30/99 5,000 $71.94
11/05/99 10,000 $45.31
- ---------------
(1) Mr. Reed and Mr. Hartshorn received these stock option grants under the
Employee Plan.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
PRINCIPAL STOCKHOLDERS
This table shows how much PacifiCare common stock is owned by the directors and
certain executive officers as of January 7, 2000, and owners of more than five
percent of PacifiCare's outstanding common stock as of February 29, 2000.
AMOUNT AND NATURE OF SHARES BENEFICIALLY OWNED
NUMBER PERCENT OF
OF SHARES RIGHT TO OUTSTANDING
NAME OWNED(1) ACQUIRE(2) SHARES
---- --------- ---------- -----------
UniHealth Foundation(3).................................. 6,194,500 -- 17.2
Capital Group International, Inc.(4)..................... 4,615,910 -- 12.8
Sanford C. Bernstein & Co., Inc.(5)...................... 3,719,675 -- 10.4
Vanguard/Windsor Funds, Inc. -- Windsor Fund(6).......... 2,619,300 -- 7.3
The Prudential Insurance Company of America(7)........... 2,556,061 -- 7.1
Wellington Management Company, LLP(8).................... 2,437,700 -- 6.8
David A. Reed............................................ 1,000 16,250 *
Terry O. Hartshorn....................................... 167,732 118,750 *
Alan R. Hoops............................................ 243,073 390,500 1.7
Jack R. Anderson(9)...................................... 392,937 28,146 1.1
Craig T. Beam............................................ 1,030 21,250 *
Richard M. Burdge, Sr.(10)............................... 89,981 23,405 *
51
54
NUMBER PERCENT OF
OF SHARES RIGHT TO OUTSTANDING
NAME OWNED(1) ACQUIRE(2) SHARES
---- --------- ---------- -----------
Bradley C. Call.......................................... 1,000 21,250 *
David R. Carpenter....................................... 1,000 44,300 *
Gary L. Leary............................................ 1,000 44,300 *
Warren E. Pinckert II.................................... 632 39,300 *
Lloyd E. Ross............................................ 1,000 32,900 *
Jean Bixby Smith......................................... 230 25,750 *
Jeffrey M. Folick........................................ 3,650 300,375 *
Bradford A. Bowlus....................................... -- 103,500 *
Richard E. Badger........................................ -- 19,716 *
Linda M. Lyons, M.D...................................... -- 91,100 *
Robert B. Stearns........................................ 2,000 125,000 *
All Directors and Executive Officers as a group(11) (35
persons)............................................... 983,915 2,300,254 8.3
- ---------------
* Less than one percent.
(1) Information with respect to the beneficial ownership is based on
information furnished to PacifiCare by each person in this table. Includes
shares for which the named person:
- has sole voting and investment power, or
- has shared voting and investment power with his or her spouse, unless
otherwise indicated in the footnotes.
(2) Shares that can be acquired through stock option exercises through March 7,
2000.
(3) UniHealth Foundation is a California nonprofit public benefit corporation.
The address of UniHealth Foundation is 3400 Riverside Drive, Burbank,
California 91505.
(4) Based on information contained in a report on Schedule 13-G filed with the
SEC on February 14, 2000. The address of Capital Group International, Inc.
is 11100 Santa Monica Boulevard, Los Angeles, California 90025.
(5) Based on information contained in a report on Schedule 13-G filed with the
SEC on February 9, 2000. The address of Sanford C. Bernstein & Co., Inc. is
767 Fifth Avenue, New York, New York 10153.
(6) Based on information contained in a report on Schedule 13-G/A filed with
the SEC on February 1, 2000. The address of Vanguard/Windsor Funds,
Inc. -- Windsor Fund is Post Office Box 2600, Valley Forge, Pennsylvania
19428.
(7) Based on information contained in a report on Schedule 13-G filed with the
SEC on February 7, 2000. The address of The Prudential Insurance Company of
America is 751 Broad Street, Newark, New Jersey 07102-3777.
(8) Based on information contained in a report on Schedule 13-G/A filed with
the SEC on February 11, 2000. The address of Wellington Management Company,
LLP is 75 State Street, Boston, Massachusetts 02109.
(9) Includes 169,526 shares of common stock held by Mr. Anderson's spouse. Mr.
Anderson disclaims beneficial ownership of these shares.
(10) Includes 15,610 shares of common stock held by Mr. Burdge's spouse and
11,136 shares of common stock held by trusts of which Mr. Burdge's
relatives are beneficiaries. Mr. Burdge disclaims beneficial ownership of
these shares.
(11) In addition to the officers and directors named in this table, 18 other
executive officers are members of the group.
52
55
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
PacifiCare and its subsidiaries purchased health care services from various
medical service organizations owned by UniHealth Foundation totaling $63 million
for the year ended December 31, 1999. UniHealth Foundation purchased health care
coverage from PacifiCare and its subsidiaries in the amount of $0.2 million for
the year ended December 31, 1999.
We contract with Joseph S. Konowiecki, a professional corporation, for his
services as General Counsel and Secretary of PacifiCare. For these services, we
pay his professional corporation $132,000 per year. Mr. Konowiecki also receives
an automobile allowance. In addition, Mr. Konowiecki is eligible to participate
in the Employee Plan and the Premium Priced Option Plan. During 1999, he
received two nonqualified stock option awards. He received 15,000 options with
an exercise price of $71.59 per share, and 35,000 options with an exercise price
of $45.31 per share. As of January 7, 2000, Mr. Konowiecki held 162,500 vested
nonqualified stock options at a weighted average exercise price of $65.73 per
share.
The contract has an indefinite term. If the contract is terminated for reasons
other than Mr. Konowiecki's incapacity, disability or misconduct, Mr.
Konowiecki's professional corporation will receive its annual fee for two years.
In addition, Mr. Konowiecki will have the right to exercise all of his vested
options within one year of the date of termination. However, if following
involuntary termination, Mr. Konowiecki is retained on a similar basis by any of
our competitors, the termination payments are reduced by amounts equal to the
payments received from the competitor.
Further, if this contract is terminated within 24 months following a change of
control of PacifiCare, Mr. Konowiecki's professional corporation will receive
its annual fee for two years. Upon a change of control (as defined in the
Employee Plan) all of Mr. Konowiecki's nonqualified options will automatically
vest and become fully exercisable. In addition, Mr. Konowiecki will receive the
cash payment on his premium priced stock options similar to the cash payment the
NEOs will receive. The maximum cash payment to Mr. Konowiecki could be
approximately $2 million.
During 1999, we paid Konowiecki & Rank LLP, a law partnership, $9 million in
legal fees. Mr. Konowiecki's professional corporation is a partner of the firm,
and receives income through the partnership.
53
56
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
The following documents are filed as part of this report:
PAGE
REFERENCE
---------
(a)1. Consolidated Financial Statements:
Consolidated Balance Sheets as of December 31, 1999 and
1998........................................................ F-1
Consolidated Statements of Operations for the years ended
December 31, 1999, 1998 and 1997............................ F-2
Consolidated Statements of Stockholders' Equity for the
years ended December 31, 1999, 1998 and 1997................ F-3
Consolidated Statements of Cash Flows for the years ended
December 31, 1999, 1998 and 1997............................ F-4
Notes to Consolidated Financial Statements.................. F-6
Report of Ernst & Young LLP, Independent Auditors........... F-25
Quarterly Information for 1999 and 1998 (unaudited)......... F-26
2. Financial Statement Schedule:
Schedule II -- Valuation and Qualifying Accounts............ F-27
All other schedules are omitted because they are not
required or the information is included elsewhere in the
consolidated financial statements
3. Exhibits: An "Exhibit Index" is filed as part of this Form
10-K beginning on page E-1 and is incorporated by reference.
(b) Reports on Form 8-K: On November 19, 1999, we filed a Form
8-K in connection with the adoption of our Stockholder
Rights agreement to protect stockholder rights in the event
of a proposed takeover.
54
57
SIGNATURES
Pursuant to the requirements of the Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this Report to be signed on
its behalf by the undersigned, thereunto duly authorized.
PACIFICARE HEALTH SYSTEMS, INC.
By:
------------------------------------
Alan R. Hoops
President and Chief Executive
Officer
Date: March 30, 2000
POWER OF ATTORNEY
We, the undersigned directors and officers of PacifiCare Health Systems, Inc.,
do hereby constitute and appoint Alan R. Hoops and Mary C. Langsdorf, or either
of them, our true and lawful attorneys and agents, to do any and all acts and
things in our name and on our behalf in our capacities as directors and officers
and to execute any and all instruments for us and in our names in the capacities
indicated below, which said attorneys and agents, or either of them, may deem
necessary or advisable to enable said corporation to comply with the Securities
Exchange Act of 1934, and any rules, regulations, and requirements of the
Securities and Exchange Commission, in connection with this Report, including
specifically, but without limitation, power and authority to sign any and all
amendments hereto; and we do hereby ratify and confirm all that said attorneys
and agents, or either of them, shall do or cause to be done by virtue hereof.
Pursuant to the requirements of the Securities Exchange Act of 1934, this Report
has been signed below by the following persons on behalf of the registrant and
in the capacities and on the dates indicated.
NAME TITLE DATE
---- ----- ----
President and Chief Executive March 30, 2000
- ----------------------------------------------------- Officer (Principal Executive
Alan R. Hoops Officer)
Senior Vice President,
- ----------------------------------------------------- Corporate Controller and
Mary C. Langsdorf Interim Chief Financial Officer
(Principal Financial and
Accounting Officer)
Chairman of the Board March 30, 2000
- -----------------------------------------------------
David A. Reed
Vice Chairman of the Board March 30, 2000
- -----------------------------------------------------
Terry O. Hartshorn
Director March 30, 2000
- -----------------------------------------------------
Jack R. Anderson
Director March 30, 2000
- -----------------------------------------------------
Craig T. Beam
Director March 30, 2000
- -----------------------------------------------------
Richard M. Burdge
Director March 30, 2000
- -----------------------------------------------------
Bradley C. Call
55
58
NAME TITLE DATE
---- ----- ----
Director March 30, 2000
- -----------------------------------------------------
David R. Carpenter
Director March 30, 2000
- -----------------------------------------------------
Gary L. Leary
Director March 30, 2000
- -----------------------------------------------------
Warren E. Pinckert II
Director March 30, 2000
- -----------------------------------------------------
Lloyd E. Ross
Director March 30, 2000
- -----------------------------------------------------
Jean Bixby Smith
56
59
PACIFICARE HEALTH SYSTEMS, INC.
CONSOLIDATED BALANCE SHEETS
(AMOUNTS IN THOUSANDS, EXCEPT PER SHARE DATA)
DECEMBER 31, DECEMBER 31,
1999 1998
------------ ------------
ASSETS
Current assets:
Cash and equivalents...................................... $ 849,064 $ 724,636
Marketable securities..................................... 999,194 875,553
Receivables, net.......................................... 306,652 275,955
Prepaid expenses and other current assets................. 48,412 24,979
Deferred income taxes..................................... 141,169 132,452
---------- ----------
Total current assets................................... 2,344,491 2,033,575
---------- ----------
Property, plant and equipment at cost, net.................. 177,521 178,520
Marketable securities-restricted............................ 86,471 82,660
Goodwill and intangible assets, net......................... 2,244,243 2,313,266
Other assets................................................ 31,295 22,923
---------- ----------
$4,884,021 $4,630,944
========== ==========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Medical claims and benefits payable....................... $ 795,200 $ 645,300
Accounts payable.......................................... 131,121 105,062
Accrued liabilities....................................... 209,786 290,726
Accrued compensation and employee benefits................ 84,264 68,382
Unearned premium revenue.................................. 565,815 509,859
Long-term debt due within one year........................ -- 87
---------- ----------
Total current liabilities.............................. 1,786,186 1,619,416
---------- ----------
Long-term debt due after one year........................... 975,000 650,006
Deferred income taxes....................................... 127,469 112,056
Other liabilities........................................... 17,314 11,015
Minority interest........................................... 333 355
Commitments and contingencies
Stockholders' equity:
Common stock, $0.01 par value; 200,000 shares authorized;
issued 46,803 shares in 1999 and 46,386 shares in
1998................................................... 468 464
Additional paid-in capital................................ 1,597,485 1,624,619
Accumulated other comprehensive (loss) income............. (24,396) 7,359
Retained earnings......................................... 928,152 649,608
Treasury stock, at cost; 9,551 shares in 1999 and 770
shares in 1998......................................... (523,990) (43,954)
---------- ----------
Total stockholders' equity............................. 1,977,719 2,238,096
---------- ----------
$4,884,021 $4,630,944
========== ==========
See accompanying notes.
F-1
60
PACIFICARE HEALTH SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(AMOUNTS IN THOUSANDS, EXCEPT PER SHARE DATA)
YEAR ENDED YEAR ENDED YEAR ENDED
DECEMBER 31, DECEMBER 31, DECEMBER 31,
1999 1998 1997
------------ ------------ ------------
Revenue:
Government premiums (Medicare and Medicaid)............. $5,875,687 $5,586,592 $5,206,919
Commercial premiums..................................... 3,994,475 3,823,587 3,728,243
Other income............................................ 118,928 111,303 47,518
---------- ---------- ----------
Total operating revenue.............................. 9,989,090 9,521,482 8,982,680
Expenses:
Health care services:
Government services..................................... 5,106,429 4,834,638 4,458,994
Commercial services..................................... 3,262,261 3,167,622 3,199,885
---------- ---------- ----------
Total health care services........................... 8,368,690 8,002,260 7,658,879
Marketing, general and administrative expenses............ 1,105,816 1,089,418 1,055,080
Amortization of goodwill and intangible assets............ 75,957 76,593 70,219
Impairment, disposition, restructuring and other (credits)
charges................................................. (2,233) 15,644 154,507
Office of Personnel Management credits.................... -- (4,624) --
---------- ---------- ----------
Operating income.......................................... 440,860 342,191 43,995
Net investment income..................................... 84,050 104,306 80,665
Interest expense.......................................... (43,001) (60,923) (64,536)
---------- ---------- ----------
Income before income taxes................................ 481,909 385,574 60,124
Provision for income taxes................................ 203,365 183,147 81,825
---------- ---------- ----------
Net income (loss)......................................... $ 278,544 $ 202,427 $ (21,701)
========== ========== ==========
Preferred dividends....................................... -- (5,259) (8,792)
---------- ---------- ----------
Net income (loss) available to common stockholders........ $ 278,544 $ 197,168 $ (30,493)
========== ========== ==========
Basic earnings (loss) per share........................... $ 6.26 $ 4.50 $ (0.75)
========== ========== ==========
Diluted earnings (loss) per share......................... $ 6.23 $ 4.40 $ (0.75)
========== ========== ==========
See accompanying notes.
F-2
61
PACIFICARE HEALTH SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
(AMOUNTS IN THOUSANDS)
ACCUMULATED
OTHER
ADDITIONAL COMPREHENSIVE
PREFERRED COMMON PAID-IN INCOME RETAINED TREASURY
STOCK STOCK CAPITAL (LOSS) EARNINGS STOCK TOTAL
--------- ------ ---------- ------------- -------- --------- ----------
BALANCES AT DECEMBER 31, 1996............. $ -- $313 $ 373,405 $ 3,451 $482,933 $ -- $ 860,102
----- ---- ---------- -------- -------- --------- ----------
Comprehensive loss:
Net loss................................ -- -- -- -- (21,701) -- (21,701)
Other comprehensive income, net of tax:
Unrealized gains on securities, net of
reclassification adjustment......... -- -- -- 6,542 -- -- 6,542
----- ---- ---------- -------- -------- --------- ----------
Comprehensive loss........................ -- -- -- 6,542 (21,701) -- (15,159)
----- ---- ---------- -------- -------- --------- ----------
Capital stock activity:
FHP acquisition......................... 105 97 1,163,393 -- -- -- 1,163,595
Employee benefit plans.................. -- 10 44,584 -- -- -- 44,594
Tax benefit associated with exercise of
stock options........................... -- -- 17,847 -- -- -- 17,847
Preferred dividends....................... -- -- -- -- (8,792) -- (8,792)
----- ---- ---------- -------- -------- --------- ----------
BALANCES AT DECEMBER 31, 1997............. 105 420 1,599,229 9,993 452,440 -- 2,062,187
----- ---- ---------- -------- -------- --------- ----------
Comprehensive income:
Net income.............................. -- -- -- -- 202,427 -- 202,427
Other comprehensive loss, net of tax:
Unrealized losses on securities, net
of reclassification adjustment...... -- -- -- (2,634) -- -- (2,634)
----- ---- ---------- -------- -------- --------- ----------
Comprehensive income...................... -- -- -- (2,634) 202,427 -- 199,793
----- ---- ---------- -------- -------- --------- ----------
Capital stock activity:
Conversion of preferred stock to common
stock................................. (105) 39 (344) -- -- -- (410)
Employee benefit plans.................. -- 5 19,438 -- -- 704 20,147
Purchase of treasury stock.............. -- -- -- -- -- (44,658) (44,658)
Tax benefit associated with exercise of
stock options........................... -- -- 6,296 -- -- -- 6,296
Preferred dividends....................... -- -- -- -- (5,259) -- (5,259)
----- ---- ---------- -------- -------- --------- ----------
BALANCES AT DECEMBER 31, 1998............. -- 464 1,624,619 7,359 649,608 (43,954) 2,238,096
----- ---- ---------- -------- -------- --------- ----------
Comprehensive income:
Net income.............................. -- -- -- -- 278,544 -- 278,544
Other comprehensive loss, net of tax:
Unrealized losses on securities, net
of reclassification adjustment...... -- -- -- (31,755) -- -- (31,755)
----- ---- ---------- -------- -------- --------- ----------
Comprehensive income...................... -- -- -- (31,755) 278,544 -- 246,789
----- ---- ---------- -------- -------- --------- ----------
Capital stock activity:................... -- -- -- -- -- -- --
Employee benefit plans.................. -- 4 29,803 -- -- -- 29,807
Purchase of treasury stock.............. -- -- -- -- -- (480,036) (480,036)
Common stock reclassification payments to
UniHealth and others.................... -- -- (61,880) -- -- -- (61,880)
Tax benefit associated with exercise of
stock options........................... -- -- 4,943 -- -- -- 4,943
----- ---- ---------- -------- -------- --------- ----------
BALANCES AT DECEMBER 31, 1999............. $ -- $468 $1,597,485 $(24,396) $928,152 $(523,990) $1,977,719
===== ==== ========== ======== ======== ========= ==========
See accompanying notes.
F-3
62
PACIFICARE HEALTH SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(AMOUNTS IN THOUSANDS)
YEAR ENDED YEAR ENDED YEAR ENDED
DECEMBER 31, DECEMBER 31, DECEMBER 31,
1999 1998 1997
------------ ------------ ------------
Operating activities:
Net income (loss)......................................... $ 278,544 $ 202,427 $ (21,701)
Adjustments to reconcile net income (loss) to net cash
flows provided by operating activities:
Amortization of goodwill and intangible assets......... 75,957 76,593 70,219
Depreciation and amortization.......................... 42,140 44,436 46,658
Deferred income taxes.................................. 26,668 (19,299) 25,579
Loss on disposal of property, plant and equipment and
other................................................ 9,283 12,547 6,715
Impairment, disposition, restructuring and other
(credits) charges.................................... (2,233) 15,644 154,507
Provision for doubtful accounts........................ 1,634 1,485 5,171
Office of Personnel Management credits................. -- (4,624) --
Changes in assets and liabilities, net of effects from
acquisitions and dispositions:
Receivables, net..................................... (32,331) 24,516 6,321
Prepaid expenses and other assets.................... (31,805) 102,696 (112,409)
Medical claims and benefits payable.................. 158,655 (47,421) (2,504)
Accounts payable, accrued liabilities and accrued
compensation and employee benefits................ (12,770) 31,549 (2,340)
Unearned premium revenue............................. 55,956 15,038 237,273
--------- --------- -----------
Net cash flows provided by operating activities... 569,698 455,587 413,489
--------- --------- -----------
Investing activities:
Purchase of marketable securities, net.................... (175,368) (16,546) (8,795)
Purchase of property, plant and equipment................. (66,211) (41,631) (68,533)
Acquisitions, net of cash acquired........................ (21,234) (750) (999,892)
Proceeds from the sale of property, plant and equipment... 15,765 41,187 3,154
Purchase of marketable securities-restricted.............. (3,811) (17,980) (15,475)
Proceeds from dispositions................................ -- 16,809 76,500
--------- --------- -----------
Net cash flows used in investing activities....... (250,859) (18,911) (1,013,041)
--------- --------- -----------
Financing activities:
Common stock repurchases.................................. (480,036) (44,658) --
Proceeds from borrowings of long-term debt................ 400,000 30,000 1,120,000
Principal payments on long-term debt...................... (75,093) (391,295) (235,166)
Common stock reclassification payments to UniHealth and
others................................................. (61,880) -- --
Proceeds from issuance of common and treasury stock....... 22,598 18,908 43,838
Preferred dividends paid.................................. -- (5,259) (8,792)
Redemption of preferred stock............................. -- (410) --
Capitalization of Talbert................................. -- -- (67,000)
Proceeds from sale of Talbert stock....................... -- -- 59,598
--------- --------- -----------
Net cash flows provided by (used in) financing
activities...................................... (194,411) (392,714) 912,478
--------- --------- -----------
Net increase in cash and equivalents........................ 124,428 43,962 312,926
Beginning cash and equivalents.............................. 724,636 680,674 367,748
--------- --------- -----------
Ending cash and equivalents................................. $ 849,064 $ 724,636 $ 680,674
========= ========= ===========
See accompanying notes.
Table continued on next page.
F-4
63
PACIFICARE HEALTH SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED)
(AMOUNTS IN THOUSANDS)
YEAR ENDED YEAR ENDED YEAR ENDED
DECEMBER 31, DECEMBER 31, DECEMBER 31,
1999 1998 1997
------------ ------------ ------------
Supplemental cash flow information:
Cash paid during the year for:
Income taxes, net of refunds........................ $ 209,754 $ 28,696 $ 100,202
Interest............................................ $ 35,621 $ 55,735 $ 55,282
Supplemental schedule of noncash investing and financing
activities:
Tax benefit associated with exercise of stock
options............................................. $ 4,943 $ 6,296 $ 17,847
Stock-based compensation............................... $ 7,209 $ 1,239 $ 756
Details of accumulated other comprehensive (loss) income:
Change in marketable securities........................ $ (51,727) $ (4,652) $ 10,577
Less change in deferred income taxes................... 19,972 2,018 (4,035)
--------- --------- -----------
Change in stockholders' equity......................... $ (31,755) $ (2,634) $ 6,542
========= ========= ===========
Details of businesses acquired in purchase transactions:
Fair value of assets acquired.......................... $ 21,234 $ 750 $ 3,376,241
Less liabilities assumed or created.................... -- -- (1,168,236)
Less common and preferred stock consideration.......... -- -- (1,163,595)
--------- --------- -----------
Cash paid for fair value of assets acquired............ 21,234 750 1,044,410
Cash acquired in acquisitions.......................... -- -- (44,518)
--------- --------- -----------
Net cash paid for acquisitions...................... $ 21,234 $ 750 $ 999,892
========= ========= ===========
Purchase accounting accrual adjustment:
Reduction of purchase accounting accruals.............. $ -- $ (79,340) $ --
Deferred income taxes.................................. -- 10,165 --
--------- --------- -----------
Net goodwill adjustment.................................. $ -- $ (69,175) $ --
========= ========= ===========
See accompanying notes.
Table continued from previous page.
F-5
64
PACIFICARE HEALTH SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. BASIS OF PRESENTATION
ORGANIZATION AND OPERATIONS. PacifiCare Health Systems, Inc. owns and operates
federally qualified health maintenance organizations ("HMOs"), that arrange
health care services principally for a predetermined, prepaid periodic fee to
enrolled subscriber groups through independent health care organizations under
contract. Our Medicare program and commercial plans are designed to deliver
quality health care and customer service to members at cost-effective prices. We
also offer a variety of specialty HMO managed care and HMO-related products and
services that employees can purchase as a supplement to our basic commercial
plans or as stand-alone products. These products include life and health
insurance, behavioral health services, dental and vision services, pharmacy
benefit management and Medicare+Choice management services. UniHealth
Foundation, a California non-profit public benefit corporation, owned
approximately 17 percent of our outstanding shares of common stock at December
31, 1999.
CONSOLIDATION. The accompanying consolidated financial statements include the
accounts of the parent company and all significant subsidiaries that are more
than 50 percent owned and controlled. All significant intercompany transactions
and balances were eliminated in consolidation.
SEGMENT INFORMATION. We present segment information externally the same way
management uses financial data internally to make operating decisions and assess
performance. Because we sell health care packages in the form of bundled HMO and
supplemental HMO products to members of all ages, we have one reportable
operating segment. These HMO members generally fall within two product lines.
Revenues from our Medicare customers are reported in the government product
line. Revenues from non-Medicare members, generally employees or early retirees
of businesses, are reported in the commercial product line. Our single largest
customer is the federal government. Sources of federal government revenues
include revenues from Medicare beneficiaries and from federal employees covered
by the Federal Employee Health Benefits Program ("FEHBP"). Federal government
revenues were $6.2 billion in 1999, $5.9 billion in 1998 and $5.5 billion in
1997.
USE OF ESTIMATES. In preparing the consolidated financial statements, we must
use some estimates and assumptions that may affect reported amounts and
disclosures. We use estimates most often when accounting for:
- - Provider receivables and reserves;
- - Allowances for doubtful premiums and accounts receivable;
- - Internally developed software;
- - Medical claims and benefits payable;
- - Professional and general liability;
- - Reserves relating to the United States Office of Personnel Management
("OPM"); and
- - Certain other reserves.
We are also subject to risks and uncertainties that may cause actual results to
differ from estimated results, such as changes in the health care environment,
competition and legislation.
RECLASSIFICATIONS. We reclassified certain prior year amounts in the
accompanying consolidated financial statements to conform to the 1999
presentation.
2. SIGNIFICANT ACCOUNTING POLICIES
CASH AND EQUIVALENTS. Cash and equivalents include items such as money market
funds and certificates of deposit, with maturity periods of three months or less
when purchased.
F-6
65
MARKETABLE SECURITIES. All marketable securities (which include municipal bonds,
corporate notes, commercial paper and U.S. government securities), except
marketable securities-restricted, are designated as available-for-sale.
Accordingly, marketable securities are carried at fair value and unrealized
gains or losses, net of applicable income taxes, are recorded in stockholders'
equity. Because marketable securities are available for use in current
operations, they are classified as current assets without regard to the
securities' contractual maturity dates.
We are required by state regulatory agencies to set aside funds to comply with
the laws of the various states in which we operate. These funds are classified
as marketable securities-restricted (which include U.S. government securities
and certificates of deposit held by trustees or state regulatory agencies).
Marketable securities-restricted are designated as held-to-maturity since we
have the intent and ability to hold such securities to maturity.
Held-to-maturity securities are stated at amortized cost, adjusted for
amortization of premiums and accretion of discounts to maturity, and are
classified as noncurrent assets. See Note 3, "Marketable Securities."
CONCENTRATIONS OF CREDIT RISK. Financial instruments that potentially subject us
to concentrations of credit risk consist primarily of investments in marketable
securities and commercial premiums receivable. Our short-term investments in
marketable securities are managed by professional investment managers within
guidelines established by our board of directors, that, as a matter of policy,
limit the amounts that may be invested in any one issuer. Concentrations of
credit risk with respect to commercial premiums receivable are limited due to
the large number of employer groups comprising our customer base. We had no
significant concentrations of credit risk at December 31, 1999.
FAIR VALUE OF FINANCIAL INSTRUMENTS. Our consolidated balance sheets include the
following financial instruments: cash and equivalents, trade accounts and notes
receivable, trade accounts payable and long-term obligations. We consider the
carrying amounts of current assets and liabilities in the consolidated financial
statements to approximate the fair value for these financial instruments because
of the relatively short period of time between origination of the instruments
and their expected realization. The carrying value of all long-term obligations
approximates the fair value of such obligations.
LONG-LIVED ASSETS.
Property, Plant and Equipment. We record property, plant and equipment at cost.
We capitalize replacements and major improvements. We charge repairs and
maintenance to expense as incurred. We eliminate the costs and related
accumulated depreciation when we sell property, plant and equipment, and any
resulting gains or losses are included in net income. We depreciate property,
plant and equipment, including assets under capital leases, evenly over the
assets' useful lives ranging from three to 25 years. We amortize leasehold
improvements evenly over the shorter of the lease term or five years.
Accumulated depreciation totaled $124 million for 1999 and $110 million for
1998.
Goodwill and Intangible Assets. When we acquire a business, we allocate the
excess of the purchase price over the fair value of the net assets acquired to
goodwill and identifiable intangible assets. Identifiable intangible assets can
include employer group contracts, Medicare contracts, provider networks and
assembled work force. We amortize goodwill and intangible assets evenly over
periods ranging from three to 40 years. Accumulated amortization totaled $236
million for 1999 and $160 million for 1998.
Long-lived Asset Impairment. We review long-lived assets for impairment when
events or changes in business conditions indicate that their full carrying value
may not be recovered. We consider assets to be impaired and write them down to
fair value if expected associated cash flows are less than the carrying amounts.
Fair value is the present value of the expected associated cash flows. We
recorded pretax charges for the impairment of goodwill and intangible assets
totaling $14 million in 1999 and $124 million in 1997. See Note 9, "Impairment,
Disposition, Restructuring, Office of Personnel Management and Other (Credits)
Charges."
Software Costs. As of January 1, 1998, we adopted Statement of Position ("SOP")
No. 98-1. This statement requires that certain internal and external costs
associated with the purchase or development of internal-use
F-7
66
software be capitalized rather than expensed. We amortize these costs evenly
over estimated useful lives ranging from three to five years. Total costs
capitalized were $20 million in 1999 and $10 million in 1998. Depreciation
expense related to these costs totaled $3 million in 1999. Development costs
that did not meet SOP No. 98-1 capitalization requirements were $33 million in
1999 and $24 million in 1998. Prior to 1998, we expensed direct costs associated
with the development of computer software as incurred. These costs totaled $20
million in 1997.
PREMIUMS AND REVENUE RECOGNITION. We report prepaid health care premiums
received from our HMOs' enrolled groups as revenue in the month that enrollees
are entitled to receive health care. We record premiums received in advance as
unearned premium revenue. Funds received under the federal Medicare program
accounted for approximately 60 percent in 1999, 59 percent in 1998 and 58
percent in 1997 as a percentage of total premiums.
HEALTH CARE SERVICES. Our HMOs arrange for comprehensive health care services to
their members principally through capitation. Capitation is a fixed monthly
payment made without regard to the frequency, extent or nature of the health
care services actually furnished. We provide benefits to enrolled members
generally through our contractual relationships with physician groups and
hospitals. Our contracted providers may, in turn, contract with specialists or
referral providers for specific services and are responsible for any related
payments to those referral providers. Our HMOs provide incentives to
participating medical groups through the use of risk-sharing agreements and
other programs. Payments are made to medical groups based on their performance
in controlling health care costs while providing quality health care. Expenses
related to these programs, that are based in part on estimates, are recorded in
the period in which the related services are dispensed. The cost of health care
provided is accrued in the period it is dispensed to the enrolled members, based
in part on estimates for hospital services and other health care costs that have
been incurred but not yet reported. We have also recorded reserves, based in
part on estimates, to indemnify our members against potential referral claims
related to insolvent medical groups. See Note 10, "Commitments and
Contingencies." Our HMOs have stop-loss insurance to cover unusually high costs
of care when incurred beyond a predetermined annual amount per enrollee.
PREMIUM DEFICIENCY RESERVES ON LOSS CONTRACTS. We assess the profitability of
our contracts for providing health care services to our members when current
operating results or forecasts indicate probable future losses. We compare
anticipated premiums to health care related costs, including estimated payments
for providers, commissions and cost of collecting premiums and processing
claims. If the anticipated future costs exceed the premiums, a loss contract
accrual is recognized. See Note 9, "Impairment, Disposition, Restructuring,
Office of Personnel Management and Other (Credits) Charges."
ACCOUNTING FOR STOCK-BASED COMPENSATION. We use Accounting Principles Board
Opinion No. 25 to account for our stock-based compensation plans. Because we
typically set the exercise price of options granted at our stock's market price
on the grant date, there is no associated compensation expense. We have,
however, granted certain options that vest only if target stock prices are met.
Because these options have variable terms, there may be compensation expense
incurred for the difference between the exercise price and the closing market
price on the vesting dates. See Note 8, "Employee Benefit Plans."
TAXES BASED ON PREMIUMS. Certain states in which we do business require the
payment of excise, per capita or premium taxes based on a specified rate for
enrolled members or a percentage of billed premiums. Such taxes may be levied
instead of state income tax. These taxes are recorded in marketing, general and
administrative expenses, and totaled $15 million in 1999, $17 million in 1998
and $13 million in 1997.
INCOME TAXES. We recognize deferred income tax assets and liabilities for the
expected future tax consequences of events that have been included in the
consolidated financial statements or tax returns. Deferred tax assets and
liabilities are determined based on differences between the financial reporting
and tax bases of assets and liabilities. We measure deferred tax assets and
liabilities by applying enacted tax rates and laws to taxable years in which
such differences are expected to reverse. See Note 7, "Income Taxes."
F-8
67
EARNINGS PER SHARE. We calculated the denominators for the computation of basic
and diluted earnings per share as follows:
1999 1998 1997
------ ------ ------
(AMOUNTS IN THOUSANDS)
Shares outstanding at the beginning of the period........ 45,616 41,995 31,301
Weighted average number of shares issued:
Conversion of Series A preferred stock................. -- 2,067 --
Treasury stock acquired, net of shares issued.......... (1,387) (543) --
Stock options exercised................................ 277 261 724
FHP acquisition........................................ -- -- 8,498
------ ------ ------
Denominator for basic earnings per share................. 44,506 43,780 40,523
Assumed conversion of Series A preferred stock........... -- 1,862 --
Employee stock options and other dilutive potential
common shares(1)....................................... 211 363 --
------ ------ ------
Denominator for diluted earnings per share............... 44,717 46,005 40,523
====== ====== ======
- ---------------
(1) Certain options to purchase common stock were not included in the
calculation of diluted earnings per share because their exercise prices were
greater than the average market price of our common stock for the periods
presented. For the year ended December 31, 1999, these weighted options
outstanding totaled 6.3 million, with exercise prices ranging from $64.65 to
$114.00 per share. For the years ended December 31, 1998 and 1997, these
weighted options outstanding totaled 3.0 million and 0.9 million
respectively, with exercise prices ranging from $74.63 to $114.00 per share.
DERIVATIVES. In June 1998, the Financial Accounting Standards Board issued SFAS
No. 133, "Accounting for Derivative Instruments and Hedging Activities." This
standard requires companies to record all derivatives on the balance sheet as
either assets or liabilities and measure those instruments at their fair value.
The manner in which companies are to record gains or losses resulting from
changes in the values of those derivatives depends on the use of the derivative
and whether it qualifies for hedge accounting. This standard is effective for
our consolidated financial statements beginning January 1, 2001, although early
adoption is permitted. We believe that the adoption of this statement will not
have a material impact to our consolidated financial position or results of
operations.
F-9
68
3. MARKETABLE SECURITIES
The following table summarizes marketable securities as of the dates indicated:
GROSS GROSS
AMORTIZED UNREALIZED UNREALIZED
COST GAINS LOSSES FAIR VALUE
---------- ---------- ---------- ----------
(AMOUNTS IN THOUSANDS)
Marketable securities:
U.S. government and agency............... $ 178,684 $ 15 $ (8,941) $ 169,758
State, municipal and state and local
agency................................ 389,623 173 (12,397) 377,399
Corporate debt and other securities...... 470,724 167 (18,854) 452,037
---------- ------- -------- ----------
Total marketable securities...... 1,039,031 355 (40,192) 999,194
---------- ------- -------- ----------
Marketable securities-restricted:
U.S. government and agency............... 41,704 40 (194) 41,550
Municipal and local agency............... 12,311 25 (322) 12,014
Corporate debt and other securities...... 32,456 14 (146) 32,324
---------- ------- -------- ----------
Total marketable
securities-restricted.......... 86,471 79 (662) 85,888
---------- ------- -------- ----------
BALANCE AT DECEMBER 31, 1999............... $1,125,502 $ 434 $(40,854) $1,085,082
========== ======= ======== ==========
Marketable securities:
U.S. government and agency............... $ 141,072 $ 3,489 $ (173) $ 144,388
State, municipal and state and local
agency................................ 330,512 6,809 (508) 336,813
Corporate debt and other securities...... 392,079 4,525 (2,252) 394,352
---------- ------- -------- ----------
Total marketable securities...... 863,663 14,823 (2,933) 875,553
---------- ------- -------- ----------
Marketable securities-restricted:
U.S. government and agency............... 48,961 658 (6) 49,613
Municipal and local agency............... 3,756 53 (2) 3,807
Corporate debt and other securities...... 29,943 176 -- 30,119
---------- ------- -------- ----------
Total marketable
securities-restricted.......... 82,660 887 (8) 83,539
---------- ------- -------- ----------
BALANCE AT DECEMBER 31, 1998............... $ 946,323 $15,710 $ (2,941) $ 959,092
========== ======= ======== ==========
As of December 31, 1999 the contractual maturities of our marketable securities
were as follows:
MARKETABLE SECURITIES --
MARKETABLE SECURITIES RESTRICTED
--------------------------- ---------------------------
AMORTIZED COST FAIR VALUE AMORTIZED COST FAIR VALUE
-------------- ---------- -------------- ----------
(AMOUNTS IN THOUSANDS)
Due in one year or less................ $ 144,799 $142,628 $56,437 $56,373
Due after one year through five
years................................ 157,567 154,772 12,175 12,119
Due after five years through ten
years................................ 399,172 376,374 10,822 10,334
Due after ten years.................... 337,493 325,420 7,037 7,062
---------- -------- ------- -------
$1,039,031 $999,194 $86,471 $85,888
========== ======== ======= =======
Proceeds from sales and maturities of marketable securities were $6.9 billion in
1999 and $1.4 billion in 1998. Gross realized gains and gross realized losses
are included in net investment income under the specific identification method.
4. ACQUISITIONS AND DISPOSITIONS
1999 ACQUISITIONS. In September 1999, we acquired ANTERO Health Plans in
Colorado for a purchase price of $14 million. This acquisition added
approximately 32,000 commercial members and 4,000 Medicare members to our
Colorado health maintenance organization. In February 1999, we acquired
approximately 15,000 commercial members in Texas for $4 million. These
acquisitions were accounted for as a purchase with substantially all of the
purchase price being allocated to goodwill and other acquired intangible assets.
The goodwill and acquired intangible assets are being amortized over a three to
20 year period. The
F-10
69
operating results of these entities are included in our consolidated financial
statements from the acquisition dates.
1998 DISPOSITIONS. On September 30, 1998, we sold our Utah HMO subsidiary. We
guaranteed the buyer that the Utah HMO would have a minimum net equity of $10
million, based on the values of the Utah HMO's assets and liabilities as of
September 30, 1998. We also extended a $700,000 subordinated loan to the Utah
HMO which was paid off in August 1999, to increase its statutory net equity. We
sold all of the issued and outstanding shares of capital stock of the Utah HMO
to the buyer for no other consideration. As of September 30, 1998, the Utah HMO
served approximately 102,000 commercial and 19,000 government members. On
October 31, 1998, we sold our workers' compensation subsidiary for $17 million.
We recognized pretax charges (credits) for these dispositions in 1998 and 1999.
See Note 9, "Impairment, Disposition, Restructuring, Office of Personnel
Management and Other (Credits) Charges."
1997 ACQUISITION. On February 14, 1997 we acquired FHP International Corporation
("FHP"). Each outstanding share of FHP's common stock was exchanged for $17.50
in cash, 0.056 shares of our Class A common stock and 0.176 shares of our Class
B common stock. Each outstanding share of FHP's preferred stock was exchanged
for $14.113 in cash and one-half of one share of our Series A preferred stock.
We paid approximately $1.0 billion in cash to FHP's common and preferred
shareholders.
The terms of the FHP acquisition required FHP to contribute $67 million to
Talbert Medical Management Corporation ("Talbert"), a wholly owned subsidiary of
FHP, increasing Talbert's net worth to approximately $60 million on February 14,
1997. Concurrently, FHP sold its investment in Talbert in exchange for a $60
million non-recourse promissory note and rights to purchase shares of Talbert
common stock. Each former FHP shareholder received Talbert rights. Holders of
Talbert rights were able to purchase one share of Talbert common stock for each
Talbert right, for the subscription price of $21.50 per share. Holders of
Talbert rights were entitled to subscribe for all, or any portion of, the shares
of Talbert common stock underlying their Talbert rights, as well as to subscribe
for any unallocated additional shares. In May 1997, Talbert successfully
completed its rights offering and shares of Talbert common stock were
distributed. Proceeds from the Talbert rights offering were used to repay the
non-recourse promissory note issued to FHP.
We accounted for the FHP acquisition as a purchase. Total consideration of
approximately $2.2 billion, including $18 million of transaction costs, was
allocated to the assets acquired and liabilities assumed based on estimates of
their fair values. The fair value of assets acquired was $0.9 billion. The fair
value of liabilities assumed was $1.1 billion. A total of $2.4 billion, net of
related deferred taxes, representing the excess of the purchase price over the
fair values of the net assets acquired, was allocated to goodwill and other
acquired intangible assets and is being amortized over a four to 40 year period.
Identified intangibles of $365 million include commercial employer group
contracts, Medicare contracts, provider networks and assembled work force. We
recorded fair value increases and decreases in tangible assets and liabilities
acquired. Fair value decreases included a $76 million decrease to property,
plant and equipment. This decrease included real property write downs based on
appraised values and the abandonment of capitalized software and equipment.
Certain liabilities were recognized in purchase accounting for exit costs and
loss contingencies. We reviewed all exit cost liabilities and determined that
certain amounts exceeded the final expected payments at December 31, 1998.
Certain of the items accrued, the related payments, and amounts reversed as a
reduction to the FHP purchase price were as follows:
LIABILITIES LIABILITIES
RECOGNIZED AT LIABILITIES OUTSTANDING AT
DATE OF FHP 1997 - 1999 REVERSED DECEMBER 31,
ACQUISITION PAYMENTS IN 1998 1999
------------- ----------- ----------- --------------
Abandonment of FHP systems....................... $ 62 $(44) $(18) $--
Losses on disposition............................ 34 (8) (25) 1
FHP severance benefits........................... 33 (31) (1) 1
FHP OPM claims accrual........................... 33 (3) -- 30
Abandonment of FHP facility leases............... 14 (6) (7) 1
Other............................................ 11 (3) (8) --
---- ---- ---- ---
Total.................................. $187 $(95) $(59) $33
==== ==== ==== ===
F-11
70
During 1998 we successfully settled audits of previously filed FHP federal tax
returns and reversed approximately $20 million of income tax liabilities. Total
purchase accounting accrual reductions were $79 million. The liabilities
reversed in 1998 had the effect of reducing the amount of tax benefits we
expected to realize in the future. As a result, we reduced our deferred tax
assets by $10 million. In total, the purchase price of FHP decreased by $69
million and is reflected as a reduction of goodwill.
FHP Systems. At the acquisition, we accrued $62 million of contractual
obligations and commitments to conform all of FHP's multiple information systems
to one uniform system. These costs were direct, incremental and were not related
to the development of new software systems that would have future economic
benefit. With the 1997 and 1998 dispositions, and other contract negotiations,
only $44 million was required.
Disposition Losses. As described below, we held certain FHP subsidiaries for
sale in 1997. These dispositions were completed in 1997 with certain liabilities
not being assumed by the buyers. Certain liabilities, including uninsured
contingencies, were resolved for amounts significantly lower than estimated.
FHP Severance. Our estimates for FHP employee severance are expected to be fully
utilized. The remaining $1 million will be paid over the next year.
FHP OPM Claims. We also accrued $33 million for FHP OPM claims based on FHP's
internal review completed just prior to the acquisition and draft audit findings
by the government. In August 1999, OPM retained $3 million due to outstanding
audit amounts for contract years 1991 - 1995. These audit years continue to be
open and additional payments could be made based on audit findings. These
matters generally take a number of years to resolve. See Note 10, "Commitments
and Contingencies."
FHP Facility Leases. Finally, property management reserves of $14 million for
various real property leases were not fully utilized as the real estate market
improved in late 1997 and early 1998. We were able to negotiate better lease
terminations than estimated and also sublet space at higher rates than
originally anticipated.
1997 DISPOSITIONS. In February 1997, we announced our intention to sell the
Illinois and New Mexico HMO subsidiaries of FHP. We classified these
subsidiaries as net assets held for sale and assigned their carrying values at
net realizable value. The Illinois HMO was sold in October 1997, and the New
Mexico HMO was sold in November 1997. Net losses measured from the date of the
FHP acquisition until their dispositions were $15 million, and disposition gains
totaled $46 million. These net losses and disposition gains were treated as part
of the FHP purchase price allocation.
In February 1997, we sold the outstanding common stock of our Florida
subsidiary, at which time the buyer assumed the daily operations. The sales
price, which approximated net book value, totaled $9 million. The sale was
closed in July 1997 when we received regulatory approval from the state of
Florida.
PRO FORMA FINANCIAL STATEMENTS. The pro forma information below presents our
consolidated results of operations as if the sale of the Utah HMO occurred on
January 1, 1998. This information reflects our actual consolidated operating
results before this transaction plus an adjustment for income taxes. Because the
purchases of the Texas and Colorado membership and the sale of the workers'
compensation subsidiary were not material to our consolidated results of
operations, these transactions were not included in the pro forma information
below.
1998
-----------------
(AMOUNTS IN
THOUSANDS, EXCEPT
PER SHARE DATA)
Total operating revenue..................................... $9,369,487
Pretax income............................................... $ 415,814
Net income.................................................. $ 220,511
Basic earnings per share.................................... $ 4.92
Diluted earnings per share.................................. $ 4.79
F-12
71
5. LONG-TERM DEBT
Beginning January 1, 1999, and continuing through the January 1, 2002 final
maturity date, the amount we may borrow under our credit facility declines
incrementally every six months. Borrowings available to us after December 31,
1999 were $1.2 billion. The facility requires mandatory step-down payments if
the principal balance exceeds certain thresholds. Based on the $875 million
outstanding at December 31, 1999, a payment of $75 million will be required by
June 30, 2001. Additional borrowings under the credit facility could trigger an
additional mandatory prepayment.
Interest under the credit facility is variable and is presently based on the
London Interbank Offered Rate ("LIBOR") plus a spread. The terms of the credit
facility contain various covenants, usual for financing of this type, including
a minimum net worth requirement, a minimum fixed charge requirement, leverage
ratios and limits on the amount of treasury stock we may purchase. At December
31, 1999, we were in compliance with all such covenants. We also have $100
million in senior notes outstanding that we assumed when we acquired FHP. These
notes carry an interest rate of seven percent, are payable semiannually and
mature on September 15, 2003.
6. STOCKHOLDERS' EQUITY
STOCKHOLDERS RIGHTS AGREEMENT. In November 1999, our board of directors adopted
a stockholder rights agreement to protect stockholder rights in the event of a
proposed takeover. The board of directors declared a dividend of one right for
each share of our common stock outstanding as of November 19, 1999. The right
entitles the registered holder to purchase from PacifiCare one one-hundredth of
a share of Series A junior participating preferred stock at a price of $180 per
one one-hundredth of a preferred share. Similar rights will generally be issued
in respect of common stock issued after November 19, 1999.
TREASURY STOCK. In October 1999, our board of directors approved a stock
repurchase program that allows us to repurchase up to 12 million shares of our
outstanding common stock, including any shares purchased from UniHealth
Foundation (see "UniHealth Stock Repurchase Agreement" below). From November 7,
1999, through December 31, 1999, we repurchased 6.3 million shares under this
current authorization. This repurchase program supersedes the stock repurchase
program approved in January 1998, under which we had purchased 3.2 million
shares. Included in this 3.2 million shares were 2.5 million shares repurchased
in 1999. As of December 31, 1999, we held approximately 9.6 million treasury
shares totaling $524 million. To purchase the maximum number of shares
authorized, we negotiated an amendment to our existing credit facility that
increases the maximum allowable amount of share repurchases to $1 billion from
$500 million. We may fund the stock repurchase program through a combination of
cash flow from operations, additional borrowings under the credit facility and
long and short term debt. We have reissued, and will continue to reissue these
shares for our employee benefit plans or for other corporate purposes.
RECLASSIFICATION OF COMMON STOCK. At our June 1999 annual meeting, our Class A
and Class B common stockholders, including UniHealth Foundation, a non-profit
public benefit corporation and our largest stockholder, approved an amended and
restated certificate of incorporation. The amended and restated certificate
combined and reclassified our Class A and Class B common stock into a single
class of voting common stock. The reclassified common stock has the same rights,
powers and limitations as the previously existing Class A common stock. The
reclassification of the Class A and Class B common stock had no impact on the
total number of our issued and outstanding shares of common stock.
Prior to the combination and reclassification of our Class A and Class B common
stock, UniHealth Foundation owned approximately 40 percent of our Class A common
stock and approximately one percent of our Class B common stock. As of December
31, 1999, UniHealth Foundation owned approximately 17 percent of our outstanding
common stock. In consideration for UniHealth Foundation's vote in favor of the
amended and restated certificate of incorporation, and in consideration of the
agreements and covenants contained in the stock purchase agreement discussed
below, we paid UniHealth Foundation $60 million in June 1999, when our
stockholders approved the amended and restated certificate of incorporation. We
also incurred $2 million of expenses related to the reclassification of our
common stock and the registration of the shares held by UniHealth Foundation.
These amounts were recorded as a reduction of stockholders' equity.
F-13
72
UNIHEALTH STOCK REPURCHASE AGREEMENT. In May 1999, we entered into a stock
purchase agreement with UniHealth Foundation to repurchase up to 5.9 million
shares of our common stock held by UniHealth Foundation. The purchase price for
the shares equals the average closing price of the stock for the 30 trading days
preceding the scheduled purchase dates. We are not required to buy if the stock
price is greater than $120 per share and UniHealth Foundation is not required to
sell if the stock price is less than $75 per share. Depending on the average
stock price, we may repurchase UniHealth Foundation shares on the following
dates and in the following installments:
AGGREGATE
REPURCHASE
PER SHARE PRICE RANGE
----------- ------------
APPROXIMATE PURCHASE DATE SHARES LOW HIGH LOW HIGH
------------------------- --------- --- ---- ---- ----
(AMOUNTS IN
MILLIONS)
August 9, 1999(1).................................. 1,000,000 $70 $120 $ 70 $120
November 15, 1999(1)............................... 1,000,000 $75 $120 75 120
February 15, 2000(1)............................... 750,000 $75 $120 56 90
May 15, 2000....................................... 750,000 $75 $120 56 90
August 15, 2000.................................... 750,000 $75 $120 56 90
November 15, 2000.................................. 750,000 $75 $120 56 90
February 15, 2001.................................. 909,500 $75 $120 68 109
--------- ---- ----
Repurchase shares............................. 5,909,500 $437 $709
========= ==== ====
- ---------------
(1) We did not purchase the August and November 1999 installments nor the
February 2000 installment because the average stock price, as defined above,
was less than $75 per share and UniHealth Foundation did not elect to sell
the shares for the average stock price. For any unpurchased installments, we
have no further obligation to buy, and UniHealth Foundation has no further
obligation to sell us the shares. We do, however, have a right of first
refusal to purchase the installments should UniHealth Foundation decide to
sell.
PREFERRED STOCK REDEMPTION. In May 1998, we announced the redemption of 10.5
million shares of our Series A preferred stock. Substantially all of the
preferred shares were converted into 3.9 million shares of common stock as of
the June 1998 redemption date. We paid approximately $5 million in dividends to
our preferred stockholders during the year ended December 31, 1998.
F-14
73
7. INCOME TAXES
The tax effects of the major items recorded as deferred tax assets and
liabilities were as follows:
1999 1998
--------- ---------
(AMOUNTS IN THOUSANDS)
Current deferred tax assets (liabilities):
Accrued expenses.......................................... $ 67,886 $ 79,624
Medical claims and benefits payable....................... 28,992 7,162
Unrealized losses (gains) on marketable securities........ 15,440 (4,532)
Accrued compensation...................................... 15,224 21,659
Provider reserves......................................... 13,236 19,366
State franchise taxes..................................... 7,620 10,765
Prepaid expenses.......................................... (4,672) (1,615)
Pharmacy rebates.......................................... (3,987) (4,486)
Other..................................................... 1,430 4,509
--------- ---------
$ 141,169 $ 132,452
========= =========
Non-current deferred tax assets (liabilities):
Identifiable intangibles.................................. $(115,484) $(119,509)
Depreciation and amortization............................. (15,240) (8,407)
Accrued expenses.......................................... -- 9,295
Other..................................................... 3,255 6,565
--------- ---------
$(127,469) $(112,056)
========= =========
The provision for income taxes consisted of the following:
1999 1998 1997
-------- -------- -------
(AMOUNTS IN THOUSANDS)
Current:
Federal........................................... $156,958 $171,478 $46,810
State............................................. 19,739 30,968 9,436
-------- -------- -------
Total current............................. 176,697 202,446 56,246
-------- -------- -------
Deferred:
Federal........................................... 19,973 (13,615) 18,754
State............................................. 6,695 (5,684) 6,825
-------- -------- -------
Total deferred............................ 26,668 (19,299) 25,579
-------- -------- -------
Provision for income taxes........................ $203,365 $183,147 $81,825
======== ======== =======
Reconciliations of the U.S. statutory income tax rate to our effective tax rate
follow:
1999 1998 1997
---- ---- -----
Computed expected provision................................. 35.0% 35.0% 35.0%
Amortization of intangibles................................. 3.8 5.1 29.7
State taxes, net of federal benefit......................... 3.6 4.3 16.9
Tax exempt interest......................................... (1.3) (1.4) (6.3)
Impairment of non-deductible goodwill....................... 0.8 -- 54.6
Disposition of subsidiaries................................. -- 1.6 --
Other, net.................................................. 0.3 2.9 6.2
---- ---- -----
Provision for income taxes.................................. 42.2% 47.5% 136.1%
==== ==== =====
The majority of the goodwill impairment charges recorded in 1997 were not
deductible for income tax purposes. See Note 9, "Impairment, Disposition,
Restructuring, Office of Personnel Management and Other (Credits) Charges."
Therefore, we did not record a benefit for most of these charges. The magnitude
of the
F-15
74
1997 charges, combined with the inability to record a related income tax
benefit, resulted in a disproportionately high effective income tax rate for
1997. The 1997 effective income tax rate, without the effect of the impairment
charges, was approximately 50 percent. Excluding the impact of non-deductible
goodwill impairment and amortization, the impact of state taxes, net of federal
benefit would have been 5.3 percent for 1997.
8. EMPLOYEE BENEFIT PLANS
SAVINGS AND PROFIT-SHARING PLANS. Most of our employees may participate in our
savings and profit-sharing plan. Features of the plan in 1999 were as follows:
- - Participants may defer up to 15 percent of annual compensation;
- - We match one-half of the deferral, up to three percent of annual compensation
per employee;
- - We automatically contribute three percent of annual compensation per
employee; and
- - We may contribute a discretionary amount to each employee's account,
generally based on a percentage of pretax income.
Charges to income for the plan were $28 million in 1999, $20 million in 1998 and
$7 million in 1997.
FHP had an employee stock ownership plan that covered most FHP employees. This
plan consisted of three separate parts:
- - An employee stock ownership plan (the "ESOP");
- - A 401(k) plan; and
- - A payroll-based tax credit employee stock ownership plan.
In February 1997, the ESOP and 401(k) components were converted to a
profit-sharing plan named the FHP Savings Plan. Our employees from FHP
participated in the FHP Savings Plan until December 31, 1997, at which time they
became eligible to participate in our plan. In April 1999, the assets from the
FHP Savings Plan attributable to FHP employees were transferred into the
PacifiCare plan. At that time, Caremark Rx, Inc. (formerly MedPartners) assumed
sponsorship of the FHP Savings Plan. The payroll-based tax credit employee stock
ownership plan was terminated in 1997.
STOCK OPTION PLANS.
1996 Employee Plan. Officers and key employees may be granted:
- - Options to purchase shares of common stock;
- - Shares of common stock; and
- - Stock appreciation rights.
We grant stock options at exercise prices that equal or exceed the market price
of our common stock on the dates granted. These options typically vest over four
years in 25 percent increments, are generally subject to continuous employment,
and expire 10 years after the grant date. At December 31, 1999, approximately
0.1 million shares were available for awards under the 1996 Employee Plan.
During 1997, we granted options that vest if certain earnings targets are
achieved. These options ultimately vest four years from the grant date. Also
during 1997, the FHP acquisition triggered accelerated vesting provisions of
some stock options. Certain employees agreed to receive additional stock options
in exchange for waiving these accelerated vesting provisions.
1996 Director Plan. We grant options to purchase 5,000 shares of our common
stock annually to each eligible non-employee director and grant options to
purchase 10,000 shares of common stock when a new director is elected or
appointed to the board of directors. Furthermore, the compensation committee can
grant
F-16
75
additional options at its discretion. These options vest immediately on the
grant date. The underlying common stock, however, may not be sold within the
first six months of the grant date.
1997 Premium Plan. We granted options to purchase 2.6 million shares (the
maximum available) of our common stock to certain executive officers under this
plan. The first 50 percent vested in May 1999 when the closing market price of
our common stock reached $92.50. These options expire in 2007. Because we apply
variable-plan accounting to these stock options, we recorded approximately $1
million in compensation expense when these options vested. The remaining 50
percent vest within five years of the grant date if the closing market price of
our common stock reaches $114.00, and expire in 2002 if the $114.00 stock price
is not reached.
Non-qualified stock option activity for all plans was as follows:
WEIGHTED AVERAGE OPTIONS WEIGHTED AVERAGE
OPTIONS EXERCISE PRICE EXERCISABLE EXERCISE PRICE
--------- ---------------- ----------- ----------------
OUTSTANDING AT DECEMBER 31, 1996........... 2,093,972 $ 48.67 1,037,150 $34.34
Granted at market price.................... 1,948,100 $ 70.98 -- $ --
Granted in excess of market price.......... 1,187,500 $ 92.50 -- $ --
Granted in excess of market price.......... 1,187,500 $114.00 -- $ --
Exchanged for FHP options.................. 933,594 $ 51.83 -- $ --
Exercised.................................. (977,813) $ 43.83 -- $ --
Canceled................................... (470,347) $ 75.04 -- $ --
--------- ------- --------- ------
OUTSTANDING AT DECEMBER 31, 1997........... 5,902,506 $ 72.83 1,502,760 $47.36
Granted at market price.................... 1,068,810 $ 77.76 -- $ --
Granted in excess of market price.......... 112,500 $ 92.50 -- $ --
Granted in excess of market price.......... 112,500 $114.00 -- $ --
Exercised.................................. (454,751) $ 39.81 -- $ --
Canceled................................... (424,707) $ 84.49 -- $ --
--------- ------- --------- ------
OUTSTANDING AT DECEMBER 31, 1998........... 6,316,858 $ 80.38 1,532,079 $55.61
Granted at market price.................... 2,422,098 $ 58.96 -- $ --
Exercised.................................. (395,031) $ 54.88 -- $ --
Canceled................................... (602,285) $ 87.76 -- $ --
--------- ------- --------- ------
OUTSTANDING AT DECEMBER 31, 1999........... 7,741,640 $ 74.41 2,981,611 $72.89
========= ======= ========= ======
The following is a summary of information about options outstanding and options
exercisable at December 31, 1999:
OPTIONS OUTSTANDING OPTIONS EXERCISABLE
--------------------------------------- ----------------------------
WEIGHTED WEIGHTED WEIGHTED
NUMBER AVERAGE AVERAGE NUMBER AVERAGE
RANGE OF EXERCISE PRICES OUTSTANDING LIFE(1) EXERCISE PRICE EXERCISABLE EXERCISE PRICE
------------------------ ----------- -------- -------------- ----------- --------------
$ 8.38 - $19.75........................ 131,850 1 $ 9.73 131,850 $ 9.73
$31.34 - $45.31........................ 1,462,088 9 $ 44.43 291,496 $41.19
$48.85 - $73.00........................ 2,606,642 8 $ 68.36 1,196,791 $67.07
$74.63 - $92.50........................ 2,516,060 8 $ 85.34 1,361,474 $90.91
$114.00................................ 1,025,000 8 $114.00 -- --
--------- ---------
7,741,640 2,981,611
========= =========
- ---------------
(1) Weighted average contractual life remaining in years.
F-17
76
PRO FORMA STOCK OPTION DISCLOSURE. We used the Black-Scholes option pricing
model to calculate the fair value of grants in the years presented below. We
applied the following assumptions to determine pro forma compensation expense:
1999 1998 1997
------ ------ ------
Expected dividend yield..................................... 0% 0% 0%
Risk-free interest rate..................................... 5% 6% 6%
Expected stock price volatility............................. 52% 45% 43%
Expected term until exercise (years)........................ 2 2 3
Weighted average fair value of options on grant date:
Granted at market prices.................................. $27.15 $30.92 $25.40
Granted in excess of market price......................... -- $29.76 $26.99
We do not record compensation expense for stock option grants. The following
table summarizes results as if we had recorded compensation expense for the
1999, 1998 and 1997 grants:
1999 1998 1997
------------ ------------ ------------
(AMOUNTS IN THOUSANDS, EXCEPT PER SHARE DATA)
Net income (loss):
As reported............................................ $278,544 $202,427 $(21,701)
Pro forma.............................................. $246,113 $168,382 $(48,359)
Basic earnings (loss) per share:
As reported............................................ $ 6.26 $ 4.50 $ (0.75)
Pro forma.............................................. $ 5.53 $ 3.85 $ (1.19)
Diluted earnings (loss) per share:
As reported............................................ $ 6.23 $ 4.40 $ (0.75)
Pro forma.............................................. $ 5.50 $ 3.66 $ (1.19)
These figures reflect only the impact of grants since October 1, 1995, and
reflect only part of the possible compensation expense that we amortize over the
vesting period of the grants (generally up to four years). Therefore, the effect
on net income and earnings per share may differ in future years from the amounts
shown above.
9. IMPAIRMENT, DISPOSITION, RESTRUCTURING, OFFICE OF PERSONNEL MANAGEMENT AND
OTHER (CREDITS) CHARGES
We recognized pretax (credits) charges in 1999, 1998 and 1997 as follows:
QUARTER PRETAX (CREDITS) NET-OF-TAX DILUTED LOSS
RECOGNIZED CHARGES AMOUNT (EARNINGS) PER SHARE
----------- ---------------- ---------- --------------------
(AMOUNTS IN MILLIONS, EXCEPT PER SHARE DATA)
1999
Ohio HMO goodwill impairment............ Third $ 14.1 $ 11.3 $ 0.25
Utah HMO changes in estimates........... Third (10.7) (6.3) (0.14)
Other disposition changes in
estimates............................. Third (5.6) (3.3) (0.07)
------ ------ ------
$ (2.2) $ 1.7 $ 0.04
====== ====== ======
1998
Sale of Utah HMO and workers'
compensation subsidiaries............. Third $ 15.6 $ 8.2 $ 0.18
OPM charges............................. Third 3.8 2.0 0.04
------ ------ ------
Total Third 19.4 10.2 0.22
OPM credits............................. Fourth (8.4) (4.4) (0.10)
------ ------ ------
$ 11.0 $ 5.8 $ 0.12
====== ====== ======
F-18
77
QUARTER PRETAX (CREDITS) NET-OF-TAX DILUTED LOSS
RECOGNIZED CHARGES AMOUNT (EARNINGS) PER SHARE
----------- ---------------- ---------- --------------------
(AMOUNTS IN MILLIONS, EXCEPT PER SHARE DATA)
1997
Impairment of long-lived assets:
Utah HMO.............................. Fourth $ 62.4 $ 55.7 $ 1.37
Washington health plan................ Fourth 40.5 36.1 0.89
Discontinued workers' compensation
products........................... Fourth 21.1 18.9 0.47
------ ------ ------
Total impairment of long-lived
assets...................... 124.0 110.7 2.73
Loss contracts.......................... Fourth 15.4 9.2 0.23
Restructuring........................... Fourth 15.1 9.0 0.22
------ ------ ------
$154.5 $128.9 $ 3.18
====== ====== ======
1999. We recognized pretax credits of $2 million (after tax charges of $2
million or $0.04 diluted loss per share) as detailed below.
- - Ohio HMO Goodwill Impairment. We recognized $14 million of Ohio HMO goodwill
impairment charges ($11 million or $0.25 diluted loss per share, net of tax).
Third quarter operating losses, provider contract terminations and a lower
membership base did not support the recoverability of goodwill. The majority
of the impairment is not deductible for income tax purposes.
- - Utah HMO Changes in Estimates. We recognized $11 million of disposition
credits ($6 million or $0.14 diluted earnings per share, net of tax). When we
sold our Utah HMO, we retained responsibility for all medical claims and
benefits payable for services rendered through September 30, 1998. Payments
made through September 30, 1999, plus our current estimate of claims incurred
but not reported, were $7 million less than original reserves existing at
disposition. In addition, $4 million of severance, legal, and receivable
reserves were settled for amounts less than originally estimated.
- - Other Disposition Changes in Estimates. We recognized $6 million of other
disposition credits for changes in estimates ($3 million or $0.07 diluted
earnings per share, net of tax). We have or expect to successfully settle
certain contingencies related to other dispositions from 1996 to 1998.
Contingencies include pending and threatened litigation as well as
indemnifications made to the buyers of sold subsidiaries.
1998. Pretax charges of $11 million ($6 million or $0.12 diluted loss per share,
net of tax) were recorded in 1998 as follows:
- - Dispositions. We recognized $16 million of disposition charges ($8 million or
$0.18 diluted loss per share, net of tax) with the sales of our Utah HMO and
workers' compensation subsidiaries. See Note 4, "Acquisitions and
Dispositions."
- - OPM. Partially offsetting the disposition charges were net OPM credits of $5
million ($3 million or $0.06 diluted income per share, net of tax). See Note
10, "Commitments and Contingencies."
1997. Pretax charges of $155 million ($129 million or $3.18 diluted loss per
share, net of tax) were recorded in 1997 as follows:
- - Utah HMO impairment. We recognized a goodwill and other intangible impairment
charge of $62 million ($56 million or $1.37 diluted loss per share, net of
tax) in anticipation of our disposition of the subsidiary. Utah's operating
losses related to lower than expected 1997 premium rate increases, combined
with a shift of membership from capitated to non-capitated health care
providers. This shift of membership resulted from a significant health care
provider contract that switched from capitation to fee-for-service. We
entered into the contract to ensure an adequate infrastructure to service the
Utah membership. At that same time, the Utah information systems migrated to
the standard FHP system in anticipation of the conversion of the FHP system
into our common system. As a result, increased utilization under the new
fee-for-service contract was not visible until the fourth quarter of 1997
when conversion reconciliations
F-19
78
discovered significant unpaid claims, as well as claims paid inaccurately.
Because the 1997 losses and the cash flow analysis did not support the
recoverability of goodwill, we recorded an impairment charge. We disposed of
our Utah operations in September 1998 with the additional disposition losses
noted above. See Note 4, "Acquisitions and Dispositions."
- - Washington health plan impairment. In 1997 we determined that the Washington
health plan goodwill and intangibles were no longer recoverable, and recorded
an impairment charge of $41 million ($36 million or $0.89 diluted loss per
share, net of tax). Since its acquisition, the Washington market has incurred
operating losses.
- - Workers' compensation subsidiary impairment. We recognized $21 million ($19
million or $0.47 diluted loss per share, net of tax) of goodwill impairment
charges, primarily for discontinued workers' compensation products. We
determined that California legislation did not allow workers' compensation
products to be priced at rates that could produce our required return on
investment. See Note 4, "Acquisitions and Dispositions."
- - Loss contracts. We recorded approximately $15 million ($9 million or $0.23
diluted loss per share, net of tax) for contracts on which the anticipated
future health care costs exceeded the premiums, the majority related to our
Utah HMO and workers' compensation subsidiary. These losses were realized
throughout 1998. Any remaining accrued losses at the disposition of Utah and
our workers' compensation subsidiary offset disposition losses.
- - Restructuring. We recognized restructuring charges of $15 million ($9 million
or $0.22 diluted loss per share, net of tax) in 1997. Work force reduction
costs of $8 million primarily included employee severance for involuntary
terminations. Lease terminations and personal property abandonment of $5
million pretax were associated with the consolidation of administration and
operations office space. Other related charges totaled $2 million, pretax.
Cash flows from operations funded all of the restructuring charges. The
restructuring was substantially complete at December 31, 1998 and actual
expenditures did not differ materially from amounts accrued.
10. COMMITMENTS AND CONTINGENCIES
PROVIDER INSTABILITY AND INSOLVENCY. Provider reserves include write-offs of
certain uncollectable receivables from our providers and the estimated cost of
unpaid health care claims normally covered by our capitation payments. Depending
on state laws, we may be held liable for unpaid health care claims that were
contractually the responsibility of the capitated provider. The balance of our
provider insolvency reserves included in medical claims and benefit payable was
$46 million at December 31, 1999 and $58 million at December 31, 1998.
The California Department of Corporations ("DOC") entered into a settlement with
Alabama-based Caremark Rx, Inc. (formerly MedPartners, Inc. "Caremark")
regarding its California subsidiary, MedPartners Network ("MPN"). MPN was a
provider organization licensed by the DOC that arranged health care services for
HMO members through arrangements between HMOs and health care providers, such as
hospitals and physician groups. MPN was one of our significant provider networks
in California. In March 1999, California regulators seized MPN and appointed a
conservator to oversee MPN. The conservator placed MPN in bankruptcy. In June
1999, the State of California, the DOC, MPN and Caremark entered into an
Operations and Settlement Agreement to ensure continuing patient care and to
resolve certain claims by and against MPN and Caremark. Under this agreement,
Caremark agreed to fund MPN's liabilities to its contracted and non-contracted
providers in California. As part of the agreement, effective June 1, 1999, we
agreed to assume financial responsibility for institutional services that were
previously the responsibility of MPN. The agreement required the institutional
providers to offer the same terms to us as MPN had through the earlier of the
termination of the provider's contract or December 31, 1999. In addition, we
have agreed to participate in the agreement, which requires us to waive or
subordinate certain claims against MPN in exchange for waivers of claims against
us in connection with services provided by MPN or its affiliates in California.
We, along with other HMOs have agreed to make a loan to Caremark for
distribution to KPC Medical Management, Inc., a purchaser of some of the MPN
practices. The loan by
F-20
79
all the HMOs is expected to be approximately $12 million, with approximately $3
million to be contributed by us. MPN has ceased doing business and all of MPN's
affiliated medical groups in California have recently been sold.
Our insolvency reserves relate to specific providers. These reserves include
estimates for potentially insolvent providers, where conditions indicate claims
are not being paid or have slowed considerably. Based on information currently
available, we believe that any liability in excess of amounts accrued would not
materially affect our consolidated financial position. However, our evaluation
of the likely impact of claims asserted against us could change in the future
and an unfavorable outcome, depending on the amount and timing, could have a
material effect on our results of operations or cash flows for a future period.
OPM. Our HMO subsidiaries have commercial contracts with OPM to provide managed
health care services to federal employees, annuitants and their dependents under
the Federal Employee Health Benefits Plan ("FEHBP"). Rather than negotiating
rates with HMOs, OPM requires HMOs to provide the FEHBP with rates comparable to
the rates charged to the two employer groups with enrollment closest in size to
the FEHBP in the applicable state after adjusting for differences in benefits,
enrollment demographics, and coordination of costs with Medicare. OPM further
requires that every HMO certify each year that its rates meet these
requirements. Approximately every three to five years, OPM's Office of Inspector
General ("OIG") audits each HMO to verify that the premiums charged are
calculated and charged in compliance with these rating regulations and
guidelines. Each audit encompasses a period of up to six years. Following the
government's initial on-site audit, OPM will provide the HMO with a post-audit
briefing indicating its preliminary results. Because these are actuarial
calculations, interpretations of the rating regulations and audit findings often
raise complex issues. The final resolution and settlement of audits have
historically taken more than three years and as many as seven years.
During the audit process, OPM may refer its findings to the United States
Department of Justice ("DOJ") if it believes that the health plan knowingly
overcharged the government or otherwise submitted false documentation or
certifications in violation of the False Claims Act. Under the False Claims Act,
an action can be considered knowingly committed if the government contractor
acted with actual knowledge, or with reckless disregard or deliberate ignorance
of the government's rules and regulations. If the government were to win a False
Claims Act lawsuit against an HMO, the government could obtain trebled damages,
a civil penalty of not less than $5,000 nor more than $10,000 for each separate
alleged false claim, and the government could permanently disqualify the HMO
from participating in all federal government programs.
Prior to the acquisition the FHP HMO subsidiary, TakeCare of California, was
audited by the OIG auditors. The OIG issued a draft audit report in September
1996 alleging that TakeCare overcharged the FEHBP by approximately $24 million
including lost investment income. TakeCare responded to this draft audit in
January 1997, questioning many of the auditors' calculations and assumptions.
When we purchased FHP International in February 1997, we were aware of the
government's claims, and we reserved for potential liabilities in accordance
with our accounting policies. In August 1999, we were notified that the auditors
had referred certain allegations to the DOJ for review of potential claims under
the False Claims Act. We are negotiating with the DOJ to resolve all outstanding
issues relating to the TakeCare of California audit amicably. We do not agree
with the auditors' interpretations of the applicable rules and guidelines or
their method of calculating rates for the applicable period, and we do not
believe there is any evidence that TakeCare of California ever engaged in
intentional wrongdoing or any action that would violate the False Claims Act.
In July 1999, we received a request from the OIG requesting documentation
regarding all of the contracts between OPM and any of the HMOs owned by FHP that
related to the contract years 1990 through 1997. The majority of these contract
years have already been audited, but are not yet settled. We have complied with
OPM's request.
OPM has conducted an audit of our Oregon HMO subsidiary for the years 1991
through 1996. We have recently been notified that the auditors had referred
certain allegations to the DOJ for review of potential claims under the False
Claims Act. We intend to negotiate with the DOJ to resolve any potential claims
amicably.
F-21
80
In addition to the HMOs currently owned, we have also agreed to indemnify the
buyers of our previously owned HMOs in Illinois, New Mexico and Utah for
potential OPM liabilities that relate to years prior to the sale. To address all
of these potential liabilities, we have established reserves based upon internal
estimates of liability and preliminary findings by the auditors for all OPM
audits not yet settled.
We intend to negotiate with OPM on any existing or future unresolved matters to
attain a mutually satisfactory result. We cannot be certain that any ongoing and
future negotiations will be concluded satisfactorily, that additional audits
will not be referred to the DOJ, or that additional, possibly material,
liabilities will not be incurred. We believe that any ultimate liability,
including any lost investment income, in excess of amounts accrued would not
materially affect our consolidated financial position. However, such liability
could have a material effect on results of operations or cash flows of a future
period if resolved unfavorably.
In late 1997, we established a formal corporate compliance program to
specifically address potential issues that may arise from the FEHBP rating
process, to work with OPM to understand its interpretation of the rules and
guidelines prior to completion of the rating process, to standardize the FEHBP
rating process among all of our HMOs, and to help reduce the likelihood that
future government audits will result in any significant findings. Based upon the
results of a limited number of audits that have been conducted for contract
years 1998 and later, we believe that this program has been effective.
LEGAL PROCEEDINGS. On November 2, 1999, Jose Cruz filed a class action complaint
against PacifiCare, our California subsidiary and FHP in San Francisco Superior
Court. On November 9, 1999, Cruz filed a first amended class action complaint
that omitted FHP as a defendant. The amended complaint relates to the period
from November 2, 1995 to the present and purports to be filed on behalf of all
enrollees in our health care plans other than Medicare and Medicaid enrollees.
The amended complaint alleges that we have engaged in unfair business acts in
violation of California law, engaged in false, deceptive and misleading
advertising in violation of California law and violated the California Consumer
Legal Remedies Act. It also alleges that we have received unjust payments as a
result of our conduct. The amended complaint seeks injunctive and declaratory
relief, an order requiring the defendants to inform and warn all California
consumers regarding our financial compensation programs, unspecified monetary
damages for restitution of premiums and disgorgement of improper profits,
attorneys' fees and interest. On December 2, 1999, we removed the action to the
United States District Court for the Northern District of California on the
grounds that the amended complaint was completely preempted by the Employee
Retirement Income Security Act of 1974 or ERISA. We also moved to compel
arbitration. The plaintiff sought to have the case returned to state court. The
court held a hearing on these motions in February 2000 and has not ruled on the
motions. We deny all material allegations in the amended complaint and intend to
defend the action vigorously.
On November 22, 1999, Debbie Hitsman filed a class action complaint against
PacifiCare in the United States District Court for the Southern District of
Mississippi, Hattiesburg Division. The complaint relates to the period from
November 22, 1995 to the present and purports to be on behalf of all enrollees
in our health care plans other than Medicare and Medicaid enrollees. The
complaint alleges causes of action for violations of the Racketeer-Influenced
and Corrupt Organizations Act and ERISA. The complaint seeks an unspecified
amount of compensatory and treble damages, injunctive and restitutionary relief,
attorneys' fees, the imposition of a constructive trust and interest. On January
13, 2000, we filed a motion to compel arbitration and a motion to dismiss or, in
the alternative, to transfer the case for lack of personal jurisdiction and
improper venue. On January 25, 2000, the court stayed the action pending
resolution by the Multi-District Litigation or MDL Panel as to whether to
consolidate and transfer this and other similar actions to the MDL Panel. We
deny all material allegations and intend to defend the action vigorously.
In 1997, Tim Brady and other individuals filed a class action suit against
PacifiCare, several PacifiCare officers and several former officers of FHP
International in the United States District Court for the Central District of
California. In addition, in 1997, Brady and other individuals filed class action
against PacifiCare and several PacifiCare officers and several former officers
of FHP in the Orange County Superior Court. Finally, in 1997, William Madruga
and another individual filed a class action suit against PacifiCare and several
of its directors and officers in the United States District Court for the
Central District of California. Each of the
F-22
81
complaints related to the period from the date of proxy statement for the FHP
acquisition through our November 1997 announcement that earnings for the fourth
quarter of 1997 would be lower than expected. These complaints primarily alleged
that we previously omitted and/or misrepresented material facts with respect to
our costs, earnings and profits. The trial courts dismissed the Brady cases,
brought on behalf of former FHP shareholders, but the cases are now on appeal.
The Madruga case, brought on behalf of our stockholders, was dismissed with
permission for the plaintiffs to amend the complaint. The plaintiffs filed an
amended complaint in November 1999 and we moved to dismiss the amended complaint
in February 2000. The court has scheduled a hearing on April 17, 2000 to
consider our motion to dismiss. We deny all material allegations and intend to
defend the actions vigorously.
We are involved in legal actions in the normal course of business, some of which
seek monetary damages, including claims for punitive damages which are not
covered by insurance. Based on current information and review, including
consultation with our lawyers, we believe any ultimate liability that may arise
from these actions (including all purported class actions) would not materially
affect our consolidated financial position, results of operations, cash flows or
business prospects. However, our evaluation of the likely impact of these
actions could change in the future and an unfavorable outcome, depending upon
the amount and timing, could have a material effect on the results of operations
or cash flows of a future period.
LEASE COMMITMENTS. We lease office space and equipment under various
non-cancelable operating leases. Rental expense totaled $55 million in 1999, $59
million in 1998, and $48 million in 1997. Future minimum lease payments will be
$55 million in 2000, $48 million in 2001, $32 million in 2002, $20 million in
2003 and $15 million in 2004. Minimum lease payments after 2004 will be $22
million.
In 1997, we entered into a real estate and equipment master transfer agreement
that allows us to lease, sublease or assign certain facilities and equipment
that we own or lease. In 1998 and 1999 all of the equipment and a portion of the
real estate covered by the master transfer agreement was sold. The net book
value of the remaining real estate was approximately $18 million at December 31,
1999 and $27 million at December 31, 1998. The leases are accounted for as
operating leases, and subleases are accounted for as rental income. The
agreement includes extensions of the individual leases to December 31, 2005, and
two five-year extension options at prevailing market rates. These options are
exercisable solely at the lessee's discretion.
EMPLOYMENT AGREEMENTS. We have employment agreements with our chief executive
officer and certain other executives. The agreements entitle these executives to
receive severance benefits, payable if employment is terminated for various
reasons, including termination following a change of control of PacifiCare. The
maximum severance amount we would owe these executives according to their
employment agreements (excluding amounts that may be payable under incentive
plans and the value of certain other benefits) was approximately $33 million at
December 31, 1999.
F-23
82
11. COMPREHENSIVE INCOME
The following tables summarize the components of other comprehensive income
(loss) for the periods indicated:
INCOME
TAX NET-OF-
PRETAX EXPENSE TAX
AMOUNT (BENEFIT) AMOUNT
-------- --------- --------
(AMOUNTS IN THOUSANDS)
1999
Unrealized holding losses arising during the
period........................................... $(50,739) $(19,591) $(31,148)
Less: reclassification adjustment for net gains
realized in net income........................... (988) (381) (607)
-------- -------- --------
Other comprehensive loss........................... $(51,727) $(19,972) $(31,755)
======== ======== ========
1998:
Unrealized holding gains arising during the
period........................................... $ 12,766 $ 5,538 $ 7,228
Less: reclassification adjustment for net gains
realized in net income........................... (17,418) (7,556) (9,862)
-------- -------- --------
Other comprehensive loss........................... $ (4,652) $ (2,018) $ (2,634)
======== ======== ========
1997:
Unrealized holding gains arising during the
period........................................... $ 12,806 $ 4,885 $ 7,921
Less: reclassification adjustment for net gains
realized in net income........................... (2,229) (850) (1,379)
-------- -------- --------
Other comprehensive income......................... $ 10,577 $ 4,035 $ 6,542
======== ======== ========
12. SUBSEQUENT EVENTS
In January 2000, we announced a restructuring that will allow us to develop
plans to strengthen our operations through planned productivity enhancements and
technology improvements to further our competitive advantages and growth
opportunities. As a result of these changes, we will record a restructuring
charge of approximately $7 million to $8 million in the first quarter of 2000.
The restructuring charge includes severance and related employee benefits.
In February 2000, we acquired Harris Methodist Texas Health Plan, Inc. and
Harris Methodist Health Insurance Company, Inc., a health plan and insurance
company in Texas for a purchase price of $121 million. This acquisition added
approximately 300,000 members to our Texas health maintenance organization.
During the first quarter of 2000, we will assume approximately 25,000 to 29,000
members in Colorado and approximately 24,000 members in Washington as a result
of transition agreements signed with QualMed Washington Health Plans, Inc., in
October 1999 and with QualMed Plans for Health of Colorado, Inc. in September
1999, each a subsidiary of Foundation Health Systems, Inc. We will pay a
per-member price based on retained membership.
F-24
83
REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS
The Board of Directors and Stockholders
PacifiCare Health Systems, Inc.
We have audited the accompanying consolidated balance sheets of PacifiCare
Health Systems, Inc. as of December 31, 1999, and 1998 and the related
consolidated statements of operations, stockholders' equity and cash flows for
each of the three years in the period ended December 31, 1999. Our audits also
included the financial statement schedule listed in the Index at Item 14(a)(2).
These consolidated financial statements and schedule are the responsibility of
the Company's management. Our responsibility is to express an opinion on these
consolidated financial statements and schedule based on our audits.
We conducted our audits in accordance with auditing standards generally accepted
in the United States. Those standards require that we plan and perform the audit
to obtain reasonable assurance about whether the consolidated financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the consolidated
financial statements. An audit also includes assessing the accounting principles
used and significant estimates made by management, as well as evaluating the
overall financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the consolidated financial position of
PacifiCare Health Systems, Inc. at December 31, 1999 and 1998, and the
consolidated results of its operations and its cash flows for each of the three
years in the period ended December 31, 1999 in conformity with accounting
principles generally accepted in the United States. Also in our opinion, the
related financial statement schedule, when considered in relation to the basic
consolidated financial statements taken as a whole, presents fairly in all
material respects the information set forth therein.
ERNST & YOUNG LLP
Irvine, California
February 3, 2000
F-25
84
PACIFICARE HEALTH SYSTEMS, INC.
QUARTERLY INFORMATION FOR 1999 AND 1998 (UNAUDITED)
QUARTERS ENDED
-------------------------------------------------------
MARCH 31 JUNE 30 SEPTEMBER 30 DECEMBER 31
---------- ---------- ------------ -----------
(AMOUNTS IN THOUSANDS, EXCEPT PER SHARE DATA)
1999(1)
Operating revenue........................ $2,451,909 $2,454,747 $2,517,917 $2,564,517
Operating expenses....................... 2,335,563 2,347,900 2,405,181 2,459,586
Net investment income.................... 20,201 20,242 20,304 23,303
Interest expense......................... (10,293) (9,512) (9,742) (13,454)
---------- ---------- ---------- ----------
Income before income taxes............... 126,254 117,577 123,298 114,780
Provision for income taxes............... 52,270 48,676 54,041 48,378
---------- ---------- ---------- ----------
Net income............................... $ 73,984 $ 68,901 $ 69,257 $ 66,402
========== ========== ========== ==========
Basic earnings per share................. $ 1.62 $ 1.50 $ 1.54 $ 1.60
========== ========== ========== ==========
Diluted earnings per share............... $ 1.61 $ 1.49 $ 1.54 $ 1.59
========== ========== ========== ==========
Membership(3)............................ 3,585 3,577 3,660 3,658
========== ========== ========== ==========
1998(2)
Operating revenue........................ $2,381,950 $2,396,259 $2,400,897 $2,342,376
Operating expenses....................... 2,309,450 2,309,987 2,316,522 2,243,332
Net investment income.................... 25,304 23,850 29,193 25,959
Interest expense......................... (17,518) (16,913) (13,828) (12,664)
---------- ---------- ---------- ----------
Income before income taxes............... 80,286 93,209 99,740 112,339
Provision for income taxes............... 38,940 44,338 46,509 53,360
---------- ---------- ---------- ----------
Net income............................... $ 41,346 $ 48,871 $ 53,231 $ 58,979
========== ========== ========== ==========
Preferred dividends...................... (2,629) (2,630) -- --
---------- ---------- ---------- ----------
Net income available to common
Stockholders........................... $ 38,717 $ 46,241 $ 53,231 $ 58,979
========== ========== ========== ==========
Basic earnings per share................. $ 0.93 $ 1.10 $ 1.17 $ 1.29
========== ========== ========== ==========
Diluted earnings per share............... $ 0.90 $ 1.06 $ 1.16 $ 1.28
========== ========== ========== ==========
Membership(3)............................ 3,689 3,660 3,645 3,527
========== ========== ========== ==========
- ---------------
(1) We recognized impairment, disposition, restructuring and other net pretax
credits in the third quarter of 1999 totaling $2 million ($2 million or
$0.04 diluted loss per share, net of tax). The after tax and per share
amounts were losses because the goodwill impairment was not deductible for
income tax purposes. See Note 9 of the Notes to Consolidated Financial
Statements.
(2) We recognized pretax charges in the third quarter of 1998 totaling $19
million ($10 million or $0.22 diluted loss per share, net of tax). These
charges included approximately $15 million ($8 million or $0.18 diluted loss
per share, net of tax) for the disposal of the Utah HMO and workers'
compensation subsidiaries. The charges also included approximately $4
million ($2 million or $0.04 diluted loss per share, net of tax) for
potential OPM claims. The 1998 charges were partially offset by $8 million
($4 million or $0.10 diluted earnings per share, net of tax) for favorable
OPM settlements in the fourth quarter. See Note 9 of the Notes to
Consolidated Financial Statements.
(3) Membership as of quarter end.
F-26
85
PACIFICARE HEALTH SYSTEMS, INC. AND SUBSIDIARIES
SCHEDULE II -- VALUATION AND QUALIFYING ACCOUNTS
(AMOUNTS IN THOUSANDS)
YEAR ENDED YEAR ENDED YEAR ENDED
DECEMBER 31, 1999 DECEMBER 31, 1998 DECEMBER 31, 1997
----------------- ----------------- -----------------
Allowance for doubtful accounts:
Beginning balance........................... $ 8,529 $13,598 $ 1,048
FHP acquisition............................. -- -- 7,036
Additions:
Charged to costs and expenses............... 1,634 1,485 5,171
Charged to other accounts................... 2,074 (4,850) 3,620
Deductions/write offs......................... (1,064) (1,704) (3,277)
------- ------- -------
Ending balance................................ $11,173 $ 8,529 $13,598
======= ======= =======
F-27
86
PACIFICARE HEALTH SYSTEMS, INC.
EXHIBIT INDEX
EXHIBIT
NUMBER DESCRIPTION
- ------- -----------
3.01 Amended and Restated Certificate of Incorporation of
Registrant (including Certificate of Designation of Series A
Junior Participating Preferred Stock) [incorporated by
reference to Exhibit 99.1 to Registrant's Registration
Statement on Form S-3 (File No. 333-83069)].(1)
3.02 Bylaws of Registrant [incorporated by reference to Exhibit
99.2 to Registrant's Registration Statement on Form S-3
(File No. 333-83069)].
4.01 First Supplemental Indenture, dated as of February 14, 1997,
by and among the Registrant, FHP International Corporation
and The Chase Manhattan Bank, N.A. [incorporated by
reference to Exhibit 4.01 to the Registrant's Form 10-Q for
the quarter ended March 31, 1997].
4.02 Form of Specimen Certificate for Registrant's Common Stock.
4.03 Registration Rights Agreement, dated as of May 4, 1999,
between the Registrant and UniHealth Foundation
[incorporated by reference to Exhibit 99.4 to Registrant's
Registration Statement on Form S-3 (File No. 333-83069)].
4.04 Rights Agreement, dated as of November 19, 1999, between the
Registrant and ChaseMellon Shareholder Services, L.L.C
[incorporated by reference to Exhibit 99.1 to Registrant's
Form 8-K, dated November 22, 1999].
10.01 Second Amended and Restated Employment Agreement, dated
December 31, 1999, between the Registrant and Alan R. Hoops
[incorporated by reference to Exhibit 99.1 to Registrant's
Form 8-K, dated February 18, 2000].(2)
10.02 Executive Employment Agreement, dated as of September 1,
1999, between the Registrant and Jeffrey M. Folick.(2)
10.03 Separation Agreement, dated as of September 15, 1999,
between the Registrant and Robert B. Stearns.(2)
10.04 Employment Agreement, dated October 6, 1997, between the
Registrant and Bradford A. Bowlus [incorporated by reference
to Exhibit 10.04 to Registrant's Form 10-K for the year
ended December 31, 1998].(2)
10.05 Employment Agreement, dated June 10, 1996, between the
Registrant and Linda M. Lyons, MD [incorporated by reference
to Exhibit 10.05 to Registrant's Form 10-K for the year
ended December 31, 1998].(2)
10.06 Form of Amendment to Employment Agreement, dated as of April
21, 1999 between Registrant and Alan R. Hoops, Jeffrey M.
Folick, Bradford A. Bowlus and Linda Lyons.(2)
10.07 Employment Agreement, dated June 26, 1998, between the
Registrant and Richard E. Badger.(2)
10.08 First Amendment to the Employment Agreement, dated July 1,
1999, between Registrant and Richard E, Badger.(2)
10.09 Form of Contract With Eligible Medicare+Choice Organization
for the period January 1, 2000 through December 31, 2000
between PacifiCare of California and the Health Care
Financing Administration.
10.10 1996 Stock Option Plan for Officers and Key Employees of the
Registrant [incorporated by reference to Exhibit 10.05 to
Registrant's Form 8-B, dated January 23, 1997].(2)
10.11 First Amendment to 1996 Stock Option Plan for Officers and
Key Employees of the Registrant [incorporated by reference
to Exhibit D to Registrant's Proxy Statement, dated May 25,
1999].(2)
10.12 Amended and Restated 1996 Non-Officer Directors Stock Option
Plan of the Registrant [incorporated by reference to Exhibit
E to Registrant's Proxy Statement, dated May 25, 1999].(2)
10.13 1996 Management Incentive Compensation Plan of the
Registrant [incorporated by reference to Exhibit 10.07 to
Registrant's Form 8-B, dated January 23, 1997].(2)
10.14 Amended 1997 Premium Priced Stock Option Plan of the
Registrant [incorporated by reference to Exhibit A to
Registrant's Definitive Proxy Statement, dated April 28,
1998].(2)
10.15 First Amendment to Amended 1997 Premium Priced Stock Option
Plan, dated as of August 27, 1998 [incorporated by reference
to Exhibit 10.12 to Registrant's Form 10-K for the year
ended December 31, 1998].(2)
E-1
87
EXHIBIT
NUMBER DESCRIPTION
- ------- -----------
10.16 PacifiCare Health Systems, Inc. Statutory Restoration Plan
[incorporated by reference to Exhibit 10.15 to the
Registrant's Form 10-K for the year ended December 31,
1997].(2)
10.17 PacifiCare Health Systems, Inc. Non-Qualified Deferred
Compensation Plan [incorporated by reference to Exhibit
10.16 to the Registrant's Form 10-K for the year ended
December 31, 1997].(2)
10.18 PacifiCare Health Systems, Inc. Stock Unit Deferred
Compensation Plan [incorporated by reference to Exhibit
10.17 to the Registrant's Form 10-K for the year ended
December 31, 1997].(2)
10.19 Credit Agreement, dated as of October 31, 1996, among
Registrant, the several financial institutions from time to
time party to the Credit Agreement, The Bank of New York,
The Bank of Nova Scotia, Banque Nationale de Paris, Dai-Ichi
Kangyo Bank, Ltd., The Industrial Bank of Japan Limited,
RaboBank Nederland, Sanwa Bank of California, The Sumitomo
Bank, Limited and Wells Fargo Bank, N.A., as co-agents, The
Chase Manhattan Bank and CitiCorp USA, Inc. as managing
agents, and Bank of America National Trust and Savings
Association, as agent for the Banks [incorporated by
reference to Exhibit 10.01 to the Registrant's Registration
Statement on Form S-4 (File No. 333-16271)].
10.20 First Amendment to Credit Agreement, dated as of August 15,
1997, among the Registrant, the Banks party to the Credit
Agreement, dated as of October 31, 1996, and Bank of America
National Trust and Savings Association, as Agent
[incorporated by reference to Exhibit 10.12 to the
Registrant's Form 10-K for the year ended December 31,
1997].
10.21 Second Amendment to Credit Agreement, dated as of December
31, 1997, among the Registrant, the Banks party to the
Credit Agreement, dated as of October 31, 1996, and Bank of
America National Trust and Savings Association, as Agent
[incorporated by reference to Exhibit 10.13 to the
Registrant's Form 10-K for the year ended December 31,
1997].
10.22 Third Amendment to Credit Agreement, dated as of December 8,
1999, among the Registrant, the Banks party to the Credit
Agreement, dated as of October 31, 1996, and Bank of America
National Trust and Savings Association, as Agent.
10.23 Stock Purchase Agreement, dated as of May 4, 1999, between
the Registrant and UniHealth Foundation [incorporated by
reference to Exhibit B to Registrant's Proxy Statement,
dated May 25, 1999].
10.24 Amended Services Agreement, dated as of June 1, 1999,
between the Registrant and Joseph S. Konowiecki, a
professional corporation.
21 List of Subsidiaries.
23 Consent of Ernst & Young LLP, Independent Auditors.
27 Financial Data Schedules (filed electronically).
- ---------------
(1) Certificate of Designation of Series A Junior Participating Preferred Stock
is incorporated by reference to Exhibit 4.1 to Registrant's Form 8-K, dated
November 19, 1999.
(2) Management contract or compensatory plan or arrangement required to be filed
as an exhibit to this Form 10-K pursuant to Item 14(c) of Form 10-K.
E-2