**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C.  20549**

 

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**FORM 10-K**

 

**ANNUAL REPORT PURSUANT TO SECTION13 OR 15(d)**

**OF THE SECURITIES EXCHANGE ACT OF1934**

 

**For the fiscal yearended December 31, 2001**

 

**Commission filenumber 1-14177**

 

**COBALT CORPORATION**

(Exact name of registrant as specified in itscharter)

 
| **Wisconsin**                                                                |   | **39-1931212**                       |
|------------------------------------------------------------------------------|--------|--------------------------------------|
| (State of incorporation)                                                     |   | (I.R.S. Employer Identification No.) |
|                                                                         |   |                                 |
| **401 West Michigan Street****Milwaukee,  Wisconsin**                        |   | **53203-2896**                       |
| (Address of principal executive offices)                                     |   | (Zip Code)                           |
|                                                                         |   |                                 |
| Registrant’s telephone number,  including area code: **(414) 226-6900** |

 

Securitiesregistered pursuant to Section 12(b) of the Act:

 

| **Title of each class**    |   | **Name of each exchange on which registered** |
|----------------------------|--------|-----------------------------------------------|
| Common Stock, no par value |   | New York Stock Exchange                       |

 

Securitiesregistered pursuant to Section 12(g) of the Act:**  None**

 

Indicate by check mark whether the registrant (1) has filed all reportsrequired to be filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days. Yes ý    No 

 

Indicate by check mark if disclosure of delinquent filers pursuant toItem 405 of Registration S-K is not contained herein, and will not becontained, to the best of registrant’s knowledge, in definitive proxy orinformation statements incorporated by reference in Part III of this Form 10-Kor any amendment to this Form 10-K.

 

As of February 28, 2002, there were outstanding 40,639,438 shares ofCommon Stock.  The aggregate marketvalue of the shares of such stock held by non-affiliates of the registrant was$71,344,267 as of the same date, assuming solely for the purposes of thiscalculation that the Wisconsin United for Health Foundation, Inc. and alldirectors and executive officers of the Registrant are “affiliates.”  This determination of affiliate status isnot necessarily a conclusive determination of other purposes.

 

**DOCUMENTSINCORPORATED BY REFERENCE**

Portions of Cobalt Corporation Proxy Statement dated on or about

April 25, 2002 (Part III)

 

 

 

COBALT CORPORATION

INDEX TO

ANNUAL REPORT ON FORM 10-K

For the Year Ended December 31, 2001

 
| **PART I**         |
|--------------------|
|               |   |
| Item  1            | Business |
| Item 2             | Properties |
| Item 3             | Legal Proceedings |
| Item 4             | Submission of Matters to a Vote of Security  Holders |
| Item 4a            | Executive Officers of the Registrant |
|               |   |
| **PART II**        |
|               |   |
| Item 5             | Market for Registrant’s Common Equity |
| Item 6             | Selected Consolidated Financial Data |
| Item 7             | Management’s Discussion and Analysis of  Financial Condition and Results of Operations |
| Item 7a            | Quantitative and Qualitative Disclosures  about Market Risk |
| Item 8             | Financial Statements and Supplementary Data |
| Item 9             | Changes in and Disagreements with  Accountants on Accounting and Financial Disclosure |
|               |   |
| **PART III**       |
|               |   |
| Item 10            | Directors and Executive Officers of the  Registrant |
| Item 11            | Executive Compensation |
| Item 12            | Security Ownership of Certain Beneficial Owners  and Management |
| Item 13            | Certain Relationships and Related  Transactions |
|               |   |
| **PART IV**        |
|               |   |
| Item 14            | Exhibits, Financial Statement Schedules,  and Reports on Form 8-K |
|               | Schedule II -  Condensed Financial Information of Registrant |
|               | Schedule IV - Reinsurance |
|               | Schedule V - Valuation and Qualifying Accounts |
| Signatures         |
| Index  to Exhibits |

 

 

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**PART I**

 

**ITEM1:  Business**

 

**General**

 

Cobalt Corporation (“Cobalt” or the “Company”) (formerly known asUnited Wisconsin Services, Inc. (“UWS”)) was created as a result of thecombination of UWS and Blue Cross & Blue Shield United of Wisconsin(“BCBSUW”) on March 23, 2001 (the “Combination”).  On that date, BCBSUW converted from a service insurancecorporation to a stockholder owned corporation.  Upon conversion, BCBSUW became a wholly-owned subsidiary of UWSthrough a combination of the two companies. At the time of the conversion and combination, BCBSUW ownedapproximately 46.6% of UWS’ outstanding common stock.  In exchange for the ownership of BCBSUW, Cobalt issued 31,313,390shares of newly issued Company common stock to the Wisconsin United for HealthFoundation, Inc. (the “Foundation”). The Foundation was established for the sole purpose of benefiting publichealth in Wisconsin from its earnings in the investment in Cobalt.  Refer to Form 8-K filed with the Securitiesand Exchange Commission (“SEC”) on April 9, 2001, for more information on the combinationof UWS and BCBSUW.

 

Cobalt’s principal executive offices are located at 401 West MichiganStreet, Milwaukee, Wisconsin 53203 and its telephone number at that address is(414) 226-6900.  As used herein,the term “Cobalt” or the “Company” includes Cobalt and its subsidiaries.

 

Cobalt offers a diverse portfolio of complementary insurance andmanaged care products to employer, individual, insurer and government customerssold primarily in Wisconsin, but also serving markets in all 50 states and theDistrict of Columbia.  Cobalt is theonly health insurer in the state operating full-service regional sales andcustomer service centers.  Cobalt sellshealth and dental products that deliver a wide array and strong combination ofbenefit plans, funding options and provider networks.  Cobalt operates the oldest health maintenance organization(“HMO”) system in Wisconsin, as well as offering a complete spectrum ofinsurance products including indemnity, Preferred Provider Organization (“PPO”)and Point of Service (“POS”) plans. Cobalt also offers Administrative Services Only (“ASO”) programs forlarge, national, self-insured employers. Cobalt also offers various specialty products and services includingprepaid dental care, life, disability, managed care workers’ compensationinsurance products and cost containment, health care electronic datainterchange, pharmaceutical management, managed care consulting and receivablesmanagement services.  Cobalt alsoprocesses Medicare claims through United Government Services, LLC (“UGS”) forproviders in all 50 states, Puerto Rico, the United States Virgin Islands,Guam, American Samoa and the Northern Mariana Islands.

 

Cobalt’s insured medical and self-funded products are sold primarily bya salaried sales force to employers and other groups.  Specialty products and services are sold through a variety ofdistribution channels to employer groups and providers in Wisconsin andthroughout the United States.

 

**Cobalt’s Strategy**

 

Cobalt believes current market conditions in health care favorcompanies that provide quality health care products and services, whileensuring meaningful cost containment for the buyer.  Cobalt also believes there are significant niches offeringopportunities for companies that are responsive to consumer demand foraffordable health care.  Cobalt is amanaged care leader in Wisconsin due to the quality and extent of its providernetwork, the number of members, the breadth of its managed care productofferings and the pricing of those products. To take advantage of market opportunities, Cobalt has developed thefollowing business strategy:

 

 

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•                                          *EmphasizeCost-Effective Access to Quality Health Care Options.* Cobalt believes that rising health care costscontinue to cause buyers to seek cost-effective quality health care options foremployees.  Cobalt focuses on thisdemand by offering a full range of managed care products coupled withstate-of-the-art managed care techniques and competitive administrativecosts.  During 2001, Cobalt focused onintroducing more affordable products, including Healthy Edition HMO and POS andBuy Direct PPO products.  Cobalt alsomarkets, in selected Wisconsin counties, its United 24 product, which combineshealth, disability and workers’ compensation coverage into a single lowerpremium product.

 

•              *Strengthof Blue Cross® Brand.*  Cobaltbelieves that its right to the exclusive use of the Blue Cross® and BlueShield® ("Blue") brands in its service area is a significantmarketing tool and intends to continue emphasizing this brand awareness amongprospective members.  During 2001, theuse of the Blue brand was expanded as Cobalt redesigned its dental portfolio ofproducts under the name "DentalBlue".

 

•                                          *PricingStrategy.* Consumers considermany factors including price when shopping for a health insurance product;therefore, Cobalt strives to offer quality individual and group products andservices at a competitive price.  Cobaltoffers products that carry flexibility and diversity, wherein the consumers cancustomize a health plan that meets both their insurance and financial needs.

 

•                                          *ExpandGeographically.* Cobaltintends to continue to expand its activities outside of its traditional areasof operation, both inside and outside of Wisconsin.  Cobalt has continued to increase its market share in southeasternWisconsin by expanding its provider networks in counties surroundingMilwaukee.  Cobalt continues to expandits life and disability products through a brokerage sales effort in the upperMidwest.  The workers’ compensationproduct is being actively marketed in Iowa and Illinois, and Cobalt seeksadditional opportunities to expand the workers’ compensation business throughacquisitions or strategic joint ventures.

 

•                                          *RegionalPresence.* Cobalt sees thevalue of meeting the various needs of each community throughout Wisconsin.  Therefore, Cobalt’s subsidiary, BCBSUW hassegmented Wisconsin into four regional markets and is the only health insurerin the state to operate regional service centers.  These offices put Cobalt close to customers and providers,allowing Cobalt to build beneficial and lasting relationships.  Each region is responsible for effectivelydeveloping, managing, and implementing marketing plans, which focus on thespecific needs of each market while portraying a consistent corporate image.

 

•              *Increase Market Share.* Cobalt continually seeks to gain marketshare, whether through the introduction of a new product, service or program,the entrance into a new market or through a new channel of distribution such aspurchasing products online.  Cobalt consistentlygathers and analyzes competitive intelligence information to strategize amarketing plan to better penetrate/target each market.  The small group market business is currentlyexperiencing significant increases in premium rates.  To maintain and gain small group market share, Cobalt hasdesigned quality products to meet various groups’ economic needs.

 

•              *Focuson Core Business. *Asevidenced by the filing of a Form 13-D indicating plans for an orderlyreduction of its 45% investment in American Medical Security Group, Inc. (NYSE:AMZ), Cobalt is focusing on its core medical business.  This strategy may result in the sale ofnon-core specialty businesses and increased emphasis on expanding margins andmarket share in Blue branded business. On March 22, 2002, AMS repurchased from BCBSUW 1.4 million shares of AMScommon stock at a price of $13 per share (see Note 19 of Notes to ConsolidatedFinancial Statements).

 

 

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•              *Internet Strategy .* Cobalt launched its Website, *www.bluecrosswisconsin.com*, in 2000.  Cobalt has gained positive presence both statewide and nationallythrough the Internet.  The productsavailable online target small businesses and younger individual consumers  Here individuals and small businesses canpurchase health insurance online at a discounted rate.  Over 20% of all new individual sales are nowmade online.  The site also allowsCobalt members to view their personal claim status, deductible and out-of-pocketamounts, hospital inpatient and outpatient authorization status and eligibility.  In addition, members can request new IDcards, access benefit booklets, select physicians and other providers anddownload provider directories.

**Products**

 

***Insured Health andSelf-Funded***

 

Cobalt offers diversity through a wide range of group and individualproducts.  Through its subsidiary,BCBSUW, the following plans are offered: (i) Group Plans—PPO;Comprehensive Major Medical, which is a traditional fee-for-service healthplan; Traditional Full-Pay, which is a plan covering full base and majormedical care; and a Pharmacy Benefit Plan, which is a prescription drug cardprogram; and (ii) Individual Products—Personal Choice and TempPlan, whichcover individuals not covered by a group plan; and Value Plus, which is aMedicare supplement plan.

 

One of BCBSUW’s products, which extends beyond the Wisconsin borders,is the Interplan Teleprocessing Services (“ITS”) system, which utilizestechnology linking Blue Cross plans throughout the United States.  This broadens BCBSUW’s national exposure andallows BCBSUW to target prospects headquartered in Wisconsin with out-of-stateand overseas locations .  Almostanywhere in the world a Blue Cross member travels, he or she receives the samelevel of benefits available at home through the Blue Cross worldwide network ofproviders.  BCBSUW believes the ITSsystem will enhance sales opportunities in the national market goingforward.  BCBSUW also participates inBlueCard, a national network of Blue Cross and Blue Shield plans, whichallows members access to care while away from home.  Through electronic communications the “host” plan verifieseligibility, pays the claim based on its local fee arrangement and is thenreimbursed by the “home” plan for the claim as well as an administrativefee.  Absent an agreement between twoplans, the BlueCross BlueShield Association (“BCA”) determines the amount ofthe administrative fee.  Both insuredand self-funded BCBSUW customers have access to the BlueCard network.

 

Cobalt’s HMO subsidiaries are Compcare Health Services InsuranceCorporation (“Compcare”), Valley Health Plan, Inc. (“Valley”) and Unity HealthPlans Insurance Corporation (“Unity”). Compcare was organized in 1971 and operates primarily in southeasternWisconsin.  Compcare is Wisconsin’soldest and third largest HMO in terms of enrollment and premium revenues.  Valley, an HMO in northwestern Wisconsin,was acquired by UWS in 1992.  Its majorprovider is Midelfort Clinic Ltd., Mayo Health Systems (“Midelfort”).  Unity, an HMO serving south central andsouthwestern Wisconsin, was formed by the combination of HMO of WisconsinInsurance Corporation (“HMOW”) and the business of U-Care HMO, Inc.(“U-Care”). HMOW and U-Care were purchased by UWS effective October 1,1994.  Community Physicians’Network, Inc. (“CPN”) and the University of Wisconsin-Madison MedicalFoundation constitute the provider networks for Unity.

 

Compcare’s operations in the six counties included in the southeasternWisconsin region comprise approximately 88% of its total membership.  The remainder of Compcare’s membership isspread throughout Wisconsin.  Compcareoffers a variety of HMO and POS products. POS products have become the coverage of choice for a number of employersas they provide a complete replacement for programs that include a PPO plan orboth traditional indemnity and HMO coverages. Compcare offers its members a broad network of providers, which includeall three of the major integrated health care systems in southeasternWisconsin.

 

 

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Valley offers the following products primarily in a 15 county area innorthwestern Wisconsin: (i) Partner Plan, a comprehensive HMO plan; (ii) POSproducts, which combine a traditional HMO plan and an out-of-network benefitwith deductible and coinsurance; (iii) a Medicare supplement product, which isdesigned to supplement the government program’s allowed payments; (iv) an HMOMedicaid/BadgerCare plan, which is a comprehensive HMO plan for eligibleMedicaid/BadgerCare recipients; and (v) Individual products, which are HMOplans designed for consumers who do not qualify for coverage through anemployer group.  These plans offercomprehensive coverage with deductibles and coinsurance.

 

Unity markets comprehensive managed care products to employer groupsand individuals in 19 counties in south central and southwesternWisconsin.  Unity’s product offeringsinclude HMO, POS and third party administrator (“TPA”) services.  The HMO product includes a variety ofbenefit coverage options with multiple co-pay and deductible options tailoredto meet customer needs.  HMO coveragegenerally requires the use of participating (network) providers.  HMO offerings include federal, state andlocal government plans, a Medicaid HMO program and a Medicare Select individualproduct.  TPA services sold under thebrand name “TPA Plus” offer employers self-funded benefit planadministration.  In addition totraditional administrative services, TPA options include the ability to selectnetwork and medical management services, which lower costs through the use ofparticipating providers.

 

**Distribution**

 

Cobalt has a streamlined sales organization, combining the productofferings by its various affiliates.  Byintegrating the marketing of various Cobalt products, the Company is able tooffer complete one-stop shopping to health care consumers.  Sales of medical and dental products areconducted by a salaried sales force throughout Wisconsin as well as throughindependent agents and brokers.

 

**Marketing and Customers**

 

Marketing group HMO products generally is a two-step process.  Presentations are made first toemployers.  Once selected by anemployer, Cobalt then directly solicits members from the employee base .  During periodic “open enrollments,” when employeesare permitted to change health care programs, Cobalt uses advertising and worksite presentations to attract new members. Virtually all of the group contracts are renewable annually.

 

Significant factors in group selection by employers and employeesinclude the composition of provider networks, quality of services, price, choiceand scope of benefits, and market presence. To the extent permitted by the Office of the Commissioner of Insuranceof the State of Wisconsin (“OCI”) and the federal government, Cobalt can offeran employer a wide spectrum of benefit options, including federally qualifiedand non-federally qualified products. To address rising health care costs, some employers now consider avariety of health care options to encourage employees to use the mostcost-effective form of health care services.

 

As of December 31, 2001, insured medical and self-fundedmembership consisted of the following (in numbers of individuals): 

 
|     |   | **HMO** |   | **PPO** |   | **POS** |   | **Medicaid** |   | **Medicare  Risk** |   | **Other/  Individual** |   | **Self-  Funded** |   | **Total** |   |
|----------|--------|---------|--------|---------|--------|---------|--------|--------------|--------|--------------------|--------|------------------------|--------|-------------------|--------|-----------|--------|
| BCBSUW   |   | —  |   | 134,511 |   | 4,298   |   | —       |   | 9,147              |   | 88,859                 |   | 164,415           |   | 401,230   |   |
| Compcare |   | 129,265 |   | —  |   | 59,889  |   | —       |   | —             |   | —                 |   | —            |   | 189,154   |   |
| Valley   |   | 24,276  |   | —  |   | 5,628   |   | 882          |   | —             |   | —                 |   | —            |   | 30,786    |   |
| Unity    |   | 56,098  |   | —  |   | 14,242  |   | 3,385        |   | —             |   | —                 |   | 5,231             |   | 78,956    |   |
|     |   | 209,639 |   | 134,511 |   | 84,057  |   | 4,267        |   | 9,147              |   | 88,859                 |   | 169,646           |   | 700,126   |   |

 

Cobalt has significant enrollment among federal, state and municipalgovernment employees, as well as employees represented by collective bargainingunits.  Cobalt believes that health carewill continue to be an important negotiating issue with organized labor groupsand the reputation of Cobalt is advantageous to its future marketing efforts.

 

 

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**Top 10 Customers**

 

The following table identifies the top ten customers based onmembership counts as of December 31, 2001:

 
|                                          |   | **Percentage of  Total Members** |   |
|-----------------------------------------------|--------|----------------------------------|--------|
| State of Wisconsin (3)                        |   | 9.4                              | %      |
| Federal Employee Health Benefits Program  (1) |   | 7.5                              |   |
| Menards, Inc. (1)                             |   | 2.1                              |   |
| Daimler Chrysler (2)                          |   | 1.7                              |   |
| Alterra Health Care Corporation (1)           |   | 1.4                              |   |
| General Motors (3)                            |   | 1.1                              |   |
| Columbia / St. Mary’s Inc. (1)           |   | 1.1                              |   |
| Milwaukee Public Schools (1)                  |   | 1.0                              |   |
| Marshall & Ilsley Corporation (3)         |   | 1.0                              |   |
| UPS (2)                                       |   | 1.0                              |   |
| Subtotal                                      |   | 27.3                             |   |
| Other employer groups                         |   | 72.7                             |   |
| Total                                         |   | 100.0                            | %      |

 

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(1)                                  Insured programs

(2)                                  Self-funded programs

(3)                                  Insuredand self-funded programs

 

For additional information regarding Cobalt’s insured and self-fundedmedical products, see Management’s Discussion and Analysis and Note 18,“Segment Reporting” of this annual report on Form 10-K.

 

**Providers**

 

BCBSUW offers the largest provider network in Wisconsin, whichstatewide includes 128 hospitals, 1,114 ancillaries and 10,370 health careprofessionals as of December 31, 2001. BCBSUW provides a diverse selection of primary care and specialty carephysicians to meet health care needs.

 

Compcare, Valley and Unity contract with physicians and hospitals toprovide medical services to their members. Compcare has an extensive provider network in southeastern Wisconsin,which included 5,985 physicians as of December 31, 2001.  Compcare is the only HMO that contracts withall eight of the largest multi–specialty clinics in Milwaukee for theprovision of health care services to its members.  This network is augmented by individual physicians, hospitals andindependent physician associations (“IPAs”) affiliated with Milwaukee’s largesthospitals.  Providers outside ofMilwaukee consist of multi–specialty clinics and hospitals.  Ancillary services are provided undercapitated arrangements through sub-networks including chiropractic, mentalhealth, oral surgery, home care, durable medical equipment and vision.  Compcare’s contracts with providersgenerally renew annually.  Compcareconsiders its relationships with its provider networks to be good and has beenable to renew its provider contracts on acceptable terms.

 

Approximately 57.7% of Valley’s medical and other benefits are providedunder an arrangement with Midelfort and its affiliate, Luther Hospital, whichCobalt believes are the leading medical service providers in Eau Claire,Wisconsin.  Arrangements with threesmaller area clinics and five other hospitals provide a majority of the othermedical and other benefits for Valley. As of December 31, 2001, Valley’s provider network consisted of 379physicians.  Approximately 87.1 % ofValley’s physician services are provided under the Midelfort arrangement.  The relationship with Midelfort is generatedby the Valley provider arrangement, which extends through December 31,2002.  Valley’s contracts with its otherproviders renew annually.  Cobaltconsiders its relationships with Midelfort and its other providers for Valleyto be good and has been able to renew provider contracts on acceptable terms.

 

 

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Unitycontracts with CPN, an IPA, and University Health Care, Inc. (“UHC”).  UHC is a non-profit tax-exempt corporationthat contracts on behalf of the University of Wisconsin Hospital and Clinics,the University of Wisconsin Medical Foundation and the University of WisconsinSchool of Medicine.  CPN and UHC providethe majority of physician services for Unity’s membership throughout its 19county service area.  CPN, UHC and Unitycollectively contract with approximately 781 primary care providers and 2,412specialists and ancillary health care providers.  In addition, Unity contracts directly with approximately 38 acutecare and specialty care hospitals.

 

Compcare,Valley and Unity manage the cost of health care provided to members through themethod of payment and risk-sharing programs with physician groups and hospitalsand through their respective utilization management programs.  The method of payment consists of acombination of capitation, fee schedules and discounted fee-for-servicearrangements.  Capitation allows thepayment of a fixed amount per member per month to providers, regardless of thelevel of services provided, which stabilizes medical and dental costs.  For the twelve months endedDecember 31, 2001, approximately 8.7%, 23.9% and 41.0% of Compcare’s,Valley’s and Unity’s medical benefits, respectively, were provided undercapitated arrangements.

 

For certainmedical providers, compensation for services is calculated on a discountedfee-for-service basis.  Under thisarrangement, Cobalt HMOs will reimburse physician groups for services renderedbased upon negotiated fee schedules or usual and customary charges, less anagreed upon discount.  Hospitals may bereimbursed at a set per diem rate for each inpatient day, on a flat rate perprocedure or case basis, according to diagnosis-related groups (“DRG”) or on adiscounted charge basis.  Infee-for-service arrangements, risks associated with utilization are retained bythe HMO.  However, such arrangementsprovide the HMO with greater pricing flexibility and opportunities to benefitby application of underwriting on a group-specific or individual basis.  Furthermore, fee schedule-based compensationallows the HMO to better target improvement in loss ratios through productdevelopment and benefit modification. It is more difficult to make such changes under capitated arrangementsbecause capitation levels must be renegotiated before any significant changecan be made to benefits or products.

 

**Operations of Provider Arrangements**

 

Valley enteredinto a joint venture agreement with Midelfort effective January 1, 1992, whichprovided for after-tax profits to be shared equally with Midelfort.  The second amended and restated jointventure effective as of January 1, 2000 changed the profit sharing betweenCobalt and Midelfort.  Under the newprovider agreement, Midelfort shares in 50% of the net profits (losses) relatingto the HMO and POS products based on the following:  Net profit/loss of HMO products are calculated over the life ofthe term and POS products are separately calculated on an annual basis.  Net losses for the HMO products are sharedonly to the extent that there are profits over the term to offset thelosses.  Midelfort’s profit (loss)sharing on the POS product is capped at $0.1 million for 2001, increasing to$0.2 million for 2002.  Total profitsharing with Midelfort, on the HMO and POS products, for the twelve monthsended December 31, 2001 equaled $0.4 million.

 

Midelfort hasan option to repurchase all the capital stock of Valley on December 31,2002 for Valley’s net equity plus $0.4 million.  If Midelfort exercises its repurchase option, Cobalt would haveno ongoing interest in Valley.

 

Unity has provider agreements with CommunityHealth Systems, LLC (“CHS”) and UHC for the period January 1, 2000 throughDecember 31, 2004.  These agreementswill automatically renew for additional five-year terms unless either CHS orUHC exercises its option to purchase the business originally sold to Cobalt orunless there is a termination of the agreements for cause.  The purchase options may be exercised onDecember 31, 2004.  Under theagreements, profit-sharing payments were eliminated with the exception ofpayments due to UHC for the years 2001 through 2004.  During each of these years, UHC is eligible to receive a portionof the pre-tax income as an annual performance bonus; however, total paymentsfor the four-year period are limited to $0.7 million.

 

 

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Thepurchase options allow CHS and UHC to repurchase the business originally soldto Cobalt as well as the increased membership relative to theirrespective provider networks.  CHS hasthe option to repurchase its proportionate share of Unity for the current networth of the business being repurchased. UHC has the option to purchase its share of Unity for $0.5 million plusthe proportionate share of the net worth of Unity attributable to the UHCbusiness, less any unpaid amount of the maximum performance bonus.  Exercise of the repurchase option ends theagreement with respect to that party. If both repurchase options are exercised, Cobalt would have no ongoinginterest in Unity.

 

**Medical Management**

 

The majority of medical management services for BCBSUW and Compcare areprovided by Innovative Resource Group, LLC (“IRG”), a wholly owned subsidiaryof Cobalt.  Medical management is donefor BCBSUW and Compcare on insured products in order to manage medical costsand utilization and is performed on behalf of the customer on group self-fundedbusiness.  Medical management for Valleyand Unity is coordinated by medical directors in conjunction with the medicalstaffs of their providers.  Cobaltbelieves that effective medical management continues to be valued by customersas health care costs continue to rise.

** **

**Management Information Services**

 

Cobalt utilizes information systems developed and/or customizedspecifically to meet its needs.  Theinformation systems support marketing, sales, underwriting, contractadministration, billing, financial and other administrative functions as wellas claims administration, provider management, quality management andutilization review.  Cobalt continuallyevaluates, upgrades and enhances the information systems that support itsoperations.  On October 1, 1998,Cobalt entered into an agreement with a service bureau to obtain certainelectronic data processing services. The agreement had an initial term of five years, with options for twoadditional one-year renewal periods, which Cobalt has agreed to extend.

 

***Specialty ManagedCare Products and Services***

 

In the last few years, Cobalt has focused on growing the specialtyproducts and services it offers.  Suchproducts and services include HMO and indemnity dental coverage, life,disability and other products, managed care workers’ compensation, costcontainment, health care electronic data interchange, pharmaceuticalmanagement, managed care consulting, receivables management and other medicalbenefits.  Such specialty products aresold through a variety of methods, including brokers, agents and an in-housesales force.  For additional informationon Cobalt’s specialty managed care products, see Management’s Discussion andAnalysis and Note 18, “Segment Reporting” of this annual report on Form10-K.

 

**Dental HMO and Indemnity Coverage**

 

Cobalt is one of the largest providers of dental coverage inWisconsin.  Dental HMO coverage isoffered through Compcare, and dental indemnity coverage is offered throughBCBSUW.  These dental HMO and indemnitybenefit products are currently marketed under the DentalBlue® brand name.

 

For the dental HMO business, Compcare contracts with dental practicesthroughout Wisconsin on both a capitated and discounted fee schedule basis,with members receiving care through their selected dental centers.  The dental HMO provider network had 414dental providers as of December 31, 2001. Additionally, Compcare offers dental POS and out-of-area indemnityproducts.  Indemnity benefits for thePOS and out-of-area indemnity products are underwritten by the Company'saffiliate, United Wisconsin Insurance Company (“UWIC”).

 

BCBSUW offers indemnity, PPO, and self-funded plans.  The indemnity and self-funded plans areadministered through a participating network that includes over 1,200 dentistsas of December 31, 2001.  PPO benefitsare provided through a network of 928 dentists as of December 31, 2001.  Providers within both the indemnity and PPOnetworks are reimbursed on a discounted fee-for-service basis.

 

 

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The dental business offered through BCBSUW and Compcare is marketedunder the DentalBlue name to take advantage of the Blue brand.  DentalBlue products compete with otherregional and national HMO, PPO, and indemnity plans.  The DentalBlue products offer varying benefit options forPreventive, Basic, and Major services. Premium revenues for the dental HMO, POS and out-of-area indemnityproducts offered by Compcare amounted to $33.2 million for the twelve monthsended December 31, 2001, with membership of 172,006 as of December 31,2001.  Premium revenues for the BCBSUWindemnity and PPO products totaled $26.8 million for the twelve months endedDecember 31, 2001, with membership of 131,974 as of December 31, 2001.  Membership for the self-funded plans totaled37,975 as of December 31, 2001.

 

**Life, Disability and Other**

 

Cobalt offers group term life and accidental death and dismemberment(“AD&D”) coverages as well as dependent life and accelerated deathbenefits.  Short and long-termdisability products have been designed to provide income replacement for anemployee who becomes disabled through a non-work related situation.  As of December 31, 2001, Cobalt had atotal of 275,495 life and disability certificates.  Net insured premium revenue related to life and disabilityproducts was $49.0 million for the twelve months ended December 31,2001.  Certain life and disabilityproducts are underwritten by United Wisconsin Life Insurance Company (“UWLIC”),a wholly owned subsidiary of American Medical Security Group, Inc. (“AMSG”),and ceded to United Heartland Life Insurance Company (“UHLIC”), a wholly-ownedsubsidiary of Cobalt which is licensed in nine states and has applicationspending in two additional states.  UWLICis licensed to do business in 40 states and the District of Columbia. UWIC, awholly owned subsidiary of Cobalt which sells disability products, is licensedin 36 states and the District of Columbia. Cobalt competes with national providers of group life and disabilitycoverage.

 

**Managed Care Workers’ Compensation**

 

Through United Heartland, Inc. (“UHI”), a wholly owned subsidiaryof Cobalt, Cobalt applies managed care techniques to the workers’ compensationmarket in Wisconsin.  The workers’compensation coverage sold through UHI is underwritten by UWIC in those stateswhere UWIC is licensed to provide such coverage .  Health services revenue attributable to UHI approximated$28.3 million for the twelve months ended December 31, 2001.  Cobalt retained 80% of the workers’compensation risk for the period of January 1, 2001 through June 30, 2001 and65% for the period of July 1, 2001 through December 31, 2001, ceding the other20% and 35%, respectively to a reinsurer. The workers’ compensation market, both nationally and in Wisconsin, isextremely competitive.  Competition hasprimarily come from the large, national multi-line property and casualtyinsurance companies.

 

Cobalt believes the key elements to success in the workers’compensation insurance business are service to employers and control of workers’compensation costs through comprehensive loss control and claims managementprocedures.  As part of its underwritingprocess, UHI performs a loss control review of each prospective insured priorto making a commitment to provide coverage. It also examines the employer’s commitment to developing or improvinglight duty/return to work programs, safety awareness programs, supervisortraining in accident investigation and enforcement of safety in theworkplace.  UHI also reviews thefinancial resources of the employers to verify an ability to follow through onany commitments made that may require a capital expenditure.

 

 

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UHI utilizes medical management resources to assist in the adjustmentof its claims, which include: (i) access to Cobalt’s usual and customarycharges database; (ii) the PPO network established by Cobalt for UHIclients; and (iii) access to the hospital bill audit and medical staff ofCobalt as needed in claims handling. Cobalt believes this managed care capability, combined with a commitmentto communicating with employers, employees and medical providers, assists UHIin monitoring the major cost factors of workers’ compensation claims.  Cost savings have been demonstrated asevidenced by the fact that UHI’s customers have experienced an average claimcost that was 29% lower than the industry average in Wisconsin.

 

In 1999, the Company formed a joint venture with Health Care ServiceCorporation ("HCSC"), a mutual legal reserve company doing businessas Blue Cross Blue Shield of Illinois to manage and sell workers’ compensationbusiness through a new managing general agency, United Heartland Illinois.  All new workers’ compensation business soldunder the joint venture and that renewed from HCSC’s prior workers’compensation insurance company, Third Coast Insurance Company, is being insuredby UWIC.  During 2001, Cobalt retained40% of the workers’ compensation risk associated with the Illinois block ofbusiness and ceded the other 60% to reinsurers.  Profits and losses incurred by the United Heartland Illinoisjoint venture are being shared equally with HCSC.  For the twelve months ended December 31, 2001, UWIC recordedearned premiums from the joint venture of $6.0 million.  The joint venture capitalizes on UHI’sexpertise in applying managed care techniques to workers’ compensationbusiness.

 

**Cost Containment Services**

 

Meridian Resource Company, LLC (“MRC”), a wholly-owned subsidiary ofCobalt, specializes in providing cost containment services to insurancecompanies, third party administrators, HMO’s, employers, providers, governmentagencies, coalitions and other organizations to assist them in reducing theirexpenses and provide more cost effective health care delivery.  Cost containment services include hospitalbill audit, provider discount network repricing, negotiations, DRG validation,claims administration audit, subrogation and recovery, electronic audit,collection and fraud investigation and recovery services.  Cobalt’s insurance subsidiaries utilize MRCfor cost containment services.  MRCcompetes against other stand-alone companies that provide similar costreduction strategies and other large insurance companies that provide theseservices.  Revenue from cost containmentservices totaled $10.5 million for the twelve months ended December 31, 2001.

 

**Health Care Electronic Data Interchange(“EDI”) Services**

 

United Wisconsin Proservices, Inc. (“Proservices”) providessoftware and claim submission services and has created the largestprovider/insurer network for such services in Wisconsin, extending to over 250hospitals and clinics in Wisconsin and over 210 home health agenciesnationwide.  Proservices electronicallytransmits more than 13 million medical claims and other health care transactionsannually for such clients as Medicare, Medicaid, private insurers, third partyadministrators and re-pricers. Proservices competes with other hospital software vendors and nationalsuppliers of electronic claims processing. Revenue from EDI services totaled $4.5 million for the twelve monthsended December 31, 2001.

 

**Managed Care Consulting**

 

IRG provides clients with a broad array of coordinated care managementservices.  The primary products includemedical utilization management and large case management, disease management,employee assistance programs, behavioral health management, integratedbehavioral health and employee assistance programs, behavioral health networksand claims administration, disability and workers’ compensation casemanagement, prenatal education programs, pharmacy management services and drugrebate programs, and health care consulting and data analysis.  IRG’s customers include self-funded employergroups, insurance companies, reinsurance companies, third party administratorsand governmental agencies.  Revenuesfrom behavioral health and managed care consulting services totaled $46.9million, for the twelve months ended December 31, 2001.  

 

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**Receivables Management**

 

Comprehensive Receivables Group, Inc. (“CRG”), is a health carereceivables management firm based in Michigan serving health care providers inthe Midwest and Southeast and insurance providers on a national level.  CRG provides collections and receivablesmanagement services to hospitals and other commercial clients.  Receivables management services providedwithin the health care industry represents 98% of CRG’s total revenues of $6.1million for the twelve months ended December 31, 2001.

 

***Government Programs***

 

UGS’ primary business is providing healthcare program administrationand payment safeguard services for the Centers for Medicare & MedicaidServices’ (“CMS”) Medicare program.  Inconnection with providing these services, UGS serves as the Medicare Part AIntermediary for California, Hawaii, Michigan, Nevada, Virginia, West Virginia,Wisconsin, American Samoa, Guam and the Northern Mariana Islands.  In addition, UGS serves as the Regional HomeHealth Intermediary for Alaska, Arizona, California, Hawaii, Idaho, Michigan,Minnesota, Nevada, New Jersey, New York, Oregon, Washington, Wisconsin, Guam,Puerto, Rico, and the United States Virgin Islands.  UGS also serves as the national Intermediary for the FederallyQualified Health Centers in all 50 states. Finally, through its Indefinite Delivery-Indefinite Quantity contract,UGS is a Program Safeguard Contractor eligible to provide fraud and abusedetection and prevention services to the Medicare program.

 

In addition to providing services to the Medicare program, UGS alsoprovides claim processing and administrative services in conjunction with theWisconsin Medicaid program and the Health Insurance Risk Sharing Plan.  UGS provides these services through asubcontract with Electronic Data Services, Inc.

 

UGS plans tocontinue to grow as a Medicare and Medicaid contractor by bidding, eitherindependently or through joint venture arrangements, on Medicare and Medicaidcontracts in other states as they become available.  UGS processed 47.1 million claims during 2001.  Revenues related to administrative fees forthese services amounted to $117.2 million for the year ended December 31, 2001.

 

**Competition**

 

The managedcare industry is highly competitive. During the past few years, the managed care industry in Wisconsin andthe upper Midwest has experienced consolidation.  Cobalt believes the principal competitive features affecting itsability to retain and increase its managed care membership include the choiceand flexibility of benefit plans offered, comprehensive access to local,national and international provider networks, quality of service (includingonline customer service),  and marketpresence and reputation.  AlthoughCobalt is a leading provider of managed care services in Wisconsin, Cobalt mayexperience increased competition in the future.  Many of Cobalt’s competitors are larger, have considerablygreater financial resources and distribution capabilities and offer morediversified types of insurance coverage than Cobalt.  Cobalt’s key competitors include Humana, Inc., UnitedHealthcare,Dean Health Plan, Physicians Plus and Wisconsin Physician Service.

 

IRG’scompetition in behavioral health care and medical management services includeproviders such as Magellan Heath Services, Cigna and United Behavioral Heath,as well as other smaller regional providers.

 

Competitionfor life, disability and workers’ compensation products comes from a variety oflarge national insurers such as Liberty Mutual and Unum as well as smallerregionally focused insurers.

 

UGS’ primarycompetitors in the Medicare arena are other Blue Plans, commercial insurancecompanies, and Program Safeguard Contractors. UGS, like its competitors, continues to pursue growth individually andthrough joint venture and/or strategic partnering arrangements.

 

 

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**Reinsurance**

 

Cobalt managesits risks through the use of reinsurance. Cobalt maintains in force both “quota share” and “excess of loss”reinsurance treaties.  Quota sharereinsurance is a contractual arrangement whereby the reinsurer assumes anagreed percentage of certain risks insured by the ceding insurer and sharespremium revenue and losses proportionately. Cobalt’s quota share reinsurance treaties allocate the total amount ofbusiness subject to the treaties between Cobalt and the respective parties tothe treaties.  Through quota sharereinsurance, UHLIC assumes 100% of certain life coverages underwritten byUWLIC.  Approximately 20% in the firsthalf of 2001 and 35% in the second half of 2001 of Cobalt’s Wisconsin and Iowaworkers’ compensation business and 60% of Cobalt’s Illinois workers’compensation business during 2001 was ceded to non-affiliated reinsurers.

 

Excess of lossreinsurance is used to limit the amount of loss retained by Cobalt onindividual claims or a series of claims. Excess of loss reinsurance is purchased on insured medical business withlimits that vary by HMO and for BCBSUW and range from $150,000 to $500,000 permember per year.  Cobalt limits itsretention per claim to $75,000 on its life business and on disability claimsincurred prior to October 1, 2001.  Itlimits its long term disability exposure to a $3,500 monthly benefit on claimsincurred on or after October 1, 2001. For workers’ compensation claims, Cobalt retains the first $250,000 of aloss, which it shares with its quota share reinsurer, and cedes losses above$250,000 on an individual excess of loss basis to third–partyreinsurers.  Reinsurance arrangements donot discharge the original insurer from its primary liability to policyholders,in the event of the failure of the reinsurer. All reinsurers with which Cobalt contracts are rated “A-” (Excellent) orbetter by A.M. Best.

 

**Investments**

 

Cobaltattempts to minimize its business risk through conservative investmentpolicies.  Investment guidelines setquality, concentration and return parameters. Cobalt’s investment guidelines permit investments in various types ofliquid assets, including U.S.  Treasuryobligations, securities of various Federal agencies, and other assets includinginvestment grade corporate debt securities, municipal securities, asset–backedsecurities, mortgage-backed securities and short-term fixed incomesecurities.  The minimum average ratingof the fixed income portfolio must be “A” or better, based on ratings ofStandard & Poor’s Corporation or another nationally recognizedsecurities rating organization.  Cobaltinvests in securities authorized by applicable state laws and regulations andfollows investment policies designed to maximize yield, preserve principal andprovide liquidity.  Cobalt’s portfoliocontains no investments in mortgage loans or non-publicly traded securities,except for investments in affiliates. At December 31, 2001, $57.4 million of Cobalt’s investmentportfolio was invested in investment-grade mortgage-backed securities.

 

With theexception of short-term investments and securities on deposit with variousstate regulators, investment responsibilities have been delegated to externalinvestment managers.  Such investmentresponsibilities, however, must be carried out within the investment parametersestablished by Cobalt, which may be amended from time to time.

 

Securitieswhich may be sold prior to maturity to support Cobalt’s investment strategies,such as in response to changes in interest rates, the yield curve concentrationor sector concentration, are classified as available-for-sale and are stated atfair value with unrealized gains and losses reported as a component ofshareholders’ equity.  Securities forwhich Cobalt has both the positive intent and ability to hold to maturity arerecorded at amortized cost.  Bonds thatare held to meet deposit requirements of the various states are classified asheld-to-maturity.

 

 

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**Regulation**

 

***General***

 

Governmentregulation of employee benefit plans, including health care coverage, healthplans and Cobalt’s specialty managed care products, is a changing area of lawthat varies from jurisdiction to jurisdiction and generally gives responsibleadministrative agencies broad discretion. Cobalt believes that it is in compliance in all material respects withthe various federal and state regulations applicable to its currentoperations.  To maintain suchcompliance, it may be necessary for Cobalt or a subsidiary to make changes fromtime to time in its services, products, structure or operations.  Additional government regulation or futureinterpretation of existing regulations could increase the cost of Cobalt’scompliance or otherwise affect Cobalt’s operations, products, profitability orbusiness prospects.

 

Federallegislation has significantly expanded regulation of group health plans andhealth care coverage.  The laws placerestrictions on the use of pre-existing conditions and eligibility restrictionsbased upon health status and prohibit cancellation of coverage due to claimsexperience or health status.  Federalregulations also prohibit insurance companies from declining coverage to smallemployers.  Additional federal laws,which took effect in 1998, include prohibitions against separate, lower dollarmaximums for mental health benefits and requirements relating to minimumcoverage for maternity inpatient hospitalization.  Cobalt does not anticipate that these laws will affect itscomparable profitability or business prospects because all insurance companiesacross the country are subject to the same requirements.

 

Furthermore,many requirements of the federal legislation are similar to small group reformsthat have been in place for many years. Cobalt will be able to utilize and expand upon the cost control measuresinitiated as a result of small group legislative reform.

 

Increasingly,states are considering various health care reform measures which, if passed,may limit the ability of Cobalt and its health plans to control which providersare part of their networks and hinder their ability to manage utilization andcost effectively.  “Patient Protection”laws, which became effective in Wisconsin in late 1998, established a prudentlayperson standard for coverage of emergency room care and provided extendedaccess to providers who are no longer part of the plan’s network.  A number of other states are consideringsimilar legislation.  While this couldaffect Cobalt’s operations in those states, comparable profitability andbusiness prospects should not be impacted because competing insurance companieswould be subject to the same legislation.

 

***HIPAA***

 

The federalHealth Insurance Portability and Accountability Act of 1996 (“HIPAA”) containedprovisions requiring mandatory standardization of certain communicationsbetween health plans, electronic clearinghouses and providers who submitcertain health information electronically. HIPAA requires health plans to use specific date content standards,mandates the use of specific identifiers (e.g., national provider identifiersand national employer identifiers) and requires specific privacy and security procedures.  Final regulations pertaining to data contentstandards were published on August 17, 2000. Although the new regulations will have a significant impact on Cobalt, theimpact will be no greater than the impact the regulations will have on other insurancecompanies across the country.  Finalregulations on the privacy of health information were released and werepublished on December 28, 2000.  Finalregulations on security have not yet been issued.  Impacted companies must comply with that portion of theregulations relating to privacy by April 14, 2003.  The deadline for complying with that portion of the regulationsrelating to data content standards has recently been extended to October 16,2003, provided the health plan submits a compliance plan to the Department ofHealth and Human Services by October 16, 2002.

 

 

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***HMOs***

 

Wisconsin hasenacted statutes regulating the activities of HMOs.  This regulation provides for periodic financial reports from HMOsand imposes minimum capital or reserve requirements.  In addition, certain of Cobalt’s subsidiaries are required bystate regulatory agencies to maintain restricted cash reserves represented byinterest-bearing instruments which are held by trustees or state regulatoryagencies to ensure that adequate financial resources are maintained or to actas a fund for insolvencies of other HMOs in the state.

 

As a federallyqualified HMO, Compcare must file periodic reports with, and is subject toperiodic review by, the Centers for Medicare and Medicaid Services.

 

Cobalt’s HMOswhich have Medicaid contracts are subject to both federal and state regulationregarding services to be provided to Medicaid enrollees, payment for thoseservices and other aspects of the Medicaid program.  Medicaid has in force and/or has proposed regulations relating tofraud and abuse, physician incentive plans and provider referrals, which mayaffect Cobalt’s operations.

 

Cobaltcontracts with the Federal Employees Health Benefit Plan (“FEHBP”).  This contract is subject to extensiveregulation, including complex rules relating to the premiums charged.  FEHBP has the authority to retroactivelyaudit the rates charged and may seek premium refunds and other sanctionsagainst health plans participating in the program.  Cobalt’s health plans that currently contract, or have contractedin past years with FEHBP, are subject to such audits and may be requested tomake such refunds.  Given Cobalt’sparticipation in this federal program, and other federal health care programs,Cobalt has implemented, and places great importance upon, an effectivecompliance program.

 

***Risk-Based CapitalRequirements***

 

Cobalt issubject to risk-based capital (“RBC”) requirements promulgated by the NationalAssociation of Insurance Commissioners (“NAIC”) for property and casualty, lifeand health insurance companies.  Theformula for calculating such risk-based capital requirements, set forth in theinstructions adopted by the NAIC, is designed to take into account asset risks,insurance risks, interest rate risks and other relevant risks with respect tothe individual insurance company’s business. Under these laws, property and casualty, life and health insurancecompanies and health maintenance organizations must submit a report of theirrisk-based capital level as of the end of the previous calendar year.  In addition, the BCA requires certain Cobaltinsurance subsidiaries to meet more stringent RBC requirements than thoserequired under the NAIC and OCI guidelines.

 

As ofDecember 31, 2001, each of Cobalt’s insurance subsidiaries' total adjustedcapital exceeded their minimum regulatory and licensure requirements of theNAIC and the BCA.  During 2001, the BCAhas included Cobalt, BCBSUW and Compcare in its Plan Performance ResponseMonitoring Process (“PPRMP”) as a result of the financial performance ofCobalt.  As a result, the BCA hasrequested that Cobalt regularly submit additional interim financial informationto the BCA.  In addition, the PPRMPmonitoring thresholds require that Cobalt maintain a prescribed level ofescrowed assets as a financial guarantee for its transactions with other BlueCross plans.  The PPRMP monitoringprocess also requires that Cobalt provide certain notices to the BCA regardingits transactions with other Blue Cross plans. Cobalt will not be required to submit such interim financial informationand maintain any escrowed assets when its statutory capital improves above theprescribed monitoring threshold.

 

To maintainits BCA licenses, Cobalt is required to maintain a minimum level of statutorycapital and surplus.  As ofDecember 31, 2001, BCBSUW and Compcare exceeded the minimum standard tomaintain its license by $15.8 million and $7.2 million, respectively.  The BCA is entitled to terminate Cobalt’license agreement with the BCA, including the right to use the Blue Cross® andBlue Shield® trademarks, if Cobalt falls below the minimum level of statutorycapital and surplus.

 

As of December31, 2001, approximately $17.0 million of invested assets are maintained underan escrow agreement with the BCA.

 

 

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***Insurance Regulation***

 

Cobalt’sinsurance subsidiaries are subject to regulation by the Department of Insurancein each state in which the entity is licensed. Regulatory authorities exercise extensive supervisory power over insurancecompanies relating to the licensing of insurance companies; the amount ofcapital which must be maintained; the approval of forms and insurance policiesused; the nature of, and limitation on, an insurance company’s investments;periodic examination of the operations of insurance companies; the form andcontent of annual statements and other reports required to be filed on thefinancial condition of insurance companies; and the establishment of capitalrequirements for insurance companies. Cobalt’s insurance company subsidiaries are required to file periodicstatutory financial statements in each jurisdiction in which they arelicensed.  Additionally, such companiesare examined periodically by the insurance departments of the jurisdiction inwhich they are licensed to do business.

 

Cobaltactively markets insurance products to Medicare eligible individuals.  Medicare supplement (or Medigap) policiesare regulated by the OCI and the subject of increasing regulation at the statelevel, as well as additional legislation at the federal level.  Cobalt continues to monitor and alterprocedures to comply with new laws and regulations.  During 2001, Cobalt was subject to regulation by CMS by virtue ofits participation in the Medicare+Choice program.  Cobalt exited this program effective January 1, 2002.

 

UnderWisconsin law, insurance companies must provide the OCI with advance notice ofany dividend that is more than 15% larger than any dividend for thecorresponding period of the previous year. In addition, the OCI may disapprove any “extraordinary” dividend,defined as any dividend which, together with other dividends paid by aninsurance company in the prior twelve months, exceeds the lesser of:(i) 10% of statutory capital and surplus as of the preceding December 31;(ii) with respect to a life insurer, net income less realized gains forthe calendar year preceding the date of the dividend; or (iii) withrespect to a non-life insurer, the greater of (A)(ii) above or (B) theaggregate net income less realized gains for the three calendar years precedingthe date of the dividend less distributions made within the first two of thosethree years. There are no dividend payments available from insurancesubsidiaries for 2002 to Cobalt without OCI approval.

 

***Insurance HoldingCompany Regulations***

 

Cobalt is aholding company that conducts all of its business through combined entities andis subject to insurance holding company laws and regulations.  Under Wisconsin law, acquisition of controlof Cobalt, and thereby indirect control of its insurance subsidiaries, requiresthe prior approval of the OCI. “Control” is defined as the direct or indirect power to direct or causethe direction of the management and policies of a person.  Any purchaser of 10% or more of the outstandingvoting stock of a corporation is presumed to have acquired control of thecorporation and its subsidiaries unless the OCI, upon application, determinesotherwise.

 

Cobalt issubject to regulation under state insurance holding company regulations.  Such insurance holding company laws andregulations generally require registration with that state’s department ofinsurance and the filing of certain reports describing capital structure,ownership, financial condition, certain intercompany transactions and generalbusiness operations.  Various notice andreporting requirements generally apply to transactions between companies withinan insurance holding company system, depending on the size and nature of thetransactions.  Certain state insuranceholding company laws and regulations require prior regulatory approval or, incertain circumstances, prior notice, of certain material intercompany transfersof assets as well as certain transactions between the regulated companies,their parent holding companies and affiliates, and acquisitions.

 

 

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***UtilizationReview Regulations***

 

A number ofstates have enacted laws and/or adopted regulations governing the provision ofutilization review activities. Generally, these laws and regulations require compliance with specificstandards for the delivery of services, confidentiality, staffing, and policiesand procedures of private review entities, including the credentials requiredof personnel.  Some of these laws andregulations may affect certain operations of Cobalt’s business units.  A few jurisdictions have enacted laws whichhold managed care organizations liable for damages resulting from wrongfuldenial of care or payment for care. Cobalt provides utilization review services through IRG in at least onestate that has passed such legislation. The liability law encompasses entities that do not provide insurancecoverage, but merely provide utilization review services.  IRG has developed risk management proceduresand believes that it will be able to minimize potential liability for coveragedecisions.

 

***ERISA***

 

The provisionof goods and services to or through certain types of employee health benefitplans is subject to ERISA.  ERISA is acomplex set of laws and regulations that are subject to periodic interpretationby the federal courts and the United States Department of Labor.  ERISA places certain controls on howCobalt’s business units may do business with employers covered by ERISA,particularly employers that maintain self-funded plans.  The Department of Labor is charged with theenforcement of ERISA and has promulgated new regulations which will expand theclaim review process.  Given that thecurrent state insurance law governing health insurers contains stringent claimappeal process requirements, Cobalt does not anticipate that the rules willsignificantly impact Cobalt’s operations. There have been continued legislative attempts to limit ERISA’spreemptive effect on state laws.  Ifsuch limitations were to be enacted, they might increase Cobalt’s liabilityexposure under state law-based suits relating to employee health benefitsoffered by Cobalt’s health plans and specialty businesses and may permitgreater state regulation of other aspects of those businesses’ operations.

 

**Employees**

 

As ofDecember 31, 2001, Cobalt employed 3,454 full-time and 145 part-timeemployees, of whom 479 were managerial and supervisory personnel.  In addition, Cobalt leases the services of68 people who manage and operate one of its subsidiaries.  Cobalt considers its relations with itsemployees to be good.

 

**Trademarks**

 

Compcare® is afederally registered service mark of Cobalt. Blue Cross® is a federally registered service mark of the BCA.  Cobalt has filed for and maintains variousother service marks and trade names at the federal level and in Wisconsin.  Although Cobalt considers its registeredservice marks, trademarks and trade names important in the operation of itsbusiness, the business of Cobalt is not dependent on any individual servicemark, trademark or trade name.  Compcareand BCBSUW use the Blue Cross® and Blue Shield® trademarks in its business,pursuant to a license agreement with the BCA as a controlled affiliate ofCobalt.  Termination of this license mayhave a material adverse effect on the Company.

 

 

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**ITEM 2. Properties**

 

Cobaltoccupies common facilities with its subsidiaries and is charged a proportionateshare of the cost of such facilities under service agreements.  Cobalt’s corporate headquarters are locatedin Milwaukee, Wisconsin in a 235,000 square foot building leased byCobalt.  In addition, Cobalt business issold and serviced in four Wisconsin regional offices located in Eau Claire,Fond du Lac, Evansville and Oshkosh in 83,000 combined leased square feet.  Cobalt also leases and occupies approximately48,500 square feet of office space in Waukesha, Wisconsin, approximately 45,000square feet in New Berlin, Wisconsin, approximately 36,750 square feet in WestAllis, Wisconsin, approximately 22,600 square feet in Platteville, Wisconsin,approximately 21,000 square feet in Stevens Point, Wisconsin, approximately15,300 square feet in Brookfield, Wisconsin, approximately 9,900 square feet inPewaukee, Wisconsin, approximately 5,500 square feet in Madison, Wisconsin andother locations individually under 5,000 square feet.  Cobalt also owns and occupies a 61,000 square foot facility inPewaukee, Wisconsin and a 40,000 square foot facility in Sauk City, Wisconsin.

 

Cobalt alsoleases and occupies approximately 63,000 square feet in three locations inCalifornia, approximately 33,000 square feet in four locations in Virginia andWest Virginia, approximately 30,200 square feet in five locations in Illinois,approximately 22,000 square feet in six locations in Michigan, approximately14,400 square feet in Houston, Texas and other locations individually under5,000 square feet.

 

In addition,in conjunction with Cobalt’s acquisition of the insurance operations of FamilyHealth Plan Cooperative, Inc. in November 2000, Cobalt assumed a 10-year leasefor a 60,000 square-foot facility in Brookfield, Wisconsin.  Cobalt intends to sub-lease this facility.

 

**ITEM3.  Legal Proceedings**

 

Cobalt iscurrently, and is from time to time, subject to claims and suits arising in theordinary course of its business. Although the results of litigation proceedings cannot be predicted withcertainty, Cobalt believes that the ultimate resolution of all currentproceedings will not have a material adverse effect on its financial conditionor results of operations.

 

**ITEM 4. Submission of Matters to a Vote of Security Holders**

 

No matterswere submitted to a vote of security holders during the fourth quarter of 2001.

 

 

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**ITEM 4a:  Executive Officers of Cobalt**

 

Prior to September 25, 1998, UWS was a Wisconsin corporation that includedthe operations of what is now Cobalt as well as the operations of AMSG.  United Wisconsin Services, Inc. prior tosuch date is referred to herein as the “Predecessor”.  Cobalt was organized in May of 1998 for the purpose of owning andoperating the managed care companies and specialty business of thePredecessor.  On May 27, 1998, the boardof directors of the Predecessor approved a formal plan to contribute themanaged care companies and specialty business to Cobalt and spin off Cobalt toits shareholders (the “spin-off”).  OnSeptember 25, 1998, upon  its formationin connection with the spin-off, Cobalt was originally named Newco/UWS,Inc.  It was subsequently renamed UnitedWisconsin Services, Inc. following the spin-off, and was again renamed CobaltCorporation in 2001.  The Predecessorwas renamed American Medical Security Group, Inc. in connection with thespin-off.

 

The name, age, title and business background of each of the executiveofficers of Cobalt are set forth below. The business address of each of the executive officers is 401 WestMichigan Street, Milwaukee, Wisconsin 53203.

 

As of February 28, 2002, the executive officers of Cobalt are asfollows:

 

| **Name**             |   | **Age** |   | **Title**                                                     |
|----------------------|--------|---------|--------|---------------------------------------------------------------|
| Thomas  R. Hefty     |   | 54      |   | Chairman  of the Board, President, Chief Executive Officer    |
| Stephen E. Bablitch  |   | 48      |   | Senior Vice President, General Counsel and  Secretary         |
| Michael E. Bernstein |   | 41      |   | Senior Vice President; and President of  Compcare             |
| Timothy F. Cullen    |   | 58      |   | Vice President, Chairman of UGS                               |
| Gail L. Hanson       |   | 46      |   | Senior Vice President, Treasurer and Chief  Financial Officer |
| James E. Hartert     |   | 47      |   | Vice President; and President of IRG                          |
| Catherine S. Harvey  |   | 39      |   | Senior Vice President                                         |
| Michael J. Murray    |   | 42      |   | Vice President and Chief Actuary                              |
| Kathryn K. Potos     |   | 50      |   | Vice President                                                |
| Penny J. Siewert     |   | 44      |   | Senior Vice President of Regional Services                    |
| Mary I. Traver       |   | 51      |   | Vice President                                                |

 

Officers areelected to serve, subject to the discretion of the Board of Directors, untiltheir successors are appointed.  Thereare no family relationships among any of the directors and/or executiveofficers of Cobalt.

 

**ThomasR. Hefty** is theChairman of the Board, President and Chief Executive Officer of Cobalt.  Mr. Hefty was elected President of thePredecessor in 1986 and Chairman of the Board and Chief Executive Officer ofthe Predecessor in 1991.  Since 1982, hehas served in various capacities with subsidiaries of the Predecessor andCobalt.  Mr. Hefty has beenChairman of the Board and a director of BCBSUW since 1986, having joined BCBSUWin 1982 and later serving as President. From 1979 to 1982, Mr. Hefty was Deputy Insurance Commissioner forthe Office of the Commissioner of Insurance for the State of Wisconsin.

 

**StephenE. Bablitch** isSenior Vice President, General Counsel and Secretary of Cobalt.  Mr. Bablitch joined the Predecessor in1996 as General Counsel, Vice President and Secretary.  He was elected Senior Vice President ofCobalt in May of 2001.  He has served invarious capacities with subsidiaries of the Predecessor and Cobalt since1996.  Mr. Bablitch has been Senior VicePresident of BCBSUW since December of 2000. He has also been General Counsel and Secretary of BCBSUW since1996.  Prior to being elected Senior VicePresident of BCBSUW, Mr. Bablitch served as Vice President since 1996.  Prior to joining the Predecessor and BCBSUW,Mr. Bablitch was an attorney with Dewitt, Ross and Stevens, Madison,Wisconsin from 1991 to 1996.

 

 

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**Michael E. Bernstein**is Senior Vice President of Cobalt.  Mr.Bernstein was elected a Senior Vice President in February of 2000.   He was elected President of Compcare inJuly of 2001. He has served in various capacities with Cobalt’s subsidiariessince 2000.   Mr. Bernstein was electedSenior Vice President of BCBSUW in March of 2000.  Prior to joining Cobalt and BCBSUW, Mr. Bernstein served asExecutive Vice President for the University of Wisconsin Medical Foundation inMadison, Wisconsin from 1998 through 1999.  From 1996 to 1998, Mr. Bernstein was Senior Vice President at UniversityHealth Care, Inc., Madison, Wisconsin.

 

**Timothy F. Cullen** isVice President of Cobalt.  Mr. Cullenwas elected a Vice President in May of 2001. He was elected president and chief operating officer of the governmentprograms division of BCBSUW in 1991, and he has been employed as chairman ofUGS since January of 1999.  Mr. Cullenhas served in various capacities with subsidiaries of the Predecessor andCobalt since 1988.  Prior to joiningCobalt and BCBSUW, he was secretary of health and social services for the Stateof Wisconsin from 1987 to 1988.  From1974 to 1986, Mr. Cullen was employed by the State of Wisconsin as a statesenator and served three terms as senate majority leader.

 

**GailL. Hanson** is SeniorVice President, Treasurer and Chief Financial Officer of Cobalt. Ms. Hansonwas Treasurer of the Predecessor since 1987 and has been Treasurer of Cobaltsince its formation in 1998.  She waselected a Vice President of the Predecessor in 1996.  Ms. Hanson was named Chief Financial Officer of Cobalt effectiveAugust 1, 1999.  She was elected SeniorVice President in May of 2001. Ms. Hanson has also served in various capacitieswith subsidiaries of the Predecessor and Cobalt since 1984.   Ms. Hanson has been Senior VicePresident of BCBSUW since December of2000; and Treasurer since 1987.  Ms.Hanson had been Vice President of BCBSUW since 1996, Chief Financial Officersince 1999 and Assistant Vice President since 1987, having joined BCBSUW in1984 as the Controller of UWIC.

 

**JamesE. Hartert, M.D.**isVice President of Cobalt.  Dr. Hartertwas elected a Vice President in May of 1999. He was elected President of IRG in July of 1999.   He has also served in various capacitieswith subsidiaries of the Predecessor and Cobalt since 1996. Prior to joiningCobalt, Dr. Hartert was employed by Humana Health Care Plans in Louisville,Kentucky, as Chief Medical Officer for the Kentucky market from 1994 to 1996.

 

**Catherine S. Harvey**is Senior Vice President of Cobalt.  Ms. Harvey was elected a Senior Vice President in February of 2000.   Ms. Harvey was elected Senior VicePresident of BCBSUW in March of 2000. Prior to joining Cobalt and BCBSUW, Ms. Harvey was Vice President ofhealth services operations/delivery systems management at UnitedHealth Group inMinneapolis, Minnesota from 1997 to 1999. From 1995 to 1996, Ms. Harvey was employed with Towers Perrin IntegratedHealthsystems Consulting in Minneapolis, Minnesota as a senior consultant.

 

**Michael J. Murray** is Vice President and Chief Actuary ofCobalt.  Mr. Murray was elected a VicePresident in June of 2001 .   Prior tojoining Cobalt, Mr. Murray was Vice President and Chief Actuary of HealthNowNew York Inc. in Buffalo, New York, (d/b/a Blue Cross & Blue Shield ofWestern New York and Blue Shield of Northeastern New York) from 1996 to 2000.

 

**Kathryn K. Potos** is Vice President of Human Resources forCobalt.  Ms. Potos was elected as VicePresident in May of 2001 .   She hasserved in various capacities with subsidiaries of the Predecessor and Cobaltsince July of 2001.   Ms. Potos wasDirector of Human Resources of the Predecessor from 1996 to 1998, having joinedthe Predecessor in 1992 as a staff attorney.  Ms. Potos has been employed with BCBSUW since 1998 as a Regional VicePresident.

 

**PennyJ. Siewert** isSenior Vice President of Regional Services for Cobalt. Ms. Siewert waselected Vice President of Regional Services of the Predecessor in 1995 andSenior Vice President of Cobalt in May of 2001.  She has served in various capacities with subsidiaries of thePredecessor and Cobalt since 1994.  Ms. Siewert joined BCBSUW in 1977 and has served in variouscapacities.   Ms. Siewert waselected Vice President of Operations for BCBSUW in 1990, Vice President ofSpecial Markets in 1992, Vice President of Regional Services in 1995 and SeniorVice President in March of 1999.  

 

**Mary I. Traver**isVice President of Cobalt.   Ms. Traverwas elected Vice President of the Predecessor in 1988 .   Ms. Traver was Vice President and GeneralCounsel of the Predecessor from 1988 to 1996 and Secretary from 1992 to1996.   Ms. Traver was General Counselof BCBSUW from 1988 to 1996; Secretary of BCBSUW from 1992 to 1996; and a VicePresident of BCBSUW from 1988 to 2001.

 

 

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**PART II**

** **

**ITEM 5. Market For Registrant’s Common Equity.**

 

The Cobaltcommon stock is traded on the New York Stock Exchange ("NYSE") underthe symbol “CBZ” .   The following tablesets forth the per share high and low sale prices for the Cobalt common stockas reported on the New York Stock Exchange for the periods after theCombination and for the UWS common stock (NYSE: UWZ) for all periods prior tothe Combination, along with the cash dividends paid per share for thoseperiods, respectively.

 
|                              |   | **High** |   | **Low** |   | **Cash  Dividends Paid** |
|-----------------------------------|--------|----------|--------|---------|--------|--------------------------|
| **Year ended December 31, 2001:** |   |     |   |    |   |                     |
| First Quarter                     |   | $        | 7.99   |    | $      | 3.38                     |   | — |
| Second Quarter                    |   | 8.00     |   | 4.90    |   | —                   |
| Third Quarter                     |   | 9.05     |   | 4.37    |   | —                   |
| Fourth Quarter                    |   | 7.00     |   | 3.99    |   | —                   |
| **Year ended December 31, 2000:** |   |     |   |    |   |                     |
| First Quarter                     |   | $        | 6.31   |    | $      | 3.94                     |   | — |
| Second Quarter                    |   | 5.81     |   | 4.81    |   | —                   |
| Third Quarter                     |   | 6.00     |   | 4.63    |   | —                   |
| Fourth Quarter                    |   | 5.25     |   | 3.31    |   | $                        | 0.05 |
|                                   |        |          |        |         |        |                          |  |  |  |  |  |

 

As of February27, 2002, there were 212 shareholders of record of Common Stock.  Based on information obtained from Cobalt’sTransfer Agent and from participants in security position listings andotherwise, Cobalt has reason to believe there are more than 1,700 beneficialowners of shares of Common Stock.

 

 

----

 

**ITEM 6. Selected Consolidated Financial Data**

 

The followingselected financial data are derived from the consolidated financial statementsof Cobalt .   The data should be read inconjunction with Cobalt’s consolidated financial statements, the related notesthereto, “Management’s Discussion and Analysis of Financial Condition andResults of Operations” and other financial information included herein.

 
|                                                          |   | **Years  Ended December 31,**                                                                                                                                                                    |      |
|---------------------------------------------------------------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|-----------|
|                                                          |   | **2001**                                                                                                                                                                                         |      | **2000** |   | **1999** |   | **1998** |   | **1997** |   |
|                                                          |   | **(In  thousands, except share data)**                                                                                                                                                           | * *  |
| **Statement of Operations Data:**                             |   |                                                                                                                                                                                             |      |
| Revenues:                                                     |   |                                                                                                                                                                                             |      |   |   |   |   |   |   |   |   |
| Health services revenue:                                      |   |                                                                                                                                                                                             |      |   |   |   |   |   |   |   |   |
| Premium                                                       |   | $                                                                                                                                                                                                | 1,262,145 |   | $ | 538,080 |   | $ | 418,949 |   | $ | 361,965 |   | $ | 345,903 |   |
| Government contract fees                                      |   | 117,192                                                                                                                                                                                          |      | 70,305 |   | 52,259 |   | 31,667 |   | 23,333 |   |
| Other                                                         |   |                                  |      | 24,715 |   | 25,970 |   | 25,302 |   | 20,606 |   |
| Investment results                                            |   | 12,526                                                                                                                                                                                           |      | 9,583 |   | 18,510 |   | 13,501 |   | 18,347 |   |
| Total revenues                                                |   | 1,451,246                                                                                                                                                                                        |      | 642,683 |   | 515,688 |   | 432,435 |   | 408,189 |   |
| Expenses:                                                     |   |                                                                                                                                                                                             |      |   |   |   |   |   |   |   |   |
| Medical and other benefits                                    |   | 1,121,357                                                                                                                                                                                        |      | 497,822 |   | 376,814 |   | 297,885 |   | 297,979 |   |
| Selling, general, administrative and other                    |   | 323,377                                                                                                                                                                                          |      | 176,878 |   | 158,187 |   | 133,153 |   | 119,036 |   |
| Profit sharing on joint ventures                              |   | 510                                                                                                                                                                                              |      | — |   | — |   | — |   | — |   |
| Interest                                                      |   | 561                                                                                                                                                                                              |      | 300 |   | 553 |   | 115 |   | 215 |   |
| Amortization of goodwill                                      |   | 5,908                                                                                                                                                                                            |      | 622 |   | 191 |   | — |   | — |   |
| Total expenses                                                |   | 1,451,713                                                                                                                                                                                        |      | 675,622 |   | 535,745 |   | 431,153 |   | 417,230 |   |
| Operating income (loss)                                       |   | (467                                                                                                                                                                                             | )         | (32,939 | ) | (20,057 | ) | 1,282 |   | (9,041 | ) |
| Gain (loss) from investment in affiliates,  net of tax        |   | (22,724                                                                                                                                                                                          | )         | (6,526 | ) | (22,690 | ) | 3,991 |   | 6,857 |   |
| Pretax income (loss)                                          |   | (23,191                                                                                                                                                                                          | )         | (39,465 | ) | (42,747 | ) | 5,273 |   | (2,184 | ) |
| Income tax expense (benefit)                                  |   | (886                                                                                                                                                                                             | )         | 548 |   | — |   | (78 | ) | (2,785 | ) |
| Net income (loss)                                             |   | $                                                                                                                                                                                                | (22,305   | ) | $ | (40,013 | ) | $ | (42,747 | ) | $ | 5,351 |   | $ | 601 |   |
| Earnings (loss) per share: (1), (2)                           |   |                                                                                                                                                                                             |      |   |   |   |   |   |   |   |   |
| Basic and diluted                                             |   | $                                                                                                                                                                                                | (0.58     | ) | $ | (1.28 | ) | $ | (1.37 | ) | $ | 0.17 |   | $ | 0.02 |   |
| Weighted average shares outstanding:                          |   |                                                                                                                                                                                             |      |   |   |   |   |   |   |   |   |
| Basic and diluted (1), (2)                                    |   | 38,434,459                                                                                                                                                                                       |      | 31,313,390 |   | 31,313,390 |   | 31,313,390 |   | 31,313,390 |   |
| **Operating Statistics:**                                     |   |                                                                                                                                                                                             |      |   |   |   |   |   |   |   |   |
| Loss ratio (3)                                                |   | 88.8                                                                                                                                                                                             | %         | 92.5 | % | 89.9 | % | 82.3 | % | 86.1 | % |
| Selling, general, administrative and other  expense ratio (4) |   | 24.5                                                                                                                                                                                             | %         | 27.9 | % | 31.8 | % | 31.8 | % | 30.5 | % |
| Net income (loss) margin (5)                                  |   | (1.5%                                                                                                                                                                                            | )         | (6.2% | ) | (8.3% | ) | 1.2 | % | 0.1 | % |
|                                                               |        |                                                                                                                                                                                                  |           |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 
|                            |   | **December  31,**   |     |
|---------------------------------|--------|---------------------|----------|
|                            |   | **2001**            |     | **2000** |   | **1999** |   | **1998** |   | **1997** |   |
|                            |   | **(In  thousands)** | * * |
| **Balance Sheet Data:**         |   |                |     |   |   |   |   |   |   |   |   |
| Cash  and investments           |   | $                   | 243,617  |   | $ | 45,678 |   | $ | 57,383 |   | $ | 109,447 |   | $ | 104,261 |   |
| Total assets                    |   | 726,805             |     | 394,205 |   | 381,400 |   | 443,186 |   | 392,699 |   |
| Note receivable from affiliate  |   | —              |     | 70,000 |   | 70,000 |   | 70,000 |   | 70,000 |   |
| Total shareholders’ equity |   | 208,222             |     | 168,943 |   | 200,109 |   | 250,991 |   | 245,857 |   |
|                                 |        |                     |          |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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(1)                                  Whenthe Company reports a net loss, potentially dilutive securities are notincluded in the calculation of earnings per share (“EPS”) because theirinclusion would have an antidilutive effect.

(2)                                  The31,313,390 shares of Cobalt stock issued to the Foundation were used tocalculate EPS for all periods prior to the Combination.

(3)                                  Representsmedical and other benefits as a percentage of premium revenue.

(4)                                  Representsselling, general, administrative and other expenses as a percentage of healthservices revenue.

(5)                                  Representsnet income (loss) as a percentage of total revenues.

 

 

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**ITEM 7. Management’s Discussion and Analysis of Financial Condition and Resultsof Operations**

 

**Overview**

 

CobaltCorporation (“Cobalt” or the “Company”) (formerly known as United WisconsinServices, Inc. (“UWS”)) was created as a result of the combination of UWS andBlue Cross & Blue Shield United of Wisconsin (“BCBSUW”) on March 23, 2001(the “Combination”).  On that date,BCBSUW converted from a service insurance corporation to a stockholder ownedcorporation.  Upon conversion, BCBSUWbecame a wholly-owned subsidiary of UWS through a combination of the twocompanies.  At the time of theconversion and combination, BCBSUW owned approximately 46.6% of UWS’outstanding common stock.  In exchangefor the ownership of BCBSUW, Cobalt issued 31,313,390 shares of newly issuedCompany common stock to the Wisconsin United for Health Foundation, Inc. (the“Foundation”).  The Foundation wasestablished for the sole purpose of benefiting public health in Wisconsin fromits earnings in the investment in Cobalt.

 

TheCombination was accounted for as a purchase by BCBSUW of the remaining9,096,303 shares of UWS that it did not already own at a market price of $6.15per share on the closing date.  Inaccordance with accounting principles generally accepted in the United States(“GAAP”), goodwill was recorded representing the excess of the market priceover the adjusted book value of UWS for the 53.4% of UWS that BCBSUW did notalready own.  Total goodwill recorded byCobalt as a result of the Combination amounted to $68.6 million, of which $22.1million related to the recognition of a valuation allowance on the net deferredincome tax assets recorded by UWS prior to the Combination.

 

For reportingpurposes, the Combination is treated as a reverse purchase transaction, wherebyBCBSUW becomes the acquirer and reporting entity for public companyreporting.  Therefore, the accompanyingaudited consolidated financial statements present the Company’s financialposition as of December 31, 2001, reflecting the purchase accountingadjustments for the Combination and include the accounts of both UWS andBCBSUW.  The financial position of theCompany presented in the December 31, 2000 balance sheet represents only theaccounts of BCBSUW, which includes BCBSUW’s 46.6% investment in UWS (see Note 6of Notes to Consolidated Financial Statements).  The consolidated statements of operations, cash flows, andchanges in stockholders’ equity and comprehensive income (loss) for the yearended December 31, 2001, reflect the operations of the combined UWS and BCBSUWentities effective March 31, 2001. Prior to March 31, 2001, the consolidated financial statements includeonly the operations of BCBSUW and its wholly-owned subsidiary, UnitedGovernment Services, LLC (“UGS”) and minority interest in UWS and AmericanMedical Security Group, Inc. (“AMSG”). For purposes of calculating earnings per common share (“EPS”) of theCompany, the 7,949,904 shares of Cobalt common stock owned by BCBSUW areaccounted for as if it were treasury stock.

 

Theconsolidated financial statements subsequent to the Combination include theaccounts of the Company’s majority owned insurance subsidiaries (BCBSUW,Compcare Health Services Insurance Corporation (“Compcare”), Unity Health PlansInsurance Corporation (“Unity”), Valley Health Plan, Inc. (“Valley”), UnitedWisconsin Insurance Company (“UWIC”), and United Heartland Life InsuranceCompany (“UHLIC”)) and other non-insurance subsidiaries.  All intra-company balances and transactionsafter March 31, 2001 have been eliminated in consolidation.

 

The Companyoffers full coverage, co-payment, preferred provider organization (“PPO”) andhealth maintenance organization (“HMO”) products to groups, along with Medicaresupplement, PPO and interim coverage options to individuals.  The Company’s subsidiary, BCBSUW, is theonly health insurer in the state operating full-service regional sales andcustomer service centers.  Through UGS,the Company is a government contractor and processes Medicare claims forproviders in all 50 states and is currently the largest Part A Medicareprocessor in the nation.  The Company isalso a leading provider of managed health care services and employee benefitproducts, HMO products, dental, life, disability and workers’ compensationproducts, managed care consulting, electronic claim submission services,pharmaceutical management, managed behavioral health services, case managementand receivables management services.

 

 

----

 

In thediscussion below, the number of “members” is equivalent to the number ofpersons covered by contracts in force.

 
| **Summary of  Membership and Ratios**               |   | **As of  December 31,** |       |
|-----------------------------------------------------|--------|-------------------------|------------|
|                                                |   | **2001**                |       | **2000** |   | **1999** |   |
| Membership at end of period:                        |   |                    |       |   |   |   |   |
| Insured medical products                            |   | 530,480                 |       | 255,289 |   | 221,266 |   |
| Specialty risk products                             |   | 1,119,226               |       | 145,955 |   | 151,471 |   |
| Specialty service products                          |   | 1,083,162               |       | — |   | — |   |
| Self-funded products:                               |   |                    |       |   |   |   |   |
| Non-HMO                                             |   | 164,415                 |       | 235,604 |   | 298,799 |   |
| HMO                                                 |   | 5,231                   |       | — |   | — |   |
| Total membership                                    |   | 2,902,514               |       | 636,848 |   | 671,536 |   |
|                                                |   |                    |       |   |   |   |   |
| Workers’ Compensation – Policies in force |   | 716                     |       | — |   | — |   |
|                                                |   |                    |       |   |   |   |   |
| Membership (as a percentage of  the total):         |   |                    | ** ** |   | ** ** |   | ** ** |
| Insured medical products                            |   | 18.3                    | %          | 40.1 | % | 32.9 | % |
| Specialty risk products                             |   | 38.6                    |       | 22.9 |   | 22.6 |   |
| Specialty  service products                         |   | 37.3                    |       | — |   | — |   |
| Self-funded products                                |   | 5.8                     |       | 37.0 |   | 44.5 |   |
| Total membership                                    |   | 100.0                   | %          | 100.0 | % | 100.0 | % |

 
| **Summary of  Operating Results and Ratios**                |   | **Years  Ended December 31,** |         |
|-------------------------------------------------------------|--------|-------------------------------|--------------|
|                                                        |   | **2001**                      |         | **2000** |   | **1999** |   |
|                                                        |   | **(In thousands)**            | *** *** |
| Revenue:                                                    |   |                          |         |   |   |   |   |
| Insured  medical products                                   |   | $                             | 1,150,420    |   | $ | 510,638 |   | $ | 392,583 |   |
| Specialty risk products                                     |   | 131,254                       |         | 29,922 |   | 27,774 |   |
| Specialty service products                                  |   | 46,496                        |         | — |   | — |   |
| Government services                                         |   | 117,192                       |         | 70,305 |   | 52,259 |   |
| Self-funded products                                        |   | 28,067                        |         | 24,716 |   | 25,970 |   |
| Other operations                                            |   | (34,709                       | )            | (2,481 | ) | (1,408 | ) |
| Total health services revenue                               |   | 1,438,720                     |         | 633,100 |   | 497,178 |   |
| Investment results                                          |   | 12,526                        |         | 9,583 |   | 18,510 |   |
| Total revenue                                               |   | $                             | 1,451,246    |   | $ | 642,683 |   | $ | 515,688 |   |
|                                                        |   |                          |         |   |   |   |   |
| Health services revenue (as a percentage of the  total):    |   |                          | ** **   |   | ** ** |   | ** ** |
| Insured medical products                                    |   | 80.0                          | %            | 80.7 | % | 79.0 | % |
| Specialty  risk products                                    |   | 9.1                           |         | 4.7 |   | 5.6 |   |
| Specialty  service products                                 |   | 3.2                           |         | — |   | — |   |
| Government services                                         |   | 8.1                           |         | 11.1 |   | 10.5 |   |
| Self-funded products                                        |   | 2.0                           |         | 3.9 |   | 5.2 |   |
| Other operations                                            |   | (2.4                          | )            | (0.4 | ) | (0.3 | ) |
| Total                                                       |   | 100.0                         | %            | 100.0 | % | 100.0 | % |
|                                                        |   |                          |         |   |   |   |   |
| Operating  ratios:                                          |   |                          |         |   |   |   |   |
| Insured medical loss ratio (1)                              |   | 90.6                          | %            | 93.5 | % | 90.5 | % |
| Specialty risk products loss ratio (1)                      |   | 74.2                          | %            | 77.1 | % | 82.7 | % |
|                                                        |   |                          |         |   |   |   |   |
| Selling, general, administrative and other  expense ratios: |   |                          |         |   |   |   |   |
| Insured medical ratio (2)                                   |   | 9.6                           | %            | 12.0 | % | 14.3 | % |
| Specialty risk products ratio (2)                           |   | 24.5                          | %            | 22.9 | % | 25.6 | % |
| Government services ratio (3)                               |   | 99.3                          | %            | 99.3 | % | 98.4 | % |
| Specialty services ratio (4)                                |   | 92.1                          | %            | — |   | — |   |

 

----

(1)     Insured medical and other benefits as apercentage of premium revenue.

(2)     Insuredselling, general, administrative and other expenses as a percentage of healthservices revenue.

(3)     Government services selling, general,administrative and other expenses as a percentage of government servicesrevenue.

(4)     Specialtyservices selling, general, administrative and other expenses as a percentage ofspecialty services revenue.

 

 

----

 

Cobalt’srevenues are derived primarily from premiums, while medical and other benefitsconstitute the majority of expenses. Profitability is directly affected by manyfactors including, among others, premium rate adequacy, estimates of medicaland other benefits, health care utilization, effective administration ofbenefit payments, operating efficiency, investment returns and federal andstate laws and regulations.

 

**Invested Assets**

 

The tablebelow reflects investment results for the periods indicated:

 
|                                               |   | **Years  Ended December 31,** |     |
|----------------------------------------------------|--------|-------------------------------|----------|
|                                               |   | **2001**                      |     | **2000** |   | **1999** |   |
|                                               |   | **(Dollars in thousands)**    | * * |
| Average invested assets (1)                        |   | $                             | 166,888  |   | $ | 47,041 |   | $ | 75,665 |   |
| Net investment income (2)                          |   | 8,109                         |     | 3,275 |   | 4,623 |   |
| Average yield                                      |   | 4.86                          | %        | 6.96 | % | 6.11 | % |
| Net realized gains (losses)                        |   | 845                           |     | (509 | ) | 8,014 |   |
| Net unrealized gains (losses) on stocks and  bonds |   | 284                           |     | 155 |   | (709 | ) |
|                                                    |        |                               |          |  |  |  |  |  |  |  |

 

----

(1)                Average ofaggregate monthly investment amounts.

(2)                Amounts arecalculated net of investment expenses, exclude intra-company investment incomefrom affiliates and other investment income.

 

**Results of Operations**

 

All financialdata in the Results of Operations section are gross numbers and, therefore, arenot net of intercompany eliminations .  For this reason, some of the financial data does not precisely match thedata in the financial tables.

 

***2001Compared with 2000***

 

The resultsfor 2001 include the operations of the combined UWS and BCBSUW entitieseffective March 31, 2001 with AMSG continuing to be accounted for using theequity method.  Prior to March 31, 2001,the results include the operations of BCBSUW, its wholly-owned subsidiary, UGS,and BCBSUW’s investment in UWS and AMSG accounted for using the equitymethod.  The comparison between 2001 and2000 is largely explained by the addition of UWS results for the last threequarters of 2001 following the Combination.

 

***TotalRevenues***

 

Total revenuesin 2001 increased 125.8% to $1,451.2 million from $642.7 million in2000.  The increase in 2001 is dueprimarily to the addition of the UWS business, which resulted from the March23, 2001 combination of BCBSUW and UWS to form Cobalt.  UWS contributed $712.3 million in revenue in2001 or 110.8% of the total 125.8% increase for the year.  Other factors contributing toward theincrease in 2001 include premium rate increases on the medical insurancebusiness, the re-pricing of self-funded products and new government fee basedcontracts.

 

**           HealthServices Revenue**

 

*Insured Medical Products*.  Insured medical premium in 2001 increased125.3% to $1,150.4 million from $510.6 million in 2000.   The increase in 2001 is primarily due tothe addition of UWS business.  The additionof UWS premiums resulted in an increase to premium revenue for 2001 of $574.4million or 112.5% of the total 125.3% increase.  The number of insured medical members in 2001 increased 107.8% to530,480 from 255,289 in 2000.  The totalmembership increase of 275,191 reflects a decrease of 18,474 members in BCBSUWinsured medical membership, offset by the addition of 293,665 members from theUWS insured medical business.

 

 

----

 

*Specialty Risk Products. *Specialty riskpremium in 2001 increased 339.1% to $131.3 million from $29.9 million in2000.  The increase in 2001 primarilyresulted from the addition of $102.7 million in revenues from the UWS specialtyrisk business, which includes life, accidental death and dismemberment, dental,disability, workers’ compensation and behavioral health. The number ofspecialty risk members in 2001 increased to 1,119,226 from 145,955 in2000.  The total increase in membershipof 973,271 reflects a decrease of 13,981 members in BCBSUW insured dentalmembership, offset by the addition of 987,252 members from the UWS specialtyrisk business.

 

*Specialty Service Products. *Specialty servicerevenue in 2001 includes $46.5 million related to the UWS specialty serviceproducts, which includes workers’ compensation third party administrator(“TPA”) business, subrogation and receivables collection, audit, electronicclaims, and medical, pharmacy and behavioral health management services.

 

*Government Services. *Government servicesrevenue in 2001 increased 66.7% to $117.2 million from $70.3 million in 2000..   The increase from 2000 to 2001 isattributable to significant growth in the volume of Medicare claims processed,due to being awarded additional government contracts.  Effective December 1, 2000, UGS became the Medicare Part A Intermediaryfor the states of California, Nevada and Hawaii, and the territories of Guam,Mariana Islands and American Samoa.  Inaddition, also effective December 1, 2000, UGS became the Regional Home HealthIntermediary for the states of California, Nevada, Arizona, Hawaii, Oregon,Idaho, Washington, and Alaska, and the territory of Guam.

 

*Self-funded Products. *Self-fundedadministrative fees in 2001 increased 13.8% to $28.1 million from $24.7 millionin 2000 .   The increase in 2001 resultsfrom an increase of approximately 60% in the administrative fee per member permonth due to the targeted re-pricing of self-funded business, in order toeliminate unprofitable business.  Thepricing increases were offset by a reduction of 30.2% in non-HMO self-funded membershipto 164,415 as of 2001 from 235,604 as of 2000.

 

**           Investment Results**

 

Net investmentresults include investment income and realized gains (losses) on the sale ofinvestments .   Net investment resultsin 2001 increased 30.2% to $12.5 million from $9.6 million in2000.   The addition of UWS increased2001 investment results by $8.0 million. However, offsetting this increase was the elimination of BCBSUWinvestment income related to intra-company financing arrangements with UWS,subsequent to March 31, 2001, due to the Combination.  This intra-company investment income amounted to $5.5 million in2000, as compared to $1.3 million in 2001, based on the amount recorded throughMarch 31, 2001.   Average annualinvestment yields, excluding net realized gains, intra-company investmentincome and other interest income were 5.8% and 7.0% for 2001 and 2000,respectively.

 

Averageinvested assets in 2001 increased 255.1% to $166.9 million from$47.0 million in 2000.  Theimprovement in 2001 is primarily the result of the acquisition of UWS at theend of the first quarter of 2001, which increased Cobalt’s invested assets by$201.2 million as of December 31, 2001.

 

Net investmentgains (losses) are realized in the normal investment process in response tomarket opportunities .   Realized gainswere $0.8 million in 2001 compared to realized losses of $0.5 million in 2000.

 

**             Expense Ratios**

 

*Loss Ratio. *The insured medical products loss ratio for2001 was 90.6%, compared with 93.5% for 2000. The decrease in the medical loss ratio in 2001 is primarily the resultof pricing increases and other cost control measures instituted in response tohigher than anticipated medical utilization and cost trends.  In addition, the higher loss ratio for 2000also reflects the effect of a premium deficiency reserve (“PDR”) of $3.6million recorded during the second half of 2000 on the Medicare Riskbusiness.  The PDR amount recorded as ofDecember 31, 2000 represented estimated losses throughout 2001.  The remainder of the PDR was reversed in2001, as a result of the Company exiting the business effective January 1,2002.

 

The specialtyrisk products loss ratio in 2001 improved to 74.2% compared with 77.1% for2000.  Results for 2000 were entirelycomprised of the BCBSUW insured dental business, which showed a slight increasein the loss ratio to 78.0% in 2001.  Theoverall improvement in 2001 resulted from the addition of the UWS specialtyrisk products, which ran at a loss ratio of 73.1% in 2001.  This loss ratio reflects improvement frompast results for the UWS specialty risk products, which on a stand-alone basis,ran at a loss ratio of 77.1% in 2000.

 

 

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*Selling, General, Administrative and OtherExpense Ratio* .  For the insurance subsidiaries, the selling, general, administrative andother (“SGA”) expense ratio includes commissions, administrative expenses,premium taxes and other assessments and claim interest expense.  For non-insurance subsidiaries, SGA includesoperating expenses only.

 

The insuredmedical products SGA expense ratio for 2001 was 9.6%, compared with 12.0% for2000.  The improved SGA expense ratio in2001 is the result of additional expense control measures instituted, combinedwith a higher premium base in 2001 due to pricing increases.  In addition, the insured medical productsSGA ratio in 2000 includes the effect of a $2.4 million write-off of deferredacquisition costs related to the Medicare Risk business.

 

The specialtyrisk products SGA ratio in 2001 increased to 24.5% compared with 22.9% for2000.  The change in the SGA ratio forspecialty risk products reflects changes in the mix of specialty risk businessdue to the addition of the UWS business.

 

The expenseratio for Government services in 2001 and 2000 remained constant at 99.3%.  The expense ratio for specialty services was92.1% for 2001.

 

**             Other Expenses**

 

The Companyhas a bank line of credit, in which certain subsidiaries participate, thatpermits aggregate borrowings up to $20.0 million, with company specificmaximums for the participating companies. Interest expense, related to the bank line of credit in 2001 and 2000was $0.6 million and $0.3 million, respectively.

 

Goodwillamortization totaling $5.9 million and $0.6 million has been recorded for 2001and 2000, respectively.  Of the total $5.9million of goodwill amortization recorded for 2001, $3.4 million relates to$68.6 million of goodwill recorded in 2001 for the Combination as a result ofpurchase accounting, which was being amortized on a straight-line basis over aperiod of 15 years.  In addition, the2001 amortization expense includes amortization related to the 1999 purchase byBCBSUW of 1.4 million additional shares of UWS stock, which has been amortizedon a straight-line basis over a period of 15 years (see Note 3 of Notes to ConsolidatedFinancial Statements).  Amortizationexpense for 2000 includes amortization related to the purchase by BCBSUW of the1.4 million additional shares of UWS stock discussed above.  In addition, goodwill amortization has beenrecorded for various past acquisitions of subsidiaries and additional insurancebusiness completed by the Company.

 

Profit sharingexpenses of $0.5 million were recorded for 2001, which relate primarily to twoHMO joint venture provider arrangements within the insured medical productssegment.

 

**             Loss from Investment in Affiliates**

** **

The loss frominvestment in affiliates increased to $22.7 million in 2001 from $6.5 millionin 2000.  The $22.7 million loss in 2001is comprised of AMSG income of $2.0 million for 2001, BCBSUW’s share of UWSincome of $0.4 million for the first quarter of 2001, and other affiliate netincome of $0.1 million, offset by a $25.2 million writedown of the investmentin AMSG to the market value as of December 31, 2001.  This writedown was deemed appropriate based on management’sdecision to no longer classify the investment in AMSG as a strategic long-termasset of the Company.  The 2000 lossfrom investment in affiliates of $6.5 million is comprised of a $7.6 millionloss related to UWS, offset by a $1.1 million gain from AMSG.

 

**             Net Loss**

 

Consolidatednet results improved in 2001 to a loss of $22.3 million compared to a loss of$40.0 million in 2000.  The $22.3million net loss in 2001 reflects an operating loss of $0.5 million and a lossfrom investment in affiliates of $22.7 as discussed above, offset by an incometax benefit of $0.9 million.  Theimproved 2001 operating results reflect improvement in the insured loss and SGAratios, increases in administrative fees on the self-funded business andcontinued growth in government contract business over the prior year.

 

 

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As of December31, 2001, Cobalt had federal net operating loss carry-forwards of approximately$141.0 million available to offset future taxable income.  A full valuation allowance has been establishedagainst net deferred tax assets.

 

Cobalt had acurrent income tax benefit of $0.9 million in 2001 in conjunction with theformation of Cobalt compared to no current income tax expense or benefit in2000.  Cobalt recorded an immaterialdeferred tax benefit in 2001 and a deferred tax expense of $0.5 million in2000, which related to a valuation allowance from a prior period.

 

***2000Compared with 1999***

 

Results for 2000 and 1999 include theoperations of BCBSUW, its wholly-owned subsidiary, UGS and BCBSUW’sinvestment in UWS and AMSG accounted for using the equity method.

 

**             Total Revenues**

 

Total revenuesin 2000 increased 24.6% to $642.7 million from $515.7 million in1999.  The increase in 2000 resultedprimarily from increased membership and premium rate increases on the medicalinsurance business and new government contracts.

 

**             Health Services Revenue**

 

*Insured Medical Products*.  Insured medical premium in 2000 increased30.1% to $510.6 million from $392.6 million in 1999.  The increased premium is due to the number of insured medicalmembers in 2000 increasing 15.4% to 255,289 from 221,266 in 1999, combined withincreases in per member per month premium due to premium rate increases.

 

*Specialty Risk Products. *Specialty riskpremium in 2000 increased 7.6% to $29.9 million from $27.8 million in1999.  The number of specialty riskmembers in 2000 decreased 3.6% to 145,955 from 151,471 in 1999.  The slight decrease in membership was offsetby premium rate increases, resulting in an overall increase in revenues.

 

*Government Services. *Government servicesrevenue in 2000 increased 34.4% to $70.3 million from $52.3 million in1999.  The increase from 1999 to 2000 islargely attributed to becoming the Medicare Part A Intermediary for the statesof Virginia and West Virginia as of September 1, 1999.

 

*Self-funded Products. *Self-fundedadministrative fees in 2000 decreased 5.0% to $24.7 million from$26.0 million in 1999.  Thedecrease in self-funded administrative fees in 2000 primarily resulted from a21.1% decrease in self-funded membership from 298,799 in 1999 to 235,604 in2000.  The decrease in membership wasoffset by an increase of 20.7% in the average self-funded administrative feeper member per month.  The decrease inrevenue and membership is due to aggressive pricing on targeted group contractsand subsequent loss of unprofitable business.

 

**             Investment Results**

 

Net investmentresults include investment income and realized gains (losses) on the sale ofinvestments.  Net investment results in2000 decreased 48.1% to $9.6 million from $18.5 million in 1999,primarily due to a decrease in average invested assets, as discussedbelow.  Average annual investmentyields, excluding net realized gains, intra-company investment income and otherinterest income were 7.0% and 6.1% for 2000 and 1999, respectively.

 

Averageinvested assets in 2000 decreased 37.9% to $47.0 million from$75.7 million in 1999.  Thedecrease in average invested assets during 2000 is a result of cashrequirements necessary to fund operating losses.

 

Net investmentgains (losses) are realized in the normal investment process in response tomarket opportunities .   Realized losseswere $0.5 million in 2000 compared to realized gains of $8.0 million in1999.  BCBSUW received interest incomeof $5.5 million and $4.8 million in 2000 and 1999, respectively, on a $70.0million note from the Company.

 

 

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**             Expense Ratios**

 

*Loss Ratio. *The insured medical products loss ratio for2000 was 93.5%, compared with 90.5% for 1999. The increase in the medical loss ratio in 2000 is primarily the resultof greater than anticipated medical utilization and cost trends partiallyrelated to BCBSUW’s Medicare Risk business, which reported premiums of $66.8million and medical expense of $85.0 million.

 

The specialtyrisk products loss ratio in 2000 improved to 77.1% compared with 82.7% for1999, primarily due to premium rate increases on the BCBSUW dental business.

 

*Selling, General, Administrative and OtherExpense Ratio.* The insured medical products SGA expense ratio for 2000 improvedto 12.0%, compared with 14.3% for 1999, despite the fact that the ratio for2000 includes the effect of a $2.4 million write-off of deferred acquisitioncosts related to the Medicare Risk business. The improvement in 2000 reflects the effect of expense controlsinstituted, combined with a higher premium base due to membership and premiumrate increases.

 

The specialtyrisk products SGA ratio in 2000 improved to 22.9% from 25.6% in 1999.  The expense ratio for Government services in2001 was 99.3% compared to 98.4% in 1999, which reflects a change in theoverall average government reimbursement level due to changes in the mix ofbusiness related to additional government business acquired in 2000.

 

**             Other Expenses**

 

The Companyhas a bank line of credit that permits aggregate borrowings up to $20 million,with company specific maximums for the participating companies.  Interest expense related to the bank line ofcredit in 2000 and 1999, was $0.3 million and $0.6 million, respectively.

 

In 1999,BCBSUW purchased 1.4 million additional shares of UWS stock.  The excess of cost over the fair value ofnet assets acquired has been recorded as goodwill and was amortized on astraight-line basis over a period of 15 years. Amortization expense was $0.6 million and $0.2 million for 2000 and1999, respectively.

 

**             Loss from Investment in Affiliates**

 

The loss frominvestment in affiliates decreased to $6.5 million in 2000 from $22.7 millionin 1999.  The loss in 2000 is comprisedof a loss of $7.6 million from UWS, offset by a gain of $1.1 million fromAMSG.  For 1999, the affiliate resultsrecorded by Cobalt include losses of $12.7 million from UWS and $10.0 millionfrom AMSG.

 

**Net Loss**

 

Consolidatednet results improved in 2000 to a loss of $40.0 million compared to a loss of$42.7 million in 1999.  The poor resultsin 2000 resulted primarily from the combination of a $32.9 million operatingloss and a $6.5 million loss from investment in affiliates, net of tax.  The $32.9 million operating loss is due to a$20.6 million loss before income taxes on insured business, which experiencedgreater than anticipated medical utilization and cost trends, combined with a$10.7 million loss before income taxes on self-funded business.  In addition, the 2000 results include theeffect of $3.3 million in transaction expenses in preparation for theCombination.  Partially offsetting theselosses was $1.2 million in income before income taxes on government contracts.  The 1999 loss was also attributable togreater than anticipated utilization on the insured business and losses on theself-insured business.

 

Because ofoperating losses, BCBSUW did not have current income tax expense or benefit in2000 or 1999.  BCBSUW had deferred taxexpense of $0.5 million in 2000, which relates to a valuation allowance from aprior period.  There was no deferred taxbenefit in 1999.

 

 

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**Liquidityand Capital Resources**

 

Cobalt’ssources of cash flow consist primarily of health services revenues andinvestment income.   The primary uses ofcash include medical and other benefit payments, as well as operating expensepayments.  Positive cash flows areinvested pending future payments of medical and other benefits and otheroperating expenses.   Cobalt’sinvestment policies are designed to maximize yield, preserve principal andprovide liquidity to meet anticipated payment obligations.

 

Cobalt’s cashflow improved in 2001 compared to 2000.  Net cash provided by operating activities was $13.0 million in 2001compared with $8.3 million in 2000.  Net cash used in operating activities in 1999 was$34.3 million.   The improvement in2001 operating cash flows is primarily due to the improved operating results. Inaddition, Cobalt’s cash flow from investing activities reflects the addition of$50.0 million for UWS cash and cash equivalents as of March 31, 2001 as aresult of the Combination.  Due toperiodic cash flow requirements, Cobalt made borrowings under its bankline-of-credit (“LOC”).  The LOC is witha commercial bank and has a rate equal to the London Interbank Offered Rate(“LIBOR”) plus 1.5%, adjusted monthly with interest payments due monthly.  The LOC permits aggregate borrowings amongcertain subsidiaries, excluding the corporate holding company and Compcare, upto $20.0 million.  Cobalt’s outstandingline of credit balance was $7.9 million as of December 31, 2001.  Cobalt had no outstanding line of creditbalance as of December 31, 2000.  Theinterest expense on the line of credit was $0.6 million and $0.3 million in2001 and 2000, respectively.  OnDecember 31, 2001, the Company originated a term business note (“term note”)for the corporate holding company with a commercial bank for $7.5 million.  The term note had an adjustable rate ofinterest with payment of principal and interest due February 15, 2002.  The term note has been extended andrenegotiated, with payment of principal and interest due in quarterlyinstallments beginning June 30, 2002 and ending June 30, 2003.  Interest is calculated at a rate equal tothe LIBOR plus 1.5%, adjusted monthly.

 

As a PrimaryLicensee of the BlueCross BlueShield Association (“BCA”), Cobalt is required tomaintain a prescribed liquidity ratio of certain liquid assets to averagemonthly expenses, as defined, in accordance with licensure requirements of theBCA.  BCBSUW and Compcare are bothconsidered larger controlled affiliate licensees by the BCA and must alsoadhere to these requirements.  BCBSUWand Compcare maintained these required levels as of December 31, 2001.

 

Cobalt’sinvestment portfolio consists primarily of investment-grade bonds andgovernment securities and has a limited exposure to equity securities.   At December 31, 2001, $188.1 million or98.1% of Cobalt’s total investment portfolio was invested in bonds comparedwith $30.0 million or 67.5% at December 31, 2000.  The bond portfolio had an average qualityrating by Moody’s Investor Service of “Aa3” at December 31, 2001 and 2000.  At December 31, 2001, $180.7 million or94.3% of Cobalt’s total investment portfolio was classified asavailable-for-sale compared with $44.4 million or 100.0% as of December 31,2000.  The fair value of the totalinvestment portfolio, which includes stocks and bonds, was greater thanamortized cost by $0.3 million and $0.2 million at December 31, 2001 and 2000,respectively.  Unrealized gains andlosses on bonds classified as available-for-sale are included as a component ofshareholders’ equity, net of applicable deferred taxes.  Cobalt has no investments in mortgage loans,no non-publicly traded securities (except for investments related to itsaffiliates), real estate held for investment or financial derivatives (exceptfor principal-only strips of U.S. Government securities).

 

Cobalt has anoutstanding line of credit in the amount of $15.0 million as of December31, 2001 available to Health Professionals of Wisconsin, Inc.  The balance was $3.0 million and $4.6million as of December 31, 2001 and 2000, respectively.  Interest on the line of credit is calculatedusing prime rate.

 

**StatutoryCapital**

 

Cobalt isrequired to maintain certain levels of statutory capital and surplus under theNational Association of Insurance Commissioners (“NAIC”) Risk Based Capital(“RBC”) requirements .   Wisconsininsurers are also subject to compulsory and security surplus requirements basedupon the amount and type of premiums written. In addition to statutory capital requirements, Cobalt, BCBSUW andCompcare are required to maintain certain levels as determined by the BCA.  Cobalt, BCBSUW and Compcare are incompliance with these requirements as of December 31, 2001.  In orderto satisfy certain intercompany receivables and continue to comply with minimumcapital and licensing standards, management has considered selling certainsubsidiaries, as well as some portion or all of its investment in AmericanMedical Security Group, Inc., or obtaining capital from outside sources.

 

 

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Included inthe statutory capital of certain insurance subsidiaries of Cobalt areparticular interests in, or obligations of, affiliates.  United Wisconsin Insurance Company (awholly-owned subsidiary of Compcare) carries as an admitted asset anintercompany secured note from Cobalt in the amount of $21.2 million payable byOctober 1, 2002.  BCBSUW also carries a$70.0 million secured note obligation from Cobalt payable January 1, 2002.  Subsequent to year-end, the maturity date onthe $70.0 million note was extended to January 2, 2003.

 

**Management’s Plan**

 

During thethree years in the period ended December 31, 2001, the Company incurredoperating losses aggregating $53.5 million. Included in these losses are $27.8 million related to the Company’sparticipation in the Medicare Risk line of business, which the Company exitedeffective January 1, 2002.   Prior tothe Combination, UWS and its subsidiaries incurred additional operating lossesaggregating $71.0 million for the first quarter of 2001 and the two years endedDecember 31, 2000.  These losses largelyrelate to the HMO business in southeast Wisconsin.  Significant actions were taken during 2001 to cancel unprofitableHMO business.  Also contributing to thecombined aggregate losses were $8.7 million of expenses relating to theCombination.   On a pro forma basis, Cobalt’soperating income for 2001 was a gain of $0.9 million (see Note 1 of Notes toConsolidated Financial Statements). Despite these recent operating losses and the implementation of changesin statutory accounting (“Codification”) effective January 1, 2001, the Companycomplied with minimum capital and liquidity requirements of the Office of theCommissioner of Insurance of the State of Wisconsin (“OCI”) during 2001, 2000and 1999.  The Company maintainedcompliance, in part, by contributing regulated and non-regulated subsidiariesto regulated entities and by collateralizing certain intra-company debtobligations with the common stock of affiliated entities.  OCIrequested and management submitted a specific plan of action to continueto exceed the minimum capital requirements of the OCI and the BCA during 2002.

 

Theoutstanding common stock of Compcare, Unity, Valley and UHI currently providethe collateral for approximately $92 million borrowed by Cobalt from BCBSUW andUWIC.   These intra-company balanceshave been eliminated in the accompanying December 31, 2001 consolidated balancesheet. However, the intra-company balances continue to be an obligation ofCobalt to BCBSUW ($70 million) and UWIC ($22 million) in the statutory-basisfinancial statements of BCBSUW and UWIC.  Cobalt is obligated to repay BCBSUW by January 2, 2003 and UWIC byOctober 1, 2002.   Transfer of thepledged collateral to BCBSUW and UWIC will satisfy the legal obligations, butwould not assist BCBSUW in complying with minimum capital and liquidityrequirements, since the minimum capital calculations for investments insubsidiaries require a greater discount than for cash, marketable securities oraffiliated receivables.   However, settlement of these obligations in cash willassist compliance with minimum capital and liquidity requirements.

 

At December31, 2001, all of the Company’s subsidiaries are accounted for in the BCBSUW orCompcare capital calculations as a result of contribution or collateralization.

 

In order toassure the Company’s regulated insurance subsidiaries continue to satisfyminimum capital and liquidity requirements, the OCI requested, managementdeveloped and Cobalt's board of directors approved a capital plan to improvethe Company’s position relative to minimum capital and liquidityrequirements.   The capital plan, whichmanagement has provided to and discussed with the OCI and BCA, includes thefollowing action steps to maintain required capital and liquidity levels during2002:

 

•                  Sell certainnon-regulated subsidiaries owned by the Company for cash and/or notes prior toOctober 1, 2002.

•                  Reduce BCBSUW’sinvestment in AMSG common stock from 45% of the shares outstanding to less than20% through public or private offerings during 2002.

•                  Obtain debtfinancing at the Company’s corporate holding company from one or moreinstitutional lenders to fund holding company liquidity needs including therepayment of the collateralized intra-company debt obligations between theholding company and its regulated subsidiaries.

•                  Achieve theCompany’s 2002 projected core earnings, which anticipate breakeven operatingresults for Compcare for the year ending December 31, 2002 as compared to anoperating loss of $32.5 million for the year ended December 31, 2001 .   Management expects Compcare’s significantchange in profitability to occur as a result of efforts in the fourth quarterof 2001 to cancel unprofitable business and implement necessary premiumincreases for the remaining business.

 

 

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•                  Adhere tocertain practices in conducting and accounting for affiliated transactions,notably involving the lending practices previously described.   The Company will not use uncollateralizednon-operating intra-company balances in complying with minimum capital andliquidity requirements.   The Companyhas reflected the revised practices in the December 31, 2001 regulatedsubsidiary statutory-basis financial statements filed with the OCI and otherregulatory agencies.

•                  Satisfy the $70million debt obligation to BCBSUW by December 31, 2002, either with cashobtained through external financing or by transferring the stock of Compcare toBCBSUW or a combination thereof.

•                  Satisfy the $22million debt obligation to UWIC by September 30, 2002, either with cashobtained through external financing or by transferring the stock of Unity,Valley and UHI to UWIC.

 

The Companyexpects to remain in compliance with minimum capital and liquidity requirementsof the OCI and the BCA throughout 2002 by substantially completing the capitalplan described above or transactions with an equivalent impact on the Company’sposition relative to minimum capital and liquidity requirements.  Non-compliance with minimum capital andliquidity requirements may subject the Company to various regulatory actions bythe OCI and BCA, including rehabilitation, revocation of the Company’s licenseto sell insurance products in Wisconsin and revocation of the Company’s licenseto operate as a Blue Cross/Blue Shield franchisee.  See “Cautionary Factors”.

** **

**Inflation**

 

Health carecosts have been rising and are expected to continue to rise at a rate that exceedsthe consumer price index.   TheCompany’s cost control measures, risk-sharing incentive arrangements withmedical care providers, and premium rate increases are designed to reduce theadverse effect of medical cost inflation on its operations.   In addition, the Company utilizes itsability to apply appropriate underwriting criteria in selecting groups andindividuals and in controlling the utilization of health care services.   However, there can be no assurance thatthese efforts will fully offset the impact of inflation or that premium revenueincreases will equal or exceed increasing health care costs.

 

**Critical Accounting Policies and Estimates**

 

The Company’sdiscussion and analysis of its financial condition and results of operationsare based upon the Company’s consolidated financial statements, which have beenprepared in accordance with accounting principles generally accepted in theUnited States ("GAAP").  Thepreparation of these financial statements requires the Company to makeestimates and judgments that affect the reported amounts of assets,liabilities, revenues and expenses, and related disclosure of contingent assetsand liabilities.  On an on-going basis,the Company evaluates its estimates, including those related to allowances fordoubtful accounts, deferred tax assets, impairment of equity methodinvestments, goodwill impairment, medical and other benefits payables, andlitigation and tax contingencies.  TheCompany bases its estimates on historical experience and on various other assumptionsthat are believed to be reasonable under the circumstances, the results ofwhich form the basis for making judgments about the carrying values of assetsand liabilities that are not readily apparent from other sources.   Actual results may differ from theseestimates under different assumptions or conditions.

 

*Allowance for Doubtful Accounts*

 

A significantportion of the Company's receivable balances result from balances due fromemployers, individuals, and providers of medical services.  The Company maintains allowances fordoubtful accounts for estimated losses resulting from the inability of itscustomers to make required payments or retroactivity in reporting membershipcancellations.  If the financial conditionof the Company’s customers were to deteriorate or if significant employeeturnover were to occur among insured employers, resulting in an impairment oftheir ability to make payments, additional allowances may be required.

 

 

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*Deferred Tax Assets*

 

The Companyrecorded a full valuation allowance against all of its net deferred tax assetsas of December 31, 2001 and 2000. Management deemed that a full valuation allowance was appropriate basedon the Company's history of losses and changes in tax planning strategies postcombination.  In the event the Companywere to determine that it would be able to realize its deferred tax assets inthe future in excess of its net recorded amount, an adjustment to the deferredtax asset would increase income or reduce recorded goodwill in the period suchdetermination was made.

 

*Impairment of Equity Method Investments*

 

The Company’sinvestment in AMSG is accounted for under the equity method of accounting.  At December 31, 2001 the Company owned6,309,525 shares of the outstanding common stock (45.2% ownership) ofAMSG.  The Company’s per share carryingvalue as of December 31, 2001 was $16.44 based on the Company’s share of AMSG’sequity.  Pursuant to current GAAP, theCompany wrote down its investment in AMSG to the current market value ($12.45as of December 31, 2001) of such stock due to the Company’s evaluation andannouncement that its holdings in AMSG no longer represented a strategicinvestment and that the Company planned an orderly reduction of itsownership.  Although any market writedowns are charged to operations, any subsequent increases in the market valueafter a market writedown are not reflected in the financial statements of theCompany until full disposition of the shares occurs or the Company’s ownershippercentage is reduced to below 20%.

 

*Goodwill Impairment*

 

In assessingthe recoverability of the Company’s goodwill and other intangibles the Companymust make assumptions regarding estimated undiscounted future cash flows andother factors to determine the accountability of the respective assets.  If these estimates or their relatedassumptions change in the future, the Company may be required to recordimpairment charges for these assets not previously recorded.  On January 1, 2002, the Company adoptedStatement of Financial Accounting Standards No. 142, “Goodwill and OtherIntangible Assets,” and will be required to analyze its goodwill for impairmentissues, based on fair values, during the first six months of fiscal 2002, andthen on a periodic basis thereafter.  During the year ended December 31, 2001, the Company did not record anyimpairment losses related to goodwill and other intangible assets.

 

*Medical and Other Benefits Payables*

 

The amount ofmedical and other benefits payables (the “loss reserves”) is determined basedon an estimation process that is very complex and uses information obtainedfrom both company specific and industry data, as well as general economicinformation (e.g., medical cost index).  The estimation process requires the Company to continuously monitor andevaluate the life cycle of claims, on type-of-business and nature-of-claimbases.  Using data obtained from thismonitoring and assumptions about the emerging trends, the Company developsinformation about the size of ultimate claims based on historical experienceand other available market information.  The most significant assumptions, which vary by class of business, usedin the estimation process include determining the trend in loss costs, theexpected consistency in the frequency and severity of claims incurred but notyet reported to prior year claims, changes in the timing of the reporting oflosses from the loss date to the notification date, and expected costs tosettle unpaid claims.   The Company alsomonitors the reasonableness of the judgments made in the prior year estimationprocess (referred to as a hindsight analysis) and adjusts current yearassumptions based on the hindsight analysis.

 

 

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Because theamount of the loss reserves is sensitive to assumptions, the Company does nottotally rely on a single estimate to determine the loss reserve .   To test the reasonableness of the bestestimate generated by the Company’s loss estimation process, the Companydevelops several estimates using generally recognized actuarial projectionmethodologies that result in a range of reasonably possible loss reserveoutcomes that are used to challenge the Company’s best estimate .   The Company will continue to closelymonitor these developments to ensure that its conclusions on the impact areappropriate .   Should other trendsemerge, the Company would react accordingly which could result in upwardadjustments to its reserves .   Anotherfactor that can significantly impact the loss reserve estimate is the impact oflegislative changes in health care, court resolutions and judicialinterpretations .   The Company onlyfactors into its assumptions actual legislative changes, court rulings andinterpretations .   Therefore, the lossreserve estimates made can be significantly impacted by future legislativeactions, rulings or interpretations.

 

*Litigation and Tax Contingencies*

 

The Companyand its affiliates are involved in various legal actions occurring in thenormal course of business.  In theopinion of management, adequate provision has been made for losses, which mayresult from these actions.  It ispossible, however, that future results of operations for any particularquarterly or annual period could be materially affected by changes in ourassumptions related to these proceedings. In addition, the Company has made no accruals for outstanding litigationin which management believes that the Company will prevail.  As of December 31, 2001, the Company hasaccrued its best estimate of the probable cost for the resolution of theseclaims.  This estimate has beendeveloped in consultation with internal and outside legal counsel that ishandling the Company’s defense in these matters and is based upon a combinationof litigation and settlement strategies. Certain litigation is being addressed before juries in states where pastjury awards have been significant .   Tothe extent additional information arises or strategies change, it is possiblethat the Company’s best estimate of its probable liability in these matters maychange.  The Company recognizes thecosts of legal defense in the periods incurred.  Accordingly, the future costs of defending claims are notincluded in the Company’s estimated liability.

 

The Companyfrequently faces challenges from domestic tax authorities regarding the amountof taxes due .   These challengesinclude questions regarding the timing and amount of deductions and theallocation of income.  In evaluating theexposure associated with the Company’s various filing positions, the Companyrecords reserves for probable exposures when identified .   Based on the Company’s evaluation of ourtax positions, the Company believes it has appropriately accrued for probableexposures .   To the extent the Companywere to prevail in matters for which accruals have been established or be requiredto pay amounts in excess of its reserves, the Company’s effective tax rate in agiven financial statement period may be materially impacted.

 

**CautionaryFactors**

 

This reportand other documents or oral presentations prepared or delivered by and on behalfof the Company contain or may contain “forward-looking statements” within themeaning of the safe harbor provisions of the United States Private SecuritiesLitigation Reform Act of 1995. Forward-looking statements are statements based upon management’sexpectations at the time such statements are made and are subject to risks anduncertainties that could cause the Company’s actual results to differmaterially from those contemplated in the statements.  Readers are cautioned not to place undue reliance on theforward-looking statements.  When usedin written documents or oral presentations, the terms “anticipate,” “believe,”“estimate,” “expect,” “forecast,” “objective,” “plan,” “possible,” “potential,”“project” and similar expressions are intended to identify forward-lookingstatements.

 

In addition tothe assumptions and other factors referred to specifically in connection withsuch statements, other factors could cause the Company’s actual results todiffer materially from those contemplated in any forward-lookingstatements.  Also, a number of factorsspecific to the Company or related to its business may impact the performanceof Cobalt common stock.  Among thesefactors are the following:

 

 

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*The Company'sRegulated Subsidiaries are Required by State Regulations and the LicenseAgreement with the BCA to Maintain Certain Levels of Capital.*

 

Stateregulations govern the amount of capital required to be retained in Cobalt’sregulated subsidiaries and the ability of those regulated subsidiaries to pay dividends.  Those state regulations include therequirement to maintain minimum levels of statutory capital and surplus,including meeting the requirements of the RBC promulgated by the NAIC.  The OCI has broad authority to take certainactions in the event those capital requirements are not met.  Those actions could significantly impact theway the Company conducts business and its ability to access capital from theoperations of its regulated subsidiaries, and could have a material adverseeffect on its results of operations and financial condition.  In addition, the BCA imposes certainfinancial and service performance requirements, including maintaining minimumcapital requirements based on RBC.  TheBCA is entitled to terminate the license agreement if the Company does notsatisfy those requirements.  Any newminimum capital requirements adopted in the future by the BCA or stateregulation may increase the capital requirements of the Company.

 

*Changes in Lawsand Government Regulations May Adversely Affect the Company’s Business.*

 

Changes inlaws and government regulations designed to protect providers and membersrather than shareholders could harm the Company’s business.  The Company’s business is extensivelyregulated by the states in which it operates and, to a lesser extent, by thefederal government.  Changes in existinglaws and rules, the enactment of new laws and rules and changinginterpretations of these laws and rules could, among other things:

 

•      force the Company to change how it doesbusiness;

•      restrict revenue and enrollment growth;

•      increase health care and administrativecosts;

•      impose additional capital requirements;and

•      increase or change the Company’s managedcare liability.

 

Suchregulations govern, among other things: (i) the amount of dividends and otherdistributions that can be paid by certain subsidiaries without prior approvalor notification; (ii) the granting and revoking of licenses to transactbusiness, trade practices, premium rate regulation, underwriting standards, policyforms, claims payment, licensing of agents and brokers, minimum reserve andcapital surplus requirements; and (iii) compelled participation in, andassessments in connection with, risk-sharing pools and guaranty funds.  Such regulation is primarily intended toprotect policyholders rather than investors.

 

Numerousproposals relating to changes in health care law have been introduced, and somehave been passed, by Congress and the states in which the Company operates ormay operate in the future.  Changes inapplicable laws and regulations are continually being considered andinterpretations of existing laws and rules may also change from time totime.  The Company is unable to predictwhat regulatory changes may occur or what effect any particular change may haveon its business.  Although some of therecent changes in government regulations, such as the removal of therequirements on the enrollment mix between commercial and public sectormembership, have encouraged managed care participation in public sectorprograms, the Company is unable to predict whether new laws or proposals willcontinue to favor or hinder the growth of managed health care.

 

The Companycannot predict the outcome of these legislative or regulatory proposals or theeffect that they might have on its business. Legislation or regulations which require changes in the Company’scurrent manner of operation, provide additional benefits or change contractarrangements may seriously harm the Company’s operations and financial results.

 

 

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*GovernmentReviews, Audits and Investigations May Adversely Affect the Company’s Business.*

 

Cobalt'ssubsidiaries are subject to various governmental reviews, audits and *investigations*. Any adverse investigation, audit results or sanctions could result in:

 

•      damage to the reputation of Cobalt and itssubsidiaries in various markets;

•      increased difficulty in selling productsand services;

•      loss of a license to act as an insurer orhealth maintenance organization or to otherwise provide a service;

•      loss of the right to participate invarious federal programs, including the Medicare Supplement and Medicare Riskprograms and Medicare Part A processing; and

•      imposition of significant fines, penaltiesand other sanctions.

 

*InadequatePremiums Would Negatively Affect Revenues and Profitability.*

 

Most ofCobalt’s revenues are generated by premiums consisting of fixed monthlypayments per member.  These premiums arefixed by contract, and the Company is obligated during the contract period toprovide health care services as established by contract.  The Company has less control over costsrelated to the provision of health care than over its selling, general andadministrative expenses.  Historically,our expenses related to health benefits as a percentage of premium revenue havefluctuated, and the percentage for any given fiscal quarter may not beindicative of full year or future results. If premiums are not increased and expenses related to health benefitsrise, Cobalt’s earnings would be impacted negatively.  In addition, actual health benefits costs may exceed estimatedcosts.  The premiums received undercurrent contracts may therefore be inadequate to cover all claims, which maycause the Company’s earnings to decline.

 

*A Reduction inthe Number of Subscribers to the Company’s Health Care Programs May HarmProfitability.*

 

A reduction inthe number of subscribers to the Company’s health care programs could adverselyaffect its financial position, results of operations and cash flows.  Factors that could contribute to the loss ofmembership include:

 

•                  failure toobtain new customers or retain existing customers;

•      premium increases and benefit changes;

•      reduction in the Company’s providernetwork;

•      the Company’s exit from markets;

•      reductions in work force by existingcustomers; or

•      negative publicity and news coverage.

 

*Cobalt’s Inability to Manage Medical Costs Effectively WouldReduce Profitability.*

 

Cobalt’sprofitability depends, to a significant degree, on its ability to predict andeffectively manage medical costs. Changes in health care regulations and practices, level of use of healthcare services, hospital costs, pharmaceutical costs, major epidemics, newmedical technologies, and other external factors, including general economicconditions or widespread bioterrorist acts, are beyond the Company’s controland would reduce its ability to predict and effectively control the costs ofproviding health care services. Although Cobalt has been able to manage medical costs through a varietyof techniques, including various payment methods to primary care physicians andother providers, advance approval for hospital services and referralrequirements, medical management and quality management programs, itsinformation systems, and reinsurance arrangements, it may not be able tocontinue to manage costs effectively in the future.

 

*Rising Health Care Costs May Reduce Profitability.*

 

Profitabilitymay be adversely affected by rising health care costs and changes in thedelivery of health care services.  Muchof the premium revenue the Company receives is based upon rates set beforeservices are delivered, and the related costs are usually incurred on aprospective annual basis.  Although theCompany attempts to base the premiums charged on an estimate of future healthcare costs over the fixed premium period, competition, regulations and othercircumstances may limit its ability to fully base premiums on these estimatedcosts.

 

 

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*Limited Abilityto Accurately Estimate Incurred Medical Expenses Could Negatively AffectReported Results.*

 

The Company’smedical expenses include estimates of medical expenses incurred but not yetreported, or IBNR.  The Companyestimates its IBNR medical expenses based on a number of factors, includingprior claims experience, maturity of markets, complexity of products andstability of provider networks. Adjustments, if necessary, are made to medical expenses in the periodduring which the actual claim costs are ultimately determined or when criteriaused to estimate IBNR change.  TheCompany utilizes the services of independent actuaries who are contracted on aregular basis to calculate and review the adequacy of its medical liabilities,in addition to using internal resources. The Company cannot be sure that its IBNR estimates are adequate or thatadjustments to such IBNR estimates will not harm its results ofoperations.  Further, the inability toaccurately estimate IBNR may also affect the Company’s ability to take timelycorrective actions, further exacerbating the negative impact on its results.

 

The Companymaintains reinsurance to protect it against severe or catastrophic medicalclaims, but there can be no assurance that such reinsurance coverage will beadequate or available in the future or that the cost of such reinsurance willnot limit the Company’s ability to obtain it.

 

*Inability toEnter into or Maintain Satisfactory Relationships With Provider Networks WouldHarm Profitability.*

 

Profitability will be dependent upon theCompany's ability, and the ability of its subsidiaries, to contract onfavorable terms with hospitals, physicians and other health careproviders.  The failure to securecost-effective health care provider contracts may result in a loss ofmembership or higher medical costs.  Inaddition, the inability to contract with providers, or the inability ofproviders to provide adequate care, could adversely affect the Company'sresults of operations.

 

The Company’sprovider arrangements with primary care physicians and specialists usually arefor one to two-year periods and automatically renew for successive one-yearterms, subject to termination for cause based on provider conduct or otherappropriate reasons.  The contractsgenerally may be cancelled by either party upon 90 to 120 days’ prior writtennotice.  Contracts with hospitals areusually for one to two-year periods and automatically renew for successiveone-year periods, subject to termination for cause due to provider misconductor other appropriate reasons. Generally, hospital contracts may be canceled by either party withoutcause on 90 to 150 days’ prior written notice. There can be no assurance that the Company will be able to continue torenew such contracts or enter into new contracts enabling it to service itsmembers profitably.  The Company will berequired to establish acceptable provider networks prior to entering newmarkets.  Although it has establishedlong-term relationships with many of its providers, the Company may be unableto enter into agreements with providers in new markets on a timely basis orunder favorable terms.  If the Companyis unable to retain current provider contracts or enter into new providercontracts timely or on favorable terms, profitability will be harmed.

*NegativePublicity May Damage the Company’s Reputation.*

 

The healthcare industry is subject to negative publicity.  Negative publicity may result in increased regulation andlegislative review of industry practices which may further increase the cost ofdoing business and adversely affect profitability by:

 

•                  adverselyaffecting the ability to market products or services;

•                  requiring theCompany to change its products and services; or

•                  increasing theregulatory burdens under which the Company operates.

 

In addition,as long as the Company uses the Blue Cross and Blue Shield names and servicemarks in marketing its managed care products, any negative publicity concerningthe BCA or other BCA licensees may adversely affect its business.

 

 

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*Lawsuits andOther Claims Against the Company Under the Health Insurance Portability andAccountability Act of 1996 May Negatively Impact Its Profitability andReputation.*

 

The HealthInsurance Portability and Accountability Act of 1996, or HIPAA, broadened thescope of fraud and abuse laws applicable to health care companies.  HIPAA created civil penalties for, amongother things, billing for medically unnecessary goods or services.  HIPAA establishes new enforcement mechanismsto combat fraud and abuse, including a whistleblower program.

 

The federalgovernment has enacted, and state governments are enacting, other fraud andabuse laws as well.  The Company’sfailure to comply with HIPAA or these other laws could result in criminal orcivil penalties and exclusion from Medicaid or other governmental health careprograms and could lead to the revocation of Cobalt’s licenses.  These penalties or exclusions, were theyimposed, would negatively impact the Company’s ability to operate its business.

 

*The Company MayBe Subject to Claims Relating to Managed Care Liability, Which Could Cause itto Incur Significant Expenses.*

 

The Company’sproviders and employees involved in care management decisions may be exposed tothe risk of managed care liability claims. In addition, states are beginning to adopt legislation that permits managedcare organizations to be held liable for negligent treatment decisions orbenefit coverage determinations.  Claimsof this nature, if successful, could result in substantial damage awardsagainst the Company that could exceed the limits of any applicable managed careliability insurance coverage. Therefore, successful claims asserted against the Company or itsemployees could adversely affect the Company’s financial condition andprofitability.

 

In addition,Cobalt may be subject to other litigation that may adversely affect itsbusiness or results of operations.  TheCompany maintains managed care liability insurance and such other lines ofcoverage as it believes are reasonable in light of its experience to date.  However, this insurance may not be sufficientor available at a reasonable cost to protect the Company from liabilities whichmight adversely affect its business or results of operations.  Even if any claims brought against it wereunsuccessful or without merit, the Company would still have to defend againstsuch claims.  Any such defenses may betime-consuming and costly, and may distract management’s attention.  As a result, the Company may incursignificant expenses and may be unable to effectively operate its business.

 

*Failure toProperly Maintain the Integrity of Proprietary Information and InformationSystems Could Result in the Loss of Customers or Decrease Profitability.*

 

Cobalt’sbusiness depends in part on its ability to maintain its information systems andto ensure the continued integrity of proprietary information.  The Company is committed to maintaining andenhancing existing information systems and developing new systems in order tokeep pace with continuing changes in information processing technology,industry standards, and customer preferences. If it does not maintain effective and efficient information systems,then the Company could experience the loss of existing customers, difficulty inattracting new customers, customer and provider disputes, regulatory problems,increases in administrative expenses or other adverse consequences.

 

*The BCA MayRevoke the Company’s License Agreements.*

 

In connectionwith the license agreement with the BCA, Cobalt and certain of its subsidiariesare subject to ongoing and customary financial and service performancereview.  Because of the financialperformance of Cobalt, BCBSUW and Compcare, the BCA has included these entitiesin its Plan Performance Response Monitoring Process, or PPRMP.  As a result, the BCA has requested thatCobalt regularly submit additional interim financial information to theAssociation.  In addition, the PPRMPthresholds require that BCBSUW maintain a prescribed level of escrowed assetsas a financial guarantee for its transactions with other Blue Cross plans.  The PPRMP also requires that BCBSUW providecertain notices to the BCA regarding transactions with other Blue Cross plans.

 

 

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To maintainits Association license, BCBSUW is required to maintain a minimum level ofstatutory capital and surplus based upon the RBC.  As of December 31, 2001, statutory and surplus for Cobalt, BCBSUWand Compcare exceeded the minimum licensure level.  The BCA is entitled to terminate its license agreement withBCBSUW, including the right to use the Blue Cross and Blue Shield trademarks,if BCBSUW’s statutory capital and surplus falls below the company action levelof RBC.  In addition, the BCA isentitled to terminate the license agreement if the Company does not satisfycertain performance requirements or if other events described in the licenseagreement, some of which are beyond the Company’s control, were to occur(including, but not limited to, violations of the ownership limitationscontained in the Company’s Amended and Restated Articles of Incorporation orviolations of divestiture deadlines by the Foundation).  Termination of this license agreement wouldsignificantly harm the Company’s ability to compete in its markets and couldsubject the Company to monetary penalties to the BCA.

 

*Cobalt isSubject to Competition Which Affects its Ability to Increase Penetration of theMarkets it Services.*

 

Cobaltcompetes on the basis of size, price, quality of provider network, benefitsprovided and quality of service.  TheCompany has numerous types of competitors, including other health plans,insurers and third-party administrators and traditional state Medicaid programsthat reimburse providers as care is provided. Some of the health plans with which the Company competes havesubstantially larger enrollments, greater financial and other resources andoffer a broader scope of products than the Company does.

 

In addition,the Company relies to a large degree on creating name brand recognition throughcommunity-based programs.  Where theCompany has only recently entered a market or competes with health plans muchlarger than Cobalt, the Company may be at a competitive disadvantage unless anduntil its community-based programs and other promotional activities createbrand awareness.

 

In certainmarkets the Company competes with organizations which have a substantial marketshare.  In other markets competinghealth plans may be owned by providers. Organizations with sizable market share or provider-owned plans canobtain favorable financial arrangements which are not available to the Company.  Without such arrangements, Cobalt cannoteffectively compete in such markets.

 

*Stock Sales bythe Foundation Could Cause the Cobalt Common Stock Price to Fall.*

 

The Foundationand Cobalt entered into a voting trust and divestiture agreement in connectionwith the combination.  The voting trustand divestiture agreement requires the Foundation to reduce its ownership ofCobalt common stock by selling shares of Cobalt common stock.  Based upon the current number of shares ofCobalt stock outstanding, the Foundation must sell approximately eleven millionshares of Cobalt common stock within three to four years after the combinationand it must sell a total of 23.2 million shares of Cobalt common stock withinfive to seven years after the combination. Given the limited historical trading volume for Cobalt common stock,significant sales of Cobalt common stock by the Foundation, and the expectationof these sales, could cause the Cobalt common stock price to fall.  The price of the Cobalt stock could be affectedby these factors for an undetermined period of time.  If the Foundation fails to meet these divestiture requirements,Cobalt will arrange for the sale of the Foundation’s shares pursuant to thevoting trust and divestiture agreement.

 

 

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*RegistrationRights of the Foundation May Inhibit the Ability of Cobalt to Raise AdditionalFunds Through Equity Offerings.*

 

The insuranceindustry is in a state of change, and, in order to take advantage ofacquisition and other investment opportunities that may arise in the future,Cobalt may desire the flexibility to raise funds quickly by selling Cobaltcommon stock in the equity markets.  Theregistration rights agreement with the Foundation could limit or make moredifficult Cobalt’s ability to raise funds through equity offerings upondesirable terms.

 

Cobalt’sfailure to raise additional equity capital when required could:

 

•                  restrict itsfuture growth, both internally and through acquisitions;

•                  inhibit itsability to invest in technology and other products and services that it mayneed;

•                  adversely affectits ability to compete in the markets it serves; and

•                  restrict theavailability of capital available for Cobalt subsidiaries.

 

*Provisions inCobalt’s Amended and Restated Articles of Incorporation and Bylaws May PreventCobalt from Being Sold to a Third Party Unless the Cobalt Board of DirectorsApproves the Sale, and May Limit or Eliminate Increases in Stock Price Based on“Takeover” Speculation.*

 

The Amendedand Restated Articles of Incorporation and Bylaws of Cobalt include provisionsrequired by the Association for its for-profit licensees which the Associationdesigned to protect the independence of its for-profit licensees from anysingle shareholder. These provisions include the following:

 

•                  ownershiplimitations that prohibit institutional investors from owning 10% or more ofthe Cobalt voting securities, and prohibit other investors from owning 5% ormore of the Cobalt voting securities; and

•                  initially, atleast 80% of the Cobalt directors must be independent directors who are notaffiliated or associated with the Foundation or any shareholder that ownsCobalt shares in excess of the ownership limits.

 

Theseprovisions make it more difficult for a third party to acquire Cobalt in atransaction that the Cobalt board of directors has not negotiated or approvedbut in which the Cobalt shareholders may receive a premium for their shares.Also, these provisions can deter a party from acquiring a significant ownershipposition in Cobalt prior to submitting an offer to the Cobalt board ofdirectors, and, as a result, the Cobalt common stock may trade at lower pricesrelative to other companies that do not have similar ownership limitations intheir charter documents.

 

*Cobalt Directors are Generally Able to Controlthe Outcome of All Matters Other Than Change of Control Proposals that areSubmitted to the Cobalt Shareholders for a Vote as Long as the FoundationBeneficially Owns a Substantial Percentage of the Outstanding Shares of CobaltCommon Stock.*

 

The Foundationbeneficially owns approximately 77.5% of the outstanding shares of Cobaltcommon stock.  The Foundation has placedall of its shares in a voting trust for a trustee to vote and dispose of underthe terms of the voting trust and divestiture agreement.

 

The trustee ofthe voting trust must, as a general matter, vote all of the Foundation’s sharesheld in the voting trust as directed by a majority of Cobalt’s independentdirectors and a majority of all of Cobalt’s directors on all proposals ormatters that may come before the Cobalt shareholders, except for mattersrelating to proposed combination and sale transactions if the Cobaltshareholders will not own a majority of the shares of the resulting company.Thus, for so long as the Foundation beneficially owns a significant number ofthe Cobalt shares, the Cobalt board of directors will be able to control theoutcome of most matters brought before the Cobalt shareholders for a vote,including amendments to the Cobalt Amended and Restated Articles of Incorporationand Bylaws and the election and removal of the Cobalt directors, subject toprior OCI approval as long as the Foundation beneficially owns more than 20% ofthe outstanding shares of Cobalt.

 

 

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*Cobalt Will Not Be Able to Sell or MergeWithout the Approval of the Foundation as Long as the Foundation BeneficiallyOwns 50% or More of the Outstanding Shares of Cobalt Common Stock.*

 

Theacquisition of Cobalt by means of a merger or consolidation will require theapproval of the Cobalt board of directors and the holders of a majority of theshares of the Cobalt common stock. As long as the Foundation beneficially ownsmore than 50% of the Cobalt common stock, it will be able—by itself—to blockany proposed sale of Cobalt even if the Cobalt board of directors and othershareholders would otherwise favor the transaction. In addition, for so long asthe Foundation beneficially owns at least 20% of the outstanding shares ofCobalt, Cobalt must consult with the Foundation prior to soliciting, or uponreceiving, a business combination proposal which, if consummated, would resultin the then existing shareholders of Cobalt owning less than a majority of theoutstanding shares of the resulting company.

 

*The Foundation May Have Interests in Cobaltthat Differ from The Interests of Other Shareholders.*

 

The Foundationis a non-stock, non-profit corporation with the purpose of benefiting thecitizens of the State of Wisconsin by funding health care initiatives developedby the University of Wisconsin Medical School and the Medical College ofWisconsin.  The Foundation is expectedto vote its shares of the Cobalt common stock on proposed merger and saletransactions based upon its best interests. The interests of the Foundation ina merger or sale transaction may be different from the interests of othershareholders.

 

*Cobalt Directors Will Be Able to Ensure TheirRe-Election and Designate Their Successors as Long as the FoundationBeneficially Owns a Substantial Number of Outstanding Shares of Cobalt CommonStock.*

 

Cobaltdirectors are elected by plurality vote, and the Cobalt shareholders do nothave cumulative voting rights. In any election of directors, the trustee of thevoting trust must vote the Foundation’s shares in favor of each nomineeapproved by a majority of the directors of Cobalt who are deemed to be“independent” under the Association’s standards and a majority of all of thedirectors of Cobalt. However, if directors are eligible for public shareholderrepresentation, the trustee will be directed to vote its shares in the sameproportion and for the same candidates voted for by the Cobalt shareholders.Also, the directors of Cobalt may be removed from office only for cause asdescribed in the Amended and Restated Articles of Incorporation and then only ifthe holders of 75% or more of the outstanding shares of Cobalt common stockvote for removal. The trustee of the voting trust will vote all of theFoundation’s shares held in the voting trust against the removal of a directorunless a majority of the independent directors of Cobalt and a majority of allof the directors of Cobalt initiate or consent to the removal. As a result, thedirectors of Cobalt will likely be able to ensure their re-election anddesignate their successors for as long as the Foundation owns a substantialnumber of shares of Cobalt common stock.

 

*There Are Additional Miscellaneous Risks thatMay Affect Future Results of Operations, Financial Condition or Business.*

 

Additionalrisks and uncertainties that may affect the Company’s future results ofoperations, financial condition or business include, but are not limited to:

 

•                  demand for, andmarket acceptance of, its products and services;

•                  ability todevelop and deliver new products and services and adapt existing products andservices to meet customer needs and expectations;

•                  ability to keeppace with technological change in order to provide better service and remaincompetitive;

•                  ability toattract and retain capital for growth and operations on competitive terms;

•                  governmentintervention in the health care industry; and

•                  changes inaccounting policies and practices.

 

 

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**ITEM 7a. Quantitative and Qualitative Disclosures about Market Risk**

 

Because ofCobalt’s investment policies, the primary market risks associated with Cobalt’sportfolio are interest rate risk, credit risk and the risk related tofluctuations in equity prices. With respect to interest rate risk, a reasonablynear-term rise in interest rates could negatively affect the fair value ofCobalt’s bond portfolio.  However,because Cobalt considers it unlikely that Cobalt would need or choose tosubstantially liquidate its portfolio, Cobalt believes that such an increase ininterest rates would not have a material impact on future earnings or cashflows. In addition, Cobalt is exposed to the risk of loss related to changes incredit spreads. Credit spread risk arises from the potential that changes in anissuer’s credit rating or credit perception may affect the value of financialinstruments.

 

The overallgoal of the investment portfolio is to support the ongoing operations ofCobalt. Cobalt’s philosophy is to manage assets to maximize total return over amultiple-year time horizon, subject to appropriate levels of risk. Cobaltmanages these risks by establishing gain and loss tolerances, targetingasset-class allocations, diversifying among asset classes and segments withinvarious asset classes, and using performance measurement and reporting.

 

Cobalt uses asensitivity model to assess the interest rate risk of its fixed incomeinvestments. The model includes all fixed income securities held as of December31, 2001 and incorporates assumptions regarding the impact of changing interestrates on expected cash flows for certain financial assets with prepaymentfeatures, such as callable bonds and mortgage-backed securities. The reductionin the fair value of Cobalt’s modeled financial assets (aggregate of BCBSUW andUWS portfolios) resulting from a hypothetical instantaneous 100 basis pointincrease in the U.S. Treasury yield curve is estimated at $7.0 million as ofDecember 31, 2001.

* *

 

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**ITEM8.**  **Financial Statements and Supplementary Data**

 
| Report of Independent Auditors                                                                   |
|--------------------------------------------------------------------------------------------------|
| Consolidated  Financial Statements                                                               |
| Consolidated  Balance Sheets                                                                     |
| Consolidated  Statements of Operations                                                           |
| Consolidated  Statements of Changes in Shareholders’ Equity and Comprehensive Income (Loss) |
| Consolidated  Statements of Cash Flows                                                           |
| Notes to the  Consolidated Financial Statements                                                  |

 

 

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Report of Independent Auditors

 

Board of Directors

Cobalt Corporation

 

We haveaudited the accompanying consolidated balance sheets of Cobalt Corporation (the“Company”) as of December 31, 2001 and 2000, and the related consolidatedstatements of operations, changes in shareholders’ equity and comprehensiveincome (loss) and cash flows for each of the three years in the period endedDecember 31, 2001.  Our audits alsoinclude the financial statement schedules listed in the index at Item14(a).  These financial statements andschedules are the responsibility of the Company’s management. Ourresponsibility is to express an opinion on these financial statements based onour audits.

 

We conductedour audits in accordance with auditing standards generally accepted in theUnited States. Those standards require that we plan and perform the audits toobtain reasonable assurance about whether the financial statements are free ofmaterial misstatement. An audit includes examining, on a test basis, evidencesupporting the amounts and disclosures in the financial statements. An auditalso includes assessing the accounting principles used and significantestimates made by management, as well as evaluating the overall financialstatement presentation. We believe that our audits provide a reasonable basisfor our opinion.

 

In ouropinion, the financial statements referred to above present fairly, in allmaterial respects, the consolidated financial position of the Company atDecember 31, 2001 and 2000, and the consolidated results of its operationsand its cash flows for each of the three years in the period endedDecember 31, 2001, in conformity with accounting principles generallyaccepted in the United States.  Also, inour opinion, the related financial statement schedules, when considered inrelation to the basic financial statements taken as a whole, present fairly inall material respects the information set forth therein.

 
| Milwaukee,  Wisconsin |   | Ernst & Young LLP |
|-----------------------|--------|-----------------------|
| March 26,  2002       |   |                  |

 

 

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Cobalt Corporation

 

Consolidated Balance Sheets

 
|                                                                                                                                                                    |   | **December  31,**  |     |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------------------|----------|
|                                                                                                                                                                    |   | **2001**           |     | **2000** |   |
|                                                                                                                                                                    |   | **(In thousands)** | * * |
| Assets                                                                                                                                                                  |   |               |     |   |   |
| Current assets:                                                                                                                                                         |   |               |     |   |   |
| Cash and cash equivalents                                                                                                                                               |   | $                  | 51,918   |   | $ | 1,305 |   |
| Investments—available-for-sale, at fair  value                                                                                                                     |   | 180,692            |     | 44,373 |   |
| Due from affiliates                                                                                                                                                     |   | 5,091              |     | 12,896 |   |
| Premium receivables                                                                                                                                                     |   | 33,971             |     | 3,325 |   |
| Due from clinics and providers                                                                                                                                          |   | 11,922             |     | 7,063 |   |
| Other receivables                                                                                                                                                       |   | 52,889             |     | 28,127 |   |
| Prepaid expenses and other current assets                                                                                                                               |   | 31,441             |     | 18,385 |   |
| Total current  assets                                                                                                                                                   |   | 367,924            |     | 115,474 |   |
|                                                                                                                                                                    |   |               |     |   |   |
| Noncurrent  assets:                                                                                                                                                     |   |               |     |   |   |
| Investments—held-to-maturity, at amortized  cost                                                                                                                   |   | 11,007             |     | — |   |
| Investment in affiliates, net                                                                                                                                           |   | 79,466             |     | 105,609 |   |
| Property and equipment, net                                                                                                                                             |   | 33,632             |     | 25,139 |   |
| Goodwill, net                                                                                                                                                           |   | 102,749            |     | 8,020 |   |
| Note receivable from affiliate                                                                                                                                          |   | —             |     | 70,000 |   |
| Prepaid pension                                                                                                                                                         |   | 53,837             |     | 36,471 |   |
| Deferred income taxes                                                                                                                                                   |   | 29,505             |     | 19,067 |   |
| Other  noncurrent assets                                                                                                                                                |   | 48,685             |     | 14,425 |   |
| Total assets                                                                                                                                                            |   | $                  | 726,805  |   | $ | 394,205 |   |
|                                                                                                                                                                    |   |               |     |   |   |
| Liabilities and shareholders’ equity                                                                                                                               |   |               |     |   |   |
| Current liabilities:                                                                                                                                                    |   |               |     |   |   |
| Medical and other benefits payable                                                                                                                                      |   | $                  | 222,768  |   | $ | 104,415 |   |
| Advance premiums                                                                                                                                                        |   | 88,495             |     | 40,745 |   |
| Due to affiliates                                                                                                                                                       |   | 59                 |     | 910 |   |
| Payables and accrued expenses                                                                                                                                           |   | 50,860             |     | 29,597 |   |
| Short-term debt                                                                                                                                                         |   | 12,369             |     | — |   |
| Other current liabilities                                                                                                                                               |   | 29,734             |     | 5,162 |   |
| Total current liabilities                                                                                                                                               |   | 404,285            |     | 180,829 |   |
|                                                                                                                                                                    |   |               |     |   |   |
| Noncurrent liabilities:                                                                                                                                                 |   |               |     |   |   |
| Other benefits payable                                                                                                                                                  |   | 47,282             |     | — |   |
| Deferred income taxes                                                                                                                                                   |   | 29,505             |     | 20,699 |   |
| Postretirement benefits other than pension                                                                                                                              |   | 18,090             |     | 12,722 |   |
| Other  noncurrent liabilities                                                                                                                                           |   | 19,421             |     | 11,012 |   |
| Total liabilities                                                                                                                                                       |   | 518,583            |     | 225,262 |   |
|                                                                                                                                                                    |   |               |     |   |   |
| Shareholders’ equity:                                                                                                                                              |   |               |     |   |   |
| Common stock (no par value, no stated  value, 48,542,947 issued (including 7,949,904 owned by subsidiary, see Note  1) and 40,593,043 outstanding at December 31, 2001) |   | 249,566            |     | — |   |
| Retained earnings (deficit)                                                                                                                                             |   | (41,979            | )        | 170,907 |   |
| Accumulated  other comprehensive income (loss)                                                                                                                          |   | 635                |     | (1,964 | ) |
| Total shareholders’ equity                                                                                                                                         |   | 208,222            |     | 168,943 |   |
| Total liabilities and shareholders’ equity                                                                                                                         |   | $                  | 726,805  |   | $ | 394,205 |   |

 

*See accompanying Notes to the ConsolidatedFinancial Statements*

 

 

----

 

Cobalt Corporation

 

Consolidated Statements of Operations

 
|                                            |   | **Years  Ended December 31,**     |      |
|-------------------------------------------------|--------|----------------------------------------|-----------|
|                                            |   | **2001**                               |      | **2000** |   | **1999** |   |
|                                            |   | **(In thousands, except share  data)** | * *  |
| Revenues:                                       |   |                                   |      |   |   |   |   |
| Health services revenue:                        |   |                                   |      |   |   |   |   |
| Premium                                         |   | $                                      | 1,262,145 |   | $ | 538,080 |   | $ | 418,949 |   |
| Government contract fees                        |   | 117,192                                |      | 70,305 |   | 52,259 |   |
| Other                                           |   | 59,383                                 |      | 24,715 |   | 25,970 |   |
| Investment results                              |   | 12,526                                 |      | 9,583 |   | 18,510 |   |
| Total revenues                                  |   | 1,451,246                              |      | 642,683 |   | 515,688 |   |
|                                            |   |                                   |      |   |   |   |   |
| Expenses:                                       |   |                                   |      |   |   |   |   |
| Medical and other benefits                      |   | 1,121,357                              |      | 497,822 |   | 376,814 |   |
| Selling, general, administrative and other      |   | 323,377                                |      | 176,878 |   | 158,187 |   |
| Profit sharing on joint ventures                |   | 510                                    |      | — |   | — |   |
| Interest                                        |   | 561                                    |      | 300 |   | 553 |   |
| Amortization of goodwill                        |   | 5,908                                  |      | 622 |   | 191 |   |
| Total expenses                                  |   | 1,451,713                              |      | 675,622 |   | 535,745 |   |
|                                            |   |                                   |      |   |   |   |   |
| Operating loss                                  |   | (467                                   | )         | (32,939 | ) | (20,057 | ) |
| Loss from investment in affiliates, net of  tax |   | (22,724                                | )         | (6,526 | ) | (22,690 | ) |
| Pretax loss                                     |   | (23,191                                | )         | (39,465 | ) | (42,747 | ) |
| Income tax expense (benefit)                    |   | (886                                   | )         | 548 |   | — |   |
| Net loss                                        |   | $                                      | (22,305   | ) | $ | (40,013 | ) | $ | (42,747 | ) |
|                                            |   |                                   |      |   |   |   |   |
| Basic and diluted loss per common share         |   | $                                      | (0.58     | ) |   |   |   |   |

 

*See accompanying Notes to the ConsolidatedFinancial Statements*

 

 

----

 

Cobalt Corporation

 

Consolidated Statement of Changes in Shareholders' Equity and ComprehensiveIncome(Loss)

 
|                                                            |   | **Common  Shares Outstanding**        |   | **Common  Stock** |    | **Retained  Earnings (Deficit)** |   | **Accumulated  Other Comprehensive Income (Loss)** |   | **Total  Shareholders’ Equity** |   |
|-----------------------------------------------------------------|--------|---------------------------------------|--------|-------------------|---------|----------------------------------|--------|----------------------------------------------------|--------|--------------------------------------|--------|
|                                                            |   | **(In thousands, except share data)** |   |
|                                                            |   |                                  |   |              |    |                             |   |                                               |   |                                 |   |
| Balance at December 31, 1998                                    |   | —                                |   | $                 | —  |                             | $      | 246,083                                            |   | $                                    | 4,908  |   | $ | 250,991 |   |
| Comprehensive loss:                                             |   |                                  |   |              |    |                             |   |                                               |   |                                 |   |
| Net loss                                                        |   | —                                |   | —            |    | (42,747                          | )      | —                                             |   | (42,747                              | )      |
| Change in unrealized gains/losses on  investments, net of tax   |   | —                                |   | —            |    | —                           |   | (11,114                                            | )      | (11,114                              | )      |
| Comprehensive loss                                              |   |                                  |   |              |    |                             |   |                                               |   | (53,861                              | )      |
| Change in ownership of affiliates                               |   | —                                |   | —            |    | 2,979                            |   | —                                             |   | 2,979                                |   |
| Balance at December 31, 1999                                    |   | —                                |   | —            |    | 206,315                          |   | (6,206                                             | )      | 200,109                              |   |
| Comprehensive loss:                                             |   |                                  |   |              |    |                             |   |                                               |   |                                 |   |
| Net loss                                                        |   | —                                |   | —            |    | (40,013                          | )      | —                                             |   | (40,013                              | )      |
| Change in unrealized gains/losses on investments,  net of tax   |   | —                                |   | —            |    | —                           |   | 4,242                                              |   | 4,242                                |   |
| Comprehensive loss                                              |   |                                  |   |              |    |                             |   |                                               |   | (35,771                              | )      |
| Change in ownership of affiliates                               |   | —                                |   | —            |    | 4,605                            |   | —                                             |   | 4,605                                |   |
| Balance at December 31, 2000                                    |   | —                                |   | —            |    | 170,907                          |   | (1,964                                             | )      | 168,943                              |   |
| Comprehensive loss:                                             |   |                                  |   |              |    |                             |   |                                               |   |                                 |   |
| Net loss                                                        |   | —                                |   | —            |    | (22,305                          | )      | —                                             |   | (22,305                              | )      |
| Change in unrealized gains/losses on  investments, net of tax   |   | —                                |   | —            |    | —                           |   | 2,599                                              |   | 2,599                                |   |
| Comprehensive loss                                              |   |                                  |   |              |    |                             |   |                                               |   | (19,706                              | )      |
| Capitalization of Wisconsin United for  Health Foundation, Inc. |   | 31,313,390                            |   | 192,577           |    | (192,577                         | )      | —                                             |   | —                               |   |
| Issuance of common stock — acquisition                     |   | 9,096,303                             |   | 55,938            |    | —                           |   | —                                             |   | 55,938                               |   |
| Issuance of common stock — options  exercised              |   | 11,250                                |   | 51                |    | —                           |   | —                                             |   | 51                                   |   |
| Issuance of common stock — 401(k)                          |   | 172,100                               |   | 1,000             |    | —                           |   | —                                             |   | 1,000                                |   |
| Change in ownership of affiliates                               |   | —                                |   | —            |    | 1,402                            |   | —                                             |   | 1,402                                |   |
| Conversion of SAR’s to options                             |   | —                                |   | —            |    | 594                              |   | —                                             |   | 594                                  |   |
| Balance at December 31, 2001                                    |   | 40,593,043                            |   | $                 | 249,566 |                             | $      | (41,979                                            | )      | $                                    | 635    |   | $ | 208,222 |   |

 

*See accompanying Notes to the Consolidated Financial Statements*

* *

 

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Cobalt Corporation

 

Consolidated Statements of Cash Flows

 
|                                                                                                   |   | **Years  Ended December 31,** |     |
|--------------------------------------------------------------------------------------------------------|--------|-------------------------------|----------|
|                                                                                                   |   | **2001**                      |     | **2000** | ** ** | **1999** |   |
|                                                                                                   |   | **(In thousands)**            | * * |
| **Operating activities**                                                                               |   |                          |     |   |   |   |   |
| Net loss                                                                                               |   | $                             | (22,305  | ) | $ | (40,013 | ) | $ | (42,747 | ) |
| Adjustments to reconcile net loss to net  cash provided by (used in) operating activities:             |   |                          |     |   |   |   |   |
| Depreciation and amortization                                                                          |   | 18,329                        |     | 8,669 |   | 8,709 |   |
| Premium deficiency reserve-Medicare Risk                                                               |   | (3,617                        | )        | 3,617 |   | — |   |
| Write-off of deferred acquisition  costs-Medicare Risk                                                 |   | —                        |     | 2,434 |   | — |   |
| Impairment of data warehouse software asset                                                            |   | —                        |     | — |   | 2,398 |   |
| Loss from investment in affiliates, net of  tax                                                        |   | 22,724                        |     | 6,526 |   | 22,690 |   |
| Realized investment (gains) losses, net                                                                |   | (845                          | )        | 509 |   | (8,014 | ) |
| Deferred income taxes                                                                                  |   | (6                            | )        | 548 |   | — |   |
| Changes in other operating accounts, net of  acquisitions and conversion/combination related activity: |   |                          |     |   |   |   |   |
| Premium receivables                                                                                    |   | 13,877                        |     | (509 | ) | (218 | ) |
| Other receivables                                                                                      |   | (4,333                        | )        | (5,943 | ) | (229 | ) |
| Due from clinics and providers                                                                         |   | 5,302                         |     | (610 | ) | (1,692 | ) |
| Medical and other benefits payable                                                                     |   | 2,919                         |     | 25,162 |   | (6,160 | ) |
| Advance premiums                                                                                       |   | (2,229                        | )        | 9,598 |   | 5,244 |   |
| Due to/from affiliates, net                                                                            |   | (8,531                        | )        | (1,612 | ) | (5,643 | ) |
| Other, net                                                                                             |   | (8,319                        | )        | (76 | ) | (8,686 | ) |
| Net cash provided by (used in) operating  activities                                                   |   | 12,966                        |     | 8,300 |   | (34,348 | ) |
|                                                                                                   |   |                          |     |   |   |   |   |
| **Investing activities**                                                                               |   |                          |     |   |   |   |   |
| Acquisitions and combination activity                                                                  |   | 48,719                        |     | (1,013 | ) | (12,214 | ) |
| Purchases of available-for-sale investments                                                            |   | (155,701                      | )        | (8,553 | ) | (73,537 | ) |
| Purchases of held-to-maturity investments                                                              |   | (1,488                        | )        | — |   | — |   |
| Proceeds from sale and maturity of  available-for-sale investments                                     |   | 146,418                       |     | 26,261 |   | 125,624 |   |
| Proceeds from maturity of held-to maturity  investments                                                |   | 325                           |     | 655 |   | 5 |   |
| Additions to property and equipment, net                                                               |   | (6,089                        | )        | (8,116 | ) | (3,488 | ) |
| Net cash provided by investing activities                                                              |   | 32,184                        |     | 9,234 |   | 36,390 |   |
|                                                                                                   |   |                          |     |   |   |   |   |
| **Financing activities**                                                                               |   |                          |     |   |   |   |   |
| Net (repayments) borrowings of debt                                                                    |   | 5,463                         |     | (11,175 | ) | (2,440 | ) |
| Net cash provided by (used in) financing  activities                                                   |   | 5,463                         |     | (11,175 | ) | (2,440 | ) |
|                                                                                                   |   |                          |     |   |   |   |   |
| Cash and cash equivalents (overdraft):                                                                 |   |                          |     |   |   |   |   |
| Increase (decrease) during year                                                                        |   | 50,613                        |     | 6,359 |   | (398 | ) |
| Balance at beginning of year                                                                           |   | 1,305                         |     | (5,054 | ) | (4,656 | ) |
| Balance at end of year                                                                                 |   | $                             | 51,918   |   | $ | 1,305 |   | $ | (5,054 | ) |

** **

*See accompanying Notes to the Consolidated Financial Statements*

 

 

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Cobalt Corporation

 

Notes to Consolidated Financial Statements

 

As of December 31, 2001 and 2000 and the Three Years in the PeriodEnded December 31, 2001

 

**1.Organization, Accounting for Conversion and Combination, and Basis ofPresentation**

 

CobaltCorporation (“Cobalt” or the “Company”) (formerly known as United WisconsinServices, Inc. (“UWS”)) was created as a result of the Combination of UWS andBlue Cross & Blue Shield United of Wisconsin (“BCBSUW”) on March 23, 2001(the “Combination”).  On that date,BCBSUW converted from a service insurance corporation to a shareholder ownedcorporation.  Upon conversion, BCBSUWbecame a wholly-owned subsidiary of UWS through a combination of the two companies.  At the time of the conversion andcombination, BCBSUW owned approximately 46.6% of UWS’ outstanding commonstock.  In exchange for the ownership ofBCBSUW, Cobalt issued 31,313,390 shares of newly issued Company common stock tothe Wisconsin United for Health Foundation, Inc. (the “Foundation”).  The Foundation was established for the solepurpose of benefiting public health in Wisconsin from its earnings in theinvestment in Cobalt.

 

TheCombination was accounted for as a purchase by BCBSUW of the remaining9,096,303 shares of UWS that it did not already own at a market price of $6.15per share on the closing date.  Inaccordance with accounting principles generally accepted in the United States(“GAAP”), goodwill was recorded representing the excess of the market priceover the adjusted book value of UWS for the 53.4% of UWS that BCBSUW did notalready own.  Total goodwill recorded byCobalt as a result of the Combination amounted to $68,624,000, of which $22,076,000related to the recognition of a valuation allowance on the net deferred incometax assets recorded by UWS prior to the Combination.

 

For financialreporting purposes, the Combination is treated as a reverse purchasetransaction, whereby BCBSUW becomes the acquirer and reporting entity forpublic company reporting.  Therefore,the accompanying audited consolidated financial statements present theCompany’s financial position as of December 31, 2001, reflecting the purchaseaccounting adjustments for the Combination and include the accounts of both UWSand BCBSUW.  The financial position ofthe Company presented in the December 31, 2000 balance sheet represents onlythe accounts of BCBSUW, which includes BCBSUW’s 46.6% investment in UWS and 44%investment in American Medical Security Group, Inc. (“AMSG”) (see Note 6).  The consolidated statements of operations,cash flows, and changes in stockholders’ equity and comprehensive income (loss)for the year ended December 31, 2001, reflect the operations of the combinedUWS and BCBSUW entities effective March 31, 2001 with AMSG continuing to beaccounted for using the equity method. Prior to March 31, 2001, the consolidated financial statements includethe operations of BCBSUW, its wholly-owned subsidiary, United GovernmentServices, LLC (“UGS”) and BCBSUW’s investment in UWS and AMSG.  For purposes of calculating earnings percommon share (“EPS”) of the Company, the 7,949,904 shares of Cobalt commonstock owned by BCBSUW is accounted for as if it were treasury stock.

 

Theconsolidated financial statements subsequent to the Combination include theaccounts of the Company’s majority owned insurance subsidiaries (BCBSUW,Compcare Health Services Insurance Corporation (“Compcare”), Unity Health PlansInsurance Corporation (“Unity”), Valley Health Plan, Inc. (“Valley”), UnitedWisconsin Insurance Company (“UWIC”), and United Heartland Life InsuranceCompany (“UHLIC”)) and other non-insurance subsidiaries (UGS, InnovativeResource Group, LLC (“IRG”), Meridian Resources Company, LLC (“MRC”),Comprehensive Receivables Group, Inc. (“CRG”), United Wisconsin Proservices,Inc. (“Proservices”), United Heartland, Inc. (“UHI”) and C.C. Holdings, LLC(“CC Holdings”)).  All intracompanybalances and transactions after March 31, 2001 have been eliminated inconsolidation.

 

 

----

 

The Companyoffers full coverage, co-payment, preferred provider organization (“PPO”) andhealth maintenance organization (“HMO”) products to groups, along with Medicaresupplement and interim coverage options to individuals.  The Company’s subsidiary, BCBSUW, is theonly health insurer in the state operating full-service regional sales andcustomer service centers. Through UGS, the Company is a government contractorand processes Medicare claims for providers in all 50 states and is currently thelargest Part A Medicare processor in the nation.  The Company is also a leading provider of managed health careservices and employee benefit products, HMO products, dental, life, disabilityand workers’ compensation products, managed care consulting, electronic claimsubmission services, pharmaceutical management, managed behavioral healthservices, case management and receivables management services.

 

Included arethe pro forma (unaudited) consolidated statements of operations of the Companyfor the years ended December 31, 2001 and 2000, presented as if the Combinationhad occurred at the beginning of each year presented.  Pro forma basic and diluted EPS calculations are based on the proforma weighted average of the Company’s outstanding common stock during theperiod presented.

 

**PRO FORMA (UNAUDITED) STATEMENTS OFOPERATIONS**

 
|                                                             |   | **Years  ended December 31,**          |       |
|------------------------------------------------------------------|--------|----------------------------------------|------------|
|                                                             |   | **2001**                               |       | **2000** | ** ** |
|                                                             |   | **(In  thousands, except share data)** | * *   |
| Revenues:                                                        |   |                                   | ** ** |   | ** ** |
| Health services revenue:                                         |   |                                   |       |   |   |
| Premium                                                          |   | $                                      | 1,480,344  |   | $ | 1,289,472 |   |
| Government contract fees                                         |   | 117,192                                |       | 70,305 |   |
| Other                                                            |   | 69,795                                 |       | 64,861 |   |
| Investment results                                               |   | 13,976                                 |       | 12,343 |   |
| Total revenues                                                   |   | 1,681,307                              |       | 1,436,981 |   |
| Expenses:                                                        |   |                                   |       |   |   |
| Medical and other benefits                                       |   | 1,313,553                              |       | 1,189,450 |   |
| Selling, general, administrative and other                       |   | 358,153                                |       | 303,782 |   |
| Profit sharing on joint ventures                                 |   | 510                                    |       | 460 |   |
| Interest                                                         |   | 744                                    |       | 1,306 |   |
| Amortization of goodwill                                         |   | 7,453                                  |       | 6,262 |   |
| Total expenses                                                   |   | 1,680,413                              |       | 1,501,260 |   |
| Operating income (loss)                                          |   | 894                                    |       | (64,279 | ) |
| Gain   (loss) from investment in affiliates, net of tax     |   | (23,158                                | )          | 766 |   |
| Pretax loss                                                      |   | (22,264                                | )          | (63,513 | ) |
| Income tax expense (benefit)                                     |   | (409                                   | )          | 711 |   |
| Net loss                                                         |   | $                                      | (21,855    | ) | $ | (64,224 | ) |
|                                                             |   |                                   |       |   |   |
| Pro forma basic and diluted loss per share                       |   | $                                      | (0.54      | ) | $ | (1.59 | ) |
|                                                             |   |                                   |       |   |   |
| Pro forma basic and diluted weighted  average shares outstanding |   | 40,453,690                             |       | 40,412,393 |   |

 

 

----

 

**2. Management’s Plan**

 

During thethree years in the period ended December 31, 2001, the Company incurredoperating losses aggregating $53.5 million. Included in these losses are $27.8 million related to the Company’sparticipation in the Medicare Risk line of business, which the Company exitedeffective January 1, 2002. Prior to the Combination, UWS and its subsidiariesincurred additional operating losses aggregating $71.0 million for the firstquarter of 2001 and the two years ended December 31, 2000.  These losses largely relate to the HMObusiness in southeast Wisconsin. Significant actions were taken during 2001 to cancel unprofitable HMObusiness.  Also contributing to thecombined aggregate losses were $8.7 million of expenses relating to theCombination. On a pro forma basis, Cobalt’s operating income for 2001 was again of $0.9 million (see Note 1). Despite these recent operating losses and the implementation of changesin statutory accounting (“Codification”) effective January 1, 2001, the Companycomplied with minimum capital and liquidity requirements of the Office of theCommissioner of Insurance of the State of Wisconsin (“OCI”) and the BlueCrossBlueShield Association (“BCA”), during 2001, 2000 and 1999.  The Company maintained compliance, in part,by contributing regulated and non-regulated subsidiaries to regulated entitiesand by collateralizing certain intra-company debt obligations with the commonstock of affiliated entities.  OCI requested and management submitted a specificplan of action to continue to exceed the minimum capital requirements of theOCI and the BCA during 2002 (see Note 15).

 

Theoutstanding common stock of Compcare, Unity, Valley and UHI currently providethe collateral for approximately $92 million borrowed by Cobalt from BCBSUW andUWIC. These intra-company balances have been eliminated in the accompanyingDecember 31, 2001 consolidated balance sheet. However, the intra-companybalances continue to be an obligation of Cobalt to BCBSUW ($70 million) andUWIC ($22 million) in the statutory-basis financial statements of BCBSUW andUWIC. Cobalt is obligated to repay BCBSUW by January 2, 2003 and UWIC byOctober 1, 2002. Transfer of the pledged collateral to BCBSUW and UWIC willsatisfy the legal obligations, but would not assist BCBSUW in complying withminimum capital and liquidity requirements, since the minimum capitalcalculations for investments in subsidiaries require a greater discount thanfor cash, marketable securities or affiliated receivables. However, settlement of theseobligations in cash will assist compliance with minimum capital and liquidityrequirements.

 

At December31, 2001, all of the Company’s subsidiaries are accounted for in the BCBSUW orCompcare capital calculations as a result of contribution or collateralization.

 

In order toassure the Company’s regulated insurance subsidiaries continue to satisfyminimum capital and liquidity requirements, the OCI requested, managementdeveloped and the Cobalt board of directors approved a capital plan to improvethe Company’s position relative to minimum capital and liquidity requirements.The capital plan, which management has provided to and discussed with the OCIand BCA, includes the following action steps to maintain required capital andliquidity levels during 2002:

 

•                  Sell certainnon-regulated subsidiaries owned by the Company for cash and/or notes prior toOctober 1, 2002.

•                  Reduce BCBSUW’sinvestment in AMSG common stock from 45% of the shares outstanding to less than20% through public or private offerings during 2002.

•                  Obtain debtfinancing at the Company’s corporate holding company from one or moreinstitutional lenders to fund holding company liquidity needs including therepayment of the collateralized intra-company debt obligations between theholding company and its regulated subsidiaries.

 

 

----

 

•                  Achieve theCompany’s 2002 projected core earnings, which anticipate breakeven operatingresults for Compcare for the year ending December 31, 2002 as compared to anoperating loss of $32.5 million for the year ended December 31, 2001.Management expects Compcare’s significant change in profitability to occur as aresult of efforts in the fourth quarter of 2001 to cancel unprofitable businessand implement necessary premium increases for the remaining business.

•                  Adhere tocertain practices in conducting and accounting for affiliated transactions,notably involving the lending practices previously described. The Company willnot use uncollateralized non-operating intra-company balances in complying withminimum capital and liquidity requirements. The Company has reflected therevised practices in the December 31, 2001 regulated subsidiary statutory-basisfinancial statements filed with the OCI and other regulatory agencies.

•                  Satisfy the $70million debt obligation to BCBSUW by December 31, 2002, either with cashobtained through external financing or by transferring the stock of Compcare toBCBSUW or a combination thereof.

•                  Satisfy the $22million debt obligation to UWIC by September 30, 2002, either with cashobtained through external financing or by transferring the stock of Unity,Valley and UHI to UWIC.

 

The Companyexpects to remain in compliance with minimum capital and liquidity requirementsof the OCI and the BCA throughout 2002 by substantially completing the capitalplan described above or transactions with an equivalent impact on the Company’sposition relative to minimum capital and liquidity requirements.  Non-compliance with minimum capital andliquidity requirements may subject the Company to various regulatory actions bythe OCI and BCA, including rehabilitation, revocation of the Company’s licenseto sell insurance products in Wisconsin and revocation of the Company’s licenseto operate as a Blue Cross/Blue Shield franchisee.

 

**3.  Significant Accounting Policies**

 

**Cash and Cash Equivalents**

 

The Companyactively manages its cash and cash equivalents position to maintain optimalasset levels. Cash and cash equivalents include operating cash and short-terminvestments with original maturities of three months or less. These amounts arerecorded at cost, which approximates fair value.

 

**Investments**

 

Investmentsare classified as either held-to-maturity or available-for-sale.  Investments that the Company has the intentand ability to hold to maturity are designated as held-to-maturity and arestated at amortized cost. All other investments are classified asavailable-for-sale and are stated at estimated fair value based on quotedmarket prices.  The net unrealized gainor loss on investment securities classified as available-for-sale, net ofdeferred income taxes, is included in accumulated other comprehensive income inshareholders’ equity.  Realized gainsand losses from the sale of available-for-sale debt and equity securities arecalculated using the first-in, first-out basis.

 

Investments inaffiliates in which the Company does not have control, but has the ability toexercise significant influence over operating and financial policies areaccounted for by the equity method.  TheCompany’s investments in AMSG common stock and pre-combination UWS common stock(see Note 6) are accounted for on the equity method.

 

 

----

 

Investments indebt and equity securities, as well as investment in affiliates, are reviewedperiodically by Company management to determine whether there is any impairmentin the historical cost of the investment deemed other than temporary.  Any impairments deemed other than temporaryare recorded as a reduction of the historical cost of the respective investmentand as a realized loss in the Company’s consolidated statement ofoperations.  Effective December 31,2001, the Company recorded a reduction in the carrying value of its investmentin AMSG (see Note 6).

 

**Premium Receivables**

 

Premiumreceivables are stated at net realizable value, net of allowances foruncollectible amounts of $2,371,000 and $227,000 at December 31, 2001 and 2000,respectively, based upon historical collection trends and management’s bestestimate of the ultimate collectibility.

 

**Due from Clinics and Providers**

 

Amounts duefrom clinics and providers are stated at net realizable value, net ofallowances for uncollectible amounts of $9,124,000 and $846,000 at December 31,2001 and 2000, respectively, based upon management’s best estimate of theultimate collectibility.

 

**Other Receivables**

 

Otherreceivables are stated at net realizable value, net of allowances foruncollectible amounts of $3,848,000 and $4,061,000 at December 31, 2001and 2000, respectively, based upon management’s best estimate of the ultimatecollectibility.

 

**Property and Equipment**

 

Property andequipment are stated at cost less accumulated depreciation. Depreciation iscomputed using the straight-line method over the estimated useful lives of therelated assets, which is 3 years for computer equipment and software, 5 to10 years for furniture and other equipment, 30 years for landimprovements and 10 to 40 years for buildings and building improvements.  Any gain or loss realized upon retirement ordisposal is reflected in selling, general, administrative and other expenses inthe Company’s consolidated statement of operations.  On an on-going basis, the Company reviews events or changes incircumstances that may indicate that the carrying value of an asset may not berecoverable.

 

**Goodwill**

 

Goodwillrepresents the excess of the market value over the adjusted book value for theadditional UWS shares purchased by BCBSUW on March 23, 2001, (see Note 1) alongwith the excess of cost over the fair value of other businesses acquired.Goodwill was amortized on a straight-line basis over a weighted average periodof approximately 16 years. Amortization of goodwill was $5,908,000,$622,000 and $191,000 for the years ended December 31, 2001, 2000 and 1999,respectively.  Accumulated amortizationwas $10,425,000 and $813,000 at December 31, 2001 and 2000, respectively.

 

The Companyreviews goodwill for impairment annually or sooner if events or changes incircumstances occur, which may affect the estimated useful life or the recoverability of the remainingbalance of goodwill. At December 31, 2001, the Company’s managementbelieved that no material impairment of goodwill existed.

 

 

----

 

**Deferred Acquisition Costs**

 

Certain costsof acquiring new insurance policies for workers’ compensation and certainindividual health products have been deferred. Deferred acquisition costs of$9,488,000 and $6,930,000 at December 31, 2001 and 2000, respectively, areincluded in other noncurrent assets and are being amortized over the estimatedpremium-paying periods of the related policies. Acquisition costs of$4,467,000, $2,661,000 and $2,946,000 were capitalized in 2001, 2000 and 1999,respectively. Deferred acquisition costs of $3,384,000, $2,289,000 and $2,092,000were amortized during 2001, 2000 and 1999, respectively.

 

In addition tothe amortization above during 2000, the Company wrote-off $2,434,000 ofdeferred acquisition costs associated with the Medicare Risk line-of-business.

 

**Medical and Other Benefits**

 

The Companycontracts with various health care providers for the provision of certainmedical care services to its members and generally compensates those providerson a fee-for-service basis or pursuant to certain risk-sharing arrangements.  Medical and other benefits expense alsoconsists of capitation expenses, health and disability benefit claims and lifeinsurance benefits. In addition to actual benefits paid, medical and otherbenefits expense includes the change in estimates of reported and unreportedclaims and accrued capitation fees and adjustments, which are unpaid as of thebalance sheet date. The estimates of reported and unreported claims and accruedcapitation fees and adjustments, which are unpaid as of the balance sheet date,are based on historical payment patterns using standard actuarial techniques.Processing costs are accrued as operating expenses based on an estimate of thecosts necessary to process these claims.

 

The Company’syear-end claim liabilities are substantially satisfied through claim paymentsin the subsequent year. Any adjustments to prior period estimates are reflectedin the current period. Capitation represents fixed payments on a per member permonth basis to participating physicians, dentists, other medical specialistsand hospital systems as compensation for providing comprehensive health ordental care services. In addition, certain subsidiaries have risk-sharing,stop-loss, and bonus arrangements with certain providers. Estimated settlementsrelating to these arrangements are developed based on historical paymentpatterns using standard actuarial techniques. The portion of medical and otherbenefits payable pertaining to long-term disability, workers’ compensation andcertain life insurance products, which is estimated to be paid more than oneyear from the balance sheet date, is included as other benefits payable on theaccompanying consolidated balance sheets.

 

**Premium Deficiency Reserves**

 

Premiumdeficiency reserves (“PDR”) are recognized when it is probable that the futurecosts associated with a group of existing contracts will exceed the anticipatedfuture premiums on those contracts.  Forpurposes of determining whether a premium deficiency exists, contracts are groupedin a manner consistent with the Company’s method of acquiring, servicing andmeasuring profitability of such contracts. The Company calculates expected PDR based on budgeted revenues andapplicable expenses excluding investment income.

 

 

----

 

As a result ofmanagement’s assessment of the profitability of its Medicare Risk line ofbusiness, during the third quarter of 2000 the Company recorded a provision forprobable future losses (premium deficiency). At December 31, 2000, $3,617,000is included in medical and other benefits payable as a PDR for this line ofbusiness.  As of December 31, 2001,there was no PDR needed as a result of the Company exiting this businesseffective January 1, 2002. The provision for probable future losses iscalculated based on a comparison of anticipated premiums to health care relatedcosts, including estimated payments for providers, commissions and the cost ofcollecting premiums and processing claims. Inadequate compensation from theCenters for Medicare and Medicaid Services and increased medical benefits contributedto the requirement for a provision for future losses.

 

**Postretirement/PostemploymentBenefits**

 

Pension costsare accrued and are funded based on the minimum contribution requirements ofthe Employee Retirement Income Security Act of 1974.  The actuarial cost method used is the projected unit creditmethod.  The Company also providescertain health and life insurance benefits to retired employees.

 

The Companyaccrues disability related postemployment benefits when it becomes probablethat such benefits will be paid and when sufficient information exists to makereasonable estimates of the amounts to be paid.

 

**Revenue Recognition**

 

Healthservices premiums and managed behavioral health fees are recognized as revenuein the period in which enrollees are entitled to care. Managed care consultingrevenues are generally recognized when services are rendered. Case managementrevenues are recognized when services are billed.  Receivables management revenues are recognized when cash isreceived.

 

As a fiscal intermediaryfor Medicare, the Company is reimbursed for administrative costs incurred inproviding this service.  In addition,the Company also administers various uninsured programs sponsored by thefederal and state government (including State of Wisconsin Medicaid as asubcontractor) and private corporations, for which the Company receivesadministrative fees.  These revenues arerecognized as the services are performed.

 

Retrospectivepremium adjustments are recognized for certain groups for which actual claimsexperience differs from that which was anticipated when the related premiumrates were established.  Financialarrangements vary based upon the group and line of insurance involved.  The amount of premium that was subject toretrospective premium adjustments in 2001, 2000 and 1999, was $14,365,000,$16,441,000 and $35,179,000, respectively.

 

 

----

 

**Income Taxes**

 

Deferred taxassets and liabilities are recognized for the estimated future tax consequencesattributable to differences between the financial statement carrying amounts ofexisting assets and liabilities and their respective tax bases and tax creditcarryforwards.  Deferred tax assets andliabilities are measured using tax rates expected to apply to taxable income inthe years in which those temporary differences are expected to be recovered orsettled. The effect on deferred tax assets and liabilities of a change in taxrates is recognized in income in the period that includes the enactmentdate.  A valuation allowance is recordedon deferred tax assets when management determines that it would be “more likelythan not” that the tax benefit of the federal and state net operating loss(“NOL”) carryovers would not be realized prior to their expiration.

 

**Self-funded Business**

 

Administrativeexpenses include costs associated with maintenance of membership records, claimprocessing and payment, coordination of benefits, billing/cash collection andother services on self-funded business. The Company is reimbursed for claimspaid and a fee is received for the administrative costs associated withproviding these services. Benefits paid on self-funded programs were$561,194,000, $522,566,000 and $527,987,000 in 2001, 2000 and 1999,respectively, are excluded from the accompanying statements of operations.  Administrative fees received related tothese programs totaled $28,067,000, $24,716,000 and $25,970,000 in 2001, 2000and 1999, respectively, and are included in other revenue in the accompanyingconsolidated statements of operations.

 

**EarningsPer Share**

 

Basic EPSexcludes dilution and is computed by dividing income available to commonshareholders by the weighted average number of common shares outstanding duringthe period.  Diluted EPS reflects thepotential dilution that could occur if all stock options were exercised andconverted into common stock.  When theCompany reports a net loss, stock options are not included in the calculationof EPS because their inclusion would have an antidilutive effect.  EPS for the year ended December 31, 2001 wascalculated based on 38,434,459 weighted average shares outstanding.  EPS was not presented for the years endedDecember 31, 2000 and 1999 because the Company was a service insurancecorporation.

 

**Use of Estimates**

 

Theaccompanying consolidated financial statements have been prepared in accordancewith GAAP, which requires management to make estimates and assumptions thataffect the amounts reported in the consolidated financial statements andaccompanying notes. Actual results could differ from those estimates.

 

 

----

 

**RecentAccounting Pronouncements**

 

In June 2001,the Financial Accounting Standards Board (“FASB”) approved the issuance of FASBstatement #142, “Goodwill and Other Intangibles”.  Under this statement, the Company must review the goodwillrecorded on its balance sheet and the impact of the statement on the carryingvalue of its investment in AMSG for impairment based on a two-step processdescribed in the statement.  The firststep is a screen for potential impairment, while the second step measures theamount of impairment, if any, based on fair value.  In addition, the statement requires the discontinuance ofgoodwill amortization upon adoption (January 1, 2002).  Although management believes that based onits review of the impact of adopting this standard, no significant impairmentcharge is expected related to goodwill recorded on its balance sheet or thecarrying value of its investment in AMSG, this analysis has not yet beencompleted.  In addition, discontinuanceof goodwill amortization, excluding its investment in AMSG, is estimated toreduce expense on the Company’s consolidated statement of operations byapproximately $8.7 million annually.

 

In August2001, the FASB approved the issuance of FASB statement #144, “Accounting forthe Impairment or Disposal of Long-Lived Assets”.  This statement, effective for the Company on January 1, 2002,amends existing guidance relating to the accounting and reporting ofimpairments or disposals of long-lived assets. Management believes that based on its review of the impact of adoptingthis standard, there is no significant impact on the carrying values ofexisting long-lived assets as of December 31, 2001.  In addition, this statement modifies existing guidance governingthe accounting for dispositions of company assets as discontinued operations inthe statement of operations.

 

**Reclassifications**

 

Certainreclassifications have been made to the consolidated financial statements for2000 and 1999 to conform to the 2001 presentation.

 

**4. ****Government Contracts**

 

The Company,through UGS, serves as a fiscal intermediary for Medicare and various othergovernment programs.  Claims processedand administrative fees received related to these services were as follows:

 
|                         |   | **Years  Ended December 31,** |       |
|------------------------------|--------|-------------------------------|------------|
|                         |   | **2001**                      |       | **2000** |   | **1999** |   |
|                         |   | **(In thousands)**            | * *   |
| Number of claims processed   |   | 47,140                        |       | 36,320 |   | 27,740 |   |
| Amount of claims paid        |   | $                             | 25,255,210 |   | $ | 13,194,510 |   | $ | 9,894,850 |   |
| Administrative fees received |   | $                             | 117,192    |   | $ | 70,305 |   | $ | 52,259 |   |

 

As a fiscalintermediary for various government programs, the Company is subject toregulations covering allowable cost reimbursements and operating procedures.The laws and regulations governing fiscal intermediaries are complex andsubject to interpretation. The Company believes that it is in compliance withall applicable laws and regulations and is not aware of any pending orthreatened investigations involving allegations of potential wrongdoing. Whileno such regulatory inquiries have been made, compliance with such laws andregulations can be subject to future government review and interpretation, aswell as significant regulatory actions including fines in excess of feesreceived, significant penalties and exclusions from being a governmentcontractor for these programs.

 

 

----

 

**5. Investments**

 

Investmentresults comprise the following:

 
|                            |   | **Years  Ended December 31,** |   |
|---------------------------------|--------|-------------------------------|--------|
|                            |   | **2001**                      |   | **2000** |   | **1999** |   |
|                            |   | **(In thousands)**            |
| Interest on fixed maturities    |   | $                             | 8,514  |   | $ | 2,729 |   | $ | 4,171 |   |
| Dividends on equity securities  |   | 474                           |   | 775 |   | 697 |   |
| Realized gains                  |   | 2,990                         |   | 638 |   | 10,393 |   |
| Realized losses                 |   | (2,145                        | )      | (1,147 | ) | (2,379 | ) |
| Gross investment results        |   | 9,833                         |   | 2,995 |   | 12,882 |   |
| Investment expenses             |   | (879                          | )      | (229 | ) | (245 | ) |
| Interest income from affiliates |   | 1,273                         |   | 5,494 |   | 4,804 |   |
| Other investment income         |   | 2,299                         |   | 1,323 |   | 1,069 |   |
|                            |   | $                             | 12,526 |   | $ | 9,583 |   | $ | 18,510 |   |

 

Proceeds fromsales of equity securities during 2001, 2000 and 1999 were $10,571,000,$6,134,000 and $43,096,000, respectively. Proceeds from sales of fixedmaturities classified as available-for-sale during 2001, 2000 and 1999,excluding maturities, were $133,193,000, $19,652,000 and $82,529,000,respectively.

 

Unrealizedgains (losses) are computed as the difference between estimated fair value andamortized cost for fixed maturities classified as available-for-sale or costfor equity securities. A summary of the net change in unrealized gains/losses,less deferred income taxes, which is included in accumulated othercomprehensive income (loss), is as follows:

 
|                                        |   | **Years  Ended December 31,** |     |
|---------------------------------------------|--------|-------------------------------|----------|
|                                        |   | **2001**                      |     | **2000** |   | **1999** |   |
|                                        |   | **(In thousands)**            | * * |
| Fixed maturities                            |   | $                             | (11      | ) | $ | 1,577 |   | $ | (3,392 | ) |
| Equity securities                           |   | (250                          | )        | (716 | ) | (3,990 | ) |
| Provision for deferred income (tax) benefit |   | (77                           | )        | (302 | ) | 2,878 |   |
| Unrealized gain (losses) of affiliates      |   | 2,937                         |     | 3,683 |   | (6,610 | ) |
|                                        |   | $                             | 2,599    |   | $ | 4,242 |   | $ | (11,114 | )  |

 

 

----

 

The amortizedcost, gross unrealized gains (losses) and estimated fair values of investmentsare as follows:

 
|                           |   | **Amortized  Cost** |    | **Gross   Unrealized   Gains** |   | **Gross   Unrealized   Losses** |   | **Estimated   Fair   Values** |   |
|--------------------------------|--------|---------------------|---------|--------------------------------|--------|---------------------------------|--------|-------------------------------|--------|
|                           |   | **(In thousands)**  |
| At December 31, 2001:          |   |                |    |                           |   |                            |   |                          |   |
| Available-for-sale:            |   |                |    |                           |   |                            |   |                          |   |
| Fixed maturity:                |   |                |    |                           |   |                            |   |                          |   |
| U.S. Treasury securities       |   | $                   | 23,088  |                           | $      | 193                             |   | $                             | (394   | ) | $ | 22,887 |   |
| State and Municipal securities |   | 100                 |    | 2                              |   | —                          |   | 102                           |   |
| Foreign securities             |   | 7,336               |    | 135                            |   | (151                            | )      | 7,320                         |   |
| Corporate debt securities      |   | 84,857              |    | 1,373                          |   | (771                            | )      | 85,459                        |   |
| Mortgage-backed securities     |   | 51,818              |    | 426                            |   | (818                            | )      | 51,426                        |   |
|                           |   | 167,199             |    | 2,129                          |   | (2,134                          | )      | 167,194                       |   |
| Equity securities:             |   |                |    |                           |   |                            |   |                          |   |
| Mutual funds-fixed income      |   | 9,839               |    | 31                             |   | —                          |   | 9,870                         |   |
| Common and preferred stock     |   | 3,760               |    | 11                             |   | (143                            | )      | 3,628                         |   |
|                           |   | 13,599              |    | 42                             |   | (143                            | )      | 13,498                        |   |
|                           |   | 180,798             |    | 2,171                          |   | (2,277                          | )      | 180,692                       |   |
| Held-to-maturity:              |   |                |    |                           |   |                            |   |                          |   |
| U.S. Treasury securities       |   | 11,007              |    | 392                            |   | (2                              | )      | 11,397                        |   |
|                           |   | $                   | 191,805 |                           | $      | 2,563                           |   | $                             | (2,279 | ) | $ | 192,089 |   |

 
|                          |   | **Amortized   Cost** |     | **Gross   Unrealized   Gains** |   | **Gross   Unrealized   Losses** |   | **Estimated   Fair   Values** |   |
|-------------------------------|--------|----------------------|----------|--------------------------------|--------|---------------------------------|--------|-------------------------------|--------|
|                          |   | **(In thousands)**   | * * |
| At December 31, 2000:         |   |                 |     |                           |   |                            |   |                          |   |
| Available-for-sale:           |   |                 |     |                           |   |                            |   |                          |   |
| Fixed maturity:               |   |                 |     |                           |   |                            |   |                          |   |   |   |   |   |
| U.S. Treasury securities      |   | $                    | 5,188    |                           | $      | 105                             |   | $                             | — |   | $ | 5,293 |   |
| Foreign government securities |   | 2,655                |     | 9                              |   | (25                             | )      | 2,639                         |   |
| Corporate debt securities     |   | 11,321               |     | 84                             |   | (395                            | )      | 11,010                        |   |
| Mortgage-backed securities    |   | 10,788               |     | 230                            |   | (2                              | )      | 11,016                        |   |
|                          |   | 29,952               |     | 428                            |   | (422                            | )      | 29,958                        |   |
| Equity securities:            |   |                 |     |                           |   |                            |   |                          |   |
| Mutual funds-fixed income     |   | 6,269                |     | 60                             |   | (2                              | )      | 6,327                         |   |
| Common and preferred stock    |   | 7,997                |     | 119                            |   | (28                             | )      | 8,088                         |   |
|                          |   |                 | 14,266   |                           |   | 179                             |   |                          | (30    | ) |   | 14,415 |   |
|                          |   | $                    | 44,218   |                           | $      | 607                             |   | $                             | (452   | ) | $ | 44,373 |   |

 

 

----

 

The amortizedcost and estimated fair values of debt securities at December 31, 2001, bycontractual maturity, are shown below. Expected maturities may differ fromcontractual maturities because borrowers may have the right to call or prepayobligations.

 
|                             |   | **Amortized  Cost** |    | **Estimated  Fair Values** |   |
|----------------------------------|--------|---------------------|---------|----------------------------|--------|
|                             |   | **(In thousands)**  |    |
| Available-for-sale:              |   |                |    |                       |   |
| Due in one year or less          |   | $                   | 1,383   |                       | $      | 1,443 |   |
| Due after one through five years |   | 49,881              |    | 50,431                     |   |
| Due after five through ten years |   | 42,375              |    | 42,184                     |   |
| Due after ten years              |   | 21,742              |    | 21,710                     |   |
|                             |   | 115,381             |    | 115,768                    |   |
| Mortgage-backed securities       |   | 51,818              |    | 51,426                     |   |
|                             |   | $                   | 167,199 |                       | $      | 167,194 |   |
|                             |   |                |    |                       |   |
| Held-to-maturity:                |   |                |    |                       |   |
| Due in one year or less          |   | $                   | 4,734   |                       | $      | 4,851 |   |
| Due after one through five years |   | 6,273               |    | 6,546                      |   |
|                             |   | $                   | 11,007  |                       | $      | 11,397 |   |

 

At December31, 2001, approximately $17,000,000 of invested assets, which are classified asavailable-for-sale, are maintained under an escrow agreement with the BCA andthe insurance subsidiaries had debt securities on deposit with various stateinsurance departments with carrying values of approximately $10,834,000, whichare classified as investments held-to-maturity on the consolidated balancesheets.

 

The Companyparticipates in securities lending programs whereby blocks of securities, whichare returnable to the Company on short-term notice and are included ininvestments, are loaned to third parties, primarily major brokerage firms. TheCompany requires a minimum of 102% of the fair value of the loaned securitiesto be separately maintained as collateral for the loans. Securities with a costor amortized cost of $11,269,000 and $3,782,000 and estimated fair value of$11,409,000 and $3,866,000 were on loan under the programs at December 31,2001 and 2000, respectively.

 

**6. Investment in Affiliates**

 

Investment in affiliates for 2001 consists of the Company’s investmentin AMSG, a leading provider of small group PPO products and life products.  Investment in affiliates for 2000 and 1999consisted of the Company’s investment in both AMSG and UWS.

 

**Investment in AMSG**

 

The Companyowned 6,309,525 shares which represented approximately 45% and 44% of totalAMSG shares outstanding at December 31, 2001 and 2000, respectively. TheCompany’s recorded investment in AMSG was $78,554,000 and $97,788,000 atDecember 31, 2001 and 2000, respectively.

 

 

----

 

At December 31,2001, the market value of AMSG stock was $12.45 per share.  Under equity accounting, the Company'sportion of AMSG's income (loss) were $1,919,000, $1,078,000 and $(9,979,000) in2001, 2000 and 1999, respectively. Included in gain (loss) from investment in affiliates in the Company’sconsolidated statement of operations for the year ended December 31, 2001, is aloss of $25,163,000 relating to a writedown of the Company’s investment in AMSGto market value as of December 31, 2001. This writedown was deemed appropriate based on management’s decision tono longer classify the investment in AMSG as a strategic long-term asset of theCompany in December, 2001.

 

AMSGrepurchased 367,262, 1,261,870 and 1,121,500 shares of its outstanding commonstock, at cost, aggregating $2,216,000, $8,292,000 and $7,488,000 in 2001, 2000and 1999, respectively. The impact of this repurchase on the Company’sinvestment in the net assets of affiliates is reported on the change inownership of affiliates line of the Company’s Consolidated Statements ofChanges in Shareholder’s Equity and Comprehensive Income (Loss). AMSG’srepurchase of common stock increased the Company’s ownership in AMSG byapproximately 1%, 3% and 3% in 2001, 2000 and 1999, respectively.

 

Summarized financial information for AMSG is as follows:

 
|                                            |   | **December 31,** |     |
|-------------------------------------------------|--------|-----------------------|----------|
| **Condensed AMSG Consolidated Balance Sheets**  |   | **2001**              |     | **2000** |   |
|                                            |   | **(In thousands)**    | * * |
| Total assets                                    |   | $                     | 473,015  |   | $ | 471,923 |   |
|                                            |   |                  |     |   |   |
| Total liabilities                               |   | $                     | 243,615  |   | $ | 250,746 |   |
| Shareholders’ equity                       |   | 229,400               |     | 221,177 |   |
| Total liabilities and shareholders’ equity |   | $                     | 473,015  |   | $ | 471,923 |   |

 

Included inAMSG’s total assets were $103,934,000 and $107,562,000 of goodwill and otherintangible assets as of December 31, 2001 and 2000, respectively.

 

 

----

 
|                                                      |   | **Years Ended  December 31,** |     |
|-----------------------------------------------------------|--------|------------------------------------|----------|
| **Condensed  AMSG Consolidated Statements of Operations** |   | **2001**                           |     | **2000** |   | **1999** |   |
|                                                      |   | **(In thousands)**                 | * * |
| Health services revenues:                                 |   |                               |     |   |   |   |   |
| Premium revenue                                           |   | $                                  | 838,672  |   | $ | 951,071 |   | $ | 1,056,107 |   |
| Other revenue                                             |   | 21,285                             |     | 20,112 |   | 22,361 |   |
| Investment results                                        |   | 16,664                             |     | 18,682 |   | 18,912 |   |
| Total revenues                                            |   | 876,621                            |     | 989,865 |   | 1,097,380 |   |
|                                                      |   |                               |     |   |   |   |   |
| Expenses:                                                 |   |                               |     |   |   |   |   |
| Medical and other benefits                                |   | 601,942                            |     | 724,613 |   | 860,473 |   |
| Selling, general and administrative                       |   | 257,742                            |     | 251,767 |   | 268,059 |   |
| Interest                                                  |   | 2,877                              |     | 3,584 |   | 3,564 |   |
| Amortization of goodwill                                  |   | 3,628                              |     | 3,785 |   | 4,273 |   |
| Total expenses                                            |   | 866,189                            |     | 983,749 |   | 1,136,369 |   |
|                                                      |   |                               |     |   |   |   |   |
| Pretax income (loss)                                      |   | 10,432                             |     | 6,116 |   | (38,989 | ) |
| Income tax expense (benefit)                              |   | 6,257                              |     | 3,447 |   | (13,043 | ) |
| Net income (loss)                                         |   | $                                  | 4,175    |   | $ | 2,669 |   | $ | (25,946 | ) |

 

The accountingpolicies of AMSG are consistent with those of the Company.

 

**Investmentin UWS**

 

The Companyowned approximately 47% of the total UWS shares outstanding as of December 31,2000 and prior to the Combination (see Note 1).

 

Summarizedfinancial information for UWS is as follows:

 
|                                            |   | **December 31,  2000** |    |
|-------------------------------------------------|--------|-----------------------------|---------|
| **Condensed  UWS Consolidated Balance Sheets**  |   |                        |
|                                            |   | **(In thousands)**          |    |
| Current assets                                  |   | $                           | 266,955 |   |
| Noncurrent  assets                              |   | 98,871                      |    |
| Total assets                                    |   | $                           | 365,826 |   |
|                                            |   |                        |    |
| Current  liabilities                            |   | $                           | 230,720 |   |
| Noncurrent  liabilities                         |   | 118,333                     |    |
| Shareholders’ equity                       |   | 16,773                      |    |
| Total liabilities and shareholders’ equity |   | $                           | 365,826 |   |

 

 

----

 

Condensed UWS ConsolidatedStatements of Operations

 
|                                           |   | **Three Month Period Ended March 31,  2001** |    | **Years  Ended December 31,** |   |
|------------------------------------------------|--------|----------------------------------------------|---------|-------------------------------|--------|
| **2000**                                       |   | **1999**                                     |
|                                           |   | **(In thousands)**                           |    |
| Revenues:                                      |   |                                         |    |                          |   |   |   |
| Health services revenues:                      |   |                                         |    |                          |   |   |   |
| Premium revenue                                |   | $                                            | 220,821 |                          | $      | 760,624 |   | $ | 651,567 |   |
| Other revenue                                  |   | 11,947                                       |    | 45,496                        |   | 41,586 |   |
| Investment results                             |   | 2,788                                        |    | 8,254                         |   | 11,371 |   |
| Total revenues                                 |   | 235,556                                      |    | 814,374                       |   | 704,524 |   |
|                                           |   |                                         |    |                          |   |   |   |
| Expenses:                                      |   |                                         |    |                          |   |   |   |
| Medical and other benefits                     |   | 194,743                                      |    | 700,094                       |   | 621,916 |   |
| Selling, general, administrative and other     |   | 36,386                                       |    | 133,020                       |   | 127,404 |   |
| Profit (loss) sharing on joint ventures        |   | —                                       |    | 460                           |   | (4,096 | ) |
| Interest                                       |   | 1,521                                        |    | 6,500                         |   | 5,293 |   |
| Amortization of goodwill                       |   | 401                                          |    | 1,065                         |   | 796 |   |
| Total expenses                                 |   | 233,051                                      |    | 841,139                       |   | 751,313 |   |
|                                           |   |                                         |    |                          |   |   |   |
| Operating income (loss)                        |   | 2,505                                        |    | (26,765                       | )      | (46,789 | ) |
| Loss from investment in affiliate, net of  tax |   | —                                       |    | (312                          | )      | — |   |
| Pretax income (loss)                           |   | 2,505                                        |    | (27,077                       | )      | (46,789 | ) |
| Income tax expense (benefit)                   |   | 1,575                                        |    | (10,649                       | )      | (17,785 | ) |
| Net income (loss)                              |   | $                                            | 930     |                          | $      | (16,428 | ) | $ | (29,004 | ) |
|                                                |        |                                              |         |                               |        |  |  |  |  |  |  |  |

 

**7. Provider Arrangements**

 

The Company isa party to certain provider arrangements in conjunction with Unity and Valley,which include profit-sharing payments to certain providers and repurchaseprovisions.  Management believes thatcontrol of Unity and Valley is not temporary because exercise of the repurchaseoptions is not probable.  Any repurchasewould not provide a substantial economic benefit to the option holders andwould require regulatory approval pursuant to change of control regulations.

 

Under theterms of the Valley purchase and sale agreement, as amended, the sellerretained an option to repurchase all of the capital stock of Valley as ofDecember 31, 2002, at a price equal to Valley’s net assets plus $400,000.

 

 

----

 

Pursuant tothe terms of the Unity purchase agreements, as amended, the sellers retainedoptions to repurchase the net assets of the acquired companies as ofDecember 31, 2004.  Theseagreements provide for an extension through December 31, 2009.  One seller has the option to repurchase aportion of Unity’s business for $500,000 plus the proportionate share of thenet worth of such business less any unpaid amount of the maximum annualperformance bonuses. The maximum annual performance bonuses are limited to$650,000 in total, in which $125,000 has been accrued for during 2001.  The other seller has the option torepurchase the remainder of the Unity business (as well as the legal entity) ata price equal to the net assets of such business.

 

Total revenuessubject to repurchase options, pursuant to the various acquisition agreements,were $191,605,000 for 2001. Profit sharing expenses related to these providerarrangements is calculated based on the profitability of the respective HMOsubsidiary and totaled $402,000 in 2001. Net income subject to repurchaseoptions, pursuant to those provider arrangements, totaled $4,188,000 for 2001.Total assets and total net assets subject to repurchase options were$66,905,000 and $24,224,000, respectively, at December 31, 2001.  The Company had no business subject torepurchase options for the periods prior to 2001.

 

**8. Property and Equipment**

 

Property andequipment are stated at cost less accumulated depreciation and are summarizedas follows:

 
|                               |   | **December  31,**  |   |
|------------------------------------|--------|--------------------|--------|
|                               |   | **2001**           |   | **2000** |   |
|                               |   | **(In thousands)** |   |
| Land and land improvements         |   | $                  | 1,316  |   | $ | 909 |   |
| Building and building improvements |   | 11,407             |   | 7,056 |   |
| Computer equipment and software    |   | 52,656             |   | 33,802 |   |
| Furniture and other equipment      |   | 24,230             |   | 19,309 |   |
|                               |   | 89,609             |   | 61,076 |   |
| Less accumulated depreciation      |   | (55,977            | )      | (35,937 | ) |
|                               |   | $                  | 33,632 |   | $ | 25,139 |   |

 

Depreciationexpense related to property and equipment totaled $10,517,000, $6,278,000 and$6,791,000 in 2001, 2000 and 1999, respectively.

 

During 1999,the Company recorded a non-cash pre-tax charge of $2,398,000 to reduce thecarrying amount of certain computer software costs. This charge is included inselling, general, administrative and other expense in the accompanyingconsolidated statements of operations and is allocated between the insured andself-funded segments. These costs were associated with the data warehouse thathad been written off by the Company where the carrying value exceeded the valueof the functionality.

 

 

----

 

**9. Reinsurance**

 

Certainpremiums and benefits are assumed from and ceded to other insurance companiesunder various reinsurance agreements. The ceded reinsurance agreements providethe Company with increased capacity to write larger risks and maintain itsexposure to loss within its capital resources. The ceding company iscontingently liable on reinsurance ceded in the event that the reinsurers donot meet their contractual obligations.

 

Amountsassumed from and ceded to other insurance companies are summarized as follows:

 
|                       |   | **Years  ended December 31,** |   |
|----------------------------|--------|------------------------------------|--------|
|                       |   | **2001**                           |   | **2000** |   | **1999** |   |
|                       |   | **(In thousands)**                 |   |
| Reinsurance assumed:       |   |                               |   |   |   |   |   |
| Insurance premiums         |   | $                                  | 20,438 |   | $ | 3,497 |   | $ | 1,843 |   |
| Medical and other benefits |   | 13,889                             |   | 2,543 |   | 2,173 |   |
|                       |   |                               |   |   |   |   |   |
| Reinsurance ceded:         |   |                               |   |   |   |   |   |
| Insurance premiums         |   | $                                  | 17,649 |   | $ | 429 |   | $ | 233 |   |
| Medical and other benefits |   | 12,933                             |   | 116 |   | 272 |   |

 

Reinsurancecontracts are accounted for in a manner consistent with the underlyingbusiness.

 

The Companyhas reinsurance recoverable amounts outstanding of $35,506,000 and $112,000 asof December 31, 2001 and 2000, respectively. These balances are includedin other current and other noncurrent assets based on the expected settlements.

 

The Companyemploys quota share and excess of loss reinsurance with third party reinsurersas follows:

 
| **Quota  Share**             |   | **Ceding Percentage**                             |
|------------------------------|--------|---------------------------------------------------|
| Workers’  Compensation: |   |                                              |
| Wisconsin                    |   | 20% pre July 1, 2001, 35%  effective July 1, 2001 |
| Illinois                     |   | 60%                                               |

 
| **Excess of  Loss**        |   | **Retention** |
|----------------------------|--------|---------------|
| Workers’ Compensation |   | $             | 250,000 |   |
| Life                       |   | $             | 75,000 |   |
| Long-term  disability      |   | $             | 75,000 |  on claims incurred prior to October 1, 2001 |
|                       |   | $             | 3,500 |  monthly benefit on claims incurred after  October 1, 2001 |
| Medical:                   |   |          |
| Valley                     |   | $             | 150,000 |   |
| Unity                      |   | $             | 225,000 |   |
| Compcare                   |   | $             | 300,000 |   |
| BCBSUW                     |   | $             | 500,000 |   |

 

 

----

 

**10. Medical and Other Benefits Payable**

 

A summary ofthe activity for medical and other benefits payable net of reinsurance for 2001and 2000 is as follows:

 
|                                                                               |   | **2001**           |    | **2000** |   |
|------------------------------------------------------------------------------------|--------|--------------------|---------|----------|--------|
|                                                                               |   | **(In thousands)** |    |
| Net  medical and other benefits payable at beginning of year                       |   | $                  | 104,415 |     | $      | 75,637 |   |
| Net  medical and other benefits payable assumed from UWS   through the Combination |   | 143,316            |    | —   |   |
| Incurred related to:                                                               |   |               |    |     |   |
| Current year                                                                       |   | 1,135,524          |    | 505,597  |   |
| Prior  years                                                                       |   | (14,167            | )       | (7,775   | )      |
| Total incurred                                                                     |   | 1,121,357          |    | 497,822  |   |
|                                                                               |   |               |    |     |   |
| Paid related to:                                                                   |   |               |    |     |   |
| Current year                                                                       |   | 943,296            |    | 411,973  |   |
| Prior years                                                                        |   | 184,736            |    | 57,071   |   |
| Total paid                                                                         |   | 1,128,032          |    | 469,044  |   |
| Net medical and other benefits payable at  end of year                             |   | $                  | 241,056 |     | $      | 104,415 |   |

 

The netmedical and other benefits payable above excludes reinsured reserves of$28,994,000 as of December 31, 2001. Reinsured reserves are classified as assets on the balance sheet.  There were no reinsured reserve balances asof December 31, 2000.  Incurred and paidclaims for 2001, related to prior years, include claims incurred prior to 2001for BCBSUW and claims incurred prior to March 31, 2001 for the former UWScompanies.  A portion of the reservesfor disability claims have been discounted on a tabular basis using the 1987CDT Table at 7% and 6.5% and waiver of premium claims have been discounted on atabular basis using the 1970 Intercompany Group Life Valuation Table at 7%.  The December 31, 2001 loss reserves include$12,667,000 of such discounted reserves. The amount of discount for case reserves is $4,446,000 at December 31,2001.

 

The Companyuses paid claims and completion factors based on historical payment patterns toestimate incurred claims. Changes in payment patterns and claims trends canresult in changes to prior years’ claims estimates.

 

 

----

 

**11. Debt**

 

The Companyhas a bank line-of-credit (“LOC”), which permits aggregate borrowings amongcertain subsidiaries, excluding the corporate holding company and Compcare, upto $20,000,000. The LOC has an adjustable rate with interest payments duemonthly. The Company pledged 2,000,000 shares of AMSG common stock ascollateral for this LOC. The outstanding LOC balance was $7,850,000 and $0 asof December 31, 2001 and 2000, respectively. The interest expense on the LOCwas $560,000, $300,000 and $553,000 in 2001, 2000 and 1999, respectively. Theweighted average interest rate on the LOC was 3.90% and 8.10% in 2001 and 2000,respectively.  In addition, on December31, 2001, the Company originated a term business note (“term note”) for thecorporate holding company with a commercial bank for $7,500,000.  The term note had an adjustable rate ofinterest with payment of principal and interest due February 15, 2002.  The term note has been extended andrenegotiated, with payment of principal and interest due in quarterlyinstallments beginning June 30, 2002 and ending June 30, 2003.  Interest is calculated at a rate equal tothe London Interbank Offered Rate plus 1.5%, adjusted monthly.  The current portion of the term notetotaling $4,500,000 has been classified in short-term debt on the accompanyingconsolidated balance sheet as of December 31, 2001.  The remaining $3,000,000 balance is classified in othernoncurrent liabilities.

 

**12. Related-Party Transactions**

 

As ofSeptember 11, 1998, UWS entered into a $70,000,000 note obligation due toBCBSUW in connection with the spin-off in 1998 of AMSG’s managed care companiesand specialty business. UWS pledged the common stock of Compcare as collateralfor the note obligation. Interest is payable quarterly at a rate equal to 9.75%and 8.06% as of December 31, 2001 and 2000, respectively.  The original maturity date of the principalbalance was extended from April 30, 2001 to January 1, 2002.  The maturity date was subsequently extendedto February 15, 2002 at an interest rate of 7.38%.  The note was amended and the maturity date was extended toJanuary 2, 2003 at an interest rate of 7.38% on February 14, 2002.  The terms and extension of the note aresubject to approval by the OCI.

 

As a result ofthe Combination, this intra-company note and related accrued interest iseliminated in the accompanying consolidated balance sheet as of December 31,2001.  As of December 31, 2000, thisnote is classified in other noncurrent assets. Interest income received totaled $5,494,000 and $4,804,000 in 2000 and1999, respectively.  Interest income of$1,339,000 received prior to Combination in 2001 is included in theaccompanying consolidated statement of operations.  Interest income subsequent to March 31, 2001 has been eliminatedin the consolidated statement of operations.

 

The Companyhas an agreement with United Wisconsin Life Insurance Company (“UWLIC”), asubsidiary of AMSG, whereby UWLIC underwrites certain life and disabilityproducts on behalf of UHLIC, a wholly-owned subsidiary of the Company.  The Company assumes 100% of the premiumrevenues on these products from UWLIC. The assumed premium revenue approximated $15,065,000 in 2001.

 

The Companyand Health Care Service Corporation (the parent corporation of BlueCrossBlueShield of Illinois) each own a 50% interest in United Heartland ofIllinois, Inc. ("UHIL"). Premium receivable related to UHIL is reported in Due from Affiliates.

 

**13****.  Income Taxes**

 

The Companyand its subsidiaries file a consolidated federal income tax return. Separatestate income tax returns are filed by each subsidiary, except IRG, MRC, UGS andCC Holdings, which are limited liability corporations and considereddisregarded entities for tax purposes.

 

 

----

 

The Companyhad net federal income tax receivables of $10,314,000 and $11,576,000 atDecember 31, 2001 and 2000, respectively, included in prepaid expenses andother current assets. Included in these amounts is a prepayment of $11,576,000made by the Company to the Internal Revenue Service (“IRS”) relating to pendingaudit adjustments for ongoing examinations. The Company anticipates fullrecovery of the prepayment upon resolution of the disputed adjustments. TheCompany has federal NOL carryforwards totaling $140,969,000 which expire in theyears 2011 through 2020, and alternative minimum tax (“AMT”) NOL carryforwardstotaling $119,938,000. The Company has state net business loss carryforwardstotaling $254,879,000 at December 31, 2001, which expire in the years 2002through 2015. The Company had federal and state income tax payments (refunds)net of $368,000, ($194,000) and ($275,000) in 2001 2000 and 1999, respectively.  The Company’s federal income tax returns areroutinely audited by the IRS.  Inmanagement’s opinion, adequate tax liabilities have been established for allopen audit years.

 

The components of federalincome tax expense (benefit) are as follows:

 
|      |   | **Years Ended  December 31,** |   |
|-----------|--------|-------------------------------|--------|
|      |   | **2001**                      |   | **2000** |   | **1999** |   |
|      |   | **(In thousands)**            |   |
| Current:  |   |                          |   |   |   |   |   |
| Federal   |   | $                             | (1,164 | ) | $ | — |   | $ | — |   |
| State     |   | 284                           |   | — |   | — |   |
|      |   | (880                          | )      | — |   | — |   |
| Deferred: |   |                          |   |   |   |   |   |
| Federal   |   | (181                          | )      | 548 |   | — |   |
| State     |   | 175                           |   | — |   | — |   |
|      |   | (6                            | )      | 548 |   | — |   |
| Total     |   | $                             | (886   | ) | $ | 548 |   | $ | — |   |

 

Thedifferences between taxes computed at the federal statutory rate and recordedincome taxes are as follows:

 
|                                                        |   | **Years  Ended December 31,** |   |
|-------------------------------------------------------------|--------|-------------------------------|--------|
|                                                        |   | **2001**                      |   | **2000** |   | **1999** |   |
|                                                        |   | **(In thousands)**            |   |
| Tax applicable to operating loss at federal  statutory rate |   | $                             | (164   | ) | $ | (11,529 | ) | $ | (7,020 | ) |
| Valuation allowance                                         |   | —                        |   | 14,877 |   | 18,608 |   |
| Goodwill amortization                                       |   | 1,555                         |   | 218 |   | 67 |   |
| Use of NOL carryover from prior years                       |   | (1,495                        | )      | — |   | — |   |
| State income and franchise taxes, net of  federal benefit   |   | 298                           |   | (2,602 | ) | (1,585 | ) |
| Release of cushion                                          |   | (1,453                        | )      | — |   | — |   |
| Prior period adjustment                                     |   | 258                           |   | — |   | (8,600 | ) |
| Meals, entertainment and dues                               |   | 170                           |   | 158 |   | 160 |   |
| Spin-off expenses                                           |   | 78                            |   | — |   | — |   |
| Other, net                                                  |   | (133                          | )      | (574 | ) | (1,630 | ) |
|                                                        |   | $                             | (886   | ) | $ | 548 |   | $ | — |   |

 

 

----

 

Tax benefitsresulting from temporary differences, including NOL’s are required to berecorded as assets to the extent that management believes it is “more likelythan not” that such tax benefits will be realized.  A full valuation allowance was recorded at the date of theCombination for the net deferred tax assets of UWS, based upon the Company’shistory of losses and changes in tax planning strategies post combination.  This valuation allowance increased goodwillby $22,075,000 at the time of the Combination. When management determines that it is “more likely than not” that thetax benefit of the federal and state NOL carryovers will be realized prior totheir expiration, the valuation allowance will be reduced.  Any reduction of the valuation allowancerecorded at the time of the Combination will be recorded as a reduction togoodwill.  All other reductions tovaluation allowances recorded by the Company will be recorded to income uponreversal.

 

Significantcomponents of the Company’s federal and state deferred tax liabilities andassets are as follows:

 
|                                            |   | **December  31, 2001** |   | **December  31, 2000** |   |
|-------------------------------------------------|--------|------------------------|--------|------------------------|--------|
|                                            |   | **Federal**            |   | **State**              |   | **Federal** |   | **State** |   |
|                                            |   | **(In thousands)**     |   |
| Deferred tax liabilities:                       |   |                   |   |                   |   |   |   |   |   |
| Claims-based receivables                        |   | $                      | (2,476 | )                      | $      | (427 | ) | $ | (700 | ) | $ | (158 | ) |
| Pension accrual                                 |   | (17,950                | )      | (4,027                 | )      | (12,937 | ) | (2,920 | ) |
| Deferred acquisition costs                      |   | (2,567                 | )      | (579                   | )      | (2,425 | ) | (547 | ) |
| Interest expense                                |   | (1,555                 | )      | (351                   | )      | (1,555 | ) | (351 | ) |
| Federal effect of state taxes                   |   | (1,862                 | )      | —                 |   | — |   | — |   |
| AMSG basis difference                           |   | (3,202                 | )      | (5,209                 | )      | — |   | — |   |
| Prepaid expenses                                |   | (3,629                 | )      | (774                   | )      | — |   | — |   |
| Other, net                                      |   | (1,252                 | )      | (206                   | )      | (308 | ) | (70 | ) |
|                                            |   | (34,493                | )      | (11,573                | )      | (17,925 | ) | (4,046 | ) |
| Deferred tax assets:                            |   |                   |   |                   |   |   |   |   |   |
| Postretirement benefits other than pensions     |   | 5,287                  |   | 1,185                  |   | 4,453 |   | 1,005 |   |
| Deferred gain on sale of building               |   | 822                    |   | 186                    |   | 1,005 |   | 227 |   |
| Employee benefits                               |   | 7,013                  |   | 1,566                  |   | 4,213 |   | 951 |   |
| Medical and other benefits payable  discounting |   | 4,087                  |   | 742                    |   | 1,691 |   | 382 |   |
| Net operating loss and other carryforwards      |   | 49,888                 |   | 20,187                 |   | 33,848 |   | 12,458 |   |
| Bad debt reserve allowance                      |   | 3,531                  |   | 795                    |   | 1,797 |   | 406 |   |
| Premium deficiency reserve                      |   | —                 |   | —                 |   | 1,266 |   | 285 |   |
| AMT credit                                      |   | 2,963                  |   | —                 |   | 2,963 |   | — |   |
| Advance premium discounting                     |   | 5,424                  |   | 1,132                  |   | — |   | — |   |
| Other, net                                      |   | 2,379                  |   | 479                    |   | 1,372 |   | 310 |   |
| Valuation allowance                             |   | (46,901                | )      | (14,699                | )      | (34,717 | ) | (11,985 | ) |
|                                            |   | 34,493                 |   | 11,573                 |   | 17,891 |   | 4,039 |   |
| Net deferred tax assets (liabilities)           |   | $                      | — |                   | $      | — |   | $ | (34 | ) | $ | (7 | ) |

 

The federaldeferred benefit arising from the deductibility of state deferred tax isincluded as a component of other federal deferred taxes. The net deferred taxassets and liabilities are included in other current or other noncurrent assetsand liabilities, as applicable.

 

 

----

 

**14. Commitments and Contingencies**

 

**Long-Term Contract**

 

OnOctober 1, 1998, the Company entered into an agreement with a servicebureau to obtain certain electronic data processing services for the Company.The agreement had an initial term of five years, with options for twoadditional one-year renewal periods which have been exercised. Expenses to thisservice bureau were $13,405,000, $14,986,000 and $13,945,000 in 2001, 2000 and1999, respectively.

 

**Operating Leases**

 

The Companyhas operating leases for office space, EDP equipment, automobiles, software andterminal lines. Future minimum lease payments under noncancelable operatingleases with initial or remaining lease terms in excess of one year atDecember 31, 2001 were $41,758,000 in total. Annually, the lease paymentsare $10,450,000, $9,360,000, $8,065,000, $5,751,000, $3,745,000 and $4,387,000in 2002, 2003, 2004, 2005, 2006 and thereafter, respectively. Rental expensetotaled $15,004,000, $9,538,000 and $13,404,000 in 2001, 2000 and 1999,respectively.

 

**Extension of Credit**

 

The Companyhas an outstanding revolving line-of-credit in the amount of $15,000,000available to Health Professionals of Wisconsin, Inc., which originated in1997. Interest is accrued based on the quarterly prime rate, with interestpayments due annually on November 1. Interest income amounted to $308,000 and $451,000 for 2001 and 2000,respectively.  The outstanding balanceas of December 31, 2001 and 2000 was $3,000,000 and $4,628,000,respectively.

 

**Litigation**

 

The Company isinvolved in various legal actions occurring in the normal course of business.In the opinion of management, adequate provision has been made for losses whichmay result from these actions and, accordingly, the outcome of theseproceedings is not expected to have a material adverse effect on theconsolidated financial statements.

 

**Risksand Uncertainties**

 

The Company’sprofitability depends in large part on accurately predicting and effectivelymanaging health care costs.  The Companycontinually reviews its premium and benefit structure to reflect its underlyingclaims experience and revised actuarial data; however, several factors couldadversely affect the medical cost ratios. Certain of these factors, which include changes in health carepractices, inflation, new technologies, major epidemics, natural disasters andmalpractice litigation, are beyond any health plan’s control and couldadversely affect the Company’s ability to accurately predict and effectivelycontrol health care costs.  Costs inexcess of those anticipated could have a material adverse effect on theCompany’s results of operations.

 

 

----

 

**15. Shareholders’ Equity**

 

**Statutory Financial Information (unaudited)**

 

The Company’sinsurance subsidiaries are required to file financial statements with the OCIand other state insurance regulators. Such financial statements are prepared in accordance with statutoryaccounting practices (“SAP”) prescribed or permitted by the OCI, which differfrom GAAP under which the accompanying consolidated financial statements areprepared.  Codification promulgated bythe National Association of Insurance Commissioners (“NAIC”) and adopted by theOCI, took effect on January 1, 2001. Codification impacts the calculation of statutory surplus for theCompany’s insurance subsidiaries.  Theimpact varies by subsidiary with the most significant changes in surplusresulting from the treatment of deferred tax assets and health care andpharmacy rebate receivables.  The 2001statutory financial statements reflect a reduction in statutory surplus of$21,188,000 as a result of implementation of codification.  The Company has taken certain actionsincluding the reallocation of capital to mitigate the impact of Codification onits insurance subsidiaries.  Significantdifferences between SAP and GAAP include certain valuations of investments,calculations of discounted claim reserves, non-recognition of certain assets(primarily health-care receivables, premium receivables greater than 90 days,property and equipment and certain intercompany receivable balances), andrecognition of deferred income tax assets based on criteria which vary fromGAAP.  While the OCI has the authorityto permit insurers to deviate from prescribed SAP, none of the Company’sinsurance subsidiaries subject to oversight by the OCI have received approvalto adopt any such practices.

 

Selected statutory informationby insurance subsidiary is as follows:

 
|                        |   | **BCBSUW**         |    | **Compcare** |   | **Unity** |   | **Valley** |   | **UWIC** |   | **UHLIC** |   |
|-----------------------------|--------|--------------------|---------|--------------|--------|-----------|--------|------------|--------|----------|--------|-----------|--------|
|                        |   | **(In thousands)** |    |
| Intercompany Receivables    |   | $                  | 86,701  |         | $      | —    |   | $          | — |     | $      | —    |   | $ | 22,581 |   | $ | 45 |   |
| Other Admitted Assets       |   | 159,988            |    | 161,289      |   | 43,062    |   | 18,848     |   | 54,804   |   | 38,976    |   |
| Total Admitted Assets       |   | $                  | 246,689 |         | $      | 161,289   |   | $          | 43,062 |     | $      | 18,848    |   | $ | 77,385 |   | $ | 39,021 |   |
|                        |   |               |    |         |   |      |   |       |   |     |   |      |   |
| Liabilities                 |   | $                  | 158,712 |         | $      | 100,452   |   | $          | 29,111 |     | $      | 11,084    |   | $ | 36,016 |   | $ | 29,174 |   |
|                        |   |               |    |         |   |      |   |       |   |     |   |      |   |
| Statutory Surplus           |   | $                  | 87,977  |         | $      | 60,837    |   | $          | 13,951 |     | $      | 7,764     |   | $ | 41,369 |   | $ | 9,847 |   |
|                        |   |               |    |         |   |      |   |       |   |     |   |      |   |
| Statutory Net Income (Loss) |   | $                  | (1,571  | )            | $      | (16,533   | )      | $          | 5,522  |     | $      | 566       |   | $ | 2,336 |   | $ | (413 | ) |

 

Included inthe admitted assets and statutory surplus of BCBSUW is the $70,000,000collateralized note obligation due from Cobalt, which is eliminated in theaccompanying financial statements.  Anextension of the maturity date to January 2, 2003 of the collateralized noteobligation was approved by the OCI on February 14, 2002 (see Note 12).  Pursuant to the terms of the extended note,the Company must meet certain requirements, including the regulatory approvalof all dividends paid by the Company’s insurance subsidiaries and regulatoryapproval of all affiliated and material non-affiliated reinsurance agreements.

 

Included inthe admitted assets and statutory surplus of Compcare is the statutory surplusvalue of UWIC and UHLIC, which are wholly-owned subsidiaries of Compcare.

 

 

----

 

Wisconsininsurance regulations also require the maintenance of a minimum compulsorysurplus based on a percentage of premiums written. As of December 31, 2001, allof the Company’s insurance subsidiaries exceeded the regulatory minimumcompulsory surplus, calculated as prescribed by the OCI.  In addition, the Company’s insurancesubsidiaries are subject to risk-based capital (“RBC”) requirements promulgatedby the NAIC.  The RBC requirementsestablish minimum levels of capital and surplus based upon the insurer’soperations and investment risk.  At December 31,2001, the Company was in compliance with these capital surplus requirements.  In addition, the Company is required tomaintain certain capital and liquidity levels in conjunction with the licensingof certain products by the BCA.  Whileexceeding the minimum standards to maintain its license by $15,790,000 and$7,175,000, respectively, for BCBSUW and Compcare, the Company is subject toongoing monitoring by the BCA.

 
|                            |   | **BCBSUW**         |   | **Compcare** |   | **Unity** |   | **Valley** |   | **UWIC** |   | **UHLIC** |   |
|---------------------------------|--------|--------------------|--------|--------------|--------|-----------|--------|------------|--------|----------|--------|-----------|--------|
|                            |   | **(In thousands)** |   |
| Compulsory Surplus  Requirement |   | $                  | 61,117 |         | $      | 15,911    |   | $          | 5,048  |     | $      | 2,420     |   | $ | 10,297 |   | $ | 2,172 |   |
| Compulsory Surplus Excess       |   | 10,968             |   | 10,001       |   | 7,224     |   | 4,557      |   | 18,401   |   | 7,676     |   |
|                                 |        |                    |        |              |        |           |        |            |        |          |        |           |        |  |  |  |  |  |  |

 

Dividends paidby insurance and HMO subsidiaries are limited by state insurance regulations.  As of December 31, 2001, the Company’sregulated subsidiaries are unable to pay dividends to the Company in 2001without regulatory approval.

 

**16. Employee Benefit Plans**

 

**Pension and Postretirement Benefits**

** **

The Companyand certain of its subsidiaries participate in two defined benefit pensionplans. In conjunction with the Combination, the pension plan previously namedthe UWSI/BCBSUW Pension Plan, a multiple employer plan sponsored by BCBSUW andthe former UWS, was amended and renamed Cobalt Corporation Pension Plan (the“Plan”).  Coincident with theCombination and the aforementioned Plan name change, the Company assumed theassets and liabilities of the Plan and became the sole sponsor.

 

EffectiveJanuary 1, 1999, a portion of the assets and liabilities of the Plan werespun-off to a new UGS Pension Plan (the “UGS Plan”). The UGS Plan providedretirement benefits for current UGS employees and past retirees, includingbenefits accrued prior to 1999, on the same basis as had been provided underthe Plan.

 

The Plan andthe UGS Plan provide retirement benefits to covered employees based primarilyon compensation and years of service. The Company contributed $3,514,000 to theUGS Plan in 2001.  No contributions weremade to any of the plans in 2000 or 1999.

 

The Companyalso has postretirement benefit plans to provide medical, dental, and visionbenefits and life insurance for certain groups of retired employees. Such planswere amended in 1997 to limit the Company’s financial contribution in futureperiods. No benefits will be provided for individuals hired after the effectivedates of these amendments.

 

The followingfinancial information includes both the Plan and the UGS Plan.

 

 

----

 

The followingtable summarizes the change in the pension and postretirement benefitobligations as of December 31, 2001 and 2000:

 
|                                                           |   | **Pension**               |    | **Postretirement** |   |
|----------------------------------------------------------------|--------|---------------------------|---------|--------------------|--------|
|                                                           |   | **2001**                  |    | **2000**           |   | **2001** |   | **2000** |   |
|                                                           |   | ***(*****In  thousands)** |    |
| Benefit  obligation at beginning of year                       |   | $                         | 82,351  |               | $      | 76,770 |   | $ | 14,318 |   | $ | 13,176 |   |
| Benefit obligation assumed from UWS through    the Combination |   | 22,080                    |    | —             |   | 3,398 |   | — |   |
| Service cost                                                   |   | 4,751                     |    | 2,393              |   | 501 |   | 284 |   |
| Interest cost                                                  |   | 6,687                     |    | 5,129              |   | 1,151 |   | 890 |   |
| Plan amendments                                                |   | —                    |    | —             |   | 32 |   | 1,400 |   |
| Actuarial (gains) losses                                       |   | (1,376                    | )       | 4,752              |   | 1,198 |   | (509 | ) |
| Company transfers                                              |   | —                    |    | (821               | )      | — |   | — |   |
| Benefits paid                                                  |   | (6,339                    | )       | (5,872             | )      | (1,313 | ) | (923 | ) |
| Benefit obligation at end of year                              |   | $                         | 108,154 |               | $      | 82,351 |   | $ | 19,285 |   | $ | 14,318 |   |

 

The pensionand postretirement plans’ assets are comprised primarily of debt, equity andother marketable securities, including 700,000 shares of Cobalt stock, held bythe Plan, with a fair value of $4,466,000 and $2,363,000 at December 31,2001 and 2000, respectively.  The Planreceived dividends in the amount of $35,000 related to the Cobalt stock heldduring 2000.  No dividends were paid tothe Plan in 2001.

 

The followingtable summarizes the change in the pension and postretirement plan assets as ofDecember 31, 2001 and 2000:

 
|                                                                      |   | **Pension**        |    | **Postretirement** |   |
|---------------------------------------------------------------------------|--------|--------------------|---------|--------------------|--------|
|                                                                      |   | **2001**           |    | **2000**           |   | **2001** |   | **2000** |   |
|                                                                      |   | **(In thousands)** |    |
| Fair value of plan assets at beginning of  year                           |   | $                  | 129,929 |               | $      | 122,341 |   | $ | 2,380 |   | $ | 3,052 |   |
| Fair value of plan assets assumed from  UWS  through the Combination |   | 39,729             |    | —             |   | — |   | — |   |
| Employer contributions                                                    |   | 3,514              |    | —             |   | 583 |   | 28 |   |
| Actual return on plan assets                                              |   | (13,647            | )       | 14,281             |   | 204 |   | 223 |   |
| Company transfers                                                         |   | —             |    | (821               | )      | — |   | — |   |
| Benefits paid                                                             |   | (6,339             | )       | (5,872             | )      | (1,313 | ) | (923 | ) |
| Fair value of plan assets at end of year                                  |   | $                  | 153,186 |               | $      | 129,929 |   | $ | 1,854 |   | $ | 2,380 |   |

 

 

----

 

The followingtable provides a reconciliation of the funded status of the plans to theprepaid pension and postretirement costs at December 31, 2001 and 2000:

 
|                                 |   | **Pension**        |   | **Postretirement** |   |
|--------------------------------------|--------|--------------------|--------|--------------------|--------|
|                                 |   | **2001**           |   | **2000**           |   | **2001** |   | **2000** |   |
|                                 |   | **(In thousands)** |   |
| Funded status of plan at end of year |   | $                  | 45,032 |               | $      | 47,578 |   | $ | (17,431 | ) | $ | (11,938 | ) |
| Unrecognized net transition asset    |   | (548               | )      | (1,577             | )      | — |   | — |   |
| Unrecognized prior service cost      |   | (7,484             | )      | (5,110             | )      | (313 | ) | (920 | ) |
| Unrecognized net (gain) loss         |   | 16,837             |   | (4,420             | )      | (346 | ) | 136 |   |
| Prepaid (accrued) at end of year     |   | $                  | 53,837 |               | $      | 36,471 |   | $ | (18,090 | ) | $ | (12,722 | ) |

 

The 2000combined ending prepaid pension balance consists of $36,964,000 for the Plan,offset by an accrued pension liability of $493,000 for the UGS Plan.  In 2001, both plans had a prepaid pensionbalance.

 

Weighted-averageassumptions used as of December 31, 2001 and 2000, the measurement date, indeveloping the projected benefit obligations are as follows:

 
|                                   |   | **December  31,** |   |
|----------------------------------------|--------|-------------------|--------|
|                                   |   | **2001**          |   | **2000** |   |
| Pension:                               |   |              |   |   |   |
| Discount rate                          |   | 7.00              | %      | 7.00 | % |
| Rate of compensation increase          |   | 4.75              |   | 4.75 |   |
| Expected rate of return on Plan assets |   | 9.25              |   | 9.25 |   |
|                                   |   |              |   |   |   |
| Postretirement:                        |   |              |   |   |   |
| Discount rate                          |   | 7.00              | %      | 7.00 | % |
| Health care cost trend                 |   | 10.50             |   | 5.00 |   |
| Expected return on Plan:               |   |              |   |   |   |
| Union plan assets                      |   | 8.00              | %      | 8.00 | % |
| Non-union plan assets                  |   | 5.00              |   | 5.00 |   |

 

Theunrecognized net asset is being amortized over the remaining estimated servicelives of participating employees at January 1, 1986: 15.4 years forsalaried employees and 16.9 years for hourly employees.

 

The effect ofa 1% increase in the medical trend rate would be a $1,267,000 increase in thebenefit obligation at December 31, 2001. The effect of a 1% decrease in the medical trend would be a $1,175,000decrease in the benefit obligation at December 31, 2001.

 

 

----

 

The componentsof the pension credit and postretirement benefit cost, which are included inselling, general, administrative and other expenses in 2001, 2000 and 1999 areas follows:

 
|                                                            |   | **Pension**        |   | **Postretirement** |   |
|-----------------------------------------------------------------|--------|--------------------|--------|--------------------|--------|
|                                                            |   | **2001**           |   | **2000**           |   | **1999** |   | **2001** |   | **2000** |   | **1999** |   |
|                                                            |   | **(In thousands)** |   |
| Service cost                                                    |   | $                  | 4,751  |               | $      | 2,393 |   | $ | 1,988 |   | $ | 501 |   | $ | 284 |   | $ | 206 |   |
| Interest cost                                                   |   | 6,687              |   | 5,129              |   | 5,175 |   | 1,152 |   | 890 |   | 737 |   |
| Expected return on plan assets                                  |   | (13,956            | )      | (10,283            | )      | (9,483 | ) | (143 | ) | (184 | ) | (224 | ) |
| Net amortization of transition asset                            |   | (1,264             | )      | (1,087             | )      | (1,137 | ) | — |   | — |   | — |   |
| Amortization of prior service cost                              |   | (1,530             | )      | (1,013             | )      | (1,013 | ) | (75 | ) | (120 | ) | (182 | ) |
| Amortization of unrecognized (gain) loss                        |   | —             |   | —             |   | 4 |   | (24 | ) | (2 | ) | (42 | ) |
| Pension (credit) and postretirement benefit  costs for the year |   | $                  | (5,312 | )                  | $      | (4,861 | ) | $ | (4,466 | ) | $ | 1,411 |   | $ | 868 |   | $ | 495 |   |

 

**DefinedContribution and Bonus Plans**

 

The Companyparticipates in defined contribution plans whereby the employer contributes apercentage of participants’ qualifying compensation up to certain limits, asdefined by the plans. The employer match is made in Cobalt common stock.  Employee directed contributions in Cobaltcommon stock are limited to 30% of their contributions exclusive of the Companymatch.  The Company also establishedvarious other profit-sharing and bonus programs. Expenses related to all ofthese plans totaled $11,058,000, $2,337,000 and $2,128,000 in 2001, 2000 and1999, respectively.

 

**Stock-Based Compensation Plans**

 

Certainemployees of the Company participated in a stock appreciation rights (“SAR”)plan, based upon the market value of Cobalt common stock.  On December 12, 2001, all 647,390outstanding SAR’s  were converted tononqualified stock options of an equal number, and at an exercise price equalto the original strike price of the SAR’s. As of that date, 347,890 of the outstanding SAR’s were vested and281,556 of the SAR’s had a strike price lower than the current marketprice.  The Company recorded expenses of$594,000 for the year ended December 31, 2001 for the excess of the marketvalue over the strike price as of the date that the SAR’s were converted tooptions.  The SAR liability outstandingof $544,000 was reclassified to retained earnings upon conversion of the SAR’sto options.  These expenses are includedin selling, general, administrative and other expenses in the accompanyingconsolidated statements of operations.

 

Prior to theCombination, the Company had no stock based compensation programs other thanthe aforementioned SAR plan.  As aresult of the Combination, the Company assumed the stock based compensationplan covering employees and directors of the former UWS.  This plan allows for option grants of up to4,500,000 shares of common stock as incentive or nonqualified stock options(“NQSOs”).  NQSOs vest 25% per year overa four year period.

 

 

----

 

Stock optionactivity for all plans as of December 31, 2001 (in thousands, except exerciseprice data) is as follows:

 
|                                          |   | **Total   Number of   NQSOs** |   | **Weighted  Average  Exercise Price** |   |
|-----------------------------------------------|--------|-------------------------------|--------|--------------------------------------------|--------|
| Beginning balance                             |   | —                        |   | —                                     |   |
| Options assumed from UWS through  Combination |   | 3,606                         |   | $                                          | 9.39   |   |
| Conversion of SARS                            |   | 647                           |   | 5.70                                       |   |
| Granted                                       |   | 49                            |   | 6.12                                       |   |
| Exercised                                     |   | (11                           | )      | 4.58                                       |   |
| Forfeited                                     |   | (1,018                        | )      | 13.16                                      |   |
| Ending balance                                |   | 3,273                         |   | $                                          | 7.43   |   |
| Exercisable at end of year                    |   | 1,955                         |   | $                                          | 8.71   |   |

 

Options withrespect to 1,226,000 shares were available for grant as of December 31, 2001.

 

Otherinformation regarding NQSOs outstanding and exercisable as of December 31, 2001(in thousands, except exercise price data) is as follows:

 
|                          |   | **Options  Outstanding** |   | **Options  Exercisable**                                         |
|-------------------------------|--------|--------------------------|--------|------------------------------------------------------------------|
| **Range of  Exercise Prices** |   | **Number  Outstanding**  |   | **Weighted  Average   Remaining Contractual  Life   (in years)** |   | **Weighted  Average Exercise Price** |   | **Number  Exercisable** |   | **Weighted  Average  Exercise  Price** |   |   |
| $                             | 4.31   | —                   | $      | 5.19                                                             |   |   | 1,294 |   | 9.31 |   | $ | 4.34 |   | 422 |   | $ | 4.33 |   |   |
| 5.50                          | — | 6.00                     |   |                                                             | 107 |   | 10.51 |   | 5.54 |   | 24 |   | 5.61 |   |   |
| 6.15                          | — | 6.87                     |   |                                                             | 29 |   | 11.31 |   | — |   | — |   | 6.27 |   |   |
| 7.19                          | — |                     |   |                                                             | 473 |   | 8.75 |   | 7.19 |   | 365 |   | 7.19 |   |   |
| 8.50                          | — | 9.19                     |   |                                                             | 424 |   | 9.10 |   | 8.53 |   | 240 |   | 8.53 |   |   |
| 9.61                          | — | 13.42                    |   |                                                             | 902 |   | 6.98 |   | 11.27 |   | 861 |   | 11.29 |   |   |
| 14.04                         | — | 16.81                    |   |                                                             | 44 |   | 6.91 |   | 15.72 |   | 44 |   | 15.72 |   |   |
|                               |        |                          |        |                                                                  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

 

 

----

 

TheBlack-Scholes option valuation model was developed for use in estimating thefair value of traded options, which have no vesting restrictions and are fullytransferable. In addition, option valuation models require the input of highlysubjective assumptions including the expected stock price volatility. Since theCompany’s employee stock options have characteristics significantly differentfrom those of traded options and because changes in the subjective inputassumptions can materially affect the fair value estimates, in management’sopinion, the existing models do not necessarily provide a reliable singlemeasure of the fair value of its employee stock options.

 

The Companyfollows Accounting Principles Board Opinion No. 25 under which nocompensation expense is recorded when the exercise price of the Company’semployee stock options equals the market price of the underlying stock on thedate of grant.  The Company’s pro formainformation, as if options were expensed in accordance with FASB 123,“Accounting for Stock-Based Compensation”, is as follows:

 
|                             |   | **Year Ended  December 31, 2001**         |    |
|----------------------------------|--------|-------------------------------------------|---------|
|                             |   | **(In thousands, except per share data)** |    |
| Pro forma net loss               |   | $                                         | (22,589 | ) |
| Pro forma loss per common share: |   |                                      |    |
| Basic and diluted                |   | $                                         | (0.59   | ) |
|                             |   |                                      |    |
| Assumptions:                     |   |                                      |    |
| Risk-free interest rate          |   | 5.44                                      | %       |
| Dividend yield                   |   | 0.67                                      | %       |
| Volatility factor                |   | 0.55                                      | %       |
| Weighted average expected life   |   | 6 years                                   |    |

 

As calculatedusing the Black-Scholes model, the weighted average, grant-date fair value ofoptions granted in which the exercise price equaled the market price on thedate of the grant was $3.69 per share for 2001.  The fair value of options granted in which the exercise price wasless than the market price on the date of grant was $4.10 per share for2001.  The fair value of options grantedin which the exercise price was greater than the market price on the date ofgrant was $3.36 per share for 2001.

 

 

----

 

**17. Quarterly Financial Information (Unaudited)**

 

Selectedquarterly financial data in 2001 and 2000 are as follows:

 
|                 |   | **Quarter**                               |    |
|----------------------|--------|-------------------------------------------|---------|
|                 |   | **First**                                 |    | **Second** |   | **Third** |   | **Fourth** |   | **Total** |   |
|                 |   | **(In thousands, except per share data)** |    |
| **2001**             |   |                                      |    |   |   |   |   |   |   |   |   |
| Total  revenues      |   | $                                         | 186,691 |   | $ | 419,371 |   | $ | 425,148 |   | $ | 420,036 |   | $ | 1,451,246 |   |
| Pretax income (loss) |   | 1,284                                     |    | (3,683 | ) | 1,589 |   | (22,381 | ) | (23,191 | ) |
| Net income (loss)    |   | 1,284                                     |    | (3,796 | ) | 1,057 |   | (20,850 | ) | (22,305 | ) |
| Basic  and diluted   |   | N/A                                       |    | (0.09 | ) | 0.03 |   | (0.51 | ) | (0.55 | ) |
| **2000**             |   |                                      |    |   |   |   |   |   |   |   |   |
| Total revenues       |   | $                                         | 146,267 |   | $ | 155,424 |   | $ | 167,492 |   | $ | 173,500 |   | $ | 642,683 |   |
| Pretax income (loss) |   | (7,908                                    | )       | (8,427 | ) | (24,216 | ) | 1,086 |   | (39,465 | ) |
| Net income (loss)    |   | (7,908                                    | )       | (8,427 | ) | (24,764 | ) | 1,086 |   | (40,013 | ) |

 

**18. Segment Reporting**

 

The Companyhas five reportable business segments: insured medical products, specialty riskproducts, specialty service products, government services and self-fundedproducts. Insured medical products include: full coverage, copayment, preferredprovider organization, Medicare supplement, interim coverage, HMO and point ofservice products sold primarily in Wisconsin. The specialty risk products include dental, life, disability andworkers’ compensation products. The specialty service products include managedcare consulting, electronic claim submission services, pharmaceuticalmanagement, managed behavioral health services, case management and receivablesmanagement services. The specialty service products segment includes activityfrom historical UWS subsidiaries; and therefore, on a historical basis thissegment does not have any activity until the second quarter of 2001.  The specialty products and services are soldthroughout the United States. Government services include processing services for Medicare providersthroughout the United States and for Medicaid in the State of Wisconsin. Theself-funded products consist of administrative services and access to BCBSUW’sextensive provider networks for uninsured contracts.

 

“OtherOperations” include activities not directly related to the business segments,unallocated corporate items (i.e. gain (loss) from investment in affiliates,amortization of goodwill and unallocated overhead expenses) and intercompanyeliminations.  The Company evaluatessegment performance based on profit or loss from operations before incometaxes. The accounting policies of the reportable segments are the same as thosedescribed in the summary of significant accounting policies.

 

 

 

----

 

Financial databy segment is as follows:

 
|                                                                       |   | **Years  Ended December 31,** |      |
|----------------------------------------------------------------------------|--------|-------------------------------|-----------|
|                                                                       |   | **2001**                      |      | **2000** |   | **1999** |   |
|                                                                       |   | **(In thousands)**            |      |
| Health services revenue:                                                   |   |                          |      |   |   |   |   |
| Insured  medical products                                                  |   | $                             | 1,150,420 |   | $ | 510,638 |   | $ | 392,583 |   |
| Specialty risk products                                                    |   | 131,254                       |      | 29,922 |   | 27,774 |   |
| Specialty service products                                                 |   | 46,496                        |      | — |   | — |   |
| Government services                                                        |   | 117,192                       |      | 70,305 |   | 52,259 |   |
| Self-funded products                                                       |   | 28,067                        |      | 24,716 |   | 25,970 |   |
| Other operations                                                           |   | (34,709                       | )         | (2,481 | ) | (1,408 | ) |
| Total consolidated                                                         |   | $                             | 1,438,720 |   | $ | 633,100 |   | $ | 497,178 |   |
|                                                                       |   |                          |      |   |   |   |   |
| Investment results:                                                        |   |                          |      |   |   |   |   |
| Insured medical products                                                   |   | $                             | 13,641    |   | $ | 8,014 |   | $ | 15,950 |   |
| Specialty risk products                                                    |   | 4,481                         |      | 473 |   | 1,133 |   |
| Specialty service products                                                 |   | 264                           |      | — |   | — |   |
| Government services                                                        |   | 752                           |      | 705 |   | 375 |   |
| Self-funded products                                                       |   | 55                            |      | 391 |   | 1,052 |   |
| Other operations                                                           |   | (6,667                        | )         | — |   | — |   |
| Total consolidated                                                         |   | $                             | 12,526    |   | $ | 9,583 |   | $ | 18,510 |   |
|                                                                       |   |                          |      |   |   |   |   |
| Income (loss) before income tax expense  (benefit):                        |   |                          |      |   |   |   |   |
| Insured medical products                                                   |   | $                             | 8,790     |   | $ | (20,553 | ) | $ | (3,665 | ) |
| Specialty risk products                                                    |   | 6,273                         |      | 408 |   | (1,229 | ) |
| Specialty service products                                                 |   | 3,184                         |      | — |   | — |   |
| Government services                                                        |   | 1,572                         |      | 1,230 |   | 1,202 |   |
| Self-funded products                                                       |   | (3,834                        | )         | (10,694 | ) | (16,365 | ) |
| Other operations:                                                          |   |                          |      |   |   |   |   |
| Corporate holding company                                                  |   | (13,713                       | )         | — |   | — |   |
| Loss from investment in affiliates, net of  tax                            |   | (22,724                       | )         | (6,526 | ) | (22,690 | ) |
| Other                                                                      |   | (2,739                        | )         | (3,330 | ) | — |   |
| Total consolidated                                                         |   | $                             | (23,191   | ) | $ | (39,465 | ) | $ | (42,747 | ) |
|                                                                       |   |                          |      |   |   |   |   |
| Health services revenue from transactions  with  other operating segments: |   |                          |      |   |   |   |   |
| Insured medical products                                                   |   | $                             | (17,215   | ) | $ | (2,481 | ) | $ | (1,408 | ) |
| Specialty risk products                                                    |   | (1,977                        | )         | — |   | — |   |
| Specialty service products                                                 |   | (15,517                       | )         | — |   | — |   |
| Investment Results from transactions with  other operating   segments:     |   |                          |      |   |   |   |   |
| Insured medical products                                                   |   | $                             | (6,667    | ) | $ | — |   | $ | — |   |
|                                                                            |        |                               |           |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

 

 

----

 

 
|                       |   | **December  31,**  |     |
|----------------------------|--------|--------------------|----------|
|                       |   | **2001**           |     | **2000** |   |
|                       |   | **(In thousands)** | * * |
| Total assets:              |   |               |     |   |   |
| Insured medical products   |   | $                  | 521,899  |   | $ | 240,787 |   |
| Specialty risk products    |   | 63,663             |     | 14,100 |   |
| Specialty service products |   | 24,013             |     | — |   |
| Government services        |   | 26,843             |     | 22,061 |   |
| Self-funded products       |   | 10,921             |     | 11,648 |   |
| Other operations           |   | 79,466             |     | 105,609 |   |
| Total Consolidated         |   | $                  | 726,805  |   | $ | 394,205 |   |

 

Total assets(excluding government services assets and investment in affiliate) areallocated by segment based on the percentage of pro forma revenue for the yearended December 31, 2001 and historical revenue for the year ended December 31,2000.  Other operations includes theinvestment in unconsolidated affiliates.

 

**19.  Subsequent Events**

 

On March 22,2002, AMS repurchased from BCBSUW 1.4 million shares of AMS common stock at aprice of $13 per share.  The aggregateproceeds from the sale will be invested by BCBSUW in fixed incomesecurities.  This sale of AMS commonstock by BCBSUW reduces its ownership percentage in AMS from 45.2% to 39.1%.

 

 

----

 

**ITEM9.**  **Changes in and Disagreements with Accountants onAccounting and Financial Disclosure.**

 

None.

 

**PART III**

 

**ITEM10.**  **Directors and Executive Officers of the Registrant*.***

 

Information required by this item with respect to directors is includedunder the heading “Election of Directors” in the Company’s definitive ProxyStatement, to be dated on or about April 25, 2002 relating to the 2 AnnualMeeting of Shareholders currently scheduled for May 29, 2002, (the “2002 ProxyStatement”) which will be filed with the Commission separately pursuant to Rule14a-6 under the 1934 Act and in accordance with General Instruction G(3) toForm 10-K, not later than 120 days after the end of the Company’s fiscal year,and which section is hereby incorporated by reference.  Information with respect to executiveofficers of the Company appears at the end of Part I of this Annual Report onForm 10-K.

 

**ITEM11.**  **Executive Compensation.**

 

Information required by this item is included under the heading“Executive Compensation” in the 2002 Proxy Statement, which section is herebyincorporated herein by reference.

 

**ITEM12.**  **Security Ownership of Certain Beneficial Owners andManagement.**

 

Information required by this item is included under the heading“Security Ownership of Certain Beneficial Owners and Management” in the 2002Proxy Statement, which section is hereby incorporated by reference.

 

**ITEM13.*** ***Certain Relationships and RelatedTransactions.**

 

Information required by this item is included under the heading“Certain Transactions” in the 2002 Proxy Statement, which section is herebyincorporated by reference.

 

 

----

 

**PART IV**

 

**ITEM14.  Exhibits, Financial StatementSchedules, and Reports on Form 8-K.**

 

(a)        1 and 2.  *Financial statements and financial statementschedules*

** **

The following consolidated financial statements of Cobalt Corporation and subsidiaries are included in Item 8:

** **

Report of Independent Auditors 

Consolidated Balance Sheets at December 31, 2001 and  2000 

ConsolidatedStatements of Operations for the years ended December 31, 2001, 2000 and 1999 

Consolidated Statements of Changes in Shareholders’ Equity andComprehensive Income (Loss) for the years ended December 31, 2001, 2000 and1999 

ConsolidatedStatements of Cash Flows for the years ended December 31, 2001, 2000 and 1999 

Notes toConsolidated Financial Statements  

** **

The following financial statement schedules of Cobalt Corporation andsubsidiaries are included in Item 14(d):

** **

Schedule II — Condensed Financial Informationof Registrant

Schedule IV — Reinsurance

Schedule V — Valuation and QualifyingAccounts

** **

All other schedules for which provision ismade in applicable accounting regulations of the Securities and ExchangeCommission are not required under the related instructions or are inapplicable,and therefore have been omitted.

 

3.  *Exhibits*

 

Reference is made to the separate Exhibit Index contained herein.

 

(b)        *Reports onForm 8–K*

 

Report on Form 8-K filed April9, 2001.

 

(c)*        Exhibits*

 

Reference is made to theseparate Exhibit Index contained herein.

 

(d)*        FinancialStatement Schedules*

 

Reference is made to thefinancial statement schedules contained herein.

 

 

----

 

**SCHEDULE II**

 

**COBALT CORPORATION**

**CONDENSED FINANCIAL INFORMATION OF REGISTRANT**

 

Condensed balance sheet ofCobalt Corporation (the “Company”) (parent company only) as of December 31,2001, and the condensed statement of operations and cash flow for the ninemonth period ended December 31, 2001 are as follows:

 

**BALANCE SHEET**

 
|                                             |   | **As of December 31,  2001** |    |
|--------------------------------------------------|--------|------------------------------|---------|
|                                             |   |                         |
|                                             |   | **(In  thousands)**          |    |
| **ASSETS**                                       |   |                         |    |
|                                             |   |                         |    |
| Cash and cash equivalents                        |   | $                            | 101     |   |
| Investment in affiliates, net                    |   | 262,116                      |    |
| Accounts receivable                              |   | 738                          |    |
| Goodwill, net                                    |   | 72,104                       |    |
| Other assets                                     |   | 13,661                       |    |
| Total assets                                     |   | $                            | 348,720 |   |
|                                             |   |                         |    |
| **LIABILITIES  AND SHAREHOLDERS’ EQUITY**   |   |                         |    |
|                                             |   |                         |    |
| Liabilities:                                     |   |                         |    |
| Notes payable to affiliates                      |   | $                            | 92,000  |   |
| Due to affiliates                                |   | 24,699                       |    |
| Debt                                             |   | 7,519                        |    |
| Payables, accrued expenses and other liabilities |   | 16,280                       |    |
|                                             |   |                         |    |
| Total liabilities                                |   | 140,498                      |    |
|                                             |   |                         |    |
| Shareholders’ equity:                       |   |                         |    |
| Common stock                                     |   | 249,566                      |    |
| Retained deficit                                 |   | (41,979                      | )       |
| Accumulated other comprehensive income           |   | 635                          |    |
| Total shareholders’ equity                  |   | 208,222                      |    |
| Total liabilities and shareholders’ equity  |   | $                            | 348,720 |   |

 

See accompanying Notes to theCondensed Financial Statements.

 

----

 

**SCHEDULE II**

 

**COBALT CORPORATION**

**CONDENSED FINANCIAL INFORMATION OF REGISTRANT**

 

**STATEMENT OF OPERATIONS**

 
|                                           |   | **Year ended  December 31, 2001** |    |
|------------------------------------------------|--------|-----------------------------------|---------|
|                                           |   | **(In  thousands)**               |    |
| Revenues:                                      |   |                              |    |
| Investment income                              |   | $                                 | 13      |   |
|                                           |   |                              |    |
| Total revenues                                 |   | 13                                |    |
|                                           |   |                              |    |
| Expenses:                                      |   |                              |    |
| Selling, general, administrative and other     |   | 2,949                             |    |
| Interest                                       |   | 6,867                             |    |
| Amortization of goodwill                       |   | 3,874                             |    |
|                                           |   |                              |    |
| Total expenses                                 |   | 13,690                            |    |
|                                           |   |                              |    |
| Operating loss                                 |   | (13,677                           | )       |
|                                           |   |                              |    |
| Loss from investment in affiliates, net of tax |   | (10,546                           | )       |
|                                           |   |                              |    |
| Pretax loss                                    |   | (24,223                           | )       |
|                                           |   |                              |    |
| Income tax benefit                             |   | (634                              | )       |
|                                           |   |                              |    |
| Net loss                                       |   | $                                 | (23,589 | ) |

 

See accompanying Notes to theCondensed Financial Statements.

 

----

 

**SCHEDULE II**

 

**COBALT CORPORATION**

**CONDENSED FINANCIAL INFORMATION OF REGISTRANT**

 

**STATEMENT OF CASH FLOW**

 
|                                                                             |   | **Nine Month Period Ended  December 31, 2001** |    |
|----------------------------------------------------------------------------------|--------|------------------------------------------------|---------|
|                                                                             |   | **(In  thousands)**                            |    |
| Operating activities:                                                            |   |                                           |    |
| Net loss                                                                         |   | $                                              | (23,589 | ) |
| Adjustments to reconcile net loss to  net cash provided by operating activities: |   |                                           |    |
| Loss from investment in affiliates net of tax                                    |   | 10,546                                         |    |
| Depreciation and amortization                                                    |   | 4,206                                          |    |
| Deferred income taxes                                                            |   | 2,435                                          |    |
| Changes in other operating accounts:                                             |   |                                           |    |
| Due to affiliates                                                                |   | 9,130                                          |    |
| Other, net                                                                       |   | 4,012                                          |    |
| Net cash provided by operating activities                                        |   | 6,740                                          |    |
|                                                                             |   |                                           |    |
| Investing activities:                                                            |   |                                           |    |
| Acquisition related activity                                                     |   | (650                                           | )       |
| Capital contribution                                                             |   | (11,000                                        | )       |
| Additions to property and equipment, net                                         |   | (229                                           | )       |
| Net cash used in investing activities                                            |   | (11,879                                        | )       |
|                                                                             |   |                                           |    |
| Financing activities:                                                            |   |                                           |    |
| Net proceeds from notes payable to affiliates                                    |   | 7,500                                          |    |
| Issuances of common stock                                                        |   | 1,030                                          |    |
| Net repayment on debt                                                            |   | (2,164                                         | )       |
| Net cash provided by financing activities                                        |   | 6,366                                          |    |
|                                                                             |   |                                           |    |
| Cash and cash equivalents:                                                       |   |                                           |    |
| Increase during year                                                             |   | 1,227                                          |    |
| Balance at beginning of year                                                     |   | (1,126                                         | )       |
| Balance at end of year                                                           |   | $                                              | 101     |   |

 

See accompanying Notes to theCondensed Financial Statements.

 

----

 

**SCHEDULEII — CONDENSED FINANCIAL INFORMATION OF REGISTRANT — CONTINUED**

 

**COBALTCORPORATION (PARENT COMPANY ONLY)**

# *** ***

# ***Notes to Condensed Financial Statements***

 

**1.  Basis of Presentation**

 

Activitypresented in the accompanying parent-company-only statement of operations andstatement of cash flow reflects activity for the nine month period endedDecember 31, 2001, subsequent to the combination of the former United WisconsinServices, Inc. (“UWS”) and Blue Cross & Blue Shield United of Wisconsin(“BCBSUW”) on March 23, 2001 (the “Combination), which created CobaltCorporation (“Cobalt” or the “Company”).  Thus, the amount of net income presented differs from the amountreflected in the Company’s consolidated statement of operations for the yearended December 31, 2001, which also includes the operations of BCBSUW and itswholly-owned subsidiary, United Government Services, LLC (“UGS”) and BCBSUW’sinvestment in UWS and American Medical Security Group, Inc. (“AMSG”) for thethree month period ended March 31, 2001 (see Note 1 of Notes to ConsolidatedFinancial Statements).

 

In the parent-company-onlyfinancial statements, the Company’s investment in subsidiaries is stated atcost plus equity in undistributed earnings of subsidiaries since date ofacquisition.  The Company’s share of netincome of its unconsolidated subsidiaries is included in consolidated incomeusing the equity method.

 

Parent-company-onlyfinancial statements should be read in conjunction with the Company’sconsolidated financial statements.

 

**2.  Notes Payable to Affiliates**

 

             Notes payable to affiliates consists of intra-companynote obligations of Cobalt to BCBSUW of $70.0 million and United WisconsinInsurance Company  (“UWIC”) of $22.0million (see Notes 2, 12 and 15 of Notes to Consolidated Financial Statements).

 

**3.  Debt**

 

Debt consists primarilyof a term business note (“term note”) originated by the Company on December 31,2001 with a commercial bank for $7,500,000. The term note had an adjustable rate of interest with payment ofprincipal and interest due February 15, 2002. The term note has been extended and renegotiated, with payment ofprincipal and interest due in quarterly installments beginning June 30, 2002and ending June 30, 2003.  Interest iscalculated at a rate equal to the London Interbank Offered Rate plus 1.5%,adjusted monthly (see Note 11 of Notes to Consolidated Financial Statements).

 

 

----

 

 

**SCHEDULE IV**

** **

**COBALT CORPORATION**

** **

**REINSURANCE**

 
|                          |   | **Gross  amount**   |      | **Ceded to  other  companies** |   | **Assumed  from other  companies** |   | **Net amount** |      | **Percentage  of amount  assumed to  net** |   |
|-------------------------------|--------|---------------------|-----------|--------------------------------|--------|------------------------------------|--------|----------------|-----------|--------------------------------------------|--------|
|                          |   | **(In  thousands)** |      |
| Year ended December 31, 1999: |   |                |      |                           |   |                               |   |           |      |                                       |   |
| Life insurance in force       |   | $                   |  0   |                           | $      | 0                                  |   | $              | 0         |                                       | $      | 0 |   | 0.0 | % |
|                          |   |                |      |                           |   |                               |   |           |      |                                       |   |
| Premiums:                     |   |                |      |                           |   |                               |   |           |      |                                       |   |
| Health and disability         |   | $                   | 417,339   |                           | $      | 233                                |   | $              | 1,843     |                                       | $      | 418,949 |   | 0.4 | % |
| Life                          |   | 0                   |      | 0                              |   | 0                                  |   | 0              |      | 0.0                                        | %      |
| Total premiums                |   | $                   | 417,339   |                           | $      | 233                                |   | $              | 1,843     |                                       | $      | 418,949 |   | 0.4 | % |
|                          |   |                |      |                           |   |                               |   |           |      |                                       |   |
| Year ended December 31, 2000: |   |                |      |                           |   |                               |   |           |      |                                       |   |
| Life insurance in force       |   | $                   | 0         |                           | $      | 0                                  |   | $              | 0         |                                       | $      | 0 |   | 0.0 | % |
|                          |   |                |      |                           |   |                               |   |           |      |                                       |   |
| Premiums:                     |   |                |      |                           |   |                               |   |           |      |                                       |   |
| Health and disability         |   | $                   | 535,012   |                           | $      | 429                                |   | $              | 3,497     |                                       | $      | 538,080 |   | 0.6 | % |
| Life                          |   | 0                   |      | 0                              |   | 0                                  |   | 0              |      | 0.0                                        | %      |
| Total premiums                |   | $                   | 535,012   |                           | $      | 429                                |   | $              | 3,497     |                                       | $      | 538,080 |   | 0.6 | % |
|                          |   |                |      |                           |   |                               |   |           |      |                                       |   |
| Year ended December 31, 2001: |   |                |      |                           |   |                               |   |           |      |                                       |   |
| Life insurance in force       |   | $                   | 17,629    |                           | $      | 1,544,772                          |   | $              | 6,886,135 |                                       | $      | 5,358,992 |   | 128.5 | % |
|                          |   |                |      |                           |   |                               |   |           |      |                                       |   |
| Premiums:                     |   |                |      |                           |   |                               |   |           |      |                                       |   |
| Health and disability         |   | $                   | 1,259,226 |                           | $      | 15,810                             |   | $              | 5,373     |                                       | $      | 1,248,789 |   | 0.4 | % |
| Life                          |   | 130                 |      | 1,839                          |   | 15,065                             |   | 13,356         |      | 112.8                                      | %      |
| Total premiums                |   | $                   | 1,259,356 |                           | $      | 17,649                             |   | $              | 20,438    |                                       | $      | 1,262,145 |   | 1.6 | % |

 

 

 

----

 

**SCHEDULE V**

 

**COBALT CORPORATION**

 

**VALUATIONAND QUALIFYING ACCOUNTS**

 
|                              |   | **Balance  beginning  of period** |   | **Balances  aquired  through  the  Combination** |   | **Net**

**charges  (credits)  to net  income** |   | **Write-offs  against  allowance** |   | **Balance  end of  period** |   |
|-----------------------------------|--------|-----------------------------------|--------|--------------------------------------------------|--------|-------------------------------------------------|--------|------------------------------------|--------|-----------------------------|--------|
|                              |   | ***(*****In thousands)**          |   |
| Year ended December 31, 1999:     |   |                              |   |                                             |   |                                            |   |                               |   |                        |   |
| Allowance for possible losses on: |   |                              |   |                                             |   |                                            |   |                               |   |                        |   |
| Premium receivables               |   | $                                 | 92     |                                             | $      | —                                          |   | $                                  | 55     |                        | $      | — |   | $ | 147 |   |
| Due from clinics and providers    |   | 942                               |   | —                                           |   | 278                                             |   | —                             |   | 1,220                       |   |
| Other                             |   | 4,179                             |   | —                                           |   | 69                                              |   | —                             |   | 4,248                       |   |
| Total allowance                   |   | $                                 | 5,213  |                                             | $      | —                                          |   | $                                  | 402    |                        | $      | — |   | $ | 5,615 |   |
|                              |   |                              |   |                                             |   |                                            |   |                               |   |                        |   |
| Year ended December 31, 2000:     |   |                              |   |                                             |   |                                            |   |                               |   |                        |   |
| Allowance for possible losses on: |   |                              |   |                                             |   |                                            |   |                               |   |                        |   |
| Premium receivables               |   | $                                 | 147    |                                             | $      | —                                          |   | $                                  | 80     |                        | $      | — |   | $ | 227 |   |
| Due from clinics and providers    |   | 1,220                             |   | —                                           |   | (374                                            | )      | —                             |   | 846                         |   |
| Other                             |   | 4,248                             |   | —                                           |   | (187                                            | )      | —                             |   | 4,061                       |   |
| Total allowance                   |   | $                                 | 5,615  |                                             | $      | —                                          |   | $                                  | (481   | )                           | $      | — |   | $ | 5,134 |   |
|                              |   |                              |   |                                             |   |                                            |   |                               |   |                        |   |
| Year ended December 31, 2001:     |   |                              |   |                                             |   |                                            |   |                               |   |                        |   |
| Allowance for possible losses on: |   |                              |   |                                             |   |                                            |   |                               |   |                        |   |
| Premium receivables               |   | $                                 | 227    |                                             | $      | 2,304                                           |   | $                                  | 417    |                        | $      | (577 | ) | $ | 2,371 |   |
| Due from clinics and providers    |   | 846                               |   | 9,380                                            |   | 1,285                                           |   | (2,387                             | )      | 9,124                       |   |
| Other                             |   | 4,061                             |   | 711                                              |   | 238                                             |   | (1,162                             | )      | 3,848                       |   |
| Total allowance                   |   | $                                 | 5,134  |                                             | $      | 12,395                                          |   | $                                  | 1,940  |                        | $      | (4,126 | ) | $ | 15,343 |   |

 

 

----

**SIGNATURES**

 

Pursuant to the requirements ofSection 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant hasduly caused this report to be signed on its behalf by the undersigned,thereunto duly authorized.

 
|   | COBALT CORPORATION |
|--------|--------------------|
|   |               |
|   | By:                | /s/ Thomas R. Hefty |
|   |               | Thomas R. Hefty, President and Chief  Executive Officer |
|   |               |
|   | Date:              | February 27, 2002 |
|        |                    |  |  |

 

Pursuant to the requirements ofthe Securities Act of 1934, this report has been signed below by the followingpersons on behalf of the Registrant and in the capacities and on the datesindicated.

 
| **Signature**                |   | **Title**                                                           |   | **Date**          |
|------------------------------|--------|---------------------------------------------------------------------|--------|-------------------|
|                         |   |                                                                |   |              |
| /s/ Thomas R. Hefty          |   | Chairman, President and Chief Executive                             |   | February 27, 2002 |
| Thomas R. Hefty              |   | Officer (Principal Executive Officer) and  Director                 |   |              |
|                         |   |                                                                |   |              |
| /s/ Gail L. Hanson           |   | Senior Vice President and Chief Financial                           |   | February 27, 2002 |
| Gail L. Hanson               |   | Officer (Principal Financial Officer and  Chief Accounting Officer) |   |              |
|                         |   |                                                                |   |              |
| /s/Richard A. Abdoo          |   | Director                                                            |   | February 27, 2002 |
| Richard A. Abdoo             |   |                                                                |   |              |
|                         |   |                                                                |   |              |
| /s/Barry K. Allen            |   | Director                                                            |   | February 27, 2002 |
| Barry K. Allen               |   |                                                                |   |              |
|                         |   |                                                                |   |              |
| /s/James L. Forbes           |   | Director                                                            |   | February 27, 2002 |
| James L. Forbes              |   |                                                                |   |              |
|                         |   |                                                                |   |              |
| /s/Michael S. Joyce          |   | Director                                                            |   | February 27, 2002 |
| Michael S. Joyce             |   |                                                                |   |              |
|                         |   |                                                                |   |              |
| /s/Dr. D. Keith Ness         |   | Director                                                            |   | February 27, 2002 |
| Dr. D. Keith Ness            |   |                                                                |   |              |
|                         |   |                                                                |   |              |
| /s/Dr. William C. Rupp       |   | Director                                                            |   | February 27, 2002 |
| Dr. William C. Rupp          |   |                                                                |   |              |
|                         |   |                                                                |   |              |
| /s/Janet D. Steiger          |   | Director                                                            |   | February 27, 2002 |
| Janet D. Steiger             |   |                                                                |   |              |
|                         |   |                                                                |   |              |
| /s/Dr. Kenneth M. Viste, Jr. |   | Director                                                            |   | February 27, 2002 |
| Dr. Kenneth M. Viste, Jr.    |   |                                                                |   |              |

 

 

----

 

**COBALT CORPORATION**

**INDEXTO EXHIBITS**

** **
| ***Exhibit Number*** |   | ***Document Description (1)***                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |
|----------------------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 2.1                  |   | Exchange  Agreement, dated December 22, 2000, by and among Cobalt Corporation (f/k/a  United Wisconsin Services, Inc. and also f/k/a Newco/UWS, Inc.) (“Cobalt”),  Wisconsin BC Holdings, LLC, and Blue Cross & Blue Shield United of  Wisconsin (“BCBSUW”) (including the proposed Amended and Restated Articles of  Incorporation and Bylaws of Cobalt, attached as Exhibits A and B thereto).  (8)                                                                                                                                                                                                                                                                                        |
|                 |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |
| 3.1                  |   | Amended and Restated  Articles of Incorporation of Cobalt. (10)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |
|                 |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |
| 3.2                  |   | Amended and  Restated Bylaws of Cobalt. (10)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
|                 |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |
| 10.1                 |   | Federal  Income Tax Allocation Agreement, dated March 23, 2001, by and among Cobalt,  Unity Health Plans Insurance Corporation (“Unity”), Hometown Insurance  Services, Inc., HMO-W, Inc., Valley Health Plan, Inc. (“Valley”), Compcare  Health Services Insurance Corporation (“Compcare”), United Wisconsin  Insurance Company (“UWIC”), Meridian Marketing Services, Inc., United  Heartland, Inc. (“UH”), United Wisconsin Proservices, Inc. (“Proservices”),  Comprehensive Receivables Group, Inc. (“CRG”), Michigan Healthcare  Collections, Inc., CNR Partners, Inc., Heartland Dental Plan, Inc. (“HDP”),  and BCBSUW. (2) |
|                 |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |
| 10.2                 |   | Tax  Indemnification and Allocation Agreement, dated September 11, 1998, by and  between United Wisconsin Services, Inc. (n/k/a American Medical Security  Group, Inc.) (“AMS”) and Cobalt. (2)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |
|                 |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |
| 10.3                 |   | Second  Amended and Restated Joint Venture Agreement by and among BCBSUW, Cobalt,  Valley, and Midelfort Clinic, Ltd.- Mayo Health Systems, dated January 1,  2000. (6)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
|                 |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |
| 10.4                 |   | Intercompany  Service Agreement among BCBSUW, Cobalt and UWIC, effective January 1, 1998.  (2)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |
|                 |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |
| 10.5                 |   | Intercompany  Service Agreement among BCBSUW, Cobalt and UH, effective January 1, 1998. (2)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
|                 |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |
| 10.6                 |   | Intercompany  Service Agreement among BCBSUW, Cobalt and Meridian Managed Care, Inc. (n/k/a  Innovative Resource Group, LLC) (“MMC”), effective January 1, 1998. (2)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |
|                 |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |
| 10.7                 |   | Intercompany  Service Agreement among BCBSUW, Cobalt, MMC, and Compcare on behalf of its  Pharmacy Services department, effective January 1, 1998. (2)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               |
|                 |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |
| 10.8                 |   | Intercompany  Service Agreement among BCBSUW, Cobalt, MMC, and Compcare on behalf of its  RxCel Department, effective January 1, 1998. (2)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           |
|                 |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |
| 10.9                 |   | Intercompany  Service Agreement among BCBSUW, Cobalt and Meridian Resource Corporation,  Inc., n/k/a Meridian Resource Company, LLC (“MRC”) on behalf of its  Investigation and Recovery Services Department, effective January 1, 1998.  (2)                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
|                 |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |
| 10.10                |   | Intercompany  Service Agreement among BCBSUW, Cobalt and MRC on behalf of its Consulting  Services Department, effective January 1, 1998. (2)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
|                 |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |
| 10.11                |   | Intercompany  Service Agreement among BCBSUW, Cobalt and MRC on behalf of its Audit  Services Department, effective January 1, 1998. (2)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             |
| 10.12                |   | Intercompany  Service Agreement among BCBSUW, Cobalt and Proservices, effective January 1,  1998. (2)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |

 

 

----

 
| 10.13  |   | Service  Agreement between BCBSUW and Valley, effective January 1, 1993. (2)                                                                                                                                                                                                                                                   |
|--------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                           |
| 10.14  |   | Service  Agreement between Cobalt and Community Health Systems, LLC, dated  November 1, 1994. (2)                                                                                                                                                                                                                         |
|   |   |                                                                                                                                                                                                                                                                                                                           |
| 10.15  |   | Second  Amended and Restated Joint Venture Agreement by and among Unity, BCBSUW,  Cobalt, University Health Care, Inc. (“U-Care”), University Community  Clinics, Inc. (f/k/a Health Professionals, Inc.), and Health Professionals of  Wisconsin, Inc., dated September 30, 1999 (as amended October 29, 1999). (4) |
|   |   |                                                                                                                                                                                                                                                                                                                           |
| 10.16  |   | Amended and  Restated Joint Venture Agreement by and among Unity, BCBSUW, Cobalt and  Community Health Systems, LLC (“CHS”), dated October 25, 1999. (5)                                                                                                                                                             |
|   |   |                                                                                                                                                                                                                                                                                                                           |
| 10.17  |   | Service  Agreement between Cobalt and CHS, dated November 1, 1994. (2)                                                                                                                                                                                                                                                    |
|   |   |                                                                                                                                                                                                                                                                                                                           |
| 10.18  |   | License  Agreement between Cobalt and U-Care, dated November 1, 1994. (2)                                                                                                                                                                                                                                                 |
|   |   |                                                                                                                                                                                                                                                                                                                           |
| 10.19  |   | Joint  Venture Agreement by and among Cobalt, BCBSUW, Compcare and Northwoods Health  Care, LLC, dated July 1, 1996, as amended October 24, 1996. (2)                                                                                                                                                                          |
|   |   |                                                                                                                                                                                                                                                                                                                           |
| 10.20  |   | Information  System Service Agreement between Blue Cross Blue Shield of South Carolina and  BCBSUW, dated August 23, 1996, as amended January 1, 1997. (2)                                                                                                                                                                     |
|   |   |                                                                                                                                                                                                                                                                                                                           |
| 10.21  |   | Form of  Trademark Assignment Agreement by and among AMS, Cobalt and United Wisconsin  Life Insurance Company (“UWLIC”). (2)                                                                                                                                                                                         |
|   |   |                                                                                                                                                                                                                                                                                                                           |
| 10.22  |   | Cobalt’s  Equity Incentive Plan as revised. (3)                                                                                                                                                                                                                                                                           |
|   |   |                                                                                                                                                                                                                                                                                                                           |
| 10.23  |   | 2001  Management Incentive Plan.                                                                                                                                                                                                                                                                                               |
|   |   |                                                                                                                                                                                                                                                                                                                           |
| 10.24  |   | Cobalt’s  Deferred Compensation Plan for Directors. (2)                                                                                                                                                                                                                                                                   |
|   |   |                                                                                                                                                                                                                                                                                                                           |
| 10.25  |   | Cobalt  401(k) Plan (f/k/a UWSI/BCBSUW 401(k) Plan). (2)                                                                                                                                                                                                                                                                       |
|   |   |                                                                                                                                                                                                                                                                                                                           |
| 10.26  |   | BCBSUW Union  Employees 401(k) Plan (f/k/a UWSI/BCBSUW 401(k) Plan). (2)                                                                                                                                                                                                                                                       |
|   |   |                                                                                                                                                                                                                                                                                                                           |
| 10.27  |   | Cobalt  Voluntary Deferred Compensation Plan. (3)                                                                                                                                                                                                                                                                              |
|   |   |                                                                                                                                                                                                                                                                                                                           |
| 10.28  |   | Cobalt  Deferred Compensation Trust. (2)                                                                                                                                                                                                                                                                                       |
|   |   |                                                                                                                                                                                                                                                                                                                           |
| 10.29  |   | Cobalt  Pension Plan. (2)                                                                                                                                                                                                                                                                                                      |
|   |   |                                                                                                                                                                                                                                                                                                                           |
| 10.30  |   | UGS Pension  Plan. (2)                                                                                                                                                                                                                                                                                                         |
|   |   |                                                                                                                                                                                                                                                                                                                           |
| 10.31  |   | Cobalt/BCBSUW  Supplemental Executive Retirement Plan. (2)                                                                                                                                                                                                                                                                     |
|   |   |                                                                                                                                                                                                                                                                                                                           |
| 10.32  |   | Promissory  Note and Pledge Agreement, dated April 30, 2001, between Cobalt and BCBSUW.  (2)                                                                                                                                                                                                                                   |
|   |   |                                                                                                                                                                                                                                                                                                                           |
| 10.33  |   | Administrative  Services Agreement between Cobalt and HMO of Wisconsin Insurance Corporation,  effective November 1, 1994. (2)                                                                                                                                                                                                 |
|   |   |                                                                                                                                                                                                                                                                                                                           |
| 10.34  |   | Assumption  and Administration Agreement by and among Wellmark, Inc., Wellmark Community  Insurance, Inc., BCBSUW and UWIC, effective June 1, 2000. (7)                                                                                                                                                                        |
|   |   |                                                                                                                                                                                                                                                                                                                           |
| 10.35  |   | Amendment to Employee  Benefits Agreement between Cobalt and AMS.(3)                                                                                                                                                                                                                                                           |

 

 

----

 

 
| 10.36  |   | Executive  Severance Agreement by and between Cobalt and Michael E. Bernstein, effective  June 8, 2000. (7)                                                                                                                                                                                         |
|--------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                     |
| 10.37  |   | 2001  Supplemental Incentive Plan Award Agreement, effective January 1, 2001. (9)                                                                                                                                                                                                                        |
|   |   |                                                                                                                                                                                                                                                                                                     |
| 10.38  |   | Voting Trust  and Divestiture Agreement dated March 23, 2001 by and between Cobalt,  Wisconsin United for Health Foundation, Inc., Wisconsin BC Holding LLC and  Marshall & Ilsley Trust Company. (10)                                                                                               |
|   |   |                                                                                                                                                                                                                                                                                                     |
| 10.39  |   | Registration  Rights Agreement dated March 23, 2001 by and between Cobalt and Wisconsin  United for Health Foundation, Inc. (10)                                                                                                                                                                         |
|   |   |                                                                                                                                                                                                                                                                                                     |
| 10.40  |   | Executive Severance  Agreement Tier I (Thomas R. Hefty). (11)                                                                                                                                                                                                                                            |
|   |   |                                                                                                                                                                                                                                                                                                     |
| 10.41  |   | Executive Severance  Agreement Tier II (Stephen E. Bablitch, Gail L. Hanson, Penny J. Siewert and  three other key employees). (11)                                                                                                                                                                      |
|   |   |                                                                                                                                                                                                                                                                                                     |
| 10.42  |   | Executive Severance  Agreement Tier III (James E. Hartert and six other key employees). (11)                                                                                                                                                                                                             |
|   |   |                                                                                                                                                                                                                                                                                                     |
| 10.43  |   | Supplemental  Retirement Agreement dated as of June 1, 2001 between Cobalt and Thomas R.  Hefty. (11)                                                                                                                                                                                                    |
|   |   |                                                                                                                                                                                                                                                                                                     |
| 10.44  |   | Stock Purchase  Agreement, dated as of March 19, 2002, by and among Cobalt, BCBSUW and AMS.  (12)                                                                                                                                                                                                        |
|   |   |                                                                                                                                                                                                                                                                                                     |
| 21     |   | Subsidiaries  of Cobalt.                                                                                                                                                                                                                                                                                 |
|   |   |                                                                                                                                                                                                                                                                                                     |
| 23.1   |   | Consent of  Ernst & Young LLP.                                                                                                                                                                                                                                                                       |
|   |   |                                                                                                                                                                                                                                                                                                     |
| 99     |   | Definitive  Proxy Statement for Cobalt’s 2002 Annual Meeting of Shareholders (which will  be filed with the Commission under Regulation 14A within 120 days after the  end of the Company’s fiscal year and which is incorporated by reference  herein to extent indicated in this Form 10-K). |

 

 

 

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(1)                                  Cobalt Corporation was organized in May of 1998for the purpose of owning and operating the managed care companies and specialtybusiness of its predecessor, United Wisconsin Services, Inc.  On May 27, 1998, the board of directors ofUnited Wisconsin Services, Inc. approved a formal plan to contribute themanaged care companies and specialty business to Cobalt and spin off Cobalt toits shareholders.  Upon its formation inconnection with the spin-off, Cobalt was originally named Newco/UWS, Inc.  It was subsequently renamed United WisconsinServices, Inc. following the spin-off, and was again renamed Cobalt Corporationin 2001.  The original United WisconsinServices, Inc. was renamed American Medical Security Group, Inc. in connectionwith the spin-off.  As a result, Cobaltis currently party to certain documents referenced in this Exhibit Index thatwere executed in the name of Cobalt’s predecessors, Newco/UWS, Inc. or UnitedWisconsin Services, Inc.  Similarly,American Medical Security Group, Inc. is currently party to certain documentsreferenced in this Exhibit Index that were executed in the name of itspredecessor, United Wisconsin Services, Inc.

 

(2)                                  Incorporatedby reference to Cobalt’s Registration Statement on Form 10 declaredeffective September 11, 1998.

 

(3)                                  Incorporatedby reference to Cobalt’s Quarterly Report on Form 10-Q for the periodended September 30, 1998.

 

(4)                                  Incorporatedby reference to Cobalt’s Quarterly Report on Form 10-Q for the periodended September 30, 1999.

 

(5)                                  Incorporatedby reference to Cobalt’s Annual Report on Form 10-K for the year endedDecember 31, 1999.

 

(6)                                  Incorporatedby reference to Cobalt’s Quarterly Report on Form 10-Q for the periodended March 31, 2000.

 

(7)                                  Incorporatedby reference to Cobalt’s Quarterly Report on Form 10-Q for the periodended June 30, 2000.

 

(8)                               Incorporatedby reference to Cobalt’s Registration Statement on Form S-4 (No. 333-52674)filed December 22, 2000.

 

(9)                                  Incorporatedby reference to Cobalt’s Annual Report on Form 10-K for the year endedDecember 31, 2000.

 

(10)                            Incorporatedby reference to Cobalt’s Current Report on Form 8-K filed April 9, 2001.

 

(11)                            Incorporatedby reference to Amendment No. 1 to Cobalt’s Quarterly Report on Form 10-Qfor the period ended June 30, 2001.

 

(12)                            Incorporatedby reference to Cobalt’s Current Report on Form 8-K filed March 26, 2002.

 

 

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