We are one of the nation’s leading health benefits companies and we operate as an independent licensee of the Blue Cross Blue Shield Association, or BCBSA. We offer Blue Cross Blue Shield branded products to customers throughout Indiana, Kentucky, Ohio, Connecticut, New Hampshire, Maine, Colorado, Nevada and Virginia (excluding the immediate suburbs of Washington, D.C.). As of December 31, 2003, we provided health benefit services to more than 11.9 million members of our health plans.
Medicaid membership represents eligible members with state sponsored managed care alternatives in the Medicaid programs that we manage for the states of Connecticut and Virginia.
The primary driver of our membership change was the increase in National Accounts membership of 645,000, or 16%, which primarily resulted from a significant increase in BlueCard activity and enrollment gains
Outpatient services costs increased approximately 10%, driven approximately two thirds by unit cost increases and one third by utilization increases. Unit costs per visit increased as more procedures are being performed during each visit to an outpatient provider, as well as the impact of price increases imposed within certain provider contracts. Efforts to mitigate unit cost trends for outpatient services include contracting strategies using fixed rate fee schedules, plan design changes to include new or higher co-payments for certain outpatient services, selective contracting with freestanding specialty facilities, expansion of our radiology management network program and broader use of national contracting programs. Increased utilization is primarily due to additional visits for outpatient surgery and radiology services, as well as a continuing shift of certain procedures previously performed in an inpatient setting to an outpatient setting, such as selected cardiac care procedures.
Benefit expense increased $2,424.5 million, or 25%, to $12,263.9 million in 2003. Included in these 2003 results was a $31.7 million net favorable prior year reserve development recorded during the second quarter of 2003, primarily in our Southeast and Midwest segments, and a $24.5 million favorable adjustment for resolution of a litigation matter in our Midwest segment in the first quarter of 2003. On a same-store basis, benefit expense increased $773.6 million, or 9%, to $9,523.6 million in 2003. Included in these same-store 2003 results was the recognition of a $24.5 million favorable adjustment for resolution of a litigation matter in our Midwest segment and a $15.9 million net favorable prior year reserve development recorded during the second quarter of 2003. Included in the same-store 2002 results was a $26.6 million net favorable prior year reserve development. Same-store benefit expense increased primarily due to increased cost of care, which was driven primarily by higher costs in professional services and outpatient services. See “Cost of Care-Year Ended December 31, 2003 Compared to the Year Ended December 31, 2002.” Our benefit expense ratio decreased 160 basis points from 82.4% in 2002 to 80.8% in 2003 due in part to the impact of our Trigon acquisition in 2002. On a same-store basis, our benefit expense ratio decreased 120 basis points to 81.4% in 2003, primarily due to lower than anticipated medical costs, the favorable resolution of litigation, disciplined pricing and mix of business shifts from fully-insured to self-funded arrangements by groups that have had historically higher loss ratios.
Net investment income increased $17.4 million, or 7%, to $278.1 million in 2003. This increase in investment income primarily resulted from the investment of additional assets in 2003 from our Trigon acquisition and reinvestment of cash generated from operations, which were partially offset by a decrease in yields from new investments.
The comparison of these two time periods is not meaningful as the period ended December 31, 2003 consists of twelve months of operating results while the period ended December 31, 2002 consists of five months of operating results.
Our Specialty segment will continue efforts to expand sales to our existing health membership in order to provide our members a wider range of cost effective products. These integration activities will occur over the next several years, and the related costs will partially offset future margin expansion in the Specialty segment as integration costs are incurred.
Pharmacy costs increased by approximately 16% including the impact of our Trigon acquisition for both rolling 12-month periods, including periods prior to our July 31, 2002 acquisition. Excluding the impact of our Trigon acquisition, our pharmacy cost trend remained consistent at approximately 16%. Increases were primarily due to the introduction of new, higher cost drugs and higher overall utilization as a result of increases in direct-to-consumer advertising by pharmaceutical companies and expanded physician-prescribed use of drugs that manage chronic conditions such as high cholesterol. In response to increasing pharmacy costs, we are evaluating different plan designs, recontracting with retail pharmacies and continuing the implementation of tiered drug benefits for our members. Three-tier drug programs reflect benefit designs that have three different co-payment levels, which depend on the drug selected. Generic drugs have the lowest co-payment, brand name drugs included in the drug formulary have a higher co-payment and brand name drugs omitted from the drug formulary have the highest co-payment. Drug formularies are lists of prescription drugs that have been reviewed and selected for their quality and effectiveness by a committee of community-based practicing physicians and clinical pharmacists. Through our pharmacy benefit design, we encourage use of these formulary listed brand name and generic drugs to ensure members receive quality and cost-effective medication. The favorable impact of three-tier drug programs on prescription drug cost trends is most significant in the first year of implementation. Excluding Southeast membership, we have already implemented three-tier drug programs for approximately 66% of our members as of December 31, 2002, as compared to approximately 60% of our members as of December 31, 2001.
Administrative expense increased $520.5 million, or 26%, in 2002. On a same-store basis, administrative expense increased $319.6 million, or 17%, primarily due to higher salary cost and merit increases, other volume sensitive costs such as higher commissions and premium taxes and higher incentive compensation costs associated with above targeted results. On a same-store basis, our administrative expense ratio remained consistent with 2001 at 19.5%.
Operating revenue increased by $145.7 million, or 19%, primarily due to higher premium rates particularly in our Local Large Group fully-insured and Small Group businesses, and higher membership in our Individual business.
Our Specialty segment’s summarized results of operations for the years ended December 31, 2002 and 2001 are as follows:
In addition to the pending claims and incurred but not reported claims, the liability for unpaid life, accident and health claims includes reserves for premium deficiencies. Premium deficiencies are recognized when it is probable that expected claims and loss adjustment expenses will exceed future premiums on existing health and other insurance contracts without consideration of investment income. For purposes of premium deficiencies, contracts are grouped in a manner consistent with our method of acquiring, servicing and measuring the profitability of such contracts.
We account for income taxes in accordance with Statement of Financial Accounting Standards No. 109, Accounting for Income Taxes. This standard requires, among other things, the separate recognition of deferred tax assets and deferred tax liabilities. Such deferred tax assets and deferred tax liabilities represent the tax effect of temporary differences between financial reporting and tax reporting measured at tax rates enacted at the time
The Company’s fixed maturity investment portfolio is sensitive to interest rate fluctuations, which impact the fair value of individual securities. All unrealized losses reported above were caused by the effect of a rising interest rate environment on certain securities with stated interest rates currently below market rates. The Company has the ability and intent to hold these securities until their full cost can be recovered. Therefore, the Company does not believe the unrealized losses represent an other-than-temporary impairment as of December 31, 2003.
Stock-Based Compensation: The Company has a plan that provides for stock-based compensation, including stock options, restricted stock awards and an employee stock purchase plan. Stock options are granted for a fixed number of shares with an exercise price at least equal to the fair value of the shares at the date of the grant. Restricted stock awards are issued at the fair value of the stock on the grant date. The employee stock purchase plan allows for a purchase price per share which is 85% of the lower of the fair value of a share of common stock on (i) the first trading day of the plan quarter, or (ii) the last trading day of the plan quarter. The Company accounts for stock-based compensation using the intrinsic method under Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, and, accordingly, recognizes no compensation expense related to stock options and employee stock purchases. For grants of restricted stock, other than those awarded under long term incentive agreements, unearned compensation equivalent to the fair value of the shares at the date of grant is recorded as a separate component of shareholders’ equity and subsequently amortized to compensation expense over the vesting period. The Company has adopted the disclosure-only provisions of FAS 123, as amended by FAS 148, Accounting for Stock-Based Compensation-Transition and Disclosure.
On May 31, 2001, Anthem Insurance and Blue Cross and Blue Shield of Kansas (“BCBS-KS”) announced they had signed a definitive agreement pursuant to which BCBS-KS would become a wholly-owned subsidiary of Anthem Insurance. On February 11, 2002, the Kansas Insurance Commissioner (“Commissioner”) disapproved the proposed transaction, which had been previously approved by the BCBS-KS policyholders in January 2002. The Company joined BCBS-KS in an appeal of the Commissioner’s decision, which was filed with the Shawnee County District Court (“District Court”) on March 7, 2002. On June 7, 2002, the District Court ruled in favor of Anthem and BCBS-KS, vacating the Commissioner’s decision and remanding the matter to the Commissioner for further proceedings not inconsistent with the District Court’s order. On June 10, 2002, the Commissioner appealed the District Court’s ruling to the Kansas Supreme Court (“Supreme Court”). On August 6, 2003, the Supreme Court overturned the District Court’s ruling and reinstated the Commissioner’s 2002 disapproval of the proposed transaction. The Company and BCBS-KS decided not to appeal this decision and the definitive agreement was terminated.
During 2002, the Company completed two other acquisitions and made an additional contingent purchase price payment on a 1999 acquisition as follows:
For grants of restricted stock, other than those awarded under long-term incentive agreements, unearned compensation equivalent to the fair market value of the shares at the date of grant is recorded as a separate component of shareholders’ equity and subsequently amortized to compensation expense over the vesting period. Compensation expense totaling $2.2 and $1.5 was recognized for 2003 and 2002, respectively.
All of the plans’ assets consist primarily of common stocks, fixed maturity securities, investment funds and short-term investments. The funding policies for all plans are to contribute amounts at least sufficient to meet the minimum funding requirements set forth in the Employee Retirement Income Security Act (“ERISA”) plus such additional amounts as are necessary to provide assets sufficient to meet the benefits to be paid to plan participants.
On July 19, 2001, the Connecticut state court suit was certified as a class action as to three of the plaintiff’s fifteen allegations. The class is defined as those physicians who practice in Connecticut or group practices which are located in Connecticut that were parties to either a Participating Physician Agreement or a Participating Physicians Group Agreement with the Company and/or its Connecticut subsidiary during the period from 1993 to the present, excluding risk-sharing arrangements and certain other contracts. The claims which were certified as class claims are: the Company’s alleged failure to provide plaintiffs and other similarly situated physicians with consistent medical utilization/quality management and administration of covered services by paying financial