The Company owns its principal executive offices in Pueblo, Colorado and leases office space for its principal executive offices in Woodland Hills, California. The Pueblo facility, with approximately 72,000 square feet, is subject to a mortgage in the aggregate principal amount of approximately $1.4 million. The Company also received three properties in 1996 with approximately 188,400 aggregate square feet and will receive approximately $4.5 million for such properties' renovation from the City of Pueblo in return for certain employment commitments. The Woodland Hills facility, with approximately 275,000 square feet, is leased pursuant to a ten year lease expiring in 2001 on an anchor full-service gross basis with annual rent in 1996 of approximately $7.8 million. The Company and its subsidiaries also lease an aggregate of approximately 450,000 square feet of additional office space. The Company's aggregate rent obligations under these leases were approximately $10.7 million in 1996. Management believes that its ownership and rental costs are consistent with those available for similar space in the applicable local area. The Company's properties are well maintained, considered adequate and are being utilized for their intended purposes.
(1) All data prior to February 6, 1992 reflects only QualMed data since Health Net prior to the conversion was not considered a predecessor company. See Note 1 to the consolidated financial statements.
The Company's overall medical loss ratio (medical expenses as a percentage of premium revenue) ("MLR"), increased to 83.3% in 1996 from 81.0% in 1995. The increase in MLR is the result of escalating health care costs coupled with a relatively flat premium environment, particularly in the California market. The increased health care costs reflect continued high pharmacy cost trends on a company-wide basis and increased outpatient costs in certain of the Company's markets outside of California. In addition, a high MLR was experienced in the Company's Philadelphia Medicaid business in 1996 as a result of a significant reduction in Medicaid reimbursement rates in February 1996. As of March 1997, the Company is no longer participating in the Pennsylvania Medicaid program. In 1995, effective medical management and the recontracting of its largely capitated provider network in California enabled the Company to maintain a stable MLR. The Company's overall MLR increased slightly to 81.0% in 1995 from 80.3% in 1994, primarily due to the increased Medicare risk business in 1995. Medicare risk MLRs typically run higher than commercial ratios due to the higher utilization of services in the senior population. A stable commercial MLR of 79.4% was achieved by the Company in 1995 by renegotiating its provider contracts in California, to offset premium pricing pressures, and quickly implementing its medical management system in its newly acquired HMO operations in the Northeast.
Premium revenue, excluding administrative services only ("ASO") revenue, increased by $441.7 million or 16.4% from 1995 to 1996, and by $402 million or 17.5% from 1994 to 1995. The factors that contributed to these increases included acquisitions completed in 1995 in the Northeast, continued growth in Medicare risk membership in the Company's existing service areas and limited premium rate increases in certain markets. Increased membership, particularly in higher premium Medicare business in California, was offset in part by premium rate reductions in the California commercial market.
million resulted from Medicare risk membership increases. Changes in premium rates in both the commercial business and Medicare risk business accounted for a decrease of $86.5 million of premium revenue in 1995. On an overall PMPM basis, the premium rate changes resulted in a decrease of 3% in commercial premium revenue to $118.51 and a increase in Medicare premium revenue of 4.5% to $394.42 in 1995. Overall, Medicare risk business accounted for an increase of $191 million of premium revenue in 1995 compared to 1994 and commercial business accounted for an increase of $211 million of premium revenue in 1995 compared to 1994.
The Company's ASO business accounted for $70.1 million, $39.7 million and $15.6 million of revenue in 1996, 1995 and 1994, respectively. Included in ASO revenue in 1996 was revenue totaling $25.1 that relates to certain businesses providing ancillary healthcare services. These business were acquired as part of the acquisition of Greater Atlantic in Philadelphia and were sold in October 1996.
Healthcare expenses increased by $342 million, or 18.6%, to $110.23 PMPM in 1995 compared to $107.82 PMPM in 1994. The Company's overall MLR increased slightly to 81.0% from 80.3% in 1994. Impacting the Company's overall healthcare expense PMPM and MLR was the growth in Medicare business and the associated higher utilization experience. The Company's MLR in the Medicare risk business increased to 88.0% in 1995 from 85.6% in 1994 due to Medicare risk membership growth in higher cost areas. Commercial healthcare expenses on a PMPM basis decreased from $97.03 in 1994 to $94.09 in 1995 and the Company's commercial MLR remained flat in 1995, at 79.4%, relative to 1994.
Depreciation and amortization expenses as a percentage of premium revenue decreased slightly from 1.8% in 1995 to 1.7% in 1996 ($48.1 million in 1995 and $52.6 million in 1996). The decrease in depreciation and amortization expenses resulted primarily from write-downs of fixed assets related to the Company's restructuring of its operations.
For the year ended December 31, 1996, cash provided by operating activities decreased to $20.3 million from $111.6 million in the prior year. In part this decrease is due to normal fluctuations in operating assets and liabilities from year to year caused by timing differences in the payment of liabilities and collection of receivables at each respective year end. The remainder of the decrease in cash provided by operations in 1996 was due to a significant reduction of claims inventory which had accumulated in late 1995. Net cash used by investing activities was $74.8 million in 1996, a decrease over the prior year cash used of $282.3 million. The reduction in cash used by investing activities was primarily the result of 1995 acquisitions in the Northeast and a reduction in the purchase of marketable securities in 1996. Net cash provided by financing activities in 1996 was $16.1 million versus $128.7 million in 1995. The decrease in 1996 is attributable to reduced borrowings under the credit facility; in 1995 such borrowings were used to fund the Northeast acquisitions. The financing of these 1995 acquisitions was through additional borrowings on the Credit Facility (see below).
Management of the Company believes that its cash from operations and existing working capital are adequate to fund existing obligations, introduce new products and services and continue to develop health care related businesses. The Company regularly evaluates cash requirements for current operations, commitments, development activities and strategic acquisitions. The Company may elect to raise additional funds for these purposes, either through the issuance of additional debt or equity, sale of investment securities or otherwise, as appropriate.
The Company's subsidiaries must comply with certain minimum capital requirements under applicable state laws and regulations. The long-term portion of principal and interest payments under the Foundation Notes is subordinated to Health Net meeting tangible net equity ("TNE") requirements under applicable California laws and regulations. As of December 31, 1996, the Company's subsidiaries were in compliance with minimum capital requirements.
The managed health care industry is labor intensive and its profit margin is low. Hence, it is especially sensitive to inflation. Increases in health care costs without corresponding increases in premiums could have a material adverse effect on the Company.
Various federal and state legislative initiatives regarding the health care industry have been proposed during recent legislative sessions, and health care reform and similar issues continue to be in the forefront of social and political discussion. If health care reform or similar legislation is enacted, such legislation could impact the Company. Management cannot at this time predict whether any such initiative will be enacted or, if enacted, the impact on the financial condition or operations of the Company.
We have audited the accompanying consolidated balance sheets of Health Systems International, Inc. and subsidiaries as of December 31, 1996 and 1995, and the related consolidated statements of income, stockholders' equity, and cash flows for each of the three years in the period ended December 31, 1996. Our audits also included the financial statement schedules listed in the index at Item 14(a)(2). These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on the financial statements and financial statement schedules based on our audits.
These consolidated financial statements present the accounts of Health Systems International, Inc. and its wholly and majority-owned subsidiaries, including Health Net, QualMed, Inc. ("QualMed"), HN Reinsurance Limited ("HNR"), M.D. Enterprises of Connecticut, Inc. ("MDEC") and HSI Eastern Holdings, Inc. (collectively, the "Company"). All significant intercompany balances and transactions have been eliminated in consolidation.
On March 31, 1995, the Company, WellPoint Health Networks Inc. and Blue Cross of California entered into a merger agreement which provided for, among other things, the business combination of the Company, WellPoint and certain commercial operations of Blue Cross of California. On December 28, 1995, the Company, WellPoint and Blue Cross of California announced that they had entered into an agreement that terminated the merger agreement. In connection with the terminated merger agreement, the Company incurred merger-related costs totaling approximately $20.2 million in 1995. Such costs include legal, accounting and consulting fees, as well as severance related costs of $12.2 million resulting from agreements with certain key executives in contemplation of the proposed merger.
The long-term portion of Health Net's debt to the Foundation, as discussed in Note 5, is subordinated to Health Net satisfying its TNE requirements. Dividends and loans by Health Net are restricted to the extent that the payment of such would reduce its TNE below the minimum requirement. As of December 31, 1996 and 1995, all of the Company's health plans exceeded their respective minimum TNE requirements. On a cumulative basis, the regulatory net worth of the Company's health plans exceeded the minimum aggregate requirement by approximately $223 million and $172 million at December 31, 1996 and 1995, respectively.
Each of the Company's individual HMOs generally provide health care to their members for a prepaid monthly fee. Premiums for members are recognized as revenue in the month in which the members are entitled to service. Premiums collected in advance are deferred and recorded as unearned subscriber premiums.
The Company generally contracts in California with various medical groups to provide professional care to certain of its members on a capitation or fixed fee PMPM. Capitation contracts generally include provisions for stop-loss and non-capitated services for which the Company is liable. Professional capitated contracts also generally contain provisions for shared risk, whereby the Company and the medical groups share in the variance between actual hospital costs and predetermined goals. Additionally, the Company contracts with certain hospitals to provide hospital care to enrolled members on a capitated basis.
Cash equivalents include all highly liquid investments with a maturity of three months or less when purchased.
The Company accounts for investments in accordance with Statement of Financial Accounting Standards (SFAS) No. 115 "Accounting for Certain Investments in Debt and Equity Securities" and has determined that all marketable securities (which are primarily comprised of debt securities) held as of December 31, 1996 and 1995 are held for sale. Accordingly, such securities are carried at fair value determined using quoted market prices, and unrealized gains or losses, net of applicable income taxes, are recorded in stockholders' equity. The Company has also determined that such marketable securities are available for use in current operations and, accordingly, has classified such securities as current assets without regard to the securities' contractual maturity dates.
The cost of marketable securities sold is determined in accordance with the specific identification method and realized gains and losses are included in investment income.
With respect to internal costs incurred in the development of computer software, the Company expenses such costs in the period they are incurred. External costs incurred in the development of computer software are capitalized. In addition, certain internal systems conversion costs are capitalized. The Company capitalized approximately $8.3 million and $12.7 million of computer software development and systems conversion costs in 1996 and 1995, respectively. Such capitalized costs are amortized using the straight- line method over the remaining estimated economic life of the product or system. Amortization expense amounted to $4.6 million, $2.2 million and $.6 million in 1996, 1995 and 1994 respectively.
The Company accounts for certain long-lived assets, identifiable intangibles, and goodwill in accordance with SFAS No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of." The standard requires long lived assets awaiting disposition or with impaired service potential to be valued at the lower of cost or undiscounted expected cash flows attributable to the assets.
Deferred income taxes reflect the net effects of temporary differences between the carrying values of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. The differences result in taxable or deductible amounts for income tax purposes when the reported amount of the asset or liability in the financial statements is recovered or settled, respectively. The Company has recorded a deferred tax asset of $29.3 million as of December 31, 1996. Although realization is not assured, management believes it is more likely than not that all of the deferred tax asset will be realized.
Earnings per share is calculated based on the weighted average shares of common stock and common stock equivalents
outstanding during the periods presented. Common stock equivalents arising from dilutive stock options are computed using the treasury stock method.
The Company estimates the fair value of financial instruments in accordance with the requirements of SFAS No. 107, "Disclosures about Fair Value of Financial Instruments." The estimated fair value amounts of cash equivalents, marketable securities held for sale and notes payable approximate their carrying amounts in the financial statements and have been determined by the Company using available market information and appropriate valuation methodologies. The carrying amount of cash equivalents approximate fair value due to the short maturity of those instruments. The fair values of marketable securities are estimated based on quoted market prices and dealer quotes for similar investments. The fair value of notes payable is estimated based on the quoted market prices for the same or similar issues or on the current rates offered to the Company for debt of the same remaining maturities. Considerable judgment is required to develop estimates of fair value. Accordingly, the estimates are not necessarily indicative of the amounts the Company could have realized in a current market exchange. The use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair value amounts.
During 1995, the Financial Accounting Standards Board issued SFAS No. 123, "Accounting for Stock-Based Compensation," which encourages but does not require companies to record stock-based compensation cost at fair value. The Company has chosen to continue accounting for stock-based compensation under the intrinsic value method prescribed in Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees." Under the intrinsic value method, compensation cost for stock options is measured at the date of grant as the excess, if any, of the quoted market price of the Company's stock over the exercise price of the option. See Note 10, Stock Option and Employee Stock Purchase Plans.
The following is a summary of marketable securities held for sale as of December 31, 1996 (in thousands):
Included in other securities is the Company's investment in Medaphis Corporation. At December 31, 1996, the unrealized loss on such investment was $11.6 million. See Note 3.
During the year ended December 31, 1996, marketable securities held for sale with a fair value at the date of sale of $224.2 million were sold. The gross realized gains on such sales totaled $2.4 million, and the gross realized losses totaled $270,000.
HDS - On June 30, 1995, the Company acquired shares of preferred stock of Health Data Sciences Corporation ("HDS"), representing a minority equity interest in HDS, for an aggregate purchase price of approximately $15.6 million. In addition, the Company entered into certain software licensing and development agreements with HDS. HDS develops, licenses and supports proprietary software and technology related to health care information management systems. On November 13, 1995 and December 29, 1995, the Company acquired additional shares of preferred stock of HDS for an aggregate purchase price of approximately $6.3 million.
In July 1996, HDS was acquired by Medaphis Corporation ("Medaphis") and the Company's preferred stock in HDS was converted into 976,771 shares of Medaphis common stock. Since the acquisition of HDS by Medaphis the value of Medaphis common stock has substantially declined, and the Company has therefore recorded an unrealized loss of $11.6 million related to its investment in Medaphis common stock. In connection with the decline in value in
November 1996, the Company filed a lawsuit against Medaphis claiming, among other things, that misleading financial performance information was given to the Company prior to the acquisition. The complaint seeks rescission of the transaction or damages in excess of $38.0 million. As of December 31, 1996, the litigation is ongoing.
MDEC - On March 15, 1995, the Company acquired all of the outstanding stock of M.D. Enterprises of Connecticut, Inc. ("MDEC"), and its wholly-owned subsidiary, M.D. Health Plan, an HMO operating in Connecticut, for $95.4 million. In addition, the Company assumed certain contractual obligations related to MDEC stock appreciation rights equal in value to $5.1 million. The acquisition has been accounted using purchase accounting and the excess of the purchase price over the fair value of assets acquired totaling $97.1 million was recorded as goodwill in the amount of $89.1 million and employer group contracts in the amount of $8.0 million.
At closing, the Company will purchase approximately $43 million worth of FOHP convertible subordinated debentures, a portion of which will reflect fees owed to the Company by FOHP pursuant to a management agreement to be entered into by the Company and FOHP. This portion of the $43 million initial investment (estimated to be approximately $1.5 million as of the closing) will immediately be converted into FOHP stock. The initial investment, and further amounts to be forwarded by the Company to FOHP prior to December 31, 1997 (such further amounts not to exceed $8.4 million), will be convertible into 71% of the outstanding equity of FOHP at the Company's discretion. The timing of payment for these contractual obligations may be subject to revision pursuant to required regulatory approvals. In 1999, the Company may effect either a cash offer for shares or a merger, business combination or consolidation transaction for the remaining shares of FOHP not owned by the Company.
Property and equipment consists of the following at December 31, 1996 and 1995 (in thousands):
The long-term portion of the principal and interest payments under these notes is subordinated to Health Net meeting its tangible net equity requirements under the Knox-Keene Health Care Service Plan Act.
Based on the terms of the Conversion as approved by the DOC, Health Net may treat as a deemed principal payment with respect to the senior secured note payable to the Foundation any taxes, penalties or interest assessed with respect to the Conversion (whether resulting from the recently completed examination or otherwise) up to a maximum of $28 million. In March 1995, Health Net and the IRS entered into a settlement of all outstanding issues raised in the audit. The settlements paid were treated as a principal payment on the notes due to the Foundation. (See Note 8).
On April 26, 1996, the Company replaced its five-year unsecured $400 million revolving credit facility obtained on April 12, 1995 with a $700 million revolving credit facility (the "Credit Facility") from a lending syndicate led by Bank of America. Under the new Credit Facility, the Company may incur permitted subordinated indebtedness in a maximum aggregate amount not to exceed $150 million which is available for acquisition purposes and to provide short-term financing to repurchase shares of stock. The Company may elect from various short-term interest rates based upon a spread above the LIBOR rate, or the greater of the bank's reference rate or the federal funds rate plus 1/2%. In addition, the Company may elect a "competitive bid auction" in which participating banks are offered an opportunity to bid alternative rates. The Credit Facility is for a term of five years from the date of execution, with two one year extension options. As of December 31, 1996, $319 million had been borrowed against the new $700 million Credit Facility.
The Company leases administrative and medical office space under various operating leases. Certain medical office space is subleased to Participating Medical Groups doing business with the Company. Certain leases contain renewal options and rent escalation clauses. Future minimum lease commitments for noncancelable operating leases at December 31, 1996 are as follows (in thousands):
Rent expense totaled $18.6 million, $17.7 million and $13.8 million in 1996, 1995 and 1994, respectively.
In 1995 the Company had five separate 401(k) retirement savings plans. All five of the 401(k) plans were consolidated into a single plan effective January 1, 1996. The plan is available to substantially all employees of certain subsidiaries age 21 or older who have completed various periods of continuous service. Non-highly compensated employees as defined by the Internal Revenue Code may defer up to a maximum of 15% of their annual compensation under the 401(k) plan, while highly compensated employees are limited to lesser maximums in compliance with discrimination tests. The Company made certain matching contributions to the plan in 1996.
The Company also has adopted the Health Net Board of Directors Retirement Plan. The plan covers all outside members of the Health Net Board of Directors retiring on or after age 65 for a duration not to exceed the period of service as a director.
The weighted-average annual assumed rate of increase in the per capita cost of covered benefits (i.e., health-care cost-trend rate) is 7.75% for 1997, and is assumed to decrease gradually to 5.5% for 2007 and remain at that level thereafter. The health-care cost- trend rate assumption has a significant effect on the amounts reported. To illustrate, increasing the assumed health care cost- trend rates by one percentage point in each year would increase the accumulated post-retirement benefit obligation as of December 31, 1996 by $650,000 and the aggregate of service and interest cost components of net periodic post-retirement benefit cost for the year then ended by $200,000. The weighted-average discount rate used in determining the accumulated post-retirement benefit obligation was 7.5% in 1996 and 1995 and 8.5% in 1994.
The Company also sponsors a life insurance plan, funded entirely by the Company. The amount of coverage varies with the maximum amount of three times earnings not to exceed $500,000. The Company's policy is to fund the cost of benefits for the health care and life insurance plans in amounts determined at the discretion of management, after consultation with an independent actuary.
The Company also has a Management Bonus Plan whereby certain executives become eligible to receive annual cash bonuses if the Company and such executives meet certain financial and operating targets.
Health Net is currently under examination by the California Franchise Tax Board. Issues under examination include, among other issues, tax ramifications of the Conversion. Additionally, certain QualMed plans are currently under examination by the Internal Revenue Service. Issues under examination include, among other issues, tax treatment of goodwill related to various acquisitions. Although it is not possible to predict with any certainty the outcome of these examinations, the Company's management believes, based on advice of legal counsel, that QualMed and Health Net have substantial bases for their positions on issues likely to arise during the course of the examinations. The ultimate resolution of these matters should not have a material adverse effect on the financial statements of the Company.
The Company is involved in various other legal proceedings, which are routine in its business. In the opinion of management, based upon current facts and circumstances known by the Company, the resolution of these matters should not have a material adverse effect on the financial position or results of operations of the Company.
In 1995, the Company advanced an aggregate sum of approximately $16.3 million to three of its former executive officers and directors in connection with the future repurchase of shares of HSI Class A Common Stock held by such individuals. This repurchase agreement was entered into in connection with certain severance agreements between the Company and each such individual in connection with his or her termination of employment. Such advances were non-interest bearing and were secured by a pledge of shares of Class A Common Stock, which shares were ultimately repurchased by the Company in January 1996.
1991 Plan - In 1991, 1,000,000 shares of the Company's Class A Common Stock were authorized to be issued under future grants to officers and employees of the Company pursuant to the 1991 Stock Option Plan. The authorized number of shares was subsequently increased to 5,000,000.
Stock option activity and weighted average exercise prices for the years ended December 31, 1996, 1995, and 1994 is present below:
During 1996 and 1995, 51,623 shares and 48,530 shares, respectively, were issued under the Employee Stock Purchase Plan at a weighted average issuance price of $23.30 and $22.07, respectively. The shares were issued at prices of $21.25 and $25.93 in 1996 and $20.93 and $23.06 in 1995.
The weighted average fair value at date of grant for options granted during 1996 and 1995 was $9.78 and $8.49, respectively. The fair value of options granted during 1996 and 1995 were estimated using the Black-Scholes option-pricing model with the following weighted average assumptions: (i) risk-free interest rate of 6.26%; (ii) expected lives of 2.92 years; (iii) expected volatility of 38.4%; and (iv) no expected dividend yield.
Significant components of the Company's deferred tax liabilities and assets as of December 31 are as follows (in thousands):
The Company has utilized pre-acquisition operating losses of subsidiaries acquired which could differ from amounts allowed by the tax authorities. Management believes it has adequately provided for any increases in taxes that might result from any reduction of the realization of net operating loss carryforwards.
Following is a reconciliation of income tax computed at the U.S. federal statutory tax rates to income tax expense for the three years ended December 31 (in thousands):
On May 15, 1996, the Company completed a public offering in which the Company sold 3,194,374 shares of Class A Common Stock and the Foundation sold 6,386,510 shares of Class A Common Stock (constituting 6,386,510 shares of Class B Common Stock which automatically converted into shares of Class A Common Stock upon the sale) for a per share purchase price to the public of $30.00 (the "Offering"). The net proceeds received by the Company from the sale of the 3,194,374 shares of Class A Common Stock were approximately $92.4 million after deducting underwriting discounts and commissions and estimated expenses of the Offering payable by the Company. The Company used its net proceeds from the Offering to repurchase 3,194,374 shares of Class A common Stock held pursuant to the Associate Trust Agreement from certain Class A Stockholders. The Company repurchased these shares of Class A Common Stock from the Class A Stockholders at $30.00 per share less transaction costs associated with the Offering, amounting to $1.08 per share. All of these 3,194,374 shares of Class A Common Stock repurchased are currently held in treasury. The Company did not receive any of the proceeds from the sale of shares of Class A Common Stock in the Offering by the Foundation.
Except as set forth below and subject to adjustment as provided in the Rights Agreement, each Right entitles its registered holder, upon the occurrence of a Distribution Date, to purchase from the Company one one-thousandth of a share of Series A Junior Participating Preferred Stock, at a price of $170.00 per one-thousandth share. However, in the event any person acquires 15% or more of the outstanding Class A Common Stock, or the Board of Directors of the
Company declares a holder of 10% or more of the outstanding Class A Common Stock to be an "Adverse Person," the Rights (subject to certain exceptions contained in the Rights Agreement) will instead become exercisable for Class A Common Stock having a market value at such time equal to $340.00. The Rights are redeemable under certain circumstances at $.01 per Right and will expire, unless earlier redeemed, on July 31, 2006.
In the fourth quarter of 1996, the Company recorded $44.1 million, or $.53 per share, in restructuring and other charges. These charges included restructuring charges of $35.6 million, the components of which were: executive, workforce and facilities consolidation costs of approximately $11.9 million; software and hardware write-offs of approximately $15.0 million; and other components which aggregated approximately $8.7 million.