The Company owns several administrative facilities in southern Nevada totalling approximately 212,000 square feet. Such facilities include an approximate 134,000 square foot six-story home office building and an approximate 43,000 square foot two-story corporate administrative headquarters. These buildings are subject to liens securing a $9.8 million loan balance from Bank of America. The Company also owns several clinical facilities in the southern Nevada area totalling approximately 309,000 square feet and consisting primarily of six medical clinics and two surgery centers. Certain clinical space is subject to a $3.2 million mortgage in favor of GE Capital Asset Management Corporation as well as a $4.7 million mortgage in favor of Key Bank of Washington. The Company leases additional office and clinical space in Nevada totalling approximately 84,000 and 52,000 square feet, respectively.
In connection with its workers' compensation insurance subsidiary, the Company leases approximately 151,000 square feet of office space in California. The Company also leases approximately 27,000 square feet of office space in various states as needed for other regional operations, including the Texas HMO.
The Company's principal expenses consist of medical expenses, specialty product expenses, and general and administrative expenses. Medical expenses represent the aggregate expenses of operating the Company's multi-specialty medical group and other provider subsidiaries as well as capitation fees and other fee-for-service payments paid to contracted physicians, hospitals and other health care providers. As a provider of managed care services, the Company seeks to manage medical expenses by employing or contracting with physicians, hospitals and other health care providers at negotiated price levels, by adopting quality assurance programs, by monitoring and managing utilization of physicians and hospital services and by providing incentives to use cost-effective providers. Specialty product expenses primarily consist of losses and loss adjustment expenses, and underwriting expenses associated with the Company's workers' compensation insurance subsidiaries. General, administrative and other expenses generally represent operational costs other than those associated with the delivery of health care services and specialty product services.
The acquisition and integration expenses represent the costs of acquiring and consolidating CII's administrative functions and information systems as well as positioning the Company to begin implementing managed care techniques in workers' compensation. These costs include: $6.4 million in professional fees, $1.7 million for the write-off of certain redundant hardware and software, $1.3 million for the cancellation of certain contractual obligations and other settlement costs, $900,000 for transition and severance-related payments, and $1.3 million for other integration costs.
Total medical expenses increased by approximately $44.9 million in 1995 compared to 1994. This 22.4% increase resulted from the consolidated member month growth discussed above, as well as the clinical expansions and increases associated with professional fee growth. These factors, as well as an increase in Medicare members as a percentage of total members, increased the Company's medical loss ratio to 72.3% for the twelve months ended December 31, 1995, from 71.1% for the comparable twelve months in 1994. The cost of providing medical care to Medicare members generally requires a greater percentage of the premium revenue received. Specialty product expenses increased by 6.5% over 1994. This increase is primarily the result of a higher loss ratio in 1995 due to the decrease in premium rates discussed above, offset in part by favorable development during 1995 in reserves for prior accident years. There can be no assurances that favorable development, or the magnitude of the development, will continue in the future. See Note 6 of Notes to Consolidated Financial Statements.
General, administrative and other ("G&A") costs increased 18.4% to $63.6 million for the twelve months ended December 31, 1995 compared to the twelve months ended December 31, 1994. As a percentage of revenues, however, G&A costs for the twelve months ended December 31, 1995 increased to 13.6% from 13.3% during the comparable period in 1994. Excluding the operations of HMO Texas, however, G&A as a percentage of revenue for 1995 decreased to 12.6%. Of the $9.9 million increase in G&A, approximately $4.8 million was due to the HMO Texas operations. Additional increases include $3.2 million of compensation costs primarily resulting from additional employees supporting expanded services, and $1.6 million in additional marketing and related fees.
The Company's effective income tax rate for the year ended December 31, 1995, was 30.4% compared to 18.2% for the year ended 1994. This change is primarily due to the non-deductibility of a significant portion of the merger costs incurred in 1995 and a $4.0 million tax benefit recorded as part of the 1994 provision as a result of a reduction of the deferred tax valuation allowance. See Note 8 of Notes to Consolidated Financial statements.
During 1995, CII sold its interest in an unprofitable subsidiary for approximately $1 million in cash and securities. This disposal resulted in a loss on discontinued operations, net of tax effects, of $6.6 million in 1995 compared to losses of $2.5 million from the discontinued operations in 1994.
Net income for 1995 decreased to $21.3 million, from $34.4 million in 1994. This decrease is primarily due to the non-recurring items previously discussed, discontinued operations, merger and integration expenses, and the change in the deferred tax valuation allowance. Excluding non-recurring items and the related tax effects, income from ongoing operations for 1995 increased 11.9% to $36.8 million from $32.9 million in 1994.
The Company's total operating revenues for 1994 increased 4.9%, to $402.1 million from $383.4 million for 1993. The increase was primarily due to medical premium revenue increases of approximately $28.7 million, or 11.9%, from the Company's HMO and managed indemnity insurance subsidiaries. Such additional premium growth resulted principally from an 11.3% increase in member months. The Company realized minimal rate changes for the HMO subsidiaries' commercial groups, and a slight rate increase by the Company's managed indemnity insurance subsidiary. Additionally, the Company experienced an overall rate reduction for its Medicare members due to an approximate 1.8% decrease in its capitation rate established by HCFA. Also, some Medicare members transferred to the Company's lower-priced Medicare plans. The $12.4 million decrease in specialty product revenues was due to an $18.8 million decrease in workers' compensation premiums. This decrease was a result of mandatory premium rate reductions and certain marketing limitations which included regulatory restrictions on certain subsidiaries' ability to pay policyholder dividends. This decrease was partially offset by a $6.4 million increase associated with a new contract, effective January 1994, to provide managed care utilization review services to Nevadans under a state insured workers' compensation medical management program.
The Company's effective federal income tax rate for the year ended December 31, 1994 was 18.2% compared to 27.3% for the year ended 1993. This change in the tax rate was primarily due to a $4.0 million tax benefit recorded as part of the 1994 provision as a result of a reduction of the deferred tax valuation allowance. In addition, the change in the valuation allowance was offset in part due to the "Omnibus Budget Reconciliation Act of 1993" (the "Act") passed by Congress during the third quarter of 1993. Certain provisions of the Act increased the statutory federal income tax rate to 35% from 34% and disallowed some previously deductible items.
Net income for 1994 increased 26.0% to $34.4 million from $27.3 million in 1993. The $7.1 million increase was primarily due to increased operating revenues, a reduction in specialty product expenses, and a decrease in the effective federal income tax rate, partially offset by additional interest expense.
Health care costs generally continue to rise at a faster rate than the Consumer Price Index. The Company has been able to lessen somewhat the impact of inflation by managing medical costs. There can be no assurance, however, that, in the future, the Company's ability to manage medical costs will not be negatively impacted by items such as technological advances, utilization changes and catastrophic items, which could, in turn, result in medical cost increases equaling or exceeding premium increases.
The Company's cash, cash equivalents and non-restricted securities increased by $23.9 million to $364.3 million at December 31, 1995, from $340.4 million at December 31, 1994. At December 31, 1995, the Company had working capital of $18.2 million. The primary source of cash received during the year ended December 31, 1995, was generated from operations.
The Company's cash flow from operating activities during the twelve months ended December 31, 1995 resulted primarily from $27.9 million of net income from continuing operations, $9.5 million in depreciation and amortization, offset by cash used by discontinued operations of $2.7 million and a $200,000 net change in operating assets and liabilities, excluding cash and cash equivalents. The decrease in cash from fluctuations in such operating assets and liabilities is principally due to increases in other assets and accounts receivable, as well as changes in minority interests and losses and loss adjustment expense reserves. These decreases in cash were offset by increases in other liabilities and medical claims payable, as well as a decrease in reinsurance recoverable.
In September 1991, CII issued convertible subordinated debentures (the "Debentures") due September 15, 2001. The Debentures bear interest at 7 1/2% which is due semi-annually on March 15 and September 15. Each $1,000 in principal is convertible into 16.921 shares of the Company's common stock at a conversion price of $59.097 per share. Unamortized issuance costs of $1,216,000 are included in other assets on the balance sheet and are being amortized over the life of the Debentures. The Debentures are general unsecured obligations of CII only and were not guaranteed by Sierra.
The accounting systems and controls of the Company are designed to provide reasonable assurance that transactions are executed in accordance with management's authorization, that the financial records are reliable for preparing financial statements and maintaining accountability for assets, and that assets are safeguarded against losses from unauthorized use or disposition. Management believes that for the year ended December 31, 1995, such systems and controls were adequate to meet the objectives discussed herein.
We have audited the consolidated balance sheets of Sierra Health Services, Inc., and its subsidiaries as of December 31, 1995 and 1994, and the related consolidated statements of operations, stockholders' equity, and cash flows for each of the three years in the period ended December 31, 1995. 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 these financial statements and financial statement schedules based on our audits. The consolidated financial statements give retroactive effect to the merger of Sierra Health Services, Inc., and its subsidiaries, and CII Financial, Inc., and its subsidiaries, which has been accounted for as a pooling of interests as described in Note 1 to the consolidated financial statements. We did not audit the balance sheet of CII Financial, Inc., and its subsidiaries, as of December 31, 1994, or the related statements of operations, stockholders' equity, and cash flows of CII Financial, Inc., and its subsidiaries, for the years ended December 31, 1994 and 1993, which statements reflect total assets of $306,987,000 as of December 31, 1994, and total revenues of $106,280,000 and $125,353,000 for the years ended December 31, 1994 and 1993, respectively. Those statements were audited by other auditors whose report has been furnished to us, and our opinion, insofar as it relates to the amounts included for CII Financial, Inc., and its subsidiaries, for 1994 and 1993, is based solely on the report of such other auditors.
In our opinion, based on our audits and the report of the other auditors, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Sierra Health Services, Inc. and its subsidiaries at December 31, 1995 and 1994, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1995 in conformity with generally accepted accounting principles.
SIERRA HEALTH SERVICES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS For the Years Ended December 31, 1995, 1994 and 1993
Business. The consolidated financial statements include the accounts of Sierra Health Services, Inc. ("Sierra") and its subsidiaries (collectively referred to as the "Company"). The Company is a managed health care organization that provides and administers the delivery of comprehensive health care and workers' compensation programs with an emphasis on quality care and cost management. The Company's broad range of managed health care services is provided through its HMO, managed indemnity plans, a third-party administrative services program for employer-funded health benefit plans and workers' compensation medical management programs. Ancillary products and services that complement the Company's managed health care product lines are also offered.
On October 1, 1995, the Company acquired a medical facility along with its related entities which include real estate and a preferred provider network. The medical facility and network serve southern Nevada and parts of Arizona. The purchase price was approximately $11.1 million which was paid in cash. The acquisition resulted in goodwill of approximately $4.9 million.
Medical Premium Revenue. Non-Medicare member enrollment is represented principally by employer groups. Medical premiums are billed to each employer group in accordance with negotiated contracts, and such premium revenue is recognized when earned. Unearned premium revenue includes payments under prepaid Medicare contracts with the Health Care Financing Administration ("HCFA") and prepaid HPN commercial and SHL indemnity premiums. HPN offers a prepaid health care program to Medicare recipients. Revenues associated with these Medicare recipients were approximately $111,584,000, $82,792,000, and $70,323,000 in 1995, 1994 and 1993, respectively.
Specialty Product Expense. This expense consists primarily of losses and loss adjustment expense and policy acquisition costs associated with issued workers' compensation policies. Losses and loss adjustment expense is based upon the accumulation of cost estimates for reported claims occurring during the period as well as an estimate for losses that have occurred but have not yet been reported. Policy acquisition costs consist of commissions, premium taxes, and other underwriting costs, which are directly related to the production and retention of new and renewal business and are deferred and amortized as the related premiums are earned. Should it be determined that future policy revenues and earnings on invested funds relating to existing insurance contracts will not be adequate to cover related costs and expenses, deferred costs are expensed. Also included in specialty product expense are costs associated with administrative services and certain ancillary products. These costs are recorded when incurred.
Restricted Cash and Securities. Certain subsidiaries are required by state regulatory agencies to maintain certain deposits and must also meet certain net worth and reserve requirements. The Company and its subsidiaries are in compliance with the applicable minimum regulatory and capital requirements.
Medical Claims Payable. Medical claims payable includes the estimated cost for unpaid claims for which health care services have been provided to enrollees and a provision of the estimated costs for claims that have occurred but have not been reported.
Reserve For Losses and Loss Adjustment Expense ("LAE"). The liability for losses and LAE consists of estimated costs of each unpaid claim reported prior to the close of the accounting period, as well as those incurred but not yet reported. The methods for establishing and reviewing such liabilities are continually reviewed and adjustments are reflected in current operations.
Discontinued Operations. During 1995 CII sold its interest in a subsidiary to a publicly traded entity for a combination of 219,200 shares of common stock and 138,400 shares of warrants of the purchaser, and cash of $5,000. The common stock and warrants had a fair market value of approximately $1,000,000 at the date of the sale and $2,658,000 at December 31, 1995. This transaction has been recorded as a discontinued operation. Net assets of the discontinued operations were $2,595,000 at December 31, 1994 and are included in other assets.
The Company capitalizes interest expense as part of the cost of construction of facilities. Interest expense capitalized in 1995, 1994, and 1993 was $183,000, $119,000, and $700,000, respectively.
After the merger of CII, the Company evaluated the consolidated security portfolio and reclassified $80,597,000 held-to-maturity securities to available-for-sale securities. The reclassification of these securities resulted in $5,641,000 of net unrealized gains as of December 31, 1995. Also, an unrealized holding gain of $1,711,000 resulting from the transfer of certain securities from available-for-sale to the held-to-maturity category is included in the net unrealized gains section of stockholders' equity and will be amortized over the remaining lives of the maturities.
The following table summarizes the Company's short-term, long-term and restricted securities as of December 31, 1995:
The following table summarizes the Company's short-term, long-term and restricted securities as of December 31, 1994:
The contractual maturities of available-for-sale short-term, long-term and restricted securities at December 31, 1995 were as follows:
CII also has reinsurance treaties in effect. The reinsurers have assumed the liability on that portion of workers' compensation claims between $250,000 and $60,000,000 per occurrence for 1995, 1994 and 1993. At December 31, 1995 and 1994, the amount of reinsurance recoverable for unpaid losses and loss adjustment expense was $25,871,000 and $29,342,000, respectively. The amount of reinsurance receivable for paid losses and loss adjustment expense was $73,000 and $65,000, respectively.
Reinsurance contracts do not relieve the Company from its obligations to enrollees or policyholders. Failure of reinsurers to honor their obligations could result in losses to the Company. The Company evaluates the financial condition of its reinsurers to minimize its exposure to significant losses from reinsurer insolvencies. All reinsurers that the Company has reinsurance with are rated A+ by the A.M. Best Company.
The Company has a $3,213,000 term loan which has an adjustable rate with an interest margin of 3% over the Federal Home Loan Bank Board 11th District Cost of Funds Index, a maximum interest rate of five percentage points above the initial rate of 11.85% and a minimum interest rate of 8%. The interest rate at December 31, 1995 was 8.06%. This term loan is secured by a medical facility.
Scheduled maturities of the Company's notes payable and future minimum payments under capital leases, together with the present value of the net minimum lease payments at December 31, 1995, are as follows:
The fair value of the Debentures at December 31, 1995 was $49,416,000, which was determined based on the quoted market price at December 31, 1995. Excluding the Debentures, the fair value of long- term debt, including the current portion, is $19,747,000, based on the borrowing rates currently available to the Company for bank loans with similar terms and average maturities.
A summary of the provision for income taxes for the years ended December 31, 1995, 1994 and 1993 is as follows:
At December 31, 1995, the Company had approximately $28,000,000 of regular tax net operating loss carryforwards which are limited to use at the rate of approximately $4,800,000 per year during the carryforward period. The net operating loss carryforwards can be used to reduce future taxable income until they expire through the year 2005. The Company has alternative minimum tax net operating loss carryforwards of approximately $4,000,000 which expire through the year 2005. The Company also has California net operating loss carryforwards of approximately $13,000,000 which expire through the year 2000. In addition to these net operating loss carryforwards, the Company has alternative minimum tax credits of approximately $800,000 which can be used to reduce regular tax liabilities in future years. There is no expiration date for the alternative minimum tax credits. The Company has tax capital loss carryforwards of approximately $600,000 expiring through 1999 which can be used to reduce future capital gains income. The majority of the above items are subject to both annual and separate company limitations required by the Internal Revenue Code.
As a result of including CII in the consolidated tax return with Sierra, it is more likely than not that an additional $5,250,000 of the benefit of the deferred tax asset will be utilized in subsequent years. Consequently, in accordance with Statement of Financial Accounting Standards No. 109 "Accounting for Income Taxes" ("FAS 109"), $5,250,000 of the valuation allowance related to the net deferred tax asset was reduced and recorded as an increase in the amount of the adjustment to the cumulative effect of adopting FAS 109, effective January 1, 1993 and is reported in the statement of operations at December 31, 1993 after income from continuing operations. The remaining valuation allowance of
$12,039,000 at December 31, 1995 is necessary under the more likely than not criteria required by FAS 109.
Employee Stock Purchase Plan. The Company has an employee stock purchase plan (the "Purchase Plan") whereby employees may purchase newly issued shares of stock through payroll deductions at 85% of the fair market value of such shares on specified dates as defined in the Purchase Plan. As of December 31, 1995, the Company had 534,114 shares reserved for purchase under the Purchase Plan. During 1995, a total of 43,796 shares were purchased at prices of $19.98 and $20.83 a share. During January 1996, 34,413 shares were issued to employees at $20.83 per share in connection with the Purchase Plan.
Defined Contribution Plan. The Company has a defined contribution pension and 401(k) plan (the "Plan") for its employees. The Plan covers all employees who meet certain age and length of service requirements. The Company contributes 2% of eligible employees' compensation and matches 50% of a participant's elective deferral up to a maximum of either 10% of an employee's compensation or the maximum allowable under current IRS statute. Prior to the merger CII maintained a 401(k) plan as well. As part of the merger of CII, the CII plan was frozen in November 1995. The Company intends to merge the two plans during 1996. Expense under both plans totaled $2,516,000, $2,573,000, and $2,199,000, in 1995, 1994 and 1993, respectively.
Stockholders' Rights Plan. On June 14, 1994, the Board of Directors of Sierra authorized and declared a dividend distribution of one right (a "Right") for each share of Sierra common stock, par value $.005 per share. The Rights were distributed to the holders of record of Common Shares at the close of business on June 30, 1994. Each Right entitles the registered holder to purchase from Sierra a unit consisting of one one-hundredth of a share of the Series A Junior Participating Preferred Shares (a "Unit"), par value $.01 per share, of Sierra, or a combination of securities and assets of equivalent value, at a purchase price of $100.00 per Unit, subject to adjustment. The Rights have certain anti-takeover effects. The Rights will cause substantial dilution to a person or group that attempts to acquire Sierra on terms not approved by Sierra's Board of Directors, except pursuant to an offer conditioned on a substantial number of Rights being acquired. The Rights should not interfere with any merger or other business combination approved by the Board of Directors since Sierra may redeem the Rights at the price of $.02 per Right prior to the time that a person or group has acquired beneficial ownership of 20% or more of Sierra common stock.
In addition, in 1995 the shareholders of the Company approved the 1995 Non-Employee Directors' Stock Plan ("Directors' Plan"). Under the Directors' Plan non-employee directors are granted an option to purchase 3,000 shares of common stock. Options are granted annually on January 20 at the current fair market value and become exercisable over a five-year period. The Company has reserved 60,000 shares under the Directors' Plan.
Prior to the approval of the LTIP and the Directors' Plan, the Company and CII had various other stock option plans that provided for the granting of either qualified or non-qualified stock options, stock appreciation rights and tax equalization payments. Grants will no longer be made under these plans.