(2) No cash dividends were declared in each of the years presented.
The following discussion of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and the related notes included elsewhere in this Annual Report on Form 10-K. The following discussion contains forward-looking statements that involve known and unknown risks and uncertainties, including those set forth in the section entitled “Risk Factors” in this Annual Report on Form 10-K. This Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in its entirety, since it contains detailed information that is important to understanding Health Net, Inc. and its subsidiaries’ results and financial condition. The Executive Summary below is qualified in its entirety by the full Management’s Discussion and Analysis of Financial Condition and Results of Operations and the information contained in the Executive Summary is as of March 15, 2004.
(G&A expenses plus depreciation) was 10.6% in 2003. We have targeted administrative costs for savings in the future. As more fully described below, as a result of the phased implementation of our Health Net One systems consolidation project, we expect improvements in G&A expenses in the second half of 2004. We expect to reduce our administrative ratio by approximately 150 basis points in the next two to three years. In 2003, our net margin was 2.1%, and was impacted by a loss in discontinued operations. Over the past several years, operating cash flow has been very strong. This cash flow has, in part, been used to repurchase shares of our common stock. Since the commencement of our stock repurchase program in May 2002, we have repurchased approximately 16.8 million shares of our common stock at an average price of $26.96.
We expect to expand our Medicare marketing efforts in 2004 in response to the new Medicare reform legislation that was passed in December 2003. The improved funding provided through this new legislation provides a basis for us to reverse Medicare enrollment declines from recent years which were caused by inadequate funding from the Centers for Medicare and Medicaid Services.
We participate in state Medicaid programs in three states, California, Connecticut and New Jersey. California Medicaid membership, where the program is known as Medi-Cal, comprises 83% of our Medicaid membership. Despite ongoing concerns about the states’ ability to adequately fund these Medicaid programs, we believe that the significant savings generated by Medicaid managed care will provide ongoing future growth opportunities, especially in California, as states may move more Medicaid enrollees into managed care plans. We will add two counties for California Medi-Cal in 2004. We believe the addition of these new counties will help counteract enrollment declines resulting from the State of California tightening eligibility requirements.
With respect to our G&A expenses, we expect that growth in overall spending will continue in the first half of 2004 with the continued funding of the Health Net One systems consolidation project described below. As a result, we expect to see a decline in the administrative ratio in the second half of 2004 as we eliminate expenses associated with the project, eliminate the need to maintain two separate technology platforms and begin to realize savings.
We incur administrative and health care expenses in connection with our administration of the TRICARE program in the regions we manage on behalf of the Department of Defense. Health care expenses are directly related to the use of civilian providers by TRICARE eligible beneficiaries and have risen in recent quarters as a direct result of increased military activity. Increased military activity results in increased enrollment and the deployment of military medical personnel overseas which reduces beneficiaries’ access to military treatment facilities. We expect that in 2004 we will continue to experience elevated levels of costs due to reservist call-ups and higher utilization of civilian providers.
However, as part of our contract with the Department of Defense, we are reimbursed for costs related to this heightened military activity. As noted above, we expect our Government contracts cost ratio to remain relatively stable in 2004 compared with 2003, even with the transition to our new TRICARE contract for the North Region.
Health Net One Systems Consolidation Project. We are in the process of converting a number of information systems in our health plan business to a single information system. This system is currently in use in our Northeast and Arizona health plans and project completion is scheduled for the third quarter of 2004. This project, known as Health Net One, also includes consolidation initiatives for other functional areas, such as claims handling, customer service and product development. We believe Health Net One will produce administrative cost savings and improved service capability over the next several years. We believe that having our health plans operate off a single information technology platform will permit us to develop and deploy new products more rapidly, thus producing a competitive advantage in our markets. We completed the conversion of our Arizona health plan to the selected system in 2003. Although we did encounter some operational issues, such as build-up in the claims backlog, these issues were eventually resolved. We have incorporated the knowledge gained from these issues into the overall Health Net One project plan. For additional information regarding our Health Net One systems consolidation project, see “Item 1. Business - Additional Information Concerning our Business - Health Net One Systems Consolidation Project.”
Provider Network. We maintain a large network of providers to service our members in the six states in which we have health plans. These networks include a broad range of hospitals, including academic medical centers and community hospitals. We maintain contracts with large integrated physician groups, Independent Practice Associations and individual primary care specialty physicians. Overall, we believe that our provider relations are generally good. In recent years, we have implemented a number of techniques specifically aimed at the review of very high cost hospital claims, a problem that has plagued the entire managed care industry and hospitals. Some of these techniques, including reviews of individual claims, create differences of interpretation between us and hospitals. We have been able to resolve these differences through negotiation or, in some cases, through arbitration. Given the high rate of growth in hospital costs, we believe we must continue to be vigilant in our review of these costs. Our efforts to maintain good relations with our providers, particularly hospitals, will have a significant impact on our ability to achieve our financial goals in 2004 and beyond. See “Risk Factors - If we are unable to maintain good relations with the physicians, hospitals and other providers that we contract with, our profitability could be adversely affected.”
Our income from continuing operations before income taxes and cumulative effect of a change in accounting principle for the year ended December 31, 2003 was $323.1 million or $2.79 per basic share and $2.73 per diluted share, compared to income from continuing operations for the same period in 2002 of $234.5 million or $1.89 per basic share and $1.86 per diluted share. Our income from operations for the year ended December 31, 2001 was $80.9 million, or $0.66 per basic share and $0.65 per diluted share. Our results for the year ended December 31, 2003 include an $18.9 million net pretax gain on sale of businesses and a $16.4 million pretax asset impairment charge related to certain of our buildings and a noncurrent asset. Also during the year ended December 31, 2003, we recognized an $89.1 million loss on settlement from disposition of discontinued operations, net of tax of $47.9 million, or $0.77 per basic share and $0.75 per diluted share, as a result of our settlement agreement with SNTL Litigation Trust, successor-in-interest to Superior National Insurance Group, Inc. (“Superior”), to settle all outstanding claims under the Superior National Insurance Group, Inc v. Foundation Health Corporation, et. al. litigation. See Notes 3, 12 and 14 to the consolidated financial statements for further information regarding the net pretax gain on sale of businesses, asset impairment charge and settlement agreement with the SNTL Litigation Trust.
Our income from operations before income taxes and cumulative effect of a change in accounting principle for the year ended December 31, 2002 include a pretax loss of $60.3 million on asset impairments and restructuring charges and a pretax loss of $5.0 million on loss on assets held for sale. We recognized a charge for a cumulative effect of a change in accounting principle of $8.9 million, or $0.07 per basic and diluted share, as a result of adopting Statement of Financial
Accounting Standards (“SFAS”) No. 142, “Goodwill and Other Intangible Assets” (“SFAS No. 142”). Our income from operations before income taxes for the year ended December 31, 2001 include a pretax loss of $72.4 million for the sales of our Florida health plan and related corporate facility building and costs of $79.7 million related to our 2001 restructuring plan. See Notes 3 and 14 to the consolidated financial statements for a discussion on asset impairments and restructuring charges and loss on assets held for sale.
(4) Return on equity is computed as net income divided by average equity (sum of equity at the beginning and end of the year divided by 2).
(5) PMPM is calculated based on total at-risk member months and excludes ASO member months.
The table below summarizes our at-risk insured health plan and ASO enrollment information for the last three fiscal years.
Commercial membership decreased by 114,000 members or 4.0% at December 31, 2003 compared to the same period in 2002. The net decrease in commercial membership is primarily due to planned exits from unprofitable large employer group accounts offset by increases in enrollment in key products and markets, particularly small group accounts, that we have been targeting in an effort to achieve a greater product diversity. The overall change in commercial membership between 2003 and 2002 reflects primarily the following:
• Net decrease in California of 87,000 members as a result of a 145,000 member decrease in our large group HMO market. The large group membership decline is primarily the result of the loss of the California Public Employees’ Retirement System (“CalPERS”) account effective January 1, 2003. The CalPERS account had more than 175,000 members. This loss is partially offset by an increase of 58,000 members in our small group and individual market as a result of sales efforts targeted at this portion of the market, improved relationships with the distribution system, including insurance brokers and general agents, pricing that is consistent with the market and health care cost trends and new and improved products.
• Decrease in Connecticut of 41,000 members as a result of membership decreases in our large group market due to conversion of groups to ASO (including The Hartford Group accounts) and significant pricing actions and a 10,000 membership decrease in our small group and individual markets due to our pricing discipline and aggressive pricing by one of our competitors,
• Decrease in Pennsylvania of 34,000 members in our large group market due to withdrawing our commercial health plan effective September 30, 2003 and withdrawing our coverage for the members enrolled in the Federal Employee Health Benefit Plan effective January 11, 2004, offset by
• Increase in New York of 23,000 members primarily in our large group market due to an enhanced product portfolio and pricing resulting from our competitive cost structure, and
• Decrease in Arizona of 2,400 members due to changes in benefit levels offered by us, and
• Decrease in California of 19,000 members due to the State of California’s efforts to disenroll Medi-Cal members no longer eligible for this program, with Los Angeles County experiencing the majority of the decrease, and
• Decrease in Connecticut of 6,000 members due to a change in law that eliminated eligibility for certain members as well as a termination of a large provider.
• Increase in Connecticut and New Jersey of 16,000 members due to expansion of Medicaid eligible population.
Government contracts covered approximately 1.5 million eligible individuals under the TRICARE program at December 31, 2003, 2002 and 2001. Dependents of active-duty military personnel and retirees and their dependents are eligible to receive benefits under the TRICARE program. HNFS currently administers three TRICARE contracts for five regions:
The transition out of the expiring TRICARE contracts and into the new TRICARE North Region contract is expected to have significant operational impacts. The new contract requires establishing 74 offices in 21 states and the District of Columbia and employing a workforce of approximately 1,220 associates, many of whom will be newly-hired to administer the new contract. In addition, approximately 800 associates will be employed by subcontractors. See “Risk Factors - There are risks associated with our new TRICARE contract for the North Region.” We are in process of determining the proper revenue and expense recognition for various other provisions of the new TRICARE contract for the North Region. The transition out of our current contracts in Regions 6, 9, 10, 11 and the transition to the new North Region contract are occurring as planned and are expected to be completed by October 31, 2004 as scheduled.
Health Plan Services premiums increased $511.6 million or 6.0% for the year ended December 31, 2003 compared to the same period in 2002. Total health plan services premiums on a PMPM basis increased to $201.97 or 8.1% for the year ended December 31, 2003 compared to the same period in 2002. These changes are primarily due to the following:
in member months. The premium increases on a PMPM basis were in large, small and individual groups across all states averaging 11%, 13% and 7%, respectively. The majority of the decrease in member months was from non-renewal of members in our large group HMO product in California and Arizona, offset by
• Decrease in Medicare risk premiums of $157.3 million or 10% for the year ended December 31, 2002 as compared to the same period in 2001 due to a 16% decrease in member months, partially offset by a 7% increase in premium yields on a PMPM basis. The decrease in member months reflects our exiting certain unprofitable counties and the sale of our Florida health plan, and
Government Contracts revenues increased by $367.1 million or 24.5% for the year ended December 31, 2003 as compared to the same period in 2002 primarily due to the following:
• Increase in risk sharing revenue of $143.4 million from increased health care cost estimates resulting from the call-up of reservists in support of the nation’s heightened military activity and an increased number of enrollees seeking care in the private sector as many military health care professionals were deployed abroad,
• Increase in revenues of $53.7 million from change order cost activities,
• Increase in revenues of $13.6 million from transition services related to the new TRICARE contract for the North Region. Transition payments for services connected to the North Region contract are on a fixed price basis. Revenues for such services are based on contract terms and approximate incurred expenses to date.
Government Contracts revenues increased by $159.6 million or 11.9% for the year ended December 31, 2002 as compared to the same period in 2001 primarily due to the following:
• Increase in revenues of $104.3 million due to higher base contract pricing on new option periods and newly negotiated contract extensions,
Investment income declined by $13.6 million or 17.2% for the year ended December 31, 2002 as compared to the same period in 2001. This decline is primarily a result of continued declines in interest rates of an average of 97 basis points in the year ended December 31, 2002, as compared to the same period in 2001 partially offset by higher average cash and investment balances.
During the year ended December 31, 2002, we sold $5.0 million, par value, of WorldCom (MCI) bonds and recognized a pretax loss of $3.2 million, included in net investment income.
Other income decreased by $21.1 million or 30.0% for the year ended December 31, 2002 compared to the same period in 2001. This decrease is primarily due to a decline in business volume and sale of our employer services claims processing subsidiary effective July 1, 2002.
Health plan services costs increased by $355.3 million or 5.0% for the year ended December 31, 2003 as compared to the same period in 2002. Total health plan services costs on a PMPM basis increased to $166.96 or 7.0% for the year ended December 31, 2003 from $155.99 for the same period in 2002. These changes are primarily due to the following:
Government Contracts costs increased by $336.6 million or 23.2% for the year ended December 31, 2003 compared to the same period in 2002, primarily due to the following:
• Increases in health care cost estimates of $196.8 million resulting from the call-up of reservists in support of the nation’s heightened military activity and an increased number of enrollees seeking care in the private sector as many military health care professionals were deployed abroad,
• Increase in transition costs of $11.6 million from transition activities related to the new TRICARE contract for the North region, partially offset by
• Decrease in administrative costs of $16.9 million attributed to cost reduction efforts.
Our Government Contracts cost ratio decreased to 95.9% for the year ended December 31, 2003 as compared to 96.9% for the same period in 2002. The improvements are primarily due to higher pricing on new option periods and favorable bid price adjustments.
Government Contracts costs increased by $128.3 million or 9.7% for the year ended December 31, 2002 compared to the same period in 2001. This increase is primarily due to increases in health care estimates and higher administrative and health care change order costs. In addition, heightened military activity during 2002 contributed to the increase in health care costs.
Our Government Contracts cost ratio decreased to 96.9% for the year ended December 31, 2002 as compared to 98.9% for the same period in 2001. The 197 basis point improvement is primarily due to risk sharing revenue increases attributable to an increase in services provided to TRICARE participants.
The administrative expense ratio decreased to 10.6% for the year ended December 31, 2002 compared to 10.8% for the same period in 2001. During the third quarter of 2001, we implemented a restructuring plan, referred to herein as the 2001 Plan, to consolidate certain administrative, financial and technology functions. The 2001 Plan included the elimination of approximately 1,500 positions. In 2002, we began to realize operating and administrative expense reductions attributed to the 2001 Plan. The decrease in the ratio attributable to the 2001 Plan is partially offset by higher information technology (“IT”) and severance costs arising from our systems consolidation project, including severance costs for such project.
The selling costs ratio (selling costs as a percentage of Health Plan Services premiums) increased to 2.6% for the year ended December 31, 2003 compared to 2.3% for the same period in 2002. This increase reflects the continued shift of our commercial health plan mix to small group with its higher selling costs.
The selling costs ratio increased to 2.3% for the year ended December 31, 2002 compared to 2.2% for the same period in 2001. This increase is due to our commercial health plan mix shifting to small group with its higher selling costs.
• Decrease in amortization expense of $4.3 million due to certain intangible assets primarily comprised of employer groups reaching the end of their useful lives in July 2002 and thus becoming fully amortized,
• Decrease in depreciation expense of $11.4 million from the assets impaired during the fourth quarter ended December 31, 2002 as a result of our systems consolidation project,
• Decrease in depreciation expense of $2.2 million due to accelerated depreciation of certain assets based on revised useful lives in 2002,
Amortization and depreciation expense decreased by $29.8 million or 30.2% for the year ended December 31, 2002 compared to the same period in 2001. This decrease is primarily due to the decrease in amortization expense of $27.6 million due to the cessation of goodwill amortization as a result of the adoption of SFAS No. 142 effective January 1, 2002.
There was an increase of $2.0 million in depreciation expense due to accelerated depreciation of certain capitalized software based on revised useful lives as a result of our systems consolidation project. This is offset by a decrease of $1.3 million in depreciation primarily due to asset impairments included in asset impairment and restructuring charges recorded in September 2001.
Interest expense decreased by $1.1 million or 2.7% for the year ended December 31, 2003 as compared to the same period in 2002. During the third quarter ended September 30, 2002, we repaid the entire balance of $120 million on our revolving credit facility balance outstanding as of June 30, 2002. This repayment has resulted in the decreases in our interest expense for the year ended December 31, 2003 as compared to the same period in 2002.
During 2000, we secured an exclusive e-business connectivity services contract from the Connecticut State Medical Society IPA, Inc. (“CSMS-IPA”) for $15.0 million that we expected to recover through future connectivity service capabilities. CSMS-IPA is an association of medical doctors providing health care primarily in Connecticut. The amounts paid to CSMS-IPA for this agreement are included in other noncurrent assets, and we periodically assess the recoverability of such assets. During 2002, we entered into various agreements with external third parties in connection with this service capability. We entered into marketing and stock issuance agreement with NaviMedix, Inc. (“NaviMedix”), a provider of online solutions connecting health plans, physicians and hospitals. In exchange for providing general assistance and advice to NaviMedix, we received 800,000 shares of NaviMedix common stock and the right to receive an additional 100,000 earnout shares for each $1 million in certain NaviMedix gross revenues generated during an annualized six-month measurement period. In March 2002, we entered into an assignment, assumption and bonus option agreement with CSMS-IPA pursuant to which CSMS-IPA received 32,000 shares or 4% of the NaviMedix shares that we received and the right to receive 4% of any of the earnout shares we may realize. Under the agreement, CSMS-IPA is also entitled to receive up to an additional 8.2% of the earnout shares from us depending on the proportion of NaviMedix gross revenue that is generated in Connecticut. In March 2002, we entered into a cooperation agreement with CSMS-IPA pursuant to which we jointly designate and agree to evaluate connectivity vendors for CSMS-IPA members. NaviMedix provides connectivity services to our subsidiary, Health Net of the Northeast, Inc. under a three-year term which expires on April 1, 2004.
Effective December 31, 2002, MedUnite, Inc., a health care information technology company in which we had invested $13.4 million, was sold. As a result of the sale, our original investments were exchanged for $1 million in cash and $1.6 million in notes. Accordingly, we wrote off the original investments of $13.4 million less the $1 million cash received and recognized an impairment charge of $12.4 million on December 31, 2002 which included an allowance against the full value of the notes received in exchange.
During the third quarter ended September 30, 2002, pursuant to SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities” (“SFAS No. 115”), we evaluated the carrying value of our investments available for sale in CareScience, Inc. The common stock of CareScience, Inc. had been consistently trading below $1.00 per share since early September 2002 and was at risk of being delisted. As a result, we determined that the decline in the fair value of CareScience’s common stock was other than temporary. The fair value of these investments was determined based on quotations available on a securities exchange registered with the SEC as of September 30, 2002. Accordingly, we recognized a pretax $3.6 million write-down in the carrying value of these investments which was classified as asset impairments and restructuring charges during the third quarter ended September 30, 2002.
The 2001 Plan included the elimination of approximately 1,500 employee positions throughout all of our functional groups, divisions and corporate offices and resulted in severance and benefit related costs of $43.3 million. As of September 30, 2002, the termination of positions in connection with the 2001 Plan had been completed and we recorded a modification of $1.5 million to reflect an increase in the severance and related benefits in connection with the 2001 Plan from the initial amount of $43.3 million to a total of $44.8 million. Various information technology systems and equipment, software development projects and leasehold improvements were affected by the 2001 Plan and resulted in $27.9 million in asset impairment charges. The 2001 Plan also resulted in $5.1 million and $3.4 million of real estate lease termination costs and other costs, respectively. No payments remain to be paid related to the 2001 Plan.
Net Gain (Loss) on Sale of Businesses and Properties and Assets Held for Sale
On October 31, 2003, we consummated the sale of our workers’ compensation services subsidiary, Health Net Employer Services, Inc. (“Health Net Employer Services”), along with its subsidiaries Health Net Plus Managed Care
On October 31, 2003, we consummated the sales of our dental and vision subsidiaries, Health Net Dental and Health Net Vision, to SafeGuard. In addition, we entered into an assumption reinsurance agreement to transfer the full responsibility for the stand alone dental and vision policies of Health Net Life Insurance Company to SafeHealth Life. As a result of the sale, we no longer underwrite or administer stand alone dental and vision products. However, we continue to make available private label dental products through our strategic relationship with SafeGuard, and continue to make available private label vision products through our strategic relationship with EyeMed to our current and prospective members. The stand alone dental products are underwritten and administered by SafeGuard companies. The stand alone vision products are underwritten by Fidelity Security Life Insurance Company and administered by EyeMed. In connection with these sales, we received approximately $14.8 million in cash and transferred $2.1 million in cash and $2.1 million in liabilities under the assumption reinsurance agreement and recognized a pretax gain of $7.8 million. Our dental and vision subsidiaries had been reported as part of our Health Plan Services reportable segment.
Effective September 30, 2003, we withdrew our commercial health plan from the commercial market in the Commonwealth of Pennsylvania. Coverage for our members enrolled in the Federal Employee Health Benefit Plan ended on January 11, 2004. We intend to maintain our network of providers in Pennsylvania to service our New Jersey members and TRICARE eligibles. As of December 31, 2003, we had approximately 3,800 members enrolled in our commercial health plan in Pennsylvania. Our Pennsylvania health plan is reported as part of our Health Plan Services reportable segment.
Effective July 1, 2002, we sold our claims processing subsidiary, EOS Claims Services, Inc. (“EOS Claims”), to Tristar Insurance Group, Inc. (“Tristar”). In connection with the sale, we received $500,000 in cash, and also entered into a Payor Services Agreement. Under the Payor Services Agreement, Tristar has agreed to exclusively use EOS Managed Care Services, Inc. (one of our then remaining subsidiaries) for various managed care services to its customers and clients. We estimated and recorded a $2.6 million pretax loss on the sale of EOS Claims during the second quarter ended June 30, 2002. During the fourth quarter ended December 31, 2003, we recorded an additional $2.1 million pretax loss on the sale due to the sale price true-up as provided for in the sale agreement. EOS Claims revenue through the date of the sale was reported as part of other income on the consolidated statements of operations.
Effective August 1, 2001, we sold our Florida health plan, known as Foundation Health, a Florida Health Plan, Inc., to Florida Health Plan Holdings II, L.L.C. In connection with the sale, we received $23 million in cash and approximately
The effective tax rates differed from the statutory federal tax rate of 35.0% due primarily to state income taxes, tax-exempt investment income, business divestitures and tax return examination settlements.
The effective income tax rate was 33.4% for the year ended December 31, 2002 compared with 37.0% for the same period in 2001. The decrease of 360 basis points in the effective tax rates is primarily due to the following:
• The adoption of SFAS No. 142 and the cessation of goodwill amortization caused the tax rate to decrease by 210 basis points. The majority of our goodwill amortization has historically been treated as a permanent difference that was not deductible for tax purposes and that increased the effective tax rate, and
Our cash flow from operating activities is impacted by the timing of collections on our amounts receivable from government contracts. Government health care receivables are best estimates of payments that are ultimately collectible or payable. Since these amounts are subject to government audit, negotiation and appropriations, amounts ultimately collected may vary significantly from current estimates. Additionally, the timely collection of such receivables is also impacted by government audit and negotiation and could extend for periods beyond a year. Amounts receivable under government contracts were $90.9 million and $78.0 million as of December 31, 2003 and 2002, respectively. The increase is primarily due to an increase in risk sharing revenues and change orders, partially offset by cash received on bid price adjustments and change orders.
Our cash flow from investing activities is primarily impacted by the sales, maturities and purchases of our available-for-sale investment securities. Our investment objective is to maintain safety and preservation of principal by investing in high-quality, investment grade securities while maintaining liquidity in each portfolio sufficient to meet our cash flow requirements and attaining the highest total return on invested funds.
• Net decrease in cash flows from accounts payable and other liabilities of $22.2 million primarily due to an increase in accruals resulting from timing of payments,
• Net decrease in cash collections from other assets of $3.2 million, offset by
• Net increase in cash flows of $29.7 million from reserves for claims and other settlements, and
• Net increase in cash flows of $2.5 million from the tax benefits on stock option exercises.
Net cash provided by operating activities was $413.5 million at December 31, 2002 compared to $544.6 million at December 31, 2001. The decrease in operating cash flows of $131.1 million was due primarily to the following:
• Net decrease in cash flows from amounts receivable/payable under government contracts of $303.4 million for the year ended December 31, 2002 as compared to the same period in 2001. This is primarily due to cash collections in January 2001 of $329 million of the outstanding TRICARE receivables as part of our global settlement with the Department of Defense. Of the $389 million global settlement, $60 million had been received in December 2000. The net settlement amount of $284 million, after paying vendors, providers and amounts owed back to the government, was applied to the continuing operating needs of the three TRICARE contracts and to reducing the outstanding balance of our then-outstanding debt on the revolving credit facility,
• Net decrease in cash flows of $14.9 million from the tax benefits on stock option exercises, partially offset by
• Net increase in cash collections from premiums receivable, unearned premiums and other assets of $147.4 million, and
• Net increase of $40.7 million in cash flows from accounts payable and other liabilities due to timing of payments.
In connection with the 2001 Plan, we decided on enterprise-wide staff reductions and consolidations of certain administrative, financial and technology functions. As of December 31, 2002, we had completed the 2001 Plan and recorded a $1.5 million true-up adjustment in severance and related benefit costs. During 2002, we paid out $26.4 million in total for the 2001 Plan.
Net cash used in investing activities was $105.5 million for the year ended December 31, 2003 as compared to $182.9 million for the same period in 2002. The resulting increase in cash flow of $77.4 million is primarily due to the following:
• An increase in maturities and sales of available for sale securities of $159.7 million primarily due to an increase in prepayments of mortgage-backed securities and called security holdings attributable to a decline in interest rates, and
• Cash proceeds of $90.3 million from the sale of our employer services subsidiary and dental and vision subsidiaries in 2003, partially offset by
Net cash used in investing activities was $182.9 million during the year ended December 31, 2002 as compared to net cash used in investing activities of $517.6 million during the same period in 2001. The $334.7 million decrease in cash flows used in investing activities is primarily due to the following:
• A decrease of $24.2 million in net purchases of property and equipment.
• 100% of the principal amount of the notes to be redeemed; and
• the sum of the present values of the remaining scheduled payments on the notes to be redeemed consisting of principal and interest, exclusive of interest accrued to the date of redemption, at the rate in effect on the date of calculation of the redemption price, discounted to the date of redemption on a semiannual basis (assuming a 360-day year consisting of twelve 30-day months) at the applicable yield to maturity (as specified in the indenture governing the notes) plus 40 basis points plus, in each case, accrued interest to the date of redemption.
Our credit facilities, which provide for an aggregate of $700 million in borrowings, consist of a $175 million 364-day revolving credit facility and a $525 million five-year revolving credit and competitive advance facility. Under the five-year facility, we can obtain letters of credit in an aggregate amount of up to $200 million. The 364-day credit facility was amended on June 25, 2003 to extend the existing credit agreement for an additional 364-day period. We must repay all borrowings, if any, under the 364-day credit facility by June 23, 2004, unless we avail ourselves of a one-year term-out option in the 364-day credit facility. The five-year credit facility expires in June 2006, and we must repay all borrowings, if any, under the five-year credit facility by June 28, 2006, unless the five-year credit facility is extended. The five-year credit facility may, at our request and subject to approval by lenders holding two-thirds of the aggregate amount of the commitments under the five-year credit facility, be extended for up to two 12 month periods to the extent of the commitments made under the five-year credit facility by such approving lenders. Swingline loans under the five-year credit facility are subject to repayment within no more than seven days. We did not have any borrowings under the credit facilities during the year ended December 31, 2003. The maximum commitment level under the credit facilities was $700 million at December 31, 2003.
• our failure to comply with the terms of other indebtedness with an aggregate amount exceeding $40 million such that the other indebtedness can be or is accelerated; or
• substantially alter the character or conduct of the business of Health Net, Inc. or any of its “significant subsidiaries” within the meaning of Rule 1-02 under Regulation S-X promulgated by the SEC;
• make restricted payments, including dividends and other distributions on capital stock and redemptions of capital stock if our debt is rated below investment grade by either Standard and Poor’s Rating Service or Moody’s Investor Services; and
• become subject to other agreements or arrangements that restrict (1) the payment of dividends by any Health Net, Inc. subsidiary, (2) the ability of Health Net, Inc. subsidiaries to make or repay loans or advances to lenders, (3) the ability of any subsidiary of Health Net, Inc. to guarantee our indebtedness or (4) the creation of any lien on property, provided that the foregoing shall not apply to (a) restrictions and conditions imposed by regulatory authorities, or (b) restrictions imposed under either the 364-day revolving credit facility or the five-year revolving credit facility.
Net cash used in financing activities was $305.6 million during the year ended December 31, 2002 as compared to $166.0 million during the same period in 2001. The change was primarily due to the repurchase of 6,519,600 shares of our Class A common stock during 2002 for $159.7 million, offset by the increase of $39.1 million in proceeds received from the exercise of stock options and employee stock purchases. We also paid down our revolving credit facility by an additional $18.9 million over 2001.
We lease office space under various operating leases. Certain leases are cancelable with substantial penalties. See “Part I. Item 2. - Properties” for additional information regarding our leases.
We have excluded from such table amounts already recorded in our current liabilities on our consolidated balance sheet as of December 31, 2003. We have also excluded from such table various contracts we have entered into with our health care providers, health care facilities, the federal government and other contracts that we have entered into for the purpose of providing health care services. We have excluded those contracts that allow for cancellation without significant penalty, obligations that are contingent upon achieving certain goals and contracts for goods and services that are fulfilled by vendors within a short time horizon and within the normal course of business.
We entered into a binding letter agreement on March 1, 2004 to purchase certain assets related to provider network and regional TRICARE Service Center operations from Sierra Military Health Services, Inc. We expect to sign the definitive agreement on or about March 31, 2004. We expect the closing date to be the last date of health care delivery for Region 1, currently expected to be August 31, 2004.
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America (“GAAP”) requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Principal areas requiring the use of estimates include revenue recognition, health care costs, reserves for contingent liabilities, amounts receivable or payable under government contracts, goodwill and recoverability of long-lived assets and investments. Accordingly, we consider accounting policies on these areas to be critical in preparing our consolidated financial statements. A significant change in any one of these amounts may have a significant impact on our consolidated results of operations and financial condition. A more detailed description of the significant accounting policies that we use in preparing our financial statements is included in the notes to our consolidated financial statements which are included elsewhere in this Annual Report on Form 10-K.
Government Contracts revenues are recognized in the month in which the eligible beneficiaries are entitled to health care services or in the month in which the administrative services are performed or the period that coverage for services is provided. Government contracts also contain cost and performance incentive provisions which adjust the contract price based on actual performance. Revenue under government contracts is subject to price adjustments attributable to inflation and other factors. The effects of these adjustments are recognized on a monthly basis, although the final determination of these amounts could extend significantly beyond the period during which the services were provided.
Reserves for claims and other settlements and health care and other costs payable under government contracts include reserves for claims (incurred but not reported claims (“IBNR”) and received but unprocessed claims), and other liabilities including capitation payable, shared risk settlements, provider disputes, provider incentives and other reserves for our two reporting segments, Health Plan Services and Government Contracts. As of December 31, 2003, Health Plan Services reserves for claims comprised approximately 76% of reserves for claims and other settlements, and Government Contracts reserves for claims comprised approximately 84% of health care and other costs payable under government contracts. See Note 16 to our accompanying consolidated financial statements for a reconciliation of changes in the reserve for claims.
We estimate the amount of our reserves for claims primarily by using standard actuarial developmental methodologies. This method is also known as the chain-ladder or completion factor method. The developmental method estimates reserves for claims based upon the historical lag between the month when services are rendered and the month claims are paid while taking into consideration, among other things, expected medical cost inflation, seasonality patterns, product mix, benefit plan changes and changes in membership. A key component of the developmental method is the completion factor which is a measure of how complete the claims paid to date are relative to the estimate of the claims for services rendered for a given period. While the completion factors are reliable and robust for older service periods, they are more volatile and less reliable for more recent periods since a large portion of health care claims are not submitted to us until several months after services have been rendered. Accordingly, for the most recent months, the incurred claims are estimated from a trend analysis based on per member per month claims trends developed from the experience in preceding months. This method is applied consistently year over year while assumptions may be adjusted to reflect changes in medical cost inflation, seasonality patterns, product mix, benefit plan changes and changes in membership.
Other relevant factors include exceptional situations that might require judgmental adjustments in setting the reserves for claims, such as system conversions, processing interruptions, environmental changes or other factors. None of these factors had a material impact on the development of our claims payable estimates during any of the periods presented in this Annual Report on Form 10-K. All of these factors are used in estimating reserves for claims and are important to our reserve methodology in trending the claims per member per month for purposes of estimating the reserves for the most recent months. In developing its best estimate of reserves for claims, we consistently apply the principles and methodology listed above from year to year, while also giving due consideration to the potential variability of these factors. Because reserves for claims includes various actuarially developed estimates, our actual health care services expense may be more or less than our previously developed estimates. Claim processing expenses are also accrued based on an estimate of expenses necessary to process such claims. Such reserves are continually monitored and reviewed, with any adjustments reflected in current operations.
Additionally, we contract with certain hospitals to provide hospital care to enrolled members on a capitation basis.
In the course of our operations, we are involved on a routine basis in various disputes with members, health care providers, and other entities, as well as audits by government agencies that relate to our services and/or business practices. We and several of our competitors were named as defendants in a number of significant class action lawsuits alleging violations of various federal statutes, including the Employee Retirement Income Security Act of 1974 and the Racketeer Influenced Corrupt Organization Act.
We recognize an estimated loss from such loss contingencies when we believe it is both probable that a loss will be incurred and that the amount of the loss can be reasonably estimated. Our loss estimates are based in part on an analysis of potential results, the stage of the proceedings, our relevant insurance coverage, consultation with outside counsel and any other relevant information available. While the final outcome of these proceedings cannot be determined at this time,
As discussed in the “Government Contracts Membership” section, we are in process of determining the proper accounting for various other provisions of the new TRICARE North Region contract.
Long-lived assets are classified as held for sale when certain criteria are met, which include: management commitment to a plan to sell the assets, the availability of the assets for immediate sale in their present condition, whether an active program to locate buyers and other actions to sell the assets has been initiated, whether the sale of the assets is probable and their transfer is expected to qualify for recognition as a completed sale within one year, whether the assets are being marketed at reasonable prices in relation to their fair value and how unlikely it is that significant changes will be made to the plan to sell the assets.
As a result of the above requirements and other regulatory requirements, certain subsidiaries are subject to restrictions on their ability to make dividend payments, loans or other transfers of cash to their parent companies. Such restrictions, unless amended or waived, or unless regulatory approval is granted, limit the use of any cash generated by these subsidiaries to pay our obligations. The maximum amount of dividends which can be paid by our insurance company subsidiaries without prior approval of the applicable state insurance departments is subject to restrictions relating to statutory surplus, statutory income and unassigned surplus.
The financial statements listed on the accompanying Index to Consolidated Financial Statements set forth on page and covered by the Report of Independent Auditors are incorporated in this Item 8 by reference and filed as part of this Annual Report on Form 10-K.