The Company believes that current and planned clinical space will be adequate for its present needs. Additional clinical space may be required, however, if membership continues to expand in southern Nevada.
On October 31, 1998, Sierra and one of its subsidiaries, Texas Health Choice, L.C. (formerly HMO Texas L.C.) completed the acquisition of certain assets of Kaiser Foundation Health Plan of Texas ("Kaiser- Texas"), a health plan operating in Dallas/Ft. Worth with approximately 109,000 members, and Permanente Medical Association of Texas ("Permanente"), a medical group with approximately 150 physicians. The purchase price was $124 million, which is net $20 million in operating cost support to be paid to Sierra by Kaiser Foundation Hospitals in five quarterly installments following the closing of the transaction. The purchase price allocation includes a premium deficiency reserve of $25 million for estimated losses on the contracts acquired from Kaiser-Texas. Of this amount, $6.8 million was reversed in 1998 to offset losses on the acquired contracts. The purchase price includes amounts for real estate and eight medical and office facilities with approximately 500,000 square feet. In December 1998, certain accreditation goals were met by the health plan resulting in a purchase price increase of $3.0 million to $127 million. The purchase price may increase up to an additional $27 million over three years if certain growth and member retention goals are met by the health plan. Sierra assumed no prior liabilities for malpractice or other litigation, or for any unanticipated future adjustments to claims expenses for periods prior to closing. The transaction was financed with a five-year revolving credit facility and a $35.2 million note payable to Kaiser Foundation Health Plan of Texas. The note is secured by the acquired real estate. Approximately $110 million of the $200 million revolving credit facility was used to fund the transaction.
On December 31, 1998, Sierra completed the acquisition of the Nevada health care business of Exclusive Healthcare, Inc., United of Omaha Life Insurance Company and United World Life Insurance Company, all of which are subsidiaries of Mutual of Omaha Insurance Company. The purchase price is contingent based on how many members are retained through 2000 and 2001. No cash will be paid until group renewals begin in 2000. Sierra retained approximately 9,000 members (approximately 4,400 HMO members) subsequent to the acquisition.
The Company's principal expenses consist of medical expenses, military contract expense, specialty product expenses, and general, administrative and marketing 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 independently 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. Military contract expenses represent the expenses of delivering health care as agreed to in the TRICARE contract with the federal government as well as administrative costs to operate the military health care subsidiary. 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 marketing expenses generally represent operational costs other than those associated with the delivery of health care services and specialty product services.
On September 30, 1997, Sierra Military Health Services, Inc. ("SMHS") was awarded a TRICARE contract to provide managed health care coverage to eligible beneficiaries in Region 1. In June 1998, the Company began providing health care benefits to approximately 606,000 individuals in Connecticut, Delaware, Maine, Maryland, Massachusetts, New Hampshire, New Jersey, New York, Pennsylvania, Rhode Island, Vermont,
Virginia, West Virginia and Washington, D.C. In 1998, the award resulted in a total of $204.8 million of revenue for the final five-months of the implementation phase and seven months of health care delivery. SMHS was notified on February 13, 1998 that the United States General Accounting Office ("GAO") sustained a competitor's protest of the contract award for TRICARE Managed Care Support Region 1 and recommended that the contract be re-bid. In December 1998, the Company reached an agreement to settle the protest. As part of the settlement, the competitor will forego any and all rights it may have to challenge the contract award and seek a re-bid (See Note 14 of Notes to the Consolidated Financial Statements).
Medical premium revenue from the Company's HMO and managed indemnity insurance subsidiaries increased $95.5 million, or 18.6%. Excluding the effect of the Kaiser-Texas acquisition in the fourth quarter of 1998, premium revenue increased $66.9 million, or 13.0%. The $66.9 million increase in premium revenue reflects a 3.4% increase in member months (the number of months of each year that an individual is enrolled in a plan). Medicare member months increased 20.1% which contributed to the increase in medical premium revenue. Such growth in Medicare member months contributes significantly to the increase in premium revenues as the Medicare per member premium rates are over three times higher than the average commercial premium rate. The Company's premium rates increased an average of 3% to 4% for its HMO commercial groups and in excess of 10% for managed indemnity commercial groups. The Company also realized a slight increase in its capitation rate established by Health Care Financing Administration ("HCFA"). Approximately 78% of the Company's Nevada Medicare members are enrolled in the Social HMO Medicare program. HCFA is considering adjusting the reimbursement factor for the Social HMO members in the future. If the reimbursement for these members decreases significantly and related benefit changes are not made timely, there could be a material adverse effect on the Company's business.
Specialty product revenue increased $2.2 million, or 1.5%, for the year ended December 31, 1998 compared to the prior year. The increase was due to revenue growth of $5.1 million in the workers' compensation insurance operation offset in part by a decrease in administrative services and other revenue of $2.9 million due primarily to the termination of the Company's workers' compensation administrative services contract with the State of Nevada. The Company's workers' compensation subsidiary signed a reinsurance agreement whereby a greater portion of premium is ceded thus reducing revenue. The agreement results in a reduction of specialty product expense as discussed later in this section. Excluding the effect of the new reinsurance agreement, the workers' compensation subsidiaries' revenue would have increased $21.2 million compared to the prior year. Professional fee revenue increased approximately $14.1 million primarily due to the January 1998 acquisition of the operations of two medical clinics in southern Nevada and the clinics acquired in the Dallas/Ft. Worth area. In addition approximately $3.5 million of the increase in professional fees was due to the operations of Total Home Care, Inc. ("THC") which was acquired in August 1997.
General, Administrative and Marketing Expenses. General, administrative and marketing ("G&A") cost increased $16.8 million, or 17.9%, compared to 1997. As a percentage of revenues, G&A costs for 1998 decreased to 10.7% from 13.0% during 1997. The decrease in the G&A ratio is primarily due to the addition of military contract revenues offset in part by costs for additional infrastructure needed to support overall Company growth. Excluding military revenues, G&A as a percentage of revenues was 13.3% in 1998. Of the $16.8 million increase in G&A, $3.2 million was due to additional G&A related to the acquired HMO business in the Dallas/Ft. Worth area. The remaining increase of $13.6 million consisted of $3.8
On March 18, 1997, the Company announced it had terminated its merger agreement with Physician Corporation of America, Inc. and recorded expenses of $11.0 million, $8.4 million after tax, for merger- related costs. During the third quarter of 1997 SMHS was awarded a contract to serve TRICARE eligible beneficiaries in Region 1. Development expenses of $18.4 million, $10.6 million net of taxes, were recorded in the third quarter primarily for expenses associated with the Company's proposal to serve TRICARE Region 1. Such expenses had been deferred until award notification.
Interest Expense and Other. Interest expense and other increased approximately $2.7 million for the year ended December 31, 1998, compared to the same period in the prior year due to an increase in debt as a result of the Kaiser-Texas acquisition.
assets and operations of THC during the third quarter of 1997. THC provides home infusion, oxygen and durable medical equipment services in Nevada and Arizona. During the fourth quarter of 1997, SMHS began the implementation period of its TRICARE contract. The military contract revenue of $4.3 million is a result of this contract. Investment and other revenue was consistent with the prior year.
General, Administrative and Marketing Expenses. G&A costs increased $21.7 million, or 30.0%, for the twelve months ended December 31, 1997 compared to the twelve months ended December 31, 1996. As a percentage of revenues, G&A costs for the twelve months ended December 31, 1997 increased to 13.0% from 12.6% during the comparable period in 1996. Of the $21.7 million increase in G&A, $8.6 million was in compensation costs primarily resulting from additional employees supporting expanded services and increased incentive amounts for management. Broker, third-party administration, and premium tax expenses increased approximately $8.5 million due to increased membership. Amortization and depreciation costs increased approximately $1.9 million primarily due to the amortization of goodwill resulting from the Prime acquisition. The remaining G&A increase was due to additional expenses in several areas including data processing maintenance.
Military Contract Expense. During the fourth quarter of 1997, SMHS began the implementation period of its TRICARE contract. The military contract expense is a result of this contract.
As a result of higher than expected claim and administrative costs relative to premium rates that can be obtained in certain regional insurance operations and the Company's inability to negotiate adequate provider contracts due to its limited presence in some of these markets, the Company adopted a plan to restructure certain insurance operations during the third quarter of 1996 and recorded a charge of $8.3 million, ($6.2 million after tax). These restructuring costs included cancellation of certain contractual obligations of $6.0 million, lease termination costs of $1.5 million and approximately $750,000 of other costs.
Interest Expense and Other. Interest expense and other increased approximately $1.6 million over the prior year primarily due to the $2.1 million benefit for minority interests recorded in 1996, offset in part by an increase in capitalized interest related to various construction projects in 1997. In November 1996, the Company acquired complete ownership of a Texas HMO in which it had previously held a 50% interest. That HMO began business in March 1995 and experienced losses in both years. In the prior year, a portion of these losses resulted in a benefit from minority interests.
Income Taxes. The Company's effective tax rate for the year ended December 31, 1997 was 11.8%, compared to 25.2% in 1996. The difference between the Company's effective tax rate and the current federal tax rate is due primarily to a $4.7 million tax benefit recorded as a result of a reduction of the deferred tax valuation allowance and the Company's portfolio of tax preferred investments. These benefits are more significant as a result of the charges related to the Physicians Corporation of America acquisition and start-up costs associated with the TRICARE contract. Excluding these costs, the effective tax rate for 1997 is 23.9%. See Note 9 of Notes to Consolidated Financial Statements.
reported. The increase in other current liabilities is primarily due to expenses related to operations of the military services subsidiary and reinsurance premiums payable due to the new reinsurance contract.
Cash flows from financing activities included net proceeds from long-term borrowings (proceeds less payments) of $113.1 million. The majority of net proceeds from long-term borrowings was used to fund the Kaiser-Texas acquisition. The transaction was financed with a five-year revolving credit facility. As of December 31, 1998, the Company had $139 million in borrowings on the $200 million line of credit. Interest under the credit facility is variable and based on the London Interbank Offering Rate ("LIBOR") plus a margin determined by reference to the Company's leverage ratio. In addition, $50 million of the outstanding balance is covered by interest-rate swap agreements. The average cost of borrowing on this line of credit for the fourth quarter of 1998, including the impact of the swap agreements, was approximately 8.0%. The terms of the credit facility contain a mandatory payment schedule that begins on June 30, 2001 and ends on September 30, 2003 if the principal balance exceeds certain thresholds. The terms of the credit facility contain certain covenants including a minimum fixed charge coverage ratio and a maximum leverage ratio. The remaining $61 million available balance on the line of credit as of December 31, 1998, may be used for general corporate purposes, including working capital.
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.
The holding company may receive dividends from its HMO and insurance subsidiaries which generally must be approved by certain state insurance departments. The Company's HMO and insurance subsidiaries are required by state regulatory agencies to maintain certain deposits and must also meet certain net worth and reserve requirements. The Company had restricted assets on deposit in various states totaling $17.8 million as of December 31, 1998. The HMO and insurance subsidiaries must also meet requirements to maintain minimum stockholder's equity, on a statutory basis, ranging from $1.1 million to $5.2 million. In addition, in conjunction with the Kaiser-Texas acquisition, Texas Health Choice, L.C. ("TXHC") entered into a letter agreement with the Texas Department of Insurance whereby TXHC agreed to maintain a net worth of $20.0 million. Of the cash and cash equivalents held at December 31, 1998, $81.3 million is designated for use only by the regulated subsidiaries. Such amounts are available for transfer to the holding company from the HMO and insurance subsidiaries only to the extent that they can be remitted in accordance with the terms of existing management agreements and by dividends. Remaining amounts are generally available on an unrestricted basis.
The National Association of Insurance Commissioners has adopted new minimum capitalization requirements for HMOs, health care insurance entities and other risk-bearing health care entities. Depending on the nature and extent of the new minimum capitalization requirements ultimately adopted by each state, there could be an increase in the capital required for certain of the Company's regulated subsidiaries. The Company intends to fund any increase from available parent company cash reserves; however, there can be no assurance that such cash reserves will be sufficient to fund these minimum capitalization requirements. The new requirements are expected to be effective on or before December 31, 1999 upon enactment by each state. The Company does not believe that any such required increase in the amount of funds to be contributed to the subsidiaries will be material.
The Company has a 1999 capital budget of approximately $60 million, primarily for computer hardware and software, furniture and equipment and other requirements due to the Company's computer system conversion and projected growth and expansion. The Company's liquidity needs over the next 12 months will primarily be for the capital items noted above, the Company's stock repurchase program, debt service and expansion of the Company's operations, including potential acquisitions. The Company believes that existing working capital, operating cash flow and, if necessary, mortgage financing, equipment leasing, and amounts available under its credit facility will be sufficient to fund its capital expenditures and debt service. Additionally, subject to unanticipated cash requirements, the Company believes that its existing working capital and operating cash flow and, if necessary, its access to new credit facilities, will enable it to meet its liquidity needs on a longer term basis.
The Company is currently in the process of modifying or replacing its mission critical financial and operational computer systems. The Company is also in the process of testing its non-information system technology for Year 2000 compliance. The Year 2000 project has been broken down into five phases: (1) inventorying Year 2000 items; (2) assessing the Year 2000 items that are determined to be material to the Company; (3) renovating or replacing material items that are determined not to be Year 2000 compliant; (4) testing and validating material items; and (5) implementing renovated and validated systems.
At December 31, 1998, the inventory and assessment phases are substantially complete as it relates to all material computer systems and approximately 50% complete as it relates to non-information system technology. The Company estimates that the replacement/renovation phases and the testing/validation phases will be 95% complete by October 31, 1999. The Company estimates that it is approximately 50% complete with the total project as of December 31, 1998. Contingency planning for the mission critical business operations is scheduled to be completed by April 1999. These plans focus on business operations involving information systems and non-information systems technologies.
The Company is in the process of implementing three major systems at an estimated cost of $36 million to $38 million, which includes the implementation costs related to the recently acquired Kaiser-Texas operations. To date the Company has spent approximately $19.0 million on the new computer systems and other Year 2000 items. The Company is expensing the costs to make modifications to existing computer systems and non-computer equipment. Management currently estimates the remaining new computer system costs and other Year 2000 costs to be $13.0 million to $16.0 million for operations in existence prior to the Kaiser-Texas transaction and $6.0 million to $8.0 million for the Kaiser-Texas operations that were acquired on October 31, 1998. While this is a substantial effort, it will give the Company the benefits of new technology and functionality for many of its financial and operational computer systems and applications.
The above contains forward-looking statements including, without limitation, statements relating to the Company's plans, strategies, objectives, expectations, intentions, and adequate resources, that are made pursuant to the "safe harbor" provisions of the Private Securities Litigation Reform Act of 1995. Readers
are cautioned that forward-looking statements contained in the Year 2000 disclosure should be read in conjunction with the following disclosure of the Company:
While the Company is unable to predict what regulatory changes may occur or the impact on the Company of any particular change, the Company's operations and financial results could be negatively affected by regulatory revisions. For example, any proposals affecting underwriting practices, limiting rate increases, requiring new or additional benefits or affecting contracting arrangements (including proposals to require HMOs and PPOs to accept any health care providers willing to abide by an HMO's or PPO's contract terms) may have a material adverse effect on the Company's business. The continued consideration and enactment of "anti-managed care" laws and regulations by federal and state bodies may make it more difficult for the Company to manage medical costs and may adversely affect financial results.
In addition to changes in applicable laws and regulations, the Company is subject to various audits, investigations and enforcement actions. These include possible government actions relating to the federal Employee Retirement Income Security Act, which regulates insured and self-insured health coverage plans offered by employers, the Federal Employees Health Benefit Plan, federal and state fraud and abuse laws, and laws relating to utilization management and the delivery of health care. Any such government action could result in assessment of damages, civil or criminal fines or penalties, or other sanctions, including
In March 1998, the Accounting Standards Executive Committee of the American Institute of Certified Public Accountants ("AcSEC") issued Statement of Position 98-1 ("SOP 98-1"), "Accounting for the Costs of Computer Software Developed For or Obtained For Internal Use". SOP 98-1 requires certain computer software costs to be capitalized and amortized over the software's estimated useful life. In June 1998, the AcSEC issued Statement of Position 98-5 ("SOP 98-5"), "Reporting on the Costs of Start-Up Activities". This standard requires organization costs and costs associated with start-up activities to be expensed as incurred. Both statements are effective for years beginning after December 15, 1998. The Company will adopt SOP 98-1 and SOP 98-5 for the fiscal year ending December 31, 1999 and does not believe these statements will have a material impact on its financial statements.
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, 1998, such systems and controls were adequate to meet the objectives discussed herein.
Paul H. Palmer Vice President, Finance Chief Financial Officer, and Treasurer
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Sierra Health Services, Inc. and its subsidiaries at December 31, 1998 and 1997, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1998 in conformity with generally accepted accounting principles. Also, in our opinion, such financial statement schedules when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information set forth therein.
SIERRA HEALTH SERVICES, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS December 31, 1998 and 1997
SIERRA HEALTH SERVICES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS For the Years Ended December 31, 1998, 1997 and 1996
The acquisition has been recorded using purchase accounting and the excess of the purchase price over the fair value of the assets acquired was recorded as goodwill. The goodwill, in the amount of $102.0 million, is being amortized on a straight line basis over 40 years.
In August 1997, the Company acquired the assets and operations of Total Home Care, Inc. ("THC") for approximately $3.1 million, net of cash acquired. THC provides home infusion, oxygen, and durable medical equipment services in Nevada and Arizona. The Company sold the Arizona operations in the first
Specialty Product Revenues. These revenues consist primarily of workers' compensation premiums. Premiums are calculated by formula such that the premium written is earned pro rata over the term of the policy. Also included in specialty product revenues are administrative services and certain ancillary product revenues. Such revenues are recognized in the period in which the service is performed or the period that coverage for services is provided. Premiums written in excess of premiums earned are recorded as an unearned premium revenue liability. Premiums earned include an estimate for earned but unbilled premiums. Also included in specialty product revenue are revenues associated with administrative services and certain ancillary products.
Investments. Short- and long-term investments consist principally of U.S. Government securities and municipal bonds, as well as corporate and mortgage backed securities. Short-term investments have maturities of one year or less. Long-term investments have maturities in excess of one year.
Restricted Cash and Investments. 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.
Military Accounts Receivable. Amounts receivable under government contracts are comprised primarily of one month's contract payment from the government in arrears, estimates of adjustments under the contract based on actual experience, and estimates of the earned portion of any change orders not originally specified in the contract.
Buildings and Improvements 30 years Leasehold Improvements 3 - 10 years Furniture, Fixtures and Equipment 3 - 5 years Data Processing Hardware and Software 3 - 5 years
Credit risk with respect to accounts receivable is generally diversified due to the large number of entities comprising the Company's customer base, other than gaming, and their dispersion across many different industries. These customers are primarily located in the states in which the Company operates. Such operations are principally in California, Nevada and Texas. However, the Company is licensed and does business in several other states as well. As of December 31, 1998, the Company has receivables outstanding from the federal government related to its TRICARE contract in the amount of $69.6 million. The Company also has receivables from certain reinsurers. 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 contracts with are rated A- or better by the A.M. Best Company.
Recently Issued Accounting Standards. In March 1998, the Accounting Standards Executive Committee of the American Institute of Certified Public Accountants ("AcSEC") issued Statement of Position 98-1 ("SOP 98-1"), "Accounting for the Costs of Computer Software Developed For or Obtained For Internal Use". SOP 98-1 requires certain computer software costs to be capitalized and amortized over the software's estimated useful life. In June 1998, the AcSEC issued Statement of Position 98-5 ("SOP 98-5"), "Reporting on the Costs of Start-Up Activities". This standard requires organization costs and costs
Stock Split. On May 5, 1998, the Company announced a three-for-two stock split. Each stockholder of record of the Company owning one share of common stock, par value of $.005, as of the close of business on the record date of May 18, 1998, received an additional one-half share on June 18, 1998. In lieu of any fractional share resulting from the stock split, a stockholder received a cash payment based on the closing price of the Company's common stock on the record date. The par value remains $.005 per share. Common stock and earnings per share amounts have been retroactively adjusted to account for the split.
The Company capitalizes interest expense as part of the cost of construction of facilities and the implementation of computer systems. Interest expense capitalized in 1998, 1997 and 1996 was $1,037,000, $1,621,000 and $245,000, respectively.
Investments that the Company has the intention and ability to hold to maturity are stated at amortized cost and categorized as held-to-maturity. The remaining investments have been categorized as available-for-sale and as a result are stated at their fair value. Unrealized holding gains and losses on available-for-sale securities are included as a separate component of stockholders' equity until realized. Gross realized gains and losses on investments in 1998 were $4.8 million and $2.5 million, respectively. Realized gains and losses are calculated using the specific identification method and are included in net income.
The contractual maturities of available-for-sale short-term, long-term and restricted investments at December 31, 1998 are shown below. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations.
The Company is covered under medical reinsurance agreements that provide coverage for 50% - 90% of hospital and other costs in excess of, depending on the contract, $100,000 to $200,000, per case, up to a maximum of $2,000,000 per member per lifetime for both the managed indemnity and HMO subsidiaries. In addition, certain of the Company's HMO members are covered by an excess catastrophe reinsurance contract. Reinsurance premiums of $2,860,000, $3,156,000 and $3,235,000 net of reinsurance recoveries of $1,185,000, $1,729,000 and $2,276,000 are included in medical expense for 1998, 1997 and 1996, respectively. In addition, SHL maintains reinsurance on certain other insurance products.
and 100% of the next $450,000. CII receives a ceding commission from the reinsurer as a partial reimbursement of its operating expenses.
The low level reinsurance agreement contains both retroactive and prospective reinsurance coverage and CII has bifurcated the low level reinsurance agreement to account for the different accounting treatments. The amount by which the estimated ceded liabilities exceed the amount paid for the retroactive coverage is amortized to income over the estimated remaining settlement period using the interest method. For the year ended December 31, 1998, CII amortized a deferred gain of $1,038,000. Any subsequent changes in estimated or actual cash flows are accounted for by adjusting the previously recorded deferred gain to the balance that would have existed had the revised estimate been available at the inception of the reinsurance transactions, with a corresponding charge or credit to income.
At December 31, 1998 and 1997, the amount of reinsurance recoverable under prospective reinsurance contracts for unpaid losses and loss adjustment expenses for CII was $37,797,000 and $21,056,000, respectively. At December 31, 1998, the amount of reinsurance recoverable under the retroactive reinsurance contract was $18,710,000. The amount of reinsurance receivable for paid losses and loss adjustment expenses was $1,917,000 and $358,000, at December 31, 1998 and 1997, 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 contracts with are rated A- or better by the A.M. Best company.
Revolving Credit Facility. On October 31, 1998, the Company replaced its prior line of credit with a $200 million credit facility under which it has $139 million in borrowings outstanding as of December 31, 1998. Interest under the credit facility is variable and based on the London Interbank Offering Rate plus a margin determined by reference to the Company's leverage ratio. Of the outstanding balance, $50.0 million is covered by interest-rate swap agreements. The average cost of borrowing on this line of credit for the fourth quarter of 1998, including the impact of the swap agreements, was approximately 8.0%. The terms of the credit facility contain a mandatory payment schedule that begins on June 30, 2001 and ends on September 30, 2003 if the principal balance exceeds certain thresholds. The terms of the credit facility
contain certain covenants including a minimum fixed charge coverage ratio and a maximum leverage ratio. In November 1998, the Company borrowed approximately $110 million to fund the acquisition of Kaiser- Texas.
6.0% Mortgage Note. In conjunction with the acquisition of Kaiser-Texas, TXHC executed a deed of trust note for $35,200,000. The note is secured by deeds of trust covering the underlying real estate and fixtures. The terms of the note include fixed monthly payments of $211,000 for five years at which time the remaining principal is due.
7 1/5% Mortgage Note. In January 1998, the Company obtained a $15,000,000 loan from Bank of America, Nevada at an interest rate of 7 1/5%. This loan is secured by a deed of trust, assignment of rents and leases, and a security agreement and fixture filing covering the newly constructed portion of the Company's administrative headquarters complex and underlying real property.
Other. The Company has obligations under capital leases with interest rates from 6.3% to 13.4%. In addition, the Company has term loans with the City of Baltimore and the State of Maryland.
The fair value of the Debentures at December 31, 1998 was $48,176,000 which was determined based on the market price on January 7, 1999. Excluding the Debentures, the fair value of long-term debt, including the current portion, is $195,057,000 based on the borrowing rates currently available to the Company for bank loans with similar terms and average maturities.
The following reconciles the difference between the 1998, 1997 and 1996 current and statutory provision for income taxes:
At December 31, 1998, the Company had approximately $20,022,000 of regular tax net operating loss carryforwards which are limited to use at the rate of approximately $7,021,000 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 2011. In addition to the net operating loss carryforwards, the Company has alternative minimum tax credits of approximately $848,000 which can be used to reduce regular tax liabilities in future years. There is no expiration date for the alternative minimum tax credits. The majority of the above items are subject to both annual and separate company limitations required by the Internal Revenue Code.
Leases. The Company is the lessee under several operating leases, most of which relate to office facilities and equipment. The rentals on these leases are charged to expense over the lease term as the Company becomes obligated for payment and, where applicable, provide for rent escalations based on certain costs and price index factors. The following is a schedule, by year, of the future minimum lease payments under existing operating leases:
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 a maximum of 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. Expense under the plan totaled $4,522,000, $3,929,000 and $3,216,000 in 1998, 1997 and 1996, respectively.
Stock Option Plans. The Company has several plans that provide common stock-based awards to employees and to non-employee directors. The plans provide for the granting of Options, Stock, and other stock-based awards. Awards are granted by a committee appointed by the Board of Directors. Options become exercisable at such times and in such installments as set by the committee. The exercise price of each option equals the market price of the Company's stock on the date of grant. Stock options generally vest at a rate of 20% - 25% per year. Options generally expire one year after the end of the vesting period.
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, 1998, the Company had 353,000 shares reserved for purchase under the Purchase Plan. During 1998, a total of 144,000 shares were purchased at prices of $17.75 and $19.06 per share. During January 1999, 72,000 shares were issued to employees at $17.85 per share in connection with the Purchase Plan.
Accounting for Stock-Based Compensation. The Company uses the intrinsic value method in accounting for its stock-based compensation plans. Accordingly, no compensation cost has been recognized for its employee stock option plans nor the Stock Purchase Plan. Had compensation cost for the Company's stock-based compensation plans been determined based on the fair value at the grant dates for awards under those plans, the Company's net income and earnings per share would have been reduced to the pro forma amounts indicated below:
The fair value of the look-back option implicit in each offering of the Purchase Plan is estimated on the date of grant using the Black-Scholes option pricing model with the following weighted average assumptions used for grants in 1998, 1997 and 1996, respectively: dividend yield of 0% for all years; expected volatility of 32%, 35% and 29%; risk-free interest rates of 5.30%, 5.32% and 5.29%; and expected lives of six months for all years.
During the fourth quarter of 1998, the Company incurred settlement expenses totaling $8 million, $5.9 million after tax, related to the settlement of a competitor's protest for the Region 1 TRICARE contract. All this amount was paid during fiscal year 1998. On September 30, 1997, SMHS was awarded a five-year, $1.2 billion contract to administer managed health care services to military families and retirees in 13 northeastern states and Washington, D.C. A competing bidder protested the contract award and claimed, among other issues, that the United States Department of Defense failed to adequately disclose the weights of the significant factors used to evaluate proposals. In December 1998, SMHS reached an agreement to settle the protest. As part of the settlement, the competitor has foregone any and all rights it may have to challenge the contract award and seek re-bid.
During the third quarter of 1997, SMHS was notified it had been awarded a TRICARE managed care contract by the Department of Defense to serve eligible beneficiaries in Region 1. This region includes more than 600,000 beneficiaries in 13 northeastern states and the District of Columbia. Development expenses of $18.4 million $10.6 million net of taxes, were recorded in the third quarter, primarily for expenses associated with the Company's proposal to serve TRICARE beneficiaries in Region 1. Such expenses had been deferred until award notification. SMHS began health care delivery on June 1, 1998. SMHS subcontracts for health care delivery, including some of the risk, for parts of the TRICARE contract.
As a result of higher than expected claim and administrative costs relative to premium rates that can be obtained in certain regional insurance operations and the Company's inability to negotiate adequate provider contracts due to its limited presence in some of these markets, the Company adopted a plan to restructure certain insurance operations during the third quarter of 1996 and recorded a charge of $8.3 million, $6.2 million after tax. These restructuring costs included cancellation of certain contractual obligations of $6.0 million, lease termination costs of $1.5 million and approximately $750,000 of other costs.
15. UNAUDITED QUARTERLY INFORMATION (Amounts in thousands, except per share data)
Sierra evaluates each segment's performance based on segment operating profit. The accounting policies of the operating segments are the same as those described in the summary of significant accounting policies.