In conjunction with the acquisition of CMSI on December 31, 2002, we assumed a lease in Green Bay, Wisconsin for approximately 9,173 square feet of office space. In addition, we acquired three properties owned by CMSI. Two of the properties are located in Green Bay, Wisconsin, one of which is 15,340 square feet and the other is 16,700 square feet. The third property is located in West Bend, Wisconsin and is 18,056 square feet. CMSI is included in our self-funded segment.
The following selected financial data are derived from our consolidated financial statements. The data should be read in conjunction with our consolidated financial statements, the related notes thereto, "Management's Discussion and Analysis of Financial Condition and Results of Operations" and other financial information included herein.
We were formed in March 2001 as the successor to substantially all of the operations of BCBSUW and UWS. Under accounting principles generally accepted in the United States, our financial statements reflect the business and assets of BCBSUW, without UWS, for periods through March 31, 2001, and the combined businesses of BCBSUW and UWS for periods after that date. This presentation limits the comparability of the financial and operating data set forth below.
The following presents our management's discussion and analysis of our financial condition and results of operations as of the dates and for the periods indicated. You should read this discussion in conjunction with our consolidated financial statements and notes thereto and the information set forth under the caption "Risk Factors." This discussion contains forward-looking statements that involve risks and uncertainties. Actual results could differ significantly from those anticipated in these forward-looking statements.
To address these issues, we developed a plan to improve our core business while divesting non-core businesses and assets. In our core business, we focused on:
Through this strategy, we have improved our core operations. Although resulting in decreased membership and premium revenue for Blue Cross & Blue Shield United of Wisconsin ("BCBSUW") and our health maintenance organizations ("HMOs"), our strategy has substantially improved loss ratios and overall profitability. Our income from continuing operations improved to $65.0 million in 2002 from losses of $23.3 million in 2001 and $40.0 million in 2000. Had the Combination occurred at the beginning of 2000 and the operations of the UWS business been included for all periods presented, the improvement in overall profitability between years would have been even greater. (See Item 8, Note 1 - "Organization, Accounting for Conversion and Combination, and Basis of Presentation.") During 2001, we experienced significant improvement in our core operations, although we recorded a substantial loss, primarily due to a $25.2 million write-down of our minority investment in AMSG. We intend to continue our strategy of focusing on our core business and pursuing opportunities to expand margins, increase market share and divest additional non-core assets.
For financial reporting purposes, we have been able to reduce income tax expense through utilization of certain net operating loss carryforwards that were subject to a full valuation allowance. The majority of such net operating loss carryforwards were exhausted during the fourth quarter of 2002 for book purposes, and our effective tax rate will therefore increase in 2003.
As of December 31, 2000 and for the year then ended, medical and other benefits expense in the consolidated statements of operations and medical and other benefits payable in the consolidated balance sheets do not include any significant amounts relating to capitated arrangements as these periods were prior to the combination of UWS and BCBSUW on March 23, 2001 (the "Combination"). For the year ended December 31, 2001, medical and other benefits expense included $94.3 million relating to capitated medical and dental arrangements, representing 8% of the total medical and other benefits expense, and medical and other benefits payable at December 31, 2001 included $4.3 million relating to capitated arrangements. For the year ended December 31, 2002, medical and other benefits expense included $105.2 million relating to capitated medical and dental arrangements, representing 9% of total medical and other benefits expense, and medical and other benefits payable at December 31, 2002 included $1.1 million relating to capitated arrangements.
Comparison of Results of Fiscal Year 2002 with Fiscal Year 2001
Self-funded administrative fees in 2002 increased 8.9% to $30.6 million from $28.1 million in 2001. Self-funded medical and dental membership increased to 515,570 as of December 31, 2002 from 169,646 as of December 31, 2001. The large increase in membership in 2002 is attributable to the acquisition of CMSI on December 31, 2002. No revenue relating to CMSI was recorded during 2002. The increase in administrative fees is attributable to increased volume in the BlueCard PPO program, offset by cancellations of commercial groups. BlueCard PPO program administrative fees in 2002 increased 60.0% to $13.4 million from $8.4 million in 2001. Under the BlueCard PPO program, we do not maintain membership but receive an administrative fee and percentage of discounts for members from other Blue Cross and Blue Shield plans ("Blue Plans") that access medical care in Wisconsin.
The expense ratio for self-funded products in 2002 improved to 91.8% from 113.9% in 2001. The improved expense ratio is primarily the result of an increase in the volume of business serviced under the BlueCard PPO program. Costs associated with servicing this business are significantly lower than the costs associated with servicing other self-funded accounts. In addition, increases in administrative fees on existing self-funded business have contributed to the improvement in the expense ratio.
SGA expenses recorded at the corporate holding company in 2002 include an accrual for a $1.0 million contribution due the Wisconsin United for Health Foundation, Inc. (the "Foundation") on February 1, 2003. In addition, during the fourth quarter of 2002, $1.2 million of offering expenses were recorded due to our decision not to sell any shares of Cobalt stock in the Foundation's offering in early 2003. Offsetting these charges was a favorable vendor settlement of $3.8 million recorded during the first quarter of 2002.
In 2002, the income from investment in affiliates improved to $15.6 million compared to a loss of $22.7 million in 2001. The results in 2002 were primarily comprised of our equity in AMSG net income of $3.8 million combined with a net gain of $10.0 million on the sale of 4.4 million shares of AMSG stock during the first two quarters. As a result of the sale of these shares, our percentage ownership of AMSG stock decreased below 20% and therefore, the remaining investment was no longer reported under the equity method of accounting as of June 1, 2002. A gain on the subsequent sale of an additional 0.5 million shares was recorded in realized investment gains. In addition, we recognized income of $1.6 million in the second quarter of 2002, which relates primarily to our proportionate share of tax benefit recorded by Family Health Systems, Inc. ("FHS"), a 50% owned affiliate, due to a change in tax laws regarding the carry-back of net operating losses.
The $22.7 million loss in 2001 is primarily comprised of equity in AMSG earnings of $2.0 million for 2001 and BCBSUW's share of UWS earnings of $0.4 million for the first quarter of 2001 (prior to the Combination), offset by a $25.2 million write-down of the investment in AMSG to its market value as of December 31, 2001. This write-down was deemed appropriate based on management's decision to no longer classify the investment in AMSG as a strategic long-term asset. The decrease in the investment in affiliates balance between 2002 and 2001 in the accompanying consolidated balance sheets primarily results from the sale of AMSG shares and the reclassification of our remaining investment in AMSG, which is no longer reported under the equity method of accounting. Effective with the June 2002 balance sheet, the investment in AMSG is reported as an available-for-sale investment at fair market value.
Income tax expense for financial reporting purposes in 2002 was reduced through utilization of certain net operating loss carryforwards that were subject to a valuation allowance that had been established by a charge to income tax expense. The majority of such net operating loss carryforwards were exhausted for book purposes during the fourth quarter of 2002, and our effective tax rate for financial reporting purposes will therefore increase in 2003. In 2002, we recorded current tax expense of $7.8 million offset by a deferred tax benefit of $0.5 million. In 2001, we recorded a current income tax benefit of $2.2 million offset by deferred tax expense of $0.3 million.
Income from discontinued operations in 2002 consisted of the first quarter net operating loss of IRG of $0.7 million and an after-tax gain on the sale of IRG on March 29, 2002 in the amount of $9.6 million.
In 2002, net income improved to $74.0 million compared to a net loss of $22.3 million for 2001. The enhanced operating results reflect improvement of $59.2 million in operating income from continuing operations, improvement of $38.3 million in income from investment in affiliates, and improvement of $8.0 million in income from discontinued operations, offset by a $9.2 million increase in income taxes. The improvement in operating income from continuing operations primarily reflects improvement in the insured medical products loss ratio (resulting from exiting the Medicare+Choice program, cancellations of unprofitable business, and premium rate increases), increased volume in the BlueCard PPO program, and the $3.8 million favorable vendor settlement recorded as a reduction to SGA expenses, offset by the $1.0 million contribution to the Foundation, and $1.2 million in offering expenses. The improvement in income from investment in affiliates reflects net realized gains of $10.0 million on the sale of certain AMSG shares, along with the $1.6 million in income related to FHS and improved 2002 operating results at AMSG. The income from discontinued operations primarily reflects the net realized gain of $9.6 million on the sale of IRG.
Comparison of Results of Fiscal Year 2001 with Fiscal Year 2000
The addition of UWS premiums resulted in an increase to premium revenue for 2001 of $574.4 million or 112.5% of the total 125.3% increase. The number of insured medical members in 2001 increased 107.8% to 530,480 from 255,289 in 2000. The total membership increase of 275,191 reflects a decrease of 18,474 members in BCBSUW insured medical membership, offset by the addition of 293,665 members from the UWS insured medical business.
Self-funded administrative fees in 2001 increased 13.8% to $28.1 million from $24.7 million in 2000. The increase in 2001 results from an increase of approximately 60% in the administrative fee per member per month due to the targeted re-pricing of self-funded business in order to eliminate unprofitable business. The pricing increases were partially offset by a reduction in non-HMO self-funded membership.
Average invested assets in 2001 increased 254.3% to $166.5 million from $47.0 million in 2000. The improvement in 2001 is due primarily to the Combination and resultant addition of UWS at the end of the first quarter of 2001.
At December 31, 2001, lower than investment grade bonds represented 0.4% of our investment portfolio.
The self-funded products expense ratio for 2001 improved to 113.9% from 144.7% in 2000. This improvement is due to continued efforts to eliminate unprofitable business through price increases.
The combined loss and expense ratio for specialty managed care products and services in 2001 improved to 98.0%, compared with 100.0% for 2000. The 2000 ratio includes only the BCBSUW dental business, whereas the 2001 ratio includes both BCBSUW dental and the UWS specialty managed care products and services business. The UWS specialty business includes cost containment services and electronic claims services, which typically run at a lower overall operating expense ratio, thus improving the combined ratio.
Goodwill amortization totaling $5.1 million and $0.6 million was recorded for 2001 and 2000, respectively. Of the total $5.1 million of goodwill amortization recorded for 2001, $3.3 million relates to $65.6 million of goodwill recorded in 2001 for the Combination as a result of purchase accounting, which until the effective date of SFAS No. 142 was being amortized on a straight-line basis over a period of 15 years. In addition, the 2001 amortization expense includes amortization related to the 1999 purchase by BCBSUW of 1.4 million additional shares of UWS stock, which had been amortized on a straight-line basis over a period of 15 years. Amortization expense for 2000 included amortization related to the purchase by BCBSUW of the 1.4 million additional shares of UWS stock discussed above. In addition, goodwill amortization has been recorded for various past acquisitions of subsidiaries and additional insurance business.
We recorded income tax expense of $0.5 million in 2000 compared to a tax benefit of $11.5 million calculated at the federal statutory rate, due primarily to the recording of a valuation allowance of $14.9 million on net deferred tax assets. The valuation allowance was recorded because management could not conclude that it was "more likely than not" that tax benefits from the 2000 loss would be realized due to a history of prior losses at BCBSUW.
Consolidated net results improved in 2001 to a loss of $22.3 million compared to a loss of $40.0 million in 2000. The $22.3 million net loss in 2001 was the combination of an operating loss of $2.4 million and a loss from investment in affiliates of $22.7 million as discussed above, offset by an income tax benefit of $1.9 million and an after-tax gain on discontinued operations of $1.0 million. The improved 2001 operating results reflect improvement in the insured loss and SGA ratios, increases in administrative fees on the self-funded business and continued growth in government contract business over the prior year.
As of December 31, 2001, a full valuation allowance was established against net deferred tax assets. We had a current income tax benefit of $2.2 million in 2001 compared to no current income tax expense or benefit in 2000. We recorded a deferred tax expense of $0.4 million in 2001 and $0.5 million in 2000, which related to a valuation allowance from a prior period.
Our sources of cash flow consist primarily of health services revenues and investment income. The primary uses of cash include medical and other benefit payments, as well as operating expense payments. Positive cash flows are invested pending future payments of medical and other benefits and other operating expenses. Our investment policies are designed to maximize yield, preserve principal, and provide liquidity to meet anticipated payment obligations.
Interest expense on the LOC, revolver and the term note discussed above totaled $0.7 million and $0.6 million for the years ended December 31, 2002 and 2001, respectively.
The Association requires BCBSUW and CompcareBlue to maintain a prescribed liquidity ratio of certain liquid assets to average monthly expenses, as defined, in accordance with licensure requirements of the Association. BCBSUW and CompcareBlue maintained these required levels as of December 31, 2002.
Operating losses incurred during 1999 through 2001 reduced the statutory surplus of our insurance subsidiaries. Despite these operating losses and the implementation of changes in statutory accounting effective January 1, 2001, we complied with minimum capital and liquidity requirements of the OCI and the Association during 1999, 2000 and 2001. We maintained compliance, in part, by contributing regulated and non-regulated subsidiaries to regulated entities and by collateralizing certain intracompany debt obligations with the common stock of affiliated entities. Following a review by the OCI of these intracompany transactions, we agreed with the OCI as to how these transactions should be treated for surplus and capital calculations. In addition, at the request of the OCI, we prepared a plan of action to satisfy these intracompany obligations and strengthen our capital to assure that our insurance subsidiaries continue to satisfy the minimum capital and liquidity requirements of the OCI and the Association.
The outstanding common stock of CompcareBlue provided the collateral for approximately $70 million we borrowed from BCBSUW. This intracompany balance has been eliminated in our consolidated balance sheets as of December 31, 2002 and 2001. In October 2002, we satisfied the $70 million obligation due BCBSUW through the transfer of all of the common stock of CompcareBlue to BCBSUW.
We have substantially completed all aspects of the capital plan, significant provisions of which included the following:
o Sell certain owned non-regulated subsidiaries for cash and/or notes prior to October 1, 2002. On March 29, 2002, we sold our behavioral health and medical management subsidiary, IRG, for $27.0 million, of which $17.0 million was received in cash.
Health care costs have been rising and are expected to continue to rise at a rate that exceeds the consumer price index. Our cost control measures, risk-sharing incentive arrangements with medical care providers, and premium rate increases are designed to reduce the adverse effect of medical cost inflation on our operations. In addition, we utilize our ability to apply appropriate underwriting criteria in selecting groups and individuals and in controlling the utilization of health care services. However, we cannot be certain that these efforts will fully offset the impact of inflation or that premium revenue increases will equal or exceed increasing health care costs.
Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States ("GAAP"). The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates, including those related to allowances for doubtful accounts, deferred tax assets, impairment of investments, goodwill impairment, medical and other benefits payables, and litigation and tax contingencies. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.
A significant portion of our receivable balances result from balances due from small and large employers, individuals, and providers of medical services. We maintain allowances for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments or retroactivity in reporting membership cancellations. If the financial condition of our customers were to deteriorate or if significant employee turnover were to occur among insured employers, resulting in an impairment of their ability to make payments, additional allowances may be required.
We account for income taxes using the liability method. Accordingly, we record deferred tax assets and liabilities for the estimated future tax consequences attributable to differences between financial statement carrying amounts and tax bases of assets and liabilities. In addition, we record a valuation allowance to reduce deferred tax assets to an amount that we believe is more likely than not to be realized. This determination involves the use of estimates and assumptions, including an estimate of future taxable income. To the extent that future taxable income or other factors differ from initial expectations, an adjustment to recorded amounts may be required.
Investments in debt and equity securities, as well as investment in affiliates, are reviewed periodically by our management to determine whether any declines in the market value of individual securities are deemed other than temporary. Any impairments deemed other than temporary are recorded as a reduction of the historical cost of the respective investment and as a realized loss in our consolidated statement of operations.
Prior to the reduction of our ownership of AMSG common stock to 14.9% on June 4, 2002, our investment in AMSG was accounted for under the equity method of accounting. At December 31, 2001, we owned 6,309,525 shares of the outstanding common stock (45% ownership) of AMSG. Our per share carrying value as of December 31, 2001 was $16.44 based on our share of AMSG's equity. Pursuant to GAAP, we wrote down our investment in AMSG to the current market value of such stock ($12.45 per share as of December 31, 2001) as a charge to operations due to our evaluation and announcement that our holdings in AMSG no longer represented a strategic investment and that we planned an orderly reduction of our ownership. Effective upon the reduction of our ownership of AMSG common stock to less than 20%, we changed our accounting for our investment in AMSG from the equity method to the fair value method. Under the fair value method, our investment in AMSG is recorded at market value, with any changes in market value being recorded as an unrealized gain or loss.
Our December 31, 2000 loss reserves contemplated, among other estimates, continued deterioration in claim experience on Medicare+Choice consistent with that experienced earlier in the year. Actual claims paid were less than anticipated. The net medical and other benefits payable assumed from UWS during 2001 developed slightly unfavorably due to the transition of provider contracts from a capitated to fee for service basis.
During late 1999, we overestimated claim payment lag times in connection with a claim adjudication system conversion. This resulted in favorable development of December 31, 1999 estimated benefits payable.
The Tax Reform Act of 1986 made all Blue Cross organizations taxable as of January 1, 1987 and included certain tax benefits designed to ease the burden of becoming a taxable entity. These benefits included opening reserve adjustments and asset basis step-ups to fair market value. The net result of these benefits was that our 1987 income tax return reported a net operating loss that was carried back to 1984 and then carried forward. Certain issues with respect to net operating loss carryforwards and other matters were raised in the federal audit of our 1984 through 1986 tax returns. To resolve these issues, we executed a formal Closing Agreement with the Internal Revenue Service ("IRS") on April 27, 1993, and we subsequently filed amended federal income tax returns for 1987 through 1992 consistent with the provisions of the Closing Agreement.
Our amended federal income tax return for 1987 was reviewed in a subsequent IRS audit in which certain benefits agreed to by the IRS in the Closing Agreement were challenged by the Field Service Branch of the IRS. We believe that the Closing Agreement is binding on both us and the IRS. We are currently litigating this matter and expect to prevail. The litigation is pending in the United States Court of Federal Claims. BCBSUW and the government have filed cross-motions for partial summary judgment on the Closing Agreement issue. The briefing with respect to those motions concluded in June 2002, and the parties are awaiting the court's decision on the motions.
The IRS' challenge of the Closing Agreement resulted in proposed income tax deficiencies, and we paid approximately $11.6 million as a deposit to close the 1987 to 1992 tax years to further assessment of tax. We were not required to make this payment, and characterize it as a deposit or advance and fully expect that it will be returned upon resolution of the dispute.
The status of this matter, the accounting treatment and the timing of the return of our deposit are reviewed on a periodic basis with our tax advisors, legal counsel, and independent auditors. We will not be able to completely close any tax year that is impacted by the 1987 loss carry-back or carry-forward until the litigation is resolved.
OUR INSURANCE SUBSIDIARIES ARE SUBJECT TO MINIMUM CAPITAL REQUIREMENTS. OUR FAILURE TO MEET THESE REQUIREMENTS COULD SUBJECT US TO REGULATORY ACTIONS OR RESULT IN THE TERMINATION OF OUR BLUE CROSS AND BLUE SHIELD LICENSE AGREEMENTS.
Our insurance subsidiaries are subject to minimum capital requirements imposed under the laws of the State of Wisconsin. These laws include minimum capital requirements based upon a percentage of underwritten premiums by line of business. Wisconsin insurance laws also include minimum capital requirements based on the RBC for Insurers Model Act adopted by the NAIC and require our insurance subsidiaries to report their results of RBC calculations to the state insurance departments and the NAIC. Any failure by one of our insurance subsidiaries to meet the minimum capital requirements imposed under Wisconsin law will subject it to corrective action, which could include the adoption of a comprehensive financial plan, examination and revocation of its license to sell insurance products in Wisconsin, or placing the subsidiary under state regulatory control. See Item 1, "Business -- Regulation -- Capital Requirements."
The Association has termination rights if our Blue Cross and Blue Shield branded licensees' capital falls below minimum capital level. See Item 1, "Business -- Blue Cross and Blue Shield Licenses." Currently, all of our Blue Cross and Blue Shield licensees maintain RBC in excess of the minimum capital level.
During 2002, Cobalt executed on its capital plan, which has improved the capital levels of CompcareBlue, Cobalt and BCBSUW and the liquidity levels of CompcareBlue and BCBSUW. See Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations--Management's Plan."
The Association could terminate our license agreements if we do not satisfy its financial and service performance requirements or if other events described in the license agreements, some of which are outside of our control, occur. These events include, but are not limited to:
o failure to meet capital and liquidity requirements of the Association;
o violation of the ownership limitations contained in our Amended and Restated Articles of Incorporation and described below;
o failure by the Foundation to divest its shares of our common stock by the deadlines specified by the voting trust and divestiture agreement;
o no institutional owner may beneficially own 10% or more of the combined voting power of all of our outstanding securities;
Although we believe that these limitations are enforceable under Wisconsin law for a corporation like ours, we are not aware of any case in which a court has specifically addressed this issue. If one of our shareholders violates the ownership limitations and disputes their enforceability and a court does not enforce the provisions of our Amended and Restated Articles of Incorporation, we could lose our licenses to use the Blue Cross and Blue Shield names and service marks.
Although we reported net income for the year ended 2002, we experienced net losses in each of the years ended December 31, 1999, 2000, and 2001. During this time period, we experienced operational difficulties that led to these losses and corresponding decreases in our capital. In an effort to remedy these difficulties, we have devoted significant resources to improving our core operations while divesting non-core assets. Nevertheless, we cannot assure you that we will be able to achieve sustained profitability. If we incur additional losses, we could have difficulty satisfying our minimum capital requirements under Wisconsin law. In addition, our relationship with the Association could be adversely affected and our stock price could decline. Moreover, our quarterly results of operations could fluctuate significantly due to a variety of factors, including steps we are taking to enhance our core operations, as well as from inherent aspects of our business, such as the need to make current estimates of future claims. These fluctuations could adversely affect the price or liquidity of our common stock.
OUR RESULTS OF OPERATIONS WILL BE ADVERSELY AFFECTED IF WE ARE UNABLE TO INCREASE PREMIUMS TO OFFSET INCREASES IN OUR HEALTH CARE COSTS.
Health care costs in recent years have generally increased substantially year-over-year, and we expect that they will continue to do so in the future. Our results of operations depend on our ability to increase premiums to offset increases in our health care costs. Although we attempt to base the premiums we charge on our estimate of future health care costs, we may not be able to charge adequate premiums as a result of competition, government regulations, and other factors. Our results of operations could be adversely affected if we are unable to set premium rates at appropriate levels or adjust premium rates in the event our health care costs increase.
AN ONGOING REDUCTION IN THE NUMBER OF SUBSCRIBERS TO OUR HEALTH CARE PROGRAMS MAY REDUCE OUR REVENUE AND PROFITABILITY.
o failure to obtain new customers or failure to retain existing customers;
o negative publicity or news coverage about us or other managed care companies.
Most of the premium revenue we receive is based upon rates set before we deliver services. As a result, our ability to price contracts profitably largely depends on our ability to accurately estimate and control future health care costs. Factors that may cause health care costs to exceed our estimates include:
o higher than expected utilization of health care services by our insured members;
o new mandated benefits or other regulatory changes that increase our costs; and
In addition to actual benefits paid, our medical and other benefits expense for any period includes our estimate of reported and unreported claims and related expenses for the period. The reserves we establish for these expenses are based upon assumptions concerning a number of factors, including prior claims experience, maturity of markets, complexity of products and stability of provider networks, trends in health care costs, our underwriting criteria, enrollment in our plans, expenses, general economic conditions, and other factors. Actual experience will likely differ from assumed experience, and to the extent the actual claims experience is less favorable than estimated based on our underlying assumptions, our incurred losses would increase and future earnings could be adversely affected.
We make adjustments, if necessary, to benefit expenses in the period during which the actual claim costs are ultimately determined or when criteria used to estimate the incurred but not reported ("IBNR") change. We utilize the services of independent actuaries to calculate and review the adequacy of our benefit liabilities, in addition to using internal resources. We cannot be sure that our IBNR estimates are adequate or that adjustments to such IBNR estimates will not harm our results of operations. Further, our inability to accurately estimate IBNR may also affect our ability to take timely corrective actions, further exacerbating the negative impact on our results.
Although we maintain reinsurance to protect us against severe or catastrophic medical claims, we cannot assure you that such reinsurance coverage will be adequate or available in the future or that the cost of such reinsurance will not limit our ability to obtain it.
OUR PROFITABILITY WILL DECLINE IF WE ARE UNABLE TO MAINTAIN OUR RELATIONSHIPS WITH CERTAIN SIGNIFICANT PROVIDER GROUPS OR IF WE ARE UNABLE TO ENTER INTO AGREEMENTS WITH ADDITIONAL PROVIDERS ON FAVORABLE TERMS.
Our managed care operations may encounter competition from companies with broader or narrower geographical markets, each of which could provide a competitor with specific competitive advantages, such as greater cost control, lower prices, or greater market share. Our financial condition or results of operations may be adversely affected by significantly lower premiums by any major competitor or by any other limitation on our ability to maintain or increase our membership or premium levels.
The health benefits industry is subject to negative publicity. Negative publicity may result in increased regulation and legislative review of industry practices, which may further increase our costs of doing business and adversely affect our profitability by:
FAILURE TO PROPERLY MAINTAIN THE INTEGRITY OF OUR PROPRIETARY INFORMATION AND INFORMATION SYSTEMS COULD RESULT IN THE LOSS OF CUSTOMERS OR DECREASE OUR PROFITABILITY.
Our business depends in part on our ability to maintain, or access through outsourcing arrangements with third parties, information systems and to ensure the continued integrity of our proprietary information. Moreover, the collection, dissemination, and use of patient data is the subject of national and state legislation. If we do not maintain or access effective and efficient information systems, then we could experience adverse consequences, which include:
o inadequate information on which to base pricing and underwriting decisions;
We depend on our investment portfolio as a source of liquidity to pay medical claims and fund other expenses. In addition, returns on our investment portfolio have historically contributed significantly to our net income. Our investment portfolio consists primarily of fixed maturity securities, short-term investments, and indexed mutual funds. The market value of our investments varies from time to time depending on factors relating specifically to the issuers of the securities as well as to more general factors such as prevailing interest rates and economic and market conditions. Fluctuations in the market value of our investment portfolio could adversely affect our liquidity. These fluctuations could also reduce our investment return or result in losses when we sell investments to fund our cash needs, which could adversely affect our overall profitability.
Our regulated subsidiaries are subject to state laws and regulations that require diversification of their investment portfolios and limit the amount of investments in certain investment categories. While we have adopted an investment policy intended to facilitate compliance with statutory and regulatory requirements, our failure to comply with these laws and regulations might cause investments exceeding regulatory limitations to be treated as non-admitted assets for purposes of measuring statutory surplus and risk-based capital, and, in some instances, require the sale of those investments.
Legislation or other regulatory reform that increases the regulatory requirements imposed on us may significantly harm our business or results of operations in the future. Legislative or regulatory changes that could significantly harm us and our subsidiaries include:
o impositions of fines or other penalties for the failure to promptly pay claims;
o prohibitions or limitations on provider financial incentives and provider risk-sharing arrangements;
o limitations on the ability to manage care and utilization due to "any willing provider" and direct access laws that limit or eliminate product features that encourage members to seek services from contracted providers or through referral by a primary care provider.
AS A MEDICARE FISCAL INTERMEDIARY, OUR UGS SUBSIDIARY IS SUBJECT TO COMPLEX REGULATIONS. IF IT FAILS TO COMPLY WITH THESE REGULATIONS, IT MAY BE EXPOSED TO CRIMINAL SANCTIONS AND SIGNIFICANT CIVIL PENALTIES.
Health Insurance Portability and Accountability Act of 1996 ("HIPAA") includes administrative provisions imposing significant requirements relating to maintaining the privacy of medical information ("Privacy"), establishing uniform health care provider and employer identifiers, requiring use of standardized transaction formats ("Transactions"), and seeking protections for confidentiality and security of patient data ("Security"). The Privacy and Transactions provisions require implementation in 2003. Final HIPAA Security rules were published on February 20, 2003, and the implementation and compliance date is April of 2005. HIPAA is far-reaching and complex, and proper interpretation and practice under the law continue to evolve. Consequently, our efforts to measure, monitor, and adjust our business practices to comply with HIPAA are ongoing. Compliance with HIPAA could require us to make significant changes to our operations and failure to comply could subject us to civil and criminal penalties. The costs of complying with HIPAA are likely to be substantial.
WE ARE SUBJECT TO LITIGATION, INCLUDING LITIGATION BASED ON NEW OR EVOLVING LEGAL THEORIES, THAT COULD SIGNIFICANTLY AFFECT OUR RESULTS OF OPERATIONS.
Due to the nature of our business, we are subject to a variety of legal actions relating to our business operations, including:
o disputes related to our non-risk business, including actions alleging breach of fiduciary duties, claim administration errors or other violations of federal or state laws;
o customer audits of our compliance with our plan obligations; and
In addition, plaintiffs continue to bring new types of legal claims against managed care companies. Recent court decisions and legislative activity increase our exposure to these types of claims. In some cases, plaintiffs may seek class action status and substantial economic, non-economic, or punitive damages. The loss of even one of these claims, if it resulted in a significant damage award, could have a significant adverse effect on our financial condition or results of operations. This risk of potential liability may make reasonable settlements of claims more difficult to obtain. We cannot determine with any certainty what new theories of recovery may evolve or what their impact may be on the managed care industry in general or on us in particular. We believe we have made adequate reserves in our financial statements against all litigation known to us, but we cannot be certain our estimates of probable outcomes of such litigation will prove to be accurate.
AS A HOLDING COMPANY, WE ARE DEPENDENT ON DIVIDENDS FROM OUR SUBSIDIARIES.
We are a holding company whose assets consist largely of the outstanding shares of common stock of our subsidiaries. As a holding company, we depend on dividends from our insurance company subsidiaries. The ability of our insurance subsidiaries to pay dividends is subject to regulation under Wisconsin law. See Item 1 "Business - Regulation - Insurance Regulation." Our ability to pay our shareholders dividends in the future and meet our obligations, including paying operating expenses and debt service on our outstanding and future indebtedness, will depend upon the receipt of dividends from our subsidiaries. An inability of our subsidiaries to pay dividends in the future in an amount sufficient for us to meet our financial obligations may materially adversely affect our business, financial condition, and results of operations.
PROVISIONS IN OUR AMENDED AND RESTATED ARTICLES OF INCORPORATION AND BYLAWS AND WISCONSIN LAW MAY MAKE IT MORE DIFFICULT FOR A THIRD PARTY TO ACQUIRE US, AND MY LIMIT OR ELIMINATE INCREASES IN STOCK PRICE BASED ON "TAKEOVER" SPECULATION.
These provisions may make it more difficult for a third party to acquire us in a transaction that our board of directors has not negotiated or approved but in which our shareholders may receive a premium for their shares. Also, these provisions can deter a party from acquiring a significant ownership position in us prior to submitting an offer to our board of directors, and, as a result, our common stock may trade at lower prices relative to other companies that do not have similar ownership limitations in their charter documents.
REGISTRATION RIGHTS OF THE FOUNDATION AND THE OVERSIGHT OF THE OCI MAY INHIBIT OUR ABILITY TO RAISE FUNDS THROUGH EQUITY OFFERINGS.
We may desire the flexibility to raise funds quickly by selling our common stock in the equity markets for general corporate purposes or to take advantage of acquisition and other investment opportunities that may arise in the future. The Registration Rights Agreement that we entered into with the Foundation in the Combination could limit or make more difficult our ability to raise funds through equity offerings.
o adversely affect our ability to compete in the markets we serve; and
OUR DIRECTORS ARE GENERALLY ABLE TO CONTROL THE OUTCOMES OF MATTERS, OTHER THAN CHANGE OF CONTROL PROPOSALS, THAT ARE SUBMITTED TO OUR SHAREHOLDERS FOR A VOTE AS LONG AS THE FOUNDATION BENEFICIALLY OWNS A SUBSTANTIAL PERCENTAGE OF THE OUTSTANDING SHARES OF OUR COMMON STOCK.
The Foundation is obligated to reduce its ownership of our common stock to 50% of the outstanding shares by March 23, 2004 and to 20% by March 23, 2006. If the Foundation fails to meet its divestiture requirements, we are entitled to arrange for the sale of the Foundation's shares. The Foundation has the right to require us to periodically file registration statements covering sales of stock by the Foundation.
From time to time, the stock price and the number of shares traded of companies in the health care industry experience periods of significant volatility. Company-specific issues and developments generally in the health care industry and in the regulatory environment may cause this volatility. Our stock price may fluctuate in response to a number of events and factors, including:
o operating and stock price performance of other companies that investors may deem comparable;
Consolidated Balance Sheets as of December 31, 2002 and 2001...............52 Consolidated Statements of Operations for the years ended December 31, 2002, 2001, and 2000.........................................53 Consolidated Statements of Changes in Shareholders' Equity and Comprehensive Income (Loss) for the years ended December 31, 2002, 2001, and 2000.........................................54 Consolidated Statements of Cash Flows for the years ended December 31, 2002, 2001, and 2000.........................................55 Notes to Consolidated Financial Statements ................................56
We have audited the accompanying consolidated balance sheets of Cobalt Corporation (the "Company") as of December 31, 2002 and 2001, and the related consolidated statements of operations, changes in shareholders' equity and comprehensive income (loss) and cash flows for each of the three years in the period ended December 31, 2002. Our audits also include the financial statement schedules listed in the index at Item 15(a). These financial statements and schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of the Company at December 31, 2002 and 2001, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2002, in conformity with accounting principles generally accepted in the United States. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein.
1. Organization, Accounting for Conversion and Combination, and Basis of Presentation
Cobalt Corporation ("Cobalt" or the "Company") (formerly known as United Wisconsin Services, Inc. ("UWS")) was created as a result of the combination of UWS and Blue Cross & Blue Shield United of Wisconsin ("BCBSUW") on March 23, 2001 (the "Combination"). On that date, BCBSUW converted from a service insurance corporation to a shareholder owned corporation. Upon conversion, BCBSUW became a wholly-owned subsidiary of UWS through a combination of the two companies. At the time of the conversion and combination, BCBSUW owned 7,949,904 shares representing approximately 46.6% of UWS' outstanding common stock. In exchange for the ownership of BCBSUW, Cobalt issued 31,313,390 shares of newly issued Company common stock to the Wisconsin United for Health Foundation, Inc. (the "Foundation"). The Foundation was established for the sole purpose of benefiting public health in Wisconsin from its earnings in the investment in Cobalt. As of December 31, 2002, the Foundation owned 75.2% of the total outstanding Company common stock (see Note 14, "Stock Offerings").
For financial reporting purposes, the Combination was treated as a reverse purchase transaction, whereby BCBSUW became the acquirer and reporting entity for public company reporting. The consolidated statements of operations, cash flows, and changes in shareholders' equity and comprehensive income (loss) for the year ended December 31, 2001, reflect the operations of the combined UWS and BCBSUW entities effective March 31, 2001 with American Medical Security Group, Inc ("AMSG") accounted for using the equity method. Prior to March 31, 2001, the consolidated financial statements include the operations of BCBSUW, its wholly-owned subsidiary, United Government Services, LLC ("UGS") and BCBSUW's investment in UWS and AMSG. During 2002, Government Health Services, LLC ("GHS") was formed to hold UGS and Trust Solutions, LLC ("TS").
The consolidated financial statements subsequent to the Combination include the accounts of the Company's wholly-owned insurance subsidiaries (BCBSUW, Compcare Health Services Insurance Corporation ("CompcareBlue"), Unity Health Plans Insurance Corporation ("Unity"), Valley Health Plan, Inc. ("Valley"), United Wisconsin Insurance Company ("UWIC"), and United Heartland Life Insurance Company ("UHLIC")) and other non-insurance subsidiaries (GHS, UGS, TS, Meridian Resource Company, LLC ("MRC"), Comprehensive Receivables Group, Inc. ("CRG"), United Wisconsin Proservices, Inc. ("Proservices"), and C.C. Holdings, LLC ("CC Holdings")) as continuing operations. All intracompany balances and transactions have been eliminated in consolidation.
1. Organization, Accounting for Conversion and Combination, and Basis of Presentation (Continued)
Included are the pro forma (unaudited) consolidated statements of operations of the Company for the years ended December 31, 2001 and 2000, presented as if the Combination had occurred at the beginning of each year presented. Pro forma basic and diluted EPS calculations are based on the pro forma weighted average of the Company's outstanding common stock during the period presented.
Investments are classified as either held-to-maturity or available-for-sale. Investments that the Company has the intent and ability to hold to maturity are designated as held-to-maturity and are stated at amortized cost. All other investments are classified as available-for-sale and are stated at estimated fair value based on quoted market prices. The net unrealized gain or loss on investment securities classified as available-for-sale, net of deferred income taxes, is included in accumulated other comprehensive income (loss) in shareholders' equity. Realized gains and losses from the sale of available-for-sale securities are calculated using the first-in, first-out basis. Included in investments classified as available-for-sale at December 31, 2002 are convertible debentures and convertible preferred stock. No convertible securities were held at December 31, 2001. The convertible securities are considered hybrid instruments, and the Company separately accounts for the derivatives embedded therein. In accordance with Statement of Financial Accounting Standards ("SFAS") No. 133, "Accounting for Derivatives and Hedging Activities," the embedded derivatives are reflected in the accompanying consolidated balance sheets at fair value, and changes in fair value are recognized currently as realized investment gains (losses).
Investments in affiliates in which the Company does not have control, but has the ability to exercise significant influence over operating and financial policies, are accounted for by the equity method.
When the fair value of an investment is lower than its cost and such decline is determined to be other-than-temporary, the carrying value of the investment is written down to fair value and the write-down is recorded as a realized loss.
The Company's goodwill represents the excess of the market value over the adjusted book value for UWS common stock acquired by BCBSUW and the excess of cost over the fair value of other businesses acquired. Beginning January 1, 2002 with the adoption of SFAS No. 142, "Goodwill and Other Intangible Assets," goodwill is no longer amortized, and is tested for impairment annually. Prior to January 1, 2002, goodwill was amortized using the straight-line method over its estimated life of 16 years.
In addition to the amortization above, during 2000 the Company wrote-off $2,434,000 of deferred acquisition costs associated with the Medicare+Choice line of business.
Due to the numerous factors influencing this liability, the Company develops a series of estimates based upon generally accepted actuarial projection methodologies using various scenarios with respect to claim submission and payment patterns and cost trends. The Company's policy is to record management's best estimate of medical and other benefits payable that adequately provides for future payments of claims incurred but not paid under moderately adverse conditions. Deviations (positive or negative) between actual experience and estimates used to establish the liability are recorded in the period of claim payment. The Company continually monitors the reasonableness of the assumptions and judgments used in prior estimates by comparison with actual claim patterns and considers this information in future estimates.
As a result of management's assessment of the profitability of its Medicare+Choice line of business, the Company recorded a provision of $3,617,000 in 2000 for probable future losses (premium deficiency). Effective January 1, 2002, the Company exited this business, therefore no PDR was needed as of December 31, 2001 or thereafter.
Certain premiums and benefits are assumed from and ceded to other insurance companies under various reinsurance agreements. The ceded reinsurance agreements provide the Company with increased capacity to write larger risks and maintain its exposure to loss within its capital resources. The ceding company is contingently liable on reinsurance ceded in the event that the reinsurers do not meet their contractual obligations.
The Company provides certain health and life insurance benefits to retired employees. These benefits are accrued in accordance with SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other than Pensions."
As a fiscal intermediary for Medicare, the Company is reimbursed for administrative costs incurred in providing this service. In addition, the Company also administers various uninsured programs sponsored by federal and certain state governments (including State of Wisconsin Medicaid as a subcontractor) and private corporations, for which the Company receives administrative fees. These revenues are recognized as the services are performed.
In accordance with SFAS No. 109, "Accounting for Income Taxes," deferred tax assets and liabilities are recognized for the estimated future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and tax credit carryforwards. Deferred tax assets and liabilities are measured using tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. A valuation allowance is recorded on deferred tax assets when management determines that it is "more likely than not" that the tax benefits will not be realized.
Regulatory initiatives undertaken at the state or federal level to reform the health care industry and/or to reduce the escalation in health care costs or to make health care more accessible, could adversely affect the Company's profitability.
Basic earnings per share ("EPS") is computed by dividing income available to common shareholders by the weighted average number of common shares outstanding during the period. Diluted earnings per share is calculated similarly, except that it includes the dilutive effect of the assumed exercise of stock options. Stock options are not considered in the calculation of EPS in loss years because their inclusion would have an antidilutive effect. The 7,949,904 shares of Cobalt Corporation common stock owned by BCBSUW are accounted for as if they were treasury stock, and are not included in the calculation of outstanding shares. EPS for the year ended December 31, 2001 was calculated based on 38,434,459 weighted average shares outstanding, which assumes that the 31,313,390 of newly issued shares to the Foundation were outstanding for the entire three months ended March 31, 2001. EPS was not presented for the year ended December 31, 2000 because the Company was a service insurance corporation.
At December 31, 2002, the Company had a stock option plan as described in Note 18. SFAS No. 123, "Accounting for Stock-Based Compensation," establishes financial accounting and reporting standards of stock-based compensation plans. SFAS No. 123 allows two alternative accounting methods: (1) a fair value based method, or (2) an intrinsic value based method which is prescribed by Accounting Principles Board Opinion ("APB") No. 25, "Accounting for Stock Issued to Employees" and related interpretations. The Company has elected to account for its stock-based incentive plans and awards under APB No. 25, and has adopted the disclosure requirements of SFAS No. 123, as amended. Under APB No. 25, no stock-based employee compensation cost is reflected in net income to the extent that stock options granted have an exercise price equal to the market value of the underlying common stock on the date of the grant and no modifications are made to option terms subsequent to their grant date.
As calculated using the Black-Scholes model, the weighted average fair value of granted options, in which the exercise price equaled the market price on the date of the grant, was $6.88 per share for 2002 and $3.69 for 2001. Prior to the Combination, the Company had no stock based compensation programs other than a stock appreciation rights ("SAR") plan (see Note 18). Thus, proforma information has not been presented for the year ended December 31, 2000.
The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions including the expected stock price volatility. Since the Company's stock options have characteristics significantly different from those of traded options and because changes in the subjective input assumptions can materially affect the fair value estimates, in management's opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its stock options.
The accompanying consolidated financial statements have been prepared in accordance with GAAP, which requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. The more significant estimates include medical and other benefits payable, carrying value of investments, fair value of goodwill and intangible assets, tax assets and liabilities, litigation and settlement costs, and allowance for doubtful accounts. Actual results could differ from those estimates.
In June of 2002, the Financial Accounting Standards Board ("FASB") issued SFAS No. 146, "Accounting for Costs Associated with Exit or Disposal Activities." This statement addresses financial accounting and reporting costs associated with exit or disposal activities and generally requires costs to be recognized when a liability is incurred. The Company intends to adopt the provisions of SFAS No. 146 for all exit or disposal activities that are initiated after December 31, 2002 in accordance with this statement. For exit and disposal activities initiated prior to December 31, 2002, the Company followed existing accounting guidance contained in Emerging Issues Task Force ("EITF"), "Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (Including Certain Costs Incurred in a Restructuring)," under which costs are recognized at the date the entity commits to an exit plan.
The net medical and other benefits payable above excludes reinsured reserves of $35,318,000 and $28,994,000 as of December 31, 2002 and 2001, respectively. There were no reinsured reserve balances as of December 31, 2000. Reinsured reserves are classified as assets in the accompanying consolidated balance sheets. Changes in prior year estimates and payments related to prior years in the 2001 column in the above table include amounts relating to claims incurred prior to 2001 for BCBSUW and claims incurred prior to March 31, 2001 for the former UWS companies. Net medical and other benefits payable at December 31, 2002 and 2001 include discounted reserves, net of reinsurance, of $13,895,000 and $11,865,000, respectively (net of discount of $4,791,000 and $4,295,000, respectively) for disability and waiver of premiums claims. These reserves were discounted using a weighted average discount rate of 6.5% and 6.9% for 2002 and 2001, respectively.
The Company's December 31, 2000 loss reserves contemplated, among other estimates, continued deterioration in claim experience on Medicare+Choice consistent with that experienced earlier in the year. Actual claims paid were less than anticipated. The net medical and other benefits payable assumed from UWS during 2001 developed slightly unfavorably due to the transition of provider contracts from a capitated to fee for service basis.
During late 1999, the Company overestimated claim payment lag times in connection with a claim adjudication system conversion. This resulted in favorable development of December 31, 1999 estimated benefits payable.
Amortized Estimated Cost Fair Values ------------------------------ (In thousands) Available-for-sale: Due in one year or less $ 12,631 $ 12,807 Due after one through five years 108,528 112,556 Due after five through ten years 90,901 95,310 Due after ten years 70,934 73,915 ------------------------------ 282,994 294,588 Mortgage-backed securities 41,849 43,205 ------------------------------ $324,843 $337,793 ==============================
At December 31, 2002, the insurance subsidiaries had debt securities on deposit with various state insurance departments with carrying values of approximately $12,780,000, which are classified as investments held-to-maturity in the accompanying consolidated balance sheets.
AMSG offers small group PPO and life products. The Company accounted for its investment in AMSG under the equity method of accounting through May 31, 2002. Because of decreased ownership and the fact that the Company no longer had the ability to exercise significant influence over AMSG, the equity method of accounting was discontinued subsequent to May 31, 2002 and the investment in AMSG was reclassified in the Company's consolidated balance sheets from investment in affiliates to investments available-for-sale.
AMSG repurchased 1,400,000, 367,262, and 1,261,870 shares of its outstanding common stock for cash amounts of $18,130,000, $2,216,000, and $8,292,000 in 2002, 2001, and 2000, respectively. AMSG's repurchase of common stock from parties other than the Company increased the Company's percentage ownership of AMSG. Increases in the Company's share of net assets of AMSG resulting from these share repurchases are reported in the accompanying consolidated statements of changes in stockholders' equity and comprehensive income (loss) during periods in which the Company recorded its investment in AMSG under the equity method of accounting.
Total liabilities $243,615 Shareholders' equity 229,400 ------------------------- Total liabilities and shareholders' equity $473,015 =========================
Information for the six months ended June 30, 2002, as reported in the unaudited statements of operations included in AMSG's (NYSE: AMZ) report on Form 10-Q dated August 13, 2002, is presented below. The periods presented include the periods during which the Company recorded its investment in AMSG under the equity method of accounting.
The Company's investment in UWS through the Combination (see Note 1) was included in investment in affiliates. The Company owned approximately 46.6% of the total UWS shares outstanding as of December 31, 2000 and prior to the Combination.
During 2002, the Company recorded additional goodwill of $13,026,000 relating to the acquisition of CMSI (see Note 23). In addition, goodwill relating to the Combination was reduced by $2,175,000 relating to a corresponding decrease in a portion of the valuation allowance established against net deferred income tax assets recorded by UWS prior to the Combination.
Insured medical products $63,090 Specialty managed care products and services 26,792 Government services - Self-funded products 13,026 ----------- Total $102,908 ===========
The following table illustrates net income (loss) and net income (loss) per share adjusted to exclude the effects of goodwill amortization in accordance with SFAS No. 142:
The Company is a party to certain provider arrangements in conjunction with Unity and Valley, which include profit-sharing payments to certain providers and repurchase provisions. Management believes that control of Unity and Valley is not temporary because exercise of the repurchase options is not probable. Repurchase would not provide a substantial economic benefit to the option holders and would require regulatory approval pursuant to change of control regulations.
Total revenues subject to repurchase options, pursuant to the various purchase agreements, were $289,259,000 for 2002. Profit sharing expenses related to these provider arrangements are calculated based on the profitability of the respective subsidiary and totaled $1,685,000 in 2002. Net income subject to repurchase options, pursuant to those provider arrangements, totaled $5,399,000 for 2002. Total assets and total net assets subject to repurchase options were $75,598,000 and $31,113,000, respectively, at December 31, 2002. The Company had no business subject to repurchase options for the periods prior to the Combination (see Note 1).
Property and equipment are stated at cost less accumulated depreciation as follows:
Depreciation expense related to property and equipment totaled $10,021,000, $9,800,000, and $6,278,000 in 2002, 2001, and 2000, respectively.
During 2002, 2001, and 2000, the Company reduced the carrying amount of certain computer software costs to net realizable value through a charge to income in the amount of $880,000, $329,000, and $223,000, respectively. This charge is included in selling, general, administrative, and other expense in the accompanying consolidated statements of operations and is reflected primarily in the Company's insured medical products and specialty managed care products and services segments.
On December 31, 2001, the Company originated a term business note ("term note") for the corporate holding company with a commercial bank for $7,500,000. The term note had an adjustable rate of interest with payment of principal and interest due February 15, 2002. The term note was extended and renegotiated, with payment of principal and interest due in quarterly installments beginning June 30, 2002 and ending June 30, 2003. Interest was calculated at a rate equal to the London Interbank Offered Rate ("LIBOR") plus 1.5%, adjusted monthly. Interest expense recorded during 2002 on the term note was $152,000 at a weighted average interest rate of 3.36%. During 2002, the note was repaid in full by the Company.
During 2002, the Company entered into a three-year revolving credit arrangement ("revolver") with a commercial bank. This revolver provides for borrowings up to $30,000,000 by the Company with the availability declining to $25,000,000 after one year and to $15,000,000 after two years. The revolver is collateralized by the common stock of BCBSUW and CompcareBlue. The revolver bears interest at a rate of LIBOR plus 1.5% to 2.5% depending on the timing and amount of the borrowings. A commitment fee of 3/8% annually is payable quarterly on the unused portion of the revolver.
The Company also has a line-of-credit ("LOC") with a commercial bank, which permits aggregate borrowings among certain subsidiaries, excluding the corporate holding company, up to $20,000,000. The LOC has an adjustable rate with interest payments due monthly. The outstanding LOC balance was $7,500,000 and $7,850,000 as of December 31, 2002 and 2001, respectively. Interest expense on the LOC was $126,000, $560,000, and $300,000 in 2002, 2001, and 2000, respectively. The weighted average interest rate on the LOC was 3.89%, 3.90%, and 8.10% in 2002, 2001, and 2000, respectively.
2003 $12,451 2004 10,000 2005 15,000 Thereafter - ---------- Total debt 37,451 Less-current portion 12,451 ---------- Long-term debt $25,000 ==========
The Company and Health Care Service Corporation ("HCSC") (the parent corporation of BlueCross BlueShield of Illinois) each owned a 50% interest in United Heartland of Illinois, Inc. ("UHIL"), a managing general agent for workers' compensation business in Illinois. Premium receivable related to UHIL of $4,952,000 at December 31, 2001 is reported in Due from Affiliates in the accompanying consolidated balance sheets. Effective December 31, 2002, the Company acquired the remaining 50% interest in UHIL from HCSC in return for assuming certain lease obligations equal to the equity value of HCSC's interest in UHIL. UHIL was dissolved and its operations were combined with UWIC at that date.
The Company and its subsidiaries file a consolidated federal income tax return. Separate state income tax returns are filed by each subsidiary, except GHS and CC Holdings, which are limited liability companies and are included in their parent's state income tax filings.
The Company had net federal income tax receivables of $6,376,000 and $10,314,000 at December 31, 2002 and 2001, respectively, included in prepaid expenses and other current assets. These amounts include a payment of $11,576,000 made to the Internal Revenue Service ("IRS") to close the 1987 to 1992 tax years with respect to further audit assessments. The Company was not required to make this payment and is disputing the 1987 proposed tax adjustments on which the assessments were based. A motion for partial summary judgment has been filed with the U.S. Court of Federal Claims, and the Company expects to prevail in this matter.
As of December 31, 2002, the Company has federal tax loss carryforwards totaling $63,652,000 and related alternative minimum tax ("AMT") loss carryforwards totaling $43,554,000, both of which expire in the years 2018 through 2020. The Company has state net business loss carryforwards totaling $105,180,000 at December 31, 2002, which expire in the years 2011 through 2017. The income tax benefits related to the majority of these tax carryforwards have been recognized in prior years' financial statements. As a result, the eventual use of these tax carryovers will not materially affect income tax expense. These tax loss carryforwards do not include amounts relating to the Company's intangibles deductions or conversion payment deduction, as discussed below.
The Company's federal income tax returns are routinely audited by the IRS. The 1984 and 1986 through 1992 (excluding 1990) tax years are closed to further tax assessments. All years from 1993 to present were open as of December 31, 2002. In management's opinion, adequate tax liabilities have been established for all open audit years.
A portion of the Company's deferred tax valuation allowance represents amounts recorded through charges to income tax expense. Subsequent reversals of such amounts are credited to income tax expense. Such reversals reflected in income tax expense (benefit) in the accompanying consolidated statements of operations during the years ended December 31, 2002 and 2001, were $18.7 million and $1.5 million, respectively, due primarily to the Company's utilization of net operating loss carryforwards.
The Company, through GHS, provides administrative, program integrity, and consulting services in connection with publicly funded health care programs. These services are provided through two subsidiaries of GHS: UGS and TS. Through UGS, the Company serves as a fiscal intermediary for Medicare and a provider of claim processing and administrative services in conjunction with various other government programs. Through TS, the Company provides benefit integrity and data analysis services as a Program Safeguard Contractor ("PSC") for Medicare.
Year ended December 31, 2002 2001 2000 -------------------------------------- (In thousands) UGS: Number of claims processed 53,964 47,140 36,320 Amount of claims paid $29,535,621 $25,255,210 $13,194,510 Administrative fees received $110,550 $117,192 $70,305
In conjunction with the assignment of a lease to a third party, the Company has guaranteed the payment of the remaining lease payments in the event that the assignee is unable to pay the lessor the payments due under the lease agreements. Annual lease payments under this assigned lease are approximately $925,000 annually and the lease term runs through 2010.
The Company is involved in various legal actions occurring in the normal course of business. In the opinion of management, adequate provision has been made for losses that may result from these actions and, accordingly, the outcome of these proceedings is not expected to have a material adverse effect on the consolidated financial statements.
The common stock of Cobalt has no par value or stated value. The number of authorized, issued, and outstanding shares of common stock are as follows:
Authorized 75,000,000 75,000,000 Issued (includes 7,949,904 shares owned by BCBSUW, see Note 1) 49,594,488 48,542,947 Outstanding 41,644,584 40,593,043
The Company's insurance subsidiaries are required to file financial statements with the Office of the Commissioner of Insurance of the State of Wisconsin ("OCI") and other state insurance regulators. Such financial statements are prepared in accordance with statutory accounting practices ("SAP") prescribed or permitted by the OCI, which differ from GAAP under which the accompanying consolidated financial statements are prepared. Significant differences between SAP and GAAP include certain valuations of investments, calculations of discounted claim reserves, non-recognition of certain assets (primarily health-care receivables, premium receivables greater than 90 days, property and equipment, and certain intracompany receivable balances), and recognition of deferred income tax assets based on criteria, which vary from GAAP. While the OCI has the authority to permit insurers to deviate from prescribed SAP, none of the Company's insurance subsidiaries regulated by the OCI have received approval to adopt any such practices.
Operating losses incurred during 1999 through 2001 reduced the statutory surplus of Cobalt's insurance subsidiaries. Despite these operating losses and the implementation of changes in statutory accounting effective January 1, 2001, the Company complied with minimum capital and liquidity requirements of the OCI and the Association during 2001, 2000, and 1999. The Company maintained compliance, in part, by contributing regulated and non-regulated subsidiaries to regulated entities and by collateralizing certain intracompany debt obligations with the common stock of affiliated entities. Following a review by the OCI of these intracompany transactions, Cobalt agreed with the OCI as to how these transactions should be treated for surplus and capital calculations. In addition, the Company prepared a plan of action to satisfy these intracompany obligations and strengthen the Company's capital to assure that the Company's insurance subsidiaries continue to satisfy the minimum capital and liquidity requirements of the OCI and the Association.
o Sell certain non-regulated subsidiaries owned by the Company for cash and/or notes prior to October 1, 2002. On March 29, 2002, the Company sold its behavioral health and medical management subsidiary, Innovative Resource Group, LLC ("IRG") (see Note 21). o Reduce BCBSUW's investment in AMSG common stock from 45% of the shares outstanding to less than 20% through public or private offerings during 2002. The Company reduced its investment in AMSG to 10.7% as of December 31, 2002, raising $73.9 million in net proceeds at BCBSUW. On January 3, 2003, the Company sold its remaining investment in AMSG raising an additional $18.7 million in net proceeds at BCBSUW. o Obtain debt financing at the Company's corporate holding company from one or more institutional lenders to fund holding company liquidity needs including the repayment of the collateralized intracompany debt obligations between the holding company and its regulated subsidiaries. The Company has obtained a $30.0 million revolver (see Note 10). During the third quarter of 2002, the Company repaid its intracompany obligation to UWIC of $22.8 million. In October 2002, the $70.0 million note between the Company and BCBSUW was satisfied through the contribution of CompcareBlue to BCBSUW. o Achieve the Company's 2002 projected core earnings, which anticipated breakeven operating results for CompcareBlue for the year ending December 31, 2002 as compared to an operating loss of $32.5 million for the year ended December 31, 2001. The Company exceeded its projected core earnings for the year ended December 31, 2002, including progress toward obtaining breakeven results for CompcareBlue.
17. Fair Value and Concentration of Credit Risk of Financial Instruments
Financial instruments that potentially subject the Company to concentrations of credit risk consist primarily of investment securities. Investment securities are managed within established guidelines that limit the amount invested in securities of a single issuer.
The pension and postretirement plans' assets are comprised primarily of debt, equity, and other marketable securities, including 700,000 shares of Cobalt Corporation common stock, held by the Plan, with a fair value of $9,660,000 and $4,466,000 at December 31, 2002 and 2001, respectively.
Weighted-average assumptions used in developing the projected benefit obligations are as follows:
Postretirement: Discount rate 6.50% 7.00% Health care cost trend: Initial 9.50 10.50 Ultimate 5.50 5.50 Expected return on Plan: Union plan assets 8.00% 8.00%
The effect of a hypothetical 1% increase in the health care cost trend rate would be a $1,366,000 increase in the benefit obligation at December 31, 2002. The effect of a hypothetical 1% decrease in the health care cost trend would be a $1,270,000 decrease in the benefit obligation at December 31, 2002. The initial health care cost trend rate is expected to decrease by 1.0% per year to an ultimate trend rate of 5.5% at December 31, 2006.
The components of the pension credit and postretirement benefit cost, which are included in selling, general, administrative, and other expenses in 2002, 2001, and 2000, are as follows:
Certain employees of the Company participated in a SAR plan, based upon the market value of Cobalt common stock. On December 12, 2001, all 647,390 outstanding SARs were converted to nonqualified stock options of an equal number, and at an exercise price equal to the original strike price of the SARs. As of that date, 347,890 of the outstanding SARs were vested and 281,556 of the SARs had a strike price lower than the current market price. The SARs liability outstanding was reclassified to retained earnings upon conversion of the SARs to options.
The Company has a stock-based compensation plan covering employees and directors that allows for option grants of up to 8,700,000 shares of common stock and cash as incentive or nonqualified stock options. Stock options granted vest at 25% per year over a four-year period.
Options, with respect to 4,936,003 shares, were available for grant as of December 31, 2002.
"Other continuing operations" include activities not directly related to the business segments, unallocated corporate items (i.e. income (loss) from investment in affiliates, amortization of goodwill, and unallocated overhead expenses), and intracompany eliminations. The Company evaluates segment performance based on income or loss from operations before income taxes.
On March 29, 2002, Cobalt sold its behavioral health and medical management subsidiary, IRG, for $17 million in cash and a $10 million (par value) three-year note, which was discounted to yield a market interest rate at the time of sale. As a result, IRG is accounted for as a discontinued operation for all periods presented. The purchase agreement also provides for certain bonuses/penalties to be received/paid between IRG and Cobalt based on IRG revenues generated from Cobalt in future years. In addition, the agreement required certain subsidiaries of Cobalt to enter into seven-year service agreements for the provision of services by IRG.
During the fourth quarter of 2002, the Company announced a plan to consolidate certain operating centers, which will result in the closing of two centers in 2003. During the fourth quarter of 2002, the Company recorded a pre-tax charge of $2,502,000 related to this consolidation in accordance with EITF No. 94-3. This charge is included in selling, general, administrative, and other expenses in the accompanying consolidated statement of operations.
On December 31, 2002, the Company purchased all of the outstanding stock of CMSI, a third party administrator of self-funded employee benefit plans. CMSI is headquartered in Green Bay, Wisconsin and recorded revenue and pre-tax income for the year ended December 31, 2002 of $21,965,000 and $2,316,000, respectively.
Goodwill in the amount of $13,026,000 was recorded in connection with this acquisition, representing the excess of the purchase price over the book value of net assets acquired. The Company is in the process of obtaining third-party valuations of assets acquired, and the allocation of the purchase price to intangible and other assets in accordance with SFAS No. 141, "Business Combinations," is subject to refinement.