On December 28, 2000, we finalized a sale-leaseback transaction that included the majority of our administrative and clinical properties in Las Vegas totaling approximately 478,000 square feet. The lease is for a term of fifteen years and we have the option of five 5-year renewal periods. We lease additional office and clinical space in Nevada totaling approximately 142,000 and 36,000 square feet, respectively. HPN and SHL have retained ownership of a 134,000 square foot administrative building at their Las Vegas headquarters, which serves as the home office and a regional home office for our Nevada HMO and health insurance subsidiaries, respectively.
In conjunction with the Kaiser-Texas acquisition, we purchased eight medical and office facilities with approximately 323,000 square feet of clinical facilities and approximately 175,000 square feet of administrative facilities. These buildings are subject to a deed of trust note with an original balance of $35.2 million and a remaining principal balance of $22.7 million at December 31, 2001. Approximately 47,000 square feet of the clinical and 60,000 square feet of the administrative space are leased by outside parties. The Texas assets have been written down to market value and are included in the assets of discontinued operations. We are actively seeking a buyer for the assets and anticipate selling them by the end of 2002.
The workers' compensation subsidiary is headquartered in Nevada and subleases space from us in one of the buildings included in the sale-leaseback transaction as well as an additional approximately 75,000 square feet of leased office space in California, Colorado and Texas.
We lease approximately 125,000 square feet of office space in other various states as needed for the military subsidiary's administrative headquarters, TRICARE service centers and other regional operations.
Years Ended December 31, 2001 2000 1999 1998 1997 ---------- ---------- ---------- ---------- ---------- (In thousands, except per share data) Statements of Operations Data: OPERATING REVENUES: Medical Premiums......................................... $ 718,994 $ 637,769 $ 594,966 $ 528,759 $481,449 Military Contract Revenues............................... 338,918 330,352 287,398 204,838 4,346 Specialty Product Revenues............................... 183,306 135,844 94,221 148,368 146,211 Professional Fees........................................ 28,985 33,102 42,069 43,609 31,238 Investment and Other Revenues............................ 21,298 22,513 20,411 28,898 25,912 --------- --------- --------- -------- ------- Total.................................................. 1,291,501 1,159,580 1,039,065 954,472 689,156 --------- --------- --------- -------- -------
OPERATING INCOME (LOSS) FROM CONTINUING OPERATIONS................................... 44,832 (32,306) 29,243 65,840 33,860
INTEREST EXPENSE AND OTHER, NET............................. (18,563) (19,362) (16,511) (7,021) (3,873) --------- --------- --------- -------- -------
NET INCOME (LOSS) FROM CONTINUING OPERATIONS.................................... 17,466 (38,793) 10,523 45,023 26,753
EARNINGS PER COMMON SHARE (2): Net Income (Loss) From Continuing Operations............. $0.63 $(1.43) $0.39 $1.65 $0.99 Loss from Discontinued Operations........................ (0.50) (5.94) (0.56) (0.20) (0.09) ----- ----- ----- ------ ----- Net Income (Loss)........................................ $0.13 $(7.37) $(0.17) $1.45 $0.90 ==== ===== ===== ==== ==== Weighted Average Number of Common Shares Outstanding..................................... 27,685 27,142 26,927 27,391 27,013 ====== ====== ====== ====== ======
December 31, 2001 2000 1999 1998 1997 ---------- ---------- ----------- ---------- -------- (In thousands)
Balance Sheet Data: Working Capital..................................... $ 106,119 $ 78,317 $ 264,973 $ 176,775 $219,975 Total Assets........................................ 1,069,962 1,165,100 1,130,112 1,045,120 723,936 Long-term Debt (Net of Current Portion)............. 181,759 224,970 224,076 206,948 90,841 Cash Dividends Per Common Share..................... none none none none none Stockholders' Equity................................ 96,519 90,473 278,412 303,714 265,682
During 2001, we made significant premium rate increases on renewing membership in our Texas HMO health care operations. In the third quarter, we embarked on a recontracting effort to reduce medical costs. It was during this recontracting effort that unsustainable cost increases were revealed, including the operation's primary hospital contract. Although considerable efforts were made to achieve profitability in Texas, it was determined that under the current operating environment, we would not be able to turn around the operating results. At the end of the third quarter, we announced a plan to exit the Texas HMO health care market and subsequently recorded exit-related charges of $17.1 million. We received formal approval from the Texas Department of Insurance to withdraw our operations and we will cease providing HMO health care coverage in Texas on April 17, 2002. In accordance with SFAS No. 144, the Texas HMO health care operations have been reclassified as discontinued operations.
Our consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America. In preparing these financial statements, we are required to make judgments, assumptions and estimates, which we believe are reasonable and prudent based on the available facts and circumstances. These judgments, assumptions and estimates affect certain of our revenues and expenses and their related balance sheet accounts and in disclosing our contingent assets and liabilities. We base our assumptions and estimates primarily on historical experience and trends and factor in known and projected trends. On an on-going basis, we re-evaluate our selection of assumptions and the method of calculating our estimates. Actual results, however, may differ from our calculated estimates and this difference would be reported in our current operations. The following discusses our most critical accounting policies and estimates.
Military contract revenue is recorded based on the contract price as agreed to by the federal government. The contract was based on prior years' data provided by the government along with assumptions of future trends. The contract contains provisions that adjust the contract price based on actual experience, which we call the bid price adjustment, or BPA, and for government-directed change orders. As the data becomes available from the government, we compare the actual results to the contract assumptions and the estimated effects of these adjustments are recognized on a monthly basis. In addition, we record revenue based on estimates of the earned portion of any contract change orders not originally specified in the contract. The BPA and government-directed change orders are subject to negotiation and we must use our judgment in making our estimates. The actual negotiated price could be substantially different from what we had originally estimated. Any difference would be reported in current operations.
Military contract health care costs are recorded in the period when services are provided to eligible beneficiaries, including estimates for provider costs which have been incurred as of the balance sheet date but not reported to us. We use a variety of actuarial projection methods to make these estimates and we must use our judgment in selecting development factors and assumed trends. Our assumptions, which are in large part related to the same assumptions we use in estimating military contract revenues, could be affected by unanticipated changes, such as new interpretations of contract provisions that result in our having to provide new or extended benefits and changes in our health care delivery system or costs. We must also factor into our assumptions the limited risk sharing that we have with the government in providing health care services. Any substantial errors in our estimates are to a large degree mitigated by the risk-sharing contract provision. Any subsequent changes in an estimate for a prior year would be reflected in the current year's operating results.
Health care medical expenses are recorded in the period when services are provided to enrolled members, including estimates for provider costs which have been incurred as of the balance sheet date but not yet reported to us. We use a variety of actuarial projection methods to make these estimates and we must use our judgment in selecting development factors and assumed trends. Our assumptions could be affected by unanticipated changes, such as adverse legal outcomes, legislative or regulatory changes, new interpretations of existing laws or regulations or disputed contract provisions that result in our having to provide new or extended benefits and changes in our health care delivery system or costs. Any subsequent changes in an estimate for a prior year would be reflected in the current year's operating results.
Reinsurance recoverable primarily represents the estimated amount of unpaid workers' compensation loss and LAE reserves that would be recovered from our reinsurers and, to a lesser extent, amounts billed to the reinsurers for their portion of paid losses and LAE and health care claims. Reinsurance receivable for ceded paid claims is recorded in accordance with the terms of the agreements and reinsurance recoverable for unpaid losses and LAE and medical claims payable is estimated in a manner consistent with the claim liability associated with the reinsurance policy. Any significant changes in the underlying claim liability could directly affect the amount of reinsurance recoverable. Reinsurance recoverable, including amounts related to paid and unpaid losses, are reported as assets rather than a reduction of the related liabilities. Reinsurance contracts do not relieve us from our obligations to enrollees, injured workers or policyholders. If our reinsurers were to fail to honor their obligations because of insolvency or disputed contract provisions, we could incur significant losses. We evaluate the financial condition of our reinsurers to minimize our exposure to significant losses from reinsurer insolvencies.
Deferred income tax assets and liabilities result from temporary differences between the tax basis of assets and liabilities and the reported amounts in the consolidated financial statements that will result in taxable or deductible amounts in future years. Our temporary differences arise principally from certain net operating losses, accrued expenses, reserves that are discounted for tax return purposes, depreciation and impairment charges. We regularly review our deferred tax assets for recoverability based on historical taxable income, projected future taxable income and the expected timing of the reversals of the existing temporary differences.
For a more extensive discussion of our accounting policies, see Note 2, Summary of Significant Accounting Policies, in the Notes to the Consolidated Financial Statements. Review the section "Risk Factors" in this 2001 Form 10-K for a more complete discussion of the risks associated with an investment in our securities.
o A decrease in investment and other revenues of $1.2 million
Medical Premiums from our HMO and managed indemnity insurance subsidiaries increased $81.2 million or 12.7%. The $81.2 million increase in premium revenue reflects a 7.9% increase in Medicare member months (the number of months individuals are enrolled in a plan) and a 10.9% increase in commercial member months. The 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. HMO premium rates for commercial groups increased approximately 6.6%, managed indemnity rates increased approximately 14.6% and Medicare rates increased approximately 4.0%. Over 97% of our Las Vegas, Nevada Medicare members are enrolled in the Social HMO Medicare program. The Centers for Medicare and Medicaid Services, or CMS, formerly known as the Health Care Financing Administration, or HCFA, may consider adjusting the reimbursement factor or changing the program 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 our business. Continued medical premium revenue growth is principally dependent upon continued enrollment in our products and upon competitive and regulatory factors.
Workers' compensation net earned premiums are the end result of direct written premiums, plus the change in unearned premiums, less premiums ceded to reinsurers. Direct written premiums decreased by 7.9% due primarily to a 29% decrease in premium production that was partially offset by a 31% increase in composite premium rates. Ceded reinsurance premiums decreased by 82.7% due to the expiration of our low level reinsurance agreement on June 30, 2000 and a new reinsurance agreement with lower ceded premiums. Direct written premiums decreased from $203.3 million in 2000 to $187.1 million in 2001.
Investment and Other Revenues decreased $1.2 million or 5.4% due primarily to a decrease in the average investment yield during the period offset by an increase in the average invested balance.
o A net increase in underwriting expenses, policyholders' dividends and other operating expenses of $7.5 million related primarily to the increase in net earned premiums.
The higher loss ratio we recorded for the 2001 accident year is in light of the lower premium rates on policies in prior years, inflationary trends in health care costs, the fact that we have seen our reserves develop adversely for the past three years and that projecting ultimate reserves cannot be done with 100% accuracy. We believed it prudent to establish reserves at a higher loss ratio to mitigate any future adverse loss development that may occur.
In the wake of the events of September 11, 2001 and the ensuing hardening of the reinsurance market, we expect our future reinsurance costs to increase and our coverage limits to decrease. We cannot currently estimate what the impact to our operating results will be when we obtain replacement coverage in January 2003. However, any increases in our reinsurance costs, including our retaining more of the risk, will most likely be factored into our premium rates.
Reinsurance contracts do not relieve us from our obligations to enrollees or policyholders. At December 31, 2001, we had over $220.1 million in reinsurance recoverable. We evaluate the financial condition of our reinsurers to minimize our exposure to significant losses from reinsurer insolvencies. At December 31, 2001, all of our reinsurers were rated AA and A+ or better by Fitch Ratings and the A.M. Best Company, respectively. Should these companies be unable to perform their obligations to reimburse us for ceded losses, we would experience significant losses.
Asset Impairment, Restructuring, Reorganization and Other Costs. We did not record any asset impairment, restructuring, reorganization and other costs in 2001. For a discussion of the costs recorded in 2000 and 1999 see the asset impairment, restructuring, reorganization and other costs section for the year ended December 31, 2000 compared to December 31, 1999.
Interest Expense and Other, Net decreased $799,000 or 4.1%. Interest expense related to the revolving credit facility decreased $13.3 million due to a decrease in the average balance of outstanding debt during the period offset by an increase in the weighted average cost of borrowing. Our average revolving credit facility balance was $61 million in 2001 compared to $183 million in 2000. Our average interest rate on the revolving credit facility, including the amortization of deferred financing fees and our interest rate swap agreement, was 10.6% in 2001 compared to 9.9% in 2000. Our average interest rate on the revolving credit facility, excluding the amortization of deferred financing fees and our interest rate swap agreement was 8.1% in 2001 compared to 9.8% in 2000. CII debenture interest decreased by $2.4 million in 2001, primarily as a result of the restructuring of the debentures. The decreases were offset by an increase in interest expense of $9.2 million related to the net financing obligations associated with the sale-leaseback transaction that was completed in December 2000. In 2001, we recorded a loss of $2.4 million on the sale of our Arizona properties compared to a net gain on sale of various assets of $1.1 million in 2000.
Medical Premiums from our HMO and managed indemnity insurance subsidiaries increased $42.8 million or 7.2%. The $42.8 million increase in premium revenue reflects a 1.2% increase in Medicare member months (the number of months individuals are enrolled in a plan) offset by a 1.2% decrease in commercial member months. The 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. HMO premium rates for commercial groups increased approximately 4% in Nevada. Our managed indemnity rates increased approximately 12% and Medicare rates increased approximately 2%.
Military Contract Revenues increased $43.0 million or 14.9%. The increase was primarily attributable to additional accrued bid price adjustment revenues related to a true-up of prior periods' information received from the government in the third quarter of 2000. Partially offsetting this was a decrease recorded in the first quarter for a reduction in the at-risk health care population of beneficiaries as additional beneficiaries enrolled with military treatment facility primary care managers. We are not at-risk for those TRICARE eligibles and receive less revenue related to them from the government.
Net earned premiums are the end result of direct written premiums, plus the change in unearned premiums, less premiums ceded to reinsurers. Direct written premiums increased by 37% due primarily to growth in California and Nevada. Partially offsetting the growth in direct written premiums was an increase in premiums ceded to reinsurers, which increased by 22%. The growth in ceded reinsurance premiums was lower than the growth in direct written premiums primarily due to the expiration of our low level reinsurance agreement on June 30, 2000 and new lower cost reinsurance agreements, all of which reduced the percentage of premiums being ceded. Direct written premiums increased from $148.8 million in 1999 to $203.3 million in 2000.
Medical expenses reported in the first quarter of 2000 included $1.0 million of prior period reserve strengthening. In the second quarter of 2000, we recorded changes in estimate charges of $15.5 million for reserve strengthening primarily due to adverse development on prior years' medical claims and $9.5 million of other non-recurring medical costs primarily related to the write-down of medical subsidiary assets.
During 1999, we reported a premium deficiency medical charge of $8.1 million related to losses in under-performing markets primarily in Arizona and rural Nevada, all of which was used during 1999. Also recorded in medical expenses during the fourth quarter was $7.2 million primarily related to an adjustment to the estimate for medical expenses recorded in previous years, and $6.8 million primarily related to contractual settlements with providers of medical services.
Military Contract Expenses increased $46.8 million or 16.9%. The increase is consistent with the increase in revenues discussed previously. Also, included in military contract expenses are costs incurred to perform specific administrative services, such as health care appointment scheduling, enrollment, network management and health care advice line services, and other administrative functions of the military health care subsidiary.
The loss and LAE reserves recorded as of December 31, 2000 reflect our best estimate of the ultimate loss costs for reported and unreported claims occurring in accident year 2000 as well as those occurring in accident years prior to 2000 and was slightly in excess of our independent actuary's estimate. Workers' compensation claim payments are made over several years from the date of the claim. Until the final payments for reported claims are made, reserves are invested to generate investment income.
Under our low level reinsurance agreement, we reinsured 30% of the first $10,000 of each claim, 75% of the next $40,000 and 100% of the next $450,000. The maximum net loss retained on any one claim ceded under this agreement was $17,000. This agreement covered all policies in force at July 1, 1998 and continued until June 30, 2000 when we exercised an option to extend coverage to all policies in force as of June 30, 2000. For policies effective from July 1, 2000, we obtained excess of loss reinsurance for 100% of the losses above $250,000 and less than $500,000. We already had an existing excess of loss reinsurance agreement that covered 100% of the losses above $500,000. (See Note 6 of Notes to the Consolidated Financial Statements).
The combined ratio is a measurement of the workers' compensation underwriting profit or loss and is the sum of the loss and LAE ratio, underwriting expense ratio and policyholders' dividend ratio. A combined ratio of less than 100% indicates an underwriting profit. Our combined ratio was 115.8% compared to 105.5% for 1999. The increase was primarily due to a higher loss and LAE ratio of 13.4 percentage points and policyholders' dividend ratio of 1.6 percentage points, offset slightly by a decrease in the underwriting expense ratio of 4.7 percentage points. The increase in the loss and LAE ratio was due to an increase in net adverse loss development, which represents 6.6 percentage points of the change in the loss and LAE ratio, and a higher loss and LAE ratio on the 2000 accident year of $8.6 million, which represents 6.8 percentage points of the change in the loss and LAE ratio.
Management adopted a plan in the second quarter of 2000 to discontinue medical delivery operations in Mohave County, Arizona and to sell the real estate assets located there, as well as an underperforming medical clinic in Las Vegas. In connection with the restructuring plans adopted and announced by us in the second quarter of 2000, we re-evaluated the recoverability of certain long-live assets, in accordance with Statement of Financial Accounting Standards No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of", or SFAS No. 121, and Accounting Principles Board Opinion No. 17, "Intangible Assets", or APB No. 17, and determined that the carrying values of certain goodwill and other long-lived assets were impaired.
The $4.3 million of costs recorded in the second quarter of 2000 relate primarily to the write-down of certain receivables as well as an accrual for certain legal settlements.
Charges recorded............................... 27,553 1,983 4,300 33,836 Cash used...................................... (1,389) (302) (1,691) Noncash activity............................... (27,553) (3,000) (30,553) Changes in estimate............................ - ------- ------ ------ ------- Balance, December 31, 2000..................... - 594 4,447 5,041
Benefit for Income Taxes was $12.9 million for 2000 compared to tax expense of $2.2 million for 1999. The effective tax rate for 2000 was 24.9% compared to 17.3% for 1999. The effective tax rates for 2000 and 1999 reflect the non-deductibility of certain portions of goodwill impairment expense recorded during the periods. In addition, during 1999, due to a change in tax law, we were able to utilize a $1.6 million net operating loss carryover that had previously not been recognized in the financial statements due to uncertainty about its realization. Excluding the effect of the items described above, the effective tax rate for both periods was approximately 33.5%. Our ongoing effective tax rate is less than the statutory rate due to tax preferred investments offset by state income taxes.
The cash flow resulting from the change in assets and liabilities of $77.5 million was primarily due to the following:
o a source of cash due to the decrease in the military accounts receivable balance of $32.4 million
o a use of cash due to the decrease in military health care payable of $7.6 million
On November 16, 2001, SMHS entered into a securitization arrangement with General Electric Capital Corporation. The arrangement provides for the sale of SMHS' Federal Government accounts receivable to SMHS Funding, LLC. SMHS Funding is a special purpose limited liability company owned by SMHS and was formed for the purpose of purchasing all receivables of SMHS. This entity is fully consolidated into SMHS. SMHS Funding, LLC may sell an undivided interest in certain of the receivables to a subsidiary of General Electric Capital Corporation in the event that additional financing by SMHS is warranted. This securitization arrangement was not utilized in 2001 and we do not anticipate utilizing it in 2002. (See Note 1 of Notes to the Consolidated Financial Statements).
Cash used in financing activities during 2001 included payments of $81.0 million on debt related items offset by $2.1 million in cash received related to the sale of stock through our employee stock purchase plan. The year 2000 included net proceeds from long-term borrowings (proceeds less payments) of $48.8 million and proceeds of $1.6 million related to the sale of stock through our employee stock purchase plan.
We are also limited in the amount of funds we can invest in our Texas and Military operations. The maximum we can invest in the Military operations is $5 million. We have not invested any of the $5 million as of December 31, 2001. After September 30, 2001, we can invest an additional $5.0 million in the Texas operations and replace the Texas real estate assets with cash and notes up to $46 million. Under the terms of the amended and restated agreement, the use of Sierra funds to pay the outstanding Texas mortgage note of $29.2 million is not considered an investment in the Texas operations. During the fourth quarter of 2001, we invested in Texas the full $5.0 million allowed under the amended and restated agreement. If we had to invest more than we are allowed, we would be required to get a waiver or an amendment to our agreement or be out of compliance. If additional funds are needed by our discontinued Texas HMO health care operations and we do not transfer such funds they may be in violation of certain insurance regulations and we may be required to get a waiver or an amendment to our agreement or be out of compliance. There is no assurance that if we needed a bank waiver or amendment that we would be able to obtain it. Based on the current estimated Texas HMO healthcare run-out costs and recorded reserves, we believe we have adequate funds available and the ability to invest adequate funds in Texas to meet the anticipated obligations.
In September 2001, the California Department of Insurance gave approval to California Indemnity, one of CII Financial's insurance subsidiaries, to pay a dividend of $5.0 million to CII Financial. CII Financial used these funds to pay the remaining $5.0 million in subordinated debentures at maturity.
CII is a holding company and its only significant asset is its' investment in California Indemnity. Of the $8.6 million in cash and cash equivalents it held at December 31, 2001, approximately $8.1 million was designated for use only by the regulated insurance companies. CII has limited sources of cash and is dependent upon dividends paid by California Indemnity. California Indemnity may only pay a dividend without the prior approval of the state insurance commissioner to the extent the cumulative amount of dividends or distributions paid or proposed to be paid in any year does not exceed the amount shown as unassigned funds (reduced by any unrealized gains or losses included in any such amount) on its statutory statement as of the previous December 31. In 2002, California Indemnity can pay dividends of up to $2.1 million without the prior approval of the state insurance commissioner. In 2001, California Indemnity received prior approval to pay an aggregate of $10 million in dividends. We are not in a position to assess the likelihood of obtaining future approval for the payment of dividends other than those specifically allowed by law in each of our subsidiaries' state of domicile.
The following schedule represents our obligations and commitments for long-term debt, capital leases and operating leases. With the exception of our revolving credit facility, the amounts below represent the entire payment, principal and interest, on our outstanding obligations. Based on the outstanding balance of the revolving credit facility of $89 million as of December 31, 2001, we are not required to make any principal payments until the balance is due in 2003.
Discontinued Operations Payments due in less than 1 year................ $188 $ 188 Payments due in 1 to 3 years.................... $ 5,065 47 5,112 Payments due in 4 to 5 years.................... 24,124 24,124 Payments due after 5 years...................... - ------- --- ------ Total Discontinued Operations.............. $ 29,189 $235 $ 29,424 ======= === ======
We have a 2002 capital budget of $16.1 million and we are limited to $19.6 million by our revolving credit facility. The planned expenditures are primarily for the purchase of computer hardware and software, furniture and equipment and other normal capital requirements. Our liquidity needs over the next 12 months will primarily be for the capital items noted above, debt service and funds required to exit the Texas HMO health care market. We believe that our existing working capital, operating cash flow and, if necessary, equipment leasing, divestitures of certain non-core assets and amounts available under our credit facility should be sufficient to fund our capital expenditures and debt service. Additionally, subject to unanticipated cash requirements, we believe that our existing working capital and operating cash flow should enable us to meet our liquidity needs on a long-term basis.
We have a $25 million interest-rate swap agreement that allows us to mitigate the risk of interest rate fluctuation on our credit facility. The intent of the agreement was to keep our interest rate on $25 million of the credit facility relatively fixed. In accordance with Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities" we recorded the interest-rate swap agreement to fair market value as of December 31, 2001. The fair market value indicated that we would need to pay $685,000 to terminate the swap agreement. If the prime rate were to decrease by 1%, we estimate our maximum increase in annual expense associated with the swap to be approximately $250,000.
While we are unable to predict what regulatory changes may occur or the impact on us of any particular change, our operations and financial results could be negatively affected by regulatory changes. For example, any proposals affecting underwriting practices, limiting rate increases, increasing litigation exposure, 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 our business. The continued consideration and enactment of "anti-managed care" laws and regulations by federal and state bodies may make it more difficult for us to manage medical costs and may adversely affect financial results.
In addition to changes in applicable laws and regulations, we are subject to various audits, investigations and enforcement actions. These include possible government actions relating to ERISA, 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 exclusion from participation in government programs. In addition, disclosure of any adverse investigation or audit results or sanctions could negatively affect our reputation in various markets and make it more difficult for us to sell our products and services.
In July 2001, the FASB issued Statement of Financial Accounting Standards No. 142, "Goodwill and Other Intangible Assets", or SFAS No. 142, which is effective January 1, 2002. SFAS No. 142 requires, among other things, the discontinuance of goodwill amortization. In addition, the pronouncement includes provisions for the reclassification of certain existing recognized intangibles as goodwill, reassessment of the useful lives of existing recognized intangibles, reclassification of certain intangibles out of previously reported goodwill and the identification of reporting units for purposes of assessing potential future impairments of goodwill. SFAS No. 142 also requires us to complete a transitional goodwill impairment test six months from the date of adoption. The net amortized goodwill balance at December 31, 2001 was $14.8 million and goodwill amortization during the year was $805,000 and would have been approximately the same amount in 2002 under current accounting standards. We have performed an evaluation of the impact of SFAS No. 142 on our operations and have determined that our recorded goodwill will not be impaired under the guidelines of the pronouncement.
In October 2001, the FASB issued Statement of Financial Accounting Standards No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets", or SFAS No. 144, which is effective for fiscal years beginning after December 15, 2001 with early adoption recommended. SFAS No. 144 requires that long-lived assets that are to be sold within one year must be separately identified and carried at the lower of carrying value or fair value less costs to sell. Long-lived assets expected to be held longer than one year are subject to depreciation and must be written down to fair value upon impairment. Long-lived assets no longer expected to be sold within one year, such as foreclosed real estate, must be written down to the lower of current fair value or fair value at the date of foreclosure adjusted to reflect depreciation since acquisition. As discussed in Note 4 of Notes to the Consolidated Financial Statements, we have elected to adopt SFAS No. 144 effective January 1, 2001.
Management Report on Consolidated Financial Statements.................................................... 47 Independent Auditors' Report.............................................................................. 48 Consolidated Balance Sheets at December 31, 2001 and 2000................................................. 49 Consolidated Statements of Operations for the Years Ended December 31, 2001, 2000 and 1999....................................................................... 50 Consolidated Statements of Stockholders' Equity for the Years Ended December 31, 2001, 2000 and 1999................................................... 51 Consolidated Statements of Cash Flows for the Years Ended December 31, 2001, 2000 and 1999....................................................................... 52 Notes to Consolidated Financial Statements................................................................ 53
The management of Sierra Health Services, Inc. is responsible for the integrity and objectivity of the accompanying consolidated financial statements. The statements have been prepared in conformity with accounting principles generally accepted in the United States of America applied on a consistent basis and are not misstated due to fraud or material error. The statements include some amounts that are based upon the Company's best estimates and judgment.
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, 2001, such systems and controls were adequate to meet the objectives discussed herein.
To the Board of Directors and Stockholders of Sierra Health Services, Inc.:
We have audited the accompanying consolidated balance sheets of Sierra Health Services, Inc. and its subsidiaries as of December 31, 2001 and 2000, and the related consolidated statements of operations, stockholders' equity and cash flows for each of the three years in the period ended December 31, 2001. Our audits also included the financial statement schedules listed in the Index at Item 14 (a)(2). These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits.
ASSETS 2001 2000 ---------- ----------- CURRENT ASSETS: Cash and Cash Equivalents............................................... $ 115,754 $ 157,564 Investments............................................................. 260,762 206,935 Accounts Receivable (Less: Allowance for Doubtful Accounts 2001 - $12,655; 2000 - $12,587)........................... 26,003 26,661 Military Accounts Receivable (Less: Allowance for Doubtful Accounts 2001 - $0; 2000 - $1,212)................................. 40,166 71,390 Current Portion of Deferred Tax Asset .................................. 35,869 46,702 Current Portion of Reinsurance Recoverable.............................. 96,762 91,477 Other Current Receivables............................................... 16,821 15,703 Prepaid Expenses and Other Current Assets............................... 14,819 15,209 Assets Held for Sale.................................................... 3,458 Assets of Discontinued Operations....................................... 28,404 36,192 --------- --------- Total Current Assets............................................... 635,360 671,291
PROPERTY AND EQUIPMENT, NET................................................... 141,451 171,032 LONG-TERM INVESTMENTS......................................................... 8,434 18,093 RESTRICTED CASH AND INVESTMENTS............................................... 26,011 24,461 REINSURANCE RECOVERABLE (Less Current Portion)................................ 123,383 160,227 GOODWILL (Less: Accumulated Amortization 2001 - $6,972; 2000 - $6,167).......................................... 14,782 15,587 DEFERRED TAX ASSET (Less Current Portion)..................................... 77,036 68,253 OTHER ASSETS.................................................................. 43,505 36,156 --------- --------- TOTAL ASSETS.................................................................. $1,069,962 $1,165,100 ========= =========
RESERVE FOR LOSSES AND LOSS ADJUSTMENT EXPENSE (Less Current Portion)............................ 243,363 239,878 LONG-TERM DEBT (Less Current Portion)......................................... 181,759 224,970 OTHER LIABILITIES............................................................. 19,080 16,805 --------- --------- TOTAL LIABILITIES............................................................. 973,443 1,074,627 ---------- ---------
STOCKHOLDERS' EQUITY: Preferred Stock, $.01 Par Value, 1,000 Shares Authorized; None Issued or Outstanding Common Stock, $.005 Par Value, 60,000 Shares Authorized; Shares Issued: 2001 - 29,648; 2000 - 28,815.......................... 148 144 Additional Paid-In Capital................................................ 181,076 177,493 Deferred Compensation..................................................... (1,058) Treasury Stock: 2001 and 2000 - 1,523 Common Stock Shares................. (22,789) (22,789) Accumulated Other Comprehensive Loss...................................... (5,636) (5,667) Accumulated Deficit....................................................... (55,222) (58,708) --------- --------- TOTAL STOCKHOLDERS' EQUITY.................................................... 96,519 90,473 --------- --------- TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY.................................... $1,069,962 $1,165,100 ========= =========
SIERRA HEALTH SERVICES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS For the Years Ended December 31, 2001, 2000 and 1999 (In thousands, except per share data)
OPERATING EXPENSES: Medical Expenses..................................................... 608,757 576,738 534,606 Military Contract Expenses........................................... 331,621 323,265 276,493 Specialty Product Expenses........................................... 188,574 152,733 96,487 General, Administrative and Marketing Expenses....................... 117,717 105,314 94,428 Asset Impairment, Restructuring, Reorganization and Other Costs.................................. 33,836 7,808 --------- --------- --------- Total............................................................. 1,246,669 1,191,886 1,009,822 --------- --------- ---------
(PROVISION) BENEFIT FOR INCOME TAXES................................. (8,803) 12,875 (2,209) --------- --------- ---------
NET INCOME (LOSS).................................................... $ 3,486 $ (199,915) $ (4,631) ========= ========= =========
EARNINGS PER COMMON SHARE ASSUMING DILUTION: Net Income (Loss) From Continuing Operations..................... $0.61 $(1.43) $ 0.39 Loss from Discontinued Operations................................ (0.49) (5.94) (0.56) ----- ----- ----- Net Income (Loss)................................................ $0.12 $(7.37) $(0.17) ==== ===== ====
Accumu- lated Other Compre- Compre- Retained Total hensive hensive Earnings Stock- (Loss) (Loss) (Accumulated holders' Income Income Deficit) Equity -------- ------ ------------ -------
Comprehensive Income: Net Loss.................... $(199,915) (199,915) (199,915) Other Comprehensive Loss, Net of Tax: Unrealized Holding Gain on Available- for-sale Investments 11,092 11,092 11,092 Reclassification Adjustment for Gains Included in Net Loss (696) (696) (696) -------- Comprehensive Loss............. $(189,519) ======== Common Stock Issued in Connection with Stock Plans............ 1,580 -------- -------- ------- BALANCE, DECEMBER 31, 2000..... (5,667) (58,708) 90,473
CASH FLOWS FROM OPERATING ACTIVITIES: Net Income (Loss)......................................... $ 3,486 $(199,915) $ (4,631) Adjustments to Reconcile Net Income (Loss) to Net Cash Provided by (Used for) Operating Activities: Loss from Discontinued Operations..................... 13,980 161,122 15,154 Depreciation and Amortization......................... 25,547 25,495 20,675 Deferred Compensation Expense......................... 342 Provision for Doubtful Accounts....................... 1,232 1,594 7,131 Provision for Asset Impairment........................ 39,079 Loss on Property and Equipment Dispositions........... 2,418 Change in Assets and Liabilities: Other Assets.......................................... (1,863) 1,451 (4,328) Deferred Tax Asset.................................... 2,029 (53,573) (30,363) Reinsurance Recoverable............................... 31,559 (115,036) (69,791) Reserve for Losses and Loss Adjustment Expenses....... 11,151 130,160 32,131 Other Liabilities..................................... 2,646 11,313 29,671 Accounts Receivable................................... (1,786) 1,278 (14,889) Other Current Assets.................................. (639) 6,065 (4,328) Military Accounts Receivable.......................... 32,436 (11,462) 8,857 Military Health Care Payable.......................... (7,598) 34,028 (2,989) Medical Claims Payable................................ 7,258 9,146 6,051 Other Current Liabilities.............................. 2,275 (15,563) 6,168 -------- -------- --------- Net Cash Provided by (Used for) Continuing Operations............................... 124,473 25,182 (5,481) -------- -------- --------
NET CASH (USED FOR) PROVIDED BY DISCONTINUED OPERATIONS............................... (34,033) 11,567 (3,918) -------- -------- --------
NET (DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS.............................................. (41,810) 103,697 (17,647)
SIERRA HEALTH SERVICES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS For the Years Ended December 31, 2001, 2000 and 1999
During the third quarter of 2001, the Company announced its plan to exit the Texas HMO health care market and received formal approval from the Texas Department of Insurance to withdraw its HMO operations in mid-October. The Company will cease providing HMO health care coverage in Texas on April 17, 2002. In accordance with Statement of Financial Accounting Standards No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets" ("SFAS No. 144"), the Company's Texas HMO health care operations have been reclassified as discontinued operations. The individual line items on the consolidated balance sheets have been presented net of discontinued operations with the total assets and liabilities of the discontinued operations presented on one line within current assets and current liabilities, respectively. The results of operations from discontinued operations have been reported net of tax as a separate component of income on the consolidated statements of operations. The cash flows from discontinued operations have been reported as a separate component on the consolidated statements of cash flows. See Note 10 for disclosure on and a description of the discontinued operations.
Medical Premiums. Membership contracts are generally established on an annual basis subject to cancellation by the employer group or Sierra generally upon 60 days written notice. Premiums, including premiums from both commercial and governmental programs, are due monthly and are recognized as revenue during the period in which Sierra is obligated to provide services to members and are net of estimated retroactive terminations of members and groups. Non-Medicare member enrollment is represented principally by employer groups. HPN offers a prepaid health care program to Medicare recipients. Revenues associated with Medicare recipients were approximately $304,734,000, $267,851,000 and $242,753,000 in 2001, 2000 and 1999, respectively. Unearned premium revenue includes payments under prepaid Medicare contracts with the Centers for Medicare and Medicaid Services ("CMS") and prepaid HPN commercial and SHL indemnity premiums.
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 fees 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.
Professional Fees. Revenue for professional medical services is recorded on the accrual basis in the period in which the services are provided. Such revenue is recorded at established rates, net of provisions for estimated contractual allowances.
Military Contract Expenses. This expense consists primarily of costs to provide managed health care services to eligible beneficiaries in accordance with the Company's TRICARE contract. Under the contract, SMHS provides health care services to approximately 639,000 dependents of active duty military personnel and military retirees and their dependents through subcontractor partnerships and individual providers. Health care costs are recorded in the period when services are provided to eligible beneficiaries including estimates for provider costs which have been incurred as of the balance sheet date but not reported to the Company. Also included in military contract expenses are costs incurred to perform specific administrative services, such as health care appointment scheduling, enrollment, network management and health care advice line services and other administrative functions of the military health care subsidiary.
As of and for the year ended December 31, 2001, SMHS has not utilized the facility and is currently incurring an unused facility fee of 0.5% per annum calculated daily and payable monthly in arrears on the unused portion of the maximum purchase limit of $32 million. As the servicer, SMHS receives servicing fees at the rate of 1.0% per annum on the capital investment.
Goodwill. Goodwill has been recorded primarily as a result of various business acquisitions by the Company. Amortization has been recorded on a straight line basis over periods not exceeding 40 years. The Company has periodically evaluated the carrying value of its intangible assets. The Company utilized the discounted cash flow method for evaluating the recoverability of goodwill. Future cash flows are estimated based on Company projections and are discounted based on the interest rates approximating long-term bond yields.
In connection with the restructuring plans adopted and announced by the Company in the second quarter of 2000, the Company re-evaluated the recoverability of certain long-lived assets, primarily those associated with the Texas HMO health care operations, in accordance with Statement of Financial Accounting Standards No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of" ("SFAS No. 121") and Accounting Principles Board Opinion No. 17, "Intangible Assets" ("APB No. 17"), and determined that the carrying value of certain goodwill was impaired. In assessing the asset impairment of the long-lived assets, the Company first allocated a portion of related goodwill to the fixed assets to be disposed of, in accordance with SFAS No. 121. The remainder of the related goodwill was then assessed for recoverability in accordance with APB No. 17 based on projected discounted cash flows and an impairment of $141,506,000 was recorded. Of the total impairment, $126,387,000 was related to and has been recorded as part of discontinued operations. See Note 10 and Note 17 for a description of the primary facts and circumstances related to the impairment.
Income Taxes. The Company accounts for income taxes using the liability method. Deferred income tax assets and liabilities result from temporary differences between the tax basis of assets and liabilities and the reported amounts in the consolidated financial statements that will result in taxable or deductible amounts in future years. The Company's temporary differences arise principally from certain net operating losses, accrued expenses, reserves, depreciation and impairment charges.
(In thousands, except per share data) Years ended December 31, 2001 2000 1999 ---- ---- ---- Income (loss) from continuing operations........................ $ 17,466 $ (38,793) $ 10,523 Loss from discontinued operations............................... (13,980) (161,122) (15,154) ------- -------- ------- Net income (loss)............................................... $ 3,486 $ (199,915) $ (4,631) ======= ======== =======
Earnings per common share: Income (loss) from continuing operations........................ $ 0.63 $ (1.43) $ 0.39 Loss from discontinued operations............................... (0.50) (5.94) (0.56) ------ ------- ------- Net income (loss).............................................. $ 0.13 $ (7.37) $ (0.17) ====== ======= =======
(In thousands) 2001 2000 ---------- ----------- Land................................................... $ 11,263 $ 14,218 Buildings and Improvements............................. 101,822 118,879 Furniture, Fixtures and Equipment...................... 39,565 39,975 Data Processing Equipment and Software................. 96,405 88,439 Software in Development and Construction in Progress......................................... 2,424 5,816 Less: Assets Held for Sale............................. (3,458) Accumulated Depreciation ..................... (110,028) (92,837) -------- ------- Property and Equipment, Net........................ $ 141,451 $171,032 ======== =======
Sale-Leaseback. On December 28, 2000, the Company sold the majority of its Las Vegas, Nevada administrative and medical clinic real estate holdings in a sale-leaseback transaction. As part of the transaction, the Company financed a portion of the sales price with mortgage notes receivable of $22.2 million and provided deposits of $4.3 million. The mortgages and deposits constitute continuing involvement as defined in Statement of Financial Accounting Standards No. 98, "Accounting for Leases" ("SFAS No. 98"), and as such the transaction did not qualify as a sale. In accordance with SFAS No. 98, the Company recorded the transaction as a financing obligation of $113,659,000, offset by the mortgage notes receivable of $22,200,000. The net book value of the assets included in the transaction was $86,890,000 at December 31, 2000. For assets that do not qualify for sale treatment, depreciation expense and interest expense are recognized on the net book value of the assets and net financing obligation outstanding, respectively.
During 2001, the Company received full payment on the outstanding mortgage notes receivable associated with three of the medical clinics. This cured the continuing involvement criteria from SFAS No. 98 and the clinics then qualified as a sale. To record the sale, the Company retired the assets and their associated accumulated depreciation and financing obligation and recorded a deferred gain to be recognized over the remaining 14 year term of the lease. The impact of the sale of the three clinics was a net reduction of $13.4 million in property and equipment, a net reduction of $14.6 million in the associated financing obligation and a deferred gain of $6.1 million. As of December 31, 2001, the remaining financing obligation was $90,810,000, offset by mortgage notes receivable of $16,862,000.
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 are stated at their fair value. Fair value is estimated primarily from published market values as of the balance sheet date. Gross realized gains on investments for 2001, 2000 and 1999 were $1,098,000, $494,000 and $334,000, respectively. Gross realized losses on investments for 2001, 2000 and 1999 were $771,000, $1,566,000 and $733,000, respectively.
Gross Gross Amortized Unrealized Unrealized Fair (In thousands) Cost Gains Losses Value -------------- ------------- ------------- ----------- Available-for-Sale Investments: Classified as Current: U.S. Government and its Agencies........................... $210,949 $1,129 $ 7,494 $204,584 Municipal Obligations......................... 16,274 31 394 15,911 Corporate Bonds............................... 29,572 81 2,110 27,543 Other......................................... 851 851 ------- ----- ------ ------- Total Debt Securities...................... 257,646 1,241 9,998 248,889 Preferred Stock............................... 8,884 40 50 8,874 ------- ----- ------ ------- Total Current.............................. 266,530 1,281 10,048 257,763 ------- ----- ------ -------
Classified as Restricted: U.S. Government and its Agencies........................... 626 24 650 Municipal Obligations.......................... 636 29 607 Corporate Bonds............................... 1,114 42 1,156 ------- ----- ------ ------- Total Restricted ................................. 2,376 66 29 2,413 ------- ----- ------ ------- Total Held-to-Maturity.................. $ 13,809 $ 263 $ 302 $ 13,770 ======= ===== ====== =======
Gross Gross Amortized Unrealized Unrealized Fair (In thousands) Cost Gains Losses Value -------------- ------------- ------------- ----------- Available-for-Sale Investments: Classified as Current: U.S. Government and its Agencies........................... $145,610 $284 $6,761 $139,133 Municipal Obligations......................... 20,303 41 549 19,795 Corporate Bonds............................... 41,040 62 1,659 39,443 ------- --- ----- ------- Total Debt Securities............................. 206,953 387 8,969 198,371 Preferred Stock............................... 7,957 50 231 7,776 ------- --- ----- ------- Total Current .................................... 214,910 437 9,200 206,147 ------- --- ----- -------
Held-to-Maturity Investments: Classified as Current: U.S. Government and its Agencies........................... $ 283 $ 3 $ 286 Municipal Obligations......................... 505 12 517 ------- --- ------- Total Current..................................... 788 15 803 ------- --- -------
Classified as Restricted: U.S. Government and its Agencies........................... 1,263 14 1,277 Corporate Bonds ................................. 499 23 522 Other.......................................... 615 615 ------- --- ------- Total Restricted........................... 2,377 37 2,414 ------- --- ----- ------- Total Held-to-Maturity.................. $ 21,258 $484 $ 849 $ 20,893 ======= === ===== =======
Amortized Cost Fair Value --------------- -------------- (In thousands) Due in one year or less...................................... $ 13,590 $ 13,609 Due after one year through five years........................ 39,511 39,865 Due after five years through ten years....................... 34,345 34,263 Due after ten years through fifteen years.................... 19,399 19,295 Due after fifteen years...................................... 174,328 165,492 ------- ------- Total................................................... $281,173 $272,524 ======= =======
Of the cash and cash equivalents and current investments that total $376.5 million in the accompanying Consolidated Balance Sheet at December 31, 2001, $341.3 million is limited for use only by the Company's regulated subsidiaries. Such amounts are available for transfer to Sierra from the regulated subsidiaries only to the extent that they can be remitted in accordance with terms of existing management agreements and by dividends, which customarily must be approved by regulating state insurance departments. The remainder is available to Sierra on an unrestricted basis.
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, $75,000 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 and SHL maintains reinsurance on certain of its insurance products. Reinsurance premiums of $1,680,000, $2,433,000 and $1,835,000, net of reinsurance recoveries of $1,760,000, $1,945,000 and $1,761,000, are included in medical expenses for 2001, 2000 and 1999, respectively.
CII has reinsurance agreements or treaties in effect with unrelated entities. Effective July 1, 1998, all claims with dates of injury occurring on or after that date were reinsured under a quota share and excess of loss agreement, "low level reinsurance", with Travelers Indemnity Company of Illinois ("Travelers"). Travelers is rated AA and A++ by Fitch Ratings and the A.M. Best Company, respectively. The low level reinsurance provided quota share protection for 30% of the first $10,000 of each loss, and excess of loss protection of 75% of the next $40,000 of each loss, and 100% of the next $450,000 on a per occurrence basis. The maximum net loss retained on any one claim ceded under this treaty was $17,000. This agreement continued until June 30, 2000, when CII exercised an option for a twelve month extension relating to the run-off of policies in force as of June 30, 2000, which covered claims arising under such policies during the term of the extension.
The low level reinsurance agreement was consummated early in the fourth quarter of 1998 but coverage was made retroactive to July 1, 1998. Therefore, this agreement contained both retroactive (covering claims occurring in the third calendar quarter of 1998) and prospective reinsurance coverage (covering claims occurring after September 30, 1998). In accordance with Statement of Financial Accounting Standards No. 113, "Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts" ("SFAS No. 113"), the Company bifurcated the low level reinsurance agreement between the retroactive and prospective components due to the different accounting treatments for each respective piece. The amount by which the estimated ceded liabilities exceeded the amount paid for the retroactive coverage was reported as a deferred gain and is amortized to income as a reduction of incurred losses over the estimated remaining settlement period using the interest method. Any subsequent changes in estimated or actual cash flows related to the retroactive coverage 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. The Company recorded an adjustment to increase its deferred gain related to retroactive reinsurance coverage by $2,996,000, $3,662,000 and $4,615,000 in 2001, 2000 and 1999, respectively. For the years ended December 31, 2001, 2000 and 1999, the Company amortized deferred gains of $2,696,000, $5,199,000 and $3,850,000, respectively. Such amortization is included as a credit to specialty product expense on the accompanying consolidated statements of operations.
Change in Recoveries Recoverable on Paid on Unpaid Premiums Losses/LAE Losses/LAE Ceded ---------- ------------ ----- (In thousands) Year Ended December 31, 2001: Low level reinsurance carrier................. $80,932 $(40,430) $ 9,136 Excess of loss reinsurance carriers........... 4,407 9,125 4,244 ------ ------- ------- Total ........................................ $85,339 $(31,305) $13,380 ====== ======= ======
The following table provides a reconciliation of the beginning and ending reserve balances for workers' compensation unpaid losses and LAE. The loss estimates are subject to change in subsequent accounting periods and any change to the current reserve estimates would be accounted for in future results of operations in the period when the change occurs.
Net Provision for Insured Events Incurred in: Current Year .......................................... 131,923 86,587 51,541 Prior Years............................................ 8,691 23,293 9,920 ------- ------- ------- Total Net Provision.................................. 140,614 109,880 61,461 ------- ------- -------
Net Payments for Losses and LAE Attributable to Insured Events Incurred in: Current Year .......................................... 28,560 26,867 21,207 Prior Years............................................ 69,599 61,521 80,416 ------- ------- ------- Total Net Payments .................................. 98,159 88,388 101,623 ------- ------- -------
Gross Ending Losses and LAE Reserve ...................... $385,705 $374,554 $244,394 ======= ======= =======
During the years ended December 31, 2001 and 2000, the Company experienced prior year net adverse loss development of $8.7 million and $23.3 million, respectively. Estimated losses and LAE incurred in accident years 1996 to 1999 have developed significantly primarily due to the continuation of increasing claim severity patterns on the Company's California book of business. Many workers' compensation insurance carriers in California are also experiencing high claim severity. Factors influencing the higher claim severity include rising average temporary disability costs, the increase in the number of major permanent disability claims, medical inflation and adverse court decisions related to medical control of a claimant's treatment. See Note 6 for a description of our reinsurance coverage.
2001 2000 ---------- ----------- (In thousands) Revolving Credit Facility............................................ $ 89,000 $135,000 Net Financing Obligations............................................ 73,948 91,253 7 1/2% Convertible Subordinated Debentures........................... 47,041 9 1/2% Senior Debentures............................................. 19,187 Other................................................................ 1,236 5,669 ------- ------- Total.............................................................. 183,371 278,963 Less Current Portion................................................. (1,612) (53,993) ------- ------- Long-term Debt....................................................... $181,759 $224,970 ======= =======
The maximum availability under the amended and restated credit agreement has been reduced to $117 million at December 31, 2001 from $135 million at the end of 2000 due to required reductions in the agreement. At December 31, 2001, the Company has $28 million available under the agreement; however, the total availability will be reduced by $6.0 million on June 30, 2002 and December 31, 2002 and finally by $10.0 million on June 30, 2003. The amount available under the credit facility can be further reduced by 80% of net proceeds from certain asset sales and excess cash flow, as well as 100% of the net proceeds of any new debt or equity issuance, excluding any issuance by CII, as defined in the amended and restated credit agreement.
Interest under the amended and restated credit agreement is variable and based on the Bank of America "prime rate" adjusted for a margin. The rate was 5.375% at December 31, 2001, which is a combination of the prime rate of 4.75% plus a margin of .625%. The Company can reduce the margin in the future by completing certain transactions and meeting certain financial ratios. Of the outstanding balance, $25 million is covered by an interest-rate swap agreement. To mitigate the risk of interest rate fluctuation on the credit facility, the Company entered into a five-year $50 million interest-rate swap agreement during the fourth quarter of 1998. The intent of the agreement was to keep the Company's interest rate on $50 million of the borrowing relatively fixed. In the fourth quarter of 2000, $25 million of the swap agreement was terminated. The interest rate swap is a derivative as described in SFAS No.133 and the Company recorded a liability for the interest-rate swap agreement at its fair market value of $685,000 as of December 31, 2001. Previously, the fair value of the asset or liability related to the swap was immaterial. The fair market value is the cost that the Company would need to pay to terminate the swap agreement as of December 31, 2001.
The average cost of borrowing on the credit facility for 2001, including the amortization of deferred financing fees and the impact of the swap agreement, was 10.6%. The terms of the amended and restated credit agreement contain certain covenants including a minimum fixed charge coverage ratio, a minimum interest coverage ratio, a maximum leverage ratio, maximum loss ratios and maximum capital expenditure amounts. The Company believes it is in compliance with these covenants at December 31, 2001.
Net Financing Obligations represent amounts recorded as a financing obligation of $90.8 million offset by notes receivable of $16.9 million as part of the sale-leaseback transaction described in Note 4. Amounts were recorded as a financing obligation as required by SFAS No. 98 using the interest method with effective interest rates of 8.16% to 8.53%. The balance outstanding under the net financing obligations was reduced by $14.6 million as described in Note 4 and by $2.7 million from the principal portion of the lease payments made during 2001.
Obligations (In thousands) Notes Under Capital Years ending December 31, Payable Leases ---------------------------------------------------- ----------- ------------------- 2002................................................. $ 1,533 $115 2003................................................. 92,171 121 2004................................................. 21,304 83 2005 ................................................ 4,011 31 2006................................................. 4,526 30 Thereafter........................................... 59,437 184 ------- ---- Total............................................. $182,982 564 ======= Less: Amounts Representing Interest................. (175) ----
The fair value of long-term debt, including the current portion, is estimated to be approximately $192,392,000 based on the borrowing rates currently available to the Company.
Statutory Rate.............................. 35% (35)% 35% State Income Taxes.......................... (1) 1 9 Tax Preferred Investments................... (2) (1) (10) Change in Valuation Allowance .............. - - (12) Intangible Amortization..................... 1 11 4 Other....................................... 1 (1) (9) -- --- --- Provision (Benefit) for Income Taxes........ 34% (25)% 17% == === ===
The tax effects of significant items comprising the Company's net deferred tax assets are as follows at December 31:
Deferred Tax Liabilities: Deferred Policy Acquisition Costs......................... 741 655 Other..................................................... 947 290 ------- ------- Total................................................... 1,688 945 ------- -------
Although considerable efforts had been made to achieve profitability in Texas, it was determined that under the current operating environment, the Company would not be able to turn around the operating results and the best course of action was to exit the market as soon as possible to limit future losses and exposure. During the third quarter of 2001, the Company announced its plan to exit the Texas HMO health care market and received formal approval from the Texas Department of Insurance to withdraw its HMO operations in mid-October. The Company intends to cease providing HMO health care coverage in Texas on April 17, 2002.
Medical Expenses................................................ 175,333 233,652 215,191 General, Administrative and Marketing Expenses.................. 29,607 31,346 43,384 Asset Impairment, Restructuring, Reorganization and Other Costs............................... (1,250) 186,604 11,000 Interest Expense and Other, Net................................. (1,532) 4,268 (1,531) ------- -------- -------
Loss from Discontinued Operations Before Tax.................... (21,026) (222,472) (23,298) Income Tax Benefit.............................................. 7,046 61,350 8,144 ------- -------- -------
Net Loss from Discontinued Operations........................... $(13,980) $(161,122) $(15,154) ======= ======== =======
All of the discontinued Texas HMO health care operations were a component of the "managed care and corporate operations" segment.
Based on the Company's Texas HMO health care operations financial projections for 2000, the Company recorded a $21.0 million premium deficiency at the end of 1999. Of this amount, $10.0 million was recorded in medical expenses and $11.0 million was recorded in asset impairment, restructuring, reorganization and other costs. The $11.0 million was an estimate of general and administrative costs, in excess of those covered by premiums, the Company expected to be incurred to service the Dallas/Ft. Worth contracts. Also recorded in medical expenses during the fourth quarter of 2000 was $4.0 million primarily related to an adjustment to the estimate for medical expenses recorded in previous years.
Included in the Texas HMO health care operations medical expenses for the year ended December 31, 2000 are $14.7 million, primarily for adverse development on prior periods' medical claims, and $15.5 million in premium deficiency medical expense related to under-performing markets in the Dallas/Ft. Worth and Houston areas. The recorded premium deficiency reflected anticipated costs after restructuring and reorganization actions taken in the first six months of 2000. During the second quarter of 2001, management revised their estimates of premium deficiency reserves and reclassified $7.8 million from premium deficiency maintenance reserve to premium deficiency medical reserve. This reclassification was based on the latest available medical cost trends, which did not become evident until late in the second quarter of 2001, and is reflected as an increase in medical expense and a decrease in general, administrative and marketing expenses on the condensed statements of operations of the discontinued Texas HMO health care operations.
As part of the Company's plan to exit Texas, the Company recorded charges of $10.6 million for premium deficiency medical costs, $1.6 million to write down certain Texas furniture and equipment, $2.0 million in lease and other termination costs, $1.8 million in legal and restitution costs, $500,000 in various other exit related costs and $570,000 in premium deficiency maintenance.
Restructuring Premium Asset and Deficiency (In thousands) Impairment Reorganization Maintenance Other Total ---------- -------------- ----------- ----- -----
Charges recorded................... 1,600 4,380 570 6,550 Cash used.......................... (3,716) (1,478) (800) (5,994) Noncash activity................... (1,600) (125) (1,725) Changes in estimate................ (7,800) (7,800) -------- ------ ------- ----- -------- Balance, December 31, 2001......... $ - $ 4,294 $ 570 $ - $ 4,864 ======== ====== ======= ===== ========
The remaining restructuring and reorganization costs of $4.3 million are primarily related to legal and restitution costs, lease and other termination costs, the cost to provide malpractice insurance on our discontinued affiliated medical groups and various other exit related costs. Management believes that the remaining reserves, as of December 31, 2001, are appropriate and that no revisions to the estimates are necessary at this time.
During 2001, Sierra participated in negotiations with Kaiser-Texas relative to the real estate properties and associated mortgage loan to Kaiser-Texas along with other matters. Sierra reached an agreement with Kaiser-Texas, effective December 31, 2001, whereby Kaiser-Texas forgave $8.5 million of the outstanding principal balance of the mortgage loan and extended the maturity from November 1, 2003 to November 1, 2006. In exchange for the consideration by Kaiser-Texas, Sierra agreed to an unconditional guaranty of the mortgage loan. In conjunction with the agreement, Sierra applied a $2.5 million outstanding receivable from Kaiser-Texas to the outstanding balance of the mortgage loan on December 31, 2001.
The agreement included concessions by Kaiser-Texas, including a reduction of principal and an extension of the maturity. In accordance with accounting principles generally accepted in the United States of America, the agreement was accounted for as a restructuring of debt. In the transaction, total future cash payments (interest and principal) were less than the balance of the mortgage loan at the time of the agreement. Accordingly, a gain on restructuring was recognized for the difference and the carrying amount of the mortgage loan is equal to the total future cash payments. Costs incurred in connection with the agreement were offset against the gain on restructuring. At December 31, 2001, the mortgage loan has a carrying value of $29.2 million, which consists of a principal balance of $22.7 million and $6.5 million in future accrued interest. Effective January 1, 2002, all future cash payments, including interest, related to the mortgage loan will be reductions of the carrying amount; therefore, no future interest expense will be recognized. The transaction resulted in an immaterial gain.
During 1997, the Company's Board of Directors authorized a $3.0 million loan from the Company to its Chief Executive Officer ("CEO"). In April 2000, the Company's Board of Directors authorized an additional $2.5 million loan from the Company to the CEO which, along with accrued interest, is due on June 30, 2002. During 2001, the CEO made payments of $898,000 and at the end of 2001, the aggregate principal balance outstanding and accrued interest for both instruments was $5.0 million. All amounts borrowed bear interest at a rate equal to the rate at which the Company could have borrowed funds under the revolving credit facility at the time of the borrowing plus 10 basis points. The amounts outstanding are collateralized by certain of the CEO's assets and rights to compensation from the Company.
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. For the six months ended June 30, 1999, the Company contributed a maximum of 2% of eligible employees' compensation and matched 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 regulations. Effective July 1, 1999, the Plan was modified such that the Company matches 50%-100% of an employee's elective deferral up to a maximum of 6% of a participant's annual compensation, subject to IRS limits. The Plan does not require additional Company contributions. Expense under the plan totaled $4.8 million, $4.7 million and $6.7 million for the years ended December 31, 2001, 2000 and 1999, respectively.
Supplemental Executive Retirement Plan ("SERP"). The Company has a defined benefit retirement plan covering certain key employees. The Company is funding the benefits through the purchase of life insurance policies. Benefits are based on, among other things, the employee's average earnings over the five-year period prior to retirement or termination, and length of service. Benefits attributable to service prior to the adoption of the plan are amortized over the estimated remaining service period for those employees participating in the plan. During 2001, one participant began to receive benefits earlier than originally estimated. The effect of this change is included in actuarial losses (gains) in the reconciliation below.
Funded Status of the Plan ............................. $(8,823) $(5,254) $(5,513) Unrecognized Actuarial Change.......................... 3,399 (851) (532) Unrecognized Prior Service Credit ..................... 7,062 7,652 8,412 Unrecognized Net Loss ................................. 4,117 2,326 1,150 ------ ------ ------ Total Recognized ...................................... $ 5,755 $ 3,873 $ 3,517 ====== ====== ======
Total Recognized Amounts in the Financial Statements Consist of: Accrued Benefit Liability ............................. $(6,134) $(1,912) $(2,439) Intangible Asset ...................................... 11,889 5,785 5,956 ------ ------ ------ Total ................................................. $ 5,755 $ 3,873 $ 3,517 ====== ====== ======
Assumptions: Discount Rate ......................................... 7.0% 7.0% 7.0% Expected Return on Plan Assets ........................ 8.0% 8.0% 8.0% Rate of Compensation Increase ......................... 3.0% 3.0% 3.0%
Components of Net Periodic Benefit Cost: Service Cost........................................... $ 322 $ 365 $ 365 Interest Cost ......................................... 1,162 887 829 Expected Return on Plan Assets......................... (987) (733) (525) Amortization of Prior Service Credits.................. 925 925 922 Recognized Actuarial Loss (Gain)....................... 159 (20) (1) ------- ------ ------ Net Periodic Benefit Cost.............................. $ 1,581 $ 1,424 $ 1,590 ====== ====== ======
$ 3.13 - $ 5.73 3,215 3,635 576 $ 4.53 $ 4.40 6.19 - 9.91 2,339 1,875 457 8.15 7.76 10.36 - 18.00 1,377 190 166 12.40 12.29 19.08 - 24.69 1,160 303 192 22.28 22.49
Employee Stock Purchase Plans. The Company has an employee stock purchase plan (the "Purchase Plan") whereby employees may purchase newly issued shares of common stock through payroll deductions at 85% of the fair market value of such shares on specified dates as defined in the Purchase Plan. During 2001, a total of 517,000 shares were purchased at prices of $2.92 and $3.60 per share. During January 2002, 203,000 shares were purchased by employees at $6.02 per share in connection with the Purchase Plan. At December 31, 2001, the Company had 531,000 shares reserved for purchase under the Purchase Plan.
Restricted Stock Units. The Company issued 244,000 restricted stock units ("units"), to certain executives during 2001. The first half of the units vest in 2003 with the remainder vesting in 2004. Each unit represents a nontransferable right to receive one share of Sierra stock and there is no cost by the recipient to exercise the units. The units are included in total outstanding common shares. In the calculation of earnings per share, the units are not included in the common shares outstanding but are included in the calculation of common shares outstanding assuming dilution. The transaction was recorded by including the value of the units as common stock and additional paid-in capital offset by a contra-equity account, deferred compensation. The value of the transaction was based on the number of units issued and the Company stock price on the date of issuance, which was $5.73. Compensation expense will be recognized over the period of vesting. Total expense associated with the plan for 2001 was $342,000.
Net Income (Loss) Per Share Assuming Dilution As reported $ .12 $ (7.37) $ (.17) Pro forma (.04) (7.49) (.34)
The fair value of each option grant is estimated on the date of grant using the Black-Scholes option pricing model with the following weighted average assumptions used for grants in 2001, 2000 and 1999, respectively: dividend yield of 0% for all years; expected volatility of 83%, 52% and 43%; risk-free interest rates of 4.34%, 6.60% and 5.87%; and expected lives of three to five years. The weighted average fair value of options granted in 2001, 2000 and 1999 was $5.58, $2.72 and $3.77, respectively.
The fair value of the look-back option implicit in each offering of the Purchase Plans is estimated on the date of grant using the Black-Scholes option pricing model with the following weighted average assumptions used for grants in 2001, 2000 and 1999, respectively: dividend yield of 0% for all years; expected volatility of 85%, 46% and 45%; risk-free interest rates of 4.36%, 5.79% and 4.66%; and expected lives of six months for all years.
Years ended December 31, 2001 2000 1999 ------------ ------------ ------------- (In thousands) Cash Paid During the Year for Interest (Net of Amount Capitalized)......................... $21,566 $26,848 $15,583 Cash Received During the Year for Income Taxes.................................... (221) (10,608) (4,900)
During 1999, the Company reported a premium deficiency medical charge of $8.1 million related to losses in under-performing markets primarily in Arizona and rural Nevada, all of which was used during 1999. Also recorded in medical expenses during the fourth quarter was $7.2 million primarily related to an adjustment to the estimate for medical expenses recorded in previous years and $6.8 million primarily related to contractual settlements with providers of medical services.
In the first quarter of 2000, the Company recorded $1.0 million of adverse development related to prior years' medical claims. Included in reported medical expenses for the second quarter of 2000 are changes in estimate charges of $15.5 million of reserve strengthening primarily due to adverse development on prior periods' medical claims. In addition, the Company recorded $9.5 million of other non-recurring medical costs primarily relating to the write-down of medical subsidiary assets.
Management adopted a plan in the second quarter of 2000 to discontinue medical delivery operations in Mohave County, Arizona and to sell the real estate assets located there, as well as an underperforming medical clinic in Las Vegas.
The charges recorded for the write-off of goodwill totaled $15.1 million and related primarily to the Prime Holdings, Inc. acquisition. The charges recorded for fixed asset impairment totaled $9.5 million for the Arizona and Nevada operations.
The $3.4 million of charges in the fourth quarter of 1999 consisted primarily of legal and contractual settlements.
Year Ended December 31, 2000 (1): Operating Revenues.................................... $265,591 $278,228 $315,300 $300,461 Operating Income (Loss) from Continuing Operations.............................. 11,263 (64,976) 10,103 11,304 Net Income (Loss) from Continuing operations.......... 4,327 (50,484) 3,541 3,823 Net Income (Loss)..................................... 1,556 (206,717) 2,669 2,577 Basic earnings per share: Income from Continuing Operations.................. $ 0.16 $ (1.87) $ 0.13 $ 0.14 Net Income (Loss).................................. 0.06 (7.64) 0.10 0.09 Diluted earnings per share: Income from Continuing Operations.................. $ 0.16 $ (1.87) $ 0.13 $ 0.14 Net Income (Loss).................................. 0.06 (7.64) 0.10 0.09
(In thousands) Managed Care Military Workers' and Corporate Health Services Compensation Operations Operations Operations Total -------------------- ------------------- ------------------ ------------ Year Ended December 31, 2001 Medical Premiums.............................. $718,994 $ 718,994 Military Contract Revenues.................... $338,918 338,918 Specialty Product Revenues.................... 7,875 $175,431 183,306 Professional Fees............................. 28,985 28,985 Investment and Other Revenues................. 2,790 2,404 16,104 21,298 ------- ------- ------- --------- Total Revenue.............................. $758,644 $341,322 $191,535 $1,291,501 ======= ======= ======= =========
Segment Operating Profit (1).................. $ 28,529 $ 9,701 $ 6,602 $ 44,832 Interest Expense and Other.................... (16,758) 11 (1,816) (18,563) ------- -------- ------- --------- Net Income from Continuing Operations Before Income Taxes...................... $ 11,771 $ 9,712 $ 4,786 $ 26,269 ======= ======= ======= =========
Segment Assets................................ $401,686 $117,302 $522,570 $1,041,558 Capital Expenditures.......................... 5,763 1,377 2,322 9,462 Depreciation and Amortization................. 20,125 4,025 1,397 25,547
Segment Operating Profit (1).................. $ 24,514 $ 7,992 $ 11,535 $ 44,041 Interest Expense and Other.................... (16,177) (611) (2,574) (19,362) Changes in Estimate Charges (2)............... (26,011) (16,500) (42,511) Asset Impairment, Restructuring, Reorganization and Other Costs........... (30,836) (3,000) (33,836) ------- ------- ------- --------- Net (Loss) Income from Continuing Operations Before Income Taxes...................... $(48,510) $ 7,381 $(10,539) $ (51,668) ======= ======= ======= =========
Year Ended December 31, 1999 Medical Premiums.............................. $594,966 $ 594,966 Military Contract Revenues.................... $287,398 287,398 Specialty Product Revenues.................... 9,869 $ 84,352 94,221 Professional Fees............................. 42,069 42,069 Investment and Other Revenues................. 4,285 706 15,420 20,411 ------- ------- ------- --------- Total Revenue.............................. $651,189 $288,104 $ 99,772 $1,039,065 ======= ======= ======= =========
Segment Operating Assets...................... $446,379 $ 76,187 $403,420 $ 925,986 Capital Expenditures.......................... 44,858 570 4,201 49,629 Depreciation and Amortization................. 16,487 2,758 1,430 20,675