(A) Per share data for all periods presented prior to 1996 have been recomputed using 66,366,500 shares, the number of shares outstanding immediately following completion of the Recapitalization. Per share data for the year ended December 31, 1996 has been calculated using such 66,366,500 shares, plus the weighted average number of shares issued since the Recapitalization.
Prior to their acquisitions by WellPoint, each of the GBO, MMHD and the BCC Commercial Operations experienced a higher overall loss ratio than the Company. The inclusion of these acquisitions has contributed to an increase in the Company's overall loss ratio. In order to control the respective loss ratios and reduce the financial risk of these acquired businesses, the Company has undertaken a variety of measures, including the imposition of significant premium increases and changes in product design. The Company also implemented a series of price increases for certain of its California managed care businesses in response to an increased loss ratio in the second and third quarters of 1997. The Company will continue to evaluate the need for further price increases, plan design changes and other appropriate actions in the future. There can be no assurances, however, that the Company will be able to take subsequent pricing or other actions or that any actions previously taken or implemented in the future will be successful in addressing any concerns that may arise with respect to the performance of certain businesses.
A variety of health care reform measures are currently pending or have been recently enacted at the Federal, state and local levels. Recent Federal legislation seeks, among other things, to insure the portability of health coverage and mandates minimum maternity hospital stays. These and other proposed measures may have the effect of dramatically altering the regulation of health care and of increasing the Company's loss ratio or decrease the affordability of the Company's products. In May 1997, the Texas Legislature adopted Senate Bill No. 386 ("SB 386"), which purports to make managed care organizations ("MCOs"), such as the Company, liable for the failure by the MCO, its employees or agents to exercise ordinary care when making "health care treatment decisions" (as defined in SB 386). The legislation became effective as of September 1, 1997. It is too early to determine what effect, if any, this legislation may have on the Company. However, to the extent that this legislation (or similar legislation that may be subsequently adopted at the Federal or state level) effectively expands the scope of liability of MCOs such as the Company, it may have a material adverse effect on the Company's results of operations and financial condition. See "Business--Government Regulation."
The Company is substantially dependent on its computer systems and applications due to the nature of its managed health care business and the increasing number of electronic transactions in the industry. Historically, some computer systems and applications were developed to recognize the year as a two-digit number, with the digits "00" being recognized as the year 1900. The year 2000 presents a number of potential problems for such systems, including potentially significant processing errors or failure. In order to address these problems, the Company has developed and is in the midst of executing a comprehensive plan designed to address the "year 2000" issue for its computer systems and applications. During 1997, the Company completed a detailed risk assessment of its various computer systems and applications, formulated a plan for specific remediation efforts and began certain of such remediation efforts. During 1998 and the first quarter of 1999, the Company expects to continue and complete its remediation efforts and to undertake internal testing of its systems and applications. In the second quarter of 1999, the Company
expects to undergo third-party testing of its applications and systems. The Company currently estimates that its costs related to year 2000 compliance remediation for Company-owned systems and applications will be approximately $20 million in 1998 and approximately $2 million in 1999. The Company expects that these costs will be expensed as incurred and will be funded through cash flow from operations.
The Company's consolidated results of operations for the year ended December 31, 1997 include a full year of earnings for MMHD and BCC Commercial Operations, and ten months of earnings for the GBO. The results of operations for the year ended December 31, 1996 include the results of MMHD for the period from April 1, 1996 (its date of acquisition) to December 31, 1996 and BCC Commercial Operations for the period from May 20, 1996 (its date of acquisition) to December 31, 1996.
(a) Medical membership includes 2,765,856 and 1,229,308 management services members as of December 31, 1997 and 1996, respectively, of which those management services members outside of California were 1,792,151 and 563,854, as of December 31, 1997 and 1996, respectively.
(c) Proprietary networks consist of California, Texas and other WellPoint-developed networks. Other networks consist of third-party networks and networks owned by the Company as a result of acquisitions that incorporate provider discounts and some basic managed care elements. Non-network consists of fee for service and percentage-of-billed charges contracts with providers.
The specialty membership as of December 31, 1997 includes the acquired GBO operations, which had approximately 0.3 million pharmacy members, 1.5 million dental members, 2.7 million utilization management members, 0.9 million life insurance members and 1.0 million disability members at the date of acquisition.
Premium revenue increased 34.7%, or $1,348.1 million, to $5,227.9 million for the year ended December 31, 1997 from $3,879.8 million for the year ended December 31, 1996. The 1997 acquisition of the GBO contributed $419.4 million, or 31.1% of this increase. The 1996 acquisitions of MMHD and the BCC Commercial Operations contributed an incremental increase in 1997 premium revenue of $163.0 million and $147.7 million, respectively, or an aggregate of 23.0% of the total increase. Also, contributing to increased premium revenue in 1997 was an increase in insured member months of 12.9%, excluding the GBO from both periods and excluding MMHD and BCC Commercial Operations from the periods prior to their respective dates of acquisition in both periods. Additionally, there was an increase in the per member per month revenues as a result of premium increases associated with several of the Company's medical products.
Management services revenue increased 159.1%, or $235.3 million, to $383.2 million for the year ended December 31, 1997 from $147.9 million for the year ended December 31, 1996. The increase was primarily due to $189.9 million of management services revenue related to the 1997 acquisition of the GBO and $18.9 million and $3.9 million, respectively, of incremental increase in management services revenue related to the acquisitions of MMHD and the BCC Commercial Operations in 1996, which together represented 90.4% of the increase. Also contributing to the increase was an increase in the California large group management services membership and the addition of a management services contract with the state of Illinois on July 1, 1997.
The loss ratio for 1997 increased to 81.2% compared to 77.4% in 1996. The acquired MMHD operations, the GBO and the BCC Commercial Operations have traditionally experienced a higher loss ratio than the Company. Additionally, the MMHD operations experienced an increase in loss ratio for the year ended December 31, 1997 in comparison to 1996 due to higher actual claims incurred as a result of higher cost trends. Excluding the effects of the acquired businesses, the loss ratio in 1997 would have been 79.2%. The increase in loss ratio excluding acquired operations is due to a loss ratio increase in the Company's California businesses, primarily due to slightly higher medical utilization for certain managed care products and increased pharmacy costs.
Selling expense consists of commissions paid to outside brokers and agents representing the Company. Selling expense for the year ended December 31, 1997 increased 16.0% to $260.5 million, compared to $224.5 million for the year ended December 31, 1996, corresponding with continued overall premium revenue growth and an additional $7.2 million in selling expense attributable to the GBO and the incremental impact in 1997 of the MMHD acquisition. The selling expense ratio for the year ended December 31, 1997 decreased to 4.6% from 5.6% for the year ended December 31, 1996, largely due to the acquisitions of the GBO and MMHD, which have lower selling expense ratios than the Company's existing business, and the BCC Commercial Operations, which has no selling expense. Excluding the effects of the acquisitions for the years ended December 31, 1997 and 1996, the selling expense ratio would have been 5.4% and 5.6%, respectively. This decrease is due to lower selling costs, in comparison to the Company's other products, for Medi-Cal and large employer group medical products which experienced higher growth in premium revenue in 1997.
The administrative expense ratio increased to 15.2% for 1997 compared to 13.6% for 1996, primarily due to the increased administrative expense associated with the Company's continued investment in national expansion and the acquisition of the GBO. The GBO has historically experienced a higher administrative expense ratio than the Company's traditional California-based businesses due to the GBO's higher percentage of management services business. The increase was partially offset by the BCC Commercial Operations' lower administrative expense ratio. The administrative expense ratio for the year ended December 31, 1997, excluding the effect of the GBO acquisition in 1997 and the incremental effect in 1997 of MMHD and BCC Commercial Operations, was 13.0%.
The Company recorded $14.5 million of nonrecurring costs for the year ended December 31, 1997, of which $8.0 million recorded in the second quarter of 1997 related primarily to the write-down of the Company's dental practice management operations and discontinuance of the Company's medical practice management operations. In addition, the Company incurred $6.5 million in the first quarter related to severance and retention payments associated with the GBO acquisition.
Earnings per share for the year ended December 31, 1997 is based upon weighted average shares outstanding of 68.8 million, excluding common stock equivalents, and 69.5 million shares, assuming full dilution. Earnings per share for the year ended December 31, 1996 has been calculated using 66.4 million shares for both measures. Common stock equivalents did not have a dilutive effect on earnings per share in 1996. The 1996 weighted average reflects the number of shares outstanding immediately following the Recapitalization, plus the weighted average number of shares issued in 1996 subsequent to the Recapitalization. For the year ended December 31, 1997, the increase in weighted average shares outstanding primarily relates to the public offering of 3,000,000 shares of the Company's common stock in April 1997 and, on a diluted basis, the inclusion of 651,000 common stock equivalents related to the Company's stock option plans.
Management services revenue increased $86.7 million to $147.9 million for the year ended December 31, 1996 from $61.2 million for the year ended December 31, 1995. The increase was primarily due to $62.9 million of management services revenue from MMHD. Also contributing to the increase were a 31.7% membership increase in the California large group market, excluding the acquired members of MMHD and the BCC Commercial Operations, new pharmacy and clinical management accounts and revenue from the BCC Commercial Operations.
Health care services and other benefits expense increased 36.5% to $3,003.1 million for the year ended December 31, 1996 from $2,200.0 million for the year ended December 31, 1995. Of the $803.1 million increase, $412.2 million was attributable to MMHD and $189.9 million was attributable to the BCC
Commercial Operations. Excluding MMHD and the BCC Commercial Operations, increased health care services expense also resulted from medical membership growth. In addition, mix and product design changes, for example, the elimination of deductibles for some PPO plans and pharmacy products, contributed to an increase in health care expenses. Growth in the workers' compensation business also contributed to the increase. These increases were partially offset by savings from hospital recontracting, which was implemented in late 1995. Additional savings were realized by savings from specialist and laboratory recontracting, which was implemented during the third quarter of 1996.
average number of common shares outstanding. Earnings per share for the year ended December 31, 1995 included nonrecurring costs of $0.52 per share. For the year ended December 31, 1995, there were no stock options outstanding and, for the year ended December 31, 1996, stock options did not have a dilutive effect on weighted average shares outstanding. Therefore, for 1995 and 1996 there is no difference between earnings per share and earnings per share assuming full dilution as calculated under SFAS No. 128.
As of December 31, 1997, $388.0 million was outstanding under the Company's long-term debt facilities, compared to $625.0 million at December 31, 1996. Debt repayments were funded from the proceeds from the Company's April 1997 common stock offering and from cash flow from operations.
The Company's primary sources of cash are premium and management services revenues received and investment income. The primary uses of cash include health care claims and other benefits, capitation payments, income taxes, repayment of long-term debt, interest expense, broker and agent commissions, administrative expenses and capital expenditures. In addition to the foregoing, other uses of cash include costs of provider networks and systems development, and costs associated with acquisitions and the integration of acquired businesses. The Company receives premium revenue in advance of anticipated claims for related health care services and other benefits. The Company's investment policies are designed to provide liquidity, preserve capital and maximize yield. Cash and investment balances maintained by the Company are sufficient to meet applicable regulatory financial stability and net worth requirements. As of December 31, 1997, the Company's investment portfolio consisted primarily of fixed maturity securities (which are primarily rated "A" or better by rating agencies) and equity securities.
Net cash used in investing activities in 1997 totaled $452.6 million, compared with net cash used in investing activities of $736.2 million in 1996. The cash used in 1997 was attributable primarily to the purchase of investments for $2,747.2 million partially offset by the proceeds from investments sold and matured of $2,009.4 million and the net cash acquired from the GBO purchase of $362.0 million. The GBO was acquired for a total purchase price of $89.7 million, all of which was funded with cash. GBO net cash acquired was $451.7 million.
The Company has a $1.0 billion unsecured revolving credit facility. Borrowings under the credit facility bear interest at rates determined by reference to the bank's base rate or to the London Interbank Offered Rate ("LIBOR") plus a margin determined by reference to the Company's leverage ratio (as defined in the credit agreement) or the then-current rating of the Company's unsecured long-term debt by specified rating agencies. Borrowings under the credit facility are made on a committed basis or pursuant to an auction-bid process. The credit facility expires as of May 15, 2002, although it may be extended for an additional one-year period under certain circumstances. The credit agreement requires the Company to maintain certain financial ratios and contains restrictive covenants, including restrictions on the occurrence of additional indebtedness and the granting of certain liens, limitations on acquisitions and investments and limitations on changes in control. The total amount outstanding under the credit facility was $368.0 million and $555.0 million as of December 31, 1997 and 1996, respectively. The weighted average interest rate for the year ended December 31, 1997, including the facility and other fees and the effect of the interest rate swaps discussed in the following paragraph, was 7.45%.
Prior to the Reincorporation, the Company held a license as a health care service plan under the Knox-Keene Act. See "Item 1. Business--Government Regulation." As such, the Company was required to maintain minimum tangible net equity ("TNE") by the DOC, in addition to meeting minimum capital requirement prescribed by the BCBSA. As a DOC licensee, the Company used TNE in measuring capital for the BCBSA. The failure to meet a specified level (the "BCBSA Minimum Capital") of the BCBSA's base capital requirement can subject the Company to certain corrective actions, while the failure to meet a lower specified level can result in the termination of the Company's license agreement with BCBSA. As a result of the Reincorporation, the Company is no longer licensed under the Knox-Keene Act (Blue Cross of California remains a DOC licensee) and, as a result, its capital for BCBSA purposes is measured based on GAAP equity. As of December 31, 1997, the Company's GAAP equity was in excess of the BCBSA's Minimum Capital requirement. A principal purpose of the Reincorporation was to allow restructuring of the Company and its various subsidiaries in order to improve the Company's capital as measured for BCBSA purposes.
In November 1996, in order to address an anticipated shortfall in its capital for BCBSA purposes, the Company entered into a subordinated debt agreement for $200 million. On March 17, 1997, prior to the Reincorporation, the Company borrowed $150.0 million under its subordinated debt agreement to ensure compliance with the Company's BCBSA capital requirements, bringing its total indebtedness under the facility to $200 million at that date. The Company used the proceeds of its April 1997 public offering of 3,000,000 shares of its common stock to pay down outstanding indebtedness under the Company's subordinated debt agreement. On July 1, 1997, the Company repaid the remaining $90.0 million outstanding under the subordinated debt agreement with borrowings under the revolving credit facility.
public offering under its debt registration statement will be sufficient to fund continuing operations and expected capital requirements for the foreseeable future.
In June 1997, the Financial Accounting Standards Board (the "FASB") issued Statement of Financial Accounting Standards No. 130, "Reporting Comprehensive Income" ("SFAS No. 130"). SFAS No. 130 will require companies to present all non-owner changes in equity, (e.g., market value adjustments to investments and adjustments to the minimum pension liability) that are currently included as a component of stockholders' equity as a component of comprehensive income. The new disclosures will be effective beginning in the first quarter of 1998.
In June 1997, the FASB also issued Statement of Financial Accounting Standards No. 131, "Disclosures About Segments of an Enterprise and Related Information" ("SFAS No. 131"). SFAS No. 131 requires that companies disclose "operating segments" based on the way management disaggregates the company for making internal operating decisions. The new disclosures will be effective for the Company's fiscal year ending on December 31, 1998. Abbreviated quarterly disclosure will be required beginning with the period ending March 31, 1999, with comparative information required for the corresponding period in the prior fiscal year.
In February 1998, the FASB issued Statement of Financial Accounting Standards No. 132, "Employers' Disclosures about Pensions and Other Postretirement Benefits" ("SFAS No. 132"). SFAS No. 132 standardizes the disclosure requirements of pension and other postretirement benefits under previous guidance. In addition, SFAS No. 132 requires additional disclosures regarding changes in the benefit obligations and fair values of plan assets, eliminates certain disclosures no longer deemed useful, permits aggregation of information about certain plans and revises disclosure about defined contribution plans. The new disclosures are required for year-end financial statements for the year ending December 31, 1998.
The Company's operations are subject to substantial regulation by Federal, state and local agencies in all jurisdictions in which the Company now operates. Many of these agencies have increased their scrutiny of managed health care companies in recent periods. Future regulatory actions by any such agencies may have a material adverse affect on the Company's business.
The Company's future results will depend in large part on accurately predicting health care costs and upon the Company's ability to control future health care costs through underwriting criteria, utilization management and negotiation of favorable provider contracts. Changes in utilization rates, demographic characteristics, health care practices, provider consolidation, inflation, new technologies, clusters of high-cost, the regulatory environment and numerous other factors are beyond the control of any health plan and may adversely affect the Company's ability to predict and control health care costs and claims, as well as the Company's financial condition or results of operations. Additionally, the Company faces competitive pressure to contain premium prices. Fiscal concerns regarding the continued viability of government sponsored programs such as Medicare and Medicaid may cause decreasing reimbursement rates for these programs. Any limitation on the Company's ability to increase or maintain its premium levels, design products, or select underwriting criteria may adversely affect the Company's financial condition or results of operations.
As a result of the Company's recent acquisitions, the Company now operates on a national basis and offers a spectrum of health care and specialty products through various risk sharing arrangements. The Company's health care products include a variety of managed care offerings as well as traditional fee-for- service coverage. With respect to product type, fee-for-service products are generally less profitable than managed care products. A critical component of the Company's expansion strategy is to transition over time the traditional insurance members of the Company's acquired businesses to more managed care products. With respect to the risk-sharing nature of products, managed care products that involve greater potential risk to the Company generally tend to be more profitable than those managed care products where the Company is able to shift risks to employer groups and management services products. Individuals and small employer groups are more likely to purchase the Company's higher-risk managed care products because such purchasers are generally unable or unwilling to bear greater liability for health care expenditures. Over the past few years, the Company has experienced greater margin erosion in its higher risk managed care products than in its lower-risk managed care and management services products. This margin erosion is attributable to product mix change, competitive pressure and greater regulatory restrictions applicable to the small employer group market. The Company has implemented price increases in certain of its managed care businesses. While these price increases are intended to improve profitability, there can be no assurance that this will occur. Subsequent unfavorable changes in the relative profitability between the Company's various products could have a material adverse effect on the Company's results of operations and on the continued feasibility of the Company's geographic expansion strategy.
(A) The first and second quarters of 1997 include nonrecurring costs of $6.5 million and $8.0 million, before taxes, $3.8 million and $4.8 million, after tax, or $0.06 and $0.07 per share on a basic and diluted basis, respectively.
(B) Per share data for all periods prior to the fourth quarter of 1997 has been restated to reflect the adoption of SFAS No. 128.