Balance Sheet Data for 1998 reflect the acquisition of the Principal Life Insurance Company health plans as of December 31, 1998 and Operations Statement Data for 1998 include the results of operations of the acquired PHC health plans beginning April 1, 1998, the date of acquisition.
(3) Predecessor company of a wholly owned subsidiary of the Company was an S Corporation.
(2) The Company closed its subsidiary, Coventry Health Care of Indiana, Inc., at the end of the fourth quarter of 2000. As a result of the cost associated with exiting the Indiana market, the Company recorded a reserve for $2.0 million in the fourth quarter of 1999.
Results of Operations The following table (in thousands, except percentages and membership data) is provided to facilitate a more meaningful discussion regarding the results of the Company’s operations for each of the three years in the period ended December 31, 2000.
During the three years ended December 31, 2000, the Company experienced substantial growth in operating revenues due primarily to membership increases. Much of the growth was in 1998 and was attributable to the acquisition of the Principal Health Care, Inc. (“PHC”) health plans effective April 1, 1998. Additional membership growth was achieved through marketing efforts, acquisitions, geographic expansion and increased product offerings. One such product offering is the expansion of the Company’s PPO risk product to all of its health plans in 2000.
As of December 31, 2000, Coventry had 1,436,618 members for whom it assumes underwriting risk (“risk members”) and 276,416 members of self-insured employers for whom it provides management services but does not assume underwriting risk (“non-risk members”) in continuing operations. The following tables show the total number of members in continuing operations as of December 31, 2000, 1999 and 1998.
For January 2001, the Company added about 12,100 members to December 2000 results. Commercial risk membership grew by about 17,300 members primarily due to the acquisition of Health Partners of the Midwest’s (“Health Partners”) commercial membership, in our St. Louis market, offset by the loss of one large group. Medicare membership decreased by about 19,100, due to the loss of membership resulting from a change in benefits. Medicaid membership increased by about 3,600 members mainly due to normal growth in the HealthCare USA plan. The remaining 10,250 member increase was a result of modest growth in non-risk membership due to the Health Partners acquisition offset by several large group terminations.
Coventry’s operating expenses are primarily medical costs, including medical claims under contractual relationships with a wide variety of providers, and capitation payments. Medical claims expense also includes an estimate of claims incurred but not reported (“IBNR”). Coventry currently believes that the estimates for IBNR liabilities are adequate to satisfy its ultimate medical claims liability after all medical claims have been reported. In determining the Company’s IBNR liabilities, Coventry employs plan by plan standard actuarial reserve methods (specific to the plan’s membership, product characteristics, geographic territories and provider network) that consider utilization frequency and unit costs of inpatient, outpatient, pharmacy and other medical costs, as well as claim payment backlogs and the timing of provider reimbursements. Reserve estimates are reviewed by underwriting, finance and accounting, and other appropriate plan and corporate personnel and judgments are then made as to the necessity for reserves in addition to the estimated amounts. Changes in assumptions for medical costs caused by changes in actual experience, changes in the delivery system, changes in pricing due to ancillary capitation and fluctuations in the claims backlog could cause these estimates to change in the near term. Coventry continually monitors and reviews its IBNR reserves, and as actual settlements are made or accruals adjusted, reflects these differences in current operations.
At the closing, Coventry also entered into a License Agreement, which was amended effective June 1, 1999, a Marketing Services Agreement and a Management Services Agreement with Principal Life. All three agreements expired on December 31, 1999. Pursuant to the latter two agreements, Coventry recognized revenue of approximately $25.5 million and $23.0 million for the years ended December 31, 1999 and 1998, respectively. Coventry no longer receives revenue under these agreements. In anticipation of the loss of these fees, Coventry commenced reducing selling, general and administrative (“SG&A”) costs through cost savings from service center consolidation, headcount reductions and across-the-board reductions in administrative expenses. In addition to SG&A reductions, Coventry plans to increase its gross margin through acquisitions and by implementing rate increases.
Effective November 30, 1998, Coventry sold its subsidiary, Principal Health Care of Illinois, Inc., for $4.3 million in cash. The Illinois health plan accounted for approximately 56,000 risk members and 2,400 non-risk members as of November 30, 1998.
The proceeds from both sales were used to retire Coventry’s credit facility, to assist in improving the capital position of its regulated subsidiaries, and for other general corporate purposes. Given the short time period between the respective acquisition and sale dates and the lack of events or other evidence which would indicate differing values, no gain or loss was recognized on the sales of the Florida and Illinois health plans, as the sale prices were considered by management to be equivalent to the fair values allocable to these plans at the date of their acquisition from Principal Life in April 1998.
In connection with the acquisition of certain PHC health plans and the sales of the Florida and Illinois plans, Coventry established reserves of approximately $33.0 million for the estimated transition costs of the PHC health plans. These reserves were primarily comprised of severance costs related to involuntary terminations of former PHC employees, relocation costs of former PHC personnel, lease termination costs and contract termination costs. Through December 31, 2000, Coventry has expended the entire $33.0 million related to these reserves.
In the fourth quarter of 1999, Coventry notified the Indiana Department of Insurance of its intention to close its subsidiary, Coventry Health Care of Indiana, Inc., formerly Principal Health Care of Indiana, Inc. As of December 31, 2000, the health plan had no remaining members throughout the state. As a result of the cost associated with exiting the Indiana market, Coventry recorded a reserve of $2.0 million in the fourth quarter of 1999. Coventry had expended approximately $1.3 million as of December 31, 2000 and closed the plan in the fourth quarter 2000.
Other Acquisitions Effective October 1, 1999, the Company acquired Carelink Health Plans (“Carelink”), the managed care subsidiary of Camcare, Inc., for a total purchase price of approximately $8.4 million including transaction costs of approximately $0.4 million. The acquisition was accounted for using the purchase method of accounting, and, accordingly, the operating results of Carelink have been included in the Company’s consolidated financial statements since the date of acquisition. The purchase price for Carelink was allocated to the assets, including the identifiable intangible assets, and liabilities based on estimated fair values. The $1.0 million excess of purchase price over the net identifiable assets acquired was allocated to goodwill, which is being amortized over a useful life of 25 years. Carelink is the market leader and has a broad provider network in West Virginia with a service area covering the majority of the state’s population.
On November 1, 1999, the Company’s subsidiary, Coventry Health Care of the Carolinas, Inc., acquired Kaiser Foundation Health Plan of North Carolina, Inc.‘s (“KFHPNC”) commercial membership, of approximately 31,000, in Charlotte, North Carolina. The total purchase price was approximately $2.1 million including transaction costs. The transaction more than doubled Coventry’s membership in the Charlotte market.
On October 2, 2000, Coventry completed the acquisition of WellPath Community Health Plans (“WellPath”), for a purchase price of $21.2 million including transition costs of $0.5 million. The acquisition was accounted for using the purchase method of accounting, and, accordingly, the operating results of WellPath have been included in the Company's consolidated financial statements since the date of acquisition. The purchase price for WellPath was allocated to the assets, including identifiable intangible assets, and liabilities based on the estimated fair values. The $5.7 million excess of purchase price over the net identifiable assets acquired was allocated to goodwill, which is being amortized over a useful life of 25 years.
Comparison of 2000 to 1999 Managed care premium revenues increased in 2000 over 1999 as a result of rate increases that occurred throughout both years and as a result of member growth, both organic and through acquisitions. Premium rate increasing by an average of $12.31 over 1999 on a per member per month (“PMPM”) basis, to $163.14 PMPM is the primary reason for the increased revenues. Coventry will continue to be diligent in attempting to obtain adequate premium increases and expects premium rates to increase more than 12.5% for renewals in the first quarter of 2001. The acquisitions that contributed to the increase in premium revenues occurred in the fourth quarter of 1999 and in the first, third, and fourth quarters of 2000. Membership, and thus premium revenues, in the Medicare and Medicaid program continues to grow not only through acquisitions, but also organically. More than half of the increase in Governmental program membership came from growth in existing markets.
Medical expense increased in 2000 compared to 1999 due almost equally to the additional expenses associated with acquisitions and medical trends. Despite the increase in expense, the medical loss ratio, excluding charges, decreased to 85.8% from 86.1% in 1999 due to medical expenses increasing at a lessor pace than that of premium rates.
SG&A expense increased due primarily to the additional expense associated with the acquired Carelink, PrimeONE, Maxicare and WellPath health plans. SG&A expense, as a percent of revenue, decreased to 12.7% in 2000, compared to 13.8% in 1999 due to improved operational efficiencies driven by the consolidation of eighteen service centers into three regional service centers and continued management scrutiny of administrative expenses.
Depreciation and amortization decreased compared to the prior year primarily due to intangible assets relating to the Principal health plan acquisition that were fully amortized by the end of 1999. The decrease of intangible asset amortization was partially offset by an increase in amortization of goodwill relating to acquisitions and an increase in computer software and hardware depreciation.
Other income, net of interest expense, increased in 2000 from 1999 due to increased investment income as a result of an increase in the Company’s long-term investments compared to the prior year. The Company incurred no interest expense in 2000 due to the extinguishment of all outstanding debt in 1999.
Comparison of 1999 to 1998 Managed care premium revenues increased in 1999 over 1998 primarily due to the additional revenue associated with the acquisitions of Carelink and the KFHPNC membership in the fourth quarter of 1999 and also due to the increase in Medicare and Medicaid membership of 34,345, or 20.6%, in continuing markets. In addition to the increase in risk membership, premiums increased by an average of $9.00, or 6.3%, over 1998 on a PMPM basis, to $150.83 PMPM, as a result of rate increases. The Medicare and Medicaid programs continued to grow in existing markets through expanded programs. On a same store basis, the increase in Medicare and Medicaid membership was offset by a decrease in commercial membership of 57,321, or 5.7%. The decrease in commercial membership occurred primarily in the western Pennsylvania market, attributable to the disruption caused by the AHERF bankruptcy filing and the conversion of a large group from a commercial risk product to a self-funded product. Membership also decreased in other markets due to Coventry’s efforts to adhere to a strict pricing discipline.
Management services revenue increased in 1999 from 1998 primarily due to an increase in self-funded membership of 19,695, or 9.0%, including the conversion of a large group from a commercial risk product to a self-funded product.
Medical expense increased in 1999 compared to 1998 due primarily to the additional expenses associated with the acquisitions of Carelink and KFHPNC membership. Exclusive of the Carelink and KFHPNC transactions, health benefits expense decreased $4.0 million. Coventry’s medical loss ratio decreased slightly to 86.1% from 86.9% in 1998 due to premium rate increases, which were a result of Coventry’s efforts to maintain a strict pricing discipline.
Depreciation and amortization increased compared to 1998 primarily as a result of the depreciation related to the net capital expenditures of $14.7 million in 1999 and the additional amortization related to the intangibles recorded as part of the acquisition of the PHC health plans in April 1998.
Liquidity and Capital Resources The Company’s total cash and investments, excluding deposits of $22.4 million restricted under state regulations, increased $140.3 million to $730.1 million at December 31, 2000 from $589.8 million at December 31, 1999. The increase was primarily due to the Company’s $88.4 million of net earnings excluding depreciation and amortization. The increase was also due in part to the cash and investments acquired of $33.3 million, net of purchase price, net worth and transactions costs, for acquisitions of PrimeONE, Maxicare, and WellPath in the year 2000.
During the quarter ended June 30, 1997, the Company entered into a securities purchase agreement (“Warburg Agreement”) with Warburg, Pincus Ventures, L.P. (“Warburg”) and Franklin Capital Associates III, L.P. (“Franklin”) for the purchase of $40.0 million of the Company’s 8.3% Convertible Exchangeable Senior Subordinated Notes (“Coventry Notes”), together with warrants to purchase 2.35 million shares of the Company’s common stock for $42.4 million. The original amounts of the Coventry Notes, $36.0 million held by Warburg and $4.0 million held by Franklin, were exchangeable at the Company’s or Warburg’s option for shares of redeemable convertible preferred stock.
Projected capital investments in 2001 of approximately $12.0 million consist primarily of computer hardware, software and related equipment costs associated with the development and implementation of improved operational and communications systems.
The Company believes that cash flows generated from operations, cash and investments, and excess funds in certain of its regulated subsidiaries will be sufficient to fund continuing operations through December 31, 2001.
In February 2001, the FASB issued a revised Exposure Draft entitled “Business Combinations and Intangibles - Accounting for Goodwill.” This proposed Statement would prohibit registrants from using the pooling method of accounting for business combinations. This guidance would also continue to require recognition of purchased goodwill as an asset but would prohibit amortization of such goodwill. Goodwill would instead be tested for impairment on an ongoing basis using a fair-value-approach, and any adjustments thereto would result in a separate charge to earnings in the period in which the impairment took place. The Statement would become effective at the beginning of the fiscal quarter immediately following the date of issuance. Earlier application would not be permitted, nor would retroactive application to financial statements of prior periods. The effect, on the Company, of the adoption of this proposed Statement would be to eliminate goodwill amortization expense.
In December 1999, the Securities and Exchange Commission (“SEC”) issued Staff Accounting Bulletin (“SAB”) No. 101, “Revenue Recognition in Financial Statements.” SAB No. 101 summarizes certain of the SEC's views in applying generally accepted accounting principles to revenue recognition in financial statements. SAB No. 101 must be adopted no later than the fourth quarter of fiscal year 2000. The adoption of SAB No.101 did not have a material effect on the Company's financial position or results of operations.
In March 2000, the FASB issued Interpretation (“FIN”) No. 44, “Accounting for Certain Transactions Involving Stock Compensation - an Interpretation of APB No. 25.” FIN No. 44 clarifies the application of Accounting Principles Board Opinion (“APB”) No. 25 for certain issues including: (a) the definition of “employee” for purposes of applying APB No. 25, (b) the criteria for determining whether a plan qualifies as a non-compensatory plan, (c) the accounting consequence of various modifications to the terms of a previously fixed stock option or award, and (d) the accounting for an exchange of stock compensation awards in a business combination. In general, FIN No. 44 was effective July 1, 2000. The adoption of FIN No. 44 did not have a material effect on the Company's financial position or results of operations.
In March 1998, the American Institute of Certified Public Accountants (“AICPA”) issued Statement of Position 98-1 (“SOP 98-1”), “Accounting for the Costs of Computer Software Developed or Obtained for Internal Use.” SOP 98-1 provides authoritative guidance for the capitalization of certain costs related to computer software developed or obtained for internal applications, such as external direct costs of materials and services, payroll costs for employees and certain interest costs. Costs incurred during the preliminary project stage, as well as training and data conversion costs, are to be expensed as incurred. SOP 98-1 was effective for fiscal years that began after December 15, 1998. The Company adopted SOP 98-1 effective January 1, 1999. The adoption of SOP 98-1 did not have a material effect on the Company’s consolidated financial statements.
Inflation Health care cost inflation has exceeded the general inflation rate and the Company has implemented cost control measures that include patient care management and provider contracting, which seek to reduce the effect of health care cost inflation. During 2000, the Company implemented increases in premium rates, which exceeded inflationary cost increases while maintaining competitive rates within its markets.
E-Commerce Initiatives The Company has launched several e-commerce initiatives. Each initiative is intended to reach a segment of our core business customers: providers, brokers, employers and members, and will have a distinct e-commerce solution. The Company's e-commerce initiatives are extending the Company's core business functions directly to the customers in an effort to deliver increased customer value, in a complex and rapidly changing business and regulatory environment.
Broker/Employer Channel. The Company continues to work with the iSolutions Group at Workscape, Inc., (“Workscape”), for the delivery of Internet solutions that automate the entire sales and enrollment process for the Company’s small group insurance market. Workscape’s iSolutions Express product is a web-based application that streamlines the end-to-end process of quoting, enrollment, underwriting, case installation and renewal for employee benefits providers, their sales representatives, agents and customers. The Company is currently live with Workscape Express at its HealthAmerica plan in central and western Pennsylvania and is currently about to go live at Group Health Plan in St Louis, Missouri, central and southern Illinois. These implementations will be followed by the Company’s other health plans in 2001 and 2002.
Later in 2001, the Company will go live with employer functionality that will allow employers to view billing and eligibility information online. This functionality will enable them to reconcile billing statements and verify eligibility without a phone call. GeoAccess continues to provide the Company with their online health care directory technology, which makes information about health plan providers available to members. GeoAccess is now live on all Company health plan web sites.
Risk Factors The risks described below are not the only ones that we face. Additional risks not presently known to us or that we currently deem immaterial may also impair our business operations.
In the future, the costs of health care services and supplies that we provide to our membership may rise faster than our ability to increase premium rates. If costs rise and we are unable to increase premium rates, our gross profit margin will shrink. A shrinking gross profit margin may reduce our net income and adversely affect the value of your investment in Coventry.
If we are unable to increase our revenues and our gross profit margin shrinks, or if we are unable to maintain our revenues, our net income may decrease.
In some of our markets, there are provider systems that have a major presence. These provider systems could adversely affect our product offerings and profitability if they refuse to contract with us, place us at a competitive disadvantage or use their market position to negotiate contracts that are unfavorable to us.
Medical cost control techniques we have utilized include capitation agreements with providers. Under these agreements, we pay providers a fixed dollar amount per member per month. In exchange for these fixed payments, providers agree to provide all of a particular type of medical service required by our members. Under these agreements, a single integrated hospital-physician provider system provides almost all hospital and medical services to a large number of members for a fixed percentage of the premium we charge for those members. While these arrangements may shift to the contracting provider system the risk that medical costs will exceed the amounts anticipated, we will be exposed to the risks if the provider systems are financially unable or unwilling to fulfill their payment or medical care obligations under the capitation agreements. In addition, members may prefer other providers in the market with whom we do not have capitation agreements. If our members choose to utilize providers with whom we do not have capitation agreements, we may incur higher costs. These higher costs may negatively affect our operating results.
As a result of our acquisition of the health plans of Principal Health Care, Inc., a subsidiary of Principal Life, in 1998, Principal Life acquired approximately 40% of our common stock, on a fully diluted basis. On September 8, 2000, Principal Life sold 10 million shares of Coventry’s common stock to affiliates of Warburg, Pincus Ventures, L.P. (“Warburg”) in a private transaction. As a result of this sale, Principal Life’s ownership interest was reduced to approximately 23.2% of our common stock. Because of previously agreed upon limitations effective through April 2003, Principal Life may purchase additional shares of our common stock up to, but not more than, 40% ownership of our fully diluted common stock.
In addition to its ownership position, Principal Life currently has four designated members serving on our ten-member board of directors. As long as Principal Life owns at least 10% of our outstanding common stock, it has the right to designate one member of our board of directors for each 6% of our outstanding common stock that it holds. On September 8, 2000, Principal Life sold 10 million shares of our outstanding common stock to Warburg in a private transaction. As a result, Principal Life’s ownership percentage decreased from approximately 39.7% to approximately 23.2% of our outstanding common stock. Accordingly, Principal Life’s right to designate members on our board of directors has correspondingly decreased and Principal Life currently has the right to designate up to at least three members of our board of directors.
Principal Life’s current ownership position and its representation on our board of directors allow it to exert significant influence over the direction and operations of Coventry. This influence could be used in a manner that is contrary to the best interests of our other shareholders and may accordingly decrease the value of your investment in Coventry.
In addition to its ownership position, Warburg has designated two directors currently serving on our board of directors. Warburg had the right to designate at least two directors of our board of directors until such time as Warburg converted its shares of our Series A convertible preferred stock into shares of our common stock, which occurred on December 26, 2000. As long as Warburg retains ownership of at least 50% of the shares of our common stock it beneficially owned at the time of its original investment in our common stock in 1997, Warburg has the right to designate at least one member on our board of directors. As of March 12, 2001, Warburg continues to hold all shares represented by its original investment in Coventry and, therefore, currently has the right to designate one member of our board of directors.
Warburg and Principal Life currently own approximately 29.5% and 23.2%, respectively, of our outstanding common shares, and could individually or together exert significant influence over the direction and operations of Coventry. The value of your investment in Coventry could decline as future investors may not consider our common stock to be an attractive stock due to the percentage of our common stock held by, or that may be held by, Principal Life and Warburg.
Our industry is heavily regulated and the laws and regulations governing the industry and interpretations of those laws and regulations are subject to frequent change. Existing or future laws could force us to change how we do business and may restrict our revenue and/or enrollment growth and/or increase our health care and administrative costs. We must obtain and maintain regulatory approvals to market many of our products and services. Delay in obtaining or failing to obtain or maintain these approvals could adversely affect our revenue or the number of our covered lives, or could increase our costs.
Coventry contracts with various federal and state governmental agencies to provide managed health care services. These agencies include:
the U. S. Health Care Financing Administration that contracts with us to provide a Medicare product to eligible beneficiaries; and
These contracts and applicable federal and state regulations, among other requirements, establish premium rating requirements or fixed premiums per member per month. These governmental agencies and states may periodically audit us to verify our compliance with their contracts and applicable federal and state laws and regulations. These audits could result in material adjustments. An adverse audit of our contracts with governmental agencies could result in the loss of licensure, the loss of the right to participate in programs, the imposition of fines, penalties, and other sanctions and could negatively affect our reputation in various markets and make it more difficult for us to sell our products and services.
The National Association of Insurance Commissioners has proposed that states adopt risk-based capital standards that, if implemented, would generally require higher minimum capitalization requirements for HMOs and other risk-bearing health care entities. Several states where we have HMO operations have adopted those standards, effective either in 2001 or to be phased-in over a period of years. While we do not expect the legislation enacted to date to have a material impact on our consolidated financial position in the near future, we cannot assure that additional legislation of this type will not unduly burden our financial resources.
We are susceptible to litigation and insurance risks, including medical malpractice liability, disputes relating to the denial of coverage and the adequacy of “stop-loss” reinsurance for costs resulting from catastrophic injuries or illnesses. We also face contingent litigation risk from discontinued operations. These litigation and insurance risks may result in losses to us that could have a material adverse effect on our operations, financial performance, cash flows or future prospects.
December 31, 2000, 1999 and 1998 A. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Coventry Health Care, Inc. (together with its subsidiaries, the “Company”, “we”, “our”, or “us”) is a managed health care company operating health plans under the names Coventry Health Care, Coventry Health and Life, HealthAmerica, HealthAssurance, HealthCare USA, Group Health Plan, SouthCare, Southern Health, Carelink Health Plans and WellPath. The Company provides a full range of managed care products and services including health maintenance organization (“HMO”), point of service (“POS”) and preferred provider organization (“PPO”) products. The Company also administers self-insured plans for large employer groups. The Company was incorporated under the laws of the state of Delaware on December 17, 1997, and is the successor to Coventry Corporation, which was incorporated on November 21, 1986.
Principles of Consolidation - The consolidated financial statements include the accounts of the Company and its subsidiaries. All significant intercompany transactions have been eliminated. Interests of other investors in the Company’s majority owned (or otherwise effectively-controlled) subsidiaries are accounted for as minority interests and are included in other long-term liabilities for financial reporting purposes.
Long-lived Assets - The Company has adopted SFAS No. 121, “Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of.” In accordance with SFAS No. 121, the Company evaluates long-lived assets to be held for events or changes in circumstances that would indicate that the carrying value may not be recoverable. In making that determination, the Company considers a number of factors, including undiscounted future cash flows, prior to interest expense. The Company measures an impairment loss by comparing the fair value of the assets to their carrying value. Fair values are determined by using market prices for similar assets, if available, or discounted future estimated cash flows, prior to interest expense. Assets held for sale are recorded at the lower of the carrying amount or fair value, less any cost of disposition.
Other Long-term Assets - Other assets consist primarily of assets related to the supplemental executive retirement plan (See Note N to consolidated financial statements).
Medical Claims Liabilities - Medical claims liabilities consist of actual claims reported but not paid and estimates of health care services incurred but not reported. The estimated claims incurred but not reported are based on historical data, current enrollment, health service utilization statistics, and other related information. Although considerable variability is inherent in such estimates, management believes that the liability is adequate. The Company also establishes reserves, if required, for the probability that anticipated future health care costs and contract maintenance costs under the group of existing contracts will exceed anticipated future premiums and reinsurance recoveries on those contracts. These accruals are continually monitored and reviewed, and as settlements are made or accruals adjusted, differences are reflected in current operations. Changes in assumptions for medical costs caused by changes in actual experience could cause these estimates to change in the near term.
Revenue Recognition - Managed care premiums are recorded as revenue in the month in which members are entitled to service. Premiums collected in advance are recorded as deferred revenue. Employer contracts are typically on an annual basis, subject to cancellation by the employer group or the Company upon thirty days written notice. Management services revenues are recognized in the period in which the related services are performed. Premiums for services to federal employee groups are subject to audit and review by the Office of Personnel Management (“OPM”) on a periodic basis. Such audits are usually a number of years in arrears. The Company provides reserves, on an estimated basis annually, based on the appropriate guidelines. Any differences between actual results and estimates are recorded in the year the audits are finalized.
In December 1999, the Securities and Exchange Commission (“SEC”) issued Staff Accounting Bulletin (“SAB”) No. 101, “Revenue Recognition in Financial Statements.” SAB No. 101 summarizes certain of the SEC’s views in applying generally accepted accounting principles to revenue recognition in financial statements. SAB No. 101 must be adopted no later than the fourth quarter of fiscal year 2000. The adoption of SAB No. 101 did not have a material effect on the Company's financial position or results of operations.
Significant Customers - For the years ended 2000, 1999, and 1998, the Company received 15.8%, 16.0%, and 15.2%, respectively, of its revenue from the Federal Medicare program throughout the Company’s various markets.
Stock-based Compensation - The Financial Accounting Standards Board (“FASB”) issued SFAS No. 123, “Accounting for Stock-Based Compensation.” As permitted by SFAS No. 123, the Company has elected to continue to account for stock-based compensation to employees under APB No. 25, and complies with the disclosure requirements for SFAS No. 123. See Note J for disclosures related to stock-based compensation.
Comprehensive Income - Effective January 1, 1998, the Company adopted SFAS No. 130, “Reporting Comprehensive Income.” SFAS No. 130 requires that changes in the amounts of certain items, including unrealized gains and losses on certain securities, be shown in the financial statements as part of comprehensive income. The adoption of this standard did not have a material effect on the Company’s consolidated financial statements.
Commercial products include HMO, PPO, and POS products. HMO products provide comprehensive health care benefits to enrollees through a primary care physician. PPO and POS products permit members to participate in managed care but allow them the flexibility to utilize out-of-network providers in exchange for an increase in out-of-pocket costs to the member.
Computer Software - Effective January 1, 1999, the Company adopted Statement of Position 98-1 (“SOP 98-1”), “Accounting for the Cost of Computer Software Developed or Obtained for Internal Use” issued by the American Institute of Certified Public Accountants (“AICPA”). SOP 98-1 provides authoritative guidance for the capitalization of certain costs related to computer software developed or obtained for internal applications, such as external direct costs of materials and services, payroll costs for employees and certain interest costs. Costs incurred during the preliminary project stage, as well as training and data conversion costs, are to be expensed as incurred. The adoption of SOP 98-1 did not have a material effect on the Company’s consolidated financial statements.
At the closing, the Company also entered into a Marketing Services Agreement and a Management Services Agreement with Principal Life. Both agreements expired on December 31, 1999. Pursuant to the agreements, the Company recognized revenue of approximately $25.5 million and $23.0 million for the years ended December 31, 1999 and 1998, respectively.
As a result of the acquisition, the Company assumed an agreement with Principal Life, whereby Principal Life paid a fee for access to the Company’s PPO network based on a fixed rate per employee entitled to access the PPO network and a percentage of savings realized by Principal Life. Effective June 1, 1999, Coventry sold the Illinois portion of the PPO network back to Principal Life. Under this agreement, the Company recognized revenue of approximately $8.0 million and $12.0 million for the years ended December 31, 1999 and 1998, respectively.
Effective November 30, 1998, the Company sold its subsidiary, Principal Health Care of Illinois, Inc., for $4.3 million in cash. The Illinois health plan accounted for approximately 56,000 risk members and approximately 2,400 non-risk members as of November 30, 1998.
C. OTHER ACQUISITIONS Effective October 1, 1999, the Company acquired Carelink Health Plans (“Carelink”), the managed care subsidiary of Camcare, Inc., for a total purchase price of approximately $8.4 million including transaction costs of approximately $0.4 million. The acquisition was accounted for using the purchase method of accounting, and, accordingly, the operating results of Carelink have been included in the Company’s consolidated financial statements since the date of the acquisition. The purchase price for Carelink was allocated to the assets, including the identifiable intangible assets, and liabilities based on estimated fair values. The $1.0 million excess of purchase price over the net identified tangible assets acquired was allocated to goodwill which is amortized over a useful life of 25 years.
Effective February 1, 2000, the Company completed its acquisition of The Anthem Company’s West Virginia managed care subsidiary, PrimeONE, Inc. (“PrimeONE”), for a purchase price of $1.25 million plus statutory net worth and transaction costs for a total approximate purchase price of $4.3 million. The acquisition was accounted for using the purchase method of accounting, and, accordingly, the operating results of PrimeONE have been included in the Company's consolidated financial statements since the date of the acquisition. The purchase price for PrimeONE was allocated to the assets, including the identifiable intangible assets, and liabilities based on estimated fair values. The $0.3 million excess of purchase price over the net identifiable assets acquired was allocated to goodwill, which is amortized over a useful life of 25 years.
On February 3, 2000, Coventry completed the acquisition of Prudential Health Care Plan, Inc.’s Medicaid business in St. Louis, Missouri for approximately $100 per member. The final payment for the purchase of the Medicaid business of approximately 9,400 members was made during the third quarter of 2000.
The following unaudited pro-forma condensed consolidated results of operations assumes the acquisitions of Carelink, PrimeONE, Maxicare and WellPath health plans occurred on January 1, 1999 and 2000, and is in thousands, except per share data.
On July 22, 1999, the Company reached a settlement with the hospitals, including Allegheny General Hospital, formerly owned by AHERF, and its new owner, Western Pennsylvania Health Care System (“West Penn”), whereby the hospitals agreed that the Company would not be liable for the payment of certain medical services rendered by the hospitals to the Company’s members prior to July 21, 1998, the date of AHERF’s bankruptcy filing. Simultaneous with the settlement, the Company signed a new three-year provider contract with West Penn. The conditions to execute the settlement and the provider contract were finalized in October 1999 and, as a result, all liability issues surrounding AHERF’s failure to fulfill its contractual obligations and the Company’s remaining obligations have been determined and all AHERF-related litigation has been concluded.
E. MERGER COSTS In connection with the acquisition of the PHC health plans, the Company relocated its corporate headquarters from Nashville, Tennessee to Bethesda, Maryland. As a result, the Company established a one-time reserve in 1998 of approximately $6.5 million for the incurred and anticipated costs related to the relocation of the corporate office and other direct merger related costs. The reserve is primarily comprised of severance costs related to involuntary terminations, relocation costs for management personnel, and lease costs, net of sublease income, related to the unused space remaining at the old headquarters location. As of December 31, 2000, the Company expended approximately $6.2 million and expects to make payments through March 2003 related to these charges.
F. PROPERTY AND EQUIPMENT Property and equipment is comprised of the following (in thousands):
The valuation allowance for deferred tax assets as of December 31, 2000 and 1999 is $3.3 million due to the Company’s belief that the realization of the deferred tax asset resulting from federal and state net operating loss carryforwards associated with certain acquisitions is doubtful.
During the second and third quarters of 1999, the Company converted all the Coventry Notes held by Warburg and Franklin totaling $47.1 million, including accumulated interest, into 4,709,545 shares of Series A redeemable convertible preferred stock (“preferred stock”) at a price of $10 per share. The preferred stock was convertible to common stock on a share-for-share basis, subject to adjustment for anti-dilution, and was callable by the Company if the market price of the Company’s common stock exceeded certain agreed upon targets. On July 20, 2000, Franklin converted all of its 473,705 shares of preferred stock into 473,752 shares of common stock of the Company on a one-for-one basis, as adjusted for anti-dilution in January 2001. On December 26, 2000, Warburg converted all of its remaining shares of preferred stock into 4,236,263 shares of common stock of the Company on a one-for-one basis, adjusted for anti-dilution, thus eliminating all outstanding shares of preferred stock.
J. STOCK OPTIONS, WARRANTS AND EMPLOYEE STOCK PURCHASE PLAN As of December 31, 2000, the Company had one stock incentive plan, the Amended and Restated 1998 Stock Incentive Plan (the “1998 Plan”) under which shares of the Company’s common stock are authorized for issuance to key employees, consultants and directors in the form of stock options, restricted stock and other stock based awards. Under the 1998 Plan, the terms and conditions of grants are established on an individual basis with the exercise price of the options being equal to not less than 100% of the market value of the underlying stock at the date of grant. Options generally become exercisable after one year in 20% to 25% increments per year and expire ten years from the date of grant. The 1998 Plan is authorized to grant either incentive stock options or nonqualified stock options at the discretion of the Compensation and Benefits Committee of the Board of Directors. At April 1, 1998, the 1998 Plan assumed the obligations of six stock option plans of Coventry Corporation with total outstanding options representing 3,322,714 shares, and one stock option plan of Principal Health Care, Inc. with total outstanding options representing 750,000 shares, as a result of the acquisition of the PHC plans. At the annual meeting of shareholders held on June 8, 2000, the Company’s shareholders voted to increase the shares of common stock authorized for issuance under the 1998 Plan from an aggregate of 7 million shares to an aggregate of 9 million shares. At December 31, 2000, the 1998 Plan had total outstanding options representing 5,203,846 shares of common stock.
The weighted-average grant date fair values for options granted in 2000, 1999 and 1998 were $6.01, $5.29, and $4.53, respectively.
At December 31, 2000, the Company had warrants outstanding granting holders the right to purchase 3,609,449 shares of common stock.
On April 1, 1998, the Company issued a warrant to PHC (the “Principal Warrant”) to purchase that number of shares of common stock equal to 66-2/3% of the total number of shares of common stock actually issued upon the exercise or conversion of the Company’s employee stock options and warrants issued and outstanding at March 31, 1998, on the same terms and conditions as set forth in the respective options and warrants. The subsequent repricing of outstanding employee stock options on September 10, 1998 (see above) did not affect the Principal Warrant. Options and warrants that terminated or expired and are not exercised, are also canceled in the Principal Warrant. At March 31, 1998, the Company had options and warrants outstanding for 5,800,480 shares of common stock, representing the right to purchase 3,866,986 shares under the Principal Warrant. On May 21, 1999, November 11, 1999 and March 31, 2000, PHC exercised a portion of the Principal Warrant pursuant to exercises of the underlying options and purchased 1,335, 10,915, and 47,533 shares of common stock, respectively. At December 31, 2000, the Principal Warrant represented the right to purchase approximately 3.1 million shares, taking into account exercises and cancellations.
L. COMMITMENTS The Company operates primarily in leased facilities with original lease terms of up to ten years with options for renewal. The Company also leases computer equipment with lease terms of approximately three years. Leases that expire generally are expected to be renewed or replaced by other leases.
M. CONCENTRATIONS OF CREDIT RISK Financial instruments which potentially subject the Company to concentrations of credit risk consist primarily of cash and cash equivalents, investments in marketable securities and accounts receivable. The Company invests its excess cash in interest bearing deposits with major banks, commercial paper, and money market funds. Investments in marketable securities are managed within guidelines established by the Board of Directors which emphasize investment-grade fixed income securities and limit the amount that may be invested in any one issuer. The fair value of the Company’s financial instruments is substantially equivalent to their carrying value and, although there is some credit risk associated with these instruments, the Company believes this risk to be minimal.
Concentration of credit risk with respect to accounts receivable is limited due to the large number of customers comprising the Company’s customer base and their breakdown among geographical locations. The Company believes the allowance for doubtful collections adequately provides for estimated losses as of December 31, 2000. The Company has a risk of incurring loss if such allowances are not adequate.
Under the New Plan, as merged, participants may defer up to 15% of their compensation, limited by the maximum compensation deferral amount permitted by applicable law. The Company makes matching contributions in the Company’s common stock equal to 100% of the participant’s contribution on the first 3% of the participant’s compensation deferral and equal to 50% of the participant’s contribution on the second 3% of the participant’s compensation deferral. Participants will vest in the Company’s matching contributions in 50% increments annually over a period of two years, based on length of service with the Company and/or its subsidiaries. All costs of the New Plan, as merged, are funded by the Company and participants as they are incurred.
On July 1, 1994, Coventry Corporation adopted a supplemental executive retirement plan (the “SERP”), which covered employees of Coventry Corporation and its subsidiaries who (1) meet certain requirements as to age and management responsibilities and/or salary, (2) are designated as being eligible to participate in the SERP by the Compensation and Benefits Committee of the Board of Directors of the Company, and (3) elect to participate in the SERP and the Plan. A similar supplemental executive retirement plan offered by HAPA was merged into the SERP effective July 1, 1994. The Company, with the approval of Coventry Corporation, adopted and became sponsor of the SERP effective April 1, 1998. Effective April 1, 1998, the SERP Plan name changed to the Coventry Health Care, Inc. Supplemental Executive Retirement Plan. Under the SERP, participants may defer up to 15% of their base salary, and up to 100% of any bonus awarded, over and beyond the compensation deferral limits of the Plan. Effective January 1, 1999, the Company amended the SERP’s definition of compensation to exclude income or proceeds from the Company’s Stock Incentive Plan and relocation payments. The Company makes matching contributions equal to 100% of the participant’s contribution on the first 3% of the participant’s compensation deferral and 50% of the participant’s contribution on the second 3% of the participant’s compensation deferral. Participants vest in the Company’s matching contributions ratably over two years, based on length of service. All costs of the SERP are funded by the Company as they are incurred.
CH&L’s authorized control level risk-based capital is approximately $12.8 million. Total adjusted statutory capital and surplus of CH&L as of December 31, 2000 was approximately $39.9 million. Statutory deposits for CH&L as of December 31, 2000 totaled approximately $3.5 million.
R. LEGAL PROCEEDINGS In the normal course of business, the Company has been named as a defendant in various legal actions such as actions seeking payments for claims denied by the Company, medical malpractice actions, and other various claims seeking monetary damages. The claims are in various stages of proceedings and some may ultimately be brought to trial. Incidents occurring through December 31, 2000 may result in the assertion of additional claims. With respect to medical malpractice, the Company carries professional malpractice and general liability insurance for each of its operations on a claims-made basis with varying deductibles for which the Company maintains reserves. In the opinion of management, the outcome of these actions should not have a material adverse effect on the financial position or results of operations of the Company.
Other managed care companies have been sued recently in class action lawsuits claiming violations of the federal racketeering act, Racketeer Influenced and Corrupt Organizations (“RICO”) and the Employee Retirement Income Security Act of 1974 (“ERISA”), and generally claiming that managed care companies overcharge consumers and misrepresent that they deliver quality health care. Although it is possible that the Company may be the target of a similar suit, the Company believes there is no valid basis for such a suit.
The Company’s industry is heavily regulated and the laws and rules governing the industry and interpretations of those laws and rules are subject to frequent change. Existing or future laws could have significant impact on the Company’s operations.
Following are reconciliations of reportable segment information to financial statement amounts, in thousands:
T. QUARTERLY FINANCIAL DATA (UNAUDITED) The following is a summary of unaudited quarterly results of operations (in thousands, except per share data) for the years ended December 31, 2000 and 1999.
On January 18, 2001, the Company announced that its subsidiary, Coventry Health Care of Kansas, Inc., had signed a definitive agreement to acquire Kaiser Foundation Health Plan of Kansas City, Inc.’s, (“Kaiser”) membership in Kansas City. Kaiser’s Kansas City operation has approximately 50,000 commercial and 5,000 Medicare members. The acquisition will ultimately bring Coventry’s total membership in Kansas City to approximately 110,000 members.