Results for 2002 include a pretax charge of $151.3 million, net, or $0.98 per diluted share, related to the Company’s offer to settle the securities class action lawsuits brought in 1997 following the October 27, 1997 decline in the price of the Company’s stock and a pretax charge of $20 million, or $0.13 per diluted share, for additional estimated legal expenses associated with such litigation. Also included in pretax earnings for 2002 were charges related to the conclusion of the Company’s outsource arrangement with CSC and the other than temporary impairment charge related to the Company’s investment in MedUnite totaling approximately $26.5 million, or $0.17 per diluted share. In addition, the 2002 period includes a reduction in estimated liabilities for New York State Market Stabilization Pools (the “Pools” or “New York Stabilization Pools”) of approximately $20.8 million for 2001 and prior years, and an increase of approximately $1.2 million in estimated recoveries for 2001 stop-loss pools for New York Mandated Plans, or a total of $0.14 per diluted share, and approximately $33.3 million, or $0.22 per diluted share, related to changes in estimates of prior period medical cost reserves, resulting primarily from ongoing incremental improvements in processes such that the level of completion of claims was, in retrospect, slightly higher than assumed for 2001. Results for 2001 were positively impacted by approximately $15 million of favorable development of prior period estimates of medical costs and recoveries from the New York Stabilization Pools. Results for 2000 were adversely affected by charges related to recapitalization transactions. An extraordinary charge of $20.3 million, net of income tax benefits of $13.9 million, was recorded in 2000 in connection with the prepayment of the
Term Loan Agreement, dated as of May 13, 1998 (the “Term Loan”) and the repurchase or tender of $200 million of its 11% Senior Notes due 2005 (the “Senior Notes”). The extraordinary charges include premiums paid, transaction costs and the write-off of unamortized original issuance debt costs. In addition, in 2000, the Company completed an exchange and repurchase agreement for all of its outstanding Series D Cumulative Preferred Stock, par value $0.01 per share, and Series E Cumulative Preferred Stock, par value $0.01 per share (together, the “Preferred Stock”) and incurred costs of approximately $41.1 million related to the write-off of unamortized Preferred Stock discount and costs from the original issuance in 1998 and related transaction fees. Results for 2000 were positively impacted by approximately $86 million of favorable development of prior period estimates of medical costs, claims recoveries and Pool recoveries. Net income for 2001 and 2000 was favorably affected by the reversal of $21 million and $10 million, respectively, of deferred tax valuation allowances.
Marketing, general and administrative expenses increased $86.3 million, or 17.6%, to $575.4 million for 2002, excluding the $151.3 million net litigation charge for the offer to settle, compared with $489.1 million for 2001. Included in administrative expenses for the year ended December 31, 2002 are termination fees and a non-cash asset impairment charge attributable to the termination of the CSC agreement of approximately $15.5 million and additional estimated legal expenses related to the securities class action litigation of $20 million. Marketing, general and administrative expenses as a percent of operating revenue was 11.8% in 2002, including the CSC charge and excluding the net litigation charge for estimated settlement, compared with 11.3% in 2001. The increase in dollars spent in 2002 when compared with the prior year is primarily due to increased broker commissions, as a result of higher premium revenue, and increased payroll, benefit and corporate insurance costs. Broker commissions and premium taxes were approximately 28.4% of marketing, general and administrative expenses in 2002, excluding the net litigation charge for estimated settlement, compared with approximately 26.3% in 2001. During 2001, the Company recorded a charge of $10 million for estimated legal expenses related to the securities class action pending against the Company that may not be recoverable from one of the Company’s primary director’s and officer’s insurance carriers due to its insolvency. Administrative costs in future periods may also be adversely affected by costs associated with responding to regulatory inquiries, investigations and defending pending securities class actions and other litigation, including fees and disbursements of counsel and other experts to the extent such costs are not reimbursed under existing policies of insurance. See “Legal Proceedings”.
The Company incurred interest and other financing charges of $11 million and $19 million in 2002 and 2001, respectively, including $9.5 million related to its outstanding debt obligations and $1.3 million of interest on delayed claims for the year ended December 31, 2002, compared with $15.6 million related to outstanding debt obligations and $3.4 million related to delayed claims in 2001. The Company’s weighted average interest rate on bank debt was 5.43% in 2002 compared with 8% in 2001. Interest expense on delayed claims declined in 2002, reflecting more timely payment of claims and lower levels of older claims outstanding. The Company made approximately $26.3 million of scheduled repayments of its New Term Loan and approximately
$0.9 million of other notes during the year ended December 31, 2002. See “Liquidity and Capital Resources - Financing”.
Total revenues for the year ended December 31, 2001 were $4.42 billion, up 7.5% from $4.11 billion in the prior year. Net income attributable to common stock in 2001 totaled $322.4 million, or $3.21 per diluted common share, compared with $191.3 million, or $2.02 per diluted common share in 2000 (including the effect of recapitalization charges in 2000). During 2000, the Company recorded an extraordinary charge of $20.3 million, net of income tax benefits of $13.9 million, in connection with the prepayment of its Term Loan and the repurchase or tender of its $200 million Senior Notes. The extraordinary charges included premiums paid, transaction costs and the write-off of unamortized original issuance debt costs. In addition, the Company completed an exchange agreement for all of its outstanding Preferred Stock and incurred costs of approximately $41.1 million related to the write-off of unamortized preferred stock discount and costs from the original issuance in 1998 and related transaction fees. Results for 2001 and 2000 were also positively impacted by approximately $15 million and $86 million, respectively, of favorable development of prior period estimates of medical costs and claims recoveries and New York Stabilization Pool recoveries. See “Liquidity and Capital Resources” and “Overview”.
In 2001 and 2000, the Company expensed a total of $59 million and $63 million, respectively, for graduate medical education and a total of $43.3 million and $38.9 million, respectively, for hospital bad debt and charity care. See “Liquidity and Capital Resources”.
The Company’s medical costs payable was $618.6 million as of December 31, 2002 compared with $595.1 million as of December 31, 2001. The increase primarily reflects higher levels of membership, per member per month increases in medical costs and improved working capital management of claims. The Company estimates the provision for IBNR using standard actuarial loss development methodologies applied to loss development data summarized on the basis of the month services are rendered and the month claims are paid, processed or received, and considers other items including, without limitation, historical levels of denied claims, medical cost trends, seasonal patterns and changes in membership mix. During the past three years, there has been no significant adverse development of prior year’s actual claims history when compared
with recorded reserves at each annual balance sheet date. Due to the nature of health care services, claims submission methods and processing, and payment practices utilized by the Company, there is a relatively short time lag between service provided and claim payment. During the past two years, approximately 95% of claims have been paid within six months of incurral. The Company revises its estimates for IBNR in future periods based upon continued actuarial analysis of claims payments, receipts and other items subsequent to the incurral period. Revisions to estimates, where material, have been disclosed and are recorded in the period they arise.
The New York State Insurance Department (“NYSID”) has created Market Stabilization Pools (the “New York Stabilization Pool”) for the small group and individual insurance markets. This pool operates on a calendar year basis. According to state regulations, certain insurers participating in the small group and/or individual markets will be required to make payments to the New York Stabilization Pool, and other insurers will receive payments from the New York Stabilization Pool. For the years 1999 and prior, two separate pools operated. Demographic data submitted by insurers was used to determine payments to and payments from one pool. Data related to the incidence of certain specified medical conditions was used to determine payments to and/or from another pool. For the years subsequent to 1999, a single pool operates based on the experience of each insurer with respect to specified medical conditions. In January 2001, the Company received distributions from the 1997 and 1998 New York Stabilization Pools of approximately $4 million and $21.1 million, respectively, which were included in income for the year ended December 31, 2000. In January 2002, the Company received an additional distribution from the 1998 New York Stabilization Pool of approximately $3.6 million that was included in income for the year ended December 31, 2001. The Company contributed approximately $7 million to the New York Stabilization Pools in 1999 and, at December 31, 2002, has established reserves of approximately $5.3 million, $15.3 million and $6 million related to the 1999, 2000 and 2002 pool years, respectively, and a receivable of approximately $10.8 million related to 2001 from the New York Stabilization Pools.
The Company has also established receivables of approximately $10.8 million and $10.1 million at December 31, 2002 for the 2001 and 2002 pool years, respectively, related to certain stop loss pools established by the State of New York under the Health Care Reform Act of New York (the “Stop Loss Pools”, together with the New York Stabilization Pool, the “Pools”), which provides a limited amount of stop loss insurance
funds to cover 90% of certain of the paid claims for the New York Mandated Plans and for the Healthy New York Plan. In the first quarter of 2002, the Company received distributions from the 2000 Stop Loss Pool of approximately $12.2 million, which was included in income for the year ended December 31, 2001.
The Company, in the opinion of management with the advice of external counsel, has substantial defenses to the plaintiff’s claims in the securities class actions and may ultimately prevail if these matters are brought to trial. There can be no assurance, however, as to the ultimate result in this litigation. In the event the Company ultimately suffers an adverse judgment, or settles such actions prior to trial: (i) the Company would be liable to fund the entire amount of such judgment or settlement up to $161.3 million, less any amount then remaining available and collectible under the Company’s primary Directors and Officers insurance, (ii) to the extent that the amount of such judgment or settlement is more than $161.3 million and less than $383.5 million, the Company would, in addition, be liable to fund 10% of the excess over $161.3 million (90% of such excess being covered by the Company’s Excess Insurance), plus all of any amount up to $20 million not collected from Reliance, and (iii) the Company would be liable to fund the entire amount of any excess over $383.5 million. Each of the amounts of $161.3 million and $383.5 million in the preceding sentence reflects the insurance carriers’ position regarding the current Retention under the Excess Insurance. Under the Company’s interpretation of the policies, these amounts would be $155 million and $377.2 million, respectively. In the event that the Excess Insurance carriers become liable to pay any losses under the policies, the Company would be obligated to pay the carriers an additional premium of $8 million.
The Company, its Excess Insurance carriers and the plaintiffs have not been able to reach a settlement in the securities class actions. On December 19, 2002, Judge Brieant scheduled a trial to begin on March 10, 2003. If the securities class actions are not settled, the class actions will go to trial. In anticipation of legal defense costs and other expenses related to trial, the Company recorded an additional liability and pretax charge of $20 million in the fourth quarter of 2002. In the event of a settlement or unfavorable trial outcome not covered by existing insurance policies, the Company would utilize some combination of parent company cash plus available credit facilities to finance such settlement or unfavorable outcome. The Company currently has in place a revolving credit facility, subject to certain restrictions and limitations, of $75 million and the availability to borrow an additional $300 million under existing credit facilities. In the event of a settlement or unfavorable outcome in excess of existing credit facilities, the Company would consider, among other things, seeking additional credit facilities.
In April 2002, the Company agreed with CSC to conclude its technology outsourcing arrangement. The Company entered into a new agreement with CSC effective July 15, 2002, whereby the Company, among other things, leased certain information technology equipment, with a fair value of approximately $14 million, from CSC over a term of 30 months. As part of the conclusion of the original agreement, the Company recorded a charge of $15.5 million, which was included in Marketing, General and Administrative expenses, during the second quarter of 2002. Included in this charge was $7.8 million of negotiated termination fees, payable to CSC over a 30-month period, and an asset impairment charge of approximately $7.7 million recognized primarily for computer systems that are no longer used in the operations. The Company believes that total administrative expenses for services transitioned to the Company, including equipment leases under the new agreement, will be less than those under the previous CSC agreement.
During 2000, the Company repurchased its remaining outstanding Preferred Stock, repurchased the remaining balance outstanding on its Term Loan and repurchased or tendered for all of its outstanding Senior Notes. The Company recorded an extraordinary charge of $20.3 million, net of income tax benefits of $13.9 million, in connection with the prepayment of the Term Loan and the repurchase or tender of the Senior Notes. The extraordinary charges include premiums paid, transaction costs and the write-off of unamortized original issuance debt costs. Simultaneously with these transactions, the Company entered into new senior bank facilities, totaling $250 million, comprised of a $175 million 5 1/2 year term loan (the “Term Loan”) and a
$75 million 5 year revolving credit facility (the “Revolver”, together with the New Term Loan, the “Senior Credit Facilities”). The proceeds of the New Term Loan were used, along with available Company cash, to fund the recapitalization. The Company has not drawn on the Revolver.
Borrowings under the Senior Credit Facilities bear interest, subject to periodic resets, at either a base rate (“Base Rate Borrowings”) or LIBOR plus an applicable margin based on the Company’s credit ratings. Interest on Base Rate Borrowings is calculated as the higher of (a) the prime rate or (b) the federal funds effective rate, as defined, plus an applicable margin based on the Company’s credit ratings. Commitment fees of 0.5% per annum are payable on the unused portion of the Revolver. The weighted average interest rate for the years ended December 31, 2002 and 2001 was 5.43% and 8%, respectively. At December 31, 2002, interest expense is based on a $62.8 million tranche at a rate of approximately 4.99% through February 13, 2003 and a $64 million tranche at a rate of 5.19% through January 16, 2003. On January 16, 2003, the rate with respect to the $64 million tranche was reset at 4.64% to expire on July 16, 2003.
Commercial membership contracts are generally established on a yearly basis subject to cancellation by the employer group, individual or the Company upon 30 days written notice. Premiums, including premiums from both commercial and governmental programs, are due monthly and are recognized as revenue during the month in which the Company is obligated to provide services to members, and are net of estimated terminations of members and groups. Premiums collected in advance of the coverage period are recorded as unearned revenue. Premiums receivable are presented net of valuation allowances for estimated uncollectible amounts, including retroactive membership adjustments, based on known activities and balances and on historical trends. The Company receives premium payments from CMS on a monthly basis for its Medicare membership. Membership and category eligibility are periodically reconciled with CMS and could result in revenue adjustments. All other material revenue is generated from investments.
At December 31, 2002, the Company maintained reserves for billing adjustments of $3.5 million compared with $9.8 million at December 31, 2001, and reserves for doubtful accounts of $10 million at December 31, 2002 and 2001. The reserve for billing adjustments was reduced during 2002 based on reduced levels of net retroactivity experienced over the last two years as a result of the Company receiving billing and member change information on a more timely basis.
The Company contracts with various health care providers for the provision of covered medical care services to its members and primarily compensates those providers on a fee-for-service basis and makes other payments pursuant to certain risk-sharing arrangements. The Company also bears the risk of health care expenses for covered services provided by non-contracted providers to members. Costs of health care and medical costs payable for health care services provided to members are estimated by management based on evaluations of providers’ claims submitted and provisions for IBNR. The Company’s liability for medical costs payable is also affected by delegation, capitation and risk transfer arrangements, including, without limitation, certain diagnostic testing, disease management and ancillary services, physician and other health care groups
The Company estimates the provision for IBNR using standard actuarial loss development methodologies applied to loss development data summarized on the basis of the month services are rendered and the month claims are paid, processed or received, and considers other items including, without limitation, historical levels of denied claims, medical cost trends, seasonal patterns and changes in membership mix. These estimates are reviewed by the Company’s external auditors and state regulatory authorities on a periodic basis. The estimates for submitted claims and IBNR are made on an accrual basis and adjusted in future periods as necessary. Adjustments to prior period estimates, if any, are included in the current period.
The financial impact to the Company of the New York Market Stabilization Pool is a function of how the Company compares to the entire market relative to the factors defined in the regulations. In this case, the Company considers a range of possible outcomes and establishes its liability or receivable from the pools based on its consideration of the overall health insurance market in New York and certain other factors that may ultimately impact current estimates. Key data considered in developing the Company’s range of outcomes includes the small group and individual enrollment of its competitors by product type and the risk profile of the Company’s membership by product. The range of outcomes also considers the likely differences between the risk profile of small group HMO and small group POS and PPO membership. Management believes this may ultimately be the key determinant of results. The dominant position of the Company in the New York City area with respect to the small group market and the relative attractiveness of the Company’s provider networks are also key considerations. Final results for any given year cannot be known with certainty until data submissions by all HMOs and insurers have been audited by the state or its designee. As a result, it is not possible to precisely forecast this outcome in advance of actual results. Final results related to the New York Market Stabilization Pools for the period 1999 to 2002 may differ significantly from current estimates. Considering the major factors that affect the outcome of the pooling mechanism as described above, and particularly the Company’s dominance in the New York City area, results for each year may vary from having a liability to the pool of approximately $15 million to having a receivable from the pool of approximately $15 million. At December 31, 2002, the Company has established reserves of approximately $5.3 million, $15.3 million and $6 million related to the 1999, 2000 and 2002 pool years, respectively, and a receivable of approximately $10.8 million related to 2001 from the New York Stabilization Pools. The Company has also established receivables of approximately $10.8 million and $10.1 million at December 31, 2002 for the 2001 and 2002 pool years, respectively, related to the New York Stop Loss Pools. Management believes that the current net receivable established as of December 31, 2002, related to the pool years 1999 through 2002 represent its best estimate in light of the limited current information available.
Also included in medical costs payable are: (i) estimated liabilities for New York’s Graduate Medical Education (“GME”) and hospital Bad Debt and Charity Care (“BDCC”) programs, which are state health care public policy initiatives aimed at defraying the costs of other health care providers, such as hospitals; (ii) amounts due to the Company’s pharmacy benefit manager (“PBM”); and (iii) estimated liabilities for various medical contracts between the Company and certain current and former providers, some of which are
currently in dispute. For a further description of the risk allocation pools and the state health care public policy initiatives referenced above, see “Cautionary Statement Regarding Forward-Looking Statements”.
The Company and certain of its former officers and present and former directors are currently defendants in certain securities class actions. The Company, in the opinion of management with the advice of external counsel, has substantial defenses to the plaintiffs’ claims and may ultimately prevail if these matters are brought to trial. In view of the inherent risks and uncertainties of litigation, however, and in anticipation of a settlement conference held in November 2002, the Company communicated to the plaintiffs and the insurance carriers the Company’s willingness to pay $161.3 million. This offer reflects the full amount of the current Retention under the insurance carriers’ interpretation of the Excess Insurance policies. As a result, the Company recorded a net liability and pre-tax charge of $151.3 million against earnings in the third quarter of 2002. This $151.3 million charge represents the Company’s settlement offer less $10 million, classified as other current receivables in the Company’s consolidated balance sheet, that the Company estimates would be available and collectible under its primary Directors and Officers insurance.
The Company, its Excess Insurance carriers and the plaintiffs have not been able to reach a settlement in the securities class actions. On December 19, 2002, Judge Brieant scheduled a trial to begin on March 10, 2003. If the securities class actions are not settled, the class actions will go to trial. In anticipation of additional legal fees and other expenses related to trial, the Company recorded an additional net liability and pretax charge of $20 million in the fourth quarter of 2002. At the present time, no total settlement amount beyond $161.3 million can be reasonably estimated. If a settlement is not reached, or if the Court does not approve any such settlement, the securities class actions would proceed to trial, and, at the present time, no amount or range of loss can be reasonably estimated. Accordingly, the Company has not recorded a net liability for a potential unfavorable judgment or settlement costs in excess of $151.3 million. There can be no assurance as to the ultimate result in this litigation. The Company is also subject to the litigation described in the footnotes to the consolidated financial statements and in “Legal Proceedings”.