(1) 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.
(2) Predecessor company of a wholly owned subsidiary of the Company was an S Corporation.
The following is a summary of unaudited quarterly results of operations (in thousands, except per share data) for the years ended December 31, 1999 and 1998.
(3) Effective April 1, 1998, the Company completed its acquisition of certain assets of PHC from Principal Life. The acquisition was accounted for using the purchase method of accounting and, accordingly, the operations of PHC have been included in the Company's consolidated financial statements since the date of acquisition. As a result of the merger, an estimated reserve of $7.8 million was established for the costs related to the relocation of the corporate office from Nashville, Tennessee to Bethesda, Maryland and other merger related expenses.
(1) The medical loss ratio (health benefits as a percentage of managed care premiums) was 86.1%, 86.9%, and 86.1% in 1999, 1998 and 1997, respectively.
Coventry Health Care, Inc. (together with its subsidiaries, the "Company", "Coventry", "we", "our", or "us"), successor-in-interest to Coventry Corporation, is a managed health care company operating health plans under the names Coventry Health Care, HealthAmerica, HealthAssurance, HealthCare USA, Group Health Plan, Southern Health, SouthCare and Carelink Health Plans. 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. Coventry was incorporated under the laws of the state of Delaware on December 17, 1997.
The Company's commercial managed care premium revenues during the three years in the period ended December 31, 1999 were comprised of premiums from its commercial HMO products and flexible provider products, including PPO and POS products for which the Company assumes full underwriting risk. Premiums for such commercial PPO and POS products are typically lower than HMO premiums due to medical underwriting and higher deductibles and copayments that are required from the PPO and POS members. Premium rates for commercial HMO products are reviewed by various state agencies based on rate filings. While the Company has not had such filings modified, no assurance can be given that approvals for rate submissions will continue.
Coincident with the closing of the transaction, Coventry entered into a Renewal Rights Agreement and a Coinsurance Agreement with Principal Life, to manage certain of Principal Life's indemnity health insurance policies in the markets where Coventry does business and, on December 31, 1999, to offer to renew such policies in force at that time. Effective June 1, 1999, Coventry amended these agreements with Principal Life and waived its rights to reinsure and renew Principal Life's health insurance indemnity business located in Coventry's service area. Coventry received $19.8 million in cash in exchange for waiving these rights. At the date of the amendment, the Renewal Rights and Coinsurance Agreements had a net book value of $19.7 million resulting in an after tax gain of $0.1 million.
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 approximately 2,400 non-risk members as of November 30, 1998.
On December 31, 1998, Coventry sold its subsidiary, Principal Health Care of Florida, Inc., for $95.0 million in cash. The Florida health plan accounted for approximately 156,000 risk members and approximately 5,500 non-risk members as of December 31, 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.
The Indiana health plan was not operating profitably or demonstrating good prospects for future growth. Although closing the plan will not have a substantial impact on consolidated earnings, it will allow Coventry to focus resources and management attention on its other markets. Coventry's transition plan gives employers and members ample time to obtain health care coverage through one of the many other companies operating in Indiana.
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 $8.3 million including transaction costs of approximately $0.3 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 October 1, 1999, 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 $4.7 million excess of purchase price over the net identified tangible assets acquired was allocated to goodwill, which is being amortized over a useful life of 25 years. The final purchase price may be adjusted subject to the results of the final determination of the balance sheet of Carelink as of October 1, 1999. 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 in Charlotte, North Carolina. The total purchase price was approximately $1.8 million including transaction costs. The transaction more than doubles Coventry's membership in the Charlotte market.
On February 3, 2000, Coventry completed the acquisition of Prudential Health Care Plan, Inc.'s 11,800-member Medicaid business in St. Louis, Missouri at approximately $100 per member. The acquisition brings Coventry's total Medicaid membership in St. Louis to more than 106,000 members, expanding Coventry's leading position in the market.
Effective May 1, 1997, the Company completed the sale of the medical offices associated with GHP, its health plan in St. Louis, Missouri, to a major health care provider organization. The sales price was $26.9 million, resulting in a pretax gain to the Company of approximately $9.6 million. Coincident with the sale, the Company entered into a long-term global capitation agreement with the purchaser covering approximately 83,000 members, pursuant to which the provider organization receives a fixed percentage of premiums to cover all of the medical treatment the globally capitated members receive.
SETTLEMENT WITH AHERF RELATED ENTITIES. The Company and certain affiliated hospitals of Allegheny Health, Education and Research Foundation (AHERF) were involved in litigation to determine if the Company had the financial responsibility for medical services provided to the Company's members by the hospitals as a consequence of the bankruptcy filed by AHERF on July 21, 1998. As a result of the bankruptcy, AHERF failed to pay for medical services under its global capitation agreement with the Company covering approximately 250,000 Company members in the western Pennsylvania market. Shortly after AHERF filed for bankruptcy protection, the Company filed a lawsuit against AHERF's non-debtor, affiliated hospitals seeking monetary damages and a declaratory judgment that the Company was not obligated to pay in excess of $21.5 million to the hospitals for medical services provided by them to the Company's members and the hospitals filed a counterclaim for payment of these services. As a result, the Company, which was ultimately responsible for medical costs delivered to its members, notwithstanding the global capitation agreement, recorded a charge of $55.0 million in the second quarter of 1998 to establish a reserve for, among other things, the medical costs incurred by its members under the AHERF global capitation agreement at the time of the bankruptcy filing. 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 Coventry's remaining obligations have been determined and all AHERF-related litigation has been concluded. As of December 31, 1999, approximately $35.4 million of the $55.0 million reserve had been paid for medical claims. As a result of the settlement, Coventry released $6.3 million from the reserve, which was reflected as a gain in the fourth quarter and year-end 1999 results. The balance of the reserve represents
UNITY ARBITRATION. Group Health Plan, Inc. ("GHP"), a health plan subsidiary of the Company, entered into an agreement, effective January 1, 1998, with Unity Health Network, L.L.C. ("Unity") for Unity's provider network to provide health care services to GHP's members in the southern and western areas of St. Louis County, Missouri. The agreement contained risk sharing provisions. Disputes arose under the agreement and the matter was submitted to arbitration before the American Arbitration Association ("AAA"). GHP demanded payment from Unity of $7.6 million and specific performance under the agreement. Unity demanded payment from GHP of $14.5 million, specific performance of certain provisions of the agreement and suspension of its payment obligations. On December 23, 1999, the AAA tribunal of arbitrators awarded GHP the sum of $1.1 million for deficiencies in risk fund pools for 1998, and awarded Unity the sum of $1.8 million as liquidated damages for GHP's failure to meet certain administrative performances standards, and held Unity contractually liable for funding any deficits in the risk fund pools for 1999. The only remaining issue pending is the readjudication of certain disputed claims submitted subsequent to June 30, 1999.
Other managed care companies have been sued recently in class action lawsuits claiming violations of the federal racketeering act (RICO) and federal employee benefits law (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.
Medical claim liability accruals are periodically monitored and reviewed with differences for actual settlements from reserves reflected in current operations. In addition to the procedures for determining reserves as discussed above, the Company reviews the actual payout of claims relating to prior period accruals, which may take up to six months to fully develop. Medical costs are affected by a variety of factors, including the severity and frequency of claims, that are difficult to predict and may not be entirely within the Company's control. The Company continually refines its reserving practices to incorporate new cost events and trends.
Depreciation and amortization increased $2.4 million, or 9.4%, compared to the prior year 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.
Coventry's net income was $43.4 million in 1999 compared to a loss of $11.7 million in 1998. Net income per diluted share was $0.69 in 1999 compared to a net loss per diluted share of $0.22 in 1998. Excluding the AHERF charge, plan shutdown expense and merger costs, Coventry would have reported earnings per diluted share of $0.65 and $0.49 in 1999 and 1998, respectively. The weighted average common shares outstanding were approximately 64,159,000 and 52,477,000 on a diluted basis for the years ended December 31, 1999 and 1998, respectively.
Health benefits expense increased $727.5 million for the year ended December 31, 1998, or 70.0%, compared to 1997. The PHC plans accounted for approximately $612.5 million, or 84.2%, of the increase. The Company's medical loss ratio increased slightly to 86.9% from 86.1% in the previous year, primarily as a result of increases in Medicare membership.
As previously discussed, in July 1998, AHERF, the global capitation provider organization in western Pennsylvania, filed for bankruptcy protection under Chapter 11. On July 22, 1999, the Company reached a settlement with the non debtor, affiliated hospitals, including Allegheny General Hospital (AGH), 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 Coventry's remaining obligations have been determined and all AHERF-related litigation has been concluded.
SG&A expense for the year ended December 31, 1998 increased $121.9 million, or 71.7%, compared to 1997. The PHC plans accounted for approximately $92.8 million, or 76.1%, of the increase. The remainder of the increase in SG&A is primarily attributable to the increased costs relating to administrative processes, particularly in claims processing, associated with the growth of the Medicare product in certain markets. SG&A expense as a percent of revenue remained at 13.8% for the year ended 1998. In an effort to control costs and improve customer service, the Company started the process of migrating certain of its operating activities (e.g., customer service, claims processing, billing and enrollment) to regional service centers.
Depreciation and amortization for the year ended December 31, 1998 increased $13.1 million, or 102.5%, compared to 1997. Depreciation expense from the PHC plans accounted for approximately $2.3 million, or 17.6%, of the increase. The remainder of the increase is attributable to the amortization of intangibles and goodwill recorded in connection with the acquisition of the PHC plans.
Other income, net of interest expense, increased $4.1 million for the year ended December 31, 1998, or 27.9%, from the corresponding period in the prior year. Other income, net of interest expense, related to the PHC plans accounted for approximately $10.1 million, or 246.3%, of the increase. Exclusive of the PHC plans, other income, net of interest expense, decreased by $6.0 million. This reduction was primarily attributable to a $15.0 million pre-tax gain related to the sale of medical offices that was recognized in the prior year, offset by increased investment income resulting from the increase in invested assets subsequent to the acquisition of the PHC plans.
The Company's net loss was $11.7 million for the year ended December 31, 1998. Net loss per common and common equivalent share was $0.22 for the year ended December 31, 1998 compared to earnings per common and common equivalent share of $0.35 for the corresponding period in 1997. Excluding the $61.5 million of charges associated with the AHERF bankruptcy and the relocation of the corporate headquarters and other merger related costs, the Company reported basic earnings per common and common equivalent share of $0.50 in 1998. The weighted average number of common shares outstanding were approximately 52,477,000 and 33,912,000 for the years ended December 31, 1998 and 1997, respectively. The increase in the weighted average number of shares outstanding in 1998 was primarily attributable to the shares issued in April 1998 related to the acquisition of the PHC plans. Effective in the fourth quarter of 1997, the Company adopted SFAS 128, "Earnings Per Share." Accordingly, prior periods have been restated.
The Company's total cash and investments, excluding deposits of $24.8 million restricted under state regulations, decreased $8.5 million to $589.8 million at December 31, 1999 from $598.3 million at December 31, 1998. This decrease was primarily a result of approximately $55.6 million that was used to pay the amount of medical claims for Principal Health Care of Florida, Inc. and Principal Health Care of Illinois, Inc., the two plans that were sold effective December 31, 1998 and November 30, 1998, respectively. The decrease is also attributable to the Company's efforts to reduce medical claims inventory in 1999.
The Company's investment guidelines emphasize investment grade fixed income instruments in order to provide short-term liquidity and minimize the risk to principal. The Company believes that since its long-term investments are available-for-sale, the amount of such investments should be added to current assets when assessing the Company's working capital and liquidity; on such basis, current assets plus long-term investments available-for-sale less short-term liabilities increased to $246.7 million at December 31, 1999 from $187.8 million at December 31, 1998.
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 Coventry'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 $42.35 million. The original amount of the Coventry Notes, $36.0 million held by Warburg and $4.0 million held by Franklin, were exchangeable at Coventry's or Warburg's option for shares of redeemable convertible preferred stock.
During the second and third quarters of 1999, Coventry converted all Coventry Notes held by Warburg and Franklin totaling $47.1 million, including 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 is subject to mandatory redemption at a price of $10 per share, plus accrued dividends, in an amount equal to one-third of the shares outstanding on May 15, 2002, 2003 and 2004. The stock is carried at its fair value, which equals both its redemption value and liquidation value as of December 31, 1999 and will accrue dividends only if the Board of Directors declares dividends on common stock. The dividends (per share) on the preferred stock would be equal to the dividends on the common stock. The preferred stock may be converted at any time at the holders' option into shares of common stock at a conversion price equal to the closing market price of the Company's common stock on the date of conversion, if the closing market price is less than $10 per share. If the closing market price of the Company's common stock is greater than $10 per share, the preferred stock is convertible to common stock on a share for share basis. The preferred stock is callable by the Company if the market price of the Company's common stock exceeds certain agreed upon targets.
Projected capital investments in 2000 of approximately $15.0 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 on hand and investments, and excess funds in certain of its regulated subsidiaries will be sufficient to fund continuing operations through December 31, 2000.
Numerous proposals have been introduced in the United States Congress and various state legislatures relating to health care reform. Some proposals, if enacted, could among other things, restrict the Company's ability to raise prices and to contract independently with employers and providers. Certain reform proposals favor the growth of
The Company may be subject to certain types of litigation, including medical malpractice claims, claim disputes pertaining to contracts and other arrangements with providers, employer groups and their employees and individual members, and disputes relating to HMO denials of coverage for certain types of medical procedures or treatments. In addition, the Company has contingent litigation risk in connection with certain discontinued operations. Such litigation may result in losses to the Company. The Company maintains insurance coverage in amounts it believes to be adequate, including professional liability (medical malpractice) and general liability insurance. Contracting physicians are required to maintain professional liability insurance. In addition, the Company carries "stop-loss" reinsurance to reimburse it for costs resulting from catastrophic injuries or illnesses to its members. Nonetheless, no assurance can be given as to the future availability or cost of such insurance and reinsurance or that litigation losses will not exceed the limits of the insurance coverage and reserves. In the opinion of management and based on the facts currently known, the outcome of these actions should not have a material adverse effect on the financial position or results of operations of the Company.
The FASB has also issued SFAS No. 130, "Reporting Comprehensive Income," which became effective for fiscal years that began after December 15, 1997. SFAS No. 130 requires that changes in the amounts of certain items, including unrealized gains and losses on certain securities, be reflected in the financial statements. The Company adopted SFAS 130 effective January 1, 1998. The adoption of this standard did not have a material effect on the Company's consolidated financial statements.
The FASB has also issued SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information." This standard requires that a public business enterprise report financial and descriptive information about its reportable operating segments. Operating segments are components of an enterprise about which separate financial information is available that is evaluated regularly by the chief operating decision maker in deciding how to allocate resources and in assessing performance. SFAS No. 131 also requires that all public business enterprises report information about the revenues derived from the enterprise's products or services (or groups of similar products and services), about the countries in which the enterprise earns revenues and holds assets and about major customers regardless of whether that information is used in making operating decisions. Effective December 31, 1998, the Company adopted SFAS 131.
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 is 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.
Health care cost inflation has exceeded the general inflation rate and the Company has implemented cost control measures and risk sharing arrangements, which seek to reduce the effect of health care cost inflation. During 1999, the Company implemented increases in premium rates which exceeded inflationary cost increases while maintaining competitive rates within its markets.
The Company's membership in January 2000 was approximately 1,485,000 members, an increase of 6.3% over January 1999. The increase was primarily attributable to the acquisitions in North Carolina and West Virginia. Of the January 2000 membership, approximately 1,246,000 were risk members and approximately 239,000 were non-risk members.
For 2000, the Company continues to pursue ways to improve its underwriting processes and oversight in both risk and management services products with the objective of increasing premium yields and profitable growth in its markets. The Company's migration of certain of its operating activities (e.g., customer service, claims processing, billing and enrollment) to regional service centers is expected to be completed by the end of the fourth quarter of 2000. The Company expects that the regional service centers will allow it to provide improved levels of service in a more cost effective manner. The integration of the PHC health plans has allowed the Company to strengthen its balance sheet and gain entry into additional markets. Management believes that existing markets have potential for growth for the Company's commercial and governmental products. Management believes that the foregoing should result in progressive improvements in 2000, although realization is dependent upon a variety of factors, some of which may be outside the control of the Company.
BROKER/EMPLOYER CHANNEL. In February 2000, the Company entered into a two-year agreement with Workscape, Inc. ("Workscape"), which specializes in the development of Internet solutions for the insurance industry. Workscape will focus on automating the full broker/small employer relationship, including enrolling customers, providing benefits information, generating customized proposals, registering agents, processing applications, underwriting
risk, and calculating rates. The Company will initially implement this initiative in its Pittsburgh and Harrisburg, Pennsylvania markets, and then into its other markets.
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 profit margins will shrink. Shrinking profit margins may reduce our net income and adversely affect the value of your investment in Coventry. Premium rates for managed care plans generally have increased in recent months, but we could experience unforeseen decreases or severely limited increases in future premium rates. Also, 27.5% of our premium revenues through February 29, 2000 were derived from governmental programs, including Medicare and Medicaid. The government generally fixes these premium rates and we cannot adjust them based on our anticipated costs. Recent legislation has limited Medicare premium rate increases substantially as compared to increases permitted in prior years. As a result, in the future the total costs of our government programs could exceed the total premiums that we receive from these programs.
IF WE ARE UNABLE TO INCREASE OUR REVENUES AND OUR PROFIT MARGINS SHRINK, OUR NET INCOME MAY DECREASE AND THE VALUE OF YOUR INVESTMENT IN COVENTRY MAY DECLINE.
In the future, we may not be able to increase or maintain our current revenues. Since we no longer receive revenues under our agreements with Principal Life, which expired on December 31, 1999, there is a risk that we may not be able to replace the revenues generated from these fees. We recognized revenues from these agreements of $25.5 million in 1999 and $23.0 million in 1998. We may also be unable to reduce our costs or increase our premium rates. If we are faced with shrinking profit margins and are unable to increase our revenues, we will have a decline in net income, which could adversely affect the value of your investment in Coventry.
If we underestimate the costs of health care services and supplies that we provide to our members, we may set our premium rates too low. Low premiums may result in an inability to generate revenues that are sufficient to pay future health care costs. This shortfall could significantly change our results of operations, affect profitability and adversely affect the value of your investment in Coventry. While we attempt to base the premiums we charge, at least in part on our estimate of expected health care costs over the fixed premium period, other factors may limit our ability to fully base premiums on estimated costs and could cause actual health care costs to exceed estimated health care costs. These factors could include:
We expect that substantially all of our members will be served by providers contracting with us to provide the requisite medical care. Our ability to contract successfully with a sufficiently large number of providers in a given geographic market will impact the relative attractiveness of managed care products in those markets. In addition, the terms of those provider contracts also have a material impact on our medical costs and our ability to control these costs.
WE MAY NOT BE ABLE TO REACH COST-EFFECTIVE AGREEMENTS WITH CERTAIN MAJOR MARKET PROVIDERS WHICH COULD REDUCE COVENTRY'S NET INCOME AND CAUSE A DECLINE IN THE VALUE OF YOUR INVESTMENT IN COVENTRY.
PRINCIPAL LIFE AND ITS AFFILIATES' ABILITY TO EXERCISE CONTROL OVER COVENTRY COULD ADVERSELY AFFECT THE VALUE OF YOUR INVESTMENT IN COVENTRY.
As a result of our acquisition of the Principal Health Care plans, Principal Life owns approximately 40% of our common stock, on a fully diluted basis. Due to previously agreed upon limitations that are effective through April 2003, Principal Life may purchase additional shares of our common stock, but only to maintain its 40% ownership of our fully diluted common stock.
In addition to its ownership position, Principal Life has designated 4 members of our 10 member Board of Directors in correspondence with its percentage ownership of our common stock. As long as Principal Life owns at least 10% of our common stock, it can designate one member of our Board of Directors for each 6% ownership of our common stock. Accordingly, Principal Life has the right to designate up to six members of our Board.
It should be noted, however, that prior to April 2003, Principal Life has agreed to vote its shares in favor of any acquisition required to be approved by our shareholders, that a Special Committee of our Board of Directors has recommended, and that a majority of our shareholders, other than Principal Life, have approved. The Special Committee will consist of members of our Board of Directors that are neither management, nor designees of Principal Life.
Once the previously agreed upon limitations imposed on Principal Life expire in April 2003, Principal Life may acquire additional shares of our common stock to the point that it exercises complete control over the Company. If Principal Life were to acquire over 50% of our common stock, it would have actual control over us, and would have a controlling vote in all actions involving a shareholder vote. As the majority shareholder, Principal Life could block transactions that were advantageous to our minority shareholders. Accordingly, 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 Principal Life.
Coventry contracts with various federal and state governmental agencies to provide managed health care services. These agencies include the United States Office of Personnel Management that contracts with us to provide managed health care services for federal employees under the Federal Employees Health Benefits Program; the U. S. Health Care Financing Administration that contracts with us to provide a Medicare product to eligible beneficiaries; and certain states that contract with us to provide a Medicaid product to eligible recipients. 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. Such 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 certain 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.
IN THE FUTURE, WE MAY NOT BE ABLE TO MEET CERTAIN MINIMUM CAPITALIZATION LIMITS THAT MAY BE ADOPTED BY STATES IN WHICH WE DO BUSINESS.
The National Association of Insurance Commissioners has proposed that states adopt risk-free capital standards that, if implemented, would generally require higher minimum capitalization limits for health care coverage provided by HMOs and other risk-bearing health care entities. To date, no state where Coventry has HMO operations has adopted those standards. We do not expect this legislation to have a material impact on our consolidated financial position in the near future. We believe that cash flows from operations will be sufficient to fund any additional regulatory risk-based capital.
COSTS ASSOCIATED WITH LITIGATION MAY RESULT IN LOSSES TO US THAT COULD NEGATIVELY IMPACT THE VALUE OF YOUR INVESTMENT IN COVENTRY.
We have audited the accompanying consolidated balance sheets of Coventry Health Care, Inc. (a Delaware corporation and successor-in-interest to Coventry Corporation) and subsidiaries as of December 31, 1999 and 1998, and the related consolidated statements of operations, stockholders' equity and cash flows for each of the three years in the period ended December 31, 1999. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Coventry Health Care, Inc. and subsidiaries as of December 31, 1999 and 1998, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1999 in conformity with accounting principles generally accepted in the United States.
COVENTRY HEALTH CARE, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (IN THOUSANDS, EXCEPT SHARE DATA)
COVENTRY HEALTH CARE, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (IN THOUSANDS, EXCEPT PER SHARE DATA)
COVENTRY HEALTH CARE, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS)
Coventry Health Care, Inc. and Subsidiaries NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1999, 1998 AND 1997
The Company began operations in 1987 with the acquisition of the American Service Companies ("ASC") entities, including the Coventry Health and Life Insurance Company ("CHLIC"). In 1988, the Company acquired HealthAmerica Pennsylvania, Inc. ("HAPA"), a Pennsylvania HMO. In 1990, the Company acquired Group Health Plan, Inc. ("GHP"), a St. Louis, Missouri HMO. Southern Health Services, Inc. ("SHS"), a Richmond, Virginia HMO, was acquired by the Company in 1994. In 1995, the Company acquired HealthCare USA, Inc. ("HCUSA"), a Jacksonville, Florida-based Medicaid managed care company. In 1998, the Company acquired certain assets of Principal Health Care, Inc. ("PHC") from Principal Mutual Life Insurance Company, now known as Principal Life Insurance Company ("Principal Life"). On October 1, 1999, the Company acquired Carelink Health Plans ("Carelink") from Camcare, Inc. 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 commercial membership. See Notes B and C to consolidated financial statements.
Use of Estimates - The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
Cash and Cash Equivalents - Cash and cash equivalents consist principally of overnight repurchase agreements, money market funds, commercial paper and certificates of deposit. The Company considers all highly liquid securities purchased with an original maturity of three months or less to be cash equivalents. The carrying amounts of cash and cash equivalents reported in the accompanying consolidated balance sheets approximate fair value.
Minority Interest - For 1997, the minority interest represents a joint venture interest of 51% in Pennsylvania HealthMate, Inc. ("HealthMate").
Stock-based Compensation - The Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards No. 123 ("SFAS 123"), "Accounting for Stock-Based Compensation." As permitted by SFAS 123, the Company has elected to continue to account for stock-based compensation to employees under APB Opinion No. 25, and complies with the disclosure requirements for SFAS 123. See Note L for disclosures related to stock-based compensation.
Comprehensive Earnings - Effective January 1, 1998, the Company adopted Statement of Financial Accounting Standards No. 130 ("SFAS 130"), "Reporting Comprehensive Income." SFAS 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 earnings. The adoption of this standard did not have a material effect on the Company's consolidated financial statements.
Segment reporting - Effective December 31, 1998, the Company adopted Statement of Financial Accounting Standards No. 131 ("SFAS 131"), "Disclosures about Segments of an Enterprise and Related Information." This standard requires that a public business enterprise report financial and descriptive information about its reportable operating segments. Operating segments are components of an enterprise about which separate financial information is available that is evaluated regularly by the chief operating decision maker in deciding how to allocate resources
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.
Governmental products include Medicare Risk, Medicare Cost, and Medicaid. The Company provides comprehensive health benefits to members participating in government programs and receives premium payments from federal and state governments. The Company evaluates the performance of its operating segments and allocates resources based on gross margin. Assets are not allocated to specific products and, accordingly, cannot be reported by segment. See Note U for disclosures on segment reporting.
Reclassifications - Certain 1997 and 1998 amounts have been reclassified to conform to the 1999 presentation.
Coincident with the closing of the transaction, the Company entered into a Renewal Rights Agreement and a Coinsurance Agreement with Principal Life, to manage certain of Principal Life's indemnity health insurance policies in the markets where the Company does business and, on December 31, 1999, to offer to renew such policies in force at that time. Effective June 1, 1999, the Company amended these agreements with Principal Life
On December 31, 1998, the Company sold its subsidiary, Principal Health Care of Florida, Inc., for $95.0 million in cash. The Florida health plan accounted for approximately 156,000 risk members and approximately 5,500 non-risk members as of December 31, 1998.
The proceeds from both sales were used to retire the Company'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, the Company established reserves of approximately $33.0 million for the estimated transition costs of the PHC health plans. These reserves are 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, 1999, the Company has expended approximately $29.7 million related to these reserves and expects to make payments on the remaining reserves through July 2002.
The following unaudited pro-forma condensed consolidated results of operations assumes the PHC acquisition and the sales of the Florida and Illinois health plans occurred on January 1, 1998 and 1997 and excludes the non-recurring charge to merger costs of $6.5 million, see Note F:
On November 1, 1999, the Company's subsidiary, Coventry Health Care of the Carolinas, Inc., acquired Kaiser Foundation Health Plan of North Carolina's ("KFHPNC") commercial membership in Charlotte, North Carolina. The total purchase price was approximately $1.8 million including transaction costs.
the globally capitated members receive. The provider organization filed for bankruptcy protection on July 21, 1998 and , as a result, the Company is no longer operating under this agreement. See Note E for AHERF Charge.
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 fulfil its contractual obligations and the Company's remaining obligations have been determined and all AHERF-related litigation has been concluded.
As of December 31, 1999, approximately $35.4 million of the $55.0 million reserve had been paid for medical claims. As a result of the settlement, the Company released $6.3 million of the reserve, which was reflected as a gain in the fourth quarter and year-end 1999 results. The balance of the reserve represents the Company's remaining obligations under the settlement and will be expended through August 2007.
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, 1999, the Company expended approximately $6.0 million and expects to make payments through March 2003 related to these charges.
The Company considers all of its investments as available-for-sale securities and, accordingly, records unrealized gains and losses, as other comprehensive earnings, in the stockholders' equity section of its consolidated balance sheets. As of December 31, 1999 and 1998, stockholders' equity was decreased by approximately $5.9 million and increased by $0.3 million, respectively, netted by a deferred tax benefit of approximately $2.3 million and deferred tax cost of $0.1 million, respectively, to reflect the net unrealized investment loss/ gain on securities.
The amortized cost, gross unrealized gain or loss and estimated fair value of short-term and long-term investments by security type were as follows at December 31, 1999 and 1998 (in thousands):
The amortized cost and estimated fair value of short-term and long-term investments by contractual maturity were as follows at December 31, 1999 and December 31, 1998 (in thousands):
The provision (benefit) for income taxes consists of the following (in thousands):
The valuation allowance for deferred tax assets as of December 31, 1999 and 1998 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 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 $42.35 million. The original amount 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.
At December 31, 1998, long-term debt of $781,000, payable to the U. S. Department of Health and Human Services, represented obligations which were assumed in the acquisition of HAPA. Under the terms of the notes, principal was payable in various annual installments through June 30, 2000 with interest payable semi-annually at rates ranging from 7.75% to 9.125%. The notes were secured by certain assets of the Company. These notes were paid in full in May 1999.
Interest expense for the year ended December 31, 1999 was $1.6 million, substantially all of which related to the Coventry Notes.
Because the SFAS 123 method of accounting has not been applied to options granted prior to January 1, 1995, the resulting pro forma compensation cost may not be representative of that to be expected in future years.
Transactions with respect to the plans for the three years ended December 31, 1999 were as follows (shares in thousands):
The following table summarizes information about stock options outstanding at December 31, 1999 (shares in thousands):
The weighted-average grant date fair values for options granted in 1999, 1998 and 1997 were $5.29, $4.53, and $8.77, respectively.
On July 7, 1997, the Company finalized the sale of $40 million of Coventry Convertible Exchangeable Subordinated Notes, together with warrants to purchase 2,352,941 shares at $10.625 per share of common stock. The purchase price for the warrants was $1.00 per share, valued by the Company and the purchaser. The warrants expire seven years from the purchase date.
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 and November 11, 1999, PHC exercised a portion of the Principal Warrant pursuant to exercises of the underlying options and purchased 1,335 and 10,915 shares of common stock, respectively. At December 31, 1999, the Principal Warrant represented the right to purchase 3,017,183 shares, taking into account exercises and cancellations.
These reinsurance agreements do not release the Company from its primary obligations to its membership. The Company remains liable to its membership if the reinsurers are unable to meet their contractual obligations under the reinsurance agreements. All reinsurance agreements are subject to certain limits on hospital costs per patient-day. To minimize its exposure to significant losses from reinsurer insolvencies, the Company evaluates the financial condition of its reinsurers on an annual basis. American Continental Insurance Company and Continental Assurance Company are both currently A rated by the A.M. Best Company.
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.
Total rent expense was approximately $14.5 million, $14.6 million and $8.3 million for the years ended December 31, 1999, 1998 and 1997, respectively.
As discussed in Notes D and E to the consolidated financial statements, the Company entered into long-term global capitation arrangements with two integrated provider organizations. Global capitation agreements limit the Company's exposure to the risk of increasing medical costs, but expose the Company to risk as to the adequacy of the financial and medical care resources of the provider organization. To the extent that the respective provider organization faces financial difficulties or otherwise is unable to perform its obligations under the global capitation agreements, the Company, which is responsible for the coverage of its members pursuant to its customer agreements, will be required to perform such obligations, and may have to incur costs in doing so in excess of the amounts it would otherwise have to pay under the global capitation agreements. To the extent that the Company becomes a party to global capitation agreements with a single provider organization serving substantial membership, the Company becomes exposed to credit risk with respect to such organizations. The Company may utilize the following to manage such risk: 1) contract with providers with significant net worth and cash reserves; 2) require letters of credit or cash to be reserved for claims payment and 3) monitor the providers' financial condition in regard to the Company membership.
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. See Note A for additional information with respect to accounting policies for accounts receivable.
The Company believes the allowance for doubtful collections adequately provides for estimated losses as of December 31, 1999. The Company has a risk of incurring loss if such allowances are not adequate.
As discussed in Note M to consolidated financial statements, the Company has reinsurance agreements with major insurance companies. The Company monitors the insurance companies' financial ratings to determine compliance with standards set by state law. The Company has a credit risk associated with these reinsurance agreements to the extent the reinsurers are unable to pay valid reinsurance claims of the Company.
On July 1, 1994, Coventry Corporation adopted an employee defined contribution retirement plan qualifying under IRC Section 401(k), the Coventry Corporation Retirement Savings Plan (the "Plan"), which covered substantially all employees of Coventry Corporation and its subsidiaries who meet certain requirements as to age and length of service and who elect to participate in the Plan. Similar retirement savings plans offered by (1) both HAPA and GHP and (2) both Coventry Healthcare Management Corporation ("CHMC") and HCUSA were merged into the Plan effective July 1, 1994 and January 1, 1996, respectively. Effective March 31, 1998, the Company was formed as the parent company of an affiliated group of companies that includes Coventry Corporation. The Company, with the approval of Coventry Corporation, adopted and became sponsor of the Plan effective April 1, 1998. On April 1, 1998, the Coventry Health Care, Inc. Retirement Savings Plan (the "New Plan") was adopted and any prior PHC and certain affiliated participant account balances included in the assets of the former PHC qualified retirement plan were rolled over into the New Plan at the election of the former PHC employees. Effective October 1, 1998, the Plan was merged with the New Plan. All employees that were participants under the Plan became participants in the New Plan. On October 1, 1998, the assets of the Plan were merged and transferred to: (1) Principal Life Insurance Company, as funding agent of the assets held under the terms of the Flexible Investment Annuity Contract with Coventry Health Care, Inc., (2) Delaware Charter Guarantee and Trust Company, as custodial trustee of the mutual funds and (3) Bankers Trust Company, as custodial trustee of the New Plan's participant loans and the Coventry Health Care, Inc. Common Stock. Effective October 1, 1999, pursuant to the merger of Coventry Health Plan of West Virginia, Inc. (CHC-WV), a wholly-owned subsidiary of the Company, and Carelink Health Plans, Inc. (Carelink) whereby Carelink was the surviving entity, Carelink became an adopting employer of the New Plan.
Other income for the years ended December 31, 1999, 1998, and 1997 includes investment income of approximately $30.3 million, $25.5 million, and $10.8 million, respectively. As described in Note D, other income includes $15.0 million in 1997 from the sale of medical offices.
Basic earnings per share ("EPS") is based on the weighted average number of common shares outstanding during the year. Diluted EPS, when applicable, assumes the conversion of convertible notes and the exercise of all options, warrants and redeemable convertible preferred stock using the treasury stock method. Net earnings is increased for the assumed elimination of interest expense on the convertible notes. In all cases, however, losses are not diluted.
BJC. Effective May 1, 1997, the Company completed its sale of the medical offices associated with Group Health Plan, Inc., its health plan in St. Louis, Missouri, to BJC Health System ("BJC"), a major provider organization in the St. Louis market, for approximately $26.9 million. Upon the sale, the Company entered into a long-term global capitation agreement with BJC, since amended, that covered approximately 33.3% of the risk membership in St. Louis at December 31, 1998. Under the agreement, BJC receives a fixed percentage of premium to cover all of the medical treatment received by the globally capitated members. Various disputes alleging breaches have arisen under the BJC global capitation agreement concerning the accuracy and timeliness of claims payments, and the accuracy of membership reconciliations that would affect the amount of premiums paid to BJC to provide its services under the agreement. BJC contends that these alleged breaches entitles it to terminate the agreement. Although the parties are obligated to arbitrate their disputes under the terms of the agreement, the parties have agreed to attempt to negotiate a resolution of the various issues while concurrently proceeding with arbitration. While the Company acknowledges certain claims payment inaccuracies, the Company denies the remaining allegations and vigorously disputes that any such claims constitute a material breach of the agreement. Management does not believe that the outcome of these disputes will have a material impact on the consolidated financial statements, although there can no assurance in this regard.
Following are reconciliations of reportable segment information to financial statement amounts:
(1) The Company will close its subsidiary, Coventry Health Care of Indiana, Inc., by the end of the fourth quarter 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.
Effective February 1, 2000, the Company completed its acquisition of The Anthem Company's West Virginia managed care subsidiary, PrimeONE, Inc. ("PrimeONE"), for the total purchase price of approximately $3.9 million including acquisition costs. The $1.5 million excess of purchase price over the net identifiable tangible assets acquired was allocated to goodwill. PrimeONE has approximately 18,000 commercial members and annual premium revenue of $32.0 million. The acquisition expands the Company's West Virginia service area and brings its total membership in the state to over 109,000 members.
On February 3, 2000, the Company completed the acquisition of Prudential Health Care Plan, Inc.'s 11,800-member Medicaid business in St. Louis, Missouri at approximately $100 per member. The acquisition brings the Company's total Medicaid membership in St. Louis to more than 106,000 members.