Amortization and depreciation expense declined by $14.6 million for the year ended December 31, 1997 as compared to the same period in 1996 due to certain intangible assets becoming fully amortized by the end of 1996, fixed assets becoming fully depreciated in early 1997 in the California division and fixed asset write-offs primarily associated with the Company's restructuring plans discussed below. Amortization and depreciation expense increased by $23.6 million for the year ended December 31, 1996 as compared to the same period in 1995 primarily due to higher levels of fixed asset expenditures and goodwill amortization as a result of acquisitions.
Interest expense increased by $18.2 million and $11.9 million during 1997 and 1996, respectively, as compared to the same periods during the prior year. The increase in interest expense during both years was due to higher debt levels associated with the Company's revolving lines of credit partially offset by lower interest rates.
Merger costs totaling $70.4 million were recorded in 1997 and included transaction, consulting, debt consolidation and other merger costs directly related to the FHS Combination. Merger costs of $8.0 million related to the terminated merger between HSI and Wellpoint Health Network were recorded in 1995.
Other costs totaling $118.6 million, including the write-off of various receivables, litigation and loss contract accruals were recorded during 1997. Additionally, during 1996, $16.7 million of other costs related to loss contract accruals and consulting were recorded. The Company also established a premium deficiency reserve of $57.5 million related to its Gem Insurance Company during 1997.
See Note 14, "Merger, Restructuring and Other Costs and Gem Costs", to the consolidated financial statements for further information.
Health care costs increased by 6.8% for the year ended December 31, 1997 as compared to the same period in 1996. In the California market, health care costs increased as a result of higher pharmacy costs for both the commercial and Medicare lines of business, percentage of premium provider contracting arrangements, increased hospital utilization in the Medicare line of business, and increased enrollment in the Medicaid line of business. While health care costs increased during 1997, the health plans' MCR declined to 84.3% for the year ended December 31, 1997 from 85.2% for the comparable period in 1996 primarily due to higher medical costs in 1996 and favorable loss reserve development in certain health plan operations during 1997. The health plans' MCR increased to 85.2% in 1996 as compared to 79.9% for the same period in 1995. Continued downward pressure on pricing, coupled with increased pharmacy costs and utilization contributed to the overall health plan MCR.
Government health care costs as a percentage of government contract revenue decreased from 77.7% in 1996 to 75.0% in 1997 as a result of improved health care and subcontractor performance on the California/Hawaii and Washington/Oregon CHAMPUS contracts, and the favorable impact of change order revenue and cost development in 1997. Cost percentages for the year 1996 compared to 1995 increased to 77.7% primarily due to the recognition of implementation revenue in 1995 for the Washington/Oregon, Region 6 and California/Hawaii CHAMPUS contracts, which did not have associated health care costs.
The Company's specialty services subsidiaries offer behavioral health, dental, vision, and pharmaceutical products and services as well as managed care products related to bill review, administration and cost containment for hospitals, health plans and other entities. Revenues generated by the Company's specialty services operations for 1997 increased by $25.1 million or 7.9% as compared to the same period in 1996 primarily due to the impact of a full year's revenue from MHN which was acquired in March 1996. The increase in revenue was offset somewhat by the sale of certain ancillary health care service operations in 1996 and reduced revenue from various ASO operations. Revenues for 1996 as compared to 1995 increased due to the acquisition of MHN in March 1996 as well as growth in ASO, bill review and other services.
Under the Quota Share Treaty, the Company ceded 30% of its net premiums earned, losses and allocated loss adjustment expenses incurred to Gen Re from July 1, 1996 to December 31, 1996 and ceded 7.5% of its net retained business from January 1, 1997 to June 30, 1997. The Quota Share Treaty contains a provisional ceding commission, which adjusts based on actual reported loss experience on the subject business. The Company stopped ceding under the quota share treaty effective July 1, 1997.
The Aggregate Treaty was entered into at a premium cost of $32 million, in exchange for $37.3 million of reinsurance coverage for the first six months of 1997. Effective July 1, 1997 a second six-month Aggregate Treaty was entered into with Gen Re at a cost of $61.5 million, in exchange for $75 million of reinsurance coverage. For the twelve months ended December 31, 1997, a total of $93.5 million of
Workers' compensation revenue of $560.9 million increased 8.1% in 1997 as compared to 1996. The increase in revenue is due to an increase in gross premium revenues, investment income and capital gains, offset by the cost of the Aggregate Excess Treaty.
Net premiums earned increased by 6.3% in 1997 as compared to 1996 due primarily to national expansion of workers' compensation in states outside California, offset by reduced premium writings in California. Premiums earned on policies issued in California continue to be negatively affected by price competition since the start of competitive rating on January 1, 1995.
Net investment income for 1997 increased $3.9 million or 11.3%. The increased investment income is due to an increase in assets available for investment, from higher operational cash flow and capital surplus contributions of $120 million in mid-1996 to the insurance operations to support premium writings.
Net investment income of $34.3 million in 1996 increased $9.9 million or 40.6% compared to 1995. The increase in investment income is due to an increase in assets available for investment from operational cash flow and capital contributions.
The following sets forth the workers' compensation companies underwriting experience as measured by its combined ratio and its components for the twelve months ended December 31, 1997, 1996 and 1995.
The underwriting expense ratio increased by 8.5% in 1997 as compared to 1996. The increase in the ratio is primarily due to the accounting for the Aggregate Treaty, which does not have an underwriting expense provision as part of the agreement. Also, under the Quota Share Treaty, the ceding of the Company's net retained business was substantially less in 1997 than in 1996. As such, ceded commission in 1996 under the Quota Share Treaty has a positive effect on the underwriting expense ratio, and a lower beneficial impact on the ratio in 1997. The pro-forma impact to the underwriting expense ratio without accounting for the Aggregate and Quota Share Treaties would have been 24.9% in 1997 compared to 24.0% in 1996.
The loss and loss adjustment expense ratio increased 166 basis points in 1996 as compared to 1995. In 1995, this ratio was favorably impacted by a $26.5 million reduction to accident year 1994 and prior loss and loss adjustment expense estimates. In 1996, the comparable amount of development for accident years 1995 and prior was an increase to the losses and loss adjustment expense incurred of $20.1 million.
The loss from discontinued operations for the segment was $30.4 million in 1997 as compared to income of $22.2 in 1996. The loss in 1997 was primarily due to the strengthening of reserves in the amount of $75.2 million in the fourth quarter of 1997. In addition, the Company recorded an estimate of the loss to be incurred when the workers' compensation insurance operations are sold of approximately $99.0 million, net of tax.
The following table presents financial information reflecting the Company's continuing operations for its primary lines of business:
FOUNDATION HEALTH SYSTEMS, INC. LINE OF BUSINESS FINANCIAL INFORMATION (IN THOUSANDS)
For the year ended December 31, 1997, cash used from operating activities was $125.9 million compared to $6.7 million in the prior year. This was due primarily to payments for merger, restructuring and other costs associated with the FHS Combination, as well as Gem costs. This was partially offset by fluctuations in operating assets and liabilities primarily caused by timing differences in the payment of accounts payables and other liabilities, reserves for claims and other settlements, and deferred taxes at each respective year end. Net cash used by investing activities was $134.8 million during 1997 as compared to $184.8 million during 1996. This decrease during 1997 was due to higher net redemptions of investments available for sale, an early payment related to the FPA note receivable, offset by the cost of the acquisitions of FOHP, Physician Health Services, Inc. ("PHS"), PACC, Advantage Health and Christiania General Insurance Corporation. Net cash generated from financing activities was $332.1 million in 1997 as
The Company has a $1.5 billion credit facility (the "Credit Facility"), with Bank of America as Administrative Agent for the Lenders thereto, which was amended pursuant to a Letter Agreement dated March 27, 1998 with the Lenders (the "Credit Facility Letter Agreement"). All previous revolving credit facilities were terminated and rolled into the Credit Facility on July 8, 1997. At the election of the Company, and subject to customary covenants, loans are initiated on a bid or committed basis and carry interest at offshore or domestic rates, at the applicable LIBOR Rate plus margin or the bank reference rate. Actual rates on borrowings under the Credit Facility vary, based on competitive bids and the Company's unsecured credit rating at the time of the borrowing. Under the Credit Facility Letter Agreement, the margins used in setting the facility fee and borrowing rates under the Credit Facility were increased. Accordingly, the Company will incur an increase in the "all in" margin of 0.05% based on its debt rating as of December 31, 1997 under the terms of the Credit Facility. Any decrease in such rating would result in an increase in such margin. The Credit Facility is available for five years, until July 2002, but it may be extended under certain circumstances for two additional years. (See, OTHER INFORMATION--REVOLVING CREDIT FACILITY contained in this report for further information concerning the Revolving Credit Facility)
The Company's subsidiaries must comply with certain minimum capital requirements under applicable state laws and regulations. The long-term portion of principal and interest payments under the CWF Notes issued to the Company in connection with the Health Net conversion is subordinated to Health Net meeting tangible equity requirements under applicable California statutes and regulations. As of December 31, 1997, the Company's subsidiaries were in compliance with minimum capital requirements.
The Year 2000 effort for the Company has the highest priority of technology projects. The project has dedicated resources with multiple teams to address unique systems environment. Uniform project management techniques are in place with overall oversight responsibility residing with the Company's Chief Technology Officer. Emphasis has been placed on business unit involvement and the use of internal staff enhanced by external specialists. Selected systems will be retired with the business functions being converted to Year 2000 compliant systems. A number of the Company's systems include packaged software from large vendors that the Company is closely monitoring to ensure that these systems are Year 2000 compliant. The Company believes that vendors will make timely updates available to ensure that all
remaining purchased software is Year 2000 compliant. The remaining systems' compliance with Year 2000 will be addressed by internal technical staff.
However, notwithstanding the foregoing, the costs of the project and the timetable in which the Company plans to complete the Year 2000 compliance requirements are based on estimates derived utilizing numerous assumptions of future events including the continued availability of certain resources, third party modification plans and other factors. There can therefore be no assurance that these estimates will be achieved and actual results could differ materially from these estimates.
In fulfilling its responsibilities in 1997, the Committee reviewed the overall scope of the independent auditors' audit plan and reviewed the independent auditors' non-audit services to the Company. The Committee also exercised oversight responsibilities over various financial and regulatory matters.
The Committee's meetings are designed to facilitate open communication between the independent auditors and Committee members. To ensure auditor independence, the Committee meets privately with the independent auditors providing for full and free access to the Committee.
We have audited the accompanying consolidated balance sheets of Foundation Health Systems, Inc. and subsidiaries (the "Company") as of December 31, 1997 and 1996, and the related consolidated statements of operations, stockholders' equity, and cash flows for each of the three years in the period ended December 31, 1997. Our audits also included the financial statement schedule of Condensed Financial Information listed in the Index at Item 14(a)(2). These financial statements and financial statement schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on the financial statements and financial statement schedule based on our audits. The consolidated financial statements and financial statement schedule give retroactive effect to the merger of Health Systems International, Inc. and Foundation Health Corporation, which has been accounted for as a pooling of interests as discussed in Note 1 to the consolidated financial statements. As described in Note 1 to the consolidated financial statements, the financial statements of Foundation Health Corporation were restated to conform to the calendar year end of Foundation Health Systems, Inc. as of December 31, 1997 and 1996 and for each of the three years in the period ended December 31, 1997.
The current operations of Foundation Health Systems, Inc. (the "Company" or "FHS") are a result of the April 1, 1997 merger transaction (the "FHS Combination") involving Health Systems International, Inc. ("HSI") and Foundation Health Corporation ("FHC"). Pursuant to the FHS Combination, FH Acquisition Corp., a wholly owned subsidiary of HSI ("Merger Sub"), merged with and into FHC and FHC survived as a wholly-owned subsidiary of HSI, which changed its name to "Foundation Health Systems, Inc." and thereby became the Company. Pursuant to the Agreement and Plan of Merger (the "Merger Agreement") that evidenced the FHS Combination, FHC stockholders received 1.3 shares of the Company's Class A Common Stock for every share of FHC common stock held, resulting in the issuance of approximately 76.7 million shares of the Company's Class A Common Stock to FHC stockholders. The shares of the Company's Class A Common Stock issued to FHC's stockholders in the FHS Combination constituted approximately 61% of the outstanding stock of the Company after the FHS Combination and the shares held by the Company's stockholders prior to the FHS Combination (i.e. the prior stockholders of HSI) constituted approximately 39% of the outstanding stock of the Company after the FHS Combination.
The FHS Combination was accounted for as a pooling of interests for accounting and financial reporting purposes. The pooling of interests method of accounting is intended to present, as a single interest, two or more common stockholder interests which were previously independent and assumes that the combining companies have been merged from inception. Consequently, the Company's consolidated financial statements have been prepared and/or restated as though HSI and FHC always had been combined. Although prior to the FHS Combination FHC reported on a fiscal year ended June 30 basis, the consolidated financial statements have been restated to reflect the Company's calendar year basis.
NOTE 1--DESCRIPTION OF BUSINESS (CONTINUED) The Company's wholly-owned subsidiary, Foundation Health Federal Services, Inc. ("Federal Services"), administers large, multi-year managed care government contracts. Federal Services subcontracts to affiliated and unrelated third parties the administration and health care risk of parts of these contracts. Federal Services currently administers health care programs covering 1.9 million eligible individuals under the Civilian Health and Medical Program of the Uniformed Services ("CHAMPUS"). Through the Federal Government's TRICARE program, Federal Services provides CHAMPUS families with improved access to primary health care, lower out-of-pocket expenses and fewer claims forms. Federal Services currently administers three TRICARE contracts in five regions that cover the following states:
- Regions 9, 10 & 12: California, Hawaii, Alaska and portions of Arizona
The Company's specialty services subsidiaries offer behavioral health, dental, vision, and pharmaceutical products and services as well as managed care products related to bill review, administration and cost containment for hospitals, health plans and other entities.
WORKERS' COMPENSATION INSURANCE SEGMENT--The Company revised its strategy of maintaining a presence in the workers' compensation insurance business and adopted a plan to discontinue this segment of its business through divestiture of its workers' compensation insurance subsidiaries. The Company is currently in negotiation for the sale of the business. As a result, the Company is reporting its workers' compensation insurance segment as discontinued operations in the consolidated financial statements (see Note 15).
The consolidated financial statements include the accounts of the Company and its wholly-owned and majority-owned subsidiaries. All significant intercompany transactions have been eliminated in consolidation except for transactions between the Company's continuing operations subsidiaries and the discontinued operations segments discussed in Note 15. The accompanying consolidated financial statements have been restated for the FHS Combination accounted for as a pooling of interests as discussed in Note 1.
The Company classifies certain debt investments held by trustees or agencies pursuant to state regulatory requirements as held to maturity based on the Company's ability and intent to hold these investments to maturity. Such investments are presented at amortized cost. All other investments are classified as available for sale and are reported at fair value based on quoted market prices, with unrealized gains and losses excluded from earnings and reported as a separate component of stockholders' equity, net of income tax effects. The cost of investments sold is determined in accordance with the specific identification method and realized gains and losses are included in investment income.
NOTE 2--SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) Restricted investments totaled $14.6 million and $14.2 million at December 31, 1997 and 1996. In addition, $20.3 million in investments are restricted in connection with the California Wellness Foundation (the "CWF") note payable at December 31, 1997 and 1996 (see Note 6).
Expenditures for maintenance and repairs are expensed as incurred. Major improvements which increase the estimated useful life of an asset are capitalized. Upon the sale or retirement of assets, recorded cost and related accumulated depreciation are removed from the accounts, and any gain or loss on disposal is reflected in operations.
Goodwill and other intangible assets consist primarily of goodwill and other intangible assets which arise as a result of various business acquisitions. Other intangible assets consist of the value of employer group contracts and provider networks. Goodwill and other intangible assets are amortized using the methods listed below over appropriate periods not exceeding 40 years. Fully amortized goodwill and other intangible assets and related accumulated amortization are removed from the accounts. The Company evaluates the carrying value of its goodwill and other intangible assets periodically based on fair values or undiscounted operating cash flows whenever significant events or changes occur which might impair recovery of recorded costs, and it writes down recorded costs of the assets to fair value when recorded costs, prior to impairment, are higher.
Goodwill and other intangible assets consisted of the following at December 31, 1996 (in thousands):
Amortization expense on goodwill and other intangible assets was $40.3 million, $45.2 million and $33.1 million for the years ended December 31, 1997, 1996 and 1995, respectively.
NOTE 2--SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) CONCENTRATIONS OF CREDIT RISK
Options to purchase an aggregate of 6.6 million, 4.1 million and 1.3 million shares of common stock during 1997, 1996 and 1995, respectively, were not included in the computation of diluted EPS because the options' exercise price was greater than the average market price of the common stock. These options expire through December 2007.
The preparation of the financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures 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.
The estimated fair value amounts of cash equivalents, investments available for sale and notes payable approximate their carrying amounts in the financial statements and have been determined by the Company using available market information and appropriate valuation methodologies. The carrying amount of cash equivalents approximate fair value due to the short maturity of those instruments. The fair values of investments are estimated based on quoted market prices and dealer quotes for similar investments. The fair value of notes payable is estimated based on the quoted market prices for the same or similar issues or on the current rates offered to the Company for debt with the same remaining maturities. Considerable judgment is required to develop estimates of fair value. Accordingly, the estimates are not necessarily indicative of the amounts the Company could have realized in a current market exchange. The use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair value amounts.
NOTE 2--SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) The fair value estimates are based on pertinent information available to management as of December 31, 1997 and 1996. Although management is not aware of any factors that would significantly affect the estimated fair value amounts, such amounts have not been comprehensively revalued for purposes of these financial statements since that date, and therefore, current estimates of fair value may differ significantly.
During 1997, the Financial Accounting Standards Board issued SFAS No. 130 "Reporting Comprehensive Income", which requires that an enterprise report, by major components and as a single total, the change in its net assets during the period from nonowner sources; SFAS No. 131 "Disclosures About Segments of an Enterprise and Related Information", which establishes annual and interim reporting standards for an enterprise's business segments and related disclosures about its products, services, geographic areas, and major customers; and SFAS No. 132 "Employers Disclosures About Pensions and Other Postretirement Benefits", which revises and standardizes pension and other benefit plan disclosures. Adoption of these statements will not impact the Company's consolidated financial position, results of operations or cash flows. These statements are effective for fiscal years beginning after December 15, 1997.
The following summarizes acquisitions and strategic investments by the Company for the three years ended December 31, 1997:
PACC--On October 22, 1997, effective October 1, 1997, the Company completed the acquisitions of PACC HMO and PACC Health Plans (collectively, "PACC"), which are managed health care companies based near Portland, Oregon, for a net purchase price of approximately $43.7 million in cash. The acquisition has been recorded using purchase accounting and the excess of the purchase price over the fair value of the assets acquired was recorded as goodwill. The goodwill, in the amount of $32.2 million, is
FOHP--On April 30, 1997 the Company made a $51.7 million investment in FOHP, Inc. ("FOHP"). FOHP was owned by physicians, hospitals and other health care providers and was the sole shareholder of First Option Health Plan of New Jersey, Inc. ("FOHP-NJ"), a managed health care company. The Company's initial investment was in the form of FOHP debentures convertible into up to 71 percent of FOHP's outstanding equity at the Company's discretion. As of December 1, 1997 the Company converted these initial FOHP debentures into 71 percent of FOHP's equity. Additionally, effective December 8, 1997 FOHP issued an additional $29.0 million of convertible debentures to the Company which immediately converted approximately $18.9 million of these debentures into an additional 27 percent of FOHP's outstanding equity increasing FHS' equity holding in FOHP to approximately 98 percent. Goodwill of $107.7 million was recorded as a result of these transactions. On December 31, 1997 the Company purchased nonconvertible debentures in the amount of $24 million from FOHP. FOHP currently has more than 250,000 members in New Jersey enrolled in its commercial, Medicare, Medicaid and PPO programs.
PHYSICIANS HEALTH SERVICES--On December 31, 1997 the Company completed the acquisition of Physicians Health Services, Inc. ("PHS"), a group of managed health care companies based in Shelton Connecticut. The Company paid approximately $265 million for the approximately nine million PHS shares then outstanding and caused PHS to cash-out approximately $6 million in PHS employee stock options as part of the acquisition. The acquisition has been recorded using purchase accounting and the excess of the purchase price over the fair value of the assets acquired was recorded as goodwill. The goodwill, in the amount of $218.9 million, is being amortized on a straight-line basis over 40 years. PHS is a 449,000 member health plan with operations in the New York metropolitan area, including northern New Jersey, and throughout the state of Connecticut.
CHRISTIANIA GENERAL INSURANCE CORPORATION--On May 14, 1997 the Business Insurance Group, Inc., a subsidiary of the Company, acquired the Christiania General Insurance Corporation of New York ("CGIC") for $12.7 million in cash. The acquisition has been recorded using purchase accounting and the excess of the purchase price over the fair value of the assets acquired was recorded as goodwill. The goodwill, in the amount of $5.2 million, is being amortized on a straight-line basis over 20 years. As discussed in Note 1, the workers' compensation segment is reported as discontinued operations and includes CGIC.
MANAGED HEALTH NETWORK--In March 1996 the Company issued stock for Managed Health Network, Inc. and its subsidiaries (collectively "MHN"), a privately held company providing employee assistance and managed behavioral health programs to more than 2.7 million covered lives through its subsidiaries, in a pooling of interests transaction valued at approximately $45 million.
MDEC--On March 15, 1995 the Company acquired all of the outstanding stock of M.D. Enterprises of Connecticut, Inc. ("MDEC"), and its wholly-owned subsidiary, M.D. Health Plan, an HMO operating in Connecticut, for $100.5 million. The goodwill, in the amount of $89.1 million and employer group contracts in the amount of $8.0 million, is being amortized on a straight-line basis over 35 and 11 years, respectively.
HDS--In 1995, the Company acquired shares of preferred stock of Health Data Sciences Corporation ("HDS"), representing a minority equity interest in HDS, for an aggregate purchase price of approximately $21.9 million. In July 1996, HDS was acquired by Medaphis Corporation ("Medaphis") and the Company's preferred stock in HDS was converted into 976,771 shares of Medaphis common stock. Since the acquisition of HDS by Medaphis the value of Medaphis common stock has substantially declined, and the Company has therefore reflected an unrealized loss of $15.6 million related to its investment in Medaphis common stock. In connection with the decline the Company filed a lawsuit against Medaphis in 1996 claiming, among other things, that misleading financial performance information was given to the Company prior to the acquisition. The complaint seeks rescission of the transaction or damages in excess of $38.0 million. As of December 31, 1997, the litigation is ongoing.
As of December 31, 1996, the amortized cost, gross unrealized holding gains and losses and fair value of the Company's investments were as follows (in thousands):
NOTE 4--INVESTMENTS (CONTINUED) At December 31, 1997, the contractual maturities of the Company's investments were as follows (in thousands):
Property and equipment comprised the following at December 31 (in thousands):
NOTE 5--PROPERTY AND EQUIPMENT (CONTINUED) Depreciation expense on property and equipment was $58.1 million, $67.7 million and $56.3 million for the years ended December 31, 1997, 1996 and 1995.
NOTE 6--NOTES PAYABLE, CAPITAL LEASES AND OTHER FINANCING ARRANGEMENTS (CONTINUED) The weighted average annual interest rate on the Company's notes payable and capital leases was approximately 6.24%, 6.39% and 7.44% for the years ended December 31, 1997, 1996 and 1995.
Scheduled principal repayments on notes payable, capital leases and other financing arrangements for the next five years are as follows (in thousands):
Under the 1989, 1990, 1991, 1992, 1993 and 1997 employee stock option plans and the non-employee director stock option plan, the Company grants options at prices at or above the market value of the stock on the date of grant. The options carry a maximum term of 10 years and in general vest ratably over 3 years, 5 years or over the 3rd, 4th and 5th anniversaries of the date of grant. The Company has reserved a total of 24.9 million shares of its Class A Common Stock for issuance under the stock option plans. The Company anticipates all future option grants will be made under the 1997 stock option plan.
The following table summarizes the weighted average exercise price and weighted average remaining contractual life for significant option groups outstanding at December 31, 1997:
The weighted average fair value for options granted during 1997, 1996 and 1995 was $9.95, $10.46 and $12.86, respectively. The weighted-average fair value for employee purchase rights during 1997, 1996 and 1995 was $5.68, $6.21 and $6.70, respectively. The fair values were estimated using the Black-Sholes option-pricing model. The following weighted average assumptions were used in the fair value calculation for 1997, 1996 and 1995, respectively: (i) risk-free interest rate of 5.71%, 6.23% and 7.70% for option grants and 5.66%, 5.79% and 7.13% for employee purchase rights; (ii) expected option lives of 3.7 years, 2.7 years and 3.1 years and expected employee purchase right lives of 2.1 months, 3.3 months, and 3.3 months; (iii) expected volatility for both options and employee purchase rights of 30.0%, 37.6% and 37.2%; and (iv) no expected dividend yield for either options or employee purchase rights.
The Company applies APB Opinion 25 and related Interpretations in accounting for its plans. Accordingly, no compensation cost has been recognized for its stock option or employee stock purchase plans. Had compensation cost for the Company's plans been determined based on the fair value at the grant dates of options and employee purchase rights consistent with the method of SFAS No. 123, the
NOTE 7--STOCK OPTION AND EMPLOYEE STOCK PURCHASE PLANS (CONTINUED) Company's net income and earnings per share would have been reduced to the pro forma amounts indicated below for the years ended December 31 (in thousands, except per share data):
As fair value criteria was not applied to option grants and employee purchase rights prior to 1995, and additional awards in future years are anticipated, the effects on net income and earnings per share in this pro forma disclosure may not be indicative of future amounts.
On May 15, 1996, the Company completed a public offering in which the Company sold 3,194,374 shares of Class A Common Stock and the CWF sold 6,386,510 shares of Class A Common Stock (constituting 6,386,510 shares of Class B Common Stock which automatically converted into shares of Class A Common Stock upon the sale) for a per share purchase price to the public of $30.00 (the "Offering"). The net proceeds received by the Company from the sale of the 3,194,374 shares of Class A Common Stock were approximately $92.4 million after deducting underwriting discounts and commissions and estimated expenses of the Offering payable by the Company. The Company used its net proceeds from the Offering to repurchase 3,194,374 shares of Class A Common Stock held pursuant to the Associate Trust Agreement from certain Class A Stockholders. The Company repurchased these shares of Class A Common Stock from the Class A Stockholders at $30.00 per share less transaction costs associated with the Offering, amounting to $1.08 per share. All of these 3,194,374 shares of Class A Common Stock repurchased are currently held in treasury. The Company did not receive any of the proceeds from the sale of shares of Class A Common Stock in the Offering by the CWF.
Except as set forth below and subject to adjustment as provided in the Rights Agreement, each Right entitles its registered holder, upon the occurrence of a Distribution Date, to purchase from the Company one one-thousandth of a share of Series A Junior Participating Preferred Stock, at a price of $170.00 per one-thousandth share. However, in the event any person acquires 15% or more of the outstanding Class A Common Stock, or the Board of Directors of the Company declares a holder of 10% or more of the outstanding Class A Common Stock to be an "Adverse Person," the Rights (subject to certain exceptions contained in the Rights Agreement) will instead become exercisable for Class A Common Stock having a market value at such time equal to $340.00. The Rights are redeemable under certain circumstances at $.01 per Right and will expire, unless earlier redeemed, on July 31, 2006.
In connection with the FHS Combination, the Company entered into Amendment No. 1 to the Rights Agreement to exempt the FHS Combination and related transactions from triggering the Rights. In addition, the amendment modified certain terms of the Rights Agreement applicable to the determination of certain "Adverse Persons," which modifications became effective upon consummation of the FHS Combination.
As part of the FHS Combination, the FHC SERPs were frozen in April 1997 at which time each participant became 100% vested in their benefits under the plans which are equal to 90% of the actuarial equivalent of the participant's retirement benefit as of December 31, 1996. All benefits under the FHC SERPs were paid out either in cash, or as a rollover to the deferred compensation plan.
The following table sets forth the funded status of the FHC SERPs and HSI SERPs and the amounts recognized in the Company's consolidated financial statements at December 31:
Under the Company's deferred compensation plan certain members of management, highly compensated employees and non-employee Board members may defer payment of up to 90% of their compensation. As part of the FHS Combination, the plan was frozen in May 1997 at which time each participant's account was credited with three times the 1996 Company match (or a lesser amount for certain prior participants) and each participant became 100% vested in all such contributions. The current provisions with respect to the form and timing of payments under the plan remain unchanged. At December 31, 1997 and 1996, the liability under the plan amounted to $29.3 million and $19.9 million. The Company's expense under the plan totaled $7.8 million, $3.7 million and $3.1 million for the years ended December 31, 1997, 1996, and 1995.
Certain subsidiaries of the Company sponsor post-retirement defined benefit health care plans that provide post-retirement medical benefits to key executives, employees and dependents who meet certain eligibility requirements. Under these plans, the Company pays a percentage of the costs of medical, dental and vision benefits during retirement. The plans include certain cost-sharing features such as deductibles, coinsurance and maximum annual benefit amounts which vary based principally on years of credited service. The accumulated post-retirement benefit obligation under the plans was $6.3 million and $5.2 million at December 31, 1997 and 1996 respectively. The net periodic post-retirement cost was $1.3 million, $828 thousand and $798 thousand for the years ended December 31, 1997, 1996 and 1995 respectively.
The weighted-average annual assumed rate of increase in the per capita cost of covered benefits (i.e. health care cost trend rate) is 7.25% for 1997, and is assumed to decrease gradually to 4.5% for 2007 and remain at that level thereafter. The impact of increasing the assumed health care cost trend rate by 1 percentage point would not have a significant effect on the accumulated post-retirement benefit obligation or the aggregate of the service and interest cost components of the net periodic post-retirement benefit cost for the year ended December 31, 1997.
In 1997, the Company had a Performance-Based Annual Bonus Plan that qualified under Section 162(m) of the Code (the "Prior 162(m) Plan"). Under the Prior 162(m) Plan, if the Company achieved $62.5 million in consolidated income from operations before taxes, certain executives were potentially eligible to receive cash bonuses from a pool of 2.5% of such consolidated operating income based on the executives' salaries in relation to the pool. Amounts payable to such executives from such pool were subject to downward adjustment by the Company's Compensation and Stock Option Committee of the Board of Directors. The $62.5 million performance goal for the Prior 162(m) Plan was not met for 1997. The Company's Stockholders adopted a new Performance-Based Annual Bonus Plan that qualifies under Section 162(m) of the Code which became effective on January 1, 1998 and replaced the Prior 162(m) Plan.
Income tax expense (benefit) is included in the financial statements as follows for the years ended December 31:
NOTE 10--INCOME TAXES (CONTINUED) A reconciliation of the statutory federal income tax rate and the effective income tax rate on income from continuing operations is as follows for the years ended December 31:
Significant components of the Company's deferred tax assets and liabilities as of December 31 are as follows:
As of December 31, 1997, the Company had federal net operating loss carryforwards of approximately $324 million from continuing operations, of which $126 million may be subject to carryover limitations under Section 382 of the Code. A valuation allowance has been provided to account for the potential limitations associated with utilization of net operating loss carryforwards. The net operating loss carryforwards expire between 2006 and 2012.
All of the Company's health plans as well as its insurance subsidiaries are required to periodically file financial statements with regulatory agencies in accordance with statutory accounting and reporting practices. Under the California Knox-Keene Health Care Service Plan Act of 1975, as amended, California plans must comply with certain minimum capital or tangible net equity requirements. The Company's non-California health plans, as well as its health and life insurance companies, must comply with their respective state's minimum regulatory net worth requirements generally under the regulation of the respective state's department of insurance.
As a result of the above requirements and certain other regulatory requirements, certain subsidiaries are subject to restrictions on their ability to make dividend payments, loans or other transfers of cash to the Company. Such restrictions, unless amended or waived, limit the use of any cash generated by these subsidiaries to pay obligations of the Company. As of December 31, 1997, restricted assets of these subsidiaries totaled approximately $52.5 million.
NOTE 12--COMMITMENTS AND CONTINGENCIES (CONTINUED) Future minimum lease commitments for noncancelable operating leases at December 31, 1997 are as follows (in thousands):
In 1995, the Company advanced an aggregate sum of approximately $16.3 million to three of its former executive officers and directors in connection with the future repurchase of shares of the Company's Class A Common Stock held by such individuals. This repurchase agreement was entered into in connection with certain severance agreements between the Company and each such individual in connection with his or her termination of employment. Such advances were non-interest bearing and were secured by a pledge of shares of Class A Common Stock, which shares were ultimately repurchased by the Company in January 1996.
Certain transactions between the Company's continuing operations subsidiaries and the discontinued operations segments are not eliminated (see Note 15).
The following sets forth the principal components of merger, restructuring and other costs for the ended December 31:
Severance and benefit related costs include a terminations benefits plan and contractually required change of control payments to senior executives. Also included are the costs of settlements of benefit plans terminated as a result of the restructuring plan to conform benefits for the merged companies. Provider network consolidation costs include costs to consolidate overlapping provider networks, primarily in California, and the costs of exiting existing provider contracts as legally, regulatory or administratively required. Real estate lease termination costs include facilities consolidation costs primarily in geographic regions where there is overlapping office space usage. Asset impairment costs are primarily a result of the Company's plan to be on common operating systems and hardware platforms. These costs include impairment of hardware, software and other systems related assets.
During the quarters ended June 30, and December 31, 1997, $86.3 million and $32.3 million, respectively, in other costs were recorded and included the following components: $30.5 million for receivables related to provider contracts that will not be renewed; $17.2 for government receivables related to prior contracts and adjustments on current contracts being negotiated with the Department of Defense; $15.1 million for litigation settlement estimates primarily related to former FHC subsidiaries; $12.6 million for the loss on sale of the United Kingdom operations; $16.1 million for loss contract accruals, including $10.1 million related to the Company's health plans in Texas, Louisiana and Oklahoma; $7.7 million related to contract termination costs; $8.2 million in other receivables; and $11.2 million of other costs.
NOTE 14--MERGER, RESTRUCTURING AND OTHER COSTS AND GEM COSTS (CONTINUED) receive certain regulatory approvals. Gem established a reserve for the estimated premium deficiency related to these policies. As of December 31, 1997, $14.0 million remained in this reserve which is expected to be adequate to cover future premium deficiencies.
Discontinued operations include the Company's workers' compensation insurance and physician practice management segments. The loss on the sale of discontinued operations, net of $18.2 million of taxes, of $88.8 million for the year ended December 31, 1997 includes an estimated loss to be incurred when the workers' compensation insurance segment is sold of approximately $99 million, and an offsetting credit of $10.2 million related to the sale of the Company's physician practice management segment.
The Company revised its strategy of maintaining a presence in the workers' compensation insurance business. As a result of this decision, the Company adopted a plan to completely discontinue this segment of its business through divestiture of its workers' compensation insurance subsidiaries. The Company is currently in negotiation for the sale of the business. As a result, the Company is reporting its workers' compensation insurance segment as discontinued operations for each year presented in the consolidated financial statements and related footnotes.
NOTE 15--DISCONTINUED OPERATIONS (CONTINUED) The following sets forth the summarized balance sheet and results of operations for the workers' compensation insurance companies to be sold as of December 31, 1997 and 1996, and for each of the three years ended December 31 (in thousands):
NOTE 15--DISCONTINUED OPERATIONS (CONTINUED) 1996. Investment income includes realized gains on sale of investments of $44 million, $31 million and $25 million for the year ended December 31, 1997, 1996 and 1995, respectively.
The workers' compensation insurance companies results of operations include certain transactions with the Company's continuing operations subsidiaries which have not been eliminated from the Company's consolidated statement of operations. Such transactions include the following amounts recorded by the workers' compensation insurance companies for the years ended December 31, 1997, 1996 and 1995: interest expense related to the note payable to Parent of $8.3 million, $4.3 million and $0, respectively; and other underwriting expenses related to services provided primarily by the Company's bill review services subsidiary of $14.5 million, $10.1 million and $5.6 million, respectively.
During 1995 and 1996, changes were occurring in the physician practice management industry which led the Company to adopt a plan to completely discontinue the operations of the Medical Practices. In connection with this changed environment and with its plan to discontinue this segment, the following transactions were entered into with FPA and certain of its affiliated entities, none of which are affiliated with the Company.
On June 28, 1996, the Company and the sole shareholder of the Medical Practices executed a Stock and Note Purchase Agreement whereby the Company sold all the outstanding stock of its management services organization and the sole shareholder sold all of the outstanding stock of the holding company for the Medical Practices to FPA. The aggregate consideration consisted of $2 million cash, $75 million of FPA common stock, $22 million bridge note receivable and $104 million of Medical Practices' notes payable to the Company assumed by FPA. At December 31, 1996, the $75 million of FPA common stock was included in investments available for sale and the $126 million of notes receivable was included in other current
During January and June of 1996, the Company completed the sale of its affiliated independent practice associations ("IPAs") in California, Florida and Arizona to FPA for total consideration of $30 million in cash and notes. Gains of $10.8 million were recognized by the Company during the year ended December 31, 1996 and are included in income from discontinued operations.
The following sets forth the summarized results of operations for the Medical Practices for the year ended December 31, 1995 and the eleven months ended November 30, 1996, (in thousands):
The Medical Practices' results of operations include certain transactions with the Company's continuing operations subsidiaries which have not been eliminated from the Company's consolidated statement of
NOTE 15--DISCONTINUED OPERATIONS (CONTINUED) operations. Such transactions include the following amounts recorded by the Medical Practices' for the eleven months ended November 30, 1996 and the year ended December 31, 1995: premiums received from certain of the Company's health plans of $129.5 million and $100.0 million, respectively; and interest expense related to a note payable to Parent of $10.8 and $10.0 million, respectively.
The following restated interim financial information presents the 1997 and 1996 results of operations on a quarterly basis (in thousands, except per share data) (see Note 1):