The following selected consolidated financial information has been derived from the consolidated financial statements of the Company and should be read in conjunction with the Consolidated Financial Statements and notes thereto included elsewhere in this report which have been audited by BDO Seidman, LLP for 1998 and 1997, and by PricewaterhouseCoopers, LLP for all prior years.
Net loss applicable to common stock was $12.4 million or ($1.20) per basic and diluted share for 1998 compared to net loss of $18.6 million or $1.84 per basic and diluted share for 1997. The Company's 1998 results continue to be unfavorably impacted by high health policy benefits, along with other operating expenses of $4.9 million, related to the start-up operations of HealthAxis. The 1998 results were favorably impacted by a net $3.0 million gain on the sale of subsidiaries and a $0.8 million ceding commission relating to the 100% ceding of the managed care business as described in the Financial Statements' Notes C and D, respectively, and later in this discussion of results of operations.
On November 12, 1998 PILIC signed an agreement to reinsure 100% of its group medical and group life inforce business and sell the Company's group medical marketing, sales distribution rights and PALHIC to CRLC. On December 31, 1998 the Company executed a series of transactions whereby PALHIC reinsured 100% of its business to PILIC, which in turn reinsured via a 100% co-insurance reinsurance agreement all of the Company's group medical and group life business to the RCH. In addition PILIC sold PALHIC and NIA to CRLC, transferred all rights and control regarding the Company's agents and entered into non-compete and non-solicitation agreements regarding the Company's agents with respect to the future sale of health insurance products by agents for a 3-year period.
At December 31, 1998 and 1997, gross annualized accident and health premium inforce on small group and managed care business amounted to $102.7 million and $96.8 million, respectively, consisting of approximately 45,000 and 50,000 certificate holders, respectively. All of the small group and managed care business is 100% ceded to RCH effective January 1, 1999.
Life and annuity premium, gross of $8.8 million for 1998 declined from $9.6 million for 1997 due to reduced pre-need premium. As a result of the transactions with CRLC and RCH, the Company anticipates a substantial decline in life premium. Included in 1998's gross premium was $2.0 million of group life premium which is 100% ceded to RCH effective January 1, 1999. Individual life insurance lapse ratios for 1998 and 1997 were 8% and 11%, respectively. Life and annuity reinsurance ceded was $0.2 million for 1998 compared to $0.5 million recaptured for 1997, which correlates to the decline in gross premium.
Ceding allowance net of policy acquisition costs of $0.8 million represents $10.0 million ceding commission received from RCH net of $5.0 million conditional payment, $3.8 million of unamortized deferred acquisition cost and $0.4 million of transaction costs. The $5.0 million contingent payment received from RCH has been accounted for as a ceding commission liability.
Other operating expenses, net of ceding allowance and deferred acquisition costs of $25.8 million for 1998 increased from $15.3 million in 1997, primarily due to $4.9 million of expenses associated with HealthAxis and higher costs associated with the Company's small group and managed care business.
Amortization of deferred policy acquisition costs of $2.0 million for 1998 decreased from $10.9 million for 1997 primarily resulting from accelerated amortization in 1997 attributable to higher than expected lapses and worse than expected loss ratios. As a result of the reinsurance agreement with RCH, the Company's managed care business is ceded 100%, effective January 1, 1999 and, accordingly, deferred policy acquisition costs were written off against the ceding allowance received from RCH. Future amortization is limited to the life business, which in 1998 was $0.6 million.
Net loss applicable to common stock was $18.6 million or $1.84 per basic and diluted share for 1997 compared to net income of $15.9 million or $1.46 per basic and diluted share for 1996. The 1997 results were unfavorably impacted by higher health policy benefits, write-off of deferred acquisition costs, and transition costs associated with the HPS outsourcing. The 1996 results were primarily the result of a gain on litigation settlement of $14.6.
At December 31, 1997 and 1996, gross annualized accident and health premium inforce on small group and managed care business amounted to $96.8 million and $70.7 million, respectively, consisting of approximately 50,000 and 36,000 certificate holders, respectively. The $26.1 million net increase in annualized premium resulted from new business of $68.1 million issued in 1997, plus premium rate increases of approximately $10.0 million less lapses amounting to approximately $49.5 million. Managed care products accounted for 82% and 65% of the inforce premium at year-end 1997 and 1996, respectively, of the group accident and health business.
Other operating expenses of $15.3 million for 1997 increased from $11.7 million for 1996, due to increased policy administration expenses caused by increased sales volume and transition expenses associated with the HPS outsourcing.
Amortization of deferred policy acquisition costs of $10.9 million for 1997 increased from $0.6 million for 1996 primarily due to accelerated amortization in 1997 due to higher than expected lapses and worse than expected loss ratios. Increased lapsation over current levels or future unprofitability in certain life products could result in an increase in the amortization rate of unamortized deferred policy acquisition costs, which would adversely impact future earnings.
During 1998, the Company's liquidity requirements were primarily created and met by PILIC and PALHIC, along with the sale proceeds of MMC, PALHIC, and NIA. The primary sources of cash for HealthAxis were the issuance of debt and equity securities to outside parties and to PILIC. The primary uses of cash for HealthAxis were operating costs and payments to AOL, Lycos and CNet.
Net cash used in operating activities of $18.2 million in 1998 reflects negative cash flow from the Company's group medical business, the impact of the transition of business to HPS, and the impact of HealthAxis' AOL, CNet and Lycos payments of $9.3 million.
Change in other assets, current and deferred income taxes and other liabilities of $2.0 million related primarily to HealthAxis' payments to AOL and Lycos, net of funds received from HPS.
The Company anticipates that it will fund surrenders and benefit payments along with other operating expenses by a significantly reduced level of premiums together with scheduled investment maturities and the liquidation of short and intermediate-term investments.
Administrative rules and legal restrictions of state insurance departments presently prevent payment of dividends by PILIC to PAMCO without regulatory approval. Payment of dividends paid by HealthAxis to PAMCO is subject to restrictions set for in the Certificate of Designation related to HealthAxis Series A and Series B Convertible Preferred Stock and subject to restrictions set for in the Certificate of Designation related to the Series C Convertible Preferred Stock once issued. HealthAxis has not nor does it anticipate paying a cash dividend in the foreseeable future.
Inflation increases the need for insurance. Many policyholders who once had adequate insurance programs increase their life insurance coverage to provide the same relative financial benefits and protection. The effect of inflation on medical costs leads to accident and health policies with higher benefits. Thus, inflation has generally increased the need for life and accident and health products.
During 1998 HealthAxis entered into an Interactive Marketing Agreement with AOL and promotional agreements with CNet and Lycos. In connection with these agreements the Company has paid $12.24 million in cash and warrants as of December 31, 1998 and is required to pay additional amounts as described in Notes F, G and H to the Company's Consolidated Financial Statements. Additionally, the Company expects to incur significant HealthAxis costs that will require additional funding.
In 1998, HealthAxis obtained $13.9 million in funding consisting of (i) a $750,000 fee paid by HPS in March 1998 in consideration of HPS being granted the right to administer certain of the health insurance business written by PILIC and PALHIC; (ii) a $5.0 million loan together with accrued interest from HPS to HealthAxis in May 1998, which was converted in September 1998 into 2,365,365 shares of HealthAxis common stock; (iii) the purchase by PILIC of $2.4 million of Series A Preferred Stock of HealthAxis in September 1998; (iv) the purchase by PAMCO of 682,395 shares of common stock of HealthAxis in November 1998 for $3.0 million; and (v) the purchase by AOL of $2.75 million of Series B Preferred Stock of HealthAxis in November, 1998.
In November HealthAxis renegotiated the AOL, CNet and Lycos Agreements in order to obtain additional time needed to test its web site and secure funds. AOL, CNet and Lycos agreed to extend HealthAxis' launch date and payment of fees. In consideration for the extension HealthAxis agreed to pay AOL an additional $2 million during the initial term, $1 million during the renewal term, revise the terms of the warrants to purchase the Company's common stock from five to seven years and issue warrants to purchase the Company's and/or HealthAxis' common stock as described in Note F. Lycos agreed to reduce the fees payable by HealthAxis by $4.57 million during the first term of the Lycos Agreement and HealthAxis agreed to an approximately 30% reduction in guaranteed impressions during the first term of the Lycos Agreement.
Year 2000 issues are the result of computer programs being written using two digits rather than four to define the applicable year. In other words, date-sensitive software may recognize a date using "00" as the year 1900 rather than the Year 2000. This could result in system failures or miscalculations causing disruptions in operations, including, among other things, a temporary inability to process transactions, send invoices, or engage in similar normal business activities.
The Company has begun an assessment of the Company's Year 2000 readiness and has identified applications owned by the Company, which are not Year 2000 compliant. Furthermore, the Company believes that the Computer Systems of many of its vendors or Carrier Partners that provide critical services to the Company are not currently Year 2000 compliant.
To date, the Company has experienced very few Year 2000 problems with those problems centering on life administration processing. The cost of programming changes as of December 31, 1998 was less than $20,000. The Company is in the process of evaluating alternatives to its life administration Year 2000 issues including the modification of the life administration system at a cost yet to be estimated or the effective replacement of the system via outsourcing of the life system at an estimated incremental annual cost of approximately $300,000 per year and a one time conversion cost of approximately $300,000. The Company anticipates selecting a Year 2000 plan to address its life administration Year 2000 issues by the end of the second quarter of 1999. To date, the Company has replaced its general ledger and accounts payable accounting systems, which were not Year 2000 compliant, in January 1998 at a cost of approximately $180,000.
There are risks associated with the Company's Year 2000 exposure relating to some external vendors with whom the Company depends on material sales and service processing. Because the Company does not control these vendors or their resources, the Company can provide no assurance that such vendors will complete their respective Year 2000 solutions in time for the Company to fully test system interfaces with them. Although the Company is coordinating its efforts with vendors to minimize this impact of Year 2000 issues, the Company is currently unable to predict the extent to which Year 2000 issues will affect its operations, or the extent to which it would be vulnerable to the failure of its vendors, Carrier Partners or other business partners to remediate any Year 2000 issues on a timely basis.
The Company has begun the process of developing a contingency plan to address possible Year 2000 risks to its Computer Systems. There is no assurance that the Company will successfully implement its contingency plan or make all of its systems Year 2000 compliant. The Company does not currently have a contingency plan in place in the event any third party in which it engages in business is not Year 2000 compliant.
Consolidated Statements of Changes in Stockholders' Equity Years ended December 31, 1998, 1997 and 1996
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Provident American Corporation and Subsidiaries as of December 31, 1996 and 1995, and the results of their operations and their cash flows for each of the three years ended December 31, 1996 in conformity with generally accepted accounting principles. In addition, in our opinion, the financial statement schedules referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information required to be included therein.
As discussed in Note B to the consolidated financial statements, the Company adopted Statement of Financial Accounting Standards No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of" during 1995.
Provident American Corporation and Subsidiaries Consolidated Statements of Changes in Stockholders' Equity
Principles of consolidation: The consolidated financial statements of PAMCO and subsidiaries have been prepared in accordance with generally accepted accounting principles (GAAP) and include the accounts of PAMCO and its subsidiaries. All significant intercompany accounts and transactions have been eliminated.
Bonds and equity securities are classified as "available-for-sale", reported at fair value, with unrealized gains and losses excluded from earnings and reported as a separate component of stockholders' equity, net of applicable deferred income taxes.
Realized gains and losses (including provisions for market declines considered to be other than temporary) are included in the determination of net income (loss) as revenues. The cost of investments sold is determined on a specific identification basis.
Goodwill represents the excess of the Company's purchase price over the fair value of the net assets acquired and is being amortized on a straight line basis over 10-20 years. The Company continually monitors the net realizable value of goodwill and recognizes a charge to expense when it is determined that a permanent impairment exists. During 1997 the Company determined the goodwill associated with the NIA and CSE acquisitions were impaired as a result of the outsourcing agreement with HPS described in Note Z and was written off. On December 31, 1998, the Company sold PALHIC and included the remaining goodwill in the determination of the realized gain on the sale of subsidiaries as described in Note C.
Income taxes: The Company files a consolidated federal income tax return, which allocates income taxes based upon the taxable income of the companies included in the return. Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes.
Future policy benefits: The liabilities for future life policy benefits have been computed using a net level premium method including assumptions as to investment yields ranging from 2 1/2% to 11 1/2%. Mortality, withdrawals and other assumptions are based either on the Company's past experience or various actuarial tables modified as necessary for possible unfavorable variations. Future policy benefits for annuities represent the policyholders' accumulated value that includes accrued interest at the credited rate and excludes any provision for surrender charges.
Policy claims: The liability for life and health policy claims is based upon the aggregate of claim estimates for reported and unreported losses based upon the Company's experience. The methods for making such estimates and establishing the resulting liabilities are continually revised and updated and any changes resulting therefrom are immediately charged or credited to income (loss) in the periods in which they are made. As a result of various reserving factors, including higher lapse rates, policy changes, and claims processing problems as described in Note T, the Company provided additional reserve strengthening of approximating $6,000 during the fourth quarter by 1998.
Reinsurance: The Company uses reinsurance to limit the impact of large losses by spreading the risk, and therefore limiting adverse claims experience. A significant portion of the reinsurance is effected under co-insurance and/or quota-share reinsurance contracts and, in some instances, by excess-of-loss reinsurance contracts. The Company's consolidated statements of operations present premium on a gross basis before reinsurance ceded together with the ceded premiums while policy benefits are presented net of reinsurance and commissions are presented net of reinsurance allowances.
In 1998, the Company adopted Statement of Financial Accounting Standard No. 130, "Reporting Comprehensive Income". This statement establishes rules for the reporting of comprehensive income and its components. Comprehensive income consists of unrealized appreciation and deprecations on available for sale securities, which prior to adoption were reported separately in shareholders equity.
Recent accounting standards: In June 1998, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments" ("SFAS 133"). SFAS 133 establishes accounting and reporting standards for derivative instruments and for hedging activities. SFAS 133 requires that an entity recognize all derivatives as either assets or liabilities and measure those instruments at fair market value. Under certain circumstances, a portion of the derivative's gain or loss is initially reported as a component of other comprehensive income and subsequently reclassified into income when the transaction affects earnings. For a derivative not designated as a hedging instrument, the gain or loss is recognized in income in the period of change. Presently, the Company does not use derivative instruments either in hedging activities or as investments. Accordingly, the Company believes that adoption of SFAS 133 will have no impact on it financial position or results of operations.
On August 15, 1996, the Company acquired Coastal Services Eastern, Inc. ("CSE") for 123,937 shares of the Company's common stock. CSE's sole business was providing the Company with policy and claims administration at the Company's facility using CSE's administration system along with its employees. This transaction was accounted for as a purchase. CSE did not conduct any business in 1998.
In February 1998 the Company sold for $4,000, 49% of Montgomery Management Corporation ("MMC") Common Stock along with a warrant to purchase an additional 31% of MMC's Common Stock for one dollar. During the fourth quarter of 1998 the buyer exercised the warrant to purchase the additional 31% of MMC's Common Stock for $8. The Company recognized a $4,008 pre-tax gain on the sale of MMC and now accounts for MMC on the equity basis of accounting. PILIC, continues to assume via reinsurance approximately 30% of the premiums, benefits and expenses of the stop-loss business administered by MMC.
HealthAxis is offering approximately $15,000 of Series C Preferred Stock solely to "accredited investors" (as defined in Rule 501 of Regulation D under the Securities Act) of which $8.8 million was received on March 30, 1999. The net proceeds from the sale of the Series C Preferred Stock are anticipated to be $14,000 and will be used to fund amounts due under the Company's strategic alliance agreements with AOL, Lycos and CNet through the end of fiscal 1999 and the balance will be used for working capital and other general corporate purposes. Although no assurance can be given that the Company will complete the offering of Series C Preferred Stock for the maximum amount offered, the Company believes that the $14,000 net proceeds together with its current cash and cash equivalents will be sufficient to fund current operations and amounts due to AOL, Cnet and Lycos in the near term. However, subsequent equity or debt financings may be necessary after 1999 to enable the Company to continue to implement its current business strategy. See Note BB.
Fair values of bond investments in good standing are principally a function of current interest rates, which are not considered in computing related future liabilities to contract holders. The presentation of estimated values for assets based on current interest yields without a corresponding revaluation of contract holder liabilities can be misinterpreted.
The Company has various financial assets and liabilities (including cash and invested assets, future policy benefits and notes payable) outstanding at December 31, 1998. Management believes that the book value of these financial instruments approximates their fair values because such instruments carry interest rates which approximate market or the amounts involved are not material.
The amortized cost and recorded fair value of bonds at December 31, 1998, by contractual maturity, is shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations.
Proceeds from sales of debt securities during 1998, 1997 and 1996 were $11,245, $35,848 and $16,719, respectively. Gross gains of $0, $455 and $200 in 1998, 1997 and 1996, respectively, and gross losses of $0, $92 and $123 in 1998, 1997 and 1996, respectively, were realized on those sales.
Equity securities representing 100,000 shares of National Media Corp. and 108,119 shares of Loewen common stock (acquired as a result of litigation) were sold during 1997.
HealthAxis's Amended and Restated Interactive Marketing Agreement ("IM Agreement") with AOL, dated November 13, 1998, provides that HealthAxis will be the exclusive third-party direct marketer of managed-care and indemnity health insurance policies, dental insurance, vision insurance, prescription coverage, critical care insurance and long-term care insurance coverage and, subject to certain restrictions, the non-exclusive third party marketer of life and long-term disability (collectively, the "Products") for individuals and groups of less than fifty individuals in the United States via AOL's online service. Under the IM Agreement, AOL will advertise the Products to its subscribers on AOL's online network and the Products will be sold online through HealthAxis's web site. The amount of promotions that AOL will provide HealthAxis is contingent upon HealthAxis's ability to offer policies in all of the fifty states, the quality of the policies offered, the adherence of HealthAxis to AOL's standards and other similar factors. The IM Agreement's initial term ends January 31, 2000, and can be extended for a renewal term of two additional years at HealthAxis's election. Upon expiration of both the initial and the renewal terms, AOL may renew the IM Agreement for additional one-year terms. See Note AA
In the event of a change in control or an initial public offering by HealthAxis, the Company will have the right to terminate HPS' right to License Fees by paying HPS the lower of: (i) eight times the HPS License Fees earned by HPS in the two quarters prior to the change in control as defined in the E-Commerce Agreement or initial public offering, or (ii) the projected License Fees based on the pro forma projections used for purposes of an HealthAxis public offering or spin-off from PAMCO.
Under the E-Commerce Agreement, HealthAxis received from HPS $750 as an off-set against the fees paid to AOL as provided in the IM Agreement which was accounted for as a deferred credit and amortized as a reduction to advertising and promotional expense over the term of the E-Commerce Agreement. In addition, PAMCO issued to HPS warrants to purchase 100,000 shares of PAMCO's common stock at an exercise price of $9.00 per share, for a period of two years. In the event that PAMCO issues any warrants after the effective date of the E-Commerce Agreement and before six months following the effective date of the E-Commerce Agreement (excluding warrants or options issued to employees, consultants, or other interactive marketing partners), having an exercise price lower than $9.00 per share, PAMCO agrees that the exercise price per share shall be reduced to such lower exercise price. The E-Commerce agreement shall further provide that PAMCO shall have the right, upon 30 days notice, to cancel any unexercised warrants in the event that the average weekly last-sale price for shares of PAMCO common stock over any consecutive eight week period exceeds $12.825. The fair value of the warrants (approximately $160) was accounted for as a capital contribution from PAMCO and a reduction of the deferred credit.
1998 1997 ----- ---- Deferred tax assets: Policy reserves $ 2,542 $ 2,589 Policy acquisition costs 0 51 Advance premiums 2 427 Post employment benefits 207 207 Net operating loss carryforwards 5,308 944 Accrued expense 49 366 Unearned ceding commission 1,750 -- Goodwill related to NIA 258 Other, net 555 432 -------- -------- 10,413 5,274 Valuation allowance for deferred tax assets 9,098 3,923 -------- -------- 1,315 1,351 -------- -------- Deferred tax liabilities: Policy acquisition costs 187 -- Real estate 720 733 Unrealized appreciation of investments 359 100 Deferred and uncollected premiums, net 408 618 -------- -------- 1,674 1,451 -------- -------- Net deferred tax asset (liability) $ (359) $ (100) ======== ========
The Company has established a valuation allowance for deferred tax assets reflecting uncertainty as to whether the deferred tax asset is fully realizable. The change in valuation allowance in 1998 amounting to $5,175 results primarily from the increase in NOLs.
The reconciliation of income tax expense (benefit) to the amount computed by applying the appropriate statutory income tax rate (35%) to income (loss) before income taxes is as follows:
Years Ended December 31, 1998 1997 1996 ------ ------ ------ Amount computed at statutory rate $(4,623) $(7,740) $ 7,881 Change in valuation allowance 5,175 2,324 (1,534) Permanent differences (167) 600 (2) State income taxes, net of tax benefit 302 Reversal of prior year federal income taxes (1,031) Other, net (385) 227 (250) ------- ------- ------- Total income tax expense (benefit) $(1,031) $(4,589) $ 6,397 ======= ======= =======
The Series B Cumulative Preferred Stock, par value $1.00 per share (the Series B Preferred Stock), held by AOL as described in Note P is also treated as minority interest.
Holders of the Series B Preferred Stock are entitled to vote on all matters as to which holders of Common Stock are entitled to vote. The holders of each share of Series B Preferred Stock entitles the holder to the number of votes equal to the nearest whole number of shares of Common Stock into which the holder's Series B Preferred Stock is convertible under the holder's optional conversion rights. Generally, the holders of Series B Preferred Stock shall vote together with the holders of Common Stock and the Series A Preferred Stock as one class.
In the event of any dissolution, liquidation or winding up of the affairs of HealthAxis, after payment or provision for payment of the debts and other liabilities of HealthAxis, the holders of the Series B Preferred Stock shall be entitled to receive, out of the assets of HealthAxis legally available for distribution to its shareholders, the amount of approximately $4.40 in cash for each share of Series B Preferred Stock, plus an amount equal to all dividends accrued and unpaid on each such share up to the date fixed for distribution, before any distribution may be made to the holders of HealthAxis's Common Stock, Series A Preferred Stock or any series of Junior Stock.
Holders of the Series B Preferred Stock have the option within six months after the later of the occurrence of a Trigger Event to redeem any or all of the shares of Series B Preferred Stock at a redemption price per share equal to the original issuance price plus an amount that would yield a total annualized return of 10%. As of December 31, 1998, HealthAxis has recorded $36 as an accretion to the stated value of the Series B Preferred Stock with a corresponding dividend charge to retained additional paid in capital.
A "Trigger Event" means: (i) January 31, 2002, if by that date, HealthAxis has not consummated an underwritten public offering of newly issued Common Stock pursuant to a registration statement filed under the Securities Act, at a net offering price per share of Common Stock that represents a pre-offering market capitalization of not less than $150,000 and with aggregate proceeds of not less than $25,000, (ii) failure to renew by HealthAxis or a material breach by any party other than AOL or termination of the IM Agreement with AOL, (iii) the date of the occurrence of a liquidation of HealthAxis (as defined above) or (iv) March 31, 1999, if by that date, HealthAxis has not consummated an equity financing yielding aggregate gross proceeds to HealthAxis of not less than $10,500 at a price per share of at least $3.74 (a "Qualified Financing"). Item (iv) was amended as described in Note BB.
In connection with AOL's purchase of the Series B Preferred Stock, HealthAxis and AOL entered into a Registration Rights Agreement ("Registration Agreement") which sets forth the rights of AOL in connection with the public offering of Common Stock acquired in connection with the conversion of Series B Preferred Stock or other shares of Common Stock acquired through the exercise of warrants granted to AOL.
The Series B Preferred Stock is not subject to any sinking fund or other similar provisions. The holders of Series B Preferred Stock are not entitled to any preemptive rights.
In addition, the Stock Purchase Agreement provides that provided AOL owns or has the right to acquire more than 1% of the outstanding Common Stock of HealthAxis, neither HealthAxis or PAMCO, nor shall PAMCO permit HealthAxis or any of its other subsidiaries, without the prior written consent of AOL, to take any action or enter into any transaction which under the circumstances under which it was entered into, could reasonably be foreseen to prejudice the interest of HealthAxis in favor of PAMCO or any PAMCO subsidiary. Notwithstanding the foregoing, the prior consent of AOL shall not be required to engage in an equity offering generating proceeds of at least $10,500 at a price per share of at least $3.74 (as adjusted for stock splits, dividends recapitalizations and like occurrences) as described in the Certificate of Designation related to the Series B Preferred Stock. Item (iv) was amended as described in Note BB.
If PAMCO or any affiliate of PAMCO that holds shares of HealthAxis ("PAMCO Group Holder') intends to engage in a "Change of Control Transaction," as defined in the Stockholders' Agreement such entity must provide AOL with 30 days prior written notice of such transaction and may not consummate such transaction unless the acquiror agrees to acquire all of the stock owned by AOL under the terms and procedures set forth in the Stockholders' Agreement.
Series B Preferred Stock, $1 par value, is identical to the Series A Preferred stock except it has only one vote per share. During 1996 all of the outstanding Series B Preferred stock was converted into common stock on a share-for-share basis. See Note BB.
At December 31, 1998, PILIC calculated its "Risk Based Capital" (RBC) utilizing a formula required by the NAIC. The results of this computation shown in the following table indicate that PILIC's adjusted capital of $5.3 million exceeded Regulatory Action Level but was below Company Action Level. PILIC's year end 1998 RBC calculation included approximately $4.8 million of RBC related to PILIC's one life group health and group life business 100% ceded to RCH effective January 1,1999. The RBC formula estimates RBC based on a variety of historical data including 1998 net earned premium. The effects of the reinsurance agreement between PILIC and RCH on PILIC's RBC calculation will not be realized until 1999. In concept, Risk Based Capital standards are designed to measure the acceptable amounts of capital an insurer should have based on inherent and specific risks of the insurer's business. This formula is a primary measurement as to the adequacy of total capital and surplus of life insurance companies. Since PILIC failed to meet its RBC requirement as of December 31, 1998 it may be subject to regulatory action. Insurers failing to meet their RBC requirement may be subject to scrutiny by its domiciled insurance department and other insurance departments, which the insurer does business in, and, ultimately, rehabilitation or liquidation. Management believes that PILIC's surplus is adequate given its reduced level of business as measured by RBC once the Reinsurance Agreement with RCH takes full effect.
The Pennsylvania Insurance Department, in which PILIC is domiciled, recognizes as net income and capital surplus (Stockholders' Equity) those amounts determined in conformity with statutory accounting principles. The amounts of statutory net income for the year ended and surplus as of December 31 were as follows:
1998 1997 1996 ---- ---- ---- PILIC (1) Net income (loss) $ (5,671) $(10,385) $ 9,668 Total capital and surplus 4,807 11,408 13,971 Adjusted capital and surplus 5,281 11,968 14,838 Company action level Risk Based Capital 6,938 9,303 6,569
PALHIC Net income (loss) $ (1,097) $ (862) $ 1,631 Total capital and surplus N/A 4,283 5,351 Adjusted capital and surplus N/A 4,302 5,367 Company action level Risk Based Capital N/A 1,730 19
Options: The Company has stock option plans which provide for the granting of options to directors and key employees of the Company and its subsidiaries and certain field representatives and agents.
The Non-Qualified Stock Option Plan for Directors ("Directors' Plan") was amended in 1996 to increase the number of shares authorized for the issuance thereunder from 585,000 shares to 1,010,000 shares and to incorporate prior amendments. Options granted under the Directors' Plan are exercisable for up to ten years from the date of grant at a price of not less than the fair market value of the shares on the date of the grant. All options granted under the Directors' Plan have been granted at 100% of the fair market value of the shares on the date of grant. During 1997, pursuant to the Directors' Plan, the Company granted to each Director, with the exception of Mr. Clemens, an option to purchase 30,000 shares of the Company's common stock at an exercise price of $2.75 per share.
In June 1998, HealthAxis adopted the 1998 Stock Option Plan (the "1998 Stock Option Plan") which provides for the award of options and stock purchase rights (collectively "Awards") to purchase HealthAxis common stock. Awards for an aggregate of 2,900,000 shares under the 1998 Stock Option Plan of which 1,956,500 shares have been granted as of December 31, 1998. Of which options to purchase 991,000, 309,000, 50,000 and 50,000 shares were granted to Mr. Ashker, Mr. Clemens, Mr. Beausang, Mr.Gillin respectively, and are immediately exercisable at a price of $1.77 per share having a term of 10 years. Options to purchase 556,500 shares of HealthAxis common stock awarded at $1.77 per share were awarded to officers and employees. These options have a term of five years and vest at a rate of 25% of the initial award on the grant date, 25% of the initial award on February 1, 1999 and the balance in quarterly installments thereafter. Options to purchase an additional 96,500 shares of Common Stock were granted to officers and employees at an exercise price of $4.00 per share. Such options have a term of five years and vest at a rate of 25% of the initial award on the grant date, 25% of the initial award on November 20, 1999 and the balance in quarterly installments thereafter.
Stock Purchase Rights ("SPRs") may be granted either alone, in addition to, or in tandem with other awards granted under the 1998 Stock Option Plan. SPRs may not be granted at less than 85% the fair market value on the date of grant (or 100% of the fair market per share for ten percent shareholders) unless otherwise determined at the time of grant under the terms of the 1998 Stock Option Plan, the SPRs shall include a stock repurchase option exercisable by the Company if the employee is terminated, voluntarily or involuntarily, following the receipt of the restricted stock.
The following table lists options granted by HealthAxis under the 1998 Stock Plan:
Weighted Average Number Exercise Weighted Average of Shares Price Fair Value --------- -------- ---------------- Granted during 1998 1,956,500 $1.88 $0.38
Outstanding, December 31, 1998 Exercisable 1,515,000 $1.77 $0.36 Exercisable 24,125 $4.00 $0.80 Not exercisable 345,000 $1.77 $0.36 Not exercisable 72,375 $4.00 $0.80 Total outstanding 1,956,500 $1.88 $0.38
In addition, a partnership of which Mr. Clemens is a partner owns options to purchase 1,000,000 shares of the Company's Common Stock at $ .9091 per share expiring from time to time between November 1999 through December 2004. Mr. Clemens also owns an option to purchase up to 550,000 shares of Series A Cumulative Convertible Preferred Stock at $3.64 per share (fair market value at date of grant) exercisable on or before March 31, 2003.
During 1998 the Company issued warrants to AOL and HPS as described in Notes F and I, respectively and to Lynx to purchase 400,000 shares of PAMCO common stock at an average price of $4.5160 for a three year period of time in accordance with the terms of a consulting agreement with Lynx to provide consulting services in regards to entering into online and internet commerce agreements and the subsequent development of the Company's capabilities and business. The warrants, valued at $663, have been accounted for as prepaid interactive marketing expense of $290 and other operating expenses, net of ceding allowance and deferred acquisition costs of $373.
Effective January 1, 1996, the Company adopted the disclosure-only provisions of SFAS 123 "Accounting for Stock Based Compensation." Accordingly, no compensation cost has been recognized for stock option and warrant grants, to employees and employee directors. The Company continues to account for stock-based compensation using the intrinsic value method prescribed in Accounting Principles Board opinion No. 25, "Accounting for Stock Issued to Employees'. Compensation cost for stock options, if any, is measured as the excess of the quoted market price of the Company's stock at the date of grant over the amount an employee must pay to acquire the stock. Compensation cost for shares issued under performance share plan is recorded based upon the current market value of the Company's stock at the end of each period. Had compensation cost for the Company's stock option grants been determined based on the fair value at the date of grants in accordance with the provisions of SFAS 123, the Company would have amortized the cost over the vesting period of the option which generally is five years for the 1996 Employee Plan and three years for the Directors Plan and 1998 Employee Plan. The Company's net income (loss) and net income (loss) per common share would have been reduced to the following pro forma amounts:
The Company received from the Loewen Group, Inc. and Loewen Group International, Inc. (collectively "Loewen") on April 1, 1996, $3,000 in cash and 718,519 shares of the common stock of Loewen Group to compensate the Company for damages sustained pursuant to a February 12, 1996 agreement between the Company and Loewen to settle certain litigation filed by the Company against Loewen. The settlement, net of legal expenses, was valued at $22,400. The impact on net income was approximately $14,600, which is net of approximately $7,800 of income taxes.
The Company sold the Loewen stock in 1996 and 1997 realizing a gain of $2,023 and $961, respectively.
During 1998, the Company, through its subsidiary NIA, which was sold on December 31, 1998, leased property under a non-cancable lease within annual payments approximating $125.
Risks Associated with the Year 2000: The Year 2000 issue is the result of computer programs being written using two digits rather than four to define the applicable year. In other words, date-sensitive software may recognize a date using "00" as the year 1900 rather than the year 2000. This could result in system failures or miscalculations causing disruptions of operations, including, among other things, a temporary inability to process transactions, send invoices, or engage in similar normal business activities.
The Company is conducting an assessment of its own systems to determine whether its existing systems correctly define the Year 2000. The Company is conducting an analysis to determine the extent to which the systems of its suppliers, Distribution Partners, Carrier Partners and other business partners (insofar as they are material to the Company's business) are subject to the Year 2000 issue. The Company is currently unable to predict the extent to which the Year 2000 issue will affect its operations, or the extent to which it would be vulnerable to the Internet partners or claims administrator's failure to remediate any Year 2000 issues on a timely basis. The failure of an Internet partner or claims administrator to convert systems on a timely basis in a manner that is compatible with the Company's systems could have a material adverse effect on the Company. The Company does not currently have a contingency plan in place in the event that it or any third party in which it engages in business is not Year 2000 compliant. In addition, policy purchases are made with credit cards, and the Company's operations may be materially adversely affected to the extent its customers are unable to use their credit cards due to the Year 2000 issues that are not rectified by their credit card vendors.
In the course of the on going monitoring and evaluation of HPS' performance under the HealthPlan Services agreement dated October 1997, the Company has determined that the level of service by HPS is below the minimum standard specified in the Agreement. Although the Company's claims management has not completed a full analysis of the claims processing accuracy of HPS, management believes that HPS has not met the minimum quality standards for dollar accuracy, procedure accuracy and technical accuracy; however, the Company's assessment of the potential transaction errors posted by HPS has not been completed. The preliminary analysis indicates that a substanial amount of over "payments", principally in the form of duplicate payments and payments outside policy parameters (such as pre-existing conditions and policy waiting periods) has occurred and that such overpayments are expected to exceed, perhaps by material amounts, the existence of "underpayments", or more appropriately, claims that have not yet been adjucated and/or paid. Although management believes that claims expense as reported in the accompanying financial statement accurately reflects all claims paid by HPS on behalf of the Company, the Company nonetheless believes, based on its analysis , as well as that of a third party claims adjudication, firm hired by the Company to investigate the matter, that actual claims expense may be over stated to the extent, if any, of overpayments of claims by HPS. As a result, the Company is currently in discussion with HPS concerning the resolution of the matter. The ultimate resolution of this matter may also have an impact on the amount of estimated reserves for future policy claims and amounts due from reinsurers. The potential effects, if any, on the financial statements cannot reasonably be determined.
The Company's business is subject to a changing legislative and regulatory environment. Some of the proposed changes include initiatives to restrict insurance pricing and the application of underwriting standards; reform health care; and restrict investment practices. Proposals on national health care reform have been under consideration that could significantly change the way healthcare is financed and provided. The effects on the Company of comprehensive healthcare reforms, which, if enacted, may have a material adverse impact upon the ability of the Company to profitably engage in the writing of accident and health insurance. Additionally, competition in the insurance industry may effect the Company's ability to reach critical mass while remaining competitive in agent compensation and product pricing. In response to these developments the Company entered into an outsourcing agreement described in Note Z and continually reviews agent compensation and product pricing.
The Company sponsors a defined contribution retirement savings plan under section 401(k) of the Internal Revenue Code covering substantially all employees. Employees may contribute up to 15% of compensation, of which the Company will match 50% of the first 5%. All contributions are subject to limitations imposed by IRS regulations. Effective January 1, 1995, employees were given the option to invest the "employer match" portion of their contribution in common stock of the Company. At December 31, 1998 and 1997, the plan held 5,736 and 1,379 shares, of the Company's common stock, respectively.
Note V - Liability for Unpaid Claims and Claim Adjustment Expenses
Payments made related to: Current year ......................... 48,186 24,754 15,705 Prior years .......................... 16,021 11,610 4,976 -------- -------- -------- Total paid ................................ 64,207 36,364 20,681
Net Balance at December 31 ................ 24,244 16,944 8,508 Plus reinsurance recoverables ........ 18,237 14,165 6,930 -------- -------- -------- Liabilty at December 31 ................... $ 42,481 $ 31,109 $ 15,438 ======== ======== ========
The 1998 and 1997 provision for prior year unpaid losses of $897 and $3,272, respectively, reflect higher than expected claim costs on the Company's managed care plans for business written during 1996 and 1997. The 1996 benefit for prior year unpaid losses of $499 reflects better than expected claim costs on the company's stop loss plans.
Effective December 31, 1998, the Company and PILIC, a subsidiary of PAMCO, signed an agreement to reinsure 100% of its group medical and group life inforce business and sell the Company's group medical marketing, sales distribution rights and all of the outstanding capital stock of PALHIC to CRLC (the "CRLC Agreement").
If RCH fails to earn the guaranteed amount within five years of the date of the closing of the CRLC transaction, PAMCO must repay RCH the lesser of the guaranteed amount less RCH's actual profits on the inforce business, or $5,000, plus 12% interest. In the unlikely event that future profits exceed the guaranteed amount, then PILIC is entitled to receive an additional payment from RCH equal to two-thirds of the policy fees collected during 1999 and one-third of the policy fees collected during 2000.
As security for PAMCO's guarantee, PAMCO executed a security agreement in favor of RCH secured by the stock of PILIC. This agreement provides that RCH will take ownership of PILIC if the Company defaults on its guarantee to RCH. PAMCO provides various affirmative covenants regarding corporate existence; compliance with laws; furnishing various notices to RCH; inspection and audit rights and insurance coverage. Additionally, PAMCO provides certain negative covenants with regard to selling, assigning, leasing or otherwise disposing of PAMCO or PILIC assets; entering into agreements materially and adversely effecting PAMCO's or PILIC's ability to carry on business; entering into an agreement materially and adversely effecting PAMCO or PILIC ability to perform obligations under the Guaranty, the reinsurance agreement with RCH, the Stock Purchase Agreement and other related agreements. There also exist various provisions regarding PAMCO or PILIC incurring or creating indebtedness or declaring dividends.
Reinsurance does not relieve the Company of its primary obligation to its policyholders and varies according to the age of the insured, type of risk and type of policy. Retention amounts for life insurance range up to $50 of coverage per individual life and for health insurance up to $85 per individual.
During 1998, the Company had Quota Share Reinsurance and Excess of Loss Reinsurance on its group medical insurance with a group of reinsurers which were terminated by the Company effective December 31, 1998 in connection with the Company entering into reinsurance and other agreements with RCH and CRLC.
Legal fees to the law firm of a former director and general counsel and secretary of the Company in 1998, 1997 and 1996, approximated $332, $282 and $298, respectively.
Consulting expenses paid to a shareholder of the Company and former Chief Executive Officer of REF amounted to $300 each in 1998, 1997 and 1996. The shareholder provided the Company with exclusive marketing, sales and product design services as part of a 36-month consulting agreement which expired December 1998.
Computer software development and consulting expense paid to an entity controlled by a former employee of the Company in 1998 amounted to $1,759.
Lynx beneficially owns 5.7% (including options) of the outstanding shares of PAMCO. The Manager of LCG, is also serving as the Chief Executive Officer and President of HealthAxis and a director of the Company. LCG is party to a consulting agreement with Provident whereby LCG provided various services during 1998 approximately$23 in fees and expenses as well as options to purchase 400,000 shares of PAMCO common stock.
The Company received $5,000 from HPS in the fourth quarter of 1997 as an inducement to enter into the Outsourcing Agreement which is accounted for as a loan payable discounted at a rate of 9.25% resulting in a reported liability of $3,865 which is being amortized over 5 years at the rate of $95,000 including principal and interest. As a result of entering into the Outsourcing Agreement in 1997 the Company incurred transition and related expenses approximating $3,134, including accelerated depreciation and amortization of goodwill.
On March 29, 1999, the Company and AOL entered into the Second Amendment (the "Second Amendment") to the Amended and Restated Interactive Marketing Agreement with AOL, dated as of February 1, 1998, which provides that the Company will be the exclusive third-party direct marketer of managed-care and indemnity health insurance policies, dental insurance, vision insurance, prescription coverage, critical care insurance and long-term care insurance coverage and, subject to certain restrictions, the non-exclusive third party marketer of life and long-term disability (collectively, the "Products") for individuals and groups of less than fifty individuals in the United States via AOL's online service. The Second Amendment provides HealthAxis with access to CompuServe and Netscape Netcenter, which the Company believes will expand its marketing scope. The Second Amendment also provides for a four month "wind down" period in the event the Company elects not to exercise its option to renew its agreement with AOL for an additional term. In the event of nonrenewable, AOL has agreed to continue to market and support HealthAxis on a non-exclusive basis until May 31, 2000. In the event the Company elects to renew its agreement with AOL for a second term, the Second Amendment extends the renewal term from 24 to 28 months beginning on February 1, 2000 and ending on May 31, 2002. The Second Amendment also modifies the payment schedule due to AOL for the renewal term from a single payment of $33.5 million on February 1, 2000 to a payment schedule of:
Additionally, the Second Amendment provides for certain modifications and enhancements with regard to the placement of the Company's impressions on AOL.
AOL has verbally acknowledged that HealthAxis has met all of the requirements regarding the "official launch" as of March 29, 1999 and has agreed to amend the terms of the Series B Preferred Stock. See Note BB.