Healthsource believes that the facilities which it currently owns or leases, together with the expansion plans and options which it has arranged, will be adequate to meet its current needs.
The following selected financial information should be read in conjunction with the accompanying Consolidated Financial Statements and the related notes thereto and Management's Discussion and Analysis of Financial Condition and Results of Operations appearing elsewhere in this Report.
General -- The Company has experienced substantial growth in both revenues and profitability since its formation in New Hampshire in 1985. Revenue growth has been accomplished through increasing membership and medical premiums per member and administrative and managed care fees from self-insured employers and through acquisitions. The Company has made acquisitions of HMO companies resulting in wholly-owned subsidiaries in South Carolina, Tennessee, Maine, Indiana, North Carolina, and Syracuse, New York. The Company has formed strategic alliances with hospitals to operate HMOs in Arkansas, Georgia, north central Texas, Worcester, Massachusetts and southwestern Ohio and has formed start-up HMOs in Connecticut and Louisville, Kentucky. It also formed a strategic alliance with Chubb Life Insurance Company to operate an HMO (ChubbHealth) in the metropolitan New York City and northern New Jersey areas. Effective May 1, 1995, the Company acquired the group health, TPA and HMO business from Provident for $231 million in cash and preferred stock. To conduct the acquired businesses, the Company organized and capitalized HPIC to assume the insured business and HPA to administer the self-insured business.
Many federal and state proposals have been made in the past to reform the healthcare system. The Company anticipates that federal and state legislatures will continue to assess alternative healthcare systems and payment methodologies. The Company is unable to predict which, if any, of these healthcare reform proposals may be adopted. While the Company does not believe it would be materially adversely impacted by most of the proposed reforms, certain proposals could have such an impact and the imposition of a single-payor system in any state could potentially eliminate the Company's business in that state. See "Business -- Governmental Regulation."
The premium pricing environment became much more competitive in the Company's markets during 1995. The Company experienced a decline in average premium of 3.5% PMPM. The Company expects a similar decline in 1996. This trend may continue beyond 1996. As a result of this premium pricing pressure, the Company's medical loss ratio and ultimately its profitability will depend on its ability to control healthcare costs. Since the Company commits to provide its services to members at prices fixed for one year, unexpected cost increases during this period cannot be passed on to employers or to members. The Company believes its continued profitability in 1995 can be attributed primarily to increases in membership, increased revenue from administrative and managed care services, its success in obtaining global capitation provider agreements and other cost control efforts, the effects of the Provident Transaction in May 1995 and the acquisition of the remaining interest in Healthsource HMO of New York (HSNY) in November 1994.
Fiscal Year 1995 Compared To Fiscal Year 1994 -- Revenue increased 100% to $1.17 billion from $584 million. The majority of the increase was the result of a 57% increase in HMO medical premium revenue to $812 million from $516 million. The change in HMO medical premium revenue was attributable to: (1) a $131 million increase due to the effect of the acquisition of the remaining interests in Healthsource North Carolina (HSNC) and HSNY and the acquisition of HMO members in the Provident Transaction (2) the combined effect of a 44% increase in average membership and a 3.5% decrease in average medical premium yield to $130 PMPM from $135 PMPM at its subsidiaries, Healthsource New Hampshire (HSNH), Healthsource Tennessee (HSTN), Healthsource Maine (HSME), Healthsource South Carolina (HSSC), Healthsource Arkansas (HSAR), and Healthsource Indiana (HSIN) ("Existing Plans"); and (3) from the commencement of operations of Healthsource Savannah (HSSV) and Healthsource Kentucky (HSKY).
In addition, there was a significant increase in other insured medical premiums to $185 million from $17 million as a result of the acquisition of Provident's fully-insured managed indemnity products and experience rated refundable premium products.
The remaining revenue increase was due to a 229% increase in administrative and managed care fee revenue to $170 million from $52 million which resulted from the Provident Transaction, continued growth of the Company's self-funded, POS business in various states, workers' compensation healthcare administration
fees in New Hampshire, and the effect of the acquisition of the remaining interest in Healthsource North Carolina Administrators, Inc. (HSNCA) during 1994.
Cost of HMO medical premiums increased 58% to $622 million from $394 million. This increase was due to the effect of the acquisition of the remaining interests in HSNC and HSNY, the combined effect of the 44% increase in average membership with a 3.7% decrease in average cost of medical premiums to $99 PMPM from $103 PMPM at Existing Plans, and the commencement of operations of HSSV and HSKY. This 3.7% decrease in costs resulted from lower inpatient and outpatient hospital costs as a result of favored hospital pricing arrangements and global capitation arrangements offsetting increases in diagnostic testing and pharmaceutical costs.
The Company's cost of HMO medical premiums as a percent of HMO medical premiums (HMO medical loss ratio or "MLR") increased to 76.6% from 76.4%. Although the 3.5% decrease in the average premium yield was less than the 3.7% decrease in average cost of medical premiums at Existing Plans, this positive effect was offset by HSNC, HSNY, HSSV, and HSKY which combined had higher medical loss ratios than the Existing Plans. The Company expects the premium pricing environment to remain competitive during 1996 and possibly beyond. The medical loss ratio may increase if the Company is unable to keep the cost of medical premiums in line with premium yields.
Interest and other income increased 60% to $21 million from $13 million. This increase resulted primarily from the increase in cash, cash equivalents and marketable securities associated with the Provident Transaction, the acquisition of HSNC and continued increases in cash available from operations. The Company incurred interest expense of $5 million in 1995 as a result of borrowings associated with the Provident Transaction.
The Company had no equity in the income of unconsolidated affiliates for the year ended December 31, 1995 as compared to $1.7 million in the same period in 1994. This decrease occurred because of the Company's acquisition of the remaining interests in HSNC and HSNY which were previously accounted for using the equity method.
The Company's effective tax rate increased to 35.4% from 31.2% due to the decline of non-taxable interest income as a percentage of total interest income and as a percentage of total operating income.
Fiscal Year 1994 compared to Fiscal Year 1993 -- Revenue increased 101% to $584 million from $291 million. The majority of the increase was due to a 115% increase in HMO medical premium revenue which was attributable to: (1) $181 million in medical premium revenue due to the acquisition of the remaining
Cost of HMO medical premiums increased 121% to $394 million from $178 million. This increase was due to the acquisition of the remaining interests in HSME, HSNC, and HSNY, the commencement of operations of HSAR, and the combined effect of the 11% increase in average membership with an increase in average costs of medical premiums of 6% to $110 PMPM from $104 PMPM at HSNH, HSIN, and HSTN. This 6% increase was primarily attributable to HSIN, which experienced unfavorable inpatient case mix and significantly higher diagnostic, physician and pharmaceutical costs.
SG&A expenses related to HMO, fully-insured medical business and corporate administration increased 107% to $83 million from $40 million. The increase was primarily due to the acquisition of the remaining interest in HSNC; the inclusion of HSSC for a full year; higher levels of membership at HSNH, HSTN, HSIN, and HSME; and the commencement of operations at HSAR. SG&A expense related to administrative and managed care fees increased 72% to $40 million from $23 million due to increases in the Company's administrative services businesses, such as its self-funded POS and managed workers' compensation businesses, the acquisition of the TPA in Arkansas, and the acquisition of the remaining interest in HSNCA.
Equity in the income of unconsolidated affiliates decreased 53% to $1.7 million from $3.5 million. This decrease occurred because of the Company's acquisition of the remaining interests in HSSC, HSME, HSNC, and HSNY which were previously accounted for using the equity method.
The following table shows certain income statement data expressed as a percentage of total operating revenues and is not intended to be indicative of margins earned on each revenue source:
Although the Company has no other present commitments for significant capital expenditures, the Company's 1996 budget reflects capital expenditures in excess of $40 million. The Company believes that its existing cash balances and cash flow generated by its wholly-owned plans coupled with the proceeds of the sale of the Notes and the amounts, if any, available for borrowing under the Chase Facility, are adequate to fund its existing operations on a short-term and long-term basis.
The Financial Accounting Standards Board has issued Statement of Financial Accounting Standards No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of" (FAS 121) and Statement of Financial Accounting Standards No. 123 "Accounting for Stock Based Compensation" (FAS 123), which are effective for fiscal years beginning after December 15, 1995.
Management believes that the adoption of FAS 121 and FAS 123 will not have a material impact on the Company's consolidated financial statements, although a detailed study has not been completed. In accordance with the provisions of FAS 123, the Company will elect to continue to account for stock based compensation under the provisions of APB 25.
The Company attempts to mitigate increases in the cost of medical premiums through some or all of the following activities: (1) securing global capitation arrangements with major hospital providers and improving its contracting methodologies with other providers to achieve lower costs and to promote risk-sharing; (2) reviewing and, as necessary, modifying benefit designs so as to discourage inappropriate levels of consumer-driven utilization; (3) using various UR techniques and technologies to mitigate inappropriate use of health care resources by providers; and (4) communicating with the Company's primary care physicians about the impact of clinically inappropriate utilization of healthcare resources.
SAFE HARBOR STATEMENT UNDER THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995: The statements contained in this Management's Discussion and Analysis of Financial Condition and Results of Operations concerning future premium pricing levels, future MLR levels, the Company's ability to control healthcare and SG&A costs and all other statements that are not historical facts are forward looking statements; actual results may differ materially from those projected in the forward looking statements, which statements involve risks and uncertainties, including but not limited to, the following: that increased regulation will increase healthcare expenses; that increased competition in the Company's markets, changes in product mix or other factors will unexpectedly reduce premium yield; that the Company will be unable to close sufficient global capitation arrangements with key providers; that healthcare costs in any given period may be greater than expected due to unexpected incidence of major cases, natural disasters, epidemics, changes in physician practices and new technologies; and that the Company will be unable to close acquisitions of other HMOs and healthcare financing companies on satisfactory terms in key markets. Shareholders are also directed to the other risks discussed in other documents filed by the Company with the Commission.
In 1993, the Company issued 738,000 shares of common stock, which were valued at $19.7 million in connection with the Physician's Health Systems, Inc. ("PHS") acquisition (See Note 4).
Principles of Consolidation The consolidated financial statements include the accounts of Healthsource, Inc. and its majority-owned subsidiaries. All significant intercompany accounts and transactions are eliminated in consolidation. Investments in entities in which ownership interests range from 20% to 50% and in which the Company exercises significant influence are accounted for by the equity method. Interests of other investors in the Company's majority-owned entities are accounted for as minority interests and are included in other liabilities for financial reporting purposes.
Marketable Securities Effective January 1, 1994, the Company adopted the provisions of Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities" (FAS 115). The cumulative effect of the adoption of FAS 115 was not material to the financial statements. The Company's investment portfolio is comprised principally of debt securities. In 1995, the Company has classified its securities as "available-for-sale" and recorded them at market value. The difference between cost and market, net of the related tax effect, has been reflected as a separate component of shareholders' equity. In 1994, certain securities were classified as "held-to-maturity" and recorded at amortized cost . The carrying value of investments sold is determined on a specific identification basis.
Property and Leasehold Improvements Property and leasehold improvements are stated at cost. Depreciation of property is computed using straight-line and accelerated methods over the estimated useful lives of the related assets, principally five to seven years. Depreciation of building and improvements is computed using the straight-line method over the estimated useful life of forty years. Amortization of leasehold improvements and assets under capital leases is computed using the straight-line method over the shorter of the estimated useful lives or the related lease terms.
Medical Claims Payable Reported claims expected to be paid after the balance sheet date for services provided to members prior to the balance sheet date are recorded as liabilities. Claims for services provided to members during the financial reporting period which are unreported at the balance sheet date are also recorded as liabilities based on the Company's claims experience. The amounts are based upon estimates of the ultimate net cost of such services provided.
Retrospective Refund Agreements The liability for retrospective refund agreements and the retrospective refund credits due and accrued represent estimated amounts to be either refunded to group contract holders or used to adjust future premiums based on formulas which compare a group's claims experience to premiums paid.
Cost of HMO Medical Premiums Cost of HMO medical premiums includes the costs of all medical services delivered to enrolled members of the Company's majority-owned HMOs and for whom the entities have recorded HMO medical premium revenue during the reporting period. These costs include payments for specific medical services and for capitation. The cost of specific medical services include those paid to physicians, hospitals, and other healthcare providers on a fee for service basis. These costs include claims paid, claims in process and pending, estimates of unreported claims, estimates of contractual adjustments pursuant to hospital and other provider contracts, and charges at the balance sheet date for which the Company will be responsible. Adjustments to prior period estimates are reflected in the current period and are not significant. The costs of capitation (fixed monthly payments per member) include payments to certain physicians, hospitals, laboratories, pharmaceutical and mental healthcare providers. Adjustment to prior period estimates are reflected in the current period and are not significant.
Cost of Other Insured Medical Premiums Cost of other insured medical premiums includes the costs of all medical services delivered to enrolled members of the Company's non-HMO medical plans for whom the entities have recorded medical premium revenue during the reporting period. These costs include claims paid, claims in process and claims pending, and estimates of unreported claims and charges at the balance sheet date for which the Company will be responsible. Adjustment to prior period estimates are reflected in the current period and are not significant.
Reinsurance The Company's operating subsidiaries are covered under medical reinsurance agreements that provide partial coverage for medical services in excess of certain amounts. Reinsurance premiums, net of recoveries, are included in the cost of medical premiums.
Accounting Pronouncements The Financial Accounting Standards Board has issued Statement of Financial Accounting Standards No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of" (FAS 121) and Statement of Financial Accounting Standards No. 123, "Accounting for Stock Based Compensation" (FAS 123), which are effective for fiscal years beginning after December 15, 1995. Management believes that the adoption of FAS 121 and FAS 123 will not have a material impact on the Company's consolidated financial statements, although a detailed study has not been completed. In accordance with the provisions of FAS 123, the Company will elect to continue to account for stock based compensation under the provisions of APB 25.
The Company's investment portfolio, which was recorded at market value for "available-for-sale" and amortized cost for "held-to-maturity" investments, consisted of the following at December 31, 1994:
On December 31, 1995, the Company reclassified its "held-to-maturity" investments to "available-for-sale," based on a one time assessment of the portfolio. The impact of the transaction was to transfer securities with a market value of $128.1 million and an amortized cost of $126.9 million from "held-to-maturity" to "available-for-sale."
Identifiable intangible assets consist of covenants not to compete, membership lists, hospital services agreements and physician networks which are being amortized over estimated useful lives ranging from three to fifteen years based on formal valuation studies. In connection with the Provident Transaction, the formal valuation study to determine the allocation of purchase price among tangible and intangible assets and the assignment of estimated lives to intangibles has not yet been completed. Amortization expense for the years ended December 31, 1995, 1994, and 1993 was $9.3 million, $4.7 million, and $3.1 million, respectively.
1995 Acquisition Effective May 1, 1995, the Company acquired the group health, HMO and third party administration business of Provident for $231 million in cash and securities. The Company paid cash of $131 million and issued to Provident non-voting non-convertible Class A Cumulative Preferred Stock with a face value of $100 million. The Preferred Stock bears a 6.25% annual dividend rate and through May 1, 1997 is redeemable at par only at the option of the Company in cash or for a 10-year subordinated note with interest at a market rate or, failing that, the dividend rate on the Preferred Stock will be reset to a market rate on May 1, 1997. The transaction was accounted for as a purchase.
In November 1994, the Company completed a cash tender offer to purchase the remaining 60% interest in Healthsource New York, Inc. (formerly CNY Patient's Network, Inc.), the parent company of Healthsource HMO of New York (HSNY) which resulted in a total purchase price of approximately $11 million. The transaction was accounted for as a purchase.
The Company has a $300 million unsecured revolving credit agreement with a bank syndicate which is committed through March 15, 2000. Interest under this revolving credit facility may range between LIBOR plus .2% and LIBOR plus .45% depending upon the Company's ratio of indebtedness to total capital. In connection with the agreement, the Company is required to maintain certain minimum financial ratios and other covenants. Management believes the Company to be in compliance with all covenants under this agreement. At December 31, 1995 the Company had $95 million outstanding under this facility. The interest rate at December 31, 1995 was approximately 6.0%. See Note 8 regarding the acquisition of substantially all of the HMO assets of Central Massachusetts Health Care, Inc. ("CMHC"). The revolving credit agreement contains restrictions on the payment of cash dividends to 50 percent of consolidated net income (as defined) plus $10 million.
Deferred income tax expense arose from differences between the reported amounts of assets and liabilities and their tax bases provided for in accordance with FAS 109.
Deferred tax assets and liabilities were not material individually or in the aggregate and are included in other current assets, other assets, other current liabilities, and other liabilities for financial reporting purposes.
The difference between the Company's effective income tax rate and the federal statutory rate is reconciled below:
Regulatory Requirements The Company's affiliated HMOs and insurance companies are subject to various regulatory requirements including maintenance of minimum statutory net worth. At December 31, 1995 the Company believes that it was in compliance with all such requirements. Certain wholly-owned and majority-owned subsidiaries are required to maintain restricted investments in the amount of approximately $131 million which includes approximately $123 million placed in a temporary trust to cover claims payments associated with the Provident Transaction until such time as the policies acquired are novated to the Company from the Provident.
exercised in accordance with the terms and conditions of each grant. Information concerning options outstanding for 1995, 1994 and 1993, is as follows:
The sum of the above quarterly amounts may not equal reported year to date amounts due to rounding.