Effective as of January 1, 1996, the Company entered into a lease for Blue Cross of California's Woodland Hills, California headquarters facility, which provides for a term expiring in December 2019 with two options to extend the term for up to two additional five-year terms. Rent expense under the lease was approximately $8.4 million during 1998. In 1997, the Company entered into a lease, which expires in December 2019, for its new headquarters facility located in Thousand Oaks, California. This facility was completed in January 1999. The Company and its subsidiaries have additional offices in the greater Los Angeles and Ventura County area. As a result of the MMHD and GBO acquisitions and the Company's continuing national expansion efforts, the Company maintains offices in various other locations, including Springfield, Massachusetts; Charlestown, Massachusetts; Schaumburg, Illinois; Dearborn, Michigan; and Plano, Texas.
(B) Per share data for all periods presented prior to 1996 have been recomputed using 66,366,500 shares, the number of shares outstanding immediately following completion of the Recapitalization. Per share data for the year ended December 31, 1996 has been calculated using such 66,366,500 shares, plus the weighted average number of shares issued since the Recapitalization.
The Company is one of the nation's largest publicly traded managed health care companies. As of December 31, 1998, WellPoint had approximately 6.9 million medical members and approximately 25 million specialty members. The Company offers a broad spectrum of network-based managed care plans. WellPoint provides these plans to the large and small employer, individual and senior markets. The Company's managed care plans include HMOs, PPOs, POS plans, other hybrid plans and traditional indemnity plans. In addition, WellPoint offers managed care services, including underwriting, claims processing, actuarial services, network access and medical cost management. The Company also provides a broad array of specialty and other products, including pharmacy, dental, utilization management, life insurance, preventive care, disability insurance, behavioral health, COBRA and flexible benefits account administration.
As discussed in Note 11 to the Consolidated Financial Statements, during 1998, the Company discontinued its workers' compensation operations. All financial information presented herein has been restated in both current and prior periods to exclude the workers' compensation operations and the discussion and analysis that follows has been modified accordingly.
In an effort to pursue the expansion of the Company's National business segment, during the past three years the Company has completed the acquisition of two businesses outside the state of California, the Life and Health Benefits Management Division ("MMHD") of Massachusetts Mutual Life Insurance Company and the Group Benefits Operations (the "GBO") of John Hancock Mutual Life Insurance Company. The purchase method of accounting has been used to account for both of the aforementioned transactions. The excess purchase price over net assets acquired was approximately $172.5 million for the GBO and $251.0 million for MMHD. During the fourth quarter of 1998, the Company re-evaluated the useful life of the intangible assets and goodwill related to these acquisitions and reduced such composite lives from 35 to 20 years. The Company's pending transaction with Cerulean Companies, Inc. is also a component of this expansion.
As a result of the GBO and MMHD acquisitions, the Company has significantly expanded its operations outside of California. In order to integrate its acquired businesses and implement the Company's regional expansion strategy, the Company will need to develop satisfactory provider and sales networks and successfully convert these books of business to the Company's existing information systems, which will require additional expenditures by the Company.
On May 20, 1996, the Company completed the Recapitalization, including the acquisition of the commercial operations of BCC (the "BCC Commercial Operations") for $235.0 million in cash. The Recapitalization included the payment of a $995.0 million special dividend funded by $775.0 million in revolving debt and the remainder in cash. In September 1998, the Company received a private letter ruling from the Internal Revenue Service with respect to the treatment of certain payments in conjunction with the Recapitalization and acquisition of the BCC Commercial Operations. The ruling allows the Company to deduct as an ordinary and necessary business expense an $800 million cash payment made by Blue Cross of California in May 1996 to one of two newly formed charitable foundations. As a result of such private letter ruling, the Company reduced the remaining intangible asset related to its acquisition of the BCC Commercial Operations to zero. (See Note 8 to the Consolidated Financial Statements.)
The Company has acquired certain businesses over the last three years which historically experienced a higher overall loss ratio than the Company. These acquired businesses have contributed to an increase in the Company's overall loss ratio. In order to control the respective loss ratios and reduce the financial risk
dependent embedded microprocessors ("non-IT systems"), such as elevators and heating and ventilation equipment.
The Company has developed and is in the midst of executing a comprehensive plan designed to address the "year 2000" issue for its IT and non-IT systems and applications. With respect to IT systems, during 1997 the Company completed a detailed risk assessment of its various computer systems, business applications and other affected systems, formulated a plan for specific remediation efforts and began certain of such remediation efforts. During 1998 and the first quarter of 1999, the Company completed its remediation efforts and undertook internal testing of its systems and applications. In the second quarter of 1999, the Company expects to undergo third-party review of certain of its year 2000 remediation efforts. This third party review will include an assessment of the procedures undertaken by the Company as well as a computer software test of selected portions of the Company's computer code. With respect to non-IT systems, the Company is currently in the process of completing the replacement or renovation of Company-owned systems to address year 2000 issues. The Company is also undertaking a review of non-IT systems in leased facilities and, where appropriate, obtaining certifications from the property owners that non-IT systems in leased facilities will be remediated or replaced on a timely basis. The Company currently expects that its year 2000 remediation efforts and third-party review with respect to non-IT systems will be completed by the second quarter of 1999.
The Company continues to assemble survey data from health care transaction clearing houses, third party vendors and certain other parties with which the Company communicates electronically to determine the compliance efforts being undertaken by these parties and to assess the Company's potential business exposure to any non-compliant systems operated by these parties. Health care claims submitted electronically to the Company are usually submitted through clearing houses on behalf of health care providers. Based on the survey data and other information compiled by the Company to date, the Company has not identified any third parties that the Company expects will suffer year 2000-related problems which are likely to have a significant adverse effect on the Company's operations. However, many of these third parties are currently in the process of implementing the critical portions of their own year 2000 compliance measures. As a result, at the current time the Company does not have sufficient information to determine whether its external relationships will be materially adversely affected by year 2000 compliance problems.
If the Company's year 2000 issues were not completely resolved prior to the end of 1999, the Company could be subject to a number of potential consequences, including, among other things, an inability to timely and accurately process health care claims, collect customers' premiums or administrative fees, verify subscriber eligibility, assess utilization trends or compile accurate financial data for use by management. In particular, the Company may experience a decrease in electronic health claims submission, which could cause the Company's claims inventory to increase on a temporary basis. An increase in claims inventory could prevent the Company from identifying emerging utilization trends quickly and taking appropriate actions to mitigate such trends through pricing actions, benefit redesign or other actions. The Company is attempting to limit its exposure to year 2000 issues by closely monitoring its own year 2000 remediation efforts, assessing the year 2000 compliance efforts of various third parties with which it interacts and developing contingency plans addressing potential problems that could have a material adverse effect on the Company's results of operations. Although the Company intends to put into place programs and procedures designed to mitigate the aforementioned risks, there can be no assurances that all potential problems may be mitigated by these procedures.
(d) Proprietary networks consist of California, Texas and other WellPoint-developed networks. Other networks consist of third-party networks and networks owned by the Company as a result of acquisitions that incorporate provider discounts and some basic managed care elements. Non-network consists of fee for service and percentage-of-billed-charges contracts with providers.
Premium revenue increased 17.1%, or $865.9 million, to $5,934.8 million for the year ended December 31, 1998 from $5,068.9 million for the year ended December 31, 1997. The overall increase was primarily due to an increase in insured member months of 12.1%, primarily in the Company's California business segment, and the implementation of price increases throughout the California market. Excluding the impact of the additional two months of premium revenue in 1998 related to the GBO of $80.1 million, the National business segment experienced a decline in overall premium revenue due to attrition on acquired MMHD membership and, to a lesser extent, the GBO membership, a portion of which was the result of recently instituted premium increases with respect to certain under-priced customer accounts. The Company expects that it will experience some level of further membership attrition of its acquired MMHD and GBO members during the first half of 1999 as it continues to increase prices and pursues its strategy of motivating members to select managed care products.
Health care services and other benefits expense increased 16.9%, or $688.9 million, to $4,776.3 million for the year ended December 31, 1998 from $4,087.4 million for the year ended December 31, 1997. The overall increase was primarily due to the aforementioned increase in insured member months of 12.1%,
primarily in the Company's California business segment. Excluding the impact of the additional two months in 1998 related to the GBO of $91.4 million, the National business segment experienced a decline in overall claims expense due to attrition on acquired MMHD membership and, to a lesser extent, the acquired GBO membership.
General and administrative expense for the year ended December 31, 1998 increased 16.6%, or $138.5 million, to $975.1 million from $836.6 million for the year ended December 31, 1997. The additional two months of the GBO in 1998 compared to 1997 in the National business segment accounted for 24.5%, or $34.0 million, of the overall increase. The remainder of the increase was primarily due to an increase in California member months of 15.9%, including management services members, and to costs associated with the Company's national expansion related to the integration of the acquired businesses to the Company's information systems. The Company's systems have been enhanced to accommodate the more complex products offered by those businesses. Costs associated with year 2000 compliance efforts also contributed to the increase. The Company incurred approximately $26.0 million of costs relating to the integration of acquired businesses during 1998.
The administrative expense ratio decreased slightly to 15.3% for 1998 compared to 15.4% for 1997. The GBO has historically experienced a higher administrative expense ratio than the Company's traditional California-based businesses due to the GBO's higher percentage of management services business. The administrative expense ratio, excluding the GBO for the period prior to its acquisition for the year ended December 31, 1998, was 15.0%. This decline in comparison to the previous year is primarily due to savings from the consolidation of various National regional offices and the integration of information system centers related to acquired businesses onto the Company's information systems platform, in addition to economies of scale associated with premium revenue growth in relation to fixed corporate administrative expenses.
Interest expense decreased for the year ended December 31, 1998 to $26.9 million, from $36.7 million for the year ended December 31, 1997. The decrease is primarily related to the repayment of indebtedness as the effective interest rate paid by the Company remained relatively stable as a result of its interest rate swaps. The Company's long-term indebtedness at December 31, 1998 was $300.0 million compared to $388.0 million at December 31, 1997. The weighted average interest rate for all debt for the year ended December 31, 1998, including the cost associated with the fee on the Company's credit agreements and its interest rate swaps was 7.6%. See "--Liquidity and Capital Resources."
The Company's income from continuing operations for the year ended December 31, 1998 was $319.5 million, compared to $229.4 million for the year ended December 31, 1997. Earnings per share from continuing operations totaled $4.63 and $3.33 for the years ended December 31, 1998 and 1997, respectively. Earnings per share from continuing operations assuming full dilution totaled $4.55 and $3.30 for the years ended December 31, 1998 and 1997, respectively. Earnings per share from continuing operations for the year ended December 31, 1997 included non-recurring costs of $0.13 per share (See Note 18 to the Consolidated Financial Statements).
COMPARISON OF RESULTS FOR THE YEAR ENDED DECEMBER 31, 1997 TO THE YEAR ENDED DECEMBER 31, 1996
Investment income increased $72.6 million to $196.2 million for the year ended December 31, 1997, compared to $123.6 million for the year ended December 31, 1996. Net realized gains from equity securities increased $45.5 million to $62.0 million for the year ended December 31, 1997 in comparison to $16.5 million for the year ended December 31, 1996. The year ended December 31, 1997 included a gain of $30.3 million related to the stock-for-stock exchange of the Company's interest in HPI for the common stock of FPA. Net interest and dividend income increased $24.0 million to $133.9 million for the year ended December 31, 1997 in comparison to $109.9 million for the year ended December 31, 1996, primarily due to increased interest income resulting from the investment portfolios of GBO and MMHD
acquired businesses and slightly higher yields in 1997 over 1996, partially offset by the foregone interest from cash and investments used to finance the GBO, MMHD and BCC Commercial Operations acquisitions, the Recapitalization and cash used for repayment of indebtedness under the Company's senior credit facility.
The administrative expense ratio increased to 15.4% for 1997 compared to 14.1% for 1996, primarily due to the increased administrative expense associated with the Company's continued investment in national expansion and the acquisition of the GBO. The GBO has historically experienced a higher administrative expense ratio than the Company's traditional California-based businesses due to the GBO's higher percentage of management services business. The increase was partially offset by the BCC Commercial Operations' lower administrative expense ratio. The administrative expense ratio for the year ended December 31, 1997, excluding the effect of the GBO acquisition in 1997 and the incremental effect in 1997 of MMHD and BCC Commercial Operations, was 13.1%.
As of December 31, 1998, $300.0 million was outstanding under the Company's long-term debt facilities, compared to $388.0 million at December 31, 1997. Debt repayments during 1998 were primarily funded from cash flow from continuing operating activities.
During the year ended December 31, 1998, the Company's Board of Directors approved a stock repurchase plan of up to eight million shares. At December 31, 1998, approximately 4.5 million shares remained available for repurchase under that plan.
The Company's primary sources of cash are premium and management services revenues received and investment income. The primary uses of cash include health care claims and other benefits, capitation payments, income taxes, repayment of long-term debt, interest expense, broker and agent commissions, administrative expenses, common stock repurchases and capital expenditures. In addition, to the foregoing, other uses of cash include costs of provider networks and systems development, and costs associated with the integration of acquired businesses.
The Company receives premium revenue in advance of anticipated claims for related health care services and other benefits. The Company's investment policies are designed to provide liquidity, preserve capital and maximize total return on invested assets. Cash and investment balances maintained by the Company are sufficient to meet applicable regulatory financial stability and net worth requirements. As of December 31, 1998, the Company's investment portfolio consisted primarily of fixed-maturity securities and equity securities.
Net cash used in financing activities totaled $241.9 million in 1998, compared to $116.6 million in 1997. The net cash used in financing activities in 1998 was primarily due to the repurchase of stock during the year totaling $193.3 million, which was financed partially by the proceeds from the sale of the Company's workers' compensation business, and repayments of long-term debt totaling $88.0 million, partially offset by proceeds of $39.4 million from the issuance of common stock through the Company's employee stock purchase and option plans.
The Company has a $1.0 billion unsecured revolving credit facility. Borrowings under the credit facility bear interest at rates determined by reference to the bank's base rate or to the London Interbank Offered Rate ("LIBOR") plus a margin determined by reference to the Company's leverage ratio (as defined in the credit agreement) or the then-current rating of the Company's unsecured long-term debt by specified rating agencies. Borrowings under the credit facility are made on a committed basis or pursuant to an auction-bid process. The credit facility expires as of May 15, 2002, although it may be extended for an additional one-year period under certain circumstances. The credit agreement requires the Company to maintain certain financial ratios and contains restrictive covenants, including restrictions on the occurrence
of additional indebtedness and the granting of certain liens, limitations on acquisitions and investments and limitations on changes in control. The total amount outstanding under the credit facility was $280.0 million and $368.0 million as of December 31, 1998 and 1997, respectively. The weighted average interest rate for the year ended December 31, 1998, including the facility and other fees and the effect of the interest rate swaps discussed in the following paragraph, was 7.6%.
As a part of a hedging strategy to limit its exposure to interest rate increases, in August 1996 the Company entered into a swap agreement for a notional amount of $100.0 million bearing a fixed interest rate of 6.45% and having a maturity date of August 17, 1999. In September 1996, the Company entered into two additional swap agreements for notional amounts of $150.0 million each, bearing fixed interest rates of 6.99% and 7.05%, respectively, and having maturity dates of October 17, 2003 and October 17, 2006, respectively. The total notional amount of the outstanding swaps exceeded the Company's long-term debt balance at December 31, 1998. The swaps that are considered hedges for currently outstanding debt are the $150 million swap at 7.05% maturing October 17, 2006 and the $150 million swap which bears a fixed interest rate of 6.99% and matures October 17, 2003.
The Company believes that cash flow generated by operations and its cash and investment balances, supplemented by the Company's ability to borrow under its existing revolving credit facility or to conduct a public offering under its debt registration statement, will be sufficient to fund continuing operations and expected capital requirements for the foreseeable future.
In April 1998, the AICPA issued Statement of Position ("SOP") No. 98-5, "Reporting on the Costs of Start-Up Activities." SOP No. 98-5 provides guidance on the accounting for start-up costs and organization costs. It requires these costs to be expensed as incurred and, with certain exceptions, requires the initial application to be reported as a cumulative effect of a change in accounting principle. This SOP is effective for fiscal years beginning after December 15, 1998. During the first quarter of 1999, the Company expects to recognize an after-tax charge of approximately $20.4 million related to the cumulative effect of the implementation of this pronouncement.
The Company regularly evaluates its asset and liability interest rate risks as well as the appropriateness of investments relative to its internal investment guidelines. The Company operates within these guidelines by maintaining a well-diversified portfolio, both across and within asset classes. The Company has retained an independent consultant to advise the Company on the appropriateness of its investment policy and the compliance therewith.
As of December 31, 1998, approximately 80% of the Company's investment portfolio consisted of fixed income securities (maturing in more than one year), the value of which generally varies inversely with changes in interest rates. However, the Company's risk of fluctuation in the value of its fixed income portfolio due to changes in interest rates is partially mitigated by the Company's existing interest rate swap agreements.
swap agreements are discussed in greater detail in Note 16 to the Consolidated Financial Statements. The results of this analysis as of December 31, 1998 are reflected in the table below.
The Company has entered into interest rate swap agreements in order to reduce the volatility of interest expense resulting from changes in interest rates. As of December 31, 1998, the Company had entered into $400 million of floating to fixed rate swap agreements and also had $300 million of LIBOR-based floating rate debt outstanding. The Company also receives a LIBOR-based payment as a result of its swap arrangements, thereby eliminating the payment exposure to changes in interest rates on that $300 million of outstanding debt. The marginal $100 million of interest rate swaps in which the Company has agreed to pay a fixed rate in exchange for receiving a LIBOR-based floating interest rate does expose the Company to receiving a lower interest payment in the event of declining interest rates. Should LIBOR decline by 100 bp, the Company would receive $1 million less in annual pre-tax interest income as a result of its swap arrangement. Rate declines of 200 bp and 300 bp would result in lower annual pre-tax interest income of approximately $2 million and $3 million, respectively.
Certain statements contained herein, such as statements concerning potential or future loss ratios, expected membership attrition as the Company continues to integrate its recently acquired operations, the pending transaction with Cerulean and other statements regarding matters that are not historical facts, are forward-looking statements (as such term is defined in the Securities Exchange Act of 1934). Such statements involve a number of risks and uncertainties that may cause actual results to differ from those projected. Factors that can cause actual results to differ materially include, but are not limited to, those discussed below and those discussed from time to time in the Company's various filings with the Securities and Exchange Commission.
Completion of the Company's pending transaction with Cerulean is contingent upon, among other things, receipt of necessary approvals from certain federal and state agencies. Broad latitude in administering the applicable regulations is given to the agencies from which WellPoint and Cerulean must seek these approvals. There can be no assurance that these approvals will be obtained. As a condition to approval of the transaction, regulatory agencies may impose requirements or limitations or costs on the way that the combined company conducts business after consummation of the transaction. If the Company or Cerulean were to agree to any material requirements or limitations in order to obtain any approvals required to consummate the transaction, such requirements or limitations or additional costs associated therewith could adversely affect WellPoint's ability to integrate the operations of Cerulean with those of WellPoint. A material adverse effect on WellPoint's revenues and results of operations following completion of the transaction could result.
As part of the Company's business strategy, over the past three years the Company has acquired substantial operations in new geographic markets. The Company has also recently entered into a merger agreement with Cerulean, pursuant to which Cerulean will become a wholly owned subsidiary of the Company. These businesses, which include substantial indemnity-based insurance operations, have experienced varying profitability or losses in recent periods. Since the relevant dates of acquisition of MMHD and GBO, the Company has continued to work extensively on the integration of these businesses; however, there can be no assurances regarding the ultimate success of the Company's integration efforts or regarding the ability of the Company to maintain or improve the results of operations of the businesses of completed or pending transactions as the Company pursues its strategy of motivating the acquired members to select managed care products. In order to implement this business strategy, the Company has and will, among other things, need to continue to incur considerable expenditures for provider networks, distribution channels and information systems in addition to the costs associated with the integration of these acquisitions. The integration of these complex businesses may result in, among other things, temporary increases in claims inventory or other service-related issues that may negatively affect the Company's relationship with its customers and contribute to increased attrition of such customers. The Company's results of operations could be adversely affected in the event that the Company experiences such problems or is otherwise unable to implement fully its expansion strategy.
The Company's operations are subject to substantial regulation by Federal, state and local agencies in all jurisdictions in which the Company operates. Many of these agencies have increased their scrutiny of managed health care companies in recent periods. The Company also provides insurance products to Medi-Cal beneficiaries in various California counties under contracts with the California Department of Health Services and provides administrative services to the Health Care Finance Administration ("HCFA") in various capacities. There can be no assurance that acting as a government contractor in these circumstances will not increase the risk of heightened scrutiny by such government agencies and that profitability from this business will not be adversely affected through inadequate premium rate increases due to governmental budgetary issues. Future actions by any regulatory agencies may have a material adverse effect on the Company's business.
As a result of the Company's recent acquisitions, the Company now operates on a national basis and offers a spectrum of health care and specialty products through various risk sharing arrangements. The Company's health care products include a variety of managed care offerings as well as traditional fee-for- service coverage. With respect to product type, fee-for-service products are generally less profitable than managed care products. A critical component of the Company's expansion strategy is to transition over time the traditional insurance members of the Company's acquired businesses to more managed care products.
With respect to the risk-sharing nature of products, managed care products that involve greater potential risk to the Company generally tend to be more profitable than management services products and those managed care products where the Company is able to shift risks to employer groups. Individuals and small employer groups are more likely to purchase the Company's higher-risk managed care products