The Company's headquarters are located in Green Bay, Wisconsin, in a 390,000 square foot office building owned by the Company. The Company also leases property at approximately 50 locations throughout the United States for its field sales and provider network offices.
American Medical Security Group, Inc., formerly known as United Wisconsin Services, Inc., together with its subsidiary companies ("AMSG" or the "Company"), is a provider of life and health insurance products for individuals and employer groups. The Company's principal product offering is small group health insurance. It also sells individual and large group health insurance and group life, dental, prescription drug, disability and accidental death insurance. The Company's products are actively marketed in 33 states and the District of Columbia through independent agents. The Company's products generally provide discounts to insureds that utilize preferred provider organizations ("PPOs"). The average group size is eight lives.
On September 11, 1998, the Company contributed all of its subsidiaries comprising the managed care and specialty business to a newly created subsidiary named "Newco/UWS, Inc.", a Wisconsin corporation ("Newco/UWS"). On September 25, 1998, the Company spun off the managed care and specialty business through a distribution of 100% of the issued and outstanding shares of common stock of Newco/UWS to the Company's shareholders of record as of September 11, 1998 (see Spin-off below). The Company thereupon adopted its current name of "American Medical Security Group, Inc." and Newco/UWS changed its name to "United Wisconsin Services, Inc." After the spin-off, the business of the Company consists solely of the Company's small group insurance business. The Consolidated Financial Statements included hereafter report the Company's managed care and specialty business as discontinued operations. The continuing operations of the Company as reported herein reflect the historical small group insurance portion of the Company's business. Certain portions of Management's Discussion and Analysis discuss pro forma information for 1996 reporting selected financial information as if the business of Old AMS were a part of the Company's business for the entire year of 1996.
On September 25, 1998, the Company completed the separation of its managed care and specialty business through the spin-off of Newco/UWS to the Company's shareholders on a share-for-share basis. The intent of the spin-off was to allow both companies to operate more effectively. Management believes that the separation should afford each company increased marketing, joint venture and acquisition opportunities.
The net assets of Newco/UWS consisted of assets and liabilities of the managed care and specialty management business along with $70.0 million in debt that was assumed by Newco/UWS in conjunction with the spin-off. The Company obtained a private letter ruling from the Internal Revenue Service to the effect that the spin-off qualifies as tax-free to the Company, Newco/UWS and the Company's shareholders (see Newco/UWS Form 10 for more details).
Accordingly, the discussions of continuing operations to follow reflect only the operations of the Company's health and life products.
After experiencing major operating losses in 1995 and 1996, a new management team for the small group business was appointed, headed by Samuel V. Miller, President and Chief Executive Officer. Management implemented a turnaround strategy to return the small group business to profitability. Actions taken included the termination of unprofitable business, enhancement of network management, significant repricing of business and the initiation of a medical management process. These actions reduced the health loss ratio from 80.3% (pro forma) in 1996 to 77.5% in 1997 and 76.7% in 1998. Management also implemented cost saving measures, including a reduction in personnel, the automation of claim payments and increased productivity which caused the health expense ratio to decline from 24.2% (pro forma) in 1996 to 23.0% in 1997. During 1998, the health expense ratio increased to 23.9% due primarily to investments in the Company's distribution channel, costs related to the Year 2000 project and higher commissions resulting from a change in product mix. Management's efforts have resulted in a significant increase in income from continuing operations from a pro forma loss of $25.1 million in 1996 to income of $8.9 million and $8.4 million in 1997 and 1998, respectively, excluding non-recurring items and interest on debt assumed by Newco/UWS.
At the same time, the Company continued to take necessary steps to improve profitability through rate increases and exiting certain markets. By the end of 1998, new sales growth combined with slower terminations caused the membership in force to begin to grow.
The following is a table reflecting the quarterly membership in force:
The tangible book value at December 31, 1998, increased to $8.95 per share compared to $8.02 at December 31, 1997. Tangible book value is computed by taking shareholders' equity adjusted by net gain (loss) on available for sale investments, less goodwill and other intangibles over end-of-period shares outstanding.
Results from continuing operations for 1998 was a loss of $3.0 million, which is a $4.6 million decrease from income of $1.6 million for 1997. Excluding non-recurring charges and excluding interest on debt assumed by Newco/UWS, income from continuing operations for 1998 was $8.4 million compared to $8.9 million for 1997. The modest decline in income from continuing operations reflects an improved loss ratio offset by increased selling, general and administrative expenses. The turnaround slowed during 1998 principally due to losses in the individual dental business and delayed rate increases in the State of Florida. Action was taken by year end 1998 with respect to both challenges which management believes will be effective.
For 1998, health insurance premiums declined 5.8% to $865.2 million from $918.6 million in 1997. The decline in premium is primarily the result of a decline in average fully insured medical membership of 7.2% in 1998 compared to 1997 reflecting the Company's efforts to cull unprofitable business. Life insurance premiums declined 15.4% in 1998 to $24.5 million from $28.9 million in 1997 which is consistent with the decline in average life membership of 16.2% in 1998 compared to 1997.
Net investment income includes investment income and realized gains. Net investment income for 1998 increased 0.6% to $24.2 million from $24.1 million in 1997. Average annual investment yields, excluding realized gains and losses, were 6.7% for the year ended December 31, 1998, compared to 7.4% for the same period in the prior year. Net investment income for 1997 includes $1.4 million of mutual fund distributions which were favorably impacted by foreign financial markets in 1997. Investment gains and losses are realized in the normal investment process in response to market opportunities.
During 1998, other revenue declined to $22.6 million from $24.2 million in 1997. The decrease is primarily due to lower administrative fee revenue from self-funded business in 1998 offset by additional fees related to the Pan American business acquired beginning in the third quarter 1998.
Amortization of goodwill and intangibles for the year ended December 31, 1998, increased to $8.8 million from $8.0 million at December 31, 1997. The increase in amortization expense in 1998 is primarily due to recorded intangible assets related to the Pan American small group business acquired in October 1997. Amortization of intangibles is expected to decline significantly in 1999 due to the write-off of the Company's distribution system intangible asset.
The effective tax rate for the year 1998 was 38.1% compared with 39.9% for the year 1997. The effective tax rate is raised by the amortization of non-deductible goodwill in relation to pretax income.
Net investment income (including realized gains/losses) for 1997 decreased 0.2% to $24.1 million from $24.6 million at December 31, 1996. Net investment income declined due to a decrease in average invested assets offset by an increase in investment yield in 1997. Average annual investment yields, excluding realized gains and losses, were 7.4% for the year ended December 31, 1997, compared to 6.8% for 1996. The average yield for 1997 includes the mutual fund distribution of $1.4 million discussed above in the comparison of years 1998 and 1997.
The effective tax rate for 1997 was 39.9%, compared with 38.2% for 1996.
Income from discontinued operations reflects the operating results of Newco/UWS (now called United Wisconsin Services, Inc.) through September 25, 1998, the distribution date of the spin-off. Reported results of discontinued operations in 1998 included direct costs associated with the spin-off of $4.9 million.
The Company's cash flows from operations were negative at $3.7 million, $31.8 million and $17.0 million for the years ended 1998, 1997 and 1996, respectively. Negative cash flows from operations are principally the result of the decline in medical and other benefits payable of $14.9 million, $32.2 million and $13.5 million for the years ended December 31, 1998, 1997 and 1996, respectively. The decline in medical and other benefits payable results primarily from a decline in business and a reduction in the inventory of claims pending adjudication. The Company's cash flows from operations were positive during the last half of 1998 and should remain positive during 1999 due to a leveling of the claims inventory, growth in membership and lower debt service costs as a result of the assumption of $70.0 million in debt by Newco/UWS in September 1998.
The Company does not expect to pay any cash dividends in the foreseeable future and intends to employ its earnings in the continued development of its business. The Company's future dividend policy will depend on its earnings, capital requirements, financial condition and other factors considered relevant by the Board of Directors.
At December 31, 1998, the fair value of the Company's borrowings under the line of credit facility approximated the carrying value. Market risk was estimated as the potential increase in the fair value resulting from a hypothetical 1% decrease in the Company's weighted average short-term borrowing rate at December 31, 1998, and was not materially different from the year end carrying value.
The Company has divided the Year 2000 issues facing the organization into three major sections: 1) software applications developed in-house ("In-house Applications"); 2) software applications acquired from a third party that have been customized by the Company ("Customized Applications"); and 3) software applications acquired from a third party that have not been customized by the Company and those products and services provided to the Company by third parties ("Third Party Products").
telephone systems, security systems and numerous other products as well as third party applications that have not been customized by the Company. The Company has evaluated various third parties that provide products or services, such as printing companies, power and utility companies and other vendors. Where appropriate, agreements with third party vendors have been amended and Year 2000 compliance certifications have been obtained. Significant business partners and vendors will be required to provide the Company with Year 2000 certified products or services. Such products and services are being tested by the Company to validate the compliance certification. The Company estimates this portion of the plan is approximately 73% complete, is on schedule and is planned for completion in September 1999.
The Company is developing a comprehensive analysis of the operational problems and costs (including loss of revenues) that could result from the unlikely failure by the Company and certain third parties to complete efforts necessary to achieve Year 2000 compliance on a timely basis. The majority of the contingency plans has been developed and documented for dealing with the worst case scenarios with the highest chance of occurring. The Company currently plans to complete such analysis and contingency planning during the second quarter of 1999.
The costs of the project and the date on which the Company plans to complete the necessary Year 2000 modifications are based on management's best estimates, which were derived using numerous assumptions of future events including the continued availability of certain resources, third party remediation plans and other factors. There can be no guarantee that these timelines or estimates will be achieved. Actual results could differ materially from those planned. Specific factors that might cause such material differences to occur include, but are not limited to, the availability and cost of personnel trained in this area; the ability to locate and correct all relevant computer codes; and the ability of the Company's significant suppliers, customers and others with which it conducts business, including federal, state and local governmental agencies, to identify and resolve their own Year 2000 issues and similar uncertainties. Due to these uncertainties, the Company may face certain claims, the impact of which is not currently estimable. No assurance can be given that the cost of defending and resolving such claims, if any, will not significantly affect the Company's results of operations. Although the Company has some agreements with third party vendors and suppliers that contain indemnification provisions that protect the Company under certain circumstances relating to Year 2000 issues, there can be no assurances that such indemnification provisions will cover all of the Company's liabilities and costs related to Year 2000 claims by third parties.
Statements contained in this report that are not historical facts are forward looking statements subject to inherent risks and uncertainties that may cause actual results or events to differ materially from those contemplated by such forward looking statements. The terms "anticipate", "believe", "estimate", "expect", "objective", "plan", "project" and similar expressions are intended to identify forward looking statements. In addition to the assumptions and other factors referred to specifically in connection with such statements, factors that may cause actual results or events to differ materially from those contemplated by such forward looking statements, include, among others, (1) the effects of either federal or state health care reform or other legislation; (2) rising health care costs, including the Company's ability to predict such costs and adequately price its products; (3) changes in membership utilization and risk; (4) government regulations, including changes in insurance, health care and other regulatory conditions; (5) delays in regulatory approvals, and regulatory action resulting from market conduct activity and general administrative compliance with state and federal laws; (6) general business conditions, including competitive practices and demand for the Company's products; (7) development of claims reserves; (8) rating agency policies and practices; (9) general economic conditions, including changes in interest rates and the effect of such changes on the Company's investment portfolio; (10) the Company's ability to integrate acquisitions; (11) unforeseen costs or consequences of Year 2000 issues; (12) the retention of key management and technical employees, and (13) other factors that may be referred to in the Company's reports filed with the Securities and Exchange Commission from time to time.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of the Company as of December 31, 1998 and 1997, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 1998, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein.
The consolidated financial statements include the accounts of the Company and all of its majority-owned subsidiaries. Significant intercompany accounts and transactions have been eliminated.
Cash and cash equivalents include operating cash and short-term investments with original maturities of three months or less. These amounts are recorded at cost, which approximates market.
The Company periodically evaluates whether events and circumstances have occurred which may affect the estimated useful life or the recoverability of the remaining balance of its intangibles. The study conducted during 1998, determined that the Company's sales distribution system intangible assets were considered to be impaired as the Company largely eliminated its commission-based sales offices, replacing them with salaried sales offices since the acquisition. This resulted in an after-tax charge of $9,251,000 or $0.56 per share, including $7,683,000 of intangible distribution system assets and $1,568,000 of related costs. The Company's management believes that no other material impairment of goodwill or other intangible assets exists at December 31, 1998.
Premiums for group life and health policies are recognized ratably over the period that insurance coverage is provided.
The effect of dilutive securities is excluded from the diluted EPS computation for the years 1998 and 1996 because employee stock options are antidilutive during such periods. Options to purchase 1,908,449 shares of common stock were outstanding and exercisable at the end of 1997 and all but 147,715 were not included in the computation of diluted earnings per share because the options' exercise price was greater than the average market price of common shares and, therefore, the effect would be antidilutive.
Certain reclassifications have been made to the 1997 and 1996 consolidated financial statements to conform with the 1998 presentation.
The net assets of Newco/UWS consisted of assets and liabilities of the managed care and specialty management business along with $70,000,000 in debt that was assumed by Newco/UWS in conjunction with the Distribution. Newco/UWS was renamed United Wisconsin Services, Inc. AMSG has obtained a private ruling from the Internal Revenue Service to the effect that the spin-off qualifies as tax free to AMSG, Newco/UWS and to AMSG shareholders. The operations of Newco/UWS, along with direct costs of approximately $4,900,000 associated with the spin-off, have been reflected in discontinued operations. All prior periods of the consolidated financial statements of AMSG have been restated to reflect Newco/UWS operations as discontinued operations in the accompanying consolidated financial statements of AMSG. Discontinued operations reported total revenues of $488,033,000, $609,109,000 and $539,764,000 for 1998, 1997 and 1996 respectively. Interest expense on the $70,000,000 debt assumed by Newco/UWS is reflected in continuing operations only through September 11, 1998.
Prior to December 3, 1996, the Company owned 12% of the common stock of American Medical Security Group, Inc., a Delaware corporation, ("Old AMS"). The Company also had a joint venture agreement with Old AMS and its subsidiaries and was a party to related reinsurance agreements. Effective December 3, 1996, the Company acquired the remaining 88% of Old AMS. The aggregate consideration for the acquisition was cash of $71,800,000, including expenses, and $98,719,000 representing the market value of 3,694,280 newly issued shares of the Company's common stock and options to purchase the Company's common stock. Most of the cash consideration came from $70,000,000 borrowed from BCBSUW. In conjunction with the acquisition, $150,018,000 of goodwill and other intangibles and $22,173,000 of related deferred tax liabilities were recorded on the consolidated balance sheet.
On a pro forma basis, assuming the acquisition had occurred on January 1, 1996, after giving effect to certain adjustments arising from the recording of the transaction, including amortization of goodwill and other intangibles, reduction of investment income due to cash payments, interest expense on debt and intercompany eliminations, 1996 revenues would have been $1,150,000,000. In addition, the loss from continuing operations would have been $25,112,000, resulting in a loss per common share of $1.95.
Unrealized gains (losses) are computed as the difference between estimated fair value and amortized cost for equity securities and fixed maturities classified as available for sale. A summary of the net increase (decrease) in unrealized gains, which is included in other accumulated comprehensive income, is as follows:
The amortized cost and estimated fair values of debt securities at December 31, 1998, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations.
The Company recognized depreciation expense on property and equipment of $5,450,000, $8,625,0000 and $1,425,000 in 1998, 1997 and 1996, respectively.
The Company believes the carrying value of all notes payable approximates their fair value. Future annual principal amounts due for all notes are $2,222,000 for 1999, $1,392,000 for 2001, $11,358,000 for 2002 and $36,200,000 for 2003. During 1998, 1997 and 1996 interest paid totaled $6,971,000, $9,320,000 and $5,105,000, respectively.
Prior to the Company's acquisition of Old AMS on December 3, 1996, the Company ceded to Old AMS, on a quota share basis, approximately 50% of the premium revenue on small group health care and life business sold by Old AMS. As a result, the Company retained 50% of the premium revenue and 50% of the profit (loss) on the products sold by Old AMS.
The Company is involved in various legal actions and other contingencies occurring in the normal course of its business. In the opinion of management, adequate provision has been made for losses which may result from these actions and, accordingly, the outcome of these matters is not expected to have a material adverse effect on the consolidated financial statements.
As of December 31, 1998, aggregate minimum rental commitments under noncancelable leases amount to $3,193,000 in 1999, $2,292,000 in 2000, $1,555,000 in 2001, $350,000 in 2002 and $58,000 in 2003.
Insurance companies are subject to state insurance regulations. These regulations require, among other matters, the filing of financial statements prepared in accordance with statutory accounting practices prescribed or permitted for insurance companies. The combined statutory surplus of the Company's insurance subsidiaries, United Wisconsin Life Insurance Company and American Medical Security Insurance Company of Georgia, at December 31, 1998 and 1997, was $183,288,000 and $176,518,000, respectively.
The Company has a stock-based compensation plan, Equity Incentive Plan (the "Plan"), for the benefit of eligible employees of the Company. The Plan permits the grant of nonqualified stock options ("NQSO"), incentive stock options, stock appreciation rights, restricted stock awards and performance awards. Persons eligible to participate in the Plan include all full-time active employees, including employees who are members of the board of directors, but excluding directors who are not employees. The Plan allows for the granting of up to 4,000,000 shares of which 1,121,303 shares are available for grant as of December 31, 1998. No benefits other than NQSOs have been granted under the plan.
executive remains continuously employed with AMSG through November 17, 2002. The Company incurred expense of $28,000 in 1998 related to this agreement.
In determining compensation cost pursuant to SFAS No. 123, the fair value for these options was estimated at the date of grant using the Black-Scholes option pricing model with the following weighted average assumptions for 1998 and 1997, respectively: risk-free interest rates of 4.53% and 5.71%; dividend yields of 0.00% and 1.78%; volatility factors of the expected market price of the Company's common stock of 0.39 and 0.38; and a weighted average expected life of the options of 3.55 and 6.03 years. As calculated using the Black-Scholes model, the weighted average, grant-date fair value of options granted in which the exercise price equaled the market price on the date of the grant was $4.83 per share for 1998 and $10.66 per share for 1997 and 1996. The weighted average grant-date fair value of options granted in which the exercise price was less than the market price on the date of the grant was $7.37 per share for 1998 and $1.29 per share for 1996. The weighted average grant-date fair value of options granted in which the exercise price was greater than market price on the date of the grant was $1.77 per share for 1998.
Selected continuing operations quarterly financial data for the years ended December 31, 1998 and 1997 are as follows: