In conjunction with the Kaiser-Texas acquisition, we purchased eight medical and office facilities with approximately 323,000 square feet of clinical facilities and approximately 175,000 square feet of administrative facilities. These buildings are subject to a deed of trust note with an original balance of $35.2 million and a remaining principal balance of $12.7 million at December 31, 2002. Four of the original eight buildings were sold during 2002. The remaining four buildings total approximately 254,000 square feet of clinical space and of this total approximately 113,000 is leased to outside parties. The Texas assets have been written down to their estimated market value and are included in the assets of the discontinued operations. We are actively seeking a buyer for the assets.
Years Ended December 31, ---------------------------------------------------------- 2002 2001 2000 1999 1998 ---------- ---------- ---------- ---------- ---------- (In thousands, except per share data) Statements of Operations Data: OPERATING REVENUES: Medical Premiums................................. $ 857,741 $ 718,994 $ 637,769 $ 594,966 $ 528,759 Military Contract Revenues....................... 373,589 338,918 330,352 287,398 204,838 Professional Fees................................ 30,923 28,985 33,102 42,069 43,609 Investment and Other Revenues.................... 16,382 16,603 18,393 16,286 22,763 ---------- ---------- ---------- ---------- ---------- Total.......................................... 1,278,635 1,103,500 1,019,616 940,719 799,969 ---------- ---------- ---------- ---------- ---------- OPERATING EXPENSES: Medical Expenses................................. 712,290 608,757 576,738 534,606 440,265 Military Contract Expenses....................... 360,375 331,621 323,265 276,493 196,625 General and Administrative Expenses.............. 133,979 122,623 112,220 103,340 105,298 Asset Impairment, Restructuring, Reorganization and Other Costs (1)............ -- -- 30,836 7,808 13,851 ---------- ---------- ---------- ---------- ---------- Total.......................................... 1,206,644 1,063,001 1,043,059 922,247 756,039 ---------- ---------- ---------- ---------- ---------- OPERATING INCOME (LOSS) FROM CONTINUING OPERATIONS........................... 71,991 40,499 (23,443) 18,472 43,930 Interest Expense.................................... (7,487) (15,786) (17,865) (12,306) (3,596) Other Income (Expense), Net......................... (108) (2,071) 1,084 (674) 588 ---------- ---------- ---------- ---------- ---------- INCOME (LOSS) FROM CONTINUING OPERATIONS BEFORE INCOME TAXES.................. 64,396 22,642 (40,224) 5,492 40,922 (PROVISION) BENEFIT FOR INCOME TAXES................ (22,088) (7,161) 9,205 1,431 (9,659) ---------- ---------- ---------- ---------- ---------- INCOME (LOSS) FROM CONTINUING OPERATIONS............................ 42,308 15,481 (31,019) 6,923 31,263 (LOSS) INCOME FROM DISCONTINUED OPERATIONS.......... (5,860) (11,995) (168,896) (11,554) 8,333 ---------- ---------- ---------- ---------- ---------- NET INCOME (LOSS)................................... $ 36,448 $ 3,486 $ (199,915) $ (4,631) $ 39,596 ========== ========== ========== ========== ========== EARNINGS PER COMMON SHARE (2): Income (Loss) From Continuing Operations......... $ 1.47 $ 0.56 $ (1.15) $ 0.26 $ 1.14 (Loss) Income from Discontinued Operations....... (0.20) (0.43) (6.22) (0.43) 0.31 ---------- ---------- ---------- ---------- ---------- Net Income (Loss)................................ $ 1.27 $ 0.13 $ (7.37) $ (0.17) $ 1.45 ========== ========== ========== ========== ========== Weighted Average Number of Common Shares Outstanding............................. 28,756 27,685 27,142 26,927 27,391 ========== ========== ========== ========== ========== EARNINGS PER COMMON SHARE ASSUMING DILUTION (2): Income (Loss) From Continuing Operations......... $ 1.36 $ 0.54 $ (1.15) $ 0.26 $ 1.13 (Loss) Income from Discontinued Operations....... (0.19) (0.42) (6.22) (0.43) 0.30 ---------- ---------- ---------- ---------- ---------- Net Income (Loss)................................ $ 1.17 $ 0.12 $ (7.37) $ (0.17) $ 1.43 ========== ========== ========== ========== ========== Weighted Average Number of Common Shares Outstanding Assuming Dilution........... 31,141 28,509 27,142 26,996 27,747 ========== ========== ========== ========== ==========
(2)	Adjusted to account for three-for-two stock split of our common stock to stockholders of record as of May 18, 1998.
The following discussion and analysis provides information which management believes is relevant for an assessment and understanding of our consolidated financial condition and results of operations. The discussion should be read in conjunction with the Consolidated Financial Statements and related Notes thereto. The information contained below may be subject to risk factors. We urge you to review carefully the section "Risk Factors" in this 2002 Form 10-K for a more complete discussion of the risks associated with an investment in our securities. See "Note on Forward-Looking Statements and Risk Factors" under Item 1.
Our principal expenses consist of medical expenses, military contract expenses, and general and administrative expenses. Medical expenses represent capitation fees and other fee-for-service payments paid to independently contracted physicians, hospitals and other health care providers to cover members, pharmacy costs, as well as the aggregate expenses to operate and manage our wholly owned multi-specialty medical group and other provider subsidiaries. As a provider of health care management services, we seek to positively affect quality of care and expenses by contracting with physicians, hospitals and other health care providers at negotiated price levels, by adopting quality assurance programs, monitoring and managing utilization of physicians and hospital services and providing incentives to use cost-effective providers. Military contract expenses represent payments to providers for health care services rendered under the TRICARE program, as well as administrative costs to operate the military health care subsidiary. General and administrative expenses generally represent operational costs other than those directly associated with the delivery of health care services and military contract services.
In conjunction with the decision to dispose of the workers' compensation operations, CII recorded valuation adjustments of $17.3 million, $11.3 million after tax, to reduce this business to its estimated net realizable value upon disposition. The valuation adjustments included the write down of accounts receivable, fixed assets and certain other assets of $4.0 million and additional loss reserves of $8.3 million for the 2002 accident year and $5.0 million for prior accident years.
Our consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America. In preparing these financial statements, we are required to make judgments, assumptions and estimates, which we believe are reasonable and prudent based on the available facts and circumstances. These judgments, assumptions and estimates affect certain of our revenues and expenses and their related balance sheet accounts and in disclosing our contingent assets and liabilities. We base our assumptions and estimates primarily on historical experience and trends and factor in known and projected trends. On an on-going basis, we re-evaluate our selection of assumptions and the method of calculating our estimates. Actual results, however, may differ from our calculated estimates and this difference would be reported in our current operations. The following discusses our most critical accounting policies and estimates, which have been reviewed by the Audit Committee of our Board of Directors.
Medical Premiums and Expenses. Medical premium revenues are recorded in the month when we are obligated to provide services to our enrolled members. Premiums received in advance of the coverage period are recorded as unearned premiums. Our premium revenues are net of an estimate for an allowance for retroactive adjustments. At December 31, 2002, our allowance for retroactive adjustments for health care premium revenues was $3.3 million. Retroactive adjustments result from changes in enrollments that relate to prior periods due to delays in processing or reporting by employers. We use historical trends and known activities to estimate our premium allowances. Any subsequent difference between actual premium adjustments and previously estimated premium adjustments would be reflected in that subsequent year's operating results.
Unrealized investment gains and losses, net of related income taxes, on the available-for-sale investments are included as a separate component of stockholders' equity until realized. Realized gains and losses are calculated using the specific identification method and are included in investment and other revenues.
Litigation and Legal Accruals. We are subject to various claims and other litigation in the ordinary course of business. Such litigation includes, but is not limited to, claims of medical malpractice, claims for coverage or payment for medical services rendered to HMO members and claims by providers for payment for medical services rendered to HMO and other members. We may also face claims for punitive damages that are not covered by insurance. We are also subject to claims for workers' compensation and claims by providers for payment for medical services rendered to injured workers. With respect to certain pending actions, we maintain commercial insurance coverage with varying deductibles for which we maintain estimated reserves for our self- insured portion based upon our current assessment of such litigation. In addition, we accrue estimated legal defense and other settlement costs based on our assessment of the available information, including our outside legal counsel's assessment of the case. We also assess potential legal exposure, based on the available information, to determine if a precautionary notice of potential claim should be reported to our insurers and if an accrual should be established.
Workers' Compensation Loss and Loss Adjustment Expenses. Discontinued operations' workers' compensation insurance losses and loss adjustment expenses, or LAE, are based upon the accumulation of cost estimates for reported claims occurring during the period as well as an estimate for losses that have occurred but have not yet been reported. Similar to the health care medical expenses, we use a variety of standard actuarial projection methods to make these estimates and we must use our judgment in selecting development factors and assumed trends. Unlike health care medical expenses, where the cost to provide health care services is substantially completed within one year, workers' compensation claims can be paid out over a substantial number of years due to certain lifetime benefits. In addition, the period between when a claim is reported to us and when the injury occurred could be longer than one year and when we are no longer insuring the account. Loss and LAE reserves have a significant degree of uncertainty when related to their subsequent payments. Although our reserves are established on the basis of a reasonable estimate, it is not only possible but probable that our reserves will differ from their related subsequent developments. Underlying causes for this uncertainty include, but are not limited to, uncertainty in development patterns, unanticipated inflationary trends affecting the cost of services covered by the insurance contract, adverse legal outcomes and new interpretations of laws or regulations or of disputed contract provisions that result in our having to provide new or extended benefits. This uncertainty can result in both adverse as well as favorable development of actual subsequent activity when compared to the reserve established. During the past four years (1999-2002), we have had adverse development in our previously recorded loss and LAE reserves that has ranged from a low of $8.7 million to a high of $24.0 million. Any subsequent change in loss and LAE reserves established in a prior year would be reflected in that subsequent year's operating results.
Management believes, based on information presently available, that the recorded liability for loss and LAE reserves is reasonable and adequate to cover future workers' compensation claim payments. At December 31, 2002, loss and LAE reserves represented 85.3% of the liabilities of discontinued operations and 47.0% of our total consolidated liabilities. A change between the recorded liability and actual developed claim payments could have a material impact to our business and results of operations. For example, a 1% increase in loss and LAE reserves, not covered by reinsurance, as of December 31, 2002, would reduce reported net income for the year 2002 by $2.8 million or 7.6% and diluted earnings per share would be reduced by $0.09.
Reinsurance Recoverable. Included in the assets of discontinued operations is reinsurance recoverable, which represents the estimated amount of unpaid workers' compensation loss and LAE reserves that would be recovered from our reinsurers and, to a lesser extent, amounts billed to the reinsurers for their portion of paid losses and LAE. Reinsurance receivable for ceded paid claims is recorded in accordance with the terms of the agreements and reinsurance recoverable for unpaid losses and LAE is estimated in a manner consistent with the claim liability associated with the reinsurance policy. Any significant changes in the underlying claim liability could directly affect the amount of reinsurance recoverable. Reinsurance recoverable, including amounts related to paid and unpaid losses, are reported as assets rather than a reduction of the related liabilities. Reinsurance contracts do not relieve us from our obligations to enrollees, injured workers or policyholders. If our reinsurers were to fail to honor their obligations because of insolvency, disputed contract provisions or for other reasons, we could incur significant losses. Prior to entering into reinsurance contracts, we evaluate the financial condition of our reinsurers to minimize our exposure to significant losses from reinsurer insolvencies. In addition, we periodically monitor the financial strength of our reinsurers to determine if an allowance for uncollectible reinsurance recoverables is warranted. To date, we have never had to write-off a workers' compensation reinsurance recoverable balance and no allowance for uncollectible amounts has been established. At December 31, 2002, reinsurance recoverable for workers' compensation was $189.4 million. Any subsequent change in reinsurance recoverable established in a prior year would be reflected in that subsequent year's operating results.
Deferred Tax Assets and Liabilities. Deferred income tax assets and liabilities result from temporary differences between the tax basis of assets and liabilities and the reported amounts in the consolidated financial statements that will result in taxable or deductible amounts in future years. Our temporary differences arise principally from certain net operating losses, accrued expenses, reserves that are discounted for tax return purposes, depreciation and impairment charges. We regularly review our deferred tax assets for recoverability based on historical taxable income, projected future taxable income and the expected timing of the reversals of the existing temporary differences. A valuation allowance is established for those portions of the deferred tax assets that we consider to be more likely than not unrealizable. At December 31, 2002, our total deferred tax assets, including discontinued operations, was $83.3 million and our total deferred tax liabilities were $1.0 million.
Management believes, based on information presently available, that the recorded deferred tax assets are reasonable and recoverable. A change between the recorded asset and the subsequently used deferred tax asset could have a material impact to our business and results of operations. For example, a 1% decrease in the deferred tax asset as of December 31, 2002 would reduce reported net income for the year 2002 by $833,000 or 2.3% and diluted earnings per share would be reduced by $0.03.
Years Ended December 31, ---------------------------------- 2002 2001 2000 ---------- ---------- ---------- OPERATING REVENUES: Medical Premiums............................... 67.1 % 65.2 % 62.5 % Military Contract Revenues..................... 29.2 30.7 32.4 Professional Fees.............................. 2.4 2.6 3.2 Investment and Other Revenues ................. 1.3 1.5 1.9 ---------- ---------- ---------- Total....................................... 100.0 100.0 100.0 ---------- ---------- ---------- OPERATING EXPENSES: Medical Expenses............................... 55.7 55.2 56.6 Military Contract Expenses .................... 28.2 30.0 31.7 General and Administrative Expenses............ 10.5 11.1 11.0 Asset Impairment, Restructuring, Reorganization and Other Costs.............. -- -- 3.0 ---------- ---------- ---------- Total.......................................... 94.4 96.3 102.3 ---------- ---------- ---------- OPERATING INCOME (LOSS) FROM CONTINUING OPERATIONS..................................... 5.6 3.7 (2.3) INTEREST EXPENSE.................................... (0.6) (1.4) (1.7) OTHER INCOME (EXPENSE), NET......................... -- (0.2) 0.1 ---------- ---------- ---------- INCOME (LOSS) FROM CONTINUING OPERATIONS BEFORE INCOME TAXES ........................... 5.0 2.1 (3.9) (PROVISION) BENEFIT FOR INCOME TAXES............... (1.7) (0.7) 0.9 ---------- ---------- ---------- INCOME (LOSS) FROM CONTINUING OPERATIONS............ 3.3 1.4 (3.0) LOSS FROM DISCONTINUED OPERATIONS................... (0.5) (1.1) (16.6) ---------- ---------- ---------- NET INCOME (LOSS)................................... 2.8 % 0.3 % (19.6)% ========== ========== ==========
Medical Premiums from our HMO and managed indemnity insurance subsidiaries increased $138.7 million or 19.3%. The $138.7 million increase in premium revenue reflects a 5.1% increase in Medicare member months (the number of months individuals are enrolled in a plan), a 52.2% increase in Medicaid member months and a 20.4% increase in commercial member months. The growth in Medicare member months contributes significantly to the increase in premium revenues as the Medicare per member premium rates are more than three times higher than the average commercial premium rate.
SMHS will complete the last year of a five-year contract in May 2003, but it has successfully completed negotiations with the DoD to extend the contract for up to four years at the government's sole option on a year-to- year basis. The DoD is also currently procuring managed care services under the Next Generation TRICARE contract, or the T-Nex contract, in a combined and larger North Region (covering Michigan, Ohio, Kentucky, Indiana, Illinois, Wisconsin, Virginia and North Carolina in addition to the areas that make up Region 1 which we currently serve). SMHS submitted its bid to the DoD for the T-Nex contract for the North Region on January 29, 2003, with Sierra as a proposed guarantor. The award decision for this contract is initially expected to be made in mid-2003. Once awarded, the new contractor is scheduled to be fully operational in Region 1 by the third quarter of 2004, based on the current timetable set by the DoD, and the new contract would supersede the remainder of the contract extension we have negotiated with the DoD under our current TRICARE Region 1 contract. In March 2003, we contributed $35.0 million of the proceeds of the Sierra Debentures to SMHS in furtherance of its bid for the T-Nex contract.
Investment and Other Revenues decreased approximately $200,000 or 1.3% due primarily to a decrease in the average investment yield during the period offset by an increase in the average invested balance. Investment and other revenues now include the revenue associated with administrative services, which were previously reported as part of specialty product revenues.
During the third quarter of 2002, the Company entered into a new hospital contract. With this new contract, which began October 1, 2002, the Company holds some form of contracted provider relationship with every hospital in the Las Vegas area.
Provision for Income Taxes was recorded at $22.1 million for 2002 compared to $7.2 million for 2001. The effective tax rate for 2002 was 34.3% compared to 31.6% for 2001. Our ongoing effective tax rate is less than the statutory rate due primarily to tax preferred investments.
During 2002, TXHC sold four real estate properties and a piece of land which resulted in a gain, net of tax, on the sale of approximately $700,000. In conjunction with the sales we were required, under the terms of the mortgage loan agreement, to pay pre-determined minimum amounts of the mortgage note. Since the principal payments resulted in a reduction of future interest, future accrued interest was reduced and a gain, net of tax, of $1.9 million was recorded.
Discontinued CII workers' compensation operations. The discontinued workers' compensation operations for 2002 had a loss of $14.3 million, which included valuation adjustments of $17.3 million, or $11.3 million after tax, to reduce this business to its estimated net realizable value upon disposition. We will continue to operate the business until a disposal occurs.
Due to the impact of new legislation in California (see below) and the continuing higher amounts of average incurred claims we have been experiencing, our rate increase in the first two months of 2003 on renewing California policies is approximately 30 - 50%. In addition, we continue to implement stricter underwriting guidelines. This has resulted in a continuation of lost business and lower amounts of new business and our premiums written for the first two months of 2003 in California are down approximately 22% over the comparable 2002 period. Premiums written in our other states are also down by approximately 11%, primarily in Colorado. Premium production results for the first two months of 2003 may not be indicative of the full year's premium production.
The loss and LAE ratio for the 2002 accident year was higher by 3.0% which resulted in an increase of approximately $5.3 million in additional losses including the $8.3 million recorded as part of the valuation adjustments. Excluding the valuation adjustment, which represents 4.7% of net earned premiums, the 2002 accident year loss and LAE ratio would have been 1.7% less than the 2001 accident year loss ratio. The decrease is due to the higher premium rates we have been obtaining which were substantially offset by higher estimated average incurred claims.
The net adverse loss development on prior accident years included those years that were covered by our low level reinsurance agreement. This resulted in an increase in the reinsurance recoverable balance which is then reduced by amounts collected from reinsurers. During the year ended December 31, 2002, we increased our ceded reserves by $45.9 million and received payments from our reinsurers totaling $74.6 million.
The combined ratio is a measurement of the workers' compensation underwriting profit or loss and is the sum of the loss and LAE ratio, underwriting expense ratio and policyholders' dividend ratio. A combined ratio of less than 100% indicates an underwriting profit. Our combined ratio, net of valuation adjustments which represent 9.6%, was 110.0% compared to 106.1% for 2001. The increase was primarily due to increased net adverse loss development for prior accident years. Excluding valuation adjustments and prior accident years' adverse loss development, the combined ratio would have been 99.3% for 2002 and 101.1% for 2001.
In February 2002, California enacted Assembly Bill 749. This new legislation increased benefits paid to injured workers starting January 1, 2003. Increased loss costs, such as benefit increases, are normally built into the rate making process so that premiums are increased to cover the increase in costs. On October 18, 2002, the California Insurance Commissioner approved an increase of 10.5% in pure premium rates for new and renewal policies effective in 2003. In addition, the Commissioner approved a 4.9% increase in pure premium rates for the unexpired terms of policies in force at January 1, 2003. Although we have increased our premiums, there is no assurance that our increase will be sufficient enough to cover the ultimate cost increases or that the estimate of cost increases provided by the Workers' Compensation Insurance Rating Bureau (the organization that accumulates premium and loss data for the State of California for rate making purposes) is accurate. Assembly Bill 749 is effective for claims occurring on and after January 1, 2003. However, due to other statutes, certain temporary total disability claims with dates of injury prior to 2003 will automatically increase to the new benefit levels effective January 1, 2003.
Under our low level reinsurance agreement, we reinsured 30% of the first $10,000 of each claim, 75% of the next $40,000 and 100% of the next $450,000. The maximum net loss retained on any one claim ceded under this agreement was $17,000. This agreement covered all policies in force at July 1, 1998 and continued until June 30, 2000, when we exercised an option to extend coverage to all policies in force as of June 30, 2000. The termination of the low level agreement resulted in our keeping more retained losses and LAE. However, our California premium rates have been increasing, which we believe will largely mitigate the loss of this favorable reinsurance protection. The premium rate increases on policies renewed in California during 2002 and 2001 were approximately 37% and 38%, respectively. For policies effective from July 1, 2000, we obtained excess of loss reinsurance for 100% of the losses above $250,000 and less than $500,000. This agreement terminated on June 30, 2001 and only covered claims with dates of injury occurring by that date. We already had an existing excess of loss reinsurance agreement that covered 100% of the losses above $500,000. The latter reinsurance agreement is a fixed rate multi-year contract that expired December 31, 2002. We executed an option to extend the coverage for all policies in force as of December 31, 2002 until they expire in 2003.
Total Operating Revenues for 2001 increased approximately 8.2% to $1.10 billion from $1.02 billion for 2000.
Military Contract Revenues increased $8.6 million or 2.6%. The increase in revenue is primarily the result of additive change order work and is significantly offset by increased military contract expenses associated with those change orders. The Congressionally approved DoD fiscal year 2001 budget included several sweeping changes to the TRICARE program. In April 2001, SMHS began implementation of a prescription drug program for beneficiaries over age 65 and the implementation of a waiver of co- payments for active duty family members. Both of these program modifications resulted from Congressional changes to the program. Likewise, in October 2001, SMHS implemented TRICARE for Life which is a comprehensive health care benefit to those retired military beneficiaries over age 65. SMHS only administers the expanded benefits to the over age 65 retiree military population.
Medical expenses reported in 2000 included change in estimate charges of $16.5 million for reserve strengthening primarily due to adverse development on prior years' medical claims and $9.5 million of other non- recurring medical costs primarily relating to the write-down of certain medical subsidiary assets.
General and Administrative Expenses, or G&A, increased $10.4 million or 9.3%. As a percentage of revenues, G&A expenses were 11.1% in 2001 compared to 11.0% in 2000. As a percentage of medical premium revenue, G&A expenses were 17.1% for 2001 compared to 17.6% for 2000. G&A expenses now include the expenses associated with administrative services which were previously reported as part of specialty product expenses.
Restructuring and Reorganization. In the second quarter of 2000, we adopted a plan and announced additional restructuring of the Arizona managed health care operations. As a result of this restructuring, we recorded charges in accordance with Emerging Issues Task Force Issue No. 94-3, "Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (Including Certain Costs Incurred in a Restructuring)" of approximately $2.0 million. Of the costs recorded, $1.2 million was for severance, $400,000 was related to clinic closures and lease termination and $400,000 was for other costs.
The remaining other costs of $3.9 million are primarily related to legal claims. Management believes that the remaining reserves as of December 31, 2002 are adequate and that no revisions to the estimates are necessary at this time.
Interest Expense decreased $2.1 million or 11.6%. Interest expense related to the revolving credit facility decreased $13.3 million due to a decrease in the average balance of outstanding debt during the period and a decrease in the weighted average cost of borrowing. Our average revolving credit facility balance was $61 million in 2001 compared to $183 million in 2000. Our average interest rate on the revolving credit facility, excluding the amortization of deferred financing fees and our interest rate swap agreement was 8.1% in 2001 compared to 9.8% in 2000. The decreases were offset by an increase in interest expense of $9.2 million related to the net financing obligations associated with the sale-leaseback transaction and $2.0 million in other interest expense.
Expenses increased in the CII workers' compensation operations by approximately $33.0 million or 21.8%. The increase in expenses is primarily due to the following:
Approximately $32.9 million in additional loss and LAE is related to the increase in net earned premiums in 2001 compared to 2000.
During the second quarter of 2000, we wrote-off capitalized costs of $3.0 million related to the application development of an information system software project, which was canceled because the vendor was unable to fulfill its contractual obligations. The amounts written off included software and consulting costs of $1.6 million and capitalized internal personnel costs of $1.4 million.
A net increase in underwriting expenses, policyholders' dividends and other operating expenses of $5.2 million related primarily to the increase in net earned premiums.
We had cash flows from operating activities for continuing operations of $136.6 million for the year ended December 31, 2002 compared to $98.2 million in 2001. We used the majority of the cash flow for the purchase of investments and for reductions of debt. Overall, discontinued operations used cash of $47.9 million in 2002 compared to $46.0 million in 2001. Excluding cash used to purchase investments, discontinued operations used cash of $700,000 in 2002 compared to $14.1 million in 2001. The improvement in continuing operations over 2001 is primarily attributable to cash from earnings and the change in assets and liabilities.
a source of cash due to the increase in other current liabilities of $14.7 million
a use of cash due to the decrease in military health care payable balance of $12.0 million
a use of cash due to the increase in the military accounts receivable balance of $7.0 million
SMHS receives monthly cash payments equivalent to one-twelfth of its annual contractual price with the Department of Defense, or DoD. SMHS accrues health care revenue on a monthly basis for any monies owed above its monthly cash receipt based on the number of at-risk eligible beneficiaries and the level of military direct care system utilization. The contractual bid price adjustment, or BPA, process serves to adjust the DoD's monthly payments to SMHS, because the payments are based in part on 1996 DoD estimates for beneficiary population and beneficiary population baseline health care cost, inflation and military direct care system utilization. As actual information becomes available for the above items, quarterly adjustments are made to SMHS' monthly health care payment in addition to lump sum adjustments for past months. In addition, SMHS accrues change order revenue for DoD directed contract changes. As a result of preliminary data accumulated from the BPA process in the last quarter of 2002, SMHS will receive an upward adjustment in 2003 of approximately $3.3 million to its monthly DoD payments starting January 2003. Our business and cash flows could be adversely affected if the timing or amount of the BPA and change order reimbursements vary significantly from our expectations.
On November 16, 2001, SMHS entered into a securitization arrangement with General Electric Capital Corporation. The arrangement provides for the assignment of SMHS' Federal Government accounts receivable to SMHS Funding. SMHS Funding is a special purpose limited liability company owned by SMHS and was formed for the purpose of purchasing all receivables of SMHS. This entity is fully consolidated into SMHS. SMHS Funding may assign an undivided interest in certain of the receivables to a subsidiary of General Electric Capital Corporation in the event that additional financing by SMHS is warranted. This securitization arrangement was not utilized in 2002 and we do not anticipate utilizing it in 2003. See Note 2 of the Notes to the Consolidated Financial Statements.
Net cash used from continuing operations for investing activities during 2002 included $12.4 million in capital expenditures associated with the continued implementation of new computer systems, leasehold improvements on facilities and furniture, equipment and other capital purchases to support our growth. This was offset by net proceeds of $680,000 from property and equipment dispositions. The net cash change in investments for the year was an increase in investments of $135.0 million as investments were purchased with available funds.
Cash used in financing activities during 2002 included payments of $30.4 million on debt related items offset by $16.9 million in proceeds received from the sale-leaseback notes and $10.2 million in cash received related to the sale of stock through our employee stock purchase plan and stock option plans. The year 2001 included net proceeds from long-term borrowings (proceeds less payments) of $53.2 million and proceeds of $2.1 million related to the sale of stock through our employee stock purchase plan.
On December 28, 2000, we sold the majority of our Las Vegas, Nevada administrative and medical clinic real estate holdings in a sale-leaseback transaction. As part of the transaction, we financed a portion of the sales price with mortgage notes receivable of $22.2 million and provided deposits of $4.3 million. In accordance with Statement of Financial Accounting Standards No. 98, "Accounting for Leases", or SFAS No. 98, we recorded the transaction as a financing obligation of $113.7 million offset by the mortgage notes receivable of $22.2 million. As of September 30, 2002, we had received the deposits back and full payment of the outstanding mortgage obligations. The payments cured the continuing involvement criteria from SFAS No. 98 and the transaction then qualified as a sale. See Note 4 of the Notes to the Consolidated Financial Statements for a further explanation.
In March 2003, we issued $115.0 million aggregate principal amount of 2¼% senior convertible debentures due March 15, 2023. We used the net proceeds of the offering to repay the $39.0 million outstanding under our existing credit facility and to contribute $35.0 million to SMHS in furtherance of its bid for the TRICARE Next Generation contract. We also used $19.9 million of the proceeds to purchase 1.6 million shares of our common stock under our repurchase program. The remainder of the net proceeds will be used for working capital and general corporate purposes, including, subject to board approval, additional share repurchases.
The debentures are convertible, at the option of the holders, into shares of Sierra Health Services, Inc. common stock at a conversion price of $18.29, upon certain conditions including the sale price of Sierra's common stock exceeding 120% of the conversion price at specified times. The debentures are puttable to us for cash or Sierra common stock, at our election, on March 15 in 2008, 2013 and 2018 and upon certain corporate events including a change in control. The debentures can be called for cash beginning on March 20, 2008.
On March 3, 2003, we entered into a new $65.0 million revolving credit facility which replaces the amended and restated credit facility. The new facility may be increased up to an aggregate amount of $125.0 million upon receipt of new commitments from existing or additional lenders. Interest on the facility is initially LIBOR plus 2.25%. The facility will expire on April 30, 2006 but can be extended, at the sole discretion of each of the lenders, until March 3, 2008. The new facility is available for general corporate purposes.
The new credit facility is secured by guarantees by certain of our subsidiaries and a first priority perfected security interest in (i) all the capital stock of each of our unregulated, material domestic subsidiaries (direct or indirect) as well as all of the capital stock of certain regulated, material domestic subsidiaries and (ii) all other present and future assets and properties of ours and those of our subsidiaries that guarantee our credit agreement obligations (including, without limitation, accounts receivable, inventory, real property, equipment, contracts, trademarks, copyrights, patents, license rights and general intangibles) subject, in each case, to the exclusion of the capital stock of CII Financial, Inc. or any of its subsidiaries and certain other exclusions.
The new revolving credit facility has covenants that restrict our ability and the ability of our subsidiaries to dispose of assets, incur indebtedness, incur other liens, make investments, loans or advances, make acquisitions, engage in mergers or consolidations, or make capital expenditures and otherwise restricts certain corporate activities. In addition, we will be required to comply with specified financial ratios as set forth in the new credit agreement.
At September 30, 2000, CII Financial, Inc., currently part of our discontinued operations, had approximately $47.1 million of subordinated debentures that were due on September 15, 2001. These subordinated debentures were neither assumed nor guaranteed by Sierra and were subordinated to Sierra's credit facility debt. In December 2000, CII Financial commenced an offer to exchange the subordinated debentures for cash and/or new debentures. On May 7, 2001, CII Financial closed its exchange offer on $42.1 million of its outstanding subordinated debentures. CII Financial purchased $27.1 million in principal amount of subordinated debentures for $20.0 million in cash and issued $15.0 million in new 9½% senior debentures, due September 15, 2004, in exchange for $15.0 million in subordinated debentures. The transaction was accounted for as a restructuring of debt; therefore all future cash payments, including interest, related to the debentures will be reductions of the carrying amount of the debentures and no future interest expense will be recognized. Accordingly, the new 9½% senior debentures have a carrying amount of $16.8 million consisting of principal of $14.0 million and $2.8 million in future accrued interest. Since the time of the exchange and as of December 31, 2002, Sierra has purchased $1.0 million in outstanding 9½% senior debentures which are eliminated upon consolidation.
To facilitate the exchange offer, Sierra lent CII Financial $17.0 million, of which $7.5 million was borrowed from California Indemnity Insurance Company, a wholly-owned subsidiary of CII Financial. In addition, California Indemnity received approval from the California Department of Insurance to pay a dividend of $15.0 million to CII Financial. In September 2001, California Indemnity received approval from the California Department of Insurance to pay an additional $5.0 million dividend to CII Financial, which was used to pay the remaining subordinated debentures that matured on September 15, 2001.
On January 7, 2003, we announced that our Board of Directors authorized a program for the repurchase of up to 2.0 million shares of our common stock. On February 25, 2003, we announced that we had repurchased approximately 600,000 shares of our common stock and that our Board of Directors had authorized us to purchase up to an additional 600,000 shares under our share repurchase program. Such purchases have been made from time to time at prevailing prices in the open market, by block purchase or in private transactions. As of March 6, 2003, we had purchased a total of 2.2 million shares for $27.6 million.
Our HMO and insurance subsidiaries are required by state regulatory agencies to maintain certain deposits and must also meet certain net worth and reserve requirements. The HMO and insurance subsidiaries, including the discontinued operations, had restricted assets on deposit in various states totaling $33.2 million at December 31, 2002. The HMO and insurance subsidiaries must also meet requirements to maintain minimum stockholders' equity, on a statutory basis, as well as minimum risk-based capital requirements, which are determined annually. Additionally, in conjunction with the Kaiser-Texas acquisition, TXHC entered into a letter agreement with the Texas Department of Insurance whereby TXHC agreed to maintain a net worth of $20.0 million, on a statutory basis, until certain income levels were achieved. In conjunction with the exit from the Texas HMO health care market, the Texas Department of Insurance approved a plan of withdrawal and TXHC is now required to maintain deposits and net worth of at least $3.5 million. We believe we are in material compliance with our regulatory requirements.
The following schedule represents our obligations and commitments for long-term debt, capital leases and operating leases at December 31, 2002. With the exception of our amended and restated revolving credit facility, the amounts below represent the entire payment, principal and interest, on our outstanding obligations. The outstanding balance of the amended and restated revolving credit facility is $60 million as of December 31, 2002. The amount has been reflected as due in 2006 as the credit facility was refinanced and terminated in conjunction with the issuance of the Sierra Debentures and the new $65 million credit facility on March 3, 2003.
Included in long-term debt payments for discontinued operations is a mortgage loan secured by certain underlying real estate assets of the discontinued operations of $15.0 million and the CII Senior Debentures of $16.8 million. We are actively seeking a buyer for the real estate assets and anticipate selling them by the end of 2003. As the assets are sold, we are required to make reductions on the mortgage note and completely satisfy the obligation once all of the assets have been sold.
We have a 2003 capital budget of $30.9 million and are also limited in the amount of capital expenditures we can make by our new revolving credit facility. The 2003 planned expenditures are primarily for a new medical clinic, the purchase of computer hardware and software, furniture and equipment and other normal capital requirements. Our liquidity needs over the next 12 months will primarily be for the capital items noted above, debt service and funds required to exit the Texas HMO health care market. We believe that our existing working capital, operating cash flow and, if necessary, equipment leasing, divestitures of certain non-core assets and amounts available under our credit facility should be sufficient to fund our capital expenditures and debt service. Additionally, subject to unanticipated cash requirements, we believe that our existing working capital and operating cash flow should enable us to meet our liquidity needs on a long-term basis.
We have a $25.0 million interest-rate swap agreement that allows us to mitigate the risk of interest rate fluctuation on our credit facility. The original intent of the agreement was to keep our interest rate on $25.0 million of the credit facility relatively fixed. In accordance with Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities," we recorded the interest- rate swap agreement at its fair value as of December 31, 2002. The fair value indicated that we would need to pay $645,000 to terminate the swap agreement. If the prime rate were to decrease by 1%, we estimate our maximum increase in annual expense associated with the swap to be approximately $250,000.
In the second quarter of 1997, our Board of Directors authorized a $3.0 million loan from us to our Chief Executive Officer, or CEO. In April 2000, our Board of Directors authorized an additional $2.5 million loan from us to our CEO. In the second quarter of 2001, our Board of Directors approved a loan amendment which extended the maturity of the principal balance along with accrued interest to December 31, 2003. During 2002 and 2001, our CEO made payments of $1.0 million and $898,000, respectively. As of December 31, 2002, the aggregate principal balance outstanding and accrued interest for both instruments was $4.2 million. All amounts borrowed bear interest at a rate equal to the rate at which we could have borrowed funds under our revolving credit facility at the time of the borrowing plus 10 basis points. The amounts outstanding are collateralized by certain of the CEO's assets and rights to compensation from us.
In June 2002, the FASB issued Statement of Financial Accounting Standards No. 146, "Accounting for Costs Associated with Exit or Disposal Activities", or SFAS No. 146. SFAS No. 146 addresses financial accounting and reporting for costs associated with exit or disposal activities and nullifies Emerging Issues Task Force Issue No. 94-3, "Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)". SFAS No. 146 requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred. A fundamental conclusion reached by the FASB in this statement is that an entity's commitment to a plan, by itself, does not create a present obligation to others that meets the definition of a liability. SFAS No. 146 also establishes that fair value is the objective for initial measurement of the liability. The provisions of this statement are effective for exit or disposal activities that are initiated after December 31, 2002, with early adoption encouraged. We did not elect to early adopt SFAS No. 146 nor do we expect the adoption to have a material effect on our consolidated financial position or results of operations.
In December 2002, the FASB issued Statement of Financial Accounting Standards No. 148, "Accounting for Stock-Based Compensation - Transition and Disclosure", or SFAS No. 148. SFAS No. 148 is an amendment of Statement of Financial Accounting Standards No. 123. SFAS No. 148 provides alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, SFAS 148 requires prominent disclosures in interim as well as annual financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported net income. The disclosure requirements of SFAS No. 148 are effective for fiscal years ended after December 15, 2002. We have not yet determined if we will implement the voluntary change to the fair value based method of accounting as allowed under SFAS No. 148 for 2003.
The accompanying consolidated financial statements have been audited by independent certified public accountants, whose audits thereof were made in accordance with auditing standards generally accepted in the United States of America and included a review of internal accounting controls to the extent necessary to design audit procedures aimed at gathering sufficient evidence to provide a reasonable basis for their opinion on the fairness of presentation of the consolidated financial statements taken as a whole.
We have audited the accompanying consolidated balance sheets of Sierra Health Services, Inc. and its subsidiaries (the "Company") as of December 31, 2002 and 2001, and the related consolidated statements of operations, stockholders' equity and cash flows for each of the three years in the period ended December 31, 2002. Our audits also included the financial statement schedules listed in the Index at Item 15 (a)(2). These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits.
2002 2001 ------------ ------------ ASSETS CURRENT ASSETS: Cash and Cash Equivalents........................................ $ 45,778 $ 107,114 Investments...................................................... 182,452 52,498 Accounts Receivable (Less Allowance for Doubtful Accounts: 2002 - $10,626; 2001 - $11,251)................... 11,232 15,334 Military Accounts Receivable (Less Allowance for Doubtful Accounts: 2002 - $0; 2001 - $0)............................. 47,126 40,166 Current Portion of Deferred Tax Asset............................ 50,402 82,277 Prepaid Expenses and Other Current Assets........................ 18,380 26,028 Assets of Discontinued Operations................................ 565,058 533,673 ------------ ------------ Total Current Assets........................................ 920,428 857,090
STOCKHOLDERS' EQUITY: Preferred Stock, $.01 Par Value, 1,000 Shares Authorized; None Issued or Outstanding Common Stock, $.005 Par Value, 60,000 Shares Authorized; Shares Issued: 2002 - 30,953; 2001 - 29,648................. 155 148 Treasury Stock: 2002 - 1,163; 2001 - 1,523 Common Stock Shares.. (17,148) (22,789) Additional Paid-In Capital....................................... 196,711 181,076 Deferred Compensation............................................ (473) (1,058) Accumulated Other Comprehensive Gain (Loss)...................... 381 (5,636) Accumulated Deficit.............................................. (23,061) (55,222) ------------ ------------ TOTAL STOCKHOLDERS' EQUITY........................................... 156,565 96,519 ------------ ------------ TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY........................... $ 1,065,966 $ 1,064,846 ============ ============
2002 2001 2000 ----------- ----------- ----------- OPERATING REVENUES: Medical Premiums............................................ $ 857,741 $ 718,994 $ 637,769 Military Contract Revenues.................................. 373,589 338,918 330,352 Professional Fees........................................... 30,923 28,985 33,102 Investment and Other Revenues............................... 16,382 16,603 18,393 ----------- ----------- ----------- Total.................................................... 1,278,635 1,103,500 1,019,616 ----------- ----------- ----------- OPERATING EXPENSES: Medical Expenses............................................ 712,290 608,757 576,738 Military Contract Expenses.................................. 360,375 331,621 323,265 General and Administrative Expenses......................... 133,979 122,623 112,220 Asset Impairment, Restructuring, Reorganization and Other Costs......................... -- -- 30,836 ----------- ----------- ----------- Total.................................................... 1,206,644 1,063,001 1,043,059 ----------- ----------- ----------- OPERATING INCOME (LOSS) FROM CONTINUING OPERATIONS............................................. 71,991 40,499 (23,443) Interest Expense............................................ (7,487) (15,786) (17,865) Other Income (Expense), Net................................. (108) (2,071) 1,084 ----------- ----------- ----------- INCOME (LOSS) FROM CONTINUING OPERATIONS BEFORE INCOME TAXES.................................... 64,396 22,642 (40,224) (PROVISION) BENEFIT FOR INCOME TAXES........................ (22,088) (7,161) 9,205 ----------- ----------- ----------- INCOME (LOSS) FROM CONTINUING OPERATIONS.................... 42,308 15,481 (31,019) LOSS FROM DISCONTINUED OPERATIONS (net of income tax benefit of $2,945, $5,403 and $65,020)................ (5,860) (11,995) (168,896) ----------- ----------- ----------- NET INCOME (LOSS)........................................... $ 36,448 $ 3,486 $ (199,915) =========== =========== =========== EARNINGS PER COMMON SHARE: Income (Loss) From Continuing Operations................ $ 1.47 $ 0.56 $ (1.15) Loss from Discontinued Operations....................... (0.20) (0.43) (6.22) ----------- ----------- ----------- Net Income (Loss)....................................... $ 1.27 $ 0.13 $ (7.37) =========== =========== =========== EARNINGS PER COMMON SHARE ASSUMING DILUTION: Income (Loss) From Continuing Operations................ $ 1.36 $ 0.54 $ (1.15) Loss from Discontinued Operations....................... (0.19) (0.42) (6.22) ----------- ----------- ----------- Net Income (Loss)....................................... $ 1.17 $ 0.12 $ (7.37) =========== =========== ===========
Accumulated Retained Total Common Stock In Treasury Additional Deferred Other Earnings Stock- --------------------- ------------------- Paid-In Compensa- Comprehensive(Accumulated holders' Shares Amount Shares Amount Capital tion Gain (Loss) Deficit) Equity ---------- --------- --------- -------- ----------- ---------- ----------- ----------- ----------- BALANCE, JANUARY 1, 2000..................... 28,400 $ 142 1,523 $(22,789) $ 175,915 $ -- $ (16,063) $ 141,207 $ 278,412 Common Stock Issued in Connection with Stock Plans........................ 415 2 -- -- 1,578 -- -- -- 1,580 Comprehensive Income: Net Loss.................................. -- -- -- -- -- -- -- (199,915) (199,915) Other Comprehensive Loss: Unrealized Holding Gain on Available- for-Sale Investments ($17,065 pretax). -- -- -- -- -- -- 11,092 -- 11,092 Reclassification Adjustment for Gains Included in Net Income ($1,071 pretax) -- -- -- -- -- -- (696) -- (696) ----------- ----------- ----------- Total Comprehensive Income (Loss)............ -- -- -- -- -- -- 10,396 (199,915) (189,519) ---------- --------- --------- -------- ----------- ---------- ----------- ----------- ----------- BALANCE, DECEMBER 31, 2000................... 28,815 144 1,523 (22,789) 177,493 -- (5,667) (58,708) 90,473
Common Stock Issued in Connection with Stock Plans........................ 589 3 -- -- 2,087 -- -- -- 2,090 Income Tax Benefit Realized Upon Exercise of Stock Options............... -- -- -- -- 97 -- -- -- 97 Issuance of Restricted Stock................. 244 1 -- -- 1,399 (1,400) -- -- -- Amortization of Deferred Compensation........ -- -- -- -- -- 342 -- -- 342 Comprehensive Income: Net Income................................ -- -- -- -- -- -- -- 3,486 3,486 Other Comprehensive Income: Unrealized Holding Gain on Available- for-Sale Investments ($374 pretax).... -- -- -- -- -- -- 243 -- 243 Reclassification Adjustment for Gains Included in Net Income ($326 pretax).. -- -- -- -- -- -- (212) -- (212) ----------- ----------- ----------- Total Comprehensive Income................... -- -- -- -- -- -- 31 3,486 3,517 ---------- --------- --------- -------- ----------- ---------- ----------- ----------- ----------- BALANCE, DECEMBER 31, 2001................... 29,648 148 1,523 (22,789) 181,076 (1,058) (5,636) (55,222) 96,519
Common Stock Issued in Connection with Stock Plans........................ 1,305 7 (360) 5,641 8,798 -- -- (4,287) 10,159 Income Tax Benefit Realized Upon Exercise of Stock Options............... -- -- -- -- 6,837 -- -- -- 6,837 Amortization of Deferred Compensation........ -- -- -- -- -- 585 -- -- 585 Comprehensive Income: Net Income................................ -- -- -- -- -- -- -- 36,448 36,448 Other Comprehensive Income: Unrealized Holding Gain on Available- for-Sale Investments ($10,671 pretax). -- -- -- -- -- -- 6,936 -- 6,936 Reclassification Adjustment for Losses Included in Net Income ($217 pretax).. -- -- -- -- -- -- 141 -- 141 Minimum Pension Liability Adjustment ($1,630 pretax)............ -- -- -- -- -- -- (1,060) -- (1,060) ----------- ----------- ----------- Total Comprehensive Income................... -- -- -- -- -- -- 6,017 36,448 42,465 ---------- --------- --------- -------- ----------- ---------- ----------- ----------- ----------- BALANCE, DECEMBER 31, 2002................... 30,953 $ 155 1,163 $(17,148) $ 196,711 $ (473) $ 381 $ (23,061) $ 156,565 ========== ========= ========= ======== =========== ========== =========== =========== ===========
Principles of Consolidation. All significant intercompany transactions and balances have been eliminated in consolidation. Sierra's consolidated subsidiaries include: Health Plan of Nevada, Inc. ("HPN") and Texas Health Choice, L.C. ("TXHC"), which are licensed HMOs; Sierra Health and Life Insurance Company, Inc. ("SHL"), a health and life insurance company; Southwest Medical Associates, Inc. ("SMA"), a multi-specialty medical provider group; Sierra Military Health Services, Inc., and its subsidiary, ("SMHS"), a company that provides and administers managed care services to certain TRICARE eligible beneficiaries; CII Financial, Inc. ("CII"), a holding company primarily engaged in writing workers' compensation insurance through its wholly-owned subsidiaries; administrative services companies; a home health care agency; a hospice; a home medical products subsidiary; and a company that provides and manages mental health and substance abuse services. CII and TXHC have been reported as part of the discontinued operations.
Medical Premiums. Membership contracts are generally established on an annual basis subject to cancellation by the employer group or Sierra generally upon 60 days written notice. Premiums, including premiums from both commercial and governmental programs, are due monthly and are recognized as revenue during the period in which members are entitled to receive services and are net of estimated retroactive adjustments of members and groups. Non-Medicare member enrollment is represented principally by employer groups. HPN offers a prepaid health care program to Medicare recipients. Revenues associated with Medicare recipients were approximately $340.1 million, $304.7 million and $267.9 million in 2002, 2001 and 2000, respectively. Premiums collected in advance are recorded as unearned premium revenue and can include payments under prepaid Medicare contracts with the Centers for Medicare and Medicaid Services ("CMS") and prepaid HPN commercial and SHL preferred provider organization premiums.
Military Contract Revenues. Revenue under the Department of Defense TRICARE contract is recorded based on the contract price as agreed to by the federal government. The contract also contains provisions which adjust the contract price based on actual experience and for government-directed change orders. The estimated effects of these adjustments are recognized on a monthly basis once the amount is reasonably known. In addition, the Company records revenue based on estimates of the earned portion of any contract change orders not originally specified in the contract. Enrollment fees collected in advance of the service period are recorded as unearned premium revenue.
Medical Expenses. Health care expenses are recorded in the period when services are provided to enrolled members, including estimates for provider costs which have been incurred as of the balance sheet date but not yet reported to the Company. The Company uses a variety of standard actuarial projection methods to make these estimates and must use judgment in selecting development factors and assumed trends. In making projections, the Company considers medical cost utilization and trends, changes in internal processes, the average interval between the date services are rendered and the date claims are received and/or paid, denied claims activity, disputed claims activity, seasonality patterns and changes in membership. Assumptions could be affected by the timing of the receipt of claims, the timing of processing claims and unanticipated changes, such as adverse legal outcomes, legislative or regulatory changes, new interpretations of existing laws or regulations or disputed contract provisions that result in the Company's having to provide new or extended benefits and changes in the Company's health care delivery system or costs. The Company believes that the recorded liability for medical claims payable, at December 31, 2002, is reasonable and adequate to cover future health care claim payments. Any subsequent changes in an estimate for a prior year would be reflected in the current year's operating results.
Military Contract Expenses. This expense consists primarily of costs to provide managed health care services to eligible beneficiaries in accordance with the Company's TRICARE contract. Under the contract, SMHS provides health care services to approximately 678,000 dependents of active duty military personnel, military retirees under the age of 65 and dependents of military retirees through a network of approximately 55,000 health care providers and certain other subcontractor partnerships. Health care costs are recorded in the period when services are provided to eligible beneficiaries including estimates for provider costs which have been incurred as of the balance sheet date but not reported to the Company. Also included in military contract expenses are costs incurred to perform specific administrative services, such as health care appointment scheduling, enrollment, network management and health care advice line services and other administrative functions of the military health care subsidiary. These administrative services are performed for active duty personnel and dependants as well as retired military families.
As of and for the year ended December 31, 2002, SMHS has not utilized the facility and is currently incurring an unused facility fee of 0.5% per annum calculated daily and payable monthly in arrears on the unused portion of the maximum purchase limit of $32 million.
The Company is covered under medical reinsurance agreements that provide coverage for 50% - 90% of hospital and other costs in excess of $300,000 per case, up to a maximum of $2.0 million per member per lifetime for both the managed indemnity and HMO subsidiaries.
Certain of the Company's HMO members are covered by an excess catastrophe reinsurance contract and SHL maintains reinsurance on certain of its insurance products. Reinsurance premiums of $2.3 million, $1.7 million and $2.4 million, net of reinsurance recoveries of $1.3 million, $1.8 million and $1.9 million, are included in medical expenses for 2002, 2001 and 2000, respectively.
See Note 9 for a discussion of the workers' compensation insurance operations' reinsurance.
Goodwill. Goodwill has been recorded as a result of various business acquisitions by the Company. On January 1, 2002, the Company adopted Statement of Financial Accounting Standards No. 142, "Goodwill and Other Intangible Assets" ("SFAS No. 142"). SFAS No. 142 required, among other things, the discontinuance of goodwill amortization and the Company to complete a transitional goodwill impairment test six months from the date of adoption and at least annually thereafter. The Company has completed its transitional goodwill test and determined that the recorded goodwill was not impaired under the guidelines of the pronouncement. This test involved the use of estimates related to the fair value of the business with which the goodwill is allocated. The goodwill balance at December 31, 2002, was $14.8 million, all of which is part of the managed care and corporate operations segment. Amortization expense, from continuing operations, associated with goodwill was $805,000, and $1.1 million for the years ended December 31, 2001 and 2000, respectively. See Note 18 for a pro forma table presenting the results of operations as though SFAS No. 142 occurred as of January 1, 2000.
Years ended December 31 ------------------------------- 2002 2001 2000 --------- --------- --------- (In thousands, except per share data) Net income (loss), as reported......................... $ 36,448 $ 3,486 $(199,915) Less: total stock-based employee compensation expense determined under fair value based methods for all awards, net of tax.................. (4,598) (3,506) (3,378) ---------- ---------- ---------- Pro forma net income (loss)............................ $ 31,850 $ (20) $(203,293) ========== ========== ==========
Net income (loss) per share, as reported............... $ 1.27 $ 0.13 $ (7.37) Pro forma net income (loss)............................ 1.11 -- (7.49)
Net income (loss) per share assuming dilution, as reported..................... $ 1.17 $ 0.12 $ (7.37) Pro forma net income (loss)............................ 1.02 -- (7.49)
Due to the fact that the Company's stock option programs vest over many years and additional awards are made each year, the above pro forma numbers are not indicative of the financial impact had the disclosure provisions of Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation" been applicable to all the years of previous option grants. The above numbers do not include the effect of options granted prior to 1995. See Note 13 for a discussion of the assumptions used in the option pricing model and estimated fair value of employee stock options.
Recently Issued Accounting Standards. 	In November 2002, the FASB issued Interpretation No. 45, "Guarantor's Accounting and Disclosure Requirements for Guarantees" ("FIN 45"). FIN 45 requires a guarantor to recognize, at the inception of a guarantee, a liability for the fair value of the obligation it has undertaken in issuing the guarantee. The Company will apply FIN 45 to guarantees, if any, issued after December 31, 2002. The Company does not expect the adoption of FIN 45 to have a material effect on our consolidated financial position or results of operations.
In April 2002, the FASB issued Statement of Financial Accounting Standards No. 145, "Recission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections" ("SFAS No. 145"). SFAS No. 145 requires that gains and losses from extinguishment of debt be classified as extraordinary items only if they meet the criteria in Accounting Principles Board Opinion No. 30 ("Opinion No. 30"). Applying the provisions of Opinion No. 30 will distinguish transactions that are part of an entity's recurring operations from those that are unusual and infrequent that meet the criteria for classification as an extraordinary item. SFAS No. 145 is effective for the Company beginning January 1, 2003. The Company does not expect the adoption of SFAS No. 145 to have a material effect on our consolidated financial position or results of operations.
In June 2002, the FASB issued Statement of Financial Accounting Standards No. 146, "Accounting for Costs Associated with Exit or Disposal Activities" ("SFAS No. 146"). SFAS No. 146 addresses financial accounting and reporting for costs associated with exit or disposal activities and nullifies Emerging Issues Task Force Issue No. 94-3, "Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)". SFAS No. 146 requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred. A fundamental conclusion reached by the FASB in this statement is that an entity's commitment to a plan, by itself, does not create a present obligation to others that meets the definition of a liability. SFAS No. 146 also establishes that fair value is the objective for initial measurement of the liability. The provisions of this statement are effective for exit or disposal activities that are initiated after December 31, 2002, with early adoption encouraged. The Company did not elect to early adopt SFAS No. 146 nor does it expect the adoption to have a material effect on its consolidated financial position or results of operations.
Reclassifications. Certain amounts in the Consolidated Financial Statements as of and for the years ended December 31, 2001 and 2000 have been reclassified to conform with the current year presentation. The reclassifications have no effect on net income or stockholders' equity as previously reported.
Years ended December 31, ---------------------------------- 2002 2001 2000 ---------- ---------- ---------- (In thousands, except per share data)
Weighted average common shares outstanding... 28,756 27,685 27,142 Dilutive options outstanding................. 2,141 787 -- Restricted Shares outstanding................ 244 37 -- Weighted average common shares outstanding ---------- ---------- ---------- assuming dilution................... 31,141 28,509 27,142 ========== ========== ==========
Stock options to purchase 325,000 shares in 2002 and 1,591,000 shares in 2001 were not dilutive and, therefore, were not included in the computations of diluted earnings per share. Stock options to purchase 4,250,000 shares of common stock were outstanding at December 31, 2000, but were not included in the computation of diluted earnings per share because the Company had a net operating loss for the year and their inclusion would have been anti-dilutive.
The Company capitalizes interest expense as part of the cost of construction of facilities and the implementation of computer systems. Interest expense capitalized in 2002, 2001 and 2000 was $50,000, $29,000, and $67,000, respectively. Depreciation expense, from continuing operations, in 2002, 2001 and 2000 was $18.2 million, $23.4 million and $23.0 million, respectively.
Investments that the Company has the intention and ability to hold to maturity are stated at amortized cost and categorized as held-to- maturity. All of the held-to-maturity investments are part of the discontinued workers' compensation operations. The remaining investments have been categorized as available-for-sale and are stated at their fair value. Fair value is estimated primarily from published market values as of the balance sheet date. Gross realized gains on investments, from continuing operations, for 2002, 2001 and 2000 were $82,000, $27,000 and $44,000, respectively. Gross realized losses on investments, from continuing operations, for 2002, 2001 and 2000 were $84,000, $92,000 and $497,000, respectively.
Amortized Unrealized Unrealized Fair Cost Gains Losses Value ---------- ---------- ---------- ---------- (In thousands) Available-for-Sale Investments: Classified as Current: U.S. Government and its Agencies........................... $ 35,338 $ 747 $ 19 $ 36,066 Municipal Obligations...................................... 87,701 21 83 87,639 Corporate Bonds............................................ 54,845 4 -- 54,849 Other Debt Securities...................................... 1,161 4 -- 1,165 ---------- ---------- ---------- ---------- Total Debt Securities................................... 179,045 776 102 179,719 Preferred Stock............................................ 2,754 20 41 2,733 ---------- ---------- ---------- ---------- Total Current................................................. 181,799 796 143 182,452 ---------- ---------- ---------- ---------- Classified as Restricted: U.S. Government and its Agencies........................... 8,785 208 -- 8,993 Municipal Obligations...................................... 1,397 43 10 1,430 Other Debt Securities...................................... 7,134 -- -- 7,134 ---------- ---------- ---------- ---------- Total Restricted.............................................. 17,316 251 10 17,557 ---------- ---------- ---------- ---------- Total Available-for-Sale............................. $ 199,115 $ 1,047 $ 153 $ 200,009 ========== ========== ========== ==========
The following table summarizes the Company's current and restricted investments, from continuing operations, as of December 31, 2001:
Gross Gross Amortized Unrealized Unrealized Fair Cost Gains Losses Value ---------- ---------- ---------- ---------- (In thousands) Available-for-Sale Investments: Classified as Current: U.S. Government and its Agencies........................... $ 36,093 $ -- $ 1,277 $ 34,816 Municipal Obligations...................................... 14,188 -- 341 13,847 Other Debt Securities...................................... 851 -- -- 851 ---------- ---------- ---------- ---------- Total Debt Securities................................... 51,132 -- 1,618 49,514 Preferred Stock............................................ 3,013 -- 29 2,984 ---------- ---------- ---------- ---------- Total Current................................................. 54,145 -- 1,647 52,498 ---------- ---------- ---------- ---------- Classified as Restricted: U.S. Government and its Agencies........................... 6,532 90 317 6,305 Municipal Obligations...................................... 1,348 39 -- 1,387 Other...................................................... 2,029 -- -- 2,029 ---------- ---------- ---------- ---------- Total Restricted.............................................. 9,909 129 317 9,721 ---------- ---------- ---------- ---------- Total Available-for-Sale............................. $ 64,054 $ 129 $ 1,964 $ 62,219 ========== ========== ========== ==========
Amortized Fair Cost Value ---------- ---------- (In thousands) Due in one year of less........................................ $ 88,842 $ 88,877 Due after one year through five years.......................... 55,212 55,719 Due after five years through ten years......................... 16,736 16,688 Due after ten years through fifteen years...................... 6,700 6,702 Due after fifteen years........................................ 28,871 29,290 ---------- ---------- Total...................................................... $ 196,361 $ 197,276 ========== ==========
Of the cash and cash equivalents and current investments that total $228.2 million in the accompanying Consolidated Balance Sheet at December 31, 2002, $168.6 million is limited for use only by the Company's regulated subsidiaries. Such amounts are available for transfer to Sierra from the regulated subsidiaries only to the extent that they can be remitted in accordance with terms of existing management agreements and by dividends, which customarily must be approved by regulating state insurance departments. The remainder is available to Sierra on an unrestricted basis.
Revolving Credit Facility. On October 31, 1998, the Company replaced its prior line of credit with a $200 million credit facility. As a result of the asset impairment and other changes in estimate charges, the Company was not in compliance with its financial covenants at June 30, 2000. On December 15, 2000, the Company entered into an amended and restated credit agreement, which was set to mature on September 30, 2003. The Company believes it complied with all covenants of the amended agreement. The amended and restated agreement was subsequently amended in April 2001 to allow for the completion of the CII debenture exchange offer and in October 2001 to provide a limited waiver for covenants affected by exiting the Texas HMO health care market. The amended and restated agreement was further amended in July and December 2002. The 2002 amendments allowed for CII to be classified as a discontinued operation and for a potential sale of CII and provided a limited waiver of covenants impacted by those actions. In addition, the 2002 amendments permitted the Company to purchase CII Debentures and Sierra common stock under certain circumstances. The amended and restated credit facility was terminated on March 3, 2003, and replaced by a new $65 million revolving credit facility. See Note 19 for a description of the new $65 million revolving credit facility.
The maximum availability under the amended and restated credit agreement was reduced to $95 million from $117 million at the end of 2001 due to required reductions in the agreement. At December 31, 2002, the Company had $35 million available under the agreement.
The Company is not allowed to pay or declare any cash dividends on Sierra common stock under the terms of the amended and restated credit agreement. The Company has not paid or declared any cash dividends since inception. The Company anticipates that future earnings will be retained for our current operations; therefore, it does not plan to pay or declare any dividends on Sierra common stock in the foreseeable future.
Interest under the amended and restated credit agreement was variable and based on the Bank of America "prime rate" adjusted for a margin. The rate was 3.875% at December 31, 2002, which is a combination of the prime rate of 4.25% less a credit of .375%. Of the outstanding balance, $25 million is covered by an interest-rate swap agreement. To mitigate the risk of interest rate fluctuation on the credit facility, the Company entered into a five-year $50 million interest-rate swap agreement during the fourth quarter of 1998. The intent of the agreement was to keep the Company's interest rate on $50 million of the borrowing relatively fixed. In the fourth quarter of 2000, $25 million of the swap agreement was terminated. The interest rate swap is a derivative as described in SFAS No. 133 and the Company recorded a liability for the interest-rate swap agreement at its fair value of $645,000 as of December 31, 2002, compared to an indicated fair value of $685,000 at December 31, 2001. Previously, the fair value of the asset or liability related to the swap was immaterial. The fair value is the cost that the Company would need to pay to terminate the swap agreement as of December 31, 2002.
The average cost of borrowing on the amended and restated credit facility for 2002, including the amortization of deferred financing fees and the impact of the swap agreement, was 7.4%.
Obligations Notes Under Capital Payable Leases ---------- ---------- (In thousands) Years ending December 31, 2003....................................................... $ 93 $ 121 2004....................................................... 31 83 2005 ...................................................... 32 31 2006....................................................... 60,033 31 2007....................................................... 34 31 Thereafter................................................. 362 153 ---------- ---------- Total................................................... $ 60,585 450 ========== Less: Amounts Representing Interest....................... (139) ---------- Present Value of Minimum Lease Payments.................... $ 311 ==========
The fair value of long-term debt, including the current portion, is estimated to be approximately $60.9 million based on the borrowing rates currently available to the Company.
2002 2001 2000 ---------- ---------- ---------- (In thousands) Provision (Benefit) for Income Taxes: Current..................................................... $ (11,498) $ (2,763) $ (1,656) Deferred.................................................... 33,586 9,924 (7,549) ---------- ---------- ---------- Total..................................................... $ 22,088 $ 7,161 $ (9,205) ========== ========== ==========
The tax effects of significant items comprising the Company's total net deferred tax assets, including discontinued operations, are as follows at December 31:
At December 31, 2002, the Company had approximately $75.9 million of regular tax net operating loss carryforwards. The net operating loss carryforwards can be used to reduce future taxable income until they expire through the year 2020. In addition to the net operating loss carryforwards, the Company has alternative minimum tax credits of approximately $848,000, which can be used to reduce regular tax liabilities in future years. There is no expiration date for the alternative minimum tax credits.
Current tax receivables, including discontinued operations, total $2.3 million at December 31, 2002 and 2001.
The following are condensed statements of operations of the discontinued Texas HMO health care operations:
Years ended December 31, ---------------------------------- 2002 2001 2000 ---------- ---------- ---------- (In thousands) Operating Revenues........................................... $ 4,791 $ 181,132 $ 233,398 ---------- ---------- ----------
Medical Expenses............................................. (8,933) 175,333 233,652 General and Administrative Expenses......................... 1,906 29,607 31,346 Asset Impairment, Restructuring, Reorganization and Other Costs............................ 5,000 (1,250) 186,604 Interest Expense and Other, Net.............................. (6,216) (1,532) 4,268 ---------- ---------- ---------- Income (Loss) from Discontinued Operations Before Income Tax. 13,034 (21,026) (222,472) Income Tax (Provision) Benefit............................... (4,562) 7,046 61,350 ---------- ---------- ---------- Income (Loss) from Discontinued Operations................... $ 8,472 $ (13,980) $ (161,122) ========== ========== ==========
All of the discontinued Texas HMO health care operations had previously been a component of the "managed care and corporate operations" segment.
As part of the Company's continual evaluation of its remaining liabilities, it was determined during the second quarter of 2002, that the medical claims run out had been favorable compared with the Company's original projection and that legal and other costs were estimated to be higher than originally anticipated. As a result, during the second quarter, the Company reduced its medical claims payable and medical expenses by $5.0 million and increased its estimate of legal, restitution and other exit related costs by $5.0 million. During the third and fourth quarters, the Company continued to have favorable development in both medical claims and legal, restitution and other exit related costs. As a result, the Company reduced its estimate for medical claims payable by $4.8 million and for legal, restitution and other exit related costs by $4.2 million. The adjustments resulted in income, net of tax, from discontinued operations of $5.9 million. See also the discussion below for a description of the $2.6 million gain, net of tax, related to the Kaiser- Texas mortgage loan and sale of Texas real estate properties.
Restructuring Asset and Premium Impair- Reorgan- Deficiency ment ization Maintenance Other Total ----------- ---------------- ------------- --------- --------- (In thousands) Balance, January 1, 2000...... $ -- $ -- $ 11,000 $ -- $ 11,000 Charges recorded.............. 162,937 11,509 10,358 1,800 186,604 Cash used..................... (7,754) (12,080) (200) (20,034) Noncash activity.............. (162,937) -- -- (800) (163,737) Changes in estimate........... -- -- -- -- -- ----------- ---------------- ------------- --------- --------- Balance, December 31, 2000.... -- 3,755 9,278 800 13,833 Charges recorded.............. 1,600 4,380 570 -- 6,550 Cash used..................... -- (3,716) (1,478) (800) (5,994) Noncash activity.............. (1,600) (125) -- -- (1,725) Changes in estimate........... -- -- (7,800) -- (7,800) ----------- ---------------- ------------- --------- --------- Balance, December 31, 2001.... -- 4,294 570 -- 4,864 Charges recorded.............. -- -- -- -- -- Cash used..................... -- (2,490) (570) -- (3,060) Noncash activity.............. -- (4,222) -- -- (4,222) Changes in estimate........... -- 5,000 -- -- 5,000 ----------- ---------------- ------------- --------- --------- Balance, December 31, 2002.... $ -- $ 2,582 $ -- $ -- $ 2,582 =========== ================ ============= ========= =========
The remaining restructuring and reorganization costs of $2.6 million are primarily due to legal and related costs and various lease and other exit related costs. Management believes that the remaining reserves, as of December 31, 2002, are appropriate and that no further revisions to the estimates are necessary at this time. Based on the current estimated Texas HMO health care run-out costs and recorded reserves, the Company believes it has adequate funds available and the ability to fund the anticipated obligations.
The following are the assets and liabilities of the discontinued Texas HMO health care operations:
The assets and liabilities above do not include an intercompany liability of $38.4 million from Texas Health Choice, L.C., ("TXHC") to Sierra at December 31, 2002. The liability is secured by certain of the TXHC land and buildings and has been eliminated upon consolidation.
In accordance with accounting principles generally accepted in the United States of America, the agreement was accounted for as a restructuring of debt. In the transaction, total future cash payments (interest and principal) were less than the balance of the mortgage loan at the time of the agreement. Accordingly, a gain on restructuring was recognized for the difference and the carrying amount of the mortgage loan is equal to the total future cash payments. Costs incurred in connection with the agreement were offset against the gain on restructuring. Effective January 1, 2002, all future cash payments, including interest, related to the mortgage loan are reductions of the carrying amount; therefore, no future interest expense will be recognized.
December 31, ------------------------- 2002 2001 ----------- ------------ (In thousands) ASSETS Cash and Cash Equivalents.................................. $ 23,060 $ 8,641 Investments................................................ 287,242 231,987 Reinsurance Recoverable.................................... 189,409 218,079 Property and Equipment, Net................................ 2,167 4,955 Other Assets............................................... 46,034 41,607 ----------- ------------ TOTAL ASSETS............................................... 547,912 505,269 ---------- ------------
LIABILITIES Accounts Payable and Other Accrued Expenses................ 30,989 28,919 Senior Debentures.......................................... 16,765 18,187 Reserve for Loss and Loss Adjustment Expenses.............. 427,192 385,705 ----------- ------------ TOTAL LIABILITIES.......................................... 474,946 432,811 ----------- ------------ NET ASSETS OF DISCONTINUED OPERATIONS...................... $ 72,966 $ 72,458 =========== ============
Years ended December 31, ------------------------------- 2002 2001 2000 --------- --------- --------- OPERATING REVENUES: (In thousands) Specialty Product Revenues............................. $ 176,189 $ 173,215 $ 125,555 Investment and Other Revenues.......................... 12,633 14,786 14,409 --------- --------- --------- Total Revenues..................................... 188,822 188,001 139,964 --------- --------- ---------
(Loss) Income from Discontinued Operations Before Income Tax .................................. (21,838) 3,628 (11,444)
2002 2001 ---------- ---------- (In thousands) Land......................................... $ 116 $ 116 Buildings and Improvements................... 1,522 2,350 Furniture, Fixtures and Equipment............ 70 2,620 Data Processing Equipment and Software....... 3,534 5,345 Software in Development and Construction in Progress............................... 45 93 Less: Accumulated Depreciation............... (3,120) (5,569) ---------- ---------- Property and Equipment, Net.............. $ 2,167 $ 4,955 ========== ==========
Amortized Unrealized Unrealized Fair Cost Gains Losses Value ---------- ---------- ---------- ---------- Available-for-Sale Investments: (In thousands) Classified as Current: U.S. Government and its Agencies........................... $ 164,404 $ 2,729 $ 423 $ 166,710 Municipal Obligations...................................... 65,454 338 501 65,291 Corporate Bonds............................................ 19,830 49 1,919 17,960 Other...................................................... 10,987 46 25 11,008 ---------- ---------- ---------- ---------- Total Debt Securities................................... 260,675 3,162 2,868 260,969 Preferred Stock............................................ 5,939 210 22 6,127 ---------- ---------- ---------- ---------- Total Current................................................. 266,614 3,372 2,890 267,096 ---------- ---------- ---------- ---------- Classified as Restricted: U.S. Government and its Agencies........................... 12,489 711 13,200 Municipal Obligations...................................... 974 62 1,036 Corporate Bonds............................................ 756 5 761 ---------- ---------- ---------- ---------- Total Restricted.............................................. 14,219 778 -- 14,997 ---------- ---------- ---------- ---------- Total Available-for-Sale............................. $ 280,833 $ 4,150 $ 2,890 $ 282,093 ========== ========== ========== ==========
Held-to-Maturity Investments: Classified as Current: Corporate Bonds............................................. $ 799 $ 3 $ $ 802 ---------- ---------- ---------- ---------- Classified as Long-term: U.S. Government and its Agencies........................... 662 10 672 Municipal Obligations...................................... 328 25 353 Corporate Bonds............................................ 1,749 113 1,862 ---------- ---------- ---------- ---------- Total Long-term................................................ 2,739 148 -- 2,887 ---------- ---------- ---------- ---------- Classified as Restricted: Municipal Obligations...................................... 637 49 686 Corporate Bonds............................................ 974 39 1,013 ---------- ---------- ---------- ---------- Total Restricted............................................... 1,611 88 -- 1,699 ---------- ---------- ---------- ---------- Total Held-to-Maturity............................... $ 5,149 $ 239 $ -- $ 5,388 ========== ========== ========== ==========
Gross Gross Amortized Unrealized Unrealized Fair Cost Gains Losses Value ---------- ---------- ---------- ---------- (In thousands) Available-for-Sale Investments: Classified as Current: U.S. Government and its Agencies........................... $ 174,856 $ 1,129 $ 6,214 $ 169,771 Municipal Obligations...................................... 2,087 30 53 2,064 Corporate Bonds............................................ 28,572 81 2,051 26,602 ---------- ---------- ---------- ---------- Total Debt Securities................................... 205,515 1,240 8,318 198,437 Preferred Stock............................................ 5,871 34 21 5,884 ---------- ---------- ---------- ---------- Total Current................................................. 211,386 1,274 8,339 204,321 ---------- ---------- ---------- ---------- Classified as Restricted: U.S. Government and its Agencies........................... 11,145 262 57 11,350 Municipal Obligations...................................... 977 12 12 977 Corporate Bonds............................................ 1,495 35 1,530 ---------- ---------- ---------- ---------- Total Restricted.............................................. 13,617 309 69 13,857 ---------- ---------- ---------- ---------- Total Available-for-Sale............................. $ 225,003 $ 1,583 $ 8,408 $ 218,178 ========== ========== ========== ==========
The contractual maturities of available-for-sale debt securities at December 31, 2002 are shown below:
Amortized Fair Cost Value ---------- ---------- (In thousands) Due in one year or less........................................ $ 56,532 $ 56,835 Due after one year through five years.......................... 56,321 57,103 Due after five years through ten years......................... 32,216 32,682 Due after ten years through fifteen years...................... 15,061 15,595 Due after fifteen years........................................ 114,764 113,751 ---------- ---------- Total..................................................... $ 274,894 $ 275,966 ========== ==========
Amortized Fair Cost Value ---------- ---------- (In thousands) Due in one year or less........................................ $ 1,274 $ 1,277 Due after one year through five years.......................... 2,248 2,400 Due after five years through ten years......................... Due after ten years through fifteen years...................... Due after fifteen years........................................ 1,627 1,711 ---------- ---------- Total..................................................... $ 5,149 $ 5,388 ========== ==========
Expected maturities may differ from contractual maturities because borrowers have the right to call or prepay obligations.
In addition to the low level reinsurance, effective January 1, 2000, CII entered into a reinsurance contract that provided statutory (unlimited) coverage for workers' compensation claims in excess of $500,000 per occurrence. The contract is in effect for claims occurring on or after January 1, 2000 through December 31, 2002. There is a twelve month run out provision in the contract which the Company exercised. The reinsurer, National Union Fire Insurance Company, is rated AAA and A++ by Fitch Ratings and the A.M. Best Company, respectively.
The low level reinsurance agreement was consummated early in the fourth quarter of 1998 but coverage was made retroactive to July 1, 1998. Therefore, this agreement contained both retroactive (covering claims occurring in the third calendar quarter of 1998) and prospective reinsurance coverage (covering claims occurring after September 30, 1998). In accordance with Statement of Financial Accounting Standards No. 113, "Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts" ("SFAS No. 113"), CII bifurcated the low level reinsurance agreement between the retroactive and prospective components due to the different accounting treatments for each respective piece. The amount by which the estimated ceded liabilities exceeded the amount paid for the retroactive coverage was reported as a deferred gain and is amortized to income as a reduction of incurred losses over the estimated remaining settlement period using the interest method. Any subsequent changes in estimated or actual cash flows related to the retroactive coverage are accounted for by adjusting the previously recorded deferred gain to the balance that would have existed had the revised estimate been available at the inception of the reinsurance transactions, with a corresponding charge or credit to income. CII recorded an adjustment to increase its deferred gain related to retroactive reinsurance coverage by $1.2 million, $3.0 million and $3.7 million in 2002, 2001 and 2000, respectively. For the years ended December 31, 2002, 2001 and 2000, CII amortized deferred gains of $1.9 million, $2.7 million and $5.2 million, respectively. Such amortization is included as a credit to specialty product expense on the accompanying condensed consolidated statements of operations.
The following table provides workers' compensation prospective reinsurance information for the three years ended December 31, 2002:
Losses and Loss Adjustment Expenses. The following table provides a reconciliation of the beginning and ending reserve balances for workers' compensation unpaid losses and LAE. The loss estimates are subject to change in subsequent accounting periods and any change to the current reserve estimates would be accounted for in future results of operations in the period when the change occurs.
2002 2001 2000 ---------- ---------- ---------- (In thousands) Net Beginning Losses and LAE Reserve .......................... $ 198,252 $ 155,797 $ 134,305 ---------- ---------- ---------- Net Provision for Insured Events Incurred in: Current Year ............................................... 139,513 131,923 86,587 Prior Years................................................. 23,998 8,691 23,293 ---------- ---------- ---------- Total Net Provision....................................... 163,511 140,614 109,880 ---------- ---------- ---------- Net Payments for Losses and LAE Attributable to Insured Events Incurred in: Current Year ............................................... 29,448 28,560 26,867 Prior Years................................................. 74,125 69,599 61,521 ---------- ---------- ---------- Total Net Payments ....................................... 103,573 98,159 88,388 ---------- ---------- ---------- Net Ending Losses and LAE Reserve ............................. 258,190 198,252 155,797 Reinsurance Recoverable ....................................... 169,002 187,453 218,757 ---------- ---------- ---------- Gross Ending Losses and LAE Reserve ........................... $ 427,192 $ 385,705 $ 374,554 ========== ========== ==========
While management of the Company believes that current estimates are reasonable, significant adverse or favorable loss development could occur in the future.
Long-Term Debt - Senior Debentures. At September 30, 2000, CII Financial, Inc. had approximately $47.1 million of subordinated debentures outstanding that were due on September 15, 2001. These subordinated debentures were neither assumed nor guaranteed by Sierra and were subordinated to Sierra's credit facility debt. In December 2000, CII Financial commenced an offer to exchange the subordinated debentures for cash and/or new debentures. On May 7, 2001, CII Financial closed its exchange offer on $42.1 million of its outstanding subordinated debentures. CII Financial purchased $27.1 million in principal amount of subordinated debentures for $20.0 million in cash and issued $15.0 million in new 9½% senior debentures, due September 15, 2004, in exchange for $15.0 million in subordinated debentures. The remaining $5.0 million in subordinated debentures were paid at maturity.
The transaction was accounted for as a restructuring of debt; therefore all future cash payments, including interest, related to the debentures will be reductions of the carrying amount of the debentures and no future interest expense will be recognized. Accordingly, at December 31, 2002, the new 9½% senior debentures have a carrying amount of $16.8 million, which consists of principal amount of $14.0 million and $2.8 million in future accrued interest. Since the time of the exchange, Sierra has purchased $1.0 million in outstanding 9½% senior debentures which are eliminated upon consolidation.
Intercompany Notes Receivable/Payable. In connection with the exchange offer for the subordinated debentures, CII has promissory notes payable to Sierra aggregating $17.0 million and bearing interest at 9½% under which principal and interest are due on demand. These notes are subordinated to the 9½% senior debentures.
Also in connection with the exchange offer for the subordinated debentures, California Indemnity Insurance Company, a wholly owned subsidiary of CII Financial, Inc., loaned Sierra $7.5 million. The loan bears interest at 8.5%, which is due semi-annually on March 31 and September 30 of each year, commencing September 30, 2001. All outstanding principal and accrued interest is due on September 30, 2004. The loan is secured by the common stock of Sierra Health and Life Insurance Company Inc., a wholly owned subsidiary of Sierra, equal to 120% of the principal amount outstanding. The intercompany notes receivable/payable have been eliminated upon consolidation.
Asset Impairment. During the second quarter of 2000, CII wrote-off capitalized costs of $3.0 million related to the application development of an information system software project for the workers' compensation operations, which was canceled because the vendor was unable to fulfill its contractual obligations. The amounts written off included software and consulting costs of $1.6 million and capitalized internal personnel costs of $1.4 million.
2003.................................................... $ 18,428 2004.................................................... 17,819 2005.................................................... 17,161 2006.................................................... 16,603 2007.................................................... 16,202 Thereafter.............................................. 123,420 ----------- Total............................................. $ 209,633 ===========
The Company is a guarantor on a mortgage loan which has a carrying value of $15.0 million, consisting of a principal balance of $12.7 million and $2.3 million in future accrued interest. The mortgage loan is related to the property of the discontinued Texas HMO health care operations as described in Note 8.
Litigation and Legal Matters. The Company is subject to various claims and other litigation in the ordinary course of business. Such litigation includes, but is not limited to, claims of medical malpractice, claims for coverage or payment for medical services rendered to HMO members and claims by providers for payment for medical services rendered to HMO and other members. Some litigation may also include claims for punitive damages that are not covered by insurance. Also included in such litigation are claims for workers' compensation and claims by providers for payment for medical services rendered to injured workers. These actions are in various stages of litigation and some may ultimately be brought to trial. With respect to certain pending actions, the Company maintains commercial insurance coverage with varying deductibles for which the Company maintains reserves for its self-insured portion based upon its current assessment of such litigation. Due to recent unfavorable changes in the commercial insurance market, the Company has, for certain risks, purchased coverage with higher deductibles and lower limits of coverage. In the opinion of management, based on information presently available, the ultimate resolution of these pending legal proceedings should not have a material adverse effect on our financial condition.
During 1997, the Company's Board of Directors authorized a $3.0 million loan from the Company to its Chief Executive Officer ("CEO"). In April 2000, the Company's Board of Directors authorized an additional $2.5 million loan from the Company to its CEO. In the second quarter of 2001, Sierra's Board of Directors approved a loan amendment which extended the maturity of the principal balance along with accrued interest to December 31, 2003. During 2002 and 2001, the CEO made payments of $1.0 million and $898,000 respectively. As of December 31, 2002, the aggregate principal balance outstanding and accrued interest for both instruments was $4.2 million. All amounts borrowed bear interest at a rate equal to the rate at which the Company could have borrowed funds under the revolving credit facility at the time of the borrowing plus 10 basis points. The amounts outstanding are collateralized by certain of the CEO's assets and rights to compensation from the Company. The loan is pledged as collateral under the Company's revolving credit facility.
The Company incurred legal fees of $24,000, $38,000 and $4,000 in the years ended December 31, 2002, 2001 and 2000 respectively, with a Nevada law firm of which a non-employee Board of Director member is a shareholder.
Defined Contribution Plan. The Company has a defined contribution pension and 401(k) plan (the "Plan") for its employees. The Plan covers all employees who meet certain age and length of service requirements. For the six months ended June 30, 1999, the Company contributed a maximum of 2% of eligible employees' compensation and matched 50% of a participant's elective deferral up to a maximum of either 10% of an employee's compensation or the maximum allowable under current IRS regulations. Effective July 1, 1999, the Plan was modified such that the Company matches 50%-100% of an employee's elective deferral up to a maximum of 6% of a participant's annual compensation, subject to IRS limits. The Plan does not require additional Company contributions. Expense under the plan totaled $4.4 million, $4.8 million and $4.7 million for the years ended December 31, 2002, 2001 and 2000, respectively.
Supplemental Executive Retirement Plan ("SERP"). The Company has a defined benefit retirement plan covering certain key employees. The Company is informally funding the benefits through the purchase of life insurance policies. Benefits are based on, among other things, the employee's average earnings over the five-year period prior to retirement or termination, and length of service. Benefits attributable to service prior to the adoption of the plan are amortized over the estimated remaining service period for those employees participating in the plan.
Fair Value of Plan Assets at End of Period (1)............. $ -- $ -- $ -- =========== ============ ===========
Assumptions: Discount Rate ............................................. 6.5% 7.0% 7.0% Rate of Compensation Increase ............................. 3.0% 3.0% 3.0%
Number Weighted of Option Average Shares Price Price ----------- ------------ ----------- (Number of shares in thousands)
Exercisable at December 31, 2002........................... 1,866 3.13 - 24.69 8.55 ===========
Employee Stock Purchase Plans. The Company has an employee stock purchase plan (the "Purchase Plan") whereby employees may purchase newly issued shares of common stock through payroll deductions at 85% of the fair market value of such shares on specified dates as defined in the Purchase Plan. During 2002, a total of 670,000 shares were purchased at prices of $6.02 and $6.91 per share. During January 2003, 145,000 shares were purchased by employees at $10.21 per share in connection with the Purchase Plan. An additional 900,000 shares were reserved for issuance under the Purchase Plan at the annual meeting of stockholders on May 23, 2002. At December 31, 2002, the Company had 761,000 shares reserved for purchase under the Purchase Plan.
Accounting for Stock-Based Compensation. The Company uses the intrinsic value method in accounting for its stock-based compensation plans. The fair value pro forma presentation presented in Note 2 was estimated at the date of grant using the Black-Scholes option pricing model with the following weighted average assumptions used for grants in 2002, 2001 and 2000, respectively: dividend yield of 0% for all years; expected volatility of 74%, 83% and 52%; risk-free interest rates of 3.32%, 4.34% and 6.60%; and expected lives of two to five years. The weighted average fair value of options granted in 2002, 2001 and 2000 was $8.60, $5.58 and $2.72, respectively.
In connection with the restructuring plans adopted and announced by the Company in the second quarter of 2000, the Company re-evaluated the recoverability of certain long-lived assets, in accordance with SFAS No. 121 and APB No. 17 and determined that the carrying values of certain goodwill and other long-lived assets were impaired.
In the second quarter of 2000, the Company adopted a plan and announced additional restructuring of the Arizona managed health care operations. As a result of this restructuring, the Company recorded charges in accordance with Emerging Issues Task Force Issue No. 94-3, "Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (Including Certain Costs Incurred in a Restructuring)" of approximately $2.0 million. Of the costs recorded, $1.2 million was for severance, $400,000 was related to clinic closures and lease termination and $400,000 was for other costs.
The table below presents a summary of asset impairment, restructuring and other costs of continuing operations for the years indicated.
Due to the classification of the workers' compensation insurance operations as discontinued operations in 2002, all amounts presented have been recast to conform with the two segment presentation at December 31, 2002.
The Company evaluates each segment's performance based on segment operating profit. The accounting policies of the operating segments are the same as those described in the summary of significant accounting policies (except as described in the notes below). Certain changes in estimate charges for the years ended December 31, 2001 and 2000 were reclassified to segment operation profit to conform with the current year presentation.
Segment Operating Profit ................................ $ 56,700 $ 15,291 $ 71,991 Interest Expense Other................................... (7,455) (32) (7,487) Other Income (Expense), Net.............................. (309) 201 (108) ---------- ---------- ---------- Income from Continuing Operations Before Income Taxes................................. $ 48,936 $ 15,460 $ 64,396 ========== ========== ==========
Segment Assets........................................... $ 387,097 $ 113,811 $ 500,908 Capital Expenditures..................................... (10,829) (1,563) (12,392) Depreciation and Amortization............................ 15,730 2,515 18,245
Segment Operating Profit ................................ $ 30,798 $ 9,701 $ 40,499 Interest Expense Other................................... (15,693) (93) (15,786) Other Income (Expense), Net.............................. (2,175) 104 (2,071) ---------- ---------- ---------- Income from Continuing Operations Before Income Taxes................................. $ 12,930 $ 9,712 $ 22,642 ========== ========== ==========
The segment operating profit excludes the effects of asset impairment, restructuring, reorganization and other costs.
On January 1, 2002, the Company adopted Statement of Financial Accounting Standards No. 142, "Goodwill and Other Intangible Assets" ("SFAS No. 142"). SFAS No. 142 requires, among other things, the discontinuance of goodwill amortization. In addition, the pronouncement includes provisions for the reclassification of certain existing recognized intangibles as goodwill, reassessment of the useful lives of existing recognized intangibles, reclassification of certain intangibles out of previously reported goodwill and the identification of reporting units for purposes of assessing potential future impairments of goodwill. SFAS No. 142 also required the Company to complete a transitional goodwill impairment test six months from the date of adoption and at least annually thereafter. The net amortized goodwill balance at December 31, 2002, is $14.8 million. The Company completed its transitional goodwill test and determined that the recorded goodwill was not impaired under the guidelines of the pronouncement.
Income from Continuing Operations............ $ 15,481 $ 523 $ 16,004 Loss from Discontinued Operations............ (11,995) -- (11,995) ------------ ----------- ------------ Net Income................................ $ 3,486 $ 523 $ 4,009 ============ =========== ============
(Loss) Income from Continuing Operations..... $ (31,019) $ 735 $ (30,284) (Loss) Income from Discontinued Operations... (168,896) 1,100 (167,796) ------------ ----------- ------------ Net (Loss) Income......................... $ (199,915) $ 1,835 $ (198,080) ============ =========== ============
Earnings per Common Share: ---------------------------- (Loss) Income from Continuing Operations..... $ (1.15) $ 0.03 $ (1.12) (Loss) Income from Discontinued Operations... (6.22) 0.04 (6.18) ------------ ----------- ------------ Net (Loss) Income......................... $ (7.37) $ 0.07 $ (7.30) ============ =========== ============
Also on March 3, 2003, the Company issued a new $65 million revolving credit facility which replaces the amended and restated credit facility. The new facility may be increased up to an aggregate amount of $125.0 million upon receipt of new commitments from existing or additional lenders. Interest on the facility is initially LIBOR plus 2.25%. The facility will expire on April 30, 2006 but can be extended, at the sole discretion of each of the lenders, until March 3, 2008. The new facility is available for general corporate purposes.
Operating Revenues as Reported......................... $ 348,580 $ 363,968 $ 381,324 $ 326,902 Reclassification for Discontinued Operations........... 44,832 47,000 50,307 -- ---------- ---------- ---------- ---------- Operating Revenues..................................... 303,748 316,968 331,017 326,902 ---------- ---------- ---------- ----------
Operating Income from Continuing Operations as Reported 13,976 17,777 19,561 19,645 Reclassification for Discontinued Operations........... 463 (31) (1,464) -- ---------- ---------- ---------- ---------- Operating Income from Continuing Operations............ 13,513 17,808 21,025 19,645 ---------- ---------- ---------- ----------
Operating Income from Continuing Operations as Reported 10,062 11,391 10,758 12,621 Reclassification for Discontinued Operations........... 1,021 1,931 545 836 ---------- ---------- ---------- ---------- Operating Income from Continuing Operations............ 9,041 9,460 10,213 11,785 ---------- ---------- ---------- ----------