The Company owns several administrative facilities in southern Nevada totaling approximately 400,000 square feet. Such facilities include an approximate 110,000 square foot six-story home office building and an approximate 43,000 square foot two-story corporate administrative headquarters. These buildings are subject to liens securing a $400,000 loan balance. Also included in this total is a 198,000 square foot six-story administrative headquarters building which became fully occupied in 1998. This building is subject to a $11.6 million loan balance. The Company also owns clinical facilities in the southern Nevada area totaling approximately 425,000 square feet and consisting primarily of ten medical clinics including one medical clinic that opened for business in January 2000 and two surgery centers. The Company leases additional office and clinical space in Nevada totaling approximately 129,000 and 90,000 square feet, respectively.
(2) Adjusted to account for three-for-two stock split of the Company's 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 the Company's consolidated financial condition and results of operations. The discussion should be read in conjunction with the Consolidated Financial Statements and Related Notes thereto. Any forward-looking information contained in this Management's Discussion and Analysis of Financial Condition and Results of Operations and any other sections of this 1999 Annual Report on Form 10-K should be considered in connection with certain cautionary statements contained in the Company's Current Report on Form 8-K filing dated March 15, 2000, incorporated herein by reference. Such cautionary statements are made pursuant to the "safe harbor" provisions of the Private Securities Litigation Reform Act of 1995 and identify important risk factors that could cause the Company's actual results to differ materially from those expressed in any projected, estimated or forward-looking statements relating to the Company.
The original liability for the estimated premium deficiency was based upon assumptions of membership and other operating information, some of which had not been received as of December 31, 1998. During 1999, the Company continued to gather such data, including data from the seller, and based upon the receipt and
analysis of this data, the Company revised the initial estimate of the premium deficiency accrual. In total the Company recorded a $72.0 million premium deficiency in conjunction with the acquisition. Of this amount, $6.8 million was utilized in 1998 to offset losses on the acquired contracts, and the remainder was utilized in 1999. Total goodwill recorded in conjunction with the acquisition was $126.8 million of which $24.8 million was a result of adjustments in 1999.
On December 31, 1998, Sierra completed the acquisition of the Nevada health care business of Exclusive Healthcare, Inc. ("EHI"), United of Omaha Life Insurance Company and United World Life Insurance Company ("United"), all of which were subsidiaries of Mutual of Omaha Insurance Company. Sierra initially retained approximately 9,000 members (approximately 4,400 HMO members) subsequent to the acquisition. Effective June 1, 1999, the Company completed the purchase of the Texas operations of EHI (approximately 1,000 HMO members) and United's related preferred provider organization ("PPO") that is part of the dual option HMO/PPO plan. The purchase price of both the Nevada and Texas transaction is contingent based on how many members are retained through 2000 and 2001. No cash will be paid until group renewals begin in 2000.
The Company derives revenues from its health maintenance organizations, managed indemnity, military health care services and workers' compensation insurance subsidiaries. To a lesser extent, the Company also derives additional specialty product revenues from non-HMO and insurance products (consisting of fees for workers' compensation administration, utilization management services and ancillary products), professional fees (consisting primarily of fees for providing health care services to non-members and co- payment fees received from members), and investment and other revenue. Medical premium revenues accounted for approximately 64.5%, 58.8% and 71.2% of the Company's total revenues for 1999, 1998 and 1997, respectively. The decrease in medical premiums as a percentage of total revenues in 1998 is primarily due to the addition of military contract revenues. The increase in the percentage of medical premiums as a percentage of total revenues in 1999 is due to the acquisitions discussed previously. Continued medical premium revenue growth is principally dependent upon continued enrollment in the Company's products and upon competitive and regulatory factors.
The Company's principal expenses consist of medical expenses, military contract expenses, specialty product expenses, and general, administrative and marketing 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 enrollees, as well as the aggregate expenses to operate and manage the Company's multi-specialty medical groups and other provider subsidiaries. As a provider of health care management services, the Company seeks to positively effect quality of care and expenses by employing or contracting with physicians, hospitals and other health care providers at negotiated price levels, by adopting quality assurance programs, by monitoring and managing utilization of physicians and hospital services and by providing incentives to use cost-effective providers. Military contract expenses represent the expenses of delivering health care, as agreed to in the TRICARE contract with the federal government, as well as administrative costs to operate the military health care subsidiary. Specialty product expenses primarily consist of losses and loss adjustment expenses, policy acquisition expenses and other general and administrative expenses associated with the Company's workers' compensation insurance subsidiaries. General, administrative and marketing expenses generally represent operational costs other than those associated with the delivery of health care services, military contract services and specialty product services.
beneficiaries in Region 1. Under the contact, SMHS provides health care services to approximately 610,000 dependents of active duty military personnel and military retirees and their dependents through subcontractor partnerships and individual providers. In June 1998, the Company began providing health care benefits to individuals in Connecticut, Delaware, Maine, Maryland, Massachusetts, New Hampshire, New Jersey, New York, Pennsylvania, Rhode Island, Vermont, Virginia, West Virginia and Washington, D.C. SMHS was notified on February 13, 1998 that the United States General Accounting Office sustained a competitor's protest of the contract award for TRICARE Managed Care Support Region 1 and recommended that the contract be re-bid. In December 1998, the Company reached an agreement to settle the protest. As part of the settlement, the competitor has foregone any and all rights it may have to challenge the contract award and seek a re-bid. (See Note 15 of Notes to the Consolidated Financial Statements).
Revenues. The Company's total operating revenues for 1999 increased approximately 23.8% to $1.28 billion from $1.04 billion for 1998. The increase was primarily due to an increase in premium revenue of $218.4 million and increases in military contract revenue of $82.6 million, offset by a decrease in specialty product revenue of $54.1 million.
Medical premium revenue from the Company's HMO and managed indemnity insurance subsidiaries increased $218.4 million, or 35.8%. Excluding the effect of the Kaiser-Texas acquisition, premium revenue increased $84.9 million, or 14.6%. The $84.9 million increase in premium revenue reflects a 7.9% increase in member months (the number of months of each year that an individual is enrolled in a plan). Additionally, Medicare member months increased 16.2%. Such growth in Medicare member months contributes significantly to the increase in premium revenues as the Medicare per member premium rates are over three times higher than the average commercial premium rate. The Company's premium rates increased approximately 4% for its Nevada HMO commercial groups and 11% for its Houston, Texas commercial groups. Compared to the fourth quarter of 1998, the commercial rates for the Company's acquired Dallas/ Ft. Worth operations have increased approximately 8%. The Company's managed indemnity rates increased approximately 8% and Medicare rates increased approximately 2%. Over 90% of the Company's Nevada Medicare members are enrolled in the Social HMO Medicare program. The Health Care Financing Administration ("HCFA") is considering adjusting the reimbursement factor for the Social HMO members in the future. If the reimbursement for these members decreases significantly and related benefit changes are not made timely, there could be a material adverse effect on the Company's business.
Military contract revenues increased $82.6 million, or 40.3%. Military contact revenue is recorded based on the contract price as agreed to by the federal government, adjusted for certain provisions based on actual experience. In addition, the Company records revenue based on estimates of the earned portion of any contract change orders not originally specified in the contract. The revenue recorded in 1999 is a result of the provision of health care services for twelve months. Revenue recorded in 1998 was comprised of revenue earned for five months of contract implementation and seven months of health care delivery.
Professional fee revenue increased $6.5 million primarily due to the Company's medical group operations in Dallas/Ft. Worth related to the Kaiser-Texas acquisition. Investment and other revenue decreased approximately $6.7 million over the comparable prior year period. Of this decrease, $2.7 million was due primarily to capital gains realized on the sale of investments in the prior year period. The remaining decrease was primarily due to a decrease in invested balances.
Medical Expenses. Total medical expenses for the year ended December 31, 1999 increased $236.6 million compared to the prior year. The following costs were included in 1999 medical expenses:
Premium Deficiency. In the first quarter of 1999, the Company recorded a premium deficiency charge of $8.1 million related to losses in underperforming markets primarily in Arizona and rural Nevada. This deficiency reserve was utilized during 1999 to offset losses as they occurred. In the fourth quarter of 1999, the Company recorded $21.0 million for estimated deficient premiums associated with contracts in the Texas market. Of this amount $10.0 million was included in medical expenses and $11.0 million was recorded in impairment, settlement and other costs.
Excluding the effect of the Dallas/Ft. Worth operations, as well as the non-recurring charges, medical expenses increased approximately $83.4 million or 17.0% compared to the prior year. Medical expenses as a percentage of medical premiums and professional fees ("Medical Care Ratio") increased from 78.4% to 85.2%, or 81.1% excluding the non-recurring charges, for the year ended December 31, 1999 compared to the prior year. The increase in the medical care ratio reflects the Kaiser-Texas membership which has a higher medical care ratio, and the charges discussed previously, as well as an increase in Medicare members as a percentage of fully-insured members, and higher pharmacy costs. The cost of providing medical care to Medicare members generally requires a greater percentage of the premiums received. Pharmacy costs increased as the management of the pharmacy benefit was transitioned from a capitated pharmacy benefits contract to in-house management in the third quarter of 1998. The costs under such capitation contract were substantially below actual claims experience. Included in medical expenses is the utilization of $43.9 million of premium deficiency reserve to offset losses on contracts from the Kaiser-Texas acquisition. Although not reflected in earnings, $20 million of these losses were funded by Kaiser as agreed to in the purchase agreement.
Military Contract Expenses. Military contract expenses for the twelve months ended December 31, 1999, increased approximately $79.9 million or 40.6%, compared to the prior year. The military contract expenses in 1999 are a result of twelve months of health care delivery. Expense in 1998 was for five months of contract implementation and seven months of health care delivery. Health care delivery 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 610,000 dependents of active duty military personnel and military retirees and their dependents through subcontractor partnerships and individual providers. Health care costs are recorded in the period when services are provided to eligible beneficiaries, including estimates for provider costs which have been incurred 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.
Specialty Product Expenses. Specialty product expenses decreased approximately $45.8 million, or 32.2%, due primarily to the implementation of the low level reinsurance agreement as discussed previously, offset by adverse development of $9.9 million on prior accident years for the Company's workers' compensation business. Effective January 1, 1998, workers' compensation claims are 100% reinsured between $500,000 and $100 million per occurrence. For claims occurring on and after July 1, 1998, that are below $500,000, the Company obtained low level quota share and excess of loss reinsurance. Under this agreement, which was not reflected in the financial statements until the fourth quarter of 1998, the Company reinsures 30% of the first $10,000 of each claim, 75% of the next $40,000 and 100% of the next $450,000. Claims occurring in the third quarter of 1998 are accounted for as retroactive reinsurance. (See Note 6 of Notes to the Consolidated Financial Statements).
The combined ratio for the workers' compensation insurance business was 105.5% in 1999 compared to 98.7% for the prior year. The increase was due to a 380 basis point increase in the net loss and loss adjustment expense ("LAE") ratio, a 290 basis point increase in the underwriting expense ratio and 10 basis points of policyholders' dividend expense incurred in 1999. The increase in the loss and LAE ratio was primarily due to 1999 net adverse loss development of $9.9 million on prior accident years compared to 1998 net favorable loss development of $9.6 million. The increase in the underwriting expense ratio was primarily due to the lower net earned premium base that resulted from higher ceded reinsurance premiums in 1999.
in 1999. In addition, continuing price competition in California has negatively affected operating ratios. However, for renewal policies issued year to date in 2000, Sierra's workers' compensation business has obtained premium rate increases in excess of 15%. The increase seen so far in 2000 is a material positive change of the previous rate trend. Based on public information, other California workers' compensation companies are issuing year 2000 policies at rates 15% to 20% in excess of the expiring premiums.
The loss and loss adjustment expense reserves booked as of December 31, 1999 reflect the Company's best estimate of the ultimate loss costs for reported and unreported claims occurring in accident year 1999 as well as those occurring in accident years prior to 1999. 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. The Company may incur future adverse or favorable loss development. Workers' compensation claim payments are made over several years from the date of the claim. Until the final payments for reported claims are made, reserves are invested and the interest proceeds are included in investment income.
Interest Expense and Other. Interest expense and other increased approximately $7.8 million for the year ended December 31, 1999, compared to the prior year due to an increase in debt primarily as a result of the Kaiser-Texas acquisition, offset by a net gain of $1.8 million on the sale of certain pharmacy assets purchased in conjunction with the Kaiser-Texas acquisition.
Revenues. The Company's total operating revenues for 1998 increased approximately 43.7% to $1.04 billion from $721.7 million for 1997. The increase was primarily due to military contract revenue of $204.8 million and an increase in premium revenue of $95.5 million. The military contract revenue is a result of the implementation of the TRICARE contract as well as the first seven months of health care delivery. Revenue under the 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. The estimated effects of these adjustments are recognized on a monthly basis.
Specialty product revenue increased $2.2 million, or 1.5%, for the year ended December 31, 1998 compared to the prior year. The increase was due to revenue growth of $5.1 million in the workers' compensation insurance operation offset in part by a decrease in administrative services and other revenue of $2.9 million due primarily to the termination of the Company's workers' compensation administrative services contract with the State of Nevada. The Company's workers' compensation subsidiary signed a reinsurance agreement whereby a greater portion of premium is ceded thus reducing revenue. The agreement results in a reduction of specialty product expenses as discussed later in this section. Excluding the effect of the new reinsurance agreement, the workers' compensation subsidiaries' revenue would have increased $21.2 million compared to the prior year. Professional fee revenue increased approximately $14.1 million primarily due to the January 1998 acquisition of the operations of two medical clinics in southern Nevada and the clinics acquired in the Dallas/Ft. Worth area. In addition approximately $3.5 million of the increase in professional fees was due to the operations of Total Home Care, Inc. ("THC") which was acquired in August 1997.
Investment and other revenue increased approximately $3.2 million over the prior year primarily due to an increase in invested balances and capital gains realized on the sale of investments.
Specialty product expenses decreased approximately $800,000, or less than 1.0%, due primarily to the implementation of the low level reinsurance agreement as discussed previously. Specialty product revenue and expense is primarily related to the workers' compensation insurance business. Effective January 1, 1998, workers' compensation claims are reinsured between $500,000 and $100 million per occurrence. For claims occurring on and after July 1, 1998, that are below $500,000, the Company obtained quota share and excess of loss reinsurance. Under this agreement, the Company reinsures 30% of the first $10,000 of each claim,
75% of the next $40,000 and 100% of the next $450,000. The Company receives a ceding commission from the reinsurer as a partial reimbursement of operating expenses. Excluding the effect of the reinsurance agreement, specialty product expenses would have increased $19.5 million compared to the prior year.
Impairment, Settlement and Other Costs. In the fourth quarter of 1998, the Company expensed approximately $13.9 million, $10.3 million after tax, of costs primarily associated with the settlement of the protest pertaining to its military services contract as well as costs associated with the integration of the Kaiser-Texas business acquired October 31, 1998. (See Note 15 of Notes to the Consolidated Financial Statements).
SMHS receives monthly cash payments equivalent to one-twelfth of its annual contractual price with the Department of Defense ("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 ("BPA") process serves to adjust the DoD's monthly payments to SMHS, because such payments are based in part on 1996 DoD estimates for beneficiary population, beneficiary population baseline health care cost, inflation and military direct care system utilization. As actual information has been made 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. During the second and fourth quarters of 1999, SMHS received $46.3 million and $34.6 million, respectively, as partial payments from the BPA process covering the period June 1, 1998 through December 31, 1999. As a result of preliminary data accumulated from the BPA process, SMHS received a partial upward adjustment of approximately $2.2 million to its monthly DoD payments for January 2000 through May 2000. SMHS received $2 million as an interim payment in the first quarter of 1999 as a result of contract change order related activities. The Company's business and cash flows could be adversely affected if the timing or amount of the BPA and change order reimbursements varies significantly from the Company's expectations. (See Note 2 of Notes to the Consolidated Financial Statements).
borrowing on this line of credit for 1999, including the impact of the swap agreements, was approximately 7.8%. The terms of the credit facility contain a mandatory payment schedule that begins on June 30, 2001 and ends on September 30, 2003 if the principal balance exceeds certain thresholds. The terms of the credit facility contain certain covenants including a minimum fixed charge coverage ratio and a maximum leverage ratio. For the quarter ended September 30, 1999, the Company exceeded the limits of certain covenants. The Company was able to obtain a waiver and re-negotiate the covenant limits. These negotiations resulted in a borrowing rate of LIBOR plus 2.375%, through September 30, 2000. The Company believes it is in compliance with debt covenants as of December 31, 1999. Of the remaining $40 million available balance on the line of credit as of December 31, 1999, $4.2 million is reserved for use by the Company's equity investee, TriWest Healthcare Alliance and the remainder may be used for general corporate purposes, including working capital.
recommended by the NAIC, the Nevada HMO would not require material contributions. The state of Texas did pass legislation in 1999 regarding risk-based capitalization requirements. As of December 31, 1999, the Texas HMO is in compliance with the requirements. Additional legislation could be passed in either state. Depending on the nature and extent of any new capitalization requirements ultimately adopted, there could be an increase in the capital required. The Company intends to fund any increase from available parent company cash reserves; however, there can be no assurance that such cash reserves will be sufficient to fund these requirements.
The workers' compensation insurance subsidiaries are also subject to minimum capitalization requirements for property-casualty insurers. As of December 31, 1999, these entities were in compliance with the requirements.
The holding company will not receive dividends from its regulated subsidiaries if such dividend payment would cause violation of statutory net worth and reserve requirements.
The Company replaced or remediated its mission critical financial systems as well as its mission critical operational computer systems, remediated databases and validated the readiness of all computing and non computing systems. The Company also engaged in a thorough evaluation to validate that all systems, computing and non-computing, were functioning. The Company is unaware of any Year 2000 related outages over the century date change.
The Company implemented two major systems in 1999 and is in the process of implementing a third, at an estimated cost of over $50 million, which includes the implementation costs related to the recently acquired Kaiser-Texas operations. To date the Company has spent approximately $48.9 million on the new computer systems and other Year 2000 items. The Company expensed the costs to make modifications to existing computer systems and non-computer equipment. Management currently estimates the remaining new computer system costs to be $4.0 million to $6.0 million. While this has been a substantial effort, the results should give the Company the benefits of new technology and functionality for many of its financial and operational computer systems and applications.
While the Company is unable to predict what regulatory changes may occur or the impact on the Company of any particular change, the Company's operations and financial results could be negatively affected by regulatory revisions. For example, any proposals affecting underwriting practices, limiting rate increases, increasing litigation exposure, requiring new or additional benefits or affecting contracting arrangements (including proposals to require HMOs and PPOs to accept any health care providers willing to abide by an HMO's or PPO's contract terms) may have a material adverse effect on the Company's business. The continued consideration and enactment of "anti-managed care" laws and regulations by federal and state bodies may make it more difficult for the Company to manage medical costs and may adversely affect financial results.
In addition to changes in applicable laws and regulations, the Company is subject to various audits, investigations and enforcement actions. These include possible government actions relating to the federal Employee Retirement Income Security Act, which regulates insured and self-insured health coverage plans offered by employers, the Federal Employees Health Benefit Plan, federal and state fraud and abuse laws, and laws relating to utilization management and the delivery of health care. Any such government action could result in assessment of damages, civil or criminal fines or penalties, or other sanctions, including exclusion from participation in government programs. In addition, disclosure of any adverse investigation or audit results or sanctions could negatively affect the Company's reputation in various markets and make it more difficult for the Company to sell its products and services.
The management of Sierra Health Services, Inc. is responsible for the integrity and objectivity of the accompanying Consolidated Financial Statements. The statements have been prepared in conformity with generally accepted accounting principles applied on a consistent basis and are not misstated due to fraud or material error. The statements include some amounts that are based upon the Company's best estimates and judgment.
The accounting systems and controls of the Company are designed to provide reasonable assurance that transactions are executed in accordance with management's authorization, that the financial records are reliable for preparing financial statements and maintaining accountability for assets, and that assets are safeguarded against losses from unauthorized use or disposition. Management believes that for the year ended December 31, 1999, such systems and controls were adequate to meet the objectives discussed herein.
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Sierra Health Services, Inc. and its subsidiaries at December 31, 1999 and 1998, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1999 in conformity with generally accepted accounting principles. Also, in our opinion, such financial statement schedules when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information set forth therein.
For the Years Ended December 31, 1999, 1998 and 1997 (Amounts in thousands)
SIERRA HEALTH SERVICES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS
Business. The consolidated financial statements include the accounts of Sierra Health Services, Inc. ("Sierra") and its subsidiaries (collectively referred to as the "Company"). The Company is a managed health care organization that provides and administers the delivery of comprehensive health care and workers' compensation programs with an emphasis on quality care and cost management. The Company's broad range of managed health care services is provided through its health maintenance organizations ("HMOs"), managed indemnity plans, military health services programs, third-party administrative services programs for employer-funded health benefit plans and its workers' compensation medical management programs. Ancillary products and services that complement the Company's managed health care product lines are also offered.
Acquisitions. On October 31, 1998, Texas Health Choice, L.C. ("TXHC") (formerly HMO Texas, L.C.), a subsidiary of Sierra, completed the acquisition of certain assets of Kaiser Foundation Health Plan of Texas ("Kaiser-Texas"), a health plan operating in Dallas/Ft. Worth and Permanente Medical Association of Texas ("Permanente"), a 150 physician medical group operating in that area. The purchase price was $124 million, which was net of $20 million in operating cost support paid to Sierra by Kaiser Foundation Hospitals in four quarterly installments following the closing of the transaction. The purchase price allocation included a premium deficiency reserve of approximately $25 million for estimated losses on the contracts acquired from Kaiser-Texas. The purchase price also included amounts for real estate and eight medical and office facilities encompassing approximately 500,000 square feet. During the first quarter of 1999, certain accreditation goals were met by the health plan resulting in a purchase price increase of $3.0 million, to $127 million. The purchase price may increase an additional $27 million over three years if certain growth and member retention goals are met by the health plan; however, preliminary results indicate these goals were not met for the first year.
The original liability for the estimated premium deficiency was based upon assumptions of membership and other operating information, some of which had yet to be received. During 1999, the Company continued to gather such data, including obtaining data from the seller, and based upon the receipt and analysis of this data, the Company revised the initial estimate of the premium deficiency accrual resulting in a total recorded amount of $72.0 million.
On December 31, 1998, Sierra completed the acquisition of the Nevada health care business of Exclusive Healthcare, Inc. ("EHI"), United of Omaha Life Insurance Company and United World Life Insurance Company ("United"), all of which are subsidiaries of Mutual of Omaha Insurance Company. Sierra initially retained approximately 9,000 members (approximately 4,400 HMO members) subsequent to the acquisition. Effective June 1, 1999, the company completed the purchase of the Texas operations of EHI (approximately 1,000 HMO members) and United's related preferred provider organization ("PPO") that is part of the dual option HMO/PPO plan. The purchase price of both the Nevada and Texas transactions is contingent based on how many members are retained through 2000 and 2001. No cash will be paid until group renewals begin in 2000.
Medical Associates, Inc. ("SMA") and The Medical Group of Texas ("TMGT"), multi-specialty medical provider groups; Sierra Military Health Services, Inc. ("SMHS"), a company that has been contracted to provide and administer managed care services to certain TRICARE eligible beneficiaries from June 1, 1998 to May 31, 2003; 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.
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. In addition, the Company records revenue based on estimates of the earned portion of any contract change orders not originally specified in the contract.
Specialty Product Revenues. These revenues consist primarily of workers' compensation premiums. Premiums are calculated by formula such that the premium written is earned pro rata over the term of the policy. Also included in specialty product revenues are administrative services and certain ancillary product revenues. Such revenues are recognized in the period in which the service is performed or the period that coverage for services is provided. Premiums written in excess of premiums earned are recorded as an unearned premium revenue liability. Premiums earned include an estimate for earned but unbilled premiums.
Professional Fees. Revenue for professional medical services is recorded on the accrual basis in the period in which the services are provided. Such revenue is recorded at established rates net of provisions for estimated contractual allowances and a provision for estimated uncollectible amounts.
Specialty Product Expenses. This expense consists primarily of losses and loss adjustment expense ("LAE"), policy acquisition costs and other general and administrative expenses associated with issued workers' compensation policies. Losses and 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. Policy acquisition costs consist of commissions, premium taxes and other underwriting costs, which are directly related to the production and retention of new and renewal business and are deferred and amortized as the related premiums are earned. Should it be determined that future policy revenues and earnings on invested funds relating to existing insurance contracts will not be adequate to cover related costs and expenses, deferred costs are expensed. Also included in specialty product expenses are costs associated with administrative services and certain ancillary products. These costs are recorded when incurred.
Investments. Investments consist principally of U.S. Government securities and municipal bonds, as well as corporate and mortgage backed securities. All non-restricted investments that are designated as available-for- sale are classified as current assets. These investments are available for use in the current operations regardless of contractual maturity dates. Non-restricted investments designated as held-to-maturity are classified as current assets if expected maturity is within one year of the balance sheet date. Otherwise, they are classified as long-term investments.
Property and Equipment. Property and equipment are stated at cost. Maintenance and repairs that do not improve or extend the life of the respective assets are charged to operations. Depreciation and amortization is computed using the straight-line method over the estimated service lives of the assets or terms of leases if shorter. Estimated useful lives are as follows:
Goodwill. Goodwill has been recorded primarily as a result of various business acquisitions by the Company. Amortization is provided on a straight line basis over periods not exceeding 40 years. The Company periodically evaluates the carrying value of its intangible assets. The Company utilizes the discounted cash flow method for evaluating the recoverability of goodwill. Future cash flows are estimated based on Company projections and are discounted based on the interest rates approximating long-term bond yields. Amortization expense associated with goodwill was $4,345,000, $2,321,000 and $1,850,000 for the years ended December 31, 1999, 1998 and 1997, respectively.
Medical Claims Payable and Military Health Care Payable. Medical claims payable and Military health care payable include the estimated cost for unpaid claims for which health care services have been provided to enrollees and TRICARE eligibles. Such provision included an estimate for the costs of claims that have been incurred but have not been reported.
period, as well as those incurred but not yet reported. The methods for establishing and reviewing such liabilities are continually reviewed and adjustments are reflected in current operations.
Concentration of Credit Risk. The Company's financial instruments that are exposed to credit risk consist primarily of investments and accounts receivable. The Company maintains cash and cash equivalents and investments with various financial institutions. These financial institutions are located in many different regions, and company policy is designed to limit exposure with any one institution.
Estimates and Assumptions. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Estimates and assumptions include, but are not limited to, medical and specialty product expenses, military revenue and expenses and goodwill recoverability. Actual results may materially differ from estimates.
The Company capitalizes interest expense as part of the cost of construction of facilities and the implementation of computer systems. Interest expense capitalized in 1999, 1998 and 1997 was $2,140,000, $1,037,000 and $1,621,000, respectively. Depreciation expense in 1999, 1998 and 1997 was $23,577,000, $16,767,000 and $10,921,000, respectively.
The following table summarizes the Company's current, long-term and restricted investments as of December 31, 1998:
The contractual maturities of available-for-sale investments at December 31, 1999 are shown below.
The contractual maturities of held-to-maturity investments at December 31, 1999 are shown below. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations. Amortized Cost Fair Value
The Company is covered under medical reinsurance agreements that provide coverage for 50% - 90% of hospital and other costs in excess of, depending on the contract, $75,000 to $200,000 per case, up to a maximum of $2,000,000 per member per lifetime for both the managed indemnity and HMO subsidiaries. In addition, certain of the Company's HMO members are covered by an excess catastrophe reinsurance contract. Reinsurance premiums of $3,269,000, $2,860,000 and $3,156,000, net of reinsurance recoveries of $2,904,000, $1,185,000 and $1,729,000, are included in medical expenses for 1999, 1998 and 1997, respectively. In addition, SHL maintains reinsurance on certain other insurance products.
CII also has reinsurance treaties in effect. In 1999 and 1998, workers' compensation claims between $500,000 and $100,000,000 per occurrence are 100% reinsured. In 1997, workers' compensation claims between $350,000 and $60,000,000 per occurrence were 100% reinsured. In addition, effective July 1, 1998, workers' compensation claims below $500,000 per occurrence are reinsured under quota share and excess reinsurance agreements (referred to as "low level reinsurance") with an A+ rated carrier. Under this agreement, CII reinsures 30% of the first $10,000 of each loss, 75% of the next $40,000 and 100% of the next $450,000. CII receives a ceding commission from the reinsurer as a partial reimbursement of its operating expenses.
The low level reinsurance agreement contains both retroactive and prospective reinsurance coverage and CII has bifurcated the low level reinsurance agreement to account for the different accounting treatments. The amount by which the estimated ceded liabilities exceed the amount paid for the retroactive coverage is reported as a deferred gain and amortized to income 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. During 1999, CII recorded an adjustment to increase its deferred gain related to retroactive reinsurance coverage by $4,615,000. For the years ended December 31, 1999 and 1998, CII amortized deferred gains of $3,850,000 and $1,038,000, respectively. The balance of unamortized deferred gains related to retroactive reinsurance was $7,015,000 and $6,250,000 at December 31, 1999 and 1998, respectively.
Reinsurance contracts do not relieve the Company from its obligations to enrollees or policyholders. Failure of reinsurers to honor their obligations could result in losses to the Company. The Company evaluates the financial condition of its reinsurers to minimize its exposure to significant losses from reinsurer insolvencies. All reinsurers that the Company has reinsurance contracts with are rated A- or better by the A.M. Best Company.
7 1/2% Convertible Subordinated Debentures. In September 1991, CII issued convertible subordinated debentures (the "Debentures") due September 15, 2001. The Debentures bear interest at 7 1/2%, which is due semi-annually on March 15 and September 15. Each $1,000 in principal is convertible into 25.382 shares of the Company's common stock at a conversion price of $39.40 per share. Unamortized issuance costs of $362,000 are included in other assets on the balance sheet and are being amortized over the life of the Debentures. Accrued interest on the Debentures as of December 31, 1999 and 1998 was $1,099,000 and $1,117,000, respectively. The Debentures are redeemable by CII, in whole or in part, at a redemption price of 100.75%, plus accrued interest. The Debentures are general unsecured obligations of CII only and were not assumed or guaranteed by Sierra. During the twelve months ended December 31, 1999 and 1998, the Company purchased $753,000 and $3,216,000, respectively, of the debentures on the open market.
Other. The Company has obligations under capital leases with interest rates from 6.7% to 13.4%. In addition, the Company has term loans with the City of Baltimore and the State of Maryland.
A summary of the provision for income taxes for the years ended December 31, 1999, 1998 and 1997 is as follows:
The following reconciles the difference between the 1999, 1998 and 1997 reported and statutory provision for income taxes:
SIERRA HEALTH SERVICES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Rent expense totaled $9,098,000, $8,763,000 and $5,827,000 in 1999, 1998 and 1997, respectively.
Executive Life Insurance Plan. Effective July 1, 1997, the Company has funded and entered into split dollar life insurance agreements with certain officers and key executives (selected and approved by the Sierra Board of Directors). The premiums paid by the Company will be reimbursed upon the occurrence of certain events as specified in the contract.
Accounting for Stock-Based Compensation. The Company uses the intrinsic value method in accounting for its stock-based compensation plans. Accordingly, no compensation cost has been recognized for its employee stock option plans nor the Purchase Plans. Had compensation cost for the Company's stock-based compensation plans been determined based on the fair value at the grant dates for awards under those plans, the Company's net income and earnings per share for the years ended December 31, would have been reduced to the pro forma amounts indicated below:
The fair value of the look-back option implicit in each offering of the Purchase Plans is estimated on the date of grant using the Black-Scholes option pricing model with the following weighted average assumptions used for grants in 1999, 1998 and 1997, respectively: dividend yield of 0% for all years; expected volatility of 45%, 32% and 35%; risk-free interest rates of 4.66%, 5.30% and 5.32%; and expected lives of six months for all years.
During 1999, the Company extended by three years the expiration date for 1,035,000 options covering shares that would have expired in 1999 and 2000. The exercise price per share for these options ranges from $10.92 to $20.50. No expense was recognized in the consolidated statement of operations related to these options. Expense of $1,445,000 is included in the Pro forma information presented.
protested the contract award and claimed, among other issues, that the United States Department of Defense failed to adequately disclose the weights of the significant factors used to evaluate proposals. In December 1998, SMHS reached an agreement to settle the protest. As part of the settlement, the competitor has foregone any and all rights it may have to challenge the contract award and seek re-bid.
During the fourth quarter of 1998, the Company incurred integration, transition and other charges totaling $3.1 million, $2.3 million after tax, related primarily to its acquisition of the Texas operations of Kaiser Foundation Health Plan. In addition, the Company incurred certain legal expenses totaling $2.7 million, $2.0 million after tax, resulting primarily from the TRICARE settlement and acquisition and integration activity. As of December 31, 1998, $2.8 million was included in accrued expenses for these integration, transition and legal costs incurred through December 31, 1998.