The Company owns several administrative facilities in southern Nevada totalling approximately 221,000 square feet. Such facilities include an approximate 134,000 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 $7.8 million loan balance from Bank of America. The Company also owns several clinical facilities in the southern Nevada area totalling approximately 319,000 square feet and consisting primarily of six medical clinics and two surgery centers. Certain clinical space is subject to a $3.2 million mortgage in favor of GE Capital Asset Management Corporation. The Company leases additional office and clinical space in Nevada totalling approximately 137,000 and 59,000 square feet, respectively. The Company owns real estate and a building in Park City, Utah purchased in 1996 to provide entertainment and a meeting environment for significant current and prospective clients, brokers and others who assist in the Company's marketing efforts. In connection with its workers' compensation insurance subsidiary, the Company leases approximately 141,000 square feet of office space in California. The Company also leases approximately 42,000 square feet of office space in various states as needed for other regional operations, including the Texas HMO.
(1) The Company's consolidated financial statements have been restated to reflect the results of acquisitions accounted for in accordance with pooling of interests method of accounting. See Note 1 of Notes to the Consolidated Financial Statements.
(2) In connection with certain acquisitions and restructurings, the Company recorded certain non-recurring incremental costs. See Note 13 of Notes to the Consolidated Financial Statements.
(3) Adjusted to account for a two-for-one stock split of the Company's common stock in 1992.
The Company derives revenues from its health maintenance organizations, managed indemnity 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 67.3%, 68.4%, and 67.0% of the Company's total revenues for 1996, 1995 and 1994, respectively. Continued medical premium revenue growth is principally dependent upon continued enrollment in the Company's products and upon competitive and regulatory factors which are expected to limit the Company's ability to implement annual premium rate increases.
The Company's principal expenses consist of medical expenses, specialty product expenses, and general, administrative and marketing expenses. Medical expenses represent the aggregate expenses of operating the Company's multi-specialty medical group and other provider subsidiaries as well as capitation fees and other fee-for-service payments paid to independently contracted physicians, hospitals and other health care providers. As a provider of managed care services, the Company seeks to manage medical 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. Specialty product expenses primarily consist of losses and loss adjustment expenses, and underwriting 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 and specialty product services.
Acquisition, restructuring and other expenses represent the non-recurring incremental costs the Company has incurred in connection with various mergers, acquisitions and planned dispositions.
General, Administrative and Marketing Expenses. General, administrative and marketing ("G&A") costs increased $8.7 million, or 13.6%, for the twelve months ended December 31, 1996 compared to the twelve months ended December 31, 1995. As a percentage of revenues, however, G&A costs for the twelve months ended December 31, 1996 decreased to 12.6% from 13.6% during the comparable period in 1995. Of the $8.7 million increase in G&A, $3.3 million is in compensation costs primarily resulting from additional employees supporting expanded services, $3.8 million is from percent of premium costs such as broker commissions and premium taxes, and the remaining $1.6 million is made up of various changes which individually are insignificant.
As a result of higher than expected claim and administrative costs relative to premium rates that can be obtained in certain regional insurance operations and the Company's inability to negotiate adequate provider contracts due to its limited presence in some of these markets, the Company adopted a plan to restructure certain insurance operations during the third quarter of 1996 and recorded a charge of $8.3 million. The plan included the sale or closure of certain regional operations in California, Arizona, and Colorado. The plan will allow the Company to focus on more favorable operating markets and improve operating efficiencies. The Company believes that this restructuring, over time, will result in improved cash flow and operating cost savings in excess of the amount of the charge.
As a result of these restructurings, the Company recorded expenses of $12.1 million. These costs included cancellation of certain contractual obligations of $6.0 million, lease termination costs of $1.5 million, and $4.6 million of other costs including the estimated costs to dispose of the hospital. As of December 31, 1996, approximately $4.1 million of these costs had been paid or otherwise charged against the accrual and the Company estimates that most of the remaining cash expenditures will be paid over the next twelve months.
Income Taxes. The Company's effective tax rate for the year ended December 31, 1996 was 25.2%, compared to 30.4% in 1995, or 25.4% after taking into account the non-deductible merger costs incurred in 1995. The difference between the Company's effective tax rate and the current federal tax rate is due primarily to a $2.7 million tax benefit recorded as a result of a reduction of the deferred tax valuation allowance and the Company's significant portfolio of tax preferred investments. See Note 8 of Notes to Consolidated Financial Statements.
Medical and Specialty Product Expense. Total medical expenses increased by approximately $44.9 million in 1995 compared to 1994. This 22.4% increase resulted from the consolidated member month growth discussed above, as well as the clinical expansions and increases associated with professional fee growth. These factors, as well as an increase in Medicare members as a percentage of total members, increased the Company's medical loss ratio to 72.3% for the twelve months ended December 31, 1995, from 71.1% for the comparable twelve months in 1994. The cost of providing medical care to Medicare members generally requires a greater percentage of the premium revenue received. Specialty product expenses increased by 6.5% over 1994. This increase is primarily the result of a higher loss ratio in 1995 due to the decrease in premium rates discussed above, offset in part by favorable development during 1995 in reserves for prior accident years. During the year, the Company had net favorable loss development on prior accident years of $20.1 million, compared to net favorable loss development of $14.0 million for the comparable prior year period. The majority of the favorable loss development occurred on the 1992 and 1993 accident years. The favorable development on the 1992 accident year appears to be primarily due to the Company's aggressive actions to resolve claims. The favorable development on the 1993 accident year appears to have been aided by the workers' compensation reforms that were enacted in July 1993 to combat the abuses in the California workers' compensation system. There can be no assurances that favorable development, or the magnitude of the development, will continue in the future. See Note 6 of Notes to Consolidated Financial Statements.
The Company's cash flow from operating activities resulted in $52.4 million of cash flow for the twelve months ended December 31, 1996. This cash flow was primarily generated from net income of $31.1 million, $10.5 million in depreciation and amortization, and a net change in operating assets and liabilities, excluding cash and cash equivalents, of $10.8 million. The increase in cash from fluctuations in such operating assets and liabilities is principally due to increases in the reserve for losses and loss adjustment expense, other liabilities and medical claims payable, as well as a decrease in reinsurance recoverable. These increases in cash were offset by increases in accounts receivable and other assets.
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 16.921 shares of the Company's common stock at a conversion price of $59.097 per share. Unamortized issuance costs of $1.1 million are included in other assets on the balance sheet and are being amortized over the life of the Debentures. The Debentures are general unsecured obligations of CII only and are not guaranteed by Sierra. During the twelve months ended December 31, 1996, the Company purchased $2.3 million of the Debentures on the open market. At December 31, 1996, CII had total assets of $315.9 million, consisting primarily of investments, and total liabilities of $271.0 million, consisting primarily of reserves for losses and loss adjustment expense and the debentures. For the year ended December 31, 1996, CII had net premiums earned of $121.0 million and investment and other revenue of $18.7 million, and total operating expenses of $128.9 million.
The Company has a 1997 capital budget of approximately $45.0 million, primarily for the completion of the construction on the new 59,000 square-foot medical facility and 180,000 square foot six-story corporate headquarters building and accompanying five-story parking structure, computer hardware and software, furniture and equipment, and other requirements due to the Company's projected growth and expansion. Completion of the medical facility is expected in the fourth quarter of 1997 at an estimated cost
of $7.3 million. Completion of the additional building at the corporate headquarters complex is expected in the fourth quarter of 1997 at an estimated cost of $35.0 million, of which $3.5 million was spent in 1996. The Company's liquidity needs over the next 12 months will primarily be for the capital items noted above to support growing membership in Nevada, as well as debt service and expansion of the Company's operations. The Company believes that existing working capital, operating cash flow and, if necessary, mortgage financing and equipment leasing, and amounts available under its credit facility will be sufficient to fund its capital expenditures, debt service and any expansion activities during the next 12 months. Additionally, subject to unanticipated cash requirements, the Company believes that its existing working capital and operating cash flow and, if necessary, its access to new credit facilities, will enable it to meet its liquidity needs on a longer term basis.
On March 18, 1997, the Company announced it had terminated its merger agreement with PCA. During the first quarter of 1997, the Company intends to record certain costs and expenses incurred as a result of the terminated merger. See Item 3. Legal Proceedings for discussion on associated litigation.
The Company has submitted a proposal as the prime contractor to OCHAMPUS to provide managed health care coverage to CHAMPUS eligible beneficiaries in Region 1. This region includes approximately 665,000 individuals in Connecticut, Delaware, Maine, Maryland, Massachusetts, New Hampshire, New Jersey, New York, Pennsylvania, Rhode Island, Vermont, northern Virginia and Washington, D.C. The Company expects to incur expenses of approximately $8.0 to $10.0 million during the Region 1 contract proposal process. The Company submitted its final bid on February 14, 1997 and anticipates learning of the result of its bid in the second quarter of 1997. The contract, if awarded to the Company, will result in approximately $1.8 billion in estimated revenues over the term of the contract.
As a result of the continued escalation of health care costs and the inability of many individuals to obtain health care insurance, numerous proposals relating to health care reform have been or may be introduced in the United States Congress and state legislatures. Any proposals affecting underwriting practices, limiting rate increases, 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.
Management Report on Consolidated Financial Statements.................. 27 Independent Auditors' Report............................................ 28 Consolidated Balance Sheets at December 31, 1996 and 1995............... 29 Consolidated Statements of Operations for the Years Ended December 31, 1996, 1995, and 1994.................................... 30 Consolidated Statements of Changes in Stockholders' Equity for the Years Ended December 31, 1996, 1995 and 1994................. 31 Consolidated Statements of Cash Flows for the Years Ended December 31, 1996, 1995, and 1994.................................... 32 Notes to Consolidated Financial Statements.............................. 33
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, 1996, such systems and controls were adequate to meet the objectives discussed herein.
We have audited the consolidated balance sheets of Sierra Health Services, Inc., and its subsidiaries as of December 31, 1996 and 1995, and the related consolidated statements of operations, stockholders' equity, and cash flows for each of the three years in the period ended December 31, 1996. Our audits also included the financial statement schedules listed in the index at Item 14 (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. The consolidated financial statements give retroactive effect to the merger of Sierra Health Services, Inc., and its subsidiaries, and CII Financial, Inc., and its subsidiaries, which has been accounted for as a pooling of interests as described in Note 1 to the consolidated financial statements. We did not audit the statements of operations, stockholders' equity, and cash flows of CII Financial, Inc., and its subsidiaries, for the year ended December 31, 1994, which statements reflect total revenues of $106,280,000 for the year ended December 31, 1994. These statements were audited by other auditors whose report has been furnished to us, and our opinion, insofar as it relates to the amounts included for CII Financial, Inc., and its subsidiaries, for 1994 is based solely on the report of such other auditors.
In our opinion, based on our audits and the report of the other auditors, the consolidated financial statements present fairly, in all material respects, the financial position of Sierra Health Services, Inc. and its subsidiaries at December 31, 1996 and 1995, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1996 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.
SIERRA HEALTH SERVICES, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS December 31, 1996 and 1995
Acquisitions. On October 31, 1995, the Company issued approximately 2.7 million shares of its common stock in exchange for all of the outstanding common stock of CII Financial, Inc., and subsidiaries ("CII"). In addition, all outstanding CII stock options were converted into options to purchase up to approximately 540,000 shares of the Company's common stock. The merger was accounted for as a pooling of interests and, accordingly, the Company's consolidated financial statements have been restated to include the accounts and operations of CII for all periods prior to the merger.
In November 1996, the Company acquired complete ownership of HMO Texas, LC ("HMO Texas") for $5,040,000. The Company had previously held a 50 percent interest in the Houston-based health plan which had approximately 12,700 members at the end of 1996. The purchase resulted in goodwill of $5,040,000.
Principles of Consolidation. All significant intercompany transactions and balances have been eliminated. Sierra's wholly owned subsidiaries include Health Plan of Nevada, Inc. ("HPN"), HMO Texas and MedOne, all 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 group, 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 and a company that provides and manages mental health and substance abuse services.
Medical Premiums. Non-Medicare member enrollment is represented principally by employer groups. Medical premiums are billed to each employer group in accordance with negotiated contracts, and such premium revenue is recognized when earned. Unearned premium revenue includes payments under prepaid Medicare contracts with the Health Care Financing Administration ("HCFA") and prepaid HPN, HMO Texas and MedOne commercial and SHL indemnity premiums. HPN offers a prepaid health care program to Medicare recipients. Revenues associated with these Medicare recipients were approximately $140,611,000, $111,584,000 and $82,792,000, in 1996, 1995 and 1994, respectively.
Discontinued Operations. During 1995 CII sold its interest in a subsidiary for a combination of common stock and warrants of the purchaser. This transaction was recorded as a discontinued operation.
Credit risk with respect to accounts receivable is generally diversified due to the large number of entities comprising the Company's customer base and their dispersion across many different industries. These customers are primarily located in the states in which the Company operates. Such operations are principally in Arizona, California, Colorado, Nevada and Texas. However, the Company is licensed and does business in several other states as well. The Company performs ongoing credit evaluations of its customers' financial condition.
The following is an analysis of property and equipment under capital leases by classification:
The Company capitalizes interest expense as part of the cost of construction of facilities. Interest expense capitalized in 1996, 1995, and 1994 was $245,000, $183,000 and $119,000, respectively.
Marketable debt investments that the Company has the intention and ability to hold to maturity are stated at amortized cost, and categorized as held-to-maturity. The remaining marketable debt and equity investments have been categorized as available-for-sale and as a result are stated at their fair value. Unrealized holding gains and losses on available-for-sale securities are included as a separate component of stockholders' equity until realized. Gross realized gains and losses in 1996 were $6,826,000 and $4,475,000, respectively. Realized gains and losses are calculated using the specific identification method and are included in net income.
The following table provides workers' compensation reinsurance information by reinsurer for the three years ended December 31, 1996:
The following table provides a reconciliation of the beginning and ending reserve balances for unpaid LAE. There can be no assurances that favorable development, or the magnitude of the development, will continue in the future.
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 16.921 shares of the Company's common stock at a conversion price of $59.097 per share. Unamortized issuance costs of $1,114,000 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, 1996 and 1995 was $1,192,000 and $1,243,000, respectively. The Debentures are redeemable by CII, in whole or in part, at redemption prices ranging from 103.00% in 1997 to 100.75% in 2000, plus accrued interest for the twelve month period beginning September 15 of the applicable year. The Debentures are general unsecured obligations of CII only and were not assumed or guaranteed by Sierra. During the twelve months ended December 31, 1996, the Company purchased $2,303,000 of the debentures on the open market.
Adjustable Rate Mortgage Note. The Company has a mortgage which has an adjustable rate with an interest margin of 3% over the Federal Home Loan Bank Board 11th District Cost of Funds Index, a maximum interest rate of five percentage points above the initial rate of 11.85% and a minimum interest rate of 8%. The interest rate at December 31, 1996 was 8%. This mortgage is secured by a medical facility.
Other. The Company has obligations under capital leases with interest rates from 7.8% to 15.6%. In addition, the Company has a term loan due July 1998 including cumulative interest at 7%. During 1994, the Company assumed a $4,860,000 mortgage note in conjunction with a related party transaction. Monthly installments of $36,144, including interest at 7.12%, were due through July 1996, at which time the balance of the note was paid.
Ongoing Initiatives. On February 14, 1997, the Company submitted its final bid to be the prime contractor to the Civilian Health and Medical Program of the Uniformed Services ("CHAMPUS") to provide managed health care coverage to CHAMPUS eligible beneficiaries in Region 1. This region includes approximately 665,000 individuals in Connecticut, Delaware, Maine, Maryland, Massachusetts, New Hampshire, New Jersey, New York, Pennsylvania, Rhode Island, Vermont, northern Virginia and Washington, D.C. The Company expects to incur total expenses of approximately $8,000,000 to $10,000,000 during the Region 1 contract proposal process. The Company submitted its final bid on February 14, 1997 and anticipates learning of the result of its bid in the second quarter of 1997. The contract, if awarded to the Company, will result in approximately $1.8 billion in estimated revenues over the term of the contract.
Rent expense totaled $6,374,000, $4,942,000 and $4,873,000 in 1996, 1995 and 1994, respectively.
Supplemental Retirement Plan. The Company has Supplemental Retirement Plans (the "SRPs") for certain officers, directors and highly compensated employees. The SRPs are non-qualified deferred compensation plans through which participants may elect to postpone the receipt and taxation of all or a portion of their salary and bonuses received from the Company. The Company also matches 50% of those contributions that participants are restricted from deferring, if any, under the Company's pension and 401(k) plan. As contracted with the Company, the participants or their designated beneficiaries may begin to receive benefits under the SRPs upon participant death, disability, retirement, termination of employment or certain other circumstances including financial hardship.
Other CII Plans. Prior to the acquisition of CII, CII maintained various supplemental benefit, executive benefit, and profit sharing plans. Subsequent to the merger all such plans have been, or are in the process of being, discontinued, terminated, or merged into the Company's existing plans. During the years ended December 31, 1995 and 1994, CII expensed $1,574,000 and $2,485,000, respectively, under the various plans. Eligible CII employees are included in the Company's plans discussed above.
In addition, in 1995 the shareholders of the Company approved the 1995 Non-Employee Directors' Stock Plan ("Directors' Plan"). Under the Directors' Plan non-employee directors are granted an option to purchase 3,000 shares of common stock. Options are granted annually on January 20 at the current fair market value and become exercisable over a five year period. The Company reserved 60,000 shares under the Directors' Plan.
Accounting for Stock-Based Compensation. At December 31, 1996, the Company had three stock- based compensation plans, which are described above. The Company applies APB 25 and related Interpretations in accounting for its plans. Accordingly, no compensation cost has been recognized for its fixed stock option plans nor the Purchase Plan. Had compensation cost for the Company's three stock- based compensation plans been determined based on the fair value at the grant dates for awards under those plans consistent with the method of FAS 123, the Company's net income and earnings per share would have been reduced to the pro forma amounts indicated below:
The fair value of each option grant is estimated on the date of grant using the Black-Scholes option pricing model with the following weighted average assumptions used for grants in 1995 and 1996, respectively: dividend yield of 0% for all years; expected volatility of 34% and 29%; risk-free interest rates of 6.12% and 5.92%; and expected lives of four years for all years. The weighted fair value of options granted in 1995 and 1996 was $9.49 and $8.47, respectively.
The fair value of the look-back option implicit in each offering of the Purchase Plan is estimated on the date of grant using the Black-Scholes option pricing model with the following weighted average assumptions used for grants in 1995 and 1996, respectively: dividend yield of 0% for all years; expected volatility of 34% and 29%; risk-free interest rates of 6.07% and 5.29%; and expected lives of six months for all years.
As a result of higher than expected claim and administrative costs relative to premium rates that can be obtained in certain regional insurance operations and the Company's inability to negotiate adequate provider contracts due to its limited presence in some of these markets, the Company adopted a plan to restructure certain insurance operations during the third quarter of 1996 and recorded a charge of $8,250,000 ($6,187,000 after tax). The plan will allow the Company to focus on more favorable operating markets and improve operating efficiencies. The Company believes that this restructuring, over time, will result in improved cash flow and operating cost savings.
These restructuring costs included cancellation of certain contractual obligations of $6,000,000, lease termination costs of $1,500,000 and approximately $4,564,000 of other costs including the estimated costs to dispose of the hospital. As of December 31, 1996, approximately $4,100,000 of these costs had been paid or otherwise charged against the accrual and the Company estimates that most of the remaining cash expenditures will be paid over the next twelve months.
On March 18, 1997, the Company announced it had terminated its merger agreement with Physician Corporation of America ("PCA"). The original agreement had been entered into in November 1996. On March 18, 1997, prior to termination of the merger agreement, PCA filed a lawsuit against the Company in the United States District Court for the Southern District of Florida (the "District Court"), seeking, among other things, specific performance of the merger agreement and monetary damages. While the Company believes the PCA lawsuit is without merit, there can be no assurance as to the outcome of the PCA lawsuit. The Company has filed a motion in the District Court seeking a dismissal of the PCA lawsuit for lack of diversity jurisdiction. The Company has also initiated a lawsuit in the Court of Chancery of the State of Delaware seeking a declaratory judgment as well as other remedies. The Company intends to vigorously pursue all remedies available to it, however, there can be no assurance that the Company will prevail in such litigation or that PCA will have sufficient funds to pay any damages that the Company may be awarded. During the first quarter of 1997 the Company intends to record certain costs and expenses incurred as a result of the terminated merger.