Prior to and for most of the year 1998, the business of the Company, then known as "United Wisconsin Services, Inc.", consisted of two main components: the small group PPO business and the managed care and specialty business. On September 11, 1998, the Company contributed all of its subsidiaries comprising the managed care and specialty business to a newly created subsidiary named "Newco/UWS, Inc.", a Wisconsin corporation ("Newco/UWS"). On September 25, 1998, the Company spun off the managed care and specialty business through a distribution of 100% of the issued and outstanding shares of common stock of Newco/UWS to the Company's shareholders of record as of September 11, 1998. The Company thereupon adopted its current name of "American Medical Security Group, Inc." and Newco/UWS changed its name to "United Wisconsin Services, Inc."
The net assets of Newco/UWS consisted of assets and liabilities of the managed care and specialty management business along with $70.0 million in debt that was assumed by Newco/UWS in conjunction with the spin-off. As a result of the spin-off, the revenues and expenses, assets and liabilities, and cash flows of the managed care and specialty business have been classified as discontinued operations in the consolidated financial statements. The continuing operations of the Company as reported herein reflect the small group PPO insurance portion of the Company's business. The Company obtained a private letter ruling from the Internal Revenue Service to the effect that the spin-off qualifies as tax-free to the Company, Newco/UWS and the Company's shareholders.
During the third quarter of 1999, the Company announced plans to cease marketing and terminate existing small group business in Florida and all remaining business in Maryland and Minnesota over a period of 18 months. This decision was made after it became clear to management that certain regulatory challenges existed which made it impossible to return these markets to profitability. Management of the Company made a considerable effort to work with state regulators on a reasonable resolution which entailed necessary rate increases. Upon notification from the state regulators that the Company was denied the rate increases considered necessary, management reevaluated the assumptions used for this grouping of markets and found it necessary to record a premium deficiency reserve. Insurance contracts are grouped as relating to highly regulated markets and all other markets. Highly regulated markets include exited and other markets. These markets are identified based on significant rating restrictions, states' general legislative and regulatory environments, and the Company's ability to effectively underwrite risk. The Company recorded a $13.7 million after-tax charge for a premium deficiency reserve to recognize expected losses related to highly regulated markets.
The expense ratio for the Company's health segment improved in 1999 compared to 1998 due mainly to management's commitment to increase operating efficiencies. The Company's low cost infrastructure and superior operating efficiencies provide flexibility and opportunities for targeted acquisitions and continued growth through new sales.
The Company's balance sheet remains strong with a book value per share of $14.86 as of December 31, 1999 and a tangible book value per share of $7.69. In addition, the Company reported positive cash flows from operations for 1999 of $26.4 million.
The Company's medical membership inforce of 630,217 at the end of 1999 was down slightly compared to 636,238 at the end of the prior year. Membership in the three states that the Company is exiting totaled 66,964 at December 31, 1999. The effect of the implemented premium rate increases and exited states is expected to result in decreased membership in 2000.
The Company experienced unrelated non-recurring items in each of the three years in the period ended December 31, 1999. Management believes that these non-recurring items are not reflective of the ongoing operations of the Company and has chosen to discuss their effects separately. The following table illustrates the effect of non-recurring items on the Company's results:
A summary description of each of the non-recurring items is as follows:
In the fourth quarter of 1997, the Company acquired from Pan American most of the health insurance business which is marketed to individuals and small employer groups. The Company incurred an after-tax charge of $4.1 million directly related to this acquisition.
The Company's intangible distribution system asset was acquired in 1996 as part of a merger. During 1997 and 1998, the Company experienced significant turnover of sales managers and began to reorganize sales offices. During that period, the Company replaced commissioned independent sales managers with salaried sales offices, while it evaluated the Company's distribution strategy. In the fourth quarter of 1998, management concluded that a salaried sales office structure was more consistent with current strategy and that the Company's intangible distribution system asset was impaired. As a result, the Company recorded an after-tax charge of $9.3 million to write-off the intangible asset and other related costs.
Health insurance premium revenue increased 13.9% to $985.3 million from $865.2 million in 1998. The increase in premium revenue reflects both internal growth and business acquired from other insurance carriers. Premium revenue related to CNA acquired business for the year ended December 31, 1999 totaled $83.4 million. In addition, the Company's average fully insured medical premium per member per month was higher in 1999 at $127 compared to $123 for 1998. Life insurance premium revenues increased 6.9% in 1999 to $26.2 million from $24.5 million in 1998, which is the result of a 6.0% increase in life membership from 1998 to 1999. Management anticipates premium revenue to remain essentially flat in 2000 as a slight membership decline is offset by premium rate increases.
Net investment income includes investment income and realized gains and losses on investments. Net investment income for 1999 decreased 21.9% to $18.9 million from $24.2 million for 1998. Investment gains and losses are realized in the normal investment process in response to market opportunities. During 1999, the Company had $0.8 million in realized investment losses compared to realized investment gains in 1998 totaling $3.7 million. Average annual investment yields, excluding realized gains and losses, were also down to 6.7% for the year ended December 31, 1999, compared to 7.3% for the same period in the prior year.
Other revenues, which is primarily made up of administrative fee income from claim processing and other administrative services, remained relatively stable decreasing to $22.4 million in 1999 from $22.6 million in 1998.
Results from continuing operations for 1998 was a loss of $3.0 million, which was a $4.6 million decrease from income of $1.6 million for 1997. Excluding non-recurring charges and excluding interest on debt assumed by Newco/UWS, income from continuing operations for 1998 was $8.4 million compared to $8.9 million for 1997. The modest decline in income from continuing operations reflected an improved loss ratio offset by increased selling, general and administrative expenses.
For 1998, health insurance premiums declined 5.8% to $865.2 million from $918.6 million in 1997. The decline in premium was primarily the result of a decline in average fully insured medical membership of 7.2% in 1998 compared to 1997 reflecting the Company's efforts to cull unprofitable business. Life insurance premiums declined 15.4% in 1998 to $24.5 million from $28.9 million in 1997 which was consistent with the decline in average life membership of 16.2% in 1998 compared to 1997.
The health loss ratio for the year ended December 31, 1998 was 76.7%, an improvement from 77.5% for 1997. The improved loss ratio for 1998, as previously mentioned, reflected the cancellation of unprofitable business, including the stand-alone dental business effective June 1, 1998, increased higher margin new business and repricing of existing business. The life loss ratio for the year ended December 31, 1998, was 31.5%, which was an improvement from 35.3% for 1997.
The expense ratio includes commissions, administrative expenses and premium taxes and assessments, but excludes non-recurring charges. For 1998, the expense ratio for health products was 23.9% compared to 23.0% for 1997. The increased health expense ratio for 1998 reflected higher commission costs related to growth in new business in 1998 over 1997 and an investment in the Company's distribution network. Also contributing to the increase in the expense ratio were expenses related to the Year 2000 initiative, and a one-time investment in re-engineering administrative work flow processes.
For 1998, interest expense decreased to $7.7 million from $9.3 million for 1997. The decrease in interest expense for 1998 reflected the assumption of $70.0 million in debt by Newco/UWS on September 11, 1998, as part of the spin-off transaction, as further described in Note 2 to the Consolidated Financial Statements. Excluding the interest on debt assumed by Newco/UWS, interest expense for 1998 was approximately $4.3 million.
Amortization of goodwill and intangibles for the year ended December 31, 1998, increased to $8.8 million from $8.0 million at December 31, 1997. The increase in amortization expense in 1998 was primarily due to recorded intangible assets related to the Pan American small group business acquired in October 1997.
The effective tax rate for the year 1998 was 38.1% compared with 39.9% for the year 1997. The change in the effective tax rate relates to the amortization of non-deductible goodwill in relation to pre-tax income.
The Company's insurance subsidiaries operate in states that require certain levels of regulatory capital and surplus and may restrict dividends to their parent companies. Based upon the financial statements of the Company's insurance subsidiaries as of December 31, 1999, as filed with the insurance regulators, no dividends may be paid by these subsidiaries without prior regulatory approval. The National Association of Insurance Commissioners ("NAIC") has adopted risk-based capital ("RBC") standards for life and health insurers designed to evaluate the adequacy of statutory capital and surplus in relation to various business risks faced by such insurers. The RBC formula is used by state insurance regulators as an early warning tool to identify insurance companies that potentially are inadequately capitalized. At December 31, 1999, the Company's principal insurance company subsidiaries had an RBC ratio that was substantially above the levels which would require regulatory action.
On July 31, 1998, the Company entered into a five-year revolving bank line of credit with a maximum commitment of $70.0 million. During 1998, the Company borrowed $45.2 million on the bank line of credit to retire its subordinated notes outstanding. Effective November 5, 1999, the Company entered into an agreement to amend the line of credit to reduce the maximum commitment from $70.0 million to $40.0 million. In conjunction with the commitment reduction, the Company paid $10.0 million on the loan outstanding on November 5, 1999, reducing the outstanding balance to $35.2 million. The maximum commitment will be further reduced to $30.0 million on July 31, 2001. The stock of American Medical Security Holdings, Inc. and United Wisconsin Life Insurance Company, subsidiaries of the Company, has been pledged as collateral for the loan. The line of credit contains certain covenants which, among other matters, require the Company to maintain a minimum tangible net worth and restricts the Company's ability to incur additional debt, pay future cash dividends and transfer assets. The Company was in compliance with all such covenants at December 31, 1999.
The bond portfolio had an average quality rating of Aa3 at December 31, 1999, and A1 at December 31, 1998, as measured by Moody's Investor Service. Almost the entire portfolio was classified as available for sale. The Company had no investment mortgage loans, non-publicly traded securities (except for principal only strips of U.S. Government securities), real estate held for investment or financial derivatives. The amortized cost of the total investment portfolio exceeded market value by $16.1 million at December 31, 1999. Management believes that cash flow from operations will be sufficient for its cash flow needs and that liquidation of its investment portfolio will not be necessary.
The primary market risk affecting the Company is interest rate risk. Assuming an immediate increase of 100 basis points in interest rates, the net hypothetical decline in fair value of shareholders' equity is estimated to be $7.5 million after-tax at December 31, 1999. This amount represents approximately 3.4% of the Company's shareholders' equity.
At December 31, 1999, the fair value of the Company's borrowings under the line of credit facility approximated the carrying value. Market risk was estimated as the potential increase in the fair value resulting from a hypothetical 1% decrease in the Company's weighted average short-term borrowing rate at December 31, 1999, and was not materially different from the year end carrying value.
During 1998 and 1999, the Company devoted significant time and resources in the effort to prepare for the Year 2000 initiative. The Year 2000 project focused on issues facing the Company in three major areas: 1) software applications developed internally, 2) software applications acquired from a third party that had been customized by the Company, and 3) software applications acquired from a third party that had not been customized by the Company and those products and services provided to the Company by third parties.
The Company evaluated all of its major business processes and developed detailed business continuity and contingency plans designed to deal with identified worst case scenarios with the highest chance of occurring. By the end of 1999, the Company had reached a state of readiness such that all significant applications were Year 2000 compliant.
The cost of the Year 2000 project was funded through operating cash flows and did not have a material impact on the Company's financial position. The Company incurred total costs of $3.2 million ($1.2 million in 1999) relating to the Year 2000 project. In addition, the Company made total capital expenditures of $4.5 million ($2.7 million in 1999). The Company does not anticipate significant future operating and capital expenditures related to the Year 2000 project.
This report and other documents or oral presentations prepared or delivered by and on behalf of the Company contain or may contain forward-looking statements. Such statements are based upon management's current expectations and are subject to risks and uncertainties that could cause the Company's actual results to differ materially from those contemplated in the statements. Readers are cautioned not to place undue reliance on the forward-looking statements. When used in written documents or oral presentations, the terms "anticipate", "believe", "estimate", "expect", "objective", "plan", "possible", "potential", "project" and similar expressions are intended to identify forward-looking statements. In addition to the assumptions and other factors referred to specifically in connection with such statements, factors that could cause the Company's actual results to differ materially from those contemplated in any forward-looking statements include, among others, the following:
- - Federal and state health care reform laws adopted in recent years, currently proposed or that may be proposed in the future which affect or may affect the Company's operations, products, profitability or business prospects. Reform laws adopted in recent years generally limit the ability of insurers and health plans to use risk selection as a method of controlling costs for small group business.
- - Factors related to the Company's plans to deal with adverse medical loss ratio trends in its small group health business (which include implementing significant rate increases, exiting three nonproductive markets, and introducing redesigned products), including the willingness of employers and individuals to accept rate increases, premium repricing and redesigned products.
- - The development of and changes in claims reserves, particularly for exited markets where insured may be inclined to increase utilization prior to termination of their policies.
- - The ability of the Company to continue the growth of its individual and small group health business, and its ancillary group products, including group life, dental and self funded business.
- - The cost and other effects of legal and administrative proceedings, including the expense of investigating, litigating and settling any claims against the Company, and the general increase in litigation involving managed care and medical insurers.
- - Unanticipated developments related to Year 2000 issues, including those affecting third parties with whom the Company does business.
- - Factors affecting the Company's ability to hire and retain key executive, managerial and technical employees.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of the Company as of December 31, 1999 and 1998, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 1999, in conformity with accounting principles generally accepted in the United States. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein.
American Medical Security Group, Inc., together with its subsidiary companies ("AMSG" or the "Company"), is a provider of health care benefits and insurance products for individuals and small employer groups. The Company's principal product offering is health insurance for small employer groups and health insurance for individuals and families ("MedOne"). The Company also offers life, dental, prescription drug, disability and accidental death insurance, and provides self funded benefit administration. The Company's products are actively marketed in 31 states and the District of Columbia through independent agents. Approximately 100 Company sales managers located in sales offices throughout the United States support the independent agents. The Company's products generally provide discounts to insureds that utilize preferred provider organizations ("PPOs"). AMSG owns a preferred provider network and also contracts with several other networks to ensure cost-effective health care choices to its customers.
The fair values of investments are reported in Note 3. The fair values of other financial instruments, principally other assets, advanced premiums, payables and accrued expenses, notes payable and other liabilities approximate their December 31, 1999 and 1998 carrying values.
The Company periodically evaluates whether events and circumstances have occurred which may affect the estimated useful life or the recoverability of the remaining balance of its intangibles. A study conducted during 1998 determined that the Company's sales distribution system intangible assets were impaired. The sales distribution system was acquired on December 3, 1996 in conjunction with the purchase of the Company's small group business. Since the acquisition, the Company has largely eliminated its commission-based sales distribution system, replacing it with salaried sales offices. This resulted in an after-tax charge to 1998 operations of $9,251,000 or $0.56 per share, including $7,683,000 of intangible distribution system assets and $1,568,000 of related costs. The Company's management believes that no impairment of goodwill or other intangible assets exists at December 31, 1999.
During 1999, the Company established a premium deficiency reserve for its highly regulated markets. At December 31, 1999, the Company has remaining recorded premium deficiency reserves totaling $16,700,000, which is included in medical and other benefits payable in the accompanying balance sheet. No premium deficiency reserves were recorded prior to 1999.
The Company limits the maximum net loss that can arise from certain lines of business by reinsuring (ceding) a portion of these risks with other insurance organizations (reinsurers) on an excess of loss or quota share basis. The Company's retention limit is $500,000 per policy year for medical claims and $50,000 for life claims. The Company is contingently liable on reinsurance ceded in the event that the reinsurers do not meet their contractual obligations.
A reconciliation of the numerator and denominator of the basic and diluted earnings per common share ("EPS") is as follows:
The amortized cost and estimated fair values of investments are as follows:
The amortized cost and estimated fair values of debt securities at December 31, 1999 by contractual maturity are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations.
Property and equipment are stated at cost and are summarized as follows:
The Company recognized depreciation expense on property and equipment of $4,544,000, $5,450,000, and $8,625,000 in 1999, 1998 and 1997, respectively.
On July 31, 1998, the Company entered into a five year revolving bank line of credit with a maximum commitment of $70,000,000, and a $10,000,000 sublimit for swingline loans. Under the bank line of credit, the Company had the option to select an interest rate based on the Eurodollar rate or alternate base rate. The alternate base rate is the larger of the bank's corporate base rate of interest or the federal funds rate plus 1/2% per annum. The swingline loans may be used for short term borrowings and are required to be repaid no later than 30 days after they are made. Swingline loans are charged the bank's daily floating rate of interest.
In conjunction with the commitment reduction, the Company paid $10,000,000 on the loan outstanding on November 5, 1999, reducing the outstanding balance to $35,158,000. The amended line of credit agreement also revises pricing schedules and certain covenants which, among other matters, require the Company to maintain a minimum tangible net worth and restrict the Company's ability to incur additional debt, pay future cash dividends and transfer assets.
The mortgage payable is collateralized by the Company's home office property located in Green Bay, Wisconsin. The Company believes the carrying value of all notes payable approximates fair value.
On August 26, 1999, a $6,900,000 verdict was entered against the Company in a lawsuit which principally alleged breach of contract involving the timing of claims payments. The Company intends to appeal this decision to a Federal Appeals Court. Management expects the verdict to be reversed or substantially reduced following appeal. As a result, the Company's accrual related to this case is not material.
On February 7, 2000, a $5,400,000 verdict was entered against the Company in a lawsuit which alleged breach of contract involving commission amounts due to a former agent. The Company has filed objections requesting reversal of the decision and intends to appeal if necessary. Management expects the verdict to be reversed or substantially reduced following appeal. As a result, the Company's accrual related to this case is not material.
The Company has a stock-based compensation plan, the Equity Incentive Plan (the "Plan"), for the benefit of eligible employees and directors of the Company. The Plan permits the grant of nonqualified stock options ("NQSO"), incentive stock options, stock appreciation rights, restricted stock awards and performance awards. Persons eligible to participate in the Plan include all full-time active employees and outside directors of the board of directors. The Plan allows for the granting of up to 4,000,000 shares of which 918,677 shares are available for grant as of December 31, 1999. No benefits other than NQSOs have been granted under the plan.
On November 17, 1998, the Company and a key executive entered into a deferred stock agreement. Under the agreement the Company has an obligation to issue 73,506 shares of AMSG common stock provided the executive remains continuously employed with AMSG through November 17, 2002. The Company incurred expense of $225,000 in 1999 and $28,000 in 1998 related to this agreement.
The Company also has a Director Stock Option Plan which permits the grant of NQSOs. As of December 31, 1999, 29,000 shares are available for grant.
The Black-Scholes option valuation model was used in estimating the fair value of traded options which have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions including the expected stock price volatility. Since the Company's employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimates, in management's opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options.
The Company has two reportable segments: 1) health insurance products and 2) life insurance products. The Company's health insurance products consist of the following coverages related to small group PPO products: MedOne and small group medical, self funded medical, dental and short-term disability. Life products consist primarily of group term-life insurance. The "All Other" segment includes operations not directly related to the business segments and unallocated corporate items (i.e., corporate investment income, interest expense on corporate debt, amortization of goodwill and intangibles and unallocated overhead expenses). The Company's All Other segment also includes data for its 80% owned HMO subsidiary. The reportable segments are managed separately because they differ in the nature of the products offered and in profit margins.