As of December 31, 2002, we leased approximately 214,000 aggregate square feet of space for our principal corporate headquarters and executive offices in Cypress and Santa Ana, California. In connection with our operations, as of December 31, 2002, we leased approximately 1.7 million aggregate square feet for office space, subsidiary operations, customer service centers and space for computer facilities. Such space corresponds to areas in which our HMOs or specialty managed care products and services operate, or where we have satellite administrative offices. Our leases expire at various dates from 2003 through 2012.
The following selected financial and operating data are derived from our audited consolidated financial statements, or from our unaudited internal financial data. The selected financial and operating data should be read in conjunction with “
Premiums for our commercial products and Medicare+Choice products are generally fixed in advance of the periods covered. Of our commercial business, more than 50% of our membership renews on January 1 of each year, with premiums that are generally fixed for periods up to one year. In addition, each of our subsidiaries that offers Medicare+Choice products must submit adjusted community rate proposals, generally by county or service area, to CMS by September 9 for each such product that will be offered in a subsequent year. As a result, increases in the costs of health care service in excess of the estimated future health care costs reflected in the premiums or the adjusted community rate proposals generally cannot be recovered in the applicable contract year through higher premiums or benefit designs.
The cost of health care provided is accrued in the month services are provided to members, based in part on estimates for hospital services and other health care costs that have been incurred but not yet reported. We develop these estimates using actuarial methods based on historical data for payment patterns, cost trends, product mix, seasonality, utilization of health care services and other relevant factors. These estimates are adjusted in future periods as we receive actual claims data, and can either increase or reduce our accrued health care costs. The cost of prescription drugs covered under our commercial and senior plans is expensed when the prescription drugs are dispensed. Our commercial and senior plans also provide incentives, through a variety of programs, for health care providers that participate in those plans to control
Pharmacy benefit management PacifiCare HMO membership represents members that are in our commercial or senior HMO. All of these members either have a prescription drug benefit or are able to purchase their prescriptions utilizing our retail network contracts or our mail service.
PacifiCare behavioral health HMO membership at December 31, 2002 decreased approximately 6% compared to the prior year due to declines in commercial HMO membership resulting from renewal premium rate increases primarily in Texas. Behavioral health unaffiliated membership at December 31, 2002 increased approximately 22% compared to the prior year due to the addition of one large employer group in the Eastern United States.
Other Income. Other income increased 15% or $26 million for the year ended December 31, 2002 compared to the same period in the prior year. The increase was primarily due to increased mail-service revenues of our pharmacy benefit management subsidiary.
During 2002, we wrote off our entire $11 million investment in MedUnite, Inc., or MedUnite. In late 2002, MedUnite was acquired by ProxyMed Inc. Additionally, during 2002, we wrote down certain telecommunications investments to market value resulting in a charge of approximately $2 million during the second quarter of 2002. In total, we recorded a charge of $13 million ($8 million, or $0.22 diluted loss per share, net of tax) for other than temporary impairments to the value of these investments which is included in net investment income. In addition to the impairment of these investments, we experienced lower pretax rates of return on our portfolio as a result of lower investable balances and interest rates that have been declining since 2001.
Commercial Medical Loss Ratio. The commercial medical loss ratio includes results from our specialty HMO and indemnity insurance operations. Our commercial medical loss ratio decreased to 87.5% for the
Commercial health care costs increased $123 million for the year ended December 31, 2002 compared to the prior year. On a per-member per-month basis, these costs increased 13% to $152.64 per member per month for the year ended December 31, 2002 compared to $135.04 in 2001. The increase was due primarily to a 10% increase in physician costs, a 13% increase in hospital costs, and a 16% increase in pharmacy costs, on a per-member per-month basis.
On an absolute dollar basis, senior health care costs decreased $1 billion for the year ended December 31, 2002 compared to the prior year due primarily to the significant decline in senior membership. However, on a per-member per-month basis, these costs increased 4% to $520.23 per member per month for the year ended December 31, 2002 as compared to $501.65 for the prior year. The per-member per-month increase was due primarily to a 4% increase in physician costs and a 4% increase in hospital costs, partially offset by a 25% decrease in pharmacy costs.
principal amount of 3% convertible subordinated debentures in the fourth quarter of 2002, which carried a lower annual interest rate than the debt we repaid using a portion of the proceeds of that offering. See Note 5 of the Notes to Consolidated Financial Statements.
Provision for Income Taxes. The effective income tax rate was 37.3% for the year ended December 31, 2002, compared with 67.9% in 2001. The decrease was primarily attributable to our adoption of Statement of Financial Accounting Standards (SFAS) No. 142, Goodwill and Other Intangible Assets, effective January 1, 2002. Under SFAS No. 142, beginning with the first quarter of 2002, goodwill is no longer being amortized. Because a significant portion of our goodwill amortization was nondeductible, this accounting change caused a significant reduction to our effective tax rate.
Reconciliation of Reported Results to Pro Forma Results. In our fourth quarter 2002 earnings announcement, we disclosed pro forma results as described in the following table. See Notes 5, 7 and 10 of the Notes to Consolidated Financial Statements.
As adjusted for the elimination of goodwill amortization under SFAS No. 142, as if adopted on January 1, 2001.
Generally accepted accounting principles (GAAP) require the use of basic weighted average shares outstanding when reporting a net loss. The diluted weighted average shares outstanding were 36,137,000 for the year ended December 31, 2002.
Membership. Total HMO membership decreased 16% to approximately 3.4 million members at December 31, 2001 from approximately 4.0 million members at December 31, 2000.
Decrease of 233,000 members in California and 138,700 members in Texas primarily due to premium rate increases that averaged 8% in California and 13% in Texas in 2001 and provider network disruptions;
Decrease of 83,500 members in Colorado, primarily due to premium rate increases that averaged 14% in 2001 and 2001 county exits; and
Decrease of 35,000 members as a result of our exit of all HMO operations in Ohio.
Senior HMO membership decreased approximately 10% at December 31, 2001 compared to the prior year primarily due to a:
Decrease of 101,900 members primarily as a result of 2000 and 2001 county exits, capacity waivers and voluntary closure notices in California, Colorado, Oregon and Washington;
Decrease of 3,500 members as a result of our exit of all HMO operations in Ohio; and
Increase of 1,500 members in Arizona primarily due to competitor exits in areas where Secure Horizons remained.
PacifiCare behavioral health HMO membership at December 31, 2001 decreased approximately 10% compared to the prior year primarily due to membership losses in Arizona, Colorado and Texas. Behavioral health unaffiliated membership at December 31, 2001 increased approximately 13% compared to the prior year primarily due to additional membership in Oregon.
Commercial Premiums. Commercial premiums include results from our specialty HMO and indemnity insurance operations. Commercial premiums decreased 2% or $116 million for the year ended December 31, 2001 compared to the prior year as follows:
Impairment, Disposition, Restructuring, OPM and Other Charges (Credits). We recognized net pretax charges of $61 million ($39 million or $1.13 diluted loss per share, net of tax) for the year ended December 31, 2001. See Note 10 of the Notes to Consolidated Financial Statements.
Lower outstanding debt balances due to payments made on our senior credit facility during 2000 and 2001; and
Lower overall interest rates paid on our senior credit facility, as a result of Federal Reserve rate reductions in 2001.
Reconciliation of Reported Results to Pro Forma Results. In our fourth quarter 2001 earnings announcement, we disclosed pro forma results as described in the following table. See Note 10 of the Notes to Consolidated Financial Statements.
Operating Cash Flows. Our consolidated cash, equivalents and marketable securities increased $0.1 billion or 5% to $2.1 billion at December 31, 2002, from $2.0 billion at December 31, 2001.
Cash flows provided by operations, excluding the impact of unearned premium revenue, were $315 million for the year ended December 31, 2002 compared to cash flows used in operations, excluding the impact of unearned premium revenue, of $86 million for the year ended December 31, 2001. The increase was primarily related to changes in assets and liabilities as discussed below in “Other Balance Sheet Explanations.”
Financing Activities. For the year ended December 31, 2002, financing activities provided $10 million of cash, compared to $52 million used during the year ended December 31, 2001. During the year ended December 31, 2002, the significant changes were as follows:
We paid $38 million in loan fees, including $20 million in connection with the 10 3/4% senior notes offering, $13 million in connection with the amendment to the senior credit facility, and $5 million in connection with the 3% convertible subordinated debentures offering. In 2001, we paid $13 million in loan fees;
We received $9 million in proceeds from a draw down on our equity commitment arrangement, with no comparable activity during 2001;
We reissued $5 million of treasury stock in connection with employee benefit plans compared with insignificant activity in 2001;
During 2001, we paid $9 million to three minority stockholders for all outstanding stock of our consolidated minority subsidiary, with no comparable activity during 2002.
In the second quarter of 2002, we sold $500 million in aggregate principal amount of 10 3/4% senior notes due in 2009 in a private placement. The 10 3/4% senior notes were issued at 99.389%, for a discount of $3 million that is being amortized over the term of the notes. We used a portion of the net proceeds from the 10 3/4% senior notes to repay $369 million in indebtedness under our senior credit facility, including $315 million under our term loan facility and $54 million under our revolving credit facility. Additionally, we used $85 million of the net proceeds to fund a restricted cash collateral account that has been and will be used, subject to our being in compliance with the senior credit facility, to repurchase or repay the FHP senior notes prior to, or on, their stated maturity date. As of December 31, 2002, we had used $42 million of the restricted cash collateral account to purchase and permanently retire FHP senior notes. We also used $22 million of the net proceeds as a deposit against outstanding letters of credit under our senior credit facility. We subsequently replaced all but approximately $1 million of these letters of credit, and the corresponding deposits were released to us. As of December 31, 2002, our letter of credit commitments totaled $19 million, and were backed by funds deposited in restricted cash accounts maintained by us. In connection with the 10 3/4% senior notes offering, we incurred approximately $20 million in fees that will be amortized over the term of the notes.
Certain of our domestic, unregulated subsidiaries fully and unconditionally guarantee the 10 3/4% senior notes. Certain of our other domestic, unregulated subsidiaries are currently restricted from guaranteeing
We may continue to seek to refinance our senior bank credit facility, which will mature in January 2005, using equity or debt financing alternatives. Our debt is rated below investment grade by the major credit rating agencies as follows:
Consequently, if we seek to raise funds in capital markets transactions, our ability to do so will be limited to issuing additional non-investment grade debt or issuing equity and/or equity-linked instruments. We may not be able to issue any such securities at all or on terms favorable to us. Any issuance of equity or equity-linked securities may result in substantial dilution to our stockholders.
In December 2001, we entered into an equity commitment arrangement with Acqua Wellington North American Equities Fund Ltd., or Acqua Wellington, an institutional investor, for the purchase by Acqua Wellington of up to 6.9 million shares or $150 million in our common stock. In April 2002, we made a draw down under our equity commitment arrangement with Acqua Wellington. As a result of this draw down, we sold 420,720 shares to Acqua Wellington for an average price of $21.39 per share. The total proceeds from the draw down were approximately $9 million. This equity commitment arrangement will expire in June 2003.
objectives. Our contractual cash obligations, including long-term debt and other commitments, as of December 31, 2002 were as follows:
As of December 31, 2002, we had $43 million available in a restricted cash collateral account that will be used to repurchase or repay the FHP senior notes.
$21 million decrease in premiums receivable primarily related to a reduction in membership and an increase in collection efforts, partially offset by premium rate increases;
$11 million decrease in trade receivables, primarily due to the impact of lower 2002 rebates earned due to changes in senior prescription drug benefits, partially offset by increased billings for new unaffiliated pharmacy benefit management customers; and
Goodwill and Intangible Assets, Net. Goodwill and intangible assets as of December 31, 2002 decreased 44% from December 31, 2001 due primarily to a $929 million goodwill impairment charge (before the deferred tax impact) and $24 million of intangible amortization expense. As more fully described in Note 7 of the Notes to Consolidated Financial Statements, we recorded impairment charges as the cumulative effect of a change in accounting principle in connection with our adoption of SFAS No. 142, Goodwill and Other Intangible Assets, as of January 1, 2002.
Medical claims and benefits payable as of December 31, 2002 decreased $51 million from December 31, 2001, primarily because senior shared-risk membership has decreased 6% since December 31, 2001. This senior membership decrease more than offset increased senior health care costs trends.
Accounts Payable and Accrued Liabilities. Accounts payable and accrued liabilities decreased $26 million from December 31, 2001, primarily due to the decrease in the OPM reserve, offset in part by increased selling, general and administrative expenses, as described in “Results of Operations - Selling, General and Administrative Expenses.”
We cannot predict whether we will be able to replace some or all of the revenue we may lose in the future from our Medicare+Choice products, with new sources of revenue. Without a replacement for any lost revenue from our Medicare+Choice products, our results of operations could be adversely affected.
We have reduced our participation in the Medicare+Choice program, which has accounted for more than 50% of our total revenue in each year since 1998, because of shortfalls in Medicare+Choice premiums compared to our rising health care services expenses and increased Medicare administration costs. These shortfalls contributed to our decision to cease offering or close enrollment in our Medicare+Choice products in various counties in 2000 through 2003, including our plan to withdraw our Medicare+Choice products in five counties in California and Texas in 2003 affecting 37,000 members or approximately 5% of our senior HMO membership. These shortfalls also contributed to changes in our benefits, copayments and deductibles.
We also expect to experience voluntary attrition, which may be significant, in our Medicare+Choice membership as we continue to scale back benefits and increase monthly premiums under our Medicare+Choice products to achieve more profitable levels. Our market exits, together with the voluntary attrition that we attribute to reduced benefits and increased premiums resulted in a reduction of approximately 225,000 members in the year ended December 31, 2002. We currently expect Medicare+Choice membership to decline 11% during 2003, due primarily to benefit design changes and our exit from five counties affecting 37,000 members. To the extent that we continue to reduce our participation in the Medicare+Choice program, our revenue will decline unless lost revenue from our Medicare+Choice products is replaced with revenue from other sources, such as our Medicare supplement product offerings or other lines of business. We cannot predict whether or when we will be able to replace some or all of our lost revenue from our Medicare+Choice products with new sources of revenue. Without a replacement for any lost revenue from our Medicare+Choice products, our results of operations could be adversely affected, for example by increasing our administrative costs as a percentage of our revenue.
Of our commercial business, more than 50% of our membership renews on January 1 of each year, with premiums that are generally fixed for periods up to one year. In addition, each of our subsidiaries that offers Medicare+Choice products must submit adjusted community rate proposals, generally by county or service area, to the CMS by September 9 for each Medicare+Choice product that will be offered in a subsequent year. As a result, increases in the costs of health care services in excess of the estimated future health care costs reflected in the premiums or the adjusted community rate proposals generally cannot be recovered in the applicable contract year through higher premiums or benefit designs. Many factors, including health care costs that rise faster than premium increases, increases in utilization and regulatory changes, could cause actual health care costs to exceed what was estimated and reflected in premiums. To the extent that such excesses occur, our results of operations will be adversely affected.
Our future profitability will depend in part on accurately pricing our products, predicting health care costs, the provider reimbursement methodology and on our ability to control future health care costs.
Our revenues have declined during 2002 compared to 2001 due to commercial and senior membership losses, primarily as a result of our exits of unprofitable markets and products, termination of contracts with network providers and increased premiums and benefit reductions. A loss of profitable membership, an inability to increase commercial membership in targeted markets, including unaffiliated membership in our PBM and other specialty businesses, including our PPO and Medicare Supplement products, an inability to gain market acceptance and expected membership in new product lines, including our PPO and Medicare Supplement products, or an inability to achieve expected premium increases could result in lower revenues than expected and negatively affect our financial position, results of operations or cash flows. Factors that could contribute to the loss of membership, failure to gain new members in targeted markets or new product lines, or lower premium revenue include:
the inability of our marketing and sales plans to attract new customers or retain existing customers for existing products and new products;
our exit from selected service areas, including Medicare+Choice markets or commercial markets;
reductions in work force by existing customers and/or reductions in benefits purchased by existing customers;
In 2001, the Texas legislature adopted changes to legislation that affect contracts that our Texas subsidiary enters into or renews with its delegated network providers after January 1, 2002. State regulators may take the position that this legislation provides that HMOs are liable for paying individual provider claims that are otherwise the financial responsibility of the capitated physician group if the HMO does not comply with the oversight requirements of the legislation. As of December 31, 2002, our Texas subsidiary had contracts with two capitated network providers that pay their own claims, covering approximately 33,000 or 17% of our Texas membership. We cannot predict whether the financial condition of our Texas providers will continue to deteriorate. To the extent that we do not accurately estimate the timing, amount or outcome of claims asserted against us based on providers with whom we have capitated contracts and who become insolvent, our results of operations or cash flows for a future period could be materially and adversely affected.
In any particular market, health care providers could refuse to contract, demand higher payments, or take other actions that could result in higher health care costs or difficulty meeting regulatory or accreditation requirements. In some markets, some health care providers, particularly hospitals, physician/hospital organizations or multi-specialty physician groups, may have significant market positions, or may be the only health care provider available in that market. If health care providers refuse to contract with us, use their market position to negotiate favorable contracts, or place us at a competitive disadvantage, then our ability to market products or to be profitable in those markets could be adversely affected. Our provider networks could also be disrupted by the financial insolvency of large provider groups such as those that occurred in Texas in 2001. A reduction in our membership resulting from disruptions in our health care provider networks would reduce our revenue and increase the proportion of our premium revenue needed to cover our health care costs.
Our results of operations could be adversely affected by understatements in our actual liabilities caused by understatements in our actuarial estimates of incurred but not reported claims.
If our claims processing system is unable to handle an increasing claims volume and unable to meet regulatory claims payment requirements, we may become subject to regulatory actions. If our claims processing system is unable to process claims accurately, our ability to accurately estimate claims liabilities and establish related reserves could be adversely affected.
Overall, prescription drug costs have been rising for the past few years. The increases are due to the introduction of new drugs costing significantly more than existing drugs, direct consumer advertising by the pharmaceutical industry creating consumer demand for particular brand drugs, patients seeking medications to address lifestyle changes, higher prescribed doses of medications and enhanced pharmacy benefits for members such as reduced copayments and higher benefit maximums. As a way of controlling this health care cost component, we have implemented a significant decrease in prescription drug benefits for our Medicare+Choice members in almost all of our geographic areas in 2002 and expect to continue to decrease these benefits in 2003. Despite these efforts, however, we may be unable to adequately control this health care cost component, which could adversely impact our profitability.
Our selling, general and administrative expenses have been rising due to our continued investment in strategic initiatives and could increase more than we anticipate as a result of a number of factors, which could adversely impact our profitability. These factors include:
the necessity to comply with regulatory requirements, including the Health Insurance Portability and Accountability Act of 1996, or HIPAA;
our ability to estimate costs for our self-insured retention for medical malpractice claims;
our inability to achieve efficiency goals and resulting cost savings from announced restructuring or other initiatives; and
We may not accurately estimate the amounts we will need to spend to comply with HIPAA, which may adversely affect our expenses and/or our ability to execute portions of our business strategy.
HIPAA includes administrative simplification provisions directed at standardizing transactions and codes and seeking protections for confidentiality and security of patient data. We expect to modify all of our information systems and business processes to comply with HIPAA regulations regarding standardizing transactions and codes. We also expect to incur expense developing systems and refining processes and contracts to comply with HIPAA security and privacy requirements. We currently estimate that our HIPAA compliance costs will approximate $19 million in 2003 as well as another $1 million in capital expenditures. We continue to evaluate the future work and costs that will be required to meet HIPAA requirements and mandated compliance timeframes. To the extent that our estimated HIPAA compliance costs are less than our actual HIPAA compliance costs, amounts we had budgeted for other purposes will need to be used for HIPAA compliance which may adversely affect our ability to execute portions of our business strategy or may increase our selling, general and administrative expenses.
We are subject to several lawsuits brought by health care providers and members alleging that we engage in a number of improper practices, as well as a lawsuit brought by the State of Texas. Depending upon their outcome, these lawsuits could result in material liabilities to us or cause us to incur material costs, to change our operating procedures or comply with increased regulatory requirements.
manipulating determinations of whether health care services are medically necessary by excluding expensive procedures and treatments from being considered medically necessary.
Recently enacted or proposed legislation, regulations and initiatives could materially and adversely affect our business by increasing our operating costs, increasing required capital amounts, reducing our membership or subjecting us to additional litigation.
proposed legislation and regulation could include adverse actions of government or other payors, including reduced Medicare or commercial premiums, reduction of provider reimbursements, discontinuance of, or limitation on, governmentally funded programs, recovery by governmental payors of previously paid amounts, the inability to increase premiums or prospective or retroactive reductions to premium rates for federal employees;
proposed legislation and regulation to provide payment and administrative relief for the Medicare+Choice program and regulate drug pricing by the state and federal government could include provisions that impact our Medicare+Choice and commercial products;
new and proposed state legislation, regulation, or litigation that would otherwise limit our ability to capitate physicians and hospitals or delegate financial risk, utilization review, quality assurance or other medical decisions to our contracting physicians and hospitals;
state and federal regulations that place additional restrictions and administrative requirements on the use, retention, transmission and disclosure of personally identifiable health information, such as HIPAA, and federal regulations that enforce the current HIPAA administrative simplification deadlines of April 2003 for privacy compliance and October 2003 for data standards compliance;
new regulations requiring protection of the integrity and availability of personally identifiable health information which exists in electronic form, including the proposed HIPAA security standards;
In the future, we may announce dispositions of assets or product exits as we continue to evaluate whether our subsidiaries or products fit within our business strategy. We may also record goodwill or long-lived asset impairment charges if one or more of our subsidiaries with operating losses generates less operating cash flows than we currently expect. In addition, as we refocus and retool our work force as part of attempting to improve our operating performance, we expect some positions to change or be eliminated, which could result in future restructuring charges. We cannot be certain that dispositions, impairments or restructuring activities will not result in additional charges. In addition, disposition or restructuring charges could have a material adverse effect on our results of operations or cash flows.
we could use a substantial portion of our consolidated cash flow from operations to pay principal and interest on our debt, thereby reducing the funds available for working capital, capital expenditures, acquisitions and other general corporate purposes, including executing our business strategy of diversifying our product offerings and making planned investments in our branding campaign, the marketing of our specialty products and technology initiatives for further streamlining our operations;
our debt service obligations increase our vulnerabilities to competitive pressures, because many of our competitors are less leveraged than we are.
Our senior credit facility and our 10 3/4% senior notes limit, and in some circumstances prohibit, our ability to:
pay dividends and make distributions in respect of our capital stock and the capital stock of our subsidiaries;
Due to changes in accounting rules implemented in 2002, our legal structure and our recent operating results, we may inadvertently fail the statistical test for being regulated as an investment company under the Investment Company Act of 1940, as amended, or the Investment Company Act. The Investment Company Act requires registration of, and imposes substantial operating restrictions on, companies that engage, or propose to engage, primarily in the business of investing, reinvesting, owning, holding, or trading in securities, or that meet certain statistical tests concerning a company’s asset composition and sources of income.
Because we are primarily engaged through our existing operating subsidiaries in the health care and insurance industries and we intend our future operating subsidiaries to be engaged in these businesses or related consumer businesses, we believe that we are primarily engaged in a business other than investing, reinvesting, owning, holding or trading in securities and that we are not an investment company. We are able to rely on an SEC rule that exempts us from the requirement of registering as an investment company for up to one year. In the interim, we and our operating subsidiaries are seeking an order from the SEC, declaring our HMO operating subsidiaries not to be investment companies - so that we would
If the SEC does not grant the requested order, to avoid registration under the Investment Company Act, we may have to restructure our subsidiaries or our investments so that we do not fail the statistical tests relating to asset composition. These changes might include increasing the component of our investments held in government securities or refraining from buying or selling securities when we would otherwise not choose to do so. This could have a negative impact on our results of operations.
See “Item 15. Exhibits, Financial Statement Schedules, and Reports on Form 8-K.”