On December 28, 2000, we finalized a sale-leaseback transaction that included the majority of our administrative and clinical properties in Las Vegas totaling approximately 478,000 square feet. The lease is for a term of fifteen years and we have the option of five 5-year renewal periods. We lease additional office and clinical space in Nevada totaling approximately 134,000 and 124,000 square feet, respectively. HPN and Sierra Health and Life Insurance Co. Inc., or SHL have retained ownership of a 134,000 square foot administrative building at their Las Vegas headquarters, which serves as the home office and a regional home office for our Nevada HMO and health insurance subsidiaries, respectively.
As a result of the asset impairment and other changes in estimate charges we took in the second quarter, we were not in compliance with our bank line of credit facility financial covenants. We were able to obtain temporary waivers from the banks by paying additional fees, pledging certain assets and having some of our subsidiaries guarantee the credit facility debt, which at June 30, 2000, was $185 million. While continuing to negotiate with the banks on a new credit agreement, we undertook steps to conserve our cash by delaying non-essential capital expenditures and reducing our corporate general and administrative expenses. We also commenced initiatives to sell our non-core assets including the majority of our Las Vegas real estate in a sale-leaseback transaction, our corporate airplane, our corporate residence in Utah used to entertain clients and our Houston HMO membership.
Total Operating Revenues for 2000 increased approximately 8.5% to $1.39 billion from $1.28 billion for 1999. Medical premium revenues accounted for approximately 62.4% and 64.5% of our total revenues for the years ended December 31, 2000 and 1999, respectively. The decrease in medical premiums as a percentage of total revenues in 2000 is primarily due to the increase in specialty product and military contract revenues and a decrease in HMO membership in Texas. Continued medical premium revenue growth is principally dependent upon continued enrollment in our products and upon competitive and regulatory factors.
Military contract revenues increased $43.0 million or 14.9%. The increase was primarily attributable to additional accrued bid price adjustment revenues related to a true-up of prior periods' information received from the government in the third quarter of 2000. Partially offsetting this was a decrease recorded in the first quarter for a reduction in the at-risk health care population of beneficiaries as additional beneficiaries enrolled with military treatment facility primary care managers. We are not at-risk for those TRICARE eligibles and receive less revenue related to them from the government. Military contract 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, we record revenue based on estimates of the earned portion of any contract change orders not originally specified in the contract.
As compared to the low level reinsurance agreement that expired on June 30, 2000, the new lower cost reinsurance agreements result in higher net earned premium revenues, as we retain more of the premium dollars, but also leads to our keeping more of the incurred losses. This may result in a higher loss and loss adjustment expense, or LAE, ratio if the percentage increase in the additional incurred losses should be greater than the percentage increase in the additional premiums we retained. The effect on the balance sheet will result in a lower amount of reinsurance recoverables. However, due to the length of time that it typically takes to fully pay a claim, we should see an increase in operating cash flow and amounts available to be invested.
Investment and other revenues decreased $1.3 million or 5.6%, due primarily to a decrease in the average invested balance during the year.
Medical expenses reported in the first quarter of 2000 included $1.0 million of prior period reserve strengthening. In the second quarter of 2000, we recorded changes in estimate charges of $29.5 million for reserve strengthening primarily due to adverse development on prior years' medical claims, $15.5 million in premium deficiency medical expenses for the Texas operations and $10.2 million for other changes in estimate charges.
We believe that the remaining premium deficiency medical reserve of $5.2 million, as of December 31, 2000, is adequate and that no revision to the estimate is necessary at this time.
We recorded net adverse loss development for prior accident years of $23.3 million in 2000 compared to $9.9 million in 1999. The net adverse development recorded in 1999 and 2000 for prior accident years was largely attributable to higher costs per claim, or claim severity, in California. Higher claim severity has had a negative impact on the entire California workers' compensation industry. The majority of the adverse loss development occurred on accident years that were not covered by our low level reinsurance agreement. While the low level reinsurance agreement is in run-off effective July 1, 2000, California premium rates have been increasing, which we believe will largely mitigate the loss of this very favorable reinsurance protection. The premium rate increases on policies renewed in California during the year ended December 31, 2000 were approximately 26% and for the second half of the year alone, averaged approximately 36%. In the first two months of 2001, the average renewal rate increase for our California policies was approximately 42%.
We recorded a higher loss and LAE ratio for the 2000 accident year, which resulted in an increase of approximately $8.6 million in specialty product expense. The majority of the increase is due to the termination of the low level reinsurance agreement on June 30, 2000, which results in a higher risk exposure on policies effective after that date and a higher amount of net incurred loss and LAE. In addition, in light of the lower premium rates on policies written in 1999, inflationary trends in health care costs, the fact that we have seen our reserves develop adversely for the past two years and that projecting ultimate reserves cannot be done with 100% accuracy, we believed it prudent to establish reserves at a higher loss ratio to mitigate any future adverse loss development that may occur.
The loss and LAE reserves booked as of December 31, 2000 reflect our best estimate of the ultimate loss costs for reported and unreported claims occurring in accident year 2000 as well as those occurring in accident years prior to 2000 and is slightly in excess of our independent actuary's estimate. Loss and LAE reserves have a significant degree of uncertainty when related to their subsequent payments. Although reserves are established on the basis of a reasonable estimate, it is not only possible but probable that current reserves will differ from their related subsequent developments. Any subsequent change in loss and LAE reserves established in a prior year would be reflected in the year when the change is identified. 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 to generate investment income.
The combined ratio is a measurement of underwriting profit or loss and is the sum of the loss and LAE ratio, underwriting expense ratio and policyholders' dividend ratio. A combined ratio of less than 100% indicates an underwriting profit. Our combined ratio was 115.8% compared to 105.5% for 1999. The increase was primarily due to a higher loss and LAE ratio of 13.4 percentage points and policyholders' dividend ratio of 1.6 percentage points, offset slightly by a decrease in the underwriting expense ratio of 4.7 percentage points. The increase in the loss and LAE ratio was due to an increase in net adverse loss development which represents 6.6 percentage points of the change in the loss and LAE ratio; and a higher loss and LAE ratio on the 2000 accident year of $8.6 million, which represents 6.8 percentage points of the change in the loss and LAE ratio.
Asset Impairment, Restructuring, Reorganization and Other Costs consist of the following:
Asset Impairments. During the first quarter of 1999, we closed all inpatient operations at Mohave Valley Hospital, a 12-bed acute care facility in Bullhead City, Arizona, and terminated over 40 employees. We recorded a charge of $3.5 million for the write-off of goodwill associated with these operations.
In assessing the asset impairment of the long-lived assets, we first allocated a portion of related goodwill to the fixed assets to be disposed of, in accordance with SFAS No. 121. The fixed assets were then written down to their estimated fair value less costs to sell, which was determined from independent valuations. The remainder of the related goodwill was then assessed for recoverability in accordance with APB No. 17 based on projected discounted cash flows.
The charges recorded for fixed asset impairment totaled $36.5 million for the Texas operations and $9.5 million for the Arizona and Nevada operations.
Other. During the fourth quarter of 1998, we incurred settlement expenses totaling $8.0 million related to the settlement of a competitor's protest for the Region 1 TRICARE contract. Also during the fourth quarter of 1998, we incurred integration, transition and other charges totaling $3.1 million related primarily to our acquisition of the Texas operations of Kaiser Foundation Health Plan of Texas. In addition, we incurred certain legal expenses totaling $2.7 million, resulting primarily from the TRICARE settlement, acquisition and integration activity.
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 increases in premium revenue of $218.4 million and military contract revenues of $82.6 million, offset by a decrease in specialty product revenue of $54.1 million. Medical premium revenues accounted for approximately 64.5% and 58.8% of our total revenues for the years ended December 31, 1999 and 1998, respectively. The increase in the percentage of medical premiums as a percentage of total revenues in 1999 was primarily due to acquisitions.
Medical premiums from the 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. Additionally, Medicare member months increased 16.2%. 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 HMO premium rates increased approximately 4% for the Nevada HMO commercial groups and 11% for the Houston, Texas commercial groups. Compared to the fourth quarter of 1998, the commercial rates for the Dallas/Ft. Worth operations have increased approximately 8%. Our managed indemnity rates increased approximately 8% and Medicare rates increased approximately 2%. Over 90% of the Nevada Medicare members are enrolled in the Social HMO Medicare program.
Investment and other revenues decreased $6.7 million or 22.8%. 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 increased $236.6 million or 46.1%. The following costs were included in 1999 medical expenses:
Premium Deficiency. In the first quarter of 1999, we 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 fully utilized during 1999 to offset losses as they occurred. In the fourth quarter of 1999, we recorded $21.0 million for estimated deficient premiums associated with 2000 contracts in the Texas market. Of this amount $10.0 million was included in medical expenses and $11.0 million of maintenance costs was recorded in asset impairment, restructuring, reorganization and other costs.
Excluding the effect of the Dallas/Ft. Worth operations, as well as the changes in estimate charges, medical expenses increased $83.4 million or 17.0% compared to the prior year. Medical expenses as a percentage of medical premiums and professional fees increased from 78.4% to 85.2%, or 81.1% excluding the changes in estimate charges. 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. 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 capitation contracts 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-Texas as agreed to in the purchase agreement.
The adverse development recorded in 1999 for the prior accident years was primarily attributable to increased California claim severity. Higher claim severity has had a negative impact on the entire California workers' compensation industry. The historical claim frequency development patterns have not significantly changed in 1999. In addition, continuing price competition in California has negatively affected operating ratios.
General, Administrative and Marketing Expenses, or G&A, increased $27.1 million or 24.5%. As a percentage of revenues, G&A costs for 1999 were 10.7%, which was consistent with 1998. Of the $27.1 million increase in G&A, $14.3 million was due to additional G&A related to the acquired HMO business in the Dallas/Ft. Worth area, net of premium deficiency utilization of $20.9 million. The remaining increase of $12.8 million included a $6.9 million increase in compensation expense, resulting primarily from additional employees supporting expanded services. Broker and premium tax expense increased approximately $2.2 million due to increased membership. In addition, depreciation expense increased $2.4 million.
Interest Expense and Other, Net increased $7.8 million or 108.6%, 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.
Benefit for Income Taxes was recorded at $5.9 million compared to a tax expense of $13.8 million in the prior year. Due to a change in tax law, which took effect in 1999, we were able to utilize a $1.6 million net operating loss carryover that had previously not been recognized in the financial statements due to uncertainty about its realization. Excluding the effect of this change, the effective tax rate was 41.3% compared to 25.8% in 1998. Including the effect of this change, the effective tax rate for 1999 was 56.2%. The difference between the effective tax rate, excluding the change in the deferred tax valuation allowance, and the statutory rate is due to income earned on tax preferred investments.
We had cash in-flows from operating activities of $41.1 million for the year ended December 31, 2000 compared to cash out-flows of $7.7 million in 1999. The improvement over 1999 is primarily attributable to cash from earnings and the change in assets and liabilities.
o a source of cash due to the increase in reserve for loss and LAE of $130.2 million in our workers' compensation business
o a source of cash due to the increase in medical claims payable, including military claims, of $54.7 million as a result of the overall increase in medical premiums and military contract revenues
o a use of cash due to the increase in the deferred tax asset of $54.5 million
o a use of cash due to the increase in reinsurance recoverable of $116.2 million primarily in our workers' compensation business
On December 28, 2000, we sold the majority of our Las Vegas real estate holdings in a sale-leaseback transaction. The transaction was recorded as a financing obligation of $113.7 million offset by mortgage notes receivable of $22.2 million, a payoff of related real estate mortgages of $9.9 million and a permanent reduction on our revolving credit facility of $50 million for a net increase in liabilities of $31.6 million.
In September 1991, CII Financial, Inc., or CII, the workers' compensation holding company, issued convertible subordinated debentures. As of December 31, 2000, $47 million in Debentures were outstanding. The Debentures pay interest at 7 1/2% per annum, which is due semi-annually on March 15 and September 15, and mature September 15, 2001. Each $1,000 in principal is convertible into 25.382 shares of common stock of Sierra at a conversion price of $39.398 per share. The Debentures have no financial ratio covenants. The primary covenants include the timely payment of principal, premium, interest and taxes. Other covenants include CII's agreement to maintain their existence, business properties and an office where the Debentures can be surrendered for payment, transfer or conversion. There are also covenants regarding CII's offering to purchase the Debentures upon specified non-approved mergers and changes in control. Since our acquisition of CII was approved by CII's board of directors and shareholders, we were not required to offer to purchase the Debentures. The Debentures are obligations of CII only and are not guaranteed by us.
CII is a holding company and its only significant asset is its investment in California Indemnity Insurance Company. Of the $28.7 million in cash and cash equivalents it held at December 31, 2000, approximately $27.4 million were designated for use only by the regulated insurance companies. CII has limited sources of cash and is dependent upon dividends paid by California Indemnity. The payment of stockholders' dividends by California Indemnity is regulated by the California Insurance Code and, at a minimum, requires a 10 workday prior notice to the California Department of Insurance. If a payment of a dividend or distribution whose fair market value, together with that of other dividends or distributions made within the preceding 12 months, exceeds the greater of ten percent of the insurer's surplus or its net income for the preceding year end, then the insurance commissioner has up to 30 days to disapprove it. The California Insurance Department will not allow a payment of a dividend or distribution if it will cause an insurer's policyholders' surplus to be unreasonable in relation to the insurer's liabilities and the adequacy of the insurer's financial needs. In making this determination, the Department of Insurance considers a variety of factors including, but not limited to, the size of the insurer, the amount, type and geographic concentration of insurance it writes, the quality of its assets and reinsurance programs, and operating trends.
CII's only significant short-term non-insurance liquidity need is the repayment of the $47 million in Debentures, which are due on September 15, 2001 as discussed above. If the proposed exchange offer for the Debentures is successful and CII Financial issues new senior subordinated debentures with an extended maturity date, then their long-term non-insurance liquidity needs will be to service this new debt. CII Financial expects to service this new debt from future cash flows, primarily from dividends that will be paid by their insurance subsidiaries from their future earnings.
Our HMO and insurance subsidiaries are required by state regulatory agencies to maintain certain deposits and must also meet certain net worth and reserve requirements. The HMO and insurance subsidiaries had restricted assets on deposit in various states totaling $24.7 million at December 31, 2000. The HMO and insurance subsidiaries must also meet requirements to maintain minimum stockholders' equity, on a statutory basis, as well as minimum risk-based capital requirements, which are determined annually. Additionally, in conjunction with the Kaiser-Texas acquisition, TXHC entered into a letter agreement with the Texas Department of Insurance whereby TXHC agreed to maintain a net worth of $20.0 million, on a statutory basis.
We have a 2001 capital budget of $18 million as limited by our revolving credit facility. The planned expenditures are primarily for the expansion of clinics and other leased facilities, the purchase of computer hardware and software, furniture and equipment and other normal capital requirements. Our liquidity needs over the next 12 months will primarily be for the capital items noted above, debt service and expansion of our operations. We believe that our existing working capital, operating cash flow and, if necessary, equipment leasing, divestitures of certain non-core assets, restructuring of the convertible subordinated debentures and amounts available under our credit facility should be sufficient to fund our capital expenditures and debt service. Additionally, subject to unanticipated cash requirements, we believe that our existing working capital and operating cash flow should enable us to meet our liquidity needs on a long-term basis.
In the second quarter of 1997, our Board of Directors authorized a $3.0 million line of credit from us to our Chief Executive Officer, or CEO. In April 2000, our Board of Directors authorized an additional $2.5 million loan from us to the CEO. The entire principal balance along with accrued interest is due on June 30, 2002. At the end of 2000, the aggregate principal balance outstanding and accrued interest for both instruments was $5.4 million. All amounts borrowed bear interest at a rate equal to the rate at which we could have borrowed funds under our revolving credit facility at the time of the borrowing plus 10 basis points. The amounts outstanding are collateralized by certain of the CEO's assets and rights to compensation from us.
In December 1999, the SEC issued Staff Accounting Bulletin No. 101, "Revenue Recognition in Financial Statements", or SAB 101. SAB 101 clarifies existing accounting principles related to revenue recognition in financial statements. We were required to comply with the provisions of SAB 101 in our quarter ended December 31, 2000 and it did not have any impact on our results of operations.
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, 2000, such systems and controls were adequate to meet the objectives discussed herein.
Paul H. Palmer Vice President, Finance Chief Financial Officer and Treasurer
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, 2000 and 1999, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2000 in conformity with accounting principles generally accepted in the United States of America. 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 STATEMENTS OF STOCKHOLDERS' EQUITY For the Years Ended December 31, 2000, 1999 and 1998 (In thousands)
SIERRA HEALTH SERVICES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS For the Years Ended December 31, 2000, 1999 and 1998
Medical Premiums. Membership contracts are generally established on an annual basis subject to cancellation by the employer group or Sierra generally upon 60 days written notice. Premiums, including premiums from both commercial and governmental programs, are due monthly and are recognized as revenue during the period in which Sierra is obligated to provide services to members and are net of estimated retroactive terminations of members and groups. Non-Medicare member enrollment is represented principally by employer groups. HPN and TXHC also offer a prepaid health care program to Medicare recipients. Revenues associated with Medicare recipients were approximately $337,545,000, $301,141,000 and $238,913,000 in 2000, 1999 and 1998, respectively. Unearned premium revenue includes payments under prepaid Medicare contracts with the Health Care Financing Administration ("HCFA") and prepaid HPN and TXHC commercial and SHL indemnity premiums.
Military Contract Revenues. Revenue under the Department of Defense TRICARE contract is recorded based on the contract price as agreed to by the federal government. The contract also contains provisions which adjust the contract price based on actual experience and for government-directed change orders. The estimated effects of these adjustments are recognized on a monthly basis. In addition, the Company records revenue based on estimates of the earned portion of any contract change orders not originally specified in the contract.
Cash and Cash Equivalents. The Company considers cash and cash equivalents as all highly liquid instruments with a maturity of three months or less at time of purchase. The carrying amount of cash and cash equivalents approximates fair value because of the short maturity of these instruments.
Property and Equipment. Property and equipment are stated at cost less accumulated depreciation. 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.
In connection with the restructuring plans adopted and announced by the Company in the second quarter of 2000, the Company re-evaluated the recoverability of certain long-lived assets, primarily those associated with the Texas operations, in accordance with Statement of Financial Accounting Standards No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of" ("SFAS No. 121") and Accounting Principles Board Opinion No. 17, "Intangible Assets" ("APB No. 17") and determined that the carrying value of certain goodwill was impaired. In assessing the asset impairment of the long-lived assets, the Company first allocated a portion of related goodwill to the fixed assets to be disposed of, in accordance with SFAS No. 121. The remainder of the related goodwill was then assessed for recoverability in accordance with APB No. 17 based on projected discounted cash flows and an impairment of $141,506,000 was recorded. See Note 16 for a description of the primary facts and circumstances related to the impairment.
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 and are principally in California, Nevada and Texas. However, the Company is licensed and does business in several other states. As of December 31, 2000, the Company has receivables outstanding from the federal government related to its TRICARE contract in the amount of $71.4 million. The Company also has receivables from its reinsurers. 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 with whom the Company has reinsurance contracts are rated A- or better by the A.M. Best Company.
Use of Estimates and Assumptions in the Preparation of Financial Statements. The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America 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 2000, 1999 and 1998 was $67,000, $2,140,000 and $1,037,000, respectively. Depreciation expense in 2000, 1999 and 1998 was $26,921,000, $23,577,000, and $16,767,000, respectively.
On December 28, 2000, the Company sold the majority of its Las Vegas, Nevada administrative and medical clinic real estate holdings in a sale-leaseback transaction. As part of the transaction, the Company financed a portion of the sales price with mortgage notes receivable of $22.2 million and provided deposits of $4.3 million. The mortgages and deposits constitute continuing involvement as defined in Statement of Financial Accounting Standards No. 98, "Accounting for Leases" ("SFAS 98") and as such the transaction does not qualify as a sale. In accordance with SFAS 98, the Company recorded the transaction as a financing obligation of $113,659,000, offset by the mortgage notes receivable of $22,200,000. The net book value of the assets included in the transaction was $86,890,000 at December 31, 2000.
The Company expects that the mortgages and deposits will be repaid to Sierra by the end of 2001. Once that occurs the transaction will qualify as a sale since the Company no longer will have continuing involvement. After qualifying as a sale, the assets, associated accumulated depreciation and financing obligation will be retired and a gain on the sale will be recorded and recognized over the remaining term of the lease. Until the transaction qualifies as a sale, depreciation expense will continue to be recorded on the assets and interest expense will be recognized on the net financing obligation.
The following table summarizes the Company's current, long-term and restricted investments as of December 31, 1999:
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 and SHL maintains reinsurance on certain other insurance products. Reinsurance premiums of $3,464,000, $3,269,000 and $2,860,000, net of reinsurance recoveries of $3,956,000, $2,904,000 and $1,185,000, are included in medical expenses for 2000, 1999 and 1998, respectively.
received a 9.25% ceding commission from the reinsurer as a partial reimbursement of its operating expenses. The low level reinsurance agreement expired on June 30, 2000; however the Company opted to continue ceding premiums and losses under the low level agreement on a run-off basis for all policies in force on June 30, 2000. Effective January 1, 2000 we entered into a reinsurance contract that provides statutory (unlimited) coverage for workers' compensation claims in excess of $500,000 per occurrence. The contract is in effect for claims occurring on or after January 1, 2000 through December 31, 2002. On July 1, 2000, the Company entered into a reinsurance agreement that covers losses on claims in excess of $250,000 up to $500,000 for policies issued after June 30, 2000.
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.
Substantially all of the reinsurance recoverables are due from reinsurers rated A+ by the A.M. Best Company and all amounts are considered to be collectible.
For the year ended December 31, 1999, the Company recorded net adverse loss development on prior accident years of $9.9 million, primarily for accident years 1996 to 1998. This adverse development was largely due to the higher average California claim severity patterns that the Company experienced in the last half of 1999. In the year ended December 31, 1998, the Company recorded net favorable loss development of $9.6 million, which was mainly attributable to lower actual paid claims than were previously reserved on accident years prior to 1996.
Revolving Credit Facility. On October 31, 1998, the Company replaced its prior line of credit with a $200 million credit facility. As a result of the asset impairment and other changes in estimate charges, the Company was not in compliance with its financial covenants at June 30, 2000. On December 15, 2000, the Company entered into an amended and restated credit agreement and is now in compliance with all covenants. The Company has $135 million available under the new agreement but that will be reduced by amounts ranging from $2.0 million to $10.0 million every six months starting in June 2001. The amount available under the credit facility can also be reduced by 80% of net proceeds from certain asset sales and excess cash flow, as defined in the amended and restated credit agreement, and, as well as 100% of net proceeds of any new debt or equity issuance, excluding any issuance by CII. The amended and restated credit agreement restricts the amount of funds that can be transferred to the Texas and SMHS operations to a maximum of $12 million and $5 million, respectively. The credit agreement also requires that the Company's purchase of the CII 7 1/2% convertible subordinated debentures with funds other than those from CII and its subsidiaries will require an equal permanent reduction in the credit facility limit. Interest under the amended and restated credit agreement is variable and based on the Bank of America "prime rate" plus a margin. The rate was 10.125% at December 31, 2000, which is a combination of the prime rate of 9.5% plus a margin of .625%. The Company can reduce the margin in the future by completing certain transactions and meeting certain financial ratios. Of the outstanding balance, $25 million is covered by an interest-rate swap agreement. To mitigate the risk of interest rate fluctuation on the credit facility, the Company entered into a five-year $50 million interest-rate swap agreement during the fourth quarter of 1998. The intent of the agreement was to keep the Company's interest rate on $50 million of the borrowing relatively fixed. In the fourth quarter of 2000, $25 million of the swap agreement was terminated. The average cost of borrowing on the credit facility for 2000, including the impact of the swap agreements, was approximately 9.9%. The terms of the amended and restated credit agreement contain certain covenants including a minimum fixed charge coverage ratio, a minimum interest coverage ratio, a maximum leverage ratio, maximum loss ratios and maximum capital expenditure amounts.
Net Financing Obligations represent amounts recorded as a financing obligation of $113,453,000 offset by notes receivable of $22,200,000 as part of the sale-leaseback transaction described in Note 4. Amounts were recorded as a financing obligation as required by SFAS 98 using the interest method with effective interest rates of 8.16% to 8.53%.
7 1/2% Convertible Subordinated Debentures. In September 1991, CII issued convertible subordinated debentures (the "Debentures") due September 15, 2001. The balance outstanding at December 31, 2000 was $47,041,000, which is net of $18,000 held by Sierra and is eliminated in consolidation. The Debentures are included in the current portion of long-term debt and pay 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 $39.398 per share. Unamortized issuance costs of $91,000 are included in other assets on the balance sheet and are amortized over the life of the Debentures. Accrued interest on the Debentures as of December 31, 2000 and 1999 was $993,000 and $1,099,000, 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 or any of its subsidiaries. During 2000, 1999 and 1998, the Company purchased $3,457,000, $753,000 and $3,216,000, of the debentures on the open market resulting in realized gains, net of taxes, of $654,000, $111,000 and $48,000, respectively.
Sale and purchase activity for the Debentures, to parties other than the Company and its subsidiaries, is believed to be minimal and there is no known market quotation system for the Debentures. The fair value of the Debentures at December 31, 2000 was $23,530,000, which is the Company's best estimate and was based on $18,000 stated value Debentures purchased for $9,000 by the Company during September 2000 and may not be indicative of the actual market value.
7 3/8% Mortgage Note. In December 1993, the Company obtained a loan from Bank of America, Nevada. The note was paid off during 2000.
Excluding the Debentures, the fair value of long-term debt, including the current portion, is estimated to be approximately $249,932,000 based on the borrowing rates currently available to the Company.
The following reconciles the difference between the reported and statutory (benefit) provision for income taxes for the years ended December 31:
At December 31, 2000, the Company had approximately $56,877,000 of regular tax net operating loss carryforwards. The net operating loss carryforwards can be used to reduce future taxable income until they expire through the year 2020. In addition to the net operating loss carryforwards, the Company has alternative minimum tax credits of approximately $5,198,000, which can be used to reduce regular tax liabilities in future years. There is no expiration date for the alternative minimum tax credits.
A valuation allowance was established in prior years to reflect the Company's inability to use tax benefits from certain acquisitions currently or in the near future. Due to a change in tax laws and the Company's ability to realize tax benefits for which a valuation allowance had been previously established, the Company reduced its valuation allowance by $1,575,000 and $4,691,000 for the years ended December 31, 1999 and 1998, respectively. The Company does not have a valuation allowance at December 31, 2000. Included in other current receivables in the December 31, 2000 and 1999 balance sheets are tax receivables of $1,326,000 and $10,518,000, respectively.
Rent expense totaled $10,133,000, $9,098,000, and $8,763,000 for the years ended December 31, 2000, 1999 and 1998, respectively.
The Company expensed $4,000, $289,000 and $78,000 in the years ended December 31, 2000, 1999 and 1998, respectively, for legal fees to a Nevada law firm of which a non-employee Board of Director member is a shareholder.
Defined Contribution Plan. The Company has a defined contribution pension and 401(k) plan (the "Plan") for its employees. The Plan covers all employees who meet certain age and length of service requirements. For the year ended December 31, 1998 and for the six months ended June 30, 1999, the Company contributed a maximum of 2% of eligible employees' compensation and matched 50% of a participant's elective deferral up to a maximum of either 10% of an employee's compensation or the maximum allowable under current IRS regulations. Effective July 1, 1999, the Plan was modified such that the Company matches 50%-100% of an employee's elective deferral and the maximum Company match is 6% of a participant's annual compensation, subject to IRS limits. The Plan does not require additional Company contributions. Expense under the plan totaled $4,707,000, $6,736,000 and $4,522,000 for the years ended December 31, 2000, 1999 and 1998, respectively.
Supplemental Executive Retirement Plan ("SERP"). The Company has a defined benefit retirement plan covering certain key employees. The Company is funding the benefits through the purchase of life insurance policies. Benefits are based on, among other things, the employee's average earnings over the five-year period prior to retirement or termination, and length of service. Benefits attributable to service prior to the adoption of the plan are amortized over the estimated remaining service period for those employees participating in the plan. In 1998, the Company expanded the SERP to include more participants. The effect of adding these participants is included in plan amendments in the reconciliation below.
Stock Option Plans. The Company has several plans that provide common stock-based awards to employees and to non-employee directors. The plans provide for the granting of Options, Stock, and other stock-based awards. Awards are granted by a committee appointed by the Board of Directors. Options become exercisable at such times and in such installments as set by the committee. The exercise price of each option equals the market price of the Company's stock on the date of grant. Stock options generally vest at a rate of 20% - 25% per year. Options expire from one to five years after the end of the vesting period.
The following table summarizes information about stock options outstanding at December 31, 2000:
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 2000, 1999 and 1998, respectively: dividend yield of 0% for all years; expected volatility of 46%, 45% and 32%; risk-free interest rates of 5.79%, 4.66% and 5.30%; and expected lives of six months for all years.
In the first quarter of 1999, the Company recorded a charge of $3.5 million related to the write-off of goodwill associated with the Mohave Valley operations. During the first quarter of 1999, the Company closed all inpatient operations at Mohave Valley Hospital, a 12-bed acute care facility in Bullhead City, Arizona, and terminated approximately 45 employees.
In the first quarter of 2000, the Company engaged a consultant to help it assess the Texas operations. In late February, the consultant issued its report and the Company implemented strategic action plans to turn around the Texas operations. These actions included the replacement of the Texas senior management, a reduction in staffing along with a consolidation of certain services to Las Vegas and a revision of product strategy. The new management was charged with further assessing the Dallas/Ft. Worth health care delivery system. In May, the Company decided that the delivery system, which emphasized the Company's affiliated medical group as the primary provider network, would be replaced by an expanded network of contracted physician groups and individuals. In addition, the contracted hospital network would be significantly expanded. As a result, during the second quarter of 2000, the Company adopted and announced a further restructuring of the Dallas/Ft. Worth operations, which entailed a significant reduction of physicians and staff and the closing of several clinic sites. In addition, management decided that the real estate assets would be sold.
In connection with the restructuring plans adopted and announced by the Company in the second quarter of 2000, the Company re-evaluated the recoverability of certain long-lived assets, primarily associated with the Texas operations, in accordance with SFAS No. 121 and APB No. 17 and determined that the carrying values of certain goodwill and other long-lived assets were impaired.
The charges recorded for the write-off of goodwill totaled $126.4 million for the Texas operations and $15.1 million related primarily to the Prime Holdings, Inc. acquisition.
During the second quarter of 2000, the Company wrote-off capitalized costs of $3.0 million related to the application development of an information system software project for the workers' compensation operations, that was canceled because the vendor was unable to fulfill its contractual obligations. The amounts written off included software and consulting costs of $1.6 million and capitalized internal personnel costs of $1.4 million.
In the first quarter of 2000, the Company announced a restructuring of the managed health care operations in Texas. As a result of this restructuring, the Company incurred approximately $1.4 million of severance pay for employees who were terminated. The restructuring involved changes in senior management at the Texas facilities and the centralization of key services to Las Vegas. Also in the first quarter of 2000, the Company incurred $1.5 million of costs, consisting primarily of consulting fees, in conjunction with a review and reorganization of the managed care operations in Texas.
In the second quarter of 2000, the Company adopted a plan and announced additional restructuring of the managed health care operations, primarily in Texas and Arizona. As a result of this restructuring, the Company recorded charges in accordance with Emerging Issues Task Force Issue No. 94-3, "Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (Including Certain Costs Incurred in a Restructuring)" of approximately $10.6 million. Of the costs recorded, $5.9 million was for severance, $2.9 million was related to clinic closures and lease termination and $1.8 million was for other costs. The severance charge resulted from the termination of 315 employees at the Company's subsidiaries and affiliated medical groups.
Based on the Company's Texas operations financial projections for 2000, the Company recorded a $21.0 million premium deficiency at the end of 1999. Of this amount, $10.0 million was recorded in medical expenses and $11.0 million was recorded in asset impairment, restructuring, reorganization and other costs. The $11.0 million was an estimate of general and administrative costs, in excess of those covered by premiums, the Company expected to be incurred to service the Dallas/Ft. Worth contracts.
The premium deficiency medical costs of $10.4 million, recorded in the second quarter of 2000, was an estimate of general and administrative costs, in excess of those covered by premiums, the Company would incur to service the Texas contracts. The amount reflects anticipated cost reductions from the restructuring and reorganization actions noted above.
During the fourth quarter of 1998, the Company incurred settlement expenses totaling $8 million related to the settlement of a competitor's protest for the Region 1 TRICARE contract. Also during the fourth quarter of 1998, the Company incurred integration, transition and other charges totaling $3.1 million related primarily to the acquisition of the Texas operations of Kaiser Foundation Health Plan of Texas. In addition, the Company incurred certain legal expenses totaling $2.7 million, resulting primarily from the TRICARE settlement and acquisition and integration activity.
The remaining $6.1 million of costs recorded in the second quarter of 2000 relate primarily to the write-down of certain receivables as well as an accrual for legal settlements.
The remaining restructuring and reorganization costs of $4.3 million are primarily related to the cost to provide malpractice insurance on our discontinued affiliated medical groups, clinic closures and lease terminations in Houston and Arizona. The remaining other costs of $5.2 million are primarily related to legal claims. Management believes that the remaining reserves as of December 31, 2000 are adequate and that no revisions to the estimates are necessary at this time.
(1) The segment operating profit excludes the effects of changes in estimate charges. (2) Represents changes in estimate charges in the current year for services or liabilities of a prior year that are reclassified to either Medical Expenses or Specialty Product Expenses for presentation in accordance with accounting principles generally accepted in the United States of America.