Health services revenues for AMS products in 1997 increased 66.8% to $981.3 million from $588.3 million in 1996, which followed an 18.8% increase from $495.3 million in 1995. The increase in AMS health services revenues for 1997 was due primarily to the acquisition of the 88% of AMSG that the Company did not already own through the merger of the Company and AMS effective December 3, 1996 (the AMS Merger). Prior to the AMS Merger, the Company retained 50% of the premium revenue and 50% of the profit (loss) on small group managed care and life
business sold by AMS. Following the AMS Merger, the Company retained 100% of the health services revenues and 100% of the profit (loss) on small group managed care and life business sold by AMS. The additional health services revenues due to the AMS Merger accounted for $475.0 million of the increase in health services revenues in 1997. Excluding the effects of the AMS Merger, AMS health services revenues for 1997 decreased 12.4% to $474.6 million from $541.5 million for 1996. While average medical premium per member increased 20.8% for 1997 compared to 1996, the average number of small group medical members outstanding decreased 27.0% for 1997 to 655,515 from 897,544 for 1996. Average medical premium per member increased 12.4% for 1996 compared to 1995. The average number of small group medical members outstanding decreased 2.2% for 1996 to 897,544 from 917,588 for 1995. Much of this membership decline was the result of AMS's efforts to return this block of business to profitability. These steps included exiting certain unprofitable markets in Texas and Kentucky and implementing substantial rate increases for certain product lines which resulted in membership losses but improved profitability on renewed business. Initiatives continue to be pursued by AMS to reverse this membership decline, including new agency sales relationships, expansion into new geographic areas, and acquisitions of blocks of business. On September 30, 1997 the Company announced that it had acquired substantially all of the small group health insurance business of Pan-American Life Insurance Company, which represents at the date of acquisition $125 million in annualized premium revenue. The Company expects to retain approximately $80 million of this business on an annualized premium basis after exiting certain unprofitable markets.
Health services revenues for specialty managed care products and services in 1997 increased 0.6% to $124.9 million from $124.1 million in 1996. Health services revenues in 1996 increased 14.8% from $108.1 million in 1995. The increased premiums from ongoing operations in 1997 were offset by a decrease of $9.5 million in premiums assumed under certain federal and state reinsurance programs. While participation in these programs added premium revenue to the financial statements of the Company, their contribution to net income was nominal. Excluding the impact of the withdrawal from these government-sponsored reinsurance programs, health services revenues for specialty managed care products and services for 1997 increased 9.0% to $123.6 million from $113.3 million in 1996. This increase was due primarily to an increase of $1.9 million in workers' compensation premiums, an increase of $2.7 million in dental premiums, an increase of $2.7 million in disability premiums, and an increase of $2.3 million in managed behavioral health revenues. The increases in dental, disability and managed behavioral health premiums were driven by membership increases, while the increase in workers' compensation premium was due primarily to a change in the reinsurance agreement related to this business. In 1996, the Company ceded 50% of the workers' compensation premiums written by United Heartland, Inc. to a third-party reinsurer. In 1997, the percentage ceded to the outside reinsurer was reduced to 40%. The increase in 1996 was due to an increase in premium revenues of $6.4 million, including an increase of $2.2 million for life and disability products and an increase of $3.6 million for dental products, driven by increases in contracts, and an increase in other revenues of $9.6 million due primarily to increased managed care and consulting services and a gain on the sale of the vision line of business.
The medical loss ratio for HMO products in 1997 was 90.1%, compared with 89.8% in 1996 and 91.1% in 1995. The increase in the medical loss ratio in 1997 for HMO products is due primarily to higher loss experience in the southeastern Wisconsin HMO market, due in part to certain high-cost claims, an increase in the drug cost component and an increase in outpatient utilization. The higher loss ratio in 1995 is attributed to the competitive market conditions in southeastern Wisconsin where pricing pressures coupled with increased utilization had an adverse impact on Compcare's loss ratio.
The medical loss ratio for AMS products in 1997 was 78.0%, compared with 80.3% in 1996 and 80.5% in 1995. The lower loss ratio in 1997 reflects improvements in medical cost trends and pricing changes achieved by AMS since the first quarter of 1996. AMS continues to reprice its products and eliminate unprofitable business. During the fourth quarter of 1997, a pre-tax charge of $3.5 million was recorded related to the acquisition of the group health business of Pan-American Life Insurance Company. During the fourth quarter of 1996, as part of the Company's state-by-state review of market profitability, a pre-tax charge of $2.0 million was recorded for the accelerated recognition of losses on two discontinued blocks of business in Texas and Kentucky. These one-time charges are not included in the reported medical loss ratio for AMS products for 1997 and 1996. The 1997 medical loss ratio would have shown stronger improvement except for unfavorable results in the one-life dental business. One-life dental policies are no longer being offered. The loss ratio for AMS life products in 1997 was 35.1%, compared with 32.8% in 1996 and 30.3% in 1995.
The loss ratio for specialty managed care products and services in 1997 was 71.8%, compared with 73.8% in 1996 and 80.6% in 1995. The lower loss ratio in 1997 is due primarily to the Company's withdrawal from the government-sponsored reinsurance programs discussed previously, which were recorded at a near-100% loss ratio. The higher loss ratio in 1995 was due primarily to higher loss experience on the life and disability products marketed by United Wisconsin Group.
SGA expenses related to specialty managed care products and services increased 14.6% in 1997 to $19.6 million from $17.1 million in 1996. SGA expenses related to specialty managed care products and services increased 13.7% in 1996 to $17.1 million from $15.0 million in 1995. Increases in SGA expenses are tied to health services revenues which increased 9.0% in 1997 compared with 1996 and increased 16.7% in 1996 compared with 1995, excluding the impact of the decrease in assumed premiums related to certain federal and state reinsurance programs.
Interest expense increased to $9.3 million in 1997 from $4.3 million in 1996 and $3.5 million in 1995. The increase is due primarily to interest expense on the $70.0 million of borrowings from Blue Cross & Blue Shield United of Wisconsin (BCBSUW) to fund the cash portion of the consideration for the AMS Merger. In conjunction with the AMS Merger, the Company also recorded $150.0 million of goodwill and other intangibles and $22.2 million of related deferred taxes. Amortization of goodwill and other intangibles totaled $8.8 million in 1997, including $8.4 million related to the AMS Merger, compared with $1.5 million and $0.7 million of amortization expense in 1996 and 1995, respectively.
Consolidated net income in 1997 increased 77.9% to $18.2 million or $1.11 per share from $10.2 million or $0.79 per share in 1996. Consolidated net income in 1996 increased 60.1% from $6.4 million or $0.50 per share in 1995. The results for 1997 and December 1996 reflect 100% of the profit on the small group managed care and life business sold by AMS, compared with 50% in the first eleven months of 1996 and all of 1995. The 1997 earnings per share calculation also reflects the new shares issued in conjunction with the AMS Merger of approximately 3.7 million shares.
The Financial Accounting Standards Board (FASB) recently issued the following accounting standards. A brief description of the standards follows, along with a discussion of the estimated impact of adopting the standards on the Company's consolidated financial statements.
EARNINGS PER SHARE - In February 1997, the FASB issued SFAS No. 128, "Earnings per Share", which became effective for the Company in 1997. The new pronouncement replaces the presentation of primary and fully diluted earnings per share (EPS) with a presentation of basic and diluted EPS. The required disclosures have been included in Note 1 of the Notes to Consolidated Financial Statements.
Based on a recent assessment, the Company determined that it will be required to modify or replace portions of its software so that its computer systems will function properly with respect to dates in the year 2000 and thereafter. The Company presently believes that with modifications to existing software and conversions to new software, the Year 2000 Issue will not pose significant operational problems for its computer systems. However, if such modifications and conversions are not made, or are not completed timely, the Year 2000 Issue could have a material impact on the operations of the Company.
We have audited the accompanying consolidated balance sheets of United Wisconsin Services, Inc. (the Company) as of December 31, 1997 and 1996, and the related consolidated statements of income, shareholders' equity and cash flows for each of the three years in the period ended December 31, 1997. Our audits also included the financial statement schedules listed in the index at item 14(a). These financial statements and schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits.
The accompanying consolidated financial statements have been prepared in accordance with generally accepted accounting principles (GAAP). The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results could differ from those estimates.
Investments are classified as either held to maturity or available for sale. Investments which the Company has the intent and ability to hold to maturity are designated as held to maturity and are stated at amortized cost. All other investments are classified as available for sale and are stated at fair value based on quoted market prices, with unrealized gains and losses excluded from earnings and reported as a separate component of shareholders' equity, net of income tax effects. In 1995, unrealized gains and losses are also net of amounts attributable to funds held on behalf of an affiliated reinsurer. Realized gains and losses from the sale of available for sale debt securities and equity securities are based on the first-in, first-out basis.
Receivables are stated at net realizable value, net of allowances of $394,000 and $284,000 at December 31, 1997 and 1996, respectively, based upon historical collection trends and management's judgment of the ultimate collectibility.
Goodwill represents the excess of cost over the fair market value of net assets acquired. Goodwill and other intangible assets are being amortized on a straight-line basis over a period of 40 years or less. Accumulated amortization was $14,465,000 and $2,397,000 at December 31, 1997 and 1996, respectively.
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. At December 31, 1997, the Company's management believed that no material impairment of goodwill or other intangible assets existed.
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 ceding company is contingently liable on reinsurance ceded in the event that the reinsurers do not meet their contractual obligations.
Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial statement purposes and the amounts used for income tax purposes. A valuation allowance is recorded on deferred tax assets that more likely than not will not be realized.
In 1997, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 128, "Earnings per Share," which replaces the presentation of primary and fully diluted earnings per share (EPS) with a presentation of basic and diluted EPS.
At December 31, 1995, the Company owned 15,000 shares of preferred stock and 12% of the common stock of American Medical Security Group, Inc., which were recorded at cost of $16,330,000 and were included in other assets. The Company also had a joint venture agreement with American Medical Security Group, Inc. and its subsidiaries (AMSG) and was a party to related reinsurance agreements.
The aggregate consideration for the merger was cash of $71,800,000, including expenses, and $98,719,000 representing the market value of 3,694,280 newly issued shares of the Company's common stock and options to purchase the Company's common stock. Most of the cash came from $70,000,000 borrowed from BCBSUW (see Note 6). The merger agreement provided that $8,000,000 of the cash consideration be deposited in escrow to indemnify the Company for breaches of certain representations, warranties, covenants and other agreements contained in the merger agreement. The escrow was reduced during 1997 to a balance of $4,000,000 at December 31, 1997.
Upon merger, the AMSG preferred stock owned by the Company was canceled and the AMSG stock options were converted into options to purchase 305,696 shares of the Company's common stock at $4.66 per share. The Company also granted options to purchase 1,000,000 shares of the Company's common stock at $32.83 per share to two of the previous shareholders of AMSG.
The above merger has been accounted for using the purchase method of accounting, and the accompanying consolidated financial statements include the results of operations from the date of merger.
The Company has included profit-sharing and repurchase provisions in certain acquisition agreements. Profit-sharing expense related to these acquisitions totaled $3,639,000, $2,827,000 and $2,625,000 in 1997, 1996 and 1995, respectively. Total revenues subject to repurchase options, pursuant to the various acquisition agreements, totaled $191,688,000, $191,342,000 and $160,003,000 for 1997, 1996 and 1995, respectively. Total assets and total net assets subject to repurchase options were $49,802,000 and $20,632,000, respectively, at December 31, 1997, and $56,281,000 and $22,475,000, respectively, at December 31, 1996.
The Company has subordinated notes (Notes) outstanding of $44,878,000 bearing interest at a rate of 7.75%. The Notes will mature on July 1, 2000, and are currently redeemable at the option of the Company at 100% of the principal amount, plus accrued interest. The Notes are subordinated in right of payment to all existing and future Senior Indebtedness of the Company and are junior to the claims of any secured obligations on specific assets of the Company's subsidiaries. Certain covenants exist which, among other matters, restrict the ability of the Company to incur additional indebtedness, limit future cash dividends and transfers of assets and require the maintenance of a minimum consolidated tangible net worth.
The Company had two mortgages on an office building. Prior to the merger of AMSG and the Company in December 1996, these mortgages were a liability of the U&C Partnership. In December 1996, the Company repaid the outstanding balance of $9,083,000 on one of the mortgages.
The remaining mortgage balance of $9,700,000 at December 31, 1997 requires monthly principal payments of $100,000 plus interest through December 1, 2003. On January 1, 2004, the outstanding principal balance and any unpaid interest are due. The mortgage bears interest at a fixed rate of 9.05%. Interest expense on these mortgages totaled $940,000 and $282,000 in 1997 and 1996, respectively.
On December 15, 1995, a subsidiary of the Company borrowed $65,000,000 from BCBSUW under a Surplus Note Agreement (Surplus Note). The Surplus Note was repaid in 1996. Interest expense on the Surplus Note totaled $1,228,000 and $196,000 in 1996 and 1995, respectively, and is reflected as an offset to investment results on the consolidated statements of income.
The Company provides marketing, underwriting, actuarial and certain administrative services for BCBSUW. In addition, BCBSUW provides health insurance to the employees of the Company and provides office space to the Company. These activities are reimbursed at amounts approximating cost, which resulted in receipts to the Company of $14,564,000, $13,315,000 and $10,028,000 in 1997, 1996 and 1995, respectively, and payments to BCBSUW of $9,278,000, $7,474,000 and $4,368,000 in 1997, 1996 and 1995, respectively. These amounts are included in selling, general and administrative expenses.
Prior to December 3, 1996, the Company had a joint venture agreement with AMSG whereby the Company underwrote all of the small group health care products and life, dental, drug and disability business sold by AMSG. Amounts related to this agreement, prior to ceded reinsurance, are as follows:
Prior to the merger of the Company and AMSG on December 3, 1996, the Company ceded to AMSG, on a quota share basis, approximately 50% of the premium revenue on small group health care and life business sold by AMSG. As a result, the Company retained 50% of the premium revenue and 50% of the profit (loss) on the products sold by AMSG. The Company held funds on behalf of AMSG equivalent to the medical and other benefits payable and the undistributed net profit. The Company credited investment income on the funds retained for AMSG at the Company's average portfolio rate.
A summary of amounts deducted from (added to) financial statement captions on the statements of income for reinsurance ceded to AMSG is as follows:
Insurance companies are subject to regulation by the Office of the Commissioner of Insurance of the State of Wisconsin and certain other state insurance regulators. These regulations require, among other matters, the filing of financial statements prepared in accordance with statutory accounting practices prescribed or permitted for insurance companies. The combined statutory surplus of insurance subsidiaries at December 31, 1997 and 1996 was $277,149,000 and $268,250,000, respectively. The combined statutory net income of insurance subsidiaries was $37,153,000, $11,847,000 and $8,437,000 in 1997, 1996 and 1995, respectively.
Based upon the financial statements of the Company's insurance subsidiaries as of December 31, 1997, as filed with the insurance regulators, the aggregate amount available for dividends in 1998 without regulatory approval is $22,388,000.
The Company and certain of its subsidiaries participate with BCBSUW in two multiple-employer defined benefit pension plans. The salaried plan, covering salaried employees, provides benefits based on compensation, years of service, year of birth and date of retirement. The hourly plan, covering hourly employees, provides for benefit payments of stated amounts, based on number of hours worked and years of credited service. Since both plans were overfunded, no contributions were made in 1997, 1996 or 1995, and a pension credit was recorded in each year.
The following table summarizes the combined funding status of the defined benefit pension plans of the Company and the amounts recorded in the consolidated balance sheets:
The components of the pension credit, which is included in selling, general and administrative expenses, are as follows:
The Company funds the plans' costs principally on a pay-as-you-go basis.
After giving effect to all administrative expense allocations between the Company and BCBSUW, plan expense, including amortization of the transition obligation and interest cost, was $261,000, $224,000 and $351,000 in 1997, 1996 and 1995, respectively. The unfunded accrued postretirement benefit liability at December 31, 1997 and 1996 was $3,994,000 and $3,728,000, respectively.
The Company has stock-based compensation plans (Stock Plans) for the benefit of eligible employees of the Company and its subsidiaries. As of December 31, 1997, the Stock Plans allow for the future granting of up to 437,000 shares as incentive or nonqualified stock options (NQSOs), stock appreciation rights, restricted stock awards and performance awards to employees of the Company.
Accrued benefits for all plans represented an expense of $44,000 and $176,000 in 1997 and 1996, respectively, and a credit of $635,000 in 1995.
The Company follows Accounting Principles Board Opinion No. 25 under which no compensation expense is recorded when the exercise price of the Company's employee stock options equals the market price of the underlying stock on the date of grant. The Company's pro forma information, as if these options had been expensed in accordance with Financial Accounting Standards No. 123 (FAS No. 123), is as follows:
In determining compensation cost pursuant to FAS No. 123, the fair value for these options was estimated at the date of grant using the Black-Scholes option pricing model with the following weighted average assumptions for 1997 and 1996, respectively: risk-free interest rates of 5.71% and 5.66%; dividend yields of 1.78% and 5.14%; volatility factors of the expected market price of the Company's common stock of 0.38 and 0.34; and a weighted average expected life of the options of 6.03 and 3.61 years. As calculated using the Black-Scholes model, the weighted average, grant-date fair value of options granted in which the exercise price equaled the market price on the date of the grant was $10.66 per share for 1997 and $7.77 per share for 1996. The weighted average, grant-date fair value of options granted in which the exercise price was less than the market price on the date of the grant was $1.29 per share for 1996.
(1) The sum of the four quarters does not equal the earnings (loss) per common share for the year due to the change in the number of shares outstanding during the year.