In California and Guam, we own two buildings encompassing approximately 225,000 aggregate square feet of space primarily used for administrative operations. All of our facilities are in good working condition, are well maintained and are adequate for our present and currently anticipated needs. We believe that we can rent additional space at competitive rates when current leases expire, or if we need additional space.
In this Annual Report on Form 10-K, we refer to PacifiCare Health Systems, Inc. as “PacifiCare,” the “Company,” “we,” “us,” or “our”. Statements that are not historical facts are forward-looking statements within the meaning of the Federal Securities laws, and may involve a number of risks and uncertainties which could cause actual results to differ materially from those anticipated as of the date of this report. In addition, past financial and/or operating performance is not necessarily a reliable indicator of future performance and you should not use our historical performance to anticipate results or future period trends. In evaluating these forward-looking statements, you should specifically consider the risks described below under “Cautionary Statements” which follows our discussion on Critical Accounting Policies and Estimates and in other parts of this report.
For our behavioral health and dental and vision subsidiaries, we previously included premium revenues in the commercial revenue line and non-premium revenues in the other income line. In 2003, all revenues (premium and non-premium) derived from our specialty companies (behavioral health, dental and vision and PBM) are now reported in the specialty and other revenues line.
Net Investment Income. Net investment income consists of interest income, gross realized gains and losses experienced on cash invested over each period.
Membership. Total HMO and other membership decreased 7% to approximately 2.9 million members at December 31, 2003 from approximately 3.1 million members at December 31, 2002.
PPO and indemnity membership increased approximately 144% at December 31, 2003 compared to the prior year primarily due to enhanced marketing and the addition of approximately 14,900 members from new product initiatives primarily in California and Colorado.
Senior HMO membership decreased approximately 10%, or 78,200 members, at December 31, 2003 compared to the prior year. This decrease primarily resulted from county exits and member disenrollments attributable to reduced benefits and increased premiums effective January 1, 2003. As previously announced, we exited five counties in California and Texas resulting in the loss of approximately 63,000 senior HMO members effective January 1, 2003.
Pharmacy benefit management unaffiliated membership at December 31, 2003 increased approximately 27%, or 436,300 members, compared to the prior year primarily due to an increase of approximately 400,000 from one group and the net addition of 20 clients. Pharmacy benefit management HMO membership at December 31, 2003 decreased approximately 7% compared to the prior year as a result of county exits and member disenrollments attributable to reduced benefits and increased premiums effective January 1, 2003 and the loss of our contract with CalPERS as discussed above.
PacifiCare dental and vision membership at December 31, 2003 increased approximately 10%, or 42,500 members, compared to the prior year primarily due to increased cross-selling of these products in conjunction with our commercial products. Dental and vision unaffiliated membership at December 31, 2003 was comparable to the prior year.
We anticipate revenue increases in 2004 primarily due to membership and rate increases. However, we do not expect the same percentage premium rate increases in 2004 that we experienced in 2003.
Specialty and Other Revenue. Specialty and other revenue of $499 million for the year ended December 31, 2003 increased 18%, or $77 million, compared to the same period in the prior year. The increase was primarily due to increased mail order revenues and unaffiliated membership from our pharmacy benefit management subsidiary.
lower pre-tax rates of return due to Federal Reserve rate reductions in 2003.
We anticipate our commercial margin in 2004 will be slightly higher than 2003.
Senior Margin. Our senior margin increased 9%, or $72 million, to $855 million for the year ended December 31, 2003, compared to $783 million the same period in the prior year as follows:
Medical Loss Ratio. Our medical loss ratios, or MLRs, are calculated using premium revenue and related health care services and other expenses and cannot be directly calculated from the line items in the Consolidated Statement of Operations. Our MLRs are calculated using the following categories of revenue and expenses:
Private - Commercial: includes premium revenue and related health care services and other expenses for our commercial HMO products (including Federal Employees Health Benefit Program, or FEHBP, and state and local government contracts), PPO products, and other indemnity, behavioral, dental and vision plans;
Private - Senior: includes premium revenue and related health care services and other expenses for our Medicare Supplement and Senior Supplement products where premiums are paid in full by the employer or the consumer;
In 2002, we calculated our MLR for our commercial and senior products based on total premiums and total health care services expenses as reported on our statement of operations. This resulted in the inclusion of certain health care costs related to the cost of acquiring drugs for our mail order business of our PBM subsidiary within our commercial MLR calculation for which there was no corresponding revenues (the related revenues were included in the other income line). Since this inadvertently had the effect of slightly increasing the MLR of our commercial product, we changed this presentation in order to provide more transparency on the trends affecting the profitability of our insured products. Under our new format, only premium revenues and the related health care and other services expenses are included in the MLR calculations. The 2002 MLR calculations have been recalculated to conform to the 2003 presentation.
The consolidated MLR and its components, unadjusted for any prior period changes in healthcare cost estimates, for the year ended December 31, 2003 and 2002 are as follows:
Private - Commercial Medical Loss Ratio. Our private - commercial medical loss ratio decreased to 84.0% for the year ended December 31, 2003 compared to 87.1% for the prior year. The decrease was driven by premium rate increases that outpaced an increase in health care services and other expenses on both an absolute dollar and per member per month basis.
Private - Senior Medical Loss Ratio. Our private - senior medical loss ratio increased to 63.4% for the year ended December 31, 2003 compared to 53.5% for the prior year. The increase was primarily driven by health care services and other expenses increases that outpaced premium revenue increases on a per member per month basis.
$5 million of favorable effect of the interest rate swap on $300 million of our 10 3/4% senior notes with no comparable activity in the prior year, and
Provision for Income Taxes. The effective income tax rate was 37.7% for the year ended December 31, 2003, compared with 37.3% in 2002. The increase in the effective tax rate from the prior year is primarily due to higher 2003 earnings resulting in a higher state tax expense while reducing the benefit that tax-exempt income had on our effective tax rate.
Senior HMO membership decreased approximately 20% at December 31, 2002 compared to the prior year due to a decrease of 150,100 members in California and Texas. This decrease primarily resulted from county exits and member disenrollments attributable to reduced benefits and increased premiums effective January 1, 2002.
PPO and indemnity membership increased approximately 96% at December 31, 2002 compared to the prior year due to enhanced marketing and new product initiatives primarily in California and Texas.
Pharmacy benefit management unaffiliated membership at December 31, 2002 increased approximately 45% compared to the prior year due to increased marketing efforts. PacifiCare pharmacy benefit management membership at December 31, 2002 decreased approximately 10% compared to the prior year as a result of county exits and member disenrollments attributable to reduced benefits and increased premiums effective January 1, 2002.
During 2002, we wrote off our entire $11 million investment in MedUnite Inc. 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 $0.11 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.
Specialty and Other Margin. Our specialty and other margin decreased 1%, or $3 million, to $245 million for the year ended December 31, 2002. The decrease was primarily driven by the loss of PacifiCare senior dental and vision members attributable to dental benefit changes effective January 1, 2002.
Private - Commercial Medical Loss Ratio. Our private - commercial medical loss ratio decreased to 87.1% for the year ended December 31, 2002 compared to 89.3% in the prior year. The decrease was driven by significant premium rate increases that outpaced an increase in health care services and other expenses on both an absolute dollar and per member per month basis.
Government - Senior Medical Loss Ratio. Our government - senior medical loss ratio decreased to 86.9% for the year ended December 31, 2002 compared to 90.1% in the prior year. The decrease was driven by a 8% increase in premium revenue, offset partially by a 4% decrease in health care services and other expenses.
diluted loss per share, net of tax) for the year ended December 31, 2002. See Note 10 of the Notes to Consolidated Financial Statements.
Interest Expense. Interest expense increased 7%, or $5 million, to $75 million for the year ended December 31, 2002, from $70 million in the prior year due to our sale of $500 million in aggregate principal amount of 10 3/4% senior notes in May 2002, which carried a higher annual interest rate than the debt we repaid using the proceeds of that offering. The increase was partially offset by cash redemptions of a portion of our outstanding 7% FHP senior notes and our sale of $135 million in aggregate 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.
Operating Cash Flows. Our consolidated cash, equivalents and marketable securities increased $411 million, or 19%, to $2.6 billion at December 31, 2003, from $2.1 billion at December 31, 2002.
Investing Activities. For the year ended December 31, 2003, investing activities used $202 million of cash, compared to $278 million used during the year ended December 31, 2002. The change was primarily related to decreased purchases of restricted marketable securities, partially offset by an increase in purchases of unrestricted marketable securities.
Financing Activities. For the year ended December 31, 2003, financing activities provided $34 million of cash, compared to $10 million provided during the year ended December 31, 2002. During the year ended December 31, 2003, the significant changes were as follows:
We paid $151 million on our previous senior credit facility and received $150 million of proceeds from our new syndicated senior credit facility in 2003.
We paid $7 million in loan fees in connection with the replacement of our senior credit facility in June 2003. In 2002, 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 previous senior credit facility, and $5 million in connection with the 3% convertible subordinated debentures offering.
We received $135 million from the 3% convertible subordinated debentures offering in 2002, with no comparable activity during 2003.
We paid $554 million under our senior credit facility, including $499 million under the term loan facility and $55 million under the revolving credit facility, and received $497 million of proceeds from the 10 3/4 senior notes offering in 2002.
We received $9 million in proceeds from a draw down on an equity commitment arrangement in 2002, with no comparable activity during 2003.
We have $135 million in aggregate principal amount of 3% convertible subordinated debentures due in 2032. The debentures are convertible into 6,428,566 shares of common stock under certain conditions, including satisfaction of a market price condition for our common stock, satisfaction of a trading price condition relating to the debentures, upon notice of redemption, or upon specified corporate transactions. Each $1,000 of the debentures is convertible into 47.619 shares of our common stock. The market price condition for conversion of the debentures is satisfied if the closing sale price of our common stock exceeds 110% of the conversion price (which is calculated at $23.10 per share) for the debentures for at least 20 trading days in the 30 consecutive trading days ending on the last trading day of any fiscal quarter. In the event that the market price condition is satisfied during any fiscal quarter, the debentures are convertible, at the option of the holder, during the following fiscal quarter. The market price condition is evaluated each quarter to determine whether the debentures will be convertible at the option of the holder during the following fiscal quarter. During the fiscal year ended December 31, 2003, the market price condition described above was satisfied for the quarters ended September 30, 2003 and December 31, 2003. As a result, the debentures were convertible during the quarter ended December 31, 2003 and remain convertible at the option of the holder at any time during the quarter ended March 31, 2004. While no debentures were converted as of December 31, 2003, they are considered common stock equivalents and are included in the calculation of weighted average shares outstanding on a diluted basis for the fourth quarter and fiscal year ended December 31, 2003.
will thereafter decline annually. Additionally, at any time on or prior to June 1, 2006, we may redeem the 10 3/4% senior notes upon a change of control, as defined in the indenture for the notes, at 100% of their principal amount plus accrued and unpaid interest and a “make-whole” premium.
In April 2003, we entered into an interest rate swap on $300 million of our 10 3/4% senior notes for the purpose of hedging the fair value of our indebtedness. This fair value hedge is accounted for using the short-cut method under SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, whereby the hedge is reported in our balance sheets at fair value, and the carrying value of the long-term debt is adjusted for an offsetting amount representing changes in fair value attributable to the hedged risk. Under the terms of the agreement, we make interest payments based on the three-month London Interbank Offered Rate (LIBOR) plus 692 basis points and receive interest payments based on the 10 3/4% fixed rate. Our rate under the swap agreement was 8.09%, at December 31, 2003 which is based on a 90-day LIBOR of 1.17% plus 692 basis points. The three-month LIBOR rate we use to determine our interest payments under the swap agreement was first established on June 2, 2003 and resets every three months thereafter, until expiration in June 2009.
The terms of the senior credit facility contain various covenants customary for financings of this type which place restrictions on our and/or our subsidiaries’ ability to incur debt, pay dividends, create liens, make investments, optionally repay, redeem or repurchase our securities, and enter into
Certain of our domestic, unregulated subsidiaries provide guarantees and have granted security interests to the lenders in substantially all of their personal property in order to secure our obligations under the senior credit facility. We have also pledged the equity of certain of our subsidiaries to the lenders. Prior to September 15, 2003, some of our domestic, unregulated subsidiaries were restricted from guaranteeing the senior credit facility by the terms of the FHP senior notes. As the FHP senior notes were repaid in full on September 15, 2003, these subsidiaries now fully and unconditionally guarantee the senior credit facility.
Receivables, Net. Receivables, net as of December 31, 2003, decreased $24 million from December 31, 2002 due to the decrease in provider receivables from collections and settlements primarily in California and Washington.
Medical Claims and Benefits Payable. The majority of our medical claims and benefits payable represents liabilities related to our risk-based contracts. Under risk-based contracts, claims are payable once incurred and cash disbursements are made to health care providers for services provided to members after the related claim has been submitted and adjudicated. Under capitated contracts, health care providers are prepaid on a fixed-fee per member per month basis, regardless of the
Medical claims and benefits payable as of December 31, 2003 decreased $17 million from the balance as of December 31, 2002, primarily due to a $90 million reduction in capitation and all other medical claims and benefits payable due primarily to annual settlements of provider risk sharing programs through payouts or by offsetting of risk program receivables against risk program liabilities. IBNR increased $73 million as a result of an increase in commercial risk membership and commercial health care costs per member, partially offset by a decrease in the elapsed time between the date health care services were provided and payment of the related claims liabilities as compared to December 31, 2002.
Accounts Payable and Accrued Liabilities. Accounts payable and accrued liabilities, including accrued compensation and employee benefits, increased $52 million from December 31, 2002, primarily due to an increase of $39 million related to increases in liabilities for reinsurance and legal expenses and the timing of payments of trade accounts payable and other accruals, an increase of $16 million in accrued compensation and an increase of $10 million in accrued taxes, partially offset by a decrease of $13 million in OPM reserves.
Stockholders’ Equity. The decrease in treasury stock and additional paid-in capital from December 31, 2002 were primarily due to the retirement of all 23 million shares of outstanding treasury stock, partially offset by the issuance of 7.6 million shares in connection with the public common stock offering and 1.5 million shares of restricted common stock that we granted as part of an employee recognition and retention program during the year ended December 31, 2003. All share data have been adjusted for the effect of the two-for-one stock split in the form of a stock dividend that was effective January 20, 2004. See Note 6 of the Notes to Consolidated Financial Statements.
When we prepare our consolidated financial statements, we use estimates and assumptions that may affect reported amounts and disclosures. The accounting estimates that we believe involve the most complex judgments, and are the most critical to the accurate reporting of our financial condition and results of operations include the following:
Reflects estimated potential changes in medical claims payable caused by changes in completion factors in each of the most recent four months.
The estimates for submitted claims and IBNR claims liabilities are made on an accrual basis and adjusted, based on actual claims data, in future periods as required. Adjustments to prior period estimates, if any, are included in the current period. We also consider exceptional situations that might require judgmental adjustments in establishing our best estimate, such as system conversions, processing interruptions, or environmental changes. None of these factors had a material impact on the development of our claims payable estimates during any of the periods reflected in this filing.
For new products, such as our PPO products, estimates are initially based on health care cost data provided by third parties. This data includes assumptions for member age, gender and geography. The models that we use to prepare estimates for each product are adjusted to be in line with the approach discussed above as we accumulate actual claims data. Such estimates could materially understate or overstate our actual liability for medical claims and benefits payable.
Our profitability will depend in part on accurately pricing our products and predicting health care costs and on our ability to control future health care costs.
Our actual health care costs may exceed our estimates reflected in premiums and adjusted community rates due to various factors, including increased utilization of medical facilities and services, including prescription drugs, changes in demographic characteristics, the regulatory environment, changes in health care practices, medical cost inflation, new treatment and technologies, continued consolidation of physician, hospital and other provider groups, termination of capitation arrangements resulting in transfer of membership to risk based arrangements and contractual disputes with providers. Our failure to adequately price our products or predict and control health care costs may result in a material adverse effect on our financial condition, results of operations or cash flows.
negative publicity and news coverage about us or litigation or threats of litigation against us.
Our operating results could be adversely affected if our actual health care claims exceed our reserves or our liability for unpaid claims of insolvent providers under capitation agreements exceeds our insolvency reserves.
We estimate the amount of our reserves for submitted claims and claims that have been incurred but not yet reported or IBNR claims primarily using standard actuarial methodologies based upon historical data. The estimates for submitted claims and IBNR claims liabilities are made on an accrual basis, are continually reviewed and are adjusted in current operations as required. Given the uncertainties inherent in such estimates, the reserves could materially understate or overstate our actual liability for claims and benefits payable. Any increases to these prior estimates could adversely affect our results of operations in future periods.
We have regulatory risk for the timely processing and payment of claims. If we, or any entities with whom we subcontract to process or pay claims, are unable to handle continued increased claims volume, or if we are unable to pay claims timely we may be subject to regulatory censure and penalties, which could have a material adverse effect on our operations and results of operations. In addition, if our claims processing system is unable to process claims accurately, the data we use for our IBNR estimates could be incomplete and our ability to estimate claims liabilities and establish adequate 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 that treat new conditions or have fewer side effects, new medications 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. We may be unable to predict these costs when establishing our premiums or completely manage these costs, which could adversely impact our profitability.
our need for additional investments in PBM expansion, branding and advertising campaigns, medical management, underwriting and actuarial resources and technology;
our need for additional investments in information technology projects, including consolidation of our existing systems that manage membership, eligibility, capitation, claims processing and payment information and other important information;
our ability to estimate costs for our self-insured retention for medical malpractice claims; and
our ability to estimate legal expenses and settlements associated with litigation that has been or could be brought against us.
Health care providers and members are currently attacking practices of the HMO industry through a number of lawsuits brought against us and other HMOs, including In re Managed Care. The class action lawsuits brought by health care providers allege that HMOs’ claims processing systems automatically and impermissibly alter codes included on providers’ reimbursement/ claims forms to reduce the amount of reimbursement, and that HMOs impose unfair contracting terms on health care providers, impermissibly delay making capitated payments under their capitated contracts, and negotiate capitation payments that are inadequate to cover the costs of health care services provided.
We are, in the ordinary course of business, subject to the claims of our members arising out of decisions to deny or restrict reimbursement for services, including medical malpractice claims related to our taking a more active role in managing the cost of medical care. The loss of even one of these claims, if it results in a significant punitive damage award, could have a material adverse effect on our business. In addition, our exposure to potential liability under punitive damage theories may significantly decrease our ability to settle these claims on reasonable terms. We maintain general liability, property, excess managed care errors and omissions and medical malpractice insurance coverage. We are at risk for our self-insured retention on these claims, and are substantially self-insured for errors and omissions and medical malpractice claims through a combination of retention and through premiums we pay to a captive insurance carrier. Coverages typically include varying and increasing levels of self-insured retention or deductibles that increase our risk of loss.
restricting a health plan’s ability to select and terminate providers in our networks;
tightening time periods for the timely payment and administration of health care claims and imposing financial and other penalties for non-compliance.
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 to fund our strategic initiatives and working capital requirements;
Nearly all of our subsidiaries are subject to HMO regulations or insurance regulations and may be subject to substantial supervision by one or more HMO or insurance regulators. Subsidiaries subject to regulation must meet or exceed various capital standards imposed by HMO or insurance regulations, which may from time to time impact the amount of funds the subsidiaries can pay to us. Our subsidiaries are not obligated to make funds available to us. Additionally, from time to time, we advance funds in the form of a loan or capital contribution to our subsidiaries to assist them in satisfying state financial requirements. We may provide additional funding to a subsidiary if a state regulator imposes additional financial requirements due to concerns about the financial position of the subsidiary or if there is an adverse effect resulting from changes to the risk-based capital requirements. This may in turn affect the subsidiary’s ability to pay state-regulated dividends or make other cash transfers.
Our senior credit facility and our 10 3/4% senior notes limit, and in some circumstances prohibit, our ability to incur additional indebtedness, pay dividends, make investments or other restricted payments, sell or otherwise dispose of assets, effect a consolidation or merger and engage in other activities.
The concentration of our commercial and government senior business in eight western states and Guam subjects us to risks from economic downturns in this region.
We cannot predict or prevent the occurrence of bioterrorism or other acts of terrorism or natural disasters, such as earthquakes, which could cause increased and unexpected utilization of health care services. These events could also have adverse effects on general economic conditions in the states where we offer products, the price and availability of products and services we purchase, the availability and morale of our employees, our operations and facilities or the demand for our products. We maintain disaster recovery plans intended to enable us to continue to operate without major disruptions in service following disasters. However, a disaster could severely impair or delay service to our members, cause us to incur significant cost of recovery and cause a loss of members.
Our PBM subsidiary, Prescription Solutions, faces regulatory and other risks associated with the pharmacy benefits management industry that differ from the risks of providing managed care and health insurance products.
Our PBM is also subject to federal and state anti-remuneration laws that govern its relationships with pharmaceutical manufacturers. Federal and state legislatures are considering new regulations for the industry that could adversely affect current industry practices, including the receipt of rebates from pharmaceutical companies. In addition, if a court were to determine that our PBM acts as a fiduciary under ERISA, we could be subject to claims for alleged breaches of fiduciary obligations in implementation of formularies, preferred drug listings and therapeutic intervention programs and other transactions. We also conduct business as a mail-order pharmacy, which subjects us to extensive federal, state and local regulation, as well as risks inherent in the packaging and distribution of pharmaceuticals and other health care products. The failure to adhere to these regulations could expose our PBM subsidiary to civil and criminal penalties. We also face potential claims in connection with claimed errors by our mail-order pharmacy.
From time to time in press releases, conference calls and otherwise, we may publish or make forecasts or other forward looking statements regarding our future results, including estimated earnings per share and other operating and financial metrics. Our forecasts are based upon various assumptions that are subject to significant uncertainties and any number of them may prove incorrect. Our estimated earnings per share are based in part upon a forecast of our weighted average shares outstanding at the time of our estimate. Our convertible subordinated debentures include a contingent conversion feature that may materially affect our weighted average shares outstanding in any quarter. If the conditions to conversion are satisfied during a quarter, then the debentures are convertible during the next quarter and the underlying shares of common stock into which they are convertible are included in the calculation of our weighted average shares outstanding. If the conditions to conversion are not met, then the underlying shares are excluded from the calculation.