In addition to the office space referenced above, we lease approximately 83 sites in 23 states, totaling roughly 915,000 square feet of space.
(1) See Note 3 to the Consolidated Financial Statements for discussion of dispositions during 2003, 2002 and 2001 impacting the comparability of information. In addition, we sold our non-affiliate pharmacy benefits management operations, our health plans in Utah, Washington, New Mexico, Louisiana, Texas and Oklahoma, our two hospitals, a third-party administrator subsidiary and a PPO network subsidiary in 1999.
We are an integrated managed care organization that delivers managed health care services through health plans and government sponsored managed care plans. Our health plans and government contracts subsidiaries provide health benefits through our HMOs, PPOs and POS plans to approximately 5.3 million individuals in 14 states. We also offer managed health care products related to behavioral health and prescription drugs. In addition, we own health and life insurance companies licensed to sell EPO, PPO, POS and indemnity products, as well as auxiliary non-health products in 36 states and the District of Columbia.
Our success in 2004 and beyond will depend, in part, on our ability to price our health plan products at a level equal to or greater than the growth in health care costs, as well as our ability to contain growth in our health care costs, especially hospital costs, by employing a range of medical management, pharmaceutical management and provider contracting strategies. In addition, we must successfully implement our new TRICARE contract for the North Region, complete our Health Net One systems consolidation project, continue to foster and improve our provider relations and continue growing and solidifying our presence in all of the markets in which we do business. It is also important that we introduce new products and variations on existing products and begin to competitively differentiate our products so that we can compete on factors other than price alone. In 2004, we will begin the rollout of a new branding initiative called the “Rosetta Stone,” which we believe could provide us with a differentiated position in the health care marketplace. For additional information regarding our new branding initiative, see “Item 1. Business - Additional Information Concerning our Business - New Branding Initiative.”
Our health plan operations in the Northeast, and, in particular, our New Jersey health plan, face unique challenges in 2004 related to hospital costs. In 2002 and 2003, we recontracted our hospital network in New Jersey, moving, in large part, to contracts with greater emphasis on reimbursement methodologies related to billed charges, stop loss provisions on the in-patient side and percentage of billed charges discounts on the out-patient side. We did not adequately incorporate the impact of these changes into our pricing models. As a result, and due to issues relating to the impact of leap year, on February 11, 2004, we lowered our earnings guidance for the first quarter and full year of 2004. In order to address the issues we have experienced in the Northeast and, in particular, New Jersey, we have reorganized our senior management team in the Northeast. Our new senior management team has commenced a focused review of hospital contracting, underwriting and premium pricing in the Northeast, as well as opportunities for administrative cost savings through reorganization and other cost-savings initiatives. We expect to report the results of our assessment of the Northeast’s performance on our earnings conference call for the first quarter of 2004.
Health Plan Operations. We are targeting future enrollment growth of 3% to 5% per year and ongoing gross and operating margin expansion in our health plan operations through a stable to slightly declining MCR and declining G&A expenditures. Over the past three years, our overall health plan enrollment has declined as we intentionally exited certain large group accounts and focused our sales and marketing efforts on small group accounts in an effort to improve profitability. In 2003, small group and individual enrollment increased 10.2% as compared to 2002. Our outlook for 2004 is continued growth in our commercial enrollment. We expect to continue pursing small group business (generally defined as an employer group with 2 to 50 employees) in the future, as we believe this is where most job growth will occur over the next several years in the markets we serve. However, we expect the rate of growth in small group enrollment to slow in 2004 because the baseline for measurement purposes increased due to the rapid growth we have experienced in small group enrollment in recent years. We expect large group enrollment in the Northeast, in particular, Connecticut, to continue to decline in 2004 due to ongoing profitability issues in certain large employer group accounts. We expect large group enrollment in California to rebound in 2004, as we gained key accounts in January 2004 representing approximately 60,000 members.
Our product line in our health plan operations has begun to change over the past few years. We have been selling PPO products at a faster growth rate than HMOs, which historically has been our largest enrollment. At the end of 2003, approximately 50% of our commercial enrollment was in HMO products, down from 65% as of December 31, 2001. In response to growing demand from employers for more flexible product lines, we are developing and plan to introduce Consumer Directed Health Plan products in the next several years. In 2003, we test marketed one such product in our Oregon health plan.
We expect commercial premium yields to increase at a slower rate in 2004 compared to the 11.8% yield achieved in 2003. This is consistent with expected declines in overall health care cost trends and in line with our philosophy of maintaining premium prices slightly higher than our health care cost trends. We believe this slowing of rate increases is consistent with industry trends for 2004. In Medicare, we expect that premium revenues will rise at a faster pace due to increased funding from the Medicare reform legislation. We expect that Medicaid premiums will again rise at a slower rate than health care costs and expect that they will decline slightly in California, due to the state’s budget pressures. This expectation is consistent with our ongoing overall strategic approach to participate selectively in the Medicaid market. Since much of our Medi-Cal membership is serviced by medical groups to whom we make capitation payments, our revenues and profit margin are not significantly impacted by these declining premiums.
We believe that managing health care costs is an essential function for a managed care company. In 2003, hospital costs rose at a faster pace than other costs. We have implemented a number of projects to curtail the rate of growth in hospital costs and expect the rate of growth to slow in 2004 from the 12.8% recorded in 2003. These projects include new contracting strategies, including an increase in the use of reimbursement methodologies that are not based on hospital billed charges, and other techniques. Among the medical management techniques we utilize to contain the growth of health care costs are pre-authorization or certification for outpatient and inpatient hospitalizations and a concurrent review of active inpatient hospital stays and discharge planning. We also contract with third parties to manage certain conditions such as neonatal intensive care unit admissions and stays, as well as chronic conditions such as asthma, diabetes and congestive heart failure. These techniques are widely used in the managed care industry and are accepted practice in the medical profession.
In 2003, our physician cost increases were 3.9%, consistent with expectations. Pharmaceutical costs for all lines declined slightly in 2003 as compared with the industry trend of an approximate 12% increase and prior year trends in the low double and high single digit percentages. Increased use of multi-tier benefits, increased use of generic drugs and the conversion of two popular medications to over-the-counter status were key factors in the slowing of the pharmaceutical costs growth rate. We have implemented a number of techniques to contain the growth of pharmaceutical costs including, without limitation, pre-authorization or certification for the use of certain high cost pharmaceuticals. We believe the rate of growth in pharmaceutical costs will grow in 2004 because of increases in the cost of certain specialty pharmaceuticals and more challenging comparisons to our performance in 2003.
TRICARE. Our Government Contracts reportable segment includes government-sponsored managed care plans through the TRICARE programs and other government contracts. In August 2003, we were awarded a new five year contract for the TRICARE North Region that supports nearly 2.8 million Military Health System eligible participants. The new North Region contract covers Connecticut, Delaware, Illinois, Indiana, Kentucky, Maine, Maryland, Massachusetts, Michigan, New Hampshire, New Jersey, New York, North Carolina, Ohio, Pennsylvania, Rhode Island, Vermont, Virginia, West Virginia, Wisconsin and the District of Columbia. In addition, the contract covers a small portion of Tennessee, Missouri and Iowa. Health care delivery is expected to begin on the new contract on July 1, 2004 for the area that was previously Regions 2 and 5 and September 1, 2004 for the area that was previously Region 1.
A description of the differences in the economic structure between our existing TRICARE contracts and the new contract for the North Region is contained in “Item 1. Business - Segment Information - Government Contracts Segment - TRICARE.” We believe that the changes in the economic structure of the new contract, when compared to our expiring contracts, should reduce our risk related to the ability to accurately project our profitability over the term of the new contract.
The table below and the discussion that follows summarize our performance in the last three fiscal years.
(1) The administrative ratio is computed as the sum of general and administrative (“G&A”) and depreciation expenses divided by the sum of health plan services premium revenues and other income.
(2) The selling costs ratio is computed as selling expenses divided by health plan premium revenues.
(3) Net margin is computed as net income divided by total revenues.
• Increase in Oregon of 41,000 members primarily due to the addition 15,000 new members from two new accounts in our large group market and increases of 12,000 new members in our small group and individual market. The stable financial position of the Oregon plan has generated confidence in the carrier and has resulted in new profitable membership.
Membership in the federal Medicare program decreased by 7,000 members or 4.0% as of December 31, 2003, compared to the same period in 2002, primarily due to the following:
• Decrease in California of 2,500 members due to planned withdrawal of participation and cancellation of the PPO/POS plan in selected counties.
Membership in the Medicaid programs decreased by approximately 28,000 members or 3.2% as of December 31, 2003, compared to the same period in 2002, primarily due to the following:
Commercial membership decreased by 138,000 members or 4.6% at December 31, 2002 compared to the same period in 2001. The net decrease in commercial membership is primarily due to planned exits from unprofitable large employer group accounts offset partially by increases in enrollment in key products and markets that we have been targeting in an effort to achieve a greater product diversity. The overall change in commercial membership between 2002 and 2001 reflects primarily the following:
• Net decrease in California of 72,000 members as a result of a 172,000 member decrease in our large group HMO market. This decline reflects disenrollment of our HMO members due to premium rate increases averaging 14% from December 2001. Membership declines in CalPERS accounted for 55,000 members of the decline in the large group market. The membership decline in the large group HMO market is partially offset by a 100,000 membership increase in our PPO/POS products in the small group and individual markets,
• Decrease in Arizona of 49,000 members as a result of membership decreases in our large group HMO market. This decline reflects disenrollment of our HMO members due to premium rate increases averaging 17% from December 2001,
• Decrease in New York of 13,000 members as a result of membership decreases in our large group HMO market. This decline reflects disenrollment of our HMO members due to premium rate increases averaging 17% from December 2001, and
• Decrease in Connecticut of 28,000 members in our large group market, offset by an increase in New Jersey of 28,000 members in our small group market.
During April 2002, CalPERS announced that we would no longer be one of the health insurance carriers available to its members. Effective January 1, 2003, the remaining 175,000 members from CalPERS were no longer enrolled in any of our plans.
Membership in the federal Medicare program decreased by 40,000 members or 18.5% at December 31, 2002 compared to the same period in 2001. The decrease in the federal Medicare program membership is primarily due to planned exits from unprofitable counties as follows:
• Decrease in California of 17,000 members, including 9,000 CalPERS members who were not offered the Medicare risk product,
• Decrease in Arizona of 11,000 members because we closed enrollment in that state effective January 2002 to avoid adverse selection from a change in one of our competitors’ benefits, and
• Decrease in Pennsylvania of 8,000 members as our withdrawal from the Pennsylvania Medicare program was completed in December 2002.
Membership in the Medicaid and other state programs increased by approximately 86,000 members or 10.9% at December 31, 2002, compared to the same period for 2001, primarily due to the following:
• Increase in California of 70,000 members, primarily from strong promotions by the State of California of the Healthy Families program, which provides health insurance to children from low-income families, and
• Regions 9, 10 and 12, covering California, Hawaii, Alaska and part of Arizona
In August 2003, we were awarded a new five year contract for the TRICARE North Region that supports nearly 2.8 million Military Health System (“MHS”) eligible beneficiaries, including providing health care and administrative services for 1.7 million TRICARE eligibles and providing only administrative services for 1.1 million other MHS-eligible beneficiaries (active duty personnel and TRICARE/Medicare dual eligible beneficiaries). This contract covers Connecticut, Delaware, Illinois, Indiana, Kentucky, Maine, Maryland, Massachusetts, Michigan, New Hampshire, New Jersey New York, North Carolina, Ohio, Pennsylvania, Rhode Island, Vermont, Virginia, West Virginia and Wisconsin and the District of Columbia. In addition, the contract covers a small portion of Tennessee, Missouri and Iowa. Health care delivery is expected to begin on the new North Region contract on July 1, 2004 for the area that was previously Regions 2 and 5 and September 1, 2004 for the area that was previously Region 1.
• Increase in Medicaid premiums by $40.3 million or 3.6% driven by an increase of 2.8% in member months combined with an increase of 0.8% in premiums on a PMPM basis. The premium increases were seen in Connecticut and New Jersey due to rate increases and increased reimbursement rates for maternity charges in New Jersey. Rates in California were relatively flat with a 1.1% decrease in DHS rates offset by an increase in the Healthy Families program rates. This was partially offset by,
• Decrease in Medicare risk premiums of $42.3 million or 3.0% primarily due to an 8.1% decrease in member months that was partially offset by an increase of 5.6% in premiums on a PMPM basis. The decrease in member months is the result of our planned exit from certain counties in California and Arizona. The increase in Medicare risk premiums reflects annual rate increases from CMS and was seen across all states.
• Increase in revenues of $54.6 million due to favorable bid price adjustments, and
• Increase in revenues of $33.0 million related to increased change order activity, and
• Increase in risk sharing revenues of $22.3 million from increased health care costs.
Other income is primarily composed of revenues from our employer services group subsidiary. Other income for 2003 was down compared to 2002 due to the sale of our employer services group subsidiary in the fourth quarter 2003. As a result of this sale, we expect that other income in 2004 will be approximately $50 million lower than in 2003 and that it will consist primarily of recognition of deferred revenue from divestitures.
Other income decreased by $2.8 million or 5.7% for the year ended December 31, 2003 as compared to the same period in 2002. This decrease is primarily due to the sale of our employer services group subsidiary effective October 31, 2003. We deferred approximately $15.9 million of the gains on the sales of our employer services subsidiary and dental and vision plans related to non-compete and network access agreements. The deferred amounts are recognized as revenues over the terms of the agreements. We expect to recognize approximately $2.8 million during 2004 related to these deferred gains and will record these amounts in other income on our consolidated statement of operations.
• Increase in commercial health care costs of $377.0 million or 7.6%, reflecting an increase of 10.8% in commercial health care costs on a PMPM basis partially offset by a decrease of 2.9% in member months primarily due to higher hospital and physician costs partially offset by moderating trends in pharmacy costs attributable to benefit changes, increased generic usage and the conversion of two popular prescribed pharmaceuticals to over-the-counter status, and
• Increase in Medicaid health care costs of $44.7 million or 4.9% primarily due to a 2.8% increase in member months and an increase of 2.0% in health care costs on a PMPM basis as a result of limited Medicaid fee schedule increases and a significant portion of providers in California being paid capitation on a percentage of premium basis, partially offset by
• Decrease in Medicare risk health care costs of $66.2 million or 5.1% primarily due to a decrease of 8.1% in member months, partially offset by an increase of 3.3% in Medicare health care costs on a PMPM basis. The decrease in member months is the result of our planned exit from certain counties in California, Arizona and Connecticut. The increases in health care costs on a PMPM basis are primarily in California and Connecticut, which experienced higher physician capitation rates and increased inpatient and outpatient utilization. These trends are also consistent with revenue increases and limited Medicare fee schedule increases.
Health Plan Services MCR decreased to 82.7% for the year ended December 31, 2003 as compared to 83.5% for the same period in 2002. The decrease is primarily due to a continued focus on pricing discipline combined with pricing increases above the health care cost trend for our commercial and Medicare Risk products. In addition, health care cost increases in our commercial, Medicare and Medicaid lines have slowed with moderating growth in hospital and pharmacy costs. The increases in our overall Health Plan Services premiums on a PMPM basis of 8.1% for the year ended December 31, 2003 as compared to the same period in 2002 outpaced the increase in our overall health care costs on a PMPM basis of 7.0% for the year ended December 31, 2003 as compared to the same period in 2002.
Total health plan services costs decreased by $82.1 million or 1.1% for the year ended December 31, 2002 as compared to the same period in 2001 primarily due to the disposition of the Florida health plan effective August 1, 2001. Total Health Plan Services costs on a PMPM basis increased by 5% to $155.99 for the year ended December 31, 2002 from $149.17 for the same period in 2001. Excluding the Florida health plan, the health plan services costs increased by $243.8 million or 3.5% for the year ended December 31, 2002, primarily due to the following:
• Increase in commercial health care costs of $259.7 million or 6% for the year ended December 31, 2002 as compared to the same period in 2001 due to a 13% increase in health care costs on a PMPM basis as a result of higher hospital unit costs, partially offset by a 7% decrease in member months,
• Decrease in Medicare risk health care costs of $162.9 million or 11% for the year ended December 31, 2002 as compared to the same period in 2001 due to a 16% decrease in member months, partially offset by a 5% increase in health care costs on a PMPM basis as a result of higher hospital unit costs, and
• Increase in Medicaid health care costs of $147.9 million or 19% for the year ended December 31, 2002 as compared to the same period in 2001 due to a 15% increase in member months and a 4% increase in health care costs on a PMPM basis as a result of increased hospital and physician utilization.
• Increase of $93.5 million related to higher option period pricing,
Amortization and depreciation expense decreased by $10.2 million or 14.8% for the year ended December 31, 2003 as compared to the same period in 2002. This decrease is primarily due to the following:
• Decrease in depreciation expense of $2.7 million due to asset retirements, offset by increase in depreciation expense of $2.7 million from additional investments in IT software, and
Interest expense decreased by $14.7 million or 26.8% for the year ended December 31, 2002 compared to the same period in 2001. During 2002, we repaid the entire balance of $195 million on our revolving credit facility balance outstanding as of December 31, 2001. This repayment has resulted in the decreases in our interest expense for the year ended December 31, 2002 as compared to the same period in 2001.
During 2002, we recorded a pretax $2.4 million estimated loss on assets held for sale related to a corporate facility building in Trumbull, Connecticut consisting entirely of non-cash write-downs of a building and building improvements. On January 26, 2004, we sold these assets for $6.9 million in cash and recognized a pretax loss of $0.7 million as an asset impairment charge in our consolidated statement of operations for the year ended December 31, 2003. We also recognized a pretax $1.9 million impairment on a corporate facility building in Carmichael, California consisting entirely of non-cash write-downs of building and building improvements. The carrying value of this facility was $1.1 million as of December 31, 2003.
During the fourth quarter ended December 31, 2003, we assessed the probability and concluded it was unlikely that we would realize any of the earnout shares to which we may be entitled under the marketing and stock issuance agreement with NaviMedix. Also in December 2003, Health Net decided to not renew the agreement with NaviMedix under which they provide connectivity services. However, we intend to enter into an agreement with NaviMedix under which they will provide connectivity services to us for a four month period beginning April 1, 2004. Accordingly, we recognized an asset impairment of $13.8 million on our $15 million asset related to the CSMS-IPA e-business connectivity services contract.
Pursuant to SFAS No. 115 and SFAS No. 118, “Accounting by Creditors for Impairment of a Loan - Income Recognition and Disclosures,” we evaluated the carrying value of our investments in convertible preferred stock and subordinated notes of AmCareco, Inc. arising from a previous divestiture of health plans in Louisiana, Oklahoma and Texas in 1999. Since August 2002, authorities in these states had taken various actions, including license denials and liquidation-related processes, that caused us to determine that the carrying value of these assets was no longer recoverable. Accordingly, we wrote off the total carrying value of our investment of $7.1 million which was included as a charge in asset impairments and restructuring charges during the third quarter ended September 30, 2002.
As part of our ongoing general and administrative expense reduction efforts, during the third quarter of 2001, we finalized a formal plan to reduce operating and administrative expenses for all business units within the Company (the “2001 Plan”). In connection with the 2001 Plan, we decided on enterprise-wide staff reductions and consolidations of certain administrative, financial and technology functions. We recorded pretax restructuring charges of $79.7 million during the third quarter ended September 30, 2001. As of September 30, 2002, we had completed the 2001 Plan.
Services, Inc. and Health Net CompAmerica, Inc., collectively known as our employer services group subsidiary, to First Health. The agreement provides Health Net Employer Services customers with continued access to Health Net’s workers’ compensation provider network, and it provides us with access to First Health’s preferred provider organization network. We also entered into a non-compete agreement with First Health. The sale of our employer services group subsidiary closed on October 31, 2003. In connection with this sale, we received $79.5 million in cash and recognized a pretax gain of $11.1 million. We deferred approximately $15.9 million of the gain on the sale of our employer services subsidiary related to non-compete and network access agreements. The deferred revenue is earned over the terms of the agreements over a four to seven year period. Employer services group subsidiary revenue through the date of the sale was reported as part of other income on the consolidated statements of operations.
In 1999, we sold our two hospital subsidiaries to Health Plus, Inc. As part of the sale, we received cash and a note for $12 million due on August 31, 2003 including any unpaid interest. On August 31, 2003, Health Plus defaulted on the note and we increased the allowance on the note by $3.4 million. The note was fully reserved as of September 30, 2003. We are in the process of trying to restructure the note and are making continued efforts to collect all outstanding principal and interest due on the note. We have recorded the additional $3.4 million allowance in general and administrative expenses in our accompanying consolidated statements of operations for the year ended December 31, 2003.
During 2002, we recorded a pretax $2.4 million estimated loss on assets held for sale related to a corporate facility building in Trumbull, Connecticut consisting entirely of non-cash write-downs of a building and building improvements. On January 26, 2004, we sold these assets for $6.9 million in cash and recognized a pretax loss of $0.7 million as an asset impairment charge in our consolidated statement of operations for the year ended December 31, 2003.
The effective income tax rate was 37.5% for the year ended December 31, 2003 compared with 33.4% for the same period in 2002. The increase of 410 basis points in the effective tax rate is primarily due to the reduction in the tax benefit associated with tax return examination settlements.
• A decrease of 110 basis points related to the tax benefit arising from the sales of a claims processing subsidiary and MedUnite, Inc.
The effective tax rate for the year ended December 31, 2002 differed from the statutory federal tax rate of 35.0% due primarily to state income taxes, tax-exempt investment income, business divestitures and tax return examination settlements.
During the third quarter ended September 30, 2003, we recognized an $89.1 million loss on settlement from disposition of discontinued operations, net of tax of $47.9 million, or $0.77 per basic share and $0.75 per diluted share, as a result of our settlement agreement with SNTL Litigation Trust, successor-in-interest to Superior National Insurance Group, Inc., to settle all outstanding claims under the Superior National Insurance Group, Inc v. Foundation Health Corporation, et. al. litigation. See Note 12 to the consolidated financial statements and “Part I - Item 3. Legal Proceedings” for additional information regarding the Superior Litigation.
A description of the cumulative effect of a change in accounting principle from adopting SFAS No. 142 is contained in Note 2 to the consolidated financial statements contained elsewhere in this Annual Report on Form 10-K.
Net cash provided by operating activities was $379.8 million for the year ended December 31, 2003 as compared to $413.5 million for the same period in 2002. The decrease in operating cash flows of $33.7 million was primarily due to the following:
• Net decrease in cash flows from premiums receivable and unearned premiums of $9.1 million primarily from enrollment decreases and
• Net increase in cash flows from amounts receivable/payable under government contracts of $40.6 million, primarily resulting from the increases in health care revenue and cost attributable to reservist activation to support increased military activity,
• Net increase in net income plus amortization and depreciation and non-cash charge items of $82.7 million,
• An increase in the purchase of available for sale securities and restricted investments of $168.6 million.
• A decrease of $252.6 million in net purchases of investments. During 2001, we repositioned a portion of our investable assets into investment vehicles with longer durations within our regulated health plans in order to increase investment income,
• A decrease of $53.5 million in cash disposed in the sale of businesses, net of cash received, and
Net cash used in financing activities was $246.2 million for the year ended December 31, 2003 as compared to $305.6 million for the same period in 2002. Under our stock repurchase program more fully described below, we repurchased and paid for 10,129,655 shares of our Class A common stock for $288.3 million during the year ended December 31, 2003 compared to 6,519,600 shares for $159.7 million during the same period in 2002. We paid down the entire outstanding balance of our revolving credit facility as of December 31, 2002. Accordingly, the repayment of our credit facility decreased by $195 million, net of $50 million in borrowings, during the year ended December 31, 2003 as compared to the same period in 2002.
In April 2002, our Board of Directors authorized us to repurchase up to $250 million (net of exercise proceeds and tax benefits from the exercise of employee stock options) of our Class A Common Stock under our stock repurchase program. In August 2003, our Board of Directors authorized us to repurchase up to an additional $200 million (net of exercise proceeds and tax benefits from the exercise of employee stock options) of our Class A Common Stock under our stock repurchase program. Share repurchases are made under our stock repurchase program from time to time through open market purchases or through privately negotiated transactions. We use cash flows from operations to fund the share repurchases.
During 2002, we received approximately $49 million in cash and recognized $18 million in tax benefits as a result of option exercises. During the year ended December 31, 2003, we received approximately $42 million in cash and recognized $15 million in tax benefits as a result of option exercises. As a result of the $67 million (in 2002) and $57 million (in 2003) in realized benefits, our total authority under our stock repurchase program is estimated at $574 million based on the authorization we received from our Board of Directors to repurchase up to an aggregate of up to $450 million (net of exercise proceeds and tax benefits from the exercise of employee stock options) of our Class A Common Stock. As of March 15, 2004, we had repurchased 17,679,355 shares at an average price of $27.22 per share pursuant to our stock repurchase program.
Our senior notes payable consists of $400 million in aggregate principal amount of 8.375 % senior notes due April 2011. The effective interest rate on the notes when all offering costs are taken into account and amortized over the term of the notes is 8.54% per annum. The notes are redeemable, at our option, at a price equal to the greater of:
On February 20, 2004, we entered into interest rate swap contracts to hedge against interest rate risk associated with our fixed rate senior notes payable. See “Quantitative and Qualitative Disclosures About Market Risk” for additional information regarding the interest rate swap.
The credit agreements governing the credit facilities provide for acceleration of repayment of indebtedness under the credit facilities upon the occurrence of customary events of default including the following:
• judgments against us involving in the aggregate an unsecured liability of $25 million or more not paid, vacated, discharged, stayed or bonded pending appeal within 60 days of the final order; our non-compliance with any material terms of HMO or insurance regulations pertaining to fiscal soundness and not cured or waived within 30 days;
• the occurrence of specified adverse events in connection with any employee pension benefit plan of ours;
The credit agreements contain negative covenants, including financial covenants, that impose performance requirements on our operations. The financial covenants in the credit agreements provide that:
• for any period of four consecutive fiscal quarters, the consolidated leverage ratio, which is the ratio of (1) our consolidated funded debt to (2) our consolidated net income before interest, taxes, depreciation, amortization and other specified items (“consolidated EBITDA”), must not exceed 3 to 1;
• for any period of four consecutive fiscal quarters, the consolidated fixed charge coverage ratio, which is the ratio of (1) our consolidated EBITDA plus consolidated rental expense minus consolidated capital expenditures to (2) our consolidated scheduled debt payments, (defined as the sum of scheduled principal payments, interest expense and rent expense) must be at least 1.5 to 1; and
• we must maintain our consolidated net worth at a level equal to at least $945 million (less the sum of a pretax charge associated with our sale of the Florida Health Plan and specified pretax charges relating to the write-off of goodwill) plus 50% of our consolidated net income and 100% of our net cash proceeds from equity issuances.
The other covenants in the credit agreements include, among other things, limitations on incurrence of indebtedness by subsidiaries of Health Net, Inc. and on our ability to:
• merge, consolidate, dispose of stock in subsidiaries, lease or otherwise dispose of assets and liquidate or dissolve;
Committed loans under the credit facilities bear interest at a rate equal to either (1) the greater of the federal funds rate plus 0.5% and the applicable prime rate or (2) LIBOR plus a margin that depends on our senior unsecured credit rating. Loans obtained through the bidding process bear interest at a rate determined in the bidding process. We pay fees on outstanding letters of credit and a facility fee, computed as a percentage of the lenders’ commitments under the credit facilities, which varies from 0.130% to 0.320% per annum for the 364-day credit facility and from 0.155% to 0.375% per annum for the five-year credit facility, depending on our senior unsecured credit rating.
Our significant contractual obligations as of December 31, 2003 and their impact on our cash flows and liquidity are summarized below for the years ending December 31 (amounts in millions):
Other purchase obligations include payments due under agreements for goods or services that are enforceable and legally binding on us and that specify all significant terms, including: fixed or minimum quantities to be purchased; fixed, minimum or variable price provisions; and the approximate timing of the transaction. We have included in the table set forth under the heading “Contractual Obligations” obligations related to a ten-year pharmacy benefit services agreement that we originally entered into in February 1999 and subsequently modified effective April 1, 2003 and a ten-year agreement for a nurse advice line and other related services that we originally entered into in December 1998 and subsequently modified effective April 1, 2003.
As of December 31, 2003, we had no off-balance sheet arrangements as defined under Regulation S-K 303(a)(4).
Health plan services premiums include HMO, POS and PPO premiums from employer groups and individuals and from Medicare recipients who have purchased supplemental benefit coverage, for which premiums are based on a predetermined prepaid fee, Medicaid revenues based on multi-year contracts to provide care to Medicaid recipients, and revenue under Medicare risk contracts to provide care to enrolled Medicare recipients. Revenue is recognized in the month in which the related enrollees are entitled to health care services. Premiums collected in advance of the month in which enrollees are entitled to health care services are recorded as unearned premiums.
Our HMO in California generally contracts with various medical groups to provide professional care to certain of its members on a capitated, or fixed per member per month fee basis. Capitation contracts generally include a provision for stop-loss and non-capitated services for which we are liable. Professional capitated contracts also generally contain provisions for shared risk. We have risk-sharing arrangements with certain of our providers related to approximately 1,238,000 members primarily in the California commercial market. Shared-risk arrangements provide for our providers and us to share in the variance between actual costs and predetermined goals. Our health plans in Connecticut, New Jersey and New York market to small employer groups through a marketing agreement with The Guardian Life Insurance Company of America. We have approximately 315,000 members under this agreement. In general, we share equally with The Guardian in the profits of the marketing agreement, subject to certain terms of the marketing agreement related to expenses.
Our HMOs in other states also contract with hospitals, physicians and other providers of health care, pursuant to discounted fee-for-service arrangements, hospital per diems, and case rates under which providers bill the HMOs for each individual service provided to enrollees.
We assess the profitability of contracts for providing health care services when operating results or forecasts indicate probable future losses. Significant factors that can lead to a change in our profitability estimates include margin assumptions, risk share terms and non-performance of a provider under a capitated agreement resulting in membership reverting to fee-for-service arrangements with other providers. Contracts are grouped in a manner consistent with the method of determining premium rates. Losses are determined by comparing anticipated premiums to the total of health care related costs less reinsurance recoveries, if any, and the cost of maintaining the contracts. Losses, if any, are recognized in the period the losses are determined and are classified as Health Plan Services. We had no premium deficiency reserves as of December 31, 2003.
based on information presently available we believe that the final outcome of such proceedings will not have a material adverse effect upon our financial condition, results of operations or liquidity. However, our belief regarding the likely outcome of such proceedings could change in the future and an unfavorable outcome could have a material adverse effect upon our financial condition, results of operations or liquidity. In addition, the ultimate outcome of these loss contingencies cannot be predicted with certainty and it is difficult to measure the actual loss, if any, that might be incurred.
Amounts receivable under government contracts are composed primarily of billed and estimated amounts receivable under cost and performance incentive provisions, price adjustments, and change orders for services not originally specified in the contracts. These receivables develop as a result of TRICARE health care costs rising faster than the forecasted health care cost used in the original contract bids, data revisions on formal contract adjustments and routine contract changes for benefit adjustments.
Change orders for services not originally specified in government contracts arise because the government often directs us to implement changes to our contracts before the scope and/or value of the related services is defined or negotiated. When such a change is implemented, we may start to incur the related costs immediately, even before we have proposed a price to the government. In these situations, our policy is to collect and defer the costs incurred; we make no attempt to estimate and record revenue. Once we have submitted a cost proposal to the government, we record the costs and the appropriate value for revenue, using our best estimate of what will ultimately be negotiated. Such estimates are determined based on information available as well as historical performance and collection of which could extend for periods beyond a year. Differences, which may be material, between the revenue amounts estimated and final amounts collected are recorded in the period when determined.
We test goodwill for impairment annually based on the estimated fair value of the reporting units which comprise our Health Plan Services and Government Contracts reportable segments. We test for impairment on a more frequent basis in cases where events and changes in circumstances would indicate that we might not recover the carrying value of goodwill. Our measurement of fair value is based on utilization of both the income and market approaches to fair value determination. As a part of assessing impairments of goodwill and other intangible assets, we perform fair value measurements and utilize an independent third-party professional services firm to assist with this assessment. The income approach is based on a discounted cash flow methodology. The discounted cash flow methodology is based upon converting expected cash flows to present value. Annual cash flows are estimated for each year of a defined multi-year period until the growth pattern becomes stable. The expected interim cash flows expected after the growth pattern becomes stable are calculated using an appropriate capitalization technique and then discounted. The market approach uses a market valuation methodology which includes the selection of companies engaged in a line (or lines) of business similar to ours to be valued and an analysis of our comparative operating results and future prospects in relation to those of the guideline companies selected. The market price multiples are selected and applied to us based on our relative performance, future prospects and risk profiles in comparison to those of the guideline companies. Methodologies for selecting guideline companies include the exchange methodology and the acquisition methodology. The exchange methodology is based upon transactions of minority-interests in publicly traded companies engaged in a line (or lines) of business similar to ours. The public companies selected are defined as guideline companies. The acquisition methodology involved analyzing the transaction involving similar companies that have been bought and sold in the public marketplace. There are numerous assumptions and estimates underlying the determination of the estimated fair value of our reporting units, including certain assumptions and estimates related to future earnings based on current and future initiatives. If these initiatives do not accomplish their targeted objectives, the assumptions and estimates underlying the goodwill impairment tests could be adversely affected and have a material effect upon our financial condition, results of operations or liquidity.
We periodically assess the recoverability of our long-lived assets including property and equipment and other long-term assets and investments where events and changes in circumstances would indicate that we might not recover the carrying value as follows:
We test long-lived assets or asset groups for recoverability when events or changes in circumstances indicate that their carrying amount may not be recoverable. Circumstances which could trigger a review include, but are not limited to: significant decreases in the market price of the asset, significant adverse changes in the business climate or legal factors, current period cash flow or operating losses combined with a history of losses or a forecast of continuing losses associated with the use of the asset and current expectation that the asset will more likely than not be sold or disposed significantly before the end of its estimated useful life.
We classify an asset or asset group that will be disposed of other than by sale as held and used until the disposal transaction occurs. The asset or asset group continues to be depreciated based on revisions to its estimated useful life until the date of disposal or abandonment.
Certain of our subsidiaries must comply with minimum capital and surplus requirements under applicable state laws and regulations, and must have adequate reserves for claims. As of December 31, 2003, we estimated that our regulated subsidiaries had approximately $918 million in statutory net worth, or approximately $361 million in excess of current regulatory requirements. We generally manage our aggregate regulated subsidiary capital against 300% of Risk Based Capital (“RBC”) Company Action Levels, although RBC standards are not yet applicable to all of our regulated subsidiaries. Certain subsidiaries must maintain ratios of current assets to current liabilities pursuant to certain government contracts. Management believes that as of December 31, 2003, all of our health plans and insurance subsidiaries met their respective regulatory requirements.
As necessary, we make contributions to and issue standby letters of credit on behalf of our subsidiaries to meet risk-based capital or other statutory capital requirements under state laws and regulations. Our parent company contributed $21.0 million to certain of its subsidiaries to meet capital requirements during the year ended December 31, 2003. Of the $21 million, we contributed $20 million to our New Jersey health plan and $1 million to our insurance company in
Connecticut. Except for the $21.0 million in capital contributions, our parent company did not make any capital contributions to its subsidiaries to meet risk-based capital or other statutory capital requirements under state laws and regulations during the year ended December 31, 2003 or thereafter through the date of the filing of this Annual Report on Form 10-K.