In conjunction with the Kaiser-Texas acquisition, the Company purchased eight medical facilities totalling approximately 323,000 square feet and administrative facilities totalling approximately 175,000 square feet. These buildings are subject to a deed of trust note securing a $35.2 million note. In addition, the Company leases additional office and clinical space in Texas totalling approximately 54,000 square feet and 77,000 square feet, respectively. The above properties are utilized primarily for the managed care operations. The workers' compensation subsidiary is headquartered in Nevada and occupies approximately 25% of the 198,000 square foot administrative building as well as leases approximately 67,000 square feet of office space in California. The Company leases approximately 150,000 square feet of office space in other various states as needed for other regional operations, for TRICARE service centers and for the military subsidiary's administrative headquarters.
The following selected consolidated financial data of Sierra Health Services, Inc., and subsidiaries (the "Company"), for each of the fiscal years in the five-year period ended December 31, 1998 should be read in conjunction with the Consolidated Financial Statements and the related Notes thereto, "Management's Discussion and Analysis of Financial Condition and Results of Operations" and other information which appears elsewhere in this Annual Report on Form 10-K. The selected consolidated financial data below has been derived from the audited Consolidated Financial Statements of the Company.
(1) The Company recorded certain identifiable integration, settlement and other costs. See Note 14 of Notes to the Consolidated Financial Statements. (2) Adjusted to account for three-for-two stock split of the Company's common stock to stockholders of record as of May 18, 1998.
The following discussion and analysis provides information which management believes is relevant for an assessment and understanding of the Company's consolidated financial condition and results of operations. The discussion should be read in conjunction with the Consolidated Financial Statements and Related Notes thereto. Any forward-looking information contained in this Management's Discussion and Analysis of Financial Condition and Results of Operations and any other sections of this 1998 Annual Report on Form 10-K should be considered in connection with certain cautionary statements contained in the Company's Current Report on Form 8-K filing dated March 17, 1999, incorporated herein by reference. Such cautionary statements are made pursuant to the "safe harbor" provisions of the Private Securities Litigation Reform Act of 1995 and identify important risk factors that could cause the Company's actual results to differ materially from those expressed in any projected, estimated or forward-looking statements relating to the Company.
In August 1997, the Company acquired the assets and operations of Total Home Care, Inc. ("THC") for approximately $3.1 million, net of cash acquired. THC provides home infusion, oxygen, and durable medical equipment services in Nevada and Arizona. The Company sold the Arizona operations in the first quarter of 1998 for approximately $1.5 million. Also, in the first quarter of 1998, the Company purchased three medical clinics in southern Nevada for approximately $7.3 million.
Effective December 31, 1996, the Company purchased Prime Holdings, Inc. ("Prime") for approximately $32.2 million in cash. At December 31, 1996, Prime operated MedOne Health Plan, Inc., a 12,800 member HMO, and also served 215,000 people through preferred provider organizations, workers' compensation programs, and administrative services products for self-insured employers and union welfare funds, primarily in the state of Nevada.
The Company derives revenues from its health maintenance organizations, managed indemnity, military health care services and workers' compensation insurance subsidiaries. To a lesser extent, the Company also derives additional specialty product revenues from non-HMO and insurance products (consisting of fees for workers' compensation administration, utilization management services and ancillary products), professional fees (consisting primarily of fees for providing health care services to non-members and co-payment fees received from members), and investment and other revenue. Medical premium revenues accounted for approximately 58.8%, 71.2% and 67.3% of the Company's total revenues for 1998, 1997 and 1996, respectively. The decrease in medical premiums as a percentage of total revenues is primarily due to the addition of military contract revenues. Continued medical premium revenue growth is principally dependent upon continued enrollment in the Company's products and upon competitive and regulatory factors.
Integration, settlement and other expenses represent identifiable incremental costs the Company has incurred primarily in connection with various mergers, acquisitions and planned dispositions as well as expenses associated with the Company's proposal to serve TRICARE beneficiaries in Region 1 and the ultimate cost to settle a bid protest. Start-up expenses associated with the proposal to serve TRICARE beneficiaries were charged to operations upon notification of award.
Investment and other revenue increased approximately $3.2 million over the comparable period in the prior year primarily due to an increase in invested balances and capital gains realized on the sale of investments.
Medical and Specialty Product Expense. Medical expenses as a percentage of medical premiums and professional fees ("Medical Care Ratio") increased from 76.9% to 78.4% for the year ended December 31, 1998 compared to the prior period. The increase in the medical care ratio was due to an increase in Medicare members as a percentage of fully-insured members, continued expansion in Texas, northern Nevada and Arizona which have higher medical care ratios, higher pharmacy costs and the acquisitions of THC and two medical clinics for which costs of operations are included in medical expenses. The cost of providing medical care to Medicare members generally requires a greater percentage of the premiums received. Pharmacy costs increased as the management of the pharmacy benefit was transitioned from a capitated pharmacy benefits contract to in-house management in the third quarter of 1998. The costs
under such capitation contract were substantially below actual claims experience. The medical care ratio is expected to further increase in 1999 due to the changes in member mix and pharmacy costs noted above. Included in medical expenses is the reversal of $4.4 million of premium deficiency reserve that was used to offset losses on contracts from the Kaiser-Texas operations that were acquired on October 31, 1998.
Specialty product expenses decreased approximately $800,000, or less than 1.0%, due primarily to the implementation of the reinsurance agreement as discussed previously. Specialty product revenue and expense is primarily related to the workers' compensation insurance business. Effective January 1, 1998, workers' compensation claims are reinsured between $500,000 and $100 million per occurrence. For claims occurring on and after July 1, 1998, that are below $500,000, the Company obtained quota share and excess of loss reinsurance. Under this agreement, the Company reinsures 30% of the first $10,000 of each claim, 75% of the next $40,000 and 100% of the next $450,000. The Company receives a ceding commission from the reinsurer as a partial reimbursement of operating expenses. Excluding the effect of the reinsurance agreement, specialty product expense would have increased $19.5 million compared to the prior year.
Military Contract Expense. The military contract expense is comprised of those expenses incurred in 1998 for five months of contract implementation and seven months of health care delivery. This expense consists primarily of costs to provide managed health care services to eligible beneficiaries in accordance with the Company's TRICARE contract. Under the contract, SMHS provides health care services to approximately 606,000 dependents of active duty military personnel and military retirees and their dependents through subcontractor partnerships and individual providers. Health care costs are recorded in the period when services are provided to eligible beneficiaries, including estimates for provider costs which have been incurred but not reported to the Company. Also, included in military contract expense are costs incurred to perform specific administrative services, such as health care appointment scheduling, enrollment, network management and health care advice line services, and other administrative functions of the military health care subsidiary.
million increased compensation expense, resulting primarily from additional employees supporting expanded services and new benefit programs for management. Broker, third party administration and premium tax expense increased approximately $900,000 due to increased membership. In addition, depreciation expense increased $1.7 million.
Income Taxes. For the period, the Company recorded approximately $13.8 million of tax expense for an effective tax rate of 25.8% compared to 23.9% in 1997, excluding the tax effects of identifiable integration, settlement and other costs. The Company's current low operating tax rate is primarily a result of tax-preferred investments and the change in the deferred tax valuation allowance, which is due primarily to the ability to use a portion of net operating loss carryovers. The effective tax rate will increase to the 32% to 34% range in 1999 as most of the valuation allowances for net operating loss carryforwards have been utilized as of December 31, 1998.
Revenues. The Company's total operating revenues for 1997 increased 25.4% to $721.7 million from $575.4 million for 1996. The increase was primarily due to medical premium revenue increases of approximately $126.9 million, or 32.8%, from the Company's HMO and managed indemnity insurance subsidiaries. Such premium growth resulted principally from an approximate 30.3% increase in member months. The Company's HMO and insurance subsidiaries' premium rates increased approximately 2.5%, primarily due to an increase in its capitation rate for its Medicare members as established by HCFA. The increase was due in part to the Company's participation in HCFA's social HMO program. The Company realized 1% to 3% rate increases for its existing HMO subsidiaries' commercial groups and the managed indemnity subsidiary. However, these increases were offset in part by lower premium rates at MedOne Health Plan, an HMO acquired on December 31, 1996. The Company's specialty product revenue increased $12.9 million, or 9.7%, to $146.2 million in 1997 from $133.3 million in 1996. The increase was due to specialty product revenue growth in the workers' compensation insurance market of approximately $8.3 million and an increase in administrative services and other of $4.6 million due primarily to the acquisition of Prime Health, Inc., at the end of 1996. Some of this increase will be offset in the future by the loss of a portion of the state of Nevada's self-insured medical business. Also, effective September 30, 1997, the Company terminated its workers' compensation administrative services contract with the state of Nevada. The contract served approximately 200,000 enrollees and provided approximately $3.2 million in revenues for the year ended December 31, 1997. The contract was terminated to allow the Company to participate in the Nevada workers' compensation insurance market when the state allows private insurance companies to begin offering products, which is anticipated for 1999. Professional fees increased $2.4 million, or 8.3%, over 1996 to $31.2 million. This increase is due in part to the acquisition of the
Medical and Specialty Product Expenses. Total medical expenses increased by $103.4 million in 1997 compared to 1996. This 32.7% increase resulted from the consolidated member month growth discussed previously. The Medical Care Ratio increased from 76.0% to 76.9% due primarily to member growth and expansion in areas with higher medical expenses, such as northern Nevada and Texas. In addition, MedOne Health Plan has a higher Medical Care Ratio, which further contributed to the increase in the Company's overall Medical Care Ratio. Specialty product expenses increased $12.3 million, or 9.4%, over 1996. This increase is due primarily to the increase in workers' compensation premiums noted above. Specialty product revenue and expense is primarily related to the workers' compensation insurance business.
The combined ratio for the workers' compensation insurance business was 101.9% for the year ended December 31, 1997, compared to 103.2% for the comparable prior year period. The reduction was due to a 40 basis point decrease in the loss ratio along with a 90 basis point decrease in the expense ratio. Compared to the prior year period, incurred losses for the current accident year were reduced as a result of the Company's ability to overlay and implement managed care techniques to the workers' compensation claims. In addition, the Company had net favorable loss development on prior accident years totaling $9.0 million compared to net favorable loss development of $15.3 million for the comparable prior year period. The favorable development is largely due to actual paid losses being below projected losses. The majority of the favorable loss development occurred on the 1992 through 1995 accident years. There can be no assurances that favorable development, or the magnitude thereof, will continue in the future. The losses and loss adjustment expense ratio for the year ended December 31, 1997 reflects the Company's current projection of the ultimate costs of claims occurring in the current as well as prior accident years. Such projections are subject to change and any change would be reflected in the income statement. Workers' compensation claims are paid over several years. Until payment is made, the Company invests the monies, earning a yield on the invested balance.
Integration, Settlement and Other Costs. On March 18, 1997, the Company announced it had terminated its merger agreement with Physician Corporation of America, Inc. and recorded and paid expenses of approximately $11.0 million, $8.4 million after tax, for merger-related costs.
During the third quarter of 1997, SMHS, a wholly owned subsidiary of the Company, was awarded a contract to serve TRICARE eligible beneficiaries in Region 1. This region includes approximately 606,000 TRICARE beneficiaries in 13 northeastern states and the District of Columbia. Development expenses of
$18.4 million, $10.6 million net of taxes, were recorded in the third quarter primarily for expenses associated with the Company's proposal to serve eligible beneficiaries in Region 1.
During 1995, as part of the Company's clinical expansion and growth efforts, the Company acquired a medical facility in Mohave County, Arizona, across the border from Laughlin, Nevada. This medical facility included a 12-bed hospital. During 1996, the Company implemented a plan to exit the hospital business and has actively pursued buyers for this business. As a result of this plan, the Company recorded a charge of $3.8 million, ($2.9 million after tax) in the fourth quarter of 1996, primarily to recognize the estimated costs to dispose of the hospital. As of December 31, 1998, the Company has been unable to reach an agreement to sell the hospital.
The Company's cash flow from operating activities of $50.1 million during the twelve months ended December 31, 1998 resulted primarily from $39.6 million of net income, $19.3 million in depreciation and amortization and $6.4 million in provision for doubtful accounts offset by a $15.2 million decrease in cash flows from changes in assets and liabilities. The decrease in cash flow resulting from the change in assets and liabilities was primarily due to an increase in reinsurance recoverable and military accounts receivable. The increase in reinsurance recoverable is primarily due to the new reinsurance agreement implemented by the Company's workers' compensation subsidiary for claims occurring on or after July 1, 1998 that are below $500,000 (see Note 6 to the Consolidated Financial Statements). Military accounts receivable increased due to the implementation of health care delivery in 1998. Military accounts receivable consists primarily of one month's contract payment from the government in arrears, estimates of bid price adjustments ("BPAs") under the contract based on actual experience and any change orders not originally specified in the contract. These cash outflows were offset in part by increases in military health care payable and other current liabilities. The increase in military health care payable is a result of health care delivery beginning June 1, 1998 for the Region 1 TRICARE contract. Military health care payable includes the estimated cost for unpaid claims for which health care services have been provided to TRICARE eligibles and a provision of the estimated costs for claims that have been incurred but have not been
SMHS receives monthly cash payments equivalent to one-twelfth of its annual contractual price with the Department of Defense ("DOD") and accrues health care revenue on a monthly basis for any monies owed above its monthly cash receipt based on the number of at-risk eligible beneficiaries. Approximately $34 million of the military accounts receivable balance is associated with monies owed to SMHS as a result of providing health care services for a larger than expected beneficiary population. SMHS expects to receive this amount at the completion of the first BPA. The BPA process serves to adjust the DOD's monthly payments to SMHS, because such payments are based in part on 1996 DOD estimates for: beneficiary population, beneficiary population baseline health care cost, inflation and military direct care system utilization. As actual information is made available for the above items, quarterly adjustments are made to SMHS' monthly health care payment in addition to a lump sum adjustment for past months. SMHS accrues for such adjustments on a monthly basis as actual information is made available. The first such adjustment did not occur as scheduled on February 28, 1999 (SMHS anticipates additional DOD delays of up to 6 months). If the timing or amount of the BPA reimbursement varies significantly from the Company's expectations, there could be a material adverse effect on the Company's business and cash flows.
During 1998 and 1997, the Company used $9.2 million and $5.5 million, respectively, to buy back Company stock on the open market.
In the second quarter of 1997, the Company's Board of Directors authorized a $3.0 million line of credit from the Company to the Company's Chief Executive Officer ("CEO"). The CEO borrowed a total of $650,000 in 1998 and $2 million in 1997 at an interest rate equal to the LIBOR Offering Rate plus 53 basis points. During the first quarter of 1999, the CEO repaid approximately $360,000 of the line of credit. The line of credit is collateralized by certain of the CEO's rights to compensation from the Company and is due and payable no later than August 15, 1999.
Each $1,000 in principal is convertible into 25.382 shares of the Company's common stock at a conversion price of $39.40 per share. Unamortized issuance costs of $500,000 are included in other assets on the balance sheet and are being amortized over the life of the Debentures. The Debentures are general unsecured obligations of CII only and are not guaranteed by Sierra Health Services, Inc. ("Sierra"). During the twelve months ended December 31, 1998, the Company purchased $3.2 million of the Debentures on the open market.
The Year 2000 issue exists because many computer systems and applications currently use two-digit date fields to designate a year. As the century date change occurs, date-sensitive systems will recognize the year 2000 as 1900, or not at all. This inability to recognize or properly treat the Year 2000 may cause systems to process critical financial and operational information incorrectly.
The Company has initiated formal communications with entities with whom it does business to assess their Year 2000 issues. Evaluations of the most critical third parties have been initiated, and follow-up reviews will be conducted through 1999. Contingency plans are being developed based on these evaluations and are expected to be completed by the middle of 1999. There can be no assurances that the systems of other companies or governmental agencies, such as HCFA and the Department of Defense ("DOD"), on which the Company relies will be timely modified for Year 2000, or that the failure to modify by another company would not have a material adverse effect on the Company. Based upon two separate reports issued by the United States General Accounting Office it is doubtful that the computer systems at both HCFA and the DOD will be fully Year 2000 compliant by the end of 1999. The Company does not currently have available data to predict the impact of such non-compliance on its business operations. Should there be any material delays caused by Year 2000 issues, the Company anticipates that the governmental entities will make estimated payments.
The failure to correct a material Year 2000 problem could result in an interruption of, or a failure of, certain business activities or operations. Such failures could materially adversely affect the Company's operations, liquidity and financial condition. Due to the general uncertainty inherent in the Year 2000 problem, resulting in part from uncertainty of the Year 2000 readiness of third parties with which the Company does business, the Company is unable to determine at this time whether the consequences of potential Year 2000 failures will have a material adverse impact on the Company's results of operations, liquidity or financial condition. The Company's Year 2000 project is expected to significantly reduce the Company's level of uncertainty about the Year 2000 problem. The Company believes that, with the implementation of the new computer systems and completion of the entire project as scheduled, the possibility of significant interruptions of operations should be reduced.
Health care costs continue to rise at a faster rate than the Consumer Price Index. The Company uses various strategies to mitigate the negative effects of health care cost inflation, including setting commercial premiums based on its anticipated health care costs, risk-sharing arrangements with the Company's various health care providers, and other health care cost containment measures. There can be no assurance, however, that, in the future, the Company's ability to manage medical costs will not be negatively impacted by items such as technological advances, competitive pressures, applicable regulations, increases in pharmacy costs, utilization changes and catastrophic items, which could, in turn, result in medical cost increases equaling or exceeding premium increases.
exclusion from participation in government programs. In addition, disclosure of any adverse investigation or audit results or sanctions could negatively affect the Company's reputation in various markets and make it more difficult for the Company to sell its products and services.
We have audited the accompanying consolidated balance sheets of Sierra Health Services, Inc., and its subsidiaries as of December 31, 1998 and 1997, and the related consolidated statements of operations, stockholders' equity, and cash flows for each of the three years in the period ended December 31, 1998. Our audits also included the financial statement schedules listed in the index at Item 14 (a)(2). These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits.
SIERRA HEALTH SERVICES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS For the Years Ended December 31, 1998, 1997 and 1996
SIERRA HEALTH SERVICES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY For the Years Ended December 31, 1998, 1997 and 1996 (Amounts in thousands)
SIERRA HEALTH SERVICES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS For the Years Ended December 31, 1998, 1997 and 1996
Business. The consolidated financial statements include the accounts of Sierra Health Services, Inc. ("Sierra") and its subsidiaries (collectively referred to as the "Company"). The Company is a managed health care organization that provides and administers the delivery of comprehensive health care and workers' compensation programs with an emphasis on quality care and cost management. The Company's broad range of managed health care services is provided through its health maintenance organizations ("HMOs"), managed indemnity plans, third-party administrative services programs for employer-funded health benefit plans, workers' compensation medical management programs and its military health services programs. Ancillary products and services that complement the Company's managed health care product lines are also offered.
Acquisitions. On October 31, 1998, Texas Health Choice, L.C. ("TXHC") (formerly HMO Texas, L.C.), a subsidiary of Sierra, completed the acquisition of certain assets of Kaiser Foundation Health Plan of Texas ("Kaiser-Texas"), a health plan operating in Dallas/Ft. Worth with approximately 109,000 members, and Permanente Medical Association of Texas ("Permanente"), a 150 physician medical group operating in that area. The purchase price was $124 million, which is net of $20 million in operating cost support to be paid to Sierra by Kaiser Foundation Hospitals in five quarterly installments following the closing of the transaction. The purchase price allocation includes a premium deficiency reserve of approximately $25 million for estimated losses on the contracts acquired from Kaiser-Texas. The purchase price includes amounts for real estate and eight medical and office facilities encompassing approximately 500,000 square feet. During the first quarter of 1999 certain accreditation goals were met by the health plan resulting in a purchase price increase of $3.0 million, to $127 million. The purchase price may increase an additional $27 million over three years if certain growth and member retention goals are met by the health plan.
The following pro forma information (unaudited) has been prepared assuming that this acquisition had taken place at the beginning of the respective periods. The pro forma information includes adjustments for the amortization of goodwill arising from the transaction and interest expense that would have been incurred to finance the purchase. The pro forma financial information is not necessarily indicative of the results of operations had the transaction been effected on the assumed dates.
quarter of 1998 for approximately $1.5 million. Also, in the first quarter of 1998, the Company purchased three medical clinics in southern Nevada for approximately $7.3 million.
Effective December 31, 1996 the Company purchased Prime Holdings, Inc. ("Prime"), for approximately $32 million in cash. At December 31, 1996 Prime operated MedOne Health Plan, Inc. ("MedOne"), a 12,800 member HMO. Prime also served 215,000 people through preferred provider organizations, workers' compensation programs and administrative service products for self-insured employers and union welfare trust funds, primarily in the state of Nevada. The acquisition resulted in goodwill of $31 million.
In November 1996, the Company acquired complete ownership of TXHC for $5,040,000. The Company had previously held a 50 percent interest in the Houston-based health plan. The purchase resulted in goodwill of $5,040,000.
Principles of Consolidation. All significant intercompany transactions and balances have been eliminated. Sierra's wholly owned subsidiaries include: Health Plan of Nevada, Inc. ("HPN"), TXHC and MedOne, all licensed HMOs; Sierra Health and Life Insurance Company, Inc. ("SHL"), a health and life insurance company; Southwest Medical Associates, Inc. ("SMA"), and The Medical Group of Texas ("TMGT"), multi-specialty medical groups; CII Financial, Inc. ("CII"), a holding company primarily engaged in writing workers' compensation insurance through its wholly owned subsidiaries; Sierra Military Health Services, Inc., ("SMHS"), a company that has been contracted to provide and administer managed care services to certain TRICARE eligible beneficiaries from June 1, 1998 to May 31, 2003; administrative services companies; a home health care agency; a hospice; a home medical products subsidiary; and a company that provides and manages mental health and substance abuse services.
Medical Premiums. Non-Medicare member enrollment is represented principally by employer groups. Medical premiums are billed to each employer group in accordance with negotiated contracts, and such premium revenue is recognized when earned. Unearned premium revenue includes payments under prepaid Medicare contracts with the Health Care Financing Administration ("HCFA") and prepaid HPN, TXHC and MedOne commercial and SHL indemnity premiums. HPN and TXHC offer a prepaid health care program to Medicare recipients. Revenues associated with these Medicare recipients were approximately $238,913,000, $186,105,000 and $140,611,000 in 1998, 1997 and 1996, respectively.
Military Contract Revenues. Revenue under the TRICARE contract is recorded based on the contract price as agreed to by the federal government. The contract also contains provisions which adjust the contract price based on actual experience. The estimated effects of these adjustments are recognized on a monthly basis. In addition, the Company records revenue based on estimates of the earned portion of any contract change orders not originally specified in the contract.
Military Contract Expenses. This expense consists primarily of costs to provide managed health care services to eligible beneficiaries in accordance with the Company's TRICARE contract. Under the contract, SMHS provides health care services to approximately 606,000 dependents of active duty military personnel and military retirees and their dependents through subcontractor partnerships and individual providers. Health care costs are recorded in the period when services are provided to eligible beneficiaries including estimates for provider costs which have been incurred as of the balance sheet date but not reported to the Company. Also included in military contract expense are costs incurred to perform specific administrative services, such as health care appointment scheduling, enrollment, network management and health care advice line services, and other administrative functions of the military health care subsidiary.
Goodwill. Goodwill has been recorded primarily as a result of various business acquisitions by the Company. Amortization is provided on a straight line basis over periods not exceeding 40 years. The Company evaluates the carrying value of its intangible assets at each balance sheet date.
Reserve for Losses and Loss Adjustment Expense. The reserve for losses and LAE consists of estimated costs of each unpaid claim reported to the Company prior to the close of the accounting period, as well as those incurred but not yet reported. The methods for establishing and reviewing such liabilities are continually reviewed and adjustments are reflected in current operations.
associated with start-up activities to be expensed as incurred. Both statements are effective for years beginning after December 15, 1998. The Company will adopt SOP 98-1 and SOP 98-5 for the fiscal year ending December 31, 1999 and does not believe these statements will have a material impact on its financial statements.
In June 1998, The Financial Accounting Standards Board issued "Accounting for Derivative Instruments and Hedging Activities" ("FAS 133"). FAS 133 is effective for fiscal years beginning after June 15, 1999. FAS 133 addresses the accounting for derivative instruments including certain derivative instruments embedded in other contracts, and hedging activities. The Company does not believe this statement will have a material impact on its financial statements.
Estimates and Assumptions. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Estimates and assumptions include, but are not limited to, medical and specialty product expenses and military revenue and expenses. Actual results may materially differ from estimates.
CII issued convertible subordinated debentures (the "Debentures") due September 15, 2001. Each $1,000 in principal is convertible into 25.382 shares of the Company's common stock at a conversion price of $39.40 per share. The Debentures were not included in the computation of EPS because their effect would be anti-dilutive.
The following table summarizes the Company's short-term, long-term and restricted investments as of December 31, 1998:
The contractual maturities of held-to-maturity short-term, long-term and restricted investments at December 31, 1998 were as follows:
Of the cash and cash equivalents that total $83,910,000 million in the accompanying Consolidated Balance Sheet at December 31, 1998, $81,328,000 million is limited for use only by the Company's regulated subsidiaries. Such amounts are available for transfer to Sierra from the regulated subsidiaries only to the extent that they can be remitted in accordance with terms of existing management agreements and by dividends which customarily must be approved by regulating state insurance departments. The remainder is available to Sierra on an unrestricted basis.
The following table provides workers' compensation prospective reinsurance information for the three years ended December 31, 1998:
7 1/2% Convertible Subordinated Debentures. In September 1991 CII issued convertible subordinated debentures (the "Debentures") due September 15, 2001. The Debentures bear interest at 7 1/2% which is due semi-annually on March 15 and September 15. Each $1,000 in principal is convertible into 25.382 shares of the Company's common stock at a conversion price of $39.40 per share. Unamortized issuance costs of $509,000 are included in other assets on the balance sheet and are being amortized over the life of the Debentures. Accrued interest on the Debentures as of December 31, 1998 and 1997 was $1,117,000 and $1,191,000, respectively. The Debentures are redeemable by CII, in whole or in part, at redemption prices of 101.05% in 1999 and 100.75% thereafter, plus accrued interest. The Debentures are general unsecured obligations of CII only and were not assumed or guaranteed by Sierra. During the twelve months ended December 31, 1998 and 1997, the Company purchased $3,216,000 and $30,000, respectively, of the debentures on the open market.
7 3/8% Mortgage Note. In December 1993, the Company obtained a loan from Bank of America, Nevada. This loan is secured by a deed of trust, assignment of rents and leases, and a security agreement and fixture filing covering a portion of the Company's administrative headquarters complex and underlying real property.
Scheduled maturities of the Company's notes payable and future minimum payments under capital leases, together with the present value of the net minimum lease payments at December 31, 1998, are as follows:
The tax effects of significant items comprising the Company's net deferred tax assets are as follows:
A valuation allowance has been set up to reflect the Company's inability to use tax benefits from certain acquisitions currently or in the near future. For the years ended December 31, 1998 and 1997, the Company was able to realize a portion of the tax benefits for which a valuation allowance had been previously established. As a result, the Company reduced its valuation allowance by $4,691,000 and $4,663,000 for the years ended December 31, 1998 and 1997, respectively.
Executive Life Insurance Plan. Effective July 1, 1997 the Company has funded and entered into split dollar life insurance agreements with certain officers and key executives (selected and approved by the Sierra Board of Directors). The premiums paid by the Company will be reimbursed upon the occurrence of certain events as specified in the contract.
Supplemental Executive Retirement Plan (SERP). Effective July 1, 1997, the Company adopted a defined benefit retirement plan covering certain key employees. The Company is funding the benefits through the
purchase of certain life insurance policies. Benefits are based on, among other things, the employee's average earnings over the five-year period prior to retirement or termination, and length of service. Benefits attributable to service prior to the adoption of the plan are amortized over the estimated remaining service period for those employees participating in the plan. In 1998, the Company expanded the SERP to include more participants. The effect of adding these participants is included in plan amendments in the reconciliation below.
The fair value of each option grant is estimated on the date of grant using the Black-Scholes option pricing model with the following weighted average assumptions used for grants in 1998, 1997 and 1996, respectively: dividend yield of 0% for all years; expected volatility of 37%, 35% and 29%; risk-free interest rates of 4.46%, 5.89% and 5.92%; and expected lives of five years for all years. The weighted fair value of options granted in 1998, 1997 and 1996 was $9.92, $8.27 and $5.65, respectively.
During 1997, the Company recorded and paid expenses of approximately $11.0 million, $8.4 million after tax, for merger-related costs. On March 18, 1997, the Company announced it had terminated its merger agreement with Physician Corporation of America. The original agreement had been entered into in November 1996.
The Company has three reportable segments based on the products and services offered: managed care and corporate operations, workers' compensation operations and military health services operations. The managed care segment includes managed health care services provided through HMOs, managed indemnity plans, third-party administrative services programs for employer-funded health benefit plans, multi-specialty medical groups, other ancillary services and corporate operations. The workers' compensation segment assumes workers' compensation claims risk in return for premium revenues. The military health services segment administers a five-year, managed care federal contract for the Department of Defense's TRICARE program in Region 1.