The company offers a comprehensive array of managed health care products and services that the company segregates into two distinct segments. The company's underwritten segment includes preferred provider organization (PPO), point-of-service (POS), health maintenance organization (HMO), Medicare supplement, specialty managed care, and managed indemnity benefit plans. The company's self-funded segment includes third-party administrator (TPA), administrative services only (ASO), and network rental services for self-insured organizations.
The following table sets forth selected operating ratios. The medical loss ratio reflects health care services expense as a percentage of premium revenue. All other ratios are shown as a percentage of premium revenue and fees and other income combined:
% December 31, (Decrease)/ Product Group 1998 1997 Increase Underwritten: PPO: Alliance PPO 141,225 149,339 (5.4) AllianceChoice POS 127,907 131,924 (3.0) HMO: Commercial (includes other POS) 129,417 134,743 (4.0) BlueCHOICE Senior 5,432 5,682 (4.4) BlueCHOICE Medicaid (MC+) 5,146 n/a Medicare supplement 57,966 62,311 (7.0) Managed indemnity 2,777 7,022 (60.5) 464,724 496,167 (6.3) Self-funded: PPO 43,688 89,300 (51.1) HMO 8,843 13,825 (36.0) ASO (includes HealthLink): Workers' Compensation 449,986 344,712 30.5 Other ASO* 1,155,658 1,013,303 14.0 Total membership 2,122,899 1,957,307 8.5
Premium revenue from Medicare supplement decreased by $2.2 million in 1998. Member months decreased by 8.1 percent partially offset by a 6.4 percent increase in net premium rates. Membership declines are partially attributable to subscribers opting for Medicare-risk programs, similar to the company's BlueCHOICE Senior product, in which medical benefits are at least as comprehensive as Medicare benefits for persons eligible to receive Medicare (parts A and B) at no additional cost to the member.
Revenue from other specialty services, which includes certain of the company's drug and dental health care benefit plans, increased $3.9 million -- $6.3 million due to a 16.2 percent increase in net premium rates partially offset by a $2.4 million decrease resulting from a 5.4 percent decrease in member months. The large rate increases relate to the company's drug products, including AllianceRx, and correspond to the high levels of prescription utilization and trends that the company, as well as the industry as a whole, have experienced in recent years.
Fees and other income from administrative services only/self-funded and network services increased in 1998 by $7.9 million. These increases are primarily due to increased 1998 revenues of $14.4 million from HealthLink, Inc. (HealthLink), the company's network rental and managed care service subsidiary. HealthLink's revenues increased due to a 21.1 percent increase in membership during 1998. This increase arose from strong sales during the period, along with the roll-out of new, open-access products. Sales during this period included a 30,000 member group that enrolled in HealthLink's self- funded ASO plan, transferring from the company's other self-funded business. HealthLink's increases to fees and other income were partially offset by decreases to revenue caused by the loss of approximately 72,000 members in the company's other self-funded business due to the nonrenewal of three large groups. HealthLink also continues to expand its service area into contiguous states, such as Arkansas, Iowa, Illinois, Indiana and Kentucky.
The overall medical loss ratio decreased by 1.3 percent to 83.5 percent in 1998 from 84.8 percent in 1997. The medical loss ratio experienced in 1998 is lower compared to that in 1997 due to the company's pricing strategy, which resulted in an overall increase in the company's premium per member per month of approximately 9.5 percent in 1998 as compared to 1997. The medical loss ratio in 1998 is slightly higher than the company previously anticipated in the beginning of the year as a result of continued escalation of the medical cost trend, driven by increased cost and utilization of both outpatient services and drug therapies. The company's medical expense on a per member per month basis increased by approximately 7.8 percent in 1998 as compared to 1997.
Depreciation and amortization expenses decreased to $19.3 million in 1998 from $23.1 million in 1997. This reduction of depreciation and amortization expenses primarily related to intangible assets that became fully amortized during 1997. In 1997, the company recorded $4.3 million of expense to complete the amortization of a prepaid reinsurance asset associated with the company's reinsurance agreements with Blue Cross and Blue Shield of Kansas City. Amortization expenses for completed components of the company's IOS project increased by $2.4 million in 1998 compared to 1997. See "Outlook - Information and operation strategy" for more information on this project.
A non-recurring charge of $900,000 was recognized in the fourth quarter of 1998 for anticipated expenses relating to the company's strategic realignment, including among other things, a planned reduction of the company's work force and changes in health care benefits. In 1997, the company expensed $3.3 million related to costs associated with the relocation of the company's St. Louis-based claims, customer service, billing, and provider services functions to its Springfield, Missouri, facility and a new facility in Cape Girardeau, Missouri.
In the third quarter of 1997, the company recorded a $29.5 million loss reserve for estimated losses relating to its contract with the Missouri Consolidated Health Care Plan (MCHCP). The reserve is based on actuarial estimates, including projected limited rate increases, and projected enrollment and medical cost trends accounted for through the year 2000 in accordance with generally accepted accounting principals. There can be no assurance that the amount of this loss reserve will be sufficient to cover all future losses that may be associated with the MCHCP contract.
The company's operating loss decreased from $61.0 million in 1997 to $4.2 million in 1998. Excluding the non-recurring relocation and restructuring charges and the charge for the MCHCP loss reserve, the operating loss decreased from $28.2 million in 1997 to $3.3 million in 1998.
PPO premium revenue increased $11.8 million in 1997 -- $17.2 million due to a 3.6 percent increase in net premium rates. This increase was partially offset by a $5.4 million decrease resulting primarily from product mix shifts within the PPO product family, such as the shift in membership to AllianceChoice, a lower-cost, non-gatekeeper point-of-service (POS) product. Alliance PPO member months decreased by 539,300 in 1997 compared to 1996, while AllianceChoice POS member months increased by 544,800 in 1997 as compared to 1996. Net rates increased due in part to the company's targeted general rate increases averaging 7 percent to 18 percent during 1997 enrollment periods. Net rate increases are lower than the targeted range due in part to changes in deductibles, the timing of group renewals throughout the year, and product mix changes. The company also began offering its PPO product in Illinois at the end of the first quarter of 1997. Included in the Alliance PPO member count in the company's membership table were 2,200 PPO Illinois members at December 31, 1997.
On August 29, 1997, the company announced that it would create a loss reserve for its contract with the Missouri Consolidated Health Care Plan (MCHCP) in the range of $30 million to $40 million as discussed elsewhere herein. The company reported in the third quarter of 1997 a $29.5 million loss reserve provision relating to the MCHCP contract.
The company's operating loss increased from $13.6 million in 1996 to $61.0 million in 1997. Excluding the non-recurring relocation charges and the charge for the MCHCP loss reserve, the operating loss increased from $9.0 million in 1996 to $28.2 million in 1997.
The operating loss, excluding non-recurring relocation charges and the charge for the MCHCP loss reserve, for the company's underwritten segment was $37.7 million in 1997 compared to a loss of $11.0 million in 1996. The increase in losses in 1997 is primarily attributable to a combination of pricing and medical cost trends, including higher outpatient utilization and drug costs.
The company's effective income tax (benefit) provision rate was (28.4) percent and 48.2 percent for 1997 and 1996, respectively. The company's effective income tax benefit rate for 1997 was affected by gains from the liquidation of company-owned life insurance policies as well as non-deductible goodwill amortization. The 1996 effective provision rate was also affected by non-deductible goodwill amortization.
The company's working capital as of December 31, 1998 was $64.5 million, a decrease of $5.2 million from December 31, 1997. The decrease is partially attributable to $8.0 million of additional debt from the company's reducing revolving credit facility that became a current payable during 1998. The company also repaid $3.9 million of the debt during 1998 pursuant to the credit facility's requirements. In addition, the company capitalized $12.5 million of costs for property and equipment purchases, $8.4 million of which relates to capitalized IOS development costs.
Net cash provided by investing activities was $7.7 million for the year ended December 31, 1998. This amount was $20.5 million less than the prior year primarily due to a decrease of $11.6 million in long- term debt and capital lease obligation payments during 1998 as compared to 1997.
In the fourth quarter of 1997, the company amended its revolving credit facility (the Credit Agreement), the material terms of which are as follows: (1) the borrowings under the Credit Agreement will bear interest at 2.75 percent above the one-month floating London Interbank Offered Rate (LIBOR), (2) certain financial covenant calculations were modified and the financial covenant requirements were adjusted, (3) the maximum commitment of the Credit Agreement was reduced to $50 million as of October 1, 1997, with $1.25 million quarterly reductions through 1998 and subsequent $2.5 million quarterly reductions through June 30, 2000, with the remaining commitment under the Credit Agreement terminating on August 10, 2000, (4) mandatory reductions to the commitment, together with prepayments, are required upon the happening of certain extraordinary events, (5) stricter limits were placed on the company's ability to incur additional debt, and (6) stricter limits were placed on capital expenditures as well as the company's ability to make investments and acquisitions. The company's commitment under the Credit Agreement was reduced by an additional $1.9 million during 1998, pursuant to the Credit Agreement, due to the sale by the company's HealthLink subsidiary of its former headquarters building. HealthLink relocated to a leased facility.
The company primarily invests positive cash flow in fixed income securities. The company's investment policies are designed to preserve principal, maximize yield and provide liquidity to meet anticipated obligations. The company's available-for-sale securities primarily include fixed-rate government securities and corporate bonds as well as mortgage-backed securities and other asset-backed securities.
On August 29, 1997, the company reported the commencement of the litigation with MCHCP and estimated losses (giving effect to all possible renewal terms of the MCHCP contract without requested rate increases) in the range of $30 million to $40 million. In the third quarter of 1997, the company took a pre-tax charge of $29.5 million, which was based on actuarial estimates, including projected limited rate increases, and projected enrollment and medical cost trends accounted for through the year 2000 in accordance with generally accepted accounting principles. The company was advised by the Missouri Department of Insurance (DOI) in March 1998, that the entire amount of the reserve for the MCHCP contract recorded by the company for projected losses under the contract through the year 2000, must, for statutory accounting purposes, be recorded by the company's subsidiary, HMO Missouri, Inc. (BlueCHOICE), on its statutory filings with the DOI. With the prior regulatory approval of the DOI, BlueCHOICE issued surplus notes to the company in the amount of $29 million to ensure the statutory solvency of BlueCHOICE. While management of the company believes the current provision for losses is adequate, if the actual public entity membership in MCHCP grows at a rate in excess of the rate used in the actuarial estimates, or if the projected limited rate increases and medical cost trends should differ materially from those assumed in the actuarial estimates, then the amount of the reserve recorded to date could be insufficient to cover all future losses which may be associated with the MCHCP contract, and such losses could have a material adverse effect on the company and the market for the company's stock.
Under applicable state regulations, certain of the company's subsidiaries are required to retain cash generated from their operations. After giving effect to such restrictions and the surplus notes issued to the company by BlueCHOICE as described in the preceding paragraph, the company had approximately $12.5 million in cash and investments available for general corporate purposes without regulatory approval. The decline in this figure from $48.5 million as of December 31, 1996, is primarily due to the funding requirements of the company's HMO subsidiary related to the MCHCP loss reserve as described elsewhere herein.
Except for the historical information contained herein, this Annual Report contains "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. These statements typically, but not exclusively, are identified by the inclusion of phrases such as "the company anticipates," "the company believes," "the company expects," "the company plans," "the company intends," and other phrases of similar meaning. Such forward- looking statements involve known and unknown risks, uncertainties, contingencies and other factors that may cause the company's actual results of operations, financial condition or business performance to be materially different from the results of operations, financial condition or business performance expressed or implied by such forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to: the possibility that court approval of the final settlement agreement, as amended, entered into with the Missouri Attorney General and Department of Insurance (DOI), referenced elsewhere herein, would not be obtained, or if obtained could include conditions that are not acceptable to the parties; the possibility that all remaining contingencies and conditions to the parties' obligations to effect the proposed settlement transaction would not be met or otherwise satisfied; the Office of Personnel Management audit of BlueCHOICE; pending litigation, including the subscriber class action litigation; potential loss of "Blue Cross" and "Blue Shield" licenses by BCBSMo, the company and its controlled affiliates; government regulation and health care reform; Missouri Consolidated Health Care Plan issues; market competition and consolidation; escalating health care costs; dependence on sales to individuals; recontracting efforts and potential nonrenewal of subscriber and provider agreements; voting control by BCBSMo; changes in key management; variability of operating results and stock price; Credit Agreement restrictions; the Year 2000 issue; and other factors discussed under the caption entitled "Factors that May Affect Future Results of Operations, Financial Condition or Business" of Part I, Item 1 of this Annual Report, the caption in Note 13 entitled, "Contingencies" of Part II, Item 8 of this Annual Report, and elsewhere in the company's SEC reports.
The company's performance targets for 1999 include: average premium revenue growth per member per month in the 9 percent to 10 percent range, reflecting price increases up to the high teens to low twenties (in percentages) for some categories of members, consistent with market trends; maintaining the medical loss ratio in the low to mid-eighties (in percentages), with an anticipated net medical cost increase per member per month of approximately 7 percent to 9 percent, inclusive of pharmacy benefits, medical services and the cost of government-mandated benefits; continued control of core overhead expenses, with amortization expense for corporate initiatives, Year 2000 programming expenses and other initiatives contributing to a general and administrative expense ratio in the low twenties (in percentages).
The company recently announced a strategic realignment of business operations to control overall general and administrative expenses for 1999. By reducing personnel and other administrative expenses, the company's goal is to offset anticipated 1999 investments in new products, further expansion of the HealthLink network in regions outside of Missouri and other items. The realignment plan calls for the reduction of approximately 135 positions, or approximately 7.5 percent of the company's workforce, by the middle of 1999. These positions are expected to be eliminated through strategic reductions and attrition and will be offset to a small degree by positions added in other growing business areas. The company's goal also is to control general and administrative costs by decreasing the use of outside consultants, changing employee health care benefits, and reducing software costs, travel, entertainment, and other expenses. As a result of the company's strategic realignment, the company recorded a charge of $0.9 million in the fourth quarter of 1998. There can be no assurance that the goals of the company's strategic realignment will be achieved.
In 1995, the company implemented a comprehensive information and operations strategy (IOS) to assist the company in implementing its managed care strategy of delivering access to cost-efficient medical care consistent with quality outcomes. The company believes that controlling medical costs in the future will be highly dependent on readily accessing both member and provider medical information at a detail level that provides real-time analytical support. The company receives capital expenditure authorizations from the Board of Directors to expend funds for the project subject to periodic review by an ad-hoc committee of the board. In 1998, the company incurred capitalized expenditures of $8.5 million on this project. Cumulatively, since 1995, the company has incurred capitalized expenditures of $47.5 million. The company anticipates that it will expend approximately $8 million to $9 million for capitalized costs related to this project in future years. While management believes that the IOS project will initially be dilutive to earnings per share, it is believed that opportunities exist for significant medical and administrative savings, which are expected to provide a payback and contribute to earnings per share over the long term.
The company has a program to evaluate its major systems, processes and equipment to minimize the possibility of a material disruption to its business due to Year 2000 problems (e.g. the difficulties of certain computers, computer programs and other equipment to distinguish between the year 1900 and the year 2000). The program was initiated in 1996 and includes an inventory of software, hardware and related infrastructure components; assessments and decisions to retire, replace or remediate these elements as well as to establish how critical they are to continued operations; a strategy to conduct integrated testing of critical applications and technology infrastructure; and the development of contingency plans.
The inventory and assessment phases of the Year 2000 program are substantially complete and include information technology such as application software on various platforms (mainframe, midrange and personal computer), system software and data/voice communication networks; as well as facility equipment such as elevators, security and building control systems. Although the company is increasing its use of client server applications, the majority of its application and system software uses a mainframe platform with COBOL programming. The company believes that at December 31, 1998, approximately 95 percent of these COBOL programs were Year 2000 ready. The remaining COBOL programs are expected to be Year 2000 ready by March 31, 1999. The balance of the company's other system modifications is expected to be completed by September 30, 1999, with the majority of these modifications currently under way. The company's plan for completion of this project is partially dependent upon the work of third parties. The company has limited internal exposure to equipment with embedded technology and expects any affected equipment to be ready before January 1, 2000.
The company's operations would be significantly impacted by incomplete or untimely resolution of Year 2000 issues, whether caused by internal or external action. The company uses automated systems to process claims, prepare invoices, collect and remit payments, maintain membership data, perform utilization management and many other processes. In the worst case, the company's inability to perform these basic operating activities in an accurate and timely manner would have a material adverse effect on the company's revenues, liquidity and results of operations, although the company is unable to estimate the total financial impact.
Health care costs in the United States have increased more rapidly than the national consumer price index in recent years, and that trend is expected to continue. The company believes that it has reduced the impact of such increases by expanding its provider networks, establishing risk-sharing agreements and strengthening its underwriting standards. However, there can be no assurance that the company's efforts to reduce the impact of inflation will be effective or that premium increases will equal or exceed increasing health care costs.
See the description under the same caption in Note 2 of the Notes to Consolidated Financial Statements of Part II, Item 8, of which is incorporated herein by reference.