(a) During 2002, the Company changed its method of accounting for goodwill and other intangible assets. See the Company's Notes to Consolidated Financial Statements, Note 2, "Adopted Accounting Standard" for a comprehensive discussion of the impact of the accounting standard.
Throughout 2003, management's primary focus was on membership and revenue growth, while maintaining the Company's positive trend in profitability. Over the past several years, the Company experienced declining revenues and membership resulting primarily from the Company's exit from unprofitable markets and discontinuance of unprofitable products. In addition, the Company's growth objectives have been hindered by a troubled economy, coupled with rapidly rising health care costs. Total revenues were $743.7 million, $786.3 million and $873.0 million in 2003, 2002 and 2001, respectively. To help mitigate the impact of rising health care costs, the Company has refined its product offerings, so that insurance consumers have a greater financial stake in their health care decisions. The Company's products offer more affordable premiums in exchange for higher deductibles and copayments, which has also contributed to the Company's decline in revenues.
Insurance premium revenues decreased 5.6% to $712.4 million in 2003 from $754.5 million in 2002. Premium revenues decreased as a result of the Company's membership decline. Total health membership, which includes medical and dental members declined to 547,000 at the end of 2003 compared with 571,000 at the end of 2002. Partially offsetting the membership decline was the effect of rising premium rates on the continuing block of business. After the effect of buydowns in coverage and terminations, average fully insured medical premium per month for 2003 increased approximately 7% compared with 2002.
Net investment income decreased to $13.5 million in 2003 from $15.0 million in 2002. The decrease resulted mainly from a decrease in the annual investment yield. The annual investment yield was 4.8% for 2003 compared to 5.5% for the prior year. During 2003, the Company realized $1.9 million of net pre-tax gains on the sale of investment securities. Net realized gains in the prior year were minimal.
Other revenue, which primarily consists of administrative fee income from claim processing on self funded business and other administrative services, decreased to $15.9 million in 2003 from $16.8 million in 2002. The decrease resulted from the decrease in membership in 2003 compared to 2002.
Insurance premium revenues decreased 10.0% to $754.5 million in 2002 from $838.7 million in 2001. Premium revenues decreased as a result of the Company's membership decline. Total medical and dental membership declined to 571,000 at the end of 2002 compared with 637,000 at the end of 2001. In addition, premium revenue was also impacted by the Company's change in its product mix. The MedOne(R) business, which became a larger percentage of the Company's total business in 2002, has a smaller premium per member compared with the small group business, which was declining in the period. Partially offsetting the membership decline was the effect of rising premium rates on the continuing block of business. After the effect of buydowns in coverage and terminations, average fully insured medical premium per month for 2002 increased 11% compared with 2001.
The health segment loss ratio improved 470 basis points to 68.1% for 2002 compared to 72.8% for 2001. The improvement in the health loss ratio was due in part to improved performance on the Company's small group business resulting from repricing efforts. In 2002, average premiums per member per month increased at a higher rate than average claims costs per member resulting in a lower loss ratio. The health loss ratio also benefited, to a lesser degree, from the change in product mix to a larger percentage of MedOne(R) business, which has a lower loss ratio. During 2002, the Company increased its reserves for litigation, which are included in medical and other benefits payable. This increase was offset by favorable claims experience on 2001 reserves during 2002. The life segment, which represented less than 2% of the Company's premium revenues in 2002, experienced a favorable loss ratio at 29.1% for 2002 compared with 36.4% for 2001.
The effective tax rate for 2002 was 39.4% compared to 58.0% for 2001. The change in the effective tax rate related to the elimination of amortization of goodwill in 2002 and the effect of other permanent items.
Actual conditions could differ from those assumed in the estimation process. Due to the uncertainties associated with the factors used in these assumptions, materially different amounts could be reported in the Company's statement of operations for a particular period under different conditions or using different assumptions. As is common in the health insurance industry, the Company believes that actual results may vary within a reasonable range of possible outcomes. Management believes that the Company's reasonable range of actual outcomes may vary up to 10% to 15% of the total liabilities for unpaid claims recorded at the end of a period.
The Company is involved in various legal and regulatory actions. Such actions typically arise in the ordinary course of the Company's business as an insurer and involve disputes relating to insurance policies or certificates including policy coverage and benefits, premium rating methodology or misrepresentations, agent and employment related issues, regulatory compliance and market conduct, contractual relationships and other matters. These disputes are typically resolved by settlement, dismissal or upon a decision rendered by a judge, jury, arbitration panel or regulatory official.
Management believes that legal matters relating to the Company's rating practices involve significantly more variability than the Company's other legal matters. Inherent uncertainties surround legal proceedings and actual results could differ materially from those assumed in estimating the liabilities. The possibility exists that a decision could be rendered against the Company, and in some circumstances, include punitive or other damage awards in excess of amounts reserved, which may have a material impact on the Company's financial condition, results of operations or cash flow of a future period. See Item 3, "Legal Proceedings" for a detailed discussion of the Company's material pending litigation.
The Company's sources of cash flow consist primarily of insurance premiums, administrative fee revenue and investment income. The primary uses of cash include payments of medical and other benefits and selling, general and administrative expenses. Positive cash flows are invested pending future payments of medical and other benefits and other operating expenses. The Company's investment policies are structured to provide sufficient liquidity to meet anticipated payment obligations. At December 31, 2003 and 2002, the Company had cash on deposit of $5.7 million and $6.1 million, respectively related to self funded employer group policies.
The Company maintains a revolving bank line of credit agreement with a maximum available facility of $50.0 million. At December 31, 2003, the outstanding balance of advances under the credit agreement was $30.2 million. The credit agreement requires a lump-sum payment of the outstanding balance at the end of 2005. The credit agreement contains customary covenants which, among other matters, require the Company to achieve certain minimum financial results, prohibit the Company from paying future cash dividends and restrict or limit the Company's ability to incur additional debt and dispose of assets outside the ordinary course of business. The Company was in compliance with all such covenants at December 31, 2003. The Company's obligations under the credit agreement are guaranteed by its subsidiary, American Medical Security Holdings, Inc. ("AMS Holdings"), and secured by pledges of stock of AMS Holdings and United Wisconsin Life Insurance Company, the Company's principal insurance subsidiary.
In an effort to continue supporting business growth, operational efficiency, service improvements and future administrative cost savings, the Company's management approved a plan to invest in an enterprise-wide information technology modernization project. The project involves the purchase of software applications and the utilization of internal and external technology and consulting resources to support most of the Company's major business processes. The design and development of the software applications began during the first quarter of 2003, with a phased implementation scheduled over the next few years. In 2002 and 2001, the Company's total capital expenditures averaged approximately $6.7 million per year. As a result of the information technology modernization project, total capital expenditures in 2003 increased to approximately $12.0 million. Management believes that the Company's existing working capital and operating cash flow will be sufficient to fund the Company's anticipated future capital expenditures related to this project.
In January 2003, the Company's Board of Directors approved a share repurchase program, which provides the Company with the authority to repurchase up to $10.0 million of its outstanding common shares. The plan allows the Company to buy back its shares, from time to time, in open market or privately negotiated transactions, subject to price and market conditions. During 2003, the Company purchased 87,900 shares of its common stock at an average market price of $15.44 per share, and at an aggregate cost of $1.4 million. The share repurchase program will continue to be supported through existing funds and future cash flow.
At December 31, 2003, the fair value of the Company's outstanding balance of advances under the credit agreement approximated the carrying value. Market risk was estimated as the potential increase in the fair value resulting from a hypothetical 1% decrease in the Company's weighted average short-term borrowing rate at December 31, 2003, and the resulting fair value was not materially different from the year-end carrying value.
Health care costs have been rising and are expected to continue to rise at a rate that exceeds the consumer price index. The Company's product pricing and features are designed to reduce the adverse effect of medical cost inflation on its operations. In addition, the Company uses its underwriting and medical management capabilities to help control inflation in health care costs. However, there can be no assurance that the Company's efforts will fully offset the impact of inflation or that premium revenue increases will equal or exceed increasing health care costs.
MEDICAL CLAIMS AND HEALTH CARE COSTS. If the Company is unable to accurately estimate medical claims and control health care costs, its results of operations may be materially adversely affected.
GOVERNMENT REGULATIONS. The Company conducts business in a heavily regulated industry, and changes in government regulation could increase the costs of compliance or cause the Company to discontinue marketing its products in certain states.
The Company's efforts to measure, monitor and adjust its business practices to comply with the law are ongoing. Failure to comply with enacted regulations, including the laws mentioned above, could require the Company to pay refunds or result in significant fines, penalties, or the loss of one or more of its licenses. From time to time the Company is subject to inquiries related to its activities and practices in states in which it operates. The Company has been subject to regulatory penalties, assessments and restitution orders in a number of states. Furthermore, federal and state laws and regulations continue to evolve. The costs of compliance may cause the Company to change its operations significantly, or adversely impact the health care provider networks with which the Company does business, which may adversely affect its business and results of operations.
For example, a Florida Circuit Court has found the Company liable for damages in a class action lawsuit in Florida. The earliest the Company expects the trial to be held to determine damages is the second quarter of 2004. Further, the Company is involved in a number of lawsuits in various states that allege misrepresentation by the Company of its renewal rating methodology. For additional information, see Part I, Item 3, "Legal Proceedings."
The nature of the Company's business subjects it to a variety of legal actions and claims relating but not limited to the following: (1) denial of health care benefits; (2) disputes over rating methodology and practices or termination of coverage; (3) disputes with agents over compensation or other matters; (4) disputes related to claim administration errors and failure to disclose network rate discounts and other fee and rebate arrangements; (5) disputes related to managed care or cost containment activities, (6) disputes over co-payment calculations; and (7) customer audits of compliance with the Company's plan obligations.
BUSINESS GROWTH STRATEGY. The Company's future operating performance is largely dependent on its ability to execute its growth strategy.
The Company has experienced a decline in membership over the last several years as part of its strategy to improve profitability and exit certain markets. The Company's challenge is to increase the number of individuals and small employer groups purchasing its products and services while encouraging its current membership to retain their business relationship with the Company. Also impacting the Company's growth prospects is the affordability of health insurance premiums as health care costs rise, as well as the downsizing or restrained hiring among small employers as a result of economic uncertainty. If the Company initiatives are not successful and the Company does not meet its growth goals, the Company's future operating performance may be adversely affected.
In addition, the Company has a relationship with a general agent who, along with affiliated subagents, generated 9% of the Company's premium revenue as of December 31, 2003. The loss of this relationship could hamper the Company's growth plans and, as a result, adversely affect the Company's future operating performance.
NEGATIVE PUBLICITY. Negative publicity regarding the Company's business practices and about the health insurance industry may harm the Company's business and operating results.
The Company's risk management program includes several insurance policies it has purchased to cover various property, business and other risks of loss. In addition, the Company carries policies to cover its directors and officers. Many of the carriers marketing these lines of coverage are experiencing unfavorable claims experience and loss of, or increased costs for, their own reinsurance coverage. Several carriers have exited markets and no longer offer certain lines of coverage. Accordingly, there is no assurance that the Company will be able to purchase insurance coverages for its own risk management at affordable premiums or with reasonable deductibles and policy limits.
The Company has entered into and may continue to enter into a variety of reinsurance arrangements under which it cedes business to other insurance companies to mitigate large claims risk. Although reinsurance allows for greater diversification of risk relating to potential losses arising from large claims, the Company remains liable if these other insurance companies fail to perform their obligations. As a result, any failure of an insurance company to perform its obligations under an agreement could expose the Company to significant losses. Also, there is no assurance that the Company will be able to purchase reinsurance.
PROVIDER NETWORK RELATIONSHIPS. The Company's inability to enter into or maintain satisfactory relationships with provider networks could harm profitability.
The Company's insurance subsidiaries are subject to regulations that limit their ability to transfer funds to the Company. If the Company is unable to obtain funds from its insurance subsidiaries, it will experience reduced cash flow, which could affect the Company's ability to pay its obligations to creditors as they become due. The Company will be required to make a lump-sum payment of the outstanding balance under its credit facility at the end of 2005. The Company's outstanding balance at December 31, 2003 was $30.2 million. If the Company's insurance subsidiaries are unable to provide these funds, the Company could default on its obligations under the credit facility.
We have audited the accompanying consolidated balance sheets of American Medical Security Group, Inc. and its subsidiaries (the "Company") as of December 31, 2003 and 2002, and the related consolidated statements of operations, changes in shareholders' equity and comprehensive income (loss) and cash flows for each of the three years in the period ended December 31, 2003. Our audits also included the financial statement schedules listed in the Index at Item 15. These financial statements and schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of the Company as of December 31, 2003 and 2002, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2003, in conformity with accounting principles generally accepted in the United States. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein.
Property and equipment are stated at cost less accumulated depreciation. Property and equipment includes capitalized costs to develop or obtain computer software for internal use when such costs are specifically identifiable, have determinate lives and relate to probable future economic benefits. Depreciation is calculated using the straight-line method over the estimated useful lives of assets. Estimated useful lives are 20 to 30 years for land improvements, 10 to 40 years for buildings and building improvements, three to five years for computer equipment and software and three to 10 years for furniture and other equipment.
The Company has various operating lease obligations primarily for office space and equipment. The Company's total lease expense was $3,433,000 in 2003, $4,197,000 in 2002 and $4,818,000 in 2001. Estimated future minimum lease payment obligations as of December 31, 2003 for each of the next five years are as follows:
2004: $ 3,138,000 2005: 1,971,000 2006: 939,000 2007: 292,000 2008: 121,000
As of December 31, 2003 and 2002, goodwill balances by segment amounted to $12,722,000 for health insurance and $19,416,000 for life insurance. The Company's other intangible asset is net of accumulated amortization of $5,346,000 at December 31, 2003 and $4,443,000 at December 31, 2002. Amortization expense is expected to be approximately $652,000 for each of the next three years.
Reinsurance premiums, commissions and expense reimbursements on reinsured business are accounted for on a basis consistent with those used in accounting for the original policies issued and the terms of the reinsurance contracts. Premiums and benefits ceded to other companies have been reported as a reduction of premium revenue and benefits in the Company's statement of operations. Reinsurance receivables and prepaid reinsurance premiums are reported as other assets on the Company's balance sheets.
Quota share reinsurance ceded: Insurance premiums $ 15,334 $ 18,975 $ 19,113 Medical and other benefits 12,375 15,001 12,251
Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial statement purposes and the amounts used for income tax purposes. A valuation allowance is recognized when, based on available evidence, it is more likely than not that the deferred tax asset may not be realized.
Basic EPS is computed by dividing earnings by the weighted average number of common shares outstanding. Diluted EPS is computed by dividing earnings by the weighted average number of common shares outstanding, adjusted for the effect of dilutive stock options.
from the computation of diluted earnings per common share for the respective years because the option's exercise price was greater than the average market price of common shares and, therefore, the effect would be antidilutive.
On January 1, 2002, the Company adopted Statement of Financial Accounting Standards No. 142, GOODWILL AND OTHER INTANGIBLE ASSETS ("Statement 142"). Statement 142 impacts the Company in two ways. First, goodwill is no longer amortized. Second, goodwill was subject to an initial impairment test in accordance with Statement 142, and any remaining balance of goodwill is subject to continuing impairment testing at least annually.
The Company completed the initial goodwill impairment test during the second quarter of 2002. The Company's measurement of fair value was based on an evaluation of ranges of future discounted cash flows, public company trading multiples and market comparisons of similar assets and liabilities. This evaluation utilized assumptions and projections based on the best information available to management. Certain key assumptions considered included forecasted trends in membership, revenue, medical costs, operating expenses and effective tax rates. As a result of this initial impairment test, the Company recognized a non-cash goodwill impairment charge of $60,098,000. The impairment charge was recorded as a cumulative effect of a change in accounting principle as of January 1, 2002. The impairment charge had no impact on cash flows or the statutory-basis capital and surplus of the Company's insurance subsidiaries.
During the third quarter of 2003, the Company sold all of the outstanding common shares of its preferred provider organization network subsidiary, AHP for $3,500,000. The network contracted with more than 900 hospitals and 100,000 physicians in eight primary states: Arizona, Florida, Iowa, Nebraska, North Dakota, South Dakota, Texas and Wisconsin. Subject to the terms of the agreement, AHP will continue to provide network services to the Company for five years. At the time of the sale, AHP served approximately 13% of the Company's members.
Included in income (loss) from discontinued operations are net operating results of the AHP networking business sold. The sale transaction resulted in a gain of $1,950,000, or $950,000 net of tax, which is included in income from discontinued operations in the Company's statement of operations for 2003. The operating results from discontinued operations in 2003, 2002 and 2001 included revenues of $1,923,000, $3,219,000 and $3,648,000 and income tax benefits of $165,000, $406,000 and $203,000, respectively. As a result of the sale transaction, goodwill on the Company's December 31, 2003 balance sheet was reduced by $708,000. All prior periods presented in the Company's statement of operations have been reclassified to exclude the results of the discontinued networking business from reported income from continuing operations.
Incurred related to: Current year 493,513 516,229 613,769 Prior years (14,659) (7,881) (12,026) - -------------------------------------------------------------------------------- Total incurred 478,854 508,348 601,743
Net balance at December 31 121,062 126,165 126,979 Plus reinsurance recoverables 1,326 312 1,351 - -------------------------------------------------------------------------------- Balance at December 31 $ 122,388 $ 126,477 $ 128,330 ================================================================================
The incurred amounts related to prior years represent the differences between the Company's estimated medical and other benefits payable for prior years' claims and the actual or remaining estimated amounts required to satisfy such claims. Actual amounts differ from previously recorded liabilities due primarily to inherent variabilities associated with estimating health insurance benefits payable and litigation liabilities. The liabilities for unpaid claims at December 31, 2002, 2001 and 2000 developed redundant in the subsequent years by $14,659,000, $7,881,000 and $12,026,000, respectively. The developed redundancy on the December 31, 2002 liability resulted primarily from lower than anticipated health care utilization and claim costs.
At December 31, 2003, the Company's insurance subsidiaries had fixed securities on deposit with various state insurance departments with carrying values of $3,377,000.
Mortgage payable, commercial bank, 9.05% interest - 3,700 - -------------------------------------------------------------------------------- $ 30,158 $ 33,858 ================================================================================
The credit agreement contains customary covenants which, among other matters, require the Company to achieve certain minimum financial results, prohibit the Company from paying future cash dividends, and restrict or limit the Company's ability to incur additional debt and dispose of assets outside the ordinary course of business. The Company was in compliance with all such covenants at December 31, 2003. The Company's obligations under the credit agreement are guaranteed by its subsidiary, American Medical Security Holdings, Inc. ("AMS Holdings"), and secured by pledges of stock of AMS Holdings and United Wisconsin Life Insurance Company, the Company's principal insurance subsidiary.
The Company had a net current federal income tax payable of $1,818,000 and $6,520,000 at December 31, 2003 and 2002, respectively. The Company and its subsidiaries had state net business loss carryforwards totaling $94,326,000 at December 31, 2003, which will begin to expire in the year 2008.
Year ended December 31, ------------------------------------------ (THOUSANDS) 2003 2002 2001 - --------------------------------------------------------------------------------
The federal deferred benefit arising from the deductibility of state deferred taxes is included as a component of other federal deferred taxes. The net deferred taxes are included in other assets in the accompanying consolidated balance sheets. During 2003 and 2002, the Company recognized, as an adjustment to additional paid-in capital, an income tax benefit of $2,881,000 and $1,769,000, respectively, resulting from the deduction received by the Company upon the exercise of employee stock options. The Company paid net federal and state income taxes of $18,498,000 and $22,903,000 in 2003 and 2002, respectively and received net federal and state income tax refunds of $739,000 in 2001.
In February 2000, a class action lawsuit was filed against the Company in the state of Florida alleging that the Company failed to follow Florida law when in 1998 it discontinued writing certain health insurance policies and offered new policies to insureds. Plaintiffs claim that the Company wrongfully terminated coverage, improperly notified insureds of conversion rights and charged improper premiums for new coverage. Plaintiffs also allege that the Company's renewal rating methodology violated Florida law. On April 24, 2002, a Circuit Court Judge ruled against the Company and ordered the question of damages be tried at a later date. The earliest the Company expects the trial to be held is the second quarter of 2004. The Company believes its practices were in full compliance with Florida law and is vigorously defending this lawsuit.
The Company is a defendant in a number of lawsuits in various states, primarily Alabama, alleging misrepresentation of the rating methodology used by the Company with respect to certain MedOne(R) products purchased by the plaintiffs. These lawsuits commonly seek unspecified damages for misrepresentation and emotional distress in addition to punitive damages. Some of these cases involve multiple plaintiffs. The cases are in various stages of litigation. The Company believes that these lawsuits are unfounded because the Company properly disclosed the nature of the products sold. The Company also believes the subject matter of the lawsuits falls under the primary jurisdiction of state insurance departments. The Company is vigorously defending itself in these actions.
The Company's employees are included in a qualified defined contribution plan (the "Retirement Savings Plan") with profit sharing and discretionary savings provisions covering all eligible salaried and hourly employees. Participant contributions up to 6% of the participant's compensation were matched 70% by the Company in 2003 and 2002 and 60% in 2001. Profit sharing contributions to the Retirement Savings Plan are determined annually by the Company. Participants vest in Company contributions in three years. The Company recognized expense associated with the Retirement Savings Plan of $2,079,000, $3,711,000 and $1,881,000 in 2003, 2002 and 2001, respectively. For 2002, the expense includes a profit sharing contribution of $1,287,000 or 2% of eligible wages. No profit sharing contributions were made in 2003 and 2001.
At December 31, 2003 and 2002, the Company has total deferred compensation payable to employees of $4,574,000 and $4,057,000, respectively.
The Company evaluates segment performance based on income or loss before income taxes, excluding realized gains and losses on the Company's investment portfolio. The accounting policies of the reportable segments are the same as those described in the summary of significant accounting policies. Significant intercompany transactions have been eliminated prior to reporting reportable segment information.