The Company owns its offices in Pueblo, Colorado and leases office space for its principal executive offices in Woodland Hills and its offices in Rancho Cordova, California.
The Pueblo facility, with approximately 72,000 square feet, is subject to a mortgage in the aggregate principal amount of approximately $1 million. The Company is also renovating three Pueblo properties which it obtained in 1996 with approximately 188,400 aggregate square feet and intends to receive public funds for certain of such properties' renovation from the City and County of Pueblo in return for certain employment commitments.
In addition to the Company's office space in Pueblo, Woodland Hills and Rancho Cordova, the Company and its subsidiaries lease approximately 220 sites in 27 states, comprising roughly 2.2 million square feet of space.
The Company owns in total approximately 1.7 million square feet of space. The Company owns approximately 535,000 aggregate square feet of space for health care centers in California and Arizona and approximately 249,000 square feet of space for two hospitals in Southern California. The Company also owns approximately a dozen office buildings, in Arizona, California, Colorado and Connecticut, which collectively encompass about 840,000 square feet of space.
FOUNDATION HEALTH SYSTEMS, INC. (AMOUNTS IN THOUSANDS, EXCEPT PER SHARE DATA)
Foundation Health Systems, Inc. (the "Company") is an integrated managed care organization which administers the delivery of managed health care services. Through its subsidiaries, the Company offers group, individual, Medicaid and Medicare health maintenance organization ("HMO") and preferred provider organization ("PPO") plans; government sponsored managed care plans; and managed care products related to bill review, administration and cost-containment, behavioral health, dental, vision and pharmaceutical products and services.
The Company's revenues grew by $525.8 million or 7.8% for the year ended December 31, 1997 as compared to the same period in 1996. Growth in revenues for the year was due to slightly higher health plan premiums for the Company's commercial membership and membership growth in Medicaid contracts in California, commercial membership growth on the east coast, and the partial year impact of acquisitions that occurred in the second and fourth quarters of 1997. Higher investment and other income includes gains on sale of the Company's investments in FPA Medical Management, Inc. ("FPA"), interest received on notes and rental income on real estate from FPA that resulted from the sale of the Company's physician practice management operations during 1996 to FPA, a gain on the redemption of notes receivable by FPA held by the Company, and a gain on the sale of certain Medicaid contracts. Revenues for the year ended December 31, 1996 increased by $1,595.6 million or 31.2% as compared to the same period in 1995. Revenue increases in 1996 were due to the full year impact of new acquisitions in Connecticut and Pennsylvania and the partial year impact of the Mental Health Network ("MHN') acquisition, commercial and Medicare risk membership growth in California, new CHAMPUS government contracts and higher cash and investment balances resulting in increased investment and other income.
The overall medical care ratio ("MCR") (medical costs as a percentage of revenue) for the year ended December 31, 1997 was 83.1% compared to 84.5% for the year ended December 31, 1996. The decline is due primarily to higher medical costs and loss contracts that negatively impacted the MCR in 1996 as well as favorable reserve development in 1997 in certain of the Company's health plans as well as improved health care and subcontractor performance on certain government contracts. The 1997 reduction in MCR was offset slightly by escalating health care costs including higher pharmacy costs coupled with a relatively flat premium environment, particularly in the California market and throughout the Company's health plans. The overall MCR for the year ended December 31, 1996 was 84.5% as compared to 79.3% during the same period in 1995. The increase in the MCR was due to the aforementioned higher medical costs and loss contracts that were charged in 1996 as well as due to continued pricing pressures throughout the Company's health plans and an increase in pharmacy costs.
The Company's selling, general and administrative ("SG&A") expenses decreased by $8.2 million or 1.0% for the year ended December 31, 1997 as compared to the same period in 1996, and increased by $202.7 million or 30.8% for the year ended December 31, 1996 as compared to the same period in 1995. The administrative expense ratio (SG&A as a percentage of health plan and government contracts revenue) decreased to 12.6% for the year ended December 31, 1997 from 13.6% for the year ended December 31, 1996. The administrative expense ratio was flat at 13.6% for the year ended December 31, 1996 as compared to the the year ended December 31, 1995. Favorable expense reductions occurred for the year ended December 31, 1997 as a percentage of revenues due to the Company's ongoing efforts to aggressively control its SG&A expenses and synergy savings associated with the integration of HSI and FHC after the FHS Combination. This was offset partially by additional SG&A expenses associated with
The reduced tax provision rate of 26.7% in 1996 relative to the 1995 rate of 39.7% was primarily a result of tax benefits associated with net operating loss carryforwards of acquired subsidiaries, increased research and development credits, elimination of a duplicate tax for undistributed income between an
acquired subsidiary and its former parent, increased proportion of tax-exempt income as a percentage of pre-tax income, and a settlement of an IRS examination.
The Company currently operates in the managed health care segment. The managed health care segment's continuing operations are in three primary lines of business (i) health plan operations; (ii) government contracts; and (iii) specialty services. Discontinued operations include the worker's compensation insurance and physician practice management ("Medical Practices") segments.
Revenues generated by the Company's health plan operations increased $434.3 million or 8.1% for the year ended December 31, 1997 compared to the same period in 1996 and $837.9 million or 18.4% for the period ended December 31, 1996 compared to the same period in 1995. The increase in revenues for the year ended December 31, 1997 as compared to the same period in 1996 is primarily due to enrollment increases in the Medicaid lines of business and enrollment and premium increases in the Medicare lines of business in California, commercial enrollment increases in Connecticut and Arizona, and the partial year impact of the acquisitions of Advantage Health in Pennsylvania, FOHP, Inc. ("FOHP") in New Jersey, and PACC HMO and PACC Health Plans (collectively, "PACC") in Oregon. The increase in revenues for the year ended December 31, 1996 as compared to the same period in 1995 is due to acquisitions in the Northeast, including M.D. Health Plan operating in Connecticut and Greater Atlantic Health Plan of Pennsylvania, and increased Medicare risk and Medicaid enrollment in California.
Government contracts revenue increased by $40.4 million or 4.4% for the year ended December 31, 1997, compared to the same period in 1996 as a result of the California/Hawaii CHAMPUS contract being active for only 9 months in 1996 compared to a full year in 1997. Revenues increased $629.4 million for the year ended December 31, 1996 or 225% compared to the same period in 1995. The increase was due to the California/Hawaii CHAMPUS contract which began in April 1996 as well as the full year impact of the Washington/Oregon and Region 6 CHAMPUS contracts (Texas, Arkansas, Oklahoma and Louisiana) which began health care delivery on March 1, 1995 and November 1, 1995, respectively.
The Company expects continued pressure from employer groups to maintain modest increases in premiums for behavioral health, dental and vision products. Specialty services costs have decreased as a percentage of specialty services revenue to 84.9% for 1997 as compared to 91.4% in 1996. The decrease is due to the adverse reserve development recognized in the fourth quarter of 1996 which resulted in a higher MCR during 1996 as well as the favorable benefit of the MHN acquisition. Specialty services costs as a percentage of revenue increased to 91.4% in 1996 from 86.6% in 1995 due to the aforementioned adverse reserve development recognized in 1996.
The Company revised its strategy of maintaining a presence in the workers' compensation insurance business as a result of various adverse developments arising in 1997 in the workers' compensation insurance business, primarily related to the workers' compensation claims environment in California. As discussed elsewhere in this Annual Report on Form 10-K, such adverse developments caused the Company to strengthen its workers' compensation reserves at the end of 1997. These developments also led the Company to adopt a plan to completely discontinue this segment of its business, through divestiture of its workers' compensation risk-assuming insurance subsidiaries. The Company is presently conducting the sale of these businesses.
The Company's workers compensation insurance companies consist of the following: California Compensation Insurance Company, a specialty workers' compensation carrier writing business primarily in California; Business Insurance Company, a national workers' compensation specialty carrier; Commercial Compensation Insurance Company, and Combined Benefits Insurance Company, writing single source workers' compensation and employee group health insurance primarily in California.
The workers' compensation companies entered into a quota share reinsurance agreement ("Quota Share Treaty") with General Reinsurance Corporation ("Gen Re") effective July 1, 1996 and also entered into an aggregate excess of loss reinsurance agreement ("Aggregate Treaty") with Gen Re effective January 1, 1997.
premiums were ceded to Gen Re for aggregate excess of loss reinsurance protection, and the Company ceded $112.3 million of ceded losses incurred for the year.
The primary ratios used to measure underwriting performance of the workers' compensation companies are the loss and loss adjustment expense ratio, the underwriting expense ratio, and the policyholder dividend ratio, which when added together constitute the combined ratio. These ratios are calculated as a percentage of net premiums earned.
The loss and loss adjustment expense ratio increased to 86.6% in 1997 as compared to 79.4% in 1996. The increase in 1997 is primarily due to an increase in the estimates for accident year 1996 and prior loss and loss adjustment expenses incurred, which estimates were increased by $75.2 million in 1997. The cause of the increase in the accident year 1996 and prior estimates was due to changes to the California permanent disability rating schedules in April 1997 which adversely affected average claim severity in California. The change to the permanent disability rating schedules had a negative affect on the entire California workers' compensation industry. In addition, a court ruling in late 1996 expanded the presumption of the treating physician related to workers' compensation workplace injuries in determining the disability of the injured worker. The impact of this court ruling also increased claim severity. The increase to accident year 1996 and prior loss estimates represented 14.7% of net premiums earned for 1997. The effect of the accounting of the Aggregate Treaty reduced the loss and loss adjustment expense ratio by 5.2%, due to more ceded losses incurred than ceded premiums earned.
Certain of the Company's subsidiaries must comply with minimum capital and surplus requirements under applicable state laws and regulations, and must have adequate reserves for claims. Certain subsidiaries must maintain ratios of current assets to current liabilities of 1:1 pursuant to certain government contracts. The Company believes it is in compliance with these contractual and regulatory requirements in all material respects.
Government health care receivables are best estimates of payments that are ultimately collectible. Since these amounts are subject to government audit and negotiation, amounts ultimately collected may vary from current estimates.
compared to $348.8 million during the same period in 1996. The increase in 1997 was due primarily to additional draws under the revolving line of credit of $566.2 million that was used primarily to finance the new acquisitions, offset by the repurchase of stock from the California Wellness Foundation of $111 million and the repayment of Senior Notes of $125 million.
On June 27, 1997 the Company consummated a cash tender offer to repurchase all of its $125 million outstanding principal amount of 7 3/4% Senior Notes due 2003. The purchase price per $1,000 principal amount of notes was $1,054.77.
During the quarter ended June 30, 1997, the Company sold 4,076,087 shares of common stock of FPA that it had received as consideration in its sale of the Medical Practices. The proceeds from the sale of stock were approximately $79 million, or an average of $19.45 per share. In addition, as of June 30, 1997 FPA prepaid approximately $98.7 million due on a promissory note received as consideration in the Company's sale of its Medical Practices.
On June 27, 1997, the Company redeemed 4,550,000 shares of Class B Common Stock from The California Wellness Foundation ("the CWF") at a price of $24.47 per share. The Company provided its consent to permit the CWF to sell 3,000,000 shares of Class B Common Stock to an unrelated third party in June of 1997 and to sell 450,000 shares of Class B Common Stock to unrelated third parties throughout August of 1997. On November 6, 1997, the Company also provided its consent to permit the CWF to sell 1,000,000 shares of Class B Common Stock to an unrelated third party. Pursuant to the Company's Certificate of Incorporation, such 3,000,000 shares, 450,000 shares and 1,000,000 shares of Class B Common Stock automatically converted into shares of Class A Common Stock in the hands of such third parties.
The managed health care industry is labor intensive and its profit margin is low; hence, it is especially sensitive to inflation. Increases in medical expenses or contracted medical rates without corresponding increases in premiums could have a material adverse effect on the Company.
Various federal and state legislative initiatives regarding the health care industry have been proposed during recent legislative sessions, and health care reform and similar issues continue to be in the forefront of social and political discussion. If health care reform or similar legislation is enacted, such legislation could impact the Company. Management cannot at this time predict whether any such initiative will be enacted and, if enacted, the impact on the financial condition or results of operations of the Company.
The Company's ability to expand its business is dependent, in part, on competitive premium pricing and its ability to secure cost-effective contracts with providers. Achieving these objectives is becoming increasingly difficult due to the competitive environment. In addition, the Company's profitability is dependent, in part, on its ability to maintain effective control over health care costs while providing members with quality care. Factors such as health care reform, integration of acquired companies, regulatory changes, utilization, new technologies, hospital costs, major epidemics and numerous other external influences may affect the Company's operating results. Accordingly, past financial performance is not necessarily a reliable indicator of future performance, and investors should not use historical records to anticipate results or future period trends.
Reference is also made to the disclosures contained under the heading "Cautionary Statements" included elsewhere in this Annual Report or Form 10-K, which could cause the Company's actual results to differ from those projected in forward looking statements of the Company made on behalf of the Company. In addition, certain of these factors may have affected the Company's past results and may affect future results.
The Company recognizes that the arrival of the Year 2000 requires computer systems to be able to recognize the date change from 1999 to 2000 and, like other companies, is assessing and modifying its computer applications and business processes to provide for their continued functionality.
The Year 2000 Issue is the result of computer programs being written using two digits rather than four to define the applicable year. Any of the Company's computer programs that have time sensitive software may recognize a date using "00" as the year 1900 rather than the year 2000. This could result in a system failure or miscalculations causing disruptions of operations, including, among other things, a temporary inability to process transactions, prepare invoices or engage in normal business activities.
The Company has initiated formal communications with others with whom it does significant business to determine their Year 2000 issues. There can be no assurances that the systems of other companies on which the Company's systems rely will be timely converted, or that the failure to convert by another company would not have a material adverse effect on the Company.
The Company does not anticipate that the related overall costs to resolve these potential Year 2000 problems will be material to any single year. The total current cost estimate for the Year 2000 project is between $13 and $17 million, of which approximately $2 million has been incurred to date. These costs are expensed as incurred.
At this time it is unclear as to the extent of existing insurance coverage, if any, the Company may have to cover potential year 2000 liabilities. The Company is currently analyzing the obtainment of such coverage.
REPORT OF THE AUDIT COMMITTEE OF THE BOARD OF DIRECTORS OF FOUNDATION HEALTH SYSTEM, INC.
The Board of Directors of the Company addresses its oversight responsibility for the consolidated financial statements through its Audit Committee (the "Committee"). The Committee currently consists of Gov. George Deukmejian, Thomas T. Farley, Earl B. Fowler (Chairman) and Richard J. Stegemeier, each of whom is an independent outside director.
To the Board of Directors and Stockholders of Foundation Health Systems, Inc. Woodland Hills, California
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Foundation Health Systems, Inc. and subsidiaries at December 31, 1997 and 1996, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1997 in conformity with generally accepted accounting principles. Also, in our opinion, such financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information set forth therein.
The Company is an integrated managed care organization which administers the delivery of managed health care services. Continuing operations consist of three separate lines of business: health plans, government contracts and specialty services. Through its subsidiaries, the Company offers group, individual, Medicaid and Medicare health maintenance organization ("HMO") and preferred provider organization ("PPO") plans; government sponsored managed care plans; and managed care products related to administration and cost-containment, behavioral health, dental, vision and pharmaceutical products and other services.
The workers' compensation insurance companies consist of the following: California Compensation Insurance Company, a specialty workers' compensation carrier writing business primarily in California; Business Insurance Company, a national workers' compensation specialty carrier; Commercial Compensation Insurance Company (f/k/a Christiania General Insurance Corporation); and Combined Benefits Insurance Company, writing single source workers' compensation and employee health insurance primarily in California.
As previously stated, the Company's consolidated financial statements have been prepared and/or restated as though HSI and FHC always had been combined. The following summary reflects the adjustments required to change FHC from a June 30 fiscal year end to the Company's calendar year end.
NOTE 1--DESCRIPTION OF BUSINESS (CONTINUED) The separate and combined results of the Company and FHC for the two years and period prior to the consummation of the FHS Combination are as follows (in thousands):
Revenue under government contracts is recognized in the month in which the eligible beneficiaries are entitled to health care services. Government contracts also contain cost and performance incentive provisions which adjust the contract price based on actual performance, and revenue under contracts is subject to price adjustments attributable to inflation and other factors. The effects of these adjustments are recognized on a monthly basis. Amounts receivable under government contracts are comprised primarily of estimated amounts receivable under these cost and performance incentive provisions, price adjustments, and change orders for services not originally specified in the contracts.
NOTE 2--SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) Specialty services revenue is recognized in the month in which the administrative services are performed or the period that coverage for services is provided.
The cost of health care services is recognized in the period in which it is provided and includes an estimate of the cost of services which have been incurred but not yet reported. Such costs include payments to primary care physicians, specialists, hospitals, outpatient care facilities and the costs associated with managing the extent of such care. The estimate for reserves for claims and other settlements is based on actuarial projections of hospital and other costs using historical studies of claims paid. Estimates are continually monitored and reviewed and, as settlements are made or estimates adjusted, differences are reflected in current operations. Such estimates are subject to the impact of changes in the regulatory environment and economic conditions. Given the inherent variability of such estimates, the actual liability could differ significantly from the amounts provided. While the ultimate amount of claims and losses paid are dependent on future developments, management is of the opinion that the reserves for claims and other settlements are adequate to cover such claims and losses. These liabilities are reduced by estimated amounts recoverable from third parties for subrogation.
The Company and its consolidated subsidiaries are required to set aside certain funds for restricted purposes pursuant to regulatory requirements. As of December 31, 1997 and 1996, cash and cash equivalent balances of $37.9 million and $5.5 million, respectively, are restricted and included in other noncurrent assets.
Property and equipment are stated at historical cost less accumulated depreciation. Depreciation is computed using the straight-line method over the lesser of estimated useful lives of the various classes of assets or the lease term. Lives of the assets range from 3 to 40 years.
Goodwill and other intangible assets consisted of the following at December 31, 1997 (in thousands):
Financial instruments that potentially subject the Company to concentrations of credit risk consist primarily of cash equivalents, investments and premium receivables. All cash equivalents and investments are managed within established guidelines which limit the amounts which may be invested with one issuer. Concentrations of credit risk with respect to premium receivables are limited due to the large number of payers comprising the Company's customer base. The Company's ten largest employer groups accounted for 36.2% and 29.9% of receivables and 16.3% and 16.8% of premium revenue as of December 31, 1997 and 1996, respectively, and for the years then ended.
In February 1997, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards ("SFAS") No. 128, "Earnings Per Share", which requires changes in current earnings per share ("EPS") reporting requirements. The Company adopted SFAS No. 128 in the fourth quarter of 1997 and restated all prior period EPS data presented in the accompanying financial statements. Basic EPS excludes dilution and reflects income divided by the weighted average shares of common stock outstanding during the periods presented. Diluted EPS is based upon the weighted average shares of common stock and dilutive common stock equivalents (stock options) outstanding during the periods presented; no adjustment to income is required. Common stock equivalents arising from dilutive stock options are computed using the treasury stock method.
During 1995, the Financial Accounting Standards Board issued SFAS No. 123, "Accounting for Stock-Based Compensation". The Company has chosen to continue accounting for stock-based compensation under the intrinsic value method prescribed in Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees." Under the intrinsic value method, compensation cost for stock options is measured at the date of grant as the excess, if any, of the quoted market price of the Company's stock over the exercise price of the option (see Note 7).
ADVANTAGE HEALTH--On April 1, 1997 the Company completed the acquisition of Advantage Health, a group of managed health care companies based in Pittsburgh, Pennsylvania, for $12.5 million in cash. The acquisition has been recorded using purchase accounting and the excess of the purchase price over the fair value of the assets acquired was recorded as goodwill. The goodwill, in the amount of $19.7 million, is being amortized on a straight line basis over 35 years. Advantage Health has approximately 35,000 full-risk members in Pennsylvania, Ohio and West Virginia. The Company purchased Advantage Health from St. Francis Health System, which has an option to re-acquire a 20 percent interest in Advantage Health for $2.5 million. Advantage Health remains a party to long-term provider agreements with the St. Francis Health System.
being amortized on a straight-line basis over 40 years. PACC is a 116,000 member health plan with operations in Oregon and Washington.
GHH--On December 1, 1995, the Company acquired the outstanding stock of G. H. Holdings ("GHH") and certain of its for-profit subsidiaries, including Greater Atlantic Health Services (now known as QualMed Plans for Health), an HMO operating in Pennsylvania and New Jersey, for $126.5 million in cash and notes (the "GHH Transaction"). The acquisition has been accounted using purchase accounting and the excess of the purchase price over the fair value of assets acquired in the amount of $88.4 million was recorded as goodwill. Goodwill is being amortized on a straight-line basis over 35 years. The Company subsequently divested certain of GHH's subsidiaries.
BICO--In February 1995, California Compensation Insurance Company acquired Business Insurance Company ("BICO"), a national workers' compensation specialty carrier, for $13.2 million in cash. The acquisition has been recorded using purchase accounting and no goodwill was recorded as a result of this transaction.
As of December 31, 1997, the amortized cost, gross unrealized holding gains and losses and fair value of the Company's investments were as follows (in thousands):
Proceeds from the sales and maturities of investments available for sale during 1996 were $441.6 million resulting in gross realized gains and losses of $2.5 million and $300 thousand, respectively.
The Company's regulated subsidiaries are required to keep investments on deposit in various states where they are licensed. At December 31, 1997, $34.9 million in securities are restricted to satisfy various state regulatory and licensing requirements.
The Company's Credit Facility, as amended, provides for an unsecured five-year $1.5 billion revolving credit facility which replaced (i) the Company's prior $700 million unsecured revolving credit facility with Bank of America, as agent, and (ii) FHC's prior $300 million unsecured revolving credit facility with Citicorp USA, Inc., as agent, and $200 million unsecured revolving credit facility with Citibank, N.A., as administrative agent. The facility is available to the Company and its subsidiaries for general corporate purposes, including permitted acquisitions.
Bank of America is the administrative agent and co-lead bank with Citibank N.A. for the other participating banks named in the Credit Agreement. At the election of the Company, and subject to customary covenants, loans are initiated on a bid or committed basis and carry interest at offshore or domestic rates, but subject to the applicable LIBOR Rate plus margin or a base rate (which is the higher of .50% above the Federal Funds Rate or the Bank of America "reference rate"). Actual rates on borrowings under the facility vary based on competitive bidding and the Company's unsecured debt rating at the time of the borrowing. The facility is available for five years, until July 2002, but may be extended, under certain circumstances, for two additional years until July 2004.
The Company has various stock option plans which cover certain employees, officers and non-employee directors, and employee stock purchase plans under which nearly all full-time employees of the Company are eligible to participate. These plans have been approved by the stockholders.
Under the 1990, 1993 and 1997 employee stock purchase plans, the Company provides employees with the opportunity to purchase stock through payroll deductions. Eligible employees may purchase up to $25,000 in fair market value annually of the Company's Class A Common Stock at 85% of the lower of the market price on either the first or last day of each offering period, except under the 1990 plan which specifies a purchase price at 85% of the market price on the date of purchase. The Company has reserved a total of 650 thousand shares of its Class A Common Stock for issuance under the 1997 plan. The 1990 and 1993 plans were terminated effective September 1997 and November 1997, respectively.
NOTE 7--STOCK OPTION AND EMPLOYEE STOCK PURCHASE PLANS (CONTINUED) Stock option activity and weighted average exercise prices for the years ended December 31 is presented below:
Under the 1990, 1993 and 1997 employee stock purchase plans, the Company sold 100 thousand, 117 thousand and 88 thousand shares of its stock to employees in 1997, 1996 and 1995, respectively.
The Company has two classes of Common Stock. The Company's Class B Common Stock has the same economic benefits as the Company's Class A Common Stock but is non-voting. Upon the sale or transfer of shares of Class B Common Stock by the CWF to an unrelated third party, such shares automatically convert into Class A Common Stock. The CWF is the only holder of record of the Company's Class B Common Stock.
NOTE 8--CAPITAL STOCK (CONTINUED) 450,000 shares and 1,000,000 shares of Class B Common Stock automatically converted into shares of Class A Common Stock in the hands of such third parties.
As a result of such transactions, the CWF now holds 10,297,642 shares of Class B Common Stock at December 31, 1997.
On May 20, 1996, the Board of Directors of the Company declared a dividend distribution of one right (a "Right") for each outstanding share of the Company's Class A Common Stock and Class B Common Stock (collectively, the "Common Stock"), to stockholders of record at the close of business on July 31, 1996 (the "Record Date"). The Board of Directors of the Company also authorized the issuance of one Right for each share of Common Stock issued after the Record Date and prior to the earliest of the Distribution Date (as defined below), the redemption of the Rights, and the expiration of the Rights and in certain other circumstances Rights will attach to all Common Stock certificates representing shares then outstanding and no separate Rights Certificates will be distributed. The Rights will separate from the Common Stock in the event any person acquires 15% or more of the outstanding Class A Common Stock, the Board of Directors of the Company declares a holder of 10% or more of the outstanding Class A Common Stock to be an "Adverse Person," or any person commences a tender offer for 15% of the Class A Common Stock (each event causing a "Distribution Date").
In 1995 the Company adopted two unfunded non-qualified defined benefit pension plans, a Supplemental Executive Retirement Plan and a Directors' Retirement Plan (collectively, the "FHC SERPs"). In 1996 the Company adopted two additional unfunded non-qualified defined benefit pension plans, a Supplemental Executive Retirement Plan and a Directors' Retirement Plan (collectively, the "HSI SERPs"). These plans cover key executives, as selected by the Board of Directors, and non-employee directors. Benefits under the plans are based on years of service and level of compensation.
Net pension costs included the following components for the years ended December 31:
NOTE 9--EMPLOYEE BENEFIT PLANS (CONTINUED) The projected benefit obligation and net pension cost were determined using discount rates of 7.50%, 7.88% and 8% for 1997, 1996 and 1995, respectively and an assumed rate of compensation increase of 4%, 5% and 4% for 1997, 1996 and 1995, respectively.
The Company sponsors employee stock purchase plans available to substantially all employees who meet certain eligibility requirements and elect to participate (see Note 7).
Significant components of the provision (benefit) for income taxes are as follows for the years ended December 31:
The valuation allowance increase of $56.2 million is due to the acquisition of a subsidiary for which the future realizability of such subsidiary's deferred tax assets, primarily related to net operating loss carryforwards, is uncertain.
The Company is involved in various legal proceedings, which are routine in its business. In the opinion of management, based upon current facts and circumstances known by the Company, the resolution of these matters should not have a material adverse effect on the financial position or results of operations of the Company.
The Company leases administrative and medical office space under various operating leases. Certain medical office space is subleased to participating medical groups doing business with the Company. Certain leases contain renewal options and rent escalation clauses.
In 1995, the Company entered into a $60 million tax retention operating lease with NationsBank of Texas, N.A., as Administrative Agent for the Lenders who are parties thereto, and First Security Bank of Utah, N.A., as Owner Trustee, (the "TROL Agreement") for the construction of health care centers and corporate facilities. Under the TROL Agreement, rental payments commence upon completion of construction, with a guarantee of 87% to the lessor of the residual value of properties leased at the end of the lease term. After the initial five year noncancelable lease term, the lease may be extended by agreement of the parties or the Company must purchase or arrange for sale of the leased properties. The Company has committed to a guaranteed residual value of $30.8 million under this agreement.
Rent expense totaled $48.7 million, $46.8 million and $39.3 million in 1997, 1996 and 1995, respectively.
In connection with the FHS Combination, the Company adopted a restructuring plan effective June 30, 1997 (the "June 1997 Plan"), the principal elements of which include: a workforce reduction of approximately 1,050 employees, the consolidation of employee benefit plans, the consolidation of facilities in geographic locations where office space is duplicated, the consolidation of overlapping provider networks, and the consolidation of information systems at all locations to standardized systems. The June 1997 Plan, which the Company anticipates will be completed by the end of 1998, resulted in a restructuring charge of $188.1 million for the quarter ended June 30, 1997.
During the quarter ended December 31, 1997, the Company adopted a restructuring plan (the "December 1997 Plan") and recorded a $6.0 million restructuring charge related to the Company's Eastern Division health plans. The plan relates to the integration of the Company's Eastern Division operations in connection with its acquisition of PHS and FOHP in the quarter ended December 31, 1997.
The Company also recorded a credit of $44.7 million for previously recorded restructuring charges during the fourth quarter. The credit consisted of $42.0 million for the June 1997 Plan and $2.7 million for the December 1996 Plan (see "1996 Costs").
The restructuring credits to the June 1997 Plan resulted from the following: $22.2 million from the Company's determination to continue to operate certain facilities originally identified for lease termination, $9.7 million from reductions to initially anticipated involuntary severance costs, $8.1 million from reductions to certain anticipated provider network consolidation and other contract termination costs and $2.0 million in reductions to asset impairment costs primarily related to the reclassification of workers' compensation insurance subsidiaries related charges to discontinued operations.
Of the $149.4 million in net restructuring costs recorded during the year ended December 31, 1997, $61.7 million represented cash payments and $15.8 million noncash activities as of December 31, 1997 and $45.2 million is expected to require future outlays of cash and $26.7 million represents future noncash activities.
In connection with the June 1997 Plan, $70.4 million in merger costs were recorded. The significant components of the charge include the following: $22.6 million of transaction costs, primarily consisting of investment banking, legal, accounting, filing and printing fees; $22.7 million of merger consulting costs; $5.9 million of former senior executive consulting costs; $2.4 million of directors and officers liability coverage required by the merger agreement; $9.6 million in costs to consolidate debt facilities; and $7.2 million of other merger related costs.
These costs were shown as other costs on the Company's consolidated statement of operations because of their unusual nature. If not for their unusual nature, approximately $53.8 million of these costs would have been recorded as health plan services, $35.0 million as selling, general and administrative and $17.2 million as government health care services.
The Company established a premium deficiency of $57.5 million related to the Company's Gem Insurance Company ("Gem") during the year ended December 31, 1997. During the quarter ended June 30, 1997, the Company had reached a definitive agreement regarding a reinsurance transaction with The Centennial Life Insurance Company ("Centennial"). Pursuant to this agreement, Centennial was to reinsure and manage Gem's accident and health, life and annuity policies in exchange for a reinsurance premium. The cost of the reinsurance along with the write-down of certain Gem assets that were not recoverable based on the terms of the agreement totaled $57.5 million. The transaction was not ultimately consummated due to the unanticipated failure to satisfy certain closing conditions, including the failure to
During the quarter ended December 31, 1996, the Company recorded restructuring costs of $27.4 million which included $5.4 million of executive and other involuntary severance costs, $17.4 million of software, hardware and other asset impairment costs, and $4.6 million of facilities consolidation costs (the "December 1996 Plan"). As stated above under "1997 Costs," $2.7 million in reductions to the December 1996 Plan were recorded during the quarter ended December 31, 1997 as a result of the Company's determination to continue to operate certain facilities originally identified for lease termination. Of the $27.4 million in restructuring costs recorded during the year ended December 31, 1996, $7.3 million has been paid and $17.4 million represented noncash write-offs as of December 31, 1997.
The Company also recorded $16.7 million of other costs in the quarter ended December 31, 1996 including loss contract accruals related to governmental employer groups in the Company's non-California markets, consulting and other costs. If not for their unusual nature, approximately $8.5 million of these costs would have been recorded as health plan services and $8.2 million as selling, general and administrative expenses.
In connection with the Company's terminated merger agreement with Wellpoint Health Networks, Inc. and Blue Cross of California announced December 28, 1995, the Company incurred restructuring and merger-related costs of $20.2 million during the year ended December 31, 1995. Such costs included $8.0 million of legal, accounting and consulting fees, as well as severance related costs of $12.2 million resulting from agreements with certain key executives in contemplation of the proposed merger.
Cash and investments at December 31, 1997 consist primarily of the following based on market values: U.S. government and agencies of 6%, obligations of states and other political subdivisions of 80%, and cash and cash equivalents of 14%. The cost and market value of cash and investments at December 31, 1997 are $716 million and $723 million, respectively, and $711 million and $714 million at December 31,
The workers' compensation insurance subsidiaries limit their exposure by reinsuring certain levels of risk with other insurers. In the event that all or any of the reinsuring companies might be unable to meet their obligations under the reinsurance agreement, the workers' compensation insurance companies would be liable for such obligations. The workers' compensation insurance companies regularly evaluate the financial condition of their reinsurers. Based on this evaluation, management believes the reinsurers are creditworthy and that any potential losses on these agreements will not have a material impact on the Company's consolidated financial statements. At December 31, 1997 and 1996, reinsurance receivable balances on ceded reserves and paid losses totaled $221.2 million and $136.1 million, respectively.
The effect of reinsurance on workers' compensation insurance companies premiums written, premiums earned and losses incurred for the three years ended December 31, 1997 is summarized as follows:
As part of these transactions, the Company's affiliated health plans entered into 30-year provider agreements with the IPAs and Medical Practices to ensure that the Company's enrollees have continued and uninterrupted access to the providers of the IPAs and Medical Practices. At December 31, 1997 and 1996, obligations under these agreements of $7.7 million and $33.8 million, respectively, are included in other current liabilities.