: SELECTED CONSOLIDATED FINANCIAL DATA (IN THOUSANDS, EXCEPT PER SHARE DATA)
(1) Coventry will close its subsidiary, Coventry Health Care of Indiana, Inc., by the end of the fourth quarter 2000. As a result of the cost associated with exiting the Indiana market, Coventry recorded a reserve for $2.0 million in the fourth quarter of 1999.
The following table (in thousands, except percentages and membership data) is provided to facilitate a more meaningful discussion regarding the results of the Company's operations for each of the three years in the period ended December 31, 1999.
During the three years ended December 31, 1999, the Company experienced substantial growth in operating revenues due primarily to membership increase. Much of the growth was in 1998 and was attributable to the acquisition of the Principal Health Care, Inc. ("PHC") plans effective April 1, 1998. Additional membership growth was achieved through marketing efforts, acquisitions, geographic expansion and increased product offerings.
The public sector managed care premium revenues consists of premiums from the Company's Medicare risk, Medicare cost and Medicaid products. The Company provides comprehensive health benefits to members participating in government programs and receives premium payments from federal and state governments. Premium rates for the Medicaid and Medicare risk products are established by governmental regulatory agencies and may be reduced by regulatory action.
As of December 31, 1999, Coventry had 1,202,304 members for whom it assumes underwriting risk ("risk members") and 237,635 members of self-insured employers for whom it provides management services but does not assume underwriting risk ("non-risk members") in continuing operations. The following tables show the total number of members in continuing operations as of December 31, 1999 and 1998.
The Company experienced strong sales and renewals for January 2000, adding about 30,000 members, excluding Indiana membership, to December 1999 results. Commercial membership grew by about 12,000 members despite pricing increases in most markets. Medicare membership was essentially flat, even though the Company exited three counties in Pennsylvania and reduced benefits and increased premiums in remaining service areas. Medicaid membership increased by about 17,000 members mainly due to the increase of membership in the Delaware plan, as a result of another carrier exiting the Medicaid program effective December 31, 1999. The remaining 1,000 member increase was a result of modest growth in non-risk membership.
Coventry's operating expenses are primarily medical costs, including medical claims under contractual relationships with a wide variety of providers, and capitation payments. Medical claims expense also includes an estimate of claims incurred but not reported ("IBNR"). Coventry currently believes that the estimates for IBNR liabilities are adequate to satisfy its ultimate medical claims liability after all medical claims have been reported. In determining the Company's IBNR liabilities, Coventry employs plan by plan standard actuarial reserve methods (specific to the plan's membership, product characteristics, geographic territories and provider network) that consider utilization frequency and unit costs of inpatient, outpatient, pharmacy and other medical costs, as well as claim payment backlogs and the timing of provider reimbursements. Reserve estimates are reviewed by underwriting, finance and accounting, and other appropriate plan and corporate personnel and judgments are then made as to the necessity for reserves in addition to the estimated amounts. Changes in assumptions for medical costs caused by changes in actual experience, changes in the delivery system, changes in pricing due to ancillary capitation and fluctuations in the claims backlog could cause these estimates to change in the near term. Coventry
Effective April 1, 1998, Coventry completed its acquisition of certain health plans of PHC from Principal Mutual Life Insurance Company, now known as Principal Life, for a total purchase price of approximately $330.2 million including transaction costs of approximately $5.7 million. The acquisition was accounted for using the purchase method of accounting and, accordingly, the operating results of PHC have been included in Coventry's consolidated financial statements since the date of acquisition. The purchase price consisted of 25,043,704 shares of Coventry's common stock at an assigned value of $11.96 per share. In addition, a warrant valued at $25.0 million ("the Warrant") was issued that grants Principal Life the right to acquire additional shares of Coventry's common stock in the event that its ownership percentage of such common stock is diluted below 40%. The Warrant is included as a component of additional paid-in capital in the accompanying consolidated financial statements. Through April 2003, Principal Life is restricted from buying additional shares of Coventry's common stock to increase its ownership percentage above 40%. As of December 31, 1999, Principal Life had exercised the Warrant to purchase 12,250 shares of the Company's common stock.
In the fourth quarter of 1999, Coventry notified the Indiana Department of Insurance of its intention to close its subsidiary, Coventry Health Care of Indiana, Inc. As of December 31, 1999, the health plan had approximately 23,000 members throughout the state. As a result of the cost associated with exiting the Indiana market, Coventry recorded a reserve of $2.0 million in the fourth quarter of 1999. Coventry has expended approximately $0.4 million as of December 31, 1999 and expects to close the plan by the end of the fourth quarter 2000.
In the fourth quarter of 1999, the Company's PHC subsidiaries changed the word Principal in their names to Coventry. All aspects of the health plans' operations, such as member coverage and access, remain unchanged. After the merger on April 1, 1998, the PHC plans continued to use the Principal brand name under the terms of the License Agreement as amended, between the parties, even though the Plans were no longer subsidiaries of Principal Life.
Effective February 1, 2000, the Company completed its acquisition of The Anthem Company's West Virginia managed care subsidiary, PrimeONE, Inc., ("PrimeONE"), for the total purchase price of approximately $3.9 million including acquisition costs. The $1.5 million excess of purchase price over the net identifiable tangible assets acquired was allocated to goodwill. The acquisition expands Coventry's West Virginia service area and brings its total membership in the state to over 109,000 members. This transaction combined with the Carelink acquisition solidifies Coventry's market leadership position in West Virginia.
Effective March 31, 1997, the Company completed the sale of the medical offices associated with HealthAmerica Pennsylvania, Inc., ("HealthAmerica"), in Pittsburgh, Pennsylvania, to a major health care provider organization. The sales price was $20.0 million, resulting in a pretax gain to the Company of approximately $6.0 million. Coincident with the sale, the Company entered into a long-term global capitation agreement with the purchaser which increased the Company's globally capitated membership in western Pennsylvania to approximately 250,000 members. Under the agreement, the provider organization received a fixed percentage of premiums to cover all of the medical treatment the globally capitated members received. The provider organization filed for bankruptcy protection on July 21, 1998 and, as a result, the Company is no longer operating under this agreement. See "Legal Proceedings - Settlement with AHERF Related Entities."
Coventry's remaining obligations under the settlement and will be expended through August 2007.
BJC. Effective May 1, 1997, the Company completed its sale of the medical offices associated with Group Health Plan, Inc., its health plan in St. Louis, Missouri, to BJC Health System ("BJC"), a major provider organization in the St. Louis market, for approximately $26.9 million. Upon the sale, the Company entered into a long-term global capitation agreement with BJC, since amended, that covered approximately 33.3% of the risk membership in St. Louis at December 31, 1998. Under the agreement, BJC receives a fixed percentage of premium to cover all of the medical treatment received by the globally capitated members. Global capitation agreements limit the Company's exposure to the risk of increasing medical costs, but expose the Company to risk as to the adequacy of the financial and medical care resources of the provider organization. To the extent that the respective provider organization faces financial difficulties or otherwise is unable to perform its obligations under the global capitation agreements, the Company, which is responsible for the coverage of its members pursuant to its customer agreements, will be required to perform such obligations, and may have to incur costs in doing so in excess of the amounts it would otherwise have to pay under the global capitation agreements. Various disputes alleging breaches have arisen under the BJC global capitation agreement concerning the accuracy and timeliness of claims payments, and the accuracy of membership reconciliations that would affect the amount of premiums paid to BJC to provide its services under the agreement. BJC contends that these alleged breaches entitles it to terminate the agreement. Although the parties are obligated to arbitrate their disputes under the terms of the agreement, the parties have agreed to attempt to negotiate a resolution of the various issues concurrent with arbitration. While the Company acknowledges certain claims payment inaccuracies, the Company denies the remaining allegations and vigorously disputes that any such claims constitute a material breach of the agreement. Management does not believe that the outcome of these disputes will have a material impact on the consolidated financial statements, although there can be no assurances in this regard.
Managed care premiums increased $48.7 million in 1999, or 2.4%, over 1998. The increase is primarily attributable to the additional revenue associated with the acquisitions of Carelink and the KFHPNC membership in the fourth quarter of 1999 and also due to the increase in Medicare risk and Medicaid membership of 34,345, or 20.6%, in continuing markets. In addition to the increase in risk membership, premiums increased by an average of $9.0, or 6.3%, over 1998 on a per member per month ("PMPM") basis, to $150.8 PMPM, as a result of rate increases. The Medicare Risk and Medicaid programs continue to grow in existing markets through recently expanded programs. On a same store basis, the increase in Medicare risk and Medicaid membership was offset by a decrease in commercial membership of 57,321, or 5.7%. The decrease in commercial membership occurred primarily in the western Pennsylvania market, attributable to the disruption caused by the AHERF bankruptcy filing and the conversion of a large group from a commercial risk product to a self-funded product. Membership also decreased in other markets due to Coventry's efforts to adhere to a strict pricing discipline. Coventry will continue to be diligent in attempting to obtain adequate premium increases and expects premium rates to increase 8% to 10% for renewals in the first quarter of 2000.
SG&A expense increased $6.0 million, or 2.1%, from 1998. SG&A expense, as a percent of revenue, remained unchanged at 13.8% in 1999, compared to 1998. The increase in SG&A expense was primarily attributable to additional expense associated with the acquired Carelink health plan and Coventry's consolidation of eighteen service centers into three regional service centers. In an effort to control costs and improve customer service, Coventry is in the process of transferring certain of its operating activities (e.g., customer service, claims processing, billing and enrollment) to regional service centers. All activities are expected to be fully transferred by the end of the fourth quarter of 2000.
Other income, net of interest expense, increased $9.5 million, or 50.6%, in 1999 from 1998, primarily due to the reduction of interest expense from the reduction of debt and increased investment income resulting from the increase in invested assets subsequent to the acquisition of the PHC health plans.
Earnings from operations increased $84.1 million, or 232.2% in 1999, compared to 1998. Excluding charges related to AHERF, plan shutdown expense and the relocation of the corporate office, operating earnings increased $18.3 million, or 72.3%, attributable to the various factors described above.
Managed care premiums increased $825.2 million, or 68.3%, in 1998 compared to 1997. The PHC plans accounted for approximately $697.7 million, or 84.6%, of the increase. Exclusive of the PHC plans, the Medicare risk membership increased by 25,285 members, or 66.0%. Medicare risk membership has a significantly higher per member per month premium (approximately three times) when compared to commercial risk membership and represented an increase in premiums, exclusive of the PHC plans, of $117.9 million from $161.1 million in 1997 to $279.0 million in 1998. The increase in Medicare risk membership was offset by a 20,047 decrease in Medicaid risk membership primarily resulting from the Company's decision to exit the Medicaid market in Pennsylvania in the first quarter of 1998. In addition, revenues per member per month, exclusive of the PHC plans, increased by 3.3% for HMO members, 8.3% for PPO/POS members and 5.5% for Medicaid members in 1998 over 1997. Excluding Medicaid membership, risk membership grew by 25,885, or 3.9%. The Company implemented rate increases that averaged approximately 7.0% in the fourth quarter of 1998.
The Company has exited the Medicare program in several counties representing approximately 18,000 members as of December 31, 1998. Approximately 10,000 of those members were in the Illinois and Florida health plans that were sold effective November 30, 1998 and December 31, 1998, respectively.
Management services revenue increased $56.8 million for the year ended December 31, 1998, or 281.2%, from the prior year. Management services and marketing services agreements that were entered into coincident with the acquisition of the PHC plans accounted for approximately $23.0 million, or 40.5%, of the increase. Approximately $30.5 million, or 53.7%, of the increase is primarily attributable to the PHC Administrative Services Only ("ASO") operations and PPO access fees. Exclusive of the PHC plans and the related agreements with Principal Life, management services revenue increased approximately $3.3 million, or 5.8%, attributable to transition services related to global capitation agreements and rate increases to ASO customers.
Loss from operations was $36.2 million for the year ended December 31, 1998. Excluding the $61.5 million of charges associated with the AHERF bankruptcy and the relocation of the corporate headquarters and other merger related costs, operating earnings were $25.3 million for the year ended December 31, 1998 compared to $5.7 million for the corresponding period in 1997. The increase in the operating earnings, exclusive of the $61.5 million of charges in 1998, is attributable to various factors as previously described.
The Company's HMOs and its insurance company subsidiary, Coventry Health and Life Insurance Company ("CHLIC"), are required by state regulatory agencies to maintain minimum surplus balances, thereby limiting the dividends the Company may receive from its HMOs and its insurance company subsidiary. After giving effect to these statutory reserve requirements, the Company's HMO subsidiaries had surplus in excess of statutory requirements of approximately $102.6 million and $93.4 million at December 31, 1999 and December 31, 1998, respectively. CHLIC had surplus in excess of statutory requirements of approximately $15.0 million and $7.8 million at December 31, 1999 and 1998, respectively. Excluding funds held by entities subject to regulation, the Company had cash and investments of approximately $61.1 million and $96.8 million at December 31, 1999 and
December 31, 1998, respectively, which are available to pay intercompany balances to regulated subsidiaries and for general corporate purposes. The Company also has entered into agreements with certain of its regulated subsidiaries to provide additional capital if necessary to prevent the subsidiary's insolvency.
On December 20, 1999, the Company announced a program to purchase up to 5% of its outstanding common stock. Stock repurchases may be made from time to time at prevailing prices in the open market, by block purchase or in private transactions. Coventry had approximately 64.2 million diluted shares of common stock outstanding as of December 31, 1999.
As part of a program previously authorized by the Board of Directors, as of March 23, 2000, the Company purchased approximately 826,200, 55,396 and 439,560 shares of its common stock in 2000, 1999 and 1997, respectively, for the treasury at an aggregate cost of $6.4 million, $0.4 million and $5.0 million in 2000, 1999 and 1997, respectively.
The Financial Accounting Standards Board ("FASB") has issued Statement of Financial Accounting Standards ("SFAS") No. 128, "Earnings Per Share", which became effective for both interim and annual reporting periods that ended after December 15, 1997. The Company adopted the new standard in its reporting for the quarter and the year ended December 31, 1997, including required restatement of prior periods. The adoption of this standard did not have a material impact on earnings per share.
In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities." SFAS 133 requires companies to record derivatives on the balance sheet as assets or liabilities, measured at fair value. Gains or losses resulting from changes in the values of the derivatives would be accounted for depending on the use of the derivatives and whether they qualify for hedge accounting. In June 1999, the FASB also issued SFAS No. 137 ("SFAS 137"), which defers the effective date of SFAS 133 until fiscal years beginning after June 15, 2000. The Company does not believe that adoption of SFAS 133 (as amended by SFAS 137) will have a material effect on its future results of operations.
The unaudited quarterly consolidated results of operations of the Company are summarized in Item 6: Selected Consolidated Financial Data, Supplementary Financial Information.
The Company operates in highly competitive markets, but generally believes that the pricing environment is improving in its existing markets, thus creating the opportunity for reasonable price increases. However, there is no assurance that the Company will be able to increase premiums at rates equal to or in excess of increases in its health care costs.
The Company is launching several e-commerce initiatives. Each initiative is intended to reach a segment of our core business customers: providers, brokers, employers and members, and will have a distinct e-commerce solution.
PROVIDER CHANNEL. In February 2000, the Company entered into a three-year agreement with Healtheon/WebMD, the first end-to-end Internet healthcare company connecting physicians and consumers to the entire healthcare industry. Initially, the Company will use Healtheon/WebMD's Internet services to manage the electronic submission and processing of eligibility determination, referrals and authorizations, claims submission, claim status, and reporting. Upon completion of the roll-out, Healtheon/WebMD will also provide administrative services to the providers in the Company's health plans' networks who have signed up for WebMD Practice. It is expected that this relationship will significantly improve service to our members and reduce administrative costs.
MEMBER CHANNEL. In March 2000, the Company announced a one-year agreement with GeoAccess to implement GeoAccess' online healthcare directory technology. This technology makes information about health plan providers available to members. The online directories will be available in all the Company's health plans. ProviderLookup Online uses GeoAccess' proprietary distance-calculation technology, which provides precise results about the providers located closest to an individual's address. The Company's members will be able to search for providers by name, geographic proximity or specific criteria.
The Company has been aware of the "Year 2000" issue that has the potential to affect products and systems that were not designed to properly handle the transition between the twentieth and twenty-first centuries. The Company recognized the need to ensure that its business operations would not be adversely impacted by the Year 2000, and it implemented a Year 2000 readiness program to facilitate the necessary readiness preparations. Through December 31, 1999, the Company incurred approximately $13.1 million in its Year 2000 assessment and remediation program, and it does not expect to incur significant further costs in this program. Prior to the end of 1999, the Company completed its readiness assessment and its implementation of all plans for handling anticipated readiness risks. The Company's transition from 1999 to 2000 occurred without any major business disruption. With the transition into the Year 2000 complete, the Year 2000 issue has not had, and the Company believes it will not have, a material impact on the Company's business, financial condition or results of operations.
The risks described below are not the only ones that we face. Additional risks not presently known to us or that we currently deem immaterial may also impair our business operations.
HEALTH CARE COSTS MAY RISE FASTER THAN OUR ABILITY TO INCREASE OUR PREMIUM RATES, CAUSING OUR PROFIT MARGINS TO SHRINK WHICH MAY IN TURN REDUCE OUR NET INCOME AND ADVERSELY AFFECT THE VALUE OF YOUR INVESTMENT IN COVENTRY.
- - rising costs - - loss of membership to our competitors - - failure to attract new members - - inability to increase premiums due to regulatory restrictions - - loss of membership due to increased premium rates - - withdrawal from unprofitable markets - - consumer preferences for lower priced health care options - - price competition
OUR FAILURE TO ACCURATELY ESTIMATE FUTURE HEALTH CARE COSTS MAY RESULT IN PREMIUMS THAT ARE NOT SUFFICIENT TO COVER MEDICAL COSTS, WHICH MAY NEGATIVELY AFFECT OUR OPERATING RESULTS AND REDUCE THE VALUE OF YOUR INVESTMENT IN COVENTRY.
- - the increased cost of individual health care services - - the type and number of individual health care services delivered exceeding our expectations - - the occurrence of catastrophes or epidemics - - seasonality and trends - - general inflation - - new mandated benefits or other regulatory changes that increase our costs - - operational issues - - insured population characteristics - - competitive pressures - - other unforeseen occurrences
FAILURE TO OBTAIN COST-EFFECTIVE AGREEMENTS WITH A SUFFICIENT NUMBER OF PROVIDERS MAY RESULT IN HIGHER MEDICAL COSTS AND LOSS OF MEMBERSHIP, WHICH COULD CAUSE A DECLINE IN THE VALUE OF YOUR INVESTMENT IN COVENTRY.
In some of our markets, there are provider systems that have a major presence. Our product offerings and profitability may be adversely affected if these provider systems refuse to contract with us, place us at a competitive disadvantage or use their market position to negotiate contracts that are unfavorable to us.
THERE IS A RISK THAT PROVIDERS WITH WHOM WE HAVE CAPITATION CONTRACTS MAY BE FINANCIALLY UNABLE OR UNWILLING TO FULFILL THEIR PAYMENT OR MEDICAL CARE OBLIGATIONS UNDER CAPITATION AGREEMENTS AND THAT OUR MEMBERS MAY PREFER TO UTILIZE OTHER PROVIDERS WITH WHOM WE DO NOT HAVE CAPITATION CONTRACTS.
Among the medical cost control techniques we have utilized are capitation agreements with providers pursuant to which we pay providers a fixed dollar amount per member per month, with the provider obligated to provide all of a particular type of medical service required by the members, and global capitation agreements pursuant to which a single integrated hospital-physician provider system provides substantially all hospital and medical services to a large number of members for a fixed percentage of the premium we charge with respect to those members. While these systems may shift to the contracting provider system the risk that medical costs will exceed the amounts anticipated, we will be exposed to the risks that the provider systems are financially unable or unwilling to fulfill their payment or medical care obligations under the capitation agreements. In addition, it is possible that members may prefer other providers in the market with whom we do not have capitation agreements. If our members choose to utilize providers with whom we do not have capitation agreements, we may incur higher costs. These higher costs may reduce our net income and negatively impact the value of your investment in Coventry.
Principal Life's ownership position and its representation on our Board of Directors, allow it to exert significant influence over the direction and operations of Coventry. In some instances, this influence could be used in a manner that is contrary to the best interests of our other stockholders, and may accordingly decrease the value of your investment in Coventry.
Additionally, prior to April 2003, Principal Life has agreed to vote its shares for the election of directors nominated by the nominating committee of the Board of Directors, and not to oppose or seek removal of any person nominated by this nominating committee.
FUTURE AND EXISTING LAWS AND RULES GOVERNING COVENTRY MAY IMPACT OUR BUSINESS AND NEGATIVELY AFFECT OUR PROFITABILITY.
Coventry's industry is heavily regulated and the laws and rules governing the industry and interpretations of those laws and rules are subject to frequent change. Existing or future laws could force us to change how we do business and may restrict our revenue and/or enrollment growth and/or increase our health care and administrative costs. Regulatory approvals must be obtained and maintained to market many of our products and services. Delays in obtaining or failing to obtain or maintain such approvals could adversely affect our revenue or the number of our covered lives, or could increase our costs.
OUR CONTRACTS WITH FEDERAL AND STATE GOVERNMENT AGENCIES ARE SUBJECT TO PERIODIC AUDITS THAT COULD HAVE AN ADVERSE RESULT THAT MAY LEAD TO A DECLINE IN THE VALUE OF YOUR INVESTMENT IN COVENTRY.
We are susceptible to litigation and insurance risks, including medical malpractice liability, disputes relating to the denial of coverage and the adequacy of "stop-loss" reinsurance for costs resulting from catastrophic injuries or illnesses. Coventry has contingent litigation risk with certain discontinued operations. Such litigation may result in losses to us that could have a material adverse effect on our operations, financial performance, cash flows or future prospects and adversely affect the value of your investment in Coventry.
COVENTRY HEALTH CARE, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997 (IN THOUSANDS)
Coventry Health Care, Inc. (together with its subsidiaries, the "Company", "we", "our", or "us"), successor-in-interest to Coventry Corporation, is a managed health care company operating health plans under the names Coventry Health Care, HealthAmerica, HealthAssurance, HealthCare USA, Group Health Plan, Southern Health, SouthCare and Carelink Health Plans. The Company provides a full range of managed care products and services including health maintenance organization ("HMO"), point of service ("POS") and preferred provider organization ("PPO") products. The Company also administers self-insured plans for large employer groups. The Company was incorporated under the laws of the state of Delaware on December 17, 1997.
Principles of Consolidation - The consolidated financial statements include the accounts of the Company and its subsidiaries. All significant intercompany transactions have been eliminated. Interests of other investors in the Company's majority owned (or otherwise effectively-controlled) subsidiaries are accounted for as minority interests and are included in other long-term liabilities for financial reporting purposes.
Investments - The Company accounts for investments in accordance with Statement of Financial Accounting Standards No. 115 ("SFAS 115"), "Accounting for Certain Investments in Debt and Equity Securities." The Company considers all of its investments as available-for-sale, and accordingly, records unrealized gains and losses, net of deferred income taxes, as a separate component of stockholders' equity. Realized gains and losses on the sale of these investments are determined on a specific identification basis.
Long-Lived Assets - The Company has adopted Statement of Financial Accounting Standards No. 121 ("SFAS 121"), "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of." In accordance with SFAS 121, the Company evaluates long-lived assets to be held for events or changes in circumstances that would indicate that the carrying value may not be recoverable. In making that determination, the Company considers a number of factors, including undiscounted future cash flows, prior to interest expense. The Company measures an impairment loss by comparing the fair value of the assets to their carrying value. Fair values are determined by using market prices for similar assets, if available, or discounted future estimated cash flows, prior to interest expense. Assets held for sale are recorded at the lower of the carrying amount or fair value, less any cost of disposition.
Goodwill and Intangible Assets - Goodwill and intangible assets consist of costs in excess of the fair value of the net assets of subsidiaries or operations acquired. Goodwill is amortized using the straight-line method over periods ranging from 15 to 35 years. The remaining unamortized goodwill and intangible asset balances at December 31, 1999 are as follows (in thousands):
Amortization expense for the years ended December 31, 1999, 1998 and 1997 was approximately $14.6 million, $13.6 million and $3.8 million, respectively. In accordance with SFAS 121 and Accounting Principles Board ("APB") Opinion No.17, the Company periodically evaluates the realizability of goodwill and intangible assets and the reasonableness of the related lives in light of factors such as industry changes, individual market competitive conditions, and operating income.
Other Assets - Other assets consist of loan acquisition costs, assets related to the supplemental executive retirement plan (See Note P to consolidated financial statements), restricted assets, deferred charges and certain costs incurred to develop new service areas and new products prior to the initiation of revenues. Loan acquisition costs are amortized over the term of the related debt while the other assets are amortized over their expected periods of benefit, where applicable. Loan acquisition costs were fully amortized in 1999. The preoperational new service area and new product costs were amortized over their expected period of benefit up to eight years. Effective April 1, 1997, the Company adopted a one-year period for amortization of new service area and new product costs. $2.7 million of expense was included in selling, general and administrative expense due to this change. These costs were fully amortized at December 31, 1997. Accumulated amortization of other assets was approximately $3.5 million and $3.4 million at December 31, 1999 and 1998, respectively.
Medical Claims Liabilities - Medical claims liabilities consist of actual claims reported but not paid and estimates of health care services incurred but not reported. The estimated claims incurred but not reported are based on historical data, current enrollment, health service utilization statistics, and other related information. Although considerable variability is inherent in such estimates, management believes that the liability is adequate. The Company also establishes reserves, if required, for the probability that anticipated future health care costs and contract maintenance costs under the group of existing contracts will exceed anticipated future premiums and reinsurance recoveries on those contracts. These accruals are continually monitored and reviewed, and as
settlements are made or accruals adjusted, differences are reflected in current operations. Changes in assumptions for medical costs caused by changes in actual experience could cause these estimates to change in the near term.
Revenue Recognition - Managed care premiums are recorded as revenue in the month in which members are entitled to service. Premiums collected in advance are recorded as deferred revenue. Employer contracts are typically on an annual basis, subject to cancellation by the employer group or the Company upon thirty days written notice. Management services revenues are recognized in the period in which the related services are performed. Premiums for services to federal employee groups are subject to audit and review by the Office of Personnel Management ("OPM") on a periodic basis. Such audits are usually a number of years in arrears. The Company provides reserves, on an estimated basis annually, based on the appropriate guidelines. Any differences between actual results and estimates are recorded in the year the audits are finalized.
Significant Customers - For the years ended 1999, 1998, and 1997, the Company received 16.0%, 15.2%, and 14.0%, respectively, of its revenue from the Federal Medicare program throughout the Company's various markets.
Income Taxes - The Company files a consolidated tax return for the Company and its wholly owned consolidated subsidiaries. The Company accounts for income taxes in accordance with Statement of Financial Accounting Standards No. 109 ("SFAS 109"). The deferred tax assets and/or liabilities are determined by multiplying the differences between the financial reporting and tax reporting bases for assets and liabilities by the enacted tax rates expected to be in effect when such differences are recovered or settled. The effect on deferred taxes of a change in tax rates is recognized in income in the period that includes the enactment date. See Note I for disclosures related to income taxes.
Earnings per Share - In the fourth quarter of 1997, the Company adopted Statement of Financial Accounting Standards No. 128 ("SFAS 128"), "Earnings per Share." SFAS 128 establishes new standards for computing and presenting earnings per share ("EPS"), replacing primary EPS with "basic EPS." Basic EPS excludes dilution and is computed by dividing income available to common stockholders by the weighted-average number of common shares outstanding for the period. The adoption of SFAS 128 did not have a material effect on the Company's earnings per share. All prior periods were previously restated to comply with SFAS 128. See Note S for calculation of EPS.
and in assessing performance. SFAS 131 also requires that all public business enterprises report information about the revenues derived from the enterprise's products or services (or groups of similar products and services), about the countries in which the enterprise earns revenues and holds assets and about major customers regardless of whether that information is used in making operating decisions. The Company has two reportable segments: Commercial products and Government products. The products are provided to a cross section of employer groups through the Company's health plans in the Midwest, Mid-Atlantic, and Southeastern United States.
Derivative Instruments - In June 1998, the FASB issued Statement of Financial Accounting Standards No. 133 ("SFAS 133"), "Accounting for Derivative Instruments and Hedging Activities." SFAS 133 requires companies to record derivatives on the balance sheet as assets or liabilities, measured at fair value. Gains or losses resulting from changes in the values of the derivatives would be accounted for depending on the use of the derivatives and whether they qualify for hedge accounting. In June 1999, the FASB also issued Statement of Financial Accounting Standards No. 137 ("SFAS 137"), which defers the effective date of SFAS 133 until fiscal years beginning after June 15, 2000. The Company does not believe that adoption of SFAS 133 (as amended by SFAS 137) will have a material effect on its future results of operations.
Effective April 1, 1998, the Company completed its acquisition of certain PHC health plans from Principal Life for a total purchase price of approximately $330.2 million including transaction costs of approximately $5.7 million. The acquisition was accounted for using the purchase method of accounting and, accordingly, the operating results of PHC have been included in the Company's consolidated financial statements since the date of acquisition. The purchase price consisted of 25,043,704 shares of the Company's common stock at an assigned value of $11.96 per share. In addition, a warrant valued at $25.0 million ("the Warrant") was issued that grants Principal Life the right to acquire additional shares of the Company's common stock in the event that its ownership percentage of such common stock is diluted below 40%. The Warrant is included as a component of additional paid-in capital in the accompanying consolidated financial statements. Through April 2003, Principal Life is restricted from buying additional shares of the Company's common stock to increase its ownership percentage above 40%.
and waived its rights to reinsure and renew Principal Life's health insurance indemnity business located in the Company's service area. The Company received $19.8 million in cash in exchange for waiving these rights. At the date of the amendment, the Renewal Rights and Coinsurance Agreements had a net book value of $19.7 million resulting in an after tax gain of $0.1 million.
As a result of the acquisition, the Company assumed an agreement with Principal Life, whereby Principal Life paid a fee for access to the Company's PPO network based on a fixed rate per employee entitled to access the PPO network and a percentage of savings realized by Principal Life. Effective June 1, 1999, Coventry sold the Illinois portion of the PPO network back to Principal Life. Under this agreement, the Company recognized revenue of approximately $8.0 million and $12.0 million for the years ended December 31, 1999 and 1998, respectively.
In the fourth quarter of 1999, the Company notified the Indiana Department of Insurance of its intention to close its subsidiary, Coventry Health Care of Indiana, Inc. As of December 31, 1999, the health plan had approximately 23,000 members throughout the state. As a result of the cost associated with exiting the Indiana market, the Company recorded a reserve of $2.0 million in the fourth quarter of 1999. The Company plans to close the health plan by the end of the fourth quarter 2000 and has expended approximately $0.4 million as of December 31, 1999.
The purchase price for certain of the PHC plans was allocated to the assets, including the identifiable intangible assets, and liabilities based on estimated fair values. The $174.0 million excess of purchase price over the net identified tangible assets acquired was allocated to identifiable intangible assets and goodwill. The allocated amounts, net of the Florida and Illinois health plans and net of the impact of waiving the Renewal Rights and Coinsurance Agreements and the expiration of the Marketing Services Agreement, Management Services Agreement and PPO access agreement, and their related useful lives are as follows:
Effective October 1, 1999, the Company acquired Carelink Health Plans ("Carelink"), the managed care subsidiary of Camcare, Inc., for a total purchase price of approximately $8.3 million including transaction costs of approximately $0.3 million. The acquisition was accounted for using the purchase method of accounting, and, accordingly, the operating results of Carelink have been included in the Company's consolidated financial statements since the date of the acquisition. The purchase price for Carelink was allocated to the assets, including the identifiable intangible assets, and liabilities based on estimated fair values. The $4.7 million excess of purchase price over the net identified tangible assets acquired was allocated to goodwill which is amortized over a useful life of 25 years. The final purchase price may be adjusted subject to the results of the final determination of the balance sheet of Carelink as of October 1, 1999.
Effective March 31, 1997, the Company completed its sale of the medical offices associated with HealthAmerica Pennsylvania, Inc., ("HealthAmerica"), in Pittsburgh, Pennsylvania, to a major health care provider organization. The sales price was $20.0 million resulting in a pretax gain of approximately $6.0 million. Coincident with the sale, the Company entered into a long-term global capitation agreement with the purchaser which increased the globally capitated membership in western Pennsylvania to approximately 250,000 members. Under the agreement, the provider organization receives a fixed percentage of premiums to cover all of the medical treatment
The Company and certain affiliated hospitals of Allegheny Health, Education and Research Foundation ("AHERF") were involved in litigation to determine if the Company had the financial responsibility for medical services provided to the Company's members by the hospitals as a consequence of the bankruptcy filed by AHERF on July 21, 1998. As a result of the bankruptcy, AHERF failed to pay for medical services under its global capitation agreement with the Company covering approximately 250,000 Company members in the western Pennsylvania market.
Shortly after AHERF filed for bankruptcy protection, the Company filed a lawsuit against AHERF's non-debtor, affiliated hospitals seeking a declaratory judgment that the Company was not obligated to pay in excess of $21.5 million to the hospitals for medical services provided by them to the Company's members. The lawsuit also included additional claims for monetary damages. In response, the hospitals filed a counterclaim alleging that the Company's subsidiary, HealthAmerica Pennsylvania, Inc., was liable to the hospitals for payment of these medical services.
Depreciation expense for the years ended December 31, 1999, 1998, and 1997 was approximately $13.6 million, $12.2 million, and $8.9 million, respectively.
Proceeds from the sale and maturities of investments were approximately $253.5 million and $122.9 million for the years ended December 31, 1999 and 1998, respectively. Gross investment gains of approximately $1.0 million and gross investment losses of approximately $1.2 million were realized on these sales for the year ended December 31, 1999 compared to gross investment gains of approximately $0.9 million and no gross investment losses on these sales for the year ended December 31, 1998.
The effect of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities at December 31, 1999 and 1998 are presented below (in thousands):
During the second and third quarters of 1999, the Company converted all Coventry Notes held by Warburg and Franklin totaling $47.1 million, including interest, into 4,709,545 shares of Series A redeemable convertible preferred stock ("preferred stock") at a price of $10 per share. The preferred stock is subject to mandatory redemption at a price of $10 per share, plus accrued dividends, in an amount equal to one-third of the shares outstanding on May 15, 2002, 2003 and 2004. The stock is carried at its fair value, which equals both its redemption value and liquidation value as of December 31, 1999 and will accrue dividends only if the Board of Directors declares dividends on common stock. The dividends (per share) on the preferred stock would be equal to the dividends on the common stock. The preferred stock may be converted at any time at the holders' option into shares of common stock at a conversion price equal to the closing market price of the Company's common stock on the date of conversion, if the closing market price is less than $10 per share. If the closing market price of the Company's common stock is greater than $10 per share, the preferred stock is convertible to common stock on a share for share basis. The preferred stock is callable by the Company if the market price of the Company's common stock exceeds certain agreed upon targets.
The fair value of the Company's long-term borrowings is based on quoted market rates. The carrying amount of the Company's borrowings approximates fair value.
As of December 31, 1999, the Company had one stock incentive plan, the Amended and Restated 1998 Stock Incentive Plan (the "1998 Plan"), with an aggregate of 7 million shares of common stock authorized for issuance thereunder to key employees, consultants and directors in the form of stock options, restricted stock and other stock-based awards. At April 1, 1998, the 1998 Plan assumed the obligations of six stock option plans of Coventry Corporation with total outstanding options representing 3,322,714 shares, and one stock option plan of Principal Health Care, Inc. with total outstanding options representing 750,000 shares, as a result of the acquisition of the PHC plans. Under the 1998 Plan, the terms and conditions of grants are established on an individual basis with the exercise price of the options being equal to not less than 100% of the market value of the underlying stock at the date of grant. Options generally become exercisable after one year in 20% to 25% increments per year and expire ten years from the date of grant. The 1998 Plan is authorized to grant either incentive stock options or nonqualified stock options at the discretion of the Compensation and Benefits Committee of the Board of Directors.
As of September 10, 1998, employees of the Company were offered an opportunity to exchange their existing options (issued at a higher exercise price) for a reduced number of new options (issued at a lower exercise price) equivalent to the same value as their existing options, based upon a Black-Scholes equal valuation model. Employees could choose to decline the offer of new options and keep their existing options. As a result, the Company canceled approximately 4,370,100 options, and reissued re-priced options equal to approximately 3,714,182 shares. The options canceled were at exercise prices ranging from a high of $22.750 to a low of $6.3750. The options were reissued in accordance with an exchange formula (using the Black-Scholes equal valuation model) that issued one-half of the new options at an exercise price of the then current market value ($5.00) and the remaining one-half at 150% of the then current market value ($7.50). The resulting value of the repriced options was the same as the exchanged options.
During 1997, the Company adopted the 1997 Stock Incentive Plan (the "1997 Plan"). Under the 1997 Plan, the Company may grant options and other rights with respect to the Company's common stock to officers, other key employees, consultants and outside directors of the Company. A total of 1,600,000 shares of common stock was reserved for this issuance.
The Company follows APB No. 25, under which no compensation cost has been recognized in connection with stock option grants. Had compensation cost for these plans been determined consistent with SFAS 123, the Company's net income and earnings per share would have been reduced to the following pro forma amounts (in thousands, except per share data):
The fair value of the stock options included in the pro forma amounts shown above was estimated as of the grant date using the Black-Scholes option-pricing model with the following weighted-average assumptions:
At December 31, 1999, the Company had outstanding warrants granting holders the right to purchase 5,690,188 shares of common stock. In July 1995, 100,000 warrants were issued at a price of $14.125 and expire in July 2000. During the first half of 1996, warrants for 170,000 shares were exercised at a price of $6.75 per share.
On May 1, 1997, the Company issued warrants to certain providers to purchase a total of 24,825 shares of common stock at an exercise price of $12.625 per share, expiring in 2002. On May 18, 1998, the Company issued warrants to four individual consultants to purchase a total of 40,000 shares of common stock at an exercise price of $13.625 per share, expiring in 2003. On October 22, 1998, the Company issued warrants to certain providers to purchase a total of 10,000 shares of common stock at an exercise price of $7.625 per share, expiring in 2003. On December 21, 1998, the Company issued a warrant to an individual in connection with the acquisition of a health plan to purchase 85,239 shares of common stock at an exercise price of $8.32 per share, expiring in 2003. On December 21, 1998, the Company issued a warrant to an individual in connection with legal services to purchase 50,000 shares of common stock at an exercise price of $7.625 per share, expiring in 2009. On April 19, 1999, the Company issued a warrant to an individual in recognition of years served on the Company's Board of Directors to purchase 10,000 shares of common stock at an exercise price of $7.625 per share, expiring in 2004.
The Company implemented an Employee Stock Purchase Plan in 1994, which allows substantially all employees who meet length of service requirements to set aside a portion of their salary for the purchase of the Company's common stock. At the end of each plan year, the Company will issue the stock to participating employees at an issue price equal to 85% of the lower of the stock price at the end of the plan year or the average stock price, as defined. The Company has reserved 1.0 million shares of stock for this plan and has issued 11,416, 15,016, and 7,074, shares in 1999, 1998, and 1997 respectively.
Throughout 1997, 1998 and the first quarter of 1999, the Company had reinsurance agreements, through its subsidiary CHLIC, with American Continental Insurance Company and Continental Assurance Company for portions of the risk it has underwritten through its products. Beginning in April 1999, the Company entered into new reinsurance agreements with Continental Assurance Company and American Continental Insurance Company with greater coverages. Reinsurance premiums for the years ended December 31, 1999, 1998 and 1997 were approximately $9.9 million, $1.0 million and $0.7 million respectively. Reinsurance recoveries, including amounts receivable, for the same periods were approximately $5.9 million, $0.6 million and $0.4 million.
Medicaid risk exposures in Missouri are reinsured through the State of Missouri mandated program. Reinsurance recoveries for the years ended December 31, 1999, 1998 and 1997 were approximately $3.1 million, $2.1 million and $3.6 million, respectively.
The minimum rental commitments payable and minimum sublease rentals to be received by the Company during each of the next five years ending December 31 and thereafter for noncancellable operating leases are as follows (in thousands):
Financial instruments which potentially subject the Company to concentrations of credit risk consist primarily of cash and cash equivalents, investments in marketable securities and accounts receivable. The Company invests its excess cash in interest bearing deposits with major banks, commercial paper, and money market funds. Investments in marketable securities are managed within guidelines established by the Board of Directors which emphasize investment-grade fixed income securities and limit the amount that may be invested in any one issuer. The fair value of the Company's financial instruments is substantially equivalent to their carrying value and, although there is some credit risk associated with these instruments, the Company believes this risk to be minimal.
Prior to 1998, under the Plan, participants were able to defer up to 15% of their compensation, limited by the maximum compensation deferral amount permitted by applicable law. The Company made matching contributions equal to 100% of the participant's contribution on the first 3% of the participant's compensation deferral and equal to 50% of the participant's contribution on the second 3% of the participant's compensation deferral. Prior to 1998, participants vested in the Company's matching contributions in 20% increments annually over a period of 5 years, based on length of service with the Company and/or its subsidiaries. Effective January 1, 1998, under the Plan and the New Plan, participants may defer up to 15% of their compensation, limited by the maximum compensation deferral amount permitted by applicable law. The Company makes matching contributions in the Company's common stock equal to 100% of the participant's contribution on the first 3% of the participant's compensation deferral and equal to 50% of the participant's contribution on the second 3% of the participant's compensation deferral. Participants will vest in the Company's matching contributions in 50% increments annually over a period of 2 years, based on length of service with the Company and/or its subsidiaries. All costs of the Plan and the New Plan are funded by the Company and participants as they are incurred.
On July 1, 1994, Coventry Corporation adopted a supplemental executive retirement plan (the "SERP"), which covered employees of Coventry Corporation and its subsidiaries who (1) meet certain requirements as to age and management responsibilities and/or salary, (2) are designated as being eligible to participate in the SERP by the Compensation and Benefits Committee of the Board of Directors of the Company, and (3) elect to participate in the SERP and the Plan. A similar supplemental executive retirement plan offered by HAPA was merged into the SERP effective July 1, 1994. The Company, with the approval of Coventry Corporation, adopted and became sponsor of the SERP effective April 1, 1998. Effective April 1, 1998, the SERP Plan name changed to the Coventry Health Care, Inc. Supplemental Executive Retirement Plan. Under the SERP, participants may defer up to 15% of their base salary, and up to 100% of any bonus awarded, over and beyond the compensation deferral limits of the Plan. Effective January 1, 1999, the Company amended the SERP's definition of compensation to exclude income or proceeds from the Company's Stock Incentive Plan and relocation payments. The Company makes matching contributions equal to 100% of the participant's contribution on the first 3% of the participant's compensation deferral and 50% of the participant's contribution on the second 3% of the participant's compensation deferral. Prior to January 1, 1998, participants vested in the Company's matching contributions in 20% increments annually over a period of 5 years, based on length of service with the Company and/or its subsidiaries. Effective January 1, 1998, participants vest in the Company's matching contributions ratably over two years, based on length of service. All costs of the SERP are funded by the Company as they are incurred.
The cost, principally employer matching contributions, of the benefit plans charged to operations for 1999, 1998 and 1997 was approximately $3.6 million, $4.0 million and $1.8 million, respectively.
The National Association of Insurance Commissioners has proposed that states adopt risk-free capital standards that, if implemented, would generally require higher minimum capitalization limits for health care coverage provided by HMOs and other risk-bearing health care entities. To date, no state where Coventry has HMO operations has adopted those standards.
CHLIC's authorized control level risk-based capital is approximately $11.8 million. Total adjusted statutory capital and surplus of CHLIC as of December 31, 1999 was approximately $38.6 million. Statutory deposits for CHLIC as of December 31, 1999 totaled approximately $3.5 million.
In the normal course of business, the Company has been named as a defendant in various legal actions seeking payments for claims denied by the Company, medical malpractice, and other monetary damages. The claims are in various stages of proceedings and some may ultimately be brought to trial. Incidents occurring through December 31, 1999 may result in the assertion of additional claims. With respect to medical malpractice, the Company carries professional malpractice and general liability insurance for each of its operations on a claims made basis with varying deductibles for which the Company maintains reserves. In the opinion of management, the outcome of these actions should not have a material adverse effect on the financial position or results of operations of the Company.
The Company's industry is heavily regulated and the laws and rules governing the industry and interpretations of those laws and rules are subject to frequent change. Existing or future laws could have significant impact on the Company's operations.
(4) The second quarter 1998 operating results were affected by the establishment of a reserve as a result of the bankruptcy filing by AHERF. The establishment of the reserves resulted in a charge to earnings of $55.0 million.
(5) The merger costs were less than the reserve established in the second quarter of 1998, resulting in a credit to earnings of $1.3 million.