: Properties As of December 31, 2000, the Company leased approximately 83,000 square feet of space for its corporate office in Bethesda, Maryland, of which approximately 38% is subleased. The Company also leased approximately 558,000 aggregate square feet for office space, subsidiary operations, and customer service centers in the various markets where the Company’s health plans operate. The Company’s leases expire at various dates from 2001 through 2009. The Company also owns a building in Richmond, Virginia with approximately 45,000 square feet, which is used for administrative services related to its health plan in that market, of which approximately 46% is leased to others. The Company believes that its facilities are adequate for its operations.
Supplementary Financial Information The following is a summary of unaudited quarterly results of operations (in thousands, except per share data) for the years ended December 31, 2000 and 1999:
(1) In October 1999, the Company reached a settlement with AHERF. As a result of the settlement, the Company released $6.3 million of its AHERF reserve that was reflected as a gain in the fourth quarter of 1999. The Company also recorded a gain in the fourth quarter of 2000, which included a $4.1 million settlement from AHERF’s bankruptcy proceedings and a $4.3 million release of the Company’s AHERF reserve.
: Management's Discussion and Analysis of Financial Condition and Results of Operations The following discussion should be read in conjunction with the accompanying audited consolidated financial statements and notes thereto.
(1) The medical loss ratio (medical expense as a percentage of managed care premiums) was 85.8%, 86.1%, and 86.9% in 2000, 1999 and 1998, respectively.
General Overview Coventry Health Care, Inc. (together with its subsidiaries, “the Company”, “Coventry”, “we”, “our”, or “us”) is a managed health care company operating health plans under the names Coventry Health Care, Coventry Health and Life, Carelink Health Plans, Group Health Plan, HealthAmerica, HealthAssurance, HealthCare USA, Southern Health, and WellPath. The Company provides a full range of managed care products and services including health maintenance organization (“HMO”), point-of-service (“POS”), preferred provider organization (“PPO”), and Medicare Risk and Medicaid products. The Company also administers self-insured plans for large employer groups. Coventry was incorporated under the laws of the State of Delaware on December 17, 1997 and is the successor to Coventry Corporation, which was incorporated on November 21, 1986.
The Company’s commercial managed care premium revenues during the three years ended December 31, 2000 were comprised of premiums from its commercial HMO products and flexible provider products, including PPO and POS products for which the Company assumes full underwriting risk. Premiums for such commercial PPO and POS products are typically lower than HMO premiums due to medical underwriting and higher deductibles and copayments that are required from the PPO and POS members. Premium rates for commercial HMO products are reviewed by various state agencies based on rate filings. While the Company has not had such filings modified, no assurance can be given that approvals for rate submissions will continue.
The public sector managed care premium revenues consist of premiums from the Company’s Medicare 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 products are established by governmental regulatory agencies and may be reduced by regulatory action.
PHC Acquisitions and Dispositions 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, 2000, Principal Life had exercised a portion of the Warrant to purchase 59,783 shares of the Company’s common stock.
Coincident with the closing of the transaction, Coventry entered into a Renewal Rights Agreement and a Coinsurance Agreement with Principal Life, to manage certain of Principal Life’s indemnity health insurance policies in the markets where Coventry does business and, on December 31, 1999, to offer to renew such policies in force at that time. Effective June 1, 1999, Coventry amended these agreements with Principal Life and waived its rights to reinsure and renew Principal Life’s health insurance indemnity business located in Coventry’s service area. Coventry 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 a gain of $0.1 million.
As a result of the acquisition, Coventry assumed an agreement with Principal Life, whereby Principal Life pays a fee for access to Coventry’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, Coventry recognized revenue of approximately $8.0 million and $12.0 million for the years ended December 31, 1999 and 1998, respectively.
The Indiana health plan did not operate profitably or demonstrate good prospects for future growth. Although closing the plan did not have a substantial effect on consolidated earnings, it did allow Coventry to focus resources and management attention on its other markets. Coventry’s transition plan gave employers and members ample time to obtain health care coverage through one of the many other companies operating in Indiana.
Effective February 1, 2000, the Company completed its acquisition of The Anthem Company’s West Virginia managed care subsidiary, PrimeONE, Inc., (“PrimeONE”), for a purchase price of $1.25 million plus statutory net worth and transaction costs for a total approximate purchase price of $4.3 million. The acquisition was accounted for using the purchase method of accounting, and, accordingly, the operating results of PrimeONE have been included in the Company’s consolidated financial statements since the date of the acquisition. The purchase price for PrimeONE was allocated to the assets, including the identifiable intangible assets, and liabilities based on estimated fair values. The $0.3 million excess of purchase price over the net identifiable assets acquired was allocated to goodwill, which is being amortized over a useful life of 25 years. This transaction, combined with the Carelink acquisition, solidifies Coventry’s market leadership position in West Virginia.
On February 3, 2000, Coventry completed the acquisition of Prudential Health Care Plan, Inc.‘s (“Prudential”) Medicaid business in St. Louis, Missouri for approximately $100 per member. The final payment for the purchase of the Medicaid business of approximately 9,400 members was made during the third quarter of 2000.
On August 1, 2000, Coventry completed the acquisition of Maxicare Louisiana, Inc., (“Maxicare”), for a purchase price of $550,000 plus statutory net worth and transaction costs for a total approximate purchase price of $3.5 million. As of the purchase date, Maxicare had approximately 14,000 members. The acquisition was accounted for using the purchase method of accounting, and, accordingly, the operating results of Maxicare have been included in the Company’s consolidated financial statements since the date of the acquisition. The purchase price for Maxicare was allocated to the assets, including identifiable intangible assets, and liabilities based on estimated fair values. The $1.7 million excess of purchase price over the net identifiable assets acquired was allocated to goodwill, which is being amortized over a useful life of 25 years.
Legal Proceedings In the normal course of business, the Company has been named as a defendant in various legal actions such as actions seeking payments for claims denied by the Company, medical malpractice actions, and other various claims seeking monetary damages. The claims are in various stages of proceedings and some may ultimately be brought to trial. Incidents occurring through December 31, 2000 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.
Other managed care companies have been sued recently in class action lawsuits claiming violations of the federal racketeering act, Racketeer Influenced and Corrupt Organizations (“RICO”), and the Employee Retirement Income Security Act of 1974 (“ERISA”), and generally claiming that managed care companies overcharge consumers and misrepresent that they deliver quality health care. Although it is possible that the Company may be the target of a similar suit, the Company believes there is no valid basis for such a suit.
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 effect on the Company’s operations.
Management services revenue decreased in 2000 from the prior year as a result of the expiration of the PPO Access, Marketing Services and Management Services Agreements with Principal Life. The expiration of these agreements was anticipated and was offset by reduced SG&A expenses as a percentage of revenue, premium rate increases and strategic acquisitions.
Medical claim liability accruals are continually monitored and reviewed, with differences for actual settlements from reserves reflected in current operations. In addition to the procedures for determining reserves as discussed above, the Company reviews the actual payout of claims relating to prior period accruals, which may take more than six months to develop fully. Medical costs are affected by a variety of factors, including the severity and frequency of claims, that are difficult to predict and may not be entirely within the Company’s control. The Company continually refines its actuarial practices to incorporate new cost events and trends.
Other income, net of interest expense, increased 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.
The Company’s investment guidelines emphasize investment grade fixed income instruments in order to provide short-term liquidity and minimize the risk to principal. The Company believes that since its long-term investments are available-for-sale, the amount of such investments should be added to current assets when assessing the Company’s working capital and liquidity. On such basis, current assets plus long-term investments available-for-sale less current liabilities increased to $285.9 million at December 31, 2000 from $225.9 million at December 31, 1999.
The Company’s HMOs and its insurance company subsidiary, Coventry Health and Life Insurance Company (“CH&L”), 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 $114.3 million and $102.6 million at December 31, 2000 and December 31, 1999, respectively. If all states adopt a policy that would require the health plans to maintain a statutory reserve equal to 200% of their Risk-Based Capital (“RBC”), the Company’s HMO subsidiaries would have a surplus in excess of statutory requirements of approximately $41.1 million at December 31, 2000. CH&L had surplus in excess of statutory requirements of approximately $7.9 million and $9.8 million at December 31, 2000 and amended 1999, respectively. The decrease was due primarily to statutory RBC requirements changing from 200% to 250% of authorized control level RBC. Excluding funds held by entities subject to regulation, the Company had cash and investments of approximately $79.1 million and $61.1 million at December 31, 2000 and December 31, 1999, 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 impairment of net worth requirements.
During the second and third quarters of 1999, the Company converted all Coventry Notes held by Warburg and Franklin totaling $47.1 million, including accumulated 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 was convertible to common stock on a share-for-share basis, subject to adjustment for anti-dilution, and was callable by the Company if the market price of the Company’s common stock exceeded certain agreed upon targets. On July 20, 2000, Franklin converted all of its 473,705 shares of preferred stock into 473,752 shares of common stock of the Company on a one-for-one basis as adjusted for anti-dilution in January 2001. On December 26, 2000, Warburg converted all of its 4,235,840 shares of preferred stock into 4,236,263 shares of common stock of the Company on a one-for-one basis adjusted for anti-dilution, thus eliminating all outstanding shares of preferred stock.
Legislation and Regulation Numerous proposals have been introduced in the United States Congress and various state legislatures relating to health care reform. Some proposals, if enacted, could among other things, restrict the Company’s ability to raise prices and to contract independently with employers and providers. Certain reform proposals favor the growth of managed health care, while others would adversely affect managed care. Although the provisions of any legislation adopted at the state or federal level cannot be accurately predicted at this time, management of the Company believes that the ultimate outcome of currently proposed legislation would not have a material adverse effect on the Company and its results of operations in the short-term.
Litigation and Insurance The Company may be subject to certain types of litigation, including medical malpractice claims, claim disputes pertaining to contracts and other arrangements with providers, employer groups and their employees and individual members, and disputes relating to HMO denials of coverage for certain types of medical procedures or treatments. In addition, the Company has contingent litigation risk in connection with certain discontinued operations. Such litigation may result in losses to the Company. The Company maintains insurance coverage in amounts it believes to be adequate, including professional liability (medical malpractice) and general liability insurance. Contracting physicians are required to maintain professional liability insurance. In addition, the Company carries “stop-loss” reinsurance to reimburse it for costs resulting from catastrophic injuries or illnesses to its members. Nonetheless, no assurance can be given as to the future availability or cost of such insurance and reinsurance or that litigation losses will not exceed the limits of the insurance coverage and reserves. In the opinion of management and based on the facts currently known, the outcome of these actions should not have a material adverse effect on the financial position or results of operations of the Company.
New Accounting Standards In June 1998, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 133, “Accounting for Derivative Instruments and Hedging Activities.” SFAS No. 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, which defers the effective date of SFAS No. 133 until fiscal years beginning after June 15, 2000. In June 2000, the FASB issued SFAS No. 138, which amends SFAS No. 133 with regards to specific hedging risks, foreign-currency-denominated assets and liabilities, and intercompany derivatives. Effective January 1, 2001, the Company adopted SFAS No. 133 (as amended by SFAS No. 137 and SFAS No. 138). Accordingly, a transition gain of $0.9 million, net of tax, at December 31, 2000, will be recorded in the first of quarter 2001 related to one financial instrument classified as derivative in nature.
The FASB has also issued SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information.” This standard requires that a public business enterprise report financial and descriptive information about its reportable operating segments. Operating segments are components of an enterprise about which separate financial information is available that is evaluated regularly by the chief operating decision-maker in deciding how to allocate resources and in assessing performance. SFAS No. 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. Effective December 31, 1998, the Company adopted SFAS No. 131.
2001 Outlook The Company’s membership in January 2001 was approximately 1,725,000 members, an increase of 16.2% over January 2000. The increase was primarily attributable to acquisitions in North Carolina, Louisiana and West Virginia. Of the January 2001 membership, approximately 1,438,000 were risk members and 287,000 were non-risk members.
For 2001, the Company continues to pursue ways to improve its underwriting processes and oversight in both risk and management services products with the objective of increasing premium yields and profitable growth in its markets. The Company’s migration of certain of its operating activities (e.g., customer service, claims processing, billing and enrollment) to regional service centers is expected to provide improved levels of service in a more cost-effective manner. Management believes that existing markets have potential for growth for the Company’s commercial and governmental products. Management believes that the foregoing should result in progressive improvements in 2001, although realization is dependent upon a variety of factors, some of which may be outside the control of the Company.
Provider Channel. The Company continues to work with WebMD, Inc., (“WebMD”), and to roll out WebMD’s full suite of services to health care providers in the Company’s multiple markets. The Company is currently implementing WebMD’s Internet services to manage the electronic submission and processing of eligibility determination, referrals and authorizations, claims submission, claim status, and reporting in two markets: Group Health Plan in St Louis, Missouri, central and southern Illinois; and HealthAmerica in central and western Pennsylvania, to be followed by the Company’s other health plans in 2001 and early 2002. In early 2001, the Company will benefit from the integration of WebMD Transaction Services, (formerly Envoy), with WebMD’s Internet services and will deliver many of the transactions formerly available only through the Internet, to any WebMD connected appliance. The Company expects to gain administrative savings from expanded real-time transaction processing, as well as enhanced provider connectivity and increased provider satisfaction. It is expected that this relationship will improve service to all our health care providers as well as the members they serve.
Member/Employer Channel. The Company continues to work with US Internetworking (“USi”) for web site design through implementation and hosting services. The USi project replaced all of the Company’s legacy corporate and health plan web sites with professionally designed “customer centric” web sites, easily navigated by members, employers, physicians and brokers for rich health plan and health care information and on-line customer service transaction functionality. The Company is also live with a new online formulary, which is being used internally by the Company’s customer support services, as well as externally by the Company’s customers.
The rollout of secure web transaction functionality for the Company’s health plan members is underway. The ‘normal business hours’ restriction no longer applies to servicing Coventry members. Members can now access eligibility, benefit, claim and referral information online as well as request ID cards. Primary care physician and address change requests may also be submitted via the web, all through the use of a secure ID and password. Additionally, the Company provides links to health care and medical information on the Internet, including the WebMD Consumer Portal.
Premium rates for managed care plans generally have increased in recent months, but we could experience severely limited increases in future premium rates. Also, we derived 27.3% of our premium revenues for the year ended December 31, 2000 from governmental programs, including Medicare and Medicaid. The government generally calculates these premium rates and we cannot adjust them based on our anticipated costs. Recent legislation has limited Medicare premium rate increases substantially as compared to increases permitted in prior years. As a result, in the future the total costs of our government programs could exceed the total premiums that these programs pay to us.
In the future, we may not be able to increase or maintain our current revenues. Increases in our revenues will generally be dependent upon our ability to increase premiums and membership. Several factors may affect our ability to maintain or increase revenues, including:
Our failure to accurately estimate future health care costs may result in premiums that are insufficient to cover medical costs, which may negatively affect our operating results.
If we underestimate the costs of health care services and supplies that we provide to our members, we may set our premium rates too low. Low premiums may render us unable to generate revenues sufficient to pay future health care costs. This shortfall could significantly change our results of operations, affect profitability and adversely affect the value of your investment in us. While we attempt to base the premiums we charge, at least in part, on our estimate of expected health care costs over the fixed premium period, various factors may limit our ability to fully base premiums on estimated costs and could cause actual health care costs to exceed estimated health care costs. These factors could include:
Failure to obtain cost-effective agreements with a sufficient number of providers may result in higher medical costs and loss of membership.
We expect that providers contracting with us will serve substantially all of our members by providing the required medical care. Our ability to contract successfully with a sufficiently large number of providers in a particular geographic market will impact the relative attractiveness of our managed care products in those markets. In addition, the terms of those provider contracts also have a material affect on our medical costs and our ability to control these costs.
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 our members may prefer to utilize other providers with whom we do not have capitation contracts.
Significant shareholders may have the ability to exercise control over us.
When Warburg purchased the 10 million shares of our common stock from Principal Life in September 2000, Warburgs’ ownership interest increased to approximately 29.5% of our fully diluted common shares. Warburg may purchase additional shares of our common stock, but Warburg has agreed, effective through May 2005, not to own more than 34.9% of our common stock on a fully diluted basis. Once the previously agreed upon limitations imposed on Warburg expire in May 2003, Warburg could acquire additional shares of our common stock to the point that it exercises virtually complete control over the Company.
Future and existing laws and regulations may impact our business and negatively affect our profitability.
the United States Office of Personnel Management that contracts with us to provide managed health care services for federal employees under the Federal Employees Health Benefits Program;
states that contract with us to provide a Medicaid product to eligible recipients.
In the future, we may not be able to meet certain minimum capitalization requirements that may be adopted by states in which we do business.
Costs associated with litigation may result in losses to us that could negatively affect us.
We have audited the accompanying consolidated balance sheets of Coventry Health Care, Inc. (a Delaware corporation) and subsidiaries as of December 31, 2000 and 1999, and the related consolidated statements of operations, stockholders' equity and cash flows for each of the three years in the period ended December 31, 2000. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Coventry Health Care, Inc. and subsidiaries as of December 31, 2000 and 1999, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2000 in conformity with accounting principles generally accepted in the United States.
The Company began operations in 1987 with the acquisition of the American Service Companies (“ASC”) entities, including the Coventry Health and Life Insurance Company (“CH&L”). In 1988, the Company acquired HealthAmerica Pennsylvania, Inc. (“HAPA”), a Pennsylvania HMO. In 1990, the Company acquired Group Health Plan, Inc. (“GHP”), a St. Louis, Missouri HMO. Southern Health Services, Inc. (“SHS”), a Richmond, Virginia HMO, was acquired by the Company in 1994. In 1995, the Company acquired HealthCare USA, Inc. (“HCUSA”), a Jacksonville, Florida based Medicaid managed care company. In 1998, the Company acquired certain assets of Principal Health Care, Inc. (“PHC”) from Principal Mutual Life Insurance Company, now known as Principal Life Insurance Company (“Principal Life”). On October 1, 1999, the Company acquired Carelink Health Plans (“Carelink”) from Camcare, Inc. On February 1, 2000, the Company acquired PrimeONE, Inc. from The Anthem Company. On August 1, 2000, the Company acquired Maxicare Louisiana, Inc. (“Maxicare”), a Louisiana HMO. On October 1, 2000, the Company acquired WellPath Community Health Plans (“WellPath”), the managed care subsidiary of Duke University Health System. See Notes B and C to consolidated financial statements for additional information on acquisitions.
Other Receivables - Other receivables include interest receivable, reinsurance claims receivable, receivables from providers and suppliers and any other receivables that do not relate to premiums.
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, 2000 are as follows (in thousands):
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 SFAS No. 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 H for disclosures related to income taxes.
In March 2000, the FASB issued Interpretation (“FIN”) No. 44, “Accounting for Certain Transactions Involving Stock Compensation - an Interpretation of APB No. 25.” FIN No. 44 clarifies the application of APB No. 25 for certain issues including: (a) the definition of “employee” for purposes of applying APB No. 25, (b) the criteria for determining whether a plan qualifies as a non-compensatory plan, (c) the accounting consequence of various modifications to the terms of a previously fixed stock option or award, and (d) the accounting for an exchange of stock compensation awards in a business combination. In general, FIN No. 44 was effective July 1, 2000. The adoption of FIN No. 44 did not have a material effect on the Company's financial position or results of operations.
Governmental products include Medicare Risk and Medicaid. The Company provides comprehensive health benefits to members participating in government programs and receives premium payments from federal and state governments. The Company evaluates the performance of its operating segments and allocates resources based on gross margin. Assets are not allocated to specific products and, accordingly, cannot be reported by segment. See Note S for disclosures on segment reporting.
Business Combinations and Intangibles, Accounting for Goodwill - In February 2001, the FASB issued a revised Exposure Draft entitled “Business Combinations and Intangibles - Accounting for Goodwill.” This proposed Statement would prohibit registrants from using the pooling method of accounting for business combinations. This guidance would also continue to require recognition of purchased goodwill as an asset but would prohibit amortization of such goodwill. Goodwill would instead be tested for impairment on an ongoing basis using a fair-value-approach, and any adjustments thereto would result in a separate charge to earnings in the period in which the impairment took place. The Statement would become effective at the beginning of the fiscal quarter immediately following the date of issuance. Earlier application would not be permitted, nor would retroactive application to financial statements of prior periods. The effect, on the Company, of the adoption of this proposed Statement would be to eliminate goodwill amortization expense, the annual amounts of which are shown previously in this Note.
Reclassifications - Certain 1998 and 1999 amounts have been reclassified to conform to the 2000 presentation.
B. PHC ACQUISITIONS AND DISPOSITIONS 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%.
Coincident with the closing of the transaction, the Company entered into a Renewal Rights Agreement and a Coinsurance Agreement with Principal Life, to manage certain of Principal Life’s indemnity health insurance policies in the markets where the Company does business and, on December 31, 1999, to offer to renew such policies in force at that time. Effective June 1, 1999, the Company amended these agreements with Principal Life 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 a gain of $0.1 million.
On December 31, 1998, the Company sold its subsidiary, Principal Health Care of Florida, Inc., for $95.0 million in cash. The Florida health plan accounted for approximately 156,000 risk members and 5,500 non-risk members as of December 31, 1998.
The proceeds from both sales were used to retire the Company’s credit facility, to assist in improving the capital position of its regulated subsidiaries, and for other general corporate purposes. Given the short time period between the respective acquisition and sale dates and the lack of events or other evidence which would indicate differing values, no gain or loss was recognized on the sales of the Florida and Illinois health plans, as the sale prices were considered by management to be equivalent to the fair values allocable to these plans at the date of their acquisition from Principal Life in April 1998.
The following unaudited pro-forma condensed consolidated results of operations assumes the PHC acquisition and the sales of the Florida and Illinois health plans occurred on January 1, 1998, and excludes the non-recurring charge to merger costs of $6.5 million (see Note E), in thousands, except per share data.
On November 1, 1999, the Company’s subsidiary, Coventry Health Care of the Carolinas, Inc., acquired Kaiser Foundation Health Plan of North Carolina’s (“KFHPNC”) commercial membership in Charlotte, North Carolina. The total purchase price was approximately $2.1 million including transaction costs.
On August 1, 2000, Coventry completed the acquisition of Maxicare Louisiana, Inc. (“Maxicare”) for a purchase price of $550,000 plus statutory net worth and transaction costs for a total approximate purchase price of $3.5 million. As of the purchase date, Maxicare had approximately 14,000 members. The acquisition was accounted for using the purchase method of accounting, and, accordingly, the operating results of Maxicare have been included in the Company’s consolidated financial statements since the date of the acquisition. The purchase price for Maxicare was allocated to the assets, including identifiable intangible assets, and liabilities based on the estimated fair values. The $1.7 million excess of purchase price over the net identifiable assets acquired was allocated to goodwill, which is amortized over a useful life of 25 years.
On October 2, 2000, Coventry completed the acquisition of WellPath Community Health Plans (“WellPath”), for a purchase price of $21.2 million including transaction costs of $0.5 million. The acquisition was accounted for using the purchase method of accounting, and, accordingly, the operating results of WellPath have been included in the Company’s consolidated financial statements since the date of the acquisition. The purchase price for WellPath was allocated to the assets, including identifiable intangible assets, and liabilities based on the estimated fair values. The $5.7 million excess of purchase price over the net identifiable assets acquired was allocated to goodwill, which is amortized over a useful life of 25 years.
D. AHERF CHARGE 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.
As a result, the Company, which is ultimately responsible for medical costs delivered to its members, notwithstanding the global capitation agreement, recorded a charge of $55.0 million in the second quarter of 1998 to establish a reserve for, among other things, the medical costs incurred by its members under the AHERF global capitation agreement at the time of the bankruptcy filing.
As of December 31, 2000, approximately $40.7 million of the $55.0 million reserve had been paid for medical claims and lease expenses. As a result of the settlement, the Company released $6.3 million and $4.3 million of the reserve, which were reflected as gains in the fourth quarter and year-end 1999 and 2000 results, respectively. The balance of the reserve represents the Company’s remaining obligations under the settlement and will be expended through August 2007. As a result of recoveries from the AHERF bankruptcy proceedings, the Company recorded an additional gain of $4.1 million in the fourth quarter of 2000.
Depreciation expense for the years ended December 31, 2000, 1999, and 1998 was approximately $16.9 million, $13.6 million, and $12.2 million, respectively.
G. INVESTMENTS IN DEBT SECURITIES The Company considers all of its investments as available-for-sale securities and, accordingly, records unrealized gains and losses, as other comprehensive income, in the stockholders’ equity section of its consolidated balance sheets. As of December 31, 2000 and 1999, stockholders’ equity was increased by approximately $10.0 million and decreased by $5.9 million, respectively, netted by a deferred tax provision of approximately $3.9 million and a deferred tax benefit of $2.3 million, respectively, to reflect the net unrealized investment loss/gain on securities.
The amortized cost, gross unrealized gain or loss and estimated fair value of short-term and long-term investments by security type were as follows at December 31, 2000 and 1999 (in thousands):
The amortized cost and estimated fair value of short-term and long-term investments by contractual maturity were as follows at December 31, 2000 and December 31, 1999 (in thousands):
H. INCOME TAXES The provision (benefit) for income taxes consists of the following (in thousands):
The expected tax provision based on the statutory rate of 35% differs from the Company’s effective tax rate as a result of the following:
The effect of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities at December 31, 2000 and 1999 are presented below (in thousands):
I. CONVERTIBLE EXCHANGEABLE SUBORDINATED NOTES AND REDEEMABLE CONVERTIBLE PREFERRED STOCK During the quarter ended June 30, 1997, the Company entered into a securities purchase agreement (“Warburg Agreement”) with Warburg, Pincus Ventures, L.P. (“Warburg”) and Franklin Capital Associates III, L.P. (“Franklin”) for the purchase of $40.0 million of the Company’s 8.3% Convertible Exchangeable Senior Subordinated Notes (“Coventry Notes”), together with warrants to purchase 2.35 million shares of the Company’s common stock for $42.35 million. The original amount of the Coventry Notes, $36.0 million held by Warburg and $4.0 million held by Franklin, were exchangeable at the Company’s or Warburg’s option for shares of redeemable convertible preferred stock.
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 cancelled 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 $22.75 to a low of $6.38. 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.
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 earnings and earnings per share (“EPS”) would have been reduced to the following pro-forma amounts (in thousands, except per share data):
Transactions with respect to the plans for the three years ended December 31, 2000 were as follows (shares in thousands):
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 $13.63 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 $7.63 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 $7.63 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 $7.63 per share, expiring in 2004. Warrants issued to West Penn Hospital to purchase 100,000 shares of common stock at $14.13 expired on July 1, 2000.
The Company’s Employee Stock Purchase Plan, implemented in 1994, 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 issues 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 7,883, 11,416, and 15,016, shares in 2000, 1999, and 1998 respectively.
K. REINSURANCE Throughout 1998, 1999 and 2000, the Company had reinsurance agreements with American Continental Insurance Company and Continental Assurance Company for portions of the risk it has underwritten through its products. Reinsurance premiums for the years ended December 31, 2000, 1999 and 1998 were approximately $14.3 million, $9.9 million, and $1.0 million respectively. Reinsurance recoveries, including estimated amounts receivable, for the same periods were approximately $21.5 million, $5.9 million, and $0.6 million.
These reinsurance agreements do not release the Company from its primary obligations to its membership. The Company remains liable to its membership if the reinsurers are unable to meet their contractual obligations under the reinsurance agreements. To minimize its exposure to significant losses from reinsurer insolvency, the Company evaluates the financial condition of its reinsurers on an annual basis. American Continental Insurance Company and Continental Assurance Company are both currently A rated by the A.M. Best Company.
Medicaid risk exposures on approximately 83% of Missouri Medicaid members were reinsured through the State of Missouri mandated program. Reinsurance premiums for the years ended December 31, 2000, 1999 and 1998 were approximately $2.6 million, $2.3 million and $1.6 million, respectively. Reinsurance recoveries through the mandated program for the years ended December 31, 2000, 1999 and 1998 were approximately $3.6 million, $3.1 million and $2.1 million, respectively. In 2001, HCUSA will be reinsured by the Company’s subsidiary Coventry Health and Life Insurance Company.
Total rent expense was approximately $14.0 million, $14.5 million, and $14.6 million for the years ended December 31, 2000, 1999 and 1998, respectively.
N. BENEFIT PLANS On July 1, 1994, Coventry Corporation adopted an employee defined contribution retirement plan qualifying under Internal Revenue Code Section 401(k), the Coventry Corporation Retirement Savings Plan (the “Plan”), which covered substantially all employees of Coventry Corporation and its subsidiaries who meet certain requirements as to age and length of service and who elect to participate in the Plan. Effective March 31, 1998, the Company was formed as the parent company of an affiliated group of companies that includes Coventry Corporation. The Company, with the approval of Coventry Corporation, adopted and became sponsor of the Plan effective April 1, 1998. On April 1, 1998, the Coventry Health Care, Inc. Retirement Savings Plan (the “New Plan”) was adopted and any prior PHC and certain affiliated participant account balances included in the assets of the former PHC qualified retirement plan were rolled over into the New Plan at the election of the former PHC employees. Effective October 1, 1998, the Plan was merged with the New Plan. All employees that were participants under the Plan became participants in the New Plan. On October 1, 1998, the assets of the Plan were merged and transferred to: (1) Principal Life Insurance Company, as funding agent of the assets held under the terms of the Flexible Investment Annuity Contract with Coventry Health Care, Inc., (2) Delaware Charter Guarantee and Trust Company, as custodial trustee of the mutual funds and (3) Bankers Trust Company, as custodial trustee of the New Plan’s participant loans and the Coventry Health Care, Inc. Common Stock. Effective October 1, 1999, pursuant to the merger of Coventry Health Plan of West Virginia, Inc. (“CHC-WV”), a wholly-owned subsidiary of the Company, and Carelink Health Plans, Inc. (“Carelink”) whereby Carelink was the surviving entity, Carelink became an adopting employer of the New Plan. Immediately upon participation in the New Plan, all participant account balances included in the assets of the former Carelink qualified retirement plan were rolled over into the New Plan. Effective February 1, 2000, pursuant to the acquisition approved by Coventry Health Care Development Corporation (“CHCDC”) and the Company, whereby PrimeONE, Inc. (“PrimeONE”) merged with and into Carelink, and Carelink was the surviving entity, PrimeONE became an adopting employer of the New Plan. Immediately upon participation in the New Plan, all participant account balances included in the assets of the former PrimeONE qualified retirement plan were rolled over into the New Plan. Effective August 1, 2000, pursuant to the merger of Coventry Health Care of Louisiana, Inc. (“CHC-LA”), a wholly-owned subsidiary of the Company, and Maxicare, Louisiana, Inc. (“Maxicare”) whereby CHC-LA was the surviving entity, all former Maxicare employees commenced participation in the New Plan. Effective October 1, 2000, pursuant to the acquisition of WellPath Community Health Plans, L.L.C. (“WellPath”) by the Company, WellPath became an adopting employer of the New Plan. Upon participation in the New Plan, all participant account balances included in the assets of the WellPath qualified retirement plans will be rolled over into the New Plan.
The cost, principally employer matching contributions, of the benefit plans charged to operations for 2000, 1999 and 1998 was approximately $3.7 million, $3.6 million, $4.0 million, respectively.
The National Association of Insurance Commissioners has proposed that states adopt risk-based capital standards that, if implemented, would generally require higher minimum capitalization requirements for HMOs and other risk-bearing health care entities. Several states where we have HMO operations have adopted those standards, effective either in 2001 or to be phased-in over a period of years. We do not expect the legislation enacted to date to have a material impact on our consolidated financial position in the near future.
P. OTHER INCOME Other income for the years ended December 31, 2000, 1999, and 1998 includes investment income of approximately $41.2 million, $30.3 million, and $25.5 million, respectively.
Q. EARNINGS PER SHARE Basic earnings per share (“EPS”) is based on the weighted average number of common shares outstanding during the year. Diluted EPS, when applicable, assumes the conversion of convertible notes and the exercise of all options, warrants and redeemable convertible preferred stock using the treasury stock method. Net earnings is increased for the assumed elimination of interest expense on the convertible notes. In all cases, however, losses are not diluted.
U. SUBSEQUENT EVENTS Effective January 1, 2001, the Company completed its acquisition of Health Partners of the Midwest’s commercial membership, for a total purchase price of approximately $4.5 million. This acquisition brings the Company’s total risk membership in St. Louis to more than 346,000 and total self-insured membership to more than 48,000.