(1) Represents reductions in the carrying value of notes receivable in 2002 and 2000, and goodwill in 1999, to their estimated realizable values. (2) The 2003 amount primarily represents a reduction in the valuation allowance on the Company's net deferred tax assets. The 2002 amount primarily represents a decrease in the accrual for estimated income tax liabilities related to certain transactions that occurred in prior years. The 1999 amount primarily represents a charge to establish a valuation allowance against net deferred tax assets. See Note 11 to the accompanying consolidated financial statements for more information on income taxes. (3) Represents reductions in the carrying value of the net assets related to certain dental practices to their estimated realizable value. (4) Effective January 31, 2001, the Company completed the conversion of $47.5 million of debt and $5.3 million of accrued interest into 30 million shares of convertible preferred stock, resulting in an extraordinary gain of $11.3 million, net of transaction expenses. (5) Includes the common share equivalents of the convertible preferred stock, because the holders of the convertible preferred stock participate in any dividends paid on the Company's common stock on an as-converted basis, and because the Company believes the convertible preferred stock is a participating security that is essentially equivalent to common stock, based on all the rights and preferences of both types of stock.
All of the risks set forth in the "Risk Factors" section of this Form 10-K could negatively impact the earnings of the Company in the future. The Company's expectations for the future are based on current information and its evaluation of external influences. Changes in any one factor could materially impact the Company's expectations related to revenue, premium rates, benefit plans offered, membership enrollment, the amount of health care expenses incurred, and profitability, and therefore, affect the forward-looking statements which may be included in this report. In addition, past financial performance is not necessarily a reliable indicator of future performance. An investor should not use historical performance alone to anticipate future results or future period trends for the Company.
The Company has classified all of its investments as "available-for-sale." Accordingly, investments are carried at fair value, based on quoted market prices, and unrealized gains and losses, net of applicable income taxes, are reported in a separate caption of stockholders' equity. In the event there was an unrealized loss on an investment that the Company believed to be other than temporary, the loss would be reported in the statement of operations, instead of in a separate caption of stockholders' equity. As of December 31, 2003, there were no unrealized losses that the Company believed to be other than temporary.
Accounts receivable represent uncollected premiums related to coverage periods prior to the balance sheet date, and are stated at the estimated collectible amounts, net of an allowance for bad debts. The Company continuously monitors the timing and amount of its premium collections, and maintains a reserve for estimated bad debt losses. The amount of the reserve is based primarily on the Company's historical experience and any customer-specific collection issues that are identified. The Company believes its reserve for bad debt losses is adequate as of December 31, 2003. However, there can be no assurance that the bad debt losses ultimately incurred will not exceed the reserve for bad debts established by the Company.
In 2003, the Company reduced the valuation allowance on its net deferred tax assets by $5.7 million, primarily due to a significant improvement in its reported operating results and its expected future operating results, compared to previous years. The Company's net deferred tax assets were fully reserved during the years ended December 31, 2002 and 2001, due to uncertainty about whether those net assets would be realized in the future.
The following table shows the Company's results of operations as a percentage of premium revenue, and is used in the year-to-year comparisons discussed below.
Premium revenue increased by $21.9 million, or 26.3%, from $83.0 million in 2002 to $104.9 million in 2003. The average membership for which the Company provided dental coverage increased by 214,000 members, or 34.7%, from approximately 616,000 members during 2002 to approximately 830,000 members during 2003. Average membership increased in 2003 by 78,000 members due to the acquisition of HN Dental in October 2003. The HN Dental acquisition added 468,000 members to the Company during the last two months of 2003, which resulted in an average increase of 78,000 members for the full year. The operations of HN Dental and HN Vision are included in the accompanying consolidated financial statements beginning on November 1, 2003. Average membership also increased in 2003 by 133,000 members due to the Paramount acquisition in August 2002. The Paramount acquisition added 200,000 members to the Company, which resulted in an average increase of 133,000 members in 2003, compared to 2002. The operations of Paramount are included in the accompanying consolidated financial statements beginning on September 1, 2002. Premium revenue increased by only 26.3% in 2003 even though average membership increased by 34.7%. This was primarily due to the Paramount acquisition, as the business acquired from Paramount consists largely of products that have significantly lower premium rates than the Company's pre-existing business. Substantially all of the Company's premium revenue was derived from dental benefit plans in 2003 and 2002. Premium revenue from vision benefit plans and other products was not material in 2003 or 2002.
There was an income tax benefit of $4.8 million in 2003, which primarily represents a decrease in the valuation allowance on the Company's net deferred tax assets. The Company reduced the valuation allowance primarily due to a significant improvement in its reported operating results and its expected future operating results. There was an income tax benefit of $820,000 in 2002, which primarily represents a decrease in the Company's accrual for estimated income tax liabilities related to certain transactions that occurred in prior years. There was no other current income tax expense in 2002, due to temporary differences between income before income taxes for accounting purposes and taxable income for tax purposes, which resulted in a loss for tax purposes in 2002. See Note 11 to the accompanying consolidated financial statements for more information on income taxes.
Health care services expense decreased by $0.8 million, or 1.3%, from $58.7 million in 2001 to $57.9 million in 2002. The loss ratio increased slightly from 69.2% in 2001 to 69.8% in 2002. The business acquired from Paramount has a significantly lower loss ratio than the Company's pre-existing business, which is primarily due to the type of benefit plan designs sold by Paramount. The effect of the Paramount acquisition on the loss ratio was offset by increases in specialty referral services, supplemental payments, and discounted fee-for-service payments to dental HMO providers. The increase in the cost of specialty referral services was due to an increase in the utilization rate for those services in 2002. Supplemental payments are additional payments made to dentists who are compensated primarily through capitation payments, in connection with the delivery of certain dental procedures by those dentists. The increases in supplemental and discounted fee-for-service payments were partially due to high-cost arrangements with certain providers, which were started early in 2002, and which were terminated prior to the end of 2002. These arrangements resulted in an unusually large amount of supplemental payments and discounted fee-for-service payments in 2002. There was also a general increase in supplemental payments in 2002, which the Company believes is due to more comprehensive submission of claims information by the dentists in its HMO network.
SG&A expense decreased by $0.5 million, or 2.0%, from $25.4 million in 2001 to $24.9 million in 2002. SG&A expense as a percentage of premium revenue was 29.9% in both 2002 and 2001. The decrease in SG&A expense is primarily due to decreases in depreciation expense and furniture rent, and a $350,000 refund of maintenance fees from one of the Company's vendors, which were partially offset by a $250,000 expense in 2002 related to the settlement of stockholder litigation, as described in Note 12 to the accompanying consolidated financial statements, and a $334,000 loss on impairment of notes receivable in 2002. The decrease in depreciation expense is primarily due to the fact that a significant component of the Company's computer software became fully depreciated during 2002. The decrease in furniture rent was due to the purchase of the office furniture used in the Company's primary administrative office through a new capital lease during the second quarter of 2002. The related furniture was formerly leased under an operating lease with relatively expensive terms, compared to the new capital lease. The new capital lease caused an increase in depreciation expense, but this was more than offset by other decreases in depreciation, as noted above. The refund of maintenance fees was primarily due to the settlement of a dispute over the amount of equipment maintenance fees paid by the Company in several prior years. The impairment loss in 2002 is due to an increase in the reserve related to notes receivable, based on the Company's estimate of the net realizable value of the promissory notes.
There was an income tax benefit of $820,000 in 2002, which primarily represents a decrease in the Company's accrual for estimated income tax liabilities related to certain transactions that occurred in prior years, as discussed in Note 11 to the accompanying consolidated financial statements. There was no current income tax expense in 2002, due to temporary differences between income before income taxes for accounting purposes and taxable income for tax purposes. Those temporary differences resulted in a loss for tax purposes in 2002. There was also no deferred income tax expense in 2002, due to the valuation allowance against the Company's net deferred tax assets, as discussed in Note 11 to the accompanying consolidated financial statements.
of HN Dental and HN Vision, which was partially offset by $2.1 million of principal payments on debt and capital lease obligations during 2003.
The acquisition of HN Dental and HN Vision was financed through the issuance of $19.0 million of unsecured convertible promissory notes to certain of the Company's principal stockholders in October 2003. The proceeds from the convertible notes were used to finance the acquisitions, to satisfy the increase in the Company's regulatory net worth requirements related to the PPO/indemnity dental and vision business that was acquired, to provide working capital that may be required in connection with the integration of the acquired businesses into the Company's pre-existing operations, and for general corporate purposes.
The convertible notes bear interest at 6.0% annually, and are convertible into the Company's common stock at the rate of $1.75 per share, at the option of the holder. There are no principal payments due under the convertible notes prior to January 31, 2010, then principal payments are due beginning on January 31, 2010, and each three months thereafter through July 31, 2013, pursuant to a ten-year amortization schedule, and the remaining balance is payable in full on October 31, 2013. The convertible notes are payable in full upon a change in control of the Company, at the holder's option. The Company has the option of redeeming the convertible notes for 229% of face value during the first seven years after the date of issuance, for 257% of face value during the eighth year after issuance, for 286% of face value during the ninth year after issuance, and for 323% of face value during the tenth year after issuance, provided that it redeems all the convertible notes held by each holder for which it redeems any of the notes.
Net cash used by investing activities was $22.9 million in 2003, compared to $0.8 million of net cash provided in 2002. In 2003, there was $10.1 million of net cash used for acquisitions, and an $11.4 million net increase in investments. The increase in investments was due to the fact that the acquired entities had an aggregate of $5.9 million of cash as of the respective closing dates, and the fact that there was $6.4 million of cash provided by operating activities in 2003, as discussed above, all of which was used to purchase investments.
If the entities to which the dental office leases have been assigned fail to make a significant amount of the lease payments, this could have a material adverse affect on the Company. See Note 10 to the accompanying consolidated financial statements for more information on other long-term liabilities, and see Note 12 for more information on operating lease commitments and contingent lease obligations.
Several of the Company's subsidiaries are subject to state regulations that require them to maintain restricted deposits in the form of cash or investments. The Company had total restricted deposits of $2.9 million and $3.3 million as of December 31, 2003 and 2002, respectively.
The Company is not a party to off-balance sheet arrangements as defined by the Securities and Exchange Commission. However, from time to time the Company enters into certain types of contracts that contingently require the Company to indemnify parties against third party claims. The contracts primarily relate to: (i) certain asset purchase agreements, under which the Company may provide customary indemnification to the seller of the business being acquired; (ii) certain real estate leases, under which the Company may be required to indemnify property owners for environmental and other liabilities, and other claims arising from the Company's use of the applicable premises; and (iii) certain agreements with the Company's officers, directors, and employees, under which the Company may be required to indemnify such persons for liabilities arising out of their employment relationship.
The terms of such obligations vary by contract and in most instances a specific or maximum dollar amount is not explicitly stated therein. Generally, amounts under these contracts cannot be reasonably estimated until a specific claim is asserted. Consequently, no liabilities have been recorded for these obligations on the Company's consolidated balance sheets for any of the periods presented.
The Consolidated Financial Statements and the related Notes and Schedule thereto filed as part of this 2003 Annual Report on Form 10-K are listed on the accompanying Index to Financial Statements on page .