As of December 31, 1998, PacifiCare leased approximately 220,000 aggregate square feet of space for its principal corporate headquarters and executive offices in Santa Ana and Costa Mesa, California. In connection with our operations, as of December 31, 1998, we leased approximately 2.2 million aggregate square feet for office space, subsidiary operations, customer service centers and space for computer facilities. Such space corresponds to areas in which our HMOs or specialty managed care products and services operate, or where we have satellite administrative offices. Our leases expire at various dates from 1999 through 2009.
- - In November 1997, we announced our intention to sell our Utah HMO and workers' compensation subsidiaries. We sold our Utah HMO subsidiary on September 30, 1998, and our workers' compensation subsidiary on October 31, 1998.
- - During 1998, we borrowed $30 million to repurchase shares of our common stock and repaid $390 million of the outstanding balance on our credit facility.
- - In January 1998, our board of directors approved a plan to repurchase shares of our outstanding common stock. During 1998, we repurchased 784,000 shares for an aggregate amount of $45 million.
- - In June 1998, substantially all of our 10.5 million shares of Series A preferred stock were converted to 3.9 million shares of Class B common stock.
- - Increases of $301 million from the inclusion of six additional weeks of results in 1998 from the FHP acquisition;
- - Increases of $130 million from premium rate increases that averaged approximately five percent; offset by
OTHER INCOME. Other income increased 134 percent in 1998 from the prior year due primarily to higher revenues from Prescription Solutions and SHUSA.
CONSOLIDATED MEDICAL CARE RATIO AND PROVIDER INSOLVENCY RESERVES. The 1998 consolidated medical care ratio (health care services as a percentage of premium revenue) declined by 0.7 percent compared to 1997. The improved commercial product performance was partially offset by increased provider insolvency reserves. Excluding these reserves, the consolidated medical care ratio was 84 percent. Provider insolvency reserves were immaterial in 1997 and totaled $95 million in 1998 as follows:
The majority of the insolvency reserves relate to specific provider bankruptcies. However, the estimate also includes reserves for potentially insolvent providers, where conditions indicate claims are not being paid or have slowed considerably.
Reserves for other providers totaled $38 million. Approximately $17 million of the reserves recognized in the third and fourth quarters related to another provider that has ceased paying claims in Nevada and Arizona. This provider has not declared bankruptcy. The membership was transitioned to other providers between December 1998 and January 1999. The remaining $21 million is the estimated liability for smaller bankrupt providers and potentially insolvent providers, primarily in California. Other provider insolvency reserves unpaid at December 31, 1998 were approximately $38 million.
Commercial insolvency reserves for FPA totaled $17 million, primarily recognized in the second and third quarters. Other provider insolvency reserves of $16 million were recognized in the fourth quarter and related to Arizona, California, Nevada, Texas and Washington. Excluding commercial provider insolvency reserves, the commercial medical care ratio was 82.0 percent.
MARKETING, GENERAL AND ADMINISTRATIVE EXPENSES. As a percentage of operating revenue, marketing, general and administrative expenses decreased slightly compared to the prior year because we realized the benefits of restructuring and a full year of synergies as a result of the FHP acquisition.
PRETAX CHARGES. The following is a summary of our net pretax charges:
We recognized $11 million of net pretax charges in 1998, primarily for dispositions of unprofitable operations. Favorable OPM settlements in the fourth quarter offset increased reserves recognized in the third quarter. In 1997, Utah, Washington and the workers' compensation subsidiary charges related to the impairment of goodwill. Restructuring reserves recognized in 1997 were spent in 1998.
INTEREST EXPENSE. Interest expense decreased approximately six percent in 1998 compared to the prior year, due to continued repayment of our credit facility and declining interest rates. The decrease was partially offset by interest on the FHP acquisition borrowings that were outstanding for six weeks longer in 1998.
PROVISION FOR INCOME TAXES. The effective income tax rate was 47.5 percent in 1998, compared with 136.1 percent in 1997. The rate declined significantly for two reasons:
DILUTED EARNINGS PER SHARE. For the year ended December 31, 1998, income excluding the pretax charges described above was $208 million or $4.52 diluted earnings per share. For the year ended December 31, 1997, income excluding the pretax charges was $107 million or $2.43 diluted earnings per share. The increase in income was due to:
MEMBERSHIP. Total membership increased 85 percent to approximately 3.8 million members at December 31, 1997, from approximately 2.0 million members at December 31, 1996. The FHP acquisition increased membership by approximately 0.4 million government members and 1.5 million commercial members.
- - HCFA premium rate increases effective January 1, 1997 averaging over six percent;
- - Lower member paid supplemental premiums in several of our markets; and
- - Enrollment gains in the government programs, net of acquisition membership.
- - Decreased membership growth, excluding the FHP acquisition, due to the sale of our Florida operations and a shift in focus from one of rapid growth to improved profit margins through the use of a more disciplined product pricing strategy.
CONSOLIDATED MEDICAL CARE RATIO. The consolidated medical care ratio increased 1.2 percent from the prior year as a result of higher FHP commercial costs. The government medical care ratio for the year ended December 31, 1997 remained flat compared to the prior year. This consistency was largely due to FHP, which had lower cost provider contracts and generally higher reimbursement for Medicare membership. Additionally, the wind down of the Medicaid business contributed to slight decreases in the government medical care ratio. These decreases were partially offset by enhanced prescription drug benefits provided to enrollees combined with lower member paid supplemental premiums. The increase in the commercial medical care ratio included higher cost FHP provider contracts, increased non-capitated physician costs and increased out of area emergency room costs compared to the prior year. The commercial medical care ratio includes the specialty managed care health care costs.
MARKETING, GENERAL AND ADMINISTRATIVE EXPENSES. As a percentage of operating revenue, marketing, general and administrative expenses decreased slightly compared to the prior year. These cost savings were caused by lower than expected staffing, and greater than expected efficiencies resulting from the integration of the FHP administrative functions and information systems.
PRETAX CHARGES. The following is a summary of our pretax charges:
We recognized $155 million of pretax charges in 1997, $124 million related to the write-off of goodwill for our Utah and Washington HMOs and our workers' compensation subsidiary. In 1996, we recognized Florida goodwill impairment of $59 million plus $42 million of OPM, restructuring and Florida disposition losses. Restructuring reserves recognized in 1996 were spent in 1996 and 1997.
The convertible preferred stock and potentially dilutive securities (including stock options) used to calculate diluted loss per share in the fourth quarter and for 1997 were anti-dilutive. Anti-dilution results when diluted earnings per share is a greater value than basic earnings per share. The net loss per share reported in 1997 was due mainly to the pretax charges recognized in the fourth quarter and the high effective tax rate. Because the actual diluted loss per share was less than the basic loss per share, the calculation of the diluted loss per share reported was equal to the basic loss per share.
OPERATING CASH FLOWS IN 1998. PacifiCare's consolidated cash, equivalents and marketable securities increased to $1.6 billion at December 31, 1998 from $1.5 billion at December 31, 1997. The combined increase in cash, equivalents and marketable securities was directly related to current-year earnings that were invested. This increase was partially offset by long-term debt principal payments.
Cash flows from operations increased by $43 million to $456 million in 1998 from $413 million in 1997 as follows:
- - Net decreases of $43 million, primarily related to changes in deferred income taxes.
INVESTING ACTIVITIES IN 1998. Net cash used in investing activities was $19 million in 1998. Purchases of property, plant and equipment of $42 million were offset by $41 million of proceeds from the sale of property, plant and equipment. In 1998, we sold several medical clinics and related personal property acquired in the FHP acquisition. Disposition proceeds were approximately $17 million and were offset by increased investments in all marketable securities totaling $35 million.
INVESTING ACTIVITIES IN 1997. Net cash used by investing activities in 1997 was $1.0 billion for the acquisition of FHP. The proceeds from the subsidiary dispositions and property, plant and equipment in 1997 were $80 million. This was offset by $69 million of property, plant and equipment purchases and $24 million of marketable securities purchases, including restricted.
FINANCING ACTIVITIES IN 1997. In 1997, our financing activities provided $912 million of cash. Of the $912 million of cash, $885 million was the net effect of borrowing $1.1 billion under our credit facility to finance the FHP acquisition, offset by $235 million of credit facility payments in 1997. Proceeds from the issuance of common stock provided $43 million of cash in 1997 while preferred stock dividend payments used $9 million of cash. Finally, in the first quarter of 1997, we made capital contributions totaling $67 million to Talbert Medical Management Corporation, a former subsidiary of FHP. In the second quarter of 1997, we received $60 million from the sale of the Talbert stock.
Provider receivables increased by $19 million. In 1998, we reduced the claims payable backlog from 33 days at the beginning of the year to 30 days at the end of the year. Accelerated claims payments often result in provider receivables that are collected through capitation withhold adjustments and other incentive settlements. Pharmacy rebate receivables increased by $12 million as 1998 prescription drug utilization increased. Premium receivables decreased $26 million. Improved collection efforts in California and Oregon contributed $17 million of the decrease. Outstanding reinsurance receivables declined by $7 million in 1998.
GOODWILL AND INTANGIBLE ASSETS, NET. Goodwill and intangible assets decreased by $145 million from 1997 as follows:
- - $69 million for FHP acquisition exit costs in excess of original estimates. See Note 4 of Notes to Consolidated Financial Statements.
MEDICAL CLAIMS AND BENEFITS PAYABLE. Medical claims and benefits payable decreased by $76 million from 1997 as follows:
- - $11 million increase in provider capitation liabilities; offset by
ACCOUNTS PAYABLE. We experienced a $73 million decline in accounts payable at December 31, 1998 compared to the prior year. This decrease was planned and is related to accounts payable systems changes effective January 1, 1999. We made an effort to decrease accounts payable inventory to ease the number of items that would be converted in the reorganization of the accounts payable system.
MEMBERSHIP. We expect government membership to increase three to four percent by December 31, 1999 compared to 1998. For 1999, we plan to expand our membership retention programs and target group retiree members in our existing markets. We expect membership increases from enhanced drug benefits and new enrollment as competitors exit markets in which Secure Horizons will remain. We also anticipate offering our
Secure Horizon programs in new geographic markets. These increases will be partially offset by the exit of rural markets.
- - Inability of marketing and sales plans to attract new customers; or
believe that the December 31, 1998 provider insolvency reserves are adequate to cover the cost of health care services rendered through 1998 that may not be paid by insolvent or unstable providers. We believe our contingency plans for shifting the membership or assisting the provider to obtain and maintain stability are adequate to cover the risk. We have and may continue to incur additional costs as a result of entering into new contracts, especially for FPA and potentially for MedPartners. The effect of these risks and the need for additional provider reserves could have a material effect on our results of operations or cash flows. We believe, however, that such reserves would not materially affect our consolidated financial position.
GOVERNMENT MEDICAL CARE RATIO. We expect the government medical care ratio in 1999 to remain flat or slightly increase from 1998. Price increases, recontracting efforts in Nevada and California, and our exit of rural markets in four states plus the disposition of Utah are expected to improve the medical care ratio. However, these improvements will be offset by changes in premium mix, increases in capitation, decreases in non-capitated contracts and changes in pharmacy costs. The implementation of the Medicare reform provisions that limit program spending and allow the entry of new providers and plans that could increase competitive pressures could also offset any increases. See Legislation and Regulation below.
MARKETING, GENERAL AND ADMINISTRATIVE SUPPORT. In 1999, marketing, general and administrative expenses as a percentage of operating revenue are expected to decline slightly because we expect to realize additional efficiencies from the FHP acquisition. Additionally, California's final conversion from FHP information systems to PacifiCare systems was completed in June 1998, so 1999 will be the first full year of integrated operations. The need for additional advertising, marketing, administrative, or management information systems expenditures, and the inability of marketing and sales plans to attract new customers, could impact marketing, general and administrative expenses.
IMPAIRMENT OF LONG-LIVED ASSETS. As circumstances warrant, we determine whether the realizable value of long-lived assets such as property and equipment, real estate and goodwill, are less than the value carried on the consolidated financial statements. We believe that any impairment of such long-lived assets would not materially affect our consolidated financial position. However, impairment charges, if material, could have an effect on our results of operations or cash flows of a future period.
YEAR 2000. PacifiCare has implemented a Year 2000 compliance program to address all major computing information systems, including core application systems, networks, desktop systems, infrastructure, and critical information supply chains. In addition to all major information systems, we are verifying that all date fields and calculations used in critical business processes will be Year 2000 compliant. Under the program we are also addressing our external Year 2000 related risks which arise from the year 2000 readiness of third parties with whom we maintain ongoing relationships.
- - Awareness and Communication. There is an on-going company-wide communication and education effort to ensure that there is a clear understanding of the Year 2000 problem and associated risks.
- - Remediation. Based upon the remediation plan developed as part of the assessment phase, appropriate action is taken to correct or remediate the Year 2000 issues associated with the system and its components to render it Year 2000 compliant. Except for the FHP core system, we expect all affected system components to be remediated by March 31, 1999. Contingency plans for critical business functions will be completed as part of this phase as well.
When our Year 2000 compliance program was first established in 1996, we focused on existing systems and did not contemplate acquisitions of other companies. These core computing programs became Year 2000 compliant in 1998. The total cost to make our pre-FHP core computing information systems Year 2000 compliant was approximately $6 million.
With the February 1997 FHP acquisition, we originally expected the Arizona, Colorado, Nevada and Ohio HMOs to shift to our pre-FHP core computing information systems throughout 1998 and 1999 as providers moved to delegated capitation arrangements. In the second quarter of 1998, we determined that while we had successfully moved some of these providers to capitation arrangements, the provider networks did not have sufficient infrastructure to administer the claims under a fully delegated capitated arrangement. We concluded that our HMOs in these states will need to continue to administer claims on behalf of providers.
Our Year 2000 compliance program establishes priorities to achieve resolution of the most business critical issues first. The program incorporates a regular reporting process which helps us to monitor and measure our progress toward Year 2000 compliance against defined goals. Through this reporting process we can focus resources on, any Year 2000 issue, as necessary.
LIQUIDITY AND CAPITAL RESOURCES. Additional borrowings on our credit facility may be necessary if HCFA and OPM are unable to remit funds as a result of Year 2000 compliance issues. We also may continue to repurchase shares of outstanding stock, resulting in reduced cash or additional borrowings on our credit facility. Additional borrowings on the credit facility may make us subject to earlier mandatory reduction of the outstanding balance. Additionally, should the credit facility be drawn, our ability to repay amounts owed under the credit facility and other long-term debt will depend on cash receipts from our subsidiaries' restricted cash reserves. These subsidiary receipts represent fees for management services rendered by us to the subsidiaries and cash dividends by the subsidiaries to us. Nearly all of the subsidiaries are subject to HMO regulations or insurance regulations and may be subject to substantial supervision by one or more HMO or insurance regulators. Subsidiaries subject to regulation must meet or exceed various capital standards imposed by HMO or insurance regulations, which may from time to time impact the amount of funds the subsidiaries can pay to us. Additionally, from time to time, we advance funds in the form of a loan or capital contribution to our subsidiaries to assist them in satisfying federal or state financial requirements. If a federal or state regulator has concerns about the financial position of a subsidiary, a regulator may impose additional financial requirements on the subsidiary, which may require additional funding from us. We believe that
- - Increases in minimum capital and reserves and other financial viability requirements;
- - Prohibition or limitation of capitated arrangements or provider financial incentives;
- - Limitations on the ability to manage care and utilization of any willing provider and direct access laws; and