(2) In connection with certain acquisitions and restructurings, the Company recorded certain non-recurring incremental costs. See Note 14 of Notes to the Consolidated Financial Statements.
On October 31, 1995, the Company acquired CII Financial, Inc., ("CII") a workers' compensation insurance holding company, for approximately $76.3 million of common stock, in a transaction accounted for as a pooling of interests. The information contained in this Annual Report on Form 10-K includes the results of CII for all periods presented.
The Company derives revenues from its health maintenance organizations, managed indemnity and workers' compensation insurance subsidiaries. To a lesser extent, the Company also derives additional specialty product revenues from non-HMO and insurance products (consisting of fees for workers' compensation administration, utilization management services and ancillary products), professional fees (consisting primarily of fees for providing health care services to non-members and co-payment fees received from members), and investment and other revenue. Medical premium revenues accounted for approximately 71.2%, 67.3% and 68.4% of the Company's total revenues for 1997, 1996 and 1995, respectively. Continued medical premium revenue growth is principally dependent upon continued enrollment in the Company's products and upon competitive and regulatory factors. Effective September 30, 1997, the Company terminated its workers' compensation administrative contract with the state of Nevada. The contract was terminated to allow the Company to participate in the Nevada workers' compensation insurance market when the state allows private insurance companies to begin offering products, which is anticipated for 1999.
During the third quarter of 1997, Sierra Military Health Services, Inc. ("SMHS"), a wholly owned subsidiary of the Company, was notified it had been awarded a multi-year triple-option health benefits ("TRICARE") managed care contract by the Department of Defense to serve TRICARE eligible beneficiaries in Region 1. This region includes more than 600,000 beneficiaries in 13 northeastern states and the District of Columbia. SMHS is currently in the implementation period of the contract with actual health care delivery to commence on June 1, 1998. SMHS subcontracts for the health care delivery, including some of the risk, for parts of the TRICARE contract. The Company believes the TRICARE contract will add approximately $240 million of annualized revenues when health care delivery begins in 1998. Revenues and expenses resulting from this contract are recorded separately on the financial statements. There can be no assurance that the Company will be successful in managing the implementation and delivery of health care services under the multi-year TRICARE contract or that such contract will provide the Company with an adequate level of profitability.
SMHS was notified on February 13, 1998 that the United States General Accounting Office ("GAO") sustained a competitor's protest of the contract award for TRICARE Managed Care Support Region 1 and recommended that the contract be re-bid. The TRICARE Management Activity ("TMA"), along with the Company, has filed a motion requesting that the GAO reconsider its recommendation. If the GAO does not change its recommendation and the TMA follows the recommendation, there are several possible outcomes, including litigation. The Company currently anticipates providing health care delivery for one year of the contract should a re-bid occur.
Revenues. The Company's total operating revenues for 1997 increased 25.4% to $721.7 million from $575.4 million for 1996. The increase was primarily due to medical premium revenue increases of approximately $126.9 million, or 32.8%, from the Company's HMO and managed indemnity insurance subsidiaries. Such premium growth resulted principally from an approximate 30.3% increase in member months (the number of months of each year that an individual is enrolled in a plan). The Company's HMO and insurance subsidiaries' premium rates increased approximately 2.5%, primarily due to an increase in its capitation rate for its Medicare members as established by the Health Care Financing Administration ("HCFA"). The increase was due in part to the Company's participation in HCFA's social HMO program. The Company realized 1% to 3% rate increases for its existing HMO subsidiaries' commercial groups and the managed indemnity subsidiary. However, these increases were offset in part by lower premium rates at Med One Health Plan, an HMO acquired on December 31, 1996. The Company's specialty product revenue increased $12.9 million, or 9.7%, to $146.2 million in 1997 from $133.3 million in 1996. The increase was due to specialty product revenue growth in the workers' compensation insurance market of approximately $8.3 million and an increase in administrative services and other of $4.6 million due primarily to the acquisition of Prime Health, Inc., at the end of 1996. Some of this increase will be offset in the future by the loss of a portion of the state of Nevada's self-insured medical business. Also, effective September 30, 1997, the Company terminated its workers' compensation administrative services contract with the state of Nevada. The contract served approximately 200,000 enrollees and provided approximately $3.2 million in revenues for the year ended December 31, 1997. The contract was terminated to allow the Company to participate in the Nevada workers' compensation insurance market when the state allows private insurance companies to begin offering products, which is anticipated for 1999. Professional fees increased $2.4 million, or 8.3%, over 1996 to $31.2 million. This increase is due in part to the acquisition of the assets and operations of Total Home Care, Inc. ("THC") during the third quarter. THC provides home infusion, oxygen and durable medical equipment services in Nevada and Arizona. During the fourth quarter of 1997, SMHS began the implementation period of its TRICARE contract. The military contract revenue of $4.3 million is a result of this contract. The Company expects these revenues to increase substantially in 1998, subject to the results of the bid protest discussed previously. Investment and other revenue was consistent with the prior year.
Medical and Specialty Product Expenses. Total medical expenses increased by $103.4 million in 1997 compared to 1996. This 32.7% increase resulted from the consolidated member month growth discussed previously. Medical expenses as a percentage of medical premiums and professional fees ("Medical Loss Ratio") increased from 76.0% to 76.9% due primarily to member growth and expansion in areas with higher medical expenses, such as northern Nevada and Texas. In addition, Med One Health Plan has a higher Medical Loss Ratio, which further contributed to the increase in the Company's overall Medical Loss Ratio. Specialty product expenses increased $12.3 million, or 9.4%, over 1996. This increase is due primarily to the increase in workers' compensation premiums noted above. Specialty product revenue and expense is primarily related to the workers' compensation insurance business.
The combined ratio for the workers' compensation insurance business was 101.9% compared to 103.2% for the comparable prior year period. The reduction was due to a 40 basis point decrease in the loss ratio along with a 90 basis point decrease in the expense ratio. Compared to the prior year period, incurred losses for the current accident year were reduced as a result of the Company's ability to overlay and implement managed care techniques to the workers' compensation claims. In addition, the Company had net favorable loss development totaling $9.0 million compared to net favorable loss development of $15.3 million for the comparable prior year period. The favorable development is largely due to actual paid losses below projected losses and the majority of the favorable loss development occurred on the 1992 through 1995 accident years. There can be no assurances that favorable development, or the magnitude thereof, will continue in the future. The losses and loss adjustment expense ratio for the year ended December 31, 1997 reflects the Company's current projection of the ultimate costs of claims occurring in the current as
well as prior accident years. Such projections are subject to change and any change would be reflected in the income statement. Workers' compensation claims are paid over several years. Until payment is made, the Company invests the monies, earning a yield on the invested balance.
Merger, Restructuring and Start-up Expenses. During 1997, the Company recorded and paid expenses of approximately $11.0 million, $8.4 million after tax, for merger-related costs. On March 18, 1997, the Company announced it had terminated its merger agreement with Physician Corporation of America, Inc. ("PCA"). The original agreement had been entered into in November 1996. On March 18, 1997, prior to termination of the merger agreement, PCA filed a lawsuit against the Company in the United States District Court for the Southern District of Florida (the "District Court"), seeking, among other things, specific performance of the merger agreement and monetary damages. The lawsuit has been dismissed for failure to join a necessary party. The Company has also initiated a lawsuit in the Court of Chancery of the State of Delaware seeking a declaratory judgment as well as other remedies. The Company intends to vigorously pursue all remedies available to it; however, there can be no assurance that the Company will prevail in such litigation.
SMHS was notified on February 13, 1998 that the GAO sustained a competitor's protest of the contract award for TRICARE Managed Care Support Region 1 and recommended that the contract be re-bid. The TMA, along with the Company, has filed a motion requesting that the GAO reconsider its recommendation. If the GAO does not change its recommendation and the TMA follows the recommendation, there are several possible outcomes, including litigation. The Company currently anticipates providing health care delivery for one year of the contract should a re-bid occur.
That HMO began business in March 1995 and experienced losses in both years. In the prior year, a portion of these losses resulted in a benefit from minority interests.
General, Administrative and Marketing Expenses. G&A costs increased $8.7 million, or 13.6%, for the twelve months ended December 31, 1996 compared to the twelve months ended December 31, 1995. As a percentage of revenues, however, G&A costs for the twelve months ended December 31, 1996 decreased to 12.6% from 13.6% during the comparable period in 1995. Of the $8.7 million increase in G&A, $3.3 million is in compensation costs primarily resulting from additional employees supporting expanded services, $3.8 million is from percent of premium costs such as broker commissions and premium taxes, and the remaining $1.6 million is made up of various changes which individually are insignificant.
The Company's cash and cash equivalents decreased by approximately $6.8 million to $96.8 million at December 31, 1997, from $103.6 million at December 31, 1996. At December 31, 1997, the Company had working capital of $88.4 million. The primary source of cash received during the year ended December 31, 1997, was operations.
In September 1991, CII issued convertible subordinated debentures (the "Debentures") due September 15, 2001. The Debentures bear interest at 7 1/2% which is due semi-annually on March 15 and September 15. Each $1,000 in principal is convertible into 16.921 shares of the Company's common stock at a conversion price of $59.097 per share. Unamortized issuance costs of $800,000 are included in other assets on the balance sheet and are being amortized over the life of the Debentures. The Debentures are general unsecured obligations of CII only and are not guaranteed by Sierra Health Services, Inc. ("Sierra"). During the twelve months ended December 31, 1997, the Company purchased $30,000 of the Debentures on the open market. At December 31, 1997, CII had total assets of $343.0 million, consisting primarily of investments, and total liabilities of $285.4 million, consisting primarily of reserves for losses and loss adjustment expense and the debentures. For the year ended December 31, 1997, CII had net premiums earned of $129.2 million, investment and other revenue of $17.4 million, and total operating expenses of $135.8 million.
On September 30, 1997, the Company was awarded a TRICARE contract to provide managed health care coverage to eligible beneficiaries in Region 1. This region includes more than 600,000 individuals in Connecticut, Delaware, Maine, Maryland, Massachusetts, New Hampshire, New Jersey, New York, Pennsylvania, Rhode Island, Vermont, Virginia, West Virginia and Washington, D.C. The contract will result in approximately $1.2 billion in estimated revenues over the five-year term of the contract. The expenses incurred in connection with obtaining this contract were expensed in the third quarter as previously discussed. The Company will fund approximately $25.0 million to SMHS during the seven-month
Health care costs generally continue to rise at a faster rate than the Consumer Price Index. The Company uses various strategies to mitigate the negative effects of health care cost inflation, including setting commercial premiums based on its anticipated health care costs, risk-sharing arrangements with the Company's various health care providers, and other health care cost containment measures. There can be no assurance, however, that, in the future, the Company's ability to manage medical costs will not be negatively impacted by items such as technological advances, competitive pressures, applicable regulations, pharmacy costs, utilization changes and catastrophic items, which could, in turn, result in medical cost increases equaling or exceeding premium increases.
In addition to changes in applicable laws and regulations, the Company is subject to various audits, investigations and enforcement actions. These include possible government actions relating to the federal Employee Retirement Income Security Act, which regulates insured and self-insured health coverage plans offered by employers, the Federal Employees Health Benefit Plan, federal and state fraud and abuse laws, and laws relating to utilization management and the delivery of health care. Any such government action could result in assessment of damages, civil or criminal fines or penalties, or other sanctions, including exclusion from participation in government programs. In addition, disclosure of any adverse investigation1
or audit results or sanctions could negatively affect the Company's reputation in various markets and make it more difficult for the Company to sell its products and services.
Statement of Financial Accounting No. 130, "Reporting Comprehensive Income" is effective for periods beginning after December 15, 1997 and requires companies to classify items of other comprehensive income by their nature in a financial statement. Management does not believe this statement will have a material impact on the Company's financial statements. Statement of Financial Accounting No. 131,
"Disclosures about Segments of an Enterprise and Related Information" is also effective for periods beginning after December 15, 1997 and establishes additional standards for segment disclosures in the financial statements. Management has not determined the effect of this statement on its financial statement disclosure.
Management Report on Consolidated Financial Statements.................... 30 Independent Auditors' Report.............................................. 31 Consolidated Balance Sheets at December 31, 1997 and 1996................. 32 Consolidated Statements of Operations for the Years Ended December 31, 1997, 1996, and 1995...................................... 33 Consolidated Statements of Changes in Stockholders' Equity for the Years Ended December 31, 1997, 1996 and 1995................... 34 Consolidated Statements of Cash Flows for the Years Ended December 31, 1997, 1996, and 1995...................................... 35 Notes to Consolidated Financial Statements................................ 36
The management of Sierra Health Services, Inc., is responsible for the integrity and objectivity of the accompanying Consolidated Financial Statements. The statements have been prepared in conformity with generally accepted accounting principles applied on a consistent basis and are not misstated due to fraud or material error. The statements include some amounts that are based upon the Company's best estimates and judgment.
We have audited the accompanying consolidated balance sheets of Sierra Health Services, Inc., and its subsidiaries as of December 31, 1997 and 1996, and the related consolidated statements of operations, stockholders' equity, and cash flows for each of the three years in the period ended December 31, 1997. Our audits also included the financial statement schedules listed in the index at Item 14 (a)(2). These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits.
SIERRA HEALTH SERVICES, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS December 31, 1997 and 1996
SIERRA HEALTH SERVICES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS For the Years Ended December 31, 1997, 1996 and 1995
SIERRA HEALTH SERVICES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS For the Years Ended December 31, 1997, 1996 and 1995
Principles of Consolidation. All significant intercompany transactions and balances have been eliminated. Sierra's wholly owned subsidiaries include Health Plan of Nevada, Inc. ("HPN"), HMO Texas and Med One, all licensed HMOs, Sierra Health and Life Insurance Company, Inc. ("SHL"), a health and life insurance company, Southwest Medical Associates, Inc. ("SMA"), a multi-specialty medical group, CII, a holding company primarily engaged in writing workers' compensation insurance through its wholly owned subsidiaries, Sierra Military Health Services, Inc., ("SMHS"), a company that has been contracted to provide and administer managed care services to certain TRICARE eligible beneficiaries, administrative services companies, a home health care agency, a hospice and a company that provides and manages mental health and substance abuse services.
Medical Expenses. Sierra contracts with hospitals, physicians and other providers of health care under capitated or discounted fee-for-service arrangements including hospital per diems to provide medical care services to enrollees. Capitated providers are at risk for the cost of medical care services provided to the Company's enrollees in the relevant geographic areas; however, the Company is ultimately responsible for the provision of services to its enrollees should the capitated provider be unable to provide the contracted services. Health care costs are recorded in the period when services are provided to enrolled members, including estimates for provider costs which have been incurred as of the balance sheet date but not reported to the Company. Losses on specific contracts, if any, are accrued when measurable.
Discontinued Operations. During 1995, CII sold its interest in a subsidiary for a combination of common stock and warrants of the purchaser. This transaction was recorded as a discontinued operation.
Estimates and Assumptions. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Estimates and assumptions include, but are not limited to, medical and specialty product expenses. Actual results may materially differ from estimates.
Reclassifications. Certain amounts in the Consolidated Financial Statements for the years ended December 31, 1996 and 1995 have been reclassified to conform with the current year presentation.
Marketable debt investments that the Company has the intention and ability to hold to maturity are stated at amortized cost and categorized as held-to-maturity. The remaining marketable debt and equity investments have been categorized as available-for-sale and as a result are stated at their fair value. Unrealized holding gains and losses on available-for-sale securities are included as a separate component of stockholders' equity until realized. Gross realized gains and losses in 1997 were $2,878,000 and $2,373,000, respectively. Realized gains and losses are calculated using the specific identification method and are included in net income.
The following table summarizes the Company's short-term, long-term and restricted investments as of December 31, 1996:
The contractual maturities of available-for-sale short-term, long-term and restricted investments at December 31, 1997 are shown below. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations.
Of the cash and cash equivalents that total $96,841,000 in the accompanying Consolidated Balance Sheet at December 31, 1997, $82,194,000 is limited for use only by the Company's regulated subsidiaries. Such amounts are available for transfer to Sierra from the regulated subsidiaries only to the extent that they can be remitted in accordance with terms of existing management agreements and by dividends which customarily must be approved by regulating state insurance departments. The remainder is available to Sierra on an unrestricted basis.
The following table provides workers' compensation reinsurance information for the three years ended December 31, 1997:
The following table provides a reconciliation of the beginning and ending reserve balances for unpaid losses and LAE. There can be no assurances that favorable development, or the magnitude of the development, will continue in the future.
Revolving Loan. As of December 31, 1997, the Company has drawn $25.0 million on its $100.0 million line of credit ("LOC") for general corporate purposes at a current interest rate of 6.3%. The remaining line of credit may be used for general corporate purposes, including acquisitions, and may be available for additional working capital, if necessary.
Adjustable Rate Mortgage Note. The Company has a mortgage which has an adjustable rate with an interest margin of 3% over the Federal Home Loan Bank Board 11th District Cost of Funds Index, a maximum interest rate of five percentage points above the initial rate of 11.85% and a minimum interest rate of 8%. The interest rate at December 31, 1997 was 8.0%. This mortgage is secured by a medical facility.
A summary of the provision for income taxes for the years ended December 31, 1997, 1996, and 1995 is as follows:
At December 31, 1997, the Company had approximately $27,048,000 of regular tax net operating loss carryforwards which are limited to use at the rate of approximately $7,021,000 per year during the carryforward period. The net operating loss carryforwards can be used to reduce future taxable income until they expire through the year 2011. The Company also has California net operating loss carryforwards of approximately $7,492,000 which expire through the year 2000. In addition to these net operating loss carryforwards, the Company has alternative minimum tax credits of approximately $848,000 which can be used to reduce regular tax liabilities in future years. There is no expiration date for the alternative minimum tax credits. The majority of the above items are subject to both annual and separate company limitations required by the Internal Revenue Code.
Rent expense totaled $5,827,000, $4,945,000 and $4,942,000 in 1997, 1996 and 1995, respectively.
SIERRA HEALTH SERVICES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS For the Years Ended December 31, 1997, 1996 and 1995
Supplemental Executive Retirement Plan. Effective July 1, 1997, the Company adopted a defined benefit retirement plan covering certain key employees. The Company is funding the benefits through the purchase of certain life insurance policies. Benefits are based on, among other things, the employee's average earnings over the five-year period prior to retirement or termination, and length of service. Benefits attributable to service prior to the adoption of the plan are amortized over the estimated remaining service period for those employees participating in the plan.
Other CII Plans. Prior to the acquisition of CII, CII maintained various supplemental benefit, executive benefit, and profit sharing plans. Subsequent to the merger all such plans have been, or are in the process of being, discontinued, terminated, or merged into the Company's existing plans. During the year ended December 31, 1995, CII expensed $1,574,000 under the various plans. Eligible CII employees are included in the Company's plans discussed above.
Stock Option Plans. During 1995 the shareholders of the Company approved the 1995 Long-Term Incentive Plan ("LTIP"). The LTIP provides for the granting of Options, Stock, and other stock-based awards. Under the LTIP 1.2 million shares were reserved along with remaining shares reserved from certain previous stock option and capital accumulation plans which have not been and will not be issued under those plans. Awards are granted by a committee appointed by the Board of Directors. Options become exercisable at such times and in such installments as set by the committee. Under this plan, the exercise price of each option equals the market price of the Company's stock on the date of grant. Options currently granted under the LTIP vest for the employees at a rate of 20% - 25% per year. Options expire one year after the end of the vesting period.
Accounting for Stock-Based Compensation. At December 31, 1997, the Company had three stock-based compensation plans, which are described above. The Company uses the intrinsic value method in accounting for its plans. Accordingly, no compensation cost has been recognized for its fixed stock option plans nor the Purchase Plan. Had compensation cost for the Company's three stock-based compensation plans been determined based on the fair value at the grant dates for awards under those plans, the Company's net income and earnings per share would have been reduced to the pro forma amounts indicated below:
The fair value of each option grant is estimated on the date of grant using the Black-Scholes option pricing model with the following weighted average assumptions used for grants in 1997, 1996 and 1995, respectively: dividend yield of 0% for all years; expected volatility of 35%, 29% and 34%; risk-free interest rates of 5.89%, 5.92%, and 6.12%; and expected lives of four years for all years. The weighted fair value of options granted in 1997, 1996 and 1995 was $12.40, $8.47 and $9.49, respectively.
During the third quarter of 1997, SMHS was notified it had been awarded a multi-year triple-option health benefits ("TRICARE") managed care contract by the Department of Defense to serve eligible beneficiaries in Region 1. This region includes more than 600,000 beneficiaries in 13 northeastern states and the District of Columbia. Development expenses of $18,350,000, $10,600,000 net of taxes, were recorded in the third quarter, primarily for expenses associated with the Company's proposal to serve TRICARE beneficiaries in Region 1. Such expenses had been deferred until award notification. SMHS is currently in the implementation period of the contract with actual health care delivery to commence on June 1, 1998. SMHS subcontracts for health care delivery, including some of the risk, for parts of the TRICARE contract.
During 1995, as part of the Company's clinical expansion and growth efforts, the Company acquired a medical facility in Mohave County, Arizona, across the border from Laughlin, Nevada. This medical facility included a 12-bed hospital. During 1996 the Company implemented a plan to exit the hospital business and has actively pursued buyers for this business. As a result of this plan, the Company recorded a charge of $3,814,000 ($2,860,000 after tax) in the fourth quarter of 1996, primarily to recognize the estimated costs to dispose of the hospital. As of December 31, 1997, the Company has been unable to reach an agreement to sell the hospital.
As a result of higher than expected claim and administrative costs relative to premium rates that can be obtained in certain regional insurance operations and the Company's inability to negotiate adequate provider contracts due to its limited presence in some of these markets, the Company adopted a plan to restructure certain insurance operations during the third quarter of 1996 and recorded a charge of $8,250,000 ($6,187,000 after tax). The plan will allow the Company to focus on more favorable operating markets and improve operating efficiencies. The Company believes that this restructuring, over time, will result in improved cash flow and operating cost savings. These restructuring costs included cancellation of certain contractual obligations of $6,000,000, lease termination costs of $1,500,000 and approximately $750,000 of other costs.