In conjunction with the Kaiser-Texas acquisition, we purchased eight medical and office facilities with approximately 323,000 square feet of clinical facilities and approximately 175,000 square feet of administrative facilities. These buildings are subject to a deed of trust note with an original balance of $35.2 million and a balance of $34.2 million on December 31, 2000. Approximately 81,000 square feet of the clinical and 67,000 square feet of the administrative space are subleased by us to outside parties. The Texas assets have been written down to market value and are classified as held for sale on our balance sheet while we actively seek a buyer for the properties.
We lease approximately 150,000 square feet of office space in other various states as needed for the military subsidiary's administrative headquarters, TRICARE service centers and other regional operations.
The table below presents our selected consolidated financial information for the years indicated. The table should be read in conjunction with the Consolidated Financial Statements and the related Notes thereto, "Management's Discussion and Analysis of Financial Condition and Results of Operations" and other information which appears elsewhere in this Annual Report on Form 10-K. The selected consolidated financial data below has been derived from our audited Consolidated Financial Statements.
(1) We recorded certain identifiable asset impairment, restructuring, reorganization and other costs. See Note 16 of Notes to the Consolidated Financial Statements.
(2) Adjusted to account for three-for-two stock split of our common stock to stockholders of record as of May 18, 1998.
The following discussion and analysis provides information which management believes is relevant for an assessment and understanding of our consolidated financial condition and results of operations. The discussion should be read in conjunction with the Consolidated Financial Statements and related Notes thereto. Any forward-looking information contained in this Management's Discussion and Analysis of Financial Condition and Results of Operations and any other sections of this 2000 Annual Report on Form 10-K should be considered in connection with certain cautionary statements contained in our Current Report on Form 8-K filed March 20, 2001, which is incorporated by reference. Such cautionary statements are made pursuant to the "safe harbor" provisions of the Private Securities Litigation Reform Act of 1995 and identify important risk factors that could cause our actual results to differ materially from those expressed in any projected, estimated or forward-looking statements relating to us.
Our principal expenses consist of medical expenses, military contract expenses, specialty product expenses, and general, administrative and marketing expenses. Medical expenses represent capitation fees and other fee-for-service payments paid to independently contracted physicians, hospitals and other health care providers to cover members, as well as the aggregate expenses to operate and manage our multi-specialty medical groups and other provider subsidiaries. As a provider of health care management services, we seek to positively affect quality of care and expenses by employing or contracting with physicians, hospitals and other health care providers at negotiated price levels, by adopting quality assurance programs, monitoring and managing utilization of physicians and hospital services and providing incentives to use cost-effective providers. Military contract expenses represent the expenses of delivering health care, as agreed to in the TRICARE contract with the federal government, as well as administrative costs to operate the military health care subsidiary. Specialty product expenses primarily consist of losses and loss adjustment expenses, policy acquisition expenses and other general and administrative expenses associated with our workers' compensation insurance subsidiaries. General, administrative and marketing expenses generally represent operational costs other than those associated with the delivery of health care services, military contract services and specialty product services.
Calendar year 2000 was one of significant challenges and successes for Sierra. In the first quarter, we engaged a consulting firm to assist us in evaluating our Texas operations. One of the results of this evaluation was the development of action plans to improve our Texas operations. This started with a major restructuring of the Dallas/Ft. Worth HMO operations of TXHC, which included replacement of the senior management, reduction in staffing along with consolidation of certain services to Las Vegas and a revision of product strategy. In the second quarter, we implemented another part of the plan by closing certain of our Texas clinic facilities and reducing the physician and support staff. We initiated plans to terminate our contracting relationship with our affiliated medical provider operations in Dallas/Ft. Worth. We stopped actively marketing our Medicare HMO product in Texas while we assessed its cost structure. We then re-evaluated our goodwill asset related to our Texas operations and determined that future cash flows would be insufficient to recover this asset and we completely wrote-off the asset. We also decided to sell our Texas real estate. The market valuations we received resulted in fixed asset impairment charges of approximately $37 million. Concurrently, our real estate holdings in Arizona and one of our underperforming Las Vegas, Nevada clinics were also determined to be impaired based on market valuations, which resulted in fixed asset impairment charges and a re-evaluation of goodwill related to our Prime Holdings, Inc. acquisition of 1997 and a subsequent goodwill impairment charge.
o An increase in medical premiums of $42.1 million o An increase in military contract revenues of $43.0 million o An increase in specialty product revenues of $41.6 million o A decrease in professional fees of $16.2 million o A decrease in investment and other revenues of $1.3 million
Specialty product revenues increased $41.6 million or 44.2%. Revenue increased in the workers' compensation insurance segment by $42.7 million, which was offset by a slight decrease in administrative services revenue of $1.1 million. The increase in the workers' compensation insurance segment was primarily due to a larger amount of direct written premiums with an 18% composite increase in premium rates for all states and a 24% increase in production growth.
Net earned premiums are the end result of direct written premiums, plus the change in unearned premiums, less premiums ceded to reinsurers. Direct written premiums increased by 37% due primarily to growth in California and Nevada. Partially offsetting the growth in direct written premiums was an increase in premiums ceded to reinsurers, which increased by 22%. The growth in ceded reinsurance premiums was lower than the growth in direct written premiums primarily due to the expiration of our low level reinsurance agreement on June 30, 2000 and new lower cost reinsurance agreements, all of which reduced the percentage of premiums being ceded.
Professional fees decreased $16.2 million or 31.3%. The revenue for 1999 included the pharmacy operations in Texas until they were sold during the fourth quarter of 1999 and the inpatient operations at the Mohave Valley Hospital until they were closed during the first quarter of 1999. The fees in 2000 also reflect staffing reductions and subsequent closure or sale of our affiliated medical groups in Texas and Arizona.
The medical expenses for 2000 include the utilization of $20.3 million of premium deficiency reserve to offset losses on contracts in Texas compared to the utilization of $43.9 million in 1999. (See Note 15 of Notes to the Consolidated Financial Statements).
Military Contract Expenses increased $46.8 million or 16.9%. The increase is consistent with the increase in revenues discussed previously. Health care delivery expense consists primarily of costs to provide managed health care services to eligible beneficiaries in accordance with Sierra's TRICARE contract. Under the contract, SMHS provides health care services to approximately 621,000 dependents of active duty military personnel and military retirees and their dependents through subcontractor partnerships and individual providers. Health care costs are recorded in the period when services are provided to eligible beneficiaries, including estimates for provider costs, which have been incurred but not reported to us. Also, included in military contract expenses are costs incurred to perform specific administrative services, such as health care appointment scheduling, enrollment, network management and health care advice line services, and other administrative functions of the military health care subsidiary.
Under our low level reinsurance agreement, we reinsure 30% of the first $10,000 of each claim, 75% of the next $40,000 and 100% of the next $450,000. The maximum net loss retained on any one claim ceded under this agreement is $17,000. This agreement covered all policies in force at July 1, 1998 and continued until June 30, 2000 when we executed an option to extend coverage to all policies in force as of June 30, 2000. For policies effective from July 1, 2000, we obtained excess of loss reinsurance for 100% of the losses above $250,000 and less than $500,000. We already had an existing excess of loss reinsurance agreement that covered 100% of the losses above $500,000. (See Note 6 of Notes to the Consolidated Financial Statements).
General, Administrative and Marketing Expenses, or G&A, decreased $1.2 million or .8%. As a percentage of revenues, G&A costs for 2000 were 9.8% compared to 10.7% in 1999 due primarily to higher revenues in 2000. As a percentage of medical premium revenue, G&A costs improved from 16.6% for 1999 down to 15.7% for 2000. Excluding the utilization of premium deficiency reserves for maintenance costs of $12.1 million for 2000 and $20.9 million for 1999, G&A costs decreased $10.1 million or 8.7% for the year. The $10.1 million decrease was primarily attributable to the consolidation of much of the Texas G&A services with our existing operations in Las Vegas as well as overall reductions in the Texas operations. This was offset by an increase in depreciation and amortization expense of $1.8 million.
In the first quarter of 2000, we engaged a consultant to help us assess our Texas operations. In late February, the consultant issued its report and we implemented strategic action plans to turn around the Texas operations. These actions included the replacement of the Texas senior management, a reduction in staffing along with a consolidation of certain services to Las Vegas and a revision of product strategy. The new management was charged with further assessing the Dallas/Ft. Worth health care delivery system. In May, we decided that the delivery system, which emphasized our affiliated medical group as the primary provider network, would be replaced by an expanded network of contracted physician groups and individuals. In addition, the contracted hospital network would be significantly expanded. As a result, during the second quarter of 2000, we adopted and announced a further restructuring of the Dallas/Ft. Worth operations, which entailed a significant reduction of physicians and staff and the closing of several clinic sites. In addition, management decided that the real estate assets would be sold.
During the second quarter of 2000, we wrote-off capitalized costs of $3.0 million related to the application development of an information system software project for the workers' compensation operations, that was canceled because the vendor was unable to fulfill its contractual obligations. The amounts written off included software and consulting costs of $1.6 million and capitalized internal personnel costs of $1.4 million.
In the first quarter of 2000, we announced a restructuring of our managed health care operations in Texas. As a result of this restructuring, we incurred approximately $1.4 million of severance pay for employees who were terminated. The restructuring involved changes in senior management at our Texas facilities and the centralization of key services to Las Vegas. Also in the first quarter of 2000, we incurred $1.5 million of costs, consisting primarily of consulting fees, in conjunction with a review and reorganization of our managed care operations in Texas.
In the second quarter of 2000, we adopted a plan and announced additional restructuring of our managed health care operations, primarily in Texas and Arizona. As a result of this restructuring, we recorded charges in accordance with Emerging Issues Task Force Issue No. 94-3, "Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (Including Certain Costs Incurred in a Restructuring)" of approximately $10.6 million. Of the costs recorded, $5.9 million was for severance, $2.9 million was related to clinic closures and lease terminations and $1.8 million was for other costs. The severance charge resulted from the termination of 315 employees at our subsidiaries and affiliated medical groups.
As compared to the quarter ended June 30, 2000, the restructuring and reorganization activities resulted in cash flow savings of approximately $2.0 to $3.0 million per quarter beginning in the fourth quarter of 2000.
Premium Deficiency Maintenance. Based on financial projections for 2000, we recorded a $21.0 million premium deficiency at the end of 1999, relative to our Texas operations. Of this amount, $10.0 million was recorded in medical expenses and $11.0 million was recorded in asset impairment, restructuring, reorganization and other costs. The $11.0 million was an estimate of G&A costs, in excess of those covered by premiums, expected to be incurred to service the Dallas/Ft. Worth contracts.
The premium deficiency maintenance costs of $10.4 million, recorded in the second quarter of 2000, were an estimate of general and administrative costs, in excess of those covered by premiums, we would incur to service the Texas contracts. The amount reflects anticipated cost reductions from the restructuring and reorganization actions noted above.
The remaining $6.1 million of costs recorded in the second quarter of 2000 relate primarily to the write-down of certain receivables and an accrual for legal settlements.
The remaining restructuring and reorganization costs of $4.3 million are primarily related to the cost to provide malpractice insurance on our discontinued affiliated medical groups, clinic closures and lease terminations in Houston and Arizona. The remaining other costs of $5.2 million are primarily related to legal claims. We believe that the remaining reserves as of December 31, 2000 are adequate and that no revisions to the estimates are necessary at this time.
Interest Expense and Other, Net increased $8.7 million or 57.7%, due primarily to an increase in the average balance of outstanding debt and an increase in the average cost of borrowing. Our average credit facility debt balance was $183 million in 2000 compared to $164 million in 1999 and our average interest rate on the credit facility was 9.9% in 2000 compared to 7.8% in 1999.
Benefit for Income Taxes was recorded at $74.2 million for 2000 compared to a tax benefit of $5.9 million recorded for 1999. During 1999, due to a change in tax law, we were able to utilize a $1.6 million net operating loss carryover that had previously not been recognized in the financial statements due to uncertainty about its realization. The effective tax rate for 2000 was 27.1% compared to 41.3% for 1999 which is exclusive of the effect of the change in tax law described above. The decrease in tax rate is due primarily to the impact of the charge for goodwill impairment combined with the magnitude of the loss for 2000 compared to 1999. The difference between the effective tax rate, excluding the change in the deferred tax valuation allowance, and the statutory rate is due primarily to non-deductible goodwill amortization. The effective tax rate for 2001 is projected to range from 33% to 35%. The difference between the anticipated tax rate and the statutory tax rate is due primarily to tax preferred investments offset by state income taxes.
Military contract revenues increased $82.6 million or 40.3%. The revenue recorded in 1999 is a result of the provision of health care services for twelve months. Revenue recorded in 1998 was comprised of revenue earned for five months of contract implementation and seven months of health care delivery.
Specialty product revenues decreased $54.1 million or 36.5%. Of the decrease, $51.1 million was due to a decrease in revenue in the workers' compensation insurance segment and $3.0 million was due to a decrease in administrative services revenue. The decrease in the workers' compensation insurance segment was primarily due to a full year of additional ceded reinsurance premiums on the low level reinsurance agreement effective July 1, 1998, totaling $60.7 million. This agreement was entered into in the fourth quarter of 1998. In addition, ongoing price competition, especially in California, was contributing to the reduction in revenue. The decrease in administrative services revenue was primarily attributable to a decrease in membership.
Professional fees increased $6.5 million or 14.3%, primarily due to our medical group operations in Dallas/Ft. Worth related to the Kaiser-Texas acquisition.
Adverse Development and Contractual Adjustments. In the fourth quarter of 1999, we recorded $18.0 million in medical expenses, of which $11.2 million primarily related to an adjustment to the estimate for medical expenses recorded in previous periods. The remaining amount primarily relates to contractual settlements with providers of medical services. (See Note 15 of Notes to the Consolidated Financial Statements).
Military Contract Expenses increased $79.9 million or 40.6%. The military contract expenses in 1999 are a result of twelve months of health care delivery. Expense in 1998 was for five months of contract implementation and seven months of health care delivery. Under the contract, SMHS provided health care services to approximately 610,000 dependents of active duty military personnel and military retirees and their dependents through subcontractor partnerships and individual providers in 1999.
Specialty Product Expenses decreased $45.8 million or 32.2%, due primarily to the implementation of the low level reinsurance agreement, as discussed previously, offset by adverse development of $9.9 million on prior accident years in our workers' compensation business. During 1999, workers' compensation claims were 100% reinsured between $500,000 and $100 million per occurrence. For claims occurring in 1999 that are below $500,000, we obtained low level quota share and excess of loss reinsurance. Under this agreement, which was not reflected in the financial statements until the fourth quarter of 1998, we reinsure 30% of the first $10,000 of each claim, 75% of the next $40,000 and 100% of the next $450,000. Claims occurring in the third quarter of 1998 were accounted for as retroactive reinsurance. (See Note 6 of Notes to the Consolidated Financial Statements).
The combined ratio for the workers' compensation insurance business was 105.5% in 1999 compared to 98.7% for the prior year. The increase was due to a 380 basis point increase in the net loss and LAE ratio, a 290 basis point increase in the underwriting expense ratio and 10 basis points of policyholders' dividend expense incurred in 1999. The increase in the loss and LAE ratio was primarily due to 1999 net adverse loss development of $9.9 million on prior accident years compared to 1998 net favorable loss development of $9.6 million. The increase in the underwriting expense ratio was primarily due to the lower net earned premium base that resulted from higher ceded reinsurance premiums in 1999.
Asset Impairment, Restructuring, Reorganization and Other Costs for 1998 and 1999 were previously discussed.
The increase in cash flow resulting from the change in assets and liabilities of $5.3 million was primarily due to the following:
o a source of cash due to the decrease in other current assets of $15.4 million
o a use of cash due to the decrease in other liabilities of $15.6 million primarily related to the decrease in the deferred tax liability
o a use of cash due to an increase in military accounts receivable of $11.5 million
o various other changes in assets and liabilities accounting for the remaining source of cash of $2.8 million
During January 2001, SMHS reached an agreement with DoD on a settlement of $58.2 million related to contract modifications issued prior to July 1, 2000. SMHS received an immediate payment of $21.3 million for outstanding receivables and the remainder of the settlement is to be paid evenly on a monthly basis until the end of the contract. Of the total settlement, SMHS estimates that approximately $18 million is owed to subcontractors.
Cash flows from financing activities included net proceeds from long-term borrowings (proceeds less payments) of $48.1 million and proceeds of $1.6 million related to the sale of stock through our employee stock purchase plan.
Our revolving credit facility balance decreased from $160 million to $135 million during the year. As a result of the asset impairment and other changes in estimate charges we took in the second quarter, we were not in compliance with our financial covenants at June 30, 2000. On December 15, 2000, we entered into an Amended and Restated Credit Agreement and have been in compliance with all covenants since that date. At December 31, 2000, the credit facility was reduced to $135 million as a result of our payment of $50 million that we received from the sale-leaseback transaction. We are required to make semi-annual principal payments, ranging from $2 million to $10 million, on the credit facility starting in June 2001. These payments result in permanent reductions in the size of the credit facility. Interest under the credit facility is variable and is based on the Bank of America "prime rate" plus a margin. The rate was 10.125% at December 31, 2000 which is a combination of the prime rate of 9.5% plus a margin of .625%. We can reduce the margin in the future by completing certain transactions and meeting certain financial ratios. Of the outstanding balance, $25 million is covered by an interest-rate swap agreement. To mitigate the risk of interest rate fluctuation on the credit facility, we entered into a five-year $50 million interest-rate swap agreement during the fourth quarter of 1998. The intent of the agreement was to keep our interest-rate on $50 million of the borrowing relatively fixed. In the fourth quarter of 2000, $25 million of the interest-rate swap agreement was terminated. The average cost of borrowing on this credit facility for 2000, including the impact of the interest-rate swap agreements, was approximately 9.9%.
Going forward, under certain circumstances, we will be required to make prepayments on the credit facility and the amount available to us under the credit facility will be reduced. For example, 80% of any excess cash flow that we have in each year must be applied to a repayment of the credit facility. In addition, if we or one of our subsidiaries (other than a regulated subsidiary and other specified subsidiaries) engage in an asset sale or a sale-leaseback transaction (with the exception of assets specified in the new credit agreement), 80% of the net cash proceeds must be applied to a repayment of the credit facility and a reduction of the amount available under the credit facility. In addition, 100% of the net cash proceeds of a debt issuance (excluding issuances by CII Financial, a wholly-owned subsidiary) must be applied to a repayment of the credit facility and a reduction in the amount available under the credit facility. We are also limited in the amount of funds we can transfer to our Texas and Military operations with a maximum of $12 million and $5 million, respectively. Subject to normal qualifications and exceptions, Sierra and CII Financial have covenants that, among other things, will restrict our ability to dispose of assets, incur indebtedness, pay dividends, make investments, loans or advances, make acquisitions, engage in mergers or consolidations, or make capital expenditures and which otherwise restrict certain corporate activities. At February 26, 2001, our credit facility had outstanding borrowings of $102 million. Unused credit facility balances are primarily reserved for our working capital purposes. Any availability under the credit facility generated from our excess cash flow must be converted annually to permanent reductions in accordance with the terms of the credit facility.
We advanced CII $365,000 in order to enable them to make the September 15, 2000 interest payment on the Debentures. Our amended and restated bank credit facility will limit our ability to make any future advances to CII . Since we do not believe that CII will have sufficient readily available sources of cash to pay the maturing Debentures, CII has filed a registration statement on Form S-4 with the Securities and Exchange Commission, or SEC, and is proposing to exchange the Debentures for a combination of cash and/or new senior subordinated debentures. The sources for the cash portion of the proposed exchange offer include a dividend by California Indemnity to CII of up to $5 million. On February 22, 2001, the California Department of Insurance approved the payment by California Indemnity of an extraordinary dividend of up to $5 million. CII will depend on loans from us and/or other affiliates for the balance of the cash portion of the exchange consideration. However, these types of loans are limited by our credit facility. In addition, in order to issue the new senior subordinated debentures in the proposed exchange offer, we will need the consent of a two-thirds majority in principal amount of the lenders under our credit facility.
On March 16, 2001, CII announced that the interest payment due March 15, 2001 on the Debentures was not made as scheduled. The Debentures have a 30-day grace period that applies to the scheduled March 15 interest payment and are not in default unless payment is not made during the grace period. CII is working to complete the proposed exchange offer.
If the proposed exchange offer is unsuccessful and CII were to default on the payment of interest or the Debentures when they mature, then there will be a cross default on our credit facility debt and the banks may demand that CII perform on its payment guaranty. If CII then had to sell its insurance subsidiaries, the net cash proceeds would probably be substantially less than if the sale were to occur when they were not in a default situation. Under certain circumstances, the California Department of Insurance could, among other things, exercise its oversight powers to preserve the assets of the insurance companies for the benefit of the policyholders and claimants and could prevent or significantly delay a possible sale of the insurance subsidiaries.
Of the $161.3 million in cash and cash equivalents held at December 31, 2000, $104.1 million was designated for use only by the regulated subsidiaries. Amounts are available for transfer to the holding company from the HMO and insurance subsidiaries only to the extent that they can be remitted in accordance with the terms of existing management agreements and by dividends. The holding company will not receive dividends from its regulated subsidiaries if such dividend payment would cause violation of statutory net worth and reserve requirements.
While we are unable to predict what regulatory changes may occur or the impact on us of any particular change, our operations and financial results could be negatively affected by regulatory revisions. For example, any proposals affecting underwriting practices, limiting rate increases, increasing litigation exposure, requiring new or additional benefits or affecting contracting arrangements (including proposals to require HMOs and PPOs to accept any health care providers willing to abide by an HMO's or PPO's contract terms) may have a material adverse effect on our business. The continued consideration and enactment of "anti-managed care" laws and regulations by federal and state bodies may make it more difficult for us to manage medical costs and may adversely affect financial results.
In addition to changes in applicable laws and regulations, we are subject to various audits, investigations and enforcement actions. These include possible government actions relating to the ERISA, 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 investigation or audit results or sanctions could negatively affect our reputation in various markets and make it more difficult for us to sell our products and services.
In June 1998, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities", or SFAS 133, which, as amended, is effective for fiscal years beginning after June 15, 2000. SFAS 133 establishes additional accounting and reporting standards for derivative instruments and hedging activities. SFAS 133 requires that an entity recognize all derivatives as either assets or liabilities in the statement of financial position. This statement also defines and allows companies to apply hedge accounting to its designated derivatives under certain instances. It also requires that all derivatives be marked to market on an ongoing basis. This applies whether the derivatives are stand-alone instruments, such as warrants or interest-rate swaps, or embedded derivatives, such as call options contained in convertible debt investments. Along with the derivatives, in the case of qualifying hedges, the underlying hedged items are also to be marked to market. These market value adjustments are to be included either in the income statement or other comprehensive income, depending on the nature of the hedged transaction. The fair value of financial instruments is generally determined by reference to market values resulting from trading on a national securities exchange or in an over-the-counter market. In cases where derivatives relate to financial instruments of non-public companies, or where quoted market prices are otherwise not available, such as for derivative financial instruments, fair value is based on estimates using present value or other valuation techniques. We do not believe that we have any significant derivative instruments or any significant hedging activities. The majority of our investments are held by insurance companies, which are regulated as to the types of investments they may hold.
SIERRA HEALTH SERVICES, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS December 31, 2000 and 1999 (In thousands, except per share data)
SIERRA HEALTH SERVICES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS For the Years Ended December 31, 2000, 1999 and 1998 (In thousands, except per share data)
SIERRA HEALTH SERVICES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS For the Years Ended December 31, 2000, 1999 and 1998 (In thousands)
Business. The consolidated financial statements include the accounts of Sierra Health Services, Inc. and its subsidiaries (collectively referred to as "Sierra" or the "Company"). Sierra is a managed health care organization that provides and administers the delivery of comprehensive health care and workers' compensation programs with an emphasis on quality care and cost management. Sierra's broad range of managed health care services is provided through its health maintenance organizations ("HMOs"), managed indemnity plans, military health services programs, third-party administrative services programs for employer-funded health benefit plans and its workers' compensation medical management programs. Ancillary products and services that complement the Company's managed health care product lines are also offered.
In June 1996, the Department of Defense awarded a TRICARE contract to TriWest Healthcare Alliance, a consortium consisting of the Company and 13 other health care companies, to provide health services to Regions 7 and 8, which includes a total of 16 states. During the first quarter of 2000, the Company sold its interest in TriWest Healthcare Alliance in exchange for a $3.7 million note, which approximated the carrying value of the Company's investment.
Principles of Consolidation. All significant intercompany transactions and balances have been eliminated. Sierra's consolidated subsidiaries include: Health Plan of Nevada, Inc. ("HPN") and Texas Health Choice, L.C. ("TXHC"), 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 provider group; Sierra Military Health Services, Inc. ("SMHS"), a company that provides and administers managed care services to certain TRICARE eligible beneficiaries; CII Financial, Inc. ("CII"), a holding company primarily engaged in writing workers' compensation insurance through its wholly-owned subsidiaries; administrative services companies; a home health care agency; a hospice; a home medical products subsidiary; and a company that provides and manages mental health and substance abuse services.
Military Contract Expenses. This expense consists primarily of costs to provide managed health care services to eligible beneficiaries in accordance with the Company's TRICARE contract. Under the contract, SMHS provides health care services to approximately 621,000 dependents of active duty military personnel and military retirees and their dependents through subcontractor partnerships and individual providers. Health care costs are recorded in the period when services are provided to eligible beneficiaries including estimates for provider costs which have been incurred as of the balance sheet date but not reported to the Company. Also included in military contract expenses are costs incurred to perform specific administrative services, such as health care appointment scheduling, enrollment, network management and health care advice line services and other administrative functions of the military health care subsidiary.
Specialty Product Expenses. This expense consists primarily of losses and loss adjustment expense ("LAE"), policy acquisition costs and other general and administrative expenses associated with issued workers' compensation policies. Losses and LAE are based upon the accumulation of cost estimates for reported claims occurring during the period as well as an estimate for losses that have occurred but have not yet been reported. Policy acquisition costs consist of commissions, premium taxes and other underwriting costs, which are directly related to the production and retention of new and renewal business and are deferred and amortized as the related premiums are earned. Should it be determined that future policy revenues and earnings on invested funds relating to existing insurance contracts will not be adequate to cover related costs and expenses, deferred costs are expensed. Also included in specialty product expenses are costs associated with administrative services and certain ancillary products. These costs are recorded when incurred. Loss and LAE reserves have a significant degree of uncertainty when related to their subsequent payments. Although reserves are established on the basis of a reasonable estimate, it is not only possible but probable that reserves will differ from their related subsequent developments. Underlying causes for this uncertainty include, but are not limited to, uncertainty in development patterns and unanticipated inflationary trends affecting the services covered by the insurance contract. This uncertainty can result in both adverse as well as favorable development of actual subsequent activity when compared to the reserve established. Any subsequent change in loss and LAE reserves established in a prior year would be reflected in the current year's operating results.
Investments. Investments consist principally of U.S. Government securities and municipal bonds, as well as corporate and mortgage-backed securities. All non-restricted investments that are designated as available-for-sale are classified as current assets. These investments are available for use in the current operations regardless of contractual maturity dates. Non-restricted investments designated as held-to-maturity are classified as current assets if expected maturity is within one year of the balance sheet date. Otherwise, they are classified as long-term investments. Realized gains and losses are calculated using the specific identification method and are included in net income. Unrealized holding gains and losses on available-for-sale securities are included as a separate component of stockholders' equity until realized.
Restricted Cash and Investments. Certain subsidiaries are required by state regulatory agencies to maintain deposits and must also meet net worth and reserve requirements. The Company and its subsidiaries are in compliance with the applicable minimum regulatory and capital requirements.
Buildings and Improvements 10 - 30 years Leasehold Improvements 3 - 10 years Furniture, Fixtures and Equipment 3 - 5 years Data Processing Hardware and Software 3 - 10 years
Amortization expense associated with goodwill was $2,824,000, $4,345,000 and $2,321,000 for the years ended December 31, 2000, 1999 and 1998, respectively.
Medical Claims Payable and Military Health Care Payable. Medical claims payable and military health care payable include the estimated cost for unpaid claims for which health care services have been provided to enrollees and to TRICARE eligibles. Such provisions included an estimate for the costs of claims that have been incurred but have not been reported.
Recently Issued Accounting Standards. The Financial Accounting Standards Board has issued Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities" ("SFAS 133"), as amended, which is effective for fiscal years beginning after June 15, 2000. SFAS 133 establishes additional accounting and reporting standards for derivative instruments and hedging activities. SFAS 133 requires that an entity recognize all derivatives as either assets or liabilities in the statement of financial position. This statement also defines and allows companies to apply hedge accounting to its designated derivatives under certain instances. It also requires that all derivatives be marked to market on an ongoing basis. This applies whether the derivatives are stand-alone instruments, such as warrants or interest-rate swaps, or embedded derivatives, such as call options contained in convertible debt investments. Along with the derivatives, in the case of qualifying hedges, the underlying hedged items are also to be marked to market. These market value adjustments are to be included either in the income statement or other comprehensive income, depending on the nature of the hedged transaction. The fair value of financial instruments is generally determined by reference to market values resulting from trading on a national securities exchange or in an over-the-counter market. In cases where derivatives relate to financial instruments of non-public companies, or where quoted market prices are otherwise not available, such as for derivative financial instruments, fair value is based on estimates using present value or other valuation techniques. The Company does not believe that it has any significant derivative instruments nor any significant hedging activities. The majority of the Company's investments are held by insurance companies, which are regulated as to the types of investments they may hold.
In December 1999, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 101, "Revenue Recognition in Financial Statements" ("SAB 101"). SAB 101 clarifies existing accounting principles related to revenue recognition in financial statements. The Company has adopted SAB 101 and it did not have a material impact on its financial statements.
Reclassifications. Certain amounts in the Consolidated Financial Statements for the years ended December 31, 1999 and 1998 have been reclassified to conform with the current year presentation.
Options to purchase 4,250,000 and 3,904,000 shares of common stock were outstanding at December 31, 2000 and 1999 respectively, but were not included in the computation of diluted earnings per share because the Company had a net loss for both years and their inclusion would have been anti-dilutive.
CII issued convertible subordinated debentures (the "Debentures") due September 15, 2001. Each $1,000 in principal is convertible into 25.382 shares of the Company's common stock at a conversion price of $39.398 per share. The Debentures were not included in the computation of EPS because their effect would be anti-dilutive. At December 31, 2000, common stock shares reserved for potential issuance in connection with the subordinated debentures were 1,442,000.
Assets held for sale on the balance sheet at December 31, 2000 consist of real estate in Texas and Arizona for which the Company is actively seeking a buyer and expects to sell within twelve months. All assets are owned by subsidiaries in the managed care and corporate operations segment. A related mortgage in the amount of $34.2 million is included in the current portion of long-term debt on the balance sheet. Because these assets have been written down to fair market value, in accordance with SFAS No. 121, the Company has ceased depreciating them. See Note 16 for a description of the primary facts and circumstances leading to the decision to sell this real estate. See Note 8 for a description of the related long-term 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 investments have been categorized as available-for-sale and are stated at their fair value. Fair value is estimated primarily from published market values as of the balance sheet date. Gross realized gains on investments for 2000, 1999 and 1998 were $497,000, $334,000 and $4,789,000, respectively. Gross realized losses on investments for 2000, 1999 and 1998 were $1,566,000, $733,000 and $2,511,000, respectively.
The following table summarizes the Company's current, long-term and restricted investments as of December 31, 2000:
The contractual maturities of available-for-sale investments at December 31, 2000 are shown below. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations.
The contractual maturities of held-to-maturity investments at December 31, 2000 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 and current investments that total $368.4 million in the accompanying Consolidated Balance Sheet at December 31, 2000, $308.3 million 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.
CII also has reinsurance agreements or treaties in effect with unrelated entities. In 1999 and 1998, workers' compensation claims between $500,000 and $100,000,000 per occurrence were 100% reinsured. In addition, effective July 1, 1998, workers' compensation claims below $500,000 per occurrence were reinsured under quota share and excess of loss reinsurance agreements (referred to as "low level reinsurance") with an A+ rated carrier. Under this agreement, the Company reinsures 30% of the first $10,000 of each loss, 75% of the next $40,000 and 100% of the next $450,000. The Company
The low level reinsurance agreement was consummated early in the fourth quarter of 1998 but coverage was made retroactive to July 1, 1998. Therefore, this agreement contained both retroactive (covering claims occurring in the third calendar quarter of 1998) and prospective reinsurance coverage (covering claims occurring after September 30, 1998) and, in accordance with Statement of Financial Accounting Standards No. 113, "Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts" ("SFAS 113"), the Company has bifurcated the low level reinsurance agreement to account for the different accounting treatments. The amount by which the estimated ceded liabilities exceed the amount paid for the retroactive coverage is reported as a deferred gain and amortized to income as a reduction of incurred losses over the estimated remaining settlement period using the interest method. Any subsequent changes in estimated or actual cash flows related to the retroactive coverage are accounted for by adjusting the previously recorded deferred gain to the balance that would have existed had the revised estimate been available at the inception of the reinsurance transactions, with a corresponding charge or credit to income. During 2000, the Company recorded an adjustment to increase its deferred gain related to retroactive reinsurance coverage by $3,662,000 compared to an increase of $4,615,000 in 1999. For the years ended December 31, 2000, 1999 and 1998, the Company amortized deferred gains of $5,199,000, $3,850,000 and $1,038,000, respectively. Such amortization is included in specialty product expense on the accompanying consolidated statements of operations.
In accordance with SFAS 113, losses ceded under prospective reinsurance reduce direct incurred losses and amounts recoverable are reported as an asset. At December 31, 2000 and 1999, the amount of reinsurance recoverable under prospective reinsurance contracts for unpaid loss and LAE was $218,757,000 and $110,089,000, respectively. At December 31, 2000 and 1999, the amount of reinsurance recoverable under the retroactive reinsurance contract was $10,863,000 and $14,842,000, respectively. The amount of reinsurance receivable for paid loss and LAE was $17,585,000 and $6,931,000 at December 31, 2000 and 1999, respectively.
The following table provides workers' compensation prospective reinsurance information for the three years ended December 31, 2000:
During the year ended December 31, 2000, the Company experienced net adverse loss development of $23.3 million related to accident years 1999 and prior. Estimated losses and LAE incurred in accident years 1996 to 1999 have developed significantly due to the continuation of increasing claim severity patterns on the Company's California book of business. Many workers' compensation insurance carriers in California are also experiencing high claim severity. Factors influencing the higher claim severity include rising average temporary disability costs, the increase in the number of major permanent disability claims, medical inflation and adverse court decisions related to medical control of a claimant's treatment. For claims occurring on and after July 1, 1998, the Company has reinsured a percentage of the higher claim severity under the Company's low level reinsurance agreement. The low level reinsurance agreement expired on June 30, 2000; however, the Company opted to continue ceding premiums and losses under the low level agreement on a run-off basis for all policies in force on June 30, 2000. Effective January 1, 2000, we entered into a reinsurance contract that provides statutory (unlimited) coverage for workers' compensation claims in excess of $500,000 per occurrence. The contract is in effect for claims occurring on or after January 1, 2000 through December 31, 2002. On July 1, 2000, the Company entered into a reinsurance agreement that covers losses on claims in excess of $250,000 up to $500,000 for policies issued after June 30, 2000.
CII has limited sources of cash and does not expect to have readily available funds to pay the Debentures when they mature. CII is exploring strategies regarding the Debentures including refinancing, extending the maturity date or exchanging the Debentures. In December 2000, CII filed a registration statement on Form S-4 with the Securities and Exchange Commission in which it proposed an exchange offer to the holders of the Debentures to restructure the debt, extend the maturity date and reduce the overall debt of the Company. The offering proposes to exchange cash plus new subordinated Debentures, with a later maturity date, for the Debentures. The sources for the cash portion of the proposed exchange offer include a cash dividend from California Indemnity Insurance Company ("California Indemnity") to CII of up to $5 million. In connection with the proposed exchange offer, California Indemnity filed an application with the California Department of Insurance to pay an extraordinary dividend of $5 million to CII. On February 22, 2001, the California Department of Insurance approved this application. The balance of the cash portion of the proposed exchange offer is expected to be loans from Sierra Health Services, Inc. and/or other affiliates. However, these types of loans are limited by the Sierra amended and restated credit agreement. In addition, in order to issue the new senior subordinated debentures in the proposed exchange offer, the consent of two-thirds majority in principal amount of the lenders under the Sierra credit facility must be obtained. On March 16, 2001, CII announced that the interest payment due March 15, 2001 on the Debentures was not made as scheduled. The Debentures have a 30-day grace period that applies to the scheduled March 15 interest payment and are not in default unless payment is not made during the grace period. CII is working to complete the proposed exchange offer. There can be no assurances that CII or the Company will have the cash resources required to meet the obligations under the Debentures or that the CII will be able to successfully implement a strategy for refinancing of the Debentures.
6% Mortgage Note. In conjunction with the acquisition of Kaiser Foundation Health Plan of Texas, the Company executed a deed of trust note for $35,200,000, which is secured by the underlying real estate and fixtures. The terms of the note include fixed monthly payments of $211,000 for five years at which time the remaining principal is due. As described in Note 4, the entire amount of this note is included in the current portion of long-term debt as it is related to the assets designated as held for sale.
7 1/5% Mortgage Note. In January 1998, the Company obtained a $15,000,000 loan from Bank of America, Nevada at an interest rate of 7 1/5%. The note balance of $9,891,000 was paid off in conjunction with the sale-leaseback transaction described above.
Other. The Company has obligations under capital leases with interest rates from 6.7% to 13.4%. In addition, the Company has term loans with the City of Baltimore and the State of Maryland. Scheduled maturities of the Company's notes payable, net financing obligations and future minimum payments under capital leases, together with the present value of the net minimum lease payments at December 31, 2000, are as follows:
(In thousands) Year Ending December 31, 2001.......................................... $ 6,724 2002.......................................... 6,227 2003.......................................... 4,763 2004.......................................... 3,687 2005.......................................... 3,332 Thereafter.................................... 6,085 --------- Total.................................... $30,818 =======
During 1997, the Company's Board of Directors authorized a $3.0 million line of credit from the Company to its Chief Executive Officer ("CEO"). In April 2000, the Company's Board of Directors authorized an additional $2.5 million loan from the Company to the CEO which, along with accrued interest, is due on June 30, 2002. At the end of 2000, the aggregate principal balance outstanding and accrued interest for both instruments was $5,416,000. All amounts borrowed bear interest at a rate equal to the rate at which the Company could have borrowed funds under the revolving credit facility at the time of the borrowing plus 10 basis points. The amounts outstanding are collateralized by certain of the CEO's assets and rights to compensation from the Company.
Supplemental Retirement Plans. The Company has Supplemental Retirement Plans (the "SRPs") for certain officers, directors and highly compensated employees. The SRPs are non-qualified deferred compensation plans through which participants may elect to postpone the receipt and taxation of all or a portion of their salary and bonuses received from the Company. The Company also matches 50% of those contributions that participants are restricted from deferring, if any, under the Company's pension and 401(k) plan. As contracted with the Company, the participants or their designated beneficiaries may begin to receive benefits under the SRPs upon a participant's death, disability, retirement, termination of employment or certain other circumstances including financial hardship.
Executive Life Insurance Plan. The Company has split dollar life insurance agreements with certain officers and key executives (selected and approved by the Sierra Board of Directors). The premiums paid by the Company will be reimbursed upon the occurrence of certain events as specified in the contract.
Employee Stock Purchase Plans. The Company has employee stock purchase plans (the "Purchase Plans") whereby employees may purchase newly issued shares of common stock through payroll deductions at 85% of the fair market value of such shares on specified dates as defined in the Purchase Plans. During 2000, a total of 415,000 shares were purchased at prices of $5.68 and $2.71 per share. During January 2001, 219,000 shares were purchased by employees at $2.92 per share in connection with the Purchase Plans. In May 2000, the shareholders of the Company approved an additional 1,250,000 shares and at December 31, 2000 the Company had 1,129,000 shares reserved for purchase under the Purchase Plans.
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 2000, 1999 and 1998, respectively: dividend yield of 0% for all years; expected volatility of 52%, 43% and 37%; risk-free interest rates of 6.60%, 5.87% and 4.46%; and expected lives of four to five years. The weighted average fair value of options granted in 2000, 1999 and 1998 was $2.72, $3.77 and $9.92, respectively.
Supplemental statements of cash flows information for the years ended December 31, 2000, 1999 and 1998 is presented below:
On December 31, 1998, Sierra completed the acquisition of the Nevada health care business of Exclusive Healthcare, Inc. ("EHI"), United of Omaha Life Insurance Company and United World Life Insurance Company ("United"), all of which were subsidiaries of Mutual of Omaha Insurance Company. Effective June 1, 1999, the company completed the purchase of the Texas operations of EHI (approximately 1,000 HMO members) and United's related preferred provider organization ("PPO") that is part of the dual option HMO/PPO plan.
During 1999, the Company reported a premium deficiency medical charge of $8.1 million related to losses in under-performing markets primarily in Arizona and rural Nevada, all of which was used during 1999. In the fourth quarter of 1999, the Company recorded a premium deficiency charge of $10.0 million related to HMO contracts in the Texas market for the year 2000. Also recorded in medical expenses during the fourth quarter was $11.2 million primarily related to an adjustment to the estimate for medical expenses recorded in previous years, and $6.8 million primarily related to contractual settlements with providers of medical services.
In the first quarter of 2000, the Company recorded $1.0 million of adverse development related to prior years' medical claims. Included in reported medical expenses for the second quarter of 2000 are changes in estimate charges of $29.5 million of reserve strengthening primarily due to adverse development on prior periods' medical claims, as well as $15.5 million in premium deficiency medical expense related to under-performing markets in the Dallas/Ft. Worth and Houston areas. The recorded premium deficiency reflects anticipated cost savings from restructuring and reorganization actions discussed below. In addition, the Company recorded $10.2 million of other non-recurring medical costs primarily relating to the write-down of medical subsidiary assets.
The total premium deficiency medical reserve utilized during the year ended December 31, 2000 was $20.3 million. Management believes that the remaining premium deficiency medical reserve of $5.2 million, as of December 31, 2000, is adequate and that no revision to the estimate is necessary at this time.
Management also adopted a plan in the second quarter of 2000 to discontinue medical delivery operations in Mohave County, Arizona and to sell the real estate assets located there, as well as an underperforming medical clinic in Las Vegas.
In assessing the asset impairment of the long-lived assets, the Company first allocated a portion of related goodwill to the fixed assets to be disposed of, in accordance with SFAS No. 121. The fixed assets were then written down to estimated fair value less costs to sell, which was determined from independent valuations. The remainder of the related goodwill was then assessed for recoverability in accordance with APB No. 17 based on projected discounted cash flows.
The charges recorded for fixed asset impairment totaled $36.6 million for the Texas operations and $9.5 million for the Arizona and Nevada operations.
The Company evaluates each segment's performance based on segment operating profit. The accounting policies of the operating segments are the same as those described in the summary of significant accounting policies (except as described in the notes below).
Information concerning the operations of the reportable segments is as follows: (In thousands)