(A) Financial information prior to 1998 has been restated to present the workers' compensation business as a discontinued operation.
(C) Per share data includes nonrecurring costs of $0.13 per share and $0.52 per share for 1997 and 1995, respectively.
In accordance with Statement of Financial Accounting Standards No. 131, "Disclosures about Segments of a Business Enterprise," the Company was organized into two primary segments, the California and National business segments, during the year ended December 31, 1998. Effective April 1, 1999, the Company intends to modify its internal business operations. It is anticipated that the impact of this internal change will also affect the disclosures of the Company's segments from that presented as of December 31, 1998. The Company is currently evaluating the effect of this proposed change and expects that future filings under the Securities Exchange Act of 1934 on or after the effective date of this reorganization will reflect such modified segments.
On July 29, 1998, WellPoint entered into a Stock Purchase Agreement (the "Stock Purchase Agreement") by and between WellPoint and Fremont Indemnity Company ("Fremont"). Pursuant to the Stock Purchase Agreement, Fremont acquired all of the outstanding capital stock of UNICARE Specialty Services, Inc., a wholly owned subsidiary of WellPoint ("UNICARE Specialty"). The transaction was completed on September 1, 1998. The principal asset of UNICARE Specialty was the capital stock of UNICARE Workers' Compensation Insurance Company ("UNICARE Workers' Compensation"). The purchase price for the acquisition was the statutory surplus (adjusted in accordance with the terms of the Purchase Agreement) of UNICARE Workers' Compensation as of the date of the closing. The purchase price based upon adjusted statutory surplus of UNICARE Workers' Compensation as of September 1, 1998, the closing date of the transaction, was approximately $110.0 million. Subsequent to September 1, 1998, the Company and Fremont are jointly marketing integrated workers' compensation and medical insurance products in the small employer group market.
On March 1, 1997, the Company completed its acquisition of the GBO. The purchase price was $89.7 million, subject to the resolution of certain items related to the post-closing audit. The purchase method of accounting has been used to account for the acquisition of the GBO. The GBO, with an associated 1.3 million acquired members, targets large employers with 5,000 or more employees and a majority of the medical members it serves are in health plans that are self-funded by employers.
of these acquired businesses, the Company has undertaken a variety of measures, including significant premium increases and changes in product design. The GBO and MMHD businesses have historically also experienced a higher administrative expense ratio than the Company's traditional California business due to the higher percentage of management services business. These higher administrative expense ratios have contributed to an increase in the Company's overall administrative expense ratio since the respective dates of acquisition.
On July 9, 1998, the Company entered into an Agreement and Plan of Merger with Cerulean Companies Inc. ("Cerulean") (See Note 23 to the Consolidated Financial Statements). Cerulean, principally through its Blue Cross Blue Shield of Georgia subsidiary, offers insured and administrative services products primarily in the State of Georgia. Cerulean has historically experienced a higher administrative expense ratio than the Company's core businesses due to its higher concentration of administrative services business. Cerulean has also historically experienced a higher loss ratio than the Company's core businesses due to its higher percentage of large group business, which generally reduces the Company's overall risk and also underwriting margins. Accordingly, it is expected that Cerulean's higher loss and administrative expense ratios will ultimately contribute to an increase in those ratios for the Company after the transaction is completed. This transaction is expected to be completed in the second half of 1999.
A variety of health care reform measures are currently pending or have been recently enacted at the Federal, state and local levels. Federal legislation enacted during the last two years seeks, among other things, to insure the portability of health coverage and mandates minimum maternity hospital stays. These and other proposed measures may have the effect of dramatically altering the regulation of health care and of increasing the Company's loss ratio or decreasing the affordability of the Company's products. In May 1997, the Texas Legislature adopted Senate Bill No. 386 ("SB 386"). Among other things, this legislation purports to make managed care organizations ("MCOs") such as the Company liable for the failure by the MCO, its employees or agents to exercise ordinary care when making "health care treatment decisions" (as defined in SB 386). The legislation was effective as of September 1, 1997. In September 1998, the United States District Court for the Southern District of Texas ruled, in part, that the MCO liability provisions of SB 386 are not preempted by the Federal Employee Retirement Income Security Act of 1974 ("ERISA"). To date, this legislation has not adversely affected the Company's results of operations. Similar legislation is currently pending in both the California and Georgia legislatures. Although the Company maintains insurance covering such liabilities, to the extent that this legislation (or similar legislation that may be subsequently adopted at the Federal or state level) effectively expands the scope of liability of MCOs such as the Company, it may have a material adverse effect on the Company's results of operations, financial condition or cash flows. Even if the Company is not held to be liable under any litigation, the existence of potential MCO liability may cause the Company to incur greater costs in defending such litigation.
The Company is substantially dependent on its computer systems, business applications and other information technology systems ("IT systems"), due to the nature of its managed health care business and the increasing number of electronic transactions in the industry. Historically, many IT systems were developed to recognize the year as a two-digit number, with the digits "00" being recognized as the year 1900. The year 2000 presents a number of potential problems for such systems, including potentially significant processing errors or failure. Given the Company's reliance on its computer systems, the Company's results of operations could be materially adversely affected by any significant errors or failures. Additionally, the year 2000 presents potential problems for other systems and applications containing date-
The Company currently estimates that its costs related to year 2000 compliance remediation for Company-owned IT systems and applications will be approximately $6 to $7 million in 1999. The amounts expected to be expended during 1999 represent less than 5% of the Company's IT systems budget. During the year ended December 31, 1998, the Company expended approximately $16.9 million and $1.3 million for remediation of its IT software systems and applications and for renovation or replacement of its telecommunications equipment, respectively. The Company currently estimates that its total costs in 1999 with respect to non-IT systems and applications will be approximately $1.0 million. The Company's expenditures with respect to non-IT systems will include the acquisition of back-up power supplies for the Company's headquarters and data center facilities. The Company expenses year 2000 remediation costs as incurred and expects to fund these costs through cash flow from operations. While the immediacy of year 2000 compliance measures has caused the Company to defer or cancel certain IT projects, the Company does not expect such actions to have a material effect on the Company's results of operations, cash flows or financial condition. Assuming the Company's pending acquisition of Cerulean is consummated (see Note 23 to the Consolidated Financial Statements), similar remediation and testing efforts with respect to Cerulean-owned IT and non-IT systems and applications may increase the Company's total expenditures.
The Company is currently formulating detailed contingency plans in the event that its various systems and applications do not achieve year 2000 compliance in a timely fashion. The contingency plans are focused on identifying potential failure scenarios for the Company's IT and non-IT systems and those of third parties with which the Company interacts and on ensuring the continuation of critical business operations. During the first half of 1999, the Company expects to integrate each of these contingency plans into a Company-wide contingency plan.
The Company's consolidated results of operations for the year ended December 31, 1998 include a full year of earnings for each of its acquired businesses. The results of operations for the year ended December 31, 1997 include ten months of earnings for the GBO, from the date of its acquisition. The results of operations for the year ended December 31, 1996 include the results of MMHD for the period from April 1, 1996 (its date of acquisition) to December 31, 1996 and BCC Commercial Operations for the period from May 20, 1996 (its date of acquisition) to December 31, 1996.
(b) Classification between California and National membership for employer groups is determined by the state of the employer's corporate office. The state designation within National is determined by the zip code of the subscriber.
(c) Medical membership includes 2,580,119 and 2,765,856 management services members as of December 31, 1998 and 1997, respectively, of which management services members outside of California were 1,600,616 and 1,792,151 as of December 31, 1998 and 1997, respectively.
Management services revenue increased 15.1%, or $56.9 million, to $434.0 million for the year ended December 31, 1998 from $377.1 million for the year ended December 31, 1997. The increase was primarily due to a 14.7% increase in management services member months, primarily in the California business segment's large employer group business. Also contributing to the increase was the incremental impact of the addition of a management services contract in the National business segment with the State of Illinois effective as of July 1, 1997. Excluding the impact of the additional two months of management services revenue in 1998 related to the GBO operations of $22.3 million, the National business segment experienced a decline in overall management services revenue due to attrition on acquired MMHD membership and, to a lesser extent, the GBO membership.
Investment income decreased $86.6 million to $109.6 million for the year ended December 31, 1998, compared to $196.2 million for the year ended December 31, 1997. The decline was primarily attributable to recognition in 1998 of an "other than temporary" decline in value of $48.7 million relating to the Company's equity holdings in FPA Medical Management, Inc. ("FPA"), which subsequently filed for bankruptcy. Further contributing to the decrease between years was the initial gain of $30.3 million recognized in 1997 related to the exchange of Health Partners Inc. ("HPI") stock for FPA. Excluding the effects of both the "other than temporary" decline in value in 1998 and the gain related to the stock-for-stock merger with FPA in 1997, investment income would have been $158.3 million and $165.9 million, for 1998 and 1997, respectively. Including the loss on FPA in 1998, and the gain on HPI in 1997, the net realized loss on investment securities for the year ended December 31, 1998 was $32.0 million compared to a net realized gain of $64.3 million for the year ended December 31, 1997. Net interest and dividend income increased $11.3 million to $145.2 million for the year ended December 31, 1998 in comparison to $133.9 million for the year ended December 31, 1997, primarily due to increased interest income resulting from the investment portfolios of the acquired GBO businesses partially offset by lower yields on invested assets in 1998 versus 1997. Net investment income also included a loss of approximately $4.5 million in 1998 related to the Company's interest rate swap agreements.
The loss ratio attributable to managed care and related products for the year ended December 31, 1998 decreased slightly to 80.5% compared to 80.6% for the year ended December 31, 1997. Excluding the GBO for the period prior to its acquisition for the year ended December 31, 1998, the loss ratio would have been 80.0%. The decline is primarily due to the aforementioned membership attrition related to underperforming MMHD and GBO acquired accounts in the Company's National business segment combined with the growth in the Company's Medi-Cal business that experienced a lower loss ratio, partially offset by increases in California large group business.
The provision for income taxes decreased $84.5 million or 53.9%, to $72.4 million for the year ended December 31, 1998. The decline was primarily due to the effect of the private letter ruling received from the IRS in September 1998, which resulted in a decrease in income tax expense of $85.5 million. (See Note 8 to the Consolidated Financial Statements.) Excluding the ruling, the provision for income taxes would have been $157.9 million, representing an overall tax rate consistent with the prior period.
Premium revenue increased 37.0%, or $1,369.6 million, to $5,068.9 million for the year ended December 31, 1997 from $3,699.3 million for the year ended December 31, 1996. The 1997 acquisition of the GBO contributed $419.4 million, or 30.6% of this increase. The 1996 acquisitions of MMHD and the BCC Commercial Operations contributed an incremental increase in 1997 premium revenue of $163.0 million and $147.7 million, respectively, or an aggregate of 22.7% of the total increase. Also, contributing to increased premium revenue in 1997 was an increase in insured member months of 12.9% primarily in the Company's California business segment, excluding the GBO from both periods and excluding MMHD and BCC Commercial Operations from the periods prior to their respective dates of acquisition in both periods. Additionally, there was an increase in the per member per month revenues as a result of premium increases associated with several of the Company's medical products.
Management services revenue increased 155.0%, or $229.2 million, to $377.1 million for the year ended December 31, 1997 from $147.9 million for the year ended December 31, 1996. The increase was primarily due to $189.9 million of management services revenue related to the 1997 acquisition of the GBO and $18.9 million and $3.9 million, respectively, of incremental increase in management services revenue related to the acquisitions of MMHD and the BCC Commercial Operations in 1996, which together represented 92.8% of the increase. Also contributing to the increase was an increase in the California large group management services membership and the addition of a management services contract in the Company's National business segment with the state of Illinois on July 1, 1997.
Health care services and other benefits expense increased 44.6%, or $1,261.5 million, to $4,087.4 million for the year ended December 31, 1997 from $2,825.9 million for the year ended December 31, 1996. The acquisition of the GBO accounted for 32.4% of the increase, or $408.2 million. The inclusion of MMHD and the BCC Commercial Operations for a full twelve months in 1997 accounted for an aggregate of 21.6% of the increase and resulted in increased health care expense of $133.9 million and $139.1 million, respectively. Additionally, the Company's health care benefits and other expenses for the year ended December 31, 1997 increased in comparison to the prior year as a result of the aforementioned increase in insured member months of 12.9%, primarily in the Company's California business segment.
The loss ratio for 1997 increased to 80.6% compared to 76.4% in 1996. The acquired MMHD operations, the GBO and the BCC Commercial Operations have traditionally experienced a higher loss ratio than the Company. Additionally, the MMHD operations experienced an increase in loss ratio for the year ended December 31, 1997 in comparison to 1996 due to higher actual claims incurred as a result of higher cost trends. Excluding the effects of the acquired businesses, the loss ratio in 1997 would have been 78.5%. The increase in loss ratio excluding acquired operations was due to a loss ratio increase in the Company's California business segment, primarily due to slightly higher medical utilization for certain managed care products and increased pharmacy costs.
Selling expense for the year ended December 31, 1997 increased 23.3% to $249.4 million, compared to $202.3 million for the year ended December 31, 1996, corresponding with continued overall premium revenue growth and an additional $7.2 million in selling expense attributable to the GBO and the incremental impact in 1997 of the MMHD acquisition. The selling expense ratio for the year ended December 31, 1997 decreased to 4.6% from 5.3% for the year ended December 31, 1996, largely due to the acquisition of the GBO and MMHD, which have lower selling expense ratios than the Company's existing business, and the BCC Commercial Operations, which has no selling expense. Excluding the effects of the acquisitions for the years ended December 31, 1997 and 1996, the selling expense ratio would have been 5.4% and 5.3%, respectively.
General and administrative expense for the year ended December 31, 1997 increased 53.9%, or $293.1 million, to $836.6 million from $543.5 million for the same period in 1996. The increase was primarily due to $196.9 million of general and administrative expense related to the Company's acquisition of the GBO in 1997 and $46.0 million and $8.0 million, of incremental increase in general and administrative expense related to the Company's acquisitions of MMHD and the BCC Commercial Operations, respectively in 1996.
Interest expense increased for the year ended December 31, 1997 to $36.7 million, from $36.6 million for the year ended December 31, 1996. The increase is primarily due to interest on debt incurred as a result of the Recapitalization in May 1996 being included in the results of operations for the entire year ended December 31, 1997 in comparison to a shorter period of time in the year ended December 31, 1996, partially offset by debt repayments during 1997. The weighted average interest rate for all debt for the year ended December 31, 1997, including the fees associated with the borrowings and interest rate swaps, was 7.45%.
The Company's income from continuing operations for the year ended December 31, 1997 was $229.4 million, compared to $198.5 million for the year ended December 31, 1996. Earnings per share from continuing operations totaled $3.33 and $2.99 for the years ended December 31, 1997 and 1996, respectively. Earnings per share from continuing operations assuming full dilution totaled $3.30 and $2.99 for the years ended December 31, 1997 and 1996, respectively. Earnings per share for 1996 has been calculated in accordance with Statement of Financial Accounting Standards No. 128, Earning Per Share ("SFAS No. 128").
Earnings per share for the year ended December 31, 1997 is based upon weighted average shares outstanding, excluding common stock equivalents, of 68.8 million and 69.5 million shares, assuming full dilution. Earnings per share for the year ended December 31, 1996 has been calculated using 66.4 million shares for both measures. Common stock equivalents did not have a dilutive effect on earnings per share in 1996. The 1996 weighted average reflects the number of shares outstanding immediately following the Recapitalization, plus the weighted average number of shares issued in 1996 subsequent to the Recapitalization. For the year ended December 31, 1997, the increase in weighted average shares outstanding primarily relates to the public offering of 3,000,000 shares of the Company's common stock in April 1997 and, on a diluted basis, the inclusion of 651,000 common stock equivalents related to the Company's stock option plans.
Overall claims liabilities increased $14.7 million, or 1.1%, from $1,305.9 million at December 31, 1997 to $1,320.6 million at December 31, 1998. This increase is due to the increase in membership offset by several factors. In 1998, the Company reduced its medical claims payable as it continued to reduce claims inventory related to its acquired MMHD business that was converted to the Company's information systems platform. The timing of pharmacy payments made at the end of 1998 further contributed to the reduction in overall claims liability. Finally, the Company experienced membership attrition in its acquired MMHD and GBO membership in its National business segment, which had higher average per member reserves compared to the average per member reserves for its California business, which experienced significant membership growth.
Stockholders' equity totaled $1,315.2 million as of December 31, 1998, an increase of $92.0 million from $1,223.2 million as of December 31, 1997. The increase resulted primarily from the net income of $231.3 million for the year ended December 31, 1998, $39.4 million in stock issuances under the Company's stock option and stock purchase plans, a $14.6 million increase in net unrealized valuation adjustments on investment securities, net of tax, offset by treasury stock repurchases totaling $193.3 million.
Net cash used in continuing investing activities in 1998 totaled $21.6 million, compared with $376.4 million in 1997. The cash used in 1998 was attributable primarily to the purchase of investments for $2,843.1 million and net purchases of property and equipment totaling $52.7 million, offset by the proceeds from investments sold and matured of $2,772.8 million, and proceeds from the sale of the workers' compensation business totaling $101.4 million.
During the quarter ended September 30, 1998, the Company received a private letter ruling from the Internal Revenue Service. The Company expects its future liquidity to be positively affected by the anticipated receipt of a $200 million tax refund and a decrease in future income tax payments of approximately $80 million (See Note 8 to the Consolidated Financial Statements).
Certain of the Company's subsidiaries are required to maintain minimum capital requirements prescribed by various regulatory agencies, including the California Department of Corporations and Departments of Insurance in various states. See Note 19 to the Consolidated Financial Statements. As of December 31, 1998, those subsidiaries of the Company were in compliance with all minimum capital requirements.
In July 1996, the Company filed a registration statement relating to the issuance of $1.0 billion of senior or subordinated unsecured indebtedness. As of December 31, 1998, no indebtedness had been issued pursuant to this registration statement.
Asset interest rate risk is managed within a duration band tied to the Company's liability interest rate risk. Credit risk is managed by maintaining high average quality ratings and a well-diversified portfolio.
The Company's use of derivative instruments is generally limited to hedging purposes and has principally consisted of forward exchange contracts intended to minimize the portfolio's exposure to currency volatility associated with certain foreign bond holdings. The Company's investment policy prohibits the use of derivatives for leveraging purposes as well as the creation of risk exposures not otherwise allowed within the policy.
In 1996, the Company entered into interest rate swap agreements by exchanging the floating debt payments due under its outstanding indebtedness for fixed rate payments. The Company believes that this allows it to better anticipate its interest payments while helping to manage the asset-liability relationship.
The Company has evaluated the net impact to the fair value of its fixed income investments and interest rate swap agreements resulting from a hypothetical change in all interest rates of 100, 200 and 300 basis points ("bp"). In doing so, optionality was addressed through Monte Carlo simulation of the price behavior of securities with embedded options. Changes in the fair value of the investment portfolio are reflected in the balance sheet through stockholders' equity. Changes in the fair value of the interest rate swap agreements, to the extent they serve as effective hedges, are not currently reflected on the balance sheet. Under the requirements of SFAS No. 133, effective January 1, 2000, all derivative financial instruments will be reflected on the balance sheet at fair value. The terms of the Company's interest rate
The Company believes that an interest rate shift in a 12-month period of 100 bp represents a moderately adverse outcome, while a 200 bp shift is significantly adverse and a 300 bp shift is unlikely given historical precedents. Although the Company holds its bonds as "available for sale" for purposes of SFAS No. 115, the Company's cash flows and the short duration of its investment portfolio should allow it to hold securities to maturity, thereby avoiding the recognition of losses, should interest rates rise significantly.
The Company's equity securities are comprised primarily of domestic stocks as well as certain foreign holdings. Assuming an immediate decrease of 10% in equity prices, as of December 31, 1998, the hypothetical loss in fair value of stockholders' equity is estimated to be approximately $27.4 million.
The Company has generally hedged the foreign exchange risk associated with its fixed income portfolio. The Company generally uses short-term foreign exchange contracts to hedge the risk associated with certain fixed income securities denominated in foreign currencies. Therefore, the Company believes that there is minimal risk to the fixed-income portfolio due to currency exchange rate fluctuations. The Company's hedging program related to its foreign currency denominated investments is described in Note 16 to the Consolidated Financial Statements.
The Company does not hedge its foreign exchange risk arising from equity investments denominated in foreign currencies. Assuming a foreign exchange loss of 10% across all foreign equity investments, the net hypothetical pre-tax loss in fair value as of December 31, 1998 is estimated to be $5.5 million.
The Company intends to incur debt to finance some or all of the cash payments to be made to Cerulean shareholders in connection with the pending acquisition. In addition, WellPoint has received authorization to, and is currently in the process of, repurchasing shares of WellPoint stock to offset shares that are expected to be issued in connection with the transaction. The Company has made significant purchases of treasury stock for this purpose utilizing excess cash as well as the incurrence of additional debt. Upon completion of the Cerulean transaction, WellPoint could incur significant additional indebtedness to fund not only the cash portion of the transaction but to fund any further repurchase of shares of WellPoint stock. Such additional indebtedness may require that a significant amount of the Company's cash flow be applied to the payment of interest, and there can be no assurance that the Company's operations will generate sufficient cash flow to service the indebtedness. Any additional indebtedness may adversely affect the Company's ability to finance its operations and could limit its ability to pursue business opportunities that may be in the best interests of the Company and its stockholders.
The Company and certain of its subsidiaries are subject to capital requirements by the California Department of Corporations, various other state departments of insurance and the Blue Cross Blue Shield Association. Although the Company is currently in compliance with all applicable requirements, there can be no assurances that such requirements will not be increased in the future.
Managed care organizations, both inside and outside California, operate in a highly competitive environment that has undergone significant change in recent years as a result of business consolidations, new strategic alliances, aggressive marketing practices by competitors and other market pressures. Additional increases in competition could adversely affect the Company's financial condition, cash flows or results of operations.
because such purchasers are generally unable or unwilling to bear greater liability for health care expenditures. Typically, government-sponsored programs involve the Company's higher-risk managed care products. Over the past few years, the Company has experienced greater margin erosion in its higher-risk managed care products than in its lower-risk managed care and management services products. This margin erosion is attributable to product mix change, product design, competitive pressure and greater regulatory restrictions applicable to the small employer group market. In 1998, the Company implemented price increases in certain of its managed care businesses. In response to higher than anticipated utilization with respect to certain co-payment products offered to the Company's individual and small group customers in California, the Company has recently implemented premium increases with respect to such products. While these price increases are intended to improve profitability, there can be no assurance that this will occur. Subsequent unfavorable changes in the relative profitability between the Company's various products could have a material adverse effect on the Company's results of operations and on the continued feasibility of the Company's geographic expansion strategy.
Substantially all of the Company's investment assets are in interest-yielding debt securities of varying maturities or equity securities. The value of fixed income securities is highly sensitive to fluctuations in short- and long-term interest rates, with the value decreasing as such rates increase or increasing as such rates decrease. In addition, the value of equity securities can fluctuate significantly with changes in market conditions. Changes in the value of the Company's investment assets, as a result of interest rate fluctuations, can affect the Company's stockholders' equity. There can be no assurances that interest rate fluctuations will not have a material adverse effect on the financial condition of the Company.
The Company is dependent on retaining existing employees and attracting additional qualified employees to meet its future needs. The Company faces intense competition for qualified personnel, especially qualified computer programmers, actuaries and other professional and technical employees. There can be no assurances that an inability to retain existing employees or attract additional employees will not have a material adverse effect on the Company's results of operations.
The location in this Form 10-K of the Company's Consolidated Financial Statements is set forth in the "Index" on page 53 hereof.
(A) Financial information for quarters prior to June 30, 1998 has been restated to include the workers' compensation business as a discontinued operation.
(B) The second quarter of 1998 includes a charge of $48.7 million, before tax, $29.0 million, after tax, or $0.26 per basic and diluted share related to the write off of the Company's investment in FPA Holdings, Inc.
(C) The third quarter of 1998 includes a tax benefit of $85.5 million, or $1.24 per basic and $1.21 per diluted share related to a favorable IRS ruling regarding the deductibility of a cash payment made by the Company's former parent company at the time of its May 20, 1996 Recapitalization.
(D) The first and second quarters of 1997 include nonrecurring costs of $6.5 million and $8.0 million, before tax, $3.8 million and $4.8 million, after tax, or $0.06 per share and $0.07 per basic and diluted share, respectively.