The Company considers its facilities to be in good working condition, well maintained and adequate for its present needs.
Government premiums rose $464 million to $1.6 billion for the year ended September 30, 1994 from $1.2 billion in the prior year. Excluding the effects of acquisitions described above, enrollment gains predominately in the Secure Horizons program contributed 80 percent of this increase. Average premium rate increases of two percent accounted for nine percent of the increase. The remainder of the change is attributable to acquisitions. In September 1994, the Company was advised by HCFA that effective January 1995, its HMOs will receive a weighted average premium rate increase of approximately 5.4 percent.
The decrease in the commercial medical loss ratio is primarily attributable to lower inpatient hospital costs. The decrease in the government medical loss ratio is primarily related to lower hospital expenses and increases in net positive reserve adjustments described below.
The health care service expenses for the years ended September 30, 1994 and 1993, reflect the impact of net positive reserve adjustments of approximately $9 million and $6 million, respectively. These net positive reserve adjustments result primarily from the periodic reconciliation of amounts reserved for physician incentive programs and revised estimates for hospital services and other health care costs which have been incurred but not yet reported. The Company periodically makes adjustments to these estimated expenses based on actual calculations and changed expectations. The $4 million increase in net positive reserve adjustments is primarily attributable to increases in members served under hospital capitation arrangements and improved contracting.
Marketing, general and administrative expenses increased $115 million to $395 million for the year ended September 30, 1994 from $280 million for 1993. As a percentage of operating revenue, marketing, general and administrative expenses increased to 13.6 percent from 12.6 percent. These increases are primarily attributable to higher costs related to developing markets, products and services in new as well as established geographic areas and incremental expenses to integrate acquisitions. Future marketing, general and administrative expenses as a percentage of operating revenue are expected to be comparable or slightly less than the current year as the Company obtains efficiency through process improvement.
Government average premium rate increases of nine percent described above were partially offset by increases in hospital capitation expenses and increased benefits provided to members, including prescription drugs. These factors resulted in a decrease in the medical loss ratio for the government program of one percent for the year ended September 30, 1993.
Marketing, general and administrative expenses increased $50 million to $280 million for the year ended September 30, 1993 from $230 million for 1992. As a percentage of total operating revenue, marketing, general and administrative expenses decreased to 12.6 percent in 1993 from 13.6 percent in 1992. This decrease was primarily attributable to increased operating revenue, decreased consulting costs and a reduction in one-time costs of approximately $6 million related to the HPA integration included in 1992.
Cash generated from operations increased by $153 million for the year ended September 30, 1994 as compared to the prior year. The majority of this change is the result of an increase of $151 million in unearned premium revenue which occurred because the advance payment for Medicare premiums for October 1994 was received in September 1994; whereas, in 1993, the October payment was received in October 1993.
PAGE ---- Consolidated Balance Sheets . . . . . . . . . . . . . . . . . . . . . . 20 Consolidated Statements of Income . . . . . . . . . . . . . . . . . . . 21 Consolidated Statements of Shareholders' Equity . . . . . . . . . . . . 22 Consolidated Statements of Cash Flows . . . . . . . . . . . . . . . . . 23 Notes to Consolidated Financial Statements. . . . . . . . . . . . . . . 24 Report of Ernst & Young LLP Independent Auditors. . . . . . . . . . . . 34 Quarterly Information for Fiscal Years 1994 and 1993 (Unaudited) . . . . . . . . . . . . . . . . . . . . . . . . . . . 35
a) Organization and Operations. PacifiCare Health Systems, Inc. (the "Company") owns and operates federally qualified health maintenance organizations ("HMOs"), which provide health care services principally for a predetermined, prepaid periodic fee to enrolled subscriber groups through independent health care organizations under contract. The Company also offers certain specialty products and services to group purchasers and to other managed care organizations and their beneficiaries, including Medicare risk management services, pharmacy benefit management, military health care management, coordination of managed care products for multi-region employers, health and life insurance, behavioral health, workers' compensation, dental and vision services and health promotion. UniHealth America ("UniHealth"), a California non-profit public benefit corporation, owned approximately 48 and 21 percent of the Company's outstanding shares of Class A and Class B Common Stock, respectively, at September 30, 1994.
b) Basis of Presentation. The accompanying consolidated financial statements include the accounts of the Company and all significant subsidiaries which are more than 50 percent owned and controlled. All significant intercompany transactions and balances have been eliminated in consolidation.
d) Goodwill and Intangible Assets. Goodwill and intangible assets represent principally the unamortized excess of the cost of acquiring subsidiary companies over the fair values of such companies' net tangible assets at the dates of acquisition. Goodwill and intangible assets are amortized on a straight-line basis over periods not exceeding forty years. Net intangible assets totaling $844,000 were written off in 1993, reducing earnings per share by approximately $0.03. These assets, which were related to the Company's health and life insurance subsidiary, were determined to have no continuing value. As of September 30, 1994 and 1993, accumulated amortization totaled $8,798,000 and $5,481,000, respectively.
e) Software Costs. Direct costs associated with the development of computer software are expensed as incurred. These costs totaled $9,626,000, $7,047,000 and $6,186,000 in 1994, 1993 and 1992, respectively.
The Company's HMOs have various programs that provide incentives to participating medical groups through the use of risk-sharing agreements and other programs. Payments are made to medical groups based on their performance in controlling health care costs while providing quality health care. Expenses related to these
h) Utilization Review and Case Management Services. The Company's HMOs conduct utilization review and case management programs to ensure that their providers deliver a consistent quality of care to members. The utilization review program essentially provides patients with second opinions, while the case management program assigns nurses to complicated, high-risk or chronic cases to evaluate and recommend treatment options to the patient and provider. The costs associated with providing these medical services are recorded in general and administrative expenses and totaled $10,856,000, $8,897,000 and $6,999,000 for the fiscal years ended September 30, 1994, 1993 and 1992, respectively.
j) Taxes Based on Premiums and Income. Certain states in which the Company does business require the remittance of excise, per capita or premium taxes based upon a specified rate for enrolled members or a percentage of billed premiums. Such taxes may be levied in lieu of a state income tax. These amounts are recorded in general and administrative expenses and totaled $4,033,000, $3,261,000 and $2,808,000 for the fiscal years ended September 30, 1994, 1993 and 1992.
As of October 1, 1993, the Company adopted SFAS No. 109, ACCOUNTING FOR INCOME TAXES and recorded a benefit for the cumulative effect prior to October 1, 1993 of the change in accounting principle of $5,658,000 or approximately $0.20 per share. SFAS No. 109 is an asset and liability approach that requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been recognized in the Company's financial statements or tax returns. In estimating future tax consequences, SFAS No. 109 generally considers all expected future events other than enactments of changes in the tax law or rates. Previously, the Company used the SFAS No. 96 asset and liability approach that gave no recognition to future events other than the recovery of assets and settlement of liabilities at their carrying amounts. As permitted by SFAS No. 109, the Company has elected not to restate the financial statements of any prior years.
The following table summarizes the unaudited pro forma consolidated results of the Company as though the completed acquisitions occurred at the beginning of the periods presented giving effect to the interest income foregone, the costs associated with the integration of the operations into those of the Company and the amortization of the excess of the purchase price over the fair value of the assets acquired. The unaudited pro forma information is not necessarily indicative of the actual consolidated results of operations that would have occurred had the completed acquisitions occurred at the beginning of the period and is not intended to be indicative of results which may occur in the future.
In January 1994, the Company established with The Chase Manhattan Bank ("Chase") and a syndicate of banks, a $130 million revolving line of credit (the "Credit Line"). The Company has and will continue to borrow under the Credit Line during a one-year period commencing January 1994, after which any amount outstanding will be converted into a two year term loan. Interest will be paid over the three year period at a rate per annum equal to the London Interbank Offered Rate plus a spread ranging from 0.3125 percent to 0.6250 percent or the prime rate. At September 30, 1994, the weighted average interest rate was 5.33 percent. Certain subsidiaries guarantee the Credit Line to the extent permitted by regulatory authorities. Advances have been classified as long-term debt because of the Credit Line's conversion feature.
The Company is currently negotiating a $250 million revolving line of credit with Bank of America and a syndicate of banks. Most of the banks in the current syndicate will participate in the new syndicate. The Company anticipates that this new credit line will be in place by December 1994.
As of September 30, 1994, the maturities of long-term debt for the years following 1994 are as follows:
In September 1994, the Company commenced a public offering of 750,000 shares of the Company's Class B Common Stock to certain physicians groups (the "Groups") which currently contract with the Company. If a Group agrees to purchase shares in this offering, it will enter into an agreement whereby it will be irrevocably obligated to purchase a fixed number of shares of the Class B Common Stock at a fixed price payable over a five year period beginning May 1, 1996. To date, the Company has not entered into any agreements with any of the Groups to sell shares under this offering.
On June 4, 1992, the shareholders of the Company approved an Amendment (the "Reclassification Amendment") to the Company's Certificate of Incorporation, as amended. The Reclassification Amendment: (a) reclassified the existing common stock as Class A Common Stock; (b) authorized a new class of non-voting common stock designated as non-voting Class B Common Stock (the Class A Common Stock together with the Class B Common Stock shall hereinafter be referred to as the "Common Stock"); (c) increased the total number of authorized shares of Common Stock from 20 million to 90 million, consisting of 30 million shares of Class A Common Stock and 60 million shares of Class B Common Stock; (d) established the rights, powers and limitations of both classes of common stock; and (e) reduced the par value of the Common Stock from $0.50 per share to $0.01 per share.
The Company purchased health care services from hospitals owned and managed by UniHealth totaling $61,497,000, $55,482,000 and, $30,160,000 for the years ended September 30, 1994, 1993 and 1992, respectively. Under the terms of a management arrangement with UniHealth, the Company paid $831,000, $1,221,000 and $832,000 for management fees, payroll processing services and other services in the years ended September 30, 1994, 1993 and 1992, respectively. Amounts payable to UniHealth were $251,000 and $410,000 at September 30, 1994 and 1993, respectively.
Joseph S. Konowiecki, the secretary and general counsel of the Company, is the sole shareholder of Joseph S. Konowiecki, Inc., a California professional corporation, which is a partner of the law firm of Konowiecki & Rank. The Company purchased legal services from Konowiecki & Rank in the amounts of $3,137,888, $2,251,000 and $2,397,000 for the years ended September 30, 1994, 1993 and 1992, respectively. The amounts payable to Konowiecki & Rank at September 30, 1994 and 1993 were $248,000 and $151,000, respectively.
Effective October 1, 1993, the Company changed its method of accounting for income taxes from the deferred method to the liability method required by FASB Statement No. 109, "Accounting for Income Taxes" (See Note 2j - "Taxes Based on Premiums and Income"). As permitted under the new rules, prior years' financial statements have not been restated.
The following table summarizes significant differences between the provision for income taxes and the amount computed by applying the statutory federal income tax rates to income before income taxes:
based upon a percentage of pretax income. Employees may defer up to twelve percent of their annual compensation under the Plan, with the Company matching one half of the deferred amount, up to a maximum of three percent of annual compensation. Amounts charged to expense applicable to the plan were $10,298,000, $7,774,000 and $4,908,000 for the years ended September 30, 1994, 1993 and 1992, respectively.
Grants under the 1985 Plan and 1989 Director Plan were suspended. The total number of shares of common stock which may be granted as incentive stock options, non-qualified stock options, stock appreciation rights and stock payments ("Awards") under the 1989 Employee Plan is up to (i) 805,558 shares for Awards granted prior to October 1, 1992 and (ii) one and one-half percent of the outstanding shares of Common Stock of the Company as of the last day of the previous fiscal year for Awards granted each fiscal year on and after October 1, 1992. Options may be granted for a term of up to ten years at a price not less than 100 percent of the fair market value of the common shares at the time of grant.
The 1992 Director Plan provides for a maximum of 140,000 shares of Class B Common Stock issuable upon the exercise of non-qualified stock options granted to eligible non-officer Directors of the Company. Any non-officer Director of the Company not eligible to receive options under the 1989 Employee Plan shall be eligible to receive options under the 1992 Director Plan.
The following table summarizes the activity in non-qualified stock options under the 1985 Plan, the 1989 Employee Plan, the 1989 Director Plan and the 1992 Director Plan for the years ended September 30, 1994 and 1993:
At September 30, 1994, approximately 1,756,000 shares were reserved for issuance upon the exercise of outstanding options. As of that date, 418,084 options were exercisable for Class A shares at an exercise price of $1.63 - $19.75 per share and 485,705 options were exercisable for Class B shares at an exercise price of $1.63 - $44.75. No stock appreciation rights have been awarded under the 1989 Employee Plan.
c) Performance Incentive Programs. The Company has a long-term performance incentive program administered by a subcommittee of the Compensation Committee of the Board of Directors (the "Committee"). Under the terms of the program, all Executive Officers (as defined in Rule 3b-7 of the Exchange Act) of the Company and certain officers and key employees of the Company and its subsidiaries are eligible for participation. Incentive compensation is based on the achievement of objectives established by the Committee and approved by the shareholders of the Company. The performance objectives are based on increases in shareholders' equity and increases in the revenue of non-core businesses, measured over a three-year period. A minimum target for return on equity must be achieved before the measurement for increasing revenue may be applied. A new three-year performance period commences annually and minimum and maximum targets for each measurement objective vary for each performance cycle. Except for Executive Officers, at the end of each performance period, the
c) Litigation. The Company is involved in legal actions in the normal course of business, some of which seek substantial monetary damages, including claims for punitive damages which are not covered by insurance. After review, including consultation with counsel, management believes any ultimate liability in excess of amounts accrued which could arise from the actions would not materially affect the Company's consolidated financial position or results of operations.
We have audited the accompanying consolidated balance sheets of PacifiCare Health Systems, Inc. as of September 30, 1994 and 1993, and the related consolidated statements of income, shareholders' equity and cash flows for each of the three years in the period ended September 30, 1994. Our audits also included the financial statement schedules listed in the Index at Item 14(a)(2). These financial statements and schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of PacifiCare Health Systems, Inc. as of September 30, 1994 and 1993, and the consolidated results of its operations and its cash flows for each of the three years in the period ended September 30, 1994 in conformity with generally accepted accounting principles. Also in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein.