-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, J8lxONcrxOJPW9PKHB2iQdxWqarS6V5eFvvwp6i93T+S1IEDI8uRm8A7JrM1uusU tvcnaD2AbyF2Z4v6HW+HTg== 0000892569-99-000592.txt : 19990301 0000892569-99-000592.hdr.sgml : 19990301 ACCESSION NUMBER: 0000892569-99-000592 CONFORMED SUBMISSION TYPE: 10-K PUBLIC DOCUMENT COUNT: 9 CONFORMED PERIOD OF REPORT: 19981231 FILED AS OF DATE: 19990226 FILER: COMPANY DATA: COMPANY CONFORMED NAME: PACIFICARE HEALTH SYSTEMS INC /DE/ CENTRAL INDEX KEY: 0001027974 STANDARD INDUSTRIAL CLASSIFICATION: HOSPITAL & MEDICAL SERVICE PLANS [6324] IRS NUMBER: 954591529 STATE OF INCORPORATION: DE FISCAL YEAR END: 0930 FILING VALUES: FORM TYPE: 10-K SEC ACT: SEC FILE NUMBER: 000-21949 FILM NUMBER: 99551333 BUSINESS ADDRESS: STREET 1: 3120 LAKE CENTER DRIVE CITY: SANTA ANA STATE: CA ZIP: 92704 BUSINESS PHONE: 7148255200 MAIL ADDRESS: STREET 1: 3120 LAKE CENTER DRIVE CITY: SANTA ANA STATE: CA ZIP: 92704 FORMER COMPANY: FORMER CONFORMED NAME: N T HOLDINGS INC DATE OF NAME CHANGE: 19961204 10-K 1 FORM 10-K FOR FISCAL YEAR ENDED DECEMBER 31, 1999 1 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 ------------------------ FORM 10-K (MARK ONE) [X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE YEAR ENDED DECEMBER 31, 1998 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM ____________ TO ____________ . COMMISSION FILE NUMBER 000-21949 ------------------------ PACIFICARE HEALTH SYSTEMS, INC. (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER) DELAWARE 95-4591529 (STATE OR OTHER JURISDICTION (IRS EMPLOYER IDENTIFICATION NUMBER) OF INCORPORATION OR ORGANIZATION)
3120 LAKE CENTER DRIVE, SANTA ANA, CALIFORNIA 92704 (ADDRESS OF PRINCIPAL EXECUTIVE OFFICES, INCLUDING ZIP CODE) (REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE) (714) 825-5200 SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT: NONE SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT: CLASS A COMMON STOCK, PAR VALUE $0.01 CLASS B COMMON STOCK, PAR VALUE $0.01 ------------------------ Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [ ] The aggregate market value of common stock held by non-affiliates of the Registrant on January 29, 1999 was approximately $2,645,900,000. The number of shares of Class A Common Stock and Class B Common Stock outstanding at January 29, 1999 was approximately 14,800,000 and 30,800,000 respectively. DOCUMENTS INCORPORATED BY REFERENCE DOCUMENT WHERE INCORPORATED PORTIONS OF THE REGISTRANT'S DEFINITIVE PROXY PART III STATEMENT TO BE FILED BY APRIL 30, 1999
- -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- 2 PACIFICARE HEALTH SYSTEMS, INC. INDEX TO ANNUAL REPORT ON FORM 10-K FOR THE YEAR ENDED DECEMBER 31, 1998
PAGE ---- PART I Item 1. Business.................................................... 1 Item 2. Properties.................................................. 9 Item 3. Legal Proceedings........................................... 9 Item 4. Submission of Matters to a Vote of Security Holders......... 9 PART II Item 5. Market for the Company's Common Equity and Related Stockholders Matters........................................ 10 Item 6. Selected Financial Data..................................... 11 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations................................... 13 Item 7A. Quantitative and Qualitative Disclosures About Market Risk........................................................ 26 Item 8. Consolidated Financial Statements and Supplementary Data.... 27 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure.................................... 27 PART III Item 10. Directors and Executive Officers of the Registrant.......... 27 Item 11. Executive Compensation...................................... 27 Item 12. Security Ownership of Certain Beneficial Owners and Management.................................................. 27 Item 13. Certain Relationships and Related Transactions.............. 27 PART IV Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K......................................................... 28
i 3 PART I ITEM 1. BUSINESS OVERVIEW PacifiCare Health Systems, Inc. is one of the nation's leading managed health care services companies, serving approximately 3.5 million members in nine states and Guam as of December 31, 1998. We operate health maintenance organizations ("HMOs") and offer HMO related products and services. HMOS AND HMO RELATED PRODUCTS AND SERVICES. PacifiCare offers HMO and HMO-related products and services primarily to the Medicare and commercial markets. An HMO is a health care organization that combines aspects of a health care insurer with those of a health care provider by arranging for health care services for its members through a defined provider network at a reduced deductible or a nominal copayment. Our Medicare programs and commercial plans are designed to deliver quality health care and customer service to members at cost-effective prices. - - SECURE HORIZONS(R). For Medicare beneficiaries, PacifiCare offers health care services through its Secure Horizons(R) programs. Secure Horizons programs are the largest Medicare+Choice programs in the United States (as measured by membership). Secure Horizons membership has grown from approximately 0.3 million members at December 31, 1993 to approximately 1.0 million members at December 31, 1998. - - COMMERCIAL. For the commercial employer market, PacifiCare offers a range of products and benefit plan designs that vary in the amount of member copayments. These options allow employers flexibility in selecting cost-effective benefit packages for their employees. PacifiCare's commercial membership has grown from approximately 0.8 million members at December 31, 1993 to 2.5 million members at December 31, 1998. We also offer a variety of specialty HMO managed care and HMO related products and services that employers can purchase as a supplement to our basic commercial plans or as stand-alone products. These products include behavioral health services, life and health insurance, dental and vision services and pharmacy benefit management. We generally provide these specialty services through subcontracts or referral relationships with other health care providers. NATURE OF OPERATIONS PacifiCare's membership at December 31, 1998 was as follows:
SECURE PERCENT HORIZONS COMMERCIAL TOTAL OF TOTAL -------- ---------- --------- -------- Arizona........................................ 86,500 107,100 193,600 5.5% California..................................... 599,800 1,595,000 2,194,800 62.2 Colorado....................................... 58,500 296,600 355,100 10.1 Guam........................................... -- 39,800 39,800 1.1 Nevada......................................... 22,900 38,900 61,800 1.7 Ohio........................................... 16,600 44,000 60,600 1.7 Oklahoma....................................... 26,900 96,300 123,200 3.5 Oregon......................................... 39,300 114,700 154,000 4.4 Texas.......................................... 61,900 127,100 189,000 5.4 Washington..................................... 60,400 94,600 155,000 4.4 ------- --------- --------- ----- Total membership............................... 972,800 2,554,100 3,526,900 100.0% ======= ========= ========= =====
SECURE HORIZONS PROGRAMS GENERAL. We have offered Secure Horizons programs to Medicare beneficiaries since 1985 through participation in the Medicare risk program with the Health Care Financing Administration or HCFA. Beginning January 1, 1999, we participate in the new Medicare+Choice program which replaced the Medicare risk program. To participate in the Medicare+Choice program, HCFA requires that HMOs be either federally qualified or meet similar requirements as a competitive medical plan to be eligible for Medicare+Choice contracts. All of our HMO operations meet these requirements. Our Medicare+Choice 1 4 contracts entitle us to annual fixed per-member premiums. Under current law, our premiums are based upon the average cost of providing traditional fee-for-service Medicare benefits to the Medicare population in each county, subject to annual limits on the growth of our premiums. Our premium growth is also limited by an overall cap on the growth of all payments under all Medicare+Choice contracts. Future premiums from HCFA will be impacted by new payment methods being developed by HCFA. See Government Regulation -- "HCFA." Our per-member premium revenue for the Secure Horizons programs usually is, and will continue to be, more than three times higher than for our commercial plans primarily because of the higher medical and administrative costs of serving a Medicare member. As a result of the premium differences, the Secure Horizons programs accounted for approximately 59 percent of our consolidated premium revenue for the year ended December 31, 1998, and an even larger percentage of our operating profit, even though it represented only 28 percent of our total membership. The Secure Horizons programs are subject to certain risks relative to our commercial plans, such as higher comparative medical costs, higher levels of utilization, government and regulatory reporting requirements, the possibility of reduced or insufficient government reimbursement in the future and higher marketing and advertising costs associated with selling to individuals rather than to employer groups. These risks may adversely affect our operating margins on these programs and our overall profitability. In addition, each Secure Horizons member enrolls individually in our program, and may disenroll by providing 30 days notice. We believe that our Secure Horizons programs have one of the lowest disenrollment rates among Medicare+Choice plans. HCFA may unilaterally revise our Medicare+Choice contracts based on updated demographic information relating to the Medicare population and the cost of providing health care in a particular geographic area. PacifiCare's Medicare+Choice contracts are automatically renewed every 12 months unless we or HCFA elect to terminate them. HCFA may also terminate our Medicare+Choice contracts if we fail to continue to meet compliance and eligibility standards. Termination of our Medicare+Choice contracts would have an effect on our financial position, results of operations, cash flows or business prospects. We have had these contracts in some states for at least 13 years. We have no reason to believe that these terminations will occur. COMMERCIAL PROGRAMS GENERAL. PacifiCare's commercial plans offer a comprehensive range of products to employer groups, including HMO, Preferred Provider Organization ("PPO") and Point of Service ("POS") plans. A PPO is a selected group of providers, such as medical groups, that offers discounted fee-for-service health care. POS plans combine the features of an HMO with the features of a traditional indemnity insurance product, allowing members to choose from a network of providers at a lower cost or from other physicians at a higher deductible or copayment. Our HMOs also have commercial contracts with the United States Office of Personnel Management ("OPM") to provide managed health care services to approximately 204,000 members under the Federal Employee Health Benefits Program ("FEHBP") for federal employees, annuitants and their dependents. COMMERCIAL RETIREE PRODUCTS. In response to the needs of employers to provide cost-effective health care coverage to their retired employees who may or may not be currently entitled to Medicare, we offer the Secure Horizons retiree product. This product draws on our Medicare expertise by offering provider networks that are similar to those offered to our Secure Horizons enrollees. We set our premiums generally based on the same revenue requirements needed to provide services to Secure Horizons members. The retiree product gives us access to individuals who, once familiar with our services and delivery system, may enroll in Secure Horizons programs when they become eligible for Medicare benefits. HMO RELATED PRODUCTS AND SERVICES. In addition to our HMO operations, PacifiCare provides a range of specialty managed care products which supplement our HMO products and are primarily sold in our commercial programs. These include: - - Behavioral Health Services. PacifiCare Behavioral Health of California, Inc. is a California licensed specialized health care service plan that provides behavioral health care services, including chemical dependency benefit programs, primarily to our California and other HMO commercial members. Outside of California, PacifiCare Behavioral Health, Inc. contracts with our HMOs, other insurers and employers to manage their respective mental health and chemical dependency benefit programs. 2 5 - - Life and Health Insurance. PacifiCare's life and health insurance subsidiaries, PacifiCare Life and Health Insurance Company and PacifiCare Life Assurance Company, offer managed health care insurance products to employer groups. We integrate these products with our existing HMO products to form multi-option health benefits programs, including our PPO and POS plans. Together, our insurance subsidiaries are licensed to operate in 38 states, including each of the states where our HMOs operate, the District of Columbia, and Guam. - - Dental and Vision Services. PacifiCare Dental and Vision is a California licensed, specialized health care service plan that provides prepaid dental and optometry benefits directly to individuals and employer groups and indirectly to our California Secure Horizons and commercial HMO members. - - Pharmacy Benefit Management. PacifiCare Pharmacy Centers, Inc., dba Prescription Solutions(R), is one of the industry's largest pharmacy benefit management companies. Prescription Solutions offers pharmacy benefit management services to HMOs and employer groups that are self-insured for prescription drugs. Clients of Prescription Solutions have access to a pharmacy provider network that features independent and chain pharmacies and a variety of cost and quality management capabilities. Prescription Solutions also provides its clients with an array of fully integrated services, including mail order distribution, an extensive network of retail pharmacies, claims processing and sophisticated drug utilization reporting. - - Medicare+Choice Management. Formed to promote our expertise in the Medicare risk area, Secure Horizons USA, Inc., ("SHUSA") licenses the Secure Horizons name and provides management services to HMOs and health care delivery systems that seek participation in the Medicare+Choice program. SHUSA's management services include, marketing, provider contracting and administrative services. The fee charged by SHUSA is generally based on a percentage of a licensee's revenue. SHUSA has agreements in New Mexico with Presbyterian Healthcare Services, Inc., in New England with Tufts Associated Health Maintenance Organization, Inc., and in Hawaii with Queens Health Plans. We anticipate that Queens Health Plan will offer a product similar to Secure Horizons beginning in the summer of 1999, if HCFA approval is received. We anticipate that with the repeal of the 50/50 Rule (the requirement that 50 percent of a Medicare+Choice health plan's enrollment be drawn from commercial contracts) and the drive to enroll Medicare beneficiaries in HMOs, SHUSA may expand into new markets by entering into licensing arrangements in a variety of geographic areas. BUSINESS STRATEGY Our current business strategy continues to focus on growing and improving our operating performance. During 1999 we will seek to increase operating income by: - - Increasing commercial membership at improved commercial premium prices; - - Managing health care costs through capitated arrangements with strong provider organizations that align the interests of our providers with ours and our members; and - - Improving our administrative and marketing efficiencies to reduce the percentage of revenue spent on marketing, general and administrative expenses. Our ability to increase operating income is subject to various risks and uncertainties described throughout this document and other documents filed by PacifiCare with the Securities and Exchange Commission. We will also focus on improving quality and service in 1999. See Nature of Operations -- "Quality Improvement." Our goals include: - - Increasing Medicare and commercial member satisfaction; - - Improving the quality and service on our basic HMO products; - - Receiving National Committee for Quality Assurance ("NCQA") accreditation in Texas, where 1999 is our initial year of application; - - Maintaining NCQA accreditation in all other states; and - - Participating in the Coalition for Affordable Quality Healthcare to inform and educate the public about managed care. 3 6 We are also having continuing discussions with HCFA regarding the Medicare+Choice changes. See Government Regulation -- "HCFA." We continue to evaluate opportunities in new and existing geographic markets that may be available through acquisitions and the development of new products. We also continuously assess our geographic markets and product lines to determine if any do not fit within our profitability objectives and current business strategy. We believe that our ability to offer a comprehensive range of products and services, combined with long-term relationships with our health care providers, will enable us to respond effectively to the changing needs of the health care marketplace. COMPETITION The health care industry is highly competitive, both nationally and in PacifiCare's various markets. Consolidation in the health care industry has resulted in fewer but larger competitors, including insurance carriers, other HMOs, employer self-funded programs and PPOs, some of which have substantially larger enrollments or greater financial resources than PacifiCare. Also, because of this consolidation, we have become one of the largest HMOs in the country. Other competitors include hospitals, health care facilities and other health care providers. These competitors have combined to form their own networks to contract directly with employer groups, and other prospective customers for the delivery of health care services. We face competition in all our markets from national HMOs, insurance carriers, local HMOs, PPOs and other local health care providers. In this increasingly competitive environment, we believe that we should continue to provide a comprehensive range of products and services, along with a strong provider network, to remain competitive. Other factors which give us some competitive advantages in this environment are: - - Strong underwriting and pricing practices and staff; - - Significant market position in certain geographic areas; - - Financial strength; - - Experience; and - - A generally favorable marketplace reputation with providers, members and employers. RISK MANAGEMENT We use underwriting criteria as an integral part of our commercial risk management efforts. Underwriting is the process by which a health plan assesses the risk of enrolling employer groups (or individuals) and establishes appropriate or necessary premium rates. The setting of premium rates directly affects a health plan's profitability and marketing success. See "Health Care Costs." We cannot employ underwriting techniques for the Secure Horizons programs because of regulations that require us to accept nearly all Medicare beneficiaries. We shift part of our risk of catastrophic losses by maintaining reinsurance coverage for certain hospital costs incurred in the treatment of catastrophic illnesses. We require contracting physicians, physician groups and hospitals to maintain individual malpractice insurance coverage. We also maintain general liability, property and medical malpractice insurance coverage in amounts that we believe to be adequate. HEALTH CARE COSTS AND PROVIDER RELATIONSHIPS GENERAL. Our profitability and the success of our business strategy depends on our ability to attract and retain a network of qualified health care providers in each geographic area we serve. We contract with various providers, including primary care physicians, specialists, hospitals, and other ancillary service providers. Our contracts typically have one year terms. However, we have entered into multiple-year contracts with certain physician groups to ensure the quality and stability of our provider network. CAPITATION ARRANGEMENTS. PacifiCare typically contracts with providers on a capitated basis (a fixed fee per member per month, regardless of the services provided each member). Capitation payments to providers are often based on a percentage of the premium we receive; this is especially true for our Secure Horizons 4 7 contracts. The percentage of premium arrangement causes provider compensation to fluctuate directly with the amount of premiums we receive. The primary care physician group influences medical utilization and controls costs through referrals, hospitalization and other services. With capitation contracts, there are two possible administration arrangements for network contracting, utilization management and claims processing: - - DELEGATED ADMINISTRATION. In the majority of our networks, providers perform some or all of the administrative functions associated with operating in a capitated environment. In those situations, we provide support for their administrative functions to help them achieve greater levels of efficiency and autonomy while promoting the wellness of our members. We believe one of our core competencies is our ability to manage delegated provider relationships. - - DIRECT ADMINISTRATION. Other providers do not have the capability to manage the administrative functions associated with operating in a capitation environment. With such providers, we perform the administrative functions on their behalf. In addition, we work with those providers to assist them in developing the capability to assume a greater share of the administrative functions. We continue to develop our own expertise in this area to ensure that we can continue to build strong provider networks for our members in existing and new markets where providers may not be capable of performing these functions. FEE-FOR-SERVICE ARRANGEMENTS. In some of our markets, some health care providers are not contracted under capitated arrangements. Non-capitated arrangements may increase health care costs when utilization is not appropriately managed. To the extent possible we have renegotiated, or are in the process of renegotiating, these contracts to move the providers to a capitated payment plan. Our ability to renegotiate provider contracts in certain markets is limited due to a lack of provider competition. INCENTIVE ARRANGEMENTS. Our HMOs share the risk of certain health care costs, primarily in capitation arrangements. We provide additional incentives to the physicians or groups for appropriate utilization of hospital inpatient, outpatient surgery and emergency room services. We may also pay incentives to providers based on their performance in controlling health care costs while providing quality health care. UTILIZATION MANAGEMENT. We operate a utilization review system through which we review routine hospital admissions and lengths of stay. Our utilization review committees are composed of several physicians at each physician group. The committees approve non-emergency hospitalizations in advance of admission. Together with our medical services utilization staff, the committees carefully monitor the member's continued stay after admission. Through our medical services departments, we are actively involved in the utilization review of chronic and complex cases. These departments also actively monitor catastrophic cases in the field to ensure that members receive appropriate medical care and suggest treatment options that may be more appropriate and cost-effective than a long-term hospital stay. NETWORK STABILITY. We work closely with our provider partners to ensure the strength and quality of our network. We track provider stability and solvency on an ongoing basis to avoid network disruptions for our members and to minimize our financial risk. Provider assessments focus on solvency indicators, including liquidity and cash management. Operational information is reviewed periodically to assess the strength of the provider's financial management. When our delegated providers require assistance, we provide clinical management tools, clinical and operational best practices and performance benchmarks. PacifiCare has multiple year contracts with MedPartners Inc. ("MedPartners"). MedPartners provides services to over 0.1 million members or 10 percent of our total Medicare membership, and approximately 0.3 million members or 12 percent of our total commercial membership. In November 1998, MedPartners announced its intention to sell its physician groups and discontinue its physician practice management business. We are implementing programs to retain our physician networks in anticipation of these sales. The loss of physician networks could have a material effect on our revenues, profitability and business prospects. PROVIDER INSOLVENCY. When a delegated provider significantly slows or stops paying claims, we may take on the administrative functions described above. We may also shift membership to other providers, a step that is taken when a provider has or is expected to declare bankruptcy. Our 1998 results include significant provider insolvency costs, primarily related to FPA Medical Management Inc., ("FPA") who declared bankruptcy in July 1998. See Management's Discussion and Analysis. Provider insolvency reserves include write-offs of providers' uncollectable receivables and the estimated cost of unpaid health care claims covered by our capitation payment. 5 8 In addition to the insolvency costs, shifting membership to other providers increases our administrative costs and may increase future health care costs. QUALITY IMPROVEMENT GENERAL. We believe that providing our members with reasonable access to quality health care services is an essential ingredient for sustained success. To assure this, we focus on provider peer review procedures, member quality initiatives and national industry measures. PROVIDER PEER REVIEW PROCEDURES. We have established a peer review procedure at each HMO, governed by a quality improvement committee. The medical director for each HMO chairs that HMO's committee. Each committee consists of health plan clinical professionals and physician representatives from the contracted physician groups of that HMO. When we identify a new physician or physician group as a potential provider, the quality improvement committee of the HMO evaluates that provider. The quality assessment includes evaluating the quality of the providers' medical facilities, medical records, laboratory and x-ray licenses and its capacity to handle membership demands. We also engage in ongoing quality reviews of our existing providers to ensure that members are receiving quality medical care. MEMBER QUALITY INITIATIVES. To improve the quality of service and clinical outcomes for our members, we have developed a comprehensive quality improvement program including: - - Offering health improvement programs, including several chronic care management initiatives, preventive health programs, smoking cessation, and senior health risk assessments; - - Standardizing and streamlining our specialty provider referral process; - - Improving our complaint management program to better coordinate problem resolution; and - - Monitoring member satisfaction through surveys and internal operational report cards compared to our current established benchmarks. In markets where these initiatives have been fully implemented, we have seen significant improvements in member health outcomes and member satisfaction. NATIONAL INDUSTRY MEASURES. Our HMOs provide quality and service information under the Health Plan Employer Data Set ("HEDIS") program. Our membership and provider quality initiatives described above are designed to improve our scores. The NCQA is an independent, non-profit organization that reviews and accredits HMOs. NCQA performs site reviews of standards established for quality improvement, utilization management, physician credentialing process, a commitment to members' rights and preventative health services. HMOs that comply with NCQA's review requirements and quality standards receive NCQA accreditation. At December 31, 1998, our HMOs in Arizona, California, Colorado, Nevada, Oklahoma and Oregon (covering approximately 87 percent of our membership) have received full three year NCQA accreditation. In 1999, we will complete the NCQA site review in Texas. MARKETING Primary marketing responsibility for each of our HMOs and HMO related products and services resides with a marketing director and direct sales force. SECURE HORIZONS MARKETING. We market our Secure Horizons programs to Medicare beneficiaries primarily through direct mail, telemarketing, television, radio and cooperative advertising with participating medical groups. Most Secure Horizons members enroll directly in a plan, generally without the involvement of insurance brokers, except when enrolling as part of an employer group retiree offering. We anticipate further growth opportunities in the Medicare+Choice program based on our current marketing strategies, and the growing senior population in the United States. See "Nature of Operations -- Secure Horizons Programs" and "Commercial Programs and Medicare+Choice Management." 6 9 COMMERCIAL MARKETING. Commercial marketing is a two-step process where we first market to employer groups, and then provide information directly to employees once the employer has selected our HMO. We solicit new employer groups of various sizes through direct, personal selling efforts and through contacts with insurance brokers and consultants. Insurance brokers and consultants represent many employer groups under contract with PacifiCare. These brokers and consultants work directly with employers to recommend or design employee benefits packages. We pay insurance brokers commissions over the life of the contract, while employers generally pay consultants directly. A significant portion of our commercial membership growth comes from existing employer groups. With each open enrollment, we identify our specific approach with certain employer groups to increase our penetration. We use various techniques to attract commercial members, including work site presentations, direct mail, medical group tours and local advertising. We also use television, radio, billboard, and print media to market our programs. MANAGEMENT INFORMATION SYSTEMS GENERAL. PacifiCare uses computer-based management information systems for various purposes, including marketing and sales tracking, underwriting, billing, claims processing, utilization management, medical cost and utilization trending, financial and management accounting, reporting, planning, and analysis. These systems also support member, group and provider service functions, including on-line access to membership verification, claims and referral status, and information regarding hospital admissions and lengths of stay. In addition, these systems support extensive analyses of cost and outcome data. We continually enhance and upgrade our computer information systems to preserve our investment in existing systems, embrace new technologies, improve the cost effectiveness and quality of our services, and introduce new products. Ongoing system enhancements include upgrading mainframe computers, enhancing existing software, implementing purchased software, and migrating to more suitable software database environments. Simplification, integration, and expansion of the systems servicing our business is an important component of controlling health care and administrative expenses and improving member and provider satisfaction. We have recovery plans in place to mitigate the effect of information systems outages, if necessary. To the extent that these systems fail to operate, however our financial results may be adversely affected. We have also developed a program to address Year 2000 issues. See "Management Discussion and Analysis -- Forward Looking Information under the Private Securities Litigation Act of 1995." GOVERNMENT REGULATION GENERAL. PacifiCare's HMOs are subject to extensive federal and state regulation which govern the scope of benefits provided to its members, financial solvency requirements, quality assurance and utilization review procedures, member grievance procedures, provider contracts, marketing and advertising. Certain federal and/or state regulatory agencies also require our HMOs to maintain restricted cash reserves represented by interest-bearing investments that are held by trustees or state regulatory agencies. These requirements, which limit the ability of our subsidiaries to transfer funds to us, may limit our ability to pay dividends. From time to time, we advance funds, to our subsidiaries to assist them in satisfying federal or state financial requirements. Our behavioral health, dental and insurance subsidiaries are also subject to extensive federal and state regulation. HCFA. PacifiCare's Secure Horizons programs are subject to regulations by HCFA and certain state agencies. These agencies govern the benefits provided, premiums paid, quality assurance procedures, marketing and advertising. See "Nature of Operations-Secure Horizons Programs." As part of its drive to encourage Medicare beneficiaries to enroll in private health care plans, the 1997 Balanced Budget Act replaced the Medicare risk contract program with the Medicare+Choice program. On June 26, 1998, HCFA published interim final regulations to implement the Medicare+Choice program. The regulations establish new or expanded requirements for organizations participating in the Medicare+Choice program. They also establish new or expanded standards for quality assurance, beneficiary protection, coordinated open enrollment, program payments, information disclosure and provider participation. While the new regulations became effective on July 27, 1998, most provisions did not affect us until we moved to the Medicare+Choice program on January 1, 1999. Compliance with and implementation of the new Medicare+Choice program regulations will increase our Medicare administration costs. We continue to evaluate the operational and financial impact of the new Medicare+Choice program. 7 10 The Balanced Budget Act also revised the formula used by HCFA to calculate payments to Medicare health plans. It established minimum payment levels, limiting annual increases and the overall rate of payment growth. Further, the Balanced Budget Act required HCFA to develop a risk adjusted payment methodology by March 1, 1999 and to implement the payment process for periods beginning January 1, 2000. On January 15, 1999, HCFA released the Year 2000 premium payment rate changes and the risk adjusted payment program. The proposed methodology relies on retrospective hospital inpatient data to establish risk premiums for individual Medicare enrollees. The new proposed risk adjusted program is scheduled to be implemented over a five-year period according to the following schedule: 10 percent in 2000, 30 percent in 2001, 55 percent in 2002, 80 percent in 2003, and 100 percent in 2004. Phase-in of the risk adjusted payments will mitigate the near term financial impact on us. However, the proposed method may have a longer-term adverse impact on us since the proposal would provide larger premiums to health plans with higher inpatient utilization. Managed care organizations, such as PacifiCare, have achieved lower inpatient utilization and have developed programs to avoid unnecessary hospitalizations through the use of other, less costly sites for providing healthcare. If this approach is implemented as proposed, we may receive lower premiums because of our lower inpatient utilization. We have provided comments to the proposed methodology and are engaged in various efforts with HCFA and others to modify the proposed process. We believe the payment formula should not create incentives for increased inpatient utilization and should not penalize health plans that have developed programs to reduce unnecessary hospitalizations. However, there can be no assurance that we will be successful in our efforts to obtain changes to the proposed methodology. The loss of Medicare contracts or terminations or modification of the HCFA risk-based Medicare program could have a material effect on our revenue, profitability and business prospects. EMPLOYEE RETIREMENT INCOME SECURITY ACT OF 1974 ("ERISA"). ERISA regulates insured and self-insured health coverage plans offered by employers, FEHBP, and federal and state fraud and abuse laws and laws relating to health care management and delivery. ERISA controls how PacifiCare may do business with employers covered by ERISA, particularly employers that maintain self-funded plans. The Department of Labor is engaged in an ongoing ERISA enforcement program which may result in additional constraints on how ERISA-governed benefit plans conduct their activities. There have been recent legislative attempts to limit ERISA's preemptive effect on state laws. If such limitations are enacted, they might increase our exposure under state law claims that relate to employee health benefits offered by PacifiCare, and may permit greater state regulation of other aspects of those business operations. OPM. PacifiCare's HMOs have commercial contracts with OPM to provide managed care health services to federal employees, annuitants and their dependents under the FEHBP. In the normal course of business, OPM audits health plans with which it contracts, among other things, to verify that the premiums calculated and charged to OPM are established in compliance with the best price community rating guidelines established by OPM. OPM typically audits plans once every five or six years and each audit covers the prior five or six year period. OPM recently completed audits of the majority of our health plans through 1996. OPM's initial on-site audits are usually followed by post-audit briefings where OPM indicates preliminary results. However, final resolution and settlement of the audits have historically taken a minimum of three to five years. In connection with the sale of our health plans in New Mexico, Illinois and Utah, we have agreed to indemnify the buyers for potential OPM liabilities that relate to the years when FHP owned these plans. PacifiCare intends to negotiate with OPM on all unresolved matters to attain a mutually satisfactory result. In addition to claims made by the OPM auditors as part of the normal audit process, OPM may also refer their results to the United States Department of Justice ("DOJ") for potential legal action under the False Claims Act. The DOJ has the authority to file a claim under the False Claims Act if it believes that the health plan knowingly overcharged the government or otherwise submitted false documentation or certifications. In actions under the False Claims Act, the DOJ may impose trebled damages and a civil penalty of not less than $5,000 nor more than $10,000 for each separate alleged false claim. In November 1997, we were notified that the 1990-1995 OPM audit of our Oklahoma HMO had been referred to the DOJ. In January 1999, we preliminarily agreed to settle the 1990-1995 Oklahoma OPM audits for $9 million, an amount which had previously been reserved. 8 11 TRADEMARKS PacifiCare owns the federally registered service marks PacifiCare(R) and SecureHorizons(R). These service marks are material to our business. EMPLOYEES At December 31, 1998, PacifiCare had approximately 8,700 full and part-time employees. None of our employees are presently covered by a collective bargaining agreement. We consider relations with our employees to be good and have never experienced any work stoppage. ITEM 2. PROPERTIES As of December 31, 1998, PacifiCare leased approximately 220,000 aggregate square feet of space for its principal corporate headquarters and executive offices in Santa Ana and Costa Mesa, California. In connection with our operations, as of December 31, 1998, we leased approximately 2.2 million aggregate square feet for office space, subsidiary operations, customer service centers and space for computer facilities. Such space corresponds to areas in which our HMOs or specialty managed care products and services operate, or where we have satellite administrative offices. Our leases expire at various dates from 1999 through 2009. We own 32 buildings encompassing approximately 914,000 aggregate square feet of space. Six of the buildings, representing approximately 348,000 aggregate square feet of space, are primarily used for administrative operations and are located in California and Guam. The remaining 26 buildings are medical office buildings leased under a master lease agreement. All 26 medical buildings are being marketed for sale. We also own nine parcels of vacant land for a total of 46 acres, all of which are being marketed for sale. Our facilities are in good working condition, are well maintained and are adequate for our present and currently anticipated needs. We believe that we can rent additional space at competitive rates when current leases expire, or if we need additional space. ITEM 3. LEGAL PROCEEDINGS As previously reported, a securities class action lawsuit, Madruga et al. v. PacifiCare Health Systems, Inc., et al. (No. SAVC-97-974 LHM, Central District of California) was brought on behalf of all purchasers of PacifiCare stock between February 14, 1997 and November 24, 1997. The complaint accuses PacifiCare and certain of its officers and directors of making false and misleading statements about the cost savings and synergies resulting from the FHP acquisition. Plaintiffs also claim we made fraudulent earnings forecasts for 1997 and 1998 and misstated financial results for the first, second and third quarters of 1997. The complaint alleges violations of certain sections of the Securities Exchange Act of 1934. On May 11, 1998, we filed a motion to dismiss the entire complaint under the Private Securities Litigation Reform Act of 1995. No discovery has been taken and all discovery has been stayed pending the resolution of our motion to dismiss. We believe that we have good defenses to these claims and are contesting the claims vigorously. We are involved in legal actions in the normal course of business, some of which seek monetary damages, including claims for punitive damages which are not covered by insurance. Based on current information and review, including consultation with our lawyers, we believe any ultimate liability which may arise from these actions (including all purported class actions) would not materially affect our consolidated financial position, results of operations, cash flows or business prospects. However, our evaluation of the likely impact of these actions could change in the future and an unfavorable outcome, depending upon the amount and timing, could have a material effect on the results of operations or cash flows of a future quarter. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matter was submitted to a vote of security holders during the three months ended December 31, 1998. 9 12 PART II ITEM 5. MARKET FOR THE COMPANY'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS PacifiCare's Class A and B common stock are listed on the Nasdaq National Market under the symbols PHSYA and PHSYB, respectively. The following tables indicate the high and low reported sale prices per share as furnished by Nasdaq.
CLASS A CLASS B COMMON COMMON STOCK STOCK ----------- ------------ HIGH LOW HIGH LOW ---- --- ---- ---- YEAR ENDED DECEMBER 31, 1998 First Quarter......................................... 74 46 3/4 75 5/8 49 Second Quarter........................................ 85 7/8 68 3/8 89 3/8 69 7/16 Third Quarter......................................... 88 7/8 53 3/4 93 1/4 55 5/8 Fourth Quarter........................................ 78 7/8 53 3/4 84 3/4 58 1/4 YEAR ENDED DECEMBER 31, 1997 First Quarter......................................... 85 5/8 68 3/4 89 1/2 72 7/8 Second Quarter........................................ 83 55 1/2 87 3/4 58 3/4 Third Quarter......................................... 71 60 1/4 74 3/4 62 Fourth Quarter........................................ 71 1/4 48 1/8 72 1/2 50 7/8
PacifiCare has never paid cash dividends on its common stock. We expect that we will not declare dividends on our common stock in the future, retaining all earnings for business development. Any possible future dividends will depend on our earnings, financial condition, and regulatory requirements. If we decide to declare common stock dividends in the future, such dividends may only be made in shares of PacifiCare's common stock, according to the terms of our credit facility. See Note 6 of the Notes to Consolidated Financial Statements. As of December 31, 1998 there were 286 shareholders of record of our Class A common stock and 335 shareholders of record of our Class B common stock. As of December 31, 1998 there were approximately 21,000 beneficial holders of our Class A and B common stock. 10 13 ITEM 6. SELECTED FINANCIAL DATA In February 1997, PacifiCare's board of directors approved a change in our fiscal year end from September 30 to December 31. This resulted in a transition period for October 1, 1996 through December 31, 1996. The following selected financial and operating data are derived from our audited consolidated financial statements, or from our unaudited internal financial data. For clarity of presentation and comparability, the following selected financial and operating data includes the unaudited period for the twelve months ended December 31, 1996. The selected financial and operating data should be read in conjunction with "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations," and also with "Item 8. Consolidated Financial Statements and Supplementary Data." INCOME STATEMENT DATA
(TRANSITION (UNAUDITED) PERIOD) TWELVE THREE YEAR ENDED YEAR ENDED MONTHS ENDED MONTHS ENDED DECEMBER 31, DECEMBER 31, DECEMBER 31, DECEMBER 31, 1998(1) 1997(2) 1996(3) 1996 ------------ ------------ ------------ ------------ (IN THOUSANDS, EXCEPT PER SHARE DATA) Operating revenue..................... $9,521,482 $8,982,680 $4,807,856 $1,234,875 ---------- ---------- ---------- ---------- Expenses: Health care services................ 8,002,260 7,658,879 4,017,383 1,039,345 Other operating expenses............ 1,166,011 1,125,299 605,546 154,996 Impairment, disposition, restructuring and other charges... 15,644 154,507 75,840 -- Office of Personnel Management (credits) charges................. (4,624) -- 25,000 -- ---------- ---------- ---------- ---------- Operating income...................... 342,191 43,995 84,087 40,534 Net investment income and interest expense............................. 43,383 16,129 44,696 12,302 ---------- ---------- ---------- ---------- Income before income taxes and cumulative effect of a change in accounting principle................ 385,574 60,124 128,783 52,836 Provision for income taxes............ 183,147 81,825 53,052 21,079 ---------- ---------- ---------- ---------- Income (loss) before cumulative effect of a change in accounting principle........................... 202,427 (21,701) 75,731 31,757 Cumulative effect on prior years of a change in accounting principle...... -- -- -- -- ---------- ---------- ---------- ---------- Net income (loss)..................... $ 202,427 $ (21,701) $ 75,731 $ 31,757 ========== ========== ========== ========== Preferred dividends................... (5,259) (8,792) -- -- ---------- ---------- ---------- ---------- Net income (loss) available to common shareholders........................ $ 197,168 $ (30,493) $ 75,731 $ 31,757 ========== ========== ========== ========== Basic earnings (loss) per share(5).... $ 4.50 $ (0.75) $ 2.43 $ 1.01 ========== ========== ========== ========== Diluted earnings (loss) per share(5)............................ $ 4.40 $ (0.75) $ 2.39 $ 1.00 ========== ========== ========== ========== OPERATING STATISTICS Medical care ratio (health care services as a percent of premium revenue) Consolidated........................ 85.0% 85.7% 84.5% 85.1% Government.......................... 86.5% 85.6% 85.6% 85.5% Commercial.......................... 82.8% 85.8% 82.8% 84.4% Marketing, general and administrative expenses as a percent of operating revenue............................. 11.4% 11.7% 12.4% 12.4% Operating income...................... 3.6% 0.5% 1.7% 3.3% Effective tax rate(6)................. 47.5% 136.1% 41.2% 39.9% Return on average shareholders' equity.............................. 9.4% (1.5)% 9.3% 3.9% YEAR ENDED YEAR ENDED YEAR ENDED SEPTEMBER 30, SEPTEMBER 30, SEPTEMBER 30, 1996(3) 1995 1994(4) ------------- ------------- ------------- (IN THOUSANDS, EXCEPT PER SHARE DATA) Operating revenue..................... $4,637,305 $3,731,022 $2,893,252 ---------- ---------- ---------- Expenses: Health care services................ 3,872,747 3,077,135 2,374,258 Other operating expenses............ 585,081 505,644 398,064 Impairment, disposition, restructuring and other charges... 75,840 -- -- Office of Personnel Management (credits) charges................. 25,000 -- -- ---------- ---------- ---------- Operating income...................... 78,637 148,243 120,930 Net investment income and interest expense............................. 44,143 33,857 24,538 ---------- ---------- ---------- Income before income taxes and cumulative effect of a change in accounting principle................ 122,780 182,100 145,468 Provision for income taxes............ 50,827 74,005 60,875 ---------- ---------- ---------- Income (loss) before cumulative effect of a change in accounting principle........................... 71,953 108,095 84,593 Cumulative effect on prior years of a change in accounting principle...... -- -- 5,658 ---------- ---------- ---------- Net income (loss)..................... $ 71,953 $ 108,095 $ 90,251 ========== ========== ========== Preferred dividends................... -- -- -- ---------- ---------- ---------- Net income (loss) available to common shareholders........................ $ 71,953 $ 108,095 $ 90,251 ========== ========== ========== Basic earnings (loss) per share(5).... $ 2.31 $ 3.69 $ 3.30 ========== ========== ========== Diluted earnings (loss) per share(5)............................ $ 2.27 $ 3.62 $ 3.22 ========== ========== ========== OPERATING STATISTICS Medical care ratio (health care services as a percent of premium revenue) Consolidated........................ 84.4% 83.6% 83.1% Government.......................... 85.4% 84.3% 85.2% Commercial.......................... 83.1% 82.5% 80.5% Marketing, general and administrative expenses as a percent of operating revenue............................. 12.4% 13.4% 13.6% Operating income...................... 1.7% 4.0% 4.2% Effective tax rate(6)................. 41.4% 40.6% 41.8% Return on average shareholders' equity.............................. 9.3% 18.9% 24.6%
See footnotes following "Balance Sheet Data." Continued on next page. 11 14 FINANCIAL STATEMENT CHANGE STATISTICS
YEAR ENDED YEAR ENDED YEAR ENDED YEAR ENDED YEAR ENDED DECEMBER 31, DECEMBER 31, SEPTEMBER 30, SEPTEMBER 30, SEPTEMBER 30, 1998 1997(7) 1996(3) 1995 1994(4) ------------ ------------ ------------- ------------- ------------- Operating revenue............................... 6.0% 86.8% 24.3% 29.0% 30.3% Net income (loss)............................... 1,032.8% (128.7)% (33.4)% 19.8% 44.0% Earnings (loss) per share....................... 686.7% (131.4)% (37.3)% 12.4% 43.1% Total assets.................................... (6.7)% 217.8% (6.2)% 25.3% 59.4% Total shareholders' equity...................... 8.5% 139.8% 12.5% 77.1% 29.5%
DECEMBER 31, DECEMBER 31, DECEMBER 31, SEPTEMBER 30, SEPTEMBER 30, SEPTEMBER 30, 1998 1997 1996 1996 1995 1994 ------------ ------------ ------------ ------------- ------------- ------------- MEMBERSHIP DATA Government (Medicare & Medicaid)..... 972,800 1,001,100 593,600 596,200 541,000 409,100 Commercial........................... 2,554,100 2,790,000 1,451,500 1,434,500 1,216,100 949,100 ---------- ---------- ---------- ---------- ---------- ---------- Total membership..................... 3,526,900 3,791,100 2,045,100 2,030,700 1,757,100 1,358,200 ========== ========== ========== ========== ========== ========== Percent change in membership......... (7.0%) 85.4% 0.7% 15.6% 29.4% 23.8% ========== ========== ========== ========== ========== ========== BALANCE SHEET DATA (IN THOUSANDS) Cash and equivalents and marketable securities......................... $1,600,189 $1,545,382 $ 962,482 $ 700,093 $ 811,525 $ 710,608 Total assets......................... $4,630,944 $4,963,046 $1,561,472 $1,299,462 $1,385,372 $1,105,548 Medical claims and benefits payable............................ $ 645,300 $ 721,500 $ 282,500 $ 268,000 $ 288,400 $ 302,900 Long-term debt, due after one year... $ 650,006 $1,011,234 $ 1,370 $ 5,183 $ 11,949 $ 101,137 Shareholders' equity................. $2,238,096 $2,062,187 $ 860,102 $ 823,224 $ 732,024 $ 413,358
- --------------- (1) The 1998 results include $11 million of net pretax charges ($6 million, or $0.12 diluted loss per share, net of tax) for the disposal of unprofitable subsidiaries and potential OPM claims. See Notes 4 and 9 of the Notes to Consolidated Financial Statements. Operating income as a percentage of operating revenue before pretax credits and charges was 3.7 percent. Return on average shareholders' equity before pretax credits and charges was 9.4 percent. (2) The 1997 results include the results of operations for the FHP International Corporation ("FHP") acquisition from February 14, 1997. The 1997 results also include $155 million of pretax charges ($129 million or $3.18 diluted loss per share, net of tax) for the impairment of long-lived assets, restructuring and certain other charges. See Notes 4 and 9 of the Notes to Consolidated Financial Statements. Operating income as a percentage of operating revenue before pretax charges was 2.2 percent. Return on average shareholders' equity before pretax charges was 6.9 percent. (3) The 1996 results include $101 million of pretax charges ($62 million or $1.96 diluted loss per share, net of tax for the fiscal year ended September 30 and $1.97 diluted loss per share for the twelve months ended December 31) for the impairment of long-lived assets, potential government claims, dispositions and certain restructuring charges. See Note 9 of the Notes to Consolidated Financial Statements. Operating income as a percentage of operating revenue before pretax charges for 1996 was 3.8 percent for the fiscal year ended September 30 and 3.9 percent for the twelve months ended December 31. Return on average shareholders' equity before pretax charges for the fiscal year ended September 30 was 17.2 percent and 17.0 percent for the twelve months ended December 31. (4) The fiscal 1994 results reflect the cumulative effect on prior fiscal years of a change in accounting principle. Diluted earnings per share before cumulative effect of a change in accounting principle for fiscal 1994 was $3.02 per share. The cumulative effect of a change in accounting principle for fiscal 1994 was $0.20 per share. The fiscal 1994 change in net income was 34.9 percent and the change in earnings per share was 34.2 percent before cumulative effect of a change in accounting principle. (5) Earnings per share were restated to conform with the provisions of Statement of Financial Accounting Standards No. 128, "Earnings per Share." See Note 2 of the Notes to Consolidated Financial Statements. (6) Effective income tax rate includes the effect of non-deductible pretax charges. (7) Changes as compared to the unaudited period for the twelve months ended December 31, 1996. 12 15 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RESULTS OF OPERATIONS OVERVIEW. PacifiCare sells HMO and HMO-related products primarily to members in two groups: the Secure Horizons program for Medicare beneficiaries and the commercial programs for members of employer groups and individuals. Our specialty managed care HMOs and HMO related products and services supplement our commercial programs. These include behavioral health services, life and health insurance, dental and vision services and pharmacy benefit management. Events significant to our business that occurred during 1998 included: - - In November 1997, we announced our intention to sell our Utah HMO and workers' compensation subsidiaries. We sold our Utah HMO subsidiary on September 30, 1998, and our workers' compensation subsidiary on October 31, 1998. - - In July 1998, FPA, one of our contracted health care providers, declared bankruptcy. As a result, we terminated all of our FPA contracts. Significant provider insolvency reserves were recognized in 1998. - - In December 1998, we recognized net pretax credits related to preliminary favorable settlements of OPM claims. - - During 1998, we borrowed $30 million to repurchase shares of our common stock and repaid $390 million of the outstanding balance on our credit facility. - - In January 1998, our board of directors approved a plan to repurchase shares of our outstanding common stock. During 1998, we repurchased 784,000 shares for an aggregate amount of $45 million. - - In June 1998, substantially all of our 10.5 million shares of Series A preferred stock were converted to 3.9 million shares of Class B common stock. - - In 1998, with the sale of our Utah HMO, we exited the Medicaid line of business. The information below includes both the Medicare and Medicaid line of business as part of the government program for the 1998 and prior periods presented. 1998 COMPARED WITH 1997 MEMBERSHIP. Total membership decreased seven percent to approximately 3.5 million members at December 31, 1998, from approximately 3.8 million members at December 31, 1997. The disposition of Utah accounted for 68 percent of the membership decline. California contributed 23 percent of the decline as we continue to emphasize renewing commercial contracts with sufficient price increases to improve gross margin. This decline was consistent with our shift in strategic focus from rapid growth to improved margin performance. The remaining nine percent was attributable to our exit of certain rural counties, where government and commercial premiums were neither sufficient to support the cost of health care nor our profitability requirements. Government membership declined three percent year over year. 1998 commercial membership decreased nine percent from 1997. PREMIUM REVENUE. During 1998, premium revenue increased five percent from the prior year, primarily due to six additional weeks of results in 1998 from the FHP acquisition. Discontinued indemnity and workers' compensation products that were not meeting profitability expectations partially offset this increase. Government premiums increased seven percent or $380 million over the prior year as a result of: - - Increases of $301 million from the inclusion of six additional weeks of results in 1998 from the FHP acquisition; - - Increases of $208 million from premium rate increases that averaged approximately four percent; offset by 13 16 - - Decreases of $129 million from net membership losses caused by our exit of certain rural geographic areas and Medicaid lines of business primarily in California, Utah and Texas. Commercial premiums increased three percent or $95 million over the prior year. The net increase was due to: - - Increases of $231 million from the inclusion of six additional weeks of results in 1998 from the FHP acquisition; - - Increases of $130 million from premium rate increases that averaged approximately five percent; offset by - - Decreases of $224 million from net membership losses caused by our disposition of Utah and by our premium rate increases primarily in California, Oklahoma and Ohio; and - - Decreases of $42 million, primarily from discontinued indemnity and workers' compensation products. OTHER INCOME. Other income increased 134 percent in 1998 from the prior year due primarily to higher revenues from Prescription Solutions and SHUSA. CONSOLIDATED MEDICAL CARE RATIO AND PROVIDER INSOLVENCY RESERVES. The 1998 consolidated medical care ratio (health care services as a percentage of premium revenue) declined by 0.7 percent compared to 1997. The improved commercial product performance was partially offset by increased provider insolvency reserves. Excluding these reserves, the consolidated medical care ratio was 84 percent. Provider insolvency reserves were immaterial in 1997 and totaled $95 million in 1998 as follows:
QUARTER GOVERNMENT COMMERCIAL TOTAL ------- ---------- ---------- ----- (IN MILLIONS) First................................. $ 3 $ 3 $ 6 Second................................ 25 10 35 Third................................. 14 6 20 Fourth................................ 20 14 34 --- --- --- Total....................... $62 $33 $95 === === ===
Provider insolvency reserves include the write-offs of the providers' uncollectable receivables and estimated cost of unpaid health care claims covered by our capitation payment. Depending on state law, we may be held liable for unpaid health care claims, which were the responsibility of the capitated provider. The majority of the insolvency reserves relate to specific provider bankruptcies. However, the estimate also includes reserves for potentially insolvent providers, where conditions indicate claims are not being paid or have slowed considerably. FPA declared bankruptcy in July 1998. FPA served approximately 200,000 PacifiCare members in Arizona, California, Nevada and Texas. Reserves for the FPA bankruptcy totaled $57 million, with $41 million attributable to our Nevada HMO. Nevada law specifically requires that we pay all health care services claims for our members including those previously covered by capitation payments. The second quarter FPA insolvency reserves were partially offset by unrelated favorable provider settlements. We periodically make changes in estimates as prior year contract issues are resolved. Increases to FPA reserves were made in the third and fourth quarters as additional claims information was presented for payment. The remaining FPA reserves of $16 million primarily relate to non-contracted claims and receivable write-offs in the remaining HMOs. Unpaid FPA reserves at December 31, 1998 were approximately $20 million. Reserves for other providers totaled $38 million. Approximately $17 million of the reserves recognized in the third and fourth quarters related to another provider that has ceased paying claims in Nevada and Arizona. This provider has not declared bankruptcy. The membership was transitioned to other providers between December 1998 and January 1999. The remaining $21 million is the estimated liability for smaller bankrupt providers and potentially insolvent providers, primarily in California. Other provider insolvency reserves unpaid at December 31, 1998 were approximately $38 million. GOVERNMENT MEDICAL CARE RATIO. The government medical care ratio for the year ended December 31, 1998 increased 0.9 percent compared to the prior year because we recognized $62 million of provider insolvency 14 17 reserves. Government insolvency reserves for FPA were $40 million, with the majority of these charges recognized in the second and third quarters. Other provider insolvency reserves of $22 million were recorded, primarily in the fourth quarter. Higher costs incurred for FPA membership shifted into new provider relationships were offset by the disposition of Utah. Excluding government provider insolvency reserves, the government medical care ratio was 85.4 percent. COMMERCIAL MEDICAL CARE RATIO. The commercial medical care ratio includes the specialty HMOs and indemnity insurance results. The commercial medical care ratio for the year ended December 31, 1998 decreased due to the following: - - Improved provider contracts; - - A favorable pricing environment; - - Improved performance from the specialty HMOs; - - Sale of our Utah HMO and workers' compensation subsidiaries; offset by - - Provider insolvency reserves of $33 million. Commercial insolvency reserves for FPA totaled $17 million, primarily recognized in the second and third quarters. Other provider insolvency reserves of $16 million were recognized in the fourth quarter and related to Arizona, California, Nevada, Texas and Washington. Excluding commercial provider insolvency reserves, the commercial medical care ratio was 82.0 percent. MARKETING, GENERAL AND ADMINISTRATIVE EXPENSES. As a percentage of operating revenue, marketing, general and administrative expenses decreased slightly compared to the prior year because we realized the benefits of restructuring and a full year of synergies as a result of the FHP acquisition. PRETAX CHARGES. The following is a summary of our net pretax charges:
QUARTER PRETAX NET OF TAX DILUTED (LOSS)/ RECOGNIZED (CHARGE)/CREDIT AMOUNT EARNINGS PER SHARE ----------- ---------------- ---------- ------------------ (DOLLARS IN MILLIONS, EXCEPT PER SHARE DATA) 1998 Sale of Utah HMO and workers' compensation subsidiaries.............. Third $ (15.6) $ (8.2) $(0.18) OPM charges.............................. Third (3.8) (2.0) (0.04) ------- ------- ------ Total Third (19.4) (10.2) (0.22) OPM credits.............................. Fourth 8.4 4.4 0.10 ------- ------- ------ $ (11.0) $ (5.8) $(0.12) ======= ======= ====== 1997 Impairment of long-lived assets: Utah HMO............................... Fourth $ (62.4) $ (55.7) $(1.37) Washington health plan................. Fourth (40.5) (36.1) (0.89) Discontinued workers' compensation products............................ Fourth (21.1) (18.9) (0.47) ------- ------- ------ Total impairment of long-lived assets....................... (124.0) (110.7) (2.73) Loss contracts........................... Fourth (15.4) (9.2) (0.23) Restructuring............................ Fourth (15.1) (9.0) (0.22) ------- ------- ------ $(154.5) $(128.9) $(3.18) ======= ======= ======
See Note 9 of the Notes to Consolidated Financial Statements. We recognized $11 million of net pretax charges in 1998, primarily for dispositions of unprofitable operations. Favorable OPM settlements in the fourth quarter offset increased reserves recognized in the third quarter. In 1997, Utah, Washington and the workers' compensation subsidiary charges related to the impairment of goodwill. Restructuring reserves recognized in 1997 were spent in 1998. 15 18 NET INVESTMENT INCOME. Net investment income increased approximately 29 percent in 1998 compared to the prior year, due primarily to gains on sales of marketable securities experienced throughout 1998 and more efficient investment through account consolidation. INTEREST EXPENSE. Interest expense decreased approximately six percent in 1998 compared to the prior year, due to continued repayment of our credit facility and declining interest rates. The decrease was partially offset by interest on the FHP acquisition borrowings that were outstanding for six weeks longer in 1998. PROVISION FOR INCOME TAXES. The effective income tax rate was 47.5 percent in 1998, compared with 136.1 percent in 1997. The rate declined significantly for two reasons: - - The 1997 effective rate was disproportionately high because most of the pretax charges recorded in the fourth quarter of 1997 were not deductible for tax purposes. The 1997 effective income tax rate without the effect of the pretax charges was approximately 50 percent. - - Nondeductible goodwill amortization was a smaller percentage of taxable income. DILUTED EARNINGS PER SHARE. For the year ended December 31, 1998, income excluding the pretax charges described above was $208 million or $4.52 diluted earnings per share. For the year ended December 31, 1997, income excluding the pretax charges was $107 million or $2.43 diluted earnings per share. The increase in income was due to: - - Increased other income; - - Improved commercial medical care ratio; - - Efficiency in marketing, general and administrative expenses; - - Increased investment income; and - - Decreased interest expense. 1997 COMPARED WITH 1996 OVERVIEW. In 1997, we began reporting on calendar year end. We previously reported a fiscal year ending September 30. This resulted in an audited transition period from October 1, 1996 to December 31, 1996. For clarity of presentation and comparability, the discussion of results of operations compares the year ended December 31, 1997 to the unaudited twelve months ended December 31, 1996, which is referred to as the prior year. On February 14, 1997, we finalized the FHP acquisition for a total purchase price, including transaction costs, of $2.2 billion. The FHP acquisition was accounted for as a purchase. Our consolidated results of operations include the results of FHP from the date of the FHP acquisition. See Note 4 of the Notes to Consolidated Financial Statements. MEMBERSHIP. Total membership increased 85 percent to approximately 3.8 million members at December 31, 1997, from approximately 2.0 million members at December 31, 1996. The FHP acquisition increased membership by approximately 0.4 million government members and 1.5 million commercial members. PREMIUM REVENUE. During 1997, total premium revenue increased 88 percent from the prior year, a direct result of the FHP acquisition. Six percent of the increase in premiums resulted from enrollment gains (net of the FHP acquisition) in both government and commercial programs. The remainder of the premium increase was mainly attributable to the government programs, along with our specialty managed care products and services. 16 19 Government premiums in 1997 increased 85 percent compared to the prior year. Approximately 81 percent of the total increase was due to the FHP acquisition. The balance of the net increase was due to the following: - - HCFA premium rate increases effective January 1, 1997 averaging over six percent; - - Increased government per member premium rates due to our exit of Medicaid lines of business in certain markets that had lower average per member premiums; - - Lower member paid supplemental premiums in several of our markets; and - - Enrollment gains in the government programs, net of acquisition membership. Commercial premiums increased 97 percent compared to the prior year. Approximately 92 percent of the total increase related to the FHP acquisition. The remainder of the net increase was due to the following: - - Enrollment gains in the commercial programs, net of acquisition membership, accounted for seven percent, while premium rates remained relatively flat; offset by - - Decreased membership growth, excluding the FHP acquisition, due to the sale of our Florida operations and a shift in focus from one of rapid growth to improved profit margins through the use of a more disciplined product pricing strategy. CONSOLIDATED MEDICAL CARE RATIO. The consolidated medical care ratio increased 1.2 percent from the prior year as a result of higher FHP commercial costs. The government medical care ratio for the year ended December 31, 1997 remained flat compared to the prior year. This consistency was largely due to FHP, which had lower cost provider contracts and generally higher reimbursement for Medicare membership. Additionally, the wind down of the Medicaid business contributed to slight decreases in the government medical care ratio. These decreases were partially offset by enhanced prescription drug benefits provided to enrollees combined with lower member paid supplemental premiums. The increase in the commercial medical care ratio included higher cost FHP provider contracts, increased non-capitated physician costs and increased out of area emergency room costs compared to the prior year. The commercial medical care ratio includes the specialty managed care health care costs. MARKETING, GENERAL AND ADMINISTRATIVE EXPENSES. As a percentage of operating revenue, marketing, general and administrative expenses decreased slightly compared to the prior year. These cost savings were caused by lower than expected staffing, and greater than expected efficiencies resulting from the integration of the FHP administrative functions and information systems. 17 20 PRETAX CHARGES. The following is a summary of our pretax charges:
QUARTER PRETAX NET OF TAX DILUTED (LOSS)/ RECOGNIZED (CHARGE)/CREDIT AMOUNT EARNINGS PER SHARE ------------ --------------- ---------- ------------------ (DOLLARS IN MILLIONS, EXCEPT PER SHARE DATA) 1997 Impairment of long-lived assets: Utah HMO.............................. Fourth $ (62.4) $ (55.7) $(1.37) Washington health plan................ Fourth (40.5) (36.1) (0.89) Discontinued workers' compensation products........................... Fourth (21.1) (18.9) (0.47) ------- ------- ------ Total impairment of long-lived assets...................... (124.0) (110.7) (2.73) Loss contracts.......................... Fourth (15.4) (9.2) (0.23) Restructuring........................... Fourth (15.1) (9.0) (0.22) ------- ------- ------ $(154.5) $(128.9) $(3.18) ======= ======= ====== 1996 OPM charges............................. Second $ (25.0) $ (14.9) $(0.47) Florida disposition..................... Second (9.3) (8.3) (0.26) Restructuring........................... Second (7.8) (4.7) (0.15) ------- ------- ------ Total Second (42.1) (27.9) (0.88) Impairment of long-lived assets - Florida...................... Third (58.7) (34.1) (1.08) ------- ------- ------ $(100.8) $ (62.0) $(1.96) ======= ======= ======
See Note 9 of the Notes to Consolidated Financial Statements. We recognized $155 million of pretax charges in 1997, $124 million related to the write-off of goodwill for our Utah and Washington HMOs and our workers' compensation subsidiary. In 1996, we recognized Florida goodwill impairment of $59 million plus $42 million of OPM, restructuring and Florida disposition losses. Restructuring reserves recognized in 1996 were spent in 1996 and 1997. NET INVESTMENT INCOME. Net investment income increased approximately $34 million for the year ended December 31, 1997 compared to the prior year. The increase was due primarily to additional investments over the prior year because of the FHP acquisition. INTEREST EXPENSE. Interest expense increased approximately $63 million for the year ended December 31, 1997 compared to the prior year. The increase was due to increased borrowings on our credit facility to finance the FHP acquisition. PROVISION FOR INCOME TAXES. The majority of the pretax charges were not deductible for income tax purposes. Therefore, we did not record an income tax benefit for most of these charges. The magnitude of these charges, combined with the inability to record a related income tax benefit, resulted in a disproportionately high effective income tax rate. The effective income tax rate, without the effect of the pretax charges, was approximately 50 percent, an increase over the prior year. This increase reflected the additional goodwill amortization expense attributed to the FHP acquisition. DILUTED EARNINGS PER SHARE. For the year ended December 31, 1997, income excluding the pretax charges described above was $107 million or $2.43 diluted earnings per share. For the year ended December 31, 1996, income excluding pretax charges was $138 million or $4.36 diluted earnings per share. The decrease over the prior year was due to increases in the following: - - Commercial medical care ratio; - - Amortization expense; - - Interest expense related to the FHP acquisition; and - - Increased shares used to calculate earnings per share. 18 21 The convertible preferred stock and potentially dilutive securities (including stock options) used to calculate diluted loss per share in the fourth quarter and for 1997 were anti-dilutive. Anti-dilution results when diluted earnings per share is a greater value than basic earnings per share. The net loss per share reported in 1997 was due mainly to the pretax charges recognized in the fourth quarter and the high effective tax rate. Because the actual diluted loss per share was less than the basic loss per share, the calculation of the diluted loss per share reported was equal to the basic loss per share. LIQUIDITY AND CAPITAL RESOURCES OPERATING CASH FLOWS IN 1998. PacifiCare's consolidated cash, equivalents and marketable securities increased to $1.6 billion at December 31, 1998 from $1.5 billion at December 31, 1997. The combined increase in cash, equivalents and marketable securities was directly related to current-year earnings that were invested. This increase was partially offset by long-term debt principal payments. Cash flows from operations increased by $43 million to $456 million in 1998 from $413 million in 1997 as follows: - - Increases of $224 million in net income; offset by - - Decreases of $138 million in impairment, disposition, restructuring and other charges; and - - Net decreases of $43 million, primarily related to changes in deferred income taxes. INVESTING ACTIVITIES IN 1998. Net cash used in investing activities was $19 million in 1998. Purchases of property, plant and equipment of $42 million were offset by $41 million of proceeds from the sale of property, plant and equipment. In 1998, we sold several medical clinics and related personal property acquired in the FHP acquisition. Disposition proceeds were approximately $17 million and were offset by increased investments in all marketable securities totaling $35 million. INVESTING ACTIVITIES IN 1997. Net cash used by investing activities in 1997 was $1.0 billion for the acquisition of FHP. The proceeds from the subsidiary dispositions and property, plant and equipment in 1997 were $80 million. This was offset by $69 million of property, plant and equipment purchases and $24 million of marketable securities purchases, including restricted. FINANCING ACTIVITIES IN 1998. Financing activities used $393 million of cash in 1998, primarily because we paid $391 million on our credit facility and other notes during the year. We also borrowed $30 million under the credit facility to repurchase shares of our outstanding common stock. As of December 31, 1998, we had repurchased 784,000 shares of our Class A and Class B common stock for $45 million. Cash received for the issuance of common and treasury stock was $19 million and was partially offset by $6 million of preferred stock dividends and cash paid on redemption of preferred stock. FINANCING ACTIVITIES IN 1997. In 1997, our financing activities provided $912 million of cash. Of the $912 million of cash, $885 million was the net effect of borrowing $1.1 billion under our credit facility to finance the FHP acquisition, offset by $235 million of credit facility payments in 1997. Proceeds from the issuance of common stock provided $43 million of cash in 1997 while preferred stock dividend payments used $9 million of cash. Finally, in the first quarter of 1997, we made capital contributions totaling $67 million to Talbert Medical Management Corporation, a former subsidiary of FHP. In the second quarter of 1997, we received $60 million from the sale of the Talbert stock. OTHER BALANCE SHEET CHANGE EXPLANATIONS RECEIVABLES, NET. Receivables, net decreased by $30 million from 1997 as follows: - - $31 million increase in provider and pharmacy rebate receivables; offset by - - $33 million decrease in premiums and reinsurance receivables; - - $19 million decrease for subsidiary dispositions and discontinued indemnity products; and - - $9 million decrease in other receivables, including the timing of net investment income receivable. 19 22 Provider receivables increased by $19 million. In 1998, we reduced the claims payable backlog from 33 days at the beginning of the year to 30 days at the end of the year. Accelerated claims payments often result in provider receivables that are collected through capitation withhold adjustments and other incentive settlements. Pharmacy rebate receivables increased by $12 million as 1998 prescription drug utilization increased. Premium receivables decreased $26 million. Improved collection efforts in California and Oregon contributed $17 million of the decrease. Outstanding reinsurance receivables declined by $7 million in 1998. GOODWILL AND INTANGIBLE ASSETS, NET. Goodwill and intangible assets decreased by $145 million from 1997 as follows: - - $76 million of goodwill and intangible amortization expense; and - - $69 million for FHP acquisition exit costs in excess of original estimates. See Note 4 of Notes to Consolidated Financial Statements. MEDICAL CLAIMS AND BENEFITS PAYABLE. Medical claims and benefits payable decreased by $76 million from 1997 as follows: - - $55 million increase in provider insolvency reserves; - - $11 million increase in provider capitation liabilities; offset by - - $92 million decrease in claims payable, both our risk and claims administered on behalf of providers; and - - $50 million decrease for dispositions, including Utah's loss contract reserves, and discontinued indemnity products. Claims payable decreased as our claims inventory fell by 47 percent from the December 1997 level. ACCOUNTS PAYABLE. We experienced a $73 million decline in accounts payable at December 31, 1998 compared to the prior year. This decrease was planned and is related to accounts payable systems changes effective January 1, 1999. We made an effort to decrease accounts payable inventory to ease the number of items that would be converted in the reorganization of the accounts payable system. INCOME TAXES. Income taxes changed from a receivable in the prior year to a payable in 1998. The change was attributable to the income tax provision on the 1998 income, partially offset by the estimated income tax payments made during the year. OTHER LIABILITIES. Other liabilities decreased by $47 million from 1997. The decrease was primarily attributable to the disposition of our workers' compensation subsidiary. FORWARD LOOKING INFORMATION UNDER THE PRIVATE SECURITIES LITIGATION ACT OF 1995 The Private Securities Litigation Reform Act of 1995 provides a "safe harbor" for forward looking statements. The Act was designed to encourage companies to provide prospective information about themselves without fear of litigation. The prospective information must be identified as forward looking and must be accompanied by meaningful cautionary statements identifying important factors that could cause actual results to differ materially from those projected in the statements. The statements about our plans, strategies, intentions, expectations and prospects contained throughout the document are based on current expectations. These statements are forward looking and actual results may differ materially from those predicted as of the date of this report in the forward looking statements, which involve risks and uncertainties. In addition, past financial performance is not necessarily a reliable indicator of future performance and investors should not use historical performance to anticipate results or future period trends. Stockholders are also directed to the other risks discussed in other documents filed by PacifiCare with the Securities and Exchange Commission. MEMBERSHIP. We expect government membership to increase three to four percent by December 31, 1999 compared to 1998. For 1999, we plan to expand our membership retention programs and target group retiree members in our existing markets. We expect membership increases from enhanced drug benefits and new enrollment as competitors exit markets in which Secure Horizons will remain. We also anticipate offering our 20 23 Secure Horizon programs in new geographic markets. These increases will be partially offset by the exit of rural markets. We expect commercial membership for the year ended December 31, 1999 to increase four to five percent compared to 1998. The majority of the growth will be in California where we plan to: - - Strengthen our sales fundamentals; - - Streamline and enhance our product mix; - - Improve underwriting practices; - - Increase the efficiency and effectiveness of our distribution channels; and - - Maximize membership renewal growth opportunities. MEMBERSHIP RISK FACTORS. An unforeseen loss of profitable membership could have an effect on our financial position, results of operations and cash flows. Factors that could contribute to the loss of membership include: - - Failure to obtain new customers or retain existing customers; - - The effect of premium increases; - - Reductions in work force by existing customers; - - Negative publicity and news coverage; - - Inability of marketing and sales plans to attract new customers; or - - The loss of key executives or key employees. PREMIUMS. Effective January 1, 1999, we received Medicare premium rate increases of two percent. We expect to continue to improve our gross margin by renewing commercial employer contracts with price increases. The price increases in our commercial product line are expected to range from zero to 12 percent depending upon competition, employer size, benefit design, geographic market and other factors. We plan to exit markets where our premium revenue does not cover the cost of providing care. While we expect to increase commercial premiums without experiencing significant membership losses, we may have to alter our pricing strategy to avoid such losses. Reduction in Medicare premiums, such as the proposed risk adjusted payment program, could have an effect on our financial position as every one percent change in premium represents approximately $56 million dollars of annual revenue. To counteract this impact, we would need to generate additional revenue or cost savings of approximately $56 per person per year. We could achieve this by increasing member premiums, office copayments, hospital deductibles or prescription copayments. OTHER INCOME. In 1999, we expect other income to be lower than 1998 because of lower SHUSA revenues. In addition, 1999 rental income is expected to be less than 1998 because several medical clinics were sold in the last half of 1998. HEALTH CARE PROVIDER CONTRACTS. Our profitability depends, in part, on our ability to control health care costs while providing quality care. Maintaining capitated arrangements with solvent providers, especially in the Nevada market, will be important to improve 1999 results of operations. Securing cost-effective contracts with existing and new physician groups has become more difficult due to increased competition. Failure to secure cost-effective contracts may result in a loss in membership or a higher medical care ratio. Additionally, the negotiation of provider contracts, generally as of January 1, may be impacted by unfavorable state and federal legislation and regulation discussed below. Our inability to contract with providers, loss of contracts with providers, inability of providers to provide adequate care, or insolvency of providers could materially affect us. Based on current information, we believe that our contingency plans are adequate to cover the potential impact of contract terminations. We continue to evaluate the financial stability of our providers, focusing on providers with significant membership in key geographic areas and providers that have been identified as a poor risk. We are also seeking to improve our performance in 1999 by taking steps to minimize our risk associated with providers. We 21 24 believe that the December 31, 1998 provider insolvency reserves are adequate to cover the cost of health care services rendered through 1998 that may not be paid by insolvent or unstable providers. We believe our contingency plans for shifting the membership or assisting the provider to obtain and maintain stability are adequate to cover the risk. We have and may continue to incur additional costs as a result of entering into new contracts, especially for FPA and potentially for MedPartners. The effect of these risks and the need for additional provider reserves could have a material effect on our results of operations or cash flows. We believe, however, that such reserves would not materially affect our consolidated financial position. GOVERNMENT MEDICAL CARE RATIO. We expect the government medical care ratio in 1999 to remain flat or slightly increase from 1998. Price increases, recontracting efforts in Nevada and California, and our exit of rural markets in four states plus the disposition of Utah are expected to improve the medical care ratio. However, these improvements will be offset by changes in premium mix, increases in capitation, decreases in non-capitated contracts and changes in pharmacy costs. The implementation of the Medicare reform provisions that limit program spending and allow the entry of new providers and plans that could increase competitive pressures could also offset any increases. See Legislation and Regulation below. COMMERCIAL MEDICAL CARE RATIO. In 1999, we expect the commercial medical care ratio to be consistent with, or improve slightly from 1998. We expect improvements as we continue to renegotiate provider contracts and implement capitated contracts and price increases. Moreover, higher premium rates offered during renewal periods should continue to result in the elimination of some high medical care ratio business. We also plan to exit markets where price increases do not cover the cost of health care. MEDICAL CARE RISK FACTORS. The government and commercial medical care ratio expectations discussed above could be affected by various uncertainties, including: - - Medical and prescription drug costs that have been rising faster than premium increases; - - Increases in utilization and costs of medical services; - - The effect of actions by competitors or groups of providers; or - - Termination of provider contracts, provider insolvency or renegotiation of such contracts at less cost-effective rates or terms of payment. MARKETING, GENERAL AND ADMINISTRATIVE SUPPORT. In 1999, marketing, general and administrative expenses as a percentage of operating revenue are expected to decline slightly because we expect to realize additional efficiencies from the FHP acquisition. Additionally, California's final conversion from FHP information systems to PacifiCare systems was completed in June 1998, so 1999 will be the first full year of integrated operations. The need for additional advertising, marketing, administrative, or management information systems expenditures, and the inability of marketing and sales plans to attract new customers, could impact marketing, general and administrative expenses. 1999 DISPOSITIONS. Dispositions could be announced as we continue to evaluate whether certain subsidiaries or products fit within our core business strategy. There can be no assurance that the dispositions will not result in additional pretax charges. We believe, however, that any disposition operating losses would not materially affect our consolidated financial position. However, the disposition losses could have a material effect on the results of operations or cash flows of a future period. IMPAIRMENT OF LONG-LIVED ASSETS. As circumstances warrant, we determine whether the realizable value of long-lived assets such as property and equipment, real estate and goodwill, are less than the value carried on the consolidated financial statements. We believe that any impairment of such long-lived assets would not materially affect our consolidated financial position. However, impairment charges, if material, could have an effect on our results of operations or cash flows of a future period. EFFECTIVE TAX RATE. We expect the 1999 effective tax rate to decrease three to five percent from 1998. Consistent with our integration strategies, we will complete a legal reorganization of the Company and its subsidiaries. The full year benefit of certain tax strategies is expected to be realized in 1999. The tax strategies are expected to reduce the effective tax rate by one to three percent. The 1998 effective tax rate includes more 22 25 than one percent related to the dispositions of Utah and the workers' compensation subsidiary that is not expected to recur. Finally, the impact of nondeductible goodwill on the effective tax rate is expected to decrease by approximately one percent because 1999 pretax income is projected to increase from 1998. There can be no assurance that these tax strategies will be successful or that pre-tax income will increase as projected, for various reasons set forth in this document and other documents we have filed with the Securities and Exchange Commission. As a result, there can be no assurance our tax rate will decrease in 1999. YEAR 2000. PacifiCare has implemented a Year 2000 compliance program to address all major computing information systems, including core application systems, networks, desktop systems, infrastructure, and critical information supply chains. In addition to all major information systems, we are verifying that all date fields and calculations used in critical business processes will be Year 2000 compliant. Under the program we are also addressing our external Year 2000 related risks which arise from the year 2000 readiness of third parties with whom we maintain ongoing relationships. The Year 2000 Compliance Program includes the following five phases which are listed in logical order, but are being addressed concurrently as appropriate: - - Awareness and Communication. There is an on-going company-wide communication and education effort to ensure that there is a clear understanding of the Year 2000 problem and associated risks. - - Inventory and Assessment. A company-wide inventory has been taken of all computer information systems and their components, including infrastructure equipment and hardware, software applications and information supply chains. Through the inventory, we are assessing the business risks and Year 2000 compliance status of each system component. For components which are not Year 2000 compliant, a remediation plan is being developed which includes the Year 2000 remediation action required and the time and resources needed to accomplish it. Priorities are also established based on the relative business critical function of each system component. - - Remediation. Based upon the remediation plan developed as part of the assessment phase, appropriate action is taken to correct or remediate the Year 2000 issues associated with the system and its components to render it Year 2000 compliant. Except for the FHP core system, we expect all affected system components to be remediated by March 31, 1999. Contingency plans for critical business functions will be completed as part of this phase as well. - - Testing and Certification. Following the completion of the remediation phase, each computer information system and its components are tested. Actual test results are reviewed and compared to expected test results based on accepted industry standards and methodologies. If the actual test results are acceptable, the system and/or component are certified as Year 2000 compliant. Testing and certification for the PacifiCare core computer system are 90 percent complete. We expect all other systems (except the FHP core system) to be tested and certified as Year 2000 compliant by June 30, 1999. Testing and certification of the FHP core computer systems will occur during 1999 and are expected to be completed in December 1999. - - Implementation and Close. There will be a final review and confirmation that the remediated systems and components have met all Year 2000 compliance objectives. When our Year 2000 compliance program was first established in 1996, we focused on existing systems and did not contemplate acquisitions of other companies. These core computing programs became Year 2000 compliant in 1998. The total cost to make our pre-FHP core computing information systems Year 2000 compliant was approximately $6 million. With the February 1997 FHP acquisition, we originally expected the Arizona, Colorado, Nevada and Ohio HMOs to shift to our pre-FHP core computing information systems throughout 1998 and 1999 as providers moved to delegated capitation arrangements. In the second quarter of 1998, we determined that while we had successfully moved some of these providers to capitation arrangements, the provider networks did not have sufficient infrastructure to administer the claims under a fully delegated capitated arrangement. We concluded that our HMOs in these states will need to continue to administer claims on behalf of providers. 23 26 Because the claims-based FHP core systems function more effectively than our core computing systems for claims administration on behalf of non-delegated delivery systems, we decided to maintain the FHP systems. As a result, the scope of our Year 2000 compliance activities was expanded to include the FHP computer system. We have a detailed project plan for modifying the FHP systems to be Year 2000 compliant in phases during 1999. Based upon an outside consultant's recommendations and internal analysis, we estimate that the total cost to make the FHP systems Year 2000 compliant ranges from $5 to $9 million. Our Year 2000 compliance program establishes priorities to achieve resolution of the most business critical issues first. The program incorporates a regular reporting process which helps us to monitor and measure our progress toward Year 2000 compliance against defined goals. Through this reporting process we can focus resources on, any Year 2000 issue, as necessary. We are also contacting our third party vendors, provider and hospital networks, business partners, contractors, and service providers, including HCFA, to assess their Year 2000 level of readiness. In some cases, we are seeking reasonable assurances with respect to Year 2000 compliance. Our priority is to assess the readiness of our providers with delegated responsibility and other third parties with which we electronically exchange data or interact. Because we do not control the products, services, or systems of our providers, vendors or customers, we cannot ensure their Year 2000 compliance. We anticipate developing business process contingency plans by June 1999 for external sources that appear to be at risk. If HCFA or certain other third parties experience significant failures or erroneous applications, it could have a material effect on our financial position, results of operations, cash flows, and business prospects. For example, if HCFA, OPM, or our commercial customers experience system failures, this could cause a delay in our receipt of payments from these customers, including a significant HCFA payment due in January 2000. Therefore, we are developing a cash receipts contingency plan. We also could have difficulties processing Medicare and other claims within required periods, collecting accurate claims and other data on which we depend, or enrolling new members. In preparing contingency plans, we are developing risk reduction strategies. However, some risks may be beyond our control. Further, our marketing, general and administrative expenses could increase due to Year 2000 compliance expenditures. OPM. OPM generally audits health plans which it contracts with every five or six years. We currently have several audits with OPM that are in various stages. We intend to negotiate with OPM and DOJ on all unresolved matters to attain a mutually satisfactory result. We cannot assure that the negotiations will conclude satisfactorily, or that there will not be additional liability upon completion of the audits. However, we believe that any ultimate liability in excess of amounts already set aside would not materially affect our consolidated financial position. The liability, if material, could have an effect on results of operations or cash flows of a future quarter. See Note 10 of the Notes to Consolidated Financial Statements. LIQUIDITY AND CAPITAL RESOURCES. Additional borrowings on our credit facility may be necessary if HCFA and OPM are unable to remit funds as a result of Year 2000 compliance issues. We also may continue to repurchase shares of outstanding stock, resulting in reduced cash or additional borrowings on our credit facility. Additional borrowings on the credit facility may make us subject to earlier mandatory reduction of the outstanding balance. Additionally, should the credit facility be drawn, our ability to repay amounts owed under the credit facility and other long-term debt will depend on cash receipts from our subsidiaries' restricted cash reserves. These subsidiary receipts represent fees for management services rendered by us to the subsidiaries and cash dividends by the subsidiaries to us. Nearly all of the subsidiaries are subject to HMO regulations or insurance regulations and may be subject to substantial supervision by one or more HMO or insurance regulators. Subsidiaries subject to regulation must meet or exceed various capital standards imposed by HMO or insurance regulations, which may from time to time impact the amount of funds the subsidiaries can pay to us. Additionally, from time to time, we advance funds in the form of a loan or capital contribution to our subsidiaries to assist them in satisfying federal or state financial requirements. If a federal or state regulator has concerns about the financial position of a subsidiary, a regulator may impose additional financial requirements on the subsidiary, which may require additional funding from us. We believe that 24 27 cash flows from operations, existing cash equivalents, marketable securities and other financing sources will be sufficient to meet the requirements of the credit facility. RISK-BASED CAPITAL REQUIREMENTS. The National Association of Insurance Commissioners has proposed that states adopt risk-based capital standards that, if implemented, would require new minimum capitalization limits for health care coverage provided by HMOs and other risk-bearing health care entities. To date, Washington is the only state where we have HMO operations that has adopted these standards. We do not expect this legislation to have a material impact on our consolidated financial position in the near future if other states where we operate HMOs adopt these standards. Further, we believe that cash flows from operations or, if necessary, borrowings under our credit facility, will be sufficient to fund any additional risk-based capital requirements. LEGISLATION AND REGULATION. Federal and state legislation and regulation significantly affect us. During 1998 our government programs, the majority of which are Medicare business, contribute 59 percent of our revenue and an even greater percentage of our profits. Changes in state and federal legislation or regulation could cause actual results to differ materially from the expected results discussed throughout this document. Changes that could effect us materially include: - - Limitations on premium levels; - - Increases in minimum capital and reserves and other financial viability requirements; - - Prohibition or limitation of capitated arrangements or provider financial incentives; - - Benefit mandates (including mandatory length of stay and emergency room coverage, many of which become effective in 1999); - - Limitations on the ability to manage care and utilization of any willing provider and direct access laws; and - - Adoption on the federal and/or state level of a "Patients Bill of Rights." Legislation and regulation could also include adverse actions of governmental payors, including reduced Medicare premiums; discontinuance of or limitation on governmentally funded programs; recovery by governmental payors of previously paid amounts; the inability to increase premiums or prospective or retroactive reductions to premium rates for federal employees; and adverse regulatory actions. OTHER. Results may differ materially from those projected, forecast, estimated and budgeted by us due to adverse results in ongoing audits or in other reviews conducted by federal or state agencies or health care purchasing cooperatives; adverse results in significant litigation matters; and changes in interest rates causing changes in interest expense and net investment income. 25 28 ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK MARKET RISK The principal objective of our asset/liability management activities is to maximize net investment income, while maintaining levels of interest rate risk and facilitating our funding needs. Our net investment income and interest expense are subject to the risk of interest rate fluctuations. To mitigate the impact of fluctuations in interest rates, we manage the structure of the maturity of debt, investments and derivatives. We use derivative financial instruments, primarily interest rate swaps, with maturities that correlate to balance sheet financial instruments. This results in a modification of existing interest rates to levels deemed appropriate based on our current economic outlook. The following table provides information about our financial instruments that are sensitive to changes in interest rates as of December 31, 1998. For investment securities and debt obligations, the table presents principal cash flows and related weighted average interest rates by expected maturity dates. Additionally, we have assumed our marketable securities and marketable securities-restricted, comprised primarily of U.S. government, state, municipal, and corporate debt securities, are similar enough to aggregate into fixed rate and variable rate securities for presentation purposes. For interest rate swaps, the table presents notional amounts by contractual maturity dates. Notional amounts are used to calculate the contractual cash flows to be exchanged under the contract.
1999 2000 2001 2002 2003 BEYOND TOTAL FAIR VALUE -------- -------- ------- -------- -------- -------- -------- ---------- (DOLLARS IN THOUSANDS) Assets: Marketable securities: Fixed rate............................. $ 20,719 $119,218 $12,850 $ 36,762 $ 34,797 $588,723 $813,069 $826,296 Average interest rate.................. 5.26% 5.34% 6.22% 6.02% 5.93% 5.57% 5.56% -- Variable rate.......................... $ 999 -- -- -- -- $ 49,590 $ 50,589 $ 49,257 Average interest rate.................. 5.03% -- -- -- -- 5.88% 5.86% -- Marketable securities - restricted: Fixed rate............................. $ 40,519 $ 27,183 $ 3,826 $ 3,494 $ 214 $ 7,424 $ 82,660 $ 83,539 Average interest rate.................. 5.25% 5.36% 6.13% 5.76% 6.35% 5.98% 5.47% -- Liabilities: Long term debt, including debt due within one year: Variable rate.......................... $ 87 $ 6 -- $550,000 $100,000 -- $650,093 $650,093 Average interest rate.................. 10.00% 11.00% -- 6.00% 7.00% -- -- -- Derivative financial instruments related to debt: Interest rate swaps: Pay variable/receive fixed............. $350,000 -- -- -- -- -- $350,000 $350,000 Average interest rate.................. 6.00% -- -- -- -- -- -- --
26 29 ITEM 8. CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA See the Index included at "Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K." ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS AND ACCOUNTING AND FINANCIAL DISCLOSURE We have not changed our independent auditors, nor have we had disagreements with such auditors on accounting principles, practices or financial statement disclosure within the last two years. PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Information about directors and executive officers is incorporated by reference from our Proxy Statement under the headings Election of Directors and Executive Officers and Directors Other Than Nominees for the 1999 Annual Meeting of Shareholders. We expect to file this Proxy Statement with the SEC no later than April 30, 1999. ITEM 11. EXECUTIVE COMPENSATION Information about executive compensation is incorporated by reference from our Proxy Statement under the heading Compensation of Executive Officers for the 1999 Annual Meeting of Shareholders. We expect to file this Proxy Statement with the SEC no later than April 30, 1999. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Information about security ownership of certain beneficial owners and management is incorporated by reference from our Proxy Statement under the heading Security Ownership of Certain Beneficial Owners and Management for the 1999 Annual Meeting of Shareholders. We expect to file this Proxy Statement with the SEC no later than April 30, 1999. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Information about certain relationships and transactions with related parties is incorporated by reference from our Proxy Statement under the heading Certain Transactions for the 1999 Annual Meeting of Shareholders. We expect to file this Proxy Statement with the SEC no later than April 30, 1999. 27 30 PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K The following documents are filed as part of this report:
PAGE REFERENCE --------- (a)1. Consolidated Financial Statements: Consolidated Balance Sheets as of December 31, 1998 and 1997...................................................... F-1 Consolidated Statements of Operations for the years ended December 31, 1998 and 1997, three months ended December 31, 1996 and the fiscal year ended September 30, 1996...................... F-2 Consolidated Statements of Shareholders' Equity for the years ended December 31, 1998 and 1997, three months ended December 31, 1996 and the fiscal year ended September 30, 1996...................................................... F-3 Consolidated Statements of Cash Flows for the years ended December 31, 1998 and 1997, three months ended December 31, 1996 and the fiscal year ended September 30, 1996..... F-4 Notes to Consolidated Financial Statements.................. F-6 Report of Ernst & Young LLP Independent Auditors............ F-24 Quarterly Information for 1998 and 1997 (unaudited)......... F-25 2. Financial Statement Schedule: Schedule II -- Valuation and Qualifying Accounts............ F-26 All other schedules are omitted because they are not required or the information is included elsewhere in the consolidated financial statements. 3. Exhibits: An "Exhibit Index" is filed as part of this Form 10-K beginning on page E-1 and is incorporated by reference. (b) Reports on Form 8-K: On November 20, 1998, PacifiCare Health Systems, Inc. filed a Form 8-K/A in connection with its sale of PacifiCare of Utah, Inc.
28 31 SIGNATURES Pursuant to the requirements of the Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. PACIFICARE HEALTH SYSTEMS, INC. By: /s/ ALAN R. HOOPS --------------------------------------- Alan R. Hoops Chairman of the Board and Chief Executive Officer Date: February 26, 1999 Pursuant to the requirements of the Securities Act of 1934, this Report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
NAME TITLE DATE ---- ----- ---- /s/ ALAN R. HOOPS Chairman of the Board and February 26, 1999 - ----------------------------------------------------- Chief Executive Officer Alan R. Hoops (Principal Executive Officer) /s/ ROBERT B. STEARNS Executive Vice President and February 26, 1999 - ----------------------------------------------------- Chief Financial Officer Robert B. Stearns (Principal Financial Officer) /s/ MARY C. LANGSDORF Senior Vice President and February 26, 1999 - ----------------------------------------------------- Corporate Controller Mary C. Langsdorf (Principal Accounting Officer) /s/ JACK R. ANDERSON Director February 26, 1999 - ----------------------------------------------------- Jack R. Anderson /s/ CRAIG T. BEAM Director February 26, 1999 - ----------------------------------------------------- Craig T. Beam /s/ RICHARD M. BURDGE Director February 26, 1999 - ----------------------------------------------------- Richard M. Burdge /s/ BRADLEY C. CALL Director February 26, 1999 - ----------------------------------------------------- Bradley C. Call /s/ DAVID R. CARPENTER Director February 26, 1999 - ----------------------------------------------------- David R. Carpenter /s/ TERRY O. HARTSHORN Vice Chairman of the Board February 26, 1999 - ----------------------------------------------------- Terry O. Hartshorn /s/ GARY L. LEARY Director February 26, 1999 - ----------------------------------------------------- Gary L. Leary
29 32
NAME TITLE DATE ---- ----- ---- /s/ WARREN E. PINCKERT II Director February 26, 1999 - ----------------------------------------------------- Warren E. Pinckert II /s/ DAVID A. REED Director February 26, 1999 - ----------------------------------------------------- David A. Reed /s/ LLOYD E. ROSS Director February 26, 1999 - ----------------------------------------------------- Lloyd E. Ross /s/ JEAN BIXBY SMITH Director February 26, 1999 - ----------------------------------------------------- Jean Bixby Smith
30 33 PACIFICARE HEALTH SYSTEMS, INC. CONSOLIDATED BALANCE SHEETS
DECEMBER 31, DECEMBER 31, 1998 1997 ------------ ------------ (IN THOUSANDS, EXCEPT PER SHARE DATA) ASSETS Current assets: Cash and equivalents...................................... $ 724,636 $ 680,674 Marketable securities..................................... 875,553 864,708 Income tax receivable..................................... -- 95,088 Receivables, net.......................................... 275,955 305,645 Prepaid expenses and other current assets................. 24,979 31,994 Deferred income taxes..................................... 132,452 112,037 ---------- ---------- Total current assets.............................. 2,033,575 2,090,146 ---------- ---------- Property, plant and equipment at cost, net of accumulated depreciation and amortization............................. 178,520 235,943 Marketable securities-restricted............................ 82,660 145,989 Goodwill and intangible assets, net......................... 2,313,266 2,458,463 Other assets................................................ 22,923 32,505 ---------- ---------- $4,630,944 $4,963,046 ========== ========== LIABILITIES AND SHAREHOLDERS' EQUITY Current liabilities: Medical claims and benefits payable....................... $ 645,300 $ 721,500 Accounts payable.......................................... 43,436 116,277 Accrued liabilities....................................... 352,352 323,495 Accrued compensation and employee benefits................ 68,382 71,055 Unearned premium revenue.................................. 509,859 496,183 Long-term debt due within one year........................ 87 154 ---------- ---------- Total current liabilities......................... 1,619,416 1,728,664 ---------- ---------- Long-term debt due after one year........................... 650,006 1,011,234 Deferred income taxes....................................... 112,056 102,793 Other liabilities........................................... 11,015 57,793 Minority interest........................................... 355 375 Commitments and contingencies Shareholders' equity: Capital stock, $0.01 par value per share: Preferred stock, 40,000 shares authorized: issued 10,517 shares of Series A Convertible Preferred Stock in 1997............................................... -- 105 Common stock: Class A, 100,000 shares authorized, voting: issued 14,880 shares in 1998 and 14,794 shares in 1997..... 149 148 Class B, 100,000 shares authorized, non-voting: issued 31,506 shares in 1998 and 27,201 shares in 1997................................................ 315 272 Additional paid-in capital................................ 1,624,619 1,599,229 Accumulated other comprehensive income.................... 7,359 9,993 Retained earnings......................................... 649,608 452,440 Treasury shares, at cost: Class A Common, 42 shares and Class B Common, 728 shares in 1998..................... (43,954) -- ---------- ---------- Total shareholders' equity........................ 2,238,096 2,062,187 ---------- ---------- $4,630,944 $4,963,046 ========== ==========
See accompanying notes. F-1 34 PACIFICARE HEALTH SYSTEMS, INC. CONSOLIDATED STATEMENTS OF OPERATIONS
THREE MONTHS YEAR ENDED YEAR ENDED ENDED YEAR ENDED DECEMBER 31, DECEMBER 31, DECEMBER 31, SEPTEMBER 30, 1998 1997 1996 1996 ------------ ------------ ------------ ------------- (IN THOUSANDS, EXCEPT PER SHARE DATA) Revenue: Government premiums (Medicare and Medicaid)............................... $5,586,592 $5,206,919 $ 722,748 $2,720,698 Commercial premiums........................ 3,823,587 3,728,243 498,832 1,866,830 Other income............................... 111,303 47,518 13,295 49,777 ---------- ---------- ---------- ---------- Total operating revenue............ 9,521,482 8,982,680 1,234,875 4,637,305 Expenses: Health care services: Government services........................ 4,834,638 4,458,994 618,265 2,322,375 Commercial services........................ 3,167,622 3,199,885 421,080 1,550,372 ---------- ---------- ---------- ---------- Total health care services......... 8,002,260 7,658,879 1,039,345 3,872,747 Marketing, general and administrative expenses................................... 1,089,418 1,055,080 153,135 575,928 Amortization of goodwill and intangible assets..................................... 76,593 70,219 1,861 9,153 Impairment, disposition, restructuring and other charges.............................. 15,644 154,507 -- 75,840 Office of Personnel Management (credits) charges.................................... (4,624) -- -- 25,000 ---------- ---------- ---------- ---------- Operating income............................. 342,191 43,995 40,534 78,637 Net investment income........................ 104,306 80,665 12,652 46,237 Interest expense............................. (60,923) (64,536) (350) (2,094) ---------- ---------- ---------- ---------- Income before income taxes................... 385,574 60,124 52,836 122,780 Provision for income taxes................... 183,147 81,825 21,079 50,827 ---------- ---------- ---------- ---------- Net income (loss)............................ $ 202,427 $ (21,701) $ 31,757 $ 71,953 ========== ========== ========== ========== Preferred dividends.......................... (5,259) (8,792) -- -- ---------- ---------- ---------- ---------- Net income (loss) available to common shareholders............................... $ 197,168 $ (30,493) $ 31,757 $ 71,953 ========== ========== ========== ========== Basic earnings (loss) per share.............. $ 4.50 $ (0.75) $ 1.01 $ 2.31 ========== ========== ========== ========== Diluted earnings (loss) per share............ $ 4.40 $ (0.75) $ 1.00 $ 2.27 ========== ========== ========== ==========
See accompanying notes. F-2 35 PACIFICARE HEALTH SYSTEMS, INC. CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
ACCUMULATED CLASS A CLASS B ADDITIONAL OTHER PREFERRED COMMON COMMON PAID IN COMPREHENSIVE RETAINED TREASURY STOCK STOCK STOCK CAPITAL INCOME EARNINGS STOCK TOTAL --------- ------- ------- ---------- ------------- -------- -------- ---------- (IN THOUSANDS) BALANCES AT SEPTEMBER 30, 1995.... $ -- $123 $186 $ 347,548 $ 4,944 $379,223 $ -- $ 732,024 ----- ---- ---- ---------- ------- -------- -------- ---------- Comprehensive income: Net income...................... -- -- -- -- -- 71,953 -- 71,953 Other comprehensive loss, net of tax: Unrealized losses on securities, net of reclassification adjustment.................. -- -- -- -- (3,651) -- -- (3,651) ----- ---- ---- ---------- ------- -------- -------- ---------- Comprehensive income.............. -- -- -- -- (3,651) 71,953 -- 68,302 ----- ---- ---- ---------- ------- -------- -------- ---------- Issuance of capital stock under employee benefit plans.......... -- 1 3 14,510 -- -- -- 14,514 Tax benefit associated with exercise of stock options....... -- -- -- 8,384 -- -- -- 8,384 ----- ---- ---- ---------- ------- -------- -------- ---------- BALANCES AT SEPTEMBER 30, 1996.... -- 124 189 370,442 1,293 451,176 -- 823,224 ----- ---- ---- ---------- ------- -------- -------- ---------- Comprehensive income: Net income...................... -- -- -- -- -- 31,757 -- 31,757 Other comprehensive income, net of tax: Unrealized gains on securities, net of reclassification adjustment.................. -- -- -- -- 2,158 -- -- 2,158 ----- ---- ---- ---------- ------- -------- -------- ---------- Comprehensive income.............. -- -- -- -- 2,158 31,757 -- 33,915 ----- ---- ---- ---------- ------- -------- -------- ---------- Issuance of capital stock under employee benefit plans.......... -- -- -- 612 -- -- -- 612 Tax benefit associated with exercise of stock options....... -- -- -- 2,351 -- -- -- 2,351 ----- ---- ---- ---------- ------- -------- -------- ---------- BALANCES AT DECEMBER 31, 1996..... -- 124 189 373,405 3,451 482,933 -- 860,102 ----- ---- ---- ---------- ------- -------- -------- ---------- Comprehensive loss: Net loss........................ -- -- -- -- -- (21,701) -- (21,701) Other comprehensive income, net of tax: Unrealized gains on securities, net of reclassification adjustment.................. -- -- -- -- 6,542 -- -- 6,542 ----- ---- ---- ---------- ------- -------- -------- ---------- Comprehensive loss................ -- -- -- -- 6,542 (21,701) -- (15,159) ----- ---- ---- ---------- ------- -------- -------- ---------- Capital stock activity: FHP acquisition................. 105 23 74 1,163,393 -- -- -- 1,163,595 Employee benefit plans.......... -- 1 9 44,584 -- -- -- 44,594 Tax benefit associated with exercise of stock options....... -- -- -- 17,847 -- -- -- 17,847 Preferred dividends............... -- -- -- -- -- (8,792) -- (8,792) ----- ---- ---- ---------- ------- -------- -------- ---------- BALANCES AT DECEMBER 31, 1997..... 105 148 272 1,599,229 9,993 452,440 -- 2,062,187 ----- ---- ---- ---------- ------- -------- -------- ---------- Comprehensive income: Net income...................... -- -- -- -- -- 202,427 -- 202,427 Other comprehensive loss, net of tax: Unrealized losses on securities, net of reclassification adjustment.................. -- -- -- -- (2,634) -- -- (2,634) ----- ---- ---- ---------- ------- -------- -------- ---------- Comprehensive income.............. -- -- -- -- (2,634) 202,427 -- 199,793 ----- ---- ---- ---------- ------- -------- -------- ---------- Capital stock activity: Conversion of preferred stock to common stock.................. (105) -- 39 (344) -- -- -- (410) Employee benefit plans.......... -- 1 4 19,438 -- -- 704 20,147 Purchase of treasury stock...... -- -- -- -- -- -- (44,658) (44,658) Tax benefit associated with exercise of stock options....... -- -- -- 6,296 -- -- -- 6,296 Preferred dividends............... -- -- -- -- -- (5,259) -- (5,259) ----- ---- ---- ---------- ------- -------- -------- ---------- BALANCES AT DECEMBER 31, 1998..... $ -- $149 $315 $1,624,619 $ 7,359 $649,608 $(43,954) $2,238,096 ===== ==== ==== ========== ======= ======== ======== ==========
See accompanying notes. F-3 36 PACIFICARE HEALTH SYSTEMS, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS
THREE MONTHS YEAR ENDED YEAR ENDED ENDED YEAR ENDED DECEMBER 31, DECEMBER 31, DECEMBER 31, SEPTEMBER 30, 1998 1997 1996 1996 ------------ ------------ ------------ ------------- (IN THOUSANDS) Operating activities: Net income (loss)................................... $202,427 $ (21,701) $ 31,757 $ 71,953 Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities: Amortization of goodwill and intangible assets.... 76,593 70,219 1,861 9,153 Depreciation and amortization..................... 44,436 46,658 5,244 22,949 Deferred income taxes............................. (19,299) 25,579 213 (25,783) Impairment, disposition, restructuring and other charges......................................... 15,644 154,507 -- 75,840 Loss on disposal of property, plant and equipment and other....................................... 12,547 6,715 191 750 Office of Personnel Management (credits) charges......................................... (4,624) -- -- 25,000 Provision for doubtful accounts................... 1,485 5,171 296 999 Changes in assets and liabilities, net of effects from acquisitions and dispositions: Receivables, net................................ 24,516 6,321 13,037 (55,971) Prepaid expenses, income tax receivable and other current assets......................... 102,696 (112,409) (13,745) (5,038) Medical claims and benefits payable............. (47,421) (2,504) 10,800 (21,261) Accounts payable, accrued liabilities, and accrued compensation and employee benefits... 31,549 (2,340) (7,139) 573 Unearned premium revenue........................ 15,038 237,273 232,357 (172,156) -------- ----------- -------- --------- Net cash flows provided by (used in) operating activities....................... 455,587 413,489 274,872 (72,992) -------- ----------- -------- --------- Investing activities: Purchase of property, plant and equipment........... (41,631) (68,533) (4,614) (22,728) Proceeds from the sale of property, plant and equipment......................................... 41,187 3,154 -- -- Purchase of marketable securities-restricted........ (17,980) (15,475) (2,993) (9,298) Proceeds from dispositions.......................... 16,809 76,500 -- -- Purchase of marketable securities, net.............. (16,546) (8,795) (33,964) (30,623) Acquisitions, net of cash acquired.................. (750) (999,892) (358) (5,403) -------- ----------- -------- --------- Net cash flows used in investing activities................................. (18,911) (1,013,041) (41,929) (68,052) -------- ----------- -------- --------- Financing activities: Principal payments on long-term debt................ (391,295) (235,166) (8,625) (8,625) Repurchase of common stock.......................... (44,658) -- -- -- Proceeds from borrowings of long-term debt.......... 30,000 1,120,000 -- -- Proceeds from issuance of common and treasury stock............................................. 18,908 43,838 612 13,342 Preferred dividends paid............................ (5,259) (8,792) -- -- Redemption of preferred stock....................... (410) -- -- -- Capitalization of Talbert........................... -- (67,000) -- -- Proceeds from sale of Talbert stock................. -- 59,598 -- -- -------- ----------- -------- --------- Net cash flows provided by (used in) financing activities....................... (392,714) 912,478 (8,013) 4,717 -------- ----------- -------- --------- Net increase (decrease) in cash and equivalents....... 43,962 312,926 224,930 (136,327) Beginning cash and equivalents........................ 680,674 367,748 142,818 279,145 -------- ----------- -------- --------- Ending cash and equivalents........................... $724,636 $ 680,674 $367,748 $ 142,818 ======== =========== ======== =========
See accompanying notes. Table continued on next page. F-4 37 PACIFICARE HEALTH SYSTEMS, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED)
THREE MONTHS YEAR ENDED YEAR ENDED ENDED YEAR ENDED DECEMBER 31, DECEMBER 31, DECEMBER 31, SEPTEMBER 30, 1998 1997 1996 1996 ------------ ------------ ------------ ------------- (IN THOUSANDS) Supplemental cash flow information: Cash paid during the year for: Income taxes, net of refunds...................... $ 28,696 $ 100,202 $ 794 $ 74,092 Interest.......................................... $ 55,735 $ 55,282 $ 241 $ 1,230 Supplemental schedule of noncash investing and financing activities: Tax benefit associated with exercise of stock options........................................... $ 6,296 $ 17,847 $ 2,351 $ 8,384 Compensation awarded in Class B common stock........ $ 1,239 $ 756 $ -- $ 1,172 Details of accumulated other comprehensive income: Change in marketable securities..................... $ (4,652) $ 10,577 $ 3,495 $ (5,955) Less change in deferred income taxes................ 2,018 (4,035) (1,337) 2,304 -------- ----------- -------- --------- Change in shareholders' equity...................... $ (2,634) $ 6,542 $ 2,158 $ (3,651) ======== =========== ======== ========= Details of businesses acquired in purchase transactions: Fair value of assets acquired....................... $ 750 $ 3,376,241 $ 448 $ 9,906 Less liabilities assumed or created, including notes to sellers........................................ -- (1,168,236) (90) (3,023) Less common and preferred stock consideration....... -- (1,163,595) -- -- -------- ----------- -------- --------- Cash paid for acquisitions.......................... 750 1,044,410 358 6,883 Cash acquired in acquisitions....................... -- (44,518) -- (1,480) -------- ----------- -------- --------- Net cash paid for acquisitions............... $ 750 $ 999,892 $ 358 $ 5,403 ======== =========== ======== ========= Purchase accounting accrual adjustment: Reduction of purchase accounting accruals........... $(79,340) $ -- $ -- $ -- Deferred income taxes............................... 10,165 -- -- -- -------- ----------- -------- --------- Net goodwill adjustment............................... $(69,175) $ -- $ -- $ -- ======== =========== ======== =========
See accompanying notes. Table continued from previous page. F-5 38 PACIFICARE HEALTH SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. BASIS OF PRESENTATION ORGANIZATION AND OPERATIONS. PacifiCare Health Systems, Inc. owns and operates federally qualified health maintenance organizations ("HMOs"), that arrange health care services principally for a predetermined, prepaid periodic fee to enrolled subscriber groups through independent health care organizations under contract. We also offer certain specialty products and services to group purchasers and to other managed care organizations and their beneficiaries, including behavioral health services, life and health insurance, dental and vision services, pharmacy benefit management, and Medicare+Choice management services. UniHealth, a California non-profit public benefit corporation, owned approximately 40 percent of our outstanding shares of Class A common stock and one percent of our Class B common stock at December 31, 1998. CONSOLIDATION. The accompanying consolidated financial statements include the accounts of the parent company and all significant subsidiaries that are more than 50 percent owned and controlled. All significant intercompany transactions and balances were eliminated in consolidation. CHANGE OF YEAR END. In 1997 we began reporting on a calendar year end. We previously reported on a fiscal year ended September 30. Accordingly, the accompanying consolidated financial statements and notes include results for the three month transition period ended December 31, 1996, as required by the Securities and Exchange Commission. SEGMENT INFORMATION. We have adopted Statement of Financial Accounting Standards ("SFAS") No. 131, "Disclosures about Segments of an Enterprise and Related Information." SFAS No. 131 establishes new standards for reporting operating segments of publicly held companies. Its guiding principle is the "management approach." This approach requires us to present segment information externally the same way management uses financial data internally to make operating decisions and assess performance. Because we sell health care packages, in the form of bundled HMO and supplemental HMO products, to members of all ages we have one reportable operating segment. These HMO members generally fall within two product lines. Revenues from our Medicare customers are reported in the government product line. Revenues from non-Medicare members, generally employees or early retirees of businesses, are reported in the commercial product line. Our single largest customer is the federal government. Sources of federal government revenues include revenues from Medicare beneficiaries and from federal employees covered by the Federal Employee Health Benefits Program ("FEHBP"). Federal government revenues were $5.9 billion in 1998, $5.5 billion in 1997, $ 0.7 billion in the 1996 transition period and $2.8 billion in fiscal 1996. USE OF ESTIMATES. In preparing the consolidated financial statements, we must use some estimates and assumptions that may affect reported amounts and disclosures. We use estimates most often when accounting for: - - Allowances for doubtful accounts receivable; - - Medical claims and benefits payable, including provider insolvency reserves; - - Professional and general liability; - - Reserves relating to the United States Office of Personnel Management ("OPM"); and - - Certain other reserves. We are also subject to risks and uncertainties that may cause actual results to differ from estimated results, such as changes in the health care environment, competition and legislation. Footnote references for 1998 represent the year ended December 31, 1998, 1997 represents the year ended December 31, 1997, 1996 transition period represents the three months ended December 31, 1996, and fiscal 1996 represents the fiscal year ended September 30, 1996. F-6 39 PACIFICARE HEALTH SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 1. BASIS OF PRESENTATION (CONTINUED) RECLASSIFICATIONS. We reclassified certain prior year amounts in the accompanying consolidated financial statements to conform to the 1998 presentation. 2. SIGNIFICANT ACCOUNTING POLICIES CASH AND EQUIVALENTS. Cash and equivalents include items such as money market funds and certificates of deposit, with maturity periods of three months or less when purchased. MARKETABLE SECURITIES. All marketable securities (which include municipal bonds, corporate notes, commercial paper and U.S. government securities), except marketable securities-restricted, are designated as available-for-sale. Accordingly, marketable securities are carried at fair value and unrealized gains or losses, net of applicable income taxes, are recorded in shareholders' equity. Because marketable securities are available for use in current operations, they are classified as current assets without regard to the securities' contractual maturity dates. We are required by state regulatory agencies to set aside funds for the protection of our plan members in accordance with the laws of the various states in which we operate. These funds are classified as marketable securities-restricted (which includes U.S. government securities and certificates of deposit held by trustees or state regulatory agencies). Marketable securities-restricted are designated as held-to-maturity since we have the intent and ability to hold such securities to maturity. Held-to-maturity securities are stated at amortized cost, adjusted for amortization of premiums and accretion of discounts to maturity, and are classified as noncurrent assets. CONCENTRATIONS OF CREDIT RISK. Financial instruments that potentially subject us to concentrations of credit risk consist primarily of investments in marketable securities and commercial premiums receivable. Our short-term investments in marketable securities are managed by professional investment managers within guidelines established by our board of directors, that, as a matter of policy, limit the amounts that may be invested in any one issuer. Concentrations of credit risk with respect to commercial premiums receivable are limited due to the large number of employer groups comprising our customer base. We had no significant concentrations of credit risk at December 31, 1998. FAIR VALUE OF FINANCIAL INSTRUMENTS. Our consolidated balance sheets include the following financial instruments: cash and equivalents, trade accounts and notes receivable, trade accounts payable and long-term obligations. We consider the carrying amounts of current assets and liabilities in the consolidated financial statements to approximate the fair value for these financial instruments because of the relatively short period of time between origination of the instruments and their expected realization. The carrying value of all long-term obligations approximates the fair value of such obligations. MARKET RISK -- INTEREST-RATE SWAPS. We enter into interest-rate swap agreements to modify the interest characteristics of our outstanding debt. Each interest-rate swap agreement is designated with all or a portion of the principal balance and term of a specific debt obligation. These agreements involve the exchange of amounts based on a fixed interest rate for amounts based on variable interest rates over the life of the agreement without an exchange of the notional amount upon which the payments are based. The differential to be paid or received as interest rates change is accrued and recognized as an adjustment of interest expense related to the debt (the accrual accounting method). The related amount payable to, or receivable from counterparties is included in other liabilities or assets. The fair value of the swap agreements and changes in the fair value as a result of changes in market interest rates are not recognized in the consolidated financial statements. Gains and losses on terminations of interest-rate swap agreements are deferred as an adjustment to the carrying amount of the outstanding debt, and amortized as an adjustment to interest expense related to the debt over the remaining term of the original contract life of the terminated swap agreement. In the event of the early extinguishment of a designated debt obligation, any realized or unrealized gain or loss from F-7 40 PACIFICARE HEALTH SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 2. SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) the swap would be recognized in income coincident with the extinguishment gain or loss. See Note 5, "Long-Term Debt." LONG-LIVED ASSETS. - - PROPERTY, PLANT AND EQUIPMENT. We record property, plant and equipment at cost. We capitalize replacements and major improvements. We charge repairs and maintenance to expense as incurred. We eliminate the costs and related accumulated depreciation when we sell property, plant and equipment, and any resulting gains or losses are included in net income. We depreciate property, plant and equipment, including assets under capital leases, evenly over the assets' useful lives ranging from five to 25 years. We amortize leasehold improvements evenly over the shorter of the lease term or 10 years. Accumulated depreciation totaled $110 million for 1998 and $129 million for 1997. - - GOODWILL AND INTANGIBLE ASSETS. When we acquire a business, we allocate the excess of the purchase price over the fair value of the net assets acquired to goodwill and identifiable intangible assets. Identifiable intangible assets can include employer group contracts, Medicare contracts, provider networks and assembled work force. We amortize goodwill and intangible assets evenly over periods ranging from four to 40 years. Accumulated amortization totaled $160 million for 1998 and $84 million for 1997. - - LONG-LIVED ASSET IMPAIRMENT. We review long-lived assets for impairment when events or changes in business conditions indicate that their full carrying value may not be recovered. We consider assets to be impaired and write them down to fair value if expected associated cash flows are less than the carrying amounts. Fair value is the present value of the expected associated cash flows. We recorded pretax charges for the impairment of goodwill and intangible assets totaling $124 million in 1997 and $59 million in fiscal 1996. See Note 9, "Impairment, Disposition, Restructuring and Other Charges." SOFTWARE COSTS. As of January 1, 1998, we adopted Statement of Position ("SOP") No. 98-1. This statement requires that certain internal and external costs associated with the purchase or development of internal-use software be capitalized rather than expensed. We amortize these costs evenly over estimated useful lives ranging from three to five years. Total costs capitalized in 1998 were $10 million. Development costs that did not meet SOP No. 98-1 capitalization requirements in 1998 were $24 million. Prior to 1998, we expensed direct costs associated with the development of computer software as incurred. These costs totaled $20 million in 1997, $3 million in the 1996 transition period and $13 million in fiscal 1996. PREMIUMS AND REVENUE RECOGNITION. We report prepaid health care premiums received from our HMOs' enrolled groups as revenue in the month that enrollees are entitled to receive health care. We record premiums received in advance as unearned premium revenue. Funds received under the federal Medicare program accounted for approximately 59 percent in 1998, 58 percent in 1997, 59 percent in the 1996 transition period and 57 percent in fiscal 1996 as a percentage of total premiums. HEALTH CARE SERVICES. Our HMOs arrange for comprehensive health care services to their members principally through capitation. Capitation is a fixed monthly payment made without regard to the frequency, extent or nature of the health care services actually furnished. We provide benefits to enrolled members generally through our contractual relationships with physician groups and hospitals. Our contracted providers may, in turn, contract with specialists or referral providers for specific services and are responsible for any related payments to those referral providers. Our HMOs 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 programs, that are based in part on estimates, are recorded in the period in which the related services are dispensed. The cost of health care provided is accrued in the period it is dispensed to the enrolled members, based in part on estimates for hospital services and other health care costs that have been incurred but not F-8 41 PACIFICARE HEALTH SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 2. SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) yet reported. We have also recorded reserves, based in part on estimates, to indemnify our members against potential referral claims related to insolvent medical groups. See Note 10 "Commitments and Contingencies." Our HMOs have stop-loss insurance to cover unusually high costs of care when incurred beyond a predetermined annual amount per enrollee. PREMIUM DEFICIENCY RESERVES ON LOSS CONTRACTS. We assess the profitability of our contracts for providing health care services to our members when current operating results or forecasts indicate probable future losses. We compare anticipated premiums to health care related costs, including estimated payments for providers, commissions and cost of collecting premiums and processing claims. If the anticipated future costs exceed the premiums, a loss contract accrual is recognized. See Note 9, "Impairment, Disposition, Restructuring and Other Charges." ACCOUNTING FOR STOCK-BASED COMPENSATION. We use Accounting Principles Board Opinion No. 25 to account for our stock-based compensation plans. Because we typically set the exercise price of options granted at our stock's market price on the grant date, there is no associated compensation expense. We have, however, granted certain options that vest only if target stock prices are met. Because these options have variable terms, there may be compensation expense incurred for the difference between the exercise price and the closing market price on the vesting dates. See Note 8, "Employee Benefit Plans." TAXES BASED ON PREMIUMS. Certain states in which we do business require the payment of excise, per capita or premium taxes based on a specified rate for enrolled members or a percentage of billed premiums. Such taxes may be levied instead of state income tax. These taxes are recorded in marketing, general and administrative expenses, and totaled $17 million in 1998, $13 million in 1997, $2 million in the 1996 transition period and $6 million in fiscal 1996. INCOME TAXES. We recognize deferred income tax assets and liabilities for the expected future tax consequences of events that have been included in the consolidated financial statements or tax returns. Deferred tax assets and liabilities are determined based on differences between the financial reporting and tax bases of assets and liabilities. We measure deferred tax assets and liabilities by applying enacted tax rates and laws to taxable years in which such differences are expected to reverse. See Note 7, "Income Taxes." EARNINGS PER SHARE. We calculated the denominators for the computation of basic and diluted earnings per share as follows:
1996 TRANSITION FISCAL 1998 1997 PERIOD 1996 ------ ------ ---------- ------ (AMOUNTS IN THOUSANDS) Shares outstanding at the beginning of the period........... 41,995 31,301 31,292 30,882 Weighted average number of shares issued: Conversion of Series A preferred stock.................... 2,067 -- -- -- Treasury stock acquired, net of shares issued............. (543) -- -- -- Stock options exercised................................... 261 724 3 209 FHP acquisition........................................... -- 8,498 -- -- ------ ------ ------ ------ Denominator for basic earnings per share.................... 43,780 40,523 31,295 31,091 Assumed conversion of Series A preferred stock.............. 1,862 -- -- -- Employee stock options and other dilutive potential common shares.................................................... 363 -- 505 580 ------ ------ ------ ------ Denominator for diluted earnings per share.................. 46,005 40,523 31,800 31,671 ====== ====== ====== ======
F-9 42 PACIFICARE HEALTH SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 2. SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) Since we reported a net loss in 1997, potentially dilutive securities were not included in the calculation of the 1997 loss per share because they were anti-dilutive. See Note 6, "Shareholders' Equity" and Note 8, "Employee Benefit Plans." DERIVATIVES. In June 1998, the Financial Accounting Standards Board issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities." This standard requires companies to record all derivatives on the balance sheet as either assets or liabilities and measure those instruments at their fair value. The manner in which companies are to record gains or losses resulting from changes in the values of those derivatives depends on the use of the derivative and whether it qualifies for hedge accounting. This standard is effective for our consolidated financial statements beginning January 1, 2000, although early adoption is permitted. Based on our current derivatives held, we believe that the adoption of this statement will not have a material impact to our consolidated financial position or results of operations. 3. MARKETABLE SECURITIES The following tables summarize marketable securities as of the dates indicated:
GROSS GROSS AMORTIZED UNREALIZED UNREALIZED COST GAINS LOSSES FAIR VALUE --------- ---------- ---------- ---------- (AMOUNTS IN THOUSANDS) Marketable securities: U.S. government and agency........................ $141,072 $ 3,489 $ (173) $ 144,388 State, municipal and state and local agency....... 330,512 6,809 (508) 336,813 Corporate debt and other securities............... 392,074 4,530 (2,252) 394,352 -------- ------- ------- ---------- Total marketable securities............... 863,658 14,828 (2,933) 875,553 -------- ------- ------- ---------- Marketable securities-restricted: U.S. government and agency........................ 48,961 658 (6) 49,613 Municipal and local agency........................ 3,756 53 (2) 3,807 Corporate debt and other securities............... 29,943 176 -- 30,119 -------- ------- ------- ---------- Total marketable securities-restricted.... 82,660 887 (8) 83,539 -------- ------- ------- ---------- BALANCE AT DECEMBER 31, 1998........................ $946,318 $15,715 $(2,941) $ 959,092 ======== ======= ======= ========== Marketable securities: U.S. government and agency........................ $427,728 $ 9,936 $ (399) $ 437,265 State, municipal and state and local agency....... 244,130 5,773 (731) 249,172 Corporate debt and other securities............... 176,543 1,941 (213) 178,271 -------- ------- ------- ---------- Total marketable securities............... 848,401 17,650 (1,343) 864,708 -------- ------- ------- ---------- Marketable securities-restricted: U.S. government and agency........................ 110,555 1,106 (1,021) 110,640 Municipal and local agency........................ 8,898 45 (42) 8,901 Corporate debt and other securities............... 26,536 39 (39) 26,536 -------- ------- ------- ---------- Total marketable securities-restricted.... 145,989 1,190 (1,102) 146,077 -------- ------- ------- ---------- BALANCE AT DECEMBER 31, 1997........................ $994,390 $18,840 $(2,445) $1,010,785 ======== ======= ======= ==========
F-10 43 PACIFICARE HEALTH SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 3. MARKETABLE SECURITIES (CONTINUED) As of December 31, 1998 the contractual maturities of our marketable securities were as follows:
MARKETABLE SECURITIES -- MARKETABLE SECURITIES RESTRICTED --------------------------- --------------------------- AMORTIZED COST FAIR VALUE AMORTIZED COST FAIR VALUE -------------- ---------- -------------- ---------- (AMOUNTS IN THOUSANDS) Due in one year or less............. $ 21,718 $ 21,636 $40,519 $40,597 Due after one year through five years............................. 203,627 204,588 34,717 35,202 Due after five years through ten years............................. 338,766 347,967 5,682 5,979 Due after ten years................. 299,547 301,362 1,742 1,761 -------- -------- ------- ------- $863,658 $875,553 $82,660 $83,539 ======== ======== ======= =======
Proceeds from sales and maturities of marketable securities were $1.4 billion in 1998 and $3.4 billion in 1997. Gross realized gains and gross realized losses are included in net investment income under the specific identification method. 4. ACQUISITIONS AND DISPOSITIONS 1998 DISPOSITIONS. On September 30, 1998, we sold our Utah HMO subsidiary. We guaranteed the buyer that the Utah HMO would have a minimum net equity of $10 million, based on the values of the Utah HMO's assets and liabilities as of September 30, 1998. We also extended a $700,000 subordinated loan to the Utah HMO to increase its statutory net equity. We sold all of the issued and outstanding shares of capital stock of the Utah HMO to the buyer for no other consideration. As of September 30, 1998, the Utah HMO served approximately 102,000 commercial and 19,000 government members. On October 31, 1998, we sold our workers' compensation subsidiary. The sales price totaled $17 million. We recognized pretax charges of approximately $15 million ($8 million or $0.18 diluted loss per share, net of tax) for these dispositions. 1997 ACQUISITION. On February 14, 1997 we acquired FHP International Corporation ("FHP"). Each outstanding share of FHP's common stock was exchanged for $17.50 in cash, 0.056 shares of our Class A common stock and 0.176 shares of our Class B common stock. Each outstanding share of FHP's preferred stock was exchanged for $14.113 in cash and one-half of one share of our Series A preferred stock. We paid approximately $1.0 billion in cash to FHP's common and preferred shareholders. The terms of the FHP acquisition required FHP to contribute $67 million to Talbert Medical Management Corporation ("Talbert"), a wholly owned subsidiary of FHP, increasing Talbert's net worth to approximately $60 million on February 14, 1997. Concurrently, FHP sold its investment in Talbert in exchange for a $60 million non-recourse promissory note and rights to purchase shares of Talbert common stock. Each former FHP shareholder received Talbert rights. Holders of Talbert rights were able to purchase one share of Talbert common stock for each Talbert right, for the subscription price of $21.50 per share. Holders of Talbert rights were entitled to subscribe for all, or any portion of, the shares of Talbert common stock underlying their Talbert rights, as well as to subscribe for any unallocated additional shares. In May 1997, Talbert successfully completed its rights offering and shares of Talbert common stock were distributed. Proceeds from the Talbert rights offering were used to repay the non-recourse promissory note issued to FHP. We accounted for the FHP acquisition as a purchase. Total consideration of approximately $2.2 billion, including $18 million of transaction costs, was allocated to the assets acquired and liabilities assumed based on estimates of their fair values. The fair value of assets acquired was $0.9 billion. The fair value of liabilities assumed was $1.1 billion. A total of $2.4 billion, net of related deferred taxes, representing the excess of the purchase price over the fair values of the net assets acquired, was allocated to goodwill and other acquired intangible assets and is being amortized over a four to 40 year period. Identified intangibles of $365 million include commercial employer group contracts, Medicare contracts, provider networks and assembled work F-11 44 PACIFICARE HEALTH SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 4. ACQUISITIONS AND DISPOSITIONS (CONTINUED) force. We recorded fair value increases and decreases in tangible assets and liabilities acquired. Fair value decreases included a $76 million decrease to property, plant and equipment. This decrease included real property write downs based on appraised values and the abandonment of capitalized software and equipment. Certain liabilities were recognized in purchase accounting for exit costs and loss contingencies. We reviewed all exit cost liabilities and determined that certain amounts exceeded the final expected payments at December 31, 1998. Certain of the items accrued, the related payments, and amounts reversed as a reduction to the FHP purchase price were as follows:
LIABILITIES LIABILITIES RECOGNIZED AT LIABILITIES OUTSTANDING AT DATE OF FHP 1998/1997 REVERSED DECEMBER 31, ACQUISITION PAYMENTS IN 1998 1998 ------------- --------- ----------- -------------- Abandonment of FHP systems.................. $ 62 $(44) $(18) $-- Losses on disposition....................... 34 (8) (25) 1 FHP severance benefits...................... 33 (29) (1) 3 FHP OPM claims accrual...................... 33 -- -- 33 Abandonment of FHP facility leases.......... 14 (3) (7) 4 Other....................................... 11 (3) (8) -- ---- ---- ---- --- Total............................. $187 $(87) $(59) $41 ==== ==== ==== ===
During 1998 we successfully settled audits of previously filed FHP federal tax returns and reversed approximately $20 million of income tax liabilities. Total purchase accounting accrual reductions were $79 million. The liabilities reversed in 1998 had the effect of reducing the amount of tax benefits we expected to realize in the future. As a result, we reduced our deferred tax assets by $10 million. In total, the purchase price of FHP decreased by $69 million and is reflected as a reduction of goodwill. At the acquisition, we accrued $62 million of contractual obligations and commitments to conform all of FHP's multiple information systems to one uniform system that will be abandoned upon the final conversion to our core computing information system. These costs were direct, incremental and were not related to the development of new software systems that would have future economic benefit. With the 1997 and 1998 dispositions, and other contract negotiations, only $44 million was required. As described below, we held certain FHP subsidiaries for sale in 1997. These dispositions were completed in 1997 with certain liabilities not being assumed by the buyers. Certain liabilities, including uninsured contingencies, were resolved for amounts significantly lower than estimated. Our estimates for FHP employee severance are expected to be fully utilized. The remaining $3 million will be paid over the next two years. We also accrued $33 million for FHP OPM claims based on FHP's internal review completed just prior to the acquisition and draft audit findings by the government. These matters generally take a number of years to resolve. See Note 10, "Commitments and Contingencies." Finally, property management reserves of $14 million for various real property leases were not fully utilized as the real estate market improved in late 1997 and early 1998. We were able to negotiate better lease terminations than estimated and also sublet space at higher rates than originally anticipated. 1997 DISPOSITIONS. In February 1997, we announced our intention to sell the Illinois and New Mexico HMO subsidiaries of FHP. We classified these subsidiaries as net assets held for sale and assigned their carrying values at net realizable value. The Illinois HMO was sold in October 1997, and the New Mexico HMO was sold in November 1997. Net losses measured from the date of the FHP acquisition until their dispositions F-12 45 PACIFICARE HEALTH SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 4. ACQUISITIONS AND DISPOSITIONS (CONTINUED) were $15 million, and disposition gains totaled $46 million. These net losses and disposition gains were treated as part of the FHP purchase price allocation. In February 1997, we sold the outstanding common stock of our Florida subsidiary, at which time the buyer assumed the daily operations. The sales price, which approximated net book value, totaled $9 million. The sale was closed in July 1997 when we received regulatory approval from the state of Florida. FISCAL 1996 ACQUISITION. In January 1996, we acquired Psychology Systems, Inc., a California-based managed care behavioral health and employee assistance program company. The acquisition was accounted for as a purchase, and its operating results were included in our consolidated financial statements from the purchase date. We amortize the excess purchase price over a period not to exceed 40 years. PRO FORMA FINANCIAL STATEMENTS. The pro forma information below presents our results of operations as if the sales of the Florida and Utah HMOs and the FHP acquisition occurred on January 1, 1997. This information reflects our actual operating results before these transactions, plus adjustments for interest expense, goodwill amortization and income taxes. No adjustment was made to give effect to synergies realized as a result of the FHP acquisition. Because the sale of the workers' compensation subsidiary, the sales of the Illinois and New Mexico HMO subsidiaries, and the fiscal 1996 acquisition were not material to our results of operations, these transactions were not included in the pro forma information below.
1998 1997 ----------- ----------- (UNAUDITED) (AMOUNTS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) Total operating revenue..................................... $9,369,487 $9,311,919 Pretax income............................................... $ 415,814 $ 160,943 Net income.................................................. $ 220,511 $ 60,431 ========== ========== Basic earnings per share.................................... $ 4.92 $ 1.22 ========== ========== Diluted earnings per share.................................. $ 4.79 $ 1.22 ========== ==========
5. LONG-TERM DEBT We have a $1.5 billion credit facility under which we had $550 million in borrowings outstanding as of December 31, 1998. The terms of this facility require a mandatory step-down payment schedule if the principal balance exceeds certain thresholds. Because the current balance is $550 million, no step-down payments are required until the final maturity date on January 1, 2002. Interest under the credit facility is variable and is presently based on the London Interbank Offering Rate ("LIBOR") plus a spread, except for $350 million of the outstanding balance that is covered by interest-rate swap agreements. The average fixed interest rate we pay on the existing swap agreements is approximately six percent. The terms of the credit facility contain various covenants usual for financing of this type, including a minimum net worth requirement, a minimum fixed charge requirement, leverage ratios and limits on the amount of treasury stock we may purchase. At December 31, 1998, we were in compliance with all such covenants. We also have $100 million in senior notes outstanding that were assumed in the FHP acquisition. These notes carry an interest rate of seven percent, are payable semiannually and mature on September 15, 2003. 6. SHAREHOLDERS' EQUITY As of December 31, 1998, we had repurchased 784,000 shares of our Class A and Class B common stock for $45 million. In May 1998, we announced the redemption of our 10,517,044 shares of Series A preferred stock. All but 15,604 shares of this stock were converted into 3,929,503 shares of Class B common stock as of the June 23, F-13 46 PACIFICARE HEALTH SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 6. SHAREHOLDERS' EQUITY (CONTINUED) 1998 redemption date. The conversion ratio was one share of Series A preferred stock to 0.37419548 of a share of Class B common stock. The shares not converted were redeemed in cash for $25.77 per share, including accrued and unpaid dividends of approximately $0.02 per share, or $0.4 million in the aggregate. During the year ended December 31, 1998, we paid approximately $5 million in dividends to our preferred shareholders. In January 1998, our board of directors approved a plan to repurchase shares of our outstanding common stock. We have and may continue to repurchase our outstanding common stock using cash flows from operations and additional borrowings under the credit facility. The terms of the credit facility permit us to repurchase up to $500 million of our outstanding common stock. Shares repurchased have been and will be reissued for our employee benefit plans or for other corporate purposes. 7. INCOME TAXES The tax effects of the major items recorded as deferred tax assets and liabilities were as follows:
1998 1997 --------- --------- (IN THOUSANDS) Current deferred tax assets (liabilities): Accrued health care costs................................. $ 56,299 $ 59,938 Accrued expenses.......................................... 30,487 37,819 Accrued compensation...................................... 21,659 14,939 Provider insolvency....................................... 19,366 -- State franchise taxes..................................... 10,765 3,852 Unrealized gains on marketable securities................. (4,532) (6,550) Other assets/liabilities.................................. 4,509 14,447 Pharmacy rebate........................................... (4,486) (11,190) Prepaid expenses.......................................... (1,615) (2,381) Other..................................................... -- 1,163 --------- --------- $ 132,452 $ 112,037 ========= ========= Non-current deferred tax assets (liabilities): Identifiable intangibles.................................. $(119,509) $(132,067) Accrued expenses.......................................... 9,295 22,922 Depreciation.............................................. (8,407) (7,374) Accrued health care costs................................. 249 6,314 Future benefits from goodwill impairment.................. -- 3,569 Other..................................................... 6,316 3,843 --------- --------- $(112,056) $(102,793) ========= =========
F-14 47 PACIFICARE HEALTH SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 7. INCOME TAXES (CONTINUED) The provision for income taxes consisted of the following:
1996 TRANSITION 1998 1997 PERIOD FISCAL 1996 -------- ------- --------------- ----------- (IN THOUSANDS) Current: Federal............................ $171,478 $46,810 $17,337 $ 62,781 State.............................. 30,968 9,436 3,529 13,829 -------- ------- ------- -------- Total current.............. 202,446 56,246 20,866 76,610 -------- ------- ------- -------- Deferred: Federal............................ (13,615) 18,754 163 (22,172) State.............................. (5,684) 6,825 50 (3,611) -------- ------- ------- -------- Total deferred............. (19,299) 25,579 213 (25,783) -------- ------- ------- -------- Provision for income taxes......... $183,147 $81,825 $21,079 $ 50,827 ======== ======= ======= ========
Reconciliations of the U.S. statutory income tax rate to our effective tax rate follow:
1996 TRANSITION 1998 1997 PERIOD FISCAL 1996 ---- ----- --------------- ----------- Computed expected provision................ 35.0% 35.0% 35.0% 35.0% Amortization of intangibles................ 5.1 29.7 0.9 1.5 State taxes, net of federal benefit........ 4.3 16.9 4.4 4.4 Disposition of subsidiaries................ 1.6 -- -- -- Tax exempt interest........................ (1.4) (6.3) (2.0) (3.6) Impairment of non-deductible goodwill...... -- 54.6 -- 1.8 Other, net................................. 2.9 6.2 1.6 2.3 ---- ----- ---- ---- Provision for income taxes................. 47.5% 136.1% 39.9% 41.4% ==== ===== ==== ====
The majority of the goodwill impairment charges recorded in 1997 was not deductible for income tax purposes. See Note 9, "Impairment, Disposition, Restructuring and Other Charges." Therefore, we did not record a benefit for most of these charges. The magnitude of the 1997 charges, combined with the inability to record a related income tax benefit, resulted in a disproportionately high effective income tax rate for 1997. The 1997 effective income tax rate, without the effect of the impairment charges, was approximately 50 percent. Excluding the impact of non-deductible goodwill impairment and amortization, the impact of state taxes, net of federal benefit would have been 5.3 percent for 1997. 8. EMPLOYEE BENEFIT PLANS SAVINGS AND PROFIT-SHARING PLANS. Most of our employees may participate in our savings and profit-sharing plan. Features of the plan in 1998 were as follows: - - Participants may defer up to 12 percent of annual compensation; - - We match one-half of the deferral, up to three percent of annual compensation per employee; - - We automatically contribute two percent of annual compensation per employee; - - We may contribute an additional amount to each employee's account, generally based on a percentage of pretax income; and - - We may make a cash profit sharing payment. F-15 48 PACIFICARE HEALTH SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 8. EMPLOYEE BENEFIT PLANS (CONTINUED) Charges to income for the plan were $20 million in 1998, $7 million in 1997, $3 million in the 1996 transition period and $14 million in fiscal 1996. FHP had an employee stock ownership plan that covered most FHP employees. This plan consisted of three separate parts: - - An employee stock ownership plan (the "ESOP"); - - A 401(k) plan; and - - A payroll-based tax credit employee stock ownership plan. In February 1997, the ESOP and 401(k) components were converted to a profit-sharing plan named the FHP Savings Plan. Our employees from FHP participated in the FHP Savings Plan until December 31, 1997, at which time they became eligible to participate in our plan. We expect the FHP Savings Plan to be merged into our plan during 1999. The payroll-based tax credit employee stock ownership plan was terminated in 1997. STOCK OPTION PLANS. 1996 Employee Plan. Officers and key employees may be granted: - - Options to purchase shares of common stock; - - Shares of Class B common stock; and - - Stock appreciation rights. We grant stock options at exercise prices that equal or exceed the market price of our common stock on the dates granted. These options typically vest over four years in 25 percent increments, are generally subject to continuous employment, and expire 10 years after the grant date. At December 31, 1998, approximately 1.1 million shares were available for awards under the 1996 Employee Plan. During 1997, we granted options that vest if certain earnings targets are achieved. These options ultimately vest four years from the grant date. Also during 1997, the FHP acquisition triggered accelerated vesting provisions of some stock options. Certain employees agreed to receive additional stock options in exchange for waiving these accelerated vesting provisions. 1996 Director Plan. We grant options to purchase 5,000 shares of our Class B common stock annually to each eligible non-employee director and grant options to purchase 10,000 shares of Class B common stock when a new director is elected or appointed to the Board. These options vest over four years in 25 percent increments. 1997 Premium Plan. We granted options to purchase 2.6 million shares (the maximum available) of our Class B common stock to certain executive officers under this plan. The first 50 percent vest within three years of the grant date if the closing market price of our Class B common stock reaches $92.50, and expire in 2000 if the $92.50 stock price is not reached. The remaining 50 percent vest within five years of the grant date if the closing market price of our Class B common stock reaches $114.00, and expire in 2002 if the $114.00 stock price is not reached. F-16 49 PACIFICARE HEALTH SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 8. EMPLOYEE BENEFIT PLANS (CONTINUED) Non-qualified stock option activity for all plans was as follows:
CLASS A WEIGHTED AVERAGE CLASS B WEIGHTED AVERAGE STOCK EXERCISE PRICE STOCK EXERCISE PRICE ------- ---------------- --------- ---------------- OUTSTANDING AT SEPTEMBER 30, 1996..... 308,834 $7.49 1,647,121 $ 53.21 Granted at market price............... -- -- 358,300 $ 80.92 Exercised............................. -- -- (9,722) $ 62.91 Canceled.............................. -- -- (210,561) $ 80.25 ------- ----- --------- ------- OUTSTANDING AT DECEMBER 31, 1996...... 308,834 $7.49 1,785,138 $ 55.79 Granted at market price............... -- -- 1,948,100 $ 70.98 Granted in excess of market price..... -- -- 1,187,500 $ 92.50 Granted in excess of market price..... -- -- 1,187,500 $114.00 Exchanged for FHP stock options....... -- -- 933,594 $ 51.83 Exercised............................. (74,784) $5.85 (903,029) $ 46.98 Canceled.............................. -- -- (470,347) $ 75.04 ------- ----- --------- ------- OUTSTANDING AT DECEMBER 31, 1997...... 234,050 $8.02 5,668,456 $ 75.51 Granted at market price............... -- -- 1,068,810 $ 77.76 Granted in excess of market price..... -- -- 112,500 $ 92.50 Granted in excess of market price..... -- -- 112,500 $114.00 Exercised............................. (94,200) $6.54 (360,551) $ 48.50 Canceled.............................. -- -- (424,707) $ 84.49 ------- ----- --------- ------- OUTSTANDING AT DECEMBER 31, 1998...... 139,850 $9.02 6,177,008 $ 82.00 ======= ===== ========= =======
Non-qualified options exercisable under all plans were as follows:
CLASS A WEIGHTED AVERAGE CLASS B WEIGHTED AVERAGE STOCK EXERCISE PRICE STOCK EXERCISE PRICE ------- ---------------- --------- ---------------- September 30, 1996.................... 308,834 $7.49 435,474 $35.57 December 31, 1996..................... 308,834 $7.49 728,316 $45.73 December 31, 1997..................... 234,050 $8.02 1,268,710 $54.62 December 31, 1998..................... 139,850 $9.02 1,392,229 $60.29
F-17 50 PACIFICARE HEALTH SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 8. EMPLOYEE BENEFIT PLANS (CONTINUED) The following is a summary of information about options outstanding and options exercisable at December 31, 1998:
OPTIONS OUTSTANDING OPTIONS EXERCISABLE ----------------------------------------- ----------------------------- WEIGHTED WEIGHTED WEIGHTED NUMBER AVERAGE AVERAGE NUMBER AVERAGE RANGE OF EXERCISE PRICES OUTSTANDING LIFE(I) EXERCISE PRICE EXERCISABLE EXERCISE PRICE ------------------------ ----------- -------- -------------- ----------- -------------- CLASS A STOCK: $ 8.38 - $19.75................ 139,850 2 $ 9.02 139,850 $ 9.02 ========= ========= CLASS B STOCK: $ 8.38 - $19.75................ 43,500 2 $ 10.43 43,500 $10.43 $29.75 - $41.30................ 241,930 5 $ 38.69 237,723 $38.69 $44.75 - $67.00................ 1,377,050 8 $ 64.74 727,698 $63.96 $68.88 - $92.50................ 3,307,028 9 $ 81.61 383,308 $72.38 $114.00........................ 1,207,500 9 $114.00 -- -- --------- --------- 6,177,008 1,392,229 ========= =========
- --------------- (i) Weighted average contractual life remaining in years. PRO FORMA STOCK OPTION DISCLOSURE. We used the Black-Scholes option pricing model to calculate the fair value of grants in the years presented below. We applied the following assumptions to determine pro forma compensation expense:
1996 TRANSITION 1998 1997 PERIOD FISCAL 1996 ------ ------ --------------- ----------- Expected dividend yield......................... 0% 0% 0% 0% Risk-free interest rate......................... 6% 6% 6% 6% Expected stock price volatility................. 45% 43% 43% 43% Expected term until exercise (years)............ 2 3 3 3 Weighted average fair value of options on grant date: Granted at market prices...................... $30.92 $25.40 $29.57 $27.69 Granted in excess of market price............. $29.76 $26.99 -- --
We do not record compensation expense for stock option grants. The following table summarizes results as if we had recorded compensation expense for the 1998, 1997, 1996 transition period and fiscal 1996 grants:
1996 TRANSITION 1998 1997 PERIOD FISCAL 1996 -------- -------- --------------- ----------- (IN THOUSANDS, EXCEPT PER SHARE DATA) Net income (loss): As reported............................... $202,427 $(21,701) $31,757 $71,953 Pro forma................................. $168,382 $(48,359) $30,996 $69,492 Basic earnings (loss) per share: As reported............................... $ 4.50 $ (0.75) $ 1.01 $ 2.31 Pro forma................................. $ 3.85 $ (1.19) $ 0.99 $ 2.24 Diluted earnings (loss) per share: As reported............................... $ 4.40 $ (0.75) $ 1.00 $ 2.27 Pro forma................................. $ 3.66 $ (1.19) $ 0.97 $ 2.19
F-18 51 PACIFICARE HEALTH SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 8. EMPLOYEE BENEFIT PLANS (CONTINUED) These figures reflect only the impact of grants since October 1, 1995, and reflect only part of the possible compensation expense that we amortize over the vesting period of the grants (generally up to four years). Therefore, the effect on net income and earnings per share may differ in future years from the amounts shown above. 9. IMPAIRMENT, DISPOSITION, RESTRUCTURING AND OTHER CHARGES We recognized pretax charges in 1998, 1997 and 1996 as follows:
QUARTER PRETAX NET OF TAX DILUTED (LOSS)/ RECOGNIZED (CHARGE)/CREDIT AMOUNT EARNINGS PER SHARE ------------ --------------- ---------- ------------------ (DOLLARS IN MILLIONS, EXCEPT PER SHARE DATA) 1998 Sale of Utah HMO and workers' compensation subsidiaries....... Third $ (15.6) $ (8.2) $(0.18) OPM charges....................... Third (3.8) (2.0) (0.04) ------- ------- ------ Total Third (19.4) (10.2) (0.22) OPM credits....................... Fourth 8.4 4.4 0.10 ------- ------- ------ $ (11.0) $ (5.8) $(0.12) ======= ======= ====== 1997 Impairment of long-lived assets: Utah HMO........................ Fourth $ (62.4) $ (55.7) $(1.37) Washington health plan.......... Fourth (40.5) (36.1) (0.89) Discontinued workers' compensation products........ Fourth (21.1) (18.9) (0.47) ------- ------- ------ Total impairment of long-lived assets..... (124.0) (110.7) (2.73) Loss contracts.................... Fourth (15.4) (9.2) (0.23) Restructuring..................... Fourth (15.1) (9.0) (0.22) ------- ------- ------ $(154.5) $(128.9) $(3.18) ======= ======= ====== 1996 OPM charges....................... Second $ (25.0) $ (14.9) $(0.47) Florida disposition............... Second (9.3) (8.3) (0.26) Restructuring..................... Second (7.8) (4.7) (0.15) ------- ------- ------ Total Second (42.1) (27.9) (.88) Impairment of long-lived assets-Florida.................. Third (58.7) (34.1) (1.08) ------- ------- ------ $(100.8) $ (62.0) $(1.96) ======= ======= ======
1998. Pretax charges of $11 million ($6 million or $0.12 diluted loss per share, net of tax) were recorded in 1998 as follows: - - Dispositions. We recognized $16 million of disposition charges ($8 million or $0.18 diluted loss per share, net of tax) with the sales of our Utah HMO and workers' compensation subsidiaries. See Note 4, "Acquisitions and Dispositions." F-19 52 PACIFICARE HEALTH SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 9. IMPAIRMENT, DISPOSITION, RESTRUCTURING AND OTHER CHARGES (CONTINUED) - - OPM. Partially offsetting the disposition charges were net OPM credits of $5 million ($3 million or $0.06 diluted income per share, net of tax). See Note 10, "Commitments and Contingencies." 1997. Pretax charges of $155 million ($129 million or $3.18 diluted loss per share, net of tax) were recorded in 1997 as follows: - - Utah HMO impairment. We recognized a goodwill and other intangible impairment charge of $62 million ($56 million or $1.37 diluted loss per share, net of tax) in anticipation of our disposition of the subsidiary. Utah's operating losses related to lower than expected 1997 premium rate increases, combined with a shift of membership from capitated to non-capitated health care providers. This shift of membership resulted from a significant health care provider contract that switched from capitation to fee-for-service. We entered into the contract to ensure an adequate infrastructure to service the Utah membership. At that same time, the Utah information systems migrated to the standard FHP system in anticipation of the conversion of the FHP system into our common system. As a result, increased utilization under the new fee-for-service contract was not visible until the fourth quarter of 1997 when conversion reconciliations discovered significant unpaid claims, as well as claims paid inaccurately. Because the 1997 losses and the cash flow analysis did not support the recoverability of goodwill, we recorded an impairment charge. We disposed of our Utah operations in September 1998 with the additional disposition losses noted above. See Note 4, "Acquisitions and Dispositions." - - Washington health plan impairment. In 1997 we determined that the Washington health plan goodwill and intangibles were no longer recoverable, and recorded an impairment charge of $41 million ($36 Million or $0.89 diluted loss per share, net of tax). Since its acquisition, the Washington market has incurred operating losses. 1998 results were break-even. - - Workers' compensation subsidiary impairment. We recognized $21 million ($19 million or $0.47 diluted loss per share, net of tax) of goodwill impairment charges, primarily for discontinued workers' compensation products. We determined that California legislation did not allow workers' compensation products to be priced at rates that could produce our required return on investment. See Note 4, "Acquisitions and Dispositions." - - Loss contracts. We recorded approximately $15 million ($9 million, or $0.23 diluted loss per share, net of tax) for contracts on which the anticipated future health care costs exceeded the premiums, the majority related to our Utah HMO and workers' compensation subsidiary. These losses were realized throughout 1998. Any remaining accrued losses at the disposition of Utah and our workers' compensation subsidiary offset disposition losses. - - Restructuring. We recognized restructuring charges of $15 million ($9 million or $0.22 diluted loss per share, net of tax) in 1997. Work force reduction costs of $8 million primarily included employee severance for involuntary terminations. Lease terminations and personal property abandonment of $5 million pretax were associated with the consolidation of administration and operations office space. Other related charges totaled $2 million, pretax. Cash flows from operations funded all of the restructuring charges. The restructuring was substantially complete at December 31, 1998 and actual expenditures did not differ materially from amounts accrued. FISCAL 1996. We recognized pretax impairment, disposition, restructuring and OPM charges for fiscal 1996 totaling $101 million ($62 million or $1.96 diluted loss per share, net of tax) as follows: - - OPM. During 1996, we recognized a pretax charge of $25 million ($15 million or $0.47 diluted loss per share, net of tax) for an increase of reserves in anticipation of negotiations relating to potential governmental claims for contracts with OPM. See Note 10, "Commitments and Contingencies." F-20 53 PACIFICARE HEALTH SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 9. IMPAIRMENT, DISPOSITION, RESTRUCTURING AND OTHER CHARGES (CONTINUED) - - Florida disposition. Effective June 1, 1996, we sold the assets of our Florida subsidiary's staff-model medical clinics, resulting in a pretax loss of $9 million ($8 million or $0.26 diluted loss per share, net of tax). - - Restructuring. We recognized a restructuring charge of $8 million ($5 million or $0.15 diluted loss per share, net of tax). This charge included employee severance for an involuntary work force reduction of approximately $4 million, write-offs of assets designated for sale totaling approximately $3 million, and other related costs of approximately $1 million. The restructuring was financed by cash flows from operations. The restructuring was substantially complete at December 31, 1998 and actual expenditures did not differ materially from amounts accrued. - - Florida impairment. We recognized a $59 million impairment charge ($34 million or $1.08 diluted loss per share, net of tax) in 1996 when we decided to sell our Florida operations. The sale was completed in early 1997. See Note 4, "Acquisitions and Dispositions." 10. COMMITMENTS AND CONTINGENCIES PROVIDER INSTABILITY AND INSOLVENCY. Our 1998 results include significant provider insolvency costs, primarily related to FPA Medical Management, Inc. ("FPA") who declared bankruptcy in July 1998. Provider insolvency reserves totaled $95 million in 1998 and were immaterial in 1997. Provider insolvency reserves include write-offs of providers' uncollectable receivables and the estimated cost of unpaid health care claims covered by our capitation payment. Depending on state law, we may be held liable for unpaid health care claims which were the responsibility of the capitated provider. The majority of the insolvency reserves relate to specific provider bankruptcies. However, the estimate also includes reserves for potentially insolvent providers, where conditions indicate claims are not being paid or have slowed considerably. FPA served approximately 200,000 PacifiCare members in Arizona, California, Nevada and Texas. Reserves for the FPA bankruptcy totaled $57 million, with $41 million attributable to our Nevada HMO. Nevada law specifically requires that we pay all health care services claims, both non-contracted and contracted. Reserves for the remaining FPA states of $16 million primarily relate to reserves for non-contracted claims and receivable write-offs. Unpaid FPA reserves at December 31, 1998 were approximately $20 million. In 1998, reserves for other providers totaled $38 million. Approximately $17 million recognized in the third and fourth quarters were attributable to another provider that has ceased paying claims in Nevada and Arizona. This provider has not declared bankruptcy. The membership was transitioned to other providers between December 1998 and January 1999. The remaining $21 million was the estimated liability for non-contracted health care services rendered through December 31, 1998 for smaller bankrupt providers and potentially insolvent providers, primarily in California. Other provider insolvency reserves unpaid at December 31, 1998 were approximately $38 million. Based on current information, we believe that any liability in excess of amounts accrued would not materially affect our consolidated financial position. However, our evaluation of the likely impact of claims asserted against us could change in the future and an unfavorable outcome, depending on the amount and timing, could have a material effect on our results of operations or cash flows for a future quarter. OPM. Our HMO subsidiaries have commercial contracts with OPM to provide managed health care services to federal employees, annuitants and their dependents under the FEHBP. In the normal course of business, OPM audits health plans with which it contracts mainly to verify that the premiums calculated and charged to OPM are established in compliance with the best price community rating guidelines established by OPM. OPM typically audits plans once every five or six years, and each audit covers the prior five or six F-21 54 PACIFICARE HEALTH SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 10. COMMITMENTS AND CONTINGENCIES (CONTINUED) year period. While the government's initial on-site audits are usually followed by a post-audit briefing in which the government indicates its preliminary results, final resolution and settlement of the audits have historically taken a minimum of three to five years. In connection with the sales of our health plans in New Mexico, Illinois and Utah, we have agreed to indemnify the buyers for potential OPM liabilities that relate to the years in which we owned these plans. We intend to negotiate with OPM on all unresolved matters to attain a mutually satisfactory result. There can be no assurance that these negotiations will be concluded satisfactorily, that additional audits will not be referred to the DOJ, or that additional, possibly material, liability will not be incurred. We believe that any ultimate liability in excess of amounts accrued would not materially affect our consolidated financial position. However, such liability could have a material effect on results of operations or cash flows of a future quarter if resolved unfavorably. In addition to claims made by the OPM auditors as part of the normal audit process, OPM may also refer their results to the United States Department of Justice ("DOJ") for potential legal action under the False Claims Act. The DOJ has the authority to file a claim under the False Claims Act if it believes that the health plan knowingly overcharged the government or otherwise submitted false documentation or certifications. In False Claims Act actions, the government may impose trebled damages and a civil penalty of not less than $5,000 nor more than $10,000 for each separate alleged false claim. In November 1997, we were notified that the 1990 through 1995 audit of the operations of our Oklahoma HMO subsidiary had been referred to the DOJ. In the third quarter of 1998 we recorded approximately $4 million ($2 million, or $0.04 diluted loss per share, net of tax) for potential OPM claims. In January 1999, we preliminarily agreed to settle the 1990-1995 Oklahoma OPM audits for $9 million. As a result of this settlement and other changes in estimate, we recognized a pretax OPM credit of $8 million ($4 million or $0.10 diluted income per share, net of tax). LEGAL PROCEEDINGS. In 1997 we were served with several purported class action suits alleging violations of federal securities laws by PacifiCare and by certain of our officers and directors. The complaints related to the period from the date of the FHP acquisition through our November 1997 announcement that earnings for the fourth quarter of 1997 would be lower than expected. These complaints primarily alleged that we previously omitted and/or misrepresented material facts with respect to our costs, earnings and profits. We have filed a motion to dismiss the entire complaint. No discovery has been taken, and all discovery has been stayed pending the resolution of our motion to dismiss. We believe we have good defenses to the claims in these suits and are contesting them vigorously. We are also involved in legal actions in the normal course of business, some of which seek monetary damages, including claims of punitive damages that are not covered by insurance. Based on current information and review with our lawyers, management believes any ultimate liability which may arise from these actions (including the purported class actions), would not materially affect our consolidated financial position, results of operations or cash flows. However, management's evaluation of the likely impact of these actions could change in the future and an unfavorable outcome, depending upon the amount and timing, could have a material effect on our results of operations or cash flows for a future quarter. LEASE COMMITMENTS. We lease office space and equipment under various non-cancelable operating leases. Rental expense totaled $59 million in 1998, $48 million in 1997, $5 million in the 1996 transition period, and $29 million in fiscal 1996. Future minimum lease payments will be $49 million in 1999, $37 million in 2000, $24 million in 2001, $17 million in 2002 and $13 million in 2003. Minimum lease payments after 2003 will be $23 million. In 1997, we entered into a real estate and equipment master transfer agreement that allows us to lease, sublease or assign facilities and equipment that we own or lease. The net book value of such facilities and F-22 55 PACIFICARE HEALTH SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 10. COMMITMENTS AND CONTINGENCIES (CONTINUED) equipment at December 31, 1998 was approximately $27 million. The leases are accounted for as operating leases, and subleases are accounted for as rental income. The agreement includes extensions of the individual leases to December 31, 2005, and two five-year extension options at prevailing market rates. These options are exercisable solely at the lessee's discretion, and include a right of first offer for the lessee to purchase the furniture, fixtures and equipment. The parties terminated a separate lease agreement for furniture, fixtures and equipment when the assets were sold in 1998. EMPLOYMENT AGREEMENTS. We have employment agreements with our chief executive officer and certain other executive officers. The agreements entitle these officers to receive severance benefits, payable if employment is terminated for various reasons, including termination following a change of ownership or control of PacifiCare. The maximum severance amount we would owe these executives according to their employment agreements (excluding amounts that may be payable under incentive plans and the value of certain other benefits) was approximately $11 million at December 31, 1998. 11. COMPREHENSIVE INCOME The following tables summarize the components of other comprehensive income (loss) for the periods indicated:
INCOME TAX NET-OF- PRETAX EXPENSE TAX AMOUNT (BENEFIT) AMOUNT -------- --------- ------- (IN THOUSANDS) 1998: Unrealized holding gains arising during the period.......... $ 12,766 $ 5,538 $ 7,228 Less: reclassification adjustment for net gains realized in net income................................................ (17,418) (7,556) (9,862) -------- ------- ------- Other comprehensive loss.................................... $ (4,652) $(2,018) $(2,634) ======== ======= ======= 1997: Unrealized holding gains arising during the period.......... $ 12,806 $ 4,885 $ 7,921 Less: reclassification adjustment for net gains realized in net income................................................ (2,229) (850) (1,379) -------- ------- ------- Other comprehensive income.................................. $ 10,577 $ 4,035 $ 6,542 ======== ======= ======= 1996 TRANSITION PERIOD: Unrealized holding gains arising during the period.......... $ 3,891 $ 1,487 $ 2,404 Less: reclassification adjustment for net gains realized in net income................................................ (396) (150) (246) -------- ------- ------- Other comprehensive income.................................. $ 3,495 $ 1,337 $ 2,158 ======== ======= ======= FISCAL 1996 Unrealized holding gains arising during the period.......... $ 7,111 $ 2,750 $ 4,361 Less: reclassification adjustment for net gains realized in net income................................................ (13,066) (5,054) (8,012) -------- ------- ------- Other comprehensive loss.................................... $ (5,955) $(2,304) $(3,651) ======== ======= =======
F-23 56 REPORT OF ERNST & YOUNG LLP INDEPENDENT AUDITORS The Board of Directors and Shareholders PacifiCare Health Systems, Inc. We audited the accompanying consolidated balance sheets of PacifiCare Health Systems, Inc. as of December 31, 1998 and 1997, and the related consolidated statements of operations, shareholders' equity and cash flows for the years ended December 31, 1998 and 1997, the three months ended December 31, 1996 and the year ended September 30, 1996. Our audits also included the financial statement schedule listed in the Index at Item 14(a)(2). These consolidated financial statements and schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and schedule based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. 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. at December 31, 1998 and 1997, and the consolidated results of its operations and its cash flows for the years ended December 31, 1998 and 1997, the three months ended December 31, 1996 and the year ended September 30, 1996 in conformity with generally accepted accounting principles. Also in our opinion, the related financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly in all material respects the information set forth therein. ERNST & YOUNG LLP Los Angeles, California February 9, 1999 F-24 57 PACIFICARE HEALTH SYSTEMS, INC. QUARTERLY INFORMATION FOR 1998 AND 1997 (UNAUDITED)
QUARTERS ENDED ------------------------------------------------------------- MARCH 31 JUNE 30 SEPTEMBER 30(1) DECEMBER 31(1) ---------- ---------- --------------- -------------- (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) 1998 Operating revenue.................. $2,381,950 $2,396,259 $2,400,897 $2,342,376 Operating expenses................. 2,309,450 2,309,987 2,316,522 2,243,332 Net investment income.............. 25,304 23,850 29,193 25,959 Interest expense................... (17,518) (16,913) (13,828) (12,664) ---------- ---------- ---------- ---------- Income before income taxes......... 80,286 93,209 99,740 112,339 Provision for income taxes......... 38,940 44,338 46,509 53,360 ---------- ---------- ---------- ---------- Net income......................... $ 41,346 $ 48,871 $ 53,231 $ 58,979 ========== ========== ========== ========== Preferred dividends................ (2,629) (2,630) -- -- ---------- ---------- ---------- ---------- Net income available to common shareholders..................... $ 38,717 $ 46,241 $ 53,231 $ 58,979 ========== ========== ========== ========== Basic earnings per share........... $ 0.93 $ 1.10 $ 1.17 $ 1.29 ========== ========== ========== ========== Diluted earnings per share......... $ 0.90 $ 1.06 $ 1.16 $ 1.28 ========== ========== ========== ========== Membership (4)..................... 3,689 3,660 3,645 3,527 ========== ========== ========== ========== 1997(2)(3) Operating revenue.................. $1,843,603 $2,381,100 $2,401,355 $2,356,622 Operating expenses................. 1,772,488 2,338,872 2,343,947 2,483,378 Net investment income.............. 17,685 20,368 22,196 20,416 Interest expense................... (9,719) (18,695) (18,069) (18,053) ---------- ---------- ---------- ---------- Income (loss) before income taxes............................ 79,081 43,901 61,535 (124,393) Provision for income taxes......... 35,587 25,904 30,767 (10,433) ---------- ---------- ---------- ---------- Net income (loss).................. $ 43,494 $ 17,997 $ 30,768 $ (113,960) ========== ========== ========== ========== Preferred dividends................ (904) (2,630) (2,629) (2,629) ---------- ---------- ---------- ---------- Net income (loss) available to common shareholders.............. $ 42,590 $ 15,367 $ 28,139 $ (116,589) ========== ========== ========== ========== Basic earnings (loss) per share.... $ 1.17 $ 0.37 $ 0.67 $ (2.78) ========== ========== ========== ========== Diluted earnings (loss) per share............................ $ 1.12 $ 0.37 $ 0.67 $ (2.78) ========== ========== ========== ========== Membership (4)..................... 3,849 3,841 3,834 3,792 ========== ========== ========== ==========
- --------------- (1) We recognized pretax charges in the third quarter of 1998 totaling $19 million ($10 million or $0.22 diluted loss per share, net of tax). These charges included approximately $15 million ($8 million or $0.18 diluted loss per share, net of tax) for the disposal of the Utah HMO and workers' compensation subsidiaries. The charges also included approximately $4 million ($2 million, or $0.04 diluted loss per share, net of tax) for potential OPM claims. The 1998 charges were partially offset by $8 million ($4 million or $0.10 diluted earnings per share, net of tax) for favorable OPM settlements in the fourth quarter. See Notes 9 and 10 of the Notes to Consolidated Financial Statements. (2) The 1997 results include the results of operations for the FHP acquisition from February 14, 1997. See Note 4 of the Notes to Consolidated Financial Statements. (3) The December 31, 1997 results include $155 million of pretax charges ($129 million or $3.18 diluted loss per share, net of tax) for the impairment of long-lived assets, restructuring and certain other charges. See Note 9 of the Notes to Consolidated Financial Statements. (4) Membership as of quarter end. F-25 58 PACIFICARE HEALTH SYSTEMS, INC. AND SUBSIDIARIES SCHEDULE II -- VALUATION AND QUALIFYING ACCOUNTS (AMOUNTS IN THOUSANDS)
YEAR ENDED YEAR ENDED THREE MONTHS ENDED FISCAL YEAR ENDED DECEMBER 31, 1998 DECEMBER 31, 1997 DECEMBER 31, 1996 SEPTEMBER 30, 1996 ----------------- ----------------- ------------------ ------------------ Allowance for doubtful accounts: Beginning balance........... $13,598 $ 1,048 $ 890 $690 FHP acquisition............. -- 7,036 -- -- Additions: Charged to costs and expenses................. 1,485 5,171 296 999 Charged to other accounts... (4,850) 3,620 (92) (85) Deductions/write offs......... (1,704) (3,277) (46) (714) ------- ------- ------ ---- Ending balance................ $ 8,529 $13,598 $1,048 $890 ======= ======= ====== ====
F-26 59 PACIFICARE HEALTH SYSTEMS, INC. EXHIBIT INDEX
EXHIBIT NUMBER DESCRIPTION - ------- ----------- 3.01 Amended and Restated Certificate of Incorporation of the Registrant [incorporated by reference to Exhibit 3.01 to the Registrant's Form 10-K for the year ended December 31, 1997]. 3.02 Certificate of Amendment of Amended and Restated Certificate of Incorporation of the Registrant [incorporated by reference to Exhibit 3.02 to the Registrant's Form 10-K for the year ended December 31, 1997]. 3.03 Bylaws of the Registrant, as amended. 4.01 Form of Specimen Certificate for Registrant's Class A Common Stock [incorporated by reference to Exhibit 4.01 to the Registrant's Form 8-K, dated February 21, 1997]. 4.02 Form of Specimen Certificate for Registrant's Class B Common Stock [incorporated by reference to Exhibit 4.02 to the Registrant's Form 8-K, dated February 21, 1997]. 4.03 First Supplemental Indenture, dated as of February 14, 1997, by and among the Registrant, FHP International Corporation and The Chase Manhattan Bank, N.A. [incorporated by reference to Exhibit 4.01 to the Registrant's Form 10-Q for the quarter ended March 31, 1997]. 10.01 Employment Agreement, dated December 1, 1994, between the Registrant and Alan R. Hoops [incorporated by reference to Exhibit 10.2 to the Registrant's Form 10-Q for the quarter ended December 31, 1994].(1) 10.02 Employment Agreement, dated December 12, 1994, between the Registrant and Jeffrey M. Folick [incorporated by reference to Exhibit 10.3 to the Registrant's Form 10-Q for the quarter ended December 31, 1994].(1) 10.03 Employment Agreement, dated June 15, 1998, between the Registrant and Robert B. Stearns [incorporated by reference to Exhibit 10.01 to the Registrant's Form 10-Q for the quarter ended September 30, 1998].(1) 10.04 Employment Agreement, dated October 6, 1997, between the Registrant and Bradford A. Bowlus.(1) 10.05 Employment Agreement, dated June 10, 1996, between the Registrant and Linda M. Lyons, MD, as amended January 1, 1998 and February 9, 1998.(1) 10.06 Form of Contract With Eligible Medicare+Choice Organization for the period January 1, 1999 through December 31, 1999 between PacifiCare of California and the Health Care Financing Administration. 10.07 1996 Stock Option Plan for Officers and Key Employees of the Registrant [incorporated by reference to Exhibit 10.05 to Registrant's Form 8-B, dated January 23, 1997].(1) 10.08 1996 Non-Officer Directors Stock Option Plan of the Registrant [incorporated by reference to Exhibit 10.06 to Registrant's Form 8-B, dated January 23, 1997].(1) 10.09 1996 Management Incentive Compensation Plan of the Registrant [incorporated by reference to Exhibit 10.07 to Registrant's Form 8-B, dated January 23, 1997].(1) 10.10 1996 Long-Term Performance Incentive Plan of the Registrant [incorporated by reference to Exhibit 10.08 to Registrant's form 8-B, dated January 23, 1997].(1) 10.11 Amended 1997 Premium Priced Stock Option Plan of the Registrant [incorporated by reference to Exhibit A to Registrant's Definitive Proxy Statement, dated April 28, 1998].(1) 10.12 First Amendment to Amended 1997 Premium Priced Stock Option Plan, dated as of August 27, 1998.(1) 10.13 PacifiCare Health Systems, Inc. Statutory Restoration Plan [incorporated by reference to Exhibit 10.15 to the Registrant's Form 10-K for the year ended December 31, 1997].(1)
E-1 60 PACIFICARE HEALTH SYSTEMS, INC. EXHIBIT INDEX
EXHIBIT NUMBER DESCRIPTION - ------- ----------- 10.14 PacifiCare Health Systems, Inc. Non-Qualified Deferred Compensation Plan [incorporated by reference to Exhibit 10.16 to the Registrant's Form 10-K for the year ended December 31, 1997].(1) 10.15 PacifiCare Health Systems, Inc. Stock Unit Deferred Compensation Plan [incorporated by reference to Exhibit 10.17 to the Registrant's Form 10-K for the year ended December 31, 1997].(1) 10.16 Credit Agreement, dated as of October 31, 1996, among Registrant, the several financial institution from time to time party to the Credit Agreement, The Bank of New York, The Bank of Nova Scotia, Banque Nationale de Paris, Dai-Ichi Kangyo Bank, Ltd., The Industrial Bank of Japan Limited, RaboBank Nederland, Sanwa Bank of California, The Sumitomo Bank, Limited and Wells Fargo Bank, N.A., as co-agents, The Chase Manhattan Bank and CitiCorp USA, Inc. as managing agents, and Bank of America National Trust and Savings Association, as agent for the Banks [incorporated by reference to Exhibit 10.01 to the Registrant's Registration Statement on Form S-4 (File No. 333-16271)]. 10.17 First Amendment to Credit Agreement, dated as of August 15, 1997, among the Registrant, the Banks party to the Credit Agreement, dated as of October 31, 1996, and Bank of America National Trust and Savings Association, as Agent [incorporated by reference to Exhibit 10.12 to the Registrant's Form 10-K for the year ended December 31, 1997]. 10.18 Second Amendment to Credit Agreement, dated as of December 31, 1997 among the Registrant, the Banks party to the Credit Agreement, dated as of October 31, 1996, and Bank of America National Trust and Savings Association, as Agent [incorporated by reference to Exhibit 10.13 to the Registrant's Form 10-K for the year ended December 31, 1997]. 21 List of Subsidiaries. 23 Consent of Ernst & Young LLP Independent Auditors. 27 Financial Data Schedules (filed electronically).
- --------------- (1) Management contract or compensatory plan or arrangement required to be filed as an exhibit to this Form 10-K pursuant to Item 14(c) of Form 10-K. E-2 EX-3.03 2 BYLAWS OF THE REGISTRANT, AS AMENDED 1 EXHIBIT 3.03 BYLAWS OF N-T HOLDINGS, INC. (A DELAWARE CORPORATION) 2 TABLE OF CONTENTS
ARTICLE I - OFFICES..........................................................................1 Section 1. Registered Office.........................................................1 Section 2. Other Offices.............................................................1 ARTICLE II - CORPORATE SEAL..................................................................1 Section 3. Corporate Seal............................................................1 ARTICLE III - STOCKHOLDERS' MEETINGS.........................................................1 Section 4. Place of Meetings.........................................................1 Section 5. Annual Meeting............................................................2 Section 6. Special Meetings..........................................................2 Section 7. Notice of Meetings........................................................2 Section 8. Quorum....................................................................3 Section 9. Adjournment and Notice of Adjourned Meetings..............................3 Section 10. Voting Rights............................................................3 Section 11. Beneficial Owners of Stock...............................................4 Section 12. List of Stockholders.....................................................4 Section 13. Action without Meeting...................................................4 Section 14. Organization.............................................................5 ARTICLE IV - DIRECTORS.......................................................................6 Section 15. Number and Term of Office................................................6 Section 16. Powers...................................................................6 Section 17. Vacancies................................................................6 Section 18. Resignation..............................................................6 Section 19. Removal..................................................................6 Section 20. Meetings.................................................................7 (a) Annual Meetings..........................................................7 (b) Regular Meetings.........................................................7 (c) Special Meetings.........................................................7 (d) Telephone Meetings.......................................................7 (e) Notice of Meetings.......................................................7 (f) Waiver of Notice.........................................................7 Section 21. Quorum and Voting........................................................7 Section 22. Action without Meeting...................................................8 Section 23. Fees and Compensation....................................................8 Section 24. Committees...............................................................8 (a) Executive Committee......................................................8 (b) Other Committees.........................................................9 (c) Term.....................................................................9 (d) Meetings.................................................................9 Section 25. Organization.............................................................9
i 3 TABLE OF CONTENTS (CONTINUED)
ARTICLE V - OFFICERS........................................................................10 Section 26. Officers Designated.....................................................10 Section 27. Tenure and Duties of Officers...........................................10 (a) General..................................................................10 (b) Duties of Chairman of the Board of Directors.............................10 (c) Duties of President......................................................10 (d) Duties of Vice Presidents................................................11 (e) Duties of Secretary......................................................11 (f) Duties of Chief Financial Officer or Treasurer..........................11 Section 28. Delegation of Authority................................................11 Section 29. Resignations............................................................11 Section 30. Removal.................................................................12 ARTICLE VI - EXECUTION OF CORPORATE INSTRUMENTS AND VOTING OF SECURITIES OWNED BY THE CORPORATION...............................................12 Section 31. Execution of Corporate Instruments......................................12 Section 32. Voting of Securities Owned by the Corporation...........................12 ARTICLE VII- SHARES OF STOCK................................................................13 Section 33. Form and Execution of Certificates.......................................13 Section 34. Lost Certificates........................................................13 Section 35. Transfers................................................................13 Section 36. Fixing Record Dates......................................................14 Section 37. Registered Stockholders..................................................15 ARTICLE VIII - OTHER SECURITIES OF THE CORPORATION..........................................15 Section 38. Execution of Other Securities............................................15 ARTICLE IX - DIVIDENDS......................................................................15 Section 39. Declaration of Dividends.................................................15 Section 40. Dividend Reserve.........................................................16 ARTICLE X - FISCAL YEAR.....................................................................16 Section 41. Fiscal Year..............................................................16 ARTICLE XI - INDEMNIFICATION................................................................16 Section 42. Indemnification of Directors, Officers, Employees and Other Agents......16 (a) Directors and Executive Officers .......................................16 (b) Other Officers, Employees and Other Agents..............................16 (c) Good Faith..............................................................16 (d) Expenses................................................................17
ii 4 TABLE OF CONTENTS (CONTINUED)
(e) Enforcement.............................................................17 (f) Non-Exclusivity of Rights...............................................18 (g) Survival of Rights......................................................18 (h) Insurance...............................................................18 (i) Amendments..............................................................18 (j) Saving Clause...........................................................18 (k) Certain Definitions.....................................................18 ARTICLE XII - NOTICES.......................................................................19 Section 43. Notices................................................................19 (a) Notice to Stockholders..................................................19 (b) Notice to Directors.....................................................20 (c) Address Unknown.........................................................20 (d) Affidavit of Mailing....................................................20 (e) Time Notices Deemed Given...............................................20 (f) Methods of Notice.......................................................20 (g) Failure to Receive Notice...............................................20 (h) Notice to Person with Whom Communication Is Unlawful....................20 (i) Notice to Person with Undeliverable Address.............................21 ARTICLE XIII - AMENDMENTS...................................................................21 Section 44. Amendments.............................................................21 ARTICLE XIV - LOANS TO OFFICERS.............................................................21 Section 45. Loans to Officers......................................................21
iii 5 BYLAWS OF N-T HOLDINGS, INC. (A DELAWARE CORPORATION) ARTICLE I OFFICES SECTION 1. REGISTERED OFFICE. The registered office of the corporation in the State of Delaware shall be in the City of Wilmington, County of New Castle. (Del. Code Ann., tit. 8 Section 131) SECTION 2. OTHER OFFICES. The corporation shall also have and maintain an office or principal place of business at such place as may be fixed by the Board of Directors, and may also have offices at such other places, both within and without the State of Delaware as the Board of Directors may from time to time determine or the business of the corporation may require. (Del. Code Ann., tit. 8, Section 122(8)) ARTICLE II CORPORATE SEAL SECTION 3. CORPORATE SEAL. The corporate seal shall consist of a die bearing the name or the corporation and the inscription, "Corporate Seal-Delaware." Said seal may be used by causing it or a facsimile thereof to be impressed or affixed or reproduced or otherwise. (Del. Code Ann., tit. 8, Section 122(3)) ARTICLE III STOCKHOLDERS' MEETINGS SECTION 4. PLACE OF MEETINGS. Meetings of the stockholders of the corporation shall be held at such place, either within or without the State of Delaware, as may be designated from time to time by the Board of Directors, or, if not so designated, then at the office of the 1 6 corporation required to be maintained pursuant to Section 2 hereof. (Del. Code Ann., tit. 8, Section 211(a)) SECTION 5. ANNUAL MEETING. (a) The annual meeting of the stockholders of the corporation, for the purpose of election of Directors and for such other business as may lawfully come before it, shall be held on such date and at such time as may be designated from time to time by the Board of Directors. (Del. Code Ann., tit. 8, Section 211(b)) SECTION 6. SPECIAL MEETINGS. (a) Special meetings of the stockholders of the corporation may be called, for any purpose or purposes, by (i) the Chairman of the Board, (ii) the President, (iii) the Board of Directors pursuant to a resolution adopted by a majority of the total number of authorized directors (whether or not there exist any vacancies in previously authorized directorships at the time any such resolution is presented to the Board for adoption)or (iv) by the holders of shares entitled to cast not less than ten percent (10%) of the votes at the meeting, and shall be held at such place, on such date, and at such time as they or he shall fix; provided, however, that following registration of any of the classes of equity securities of the corporation pursuant to the provisions of the Securities Exchange Act of 1934, as amended, special meetings of the stockholders may only be called by the Board of Directors pursuant to a resolution adopted by a majority of the total number of authorized Directors. (b) If a special meeting is called by any person or persons other than the Board of Directors, the request shall be in writing, specifying the time of such meeting and the general nature of the business proposed to be transacted, and shall be delivered personally or sent by registered mail or by telegraphic or other facsimile transmission to the Chairman of the Board, the President, any Vice President, or the Secretary of the corporation. No business may be transacted at such special meeting otherwise than specified in such notice. The officer receiving the request shall cause notice to be promptly given to the stockholders entitled to vote, in accordance with the provisions of Section 7 of these Bylaws, that a meeting will be held not less than thirty-five (35) nor more than sixty (60) days after the receipt of the request. If the notice is not given within twenty (20) days after the receipt of the request, the person or persons requesting the meeting may give the notice. Nothing contained in this paragraph (b) shall be construed as limiting, fixing, or affecting the time when a meeting of stockholders called by action of the Board of Directors may be held. SECTION 7. NOTICE OF MEETINGS. Except as otherwise provided by law or the Certificate of Incorporation, written notice of each meeting of stockholders shall be given not less than ten (10) nor more than sixty (60) days before the date of the meeting to each stockholder entitled to vote at such meeting, such notice to specify the place, date and hour and purpose or purposes of the meeting. Notice of the time, place and purpose of any meeting of stockholders may be waived in writing, signed by the person entitled to notice thereof, either before or after such meeting, and will be waived by any stockholder by his attendance thereat in person or by proxy, except when 2 7 the stockholder attends a meeting for the express purpose of objecting, at the beginning of the meeting, to the transaction of any business because the meeting is not lawfully called or convened. Any stockholder so waiving notice of such meeting shall be bound by the proceedings of any such meeting in all respects as if due notice thereof had been given. (Del. Code AM., tit. 8, Sections 222, 229) SECTION 8. QUORUM. At all meetings of stockholders, except where otherwise provided by statute or by the Certificate of Incorporation, or by these Bylaws, the presence, in person or by proxy duly authorized, of the holders of a majority of the outstanding shares of stock entitled to vote shall constitute a quorum for the transaction of business. Any shares, the voting of which at said meeting has been enjoined, or which for any reason cannot be lawfully voted at such meeting, shall not be counted to determine a quorum at such meeting. In the absence of a quorum any meeting of stockholders may be adjourned, from time to time, either by the chairman of the meeting or by vote of the holders of a majority of the shares represented thereat, but no other business shall be transacted at such meeting. The stockholders present at a duly called or convened meeting, at which a quorum is present, may continue to transact business until adjournment, notwithstanding the withdrawal of enough stockholders to leave less than a quorum. Except as otherwise provided by law, the Certificate of Incorporation or these Bylaws all action taken by the holders of a majority of the voting power represented at any meeting at which a quorum is present shall be valid and binding upon the corporation; provided, however, that Directors shall be elected by a plurality of the votes of the shares present in person or represented by proxy at the meeting and entitled to vote on the election of Directors. Where a separate vote by a class or classes is required, a majority of the outstanding shares of such class or classes, present in person or represented by proxy, shall constitute a quorum entitled to take action with respect to that vote on that matter and the affirmative vote of the majority (plurality, in the case of the election of Directors) of shares of such class or classes present in person or represented by proxy at the meeting shall be the act of such class. ('Del. Code Ann., tit. 8, Section 216) SECTION 9. ADJOURNMENT AND NOTICE OF ADJOURNED MEETINGS. Any meeting of stockholders, whether annual or special, may be adjourned from time to time either by the chairman of the meeting or by the vote of a majority of the shares represented thereat. When a meeting is adjourned to another time or place, notice need not be given of the adjourned meeting if the time and place thereof are announced at the meeting at which the adjournment is taken. At the adjourned meeting the corporation may transact any business which might have been transacted at the original meeting. If the adjournment is for more than thirty (30) days, or if after the adjournment a new record date is fixed for the adjourned meeting, a notice of the adjourned meeting shall be given to each stockholder of record entitled to vote at the meeting. (Del. Code Ann., tit. 8, Section 222(c)) SECTION 10. VOTING RIGHTS. (a) For the purpose of determining those stockholders entitled to vote at any meeting of the stockholders, except as otherwise provided by law, only persons in whose names shares stand on the stock records of the corporation on the record date, as provided in Section 12 or these Bylaws, shall be entitled to vote at any meeting of stockholders. Except as may be 3 8 otherwise provided in the Certificate of Incorporation or these Bylaws, each stockholder shall be entitled to one vote for each share of capital stock held by such stockholder. Every person entitled to vote or execute consents shall have the right to do so either in person or by an agent or agents authorized by a written proxy executed by such person or his duly authorized agent, which proxy shall be filed with the Secretary at or before the meeting at which it is to be used. An agent so appointed need not be a stockholder. No proxy shall be voted after three (3) years from its date of creation unless the proxy provides for a longer period. All elections of Directors shall be by written ballot, unless otherwise provided in the Certificate of Incorporation. (Del. Code Ann., tit. 8, Sections 211(e), 212(b)) SECTION 11. BENEFICIAL OWNERS OF STOCK. (a) If shares or other securities having voting power stand of record in the names of two (2) or more persons, whether fiduciaries, members of a partnership, joint tenants, tenants in common, tenants by the entirety, or otherwise, or if two (2) or more persons have the same fiduciary relationship respecting the same shares, unless the Secretary is given written notice to the contrary and is furnished with a copy of the instrument or order appointing them or creating the relationship wherein it is so provided, their acts with respect to voting shall have the following effect: (a) if only one (1) votes, his act binds all; (b) if more than one (1) votes, the act of the majority so voting binds all; (c) if more than one (1) votes, but the vote is evenly split on any particular matter, each faction may vote the securities in question proportionally, or may apply to the Delaware Court of Chancery for relief as provided in the General Corporation Law of Delaware, Section 217(b). If the instrument filed with the Secretary shows that any such tenancy is held in unequal interests, a majority or even-split for the purpose of this subsection (c) shall be a majority or even-split in interest. (Del. Code Ann., tit. 8, ~ 217(b)) (b) Persons holding stock in a fiduciary capacity shall be entitled to vote the shares so held. Persons whose stock is pledged shall be entitled to vote, unless in the transfer by the pledgor on the books of the corporation he has expressly empowered the pledgee to vote thereon, in which case only the pledgee, or his proxy! may represent such stock and vote thereon. (Del. Code Ann., tit. 8, Section 217(a)) SECTION 12. LIST OF STOCKHOLDERS. The Secretary shall prepare and make, at least ten (10) days before every meeting of stockholders, a complete list of the stockholders entitled to vote at said meeting, arranged in alphabetical order, showing the address of each stockholder and the number of shares registered in the name of each stockholder. Such list shall be open to the examination of any stockholder, for any purpose germane to the meeting, during ordinary business hours, for a period of at least ten (10) days prior to the meeting, either at a place within the city where the meeting is to be held, which place shall be specified in the notice of the meeting, or, if not specified, at the place where the meeting is to be held. The list shall be produced and kept at the time and place of meeting during the whole time thereof, and may be inspected by any stockholder who is present. (Del. Code Ann., tit. 8, Section 219(a)) SECTION 13. ACTION WITHOUT MEETING. 4 9 (a) Any action required by statute to be taken at any annual or special meeting of the stockholders, or any action which may be taken at any annual or special meeting of the stockholders, may be taken without a meeting, without prior notice and without a vote, if a consent or consents in writing, setting forth the action so taken, are signed by the holders of outstanding stock having not less than the minimum number of votes that would be necessary to authorize or take such action at a meeting at which all shares entitled to vote thereon were present and voted. (b) Every written consent shall bear the date of signature of each stockholder who signs the consent, and no written consent shall be effective to take the corporate action referred to therein unless, within sixty (60) days of the earliest dated consent delivered to the Corporation in the manner herein required, written consents signed by a sufficient number of stockholders to take action are delivered to the corporation by delivery to its registered office in the State of Delaware, its principal place of business or an officer or agent of the corporation having custody of the book in which proceedings of meetings of stockholders are recorded. Delivery made to a corporation's registered office shall be by hand or by certified or registered mail, return receipt requested. (Del. Code Ann., tit. 8, Section 22S) (c) Prompt notice of the taking of the corporate action without a meeting by less than unanimous written consent shall be given to those stockholders who have not consented in writing. If the action which is consented to is such as would have required the filing of a certificate under any section of the General corporation Law of Delaware if such action had been voted on by stockholders at a meeting thereof, then the certificate filed under such section shall state, in lieu of any statement required by such section concerning any vote of stockholders, that written notice and written consent have been given as provided in Section 228 of the General Corporation Law of Delaware. SECTION 14. ORGANIZATION. (a) At every meeting of stockholders, the Chairman of the Board of Directors, or, if a Chairman has not been appointed or is absent, the President, or, if the President is absent the most senior Vice President present, or in the absence of any such officer, a chairman of the meeting chosen by a majority in interest of the stockholders entitled to vote, present in person or by proxy, shall act as chairman. The Secretary, or, in his absence, an Assistant Secretary directed to do so by the President, shall act as secretary of the meeting. (b) The Board of Directors of the corporation shall be entitled to make such rules or regulations for the conduct of meetings of stockholders as it shall deem necessary, appropriate or convenient. Subject to such rules and regulations of the Board of Directors, if any, the chairman of the meeting shall have the right and authority to prescribe such rules, regulations and procedures and to do all such acts as, in the judgment of such chairman, are necessary, appropriate or convenient for the proper conduct of the meeting, including, without limitation, establishing an agenda or order of business for the meeting, rules and procedures for maintaining order at the meeting and the safety of those present, limitations on participation in such meeting to stockholders of record of the corporation and their duly authorized and constituted proxies, 5 10 and such other persons as the chairman shall permit, restrictions on entry to the meeting after the time fixed for the commencement thereof, limitations on the time allotted to questions or comments by participants and regulation of the opening and closing of the polls for balloting on matters which are to be voted on by ballot. Unless, and to the extent determined by the Board of Directors or the chairman of the meeting, meetings of stockholders shall not be required to be held in accordance with rules of parliamentary procedure. ARTICLE IV DIRECTORS SECTION 15. NUMBER AND TERM OF OFFICE. The authorized number of directors of the corporation shall be three (3), or as may be amended from time to time by approval of the Board of Directors. Directors need not be stockholders unless so required by the Certificate of Incorporation. (Del. Code Ann., tit. 8, Sections 141(b), 211(b), (c)) SECTION 16. POWERS. The powers of the corporation shall be exercised, its business conducted and its property controlled by the Board of Directors, except as may be otherwise provided by statute or by the Certificate of Incorporation. (Del. Code Ann., tit. 8, Section 141(a)) SECTION 17. VACANCIES. Unless otherwise provided in the Certificate of Incorporation, vacancies and newly created directorships resulting from any increase in the authorized number of Directors may be filled by a majority of the Directors then in office, although less than a quorum, or by a sole remaining Director, and each Director so elected shall hold office for the unexpired portion of the term of the Director whose place shall be vacant and until his successor shall have been duly elected and qualified. A vacancy in the Board of Directors shall be deemed to exist under this Section 17 in the case of the death, removal or resignation of any Director, or if the stockholders fail at any meeting of stockholders at which Directors are to be elected (including any meeting referred to in Section 19 below) to elect the number of Directors then constituting the whole Board of Directors. (Del. Code Ann., tit. 8, Section 223(a), (b)) SECTION 18. RESIGNATION. Any Director may resign at any time by delivering his written resignation to the Secretary, such resignation to specify whether it will be effective at a particular time, upon receipt by the Secretary or at the pleasure of the Board of Directors. If no such specification is made, it shall be deemed effective at the pleasure of the Board of Directors. When one or more Directors shall resign from the Board of Directors, effective at a future date, a majority of the Directors then in office, including those who have so resigned, shall have power to fill such vacancy or vacancies, the vote thereon to take effect when such resignation or resignations shall become effective, and each Director so chosen shall hold office for the unexpired portion of the term of the Director whose place shall be vacated and until his successor shall have been duly elected and qualified. (Del. Code Ann., tit. 8, Sections 141(b), 223(d)) SECTION 19. REMOVAL. At a special meeting of stockholders called for the purpose in the manner hereinabove provided, subject to any limitations imposed by law or the Certificate of Incorporation, the Board of Directors, or any individual Director, may be removed from office. 6 11 with or without cause, and a new Director or Directors elected by a vote of stockholders holding a majority of the outstanding shares entitled to vote at an election of Directors. (Del. Code Ann., tit. 8, Section 141(k)) SECTION 20. MEETINGS. (a) ANNUAL MEETINGS. The annual meeting of the Board of Directors shall be held immediately after the annual meeting of stockholders and at the place where such meeting is held. No notice of an annual meeting of the Board of Directors shall be necessary and such meeting shall be held for the purpose of electing officers and transacting such other business as may lawfully come before it. (b) REGULAR MEETINGS. Except as hereinafter otherwise provided, regular meetings of the Board of Directors shall be held in the office of the corporation required to be maintained pursuant to Section 2 hereof. Unless otherwise restricted by the Certificate of Incorporation, regular meetings of the Board of Directors may also be held at any place within or without the State of Delaware which has been determined by the Board of Directors. (Del. Code Ann., tit. 8, Section 141 (g)) (c) SPECIAL MEETINGS. Unless otherwise restricted by the Certificate of Incorporation, special meetings of the Board of Directors may be held at any time and place within or without the State of Delaware whenever called by the President or a majority of the Directors. (Del. Code Ann., tit. 8, Section 141(g)) (d) TELEPHONE MEETINGS. Any member of the Board of Directors, or of any committee thereof, may participate in a meeting by means of conference telephone or similar communications equipment by means of which all persons participating in the meeting can hear each other, and participation in a meeting by such means shall constitute presence in person at such meeting. (Del. Code Ann., tit. 8, Section 141(i)) (e) NOTICE OF MEETINGS. Written notice of the time and place of all special meetings of the Board of Directors shall be given at least one (1) day before the date of the meeting. Notice of any meeting may be waived in writing at any time before or after the meeting and will be waived by any Director by attendance thereat, except when the Director attends the meeting for the express purpose of objecting, at the beginning of the meeting, to the transaction of any business because the meeting is not lawfully called or convened. (Del. Code Ann. tit. 8, Section 229) (f) WAIVER OF NOTICE. The transaction of all business at any meeting of the Board of Directors, or any committee thereof, however called or noticed, or wherever held, shall be as valid as though had at a meeting duly held after regular call and notice, if a quorum be present and if, either before or after the meeting, each of the Directors not present shall sign a written waiver of notice, or a consent to holding such meeting, or an approval of the minutes thereof. All such waivers, consents or approvals shall be filed with the corporate records or made a part of the minutes of the meeting. (Del. Code AM., tit. 8, Section 229) 7 12 SECTION 21. QUORUM AND VOTING. (a) Unless the Certificate of Incorporation requires a greater number and except with respect to indemnification questions arising under Section 42 hereof, for which a quorum shall be one-third of the exact number of Directors fixed from time to time in accordance with Section 15 hereof, but not less than one (1), a quorum of the Board of Directors shall consist of a majority of the exact number of Directors fixed from time to time in accordance with Section 15 of these Bylaws, but not less than one (1); provided, however, at any meeting whether a quorum be present or otherwise, a majority of the Directors present may adjourn from time to time until the time fixed for the next regular meeting of the Board of Directors, without notice other than by announcement at the meeting. (Del. Code Ann., tit. 8, Section 141(b)) (b) At each meeting of the Board of Directors at which a quorum is present all questions and business shall be determined by a vote of a majority of the Directors present, unless a different vote be required by law, the Certificate of Incorporation or these BYLAWS. (Del. Code Ann., tit. 8, Section 141(b)) SECTION 22. ACTION WITHOUT MEETING. Unless otherwise restricted by the Certificate of Incorporation or these Bylaws, any action required or permitted to be taken at any meeting of the Board of Directors or of any committee thereof may be taken without a meeting, if all members of the Board of Directors or committee, as the case may be, consent thereto in writing, and such writing or writings are filed with the minutes of proceedings of the Board of Directors or committee. (Del. Code Ann., tit. 8, Section 141(f)) SECTION 23. FEES AND COMPENSATION. Directors shall be entitled to such compensation for their services as may be approved by the Board of Directors, including, if so approved, by resolution of the Board of Directors, a fixed sum and expenses of attendance, if any, for attendance at each regular or special meeting of the Board of Directors and at any meeting of a committee of the Board of Directors. Nothing herein contained shall be construed to preclude any Director from serving the corporation in any other capacity as an officer, agent, employee, or otherwise and receiving compensation therefor. (Del. Code Ann., tit. 8, Section 141(h)) SECTION 24. COMMITTEES. (a) EXECUTIVE COMMITTEE. The Board of Directors may by resolution passed by a majority of the whole Board of Directors, appoint an Executive Committee to consist of one ( 1) or more members of the Board of Directors. The Executive Committee, to the extent permitted by law and specifically granted by the Board of Directors, shall have and may exercise when the Board of Directors is not in session all powers of the Board of Directors in the management of the business and affairs of the corporation, including, without limitation, the power and authority to declare a dividend or to authorize the issuance of stock, except such committee shall not have the power or authority to amend the Certificate of Incorporation, to adopt an agreement of merger or consolidation, to recommend to the stockholders the sale, lease or exchange of all or substantially all of the corporation's property and assets, to recommend to the stockholders of the 8 13 corporation a dissolution of the corporation or a revocation of a dissolution or to amend these Bylaws. (Del. Code Ann., tit. 8, Section 141(c)) (b) OTHER COMMITTEES. The Board of Directors may, by resolution passed by a majority of the whole Board of Directors, from time to time appoint such other committees as may be permitted by law. Such other committees appointed by the Board of Directors shall consist of one (1) or more members of the Board of Directors, and shall have such powers and perform such duties as may be prescribed by the resolution or resolutions creating such committees, but in no event shall such committee have the powers denied to the Executive Committee in these Bylaws. (Del. Code Ann., tit. 8, Section 141(c)) (c) TERM. The members of all committees of the Board of Directors shall serve a term coexistent with that of the Board of Directors which shall have appointed such committee. The Board of Directors, subject to the provisions of subsections (a) or (b) of this Section 24, may at any time increase or decrease the number of members of a committee or terminate the existence of a committee. The membership of a committee member shall terminate on the date of his death or voluntary resignation from the committee or from the Board of Directors. The Board of Directors may at any time for any reason remove any individual committee member and the Board of Directors may fill any committee vacancy created by death, resignation, removal or increase in the number of members of the committee. The Board of Directors may designate one or more Directors as alternate members of any committee, who may replace any absent or disqualified member at any meeting of the committee, and, in addition, in the absence or disqualification of any member of a committee, the member or members thereof present at any meeting and not disqualified from voting, whether or not he or they constitute a quorum, may unanimously appoint another member of the Board of Directors to act at the meeting in the place of any such absent or disqualified member. (Del. Code Ann., tit. 8 Section 141(c)) (d) MEETINGS. Unless the Board of Directors shall otherwise provide, regular meetings of the Executive Committee or any other committee appointed pursuant to this Section 24 shall be held at such times and places as are determined by the Board of Directors, or by any such committee, and when notice thereof has been given to each member of such committee, no further notice of such regular meetings need be given thereafter. Special meetings of any such committee may be held at any place which has been determined from time to time by such committee, and may be called by any Director who is a member of such committee, upon written notice to the members of such committee of the time and place of such special meeting given in the manner provided for the giving of written notice to members of the Board of Directors of the time and place of special meetings of the Board of Directors. Notice of any special meeting of any committee may be waived in writing at any time before or after the meeting and will be waived by any Director by attendance thereat, except when the Director attends such special meeting for the express purpose of objecting, at the beginning of the meeting, to the transaction of any business because the meeting is not lawfully called or convened. A majority of the authorized number of members of any such committee shall constitute a quorum for the transaction of business, and the act of a majority of those present at any meeting at which a quorum is present shall be the act of such committee. (Del. Code Ann., tit. 8, Sections 141(c), 229) 9 14 SECTION 25. ORGANIZATION. At every meeting of the Directors, the Chairman of the Board of Directors, or, if a Chairman has not been appointed or is absent, the President, or if the President is absent, the most senior Vice President, or, in the absence of any such officer, a chairman of the meeting chosen by a majority of the Directors present, shall preside over the meeting. The Secretary, or in his absence, an Assistant Secretary directed to do so by the President, shall act as secretary of the meeting. ARTICLE V OFFICERS SECTION 26. OFFICERS DESIGNATED. The officers of the corporation shall be the Chairman of the Board of Directors, the President, one or more Vice Presidents, the Secretary and the Chief Financial Officer or Treasurer, all of whom shall be elected at the annual organizational meeting of the Board of Directors. The order of the seniority of the Vice Presidents shall be in the order of their nomination, unless otherwise determined by the Board of Directors. The Board of Directors may also appoint one or more Assistant Secretaries, Assistant Treasurers, and such other officers and agents with such powers and duties as it shall deem necessary. The Board of Directors may assign such additional titles to one or more of the officers as it shall deem appropriate. Any one person may hold any number of offices of the corporation at any one time unless specifically prohibited therefrom by law. The salaries and other compensation of the officers of the corporation shall be fixed by or in the manner designated by the Board of Directors. (Del. Code Ann., tit. 8, Sections 122(5), 142(a), (b)) SECTION 27. TENURE AND DUTIES OF OFFICERS. (a) GENERAL. All officers shall hold office at the pleasure of the Board of Directors and until their successors shall have been duly elected and qualified, unless sooner removed. Any officer elected or appointed by the Board of Directors may be removed at any time by the Board of Directors. If the office of any officer becomes vacant for any reason, the vacancy may be filled by the Board of Directors. (Del. Code Ann., tit. 8, Section 141(b), (e)) (b) DUTIES OF CHAIRMAN OF THE BOARD OF DIRECTORS. The Chairman of the Board of Directors, when present, shall preside at all meetings of the stockholders and the Board of Directors. The Chairman of the Board of Directors shall perform other duties commonly incident to his office and shall also perform such other duties and have such other powers as the Board of Directors shall designate from time to time. If there is no President, then the Chairman of the Board of Directors shall also serve as the Chief Executive Officer of the corporation and shall have the powers and duties prescribed in paragraph (c) of this Section 27. (Del. Code Ann., tit. 8, Section 142(a)) (c) DUTIES OF PRESIDENT. The President shall preside at all meetings of the stockholders and at all meetings of the Board of Directors, unless the Chairman of the Board of Directors has been appointed and is present. The President shall be the Chief Executive Officer of the corporation and shall, subject to the control of the Board of Directors, have general 10 15 supervision, direction and control of the business and officers of the corporation. The President shall perform other duties commonly incident to his office and shall also perform such other duties and have such other powers as the Board of Directors shall designate from time to time. (Del. Code Ann., tit. 8, Section 142(a)) (d) DUTIES OF VICE PRESIDENTS. The Vice Presidents, in the order of their seniority, may assume and perform the duties of the President in the absence or disability of the President or whenever the office of President is vacant. The Vice Presidents shall perform other duties commonly incident to their office and shall also perform such other duties and have such other powers as the Board of Directors or the President shall designate from time to time. (Del. Code Ann., tit. 8, Section 142(a)) (e) DUTIES OF SECRETARY. The Secretary shall attend all meetings of the stockholders and of the Board of Directors, and shall record all acts and proceedings thereof in the minute book of the corporation. The Secretary shall give notice in conformity with these Bylaws of all meetings of the stockholders, and of all meetings of the Board of Directors and any committee thereof requiring notice. The Secretary shall perform all other duties given him in these Bylaws and other duties commonly incident to his office and shall also perform such other duties and have such other powers as the Board of Directors shall designate from time to time. The President may direct any Assistant Secretary to assume and perform the duties of the Secretary in the absence or disability of the Secretary, and each Assistant Secretary shall perform other duties commonly incident to his office and shall also perform such other duties and have such other powers as the Board of Directors or the President shall designate from time to time. (Del. Code Ann., tit. 8, Section 142(a)) (f) DUTIES OF CHIEF FINANCIAL OFFICER OR TREASURER. The Chief Financial Officer or Treasurer shall keep or cause to be kept the books of account of the corporation in a thorough and proper manner, and shall render statements of the financial affairs of the corporation in such form and as often as required by the Board of Directors or the President. The Chief Financial Officer or Treasurer, subject to the order of the Board of Directors, shall have the custody of all funds and securities of the corporation. The Chief Financial Officer or Treasurer shall perform other duties commonly incident to his office and shall also perform such other duties and have such other powers as the Board of Directors or the President shall designate from time to time. The President may direct any Assistant Treasurer to assume and perform the duties of the Chief Financial Officer or Treasurer in the absence or disability of the Chief Financial Officer or Treasurer, and each Assistant Treasurer shall perform other duties commonly incident to his office and shall also perform such other duties and have such other powers as the Board of Directors or the President shall designate from time to time. (Del. Code Ann., tit. 8, Section 142(a)) SECTION 28. DELEGATION OF AUTHORITY. The Board of Directors may from time to time delegate the powers or dudes of any officer to any other officer or agent, notwithstanding any provision hereof. SECTION 29. RESIGNATIONS. Any officer may resign at any time by giving written notice to the Board of Directors or to the President or to the Secretary. Any such resignation shall be 11 16 effective when received by the person or persons to whom such notice is given, unless a later time is specified therein, in which event the resignation shall become effective at such later time. Unless otherwise specified in such notice, the acceptance of any such resignation shall not be necessary to make it effective. Any resignation shall be without prejudice to the rights, if any, of the corporation under any contract with the resigning officer. (Del. Code Ann., tit. 8, Section 142(b)) SECTION 30. REMOVAL. Any officer may be removed from office at any time, either with or without cause, by the vote or written consent of a majority of the Directors in office at the time, or by any committee or superior officers upon whom such power of removal may have been conferred by the Board of Directors. ARTICLE VI EXECUTION OF CORPORATE INSTRUMENTS AND VOTING OF SECURITIES OWNED BY THE CORPORATION SECTION 31. EXECUTION OF CORPORATE INSTRUMENTS. The Board of Directors may, in its discretion, determine the method and designate the signatory officer or officers, or other person or persons, to execute on behalf of the corporation any corporate instrument or document, or to sign on behalf of the corporation the corporate name without limitation, or to enter into contracts on behalf of the corporation, except where otherwise provided by law or these Bylaws, and such execution or signature shall be binding upon the corporation. (Del. Code Ann., tit. 8, Sections 103(a), 142(a), 158) Unless otherwise specifically determined by the Board of Directors or otherwise required by law. promissory notes, deeds of trust, mortgages and other evidences of indebtedness of the corporation, and other corporate instruments or documents requiring the corporate seal, and certificates of shares of stock owned by the corporation, shall be executed, signed or endorsed by the Chairman of the Board of Directors, or the President or any Vice President, and by the Secretary or Chief Financial Officer or Treasurer or any Assistant Secretary or Assistant Treasurer. All other instruments and documents requiring the corporate signature, but not requiring the corporate seal, may be executed as aforesaid or in such other manner as may be directed by the Board of Directors. (Del. Code Ann., tit. 8, Sections 103(a), 142(a), 158) All checks and drafts drawn on banks or other depositaries on funds to the credit of the corporation or in special accounts of the corporation shall be signed by such person or persons as the Board of Directors shall authorize so to do. Unless authorized or ratified by the Board of Directors or within the agency power of an officer, no officer, agent or employee shall have any power or authority to bind the corporation by any contract or engagement or to pledge its credit or to render it liable for any purpose or for any amount. (Del. Code AM., tit. 8, Sections 103(a), 142(a), 158) 12 17 SECTION 32. VOTING OF SECURITIES OWNED BY THE CORPORATION. All stock and other securities of other corporations owned or held by the corporation for itself, or for other parties in any capacity, shall be voted, and all proxies with respect thereto shall be executed, by thc person authorized so to do by resolution of the Board of Directors, or, in the absence of such authorization, by the Chairman of the Board of Directors, the President, or any Vice President. (Del. Code AM., tit. 8, Section 123) ARTICLE VII SHARES OF STOCK SECTION 33. FORM AND EXECUTION OF CERTIFICATES. Certificates for the shares of stock of the corporation shall be in such form as is consistent with the Certificate of Incorporation and applicable law. Every holder of stock in the corporation shall be entitled to have a certificate signed by or in the name of the corporation by the Chairman of the Board of Directors, or the President or any Vice President and by the Treasurer or Assistant Treasurer or the Secretary or Assistant Secretary, certifying the number of shares owned by him in the corporation. Where such certificate is countersigned by a transfer agent other than the corporation or its employee, or by a registrar other than the corporation or its employee, any other signature on the certificate may be a facsimile. In case any officer, transfer agent, or registrar who has signed or whose facsimile signature has been placed upon a certificate shall have ceased to be such officer, transfer agent, or registrar before such certificate is issued, it may be issued with the same effect as if he were such officer, transfer agent, or registrar at the date of issue. Each certificate shall state upon the face or back thereof, in full or in summary, all of the designations, preferences, limitations, restrictions on transfer and relative rights of the shares authorized to be issued. (Del. Code Ann., tit. 8, Section 158) SECTION 34. LOST CERTIFICATES. A new certificate or certificates shall be issued in place of any certificate or certificates theretofore issued by the corporation alleged to have been lost, stolen, or destroyed, upon the making of an affidavit of that fact by the person claiming the certificate of stock to be lost, stolen, or destroyed. The corporation may require, as a condition precedent to the issuance of a new certificate or certificates, the owner of such lost, stolen, or destroyed certificate or certificates, or his legal representative, to advertise the same in such manner as it shall require or to give the corporation a surety bond in such form and amount as it may direct as indemnity against any claim that may be made against the corporation with respect to the certificate alleged to have been lost, stolen, or destroyed. (Del. Code Ann., tit. 8, Section 167) SECTION 35. TRANSFERS. (a) Transfers of record of shares of stock of the corporation shall be made only upon its books by the holders thereof, in person or by attorney duly authorized, and upon the surrender of a properly endorsed certificate or certificates for a like number of shares. (Del. Code Ann., tit. 8, Section 201, tit. 6, Section 8 401(1)) 13 18 (b) The corporation shall have power to enter into and perform any agreement with any number of stockholders of any one or more classes of stock of the corporation to restrict the transfer of shares of stock of the corporation of any one or more classes owned by such stockholders in any manner not prohibited by the General Corporation Law of Delaware. (Del. Code Ann., tit. 8, Section 160 (a)) SECTION 36. FIXING RECORD DATES. (a) In order that the Corporation may determine the stockholders entitled to notice of or to vote at any meeting of stockholders or any adjournment thereof, the Board of Directors may fix, in advance, a record date, which record date shall not precede the date upon which the resolution fixing the record date is adopted by the Board of Directors, and which record date shall not be more than sixty (60) nor less than ten (10) days before the date of such meeting. If no record date is fixed by the Board of Directors, the record date for determining stockholders entitled to notice of or to vote at a meeting of stockholders shall be at the close of business on the day next preceding the day on which notice is given, or if notice is waived, at the close of business on the day next preceding the day on which the meeting is held. A determination of stockholders of record entitled to notice of or to vote at a meeting of stockholders shall apply to any adjournment of the meeting; provided, however. that the Board of Directors may fix a new record date for the adjourned meeting. (b) In order that the Corporation may determine the stockholders entitled to consent to corporate action in writing without a meeting, the Board of Directors may fix, in advance, a record date, which record date shall not precede the date upon which the resolution fixing the record date is adopted by the Board of Directors, and which date shall not be more than ten (10) days after the date upon which the resolution fixing the record date is adopted by the Board of Directors. If no record date has been fixed by the Board of Directors, the record date for determining stockholders entitled to consent to corporate action in writing without a meeting, when no prior action by the Board of Directors is required by law, shall be the first date on which a signed written consent setting forth the action taken or proposed to be taken is delivered to the Corporation by delivery to its registered office in the State of Delaware, its principal place of business or an officer or agent of the Corporation having custody of the book in which proceedings of meetings of stockholders are recorded. Delivery made to a Corporation's registered office shall be by hand or by certified or registered mail, return receipt requested. If no record date has been fixed by the Board of Directors and prior action by the Board of Directors is required by law, the record date for determining stockholders entitled to consent to corporate action in writing without a meeting shall be at the close of business on the day on which the Board of Directors adopts the resolution taking such prior action. (c) In order that the corporation may determine the stockholders entitled to receive payment of any dividend or other distribution or allotment of any rights or the stockholders entitled to exercise any rights in respect of any change, conversion or exchange of stock, or for the purpose of any other lawful action, the Board of Directors may fix, in advance, a record date, which record date shall not precede the date upon which the resolution fixing the record date is adopted, and which record date shall be not more than sixty (60) days prior to such action. If no 14 19 record date is fixed, the record date for determining stockholders for any such purpose shall be at the close of business on the day on which the Board of Directors adopts the resolution relating thereto. (Del. Code Ann., tit. 8, Section 213) SECTION 37. REGISTERED STOCKHOLDERS. The corporation shall be entitled to recognize the exclusive right of a person registered on its books as the owner of shares to receive dividends, and to vote as such owner, and shall not be bound to recognize any equitable or other claim to or interest in such share or shares on the part of any other person whether or not it shall have express or other notice thereof, except as otherwise provided by the laws of Delaware. (Del. Code Ann., tit. 8, Sections 213(a), 219) ARTICLE VIII OTHER SECURITIES OF THE CORPORATION SECTION 38. EXECUTION OF OTHER SECURITIES. All bonds, debentures and other corporate securities of the corporation, other than stock certificates (covered in Section 33), may be signed by the Chairman of the Board of Directors, the President or any Vice President, or such other person as may be authorized by the Board of Directors, and the corporate seal impressed thereon or a facsimile of such seal imprinted thereon and attested by the signature of the Secretary or an Assistant Secretary, or the Chief Financial Officer or Treasurer or an Assistant Treasurer; provided, however, that where any such bond, debenture or other corporate security shall be authenticated by the manual signature of a trustee under an indenture pursuant to which such bond debenture or other corporate security shall be issued, the signatures of the persons signing and attesting the corporate seal on such bond, debenture or other corporate security may be the imprinted facsimile of the signatures of such persons. Interest coupons appertaining to any such bond debenture or other corporate security, authenticated by a trustee as aforesaid, shall be signed by the Treasurer or an Assistant Treasurer of the corporation or such other person as may be authorized by the Board of Directors, or bear imprinted thereon the facsimile signature of such person. In case any officer who shall have signed or attested any bond, debenture or other corporate security, or whose facsimile signature shall appear thereon or on any such interest coupon. shall have ceased to be such officer before the bond, debenture or other corporate security so signed or attested shall have been delivered, such bond, debenture or other corporate security nevertheless may be adopted by the corporation and issued and delivered as though the person who signed the same or whose facsimile signature shall have been used thereon had not ceased to be such officer of the corporation. ARTICLE IX DIVIDENDS SECTION 39. DECLARATION OF DIVIDENDS. Dividends upon the capital stock of the corporation, subject to the provisions of the Certificate of Incorporation, if any, may be declared by the Board of Directors pursuant to law at any regular or special meeting. Dividends may be 15 20 paid in cash, in property, or in shares of the capital stock, subject to the provisions of the Certificate of Incorporation. (Del. Code Ann., tit. 8, Sections 170, 173) SECTION 40. DIVIDEND RESERVE. Before payment of any dividend, there may be set aside out of any funds of the corporation available for dividends such sum or sums as the Board of Directors from time to time, in their absolute discretion, think proper as a reserve or reserves to meet contingencies, or for equalizing dividends, or for repairing or maintaining any property of the corporation, or for such other purpose as the Board of Directors shall think conducive to the interests of the corporation, and the Board of Directors may modify or abolish any such reserve in the manner in which it was created. (Del. Code AM., tit. 8, Section 171) ARTICLE X FISCAL YEAR SECTION 41. FISCAL YEAR. The fiscal year of the corporation shall be fixed by resolution of the Board of Directors. ARTICLE XI INDEMNIFICATION SECTION 42. INDEMNIFICATION OF DIRECTORS, OFFICERS, EMPLOYEES AND OTHER AGENTS. (a) DIRECTORS AND EXECUTIVE OFFICERS. The corporation shall indemnify its Directors and executive officers to the fullest extent not prohibited by the Delaware General Corporation Law; provided, however, that the corporation may limit the extent of such indemnification by individual contracts with its Directors and executive officers; and, provided, further, that the corporation shall not be required to indemnify any Director or executive officer in connection with any proceeding (or part thereof) initiated by such person or any proceeding by such person against the corporation or its Directors, officers, employees or other agents unless (i) such indemnification is expressly required to be made by law, (ii) the proceeding was authorized by the Board of Directors of the corporation or (iii) such indemnification is provided by the corporation, in its sole discretion, pursuant to the powers vested in the corporation under the Delaware General Corporation Law. (b) OTHER OFFICERS, EMPLOYEES AND OTHER AGENTS. THE CORPORATION SHALL have power to indemnify its other officers, employees and other agents as set forth in the Delaware General Corporation Law. (c) GOOD FAITH. 16 21 (1) For purposes of any determination under this Bylaw, a Director or executive officer shall be deemed to have acted in good faith and in a manner he reasonably believed to be in or not opposed to the best interests of the corporation, and, with respect to any criminal action or proceeding, to have had no reasonable cause to believe that his conduct was unlawful, if his action is based on information, opinions, reports and statements, including financial statements and other financial data, in each case prepared or presented by: (i) one or more officers or employees of the corporation whom the Director or executive officer believed to be reliable and competent in the matters presented; (ii) counsel, independent accountants or other persons as to matters which the Director or executive officer believed to be within such person's professional competence; and (iii) with respect to a Director, a committee of the Board upon which such Director does not serve, as to matters within such Committee's designated authority, which committee the Director believes to merit confidence; so long as, in each case, the Director or executive officer acts without knowledge that would cause such reliance to be unwarranted. (2) The termination of any proceeding by judgment, order, settlement, conviction or upon a plea of nolo contendere or its equivalent shall not, of itself, create a presumption that the person did not act in good faith and in a manner which he reasonably believed to be in or not opposed to the best interests of the corporation, and, with respect to any criminal proceeding, that he had reasonable cause to believe that his conduct was unlawful. (3) The provisions of this paragraph (c) shall not be deemed to be exclusive or to limit in any way the circumstances in which a person may be deemed to have met the applicable standard of conduct set forth by the Delaware General Corporation Law. (d) EXPENSES. The corporation shall advance, prior to the final disposition of any proceeding, promptly following request therefor, all expenses incurred by any Director or executive officer in connection with such proceeding upon receipt of an undertaking by or on behalf of such person to repay said amounts if it should be determined ultimately that such person is not entitled to be indemnified under this Bylaw or otherwise. Notwithstanding the foregoing, unless otherwise determined pursuant to paragraph (e) of this Bylaw, no advance shall be made by the corporation if a determination is reasonably and promptly made (1) by the Board of Directors by a majority vote of a quorum consisting of Directors who were not parties to the proceeding, or (2) if such quorum is not obtainable, or, even if obtainable, a quorum of disinterested directors so directs, by independent legal counsel in a written opinion, that the facts known to the decision making party at the time such determination is made demonstrate clearly and convincingly that such person acted in bad faith or in a manna that such person did not believe to be in or not opposed to the best interests of the corporation. 17 22 (e) ENFORCEMENT. Without the necessity of entering into an express contract all rights to indemnification and advances to Directors and executive officers under this Bylaw shall be deemed to be contractual rights and be effective to the same extent and as if provided for in a contract between the corporation and the Director or executive officer. Any right to indemnification or advances granted by this Bylaw to a Director or executive officer shall be enforceable by or on behalf of the person holding such right in any court of competent jurisdiction if (i) the claim for indemnification or advances is denied, in whole or in part, or (ii) no disposition of such claim is made within ninety (90) days of request therefor. The claimant in such enforcement action, if successful in whole or in part, shall be entitled to be paid also the expense of prosecuting his claim. The corporation shall be entitled to raise as a defense to any such action that the claimant has not met the standards of conduct that make it permissible under the Delaware General Corporation Law for the corporation to indemnify the claimant for the amount claimed. Neither the failure of the corporation (including its Board of Directors, independent legal counsel or its stockholders) to have made a determination prior to the commencement of such action that indemnification of the claimant is proper in the circumstances because he has met the applicable standard of conduct set forth in the Delaware General Corporation Law, nor an actual determination by the corporation (including its Board of Directors, independent legal counsel or its stockholders) that the claimant has not met such applicable standard of conduct, shall be a defense to the action or create a presumption that claimant has not met the applicable standard of conduct. (f) NON-EXCLUSIVITY OF RIGHTS. The rights conferred on any person by this Bylaw shall not be exclusive of any other right which such person may have or hereafter acquire under any statute, provision of the Certificate of Incorporation, Bylaws, agreement, vote of stockholders or disinterested Directors or otherwise, both as to action in his official capacity and as to action in another capacity while holding office. The corporation is specifically authorized to enter into individual contracts with any or all of its Directors, officers, employees or agents respecting indemnification and advances, to the fullest extent not prohibited by the Delaware General Corporation Law. (g) SURNYA1 OF RIGHTS. The rights conferred on any person by this Bylaw shall continue as to a person who has ceased to be a Director, officer, employee or other agent and shall inure to the benefit of the heirs, executors and administrators of such a person. (h) INSURANCE. To the fullest extent permitted by the Delaware General Corporation Law, the corporation, upon approval by the Board of Directors, may purchase insurance on behalf of any person required or permitted to be indemnified pursuant to this Bylaw (i) AMENDMENTS. Any repeal or modification of this Bylaw shall only be prospective and shall not affect the rights under this Bylaw in effect at the time of the alleged occurrence of any action or omission to act that is the cause of any proceeding against any agent of the corporation. (j) SAVING CLAUSE. If this Bylaw or any portion hereof shall be invalid on any ground by any court of competent jurisdiction, then the corporation shall nevertheless indemnify 18 23 each Director and executive officer to the full extent not prohibited by any applicable portion of this Bylaw that shall not have been invalidated, or by any other applicable law. (k) CERTAIN DEFINITIONS. For the purposes of this Bylaw, the following definitions shall apply: (1) The term "PROCEEDING" shall be broadly construed and shall include, without limitation, the investigation, preparation, prosecution, defense, settlement, arbitration and appeal of, and the giving of testimony in, any threatened, pending or completed action, suit or proceeding, whether civil, criminal, administrative or investigative. (2) The term "EXPENSES" shall be broadly construed and shall include, without limitation, court costs, attorneys' fees, witness fees, fines, amounts paid in settlement or judgment and any other costs and expenses of any nature or kind incurred in connection with any proceeding. (3) The term the "CORPORATION" shall include, in addition to the resulting corporation, any constituent corporation (including any constituent of a constituent) absorbed in a consolidation or merger which, if its separate existence had continued, would have had power and authority to indemnify its directors, officers, and employees or agents, so that any person who is or was a director, officer, employee or agent of such constituent corporation, or is or was serving at the request of such constituent corporation as a director, officer, employee or agent of another corporation, partnership, joint venture, trust or other enterprise, shall stand in the same position under the provisions of this Bylaw with respect to the resulting or surviving corporation as he would have with respect to such constituent corporation if its separate existence had continued. (4) References to a "DIRECTOR," "OFFICER," "EMPLOYEE," OR "AGENT" of the corporation shall include, without limitation, situations where such person is serving at the request of the corporation as a director, officer, employee, trustee or agent of another corporation, partnership, joint venture, trust or other enterprise. (5) References to "OTHER ENTERPRISES" shall include employee benefit plans; references to "fines" shall include any excise taxes assessed on a person with respect to an employee benefit plain; and references to "SERVING AT THE REQUEST OF THE CORPORATION" shall include any service as a director, officer, employee or agent of the corporation which imposes duties on, or involves services by, such director, officer, employee, or agent with respect to an employee benefit plan, its participants, or beneficiaries; and a person who acted in good faith and in a manner he reasonably believed to be in the interest of the participants and beneficiaries of an employee benefit plan shall be deemed to have acted in a manner "NOT OPPOSED TO THE BEST INTERESTS OF THE CORPORATION" as referred to in this Bylaw. ARTICLE XII 19 24 NOTICES SECTION 43. NOTICES. (a) NOTICE TO STOCKHOLDERS. Whenever, under any provisions of these Bylaws, notice is required to be given to any stockholder, it shall be given in writing, timely and duly deposited in the United States mail, postage prepaid, and addressed to his last known post office address as shown by the stock record of the corporation or its transfer agent. (Del. Code Ann., tit. 8, Section 222) (b) NOTICE TO DIRECTORS. Any notice required to be given to any Director may be given by the method stated in subsection (a), or by facsimile, telex or telegram, except that such notice other than one which is delivered personally shall be sent to such address as such Director shall have filed in writing with the Secretary, or, in the absence of such filing, to the last known post office address of such Director. (c) ADDRESS UNKNOWN. If no address of a stockholder or Director be known, notice may be sent to the office of the corporation required to be maintained pursuant to Section 2 hereof. (d) AFFIDAVIT OF MAILING. An affidavit of mailing, executed by a duly authorized and competent employee of the corporation or its transfer agent appointed with respect to the class of stock affected, specifying the name and address or the names and addresses of the stockholder or stockholders, or Director or Directors, to whom any such notice or notices was or were given, and the time and method of giving the same, shall be conclusive evidence of the statements therein contained. (Del. Code Ann., tit. 8, Section 222) (e) TIME NOTICES DEEMED GIVEN. All notices given by mail, as above provided, shall be deemed to have been given as at the time of mailing and all notices given by facsimile, telex or telegram shall be deemed to have been given as of the sending time recorded at time of transmission. (f) METHODS OF NOTICE. It shall not be necessary that the same method of giving notice be employed in respect of all Directors, but one permissible method may be employed in respect of any one or more, and any other permissible method or methods may be employed in respect of any other or others. (g) FAILURE TO RECEIVE NOTICE. The period or limitation of time within which any stockholder may exercise any option or right, or enjoy any privilege or benefit, or be required to act, or within which any Director may exercise any power or right, or enjoy any privilege, pursuant to any notice sent him in the manner above provided, shall not be affected or extended in any manner by the failure of such stockholder or such Director to receive such notice. 20 25 (h) NOTICE TO PERSON WITH WHOM COMMUNICATION IS UNLAWFUL. Whenever notice is required to be given, under any provision of law or of the Certificate of Incorporation or Bylaws of the corporation, to any person with whom communication is unlawful, the giving' of such notice to such person shall not be required and there shall be no duty to apply to any governmental authority or agency for a license or permit to give such notice to such person. Any action or meeting which shall be taken or held without notice to any such person with whom communication is unlawful shall have the same force and effect as if such notice had been duly given. In the event that the action taken by the corporation is such as to require the filing of a certificate under any provision of the Delaware General Corporation Law, the certificate shall state, if such is the fact and if notice is required, that notice was given to all persons entitled to receive notice except such persons with whom communication is unlawful. (i) NOTICE TO PERSON WITH UNDELIVERABLE ADDRESS. Whenever notice is required to be given, under any provision of law or the Certificate of Incorporation or Bylaws of the corporation, to any stockholder to whom (i) notice of two consecutive annual meetings, and all notices of meetings or of the taking of action by written consent without a meeting to such person during the period between such two consecutive annual meetings, or (ii) all, and at least two, payments (if sent by first class mail) of dividends or interest on securities during a twelve month period, have been mailed addressed to such person at his address as shown on the records of the Corporation and have been returned undeliverable, the giving of such notice to such person shall not be required. Any action or meeting which shall be taken or held without notice to such person shall have the same force and effect as if such notice had been duly given. If any such person shall deliver to the corporation a written notice setting forth his then current address, the requirement that notice be given to such person shall be reinstated. In the event that the action taken by the corporation is such as to require the filing of a certificate under any provision of the Delaware General Corporation Law, the certificate need not state that notice was not given to persons to whom notice was not required to be given pursuant to this paragraph. (Del. Code Ann, tit. 8, Section 230) ARTICLE XIII AMENDMENTS SECTION 44. AMENDMENTS. Except as otherwise set forth in paragraph (i) of Section 42 of these Bylaws, these Bylaws may be amended or repealed and new Bylaws adopted by the stockholders entitled to vote. The Board of Directors shall also have the power, if such power is conferred upon the Board of Directors by the Certificate of Incorporation, to adopt, amend or repeal Bylaws (including, without limitation, the amendment of any Bylaw setting forth the number of Directors who shall constitute the whole Board of Directors). (Del. Code Ann., tit. 8, Sections 109(a), 122(6)) ARTICLE XIV 21 26 LOANS TO OFFICERS SECTION 45. LOANS TO OFFICERS. The corporation may lend money to, or guarantee any obligation of, or otherwise assist any officer or other employee of the corporation or of its subsidiaries, including any officer or employee who is a Director of the corporation or its subsidiaries, whenever, in the judgment of the Board of Directors, such loan, guarantee or assistance may reasonably be expected to benefit the corporation. The loan, guarantee or other assistance may be with or without interest and may be unsecured, or secured in such manner as the Board of Directors shall approve, including, without limitation, a pledge of shares of stock of the corporation. Nothing in this Section 46 shall be deemed to deny, limit or restrict the powers of guaranty or warranty of the corporation at common law or under any statute. (Del. Code Ann., tit. 8, Section 143) 22 27 FIRST AMENDMENT TO BYLAWS OF PACIFICARE HEALTH SYSTEMS This First Amendment (the "First Amendment"), effective as of February 27, 1997, to the Bylaws (the "Bylaws") of PacifiCare Health Systems, Inc., a Delaware corporation (the "Company") has been adopted by the board of directors of the Company (the "Board"), at a duly held meeting with reference to the following facts: WHEREAS, Article II, Section 2 of the Company"s Bylaws currently provides that the annual meeting of the stockholders shall be held each year on the first Wednesday in March, if not a legal holiday, and if a legal holiday, then on the next secular day following, at 10:00 a.m. or at such other date and time as may be determined from time to time by resolution adopted by the Board of Directors, when they shall elect by a plurality vote of the Board of Directors, and transact such other business as may properly be brought before the meeting. At each annual meeting Directors shall be elected and any other proper business transacted; WHEREAS, the Board deems it to be advisable and in the best interest of the Company to amend Article II Section 2 of the Bylaws to change the date of the annual meeting of shareholders from the first Wednesday in March to the first Wednesday in June beginning in 1998; WHEREAS, Section 109(a) of the Delaware General Corporation Law permits the board of directors of a corporation to adopt, amend or repeal the bylaws of such corporation if the certificate of incorporation confers such power on the board of directors; WHEREAS, Article VIII of the Company's Amended and Restated Certificate of Incorporation, as amended, and Article VII, Section 1, of the Bylaws permits the Board to adopt, amend or repeal the Bylaws; RESOLVED, that the Board deems it advisable and in the best interests of the Company that Article II, Section 2 of the Bylaws be amended and restated to read in its entirety as follows (the "Amendment"): Section 2. Beginning in 1998, the annual meeting of the stockholders shall be held each year on the first Wednesday in June, if not a legal holiday, and if a legal holiday, then on the next secular day following, at 10:00 a.m. or at such other date and time as may be determined from time to time by resolution adopted by the Board of Directors, when they shall elect by a plurality vote of the Board of Directors, and transact such other business as may properly be brought before the meeting. At each annual meeting Directors shall be elected and any other proper business transacted RESOLVED, that the Bylaws shall not be further amended and that the Bylaws, as hereby amended, shall remain in full force and effect and shall be enforced in accordance with their terms, as amended. 1 28 SECOND AMENDMENT TO THE BYLAWS OF PACIFICARE HEALTH SYSTEMS, INC. This SECOND AMENDMENT TO THE BYLAWS OF PACIFICARE HEALTH SYSTEMS, INC. (this "Second Amendment") is effective November 1, 1998 (the "Effective Date"), with reference to the following facts: RECITALS: WHEREAS, the Corporation has adopted the bylaws, adopted on or about the 2nd day of August, 1996, as the official bylaws of the Corporation, as amended by that certain First Amendment to Bylaws effective as of February 27, 1997 (the "First Amendment") (as so amended the "Bylaws"); WHEREAS, the Corporation's Board of Directors (the "Board") deems it advisable and in Corporation's best interests to amend the Bylaws. NOW THEREFORE BE IT RESOLVED, that the Bylaws are hereby amended as follows: 1. Article IV, Section 1 of the Bylaws is hereby deleted in its entirety and the following paragraph is substituted therefore: "Section 1. OFFICERS. The officers of this Corporation shall be chosen by the Board of Directors and shall include: a Chief Executive Officer (who shall be either the Chairman of the Board or President, as provided in these By-Laws), a President, a Chief Operating Officer, a Secretary and a Treasurer. The Corporation may also have at the discretion of the Board of Directors such other officers as are desired, including: a Chairman of the Board, a Vice Chairman of the Board, one or more Vice Presidents, one or more Assistant Secretaries or Assistant Treasurers, and such other officers as may be appointed in accordance with the provisions of Section 3 hereof. In the event there are two or more Vice Presidents, then one or more may be designated as Executive Vice President, Senior Vice President, or other similar or dissimilar title. At the time of the election of officers, the Directors may by resolution determine the order of their rank. Any number of offices may be held by the same person, unless the Certificate of Incorporation or these By-Laws otherwise provide." 2. Article IV, Section 6 of the Bylaws is hereby deleted in its entirety and the following paragraph is substituted therefor: "Section 6. CHIEF EXECUTIVE OFFICER. If there is a Chairman of the Board and the Board of Directors designates the Chairman of the 29 Board as the Chief Executive Officer, then the Chairman of the Board shall be the Chief Executive Officer of the Corporation. Otherwise, the President shall be the Chief Executive Officer of the Corporation. Subject to the direction and control of the Board of Directors, the Chief Executive Officer shall supervise and control the management of the Corporation and shall have such duties and authority as are normally incident to the office of chief executive officer of a corporation and such duties and authority as may be prescribed from time to time by the Board of Directors or as are provided for elsewhere in these By-Laws." 3. Article IV of the Bylaws is amended by adding new Sections 6.1, 6.2 and 6.3 as follows: "Section 6.1. CHAIRMAN OF THE BOARD. The Chairman of the Board, if such an officer be elected, shall, if present, preside at all meetings of the Board of Directors and exercise and perform such other duties and authority as may be from time to time assigned to the Chairman of the Board by the Board of Directors or prescribed by these By-Laws. If there is a Chairman of the Board and such Chairman of the Board is also designated by the Board of Directors to be the Chief Executive Officer, then the Chairman of the Board shall also have all of the duties and authority of the Chief Executive Officer described in Section 6 of this Article IV. "Section 6.2. VICE CHAIRMAN OF THE BOARD. The Vice Chairman of the Board, if such an officer be elected, shall be a director and shall preside at all meetings of the Board of Directors in the absence or disability of the Chairman of the Board. The Vice Chairman shall perform such other duties as may be prescribed from time to time by the Chairman of the Board or the Board of Directors. "Section 6.3. CHIEF OPERATING OFFICER. If there is a Chairman of the Board who is also the Chief Executive Officer, then the President shall be the Chief Operating Officer. If the President is the Chief Executive Officer, then the President shall also serve as the Chief Operating Officer unless the Board of Directors designates some other officer of the Corporation as the Chief Operating Officer. Subject to the direction and control of the Chief Executive Officer and the Board of Directors, the Chief Operating Officer shall supervise and control the operations of the Corporation, shall have the duties and authority as are normally incident to the office of chief operating officer of a corporation and such other duties as may be prescribed from time to time by the Chief Executive Officer or the Board of Directors, and, in the absence or disability of the Chief Executive Officer, shall have the authority and perform the duties of the Chief Executive Officer." 30 4. Article IV, Section 7 of the Bylaws is hereby deleted in its entirety and the following paragraph is substituted therefor: "Section 7. PRESIDENT. Unless there is a Chairman of the Board who is also designated the Chief Executive Officer, the President shall be the Chief Executive Officer of the Corporation and shall have all of the duties and authority of the Chief Executive Officer described in Section 6 of this Article IV. If the President is not the Chief Executive Officer, or the President is the Chief Executive Officer and no other officer has been designated by the Board of Directors as the Chief Operating Officer, then the President shall be the Chief Operating Officer and shall have all of the duties and authority of the Chief Operating Officer described in Section 6.3 of this Article IV. The President shall preside at all meetings of the stockholders and, in the absence or disability of the Chairman of the Board and the Vice Chairman of the Board, if there be such officers, shall preside at all meetings of the Board of Directors. The President shall be an ex-officio member of all Committees and shall, subject to the control of the Board of Directors and such supervisory powers, if any, as may be given by the Board of Directors to the Chairman of the Board or the Vice Chairman of the Board, if there be such officers, shall have general supervision, direction and control of the business and officers of the Corporation, shall have such duties and authority as are normally incident to the office of president of a corporation and such duties and authority as may be prescribed from time to time by the Board of Directors or as are provided for elsewhere in these By-Laws." 5. Except as amended by this Second Amendment, the Corporation's Restated Bylaws shall not be further amended, modified, or revised and the Restated Bylaws, as hereby amended, shall continue in full force and effect and shall be enforced in accordance with their terms. 6. The official bylaws of the Corporation shall consist of the bylaws adopted on August 2, 1996, the First Amendment adopted on February 27, 1997 and this Second Amendment adopted on November 1, 1998. Any reference to the term "bylaws" shall mean and refer to the bylaws as amended by the First Amendment and Second Amendment. EX-10.04 3 EMPLOYMENT AGREEMENT-BRADFORD A. BOWLUS 1 EXHIBIT 10.04 EMPLOYMENT AGREEMENT This EMPLOYMENT AGREEMENT (this "Agreement") is made and entered into as the 6th day of October 1997, by and between PACIFICARE HEALTH SYSTEMS, INC., a Delaware corporation (the "Company"), with its principal place of business located at 3120 Lake Center Drive, Santa Ana, California 92704 and Brad Bowlus ("Executive"), residing at 630 Ramona Drive, Corona Del Mar, California 92626. RECITALS WHEREAS, the Company desires to employ Executive in the capacity of Vice President and Plan President of PacifiCare of California during the period beginning October 6, 1997 and ending January 1, 1998 (the "Interim Term"). WHEREAS, immediately following the Interim Term, the Company desires to continue to employ Executive in the capacity of President and Chief Executive Officer of PacifiCare of California and Regional Vice President of the West. WHEREAS, the Company and Executive are entering into this Agreement to establish the terms and conditions of the desired employment relationship. NOW, THEREFORE, in consideration of the following covenants, conditions and promises contained herein, and other good and valuable consideration, the Company and Executive hereby agree as follows: 1. EMPLOYMENT 1.1 Executive's General Duties. The Company hereby employs Executive and Executive hereby agrees to serve the Company in the capacity of Vice President and Plan President of PacifiCare of California during the Initial Term; and immediately after the Initial Term the Company shall employ and Executive agrees to serve the Company in the capacity of President and Chief Executive Officer of PacifiCare of California and Regional Vice President of the West having such usual and customary duties and authority as an officer of similar capacity in a corporation of comparable size, holdings, and business as that of the Company. Executive shall do and perform all services, acts, or things necessary or advisable to manage and conduct the business of the Company and shall preside over such other areas of corporate activity as specified from time to time by the Board of directors of the Company. During the term of this Agreement, Executive shall perform such additional or different duties, and accept the election or appointment to such other offices or positions as are mutually agreed upon by Executive and the Company. -1- 2 1.2 Devotion of Executive. During the term of this Agreement, Executive shall devote his entire productive time, ability, and attention to the business of the Company. Executive shall use his best efforts, skills, and abilities to promote the general welfare and interests of the Company and to preserve, maintain, and foster the Company's business and business relationships with all persons and entities associated therewith, including, without limitation, employer groups, medical service providers, shareholders, affiliates, officers, employees, and banks and other financial institutions. The Company shall give Executive a reasonable opportunity to perform his duties and shall neither expect Executive to devote more time, nor assign more duties or functions to Executive, than are customary and reasonable for an executive in Executive's position. 2. TERM AND TERMINATION 2.1 Term. The term of Executive's employment under this Agreement shall commence on October 6, 1997, and shall continue unless terminated as provided in Section 2.2. 2.2 Termination. This Agreement shall be terminated upon the occurrence of any one of the following events: a. The death of the Executive. b. Executive becomes incapacitated or disabled, which incapacity or disability prevents Executive from fully performing his duties to the Company for a period in excess of 90 days and, after such 90-day period, the Company and a physician, duly licensed and qualified in the specialty of Executive's incapacity, decide in their reasonable judgments, that such incapacity will be permanent or of such continued duration as to prevent Executive from resuming the rendition of services to the Company for at least an additional six-month period. For purposes of this Agreement, Executive shall be deemed permanently disabled, and this Agreement terminated upon the date Executive receives written notice from the Company that such determination has been made. c. Executive habitually neglects his duties to the Company or engages in gross misconduct during the term of this Agreement. For the purposes of this Agreement, "gross misconduct" shall mean Executive's misappropriation of funds; securities fraud; insider trading; unauthorized possession of corporate property; the sale, distribution, possession or use of a controlled substance; or conviction of any criminal offense (whether or not such criminal offense is committed in connection with Executive's duties hereunder or in the course of his employment with the Company). In such event, Executive's termination shall be effective immediately upon receipt of written notice from the Company. d. Either party hereto may terminate this Agreement, with or without cause, upon ninety (90) days prior written notice to the other party. Except for the circumstances described in Section 2.2(c) above, Executive's termination shall be effective ninety (90) days after receipt of such written notice. Any termination of this Agreement in -2- 3 accordance with this Section 2.2(d) shall not limit, restrict, or reduce, in any manner, Executive's rights to the compensations and benefits available under Sections 3.1(b) and 4 below. 2.3 Effect of Termination. No termination of this Agreement shall affect or impair any rights or obligations of the parties respecting certain compensation accruing prior thereto or continuing thereafter in accordance with the terms set forth in Section 3.2 and Section 4. 3. COMPENSATION 3.1 Compensation During the Term of this Agreement a. As long as Executive satisfactorily performs all of his obligations hereunder, the Company shall pay Executive an annual base salary, as determined by the Compensation Committee of the Board of Directors, payable in equal installments on the Company's regular payroll dates, which as of the date hereof is $350,000. On an annual basis, the Company's compensation committee shall review Executive's salary, but shall be under no obligation to increase Executive's salary. Executive authorizes the Company to take such deductions and withholdings from his salary as are required by law, directed by Executive, or as reasonably directed by the Company for its employees, which deductions shall include, without limitation, withholding for federal and state income taxes and social security. b. Executive shall be entitled to participate in the 1996 Stock Option Plan for Officers and Key Employees of PacifiCare Health Systems, Inc. (the "1996 Stock Option Plan"), as such plan from time to time may be amended, modified or replaced, in accordance with the terms and conditions set forth herein and therein. Pursuant thereto, on October 1, 1997, (the "Grant Date"), the Company granted to Executive non-qualified options to purchase 15,000 shares of the Company's Class B Common Stock, par value $0.01 per share (the "Options"). On the first anniversary of the Grant Date, 25 percent of the Options shall become vested, and an additional 25 percent of the Options shall become vested on each succeeding anniversary of the Grant Date until the fourth anniversary of the Grant Date when all the Options shall become vested. The Options shall be subject to the 1996 Stock Option Plan and are evidenced by a stock option agreement between Executive and the Company. c. Executive shall be entitled to fully participate in all of the employee benefit plans and programs available to other high-level executives of the Company, including, without limitation, health, dental, and life insurance benefits for Executive and Executive's dependents, pension and profit sharing programs, and vacation and sick leave benefits. However, the terms of this Agreement shall not restrict the Company's right to change, amend, modify, or terminate any existing benefit plan or program, or to change any -3- 4 insurance company or modify any insurance policy adopted incident to such existing benefit plan and program. d. The Company shall provide Executive with a $750 per month automobile allowance. The Company shall furnish Executive's automobile with a cellular car telephone. Executive shall provide and maintain automobile insurance for Executive's car including collision, comprehensive liability, personal and property damage, and uninsured and underinsured motorist coverage in amounts customarily obtained to cover such contingencies in California. Executive shall provide proof of such coverage to the Company upon the Company's request. e. The Company shall pay for or reimburse Executive for all other reasonable travel, entertainment, and other business expenses incurred or paid for by Executive in connection with the performance of his services under this Agreement. The Company shall not be obligated to make any such reimbursement unless Executive presents corresponding expense statements or vouchers and such other supporting information as the Company may from time to time reasonably request. The Company reserves the right to place subsequent limitations or restrictions on business expenses to be incurred or reimbursed. f. Executive shall be entitled to participate fully in the Company's Management Incentive Compensation Plan, as amended (the "MICP"), as may be amended, modified, or replaced, in accordance with the terms and conditions set forth herein and therein. g. During the term of this Agreement, the Company shall insure Executive under its general liability insurance for all conduct committed in good faith while acting in the capacity of Vice President and Plan President of PacifiCare of California during the Initial Term; and immediately after the Initial Term for all conduct committed in good faith while acting in the capacity of Regional Vice President of the West and President and Chief Executive Officer of PacifiCare of California or in any other capacity to which Executive may be appointed or elected. h. In the event Executive is involuntarily terminated, without cause, except in the case of death or incapacity or disability, the Company shall provide outplacement services to Executive to assist Executive in securing a position comparable to the one from which he was terminated. The Company shall be obligated to provide those outplacement services as customarily provided by companies of similar size and holdings as those of the Company to executives with comparable responsibility and longevity as Executive and for reasonable cost as approved by the Company. The Company's provision of such outplacement services shall not limit, restrict, or reduce, in any manner, any and all other compensation to which Executive is entitled hereunder. i. As part of the compensation for services rendered under this Agreement, Executive shall be entitled to participate in the PacifiCare Health Systems, Inc. Savings -4- 5 and Profit-Sharing Plan, and the trust agreement implemented pursuant thereto, adopted as of June 1, 1985, as from time to time may be amended modified, or replaced, in accordance with the terms and conditions set forth therein. j. Executive shall be entitled to the benefits provided under the Company's Statutory Restoration Plan, as such plan from time to time may be amended, modified or replaced, in accordance with the terms set forth herein and therein. 3.2 Compensation Following Termination a. In the event that this Agreement is terminated by reason of Executive's death, Executive's estate or legal representative shall be entitled to receive the following: 1. Payment of benefits under the life insurance policy purchased by the Company on Executive's behalf, if any; 2. Payments of benefits under the Long-Term Performance Incentive Plan ("LTPIP"), if performance cycles remain outstanding, and the MICP set forth in Section 3.1(f), which will be deemed to have accrued as of the date of Executive's death; and 3. Executive's legal representative shall be permitted to exercise any vested and unexercised options under the 1996 Stock Option Plan set forth in Section 3.1(b) and shall be permitted to exercise any other vested and unexercised options granted under any other stock option plans of the Company ("Prior Stock Option Plans") in accordance with their terms for a period of one year following Executive's death. The 1996 Stock Option Plan and the Prior Stock Option Plans shall together be referred to herein as the "Stock Option Plans." b. In the event that Executive is terminated because of an incapacity or disability, the Company shall provide Executive with the following: 1. Payment of benefits under the disability insurance policy maintained by the Company on Executive's behalf, if any; 2. Payment of benefits under the LTPIP, if performance cycles remain outstanding, and the MICP set forth in Section 3.1(f), which will be deemed to have accrued as of the effective date of such termination; 3. The right to exercise any vested and unexercised options under the Stock Option Plans in accordance with the terms stated therein; and 4. Payment of the automobile allowance as provided under Section 3.1(d) for a period of 24 months following the effective date of such termination. -5- 6 c. In the event this Agreement is terminated because of Executive's habitual neglect or gross misconduct pursuant to Section 2.2(c) or because of Executive's voluntary termination, the Company shall be relieved from any and all further or future obligations to compensate Executive; provided, however, that Executive shall be able to exercise any vested and unexercised awards under the Stock Option Plans in accordance with the terms set forth therein. d. In the event that the Company terminates Executive, for any reason other than Executive's incapacity or disability or misconduct as described in Sections 2.2(b) and 2.2(c), respectively, Executive shall be entitled to the following severance compensation, on the condition that Executive executes a severance agreement including a general release of the Company, including its owners, partners, stockholders, directors, officers, employees, independent contractors, agents, attorneys, representatives, predecessors, successors and assigns, parents, subsidiaries, affiliated entities and related entities: 1. Executive's then current annual salary under Section 3.1(a) for a period of 24 months following the effective date of such termination; 2. Payment of benefits under the LTPIP, if performance cycles remain outstanding, and the MICP set forth in Section 3.1(f), which will be deemed to have accrued as of the effective date of such termination; 3. The right to exercise any vested and unexercised options under the Stock Option Plans in accordance with their terms within one year of the effective date of such termination; 4. Notwithstanding the foregoing, in the event Executive engages in employment with a competitor of the Company during the 24 month period in which Executive's salary continues pursuant to Section 3.2(d)(1), the severance compensation available to Executive under this Section 3.2(d) shall be reduced by the amount of any and all gross earnings Executive earns while engaged in employment with any such competitor or competitors. For the purposes of this Section 3.2(d)(4), a "competitor of the Company" shall include, without limitation, a health maintenance organization, competitive medical plan, or preferred provider organization, or health or life insurance company which owns a managed care plan or program. Executive agrees to provide immediate notice to Company upon receipt of any gross earnings received by Executive from a competitor of Company; 5. Payment of the automobile allowance as provided in Section 3.1(d) for a period of 24 months following the effective date of such termination; and 6. The Company shall provide to Executive the outplacement services described in Section 3.1(h). -6- 7 e. Notwithstanding anything which may be expressed in, or inferred from the provisions of this Section 3.2 or Section 4.1, this Agreement should not be construed to limit, restrict, or deny Executive any benefits to which he otherwise may be entitled under the LTPIP, the MICP, the Stock Option Plans, the Company's pension plan or otherwise which arise from circumstances not addressed in this Agreement. 4. TERMINATION AS A RESULT OF A CHANGE OF CONTROL OR FOR GOOD CAUSE 4.1 Executive's Rights. In the event that, during the term of this Agreement, the Company undergoes a "change of ownership or control," as that term is defined in Section 4.3, and if within 24 months after the consummation of such change either (1) Executive is involuntarily terminated, except as provided in Section 4.2, or (2) Executive voluntarily terminates his employment for "good cause" as defined in Section 4.4, then Executive shall be entitled to the following compensation: a. Executive's then current annual salary under Section 3.1(a) for a period of 24 months following the effective date of such termination; b. Payment of health insurance premiums under the Consolidated Omnibus Budget Reconciliation Act of 1985, as amended, for Executive and Executive's dependents for a period of 24 months following the effective date of such termination; c. Annual payment of benefits under the LTPIP for each performance period of the LTPIP which is still outstanding for a period of 24 months following the effective date of such termination; d. Annual payment of benefits under the MICP set forth in Section 3.1(f), for a period of 24 months following the effective date of such termination; e. The right to exercise any and all granted and unexercised stock options, under the Stock Option Plans in accordance with their terms (whether or not such options are actually vested), as if all such unexercised stock options were fully vested, within one year of the effective date of such termination; f. Payment of the automobile allowance as provided under Section 3.1(d) for a period of 24 months following the effective date of such termination; and g. The Company shall provide to Executive the outplacement services described in Section 3.1(h). 4.2 Limitation of Benefits. In the event that Executive is terminated within 12 months after a change of ownership or control of the Company, and such termination results from either Executive's incapacity or disability or habitual neglect or gross misconduct, then, notwithstanding -7- 8 anything in this Section 4 to the contrary, Executive shall receive only that compensation, if any, to which he is entitled to under Sections 3.2(b) and 3.2(c), respectively. In no event shall the aggregate amount of all compensation which Executive may receive pursuant to the provisions of this Section 4, including without limitation, any salary, bonuses, stock options, employee benefits and all other cash and in-kind compensation, exceed an amount (the "Maximum Compensation Amount") which would give rise to an "excess parachute payment" as determined by Section 280G of the Internal Revenue Code of 1986, as amended, and any regulations promulgated thereunder. In the event that this Section 4 would entitle Executive to sums in excess of the Maximum Compensation Amount, the Company shall use its sound discretion, in good faith, to furnish Executive with a post-termination compensation package which is substantially equal to the Maximum Compensation Amount. 4.3 Change of Control. As used in this Section 4, the term "change of ownership or control" means and refers to: a. any merger, consolidation, or sale of the Company such that any individual, entity or group (within the meaning of Section 13(d)(3) or 14(d)(2) of the Securities Exchange Act of 1934, as amended (the "Exchange Act")) acquires beneficial ownership, within the meaning of Rule 13d-3 of the Exchange Act, of 20 percent or more of the voting common stock of the Company and the ownership interest of the voting common stock owned by UniHealth America is less than or equal to the ownership interest of the voting common stock of such individual, entity or group; b. any transaction in which the Company sells substantially all of its material assets; c. a dissolution or liquidation of the Company; or d. the Company becomes a non-publicly held company. 4.4 Good Cause. As used in this Section 4, "good cause" for Executive to terminate his employment shall be deemed to exist if Executive voluntarily terminates his employment for any of the following reasons: a. Without Executive's express prior written consent, Executive: (i) is assigned duties materially inconsistent with Executive's position, duties, responsibilities, or status with the Company which substantially varies from that which existed immediately prior to such change of ownership or control; (ii) experiences a change in his reporting level, titles, or business location (to a point more than 50 miles outside of Orange County, California) which substantially varies from that which existed immediately prior to the change of ownership or control; or -8- 9 (iii) with respect to any position held immediately prior to the change of ownership or control, is removed or fails to obtain reelection, which removal or failure to reelect is not directly related to Executive's incapacity or disability, habitual neglect, gross misconduct or death; b. Without Executive's express prior written consent, Executive's salary is reduced below that which existed immediately prior to the change of ownership or control and such change is not otherwise applied to others in the Company with at least Executive's position or title; c. Without Executive's express prior written consent, any employee benefit, business expense reimbursement or allotment, incentive bonus program, or any other manner or form of compensation available to Executive immediately prior to the change of ownership or control is reduced or eliminated and such change is not otherwise applied to others in the Company with at least Executive's position or title; d. The Company fails to obtain from any successor, before the succession takes place, a written commitment obligating the successor to perform this Agreement in accordance with all of its terms and conditions; or e. The Company or any successor thereto purports to terminate Executive without first giving Executive prior written notice thereof that specifies: (i) the exact provision of Section 2.2 relied upon; and (ii) the facts and circumstances, in reasonable detail, serving as the basis for Executive's termination. 5. NOTICES All notices or other communications required or permitted to be made hereunder shall be given in writing and sent by either personal delivery, overnight delivery, or United States registered or certified mail, return receipt requested, all of which shall be properly addressed with postal or delivery charges prepaid, to the parties at their respective addresses set forth below, or to such other addresses as either party may designate to the other in accordance with this Section 5: If to the Company: PacifiCare Health Systems, Inc. 3120 Lake Center Drive Santa Ana, California 92704 Attn: President and Chief Executive Officer -9- 10 If to Executive: Brad Bowlus 630 Ramona Drive Corona Del Mar, California 92626 All notices sent by personal delivery shall be deemed given when actually received. All notices sent by overnight delivery shall be deemed given on the next business day. All other notices sent via United States mail shall be deemed given no later than two business days after mailing. Any notice given by any method not expressly authorized herein, shall nevertheless be effective if actually received and shall be deemed given upon actual receipt. 6. GENERAL PROVISIONS 6.1 Assignability. This Agreement shall inure to the benefit of, and shall be binding upon the heirs, executors, administrators, successors, and legal representatives of Executive and shall inure to the benefit of, and be binding upon the Company and its successors and assigns. Executive shall not assign, delegate, subdelegate, transfer, pledge, encumber, hypothecate, or otherwise dispose of this Agreement, or any rights, obligations, or duties hereunder, and any such attempted delegation or disposition shall be null and void and without any force or effect; provided however, that nothing contained herein shall prevent Executive from designating beneficiaries for insurance, death, or retirement benefits. 6.2 Entire Agreement. This Agreement is a fully integrated document and contains any and all promises, covenants, and agreements between the parties hereto with respect to Executive's employment. This Agreement supersedes any and all other, prior or contemporaneous, discussions, negotiations, representations, warranties, covenants, conditions, and agreements, whether written or oral, between the parties hereto. Except as expressed herein, the parties have not exchanged any other representations, warranties, inducements, promises, or agreements respecting Executive's employment with the Company. 6.3 Severability. In the event any one or more of the provisions of this Agreement shall be rendered by a court of competent jurisdiction to be invalid, illegal, or unenforceable, in any respect, such invalidity, illegality, or unenforceability shall not affect or impair the remainder of this Agreement which shall remain in full force and effect and enforced accordingly, unless a party demonstrates by a preponderance of the evidence that the invalidated provision was an essential economic term of this Agreement. 6.4 Amendment. This Agreement shall not be changed, amended, or modified, nor shall any performance or condition hereunder be waived, in whole or in part, except by written instrument signed by the party against whom enforcement or waiver is sought. The waiver of any breach of any term or condition of this Agreement shall not be deemed to constitute the waiver of any other or subsequent breach of the same or any other term or condition of this Agreement. -10- 11 6.5 Governing Law. This Agreement shall be governed by, enforced under, and construed in accordance with the laws of the State of California. IN WITNESS WHEREOF, the parties hereto have executed this Agreement as of the date first written above. The Company: PACIFICARE HEALTH SYSTEMS, INC., a Delaware corporation /s/ Alan R. Hoops -------------------------------- By: Alan R. Hoops Title: President and Chief Executive Officer Executive: /s/ Brad Bowlus --------------------------------- Brad Bowlus -11- EX-10.05 4 EMPLOYMENT AGREEMENT-LINDA M. LYONS, MD 1 EXHIBIT 10.05 EMPLOYMENT AGREEMENT This EMPLOYMENT AGREEMENT (this "Agreement") is made and entered into as of the 10th day of June 1996, by and between PACIFICARE HEALTH SYSTEMS, INC., a Delaware corporation (the "Company"), with its principal place of business located at 5995 Plaza Drive, Cypress, California 90630 and Linda Lyons, M.D., F.A.C.P. ("Executive"), residing at 14886 De La Valle Place, Del Mar, California 92014. RECITALS WHEREAS, the Company desires to employ Executive in the capacity of Senior Vice President, Health Services. WHEREAS, the Company and Executive are entering into this Agreement to establish the terms and conditions of the desired employment relationship. NOW, THEREFORE, in consideration of the following covenants, conditions and promises contained herein, and other good and valuable consideration, the Company and Executive hereby agree as follows: 1. EMPLOYMENT 1.1 Executive's General Duties. The Company hereby employs Executive and Executive hereby agrees to serve the Company in the capacity of Senior Vice President, Health Services of the Company having such usual and customary duties and authority as an officer of similar capacity in a corporation of comparable size, holdings, and business as that of the Company. Executive shall do and perform all services, acts, or things necessary or advisable to manage and conduct the business of the Company and shall preside over such other areas of corporate activity as specified from time to time by the Board of Directors of the Company. During the term of this Agreement, Executive shall perform such additional or different duties, and accept the election or appointment to such other offices or positions, as are mutually agreed upon by Executive and the Company. 1.2 Devotion of Executive. During the term of this Agreement, Executive shall devote her entire productive time, ability, and attention to the business of the Company. Executive shall use her best efforts, skills, and abilities to promote the general welfare and interests of the Company and to preserve, maintain, and foster the Company's business and business relationships with all persons and entities associated therewith, including, without limitation, employer groups, medical service providers, shareholders, affiliates, officers, employees, and banks and other financial institutions. The Company shall give Executive a reasonable opportunity to perform her duties and shall neither expect Executive to devote more time, nor assign more duties or functions to Executive, than are customary and reasonable for an executive in Executive's position. -1- 2 2. TERM AND TERMINATION 2.1 Term. The term of Executive's employment under this Agreement shall commence on June 10, 1996 and shall continue unless terminated as provided in Section 2.2. 2.2 Termination. This Agreement shall be terminated upon the occurrence of any one of the following events: a. The death of the Executive. b. Executive becomes incapacitated or disabled, which incapacity or disability prevents Executive from fully performing her duties to the Company for a period in excess of 90 days and, after such 90-day period, the Company and a physician, duly licensed and qualified in the specialty of Executive's incapacity, decide in their reasonable judgments, that such incapacity will be permanent or of such continued duration as to prevent Executive from resuming the rendition of services to the Company for at least an additional six-month period. For purposes of this Agreement, Executive shall be deemed permanently disabled, and this Agreement terminated upon the date Executive receives written notice from the Company that such determination has been made. c. Executive habitually neglects her duties to the Company or engages in gross misconduct during the term of this Agreement. For the purposes of this Agreement, "gross misconduct" shall mean Executive's conviction of any criminal offense, misappropriation of funds, securities fraud, insider trading, unauthorized possession of corporate property or the sale, distribution, possession or use of a controlled substance (whether or not such felony or criminal offense is committed in connection with Executive's duties hereunder or in the course of her employment with the Company). In such event, Executive's termination shall be effective immediately upon receipt of written notice from the Company. d. Either party hereto may terminate this Agreement, with or without cause, upon 30 days prior written notice to the other party. Executive's termination shall be effective 60 days after receipt of such notice. 2.3 Effect of Termination. No termination of this Agreement shall affect or impair any rights or obligations of the parties respecting certain compensation accruing prior thereto or continuing thereafter in accordance with the terms set forth in Section 3.2 and Section 4. 3. COMPENSATION 3.1 Compensation During the Term of this Agreement a. As long as Executive satisfactorily performs all of her obligations hereunder, the Company shall pay Executive an annual base salary, as determined by the compensation committee of the board of directors, payable in equal installments on the Company's regular payroll dates, which as of the date hereof is $260,000. On an annual basis beginning in January, 1997, the Company's compensation committee shall review Executive's salary, but shall be under no obligation to increase Executive's salary. In addition, Executive will receive an advance to her annual base salary in the amount of $50,000 (the "Advance"). The Advance will be payable in three installments: $20,000 payable on July 10, 1996; $10,000 on December 10, 1996; and $20,000 on June 10, 1997. If Executive voluntarily leaves the -2- 3 Company or Executive is terminated pursuant to the provisions of Section 2.2(c) hereof prior to June 10, 1997, Executive shall be required to repay the Advance in full or such portion of the Advance which has been paid to Executive. Executive authorizes the Company to take such deductions and withholdings from her salary as are required by law, directed by Executive, or as reasonably directed by the Company for its employees, which deductions shall include, without limitation, withholding for federal and state income taxes and social security. b. On June 10, 1996 (the "Grant Date"), the Company will grant to Executive non-qualified options to purchase 20,000 shares of the Company's Class B Common Stock, par value $0.01 per share (the "Options"). On the first anniversary of the Grant Date, 25 percent of the Options shall become vested and an additional 25 percent of the Options shall become vested on each succeeding anniversary of the Grant Date until the fourth anniversary of the Grant Date when all the Options shall become vested. The Options shall be subject to the 1989 Stock Option Plan (as defined herein) and are evidenced by a stock option agreement between Executive and the Company. c. The Company will provide Executive up to $2,000 per month to reimburse you for hotel, lodging, meals, flights and other expenses related to Executive's transition with the Company (the "Transition Expenses"). Transition Expenses will be reimbursed by the Company through June 10, 1998. The Company shall not be obligated to make any such reimbursement unless Executive presents corresponding expense statements and such other supporting information as the Company may from time to time reasonably request. d. During the first two years of employment with the Company, Executive will be eligible for relocation services as set forth in the letter of employment, dated May 10, 1996 (the "Relocation Services"). In addition, Executive shall also receive a relocation allowance of $13,000 (the "Relocation Allowance"). If Executive voluntarily leaves the Company or Executive is terminated pursuant to the provisions of Section 2.2(c) hereof prior to two years from the commencement of such relocation services (the "Relocation Services Commencement Date"), Executive shall reimburse the Company for the full gross amount of all relocation services provided to Executive, including the Relocation Allowance. e. Executive shall be reimbursed for non-recurring closing costs, up to two percent of the purchase price of a home for fees related to mortgage placement and normal non-recurring closing costs. f. Executive shall be entitled to fully participate in all of the employee benefit plans and programs available to other high-level executives of the Company, including, without limitation, health, dental, and life insurance benefits for Executive and Executive's dependents, pension and profit sharing programs, and vacation and sick leave benefits. The terms of this Agreement, however, shall not restrict the Company's right to change, amend, modify, or terminate any existing benefit plan or program, or to change any insurance company or modify any insurance policy adopted incident to such existing benefit plan and program. g. The Company shall provide Executive with a $600 per month automobile allowance. The Company shall furnish Executive's automobile with a cellular car telephone. Executive shall provide and maintain automobile insurance for Executive's car including collision, comprehensive liability, personal and property damage, and uninsured and underinsured motorist coverage in amounts customarily obtained to cover such contingencies -3- 4 in California. Executive shall provide proof of such coverage to the Company upon the Company's request. h. The Company shall pay for or reimburse Executive for all other reasonable travel, entertainment, and other business expenses incurred or paid for by Executive in connection with the performance of her services under this Agreement. The Company shall not be obligated to make any such reimbursement unless Executive presents corresponding expense statements or vouchers and such other supporting information as the Company may from time to time reasonably request. The Company reserves the right to place subsequent limitations or restrictions on business expenses to be incurred or reimbursed. i. Executive shall be entitled to participate fully in the Company's Amended Long-Term Performance Incentive Plan, as amended (the "LTPIP"), as from time to time may be amended, modified or replaced, in accordance with the terms and conditions set forth herein and therein. Beginning with the 1996 through 1998 performance cycle and for each successive performance cycle, the target bonus award which Executive may be eligible to receive under the LTPIP, if the performance objectives for the performance cycle are achieved, shall be 25 percent of the average of Executive's annual base salary for the three years of the performance cycle up to a maximum bonus award of 50 percent of the average of Executive's annual base salary for the three years of the performance cycle. If the percentage of salary for the target and maximum award under the LTPIP is changed, such change shall be reflected on Schedule I attached hereto. j. Executive shall be entitled to participate fully in the Company's Amended Management Incentive Compensation Plan, as amended (the "MICP"), as may be amended, modified, or replaced, in accordance with the terms and conditions set forth herein and therein. Beginning with the Company's 1996 fiscal year and during the term of this Agreement, the target bonus award which Executive may be eligible to receive under the MICP, if the performance objectives for the fiscal year are achieved, shall be 30 percent of Executive's annual base salary applicable at the end of the fiscal year preceding the payment of the award up to a maximum bonus award of 60 percent of Executive's annual base salary applicable at the end of the fiscal year preceding the payment of the award. If the percentage of salary for the target and maximum award under the MICP is changed, such change shall be reflected on Schedule I attached hereto. k. Executive shall be entitled to participate in the Second Amended and Restated 1989 Stock Option Plan for Officers and Key Employees of PacifiCare Health Systems, Inc., as amended (the "1989 Stock Option Plan"), as such plan from time to time may be amended, modified or replaced, in accordance with the terms and conditions set forth herein and therein. l. During the term of this Agreement, the Company shall insure Executive under its general liability insurance for all conduct committed in good faith while acting in the capacity as Senior Vice President, Health Services or in any other capacity to which Executive may be appointed or elected. m. In the event Executive is involuntarily terminated, without cause, except in the case of death or incapacity or disability, the Company shall provide outplacement services to Executive to assist Executive in securing a position comparable to the one from which she was terminated. The Company shall be obligated to provide those outplacement services as customarily provided by companies of similar size and holdings as those of the Company to executives with comparable responsibility and longevity as Executive and for reasonable cost as approved by the Company. The Company's provision of such -4- 5 outplacement services shall not limit, restrict, or reduce, in any manner, any and all other compensation to which Executive is entitled hereunder. n. As part of the compensation for services rendered under this Agreement, Executive shall be entitled to participate in the PacifiCare Health Systems, Inc. Savings and Profit-Sharing Plan, and the trust agreement implemented pursuant thereto, adopted as of June 1, 1985, as from time to time may be amended modified, or replaced, in accordance with the terms and conditions set forth therein. o. Executive shall be entitled to the benefits provided under the Company's Statutory Restoration Plan, as such plan from time to time may be amended, modified or replaced, in accordance with the terms set forth herein and therein. 3.2 Compensation Following Termination a. In the event that this Agreement is terminated by reason of Executive's death, Executive's estate or legal representative shall be entitled to receive the following: 1. Payment of benefits under the life insurance policy purchased by the Company on Executive's behalf, if any; 2. Payments of benefits under the LTPIP and the MICP set forth in Sections 3.1(i) and 3.1(j), respectively, which will be deemed to have accrued as of the date of Executive's death; 3. Executive's legal representative shall be permitted to exercise any vested and unexercised options under the 1989 Stock Option Plan set forth in Section 3.1(j); and 4. If Executive's death occurs prior to June 10, 1997, Executive's estate or legal representative will not be required to repay the Advance. 5. If Executive's death occurs within two years of the Relocation Services Commencement Date, Executive's estate or legal representative will not be required to repay any amounts paid by the Company for Relocation Services for Executive or the Relocation Allowance. b. In the event that Executive is terminated because of an incapacity or disability, the Company shall provide Executive with the following: 1. Payment of benefits under the disability insurance policy maintained by the Company on Executive's behalf, if any; 2. Payment of benefits under the LTPIP and the MICP set forth in Sections 3.1(i) and 3.1(j), respectively, which will be deemed to have accrued as of the effective date of such termination; 3. The right to exercise any vested and unexercised options under the 1989 Stock Option Plan in accordance with the terms stated therein; 4. Payment of the automobile allowance as provided under Section 3.1(g) for a period of 12 months following the effective date of such termination; and -5- 6 5. If Executive is disabled or incapacitated prior to June 10, 1997, Executive will not be required to repay the Advance. 6. If Executive is disabled or incapacitated within two years of the Relocation Services Commencement Date, Executive will not be required to repay any amounts paid by the Company for Relocation Services for Executive or the Relocation Amount. c. In the event this Agreement is terminated because of Executive's habitual neglect or gross misconduct pursuant to Section 2.2(c) or because of Executive's voluntary termination, the Company shall be relieved from any and all further or future obligations to compensate Executive; provided, however, that Executive shall be able to exercise any vested and unexercised awards under the 1989 Stock Option Plan in accordance with the terms set forth therein. In addition, if this Agreement is terminated pursuant to the provisions contained in this Section 3.2(c) prior to June 10, 1997, Executive will be required to repay the Advance or any portion which has been paid in full. Further, if this Agreement is terminated pursuant to the provisions contained in this Section 3.2(c) within two years of the Relocation Services Commencement Date, Executive will be required to repay any amounts paid by the Company for Relocation Services for Executive and the Relocation Amount. d. In the event that the Company terminates Executive, for any reason other than Executive's incapacity or disability or misconduct as described in Sections 2.2(b) and 2.2(c), respectively, Executive shall be entitled to the following severance compensation: 1. Executive's then current annual salary under Section 3.1(a) for a period of 12 months following the effective date of such termination; 2. Payment of benefits under the LTPIP and the MICP set forth in Sections 3.1(i) and 3.1(j), respectively, which will be deemed to have accrued as of the effective date of such termination; 3. The right to exercise any vested and unexercised options under the 1989 Stock Option Plan in accordance with their terms within one year of the effective date of such termination; 4. Notwithstanding the foregoing, in the event Executive engages in employment with a competitor of the Company during the 12 month benefit period, the severance compensation available to Executive under this Section 3.2(d) shall be reduced by the amount of any and all gross earnings Executive earns while engaged in employment with any such competitor or competitors. For the purposes of this Section 3.2(d)(4), a "competitor of the Company" shall include, without limitation, an health maintenance organization, competitive medical plan, or preferred provider organization, or health or life insurance company which owns a managed care plan or program. Executive agrees to provide immediate notice to Company upon receipt of any gross earnings received by Executive from a competitor of Company; 5. Payment of the automobile allowance as provided in Section 3.1(g) for a period of 12 months following the effective date of such termination; -6- 7 6. The Company shall provide to Executive the outplacement services described in Section 3.1(m); and 7. If Executive's termination occurs prior to June 10, 1997, Executive will not be required to repay the Advance. 8. If Executive's termination occurs within two years of the Relocation Services Commencement Date, Executive will not be required to repay any amounts paid by the Company for Relocation Services for Executive or the Relocation Amount. e. Notwithstanding anything which may be expressed in, or inferred from the provisions expressed in, or inferred from the provisions of this Section 3.2 or Section 4.1, this Agreement should not be construed to limit, restrict, or deny Executive any benefits to which she otherwise may be entitled to under the LTPIP, the MICP, the 1989 Stock Option Plan, the Company's pension plan or otherwise which arise from circumstances not addressed in this Agreement. 4. TERMINATION AS A RESULT OF A CHANGE OF CONTROL OR FOR GOOD CAUSE 4.1 Executive's Rights. In the event that, during the term of this Agreement, the Company undergoes a "change of ownership or control," as that term is defined in Section 4.3, Executive shall be entitled to the following compensation if within 24 months after the consummation of such change Executive is involuntarily terminated, except as provided in Section 4.2, or Executive voluntarily terminates her employment for "good cause" as defined in Section 4.4: a. Executive's then current annual salary under Section 3.1(a) for a period of 12 months following the effective date of such termination; b. Payment of health insurance premiums under the Consolidated Omnibus Budget Reconciliation Act of 1985, as amended, for Executive and Executive's dependents for a period of 12 months following the effective date of such termination; c. Annual payment of benefits under the LTPIP set forth in Section 3.1(i) for each performance period of the LTPIP for a period of 12 months following the effective date of such termination; d. Annual payment of benefits under the MICP set forth in Section 3.1(j), for a period of 12 months following the effective date of such termination; e. The right to exercise any and all granted and unexercised stock options, under the 1989 Stock Option Plan in accordance with their terms (whether or not such options are actually vested), as if all such unexercised stock options are fully vested within one year of the effective date of such termination; f. Payment of the automobile allowance as provided under Section 3.1(g) for a period of 12 months following the effective date of such termination; g. The Company shall provide to Executive the outplacement services described in Section 3.1(m); and -7- 8 h. If Executive's termination is a result of a Change of Control or Executive voluntarily terminates for "good cause" and such termination occurs prior to June 10, 1997, Executive will not be required to repay the Advance. i. If Executive's termination is a result of a Change of Control or Executive voluntarily terminates for "good cause" and such termination occurs within two years of the Relocation Services Commencement Date, Executive will not be required to repay any amounts paid by the Company for Relocation Services for Executive or the Relocation Amount. 4.2 Limitation of Benefits. In the event that Executive is terminated within 12 months after a change of ownership or control of the Company, and such termination results from either Executive's incapacity or disability or habitual neglect or gross misconduct, then, notwithstanding anything in this Section 4 to the contrary, Executive shall receive only that compensation, if any, to which she is entitled to under Sections 3.2(b) and 3.2(c), respectively. In no event shall the aggregate amount of all compensation which Executive may receive pursuant to the provisions of this Section 4, including without limitation, any salary, bonuses, stock options, employee benefits and all other cash and in-kind compensation exceed an amount (the "Maximum Compensation Amount") which would give rise to an "excess parachute payment" as determined by Section 280G of the Internal Revenue Code of 1986, as amended, and any regulations promulgated thereunder. In the event that this Section 4 would entitle Executive to sums in excess of the Maximum Compensation Amount, the Company shall use its sound discretion, in good faith, to furnish Executive with a post-termination compensation package which is substantially equal to the Maximum Compensation Amount. 4.3 Change of Control. As used in this Section 4, the term "change of ownership or control" means and refers to: a. any merger, consolidation, or sale of the Company such that any individual, entity or group (within the meaning of Section 13(d)(3) or 14(d)(2) of the Securities Exchange Act of 1934, as amended (the "Exchange Act")) acquires beneficial ownership, within the meaning of Rule 13d-3 of the Exchange Act, of 20 percent or more of the voting common stock of the Company and the ownership interest of the voting common stock owned by UniHealth is less than or equal to the ownership interest of the voting common stock of such individual, entity or group; b. any transaction in which the Company sells substantially all of its material assets; c. a dissolution or liquidation of the Company; or d. the Company becomes a non-publicly held company. 4.4 Good Cause. As used in this Section 4, "good cause" for Executive to terminate her employment shall be deemed to exist if Executive voluntarily terminates her employment for any of the following reasons: a. Without Executive's express prior written consent, Executive: -8- 9 (i) is assigned duties materially inconsistent with Executive's position, duties, responsibilities, or status with the Company which substantially varies from that which existed immediately prior to such change of ownership or control; (ii) experiences a change in her reporting level, titles, or business location (to a point more than 50 miles outside of Orange County, California) which substantially varies from that which existed immediately prior to the change of ownership or control; or (iii) with respect to any position held immediately prior to the change of ownership or control, is removed or fails to obtain reelection, which removal or failure to reelect is not directly related to Executive's incapacity or disability, habitual neglect, gross misconduct or death; b. Without Executive's express prior written consent, Executive's salary is reduced below that which existed immediately prior to the change of ownership or control and such change is not otherwise applied to others in the Company with at least Executive's position or title; c. Without Executive's express prior written consent, any employee benefit, business expense reimbursement or allotment, incentive bonus program, or any other manner or form of compensation available to Executive immediately prior to the change of ownership or control is reduced or eliminated and such change is not otherwise applied to others in the Company with at least Executive's position or title; d. The Company fails to obtain from any successor, before the succession takes place, a written commitment obligating the successor, to perform this Agreement in accordance with all of its terms and conditions; or e. The Company or any successor thereto, purports to terminate Executive without first giving Executive prior written notice thereof, in accordance with the provisions of Section 2.2(d), that specifies: (i) the exact provision of Section 2.2 relied upon; and (ii) the facts and circumstances, in reasonable detail, serving as the basis for Executive's termination. -9- 10 5. NOTICES All notices or other communications required or permitted to be made hereunder shall be given in writing and sent by either personal delivery, overnight delivery, or United States registered or certified mail, return receipt requested, all of which shall be properly addressed with postal or delivery charges prepaid, to the parties at their respective addresses set forth below, or to such other addresses as either party may designate to the other in accordance with this Section 5: If to the Company: PacifiCare Health Systems, Inc. 5995 Plaza Drive Cypress, California 90630 Attn: President and Chief Executive Officer If to Executive: Linda Lyons, M.D., F.A.C.P. 14886 De La Valle Place Del Mar, California 92014 All notices sent by personal delivery shall be deemed given when actually received. All notices sent by overnight delivery shall be deemed given on the next business day. All other notices sent via United States mail shall be deemed given no later than two business days after mailing. 6. GENERAL PROVISIONS 6.1 Assignability. This Agreement shall inure to the benefit of, and shall be binding upon the heirs, executors, administrators, successors, and legal representatives of Executive and shall inure to the benefit of, and be binding upon the Company and its successors and assigns. Executive shall not assign, delegate, subdelegate, transfer, pledge, encumber, hypothecate, or otherwise dispose of this Agreement, or any rights, obligations, or duties hereunder, and any such attempted delegation or disposition shall be null and void and without any force or effect; provided however, that nothing contained herein shall prevent Executive from designating beneficiaries for insurance, death, or retirement benefits. 6.2 Entire Agreement. This Agreement is a fully integrated document and contains any and all promises, covenants, and agreements between the parties hereto with respect to Executive's employment. This Agreement supersedes any and all other, prior or contemporaneous, discussions, negotiations, representations, warranties, covenants, conditions, and agreements, whether written or oral, between the parties hereto. 6.3 Severability. In the event any one or more of the provisions of this Agreement shall be rendered by a court of competent jurisdiction to be invalid, illegal, or unenforceable, in any respect, such invalidity, illegality, or unenforceability shall not affect or impair the remainder of this Agreement which shall remain in full force and effect and enforced accordingly. 6.4 Amendment. This Agreement shall not be changed, amended, or modified, nor shall any performance or condition hereunder be waived, in whole or in part, except by written instrument signed by the party against whom enforcement or waiver is sought. The waiver of any breach of any term or condition of this Agreement shall not be deemed to constitute the waiver of any other or subsequent breach of the same or any other term or condition of this Agreement. -10- 11 6.5 Governing Law. This Agreement shall be governed by, enforced under, and construed in accordance with the laws of the State of California. IN WITNESS WHEREOF, the parties hereto have executed this Agreement as of the date first written above. The Company: PACIFICARE HEALTH SYSTEMS, INC., a Delaware corporation /s/ Alan Hoops -------------------------------- By: Alan Hoops Title: President and Chief Executive Officer Executive: /s/ Linda Lyons -------------------------------- Linda Lyons, M.D., F.A.C.P. -11- 12 SCHEDULE I LTPIP TARGET and MAXIMUM BONUS AWARD CHANGES
Target Maximum ------ -------
MICP TARGET and MAXIMUM BONUS AWARD CHANGES
Target Maximum ------ -------
13 FIRST AMENDMENT EXECUTIVE EMPLOYMENT AGREEMENT This First Amendment, dated as of January 1, 1998 (the "Amendment"), to the Executive Employment Agreement, dated as of June 10, 1996 (the "Agreement"), between PacifiCare Health Systems, Inc., a Delaware corporation, and Linda Lyons, M.D., F.A.C.P., an individual ("Executive"), hereby amends the Agreement as follows: 1. AMENDMENT TO SECTIONS 3.2(d)(1) AND 4.1(a). Sections 3.2(d)(1) and 4.1(a) are hereby amended such that the period for which Executive is to receive her annual base salary under such sections is hereby changed from 12 to 24 months. 2. AMENDMENT TO SECTIONS 3.2(b)(4), 3.2(d)(4), 4.1(c), 4.1(d) AND 4.1(f). Sections 3.2(b)(4), 3.2(d)(4), 4.1(c), 4.1(d) and 4.1(f) are hereby amended such that the period for which Executive is to receive the benefit specified in such sections is hereby changed from 12 to 24 months. 3. AMENDMENT TO SECTION 4.1(b). Section 4.1(b) of the Agreement is hereby amended such that the payment of health insurance premiums under the Consolidated Omnibus Budget Reconciliation Act of 1985, as amended, for Executive and Executive's dependents shall be made for a period of 18 months following the effective date of such termination. 4. LIMITATION OF AMENDMENTS. Except as expressly provided herein, no terms or provision of any agreement or instrument are modified or changed by this Amendment and the terms and provisions of the Agreement, as amended by this Amendment, shall continue in full force and effect. 5. GOVERNING LAW. This Amendment shall be construed, interpreted and enforced in accordance with, and governed by California law. 6. CAPITALIZED TERMS. Capitalized terms not defined herein shall have the meanings ascribed to them in the Agreement. 7. DUPLICATE ORIGINALS; EXECUTION IN COUNTERPART. Two or more duplicate originals of this Amendment may be signed by the parties, each of which shall be an original but all of which together shall constitute one and the same instrument. 8. WAIVERS AND AMENDMENTS. Neither this Amendment nor any term hereof may be changed, waived, discharged or terminated orally, or by any action or inaction, but only by an instrument in writing signed by the party against which enforcement of the change, waiver, discharge or termination is sought. 9. SECTION HEADINGS. The titles of the sections hereof appear as a matter of convenience only, do not constitute a part of this Amendment and shall not affect the construction hereof. 14 IN WITNESS WHEREOF, the parties hereto have executed this Amendment as of the date first written above. PACIFICARE HEALTH SYSTEMS, INC., a Delaware corporation /s/ Alan R. Hoops -------------------------------- By: Alan R. Hoops Title: President and Chief Executive Officer /s/ Linda Lyons -------------------------------- Linda Lyons, M.D., F.A.C.P. 15 SECOND AMENDMENT EXECUTIVE EMPLOYMENT AGREEMENT This Second Amendment, dated as of February 9, 1998 (the "Second Amendment") to the Employment Agreement, dated as of June 10, 1996, as amended by that certain First Amendment to Executive Employment Agreement, dated as of January 1, 1998 (collectively, the "Agreement"), between PacifiCare Health Systems, Inc., a Delaware corporation (the "Company"), and Linda Lyons, M.D., F.A.C.P., an individual ("Executive") is made with reference to the following facts: PREAMBLE A. WHEREAS, under the provisions of the original Agreement, the Company agreed to provide Executive with certain relocation benefits. B. WHEREAS, the parties believe that it is in their best interests to amend the Agreement to provide that in lieu of such relocation benefits, the Company will provide Executive with a $50,000 relocation benefit ("Relocation Benefit"), which amount shall be repaid by Executive if she does not continue in her employment with the Company for a sufficient period of time in order to earn the Relocation Benefit. NOW THEREFORE, in consideration of the above premises, the parties hereby agree to amend the Agreement as follows: 1. AMENDMENT TO SECTION 3.1(d). Section 3.1(d) of the Agreement is hereby deleted in its entirety and restated in its entirety to read as follows: "d. As of the date hereof, Company shall discontinue providing Executive any of the Relocation Services set forth in the May 10, 1996 letter of employment from the Company to Executive and referred to in the Agreement. In lieu of such Relocation Services and the Relocation Allowance (as defined in the Agreement), Executive shall receive a relocation benefit in the amount of $50,000 (the "Relocation Benefit"). If Executive voluntarily leaves the Company or Executive is terminated pursuant to the provisions of Section 2.2(c) prior to January 3, 2001, Executive shall be required to repay the gross amount of the Relocation Benefit as follows: (i) if Executive leaves the Company prior to January 3, 1999, Executive shall be required to repay $33,333 of the Relocation Benefit; (ii) if Executive leaves the Company prior to January 3, 2000, Executive shall be required to repay $16,667 of the Relocation Benefit; and (iii) if Executive leaves the Company subsequent to January 3, 2001, Executive shall be deemed to have earned the Relocation Benefit in full and shall not be required to repay the Relocation Benefit. 2. AMENDMENT TO SECTION 3.1(e). Section 3.1(e) of the Agreement is hereby amended and restated in its entirety to read as follows: "(e) Intentionally omitted." 16 4. LIMITATION OF AMENDMENTS. Except as expressly provided herein, no terms or provision of any agreement or instrument are modified or changed by this Amendment and the terms and provisions of the Agreement, as amended by this Amendment, shall continue in full force and effect. 5. GOVERNING LAW. This Amendment shall be construed, interpreted and enforced in accordance with, and governed by California law. 6. CAPITALIZED TERMS. Capitalized terms not defined herein shall have the meanings ascribed to them in the Agreement. 7. DUPLICATE ORIGINALS; EXECUTION IN COUNTERPART. Two or more duplicate originals of this Amendment may be signed by the parties, each of which shall be an original but all of which together shall constitute one and the same instrument. 8. WAIVERS AND AMENDMENTS. Neither this Amendment nor any term hereof may be changed, waived, discharged or terminated orally, or by any action or inaction, but only by an instrument in writing signed by the party against which enforcement of the change, waiver, discharge or termination is sought. 9. SECTION HEADINGS. The titles of the sections hereof appear as a matter of convenience only, do not constitute a part of this Amendment and shall not affect the construction hereof. IN WITNESS WHEREOF, the parties hereto have executed this Amendment as of the date first written above. PACIFICARE HEALTH SYSTEMS, INC., a Delaware corporation /s/ Alan R. Hoops -------------------------------- By: Alan R. Hoops Title: President and Chief Executive Officer /s/ Linda Lyons -------------------------------- Linda Lyons, M.D., F.A.C.P. EX-10.06 5 FORM OF CONTRACT WITH ELIGIBLE MEDICARE+CHOICE 1 EXHIBIT 10.06 (Contract Period ______ to ______ ) Contract With Eligible Medicare+Choice Organization Pursuant to sections 1851 through 1859 of the Social Security Act for the operation of a Medicare+Choice coordinated care plan(s) CONTRACT (P) Between Health Care Financing Administration (hereinafter referred to as HCFA) and - ----------------------------------------------- (hereinafter referred to as the M+C Organization) HCFA and the M+C Organization, an entity which has been determined to be an eligible Medicare+Choice organization by the Administrator of the Health Care Financing Administration under 42 CFR 422.501, agree to the following for the purposes of sections 1851 through 1859 of the Social Security Act (hereinafter referred to as the Act): (NOTE: Citations indicated in brackets are placed in the text of this contract to note the authority for certain contract provisions in the regulations promulgated pursuant to the Balanced Budget Act of 1997. All references to part 422 are to 42 CFR part 422.) Article I Term of Contract A. Term: The term of this contract shall be from January 1, 1999 through December 31, 1999. This contract governs the transitional phase of the implementation of the Medicare+Choice program for coordinated care plans and is based on the interim final regulations published on June 26, 1998. 2 [422.504] Article II Coordinated Care Plan The Medicare+Choice Organization agrees to operate the following coordinated care plans (as defined in 42 CFR Section 422.2) in compliance with the requirements of this contract, and the Federal statutes, regulations, and rules applicable to the Medicare+Choice program: - ------------------------------ ---------------------------- "H" Number/Service Area "H" Number/Service Area - ------------------------------ ----------------------------- "H" Number/Service Area "H" Number/Service Area Article III Functions To Be Performed By Medicare+Choice Organization A. PROVISION OF BENEFITS The M+C Organization agrees to provide enrollees in each of its M+C plans the basic benefits as required under Section 422.101 and, to the extent applicable, supplemental benefits under Section 422.102. The M+C Organization agrees to provide access to such benefits as required under subpart C in a manner consistent with professionally recognized standards of health care and according to the access standards stated in Section 422.112. [422.502(a)(3)] B. ENROLLMENT REQUIREMENTS 1. The M+C Organization agrees to accept new enrollments, make enrollments effective, process voluntary disenrollments, and limit involuntary disenrollments, as provided in subpart B of part 422. 3 2. The M+C Organization shall comply with the provisions of Section 422.110 and Section 422.111 concerning prohibitions against discrimination in beneficiary enrollment. [422.502(a)(1)] C. BENEFICIARY PROTECTIONS 1. The Medicare+Choice Organization agrees to comply with all requirements in subpart M of part 422 governing coverage determinations, grievances, and appeals. [422.502(a)(7)] 2. The Medicare+Choice Organization agrees to comply with the confidentiality and enrollee record accuracy requirements in Section 422.118. 3. Beneficiary Financial Protection. The M+C Organization agrees to comply with the following requirements: (a) Each M+C Organization must adopt and maintain arrangements satisfactory to HCFA to protect its enrollees from incurring liability for payment of any fees that are the legal obligation of the M+C organization. To meet this requirement the M+C Organization must- (i) Ensure that all contractual or other written arrangements with providers prohibit the Organization's providers from holding any beneficiary enrollee liable for payment of any fees that are the legal obligation of the M+C Organization; and (ii) Indemnify the beneficiary enrollee for payment of any fees that are the legal obligation of the M+C Organization for services furnished by providers that do not contract, or that have not otherwise entered into an agreement with the M+C Organization, to provide services to the organization's beneficiary enrollees. [422.502(g)(1)] (b) The M+C Organization must provide for continuation of enrollee health care benefits- (i) For all enrollees, for the duration of the contract period for which HCFA payments have been made; and (ii) For enrollees who are in an inpatient setting on the date its contract with HCFA terminates, or, in the event of an insolvency, through the date of discharge. [422.502(g)(2)] (c) In meeting the requirements of this section (C), other than the provider contract requirements specified in paragraph (C)(3)(a) of this Article, the M+C Organization may use- 4 (i) Contractual arrangements; (ii) Insurance acceptable to HCFA; (iii) Financial reserves acceptable to HCFA; or (iv) Any other arrangement acceptable to HCFA. [422.502(g)(3)] D. PROVIDER PROTECTIONS 1. The M+C Organization agrees to comply with all applicable provider requirements in subpart E of part 422, including provider certification requirements, anti-discrimination requirements, provider participation and consultation requirements, the prohibition on interference with provider advice, limits on provider indemnification, rules governing payments to providers, and limits on physician incentive plans. [422.506(a)(6)] 2. Prompt Payment. (a) The M+C Organization must pay 95 percent of the "clean claims" within 30 days of receipt if they are claims for services that are not furnished under a written agreement between the organization and the provider. (i) The M+C Organization must pay interest on clean claims that are not paid within 30 days in accordance with sections 1816(c)(2)(B) and 1842(c)(2)(B) of the Act. (ii) All other claims must be approved or denied within 60 calendar days from the date of the request. [422.520(a)] (b) Contracts or other written agreements between the M+C Organization and its providers must contain a prompt payment provision, the terms of which are developed and agreed to by both the M+C Organization and the relevant provider. [422.520(b)] (c) If HCFA determines, after giving notice and opportunity for hearing, that the M+C Organization has failed to make payments in accordance with paragraph (2)(a) of this section, HCFA may provide- (i) For direct payment of the sums owed to providers, or M+C private fee-for-service plan enrollees; and 5 (ii) For appropriate reduction in the amounts that would otherwise be paid to the M+C Organization, to reflect the amounts of the direct payments and the cost of making those payments. [422.520(c)] E. QUALITY ASSESSMENT AND PERFORMANCE IMPROVEMENT PROGRAM 1. The M+C Organization agrees to operate an ongoing quality assessment and performance improvement program (as stated in 422.154 of subpart D). The quality assurance program must incorporate and meet the standards and guidelines outlined in the Quality Improvement System for Managed Care (QISMC) Interim Standards and Guidelines (HCFA Operational Policy Letter 098.72). 2. Quality Assessment and Performance Improvement Projects: The M+C Organization agrees to: (a) initiate two quality assessment and performance improvement (QAPI) projects annually. These projects must be outcomes-oriented and targeted at achieving demonstrable, sustained improvement in significant aspects of specified clinical and non-clinical areas which can be expected to have a favorable effect on enrollees' health outcomes and satisfaction. For 1999, one of the two projects must focus on diabetes. The M+C Organization may participate in the HCFA-sponsored national diabetes project or substitute a diabetes project of their own design; however, the substituted project must utilize the Diabetes Quality Improvement Project (DQIP) indicators. (b) QAPI project focus areas must be representative of the entire spectrum of clinical and non-clinical care areas associated with a plan. (i) The clinical areas include: (aa) prevention and care of acute and chronic conditions (bb) high-volume services (cc) high-risk services (dd) continuity and coordination of care (ii) The non-clinical areas include: (aa) appeals, grievances and other complaints (bb) access to, and availability of services (such as culturally competent care) (c) HCFA may require that the M+C Organization conduct a QAPI project in a particular clinical or non-clinical area when HCFA determines that the M+C Organization's overall performance would be improved significantly by the M+C 6 Organization's improvement in that particular area. Such a HCFA-mandated QAPI project would constitute one of the two required QAPI projects. (d) For each QAPI project, the M+C Organization must: (i) use quality indicators that are objective, clearly and unambiguously defined, and based on current clinical knowledge or health services research; (ii) assure that those quality indicators are capable of measuring outcomes such as changes in health and functional status, enrollee satisfaction, or valid proxies of those outcomes; (iii) assess performance on selected indicators using systematic on-going collection and analysis of valid, reliable data; (iv) perform ongoing measurement of performance; (aa) The M+C Organization must measure and report to HCFA performance achieved under the project, utilizing standard measures. The standard measures required by HCFA during the term of this contract will be uniform data collection and reporting instruments, to include the Health Employer Data Information Set (HEDIS), Consumer Assessment of Health Plan Satisfaction (CAHPS) survey, and Health of Seniors (HOS). (bb) These measures must address clinical areas, including effectiveness of care, enrollee perception of care and use of services; and non-clinical areas including access to and availability of services, appeals and grievances, and organizational characteristics. [422.152(c)(1)]. (v) conduct system interventions, including the adoption and/or revision of practice guidelines; (vi) improve performance; and (vii) perform systematic follow-up on the effect of the interventions [422.152(d)] 3. Utilization Review: If the M+C Organization uses written protocols for utilization review, those policies and procedures must reflect current standards of medical practice in processing requests for initial or continued authorization of services.[422.152(b)(3)]. The M+C Organization must also have in effect mechanisms to detect both underutilization and overutilization of services.[422.152(b)(4)] . 4. Information Systems: 7 (a) The M+C Organization must make available to HCFA information on quality and outcomes measures that will enable beneficiaries to compare health coverage options and select among them, as provided in Section 422.64(c)(10). [422.152(b)(5)]. (b) The M+C Organization must maintain a health information system that: (i) collects, analyzes and integrates the data necessary to implement its quality assessment and performance improvement program, and (ii) assures that the information entered into the system (particularly that received from providers) is reliable and complete. (c) The M+C Organization must make all collected data, including information on quality and outcomes measures, available to HCFA to enable beneficiaries to compare health coverage options and select among them, as provided in Section 422.64(c)(10). [422.152(b)(5)] 5. External Review: The M+C Organization will have an agreement with an independent quality review and improvement organization (review organization) approved by HCFA. [422.154(a)] (a) The agreement will be consistent with HCFA guidelines and will: (i) Require that the M+C Organization allocate adequate space for use of the review organization whenever it is conducting review activities and provide all pertinent data, including patient care data, at the time the review organization needs the data to carry out the reviews and make its determinations, and (ii) Except in the case of complaints about quality, exclude review activities that HCFA determines would duplicate review activities conducted as part of an accreditation process or as part of HCFA monitoring. [422.154(b)] F. COMPLIANCE PLAN 1. The M+C Organization agrees to develop and submit a compliance plan that includes the elements set forth below, and fully implement all elements of this plan by December 31, 1999. HCFA will consider the M+C Organization's progress in implementing this requirement as a factor in its decision, required by May 1, 1999, to renew the M+C Organization's contract for 2000. The compliance plan required under this article shall consist of the following: (a) Written policies, procedures, and standards of conduct that articulate the M+C Organization's commitment to comply with all applicable Federal and State standards. 8 (b) The designation of a compliance officer and compliance committee that are accountable to senior management. (c) Effective training and education between the compliance officer and organization employees. (d) Effective lines of communication between the compliance officer and the organization's employees. (e) Enforcement of standards through well-publicized disciplinary guidelines. (f) Provision for internal monitoring and auditing. 2. The M+C Organization's compliance plan shall operate in such a manner as to ensure a prompt organizational response to detected offenses and development of corrective action initiatives. The compliance plan shall also establish an adhered-to process for reporting to HCFA and/or the Office of the Inspector General credible information of violations of law by the M+C Organization, plan, subcontractors or enrollees for a determination as to whether criminal, civil, or administrative action may be appropriate. With respect to enrollees, this reporting requirement shall be restricted to credible information on violations of law with respect to enrollment in the plan, or the provision of, or payment for, health services. When the potential violation of law concerns potential false claims or fraud on the United States, the M+C Organization shall report the information directly to HCFA and/or the OIG and shall not file actions under the qui tam provisions of the False Claims Act, 31 U.S.C. 3729, et seq. [422.501(b)(3)(vi)] G. YEAR 2000 READINESS The M+C Organization shall ensure that all necessary actions and system changes to internal mission-critical systems have been made and tested so that they are Year 2000 compliant. Year 2000 compliant means information technology that accurately processes date and time data (including, but not limited to, calculating, comparing, and sequencing) from, into, and between the nineteenth, twentieth, and twenty-first centuries, and the years 1999 and 2000 and leap year calculations. Furthermore, Year 2000 compliant information technology, when used in combination with other information technology, must accurately process date and time data if the other information technology properly exchanges date and time data with it. Mission-critical systems are defined as those systems and interfaces which materially affect the M+C Organization's accurate and timely performance of the functions under this contract. [422.502(j)] Article IV 9 HCFA Payment to M+C Organization A. The M+C Organization agrees to develop its annual adjusted community rate (ACR) proposal and submit to HCFA all required information on premiums, benefits, and cost sharing by May 1 of each year, as required under 42 CFR 422, subpart G. [422.502(a)(10)] B. Methodology. HCFA agrees to pay the M+C Organization under this contract in accordance with the payment rules in subpart F of part 422. HCFA agrees to make monthly payments based on the greatest of the blended capitation rate under Section 422.252(a), the minimum amount rate under Section 422.252(b), or the minimum percentage increase rate under Section 422.252(c), as adjusted by such demographic risk factors as a beneficiary's age, disability status, sex, institutional status, and such factors as HCFA determines appropriate per Section 422.250(a) [422.502(a)(9)] C. Certification of data that determine payment. As a condition for receiving a monthly payment under paragraph B of this article, subpart F of part 422, the M+C Organization agrees that its chief executive officer (CEO) or chief financial officer (CFO) must request payment under the contract on the forms attached as Attachment A (enrollment certification) and Attachment B (inpatient encounter data and adjusted community rate (ACR) proposal information certification) hereto which certify the accuracy, completeness, and truthfulness of the data identified on these attachments. Attachment A requires certification based on best knowledge, information, and belief, that each enrollee for whom the M+C Organization is requesting payment is validly enrolled in an M+C plan offered by the M+C Organization. The M+C Organization shall submit completed enrollment certification forms to HCFA on a monthly basis. In addition, the following certifications shall be made on Attachment B by the CEO or CFO of an M+C Organization when the M+C Organization submits the following types of information to HCFA: (1) Based on best knowledge, information, and belief, the inpatient encounter data the M+C Organization submits under Section 422.257 are accurate, complete, and truthful. If such encounter data are generated by a related entity, contractor, or subcontractor of the M+C Organization, such entity, contractor, or subcontractor must similarly certify the accuracy, completeness, and truthfulness of the data.[422.502(l)] (2) Based on best knowledge, information, and belief, all information and documentation comprising the ACR proposal are accurate, complete, and truthful. The M+C Organization must submit its ACR proposal(s) to HCFA by May 1 of each year. [422.502(m)] Article V 10 M+C Organization Relationship with Related Entities, Contractors, and Subcontractors A. Notwithstanding any relationship(s) that the M+C Organization may have with related entities, contractors, or subcontractors, the M+C Organization maintains full responsibility for adhering to and otherwise fully complying with all terms and conditions of its contract with HCFA. [422.502(i)(1)] B. The M+C Organization agrees to require all related entities, contractors, or subcontractors to agree that- (1) HHS, the Comptroller General, or their designees have the right to inspect, evaluate, and audit any pertinent contracts, books, documents, papers, and records of the related entity(s), contractor(s),or subcontractor(s) involving transactions related to the this contract; and (2) HHS's, the Comptroller General's, or their designee's right to inspect, evaluate, and audit any pertinent information for any particular contract period will exist through 6 years from the final date of the contract period or from the date of completion of any audit, whichever is later. [422.502(i)(2)] C. The M+C Organization agrees that all contracts or written arrangements into which the M+C Organization enters with providers, related entities, contractors, or subcontractors on or after January 1, 1999 shall contain each of the contract elements stated below. For those providers, related entities, contractors, or subcontractors with which the M+C Organization has a contract or written agreement prior to January 1, 1999, the M+C Organization agrees to design and implement a plan for securing on or before December 31, 1999 contracts or written arrangements with such parties which contain each of the contract elements stated below. HCFA will consider the M+C Organization's progress in implementing this requirement as a factor in its decision, required by May 1, 1999, to renew the M+C Organization's contract for 2000. The required contract elements are as follows: (1) Enrollee protection provisions that provide- (a) Consistent with Article III(C), arrangements that prohibit providers from holding an enrollee liable for payment of any fees that are the legal obligation of the M+C Organization; and (b) Consistent with Article III(C), provision for the continuation of benefits. (2) Accountability provisions that indicate that- 11 (a) The M+C Organization oversees and is accountable to HCFA for any functions or responsibilities that are described in these standards; and (b) The M+C Organization may only delegate activities or functions to a provider, related entity, contractor, or subcontractor in a manner consistent with requirements set forth at paragraph D of this article. (3) A provision requiring that any services or other activity performed by a related entity, contractor or subcontractor in accordance with a contract or written agreement between the related entity, contractor, or subcontractor and the M+C Organization will be consistent and comply with the M+C Organization's contractual obligations. [422.502(i)(3)] D. If any of the M+C Organization's activities or responsibilities under this contract with HCFA are delegated to other parties, the following requirements apply to any related entity, contractor, subcontractor, or provider: (1) Written arrangements must specify delegated activities and reporting responsibilities. (2) Written arrangements must either provide for revocation of the delegation activities and reporting requirements or specify other remedies in instances where HCFA or the M+C Organization determine that such parties have not performed satisfactorily. (3) Written arrangements must specify that the performance of the parties is monitored by the M+C Organization on an ongoing basis. (4) Written arrangements must specify that either- (a) The credentials of medical professionals affiliated with the party or parties will be either reviewed by the M+C Organization; or (b) The credentialing process will be reviewed and approved by the M+C Organization and the M+C Organization must audit the credentialing process on an ongoing basis. (5) All contracts or written arrangements must specify that the related entity, contractor, or subcontractor must comply with all applicable Medicare laws, regulations, and HCFA instructions. [422.502(i)(4)] E. If the M+C Organization delegates selection of the providers, contractors, or subcontractors to another organization, the M+C Organization's written arrangements with that organization must state that the M+C Organization retains the right to approve, suspend, or terminate any such arrangement. [422.502(i)(5)] Article VI 12 Records Requirements A. MAINTENANCE OF RECORDS 1. The M+C Organization agrees to maintain for 6 years books, records, documents, and other evidence of accounting procedures and practices that- (a) Are sufficient to do the following: (i) Accommodate periodic auditing of the financial records (including data related to Medicare utilization, costs, and computation of the ACR) of the M+C Organization. (ii) Enable HCFA to inspect or otherwise evaluate the quality, appropriateness and timeliness of services performed under the contract, and the facilities of the M+C Organization. (iii) Enable HCFA to audit and inspect any books and records of the M+C Organization that pertain to the ability of the organization to bear the risk of potential financial losses, or to services performed or determinations of amounts payable under the contract. (iv) Properly reflect all direct and indirect costs claimed to have been incurred and used in the preparation of the ACR proposal. (v) Establish component rates of the ACR for determining additional and supplementary benefits. (vi) Determine the rates utilized in setting premiums for State insurance agency purposes and for other government and private purchasers; and (b) Include at least records of the following: (i) Ownership and operation of the M+C Organization's financial, medical, and other record keeping systems. (ii) Financial statements for the current contract period and six prior periods. (iii) Federal income tax or informational returns for the current contract period and six prior periods. (iv) Asset acquisition, lease, sale, or other action. (v) Agreements, contracts, and subcontracts. 13 (vi) Franchise, marketing, and management agreements. (vii) Schedules of charges for the M+C Organization's fee-for-service patients. (viii) Matters pertaining to costs of operations. (ix) Amounts of income received, by source and payment. (x) Cash flow statements. (xi) Any financial reports filed with other Federal programs or State authorities. [422.502(d)] 2. Access to facilities and records. The M+C Organization agrees to the following: (a) The Department of Health and Human Services (HHS), the Comptroller General, or their designee may evaluate, through inspection or other means- (i) The quality, appropriateness, and timeliness of services furnished to Medicare enrollees under the contract; (ii) The facilities of the M+C Organization; and (iii) The enrollment and disenrollment records for the current contract period and six prior periods. (b) HHS, the Comptroller General, or their designees may audit, evaluate, or inspect any books, contracts, medical records, documents, papers, patient care documentation, and other records of the M+C Organization, related entity, contractor, subcontractor, or its transferee that pertain to any aspect of services performed, reconciliation of benefit liabilities, and determination of amounts payable under the contract, or as the Secretary may deem necessary to enforce the contract. (c) The M+C Organization agrees to make available, for the purposes specified in section (A) of this article, its premises, physical facilities and equipment, records relating to its Medicare enrollees, and any additional relevant information that HCFA may require, in a manner that meets HCFA record maintenance requirements. (d) HHS, the Comptroller General, or their designee's right to inspect, evaluate, and audit extends through 6 years from the final date of the contract period or completion of audit, whichever is later unless- (i) HCFA determines there is a special need to retain a particular record or group of records for a longer period and notifies the M+C Organization at least 30 days before the normal disposition date; 14 (ii) There has been a termination, dispute, or fraud or similar fault by the M+C Organization, in which case the retention may be extended to 6 years from the date of any resulting final resolution of the termination, dispute, or fraud or similar fault; or (iii) HHS, the Comptroller General, or their designee determine that there is a reasonable possibility of fraud, in which case they may inspect, evaluate, and audit the M+C Organization at any time. [422.502(e)] B. REPORTING REQUIREMENTS 1. The M+C Organization shall have an effective procedure to develop, compile, evaluate, and report to HCFA, to its enrollees, and to the general public, at the times and in the manner that HCFA requires, and while safeguarding the confidentiality of the doctor-patient relationship, statistics and other information as described in the remainder of this section (B). [422.516(a)] 2. The M+C Organization agrees to submit to HCFA certified financial information that must include the following: (a) Such information as HCFA may require demonstrating that the organization has a fiscally sound operation, including: (i) The cost of its operations; (ii) A description, submitted to HCFA annually and within 120 days of the end of the fiscal year, of significant business transactions (as defined in Section 422.500) between the M+C Organization and a party in interest showing that the costs of the transactions listed in paragraph (1)(d) of this section do not exceed the costs that would be incurred if these transactions were with someone who is not a party in interest; or (iii) If they do exceed, a justification that the higher costs are consistent with prudent management and fiscal soundness requirements. (iv) A combined financial statement for the M+C Organization and a party in interest if either of the following conditions is met: (aa) Thirty-five percent or more of the costs of operation of the M+C Organization go to a party in interest. (bb) Thirty-five percent or more of the revenue of a party in interest is from the M+C Organization. [422.516(b)] 15 (v) Requirements for combined financial statements. (aa) The combined financial statements required by paragraph (1)(c) must display in separate columns the financial information for the M+C Organization and each of the parties in interest. (bb) Inter-entity transactions must be eliminated in the consolidated column. (cc) The statements must have been examined by an independent auditor in accordance with generally accepted accounting principles and must include appropriate opinions and notes. (dd) Upon written request from the M+C Organization showing good cause, HCFA may waive the requirement that the organization's combined financial statement include the financial information required in this paragraph (1)(d) with respect to a particular entity. [422.516(c)] (vi) A description of any loans or other special financial arrangements the M+C Organization makes with contractors, subcontractors, and related entities. (b) Such information as HCFA may require pertaining to the disclosure of ownership and control of the M+C Organization. [422.502(f)(1)(ii)] (c) Patterns of utilization of the M+C Organization's services. 3. The M+C Organization agrees to participate in surveys required by HCFA and to submit to HCFA all information that is necessary for HCFA to administer and evaluate the program and to simultaneously establish and facilitate a process for current and prospective beneficiaries to exercise choice in obtaining Medicare services. This information includes, but is not limited to: (a) The benefits covered under the M+C plan; (b) The M+C monthly basic beneficiary premium and M+C monthly supplemental beneficiary premium, if any, for the plan. (c) The service area and continuation area, if any, of each plan and the enrollment capacity of each plan; (d) Plan quality and performance indicators for the benefits under the plan including - (i) Disenrollment rates for Medicare enrollees electing to receive benefits through the plan for the previous 2 years; 16 (ii) Information on Medicare enrollee satisfaction; (iii) The patterns of utilization of plan services; (iv) The availability, accessibility, and acceptability of the plan's services; (v) Information on health outcomes and other performance measures required by HCFA; (vi) The recent record regarding compliance of the plan with requirements of this part, as determined by HCFA; and (vii) Other information determined by HCFA to be necessary to assist beneficiaries in making an informed choice among M+C plans and traditional Medicare; (e) Information about beneficiary appeals and their disposition; (f) Information regarding all formal actions, reviews, findings, or other similar actions by States, other regulatory bodies, or any other certifying or accrediting organization; (g) Any other information deemed necessary by HCFA for the administration or evaluation of the Medicare program. [422.502(f)(2)] 4. The M+C Organization agrees to provide to its enrollees and upon request, to any individual eligible to elect an M+C plan, all informational requirements under Section 422.64 and, upon an enrollee's, request, the financial disclosure information required under Section 422.516. [422.502(f)(3)] 5. Reporting and disclosure under ERISA. (a) For any employees' health benefits plan that includes an M+C Organization in its offerings, the M+C Organization must furnish, upon request, the information the plan needs to fulfill its reporting and disclosure obligations (with respect to the M+C Organization) under the Employee Retirement Income Security Act of 1974 (ERISA). (b) The M+C Organization must furnish the information to the employer or the employer's designee, or to the plan administrator, as the term "administrator" is defined in ERISA. [422.516(d)] 6. Electronic communication. The M+C Organization must have the capacity to communicate with HCFA electronically. [422.502(b)] 7. Encounter data. The M+C Organization agrees to comply with the requirements in Section 422.257 for submitting encounter data to HCFA. [422.502(a)(8)] 17 Article VII Renewal of the M+C Contract A. Renewal of contract: In accordance with Section 422.506, the contract is renewable annually only if- (1) HCFA informs the M+C Organization that it authorizes a renewal; and (2) The M+C Organization has not provided HCFA with a notice of intention not to renew. [422.504(c)] B. Nonrenewal of contract: (1) Nonrenewal by the Organization. (a) In accordance with Section 422.506, the M+C Organization may elect not to renew its contract with HCFA as of the end of the term of the contract for any reason, provided it meets the time frames for doing so set forth in paragraphs (b) and (c) of this paragraph. (b) If the M+C Organization does not intend to renew its contract, it must notify- (i) HCFA in writing, by May 1 of the year in which the contract would end; (ii) Each Medicare enrollee, at least 90 days before the date on which the nonrenewal is effective. This notice must include a written description of all alternatives available for obtaining Medicare services within the service area of the M+C plans that the M+C Organization offers, including alternative M+C plans, original Medicare, and Medigap options and must receive HCFA approval. (iii) The general public, at least 90 days before the end of the current calendar year, by publishing a HCFA-approved notice in one or more newspapers of general circulation in each community located in the M+C Organization's service area. (c) HCFA may accept a nonrenewal notice submitted after May 1 if- (i) The M+C Organization notifies its Medicare enrollees and the public in accordance with paragraph (1)(b)(ii) and (1)(b)(iii) of this section; and (ii) Acceptance is not inconsistent with the effective and efficient administration of the Medicare program. 18 (d) If the M+C Organization does not renew a contract under this paragraph (1), HCFA will not enter into a contract with the Organization for 5 years from the date of contract separation unless there are special circumstances that warrant special consideration, as determined by HCFA. [422.506(a)] (2) HCFA decision not to renew. (a) HCFA may elect not to authorize renewal of a contract for any of the following reasons: (i) The M+C Organization has not fully implemented or shown discernable progress in implementing quality assessment and performance improvement projects as defined in Section 422.152(d). (ii) The M+C Organization's level of enrollment, growth in enrollment, or insufficient number of contracted providers is determined by HCFA to threaten the viability of the organization under the M+C program and or be an indicator of beneficiary dissatisfaction with the M+C plan(s) offered by the organization. (iii) For any of the reasons listed in Section 422.510(a) [Article VII, section (B)(1)(a) of this contract], which would also permit HCFA to terminate the contract. (iv) The M+C Organization has committed any of the acts in Section 422.752(a) that would support the imposition of intermediate sanctions or civil money penalties under subpart O of part 422. (b) Notice. HCFA shall provide notice of its decision whether to authorize renewal of the contract as follows: (i) To the M+C Organization by May 1 of the contract year. (ii) To the M+C Organization's Medicare enrollees by mail at least 90 days before the end of the current calendar year. (iii) To the general public at least 90 days before the end of the current calendar year, by publishing a notice in one or more newspapers of general circulation in each community or county located in the M+C Organization's service area. (c) Notice of appeal rights. HCFA shall give the M+C Organization written notice of its right to reconsideration of the decision not to renew in accordance with Section 422.644. [422.506(b)] Article VIII 19 Modification or Termination of the Contract A. Modification or Termination of Contract by Mutual Consent 1. The M+C Organization agrees to include in this contract such other terms and conditions as HCFA may find necessary and appropriate in order to implement the requirements of the M+C program. 2. This contract may be modified or terminated at any time by written mutual consent. (a) If the contract is terminated by mutual consent, except as provided in section (A)(3) of this article, the M+C Organization must provide notice to its Medicare enrollees and the general public as provided in Section 422.512(b)(2) and (b)(3) [Article VIII, section B(2)(b) of this contract]. (b) If the contract is modified by mutual consent, the M+C Organization must notify its Medicare enrollees of any changes that HCFA determines are appropriate for notification within time frames specified by HCFA. 3. If this contract is terminated by mutual consent and replaced the day following such termination by a new M+C contract, the M+C Organization is not required to provide the notice specified in section B of this article. [422.508] B. Termination of the Contract by HCFA or the M+C Organization 1. Termination by HCFA. (a) HCFA may terminate a contract for any of the following reasons: (i) The M+C Organization has failed substantially to carry out the terms of its contract with HCFA. (ii) The M+C Organization is carrying out its contract with HCFA in a manner that is inconsistent with the effective and efficient implementation of this part. (iii) HCFA determines that the M+C Organization no longer meets the requirements of this part for being a contracting organization. (iv) The M+C Organization commits or participates in fraudulent or abusive activities affecting the Medicare program, including submission of fraudulent data. (v) The M+C Organization experiences financial difficulties so severe that its ability to make necessary health services available is impaired to the point of posing an imminent 20 and serious risk to the health of its enrollees, or otherwise fails to make services available to the extent that such a risk to health exists. (vi) The M+C Organization substantially fails to comply with the requirements in subpart M of this part relating to grievances and appeals. (vii) The M+C Organization fails to provide HCFA with valid encounter data as required under Section 422.257. (viii) The M+C Organization fails to implement an acceptable quality assessment and performance improvement program as required under subpart D of Section 422. (ix) The M+C Organization substantially fails to comply with the prompt payment requirements in Section 422.520. (x) The M+C Organization substantially fails to comply with the service access requirements in Section 422.112 or Section 422.114. (xi) The M+C Organization fails to comply with the requirements of Section 422.208 regarding physician incentive plans. (b) Notice. If HCFA decides to terminate a contract for reasons other than the grounds specified in section (B)(1)(a) above, it will give notice of the termination as follows: (i) HCFA will notify the M+C Organization in writing 90 days before the intended date of the termination. (ii) The M+C Organization will notify its Medicare enrollees of the termination by mail at least 30 days before the effective date of the termination. (iii) The M+C Organization will notify the general public of the termination at least 30 days before the effective date of the termination by publishing a notice in one or more newspapers of general circulation in each community or county located in the M+C Organization's service area. (c) Immediate termination of contract by HCFA. (i) For terminations based on violations prescribed in paragraph (B)(1)(a)(v) of this article, HCFA will notify the M+C Organization in writing that its contract has been terminated effective the date of the termination decision by HCFA. If termination is effective in the middle of a month, HCFA has the right to recover the prorated share of the capitation payments made to the M+C Organization covering the period of the month following the contract termination. 21 (ii) HCFA will notify the M+C Organization's Medicare enrollees in writing of HCFA's decision to terminate the M+C Organization's contract. This notice will occur no later than 30 days after HCFA notifies the plan of its decision to terminate this contract. HCFA will simultaneously inform the Medicare enrollees of alternative options for obtaining Medicare services, including alternative M+C Organizations in a similar geographic area and original Medicare. (iii) HCFA will notify the general public of the termination no later than 30 days after notifying the M+C Organization of HCFA's decision to terminate this contract. This notice will be published in one or more newspapers of general circulation in each community or county located in the M+C Organization's service area. (d) Corrective action plan (i) General. Before terminating a contract for reasons other than the grounds specified in section (B)(1)(a)(v) of this article, HCFA will provide the M+C Organization with reasonable opportunity, not to exceed time frames specified at subpart N of Section 422, to develop and receive HCFA approval of a corrective action plan to correct the deficiencies that are the basis of the proposed termination. (ii) Exception. If a contract is terminated under section (B)(1)(a)(v) of this article, the M+C Organization will not have the opportunity to submit a corrective action plan. (e) Appeal rights. If HCFA decides to terminate this contract, it will send written notice to the M+C Organization informing it of its termination appeal rights in accordance with subpart N of Section 422. [422.510] 2. Termination by the M+C Organization (a) Cause for termination. The M+C Organization may terminate this contract if HCFA fails to substantially carry out the terms of the contract. (b) Notice. The M+C Organization must give advance notice as follows: (i) To HCFA, at least 90 days before the intended date of termination. This notice must specify the reasons why the M+C Organization is requesting contract termination. (ii) To its Medicare enrollees, at least 60 days before the termination effective date. This notice must include a written description of alternatives available for obtaining Medicare services within the service area, including alternative M+C plans, Medigap options, and original Medicare and must receive HCFA approval. (iii) To the general public at least 60 days before the termination effective date by publishing a HCFA-approved notice in one or more newspapers of general circulation in each community or county located in the M+C Organization's geographic area. 22 (c) Effective date of termination. The effective date of the termination will be determined by HCFA and will be at least 90 days after the date HCFA receives the M+C Organization's notice of intent to terminate. (d) HCFA's liability. HCFA's liability for payment to the M+C Organization ends as of the first day of the month after the last month for which the contract is in effect. (e) Effect of termination by the organization. HCFA will not enter into an agreement with the M+C Organization for a period of five years from the date the Organization has terminated this contract, unless there are circumstances that warrant special consideration, as determined by HCFA. [422.512] Article IX Requirements of Other Laws and Regulations A. The M+C Organization agrees to comply with- (1) Title VI of the Civil Rights Act of 1964 as implemented by regulations at 45 CFR part 84; (2) The Age Discrimination Act of 1975 as implemented by regulations at 45 CFR part 91; (3) The Americans With Disabilities Act; and (4) Other laws applicable to recipients of Federal funds; and (5) All other applicable laws, regulations, and rules. [422.502(h)(1)] B. The M+C Organization is receiving Federal payments under this contract, and related entities, contractors, and subcontractors paid by the M+C Organization to fulfill its obligations under this contract are subject to certain laws that are applicable to individuals and entities receiving Federal funds. The M+C Organization agrees to inform all related entities, contractors and subcontractors that payments that they receive are, in whole or in part, from Federal funds. [422.502(h)(2)] C. In the event that any provision of this contract conflicts with the provisions of any statute or regulation applicable to an M+C Organization, the provisions of the statute or regulation shall have full force and effect. [422.502(j)] 23 Article X Severability The M+C Organization agrees that, upon HCFA's request, this contract will be amended to exclude any M+C plan or State-licensed entity specified by HCFA, and a separate contract for any such excluded plan or entity will be deemed to be in place when such a request is made.[422.502(k)] In witness whereof, the parties hereby execute this contract. FOR THE M+C ORGANIZATION - ---------------------------- -------------------------- Printed Name Title - ---------------------------- --------------------------- Signature Date - ---------------------------- --------------------------- Organization - --------------------------- Address FOR THE HEALTH CARE FINANCING ADMINISTRATION - -------------------------- Gary A. Bailey Director, Health Plan Purchasing and Administration Group Center for Health Plans and Providers 24 ATTACHMENT A CERTIFICATION OF ENROLLMENT INFORMATION RELATING TO HCFA PAYMENT TO A MEDICARE+CHOICE ORGANIZATION Pursuant to the contract(s) between the Health Care Financing Administration (HCFA) and (INSERT NAME OF M+C ORGANIZATION), hereafter referred to as the "M+C Organization," governing the operation of the following Medicare +Choice plans (INSERT PLAN IDENTIFICATION NUMBERS HERE), the M+C Organization hereby requests payment under the contract, and in doing so, makes the following certifications concerning HCFA payments to the M+C Organization. The M+C Organization acknowledges that the information described below directly affects the calculation of HCFA payments to the M+C Organization and that misrepresentations to HCFA about the accuracy of such information may result in Federal civil action and/or criminal prosecution. 1. The M+C Organization has reported to HCFA for the month of (INDICATE MONTH AND YEAR) all new enrollments, disenrollments, and changes in enrollees' institutional status with respect to the above-stated M+C plans. Based on best knowledge, information, and belief, all information submitted to HCFA in this report is accurate, complete, and truthful. 2. The M+C Organization has reviewed the HCFA monthly membership report and reply listing for the month of (INDICATE MONTH AND YEAR) for the above-stated M+C plans and has reported to HCFA any discrepancies between the report and the M+C Organization's records. For those portions of the monthly membership report and the reply listing to which the M+C Organization raises no objection, the M+C Organization, through the certifying CEO/CFO, will be deemed to have attested, based on best knowledge, information, and belief, to their accuracy, completeness, and truthfulness. - ----------------------------- (INDICATE TITLE [CEO or CFO]) on behalf of (INDICATE M+C ORGANIZATION) 25 ATTACHMENT B CERTIFICATION OF ENCOUNTER AND ADJUSTED COMMUNITY RATE INFORMATION RELATING TO HCFA PAYMENT TO A MEDICARE+CHOICE ORGANIZATION Pursuant to the contract(s) between the Health Care Financing Administration (HCFA) and (INSERT NAME OF M+C ORGANIZATION), hereafter referred to as the "M+C Organization," governing the operation of the following Medicare +Choice plans (INSERT PLAN IDENTIFICATION NUMBERS HERE), the M+C Organization hereby requests payment under the contract, and in doing so, makes the following certifications concerning HCFA payments to the M+C Organization. The M+C Organization acknowledges that the information described below directly affects the calculation of HCFA payments to the M+C Organization or additional benefit obligations of the M+C Organization and that misrepresentations to HCFA about the accuracy of such information may result in Federal civil action and/or criminal prosecution. 1. The M+C Organization has reported to HCFA for the period of (INDICATE DATES) all inpatient encounter data with respect to the above-stated M+C plans. Based on best knowledge, information, and belief, all information submitted to HCFA in this report is accurate, complete, and truthful. 2. The M+C Organization has submitted to HCFA an adjusted community rate (ACR) proposal for the period (INDICATE DATES). Based on best knowledge, information, and belief, all of the information submitted to HCFA in this ACR proposal is accurate, complete, and truthful. - ----------------------------- (INDICATE TITLE [CEO or CFO]) on behalf of (INDICATE M+C ORGANIZATION) EX-10.12 6 1ST AM. TO AMENDED 1997 PREMIUM PRICED STOCK OPTIO 1 EXHIBIT 10.12 FIRST AMENDMENT TO THE AMENDED 1997 PREMIUM PRICED STOCK OPTION PLAN This First Amendment, dated as of August 27, 1998 (the "Amendment"), to the Amended 1997 Premium Priced Stock Option Plan ("Plan") hereby amends the Plan as follows: 1. Amendment to Section 4.2(b). Section 4.2 (b) is hereby amended and restated in its entirety to read as follows: Section 4.2 - Commencement of Exercisability (b) Subject to the provisions of Section 4.2(a), 4.2(c) and 7.2, Options shall become exercisable in two installments as follows: (i) The first installment shall consist of 50 percent of the shares covered by the Option and shall become exercisable if, within three years from October 6, 1997, the Class B Common Stock achieves a last reported sales price, as reported by Nasdaq, of at least $92.50 during any 12 month period. (ii) The second installment shall consist of the remaining 50 percent of the shares covered by the Option and shall become exercisable if, within five years from October 6, 1997, the Class B Common Stock achieves a last reported sales price, as reported by Nasdaq, of at least $114.00 during any 12 month period. 2. Amendment to Sections 4.3(a) and (b). Sections 4.3 (a) and (b) are hereby amended and restated in their entirety to read as follows: Section 4.3 - Expiration of Options (a) Fifty percent of the Options shall expire on October 6, 2000, if the $92.50 stock price is not achieved by such date. (b) The remaining 50 percent of the Options shall expire on October 6, 2002 if the $114.00 stock price is not achieved. 3. Effectiveness of Plan. Except as expressly amended herein, the Plan shall continue in full force and effect and is hereby ratified and confirmed in all respects on as of the date hereof. 4. Governing Law. This Amendment and the Plan shall be construed, interpreted and enforced in accordance with the laws of the United States and to the extent not preempted by such law by the laws of the State of California. 1 2 5. Capitalized Terms. Capitalized terms not defined herein shall have the meanings ascribed to them in the Plan. 6. Section Headings. The titles of the sections hereof appear as a matter of convenience only, do not constitute a part of this Amendment and shall not affect the construction hereof. 2 EX-21 7 LIST OF SUBSIDIARIES 1 EXHIBIT 21 PACIFICARE HEALTH SYSTEMS, INC. LIST OF SUBSIDIARIES
NAME OF SUBSIDIARY STATE OF INCORPORATION/PARTNERSHIP ------------------ ---------------------------------- CRM Insurance Services, Inc. California FHP International Corporation Delaware FHP Reinsurance Limited Bermuda Health Maintenance Life, Inc. Guam PacifiCare Behavioral Health of California, Inc. Delaware PacifiCare Behavioral Health, Inc. Delaware PacifiCare Benefit Administrators, Inc. Washington PacifiCare Credentialing, Inc. California PacifiCare Dental and Vision California PacifiCare Dental of Colorado, Inc. Colorado PacifiCare Health Plan Administrators, Inc. Indiana PacifiCare Life and Health Insurance Company Indiana PacifiCare Life Assurance Company Colorado PacifiCare Life Insurance Company Arizona PacifiCare of Arizona, Inc. Arizona PacifiCare of California California PacifiCare of Colorado, Inc. Colorado PacifiCare of Nevada, Inc. Nevada PacifiCare of Ohio, Inc. Ohio PacifiCare of Oklahoma, Inc. Oklahoma PacifiCare of Oregon, Inc. Oregon PacifiCare of Texas, Inc. Texas PacifiCare of Washington, Inc. Washington PacifiCare Operations, Inc. Delaware PacifiCare Pharmacy Centers, Inc. California PacifiCare Ventures, Inc. California PC-CWD Vista Associates California Secure Horizons USA, Inc. California
EX-23 8 CONSENT OF ERNST & YOUNG LLP INDEPENDENT AUDITORS 1 EXHIBIT 23 CONSENT OF ERNST & YOUNG LLP INDEPENDENT AUDITORS We consent to the incorporation by reference in the Registration Statement (Form S-8 number 333-21713) and related Prospectus pertaining to the 1996 Stock Option Plan for Officers and Key Employees and the related Prospectus pertaining to the 1996 Non-Officer Directors Stock Option Plan of PacifiCare Health Systems, Inc. and in the Registration Statement (Form S-8 number 333-48377) and related Prospectus pertaining to the 1997 Premium Priced Stock Option Plan and the related Prospectus pertaining to the Amendment and Restatement of the PacifiCare Health Systems, Inc. Savings and Profit-Sharing Plan of PacifiCare Health Systems, Inc. of our report dated February 9, 1999 with respect to the consolidated financial statements and schedule of PacifiCare Health Systems, Inc. included in the Annual Report on Form 10-K for the year ended December 31, 1998. ERNST & YOUNG LLP Los Angeles, California February 19, 1999 EX-27 9 FINANCIAL DATA SCHEDULE
5 This schedule contains summary financial information extracted from PacifiCare Health Systems, Inc.'s consolidated balance sheets as of December 31, 1998 and December 31, 1997 and related consolidated statements of operations for the years ended December 31, 1998 and December 31, 1997 and is qualified in its entirety by reference to such financial statements. 1,000 12-MOS 12-MOS DEC-31-1998 DEC-31-1997 JAN-01-1998 JAN-01-1997 DEC-31-1998 DEC-31-1997 724,636 680,674 875,553 864,708 284,484 319,243 8,529 13,598 0 0 2,033,575 2,090,146 288,987 365,382 110,467 129,439 4,630,944 4,963,046 1,619,416 1,728,664 0 0 0 0 0 105 464 420 2,237,632 2,061,662 4,630,944 4,963,046 0 0 9,521,482 8,982,680 0 0 8,002,260 7,658,879 1,175,546 1,274,635 1,485 5,171 60,923 64,536 385,574 60,124 183,147 81,825 202,427 (21,701) 0 0 0 0 0 0 202,427 (21,701) 4.50 (0.75) 4.40 (0.75)
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