-----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, Tx4Q/PWIi3oJr21kgSmfC1t7o/3JtIQex7mDAX6ttuJGsAHHPtKj5DJpmptipLCf 8XZEN4Mdyn97AF4Y3bxosg== 0000049071-95-000025.txt : 19951026 0000049071-95-000025.hdr.sgml : 19951026 ACCESSION NUMBER: 0000049071-95-000025 CONFORMED SUBMISSION TYPE: 8-K PUBLIC DOCUMENT COUNT: 2 CONFORMED PERIOD OF REPORT: 19951011 ITEM INFORMATION: Acquisition or disposition of assets ITEM INFORMATION: Financial statements and exhibits FILED AS OF DATE: 19951025 SROS: NYSE FILER: COMPANY DATA: COMPANY CONFORMED NAME: HUMANA INC CENTRAL INDEX KEY: 0000049071 STANDARD INDUSTRIAL CLASSIFICATION: HOSPITAL & MEDICAL SERVICE PLANS [6324] IRS NUMBER: 610647538 STATE OF INCORPORATION: DE FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 8-K SEC ACT: 1934 Act SEC FILE NUMBER: 001-05975 FILM NUMBER: 95584103 BUSINESS ADDRESS: STREET 1: 500 W MAIN ST CITY: LOUISVILLE STATE: KY ZIP: 40202 BUSINESS PHONE: 5025803708 FORMER COMPANY: FORMER CONFORMED NAME: EXTENDICARE INC DATE OF NAME CHANGE: 19740404 FORMER COMPANY: FORMER CONFORMED NAME: HERITAGE HOUSE OF AMERICA INC DATE OF NAME CHANGE: 19671129 8-K 1 SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 _______________ FORM 8-K CURRENT REPORT Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 Date of Report: October 11, 1995 (Date of Earliest Event Reported) HUMANA INC. (Exact name of Registrant as specified in its Charter) Delaware 1-5975 61-0647538 (State of Incorporation) (Commission (I.R.S. Employer File Number) Identification No.) 500 West Main Street, Louisville, Kentucky 40202 (Address of principal executive offices) (Zip Code) (502) 580-1000 (Registrant's telephone number, including area code) 1 of 43 ITEM 2. ACQUISITION OR DISPOSITION OF ASSETS Upon the terms and subject to the conditions set forth in the Offer to Purchase, dated August 16, 1995, (the "Offer"), HEW, Inc., a Delaware corporation (the "Offeror") and a wholly owned subsidiary of Humana Inc., a Delaware corporation (the "Company"), offered to purchase all outstanding shares of common stock, par value $0.01 per share (the "Shares"), of EMPHESYS Financial Group, Inc., a Delaware corporation ("EMPHESYS"), at a purchase price of $37.50 per Share, net to the seller in cash, without interest (the "Offer Price"). The Offer Price was determined by the Company and its investment advisor, Smith Barney Inc., through a valuation of EMPHESYS based upon public information and information provided to the Company. EMPHESYS received an opinion dated August 8, 1995, from Morgan Stanley & Co. Incorporated (EMPHESYS' investment advisor) to the effect that the Offer Price was fair to EMPHESYS' stockholders from a financial point of view. The Offer was made pursuant to the Agreement and Plan of Merger, dated as of August 9, 1995 (the "Merger Agreement"), among the Company, the Offeror and EMPHESYS. The Merger Agreement provided, among other things, that as soon as practicable after the purchase of Shares pursuant to the Offer and the satisfaction of the other conditions set forth in the Merger Agreement and in accordance with the relevant provisions of the General Corporation Law of the State of Delaware (the "DGCL"), the Offeror would be merged with and into EMPHESYS (the "Merger"). Other than as described in the Merger Agreement, there were no material relationships between the Company, the Offeror and EMPHESYS. As a result of all conditions of the tender offer being met, including obtaining all necessary regulatory approvals and the attainment by EMPHESYS of certain specified financial and operational targets, the tender offer was closed and all shares tendered were acquired on October 11, 1995. At the close of the tender, 16,890,756 or 99 percent of the Shares were acquired. Under the DGCL, if 90 percent or more of the shares are acquired, the Merger can be consummated without the vote of the remaining stockholders. The Merger was consummated on October 13, 1995. At the effective time of the Merger, each remaining issued and outstanding Share not purchased in the tender offer was converted into and represented the right to receive the Offer Price. Following consummation of the Merger, EMPHESYS continued as the surviving corporation and became a wholly owned subsidiary of the Company. The aggregate purchase price of approximately $650 million was funded by the Company through available cash, the sale of selected marketable securities and bank borrowings. The bank borrowings of approximately $250 million were pursuant to a credit agreement, as amended and restated, dated as of September 26, 1995, among the Company, Chemical Bank, as agent, and several other banks. 2 ITEM 7. FINANCIAL STATEMENTS AND EXHIBITS Page (a) Financial Statements of Business Acquired EMPHESYS Financial Group, Inc. and Subsidiaries Index to Consolidated Financial Statements Consolidated Balance Sheets as of June 30, 1995 (unaudited) and December 31, 1994 4-5 Consolidated Statements of Income for the three and six month periods ended June 30, 1995 and 1994 (unaudited) 6 Consolidated Statements of Cash Flows for the six months ended June 30, 1995 and 1994 (unaudited) 7 Notes to Consolidated Financial Statements (unaudited) 8-10 Report of Independent Accountants 11 Consolidated Balance Sheets as of December 31, 1994 and 1993 12-13 Consolidated Statements of Income for the years ended December 31, 1994, 1993 and 1992 14 Consolidated Statements of Stockholders' Equity for the years ended December 31, 1994, 1993 and 1992 15 Consolidated Statements of Cash Flows for the years ended December 31, 1994, 1993 and 1992 16 Notes to Consolidated Financial Statements 17-34 (b) Pro forma Financial Information (Unaudited) Introduction to Pro forma Condensed Consolidated Financial Statements 35-36 Pro forma Condensed Consolidated Balance Sheet as of June 30, 1995 37 Pro forma Condensed Consolidated Statement of Income for the six months ended June 30, 1995 38 Notes to Pro forma Condensed Consolidated Financial Statements as of and for the six months ended June 30, 1995 39 Pro forma Condensed Consolidated Statement of Income for the year ended December 31, 1994 40 Notes to Pro forma Condensed Consolidated Statement of Income for the year ended December 31, 1994 41 (c) Exhibit Index 42 3 EMPHESYS FINANCIAL GROUP, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (In thousands, except per share amounts) June 30, December 31, 1995 1994 (unaudited) ASSETS Investments: Securities available for sale, at fair value: Fixed income (amortized cost: 1995--$556,851; 1994--$562,366) $ 580,584 $ 542,150 Equity (cost: 1995--$6,940 and 1994--$7,170) 7,725 7,337 Commercial mortgages 59,478 60,203 Real estate 1,142 1,107 Short-term investments 47,317 34,823 Other investments 4,023 5,200 Total investments 700,269 650,820 Property and equipment: Land 2,071 2,071 Land improvements 3,857 3,857 Building and improvements 25,145 24,820 Office equipment 56,476 51,655 87,549 82,403 Less accumulated depreciation (39,397) (37,646) Net property and equipment 48,152 44,757 Receivables and other assets: Premiums receivable, less allowance for doubtful accounts (1995 and 1994-- $464) 16,675 15,179 Accrued investment income 11,104 12,686 Due from reinsurers 1,767 1,293 Deferred income taxes 22,652 30,012 Other assets 5,884 6,052 Total receivables and other assets 58,082 65,222 Intangible assets: Excess of purchase price over fair value of net assets acquired, less accumulated amortization (1995-- $19,649; 1994--$17,434) 55,504 48,886 Present value of insurance in force and other intangible assets, less accumulated amortization (1995 -- $6,188; 1994 -- $5,171) 7,139 4,304 62,643 53,190 Separate account assets 10,431 12,397 $ 879,577 $ 826,386 See notes to consolidated financial statements. 4 EMPHESYS FINANCIAL GROUP, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (continued) (In thousands, except per share amounts) June 30, December 31, 1995 1994 (unaudited) RESERVES, LIABILITIES AND STOCKHOLDERS' EQUITY Insurance reserves and liabilities: Claim liabilities: Accident and health $ 304,527 $ 296,048 Group life and other 5,932 5,579 Future policy benefits 9,715 9,536 Total insurance reserves and liabilities 320,174 311,163 Other liabilities: Premiums paid in advance 29,628 26,279 Other policyholders' funds 3,683 7,533 Amounts due reinsurers 792 4,072 Accrued expenses and other liabilities 85,104 97,639 Federal income taxes 9,492 10,233 Notes payable 56,380 55,947 Total other liabilities 185,079 201,703 Separate account liabilities 10,431 12,397 Stockholders' equity: Preferred stock ($0.01 par value, 1,000,000 shares authorized, 1995 and 1994 - none outstanding) - - Common stock ($0.01 par value, 50,000,000 shares authorized, June 30, 1995 - 17,063,997 out- standing; December 31, 1994 - 17,025,840 outstanding) 171 170 Additional paid-in capital 170,719 169,279 Retained earnings 179,142 153,653 Unearned compensation - restricted stock awards (2,075) (1,930) Net unrealized gain (loss) on securities available for sale 15,936 (20,049) Total stockholders' equity 363,893 301,123 $ 879,577 $ 826,386 See notes to consolidated financial statements. 5 EMPHESYS FINANCIAL GROUP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME (Unaudited) (In thousands, except per share amounts) Three Months Ended Six Months Ended June 30, June 30, 1995 1994 1995 1994 Premium revenues $ 398,039 $ 341,226 $ 781,933 $ 677,981 Net investment income 13,551 11,749 26,681 23,942 Realized gain on investments 1,212 148 777 647 Administrative fees and other 7,958 5,446 16,512 10,298 Total revenue 420,760 358,569 825,903 712,868 Policy benefits paid or provided 302,643 248,413 587,044 494,419 Salaries and other operating expenses 62,296 54,552 122,498 107,670 Commissions 31,176 26,335 62,512 54,587 Amortization of intangible assets 1,745 1,290 3,233 2,378 Interest expense 1,041 713 2,036 926 Total benefits and expenses 398,901 331,303 777,323 659,980 Income before federal income taxes 21,859 27,266 48,580 52,888 Federal income taxes 8,086 10,114 17,972 19,594 Net income $ 13,773 $ 17,152 $ 30,608 $ 33,294 Net income per common and common equiva- lent share $ 0.81 $ 1.01 $ 1.79 $ 1.96 Net income per common share-assuming full dilution $ 0.81 $ 1.00 $ 1.79 $ 1.95 Dividends declared per share $ 0.15 $ 0.15 $ 0.15 $ 0.15 See notes to consolidated financial statements. 6 EMPHESYS FINANCIAL GROUP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited) (In thousands) Six Months Ended June 30, 1995 1994 Operating activities Net income $ 30,608 $ 33,294 Adjustments to reconcile net income to net cash provided by operating activities: Decrease (increase) in receivables and other assets 26 (2,852) Increase (decrease) in insurance reserves and liabilities 8,681 4,530 Increase (decrease) in other liabilities (13,811) 6,645 Amortization of intangible assets and restricted stock awards 4,527 2,735 Provision for depreciation 5,085 4,261 Provision (credit) for deferred federal income taxes (1,049) 27 Realized gain on investments (777) (647) Net amortization of investment premium (discount) (659) 222 Net cash provided by operating activities 32,631 48,215 Investing activities Purchase of fixed income securities (22,059) (62,501) Purchase of equity securities (12,699) (6,740) Purchase of commercial mortgages - - Proceeds from the sale of fixed income securities 14,978 4,275 Proceeds from the sale of equity securities - 4 Proceeds from maturities, redemptions and principal repayments of fixed income securities 17,012 21,710 Purchase of property and equipment (7,668) (3,879) Carrying value of property and equipment sold 78 37 Other (153) 59 Net cash used in investing activities (10,511) (47,035) Financing activities Dividends paid to stockholders (5,119) (7,687) Repayment of notes payable (275) (914) Decrease in cash overdraft (4,232) (579) Net cash used in financing activities (9,626) (9,180) Increase (decrease) in cash and cash equivalents 12,494 (8,000) Cash and cash equivalents at beginning of period 34,823 8,000 Cash and cash equivalents at end of period $ 47,317 $ - See notes to consolidated financial statements. 7 EMPHESYS FINANCIAL GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JUNE 30, 1995 (Unaudited) 1. Business EMPHESYS Financial Group, Inc. ("EMPHESYS"), through its subsidiary, Employers Health Insurance ("EHI"), is a leading provider of a broad range of employee benefit products to small businesses, including managed care group medical, group life, group dental and group disability income insurance. The Company also provides administrative and managed care services to medium and large employers, flexible benefits services to employers of all sizes, purchasing pool marketing and administration for governmental and private organizations, and distribution of group health insurance products. EMPHESYS operates in one segment - the employer-based, managed care medical and insurance services segment of the insurance industry. 2. Basis of Presentation The consolidated financial statements include the accounts of EMPHESYS and its subsidiaries, collectively referred to as the Company. All significant intercompany transactions have been eliminated. The accompanying financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Certain information and footnote disclosures normally included in complete financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted. The interim financial data is unaudited; however, in the opinion of management, the interim data includes all adjustments (consisting only of normal recurring accruals) necessary for a fair presentation of the results for interim periods. The results of operations for the three and six month periods ended June 30, 1995 is not necessarily indicative of the results to be expected for the year ended December 31, 1995. The accompanying financial statements should be read in conjunction with the consolidated financial statements and footnotes for the year ended December 31, 1994, incorporated by reference in the Company's Annual Report on Form 10-K filed in March 1995 with the Securities and Exchange Commission. 3. Investments The Company's fixed income securities and equity securities (common and non-redeemable preferred stock) are classified as "available for sale" and, accordingly, are carried at fair value. The cost of fixed income securities is adjusted for amortization of premiums and discounts. Unrealized gains and losses associated with available for sale securities are excluded from net income and are recorded as a component of stockholders' equity, net of deferred income taxes. Fixed income securities and equity securities deemed to have declines in value that are other than temporary are written down through the statement of income to carrying values equal to their estimated fair values. Realized gains (losses) on investments are recognized in net income using the specific identification method. 8 EMPHESYS FINANCIAL GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) For the mortgage-backed securities portion of the fixed income securities portfolio, including collateralized mortgage obligations, the Company recognizes income using a constant effective yield based on anticipated prepayments and the estimated economic life of the securities. When actual prepayments differ significantly from anticipated prepayments, the effective yield is recalculated to reflect actual payments to date and anticipated future payments. The net investment in each security is adjusted to the amount that would have existed had the new effective yield been applied since the acquisition of the security. This adjustment is reflected in net investment income. Commercial mortgages are carried at their outstanding principal balances less unaccrued discounts and allowances for loan losses. Real estate, acquired principally through foreclosure, is carried at the lower of depreciated cost or fair value. Short-term and other investments are carried at cost, which approximates fair value. 4. Notes Payable Notes payable consist principally of a $50 million term note payable to Lincoln National Corporation or its subsidiaries issued on March 4, 1994. The principal amount of the term note is payable in full on or before December 31, 1996. The term note bears interest at a variable rate equal to .75% over the three-month LIBOR rate, adjusted quarterly. The rate of interest in effect for the three months ended June 30, 1995 and 1994 was 7% and 4.8%, respectively. For the six months ended June 30, 1995 and 1994, the interest rate was 7.1% and 4.8%, respectively. Interest is payable quarterly through the end of the loan term. The term note is secured by a pledge of 20% of the outstanding common stock of EHI. In addition, the term note contains restrictive covenants which, among other things, limit the acquisition or disposition of assets or business units by EMPHESYS and the repurchase or redemption of EMPHESYS' common stock. The term note contains covenants which impose borrowing limits on the Company and EHI and requires the maintenance of a $200,000,000 minimum level of surplus for EHI. 5. Federal Income Taxes The Company provides for income taxes using the liability method of accounting, whereby deferred income tax assets or liabilities are recognized on the differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. These differences relate primarily to accelerated depreciation on property and equipment, unrealized gains and losses on investment securities, discounting of accident and health claims liabilities for tax purposes, premiums paid in advance, the deferral of certain policy acquisition costs for tax purposes, differences in claims liability reserves calculated for book and tax purposes and the accrual of estimated salvage and subrogation receivable for tax purposes. Such tax assets or liabilities are adjusted regularly to amounts estimated to be receivable or payable based on enacted future tax laws and rates. Valuation allowances are provided for those deferred tax assets whose realization is uncertain. Changes in the valuation allowance related to deferred tax assets provided on unrealized losses on available for sale securities are charged directly to stockholders' equity. 9 EMPHESYS FINANCIAL GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) 6. Contingent Liabilities The Company is involved in various pending or threatened legal proceedings arising from the normal conduct of business. It is management's opinion that these proceedings ultimately will be resolved without materially affecting the financial position of the Company. 7. Earnings per Share Earnings per share are calculated based on the weighted average shares of common stock and common stock equivalents outstanding during the periods presented. Common stock equivalents arising from dilutive stock options are computed using the treasury stock method. 8. Dividends On August 2, 1995, the Company's Board of Directors declared a quarterly dividend of $0.15 per share, payable on September 15, 1995 to shareholders of record on September 1, 1995. 9. Reclassifications Certain 1994 amounts have been reclassified to conform to the 1995 presentation. 10 Report of Ernst & Young, LLP, Independent Auditors The Board of Directors and Stockholders EMPHESYS Financial Group, Inc. and Subsidiaries We have audited the accompanying consolidated balance sheets of EMPHESYS Financial Group, Inc. and Subsidiaries (the "Company") as of December 31, 1994 and 1993, and the related consolidated statements of income, stockholders' equity and cash flows for each of the three years in the period ended December 31, 1994. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements 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 financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the 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 EMPHESYS Financial Group, Inc. and Subsidiaries at December 31, 1994 and 1993, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 1994, in conformity with generally accepted accounting principles. As discussed in Notes 2 and 3 to the consolidated financial statements, in 1993 the Company changed its method of accounting for post-retirement benefits other than pensions, income taxes and certain investments in debt and equity securities. Milwaukee, Wisconsin January 27, 1995 11 EMPHESYS FINANCIAL GROUP, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (in thousands, except share amounts) December 31, 1993 1994 ASSETS Investments: Securities available for sale, at fair value: Fixed income (amortized cost: 1993-- $522,716; 1994--$562,366) $ 563,719 $ 542,150 Equity (cost: 1993--$3,045; and 1994--$7,170) 3,489 7,337 Commercial mortgages, less allowance for losses (1993 - $2,120) 64,027 60,203 Real estate 1,100 1,107 Short-term investments 8,000 34,823 Other investments 3,398 5,200 Total investments 643,733 650,820 Property and equipment: Land 2,071 2,071 Land improvements 3,848 3,857 Building and improvements 24,373 24,820 Office equipment 41,757 51,655 72,049 82,403 Less accumulated depreciation (29,757) (37,646) Net property and equipment 42,292 44,757 Receivables and other assets: Premiums receivable, less allowance for doubtful accounts (1993 - $428; 1994- $464) 8,933 15,179 Accrued investment income 9,686 12,686 Due from reinsurers 2,983 1,293 Deferred income taxes 15,519 30,012 Other assets 4,201 6,052 Total receivables and other assets 41,322 65,222 Intangible assets: Excess of purchase price over fair value of net assets acquired, less accumulated amortization (1993- $13,100; 1994--$17,434) 49,447 48,886 Present value of insurance inforce and other intangible assets, less accumulated amortization (1993 - $4,150; 1994 - $5,171) 2,850 4,304 Total intangible assets 52,297 53,190 Separate account assets 13,899 12,397 $ 793,543 $ 826,386 12 EMPHESYS FINANCIAL GROUP, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS, continued (in thousands, except share amounts) December 31, 1993 1994 RESERVES, LIABILITIES AND STOCKHOLDERS' EQUITY Insurance reserves and liabilities: Claim liabilities: Accident and health $ 293,217 $ 296,048 Group life and other 5,538 5,579 Future policy benefits 8,507 9,536 Total insurance reserves and liabilities 307,262 311,163 Other liabilities: Premiums paid in advance 21,053 26,279 Other policyholders' funds 4,039 7,533 Amounts due reinsurers 4,530 4,072 Accrued expenses and other liabilities 80,449 97,639 Dividends payable 5,156 - Federal income taxes 10,541 10,233 Notes payable 6,459 55,947 Total other liabilities 132,227 201,703 Separate account liabilities 13,899 12,397 Commitments and contingent liabilities (Notes 7 and 12) Stockholders' equity: Preferred stock (1994 - $0.01 par value, 1,000,000 shares authorized, none out- standing) - - Common stock (1994 - $0.01 par value, 50,000,000 shares authorized, 17,025,840 outstanding; 1993 - $8 par value, 15,000,000 shares authorized, 1,104,167 outstanding) (Note 1) 8,893 170 Additional paid-in capital 207,228 169,279 Retained earnings 97,032 153,653 Unearned compensation - restricted stock awards - (1,930) Net unrealized gain (loss) on securities available for sale 27,002 (20,049) Total stockholders' equity 340,155 301,123 $ 793,543 $ 826,386 See notes to consolidated financial statements. 13 EMPHESYS FINANCIAL GROUP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME (In thousands, except per share amounts) For the Year Ended December 31, 1992 1993 1994 Revenues: Premiums $ 1,191,470 $ 1,239,782 $ 1,386,814 Net investment income 43,453 47,378 48,619 Realized gain on investments 1,293 2,068 1,539 Administrative fees and other 11,384 15,445 25,299 Total revenues 1,247,600 1,304,673 1,462,271 Policy benefits and expenses: Policy benefits paid or provided 900,115 919,255 1,020,283 Salaries and other operating expenses 177,179 192,691 222,544 Commissions 97,751 98,595 109,217 Amortization of intangible assets 2,407 3,980 5,354 Interest expense - - 2,807 Total benefits and expenses 1,177,452 1,214,521 1,360,205 Income before federal income taxes and cumulative effect of changes in accounting principle 70,148 90,152 102,066 Federal income taxes 26,275 32,099 37,786 Income before cumulative effect of changes in accounting principle 43,873 58,053 64,280 Cumulative effect of changes in accounting principle, net of income taxes - (2,815) - Net income $ 43,873 $ 55,238 $ 64,280 Per common and common equivalent share: Income before cumulative effect of changes in accounting principle $ 2.58 $ 3.42 $ 3.77 Cumulative effect of changes in accounting principle - (0.17) - Net income $ 2.58 $ 3.25 $ 3.77 See notes to consolidated financial statements. 14 EMPHESYS FINANCIAL GROUP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (in thousands, except share amounts) Unrealized Unearned Gain (Loss) Total Common Stock Additional Compensation on Securities Stock- Paid-In Retained -Restricted Available holders' Shares Amount Capital Earnings Stock Awards For Sale Equity Balance at January 1, 1992 1,104,167 $ 8,893 $ 207,228 $ 44,163 $ - $ 1,663 $ 261,947 1992 net income 43,873 43,873 Dividends declared (25,617) (25,617) Change in unrealized gain (loss) 55 55 Balance at December 31, 1992 1,104,167 8,893 207,228 62,419 - 1,718 280,258 1993 net income 55,238 55,238 Dividends declared (20,625) (20,625) Change in unrealized gain (loss) 25,284 25,284 Balance at December 31, 1993 1,104,167 8,893 207,228 97,032 - 27,002 340,155 Reclassification to recognize effect of the reorgani- zation 15,773,102 (8,724) 8,724 - Distribution to parent pursuant to the reorgani- zation (50,000) (50,000) Restricted stock issued pursuant to the initial public offering 122,731 1 2,757 (2,758) - 1994 net income 64,280 64,280 Dividends declared (7,659) (7,659) Change in unrealized gain (loss) (47,051) (47,051) Issuance of restricted stock pursuant to benefit plans 25,840 570 570 Amortization of restricted stock grants 828 828 Balance at December 31, 1994 17,025,840 $ 170 $ 169,279 $ 153,653 $ (1,930) $ (20,049) $ 301,123 See notes to consolidated financial statements. 15 EMPHESYS FINANCIAL GROUP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (In thousands) For the year ended December 31, 1992 1993 1994 Operating activities: Net income $ 43,873 $ 55,238 $ 64,280 Adjustments to reconcile net income to net cash provided by operating activities: Decrease (increase) in receivables and other assets 1,600 (6,582) (9,020) Increase in insurance reserves and liabilities 19,663 46,452 3,901 Increase (decrease) in other liabilities (1,046) 11,758 24,303 Amortization of intangible assets and restricted stock awards 2,407 3,980 6,182 Provision for depreciation 5,061 7,877 9,291 Provision (credit) for deferred federal income taxes (11,501) (7,691) 198 Proceeds from sale of trading account securities 1,954 2,015 - Realized gain on investments (1,293) (2,068) (1,539) Net amortization of investment premium or discount (1,065) (2,398) 782 Cumulative effect of changes in accounting principle - 2,815 - Net cash provided by operating activities 59,653 111,396 98,378 Investing activities: Purchase of fixed income securities (114,793) (146,919) (95,346) Purchase of equity securities - (1,625) (8,096) Purchase of commercial mortgages (15,050) (34,420) (143) Proceeds from sale of fixed income securities 54,495 20,212 20,839 Proceeds from sale of equity securities - 108 6 Proceeds from maturities, redemptions and principal repay- ments of fixed income securities 47,904 79,185 37,719 Purchase of property and equipment (7,131) (13,634) (11,682) Carrying value of property and equipment sold 439 128 150 Other 957 (16) (903) Net cash used in investing activities (33,179) (96,981) (57,456) Financing activities: Dividends paid to stockholders (25,474) (21,874) (12,815) Proceeds from (repayment of) notes payable - 6,459 (1,284) Net cash used in financing activities (25,474) (15,415) (14,099) Increase (decrease) in cash and cash equivalents 1,000 (1,000) 26,823 Cash and cash equivalents at beginning of year 8,000 9,000 8,000 Cash and cash equivalents at end of year $ 9,000 $ 8,000 $ 34,823 Supplementary data: Interest paid $ - $ - $ 2,807 Income taxes paid 39,846 45,619 38,177 Distribution to Lincoln Life in the form of note payable - - 50,000 Insurance reserves assumed from Lincoln Life 41,168 7,373 - See notes to consolidated financial statements. 16 EMPHESYS FINANCIAL GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 1994 1. BASIS OF PRESENTATION BUSINESS EMPHESYS Financial Group, Inc. ("EMPHESYS"), through its subsidiary, Employers Health Insurance ("EHI"), is a leading provider of a broad range of employee benefit products to small businesses, including managed care group health, group life, dental and disability income insurance. The Company also provides administrative and managed care services to medium and large employers, flexible benefits services to employers of all sizes, purchasing pool marketing and administration for governmental and private organizations, and distribution of group health insurance products. Wisconsin Employers Group, Inc.'s ("WEG") operations are limited to leasing certain office equipment to EHI. EMPHESYS operates in one segment - the employer-based, managed care medical and insurance services segment of the insurance industry. BASIS OF CONSOLIDATION The consolidated financial statements as of and for the year ended December 31, 1994, include the accounts of EMPHESYS and its subsidiaries, EHI and WEG, collectively referred to as the Company. All significant intercompany transactions have been eliminated. Financial statements as of December 31, 1993, and for the years ended December 31, 1993 and 1992, prior to the reorganization described below, reflect the combined financial position and results of operations and cash flows of EHI and WEG. Amounts relating to EHI and WEG at December 31, 1993 are summarized as follows: Total Stockholders' Assets Equity (in thousands) EHI $ 793,702 $ 340,315 WEG (159) (160) $ 793,543 $ 340,155 REORGANIZATION EMPHESYS was formed on December 15, 1993 by the Lincoln National Life Insurance Company ("Lincoln Life") to act as a holding company for EHI and WEG. Under a preorganization subscription agreement dated December 15, 1993, Lincoln Life, upon receiving required regulatory approvals, transferred its 100% stock ownership in EHI and WEG to EMPHESYS in exchange for 17,000,000 shares of EMPHESYS' common stock and a $50,000,000, three-year term note. The reorganization was completed on March 4, 1994. The reorganization transaction was a transfer among entities under common control and, therefore, was accounted for using historical values similar to pooling-of-interests accounting. On December 16, 1993, the Company filed a Registration Statement on Form S-1 with the Securities and Exchange Commission for the initial public offering of 10,500,000 shares of its common stock. The closing of the transaction occurred on March 21, 1994. All shares in the public offering were offered for sale by Lincoln Life, with all proceeds from the offering being retained by Lincoln Life. In connection with the public offering, Lincoln Life also sold 200,000 shares of the Company's Common Stock to EHI, which EHI subsequently contributed to its profit sharing 401(k) plan and trust. Lincoln Life also contributed 127,293 shares of the Company's Common Stock to the Company of which 122,731 17 EMPHESYS FINANCIAL GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued shares were awarded to certain members of the Company's management in the form of restricted stock awards. In addition, the underwriters, on April 13, 1994, notified the Company and Lincoln Life of the exercise of their over-allotment option to purchase an additional 1,186,200 shares of Common Stock from Lincoln Life. On April 19, 1994, Lincoln Life transferred its retained stock ownership in the Company to Lincoln National Corporation ("LNC"). At December 31, 1994, and after consideration of the transactions described above, LNC held 4,986,507 shares or approximately 29.3% of the issued and outstanding Common Stock of the Company. 2. SIGNIFICANT ACCOUNTING POLICIES INVESTMENTS As of December 31, 1993, in accordance with Statement of Financial Accounting Standards No. 115, fixed income securities and equity securities (common and nonredeemable preferred stocks) are classified as "available for sale" and, accordingly, are carried at fair value. The cost of fixed income securities is adjusted for amortization of premiums and discounts. Unrealized gains and losses associated with available for sale securities are excluded from net income and are recorded as a component of stockholders' equity, net of deferred income taxes. Fixed income securities and equity securities deemed to have declines in value that are other than temporary are written down through the statement of income to carrying values equal to their estimated fair values. Realized gains (losses) on investments are recognized in net income using the specific identification method. Prior to December 31, 1993, the Company classified fixed income securities in accordance with existing accounting standards and, accordingly, identified those fixed income securities that were not intended to be held to maturity as either "trading" or "held for sale." Trading securities were carried at fair value, with unrealized gains or losses excluded from net income and recorded as a separate component of stockholders' equity, net of deferred income taxes. Held for sale securities were carried at the lower of aggregate amortized cost or fair value. For the mortgage-backed securities portion of the fixed income securities portfolio, including collateralized mortgage obligations, the Company recognizes income using a constant effective yield based on anticipated prepayments and the estimated economic life of the securities. When actual prepayments differ significantly from anticipated prepayments, the effective yield is recalculated to reflect actual payments to date and anticipated future payments. The net investment in each security is adjusted to the amount that would have existed had the new effective yield been applied since the acquisition of the security. This adjustment is reflected in net investment income. Commercial mortgages are carried at their outstanding principal balances less unaccrued discounts and allowances for loan losses. Real estate, acquired principally through foreclosure, is carried at the lower of depreciated cost or fair value. Short-term and other investments are carried at cost, which approximates fair value. 18 EMPHESYS FINANCIAL GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued PROPERTY AND EQUIPMENT Property and equipment is recorded at cost. Provisions for depreciation are computed principally by the straight-line method at rates based on estimated useful lives of 3 to 7 years for equipment and 40 years for buildings. INTANGIBLE ASSETS The excess purchase price over fair value of net assets acquired consists primarily of goodwill associated with Lincoln Life's 1986 acquisition of EHI ("Lincoln goodwill"). Prior to January 1, 1993, Lincoln goodwill was being amortized and charged to income over 40 years. Effective January 1, 1993, the remaining amortization period for the unamortized balance of Lincoln goodwill was reduced to 14 years based on management's estimate of the remaining life of this asset. The effect of this change was to reduce net income for the years ended December 31, 1993 and 1994 by approximately $2,237,000. Other goodwill consists of the excess purchase price over the fair value of net assets of acquired subsidiaries and divisions of EHI. These amounts are being amortized over their estimated lives of three to five years. The estimated present values of acquired group accident and health insurance blocks of business are being amortized in relation to estimated future profits associated with the acquired policies and charged to income as the estimated profits are recognized. Other intangible assets, consisting of trademarks, customer lists and agreements not to compete, are being amortized over their estimated useful lives of approximately three years. The Company periodically reviews goodwill and other intangible assets to assess permanent impairment. Impairment is recognized in income when the expected, undiscounted future operating cash flows from the underlying asset or business unit are less than the carrying value of the related intangible asset. FUTURE POLICY BENEFITS Liabilities for future policy benefits principally related to annuity policies are based on cash values of the related policies including interest additions at current rates. CLAIM LIABILITIES The liabilities for insurance claims are determined using statistical analyses and represent estimates of the ultimate net cost of all reported and unreported claims which are unpaid at year end. The Company's year-end claim liabilities are substantially satisfied through claim payments in the subsequent year. Although it is not possible to measure the degree of variability inherent in such estimates, management believes that the liabilities for insurance claims are adequate. In recent years, the ultimate settlement of claims has resulted in claims liabilities in excess of subsequent payments by amounts less than 5% of annual benefit costs. The estimates are reviewed periodically and as adjustments to these liabilities become necessary, these adjustments are reflected in current operations. ACCRUED EXPENSES AND OTHER LIABILITIES Included in accrued expenses and other liabilities are cash credit balances totalling $26,284,000 and $37,659,000 at December 31, 1993 and 1994, respectively. 19 EMPHESYS FINANCIAL GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued SEPARATE ACCOUNT The separate account assets and liabilities reflected in the balance sheets represent the assets (principally certificates of deposit) and liabilities for group annuity contracts issued through financial institutions. The assets of the separate accounts are segregated from the Company's other assets both for investment and administrative purposes. Investment income on the specific certificates of deposit purchased with the annuitants' premium payments is utilized to fund the annuity benefits and to pay the Company a contractually predetermined administrative fee which is recognized over the life of the contract. RECOGNITION OF PREMIUM REVENUE AND RELATED BENEFITS AND EXPENSES Premiums for group life and accident and health policies are recognized ratably over the period of insurance coverage. Benefits and expenses are recorded on a basis consistent with the recognition of premium revenue. REINSURANCE ASSUMED AND CEDED The Company assumes and cedes reinsurance to provide for greater diversification of business and to reduce its exposure to potential losses arising from large risks. Premiums paid for reinsurance ceded are recognized during the period coverage is in effect. Amounts recoverable from reinsurance are estimated in a manner consistent with the claim liability associated with the reinsured policies. FEDERAL INCOME TAXES Prior to January 1, 1993, deferred federal income taxes were provided for timing differences between financial statement income and income reported for tax purposes. Subsequent to December 31, 1992, deferred income tax assets or liabilities are recognized on the differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Valuation allowances are provided for those deferred tax assets whose realization is uncertain. Changes in the valuation allowance related to deferred tax assets provided on unrealized losses on available for sale securities are charged directly to stockholders' equity. CASH FLOWS For purposes of the statements of cash flows, the Company considers highly liquid, short-term investments with an original maturity of three months or less and investments in money market funds to be cash equivalents. EARNINGS PER SHARE Earnings per share are calculated based on the weighted average shares of common stock and common stock equivalents outstanding during the periods presented. Common stock equivalents arising from dilutive stock options are computed using the treasury stock method. For periods prior to March 4, 1994 (the date of the Company's reorganization), earnings per share is computed assuming 17,000,000 shares of common stock are outstanding. 20 EMPHESYS FINANCIAL GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued RECLASSIFICATIONS Certain prior year amounts have been reclassified to conform with the 1994 presentation. 3. ACCOUNTING CHANGES POST-RETIREMENT BENEFITS The Company adopted the provisions of Statement of Financial Accounting Standards ("SFAS") No. 106, "Employers' Accounting for Post-Retirement Benefits Other Than Pensions," effective January 1, 1993, by electing the immediate recognition of the transition obligation as defined in the statement. The cumulative effect of adopting this statement was a one-time charge to income of $3,876,000 (net of the applicable tax benefit of $1,997,000). INCOME TAXES The Company adopted SFAS No. 109, "Accounting for Income Taxes," on January 1, 1993. The cumulative effect of adopting this statement was to increase net income by $1,061,000. Financial statements for 1992 were not restated to reflect this new accounting principle. 4. INVESTMENTS The amortized cost and estimated fair values of fixed income securities, by category, are as follows: December 31, 1993 Gross Gross Amortized Unrealized Unrealized Estimated Cost Gains Losses Fair Value (in thousands) U.S. Government $ 35,671 $ 3,664 $ - $ 39,335 Corporate securi- ties 339,420 27,940 1,418 365,942 Foreign bonds 998 66 - 1,064 Mortgage-backed securities 146,627 11,293 542 157,378 $ 522,716 $ 42,963 $ 1,960 $ 563,719 December 31, 1994 Gross Gross Amortized Unrealized Unrealized Estimated Cost Gains Losses Fair Value (in thousands) U.S. Government $ 35,324 $ 664 $ 380 $ 35,608 States and munici- pals 13,469 130 1 13,598 Corporate securi- ties 384,411 3,209 21,000 366,620 Foreign bonds 999 - 102 897 Mortgage-backed securities 128,163 2,373 5,109 125,427 $ 562,366 $ 6,376 $ 26,592 $ 542,150 21 EMPHESYS FINANCIAL GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued Fair values of fixed income securities are based on quoted market prices, where available. For fixed income securities not actively traded, fair values are estimated using values obtained from independent pricing services, or, in the case of private placements, are estimated by discounting expected future cash flows using a current market rate applicable to the coupon rate, credit quality and maturity of the investments. The amortized cost and estimated fair value of fixed income securities at December 31, 1994, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or repay obligations with or without call or prepayment penalties. Amortized Estimated Cost Fair Value (in thousands) Due in one year or less $ 11,754 $ 11,724 Due after one year through five years 101,864 100,994 Due after five years through ten years 175,149 166,903 Due after ten years 145,436 137,102 434,203 416,723 Mortgage-backed securities 128,163 125,427 $ 562,366 $ 542,150 Proceeds from sales of investments in fixed income securities (excluding maturities and redemptions) were as follows: Gross Gross Proceeds Realized Realized From Sales Gains Losses (in thousands) Year ended December 31, 1992: Held for sale securities $ 54,495 $ 4,144 $ 593 Trading account securities 1,954 - 1 $ 56,449 $ 4,144 $ 594 Year ended December 31, 1993: Held for sale securities $ 20,212 $ 782 $ 168 Trading account securities 2,015 8 - $ 22,227 $ 790 $ 168 Year ended December 31, 1994: Available for sale securities $ 20,839 $ 599 $ 691 22 EMPHESYS FINANCIAL GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued Realized and unrealized gains and losses on investments, including gains and losses on securities called in advance of their maturity by the issuer, are as follows: For the Year Ended December 31, 1992 1993 1994 (in thousands) Net realized gains (losses): Fixed income securities $ 3,551 $ 2,514 $ 7 Equity securities 82 (12) 2 Trading account securities (1) - - Recoveries (provisions and writedowns): Commercial mortgages (1,572) (121) 1,480 Real estate - (313) 40 Fixed income securities (767) - 10 $ 1,293 $ 2,068 $ 1,539 December 31, 1992 1993 1994 (in thousands) Unrealized gains (losses): Equity securities: Gross unrealized gains $ 710 $ 682 $ 627 Gross unrealized losses (278) (238) (460) Deferred income tax expense (benefit) (132) (135) - Fixed income securities: Gross unrealized gains 2,148 42,963 6,376 Gross unrealized losses - (1,960) (26,592) Deferred income tax expense (benefit) (730) (14,310) - $ 1,718 $ 27,002 $(20,049) The net change in net unrealized gains (losses) on investment securities is as follows: For the Year Ended December 31, 1992 1993 1994 (in thousands) Increase (decrease) in net unrealized gains (losses): Equity securities $ 153 $ 12 $ (277) Fixed income securities (71) 38,855 (61,219) Applicable income taxes (27) (13,583) 14,445 Net increase (decrease) $ 55 $ 25,284 $(47,051) Net investment income is comprised of the following: For the Year Ended December 31, 1992 1993 1994 (in thousands) Fixed income securities $ 40,683 $ 42,664 $ 42,868 Equity securities 139 121 118 Commercial mortgages 1,946 3,573 5,158 Short-term, real estate and other investments 1,371 1,464 1,346 Gross investment income $ 44,139 $ 47,822 $ 49,490 Investment expenses (686) (444) (871) $ 43,453 $ 47,378 $ 48,619 23 EMPHESYS FINANCIAL GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued The carrying value of investments which are non-income producing and commercial mortgages considered to be impaired under SFAS No. 114 are as follows: December 31, 1993 1994 (in thousands) Fixed income securities $ 1,759 $ 1,815 Real estate 1,100 1,107 Commercial mortgages 5,000 - Valuation allowances of $2,120,000 were provided on $5,000,000 of impaired commercial mortgages at December 31, 1993. All impaired commercial mortgage loans are on a non-accrual basis. Interest income recognized on impaired loans was as follows: For the Year Ended December 31, 1992 1993 1994 (in thousands) Impaired commercial mortgages, average balance $ 7,000 $ 5,500 $ 4,566 Interest income contractually due 673 515 422 Interest income recognized - - 51 Interest income received - cash basis - - 51 A summary of activity in the allowance for loan losses is as follows: For the Year Ended December 31, 1992 1993 1994 (in thousands) Balance at beginning of year $ 1,000 $ 2,572 $ 2,120 Provisions (recoveries) 1,572 121 (1,480) Charge-offs - (573) (640) Balance at end of year $ 2,572 $ 2,120 $ - The Company has estimated the fair value of its investment in commercial mortgages using a discounted cash flow method based on rating, maturity and future income when compared to the expected yield for mortgages having similar characteristics. The ratings for mortgages in good standing are based on property type, location, market conditions, occupancy, debt service coverage, loan to value ratio, caliber of tenancy, borrower and payment record. The fair value of impaired mortgages considers such factors as the degree of default, whether or not payments are still being made, interest rate, maturity and operating performance of the underlying collateral. 24 EMPHESYS FINANCIAL GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued A summary of the fair values of the Company's financial assets (liabilities) follows: December 31, 1993 1994 Fair Carrying Fair Carrying Value Value Value Value (in thousands) Securities avail- able for sale: Fixed income $ 563,719 $ 563,719 $ 542,150 $ 542,150 Equity 3,489 3,489 7,337 7,337 Commercial mortgages 65,400 64,027 56,805 60,203 Short-term invest- ments 8,000 8,000 34,823 34,823 Other investments 3,398 3,398 5,200 5,200 Notes payable (6,459) (6,459) (55,947) (55,947) The Company does not have a material concentration of financial instruments in a single investee, industry or geographic location or off-balance sheet risks which would expose the Company to credit risk. 5. FEDERAL INCOME TAXES The components of federal income tax expense are as follows: For the Year Ended December 31, 1992 1993 1994 Deferred Method Liability Method (in thousands) Current $ 37,776 $ 39,790 $ 37,588 Deferred (credit) (11,501) (7,691) 198 $ 26,275 $ 32,099 $ 37,786 A reconciliation of the differences between income tax expense determined using the statutory federal income tax rate and the Company's effective income tax rate is as follows: For the Year Ended December 31, 1992 1993 1994 Deferred Method Liability Method (in thousands) Income tax at statutory rate applied to income before taxes $ 23,851 $ 31,553 $ 35,721 Add (deduct) tax effect of: Tax-exempt interest and dividends received deduction (86) (27) (33) Intangible asset amorti- zation 532 1,331 1,487 Other non-deductible expenses 57 563 717 Increase in statutory tax rates - (555) - Other 1,921 (766) (106) $ 26,275 $ 32,099 $ 37,786 25 EMPHESYS FINANCIAL GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued Significant components of the Company's deferred federal tax liabilities and assets are as follows: December 31, 1993 1994 (in thousands) Deferred tax liabilities: Accelerated depreciation $ 2,854 $ 3,064 Discount on bonds 431 680 Unrealized gains on available for sale securities 14,492 - Total deferred tax liabilities 17,777 3,744 Deferred tax assets: Post-retirement benefits other than pensions 2,526 3,153 Advance premium discounting 1,474 1,833 Deferred acquisition costs 558 692 Medical reserves discounting 2,802 2,865 Claim liability reserves 18,451 16,671 Salvage and subrogation 5,165 5,588 Accrual differences 1,391 2,785 Investment write-downs 929 169 Unrealized losses on available for sale securities - 7,017 Total deferred tax assets 33,296 40,773 Less: valuation allowance - (7,017) Net deferred tax assets $ 15,519 $ 30,012 The components of the deferred income tax expense (credit) are as follows: For the Year Ended December 31, 1992 1993 1994 Deferred Method Liability Method (in thousands) Financial accounting increase in claim liabilities less than (greater than) the increase for tax purposes $ (11,958) $ (6,926) $ 1,717 Post-retirement benefits other than pensions - (529) (627) Premiums recognized as income for tax purposes and prepaid for financial accounting purposes 503 (20) (359) Estimated salvage and subrogation recognized as income for tax purposes (408) 59 (423) Provision for losses on real estate, loans and fixed income securities (795) 206 760 Other 1,157 (481) (870) $ (11,501) $ (7,691) $ 198 Prior to March 4, 1994, the Company filed a consolidated federal income tax return with LNC. Under an agreement with LNC, the Company provided for income taxes as though a separate return was being filed and the taxes computed were remitted to or collected from LNC. 26 EMPHESYS FINANCIAL GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued 6. NOTES PAYABLE In connection with the reorganization (see Note 1), the Company issued, on March 4, 1994, a $50,000,000 term note payable to Lincoln Life. The principal amount of the term note is payable in full on or before December 31, 1996. The term note bears interest at a variable rate equal to .75% over the three-month LIBOR rate, adjusted quarterly. The average rate of interest in effect during the year ended December 31, 1994 was 5.36%. Interest is payable quarterly through the end of the loan term. The term note is secured by a pledge of 20.0% of the outstanding common stock of EHI. In addition, the term note contains restrictive covenants, which, among other things, limit the acquisition or disposition of assets or business units by EMPHESYS and the repurchase or redemption of EMPHESYS' common stock. The term note also contains covenants which impose borrowing limits on the Company based on the achievement of certain financial targets and requires the maintenance of minimum levels of capital and surplus for EHI. The Company has also borrowed to finance the acquisition of computer equipment. This note payable has an outstanding balance of $5,321,000 at December 31, 1994 and bears interest at 6.17%. This note is due in equal monthly installments of $125,000, including accrued interest, through January 1, 1999. The note payable is secured by a security interest in the underlying equipment. In connection with the acquisition of certain businesses, the Company assumed liabilities, principally to the former owners of the acquired businesses. These notes total $627,000 at December 31, 1994 and bear interest at rates from 8.5% to 10.0%. The notes are due in monthly installments of principal and interest through July 1999. The Company believes the carrying value of all notes payable approximates their fair value. Annual principal amounts due under all notes for the years following December 31, 1994 are as follows (in thousands): 1995 $ 1,433 1996 51,496 1997 1,449 1998 1,536 1999 33 $ 55,947 EHI has an unsecured line of credit agreement with a commercial bank with maximum borrowings of $20,000,000 which expires November 14, 1995. Borrowings under the agreement bear interest at 1% below the bank's prime rate. The agreement contains certain conditions including, but not limited to, restrictions on additional indebtedness of EHI and guarantees of the debt of others. In addition, the agreement requires EHI to maintain a minimum statutory capital and surplus of $200,000,000. At December 31, 1994, the Company had no borrowings under this agreement. 27 EMPHESYS FINANCIAL GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued 7. LEASES The Company leases certain office space, automobiles and computer equipment under operating leases. Rent expense was $7,247,000, $7,060,000 and $5,540,000 in 1992, 1993 and 1994, respectively. Future minimum lease payments under noncancellable operating leases for the years following December 31, 1994 are as follows (in thousands): 1995 $ 4,498 1996 3,485 1997 2,504 1998 985 1999 897 Thereafter 1,712 Total minimum lease payments $ 14,081 8. REINSURANCE The Company reinsures portions of its business through various reinsurance treaties. Under terms of the agreements, the Company generally retained $250,000, $350,000 and $500,000 of each accident and health insurance risk written in 1992, 1993 and 1994, respectively. Premiums paid for reinsurance ceded totalled $19,022,000, $14,994,000 and $13,161,000 during 1992, 1993 and 1994, respectively. Included in these amounts are premiums paid to Lincoln Life for reinsurance ceded of $1,116,000, $1,468,000 and $7,258,000 for 1992, 1993 and 1994, respectively. Although the reinsurer in each case is primarily liable for the insurance ceded, the Company remains liable to the insured whether or not the reinsurer meets its contractual obligations. In addition, the Company assumes certain accident and health and life business, principally from Lincoln Life. Amounts related to reinsurance assumed are as follows: For the Year Ended December 31, 1992 1993 1994 (in thousands) Premiums assumed from Lincoln Life $ 319,668 $ 322,158 $ 339,712 Premiums assumed from others - - 8,101 Service charges to Lincoln Life 5,027 2,787 2,564 Premium taxes to Lincoln Life 6,997 7,068 7,157 Commissions to Lincoln Life 31,226 30,710 31,773 Amounts payable to Lincoln Life in connection with these contracts at December 31, 1993 and 1994 totalled $1,706,000. 28 EMPHESYS FINANCIAL GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued Effective January 1, 1995, the Company entered into an escrow agreement which provides Lincoln Life with a security interest in a portion of the Company's investment securities in an amount based on the claims liabilities associated with the group health, accident, disability and life business assumed from Lincoln Life. The escrow agreement does not affect the Company's ability to collect income or principal payments, dispose of or substitute investment securities which are pledged, subject to certain requirements relating to the credit quality, issuer and maturity of the pledged securities. On January 1, 1995, securities with a cost and fair value of $62,419,000 and $61,763,000, respectively, were pledged under the escrow agreement. 9. EMPLOYEE BENEFIT PLANS PROFIT SHARING 401(K) PLAN AND TRUST The Company's employees are included in a defined contribution plan (the "Plan") with profit-sharing and discretionary savings provisions covering all eligible salaried and hourly employees. Employees become eligible on the semi-annual entry date (January 1 or July 1). Prior to August 1, 1994, participant contributions up to 5% of the participant's compensation were matched by the Company on a scale between 20% and 50% based on the participant's length of service. Subsequent to August 1, 1994, the matching scale was amended to 100% of the first 2% of a participant's compensation and between 50% and 100% of the next 4% of a participant's compensation based on achievement of certain Company growth and profitability criteria. Matching contributions are made in the form of Company stock. The expense related to the matching provision of the Company's discretionary savings plan was $729,000, $900,000 and $1,913,000 for 1992, 1993 and 1994, respectively. Profit-sharing contributions to the Plan are determined annually by the Company's Board of Directors. Profit-sharing contributions may be made in the form of cash or Company stock or any combination thereof. The expense associated with the Company's profit-sharing contribution was $5,210,000, $6,805,000 and $6,240,000 in 1992, 1993 and 1994, respectively. POST-RETIREMENT HEALTH PLAN The Company sponsors an unfunded, post-retirement defined benefit health and life insurance plan for all full-time employees who are at least 55 years old and their eligible dependents. Coverage is coordinated with Medicare when an employee reaches age 65. The Company's contribution to the retiree's health insurance premium is 50% of premium upon completion of 15 years of credited service and increases ratably to 100% after 40 years of credited service. The Company has the ability to change these benefits at any time. 29 EMPHESYS FINANCIAL GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued The following table presents the funded status of the post-retirement benefit plans, reconciled with the liability recognized on the Company's balance sheet at the dates indicated: December 31, 1993 1994 (in thousands) Accumulated post-retirement benefit obligation: Retirees and dependents $ 261 $ 256 Active plan participants: Fully eligible 497 813 Other 6,602 7,904 7,360 8,973 Plan assets - - Accumulated post-retirement benefit obligation in excess of plan assets 7,360 8,973 Unrecognized net loss due to change in assumptions (193) (207) Accrued liability for post-retirement benefits other than pensions, included in accrued expenses and other liabilities $ 7,167 $ 8,766 The components of net periodic post-retirement benefit cost, excluding the cumulative effect of initially adopting SFAS No. 106 in 1993, is comprised of the following: For the Year Ended December 31, 1992 1993 1994 (in thousands) Service cost $ 51 $ 905 $ 1,090 Interest cost - 440 551 Amortization of net loss from change in assumptions - - 9 Net periodic post-retirement benefit cost $ 51 $ 1,345 $ 1,650 The cost for post-retirement benefits for the year ended December 31, 1992 is prior to the adoption of SFAS No. 106 and, therefore, represents the total amount of benefits actually paid. The weighted average discount rate used in determining the accumulated post- retirement benefit obligation was 7.5% at December 31, 1993 and 8.0% at December 31, 1994 and the assumed rate of compensation increase was 5.0% at December 31, 1993 and 5.5% at December 31, 1994. The healthcare cost trend rate at December 31, 1993 was 11.5% graded down over ten years to 5.5% and at December 31, 1994, 11.5% graded down over ten years to 6.0%. A one percentage point increase in the assumed healthcare cost trend rate would have increased the accumulated benefit obligation by $2,683,000 at December 31, 1994 and the aggregate service and interest cost components of projected net periodic post-retirement benefits cost for 1994 by $492,000. The Company amortizes experience gains and losses straight line over the estimated average future service periods of the active participants expected to receive benefits. Excluding the cumulative effect of initial adoption, the impact of adopting the statement was to increase net periodic post-retirement benefit cost by $1,294,000 and $1,599,000 in 1993 and 1994, respectively, and to decrease income before cumulative effect of changes in accounting principle by $841,000 in 1993 and $1,007,000 in 1994. Net income for 1992 has not been restated for the accounting change. 30 EMPHESYS FINANCIAL GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued STOCK INCENTIVE PLAN The Company maintains a stock incentive plan for key employees which provides for the issuance of stock options, stock appreciation rights, restricted stock awards and stock incentive awards. Stock options granted under the plan may be designated as either non- qualified or incentive stock options and have an exercise price at least equal to the market value of the Company's stock on the date of grant. The options generally vest over a four-year period and, subject to termination of employment, expire ten years from the date of grant. Information with respect to the stock incentive plan is as follows: Options Outstanding Shares Available Average For Grant Shares Option Price Balance at March 21, 1994 (inception of plan) 819,693 - Options granted (188,600) 188,600 $ 22.06 Options exercised - Options expired - Restricted stock awarded (148,571) Balance at December 31, 1994 482,522 188,600 $ 22.06 Shares under option agreements which become exercisable on January 1, 1995 totalled 47,150. 10. RELATED-PARTY TRANSACTIONS Short-term investments aggregating $8,000,000 at December 31, 1993 were invested in LNC's short-term investment pool. Interest earned on these investments totalled $416,000, $771,000 and $127,000 during 1992, 1993 and 1994, respectively. The Company's investment in commercial mortgages consists principally of participating interests in loans originated and serviced by LNC. The Company pays amounts to LNC for management, administrative and other services. The Company believes that amounts paid to LNC are, in the aggregate, comparable to amounts which would have been paid to independent third parties for similar services. These amounts are summarized as follows: For the Year Ended December 31, 1992 1993 1994 (in thousands) Investment management fees $ 266 $ 444 $ 670 Agent compensation 1,512 1,822 1,735 Management services 3,152 3,507 1,923 Corporate insurance premiums 5,027 2,274 441 $ 9,957 $ 8,047 $ 4,769 31 EMPHESYS FINANCIAL GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued 11. RESTRICTIONS ON STOCKHOLDERS' EQUITY In connection with requirements prescribed by the Insurance Department of the State of Wisconsin ("OCI"), EHI is required to maintain minimum levels of statutory capital and surplus. A reconciliation of EHI's statutory capital and surplus to amounts reported under generally accepted accounting principles is as follows: December 31, 1993 1994 (in thousands) Amounts reported on a statutory basis $ 235,642 $286,174 Adjustments: Intangible assets 52,297 47,946 Unrealized gain (loss) on investments 41,144 (20,090) Deferred income taxes 15,837 29,777 Receivables from affiliates 1,219 6,358 Non-admitted assets 10,404 12,601 Post-retirement benefit obligation (6,602) (7,904) Statutory investment valuation reserves 5,788 6,704 Other (15,414) (13,648) Amounts as reported under generally accepted accounting principles $ 340,315 $ 347,918 At December 31, 1994, EHI's statutory security surplus requirement was $151,571,000 and EHI's statutory capital and surplus was $286,174,000 which exceeded the security surplus requirement by $134,603,000. Statutory net income was $41,238,000, $58,295,000 and $71,771,000 in 1992, 1993 and 1994, respectively. EHI is required to prepare its statutory financial statements in accordance with accounting practices prescribed or permitted by the OCI. Prescribed statutory accounting practices include those set forth in a variety of publications of the National Association of Insurance Commissioners ("NAIC") as well as state laws, regulations and general administrative rules. Permitted statutory accounting practices encompass all accounting practices accepted by the OCI in statutory- basis filings not so prescribed. The Company prepares its statutory financial statements solely on the basis of prescribed accounting practices. Wisconsin insurance laws and regulations require that, with respect to EHI, any dividend, together with other dividends paid in the preceding 12 months, that exceeds the lesser of (1) 10% of statutory surplus at the end of the prior year or (2) the total net gain from operations of the insurer for the preceding calendar year, less realized capital gains for such year, is deemed "extraordinary" and must receive the written prior approval of the OCI. After taking into account dividends paid through December 31, 1994, EHI would be able to pay approximately $16,516,000 in dividends without being subject to the restrictions governing payment of extraordinary dividends. The Wisconsin statutes require a report of all other distributions to stockholders other than a stock dividend at least thirty days prior to payment. 12. CONTINGENT LIABILITIES The Company is involved in various pending or threatened legal proceedings arising from the normal conduct of business. It is management's opinion that these proceedings ultimately will be resolved without materially affecting the financial position of the Company. 32 EMPHESYS FINANCIAL GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued 13. QUARTERLY RESULTS OF OPERATIONS (Unaudited) The following is a summary of the quarterly results of operations for the years ended December 31, 1994 and 1993: Quarter Ended MAR 31 JUN 30 SEP 30 DEC 31 (in millions, except per share data) 1994 Revenues: Premiums $ 336.8 $ 341.2 $ 346.8 $ 362.0 Net investment income 12.1 11.8 12.2 12.5 Realized gain on investments 0.5 0.1 - 0.9 Administrative fees and other 4.9 5.5 7.3 7.7 Total revenues 354.3 358.6 366.3 383.1 Policy benefits and expenses: Policy benefits paid or provided 246.0 248.4 253.2 272.7 Salaries and other operating expenses 53.1 54.6 56.3 58.5 Commissions 28.3 26.3 27.1 27.5 Amortization of intangible assets 1.1 1.3 1.5 1.5 Interest expense 0.2 0.7 0.9 1.0 Total benefits and expenses 328.7 331.3 339.0 361.2 Income before federal income taxes 25.6 27.3 27.3 21.9 Federal income taxes 9.5 10.1 10.0 8.2 Net income $ 16.1 $ 17.2 $ 17.3 $ 13.7 Net income per common and common equiva- lent share $ 0.95 $ 1.01 $ 1.01 $ 0.80 33 EMPHESYS FINANCIAL GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued Quarter Ended MAR 31 JUN 30 SEP 30 DEC 31 (in millions, except per share data) 1993 Revenues: Premiums $ 300.8 $ 302.8 $ 311.9 $ 324.3 Net investment income 11.0 11.5 11.8 13.1 Realized gain on investments 0.1 0.5 0.6 0.9 Administrative fees and other 4.0 2.9 4.6 3.9 Total revenues 315.9 317.7 328.9 342.2 Policy benefits and expenses: Policy benefits paid or provided 229.1 224.5 216.7 249.0 Salaries and other operating expenses 44.8 47.1 50.4 50.4 Commissions 25.0 23.2 24.8 25.6 Amortization of intangible assets 0.4 1.6 1.0 1.0 Total benefits and expenses 299.3 296.4 292.9 326.0 Income before taxes and cumulative effect of changes in accounting principle 16.6 21.3 36.0 16.2 Federal income taxes 5.5 7.3 13.0 6.3 Income before cumulative effect of changes in accounting principle 11.1 14.0 23.0 9.9 Cumulative effect of changes in accounting principle (1) (2.8) - - - Net income $ 8.3 $ 14.0 $ 23.0 $ 9.9 Net income per common and common equivalent share (2) $ 0.49 $ 0.83 $ 1.35 $ 0.58 (1) Reflects the cumulative effect of the adoption of SFAS No. 106, "Employers' Accounting for Post-Retirement Benefits Other Than Pensions" of $(3.9) million and SFAS No. 109, "Accounting for Income Taxes" of $1.1 million. (2) Determined assuming 17,000,000 shares of common stock are outstanding. 34 INTRODUCTION TO PRO FORMA CONDENSED CONSOLIDATED FINANCIAL STATEMENTS Upon the terms and subject to the conditions set forth in the Offer to Purchase, dated August 16, 1995, (the "Offer"), HEW, Inc., a Delaware corporation (the "Offeror") and a wholly owned subsidiary of Humana Inc., a Delaware corporation (the "Company"), offered to purchase all outstanding shares of common stock, par value $0.01 per share (the "Shares"), of EMPHESYS Financial Group, Inc., a Delaware corporation ("EMPHESYS"), at a purchase price of $37.50 per Share, net to the seller in cash, without interest (the "Offer Price"). The Offer was made pursuant to the Agreement and Plan of Merger, dated as of August 9, 1995 (the "Merger Agreement"), among the Company, the Offeror and EMPHESYS. The Merger Agreement provided, among other things, that as soon as practicable after the purchase of Shares pursuant to the Offer and the satisfaction of the other conditions set forth in the Merger Agreement and in accordance with the relevant provisions of the General Corporation Law of the State of Delaware (the "DGCL"), the Offeror would be merged with and into EMPHESYS (the "Merger"). As a result of all conditions of the tender offer being met, including obtaining all necessary regulatory approvals and the attainment by EMPHESYS of certain specified financial and operational targets, the tender offer was closed and all shares tendered were acquired on October 11, 1995. At the close of the tender offer, 16,890,756 or 99 percent of the Shares were acquired. Under the DGCL, if 90 percent or more of the Shares are acquired, the Merger can be consummated without the vote of the remaining stockholders. The Merger was consummated on October 13, 1995. At the effective time of the Merger, each remaining issued and outstanding Share not purchased in the tender offer was converted into and represented the right to receive the Offer Price. Following consummation of the Merger, EMPHESYS continued as the surviving corporation and became a wholly owned subsidiary of the Company. The aggregate purchase price of approximately $650 million was funded by the Company through available cash, the sale of selected marketable securities and bank borrowings. The bank borrowings of approximately $250 million were pursuant to a credit agreement as amended and restated dated as of September 26, 1995, among the Company, Chemical Bank, as agent, and several other banks (the "Credit Agreement"). The Credit Agreement, which expires September 25, 2000, provides for a $600 million revolving line of credit. Principal amounts outstanding under the Credit Agreement bear interest based upon the consolidated capitalization ratio (defined as total debt divided by total debt plus net worth) at rates ranging from LIBOR plus 16 basis points to LIBOR plus 40 basis points, although the facility also provides for an auction process which could result in lower rates. The Credit Agreement contains customary covenants and events of default. The unaudited pro forma condensed consolidated balance sheet of the Company and EMPHESYS (collectively the "Combined Entities") as of June 30, 1995, presents the financial position of the Combined Entities assuming the Merger had occurred on June 30, 1995. Prior to June 30, 1995, EMPHESYS' historical balance sheet had been presented on an unclassified basis. As a result of the Merger, EMPHESYS' balance sheet was classified between short-term and long-term assets and liabilities to conform with the Company's presentation. The unaudited pro forma condensed consolidated statements of income of the Combined Entities for the six months ended June 30, 1995, and for the year ended December 31, 1994, present the results of operations of the Combined Entities assuming the Merger and related transactions had occurred on January 1, 1994. All material adjustments required to reflect the Merger and related transactions are set forth in the "Pro Forma Adjustments" column. The pro forma adjustments are based on preliminary assumptions of the allocation of the purchase price and are subject to substantial revision once appraisals, evaluations and other studies of the fair value of EMPHESYS' assets and liabilities are completed. Actual purchase accounting adjustments may differ from the pro forma adjustments presented herein. 35 INTRODUCTION TO PRO FORMA CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued) The unaudited pro forma condensed consolidated financial statements should be read in conjunction with the historical consolidated financial statements of the Company and EMPHESYS. The pro forma data is for informational purposes only and may not necessarily reflect future results of operations and financial position or what the results of operations or financial position would have been had the Company and EMPHESYS merged at the beginning of the periods presented. 36 Humana Inc. Pro forma Condensed Consolidated Balance Sheet June 30, 1995 (Unaudited) (Dollars in millions except per share amounts) Humana Historical Pro forma Pro forma Humana EMPHESYS Adjustments Combined Assets Current assets: Cash and cash equivalents $ 447 $ 14 $ (155)(a) $ 306 Marketable securities 528 586 1,114 Premiums receivable, net 80 17 97 Deferred income taxes 42 21 8 (b) 71 Other 64 18 82 Total current assets 1,161 656 (147) 1,670 Property and equip- ment, net 320 48 15 (c) 383 Long-term marketable securities 388 67 (250)(a) 205 Cost in excess of net assets acquired 159 56 251 (d) 466 Deferred income taxes 50 2 (33)(b) 19 Other 85 7 70 (e) 162 Total Assets $ 2,163 $ 836 $ (94) $ 2,905 Liabilities and Common Stockholders' Equity Current liabilities: Medical costs payable $ 554 $ 263 $ 10 (f) $ 827 Trade accounts payable and accrued expenses 166 46 10 (g) 222 Unearned premium revenues 127 30 157 Income taxes payable 52 9 61 Total current liabilities 899 348 20 1,267 Long-term debt 1 56 250 (h) 307 Professional liability and other obligations 87 68 155 Total liabilities 987 472 270 1,729 Contingencies Common stockholders' equity: Common stock,$.16 2/3 par; authorized 300,000,000 shares; issued and outstanding 161,820,165 shares 27 1 (1)(i) 27 Other 1,149 363 (363)(i) 1,149 Total common stock- holders' equity 1,176 364 (364) 1,176 Total Liabilities and Common Stockholders' Equity $ 2,163 $ 836 $ (94) $ 2,905 See notes to pro forma condensed consolidated financial statements. 37 Humana Inc. Pro forma Condensed Consolidated Statement of Income For the six months ended June 30, 1995 (Unaudited) (Dollars in millions except per share results) Humana Historical Pro forma Pro forma Humana EMPHESYS Adjustments Combined Revenues: Premiums $ 2,073 $ 782 $ 2,855 Interest 38 27 $ (10)(j) 55 Other income 7 17 - 24 Total revenues 2,118 826 (10) 2,934 Operating expenses: Medical costs 1,686 587 - 2,273 Selling, general and administrative 250 180 430 Depreciation and amortization 30 8 9 (k) 47 Total operating expenses 1,966 775 9 2,750 Income from operations 152 51 (19) 184 Interest expense 4 2 8 (l) 14 Income before income taxes 148 49 (27) 170 Provision for income taxes 50 18 (9)(m) 59 Net income $ 98 $ 31 $ (18) $ 111 Earnings per common share $ 0.60 $ 0.19 $ (0.11) $ 0.68 Weighted average common shares outstanding (000's) 162,148 162,148 162,148 162,148 See notes to pro forma condensed consolidated financial statements. 38 NOTES TO PRO FORMA CONDENSED CONSOLIDATED FINANCIAL STATEMENTS As of and for the six months ended June 30, 1995 (Unaudited) Note 1: Pro forma Adjustments - Condensed Consolidated Balance Sheet as of June 30, 1995 (a) To record the use of existing cash and cash equivalents and long- term marketable securities necessary to finance a portion of the acquisition costs. (b) To record deferred taxes associated with the identifiable intangibles, the revaluation of property and equipment and additional medical claims and accrued liabilities. (c) To record the revaluation of property and equipment acquired to estimated fair market value. (d) To record the purchase price in excess of net tangible and identifiable intangible assets acquired. (e) To record the fair value of identifiable intangible assets acquired. (f) To record additional medical costs payable, necessary to conform EMPHESYS' actuarial method used to determine medical costs payable with the Company's actuarial method. (g) To record estimated liabilities associated with the acquisition transaction including severance, lease terminations and the discontinuance of certain non-core businesses. (h) To record bank borrowings necessary to finance the remaining portion of the acquisition cost. (i) To eliminate the acquired equity of EMPHESYS as of June 30, 1995. Note 2: Pro forma Adjustments - Condensed Consolidated Statement of Income for the six months ended June 30, 1995. (j) To reduce interest income for the estimated forgone interest income resulting from the use of cash and cash equivalents and marketable securities to finance the acquisition. The calculation is based upon the nominal monthly portfolio yield for investments held by the Company (at the parent level) over the six-month period. (k) To record depreciation and amortization related to property and equipment, identifiable intangible assets and the excess of purchase price over net tangible assets acquired. Identifiable intangible assets will be amortized over 10 years and the excess of purchase price over net assets acquired will be amortized over 40 years. Acquired property and equipment (primarily buildings) will be depreciated over 30 years, the estimated remaining useful life. (l) To recognize estimated interest expense related to bank borrowings necessary to finance the acquisition. The bank borrowings have an assumed interest rate of LIBOR plus 3/8 percent over the six month period. Note 3: Income Taxes (m) Estimated pro forma income taxes were recorded at an assumed combined federal and state income tax rate of 34.6 percent. 39 Humana Inc. Pro forma Condensed Consolidated Statement of Income For the year ended December 31, 1994 (Unaudited) (Dollars in millions except per share results) Humana Historical Pro forma Pro forma Humana EMPHESYS Adjustments Combined Revenues: Premiums $ 3,576 $ 1,387 $ 4,963 Interest 62 50 $ (16)(a) 96 Other income 16 25 - 41 Total revenues 3,654 1,462 (16) 5,100 Operating expenses: Medical costs 2,918 1,020 - 3,938 Selling, general and administrative 436 323 759 Depreciation and amortization 50 14 17 (b) 81 Restructuring and unusual charges 18 - 18 Total operating expenses 3,422 1,357 17 4,796 Income from operations 232 105 (33) 304 Interest expense (recovery) (25) 3 12 (c) (10) Income before income taxes 257 102 (45) 314 Provision for income taxes 81 38 (15)(d) 104 Net income $ 176 $ 64 $ (30) $ 210 Earnings per common share $ 1.10 $ 0.40 $ (0.19) $ 1.31 Weighted average common shares outstanding (000's) 160,911 160,911 160,911 160,911
See notes to pro forma condensed consolidated statement of income. 40 NOTES TO PRO FORMA CONDENSED CONSOLIDATED STATEMENT OF INCOME For the year ended December 31, 1994 (Unaudited) Note 1: Pro forma Adjustments (a) To reduce interest income for the estimated forgone interest income resulting from the use of cash and cash equivalents and marketable securities to finance the acquisition. The calculation is based upon the nominal monthly portfolio yield for investments held by the Company (at the parent level) over the twelve-month period. (b) To record depreciation and amortization related to property and equipment, identifiable intangible assets and the excess of purchase price over net tangible assets acquired. Identifiable intangible assets will be amortized over 10 years and the excess of purchase price over net assets acquired will be amortized over 40 years. Acquired property and equipment (primarily buildings) will be depreciated over 30 years, the estimated remaining useful life. (c) To recognize estimated interest expense related to bank borrowings necessary to finance the acquisition. The bank borrowings have an assumed interest rate of LIBOR plus 3/8 percent over the twelve month period. Note 2: Income Taxes (d) Estimated pro forma income taxes were recorded at an assumed combined federal and state income tax rate of 33 percent. 41 ITEM 7. FINANCIAL STATEMENTS AND EXHIBITS (c) Exhibits 2.1 Offer to Purchase, dated August 16, 1995. Exhibit (a)(1) to the Company's Schedule 14D-1 and 13D dated August 16, 1995, is incorporated by reference herein. 2.2 Agreement and Plan of Merger, dated August 9, 1995 among the Company, EMPHESYS and HEW, Inc. Exhibit (a)(10) to the Company's Schedule 14D-1 and 13D is incorporated by reference herein. 2.3 Stock Option and Tender Agreement, dated as of August 9, 1995, among the Company, Lincoln National Corporation and American States Insurance Company. Exhibit (c)(1) to the Company's Schedule 14D-1 and 13D is incorporated by reference herein. 2.4 Amendment No. 1 dated August 24, 1995, to the Company's Schedule 14D-1 and 13D is incorporated by reference herein. 2.5 Amendment No. 2 dated August 30, 1995, to the Company's Schedule 14D-1 and 13D is incorporated by reference herein. 2.6 Amendment No. 3, dated September 15, 1995, to the Company's Schedule 14D-1 and 13D is incorporated by reference herein. 2.7 Amendment No. 4, dated September 28, 1995, to the Company's Schedule 14D-1 and 13D is incorporated by reference herein. 2.8 Amendment No. 5, dated October 3, 1995, to the Company's Schedule 14D-1 and 13D is incorporated by reference herein. 2.9 Amendment No. 6, dated October 10, 1995, to the Company's Schedule 14D-1 and 13D is incorporated by reference herein. 2.10 Amendment No. 7, dated October 12, 1995, to the Company's Schedule 14D-1 and 13D is incorporated by reference herein. 20.1 Credit Agreement, dated as of January 12, 1994, as amended by an Agreement and Amendment dated as of October 27, 1994, an Amendment dated as of August 1, 1995, and an Amendment and Restatement dated as of September 26, 1995 among Chemical Bank as Agent, the Banks party thereto, and the Company. Exhibit (b)(2) to Amendment No. 4 of the Company's Schedule 14D-1 and 13D is incorporated by reference herein. 23.1 Consent of Ernst and Young LLP, Independent Auditors. 42 SIGNATURE Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned hereunto duly authorized. Humana Inc. Date: October 25, 1995 /s/James E. Murray James E. Murray Vice President and Controller (Principal Accounting Officer) 43 EX-23 2 Exhibit 23.1 Consent of Ernst & Young LLP, Independent Auditors We consent to the incorporation by reference in the registration statements of Humana Inc. (Form S-8 No. 2- 39061, No. 2-79239, No. 2-96154, No. 33-33072, No. 33-49305, No. 33-52593 and No. 33-54455), of our report dated January 27, 1995, included in the 1994 Annual Report to Stockholders of EMPHESYS Financial Group, Inc. Ernst & Young LLP Milwaukee, Wisconsin October 20, 1995 -----END PRIVACY-ENHANCED MESSAGE-----