-----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, FA+zFJhWX8YhKxFxbw9/UZ+/pF0lvvTZjyy3TnF3dOzTdt94qU+9tn+tqIUw+q2R fWkEA6RcG8wnREaiOH1Wlw== 0000950130-97-003303.txt : 19970728 0000950130-97-003303.hdr.sgml : 19970728 ACCESSION NUMBER: 0000950130-97-003303 CONFORMED SUBMISSION TYPE: 10-K405/A PUBLIC DOCUMENT COUNT: 2 CONFORMED PERIOD OF REPORT: 19961231 FILED AS OF DATE: 19970725 SROS: NASD FILER: COMPANY DATA: COMPANY CONFORMED NAME: PHYSICIANS HEALTH SERVICES INC CENTRAL INDEX KEY: 0000867098 STANDARD INDUSTRIAL CLASSIFICATION: SERVICES-HEALTH SERVICES [8000] IRS NUMBER: 061116976 STATE OF INCORPORATION: DE FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K405/A SEC ACT: SEC FILE NUMBER: 000-21098 FILM NUMBER: 97645620 BUSINESS ADDRESS: STREET 1: 120 HAWLEY LANE STREET 2: 1243 BROADRICK DRIVE CITY: TRUMBULL STATE: CT ZIP: 06611 BUSINESS PHONE: 2033816400 10-K405/A 1 FORM 10-K405/A - ------------------------------------------------------------------------------- - ------------------------------------------------------------------------------- SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 ---------------- FORM 10-K/A-2 [X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED DECEMBER 31, 1996 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 0-21098 PHYSICIANS HEALTH SERVICES, INC. (EXACT NAME OF COMPANY AS SPECIFIED IN CHARTER) 06-1116976 DELAWARE (IRS EMPLOYER (STATE OR OTHER JURISDICTION OF IDENTIFICATION NUMBER) INCORPORATION OR ORGANIZATION) ONE FAR MILL CROSSING 06484 SHELTON, CONNECTICUT (ZIP CODE) (ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) COMPANY'S TELEPHONE NUMBER, INCLUDING AREA CODE (203) 381-6400 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 $.01 PER SHARE (TITLE OF CLASS) Indicate by check mark whether the Company: (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 Company 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 Company'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 [X] Aggregate market value of the voting stock held by non-affiliates at March 25, 1997 amounted to $114,394,815 (assuming for purposes of this calculation only, that all directors and executive officers are affiliates). (Class B Common Stock is assumed to have a market value of $19.875 per share) Indicate the number of shares of each of the Company's classes of Common Stock, as of the latest practicable date. Shares of Common Stock outstanding as of March 25, 1997: 5,763,905 SHARES OF CLASS A COMMON STOCK 3,546,212 SHARES OF CLASS B COMMON STOCK DOCUMENTS INCORPORATED BY REFERENCE: NONE - ------------------------------------------------------------------------------- - ------------------------------------------------------------------------------- This amendment to the Annual Report on Form 10-K of Physicians Health Services, Inc. (the "Company") for the fiscal year ended December 31, 1996, as amended by Amendment No. 1 thereto (as so amended, the "Original Form 10-K"), amends and modifies the Original Form 10-K as follows, in response to comments from the Securities and Exchange Commission: (1) The fifth and seventh paragraphs under "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations" have been revised to refer to the impact of arrangements between the Company and The Guardian Life Insurance Company, Inc. (the "Guardian"). (2) "Note 2. Significant Accounting Policies," which is part of the Notes to the Consolidated Financial Statements submitted with the Original Form 10-K in response to Item 8, has been revised to add a paragraph entitled "Impairment of long-lived assets." (3) "Note 10. Arrangement with the Guardian Life Insurance Company of America," which is part of the Notes to the Consolidated Financial Statements submitted with the Original Form 10-K in response to Item 8, has been revised to explain what indemnity costs that appear on the Statements of Operations represent (fifth paragraph), to describe "Guardian joint marketing expenses, net" (tenth paragraph), to clarify how the Company reports the effects of the profit sharing arrangement with the Guardian (second paragraph) and to clarify what revenues and costs generated under the "jointly marketed products" represent (seventh and eighth paragraphs). (4) Exhibit 23.1 is filed herewith. In addition, a correction has been made to the cover page of the Original Form 10-K to include a check mark to indicate that disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained therein. 2 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following table shows certain income statement data expressed as a percentage of total revenues for the years indicated:
YEAR ENDED DECEMBER 31 -------------------------- 1996 1995 1994 ------- ------- ------- Revenues: Premiums.......................................... 98.7% 98.0% 98.6% Investment and other income....................... 1.3 2.0 1.4 ------- ------- ------- Total revenues.................................. 100.0 100.0 100.0 ------- ------- ------- Health care expenses: Hospital services................................. 36.5 32.0 32.3 Physicians and related health care services....... 40.7 37.5 39.9 Other health care services........................ 8.7 5.3 4.4 Indemnity costs................................... 1.4 0.6 ------- ------- ------- Total health care expenses...................... 87.3 75.4 76.6 ------- ------- ------- Selling, general and administrative expenses........ 17.8 16.7 15.0 Guardian joint marketing (income) expense, net...... (0.2) 0.7 0.0 Proxy defense costs................................. -- 0.2 -- Interest............................................ 0.1 0.0 0.0 ------- ------- ------- Total expenses.................................. 105.0 93.0 91.6 ------- ------- ------- Income (loss) before taxes.......................... (5.0) 7.0 8.4 Income tax expense (benefit)........................ (2.3) 2.4 3.6 ------- ------- ------- Net income (loss)................................... (2.7)% 4.6% 4.8% ======= ======= =======
The Company's subsidiaries, PHS/CT, PHS/NY, PHS/NJ and Bermuda, have entered into several marketing and reinsurance agreements with The Guardian. Under these agreements, jointly developed managed care and indemnity products are offered to existing Guardian insureds as well as to new prospects. The Company and The Guardian have implemented different ways to share profits and losses under these agreements which vary among the particular states and time periods as described below. In Connecticut, PHS/CT wrote 100% of the managed care business and The Guardian wrote 100% of the indemnity business. The parties shared profits and losses through September 30, 1996 pursuant to a "selection adjustment payment" mechanism. Under this arrangement, each party calculated its quarterly profit or loss (net premiums earned, minus claims payments, capitation payments and withholds paid with respect to managed care plans, reserve increases or decreases, administrative charges, commissions and premium taxes, plus investment income). The selection adjustment payment, which was designed to mitigate the effect of potential adverse selection in groups which selected Healthcare Solutions products and enable the parties to share in any long-term profits or loses, then provided that if both parties had losses, no adjustment would be made from one to the other, and each would retain its respective loss. If both parties had profits, the amounts were combined, and the party with the greater profit would make a selection adjustment payment to the other, in an amount equal to half of the profit differential. If only one party had a profit, the profitable party made a selection adjustment payment equal to that party's reported profit, thereby partially or fully reimbursing the other party's loss. If the result was a combined profit, the profitable party would make a selection adjustment payment equal to the other party's loss, increased by half of the combined profit. Selection adjustment calculations were done on a cumulative basis, and accordingly, losses are carried forward to offset against future profits. Because both PHS and The Guardian incurred losses in Connecticut in 1996, no selection adjustment payment was made, and the Company reported 100% of the cumulative losses on the managed care products sold under the Healthcare Solutions product line. 3 The parties entered into new agreements with respect to the Connecticut Healthcare Solutions business that were effective as of October 1, 1996. The selection adjustment methodology was replaced with a reinsurance agreement pursuant to which the Company cedes 50% of the risk on the managed care portion of the Healthcare Solutions products to The Guardian. In connection with the conversion to reinsurance, the parties agreed that 50% of the cumulative losses in Connecticut would be offset from amounts otherwise due to The Guardian under the reinsurance agreement when profits, if any, are generated. In New York, The Guardian cedes 50% of its risk for the out-of-network portion of the POS Healthcare Solutions products to Bermuda and the Company cedes 50% of its risk for HMO products and the in-network portion of the POS Healthcare Solutions products to The Guardian. In New Jersey, the Company cedes 100% of the risk of the out-of-network portion of the POS Healthcare Solutions products and 50% of the risk on the other HMO Healthcare Solutions products to The Guardian and The Guardian retrocedes 50% of the risk for the out-of-network portion of the POS Healthcare Solutions products back to Bermuda. The reinsurance agreements were amended in 1996 to reduce the Company's risk for indemnity Healthcare Solutions products. In New York, the Company was responsible for 10% of the associated losses on the indemnity business between January 1 and June 30, 1996 and did not share risk with respect to the indemnity portion of the Healthcare Solutions business after June 30, 1996. In Connecticut, the agreements were amended effective October 1, 1996 so that the Company will not share risk with respect to the indemnity business in those states following September 30, 1996. As a result of its arrangements with The Guardian, the Company's percentage growth in its aggregate premium revenue has lagged its percentage growth in enrollment, since a portion of the Healthcare Solutions revenues and expenses that were ceded to The Guardian are omitted from the Company's Statement of Operations. The Company expects that this trend will continue if its Healthcare Solutions products continue to be successful and the enrollment mix between its proprietory products and the Healthcare Solutions products shifts to a greater percentage in Healthcare Solutions. The aggregate revenue is impacted by this mix due to the fact that for its proprietary products the Company retains 100% of the revenue and related health care expenses while under the Healthcare Solutions product, 50% of the revenue and related health care expenses are ceded to The Guardian, therefore impacting the aggregate revenue growth compared to aggregate membership growth. Per member, per month ("PMPM") amounts are similarly impacted by this mix due to the fact Healthcare Solutions membership is reflected at 100% and revenue and related health care expenses are reflected at 50%. The marketing and reinsurance agreements with the Guardian have had a significant impact on the Company's results of operations. In 1996, the arrangements with the Guardian resulted in approximately $14.6 million of pretax losses while in 1995, the arrangements resulted in approximately $1.3 million of pretax income. RESULTS OF OPERATIONS YEAR ENDED DECEMBER 31, 1996 COMPARED TO YEAR ENDED DECEMBER 31, 1995 Premium revenue increased 40.4% to $481.5 million in 1996 from $343.0 million in 1995, while enrollment at December 31, 1996 increased 49.8% over 1995 to 400,021. As of December 31, 1996, fully-insured enrollees increased 59.9% to 332,363 members up from 207,856 as of December 31, 1995, while self- funded enrollees increased 14.2% to 67,658 members as of December 31, 1996, up from 59,260 at December 31, 1995. The aggregate premium revenue increase lagged the membership growth due primarily to the growth of membership in the Healthcare Solutions product where 50% of the premium revenue and related healthcare costs are ceded to The Guardian pursuant to the agreement and a membership shift in the fully insured product mix to lower benefit, lower PMPM revenue products. Also, enrollee statistics include 100% of the approximately 112,000 members enrolled in Healthcare Solution products at December 31, 1996, while premium revenue includes only the Company's 50% share of the Healthcare Solutions revenues derived from the New York arrangements which became effective July 1, 1995, the New Jersey arrangements effective January 1, 1996, and the Connecticut arrangements effective October 1, 1996. 4 Investment and other income declined 5.6% in 1996 from $7.0 million for the year ended December 31, 1995 to $6.6 million for the year ended December 31, 1996. The decline in investment income is due primarily to a decline in invested assets and lower investment yields due to lower interest rates. Health care expenses as a percentage of premium revenue (medical loss ratio) increased to 89.8% for 1996 from 78.2% for 1995. The increase in the medical loss ratio resulted from a 7.4% increase in medical costs on a PMPM basis (primarily hospital and prescription drug costs as discussed below) and a decline of 6.5% in the PMPM premium revenue. Hospital services expenses increased 59.1% to $178.1 million in 1996 from $111.9 million in 1995. The increase is due primarily to an increase in fully- insured membership. On a PMPM basis, however, hospital services increased 5.7% from 1995 to 1996. This increase is attributable primarily to the recent trend to perform certain lower cost services, which historically had been performed in an in-patient setting, in an out-patient setting. This results in a higher average cost for those services which are still performed in an in-patient setting. Inpatient hospital utilization for fully-insured commercial enrollees decreased 3.2% to 272 days per thousand members, per year for the year ending December 31, 1996 from 281 days per thousand members, per year for the same 1995 period. This decrease was primarily due to the continued trend towards less expensive treatment being provided in the out-patient setting and more effective medical management techniques. Physician and related health care expenses increased 51.6% in 1996 from 1995. The increase is primarily due to the 59.9% increase in fully insured membership as well as increases in non-capitated expenses, including costs for out-of-network physicians' services. Other health care expenses increased by $23.7 million from 1995 to 1996 due primarily to higher prescription drug costs resulting from an increase in the number of members covered by prescription drug riders. Additionally, there was a shift in membership to drug riders which offered greater benefits. At the same time, fewer generic drugs were prescribed resulting in increased pharmacy costs. Indemnity costs reflect the medical costs associated with the indemnity revenue assumed in connection with The Guardian reinsurance arrangement in New York which began in 1995. The Company's net indemnity costs for 1996 were $7.0 million, up from $2.2 million for 1995. As a result of continuing adverse experience related to this business, the Company amended the New York reinsurance agreement to reduce the Company's share of the indemnity business assumed from 50% to 10%, for the period from January 1, 1996 to June 30, 1996. The impact of this adjustment reduced the after tax loss associated with the indemnity business by approximately $900 thousand, which was recorded in the second quarter of 1996. The amendment also provided that the Company will assume no further indemnity risk in the New York market for claims incurred after June 30, 1996. As noted above, after September 30, 1996 the Company did not share risk in connection with the Healthcare Solutions indemnity business in the Connecticut market. Selling, general and administrative expenses increased 48.2% to $86.7 million in 1996 from $58.5 million in 1995. The increase was principally due to additional staffing, outside services and other costs needed to support geographic expansion, product diversification and enrollment growth. The Company's effective tax benefit rate was 46.5% for the year ended December 31, 1996, as compared to an effective tax provision rate of 34.6% for the comparable 1995 period. The 1996 effective tax rate resulted primarily from the favorable effect of the income from tax exempt securities which increases the tax benefit when there are losses. The Company has undertaken a number of actions intended to restore profitability in 1997. It increased its premiums an average of 4.4% at the end of 1996 for groups renewing in 1997 and may make further adjustments subject to competitive conditions. It has moved to introduce enhanced medical management, which is intended to result in reduced health care expenses on a PMPM basis in 1997. In addition, its contracts with risk entities shift a greater amount of the risk of overutilization to the risk entities, which will provide further protection against rising health care costs. Moreover, the Company has shifted a portion of the Healthcare Solutions membership to capitation arrangements with the Physician Groups. Although there can be no assurance that these changes, among others, will enable the Company to be profitable in 1997, the Company expects to see significant improvement in its financial results in 1997. See "Management's Discussion and Analysis of Financial Condition and Results of Operations--Cautionary Statement." 5 YEAR ENDED DECEMBER 31, 1995 COMPARED TO YEAR ENDED DECEMBER 31, 1994 Premium revenue increased 18.4% to $343.0 million in 1995 from $289.8 million in 1994 while enrollment at December 31, 1995 increased 48.8% over 1994 to 267,116. As of December 31, 1995, fully-insured enrollees increased 55.5% to 207,856 members from 133,676 as of December 31, 1994, while self- funded enrollees increased 29.2% to 59,260 members as of December 31, 1995, up from 45,874 as of December 31, 1994. The premium revenue increase lagged the membership growth due to more aggressive pricing and a shift in fully insured product mix to lower revenue yielding products. Also, enrollee statistics include 100% of the enrollees in New York, while premium revenue includes only the Company's 50% share of revenues derived from the New York Guardian arrangements which become effective July 1, 1995. Investment and other income was up 67.5% in 1995 from $4.2 million for the year ended December 31, 1994 to $7.0 million for the year ended December 31, 1995. The increase in investment income was due to improved portfolio yields and a reduction in realized losses. Health care expenses as a percentage of premium revenue (medical loss ratio) decreased to 78.2% for 1995 from 79.0% for 1994. The decrease in the medical loss ratio resulted from a 7.0% decline in medical costs on a per member per month basis which was partially offset by a 6.4% decline in the per member per month premium revenue. Total health care expenses increased 17.1% to $263.8 million in 1995 from $225.3 million for 1994. Hospital services expenses increased 17.9% to $111.9 million in 1995 from $94.9 million in 1994. On a PMPM basis, hospital services declined 6.8% from 1994 to 1995. The decline was due primarily to a reduction in in-patient hospital utilization which was partially offset by higher out-patient utilization. In-patient hospital utilization for fully-insured enrollees, excluding Medicare cost contract enrollees, decreased 14.1% to 281 days per thousand members per year for the year ending December 31, 1995 from 327 days per thousand members for the same 1994 period. Physician and related health care expenses increased 11.6% in 1995 from 1994 despite a 55.5% increase in fully insured enrollees. As a result, physician expense declined 11.8% on a per member per month basis for the year ended December 31, 1995 as compared to the same 1994 period. The decrease is largely due to more favorable capitation arrangements with providers and a shift in membership to lower cost capitated products. Other health care expenses increased by $5.8 million from 1994 to 1995 due primarily to higher prescription drug expense resulting from an increase in prescription drug benefit coverage and increased utilization. Additionally, in 1995, other health care expenses includes the Healthcare Solutions profit sharing expense which resulted from The Guardian reinsurance arrangement in Connecticut. Indemnity costs reflect the medical costs associated with the indemnity revenue assumed in connection with The Guardian reinsurance arrangement in New York which began in 1995. Selling, general and administrative expenses increased 32.7% to $58.5 million in 1995 from $44.1 million in 1994. The increase was principally due to continuing resource commitments to support enrollment growth and the expansion into the Connecticut, New York and New Jersey tri-state region. Additionally, the related administrative infrastructure was also expanded to accommodate the increased growth. The Company's effective tax rate declined to 34.6% for the year ended December 31, 1995 from 42.5% for the comparable 1994 period. The decline in the effective tax rate resulted primarily from the shift of much of the Company's investment portfolio into tax exempt municipal bonds and to a slight decline in the statutory state income tax rates. Additionally, the effective tax rate for 1995 was favorably affected by the reconciliation of prior provisions. 6 LIQUIDITY AND CAPITAL RESOURCES PHS has historically financed its operations primarily through internally generated funds. The Company's primary capital requirements are for working capital, principally to fund geographic and product expansion, and to maintain necessary regulatory capital. In addition, the Company's HMO subsidiaries, PHS/CT, PHS/NY and PHS/NJ, and its insurance subsidiaries, are subject to statutory regulations that restrict the payment of dividends. Net cash flows for the year ended December 31, 1996 resulted in an increase in cash and cash equivalents of $31.7 million. Although operating cash flows were unfavorably affected by the Company's 1996 loss of $13.0 million, net cash was provided by operating activities of $24.6 million for the year ended December 31, 1996. The difference between the net loss and the net cash provided from operating activities resulted primarily from a $22.3 million increase in hospital incurred but not reported ("IBNR") claims, which was generated from the increase in the volume of claims activity due to the rise in membership and the timing of the related claims payments and from the collection of outstanding advances to hospitals which totalled $5.5 million. Additionally, the amounts due to IPAs, physicians and other providers increased $15.3 million in 1996, reflecting an increase in the amounts payable to non-capitated providers, such as out of network providers, and the timing of those related payments. These items were offset in part by the net increase in receivables of approximately $10.0 million which occurred due to the growth in enrollment from both the Company's proprietary business and from its arrangements with The Guardian. Approximately $44.0 million of net cash was provided by the sales and maturities of marketable securities, of which $34.6 million was used to fund the enhancement of the Company's computer infrastructure and to purchase the Company's new corporate headquarters . PHS's net cash used in operations amounted to $9.5 million in 1995. Since The Guardian holds the funds generated by Healthcare Solutions, on which the Company earns interest, and since the funds were not released by year end, operating cash flows in 1995 were unfavorably affected by the arrangements with The Guardian. In addition, IPA withhold percentages were generally decreased in 1995, and as a result, the amounts owed to the IPAs tended to be paid over on a more rapid schedule. Further, accelerated payments related to income taxes and the Medicare cost contract decreased operating cash flows. These items were partially offset by the net income of $16.0 million generated during the year. Cash used for investing activities was $11.7 million for the year ended December 31, 1995, primarily due to capital expenditures of $15.2 million which represented investments in optical imaging technology and other improvements in the computer infrastructure needed to support the Company's expansion. Net cash flow during 1994 resulted in an increase in cash and investments to $139.8 million at December 31, 1994 from $112.2 million at December 31, 1993. Cash provided by operating activities totaled $39.3 million, resulting primarily from net income of $14.1 million generated during the period, the timing of the receipt of medical claims and the timing of payments related to other liabilities. At December 31, 1994, PHS was no longer required to maintain a restricted cash reserve to comply with the requirement of the Office of Prepaid Healthcare in connection with the Medicare cost contract. In New York, the Company is required to maintain an escrow reserve equal to 5% of estimated health care expenses for the current year, for the protection of enrollees, which, as of December 31, 1996 was $9.0 million. In Connecticut, the Company is required to maintain a statutory minimum unimpaired capital surplus of $1.0 million. The Company is currently in compliance with all applicable statutory capital requirements. The Company is subject to various laws and regulations which, at December 31, 1996, caused the aggregate amount of its restricted net assets to be approximately $38.8 million. The Company's expenditures for capital equipment, primarily for computers and related equipment, and in 1996 for the purchase of the Company's new headquarters, totaled $34.6 million, $15.2 million and $9.7 million for the years ended December 31, 1996, 1995 and 1994, respectively. The Company expects to spend additional capital, principally in computer and technology systems enhancements, over the next several years. The Company expects to require additional capital over the next several years and, although it can provide no assurances in this regard, believes that in addition to its current capital resources and internally generated funds, it will be able to obtain financing, if necessary, sufficient for its continued operations. 7 EFFECT OF INFLATION Health care industry costs have been rising annually at rates higher than the Consumer Price Index. To offset this trend, PHS has been able to achieve premium rate increases for its 1997 business which should help mitigate the effect of medical cost inflation on its operations. The Company's premiums are higher than many of its competitors, however, and there can be no assurance that the Company will be able to increase premiums sufficiently to offset the rise in health care costs without jeopardizing the Company's competitive position. In addition, PHS contracts with several major hospitals on a multi- year basis with fixed annual increases. The Company's risk sharing arrangements with its Physician Groups and other cost control measures, such as its utilization review program, also help to mitigate the effects of price increases on operations. There can be no assurance that the Company's efforts to reduce the impact of inflation will be successful. CAUTIONARY STATEMENT In connection with the "safe harbor" provisions of the Private Securities Litigation Reform Act of 1995, the Company is hereby making cautionary statements identifying important risk factors that could cause the Company's actual results to differ materially from those projected in forward-looking statements made by or on behalf of the Company. The Company wishes to caution readers that the following important factors, among others, could cause the Company's actual financial or enrollment results to differ materially from those expressed in any projected, estimated or forward-looking statements relating to the Company. Premium Structure; Unpredictability of Medical Costs. A substantial amount of the Company's revenues are generated by premiums which represent fixed monthly payments for each person enrolled in the Company's plans. If the Company is unable to obtain adequate premiums because of competitive or regulatory considerations, the Company could incur decreased margins or significant losses. The Company believes that commercial premium pricing will continue to be highly competitive. The Company's revenues from its Medicare and Medicaid programs could be adversely affected if reimbursement rates do not keep pace with rising medical costs. Historically, these rates have been subject to wide variations from year to year. In the event reimbursement were to decline from projected amounts, the Company would attempt to renegotiate its contracts with its health care providers. There can be no assurance that it could successfully renegotiate these financial arrangements and failure to reduce the health care costs associated with such programs could have a material adverse effect upon the Company's business. The Company's profitability is also dependent, in large part, upon its ability to accurately project and manage health care costs, including without limitation, appropriate benefit design, utilization review and case management programs, and its risk sharing arrangements with providers, while providing members with quality health care. Health care costs are affected by a variety of factors that are difficult to predict and are not entirely within the Company's control, including the severity and frequency of claims. Medical cost inflation, mandated benefits and other regulatory changes, new technologies, natural disasters, epidemics and other external factors relating to the delivery of health care services, inability to establish acceptable risk sharing arrangements with providers and other factors may adversely affect the Company's ability to manage the costs of providing health care services. In addition, the Company experienced high out-of-network utilization in connection with its POS products in 1996 in New York, which resulted in medical costs for the POS products exceeding budgeted amounts. The Company is seeking to expand its network in New York and institute other measures to limit the risk of high out-of-network utilization. The Company is implementing a variety of measures to help it manage health care costs better. However, there can be no assurance that the Company will be able to continue to reduce its medical costs sufficiently to restore profitability in all its product lines. In light of the expected continuing growth of the POS products, failure to reduce out-of-network utilization could adversely affect the Company's profitability. Accrued health care expenses payable in the Company's financial statements include reserves for incurred but not reported claims ("IBNR"), the amount of which is estimated by the Company. The Company estimates the amount of such reserves using standard actuarial methodologies based upon historical data including the 8 average interval between the date services are rendered and the date claims are paid, expected medical cost inflation, seasonality patterns and increases in membership. The Company believes that its reserves for IBNR are adequate in order to satisfy its ultimate claims liability. However, there can be no assurances as to the ultimate accuracy or completeness of such estimates or that adjustments to reserves will not cause volatility in the Company's results of operations. Dependence upon Key Employer Agreements. The Company's ability to obtain and maintain favorable group benefit agreements with employer groups affects the Company's profitability. Currently, 17% of its total commercial enrollment (those groups which are fully insured, which includes 332,363 enrollees) is derived from its largest five fully insured accounts. Fully insured groups produce the highest PMPM revenues for the Company. Although during the Company's most recent fiscal year, no employer group accounted for more than 7.5% of total revenues, the loss of one or more of the larger employer group accounts could have a material adverse effect upon the Company's business. Although only 8% of the Company's total membership in 1996 was enrolled in Medicare and Medicaid programs, that percentage is expected to increase in the future. Loss of one or more of the contracts the Company currently has or expects to have to serve Medicaid or Medicare participants could have a material adverse effect upon the Company's business. Finally, the Company has agreed to certain performance guarantees for certain of the large employer groups with which it contracts. Failure to satisfy such guarantees could result in financial penalties. Key Partnership. The Company's contracts with The Guardian are expected to represent a significant percentage of the Company's revenue and enrollment in future years. See "Business--Joint Marketing Arrangement with The Guardian." The loss of this relationship could have a material adverse effect on the Company's business. Competition. Managed care companies and HMOs operate in a highly competitive environment. The Company has numerous types of competitors, both local and national, including, among others, HMOs, PPOs, self-insured employer plans and traditional indemnity carriers, many of which have substantially larger total enrollments, greater financial resources and other characteristics that give them an advantage in competing with the Company. Additional competitors with needs or desires for immediate market share or those with greater financial resources than the Company have entered or may enter the Company's market. The Company also believes that the addition of new competitors can occur relatively easily. In addition, certain of the Company's customers may decide to perform for themselves certain administrative services currently provided by the Company, which could adversely affect the Company's revenues. Significant merger and acquisition activity has occurred in the managed care industry as well as in industries which are suppliers to the Company. This activity may result in stronger competitors or increased health care costs. Increased competitive pressures may limit the Company's ability to increase, or in some instances, maintain premiums, reduce membership levels or decrease profit margins, and there can be no assurance that the Company will not incur increased pricing and enrollment pressure from local and national competitors. Any such pressures could materially affect the Company's results of operations. Government Regulation. The Company's business is subject to extensive federal and state laws and regulations, including, but not limited to, financial requirements, licensing requirements, enrollment requirements and periodic examinations by governmental agencies. The laws and regulations governing the Company's business and the interpretation of those laws and regulations are subject to frequent change. Existing or future laws or regulations could force the Company to change the way it does business and may restrict the Company's revenue or enrollment growth or increase its health care and/or administrative costs. In particular, the Company's HMO and insurance subsidiaries are subject to regulations relating to cash reserves, minimum net worth, premium rates and approval of policy language and benefits. Although such regulations have not significantly impeded the growth of the Company's business to date, there can be no assurance that the Company will be able to continue to obtain or maintain required governmental approvals or licenses or that regulatory changes will not have a material adverse effect on the Company's business. In addition, delays in obtaining regulatory approvals or moratoriums imposed by regulatory authorities could adversely effect the Company's ability to bring new products to market as forecasted. The Company is also subject to various governmental audits and investigations. 9 Such activities could result in the loss of required licenses or the right to participate in certain programs, or the imposition of penalties and/or other sanctions. In addition, disclosure of any adverse investigation or audit results or sanctions could negatively affect the Company's reputation in various markets and make it more difficult for the Company to sell its products and services. Management Information System. The Company's management information system is critical to its current and future operations. The information gathered and processed by the Company's management information system assists the Company in, among other things, pricing its services, monitoring utilization and other cost factors, processing provider claims, providing bills on a timely basis and identifying accounts for collection. Any difficulty associated with or failure to successfully implement the current conversion of its management information system, or any inability to expand processing capability in the future in accordance with its business needs, could result in a loss of existing customers and difficulty in attracting new customers, customer and provider disputes, regulatory problems, increases in administrative expenses or other adverse consequences. New Service Areas and Products. The Company recently undertook a significant expansion of its geographic market area. In addition, it recently introduced several new products, including Medicare risk and Medicaid products. The success of its geographic and product expansion efforts depends in large part on its ability to develop market share in a highly competitive market and to develop the infrastructure necessary to support the forecasted enrollment growth. The Company believes that it has budgeted sufficient amounts to meet its growth expectations; however, there can be no assurance that it will not require greater resources than expected or that it will be successful in its marketing efforts. Furthermore, although it believes it has introduced programs to effectively manage its new products, there can be no assurance that the health care and other costs associated with such programs will not be greater than revenues. Medicare risk contracts provide revenues which are generally higher per member than those for non-Medicare members, and thus provide an opportunity for increased profits and cash flow. Such risk contracts, however, also carry certain risks such as higher comparative medical costs, government regulatory and reporting requirements, the possibility of reduced or insufficient government reimbursement in the future, and higher marketing and advertising costs per member as the result of marketing to individuals as opposed to groups. Possible Volatility of Common Stock Price. Recently, there has been significant volatility in the market prices of securities of companies in the health care industry, including the price of the Company's Common Stock. Many factors, including medical cost increases, analysts' comments, speculation about a possible merger or acquisition, announcements of new legislative proposals or laws relating to health care reform, the performance of, and investor expectations for, the Company, the trading volume of the Company's Common Stock and general economic and market conditions, may influence the trading price of the Company's Common Stock. Accordingly, there can be no assurance as to the price at which the Company's Common Stock will trade in the future. Negative Publicity. The managed care industry has recently received a significant amount of negative publicity. Such general publicity, or any negative publicity regarding the Company in particular, could adversely affect the Company's ability to sell its products or services or could create regulatory problems for the Company. Recently, the managed care industry has experienced significant merger and acquisition activity. Speculation or uncertainty about the Company's future could adversely affect the ability of the Company to market its products. Accreditation. Certain of the Company's customers or potential customers consider rating, accreditation or certification of the Company by various private or governmental bodies or rating agencies as necessary and/or important. The Company currently has three year accreditation from the National Committee on Quality Assurance ("NCQA") which will expire in May, 1997. NCQA visited the Company's offices in connection with its reaccreditation in late March 1997. Should the Company fail to maintain three- year NCQA accreditation, or obtain any other certification or accreditation as may be deemed to be necessary and/or important by customers, it may adversely affect the Company's ability to obtain or retain the business of such customers. Administrative Expense. The level of administrative expense is a partial determinant of the Company's profitability. While the Company attempts to effectively manage such expenses, increases in staff-related and 10 other administrative expenses may occur as a result of business or product expansion, changes in business, acquisitions, regulatory requirements or other reasons. Such expense increases are not clearly predictable and increases in administrative expenses may adversely affect financial results. The Company currently believes that it has a relatively experienced, capable management staff. Loss of certain managers or a number of such managers could adversely affect the Company's ability to administer and manage its business. Litigation and Insurance. The Company is subject to a variety of legal actions to which any corporation may be subject. In addition, because of the nature of its business, the Company incurs and likely will continue to incur potential liability for claims related to its business, such as failure to pay for or provide health care, poor outcomes for care delivered or arranged, provider disputes and claims related to self-funded business. It is possible that punitive or substantial non-economic damages may be sought in cases of this nature. While the Company currently has insurance coverage for some of these potential liabilities, others may not be covered by insurance, the insurers may dispute coverage or the amount of insurance may not be enough to cover the damages awarded. In addition, certain types of damages, such as punitive damages, may not be covered by insurance and insurance coverage for all or certain forms of liability may become unavailable or prohibitively expensive in the future. Provider Relations. One of the significant techniques that the Company uses to manage health care costs and utilization is contracting with physicians, hospitals and other providers. Because of the large number of providers with which the Company contracts, the Company currently believes that it has a limited exposure to provider relations issues. In any particular market, however, providers could refuse to contract with the Company, demand higher payments or take other actions which could result in higher health care costs, less desirable products for customers and members or difficulty in meeting regulatory or accreditation requirements. In some markets, certain providers, particularly hospitals, physician/hospital organization or multi-speciality physician groups, may have significant market positions. Such groups may also compete directly with the Company. If such providers refuse to contract with the Company or utilize their market position to negotiate favorable contacts or place the Company at a competitive disadvantage, the Company's ability to market products or to be profitable in those areas could be adversely affected. In addition, the Company has recently entered into a number of contracts with physician/hospital organizations and other physician groups that place a significant percentage of the risk of overutilization on those groups. Although this technique is believed to be advantageous to the Company insofar as it limits the Company's risk, failure of one or more of the physician/hospital or other physician groups to successfully manage the risk could have a material adverse effect on the Company's business and results of operations. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The response to this Item is submitted in Item 14 of this Report. 11 ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K. (a) 1. All financial statements -- see Index to Consolidated Financial Statements and Schedules attached hereto. 2. Financial statement schedules -- see Index to Consolidated Financial Statements and Schedules attached hereto. 3. Exhibits -- see Exhibit Index on page E-1. (b) Reports on Form 8-K None 12 PHYSICIANS HEALTH SERVICES, INC. AND SUBSIDIARIES INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND SCHEDULES Page ---- Report of Independent Auditors....................................... F-1 Consolidated Balance Sheets as of December 31, 1996 and 1995......... F-2 Consolidated Statements of Operations for the years ended December 31, 1996, 1995 and 1994................................... F-3 Consolidated Statements of Shareholders' Equity for the years ended December 31, 1996, 1995 and 1994....................... F-4 Consolidated Statements of Cash Flows for the years ended December 31, 1996, 1995 and 1994................................... F-5 Notes to Consolidated Financial Statements........................... F-6 Schedule I -- Condensed Financial Information of Registrant.......... F-17 Schedule II -- Valuation and Qualifying Accounts..................... F-20 13 REPORT OF INDEPENDENT AUDITORS Board of Directors Physicians Health Services, Inc. We have audited the consolidated balance sheets of Physicians Health Services, Inc. and subsidiaries as of December 31, 1996 and 1995, and the related consolidated statements of operations, stockholders' equity, and cash flows for the three years in the period ended December 31, 1996. Our audits also included the financial statement schedules listed in the Index at Item 14(a). 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 financial statements referred to above present fairly, in all material respects, the consolidated financial position of Physicians Health Services, Inc. and subsidiaries at December 31, 1996 and 1995, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1996, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. As discussed in Note 2 to the consolidated financial statements, in 1994 the Company changed its method of accounting for certain investments in debt and equity securities. Ernst & Young LLP Stamford, Connecticut March 14, 1997 F-1 PHYSICIANS HEALTH SERVICES, INC. CONSOLIDATED BALANCE SHEETS
DECEMBER 31, ----------------------- 1996 1995 ----------- ----------- (DOLLARS IN THOUSANDS) ASSETS Current assets: Cash and cash equivalents............................. $ 39,213 $ 7,536 Investments available for sale, at fair value: Fixed maturity securities............................. 59,115 102,130 Equity securities..................................... -- 1,355 Accounts receivable, less allowances (1996-$1,781 and 1995-$1,050)......................................... 38,028 31,548 Other receivables..................................... 19,696 14,815 Advances to participating hospitals................... 400 5,903 Prepaid expenses and other............................ 1,154 204 ----------- ----------- Total Current Assets................................. 157,606 163,491 Property, plant and equipment: Land.................................................. 8,822 3,322 Building and improvements............................. 26,938 14,645 Furniture and equipment............................... 46,559 29,817 ----------- ----------- 82,319 47,784 Less accumulated depreciation and amortization......... 15,273 11,028 ----------- ----------- 67,046 36,756 Other assets (including restricted investments)........ 13,658 10,821 ----------- ----------- Total Assets......................................... $ 238,310 $ 211,068 =========== =========== LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Accrued hospital and other health care expenses....... $ 46,153 $ 23,878 Unearned premiums..................................... 27,757 25,022 Amounts due to IPAs, physicians and other providers... 53,103 37,806 Accounts payable and accrued expenses................. 13,849 14,199 ----------- ----------- Total Current Liabilities............................ 140,862 100,905 Excess of net assets over cost of company acquired..... 1,162 1,282 ----------- ----------- Total Liabilities.................................... 142,024 102,187 Stockholders' equity: Preferred Stock, par value $0.01 per share--authorized 500 shares, none issued.............................. -- -- Class A Common Stock, par value $0.01 per share-- authorized 13,000,000 shares; issued and outstanding 1996--5,566,023 shares; 1995--5,310,347 shares; voting rights--1 per share........................... 56 53 Class B Common Stock, par value $0.01 per share; non- transferable; authorized and issued 1996--3,829,880 shares; 1995--4,052,974 shares; voting rights--10 per share................................................ 38 41 Additional paid-in capital............................. 41,360 40,760 Net unrealized gains on marketable securities, net of tax................................................... 279 510 Retained earnings...................................... 54,554 67,518 ----------- ----------- 96,287 108,882 Less cost of Class B Common Stock (86,400 shares) in Treasury.............................................. 1 1 ----------- ----------- Total Stockholders' Equity........................... 96,286 108,881 ----------- ----------- Total Liabilities and Stockholders' Equity............ $ 238,310 $ 211,068 =========== ===========
See notes to consolidated financial statements. F-2 PHYSICIANS HEALTH SERVICES, INC. CONSOLIDATED STATEMENTS OF OPERATIONS
YEAR ENDED DECEMBER 31, --------------------------- 1996 1995 1994 -------- -------- -------- (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) REVENUES: Premiums......................................... $481,534 $342,975 $289,784 Investment and other income...................... 6,574 6,968 4,160 -------- -------- -------- 488,108 349,943 293,944 Costs and expenses: Hospital services................................ 178,059 111,947 94,934 Physicians and related health care services...... 198,591 131,019 117,393 Other health care services....................... 42,382 18,707 12,943 Indemnity costs.................................. 7,008 2,157 -- Selling, general and administrative expenses..... 86,728 58,504 44,089 Guardian joint marketing expense (income), net... (809) 2,298 -- Proxy defense costs.............................. -- 892 -- Interest expense................................. 388 -- -- -------- -------- -------- 512,347 325,524 269,359 Income (loss) before income taxes.................. (24,239) 24,419 24,585 Income tax expense (benefit)....................... (11,275) 8,449 10,451 -------- -------- -------- Net income (loss).................................. $(12,964) $ 15,970 $ 14,134 ======== ======== ======== Net income (loss) per common share................. $ (1.39) $ 1.70 $ 1.52 ======== ======== ======== Weighted average number of common and common equivalent shares outstanding..................... 9,301 9,403 9,307 ======== ======== ========
See notes to consolidated financial statements. F-3 PHYSICIANS HEALTH SERVICES, INC. CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
YEAR ENDED DECEMBER 31, --------------------------- 1996 1995 1994 -------- -------- ------- (DOLLARS IN THOUDANDS) CLASS A COMMON STOCK Balance at beginning of period..................... $ 53 $ 49 $ 45 Conversion of Class B Common Stock into Class A Common Stock: 1996--223,094 shares, 1995--437,537 shares, 1994-- 435,228 shares................................... 3 4 4 Options exercised: 1996--32,582 shares, 1995--14,974 shares, 1994-- 3,558 shares..................................... -------- -------- ------- Balance at end of period........................... $ 56 $ 53 $ 49 ======== ======== ======= CLASS B COMMON STOCK Balance at beginning of period..................... $ 41 $ 45 $ 49 Conversion of Class B Common Stock into Class A Common Stock: 1996--223,094 shares, 1995--437,537 shares, 1994-- 435,228 shares................................... (3) (4) (4) -------- -------- ------- Balance at end of period........................... $ 38 $ 41 $ 45 ======== ======== ======= ADDITIONAL PAID-IN CAPITAL Balance at beginning of period..................... $ 40,760 $ 40,514 $40,461 Exercise of stock options.......................... 600 246 53 -------- -------- ------- Balance at end of period........................... $ 41,360 $ 40,760 $40,514 ======== ======== ======= NET UNREALIZED GAINS (LOSSES) ON MARKETABLE SECURI- TIES, NET OF TAX Balance at beginning of period..................... $ 510 $ (949) $ -- Net unrealized gain at date of adoption of SFAS 115, net of tax................................... -- -- 184 Net unrealized gain (loss)......................... (231) 1,459 (1,133) -------- -------- ------- Balance at end of period........................... $ 279 $ 510 $ (949) ======== ======== ======= RETAINED EARNINGS Balance at beginning of period..................... $ 67,518 $ 51,548 $37,414 Net income (loss).................................. (12,964) 15,970 14,134 -------- -------- ------- Balance at end of period........................... $ 54,554 $ 67,518 $51,548 ======== ======== ======= TREASURY STOCK Balance at beginning and end of period............. $ (1) $ (1) $ (1) TOTAL STOCKHOLDERS' EQUITY Balance at beginning of period..................... $108,881 $ 91,206 $77,968 Exercise of stock options.......................... 600 246 53 Net income (loss).................................. (12,964) 15,970 14,134 Net unrealized gain (loss) on marketable securities, net of tax............................ (231) 1,459 (949) -------- -------- ------- Balance at end of period........................... $ 96,286 $108,881 $91,206 ======== ======== =======
See notes to consolidated financial statements. F-4 PHYSICIANS HEALTH SERVICES, INC. STATEMENTS OF CASH FLOWS
YEAR ENDED DECEMBER 31, ---------------------------- 1996 1995 1994 -------- -------- -------- (DOLLARS IN THOUSANDS) OPERATING ACTIVITIES Net income (loss)............................... $(12,964) $ 15,970 $ 14,134 Adjustments to reconcile net income (loss) to net cash provided by (used for) operating activities: Depreciation and amortization.................. 4,302 3,064 2,364 Provision for doubtful accounts................ 1,485 103 1,423 Amortization of excess of net assets over cost of company acquired........................... (120) (120) (120) Deferred income tax expense (benefit).......... 690 1,421 (233) Changes in assets and liabilities: Accounts receivable........................... (7,965) (4,453) (3,273) Other receivables............................. (4,881) (13,043) (1,217) Advances to participating hospitals........... 5,503 1,619 3,794 Prepaid expenses and other.................... (950) 708 (114) Accrued health care expenses.................. 22,275 (1,232) (4,028) Unearned premiums............................. 2,735 631 2,233 Due to IPAS, Physicians and other providers... 15,297 (5,793) 8,076 Accounts payable and accrued expenses......... (856) (8,367) 16,292 -------- -------- -------- Net cash provided by (used for) operating activities..................................... 24,551 (9,492) 39,331 INVESTING ACTIVITIES Purchases of property, plant and equipment...... (34,633) (15,168) (9,711) Disposals of property, plant and equipment...... 41 14 226 Net increase in other assets.................... (2,837) (6,916) (674) Purchases of marketable securities.............. (242,451) (324,877) (340,176) Proceeds from sales of marketable securities.... 286,406 335,262 332,629 -------- -------- -------- Net cash provided from (used for) investing activities..................................... 6,526 (11,685) (17,706) FINANCING ACTIVITIES Proceeds from revolving credit line............. 18,000 -- -- Repayment of revolving credit line.............. (18,000) -- -- Exercise of stock options....................... 600 246 53 -------- -------- -------- Net cash provided by financing activities....... 600 246 53 -------- -------- -------- Increase (decrease) in cash and cash equivalents.................................... 31,677 (20,931) 21,678 Cash and cash equivalents at beginning of year.. 7,536 28,467 6,789 -------- -------- -------- Cash and cash equivalents at end of year........ $ 39,213 $ 7,536 $ 28,467 ======== ======== ========
See notes to consolidated financial statements. F-5 PHYSICIANS HEALTH SERVICES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1996 1. ORGANIZATION AND BUSINESS Physicians Health Services, Inc. (the "Company" or "PHS") is a holding company which owns nine subsidiary corporations: Physicians Health Services of Connecticut, Inc. (PHS/CT), Physicians Health Services of New York, Inc. (PHS/NY), Physicians Health Insurance Services, Inc. (PHIS), PHS Investments, Inc., Physicians Health Services (Bermuda), Ltd. (PHS/Bermuda), Physicians Health Services of New Jersey, Inc. (PHS/NJ), (which was licensed in January 1996), PHS Insurance of Connecticut, Inc. (PHS Insurance CT), Physicians Health Services Insurance of New York, Inc. (PHS Insurance NY), and PHS Real Estate, Inc. (PHS RE). PHS/CT and PHS/NY have been designated by the Department of Health and Human Services (DHHS) as federally qualified Health Maintenance Organizations (HMOs). PHS/CT, PHS/NY and PHS/NJ operate as health maintenance organizations in Connecticut, New York and New Jersey, respectively, and are regulated by their respective state insurance departments. PHS/NY and PHS/NJ are also regulated by the Department of Health and Human Services and New Jersey Department of Health and Senior Services, respectively. State regulations include reserve and cash flow requirements and restrictions on the ability to pay dividends. Subscribers pay monthly premiums which entitle them to comprehensive health services as needed, according to the terms of their contracts. PHIS, which is licensed as an insurance broker, was formed to market insurance products to enrollees. The operations of PHIS for all years presented were not significant. PHS Insurance CT and PHS Insurance NY operate in and are regulated by the Insurance Departments of Connecticut and New York, respectively. These companies are licensed to write accident and health indemnity insurance although no business has yet been written. PHS/Bermuda is an offshore property and casualty reinsurer that was formed to support the business needs of the Company. This includes an agreement to reinsure certain business with The Guardian Life Insurance Company of America (see Note 10). PHS/CT operates throughout most of Connecticut with a significant portion of its enrollees currently located in Fairfield County. PHS/NY operates only in New York's Westchester, Putnam, Dutchess, Rockland and Orange Counties, and the metropolitan New York City and Long Island regions. PHS/NJ operates throughout New Jersey. The Company's membership consists of commercial, government and self-funded members. PHS RE has a wholly owned subsidiary, PHS Real Estate II, Inc. (PHS RE II), which owns the Company's new corporate headquarters. The operations of PHS RE and PHS RE II were not significant. The Company's managed care products include traditional HMO products, in both open access and gatekeeper models, point of service ("POS") products, administrative services only ("ASO") plans and Medicare and Medicaid plans. The Company contracts with physician groups, such as IPAs, PHOs, and multi- specialty groups (collectively, "Physician Groups"), individual physicians and other health care providers for a defined range of health services, including primary and specialty care. The Company's contracts with providers include discounted fee for service arrangements as well as capitated group arrangements in which the contracting Physician Group assumes a significant amount of the risk of overutilization. The Company currently has contracts with four IPAs, three PHOs and one large physician group ("Group") that provide for most of its physician services in its Connecticut service area. In New York and New Jersey, the Company generally F-6 PHYSICIANS HEALTH SERVICES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) contracts directly with physicians and other health care providers. Under the typical Physician Group arrangements, the Physician Group receives a fixed monthly capitation payment for each member selecting a primary care physician from that Physician Group. Capitation rates and any increases thereto are negotiated for the term of the contract. The capitation payment is designed to cover not only the professional medical services (including ancillary tests and services) rendered by the physicians and other providers associated with that Physician Group but also includes payments for certain other services rendered to the enrollee by providers who are not members of the Physician Group. Services covered by the capitation payment include, among other things, virtually all physician claims (whether inpatient or outpatient, including authorized out-of-plan care) and care rendered by other professionals such as physical therapists and psychologists. In certain of the contracts, the Physician Groups also are at risk for hospital, pharmacy and other facility expenses. The Company does not capitate physicians directly. The capitation payments to Physician Groups other than the PHOs typically do not cover hospital and other facility expenses, although the Physician Groups are partially at risk for non-Medicare and non-Medicaid hospital utilization. The Company establishes an annual per member, per month target for hospital expenses. The amount varies by benefit plan and Physician Group, and encompasses both inpatient and outpatient costs. If total hospital expenses generated by the Physician Group exceed the applicable hospital expense target, the Company withholds from amounts owed by it to the Physician Group all or a portion of the excess over budget, in most cases one-half of the excess over budget. If actual costs are less than budgeted targets, the Physician Group receives from the Company an incentive credit typically equal to forty to fifty percent of the amount by which actual costs are less than budgeted targets. In its New York and New Jersey expansion areas and in areas in Connecticut not served through Physician Group contracts, the Company contracts for services principally through direct contracts with individual physicians and other health care providers. In addition, the Company contracts with two IPAs in the northern counties of its New York service area. The Company withholds a percentage of reimbursement for services rendered pursuant to its direct physician contracts against budgeted amounts to manage excessive utilization. The Company generally negotiates contracts with hospitals that include compensation on a per diem basis (at a daily rate, without regard to the scope of services actually provided). Other compensation arrangements with hospitals include charged-based discounts (negotiated discounts from the hospital's billed charges) and all inclusive case rates. In the case of non-participating hospitals, the Company pays either hospital billed charges or negotiated discounted charges. Additionally, some hospital contracts include per case, all-inclusive payment arrangements for select procedures such as maternity care. At December 31, 1996, three of the IPA's own common stock of the Company aggregating approximately 32% (which entitle them to 68% of the vote on matters submitted to the Stockholders), with one IPA (Greater Bridgeport Individual Practice Association) owning approximately 27% (58% of the vote). Capitation expenses incurred relating to these three IPA's which are included in physician and related healthcare expenses in the accompanying statements of operations amounted to $55,019,000, $68,523,000 and $65,091,000 for the years ended December 31, 1996, 1995 and 1994 respectively. At December 31, 1996 and 1995 amounts payable to these IPA's were $21,622,000 and $10,388,000, respectively. 2. SIGNIFICANT ACCOUNTING POLICIES PRINCIPLES OF CONSOLIDATION The consolidated financial statements include the accounts of the Company and its subsidiaries, all of which are wholly-owned except for PHS/NJ which is 80% owned by the Company with a 20% minority interest owned F-7 PHYSICIANS HEALTH SERVICES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) by Mastercare Companies, Inc. (See Note 11). Such minority interest was not material to the accompanying consolidated financial statements. Significant intercompany accounts and transactions have been eliminated in consolidation. USE OF ESTIMATES The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates. REVENUE RECOGNITION Premiums from subscribers and assumed or ceded under reinsurance agreements are reflected in operations as earned on a pro-rata basis over the period of coverage. Premiums for periods extending beyond year-end are classified as unearned premiums. The Company maintains an allowance for doubtful accounts at a level management believes is sufficient to cover potentially uncollectible amounts. PHYSICIANS AND RELATED HEALTH CARE SERVICES The costs of physicians and related health care services are accrued for in the period they are provided to enrollees. For the services provided for by individually contracted physicians, the accrual for the incurred but not reported claims represent the estimated liability on outstanding claims, based upon an evaluation of reported claims. Such estimates are continually monitored and, as estimates are adjusted, they are reflected in current operations. The amounts accrued under capitation arrangements with IPA's are increased or decreased based on a comparison of the HMO's hospitalization costs to contractual targets. HOSPITAL AND OTHER HEALTH CARE SERVICES The cost of health care services is accrued in the period they are provided to enrollees. The amounts accrued for hospital and other health care expenses represent the estimated liabilities for reported and unreported claims. The reserves for incurred but not reported claims represent the estimated liability on outstanding claims, based on an evaluation of reported claims. The estimates are continually monitored and reviewed and, as settlements are made or estimates adjusted, the resulting differences are reflected in current operations. Although considerable variability is inherent in such estimates, management believes that reported reserves are adequate in the aggregate to cover the ultimate resolution of incurred claims. CONTRACTS WITH HEALTH CARE FINANCING ADMINISTRATION Prior to 1996, the Company had entered into a "cost based" contract with the Health Care Financing Administration ("HCFA"). Under this contract, HCFA pays the Company a fixed per member per month amount for physician services, while HCFA pays the costs for inpatient and outpatient services. During 1996, the Company entered into a "risk based" contract with HCFA. Under the risk-based contract the Company is paid a fixed per member, per month amount by HCFA for all services provided. The Company bears the risk that the actual costs of health care services may exceed the per member, per month amount. The risk based contract is intended to replace the cost based contract for new enrollees. PROPERTY, PLANT AND EQUIPKMENT Property, plant and equipment are stated at cost, less accumulated depreciation and amortization. Provisions for depreciation and amortization are computed using the straight-line method over the estimated useful lives of F-8 PHYSICIANS HEALTH SERVICES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) the assets or the terms of the leases, if shorter. Included in property, plant and equipment are the costs related to the development of a new managed care information system, approximately $18,600,000 at December 31, 1996. This new system is expected to be implemented in late 1997. Amortization of the cost of the new system will begin upon its implementation and continue on a straight- line basis over its estimated useful life. EXCESS OF NET ASSETS OVER COST OF COMPANY ACQUIRED The excess of net assets over the cost of company acquired is being amortized by the straight-line method over a 20 year period ending August 31, 2006. Accumulated amortization was $1,240,000 and $1,120,000 at December 31, 1996 and 1995, respectively. PER SHARE DATA Per share data are based on the weighted average number of common and common equivalent shares outstanding during the period. Common stock equivalents consist of stock options. Fully diluted per share data are not presented as they are not materially different from primary earnings per share data. STOCK BASED COMPENSATION In 1996, the Company implemented the supplemental pro forma provisions of Statement of Financial Accounting Standards ("SFAS") No. 123, "Accounting for Stock-Based Compensation" ("SFAS 123"). SFAS 123, if adopted, requires companies to recognize compensation expense for grants of restricted stock, stock options and similar equity instruments to employees and directors based on their respective fair values at the date of grant. However, the provisions of Accounting Principles Board ("APB") Opinion No. 25, "Accounting for Stock Issued to Employees" ("APB 25") may still be utilized with supplemental pro forma disclosures of net income and earnings per share being made in the footnotes as if the accounting provisions of SFAS 123 had been adopted. SFAS 123 is effective for fiscal years beginning after December 15, 1995. The Company continues to apply the requirements of APB 25 in the accompanying financial statements with supplemental pro forma disclosures provided in the notes to the consolidated financial statements (See note 8). CASH AND CASH EQUIVALENTS Cash and cash equivalents consist of highly liquid investments with a maturity of three months or less at the time of purchase. FAIR VALUE OF FINANCIAL INSTRUMENTS Cash and cash equivalents, accounts receivable, other receivables, advances to participating hospitals and all current liabilities have fair values that approximate their carrying amounts. INVESTMENTS In May 1993, the Financial Accounting Standards Board issued SFAS 115, "Accounting for Certain Investments in Debt and Equity Securities." The Company adopted the provisions of the new standard as of January 1, 1994, and categorizes its investments in fixed maturity and equity securities as "available for sale." Accordingly, such investments are reported at fair value with changes in unrealized gains and losses disclosed separately, net of taxes, in stockholders' equity. Fair values are based primarily on quoted market prices. Investment income includes realized investment gains and losses on the sale or maturity of investments, determined by the specific identification method, and dividends and interest, which are recognized when earned. The amortization of premium and accretion of discount for fixed maturities is computed utilizing the interest method. INCOME TAXES Income taxes have been provided using the liability method in accordance with SFAS 109, "Accounting for Income Taxes." F-9 PHYSICIANS HEALTH SERVICES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) IMPAIRMENT OF LONG-LIVED ASSETS In March 1995 the FASB issued Statement of Financial Accounting Standards ("SFAS") No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of." At December 31, 1996, the Company had no long-lived assets held for disposal. In accordance with SFAS No. 121, the Company monitors its long-lived assets for any indicators of impairment. To the extent such indicators are present, a comparison is made of the asset's carrying value to the estimated undiscounted cash flows related to the asset. If the undiscounted cash flows of the asset are less than its carrying value, the Company would recognize an impairment loss equal to the amount by which the asset's carrying value exceeds its fair value. At December 31, 1996, the Company noted no indicators of impairment related to its long-lived assets. RECLASSIFICATIONS Certain reclassifications were made to conform prior year amounts to current year presentation. 3. EXCESS OF LOSS REINSURANCE AGREEMENT During 1996 the Company limited the amount of its risk on eligible hospital claims for any one member in a contract year by acquiring reinsurance coverage for claims in excess of $600,000 per member, per year for PHS/CT, PHS/NY and PHS/NJ. The reinsurance contracts allow the Company to transfer to the reinsurer 80% of the next $400,000 of claims per member per year. The contract limits covered claims to $2 million per member per lifetime (including the deductible). During 1995 and 1994, the Company acquired reinsurance coverage for claims in excess of $250,000 per member, per year for PHS/CT and $100,000 per member, per year for PHS/NY. Those reinsurance policies allowed the Company to transfer to the reinsurer 80% of the next $750,000 (PHS/CT) and $900,000 (PHS/NY) of the amount of claims in excess of the aforementioned annual retentions. Reinsurance expense and recoveries are included in other health care services. Reinsurance expense was $910,000, $1,300,000, and $636,000, for 1996, 1995 and 1994, respectively. Recoveries were $311,000, $60,000, and $106,000 for 1996, 1995, and 1994, respectively. 4. INVESTMENTS AND OTHER INCOME The amortized cost, gross unrealized gains and losses, and estimated fair values of investments are as follows (in thousands):
DECEMBER 31, 1996 ---------------------------------------- GROSS GROSS AMORTIZED UNREALIZED UNREALIZED FAIR COST GAINS LOSSES VALUE --------- ---------- ---------- -------- U.S. Government and its agencies....... $ 5,598 $-- $ 15 $ 5,583 Corporate securities................... 12,803 5 20 12,788 Municipals............................. 40,242 503 1 40,744 -------- ---- ---- -------- Total fixed securities................. $ 58,643 $508 $ 36 $ 59,115 ======== ==== ==== ======== DECEMBER 31, 1995 ---------------------------------------- GROSS GROSS AMORTIZED UNREALIZED UNREALIZED FAIR COST GAINS LOSSES VALUE --------- ---------- ---------- -------- U.S. Government and its agencies....... $ 10,629 $ 22 $-- $ 10,651 Corporate securities................... 1,535 14 -- 1,549 Municipals............................. 89,017 936 23 89,930 -------- ---- ---- -------- Fixed securities..................... 101,181 972 23 102,130 Equity securities...................... 1,417 -- 62 1,355 -------- ---- ---- -------- Total................................ $102,598 $972 $ 85 $103,485 ======== ==== ==== ========
F-10 PHYSICIANS HEALTH SERVICES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) At December 31, 1996, the contractual maturities of investments in fixed maturities are as follows (in thousands):
AMORTIZED FAIR COST VALUE --------- ------- Due in one year or less................................... $25,037 $25,131 Due after one year through five years..................... 33,106 33,485 Due after ten years....................................... 500 499 ------- ------- $58,643 $59,115 ======= =======
Major sources of and related amounts of net investment and other income are as follows (in thousands):
YEAR ENDED DECEMBER 31 -------------------------- 1996 1995 1994 -------- ------- ------- Dividends and interest income from investments.. $ 5,444 $ 7,099 $ 5,091 Realized gains............ 139 385 290 Realized losses........... (99) (366) (1,170) Investment expenses....... (132) (193) (258) -------- ------- ------- Net investment income..... 5,352 6,925 3,953 Interest on Guardian Receivable............... 866 -- -- Other income.............. 356 43 207 -------- ------- ------- Net investment and other income................... $ 6,574 $ 6,968 $ 4,160 ======== ======= ======= 5. INCOME TAXES Significant components of income tax expense (benefit) were as follows (in thousands): YEAR ENDED DECEMBER 31 -------------------------- 1996 1995 1994 -------- ------- ------- Current income tax expense (benefit): Federal................. $(10,004) $ 5,428 $ 7,720 State................... (1,961) 1,600 2,964 -------- ------- ------- (11,965) 7,028 10,684 Deferred income tax expense (benefit)........ 690 1,421 (233) -------- ------- ------- Income tax expense (benefit)................ $(11,275) $ 8,449 $10,451 ======== ======= ======= The following is a reconciliation of federal income tax expense computed at statutory rates to the amount of income tax expense reflected in the consolidated statements of operations (in thousands): YEAR ENDED DECEMBER 31 -------------------------- 1996 1995 1994 -------- ------- ------- Federal income tax (benefit) at statutory rates.................... $ (8,484) $ 8,547 $ 8,605 State income taxes (net of federal tax benefit)..... (1,750) 1,773 1,938 Tax exempt interest....... (1,239) (1,790) -- Other..................... 198 (81) (92) -------- ------- ------- Income tax expense (benefit)................ $(11,275) $ 8,449 $10,451 ======== ======= =======
F-11 PHYSICIANS HEALTH SERVICES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) Net deferred tax liabilities, which are included in accounts payable and accrued expenses, reflect the tax effect of temporary differences between the carrying amounts of assets and liabilities for financial reporting and income tax purposes. Significant components of the Company's net deferred tax liabilities as of December 31 are as follows (in thousands):
1996 1995 ------ ------ Deferred tax assets: Provision for bad debts........................................ $ 748 $ 444 Nondeductible hospitalization accruals......................... 968 643 Accrued vacation............................................... 611 428 State net operating loss carryforward.......................... 1,864 -- Other.......................................................... 370 -- ------ ------ Total deferred tax assets........................................ 4,561 1,515 Deferred tax liabilities: Unrealized gains on investments................................ 193 377 Depreciation................................................... 1,075 1,090 Tax credit for research activities............................. 4,242 751 Prepaid expenses............................................... 240 -- Accrued market discount on bonds held.......................... 443 423 ------ ------ Total deferred tax liabilities................................... 6,193 2,641 ------ ------ Net deferred tax liability....................................... $1,632 $1,126 ====== ======
As a result of current year losses, approximately $27.0 million of state tax loss carryforwards will be available for use to offset future state taxable income through 2001. The Company paid income taxes of $904,000 in 1996, $10,754,000 in 1995, and $7,059,000 in 1994. 6. LEASES The Company leases office space for ten branch locations. Future minimum lease payments under noncancelable operating leases with remaining terms of one year or more consisted of the following at December 31, 1996 (in thousands): 1997................................................................. $ 2,530 1998................................................................. 2,573 1999................................................................. 2,465 2000................................................................. 2,264 2001................................................................. 1,779 2002 and thereafter.................................................. 5,094 ------- $16,705 =======
Total rent expense was $2,784,000 in 1996, $1,423,000 in 1995, and $420,000 in 1994. 7. COMMITMENTS AND CONTINGENCIES The Company is involved in various litigation and claims arising in the normal course of business which management believes, based upon discussions with legal counsel, will not have a material adverse effect on the accompanying financial statements. F-12 PHYSICIANS HEALTH SERVICES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) During 1996, the Company entered into a revolving credit agreement under which it borrowed $18 million to provide short-term financing for the purchase of the Company's new headquarters. In the fourth quarter the Company repaid amounts due under the credit agreement and terminated the credit line. Total interest expense paid in connection with this agreement was approximately $388,000. The Health Reinsurance Association ("HRA") provides for otherwise unavailable health insurance coverage to uninsured or underinsured Connecticut residents. All health insurers, including HMOs, licensed in Connecticut are subject to assessment by the HRA to the extent the HRA incurs net losses. Assessments are based on premiums written and amounted to $1,018,000, $692,000, and $800,000 in 1996, 1995 and 1994, respectively. PHS/NY is subject to a community rating law which establishes a pooling mechanism providing for payments to insurers writing policies for a disproportionate share of individuals with certain demographic characteristics and catastrophic medical expenses. Depending on the age and sex characteristics of an insurer's members, an insurer will either make payments to or receive payments from the state pooled fund. Expenses related to the demographic pool were $3,180,000 in 1996, $1,483,000 in 1995 and $1,152,000 in 1994. For further commitments, refer to Note 11. 8. EMPLOYEE BENEFIT AND STOCK OPTION PLANS The Company sponsors a defined contribution pension plan covering all full- time eligible employees (as defined). Contributions are based on a percentage of eligible salaries as determined by the Board of Directors. This plan also allows for additional voluntary contributions by covered full-time employees. Pension cost was approximately $1,061,000 in 1996, $853,000 in 1995 and $696,000 in 1994. The Company also has a 401(k) plan which covers substantially all eligible employees (as defined). This plan allows for voluntary employee contributions and a corporate match of 75% up to 4% of each employee's compensation. In addition, the Company contributes 1% of each eligible employee's compensation (as defined) to the plan. Expense related to the 401(k) plan was $858,000 in 1996, $654,000 in 1995, and $519,000 in 1994. The Company's Board of Directors, on November 17, 1992, and subsequently on November 21, 1995, adopted two Stock Option Plans (the "Plans") under which the Company may grant to certain officers and key employees (and, under the 1995 Plan, directors) incentive and nonqualified stock options for up to an aggregate maximum of 1,400,000 shares of Class A Common Stock. Under the Plans, the Board or Compensation Committee sets the exercise price for such options, but for incentive stock options, the exercise price shall not be less than the fair market value of the stock at the date of grant. Under the Plans, options may be exercised only at such times and under such conditions as determined by the Board or the Compensation Committee, but in no event more than ten years after the date of grant. The options that have been granted to date become exerciseable in equal installments over a period of three years and expire after ten years except for ten percent shareholders for which such options expire five years after the grant dates and certain performance based options granted in 1996, whose vesting may be accelerated based upon achievement of certain earnings targets. F-13 PHYSICIANS HEALTH SERVICES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) Information relating to stock options during 1996, 1995, and 1994 is as follows:
1996 1995 1994 ------------------- ------------------ ------------------ WEIGHTED WEIGHTED WEIGHTED AVERAGE AVERAGE AVERAGE NUMBER EXERCISE NUMBER EXERCISE NUMBER EXERCISE OF SHARES PRICE OF SHARES PRICE OF SHARES PRICE --------- -------- --------- -------- --------- -------- Outstanding at beginning of year................ 574,478 $24.78 187,514 $18.40 86,848 $15.00 Granted................. 565,040 22.09 413,098 27.45 111,950 20.86 Exercised............... (32,582) 18.43 (14,974) 16.73 (3,558) 15.00 Canceled................ (37,153) 29.29 (11,160) 27.05 (7,726) 17.36 --------- ------ ------- ------ ------- ------ Outstanding at end of year................... 1,069,783 $23.40 574,478 $24.78 187,514 $18.40 ========= ====== ======= ====== ======= ====== Exercisable at end of year................... 317,478 $22.90 73,364 $17.55 25,318 $15.00 Available for grant, at end of year............ 279,103 -- 506,990 -- 408,928 --
Supplemental and Pro Forma Disclosure: The following pro forma information regarding net income (loss) and net income (loss) per share, required by SFAS 123, has been determined as if the Company had accounted for its stock-based compensation plans under the fair value methods described in that statement. The fair value of options granted under the Company's stock-based compensation plans was estimated at the date of grant using a Black-Scholes option pricing model. The Black-Scholes option pricing model was developed for use in estimating the fair value of traded options which have no vesting restrictions and are fully transferable. In addition, option pricing models require the input of highly subjective assumptions including the expected dividend yield, the expected life of the options, the expected price volatility and the risk free interest rate. The weighted averages of the assumptions used are set forth in the following paragraph. The weighted average dividend yield for stock option grants during 1996 and 1995 was 0%. The weighted average expected life for 1996 and 1995 was 5 years. The weighted average volatility for 1996 and 1995 was .46%. The weighted average risk-free interest rate for 1996 and 1995 was 5.87% and 6.99%, respectively. For purposes of pro forma disclosure, the estimated fair values of the options awarded are amortized to expense over the options' vesting period and do not include grants prior to January 1, 1995. As such, the pro forma information is not indicative of future years. The Company's pro forma information was as follows (in thousands, except per share data):
1996 1995 -------- ------- Net income (loss): As reported................................................ $(12,964) $15,970 Pro forma.................................................. (14,379) 15,535 Net income (loss) per common share: As reported................................................ $ (1.39) $ 1.70 Pro forma.................................................. (1.54) 1.65
9. DIVIDEND AND INVESTMENT RESTRICTIONS OF SUBSIDIARIES The Company's HMO and insurance subsidiaries are subject to statutory regulations that restrict the payment of dividends. Based on laws currently in effect, PHS/CT generally may not pay dividends in excess of the greater of (1) the net gain from operations for the preceding calendar year, or (2) 10% of capital and surplus as of the preceding year end, both as determined in accordance with statutory accounting practices, without F-14 PHYSICIANS HEALTH SERVICES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) receiving approval of the Connecticut Insurance Commissioner. The maximum amount of cash dividends that PHS/CT could pay in 1997 without regulatory approval is approximately $2,800,000. The Company is required by the State of New York to maintain an escrow reserve, currently held in U.S. government obligations, equal to 5% of PHS/NY's estimated health care expenses for the upcoming year. The escrow reserve was approximately $9,113,000 and $7,087,000 at December 31, 1996 and 1995, respectively. The Company is required by the New Jersey State Insurance Department to maintain an escrow reserve of $300,000 in the event of insolvency. The escrow reserve was approximately $322,000 at December 31, 1996. Based on statutory rules and restrictions, the amount of restricted net assets of consolidated subsidiaries at December 31, 1996 was approximately $38.8 million. 10. ARRANGEMENT WITH THE GUARDIAN LIFE INSURANCE COMPANY OF AMERICA In 1995, the Company's subsidiaries, PHS/CT, PHS/NY and PHS/Bermuda, entered into several marketing and reinsurance agreements with The Guardian Life Insurance Company of America ("Guardian") and, together, the "companies". Under these agreements, jointly developed managed care and indemnity products are marketed to existing insureds of Guardian. In addition, the companies distributed these products through the brokerage community and an integrated marketing effort by the companies under the trade name "Healthcare Solutions." In 1995 and for the first nine months of 1996, PHS/CT, under the terms of the marketing agreement, wrote 100% of the HMO/POS business and Guardian wrote 100% of the indemnity business in Connecticut. Under the terms of the profit sharing agreement, a profit or loss was determined for each line of business. If both lines were profitable, profits, after provisions for related expenses, as defined, were shared equally. If neither line were profitable, each company retained losses, after provisions for related expenses, for its line of business written. If one line was profitable and the other unprofitable, payments, as defined, were to be made by the company writing the profitable line to the company with the unprofitable line, before net profits, if any, were shared. The Company reported the profits, if any, which inure to Guardian under this agreement as a component of Guardian joint marketing expenses net. In connection with this agreement, PHS/CT reported income of $574,000 in 1995, which represented 50% of the net income in accordance with the terms of the agreement. In 1996, PHS/CT reported losses after operating expenses of $7.6 million for the HMO/POS business, which represented 100% of the losses in accordance with the terms of the agreement. As of October 1, 1996, PHS/CT writes 100% of the HMO/POS business and, under the terms of a quota share reinsurance agreement, cedes 50% of it to Guardian. Accordingly, profits and losses, after provisions for related expenses, as defined, are shared equally. Additionally, 50% of losses previously reported under the agreement discussed in the preceeding paragraph are recoverable from future profits, if any, under the reinsurance agreement. Since there is no assurance that there will be future profits under this agreement, the Company has not recorded a receivable from Guardian or recognized income for any future profits. After September 30, 1996, PHS/CT no longer participates in the indemnity business. In 1995, PHS/NY wrote the HMO/POS In-Network business and, under the terms of a quota share reinsurance agreement, ceded 50% of it to Guardian, while Guardian wrote 100% of the Indemnity/POS Out-of-Network business and, under the terms of a quota share reinsurance agreement with PHS/Bermuda, ceded 50% of it to PHS/Bermuda. As such, profits and losses, after provisions for related expenses, as defined, were shared equally. From January 1, 1996 to June 30, 1996, PHS/NY's participation in the Indemnity business was reduced from 50% to 10%. Indemnity costs that appear on the Statements of Operations represent the Company's F-15 PHYSICIANS HEALTH SERVICES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) proportionate share of medical costs assumed from Guardian associated with the New York indemnity business. After June 30, 1996, PHS/NY no longer participates in the Indemnity business. In 1996, PHS/NJ entered into marketing and reinsurance agreements with Guardian. PHS/NJ writes the HMO/POS In-Network business and, under the terms of the quota share reinsurance agreement, cedes 50% of it to Guardian PHS/NJ writes the HMO/POS out-of-network business and under the terms of a quota share reinsurance agreement, ceded 100% of it to Guardian, who retrocedes 50% of it back to PHS. As such, profits and losses, after provisions for related expenses, as defined, are shared equally. In 1996, approximately $114.5 million of total revenues and $129.1 million of medical costs and other expenses for PHS were generated under the various marketing and reinsurance arrangements with Guardian described above. In 1995, approximately $21.5 million of total revenues and $20.2 million of medical costs and other expenses for PHS were generated under the various marketing and reinsurance arrangements with Guardian described above. Other receivables at December 31, 1996 and 1995 includes amounts due from Guardian under profit sharing and reinsurance agreements of approximately $18.4 million and $11.8 million, respectively. As part of the arrangements, the Company recovers from Guardian, a specified portion of the administrative expenses related to the Healthcare Solutions activity. Additionally, the direct costs for marketing the Healthcare Solutions products are shared equally. Both of these expenses as well as the profits, if any, that inure to Guardian under the profit sharing arrangement with PHS/CT as described above are included in Guardian joint marketing expense, net. The components of this line item are as follows:
YEAR ENDED DECEMBER 31 ---------------------- 1996 1995 ----------- ----------- Administrative recovery......................... ($ 1,998) ($ 542) Direct marketing expense........................ 1,189 1,494 Profit sharing expense.......................... -- 1,346 ----------- ---------- ($ 809) $ 2,298 =========== ==========
In October 1996, Guardian canceled its warrant that was issued by the Company in 1995, which originally provided for the purchase of one million shares of the Company's Class A common stock, once certain operating conditions had been met. Based upon a subsequent agreement with Guardian, the number of shares available for purchase under the warrant at the time it was canceled had been substantially reduced as a result of the Guardian's purchase of shares of the Company's Class A common stock on the open market. The Company had not recognized any expense related to the warrant as the conditions to its exercisability had not been met, nor was it deemed probable that they would be met up to the date of cancellation. 11. SALE OF TEC AND INVESTMENT IN MASTERCARE COMPANIES, INC. In September 1995, the Company sold 81% of its wholly-owned subsidiary Total Employee Care, Inc. to Mastercare Companies, Inc. (Mastercare) for 625,000 voting shares of Mastercare common stock. There was no gain or loss recognized on the transaction since the estimated fair value of the Mastercare stock received approximated the book value of the TEC stock sold. In addition, the Company purchased additional shares of Mastercare voting stock in the amount of 1,250,000 shares at $1.20 per share. The Company owns less than 20% of the voting stock and does not have the ability to exercise significant influence over the operating and financial policies of Mastercare and, accordingly has reported this investment at cost which approximates fair value. F-16 12. QUARTERLY RESULTS OF OPERATIONS (UNAUDITED) Selected unaudited data reflecting the Company's results of operations for each of the last eight fiscal quarters are shown in the following table (dollars in millions):
1996 ----------------------------- 1ST 2ND 3RD 4TH ------ ------ ------ ------ Premium revenues................................. $111.8 $118.4 $123.2 $128.1 Total health care expenses....................... 92.9 108.9 109.6 114.6 Selling general and administrative expenses...... 19.4 20.0 23.4 23.2 Net income (loss)................................ .9 (5.0) (4.5) (4.4) Net income (loss) per share...................... 0.09 (0.54) (0.49) (0.46)
1995 ----------------------- 1ST 2ND 3RD 4TH ----- ----- ----- ----- Premium revenues....................................... $79.6 $78.7 $85.7 $99.0 Total health care expenses............................. 62.5 60.8 63.7 76.8 Selling general and administrative expenses............ 12.6 14.0 15.4 18.8 Net income............................................. 3.1 3.7 5.2 4.0 Net income per share................................... 0.33 0.39 0.55 0.42
Note: The sum of the quarters' net income (loss) per share does not equal the full year per share amount due to rounding. F-17 SCHEDULE I PHYSICIANS HEALTH SERVICES, INC. CONDENSED FINANCIAL INFORMATION OF REGISTRANT (DOLLARS IN THOUSANDS) BALANCE SHEETS (PARENT COMPANY)
DECEMBER 31 ------------------ 1996 1995 -------- -------- ASSETS Cash....................................................... $ 15,572 $ 187 Other receivables.......................................... 219 192 Prepaid expenses and other................................. 1,128 99 -------- -------- TOTAL CURRENT ASSETS................................... 16,919 478 -------- -------- Property, plant and equipment.............................. 408 250 Other assets............................................... 2,319 2,306 Investment in and advances to wholly-owned subsidiaries.... 86,603 106,206 -------- -------- TOTAL ASSETS........................................... $106,249 $109,240 ======== ======== LIABILITIES AND STOCKHOLDERS' EQUITY Accounts payable and accrued expenses...................... $ 9,963 $ 359 -------- -------- TOTAL CURRENT LIABILITIES.............................. 9,963 359 -------- -------- Stockholders' equity Common Stock............................................. 94 94 Additional paid-in capital............................... 41,360 40,760 Net unrealized gains on marketable securities of subsidiaries, net of tax................................ 279 510 Retained earnings........................................ 54,554 67,518 -------- -------- 96,287 108,882 Less treasury stock........................................ (1) (1) -------- -------- TOTAL STOCKHOLDERS' EQUITY............................. 96,286 108,881 -------- -------- TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY............... $106,249 $109,240 ======== ========
The condensed financial information should be read in conjunction with the consolidated financial information and the accompanying notes thereto. F-18 SCHEDULE I PHYSICIANS HEALTH SERVICES, INC. CONDENSED FINANCIAL INFORMATION OF REGISTRANT (DOLLARS IN THOUSANDS) STATEMENTS OF OPERATIONS (PARENT COMPANY)
YEAR ENDED DECEMBER 31 -------------------------- 1996 1995 1994 -------- ------- ------- Revenue: Investment income................................ $ 92 $ 8 $ -- -------- ------- ------- Costs and expenses: General and administrative expenses.............. -- 2,188 1,243 Interest expense................................. 381 -- -- -------- ------- ------- 381 2,188 1,243 -------- ------- ------- LOSS BEFORE INCOME TAXES........................... (289) (2,180) (1,243) Income tax expense (benefit)....................... 249 505 (154) -------- ------- ------- Loss before equity in net income (loss) of wholly- owned subsidiaries................................ (538) (2,685) (1,089) Equity in net income (loss) of wholly-owned subsidiaries, net of taxes........................ (12,426) 18,655 15,223 -------- ------- ------- NET INCOME (LOSS).................................. $(12,964) $15,970 $14,134 ======== ======= =======
The condensed financial information should be read in conjunction with the consolidated financial information and the accompanying notes thereto. F-19 SCHEDULE I PHYSICIANS HEALTH SERVICES, INC. CONDENSED FINANCIAL INFORMATION OF REGISTRANT (DOLLARS IN THOUSANDS) STATEMENTS OF CASH FLOWS (PARENT COMPANY)
YEAR ENDED DECEMBER 31 ---------------------------- 1996 1995 1994 -------- -------- -------- OPERATING ACTIVITIES Net income (loss)................................ $(12,964) 15,970 $ 14,134 Plus equity in net loss (income) of subsidiaries. 12,426 (18,655) (15,223) Adjustments to reconcile net income (loss) to cash provided by (used for) operating activities...................................... 8,377 2,382 1,271 -------- -------- -------- Net cash provided by (used for) operating activities...................................... 7,839 (303) 182 FINANCING ACTIVITIES Advances to subsidiaries......................... (40,198) (9,000) (10,000) Dividends and return of capital from subsidiaries.................................... 47,144 9,000 10,000 Exercise of stock options........................ 600 246 53 -------- -------- -------- Net cash provided by financing activities........ 7,546 246 53 Increase (decrease) in cash...................... 15,385 (57) 235 Cash at beginning of year........................ 187 244 9 -------- -------- -------- Cash at end of year.............................. $ 15,572 $ 187 $ 244 ======== ======== ========
The condensed financial information should be read in conjunction with the consolidated financial information and the accompanying notes thereto. F-20 SCHEDULE II PHYSICIANS HEALTH SERVICES, INC. AND SUBSIDIARIES DECEMBER 31, 1996 VALUATION AND QUALIFYING ACCOUNTS (DOLLARS IN THOUSANDS)
BALANCE AT CHARGE TO BALANCE AT BEGINNING COST AND END OF OF PERIOD EXPENSES DEDUCTIONS PERIOD ---------- --------- ---------- ---------- Year ended December 31, 1994 Allowance for doubtful accounts.... $ 926 $1,423 $(549) $1,800 ====== ====== ===== ====== Year ended December 31, 1995 Allowance for doubtful accounts.... $1,800 $ 103 $(853) $1,050 ====== ====== ===== ====== Year ended December 31, 1996 Allowance for doubtful accounts.... $1,050 $1,485 $(754) $1,781 ====== ====== ===== ======
F-21 SIGNATURES PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934, THE COMPANY HAS DULY CAUSED THIS REPORT TO BE SIGNED ON ITS BEHALF BY THE UNDERSIGNED, THEREUNTO DULY AUTHORIZED, IN THE TOWN OF SHELTON AND STATE OF CONNECTICUT ON THE 24TH DAY OF JULY, 1997. Physicians Health Services, Inc. /s/ Robert L. Natt By: _________________________________ PRESIDENT AND CO-CHIEF EXECUTIVE OFFICER S-1 Exhibit Index Exhibit No. Description of Document - ----------- ----------------------- 23 Consent of Independent Auditors (filed herewith). EX-23 2 CONSENT OF INDEPENDENT AUDITORS EXHIBIT 23 Consent of Independent Auditors We consent to the incorporation by reference in the Registration Statement (Form S-8, No. 33-74486) pertaining to the Physicians Health Services, Inc. 1992 Stock Option Plan, in the Registration Statement (Form S-8, No. 33-81196) pertaining to the Physicians Health Services, Inc. Pension Plan, and in the Registration Statement (S-8, No. 33-81142) pertaining to the Physicians Health Services, Inc. 401(k) Profit Sharing Plan and to the used of our report dated March 14. 1997, included in the Annual Report on Form 10-K of Physicians Health Services, Inc. for the year ended December 31, 1996, with respect to the consolidated financial statements and schedules of Physicians Health Services, Inc., as amended, included in this Form 10-K/A-2. /s/ Ernst & Young LLP ERNST & YOUNG LLP Stamford, Connecticut July 23, 1997 -----END PRIVACY-ENHANCED MESSAGE-----