SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
{X} ANNUAL REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 1998
OR
{ } TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the transition period from to
Commission file number 0-15846
First Health Group Corp.
(Formerly HealthCare COMPARE Corp.)
(Exact name of registrant as specified in its charter)
Delaware 36-3307583
(State or other jurisdiction of (I.R.S. Employer Identification Number)
incorporation or organization)
3200 Highland Avenue
Downers Grove, Illinois 60515
(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code: (630) 241-7900
Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act:
Common Stock $.01 par value
(Title of Class)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange
Act of 1934 during the preceding 12 months (or for such shorter period
that the registrant was required to file such reports) and (2) has been
subject to such filing requirements for the past 90 days.
Yes X No
Indicate by check mark if disclosure of delinquent filers pursuant to
Item 405 of Regulation S-K is not contained herein, and will not be
contained, to the best of registrant's knowledge, in definitive proxy or
information statements incorporated by reference in Part III of this Form
10-K or any amendment to this Form 10-K. [ ]
The aggregate market value of voting stock held by non-affiliates of the
registrant on March 18, 1999, was approximately $477,695,094. On that
date, there were 30,881,299 shares of Common Stock issued and
outstanding. For the purposes of the foregoing calculation only, all
directors, executive officers and five percent stockholders of the
registrant have been deemed to be affiliates.
<PAGE>
DOCUMENTS INCORPORATED BY REFERENCE
1998 Annual Report to Stockholders..................Parts I, II and IV
Proxy Statement for the Annual Meeting of
Stockholders scheduled to be held on
May 18, 1999...........................................Parts I and III
PART I
Item 1.Business
General
First Health Group Corp., together with its subsidiaries hereinafter
collectively referred to as the "Company" or "First Health", is a full-
service national health benefits company. The Company specializes in
serving large, national employers with a single source for their group
health programs -- providing comprehensive, cost-effective and innovative
solutions for all the health benefits needs of their employees
nationwide. Through its workers' compensation service line, the Company
provides a full range of auto managed care and workers' compensation
services for insurance carriers, state insurance funds, third party
administrators and large, self-insured national employers. Through its
First Health Services service line, the Company provides services to
various state Medicaid and entitlement programs for claims
administration, pharmacy benefit management programs and medical
management and quality review services.
The Company, which is a Delaware corporation, was organized in 1982.
The Company's principal executive offices are located at 3200 Highland
Avenue, Downers Grove, Illinois 60515, and its telephone number is (630)
241-7900.
Recent Developments
On May 19, 1998, the Company's Board of Directors authorized a 2-for-1
Common Stock split effected in the form of a 100% distribution. The 2-
for-1 split was payable on June 23, 1998, to stockholders of record on
June 2, 1998. Stockholders received one additional share of Common Stock
for each share held of record. The stock split is intended to result in a
wider distribution and ownership of First Health's stock by enhancing
liquidity and making the stock more attractive to a broader range of
investors. The Company's last stock split, a 2-for-1, was in the second
quarter of 1991.
December 1, 1998, the Company's Board of Directors approved the
repurchase by the Company of up to an additional 15,000,000 shares or
approximately 26% of its outstanding common stock. From August 1996
through December 31, 1998, the Company has repurchased approximately 18.4
million of its shares. The Company may utilize working capital or
capacity under its existing $350 million credit facility to purchase
shares. At February 28, 1999, the Company had approximately 12.8 million
shares remaining under this authorization.
<PAGE>
Strategy
First Health assists its group clients through an integrated health
benefits system that promotes the well-being and satisfaction of
participants while positively impacting an organization's medical cost
trends through:
* Single source accountability;
* 24-hours-a-day, 7 days-a-week availability to help participants
become more informed health care consumers;
* A broad national network of quality, cost-effective health care
providers--wherever care is needed;
* Timely service before, during and after care is delivered; and
* Services for lowering costs for medical care outside of the
Company's PPO network.
Its various medical review programs help First Health's clients manage
the number of units of medical services (volume) while its PPO products
help First Health's clients manage the cost of those units of service
(price). Through its OUCH System capabilities, the Company provides
workers' compensation bill review services nationally. These services
are coupled with the Company's review programs and PPO networks in order
to provide a comprehensive product offering in the workers' compensation
arenas where, in recent years, medical costs have been rising faster than
in the group health arenas. Through First Health Services, the Company
provides claims administration, pharmacy benefits management and medical
management and quality review services to public sector payors such as
state Medicaid and state entitlement programs.
First Health seeks to develop medical management programs designed to
control the number of health care units, such as its hospital review
program. First Health offers additional cost management programs which
are also intended to control the number of health care units provided,
including programs concentrating on mental health services, physical
therapy and chiropractic services. First Health's management believes
that the continuous offering of new and improved programs is important to
the expansion of its business.
Through The First Health Network, First Health also offers its
clients services designed to control the price of a health care unit of
service. First Health specializes in the development of PPOs and the
collection and analysis of health care cost data. First Health's
capability to analyze health care cost data allows it to use a client's
actual history of health care usage to structure networks of providers
tailored to client needs.
The Company's acquisition of small indemnity insurance companies in
1996 and 1997 has enabled the Company to expand its product offering to
leverage its managed care assets of The First Health Network and its
clinical management services. The introduction of new products will allow
the Company to provide a national HMO-like product for self-insured ERISA
plans and stop-loss insurance products.
<PAGE>
Through the acquisition of First Health in July 1997, the Company
believes it has rounded out the range of services necessary to offer a
full spectrum of integrated managed care products to clients and
prospective clients for claims processing services and managed care
services such as PPO, risk and medical management services.
Health Care Reform, Expenditures and Managed Care
In recent years, political, economic and regulatory influences have
subjected the health care industry to fundamental change and
consolidation. Since 1993, the Clinton Administration has proposed
various programs to reform the health care system and expressed its
commitment to (I) increasing health care coverage for the uninsured, (II)
controlling the continued escalation of health care expenditures, and
(III) using health care reimbursement policy to help control the federal
deficit. Even though Congress rejected the Clinton Administration's
proposals, several potential approaches remain under consideration,
including broad insurance reform proposals, tax incentives for
individuals and the self-employed to purchase insurance, controls on the
growth of Medicare and Medicaid spending, the creation of insurance
purchasing groups for small businesses and individuals, and market-based
changes to the health care delivery system. Proposals under
consideration at the federal level also would provide incentives for the
provision of cost-effective, quality health care through encouraging
managed care systems. In addition, many states are considering various
health care reform proposals. At both the federal and state level, there
is growing interest in legislation to regulate how managed care companies
interact with providers and health plan members. The Company anticipates
that Congress and state legislatures will continue to review and assess
alternative health care delivery systems and payment methodologies, and
that the public debate of these issues will likely continue in the
future. Although the Company believes it is well-positioned to respond
to the stated concerns, the Company cannot predict what impact the
proposed measures may have on its business. Concern about the proposed
reform measures and their potential effect has been reflected in the
volatility of the stock prices of companies in health care and related
industries, including the Company.
The Company is monitoring developments concerning health care reform
and preparing strategic responses to the different reform scenarios. In
response to pending legislation and market pressures and in anticipation
of future health care reform, the Company is broadening and diversifying
its services so it will be less affected if health care reform proposals
are enacted.
First Health offers numerous programs designed to help payers of
health care control their medical costs. Unlike HMOs, clinical
management and PPO companies typically do not underwrite health insurance
or assume related risks. Clinical management and PPO services have been
offered on a commercially significant scale for the last ten years by
independent firms which are engaged primarily in providing these types of
services. The industry is currently highly fragmented with numerous
independent firms providing medical utilization review and PPO services,
primarily on a regional or local level. In addition, a growing number of
health insurance carriers, HMOs and third party administrators have
established internal clinical management and PPO departments. However,
due to the tremendous resources required to develop an exclusive PPO
network, these organizations have not had nearly the same success in
establishing a national PPO network as the Company.
<PAGE>
In workers' compensation, medical costs are rising at almost twice the
rate of general medical inflation. Though such medical costs represent
only about 5% of total health care expenditures, the increase in costs is
significant for employers and insurance carriers and have risen more than
1000% since 1970. First Health and4certain other cost management firms
offer numerous programs designed to control escalating medical expenses
and indemnity payments for lost time, reduce litigation and allow injured
employees to return to work as soon as possible. Many of the services
used in group health are also applied to the workers' compensation
market. PPOs are utilized to manage price. Clinical management services
are targeted toward managing the number of units of service and the
quality of that service, and helping the employee return to productive
employment. In addition, bill review services are applied on a national
basis in the 40 states that have a medical fee schedule and in the
remaining states which allow a usual and customary review. Additionally,
at least 30 states have adopted legislation that enables workers'
compensation managed care services, and legislation has been proposed in
other states. The combination of these services offers workers'
compensation insurance carriers and employers significant cost savings.
PPO Services - The First Health Network
Established in 1983, The First Health Network, also known as The
AFFORDABLE Medical Network, develops and manages payer-based PPO networks
throughout the country that incorporate both group health and workers'
compensation medical providers. This is the largest area of the
Company's business. The networks consist of hospitals, physicians and
other health care providers who offer their services to clients at
negotiated rates in order to gain access to a growing national client
base.
The Company's hospital network, as of March 1999, includes
approximately 3,200 hospitals in 49 states, the District of Columbia and
Puerto Rico. In each case, rates are individually negotiated for the
full range of hospital services, including hospital inpatient and
outpatient services. In addition, the Company has established an
outpatient care network (OCN) comprising approximately 290,000 physicians,
clinical laboratories, surgery centers, radiology facilities and other
providers in 49 states, the District of Columbia and Puerto Rico.
During the last 10 years, the Company incurred substantial expense in
expanding its PPO networks. The expansion has occurred in the number of
health care providers within existing areas and in the number of networks
throughout the country. The Company has expanded the number of hospital
networks not only in major metropolitan markets, but also in targeted
secondary and tertiary markets; many of the hospital and OCN providers
that have been added during the past few years have been in these areas.
Management expects to continue to incur significant expenses to further
expand its hospital and outpatient care networks, particularly in
secondary and tertiary markets and believes that its investment in
developing these markets significantly differentiates it from
competitors.
<PAGE>
The following table sets forth information with respect to the
approximate number of participating providers in The First Health Network
at the end of each of the past five years:
<TABLE>
December 31,
----------------------------------------
1994 1995 1996 1997 1998
---- ---- ---- ---- ----
<S> <C> <C> <C> <C> <C>
Number of Hospitals in Network 1,900 2,100 2,320 2,650 3,220
Outpatient Care Network Providers 150,000 181,000 207,000 231,000 288,000
</TABLE>
The First Health Network was developed in response to the needs of the
Company's national client base. These clients provide the leverage
necessary to enable First Health to negotiate favorable rates with
providers throughout the country. The First Health client base
includes a diverse group of health care payers, such as group health and
workers' compensation insurance carriers, third party administrators,
HMOs, self-insured employers, union trusts and government employee plans.
The Company believes the amalgamated buying leverage of these clients
provides it with strength in negotiating PPO contracts with current and
prospective health care providers.
Compensation. As a fee for developing and managing PPO networks, in
virtually all cases, the Company charges a percentage of savings realized
by its clients. The amount of this fee varies depending on a number of
factors including number of enrollees, networks selected, length of
contract and out-of-pocket benefit copayments.
The Company competes with national and local firms which develop PPOs
and with major insurance carriers, third party administrators and
utilization review firms which have implemented their own preferred
provider network as well as with firms which specialize in the collection
and analysis of health care cost data.
Approach to Network Development
The strategy of The First Health Network is to create a selective
network of individual providers which will meet the medical, financial,
geographic and quality needs of its clients and their beneficiaries.
First Health contracts directly with each hospital and generally does not
contract with groups of hospitals or provider networks established by
other organizations. Management believes this provides the maximum
control over the composition and rates in the network and ensures
provider stability in The First Health Network. To further promote
stability and savings in the network, when possible, First Health enters
into multi-year agreements with its providers with nominal annual rate
increases.
The selected providers benefit from their participation in The First
Health Network through increased patient volume as patients are directed
to them through health benefit plans maintained by First Health's clients
and other channeling mechanisms, such as the Company's clinical
management services and electronic and internet provider directory
applications.
<PAGE>
The network consists of a full array of providers, including hospitals
and outpatient providers (physicians, laboratories, radiological
facilities, outpatient surgical centers, mental health providers,
physical therapists, chiropractors, and other ancillary providers). By
establishing contractual relationships with the complete range of
providers, First Health is able to impact the vast majority of the
client's health costs and to facilitate referrals within the network for
all needed care.
The rate structure negotiated by First Health maximizes the savings
for the client and gives incentives to providers to deliver cost
effective care. Unlike many other PPOs which negotiate price discounts
or separate rates for intensive care and other specialty units, First
Health strives to negotiate a single all inclusive per diem for
medical/surgical and intensive care unit days in hospitals. The majority
of the Company's hospital PPO contracts are negotiated with an all-
inclusive rate structure. The charges for hospital outpatient care are
controlled as well through reimbursement caps. Fees for physicians and
other outpatient providers are set by fee schedules established by First
Health. The negotiated rates have resulted in typical savings of more
than 40% on inpatient hospital costs and 20-30% for physician and
outpatient costs.
After a network has been established, First Health provides ongoing
consulting services to clients, re-negotiates contracts with providers
and prepares annual evaluations which profile for its clients the
effectiveness of the network. The networks are continuously undergoing
refinements with active redevelopment activity to expand geographic
coverage and to improve rate structure as care continues to shift to
outpatient settings.
In order to promote an ongoing and long term positive business
relationship with network providers, First Health has established an
extensive provider relations program. Dedicated staff perform a variety
of activities including responding to hospital claims inquiries,
conducting site visits, preparing provider newsletters and participating
in joint hospital/First Health functions which are intended to promote
goodwill and increased utilization of network providers. The Company's
retention rate for hospitals has been more than 99% and more than 97% for
physicians and other outpatient providers.
<PAGE>
PPO Quality Assessment
Quality assessment of network providers is a critical component in the
selection and retention process. The Company has established an
intensive program which evaluates each individual provider against
standards set for various quality indicators. Provider evaluation occurs
prior to the selection of the provider and continues while they are in
the network.
Information Systems
First Health utilizes a broad range of proprietary information systems
applications to support its PPO business. Present information systems
support management of all aspects of provider recruitment, including
maintenance of a comprehensive data base of information about members of
each PPO network. Additional information systems are utilized to develop
rate and fee objectives and strategies prior to initiating contract
negotiations with providers. The Company has invested substantially in
its information systems and anticipates continuing these investments in
the future. Currently the Company has major upgrades underway within its
clinical management and claims systems. First Health also maintains an
array of information systems to re-price health care claims to the
contracted rate for its clients.
In addition, health care cost data analysis services are available to
the Company's clients for a fee on a stand-alone basis. These services
provide clients with in-depth customized information concerning their
health care cost and utilization experience. Using its internally
developed proprietary software, the Company analyzes its clients' health
care claims information and benefit plans in order to provide each
client's specific health care cost profile and evaluate appropriate cost
management programs. This software also allows the Company to simulate
how changes in a benefit plan's structure will change the overall cost of
a benefit program. The Company also provides clients with customized
software products to allow further analysis of health care cost issues.
Claims Administration Capabilities
The Company provides "one-stop shopping" for employers offering
indemnity, PPO and point of service plans through its core competency of
claims administration and customer service. The Company provides clients
with an integrated package of health care benefits administration
services, including:
* medical, disability, dental and vision claims processing
* utilization management and case management
* national PPO network arrangements
* prescription drug plan administration and network management
* COBRA administration
* Flexible Spending Account administration
* stop-loss brokerage
* data analysis
<PAGE>
The Company's claims administration product is a sophisticated,
technologically advanced claims processing, tracking and reporting
system. A majority of this processing is performed by the Company's
fully integrated and proprietary system, known as The Act System.
ACT was developed completely in-house by First Health through its
acquisition in July, 1997 and is owned entirely by the Company.
ACT supports a broad range of benefit programs, including medical care,
prescription drugs, long-term disability, short-term disability, FLEX
accounts, vision care and dental care. Additionally, in order to enhance
the Company's claims processing capabilities, the Company is in the
process of enhancing the ACT system. The Company currently estimates
that these development efforts will significantly enhance and improve
upon the capabilities of ACT and these efforts are expected to cost in
total approximately $15 million to become commercially viable. Such
modifications are expected to be completed in the next 1 to 2 years, with
a substantial portion of the expenditures being incurred during 1999.
The system helps clients increase the cost effectiveness of their
benefit plans by offering such features as on-line reporting capability,
Electronic Data Interchange ("EDI"), rapid and responsive customer
service, automatic tracking of annual, lifetime, per-case, and floating
maximums, and full integration with all other First Health departments
and services. This integration benefits clients since the Company can
analyze claims data as well as clinical management data and network usage
data. This analysis enables the Company to provide comprehensive
management reports that can impact medical costs. In addition, because
First Health's claims system is an on-line, "real time," interactive
system, clients can expect member issues to be minimized because claims
can be paid promptly and accurately.
This single-vendor environment is a benefit for participants as well.
They have just one number to call for all health care benefit
information. The round-the-clock, toll-free number they call to locate a
network provider or to obtain general health information is the same
number they call with claims inquiries. Additionally, First Health's
claims process can be virtually paperless for the participant, especially
when a network provider is used -- which is a critical step to enhancing
participant satisfaction.
This system automatically calculates benefits and issues checks,
letters, and explanation of benefits (EOBs) to plan participants and
providers.
<PAGE>
The system incorporates advanced technologies available, including:
* Online reporting and data retrieval capabilities
After a claim is entered into the system, it verifies
eligibility, applies appropriate deductibles, adjudicates the
claims against predetermined negotiated or usual and customer
guidelines, matches precertification, searches for previous
history of coordination of benefits, and presents final
adjudication information to the benefit examiner for his or her
approval. Once the benefit examiner has reviewed and approved
the information on the screen, the system generates a check and
explanation of benefits that evening, which are mailed the next
day.
* Electronic Data Interchange (EDI)
First Health contracts with several commercial claims
clearinghouses to gather EDI claims from providers. Providers
transmit claims to one of these clearinghouses. The
clearinghouses then batch claims destined for First Health and
forwards them to the Company each day. Performing these
functions electronically enhances efficiency and accuracy.
* Tracking of annual, lifetime and floating maximums
When a new client is loaded onto the system, the
Company will transfer claims history from the previous
administrator. The system tracks benefit maximums on-line for
every participant. When an individual has reached a specified
maximum, the system will automatically reduce the benefit payment
as specified in each client's plan document.
* Responsive and comprehensive customer service capabilities
The integration inherent in First Health On-Call
enables the participant to access all claims information
including claims history, eligibility, deductibles and maximum
accumulations, as well as Explanation of Benefit (EOB)
information through the round-the-clock, toll-free number.
These advanced technologies enable First Health's system to support a
broad range of benefit programs, including medical, dental and vision
care, Medicare, prescription drugs, Consolidated Omnibus Budget
Reconciliation Act (COBRA), Health Insurance Portability and
Accountability Act (HIPAA), long- and short-term disability, and flexible
spending accounts.
<PAGE>
Clinical Management Services
First Health provides centralized clinical management programs
(utilization review and medical case management services) from its
headquarters in Downers Grove, Illinois, and Scottsdale, Arizona, through
an internal staff consisting primarily of allied health professionals,
licensed practical and registered nurses and physicians. First Health
also has a nationwide network of consulting physicians in various
specialties. Historically, First Health charged its clients a "capitated
fee," i.e., a fixed monthly fee for each participant (excluding covered
dependents) in a client-sponsored health care plan, plus an hourly fee
for case management. The amount of the capitated fee varies depending on
the size of the client and the number and type of review programs
selected by the client. Several years ago, the Company began selling its
clinical management services coupled with its PPO services. As a result,
the fee is an "add-on" to the PPO fee. For other medical consulting
services, the Company charges fees on an hourly basis rather than a
capitated basis.
Clients who purchase First Health's clinical management programs
advise their participants and dependents of review requirements. A
participant, or his or her attending physician, utilizes a clinical
management program by calling one of First Health's toll-free numbers
prior to the proposed hospitalization or outpatient service or within two
business days of an emergency admission or outpatient service. From
these calls, First Health's clinical management staff gathers the
demographic and medical information necessary to enable it to perform a
review and enters this information into First Health's proprietary review
system. Based on this information, and using First Health's clinically
valid and proprietary review criteria, First Health determines whether it
can recommend certification for the proposed hospitalization or
outpatient service as medically necessary under the participant's health
care plan.
<PAGE>
Upon completion of the review, First Health notifies the participant,
the attending physician and other affected providers of the outcome of
the review. It also notifies its client as to whether the proposed
hospitalization and length of stay or outpatient service can be certified
as medically necessary and appropriate under the terms of the client's
benefit plan. First Health does not practice medicine and its services
are advisory in nature. All decisions regarding the payment or denial of
benefits and about eligibility or coverage under the benefit plan are
made only by the claims administrator. All decisions regarding the
patient's medical treatment are made by the patient and the patient's
attending physician, not by First Health.
First Health provides standard educational materials which can be used
by its clients for advising participants of the utilization management
services. First Health also works with clients in developing customized
materials for this purpose. Participants can call First Health on a
toll-free line if they have questions regarding its services. Clients
and their claim administrators also can obtain additional information
from the Client Services staff.
First Health offers several clinical management services from which
its clients may select. Most of First Health's clients subscribe to its
hospital review services, which forms as the base to which First Health's
other programs may be added. More than 90% of First Health's clients
subscribe to at least one additional First Health service First Health
also offers its services on a stand-alone basis, without requiring
participation in its hospital review program. The following is a summary
of the Company's current principal programs.
Hospital Review. First Health's hospital review program is designed
to reduce a client's hospitalization costs by identifying (for the
purposes of benefit plan coverage only) hospital admissions and lengths
of stay which are medically unnecessary or excessive compared to
established national criteria. Additionally, First Health remains
actively involved during the hospitalization in reviewing and monitoring
the patient's length of stay. This same process is applied to workers'
compensation admissions.
Case Management. The medical case management program is designed to
provide clients with a careful review of all cases which involve complex
high cost or chronic diseases, conditions or catastrophic illnesses.
Through periodic reviews, First Health's nurse case managers and
physicians identify potentially large claim cases. These services consist
primarily of conferring with the attending physician and other providers
to identify cost-effective treatment alternatives. Such alternatives may
include moving a patient from an acute care hospital to less expensive
settings -- often the home -- as soon as the patient's physician
determines that it is safe and medically feasible. If such a move
requires a home nursing service or medical equipment, First Health serves
as a referral for alternative available services, provides
recommendations regarding continued usage of these services and
negotiates discounts with the providers where network providers are not
appropriate or not available. In all cases, the decision to proceed with
the course of treatment initially prescribed by the attending physician
or a more cost-efficient alternative identified by First Health is made
by the patient and his physician. Clients which select stand-alone case
management independently identify those cases which involve potentially
high cost diseases, conditions or procedures and refer such cases to
First Health to identify cost-effective treatment alternatives.
<PAGE>
The medical management process for Workers' Compensation monitors an
injured worker's care and identifies opportunities for cost-effective
alternative care and treatment with the goal of returning the worker to
the client's work force or to reach Maximum Medical Improvement (MMI), as
soon as medically feasible. The case manager is responsible for the
overall coordination of the many comprehensive services that may be
needed, such as review of rehabilitation and chiropractic care, home
health services and others, with a constant focus on the injured worker's
ability to return to productivity.
Referral Management. For clients who subscribe to First Health's
point-of-service program, referral to physician specialists is managed
through the Clinical Management area. When a referral from a primary
care physician to a specialist is required, a patient calls the toll-free
telephone number. These referrals are reviewed and authorized for a
specified period of time.
PPO Redirection and Telephonic Provider Directory. For clients who
subscribe to First Health's clinical management program and The First
Health Network, the Company will attempt to redirect the patient to a PPO
hospital or outpatient provider located near the patient. Additionally,
the clients' participants can call the Company's telephonic provider
directory line to request a network provider of their choosing who is
within a reasonable proximity to their residence or place of work. By
utilizing a PPO network hospital or outpatient provider, the payer and
the patient will achieve savings from what the billed charges would
otherwise be.
24/7 Health Information Line. This is a 24-hour-a-day, 7-day-a-week
service that ties together the full range of First Health's programs by
providing participants with a single source for guidance through the
health care delivery system. The services of this program include:
* Helping members obtain answers to general medical questions;
* Assisting members to make informed health care decisions;
* Locating appropriate network providers;
* Facilitating communication between providers and members;
* Identifying patient situations that may be appropriate for referral
to clinical management services;
* Initiating pre-certification for medical and mental health care;
* Answering claims questions and inquiries; and
* Answering pharmacy program questions or referrals.
This service is offered to clients who participate in the full range
of network and clinical management programs.
Other Clinical Management Programs:
* Managed Surgical Opinion * Prospective Chiropractic Review
* Mental Health Review Services * Maternity Risk Assessment
<PAGE>
Physician Resources
First Health believes that its in-house physician staff is an
invaluable resource in its clinical management programs. The staff
includes approximately 25 experienced board certified physicians in such
specialties as family practice, internal medicine, cardiology,
gynecology, urology, orthopedics, psychiatry, pediatrics, and surgery as
well as other doctoral level practitioners such as clinical psychology
and chiropractic medicine. In addition, First Health has a nationwide
network of consulting physicians in the significant specialties. This
physician staff is crucial to the development and maintenance of up-to-
date clinically valid review criteria and protocols and the network
quality assessment efforts.
Benefit Plan Recommendations
Clients can take various steps in benefit plan design that will help
accomplish the goal of managing long-term health care costs. The
client's ability to accomplish this goal through First Health is
contingent on:
* Reasonable incentives or disincentives for plan participants to comply
with the notification procedures and clinical management
recommendations of First Health. Because early notification is
essential to effective case management, these incentives help ensure
not only cost effectiveness but quality outcomes.
* An effective benefit differential between in-network and out-of-
network services of at least 10% for inpatient and outpatient
services, to include annual stop-loss provisions sufficiently large so
as to reinforce copayment/coinsurance differentials.
* Coverage for travel and organ-donor costs for services at network
transplant providers, and coverage of well-baby care for participation
in the maternity screening services.
* Distribution to all plan participants of a First Health identification
card, including the toll-free health information line, prior to the
implementation date. Because the toll-free number is such an integral
part of the program, the more familiar the participant is with the
number, the more likely he or she is to use it -- and the sooner the
client will begin realizing cost savings.
* A program of effective communication to plan participants about First
Health programs at least semi-annually. Well-planned, timely
communication increases participant satisfaction and compliance
significantly.
<PAGE>
Information System
Management of First Health believes its interactive, on-line computer-
based information system has been a major factor in its ability to
provide clients with comprehensive healthcare information. First Health's
proprietary software programs record and access patient and provider
information. This allows Company personnel to access utilization norms
and standards as part of the review process or to analyze cost data in
negotiating reimbursement rates with health care providers. First
Health's proprietary software generates extensive internal reports to
supplement the review process by informing reviewers when specific
follow-up activities, such as case management screening, are required to
be performed by First Health personnel.
The patient-specific database consists of data that has been collected
concerning each proposed hospital admission, including patient
demographics, medical history and diagnostic and procedural information.
First Health's review personnel can access the current status of the
patient's case to identify more cost-effective treatment alternatives.
All correspondence confirming First Health's recommendations with
respect to a prescribed treatment plan is automatically generated and
sent to the attending physician, participant and plan administrator by
the system.
Bill Review Using the OUCH System
The Company provides comprehensive workers' compensation medical
bill review services through a sophisticated computer system that
enforces administration policies, applies state-specific workers'
compensation fee schedules, checks for billing infractions and applies
provider contract rates. Since all of these functions are consolidated
and automated, they reduce paperwork and costs associated with claims
processing and are highly cost effective for larger workers' compensation
entities who generally process in excess of 500,000 bills annually.
Since these system capabilities are integrated with its utilization
management and PPO services, the Company believes it offers one of the
most comprehensive workers' compensation medical cost management programs
in the industry. This workers' compensation program was introduced in
California in 1986.
Marketing. First Health markets the workers' compensation programs to
insurance carriers, third party administrators, state workers'
compensation funds, and self-insured, self-administered companies. The
Company's payer clients include at least some offices of six of the ten
largest workers' compensation insurers and the largest industrial company
in the world. Worksite posters, provider directories (either paper or
electronic) and other materials provided by its payer clients encourage
injured employees to utilize First Health's provider network.
<PAGE>
Bill Review. Services offered by the Company include a computer
assisted review of medical provider billings to ensure accuracy and
adherence to established rates and billing rules. In 40 states,
including California, Texas, Arizona, Michigan, Ohio and Florida, a
schedule of presumed maximum fees (fee schedule) has been established for
workers' compensation medical claims. The review process corrects errors
a provider might make in applying these fee schedules. OUCH Systems also
reviews whether the appropriate level of service was billed. Provider
network discounts are applied as well during the review. Additionally,
through the system, the Company is able to go beyond "traditional" bill
review services to provide enhanced systems savings by reorganizing non-
related services, upcoding and unbundling of charges and other features.
Finally, bill review data is integrated with medical management and
quality assessment activities.
The Company has an agreement with Electronic Data Systems Corporation
("EDS") which enables it to utilize EDS' extensive data processing and
communications networks. EDS modified its comprehensive bill review and
audit processing system to handle workers' compensation claims and
integrated the system with First Health's clinical management programs.
Systems development occurred throughout the latter half of 1989, with
operations beginning in the first quarter of 1990.
Bill review decreases workers' compensation payers' administrative
costs because First Health maintains virtually all aspects of the
program.
First Health offers three variations of the bill review program:
* Systems Lease: The systems technology is brought to the
client's office where their staff performs
bill review.
* Service Bureau: Bills are sent to First Health's processing
centers and First Health keys the bills and
performs bill review.
* EDI Service Bureau: Clients electronically transmit key data
elements to First Health and First Health
performs bill review.
Compensation. The Company generally receives an agreed upon
percentage of total savings generated for clients through bill review
plus a per-bill fee, including provider network discounts, adjustments to
applicable billing rules and regulations and utilization reviews.
Savings are generally calculated as the difference between the amount
medical providers bill the payer clients and the amount First Health
recommends for payment.
<PAGE>
Customers and Marketing
First Health primarily markets its services to national multi-sited
direct accounts, including self-insured employers, government employee
groups and multi-employer trusts. In addition, First Health markets its
services to and through group health and workers' compensation insurance
carriers. The following are representative customers of First Health:
American International Group NALCO Chemical Company
Boilermakers National Health National Association of Letter Carriers
and Welfare Fund Norwest Corporation
CNF Transportation, Inc. State Farm Mutual Automobile
ConAgra, Inc. Insurance Company
Eaton Corporation Tandy Corporation
General Motors Corporation Texas Instruments Employees' Health
Hewlett-Packard Company Benefits Trust
Hartford Financial Services, Inc. The RETA Trust
Kemper National Services The Sherwin-Williams Company
Liberty Mutual Insurance Company Travelers Property Casualty
McDonald's Corporation Walgreen Co.
The Company presently has approximately 50 group health and workers'
compensation insurance carrier clients. Typically, First Health enters
into a master service agreement with an insurance carrier under which
First Health agrees to provide its cost management services to health
care plans maintained by the carrier's policyholders. First Health's
services are offered not only to new policyholders, but also to existing
policyholders at the time their policies are renewed. The insurance
carrier's sales and marketing staff ordinarily has the responsibility for
offering First Health's services to its policyholders, thus relieving the
Company of a significant marketing expense.
First Health typically enters into standardized service contracts with
its direct accounts and master service agreements with its insurance
carrier and third party administrator clients. These contracts and
agreements have automatically renewable successive terms of between one
and three years, and are generally terminable upon one to six months'
notice prior to their expiration. These contracts are generally non-
exclusive and permit the client to provide medical review services on an
in-house basis; however, these contracts are generally exclusive as to
the client's ability to use other PPO firms during their term.
Risk Products and Insurance Company Acquisitions
As an extension of the Company's cost management services, in February
1996 the Company acquired American Life and Health Insurance Company and
a subsidiary insurance company (collectively "American"). American is a
small medical indemnity insurer with licenses in 26 states and
approximately $8 million in annual premiums. In September 1997, the
Company acquired Loyalty Life Insurance Company ("Loyalty"), a 49-state
insurance shell.
The Company acquired American and Loyalty in order to obtain the
infrastructure and licenses to enable the Company to leverage its managed
care assets into various medical plans for multi-sited employers. The
medical plans are expected to provide HMO-like performance for self-
funded ERISA plans and stop-loss insurance products.
<PAGE>
The Company's product promotes the continuity of care through a single
point of entry into the health care delivery system. By calling,
employees can obtain information on all aspects of their health benefit
program. This includes information ranging from preventive care and
claims status, to inquiries regarding network providers and benefit plan
coverage.
The program integrates the Company's PPO network of providers, The
First Health Network, with clinical management programs. Access to First
Health's national network of providers, including specialty and sub-
specialty care such as transplant, gives unparalleled provider coverage
not only locally but throughout the country.
Claims administration is provided through the Company's internal
capabilities, which have been developed since the time of the American
acquisition, and is integrated throughout the entire process so as to
take advantage of the potential synergies and competencies.
For a single guaranteed cost, the Company's clients can be assured of
a comprehensive health care benefit plan that ensures the earliest
possible impact on patient care which provides a higher quality of
employee healthcare at a lesser cost.
Stop-loss Insurance
The Company's stop-loss insurance capabilities through its wholly-
owned insurance companies allow another dimension to First Health's
ability to serve as an integrated single source for managed care needs.
Because First Health's stop-loss rates are based on the savings and value
generated through the Company's various services, First Health is able to
offer competitive rates and policies. The Company can offer multiple-
year rate guarantees that include fixed-percent increases and that are
based upon loss results. Stop-loss policies are written through the
Company's wholly-owned insurance subsidiaries. Policies can be written
for either specific or aggregate stop-loss insurance.
Specific Stop-Loss Insurance
Specific stop-loss insurance provides protection against high medical
claims on any one individual during the plan year. It limits the client's
cost of eligible medical expenses for each plan participant.
If eligible medical expenses on a covered individual are incurred and
paid during the contract period, and the individual's deductible is
exceeded, the client will be reimbursed for the amount of the loss that
exceeds the deductible. The per-person deductible is determined prior to
the start of the contract period and all reimbursements will be paid
directly to the client, not the participant or provider.
Aggregate Stop-Loss Insurance
Aggregate stop-loss insurance helps limit clients' overall annual
claims cost. It will reimburse the client when eligible claims for the
self-funded plan, as a whole, exceed the aggregate deductible level and
are incurred and paid during the contract period. This protection guards
against unexpected fluctuations in claims frequency or large dollar
volume.
<PAGE>
Health plan benefits such as medical, dental, vision, prescription
drugs and short-term disability may or may not be included in an
aggregate stop-loss contract, depending on the client's needs.
First Health Services Overview
First Health Services ("Services") provides value-added automation,
administration, payment, and health care management services for public
sector clients. Services provides: 1) Pharmacy Benefit Management,
which manages pharmacy benefit plans for managed care
organizations, HMOs, Insurers, Specialty & Elderly Rx programs, Medicaid
programs, state-funded specialty programs, and self-funded employers; 2)
First Mental Health, which provides psychiatric utilization review, long-
term care review and quality of care evaluation services for state
government clients; and 3) Fiscal Agent, which administers state Medicaid
health plans and other state funded health care programs.
First Health has been able to leverage its Medicaid fiscal agent
expertise, its base of experience in the public sector and its client
relationships with over 20 state governments, to provide new products and
services as the public sector health programs (including Medicare and
Medicaid) move toward managed care.
Pharmacy Benefit Management (PBM)
Services' PBM service line is one of the largest PBMs in the country.
Services' PBM business provides a full range of services, including:
pharmacy point-of-sale ("POS") eligibility verification and claims
processing; provider network development and management; disease state
management programs; prospective and retrospective drug utilization
reviews ("DUR"); provider profiling; formulary development;
manufacturers' rebate administration; and RxPert, a proprietary database
and decision support system for pharmacy utilization monitoring and plan
management.
PBM services are increasingly required by both public and private
third-party payers as prescription drug expenses grow. Services' PBM
program is one of the few large-scale participants in the market not
aligned with or controlled by a drug manufacturer. Management believes
that Services' role as an objective provider is a distinct competitive
advantage in the growing sectors of managed care organizations and state
government plans, where clinical autonomy is often a requirement.
Furthermore, Services is the national leader with substantial experience
managing pharmacy plans for Medicaid and elderly populations. This
clinical and management expertise gives Services a competitive advantage
in the rapidly growing market of managed care organizations serving
capitated public sector lives (Medicare and Medicaid).
<PAGE>
Services provides clinical Drug Utilization Review services. The
primary objective of DUR is to provide pertinent health-related
information to providers to assist in the clinical management of their
patients. Services' DUR programs operate at the individual patient level
and are defined as follows:
* Prospective DUR. On-line real-time DUR alert messaging to the
pharmacy which operates as part of the POS claims adjudication
process; occurs before prescription is filled.
* Retrospective DUR. Computer-generated patient profiles identifying
trends or patterns of drug use; occurs after prescription is filled.
Based on DUR findings, interventions or actions can improve quality of
care and modify drug utilization patterns which produce cost savings,
help to maintain program integrity and assist in identification and
correction of drug misuse or fraud and abuse.
Services also offers Disease Management Programs ("DMP") to assist
physicians and network pharmacies in the treatment of prevalent, high-
cost disease states. This program provides physicians with diagnosis,
treatment, and formulary guidelines which have been developed by
nationally recognized clinicians and medical academicians. Services' DMP
focuses on that percentage of patients who experience preventable
therapeutic problems (i.e., non-compliance, inappropriate therapy,
adverse drug reactions, etc.). The program includes prior authorization
initiatives, prospective DUR, retrospective DUR, and educational
intervention initiatives (concurrent DUR).
First Mental Health
First Mental Health provides an array of quality evaluation and
utilization review services to Medicaid programs, state mental health
agencies, HMOs, managed care organizations, and other health care
programs desiring to improve quality of care, contain costs, ensure
appropriate care, and measure outcomes. Products include: 1) External
Quality Reviews; 2) Utilization Review; and 3) Long Term Care Reviews.
When a state initiates a capitated Medicaid Managed Care Program, the
federal Health Care Finance Administration (HCFA) requires that an
External Quality Review Organization (EQRO) be employed to monitor health
care quality and service quality of the HMOs and MCOs serving Medicaid
enrollees. The External Quality Review encompasses the entire medical
delivery mechanism, not just the mental health portion. There is a new
market rapidly developing as various states implement this type of
program to move Medicaid recipients into Managed Care Organizations.
<PAGE>
First Mental Health provides Utilization Review Services for a variety
of behavioral health programs, including Medicaid Under 21 acute
psychiatric treatment, adult and geriatric acute psychiatric treatment,
residential services, and other alternative services. First Mental
Health also provides on-site quality reviews and inspection of care for
community mental health centers, residential treatment centers and
inpatient psychiatric programs. As state Medicaid programs and state
departments of mental health spend increasing proportions of public funds
on the treatment of mental and substance abuse illnesses, the need for
utilization review services is increasing. Some states are moving toward
capitated contracts with private sector firms to help manage this
problem; however, many states are opting to contract for utilization
review services to ensure appropriate mental health care while containing
costs.
Under the Long Term Care Review program, First Mental Health provides
level-of-care determinations as well as preadmission screenings and
annual resident reviews ("PASARRs") to determine the need for specialized
services for mental illness, mental retardation or related conditions.
Fiscal Agent
Services' Fiscal Agent service line provides customers with full
fiscal agent operations and systems maintenance and enhancement. Under
this product line, Services provides eligibility verification and ID card
issuance, health care claims receipt, resolution, processing and payment,
provider relations, third party liability processing, financial
reconciliation functions and client reporting. Customers of Services
include state Medicaid agencies, state departments of human services,
departments of health and managed care organizations serving Medicaid
populations. Fiscal Agent administrative services may also be procured
to support other government programs, such as state employee benefit
plans, early intervention programs, or other health care initiatives.
Typically, Fiscal Agent systems are modified to meet specific states'
program policy and administration requirements, and services are offered
for all claim types.
Services is one of four major competitors in the Medicaid fiscal agent
field. Services has developed and operates a HCFA-approved information
system for each of these contracts. These systems are utilized to
process and adjudicate eligibility, health care claims and encounters,
pay providers under a full range of reimbursement methods and to generate
reports for use in managing the program.
<PAGE>
Contract for state funded health care programs, in addition to the
Medicaid fiscal agent contracts above, include the following:
* Health Benefits Management. Education, outreach, enrollment and
call-center services for the Missouri Managed Care Program known as
MC+. MC+ is a phased-in transition of member Medicaid population
into a managed care environment. Services contacts Medicaid
recipients, educates them on HMO options available, and enrolls them
into the member selected MCO plan.
* City Early Intervention Programs. A legislated entitlement program
designed to provide managed care services from birth to age two for
children who exhibit a disability or delay that is cognitive,
physical, communicative, social, emotional or adaptive, irrespective
of financial resources.
Services management believes there are significant future
opportunities in this market and has been recently awarded significant
additional business from the Commonwealth of Virginia. In addition,
there are several benefits that Services receives from operating the
Fiscal Agent business: 1) the contracts are profitable, with very little
new capital investment in the business required; 2) the expertise,
capabilities and systems developed from these contracts have provided a
platform for expansion into other products, services and customer
segments; and 3) customer relationships with the states have proven
valuable to First Health Services in developing other business in PBM and
First Mental Health.
Integrated Managed Care Products
The Company has introduced a number of new services during the last
few years that incorporate various features of First Health's clinical
management and PPO services in order to provide clients increased
opportunities for medical cost savings. Common characteristics of these
new services include:
* More aggressively managed provider networks.
* More aggressive risk sharing financial arrangements with providers.
* Improved communication and linkage with members and participants.
* Longer term contracts with providers.
* Intensive medical case management intervention.
These programs constitute important elements of the Company's risk
products and programs it is in the process of introducing.
First Health National Transplant Program. As medical technology
advances, new and more complicated procedures, such as transplants, have
evolved. In an attempt to assist the Company's clients in meeting these
technological advances and their related costs, First Health has
developed The National Transplant Program.
This program has been designed to facilitate the cost-effective use of
high quality transplant services through an integrated system whereby
case management staff assists in the coordination of the process from the
determination of the need for a transplant through follow up care for one
year after the transplant is performed.
<PAGE>
The goals of The National Transplant Program include:
* Enhancing quality of care and favorable outcomes through case
management and direction of patients to a selected number of
transplant programs that meet stringent quality and performance
standards;
* Reducing health care costs by contracting a cost-effective package
rate with high quality transplant centers that have a proven
performance record of desirable outcomes;
* Improving predictability of transplant costs by establishing fixed
fees that share risk with the providers and spread payment out over
a one-year period.
Transplants included in the program include: heart, lung, heart/lung,
liver, kidney, kidney/pancreas and bone marrow (both allogenic and
autologous).
FIRST HEALTH Point of Service Program. The Point of Service Program
is comparable to a "gatekeeper" approach whereby a primary care physician
(PCP) coordinates his/her patients' use of the health care system. The
gatekeeper approach has been set up to attain two major objectives: (1)
to coordinate and manage a patient's course of treatment and (2) to
control costs and utilization.
The Company has developed a program to more effectively address both
client objectives for, and drawbacks to, current approaches. In addition
to coordinating the course of treatment and controlling costs and
utilization, the objectives of the Company's Point of Service Program are
to:
* Encourage the use of primary care network providers as the first
course of treatment and network providers, in general, as required;
* Provide early case identification of complex or chronic patients who
could benefit from case management intervention; and,
* Maintain the element of choice for the patient's selection of their
physician.
Year 2000 Matters
See Management's Discussion and Analysis of Financial Condition and
Results of Operations in the Company's 1998 Annual Report to
Stockholders. Such information is incorporated herein by reference.
Competition
First Health competes in a highly fragmented market with national
and local firms specializing in utilization review and PPO cost
management services and with major insurance carriers and third party
administrators which have implemented their own internal cost management
services. In addition, other health care programs, such as HMOs, compete
for the enrollment of benefit plan participants. First Health is subject
to intense competition in each market segment in which it competes. Many
of First Health's competitors are significantly larger and have greater
financial and marketing resources than First Health.
<PAGE>
First Health competes on the basis of the quality and cost-
effectiveness of its programs, its proprietary computer-based information
system and its emphasis on commitment to service and high degree of
physician involvement. Due to the quality of the services offered, First
Health tends to charge more for its services than many of its
competitors.
The insurer market for workers' compensation programs is somewhat
concentrated with the top ten insurers controlling over 50% of the
insured market. The loss or addition of any one of these insurers could
have a material impact on revenues. First Health currently has as
clients at least some offices of six of the top ten insurers. While
experience differs with various clients, obtaining a new client requires
extended discussions and significant time.
Over the last few years, the Company believes a major competitive
threat has arisen as a result of the so-called "Silent" Preferred
Provider Organizations (PPO) or non-directed networks. In this
situation, medical reimbursement payers lay claim to PPO discounts
without providing any patient channeling mechanisms. These "networks"
use the camouflage of directed networks to secure rewards of managed care
discounts from medical providers without the responsibilities. These
organizations betray the trust of providers who offer preferred rates to
networks anticipating active patient directing programs, thus
undercutting the integrity of managed care business relationships,
threatening the viability of legitimate networks, such as the Company's,
and jeopardizing provider finances.
Since managed care is fundamentally a bargain between a managed care
organization and a medical provider in which the managed care
organization channels patients to the provider in exchange for favorable
price consideration and the adherence to managed care guidelines, the
"silent" PPO networks can and do undermine that bargain. To the extent
that providers are defrauded in that price for volume trade-off, the
ability of legitimate managed care companies to obtain appropriate priced
considerations will be diminished.
Employees
As of December 31, 1998, First Health had approximately 4,000
employees, including approximately 1,900 employees involved in claims
processing and related activities; 650 employees in various clinical
management and quality assessment activities; 500 employees in
information systems; 230 employees in sales and marketing and the
remainder involved with accounting, human resources, facilities, and
other administrative, support and executive functions. First Health also
has a nationwide network of conferring physicians in various specialties,
most of whom are compensated on an hourly or per visit basis when
requested by First Health to render consulting services. None of the
Company's employees are presently covered by a collective bargaining
agreement. The Company considers its relations with its employees to be
good.
Government Regulations and Risk Management
The Company believes that its methods of operation are in material
compliance with all applicable laws, including statutes and regulations
relating to PPO and clinical management operations.
<PAGE>
Although First Health believes that its level of Directors' and
Officers' and Errors and Omissions insurance coverage is appropriate, no
assurance can be given that insurance coverage would protect it from loss
in the event of any litigation or adverse interpretation of statutes and
regulations by governmental or other bodies. Further, there can be no
assurance that such insurance will continue to be available on a
commercially reasonable basis.
Item 2. Properties
First Health owns four office buildings consisting of an aggregate of
approximately 465,000 square feet of space. One is in Downers Grove,
Illinois where the Company is headquartered, and the other three are in
West Sacramento, California; Houston, Texas and Scottsdale, Arizona.
Additionally, the Company leases significant office space in the Salt
Lake City, Utah; Milwaukee, Wisconsin; Richmond, Virginia; Pittsburgh,
Pennsylvania; Boise, Idaho; and the Los Angeles, California area.
Additionally, the Company has numerous other smaller locations throughout
the nation.
All of the Company's buildings and equipment are being utilized, have
been maintained adequately and are in good operating condition. These
assets, together with planned capital expenditures, are expected to meet
the Company's operating needs in the foreseeable future.
Item 3. Legal Proceedings
First Health is subject to various legal proceedings arising in the
ordinary course of business. In the opinion of management, the ultimate
resolution of these pending suits will not have a material adverse effect
on the business or financial condition of First Health.
<PAGE>
Item 4. Submission of Matters to a Vote of Security Holders
No matters were submitted to a vote of the Company's security holders
during the fourth quarter of the year ended December 31, 1998.
<TABLE>
Executive Officers of the Company
Name Age Position
---- --- --------
<S> <C> <C>
James C. Smith 58 President and Chief Executive Officer
Daniel Brunner 55 Executive Vice President,
Government Affairs
Mary Anne Carpenter 53 Executive Vice President, Service Products
A. Lee Dickerson 49 Executive Vice President, Provider Networks
Patrick G. Dills 45 Executive Vice President, Sales
Ronald H. Galowich 63 Secretary
Lottie A. Kurcz 44 Senior Vice President, Strategic
Business Development
Jerry L. Seiler 58 Controller
Susan T. Smith 48 General Counsel, Assistant Secretary
Joseph E. Whitters 40 Vice President, Finance and
Chief Financial Officer
Edward L. Wristen 47 Executive Vice President,
Chief Operating Officer
</TABLE>
James C. Smith has served as President and Chief Executive Officer and
director of First Health since January, 1984.
Daniel Brunner, a director of the Company, has been Executive Vice
President, Government Affairs since January, 1994. Prior to that, he was
Corporate Operating Officer in charge of government affairs since
February, 1992. Mr. Brunner has served as President of AFFORDABLE since
April, 1983.
Mary Anne Carpenter has held various senior management positions in
the Company since joining the Company in 1983. In June, 1997, Ms.
Carpenter was promoted to Executive Vice President, Service Products.
Prior to that, from March, 1994 to May, 1997, she was Executive Vice
President, Clinical Operations and Claims Repricing. Prior to joining
the Company, Ms. Carpenter held various positions in the health care
industry.
<PAGE>
A. Lee Dickerson joined First Health in 1988 as Regional Director,
Hospital Contracting. Mr. Dickerson was promoted into his current
position in November 1995. Previously he held various senior level
positions in the Company's Provider Networks area. Mr. Dickerson has
over 20 years experience in the health care industry.
Patrick G. Dills joined First Health in 1988 as Senior National
Director, Sales and Marketing. Mr. Dills was promoted to Executive Vice
President, Managed Care Sales in January, 1994. Prior to joining First
Health, Mr. Dills held various senior sales positions at M&M/Mars, and
various divisions of Mars, Inc. for the prior six years.
Ronald H. Galowich has served as Secretary of the Company since 1983,
General Counsel from 1983 to March 1997, Executive Vice President of the
Company from 1983 to May, 1994 and Chairman of the Board of Madison Group
Holdings, Inc., a multi-purpose business and investment company, since
1990.
Lottie A. Kurcz joined First Health in 1986 as Manager of National
Accounts. Since joining First Health, Ms. Kurcz has held various senior
sales and marketing positions. Ms. Kurcz was promoted in 1998 to Senior
Vice President, Strategic Business Development. Prior to her promotion,
Ms. Kurcz was Senior Vice President, Risk Products. Prior to joining
First Health, Ms. Kurcz held various senior positions in private
industry.
Jerry L. Seiler joined the Company in May, 1989 as Accounting Manager
and was promoted to Corporate Controller in 1990 and has served in that
capacity since.
Susan T. Smith has served as General Counsel of the Company since
March, 1997. She was Associate General Counsel from September 1994 and
joined the Company in July 1992. Prior to joining First Health, Ms.
Smith was a partner at Pryor, Carney and Johnson, a large Denver law firm
where she headed the firm's healthcare law practice.
Joseph E. Whitters joined the Company as Controller in October, 1986
and has served as its Vice President, Finance since August, 1987 and its
Chief Financial Officer since March, 1988.
Edward L. Wristen joined First Health in November, 1990 as Director of
Strategic Planning and was promoted to Vice President, Managed Outpatient
Care Programs, in April, 1991. In February, 1992, he became Executive
Vice President and Corporate Operating Officer in charge of Provider
Networks. In January, 1995, Mr. Wristen became Executive Vice President,
Risk Products. In September 1998, Mr. Wristen became Chief Operating
Officer. Prior to joining First Health, Mr. Wristen was President of
Parkside Data Services, a subsidiary of Parkside Health Management
Corporation, a firm engaged in data and analytic services, from March,
1989 to November, 1990. From February, 1987 to February, 1989 Mr.
Wristen was Chief Operating Officer and Executive Vice President of
Addiction Recovery Corporation, a regional chain of chemical dependency
hospitals. Mr. Wristen has over 18 years experience in the health care
industry.
The Company's officers serve at the discretion of the Board of
Directors.
<PAGE>
PART II
Item 5.Market for Registrant's Common Equity and Related Stockholder
Matters.
The Company's Common Stock has been quoted on the Nasdaq National
Market under the symbol "FHCC" since the Company's corporate name change
on January 1, 1998 and prior to that was quoted under the symbol "HCCC".
Information concerning the range of high and low sales prices of the
Company's Common Stock on the Nasdaq National Market and the approximate
number of holders of record of the Common Stock is set forth under
"Common Stock" in the Company's 1998 Annual Report to Stockholders.
Information concerning the Company's dividend policy is set forth under
"Dividend Policy" in the Company's 1998 Annual Report to Stockholders.
All such information is incorporated herein by reference.
Item 6.Selected Financial Data.
Selected financial data of the Company for each of its last five
fiscal years is set forth under "Selected Financial Data" in the
Company's 1998 Annual Report to Stockholders. Such information is
incorporated herein by reference.
Item 7.Management's Discussion and Analysis of Financial Condition and
Results of Operation.
The information required by this item is set forth under "Management's
Discussion and Analysis of Financial Condition and Results of Operations"
in the Company's 1998 Annual Report to Stockholders and is incorporated
herein by reference.
Item 7a. Quantitative and Qualitative Disclosures About Market Risk.
The disclosures about Market Risk required by this item are contained
in the Company's 1998 Annual Report on page 22 and are incorporated
herein by reference.
<PAGE>
Item 8.Financial Statements and Supplementary Data.
The financial statements required by this item are contained in the
Company's 1998 Annual Report to Stockholders on the pages indicated below
and are incorporated herein by reference.
Financial Statements: Page No.
Report of Independent Auditors 27
Consolidated Balance Sheets as of 28
December 31, 1997 and 1998
Consolidated Statements of Operations for the Years Ended 29
December 31, 1996, 1997 and 1998
Consolidated Statements of Comprehensive Income for the Years 29
Ended December 31, 1996, 1997 and 1998
Consolidated Statements of Cash Flows for the 30-31
Years Ended December 31, 1996, 1997 and 1998
Consolidated Statements of Stockholders' Equity for the 32-33
Years Ended December 31, 1996, 1997 and 1998
Notes to Consolidated Financial Statements 34-43
Item 9.Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure
Not applicable.
Item 10. Directors and Executive Officers of the Registrant.
Certain information regarding the Company's executive officers is set
forth under the caption "Executive Officers of the Company" in Part I.
Other information regarding the Company's executive officers, as well as
certain information regarding First Health's directors, will be included
in the Proxy Statement for the Company's Annual meeting of Stockholders
to be held on May 18, 1999 (the "Proxy Statement"), and such information
is incorporated herein by reference.
<PAGE>
PART III
Item 11. Executive Compensation.
The information required by this Item will be included in the Proxy
Statement and is incorporated herein by reference. However, neither the
Report of the Compensation Committee of the Board of Directors on
Executive Compensation nor the Performance Graph contained in the Proxy
Statement is incorporated by reference herein, in any of the Company's
previous filings under either the Securities Act of 1933, as amended, or
the Securities Exchange Act of 1934, as amended, or in any of the
Company's future filings.
Item 12. Security Ownership of Certain Beneficial Owners and Management.
The information required by this Item will be included in the Proxy
Statement and is incorporated herein by reference.
Item 13. Certain Relationships and Related Transactions.
The information required by this Item will be included in the Proxy
Statement and is incorporated herein by reference.
PART IV
Item 14. Exhibits, Financial Statement Schedule, and Reports on Form 8-K.
(a) The following documents are filed as part of this report:
(1) The Index to Financial Statements is set forth on page 28
of this report.
(2) Financial Statements Schedules:
Schedule II - Valuation and Qualifying Accounts and
Reserves.
Schedule IV - Reinsurance
(3) Exhibits
(b) Report on Form 8-K:
The Company did not file a current report on Form 8-K during the
fourth quarter of fiscal 1998.
<PAGE>
<TABLE>
First Health Group Corp.
Schedule II - Valuation and Qualifying Accounts and Reserves
Years Ended December 31, 1998, 1997 and 1996
Additions
Balance at Charged to Adjustments Balance at
Beginning Costs and and End of
Description of Period Expenses Charge-offs Period
- ----------- ---------- ---------- ----------- ----------
<S> <C> <C> <C> <C>
Year Ended
December 31, 1998:
Allowance for Doubtful
Accounts $10,064,000 $ 897,000 $ 190,000 $11,151,000
========== ========== =========== ==========
Accrued Restructuring
Expenses $28,166,000 $ -- $(12,863,000) $15,303,000
========== ========== =========== ==========
Year Ended
December 31, 1997:
Allowance for Doubtful
Accounts $ 2,573,000 $ 9,799,000 (1) $ (2,308,000) $10,064,000
========== ========== =========== ==========
Accrued Restructuring
Expenses $ 1,141,000 $26,036,000 (2) $ 989,000 $28,166,000
========== ========== =========== ==========
Year Ended
December 31, 1996:
Allowance for Doubtful
Accounts $ 2,807,000 $ (200,000) $ ( 34,000) $ 2,573,000
========== ========== =========== ==========
Accrued Restructuring
Expenses $ 1,436,000 $ 69,000 $ (364,000) $ 1,141,000
========== ========== =========== ==========
</TABLE>
(1) Additions include $5,453,000 of allowance for doubtful accounts which were
included in the purchase accounting adjustments related to the acquisition
of FHC, not charged to expenses.
(2) Additions include $26,036,000 of accrued restructuring expenses which were
included in the purchase accounting adjustments related to the acquisition
of FHC, not charged to expenses.
<PAGE>
<TABLE>
First Health Group Corp.
Schedule IV - Reinsurance
Years Ended December 31, 1998, 1997 and 1996
Percentage
Ceded Assumed of Amount
Gross to Other from Other Net Assumed
Amount Companies Companies Amount to Net
------------- --------------- ----------- ----------- ----
<S> <C> <C> <C> <C> <C>
Year ended 12/31/98:
Life insurance in force: $ 585,037,000 $ (545,305,000) $ -- $ 39,732,000 --%
============= =============== =========== =========== ====
Premiums:
Life insurance 8,845,000 (8,442,000) 54,000 457,000 12%
Accident and health
insurance 19,539,000 (3,044,000) 2,039,000 18,534,000 11%
------------- --------------- ----------- ----------- ---
Total premiums $ 28,384,000 $ (11,486,000) $ 2,093,000 $ 18,991,000 11%
============= =============== =========== =========== ====
Year ended 12/31/97:
Life insurance in force: $1,507,194,000 $ (1,470,903,000) $ 1,151,000 $ 37,442,000 3%
============= =============== =========== =========== ====
Premiums:
Life insurance 7,424,000 (7,104,000) 94,000 414,000 23%
Accident and health
insurance 11,046,000 (2,859,000) 2,147,000 10,334,000 21%
------------- --------------- ----------- ----------- ---
Total premiums $ 18,470,000 $ (9,963,000) $ 2,241,000 $ 10,748,000 21%
============= =============== =========== =========== ====
Year ended 12/31/96:
Life insurance in force: $ 26,915,000 $ (13,804,000) $ 18,071,000 $ 31,182,000 58%
============= =============== =========== =========== ====
Premiums:
Life insurance 360,000 (149,000) 59,000 270,000 22%
Accident and health
insurance 14,107,000 (7,643,000) 1,172,000 7,636,000 15%
------------- --------------- ----------- ----------- ----
Total premiums $ 14,467,000 $ (7,792,000) $ 1,231,000 $ 7,906,000 16%
============= =============== =========== =========== ====
</TABLE>
<PAGE>
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this report to be
signed on its behalf by the undersigned, thereunto duly authorized.
FIRST HEALTH GROUP CORP.
By: /s/James C. Smith
James C. Smith, President
and Chief Executive Officer
Date: March 29, 1999
Pursuant to the requirements of the Securities Exchange Act of 1934,
this report has been signed below by the following persons on behalf of
the Registrant and in the capacities indicated on March 29, 1999:
Signature Title
--------------------------- -------------------------------------
/s/Thomas J. Pritzker Chairman of the Board
Thomas J. Pritzker
/s/James C. Smith President, Chief Executive Officer,
James C. Smith Director (Principal Executive Officer)
/s/Joseph E. Whitters * Chief Financial Officer
Joseph E. Whitters (Principal Financial Officer)
/s/Jerry L. Seiler * Controller
Jerry L. Seiler (Principal Accounting Officer)
/s/Ronald H. Galowich * Secretary
Ronald H. Galowich Director
/s/Michael J. Boskin * Director
Michael J. Boskin
/s/Burton W. Kanter * Director
Burton W. Kanter
/s/David Simon * Director
David Simon
/s/Daniel Brunner * Executive Vice President, Government
Daniel Brunner Affairs, Director
/s/Robert S. Colman * Director
Robert S. Colman
/s/Harold S. Handelsman * Director
Harold S. Handelsman
/s/Don Logan * Director
Don Logan
* By: /s/ Joseph E. Whitters
Joseph E. Whitters, Attorney in Fact
<PAGE>
INDEPENDENT AUDITORS' REPORT
Board of Directors and Stockholders
First Health Group Corp.
Downers Grove, IL 60515
We have audited the consolidated financial statements of First Health
Group Corp as of December 31, 1998 and 1997, and for each of the three
years in the period ended December 31, 1998 and have issued our report
thereon, dated February 19, 1999; such consolidated financial statements
and report are included in your 1998 Annual Report to Stockholders and
are incorporated herein by reference. Our audits also included the
consolidated financial statement schedules of First Health Group Corp.
listed in Item 14. These consolidated financial statement schedules are
the responsibility of the Corporation's management. Our responsibility
is to express an opinion based upon our audits. In our opinion, such
consolidated financial statement schedules, when considered in relation
to the basic consolidated financial statements taken as a whole, present
fairly in all material respects the information set forth therein.
DELOITTE & TOUCHE LLP
Chicago, Illinois
February 19, 1999
<PAGE>
INDEX TO EXHIBITS
Exhibit No. Description
2.1. Omitted
3.1. Restated Certificate of Incorporation of the Company.
{3.1} (1)
3.2. Amendment to Restated Certificate of Incorporation of
the Company. {3.2} (9)
3.3. Restated Certificate of Designation of Preferences,
Rights and Limitations. {3.2} (1)
3.4. Amended and Restated By-Laws of the Company. {3.3} (1)
3.5. Amendment, dated as of May 20, 1987, to Amended and
Restated By-Laws of the Company {3.4} (2)
3.6. Amendment to Amended and Restated By-Laws of the
Company.{3.5} (6)
3.7. Amendment to Amended and Restated By-Laws of the
Company.{3.6} (6)
4. Specimen of Stock Certificate for Common Stock. {4} (2)
9. Omitted
9.1. Omitted
9.2. Omitted
10.1 - 10.24. Omitted
10.25. Form of Consulting Physician Agreement, {10.20} (2)
10.26. Form of Consulting Specialist Agreement. {10.21} (2)
10.27-10.35. Omitted
10.36. HealthCare COMPARE Corp. 1989 Employee Stock Purchase
Plan. {10.36} (7)
10.37-10.54. Omitted
10.54. Form of Indemnification Agreement entered dated June
19, 1989 between OUCH and executive officers and
directors of OUCH (Incorporated by reference to Exhibit
B of definitive proxy materials filed by OUCH with the
SEC on April 7, 1989) {10.54} (11)
<PAGE>
Exhibit No. Description
10.55-10.68. Omitted
10.69. Second Restatement of the HealthCare COMPARE Corp.
Retirement Savings Plan. {10.69} (14)
10.70. HealthCare COMPARE Corp. Director's Option Plan dated
May 23, 1991. {10.70} (14)
10.71. HealthCare COMPARE Corp. Stock Option Plan (for
employees of OUCH). {10.71} (14)
10.72. - 10.75. Omitted
10.76. Employment Agreement dated as of July 1, 1993 by and
between COMPARE and Daniel S. Brunner. {10.76} (15)
10.77.- 10.89. Omitted
10.90. Retainer Agreement dated January 1, 1994 between
HealthCare COMPARE Corp. and Ronald H. Galowich.
{10.90}
10.91-10.93. Omitted.
10.94. HealthCare COMPARE Corp. 1995 Employee Stock Option
Plan. (4.1) {18}
10.95. Employment Agreement dated January 1, 1997 between
HealthCare COMPARE Corp. and James C. Smith. {10.95} (20)
10.96. Option Agreement dated as of January 1, 1997 by and
between The Company and James C. Smith. {10.96} (20)
10.97. Option Agreement dated as of January 1, 1997 by and
between The Company and James C. Smith. {10.97} (20)
10.98. Option Agreement dated as of January 1, 1997 by and
between The Company and James C. Smith. {10.98} (20)
10.99. Agreement dated as of September 1, 1995 between
HealthCare COMPARE Corp. and Electronic Data Systems.
{10.99} (20)
10.100. Employment Agreement dated July 1, 1997 between
HealthCare COMPARE Corp. and Joseph E. Whitters.
{10.100} (22)
10.101. Employment Agreement dated July 1, 1997 between
HealthCare COMPARE Corp. and Ed Wristen. {10.101} (22)
<PAGE>
Exhibit No. Description
10.102. Employment Agreement dated July 1, 1997 between
HealthCare COMPARE Corp. and Lottie Kurcz. {10.102}
(22)
10.103. Employment Agreement dated July 1, 1997 between
HealthCare COMPARE Corp. and Mary Anne Carpenter.
{10.103} (22)
10.104. Employment Agreement dated July 1, 1997 between
HealthCare COMPARE Corp. and Susan T. Smith. {10.104}
(22)
10.105. Employment Agreement dated July 1, 1997 between
HealthCare COMPARE Corp. and A. Lee Dickerson. {10.105}
(22)
10.106. Employment Agreement dated April 29, 1997 between
HealthCare COMPARE Corp. and Patrick G. Dills. {10.106}
(22)
10.107. Employment Agreement dated July 1, 1997 between
HealthCare COMPARE Corp. and Jerry L. Seiler. {10.107}
(22)
10.108. Stock Purchase Agreement among HealthCare COMPARE
Corp., First Financial Management Corporation and First
Data Corporation dated as of May 22, 1997, incorporated
by reference from the Company's Second Quarter 1997
Form 10-Q dated August 13, 1997. {10.108}
10.109. Amended and Restated Credit Agreement dated as of
October 22, 1997 by and among HealthCare COMPARE Corp.
as borrowers; LaSalle National Bank as administrative
agent, issuing bank and lender; First Chicago Capital
Markets, Inc., as syndication agent; and the other
financial institutions party hereto as lenders.
{10.109} (22)
10.110. First Amendment to Amended and Restated Credit
Agreement dated as of October 22, 1997, by and among
First Health Group Corp. (f/k/a HealthCare COMPARE
Corp.), as Borrower, LaSalle National Bank, as
Administrative Agent, and the other parties thereto
(the "Amendment").
10.111. 1998 Stock Option Plan {4} (23)
10.112. 1998 Directors Stock Option Plan {4} (24)
11. Computation of Basic and Diluted Earnings Per Share.
13. 1998 Annual Report to Stockholders.
22. Subsidiaries of the Company.
23. Consent of Deloitte & Touche LLP
<PAGE>
Exhibit No. Description
27. Financial data schedules of the Company.
{ } Exhibits so marked have been previously filed with the
Securities and Exchange Commission as exhibits to the
filings shown below under the exhibit number indicated
following the respective document description and are
incorporated herein by reference.
(1) Registration Statement on Form S-1 ("Registration
Statement"), as filed with the Securities and Exchange
Commission on April 17, 1987.
(2) Amendment No. 2 to Registration Statement, as filed
with the Securities and Exchange Commission on May 22,
1987.
(3) Amendment No. 3 to Registration Statement, as filed
with the Securities and Exchange Commission on May 29,
1987.
(4) Annual Report on Form 10-K for the fiscal year ended
August 31, 1987, as filed with the Securities and
Exchange Commission on November 27, 1987.
(5) Registration Statement on Form S-8, as filed with the
Securities and Exchange Commission on January 12, 1988.
(6) Registration Statement on Form S-1, as filed with the
Securities and Exchange Commission on July 12, 1988.
(7) Registration Statement on Form S-8, as filed with the
Securities and Exchange Commission on January 18, 1989.
(8) Annual Report on Form 10-K for the year ended August
31, 1989, as filed with the Securities and Exchange
Commission on November 28, 1989.
(9) Annual Report on Form 10-K for the year ended December
31, 1990, as filed with the Securities and Exchange
Commission on March 30, 1991.
(10) Registration Statement on Form S-8, as filed with the
Securities and Exchange Commission on November 1, 1991.
(11) Registration Statement of Form S-4, as filed with the
Securities and Exchange Commission on January 27, 1992.
(12) Registration Statement on Form S-8, as filed with the
Securities and Exchange Commission on March 4, 1992.
(13) Annual Report on Form 10-K for the year ended December
31, 1991 as filed with the Securities and Exchange
Commission on March 27, 1992.
<PAGE>
Exhibit No. Description
(14) Annual Report on Form 10-K for the year ended December
31, 1992 as filed with the Securities and Exchange
Commission on March 26, 1993.
(15) Annual Report on Form 10-K for the year ended December
31, 1993 as filed with the Securities and Exchange
Commission on March 25, 1994.
(16) Registration Statement on Form S-8, as filed with the
Securities and Exchange Commission on December 27,
1994.
(17) Annual Report on Form 10-K for the year ended December
31, 1994 as filed with the Securities and Exchange
Commission on March 24, 1995.
(18) Registration Statement on Form S-8 as filed with the
Securities and Exchange Commission on September 20,
1995.
(19) Annual Report on Form 10-K for the year ended December
31, 1995 as filed with the Securities and Exchange
Commission on March 27, 1996.
(20) Annual Report on Form 10-K for the year ended December
31, 1996 as filed with the Securities and Exchange
Commission on March 27, 1997.
(21) Registration Statement on Form S-8 as filed with the
Securities Exchange Commission on July 23, 1997.
(22) Annual Report on Form 10K for the year ended December
31, 1997 and filed with the Securities and Exchange
Commission on March 25, 1998.
(23) Registration Statement on Form S-8 as filed with the
Securities and Exchange Commission on December 15,
1998.
(24) Registration Statement on Form S-8 as filed with the
Securities and Exchange Commission on December 15,
1998.
FIRST AMENDMENT TO AMENDED AND RESTATED CREDIT AGREEMENT
By and among FIRST HEALTH GROUP CORP. (f/k/a HealthCare Compare Corp.),
as Borrower,
LASALLE NATIONAL BANK, as Administrative Agent, Issuing Bank and Lender,
FIRST CHICAGO CAPITAL MARKETS, INC.,as Syndication Agent, and
THE OTHER FINANCIAL INSTITUTIONS PARTY THERETO, as Lenders,
Dated as of October 22, 1997
This First Amendment to Amended and Restated Credit Agreement dated
as of December 17, 1998, (this "Amendment") is entered into by and among
First Health Group Corp. (f/k/a HealthCare Compare Corp.), a Delaware
corporation (the "Borrower"), the several financial institutions party to
the Amendment (collectively, the "Lenders" and individually each a
"Lender"), LaSalle National Bank, as a Lender, Issuing Bank and as
administrative agent (the "Administrative Agent") for the Lenders and
First Chicago Capital Markets, Inc., as syndication agent for the Lenders
(the "Syndication Agent").
RECITALS
WHEREAS, the Borrower, the Lenders, the Administrative Agent, the
Issuing Bank and the Syndication Agent (each as defined therein) entered
into that certain Credit Agreement dated as of July 1, 1997 (the
"Original Credit Agreement") pursuant to which the Lenders agreed to make
available to the Borrower a revolving credit facility upon and subject to
the terms and conditions set forth in the Original Credit Agreement;
WHEREAS, the Borrower, Lenders, the Administrative Agent, the
Issuing Bank and the Syndication Agent (each as defined therein)
subsequently amended and restated the Original Credit Agreement and
entered into an Amended and Restated Credit Agreement dated as of October
22, 1997 (the "Agreement"), to provide for a letters of credit; and
WHEREAS, the Borrower desires to implement a stock repurchase plan
pursuant to which it will effect the purchase of common stock of the
Borrower (the "Plan") and has requested a modification of the Agreement
to permit the implementation of the Plan; and
WHEREAS, the Lenders have agreed to make such modifications and the
parties hereto have agreed to amend the Agreement as set forth herein;
NOW, THEREFORE, in consideration of the mutual promises and
agreements of the parties hereinafter set forth and for other good and
valuable consideration, the receipt and sufficiency of which are hereby
acknowledged, the parties hereto agree as follows:
<PAGE>
SECTION 1. AMENDMENTS TO AGREEMENT
1.1. Section 1.1 of the Agreement is hereby amended by:
1.1.1. deleting the definition of "Applicable Margin" and
substituting the following in its place and stead:
"Applicable Margin" means with respect to LIBOR Rate Revolving
Loans, Base Rate Revolving Loans, and Facility Fees, respectively,
the applicable LIBOR margin, Base Rate margin, or Facility Fee
margin in effect from time to time determined using either the
Borrower's Senior Long-term Debt Rating then in effect or the
Borrower's Debt to EBITDA Ratio, at the Borrower's option from time
to time, pursuant to the appropriate column under the following
table:
<TABLE>
Senior Long-term Applicable Applicable
Debt Rating Debt to Applicable Base Facility Fee
----------- EBITDA LIBOR Margin Rate Margin
Ratio Margin
S&P Moody's
---- ------- --------- -------- ------ --------
<S> <C> <C> <C> <C> <C>
>=A- >=A3 <.50 30.0 bps 0 20.0 bps
BBB+ Baa1 .50-1.00 40.0 bps 0 22.5 bps
BBB Baa2 1.01-1.50 50.0 bps 0 25.0 bps
BBB- Baa3 1.51-2.00 75.0 bps 0 25.0 bps
BB+ Ba1 2.01-2.50 100.0 bps 0 25.0 bps
=<BB =<Ba2 >2.51 120.0 bps 0 30.0 bps
</TABLE>
<PAGE>
The Applicable Margin shall be adjusted from time to time upon
delivery to the Administrative Agent of (i) the quarterly financial
statements required to be delivered pursuant to Section 6.1 hereof
accompanied by a written calculation of the Debt to EBITDA Ratio
certified by a Responsible Officer as of the end of the fiscal
quarter for which such financial statements are delivered or (ii) a
statement of the Borrower's Senior Long-term Debt Rating by S&P and
Moody's, if any, certified by a Responsible Officer. If the Senior
Long-term Debt Rating by S&P and Moody's differ, for the purpose of
calculating the Applicable Margin, the Borrower's Senior Long-term
Debt Rating shall be deemed to be one level higher than the lower
rating given by S&P and Moody's. If such calculation or statement
indicates that the Applicable Margin shall increase or decrease,
then one (1) Business Day after the date of delivery of such
financial statements and written calculation or statement the
Applicable Margin shall be adjusted in accordance therewith;
provided, however, that if Borrower shall fail to deliver any such
financial statements for any such fiscal quarter by the date
required pursuant to Section 6.1, then, effective as of the Business
Day on which such financial statements were to have been delivered,
and continuing through the date which is one (1) Business Day after
the date (if ever) when such financial statements and such written
calculation are finally delivered, the Applicable Margin shall be
conclusively presumed to equal the highest Applicable Margin
specified in the pricing table set forth above.
1.1.2. deleting the definition of "Net Worth" and substituting
the following in its place and stead:
"Net Worth" means shareholders' equity of the Borrower as determined
in accordance with GAAP, plus (i) the lesser of (a) the amount of
the total consideration paid by the Borrower to acquire the
Borrower's stock subsequent to the date hereof and retired or held
by the Borrower as treasury stock under GAAP accounting, or (b)
$350,000,000.
1.2. A new Section 5.23 is inserted as follows:
5.23 Corporate Authorization of the Plan. The implementation of
the Plan is within the corporate powers of the Borrower, has been
duly authorized by all necessary corporate action, requires no
action by or in respect of, or filing with, any governmental body,
agency or official which will have not been taken or made prior to
the time required to be taken or made and does not contravene, or
constitute a default under, any provision of applicable law or
regulation or of the certificate of incorporation or by-laws of the
Borrower or of any debt instrument or material agreement, judgment,
injunction, order, decree or other instrument binding upon the
Borrower or any of its Subsidiaries.
<PAGE>
1.3. Section 7.11 is deleted in its entirety and the following
is substituted in its place and stead:
Restricted Payments. The Borrower shall not, and shall not suffer
or permit any of its Subsidiaries to, declare or make any dividend
payment or other distribution of assets, properties, cash, rights,
obligations or securities on account of any shares of any class of
its capital stock, or purchase, redeem or otherwise acquire for
value any shares of its capital stock or any warrants, rights or
options to acquire such shares, now or hereafter outstanding; except
that any Subsidiary of the Borrower may declare and pay dividends to
the Borrower or any Wholly-Owned Subsidiary of the Borrower and to
its other equity holders; provided, that any such dividend shall not
exceed the net worth of the applicable Subsidiary, and except that
the Borrower may:
(a) declare and make dividend payments or other distributions
payable solely in its common stock;
(b) purchase, redeem or otherwise acquire shares of its common
stock or warrants or options to acquire any such shares with the
proceeds received from the substantially concurrent issue of new
shares of its common stock; and
(c) declare or pay cash dividends to its stockholders and
purchase, redeem or otherwise acquire shares of its capital stock or
warrants, rights or options to acquire any such shares for cash (i)
in an aggregate amount not to exceed $350,000,000 pursuant to the
Plan subsequent to the date hereof, plus (ii) solely out of 50% of
Consolidated Net Income of the Borrower for fiscal quarters
beginning with the quarter ending March 31, 1999, computed on a
cumulative consolidated basis, provided, that, immediately after
giving effect to such proposed action, no Default or Event of
Default would exist;
1.4. Section 7.13 is deleted in its entirety and the following
is substituted in its place and stead:
Consolidated Net Worth. The Borrower shall not permit its Net
Worth, as determined as of the end of each fiscal quarter, to be
less than the sum of (i) $170,000,000, plus (ii) 50% of the
Borrower's Consolidated Net Income earned each fiscal quarter
commencing with the fiscal quarter ending December 31, 1998
(provided that if, for any fiscal quarter, the Borrower's
Consolidated Net Income shall be less than zero, then for purposes
of calculating the Borrower's compliance with this covenant, the
Borrower's Consolidated Net Income shall be deemed to be zero for
that fiscal quarter), plus (iii) 50% of the net proceeds received
from any stock offering of the Borrower (other than from the
exercise of option or from offerings only available to Affiliates of
the Borrower).
1.5. Attachment 2 to Exhibit E to the Agreement is deleted and
the attached Attachment 2 is substituted therefor.
<PAGE>
SECTION 2. REPRESENTATIONS AND WARRANTIES
To induce Lenders to amend the Agreement and to consider making
future loans thereunder, Borrower represents and warrants to Lenders
that:
2.1. Compliance with Agreement. On the date hereof, Borrower
is in compliance of all of the terms and provisions set forth in the
Agreement (as modified by this Amendment) and no Event of Default
specified in Section 8.1 of the Agreement nor any event which, upon
notice or lapse of time, or both, would constitute such an Event of
Default, has occurred.
2.2. Representations and Warranties. On the date hereof, the
representations and warranties set forth in Sections 5.1 through 5.22 of
the Agreement (as modified by this Amendment) are true and correct with
the same effect as though such representations and warranties had been
made on the date hereof, except to the extent that such representations
and warranties expressly related to an earlier date.
2.3. Corporate Authority of Borrower. Borrower has full power
and authority to enter into this Amendment, to make the borrowings under
the Agreement as amended by this Amendment, and to incur and perform the
obligations provided for under the Agreement and this Amendment, all of
which have been duly authorized by all proper and necessary corporate
action. No consent or approval of stockholders or of any public
authority or regulatory body is required as a condition to the validity
or enforceability of this Amendment.
2.4. Amendment as Binding Agreement. This Amendment
constitutes the valid and legally binding obligation of Borrower, fully
enforceable against Borrower, in accordance with its terms except as
enforceability may be limited by applicable bankruptcy, insolvency, or
similar laws affecting the enforcement of creditors' rights generally or
by equitable principles relating to enforceability.
2.5. No Conflicting Agreements. The execution and performance
by Borrower of this Amendment and the borrowings by Borrower under the
Agreement, as amended, will not (i) violate any provision of law, any
order of any court or other agency of government, or the constituent
documents of Borrower, or (ii) violate any indenture, contract, agreement
or other instrument to which Borrower is a party, or by which its
property is bound, or be in conflict with, result in a breach of or
constitute (with due notice or lapse of time) a default under, any such
indenture, contract, agreement or other instrument or result in the
creation or imposition of any lien, charge or encumbrance of any nature
whatsoever upon any of the property or assets of Borrower.
SECTION 3. OTHER PROVISIONS
3.1. Approval of Majority Lenders. The agreement by Lenders to
amend the Agreement is subject to the condition precedent that this
Amendment shall have been executed by the Majority Lenders, the Borrower
and the Administrative Agent.
<PAGE>
3.2. Amendment Fee. Borrower shall pay to each Lender that
executes this Amendment on or before the date it becomes effective a fee
equal to the product of (i) such Lender's Revolving Loan Commitment,
multiplied by (ii) 15 basis points (0.0015). The fee shall be paid by
the Borrower and distributed by the Administrative Agent no later than
two days after this Amendment becomes effective.
SECTION 4. REAFFIRMATIONS
4.1. Borrower hereby expressly reaffirms and assumes all of
Borrower's obligations and liabilities to Lenders as set forth in the
Agreement, and agrees to be bound by and abide by and operate and perform
under and pursuant to and comply fully with all of the terms, conditions,
provisions, agreements, representations, undertakings, warranties,
indemnities, grants of security interests and covenants contained in the
Agreement, in so far as such obligations and liabilities may be modified
by this Amendment, as though such Agreement was being re-executed on the
date hereof.
SECTION 5. GENERAL PROVISIONS
5.1. The capitalized terms used in this Amendment shall have
the same meanings ascribed to them in the Agreement unless otherwise
defined herein.
5.2. Except as amended by this Amendment, the terms and
provisions of the Agreement shall remain in full force and effect and are
in all other respects ratified and confirmed.
5.3. This Amendment shall be construed in accordance with and
governed by the laws of the State of Illinois, and the obligations of
Borrower under this Amendment are and shall arise absolutely and
unconditionally upon the execution and delivery of this Amendment.
5.4. This Amendment may be executed in any number of
counterparts.
5.5. On or after the effective date hereof, each reference to
this "Agreement", "hereof" or words of like import, in the Agreement, and
all documents executed in connection therewith, shall, unless the context
otherwise requires, be deemed to refer to the Agreement as amended
hereby, and as may be amended from time to time hereafter.
5.6. Borrower agrees to furnish to Administrative Agent upon
request, such resolutions, opinions, certificates, documents and
assurances which Lenders may request in connection with this Amendment.
5.7. This Amendment shall be binding upon Borrower and Lenders
and their respective successors and assigns, and shall inure to the
benefit of Lenders and Borrower and their respective successors and
assigns.
<PAGE>
Dated as of the date and year first above written.
FIRST HEALTH GROUP CORP. (f/k/a HEALTHCARE
COMPARE CORP.)
By:______________________________
Title: Vice President Finance & CFO
Address for notices:
3200 Highland Avenue
Downers Grove, IL 60615
Attn: Joseph Whitters
Facsimile: (630) 719-0093
Tel: (630) 241-7510
LASALLE NATIONAL BANK,
as Administrative Agent
By:______________________________
Title: ____________________________
Address for Payments, Notices of Borrowing,
Notices of Continuation/Conversion:
135 South LaSalle Street
Chicago, IL 60603
Attn: Administrative Services
Diana Novoa
Facsimile: (312) 904-1662
Tel: (312) 904-4448
FIRST CHICAGO CAPITAL MARKETS, INC., as
Syndication Agent
By: ________________________________
Title: _______________________________
Address for notices:
One First National Plaza
Chicago, IL 60607
Attn: Peter Bartol
Facsimile: (312) 732-2740
Tel: (312) 732-7455
<PAGE>
LASALLE NATIONAL BANK, as Lender and Issuing Bank
By:______________________________
Title: ____________________________
Address for notices:
135 South LaSalle Street
Chicago, IL 60603
Attn: Susan M. Kaminski
Facsimile: (312) 904-6546
Tel: (312) 904-2747
Lending Office:
135 South LaSalle Street
Chicago, IL 60603
Attn: Susan M. Kaminski
Facsimile: (312) 904-6546
Tel: (312) 904-2747
THE FIRST NATIONAL BANK
OF CHICAGO, as Lender
By: __________________________________
Title: _________________________________
Address for notices:
One First National Plaza, Suite 0091
Chicago, IL 60607
Attn: Jay Sepanski
Facsimile: (312) 732-2016
Tel: (312) 732-6726
Lending Office:
One First National Plaza, Suite 0091
Chicago, IL 60607
Attn: Ken Fecko
Facsimile: (312) 732-2016
Tel: (312) 732-4616
<PAGE>
THE INDUSTRIAL BANK OF
JAPAN, LIMITED, CHICAGO BRANCH, as Lender
By:____________________________________
Title:__________________________________
Address for notices:
227 West Monroe Street, Suite 2600
Chicago, IL 60606
Attn: Margie Smith
Facsimile: (312) 855-8200
Tel: (312) 855-8447
Lending Office:
227 West Monroe Street, Suite 2600
Chicago, IL 60606
Attn: Suzanne Stafford
Facsimile: (312) 855-8498
Tel: (312) 855-8200
CIBC, INC., as Lender
By:____________________________________
Title:__________________________________
Address for notices:
Two Paces West
2727 Paces Ferry Road, Suite 1200
Atlanta, GA 30339
Attn: Sylvia Appleby
Facsimile: (770) 319-4950
Tel: (770) 319-4849
Lending Office:
425 Lexington Avenue
8th Floor
New York, NY 10017
Attn: John Malkin
Facsimile: (212) 856-3649
Tel: (212) 856-3627
<PAGE>
UNION BANK OF CALIFORNIA, N.A., as Lender
By:____________________________________
Title:__________________________________
Address for notices:
445 South Figueroa Street
16th Floor
Los Angeles, CA 90071
Attn: Heather Mo
Facsimile: (213) 236-7636
Tel: (213) 236-4065
Lending Office:
445 South Figueroa Street
16th Floor
Los Angeles, CA 90071
Attn: Patricia Samson
Facsimile: (213) 236-7814
Tel: (213) 236-7754
BANQUE NATIONALE DE PARIS
By:____________________________________
Title:__________________________________
Address for notices:
209 South LaSalle Street
5th Floor
Chicago, IL 60604
Attn: Stephen Christie
Facsimile: (312) 977-1380
Tel: (312) 977-2250
Lending Office:
209 South LaSalle Street
5th Floor
Chicago, IL 60604
Attn: Christine Howatt
Facsimile: (312) 977-1380
Tel: (312) 977-1383
<PAGE>
THE BANK OF NEW YORK, as Lender
By:____________________________________
Title:__________________________________
Address for notices:
One Wall Street, 19th Floor
New York, NY 10286
Central Division
Attn: Meena Bolli
Facsimile: (212) 635-7923/24
Tel: (212) 635-8216
Lending Office:
One Wall Street, 19th Floor
New York, NY 10286
Central Division
Attn: John Lokay
Facsimile: (212) 635-1208/09
Tel: (212) 635-1172
CREDIT LYONNAIS, NEW YORK BRANCH, as Lender
By:____________________________________
Title:__________________________________
Address for notices:
1301 Avenue of the Americas
New York, NY 10019
Attn: Kenia A. Perez
Facsimile: (212) 261-3440
Tel: (212) 261-7313
Lending Office:
1301 Avenue of the Americas
New York, NY 10019
Attn: John C. Oberle
Facsimile: (212) 261-3440
Tel: (212) 261-7344
<PAGE>
THE NORTHERN TRUST COMPANY, as Lender
By:____________________________________
Title:__________________________________
Address for notices:
50 S. LaSalle Street
Chicago, IL 60675
Attn: Edie Reed
Facsimile: (312) 630-1566
Tel: (312) 444-3352
Lending Office:
50 S. LaSalle Street
Chicago, IL 60675
Attn: Ron Mallicoat
Facsimile: (312) 444-7028
Tel: (312) 444-3428
SUNTRUST BANK,
NASHVILLE, N.A., as Lender
By:____________________________________
Title:__________________________________
Address for notices:
201 4th Avenue North
Nashville, TN 37219
Attn: Leigh Anne Gregory
Facsimile: (615) 748-4611
Tel: (615) 748-5461
Lending Office:
201 4th Avenue North
Nashville, TN 37219
Attn: Karen Cole Ahern
Facsimile: (615) 748-5269
Tel: (615) 748-5817
<PAGE>
HARRIS TRUST & SAVINGS BANK, as Lender
By:____________________________________
Title:__________________________________
Address for notices:
111 West Monroe Street
Chicago, IL 60603
Attn: Julia Rogers
Facsimile: (312) 461-7365
Tel: (312) 461-2106
Lending Office:
111 West Monroe Street
Chicago, IL 60603
Attn: Christopher S. Randall
Facsimile: (312) 461-7365
Tel: (312) 461-5068
BANQUE PARIBAS, as Lender
By:____________________________________
Title:__________________________________
Address for notices:
227 West Monroe
Suite 3300
Chicago, IL 60606
Attn: Barbara Lopez
Facsimile: (312) 853-3087
Tel: (312) 6032
Lending Office:
787 Seventh Avenue
New York, NY 10019
Attn: Russell Pomerantz
Facsimile: (212) 841-2292
Tel: (212) 841-2561
<PAGE>
NATIONSBANK N.A., as Lender
By:____________________________________
Title:__________________________________
Address for notices:
101 N. Tryon Street
Charlotte, North Carolina 28255
NC1-001-15-05
Attn: Matthew Menz
Facsimile: (704) 386-8694
Tel: (704) 388-1111
Lending Office:
700 Louisiana
8th Floor
Houston, TX 77002-2700
Attn: Larry Gordon
Facsimile: (713) 247-6719
Tel: (713) 247-6619
<PAGE>
Attachment 2
Consolidated Net Worth
I. Borrower's Net Worth
1. Shareholders' equity of the Borrower determined in
accordance with GAAP..................$__________
2. Consideration paid by Borrower for repurchase of
Borrower's stock subsequent to December ___, 1998 or
$350,000,000, whichever
is less ..............................$__________
3. Net Worth: The sum of Items 1 and 2 ..$__________
II. Compliance with Net Worth Covenant (Section 7.13)
1. The amount of.........................$170,000,000
2. The sum of 50% of the Borrower's Consolidated Net
Income earned each fiscal quarter commencing with
the fiscal quarter ending December 31, 1998 (provided
that if, for any fiscal quarter, the Borrower's
Consolidated Net Income shall be less than zero,
then for purposes of this calculation, the Borrow's
Consolidated Net Income shall be deemed to be zero
for the fiscal quarter)...............$__________
3. 50% of the net proceeds received from any
stock offering of the Borrower........$__________
4. Minimum covenanted Net Worth (pursuant to Section
7.13): The sum of Items 1, 2 and 3....$__________
<TABLE>
Exhibit 11
First Health Group Corp.
Computation of Diluted Earnings Per Common Share
Year Ended December 31,
1996 1997 1998
---------- ---------- ----------
<S> <C> <C> <C>
Net Income ............... $78,995,000 $ 7,075,000 $88,003,000
========== ========== ==========
Weighted average number of common
shares outstanding:
Shares outstanding from beginning of
period ................ 69,270,000 67,394,000 63,890,000
Purchase of treasury stock (1,220,000) (2,692,000) (3,208,000)
Other issuances of common stock 836,000 346,000 988,000
Common share equivalents:
Assumed exercise of common stock
options ............... 1,602,000 1,784,000 988,000
---------- ---------- ----------
Weighted average common and common
share equivalents ..... 70,488,000 66,832,000 62,658,000
========== ========== ==========
Net income per share ..... $ 1.12 $ .11 $ 1.40
========== ========== ==========
<PAGE>
Exhibit 11
First Health Group Corp.
Computation of Basic Earnings Per Common Share
Year Ended December 31,
1996 1997 1998
---------- ---------- ----------
<S> <C> <C> <C>
Net Income .................. $78,995,000 $ 7,075,000 $88,003,000
========== ========== ==========
Weighted average number of common
shares outstanding:
Shares outstanding from beginning of
period ................... 69,270,000 67,394,000 63,890,000
Purchase of treasury stock .. (1,220,000) (2,692,000) (3,208,000)
Other issuances of common stock 836,000 346,000 988,000
---------- ---------- ----------
Weighted average common and common
share equivalents ........ 68,886,000 65,048,000 61,670,000
========== ========== ==========
Net income per share ........ $ 1.15 $ .11 $ 1.43
========== ========== ==========
</TABLE>
<TABLE>
SELECTED FINANCIAL DATA
Years Ended December 31,
1994 1995 1996 1 1997 2 1998
(in thousands except per share data)
<S> <C> <C> <C> <C> <C>
Statement of operations
data:
Revenues $186,606 $214,338 $247,804 $388,975 $503,077
Operating expenses:
Cost of services 62,876 63,963 72,284 154,513 228,108
Selling and marketing 22,456 26,000 29,148 42,376 49,574
General and administrative 10,243 10,723 13,745 29,204 42,724
Health care benefits -- -- 5,479 8,870 18,542
In-process research and
development -- -- -- 80,000 --
Depreciation and
amortization 11,001 10,542 12,334 17,185 25,235
Interest income (4,993) (7,984) (13,581) (15,013) (20,470)
Interest expense -- -- -- 6,273 12,642
------- ------- ------- ------- -------
Total operating expenses 101,583 103,244 119,409 323,408 356,355
Income before income taxes 85,023 111,094 128,395 65,567 146,722
Income taxes (34,354) (44,557) (49,400) (58,492) (58,719)
------- ------- ------- ------- -------
Net income $ 50,669 $ 66,537 $ 78,995 $ 7,075 $ 88,003
------- ------- ------- ------- -------
Weighted average
shares outstanding
- basic 3 68,844 68,630 68,886 65,048 61,670
Net income per common
share - basic 3 $ .74 $ .97 $ 1.15 $ .11 $ 1.43
Weighted average
shares outstanding
- diluted 3 70,004 70,246 70,488 66,832 62,658
Net income per common
share - diluted 3 $ .72 $ .95 $ 1.12 $ .11 $ 1.40
Balance sheet data:
Cash and investments $ 138,684 $221,370 $265,897 $286,167 $199,776
Working capital 78,444 157,124 167,544 80,524 15,409
Total assets 215,009 297,194 360,546 707,878 557,879
Total liabilities
(excluding debt) 15,452 16,924 37,340 248,271 194,752
Long-term debt -- -- -- 200,000 225,000
Stockholders' equity $ 199,557 $280,270 $323,206 $259,607 $138,127
</TABLE>
<PAGE>
1 On February 1, 1996, the Company completed the acquisition of American
Life and Health Insurance Company and its subsidiary insurance company.
Under the terms of the acquisition, which was accounted for as a
purchase, the Company paid a purchase price of approximately $12
million.
2 On July 1, 1997, the Company completed the acquisition of FIRST HEALTH
Strategies, Inc. ("Strategies") and FIRST HEALTH Services Corporation
("Services), excluding the stock of Viable Information Processing
Systems, Inc., a wholly-owned subsidiary of Services, from First
Financial Management Corporation and First Data Corporation for a net
purchase price of approximately $196 million. In connection with this
acquisition, the Company recorded a one time charge of $80 million for
in-process research and development costs which had no alternative
future use for the Company. The acquisition was financed with a $200
million credit agreement underwritten by the Company's bank group.
On August 30, 1997, the Company completed the acquisition of Loyalty
Life Insurance Company for a purchase price of approximately $12
million in cash. Both acquisitions in 1997 were accounted for under
the purchase method of accounting. Consequently, prior period results
were not restated.
3 All historical common share data have been adjusted for a 2-for-1
stock split in the form of a 100% stock distribution paid on June 23,
1998 to stockholders of record on June 2, 1998.
<PAGE>
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
This Management's Discussion and Analysis of Financial Condition and
Results of Operations may include certain forward-looking statements,
within the meaning of Section 27A of the Securities Act of 1933, as
amended, and Section 21E of the Securities Exchange Act of 1934, as
amended, including (without limitation) statements with respect to
anticipated future operating and financial performance, growth and
acquisition opportunities and other similar forecasts and statements of
expectation. Words such as "expects," "anticipates," "intends," "plans,"
"believes," "seeks," "estimates" and "should" and variations of these
words and similar expressions, are intended to identify these forward-
looking statements. Forward-looking statements made by the Company and
its management are based on estimates, projections, beliefs and
assumptions of management at the time of such statements and are not
guarantees of future performance. The Company disclaims any obligations
to update or revise any forward-looking statement based on the occurrence
of future events, the receipt of new information or otherwise.
Actual future performance, outcomes and results may differ
materially from those expressed in forward-looking statements made by the
Company and its management as a result of a number of risks,
uncertainties and assumptions. Representative examples of these factors
include (without limitation) general industry and economic conditions;
interest rate trends; cost of capital and capital requirements;
competition from other managed care companies; the ability to expand
certain areas of the Company's business; shifts in customer demands; the
timely completion of modifications to ensure that the Company's systems
are Year 2000 compliant; changes in operating expenses including employee
wages, benefits and medical inflation; governmental and public policy
changes and the continued availability of financing in the amounts and at
the terms necessary to support the Company's future business. In
addition, if the Company does not continue to successfully integrate FHC
(as defined below) into its existing business, successfully implement new
contracts and programs and control healthcare benefit expenses, the
Company may not achieve its projected 1999 financial results (discussed
below).
<PAGE>
Recent Developments. On July 1, 1997, the Company acquired all of
the outstanding shares of capital stock of FIRST HEALTH Strategies, Inc.
and FIRST HEALTH Services Corporation (collectively "FHC"), excluding the
stock of Viable Information Processing Systems, Inc., a wholly-owned
subsidiary of FIRST HEALTH Services Corporation, from First Financial
Management Corporation and First Data Corporation for a purchase price of
approximately $196 million. In connection with the acquisition, which
was accounted for as a purchase, the Company recorded a charge to
earnings of $80 million for purchased in-process research and development
which was not deductible for income tax purposes. In-process research
and development relates to the next generation of FHC's claims processing
system software which had not yet reached the stage of technological
feasibility and had no alternative future use; therefore, the ultimate
revenue generating capability of these projects was uncertain. The
research and development acquired will require additional development
efforts, estimated to cost $15 million, to become commercially viable.
Such modifications include the enhancement of various modules to perform
claims adjudication, reporting, imaging and correspondence, and are
expected to be completed within the next year, with a substantial portion
of the expenditures being incurred by mid- to late-1999. Management
believes the technology will be commercially viable subsequent to these
modifications, and such technology will be fully operational on or about
January 1, 2000. Use of this technology is expected to ultimately
decrease claims processing costs by up to 20% per claim.
At the date of acquisition, management estimated the Company would
spend approximately $10 million in additional development expenditures
over a 2 to 3 year period to make the purchased research and development
commercially viable. Total development costs are now expected to
approximate $15 million. The increase in estimated total costs is due to
enhancements beyond those originally planned by the Company.
The purchased research and development was valued by an independent
appraiser using a discounted, risk-adjusted future income approach taking
into account risks related to existing and future markets and an
assessment of the life expectancy of the technology. The discount rate
used in the appraisal was 12%, and the life expectancy of the technology
was 10 years. The discount rate used was based on the Company's weighted
average cost of capital, and the life expectancy of the technology was
based on the Company's current services and products offered, the demand
for claims processing, and the anticipated features and benefits of the
new technology.
<PAGE>
Prior to the acquisition, First Data Corporation had spent in excess
of $75 million on the research and development of the technology.
On August 30, 1997, the Company acquired Loyalty Life Insurance
Company ("Loyalty"), which is licensed to conduct health insurance
business in 49 states, for a purchase price of approximately $12 million.
The acquisition was accounted for as a purchase. On October 1, 1996, in
anticipation of the acquisition, Loyalty entered into a reinsurance
agreement with a former affiliate, National Farmers Union Life Insurance
Company ("National Farmers"). Under the terms of the reinsurance
agreement, all premiums and deposits received by Loyalty, which relate to
reinsured policies, were transferred to National Farmers. Premiums and
policy benefits, which are not material in amount, were ceded to National
Farmers and shown net of such cessions in the consolidated statements of
operations. Reinsurance recoverable and the related claim reserves are
reported separately in the consolidated balance sheets. Loyalty
continues to have primary liability as a direct insurer for risks
reinsured. Loyalty is currently seeking approvals from the insurance
regulators and policy holders, as necessary, which would permit the legal
replacement of Loyalty by National Farmers. Such approvals would release
Loyalty from future liability under its existing insurance policies and
result in the removal of policy liabilities from the Company's
consolidated balance sheets. The Company anticipates receiving the
remainder of the approvals in 1999, although there can be no assurance
that such approvals will be obtained. In 1998, Loyalty changed its name
to First Health Life and Health Insurance Company. This name change is
pending approval from a number of state insurance regulators.
The Company acquired American Life and Health Insurance Company
("American") and its subsidiary insurance company on February 1, 1996.
American is a small health and life insurer with licenses in 26 states.
Under the terms of the acquisition, which was accounted for as a
purchase, the Company paid a purchase price of approximately $12
million.
Results of Operations. The following table presents the Company's
sources of revenues and percentages of those revenues represented by
certain statement of operations items.
<TABLE>
SOURCES OF REVENUE: Years Ended December 31,
1996 % 1997 % 1998 %
($ in thousands)
------- --- ------- --- ------- ---
<S> <C> <C> <C> <C> <C> <C>
PPO services $191,008 77% $220,120 57% $223,328 44%
Claims administration -- --% 94,135 24% 182,537 36%
Clinical management
services 22,221 9% 35,375 9% 44,094 9%
Fee schedule services 26,669 11% 27,625 7% 30,981 6%
Premiums, Net 7,906 3% 10,748 3% 18,991 4%
Service -- --% 972 --% 3,146 1%
------- --- ------- --- ------- ---
Total $247,804 100% $388,975 100% $503,077 100%
======= === ======= === ======= ===
</TABLE>
<PAGE>
<TABLE>
PERCENT OF REVENUE: Years Ended December 31,
1996 1997 1998
---- ---- ----
<S> <C> <C> <C>
Expenses:
Cost of services 29% 40% 45%
Selling and marketing 12% 11% 10%
General and administrative 5% 7% 8%
Health care benefits 2% 2% 4%
In-process research &
development --% 21% --%
Depreciation and
amortization 5% 4% 5%
Interest income (5)% (4)% (4)%
Interest expense --% 2% 3%
---- ---- ----
Subtotal 48% 83% 71%
---- ---- ----
Income before income taxes 52% 17% 29%
---- ---- ----
Net income 32% 2% 17%
---- ---- ----
</TABLE>
Revenues. The Company's revenues consist primarily of fees for cost
management services provided under contracts on a percentage of savings
basis (PPO and fee schedule services) or on a predetermined contractual
basis. The Company also derives revenues based upon a fixed monthly
charge for each participant, excluding covered dependents, in a client-
sponsored health care plan or on a per-transaction basis. As a result of
the Company's insurance company acquisitions, revenues also include
premium revenue.
Total revenues increased $114,102,000 (29%) from 1997 to 1998 and
$141,171,000 (57%) from 1996 to 1997. This growth is primarily
attributable to:
1) The inclusion of six months of FHC revenues in 1997 and twelve
months of FHC revenues in 1998;
2) Increased utilization of the Company's PPO services by existing
clients;
3) Expansion and development of the Company's PPO networks,
especially in secondary and tertiary markets;
4) New clients; and
5) Premium revenue earned in 1997 and 1998 by the Company's
insurance subsidiaries.
<PAGE>
Revenue from PPO services increased from 1996 to 1998 as a result of
increased utilization of the PPO network by existing clients, expansion
of the PPO network and new client additions. The increase from 1997 to
1998 was lower than expected due to the loss of a number of traditional
FIRST HEALTH Strategies clients (see "FHC Integration Status" below) and
to a lesser extent, some of the Company's traditional clients. Claims
administration and related primarily represents FHC revenue earned from
processing claims in client-sponsored health care plans. The increase
from 1997 to 1998 is due primarily to the inclusion of twelve months of
FHC operations included in the 1998 results compared with six months in
1997. Revenue from clinical management services increased from 1996 to
1998 due primarily to the acquisition of FHC. The increase in clinical
management services in 1998 was also lower than expected due to the loss
of business discussed above. Fee schedule services revenue increased
from 1996 to 1998 due to new and expanded contract activity with several
existing clients. Premium revenue increased from 1996 to 1998 due to new
clients. Risk-related service revenue represents the Company's national
HMO-like product for self-funded ERISA plans. The increase from 1997 to
1998 is due to new clients. Price increases have not been an important
factor in the Company's revenue growth. As with any future event, future
revenue growth may differ substantially from historical levels.
Cost of Services. Cost of services consists primarily of salaries
and related costs for personnel involved in claims administration, PPO
administration, development and expansion, clinical management programs,
fee schedule and other cost management and administrative services
offered by the Company. To a lesser extent, it includes telephone
expenses, facility expenses and information processing costs. Cost of
services as a percent of revenue increased from 29% in 1996, to 40% in
1997 to 45% in 1998. The dramatic increase in these expenses from 1996
to 1998 was related to the nature of FHC's business. Claims
administration is a labor-intensive, high-volume, low-margin business.
The Company has initiated cost cutting measures during the integration of
FHC which are intended to make the operations more efficient. Cost of
services may continue to increase as a percent of revenue as the Company
fully integrates the FHC business into its operations.
Selling and Marketing. Selling and marketing expenses have increased
as a result of the hiring and training of new sales and marketing
colleagues primarily associated with the FHC acquisition. To a lesser
extent, the increase relates to commissions paid to agents and third-
party administrators by the Company's insurance entities. As a
percentage of revenues, selling and marketing expenses have decreased
from 12% in 1996 to 11% in 1997 and 10% in 1998.
General and Administrative. General and administrative costs
increased from 5% of revenues in 1996 to 7% of revenues in 1997 to 8% of
revenues in 1998 primarily due to the addition of FHC as well as growth
in the Company's insurance subsidiaries.
Health Care Benefits. These expenses represent medical losses
incurred by insureds of the Company's insurance entities. The medical
loss ratio (losses as a percent of premiums) was 69% for 1996, 83% for
1997 and 98% for 1998. The increase from 1996 relates to medical losses
incurred for the Company's small group and stop loss clients.
<PAGE>
Depreciation and Amortization. These expenses increased from 1996 to
1998 principally as a result of the purchase of additional computer
hardware and software as well as the purchase of the Company's Phoenix
facility and amortization of goodwill associated with the FHC and Loyalty
acquisitions. As a percentage of revenues, these costs remained in the
4% to 5% range from 1996 to 1998.
Interest Income. The Company invests a significant portion of its
available cash in various interest-bearing instruments. The net interest
income realized from such investments represented 5% of revenues in 1996,
4% of revenues in 1997 and 4% of revenues in 1998. The Company expects
interest income to substantially decrease in 1999 due to the repurchase
of more than $200 million of the Company's common stock during 1998 and
potential repurchases in 1999. These common stock repurchases are
expected to result in a decrease in the balance of cash equivalents and
investments in 1999 compared with 1998.
Interest Expense. Interest expense represents interest paid on the
revolving credit agreement entered into on July 1, 1997 to finance the
FHC acquisition. The interest rate paid was approximately 6% during the
last 6 months of 1997 and throughout the year ended December 31, 1998.
Income Taxes. Income taxes were provided at an effective rate of 38%
in 1996 compared to 89% in 1997 and 40% in 1998. The higher than
statutory rate for 1996 and 1998 includes provisions for state income
taxes. The tax rate in 1997 reflects the inclusion in income of
$80,000,000 of non-deductible in-process research and development
expenses. If these expenses were excluded, the effective tax rate would
have been 40%, which is consistent with 1996 and 1998.
Seasonality. The Company has historically experienced increases in
salaries and related costs during its first and fourth calendar quarters
in anticipation of an increase in the number of new participants in
client-sponsored health care plans. Since group health care plans
typically offer an open enrollment period for new participants during
January of each year, the Company anticipates that its future first and
fourth quarters will continue to reflect similar cost increases. The
Company's future earnings could be adversely affected if the Company were
to incur costs in excess of those necessary to service the actual number
of new participants resulting from the open enrollment.
Inflation. Although inflation has not had a significant effect on
the Company's operations to date, management believes that the rate at
which health care costs have increased has contributed to the demand for
PPO, clinical cost management and other cost management services,
including the services provided by the Company.
Other Information. Since 1993, there has been considerable
discussion of health care reform. Although specific features of any
legislation that ultimately may be enacted into law cannot be predicted
at this time, based on the Company's review of legislation previously
considered by Congress and various state legislatures, management
believes that the Company's existing programs and those under development
provide a foundation that will prevent any material adverse affect on the
operations of the Company.
<PAGE>
Liquidity and Capital Resources. The Company had $15,409,000 of
working capital at December 31, 1998 compared to $80,524,000 at December
31, 1997 and $167,544,000 at December 31, 1996. The decrease is
primarily attributable to the repurchase of 4,273,000 shares of Company
common stock during 1997 for a total cost of $100,802,000 and the
repurchase of 11,283,000 shares of Company common stock during 1998 for a
total cost of $215,594,000 ($25,000,000 of which was payable at December
31, 1998 for trades not yet settled). Total cash and investments of the
Company amounted to $199,776,000 at December 31, 1998, $286,167,000 at
December 31, 1997 and $265,897,000 at December 31, 1996.
During the three year period ended December 31, 1998, the Company
generated $328,302,000 of cash from operating activities. Investment
activities generated $353,000 in cash during 1998 representing net sales
of investments of $52,954,000 partially offset by capital expenditures of
$52,428,000. Investment activities used $222,740,000 in cash during 1997
representing net cash paid for acquisitions of $202,423,000 ($191,512,000
for FHC and $10,911,000 for Loyalty) and capital expenditures of
$31,372,000 partially offset by net sales of investments of $11,055,000.
Investment activities used $52,926,000 of cash in 1996 representing net
purchases of investments of $28,201,000, capital expenditures of
$14,635,000 and the acquisition of American for $10,090,000. Financing
activities used $158,948,000 in cash during 1998 representing
$204,219,000 in purchases of treasury stock (of which $159,919,000 was
purchased on the open market with the balance being purchased through the
exercise of put options and the funding of stock option exercises)
partially offset by $25,000,000 in proceeds from the issuance of long-
term debt and $20,894,000 in proceeds from the issuance of common stock.
Financing activities provided $123,292,000 in cash during 1997
representing $200,000,000 in proceeds from the issuance of long-term
debt, $14,163,000 in proceeds from sale of put options and $9,931,000 in
proceeds from the issuance of common stock partially offset by
$100,802,000 in purchases of treasury stock. Financing activities used
$41,668,000 in cash during 1996 representing $61,134,000 in purchases of
treasury stock partially offset by $12,738,000 in proceeds from the
issuance of common stock and $6,728,000 in proceeds from sale of put
options.
On July 1, 1997, the Company entered into a $200 million revolving
credit agreement (the "Agreement") to facilitate the acquisition of FHC.
In August, 1997, the Agreement was amended to increase available
borrowings to $350 million. As of December 31, 1998, $225 million was
outstanding under the Agreement.
The Company believes that its working capital, long-term
investments, amounts available under the credit agreement and cash
generated from future operations will be sufficient to fund the Company's
operations and anticipated expansion plans.
Market Risk. Market risk is the risk that the Company will incur
losses due to adverse changes in interest rates and prices. The
Company's market risk exposure is limited to the $126,081,000 of
marketable securities owned by the Company and the $225,000,000 of
variable rate debt held by the Company. The Company does not hold any
market risk sensitive instruments for trading purposes. The Company has
established policies and procedures to manage sensitivity to interest
rate and market risk. These procedures include the monitoring of the
Company's level of exposure to each market risk and the use of derivative
financial instruments to reduce risk.
<PAGE>
The Company's marketable equitable securities are classified as
available for sale and are recorded on the consolidated statements of
financial condition at fair value with unrealized gains or losses
reported as a separate component of other comprehensive income and
stockholders' equity, net of applicable deferred taxes. As of December
31, 1998, the fair value of the Company's marketable securities portfolio
was $126,081,000, consisting of $83,719,000 invested in debt securities
and $42,362,000 invested in equity securities. The Company measures its
interest rate risk by estimating the net amount by which potential future
net earnings would be impacted by hypothetical changes in market interest
rates related to all interest rate sensitive assets and liabilities,
including derivative financial instruments. Assuming a hypothetical 20%
increase in interest rates as of December 31, 1998, the estimated
reduction in future earnings, net of tax, would be approximately $1.6
million. Equity price risk arises when the Company could incur economic
losses due to adverse changes in a particular stock index or price. The
Company's investments in equity securities are exposed to equity price
risk and the fair value of the portfolio is correlated to the S&P 500.
Management estimates that an immediate 10% change in the S&P 500 would
affect the fair value of its equity securities by approximately $4.2
million.
Derivative Financial Instruments. As discussed in Note 12 to the
financial statements, the Company uses derivative financial instruments
to reduce interest rate risk and potentially increase the return on
invested funds and to manage the cost of its common stock repurchase
programs. In addition, collaterized mortgage securities have been
purchased that have relatively stable cash flow patterns in relation to
interest rate changes. Investments in derivative financial instruments
are approved by the Audit Committee or Board of Directors of the Company.
The Company's exposure related to such transaction risk, in the
aggregate, is not material to the Company's financial position, results
of operations and cash flows.
FHC Integration Status. The Company currently estimates that the
integration of FHC will be completed in early 1999. The Company is
focusing FIRST HEALTH Strategies on the niche of serving multi-sited
employers of 1,000 or more employees. As a result of this focus, the
Company has sold several hundred client contracts that do not fit into
this niche which represented approximately $20 million in annual revenue.
The Company did not receive material consideration for this sale. The
Company has closed sales and claims processing locations throughout the
country to centralize activities and fully integrate duplicate support
and administrative functions.
The Company has completed the contract renewal phase with numerous
traditional FIRST HEALTH Strategies clients including significant price
increases, particularly for clients that have been paying fees at
unacceptable profit levels. These actions have resulted in the loss of a
significant number of clients. The Company is negotiating with current
claims administration clients to provide its PPO, clinical management and
pharmacy benefit management services to them. In addition, the Company
is offering stop loss insurance where appropriate. The Company's
inability to successfully complete the integration of FHC may have a
material adverse impact on the Company's business.
<PAGE>
Traditional Business. In 1998, the Company lost some group health
business particularly in the Federal Employee Health Benefit (FEHBA)
area. The Company also anticipates realizing a loss in business from
clients that have not instituted more aggressive managed care programs to
better control escalating health care costs. As the Company prepares for
1999, it does not anticipate the loss of any additional business from its
traditional client base which would have a material affect on its
operations.
1999 Outlook
Currently, the Company anticipates that its earnings per share
("EPS") in 1999 will be comparable to 1998 with an estimated decline in
revenue of approximately 5% from 1998. These expectations are driven
by:
PPO, which the Company expects to grow at a minimal rate.
Fee Schedule growth is anticipated to exceed 20% as the workers'
compensation business is the Company's fastest growing area. This
growth is dependent on the addition of new clients with whom the
Company is currently engaged in discussions.
Utilization Management and Claims Administration revenue are
estimated to decline by more than 10% due to the loss of customers
resulting from the Company's renewal strategy which requires clients to
purchase all services the Company offers and instituting substantial
price increases. Management anticipates that numerous clients that are
principally single-sited, such as school districts, hospitals and
municipalities will not renew their contracts. Contract renewal by
traditional First Health clients has progressed at a rate which is
lower than previously anticipated; certain large clients that the
Company had hoped to retain chose not to renew their contracts.
Accordingly, the 1999 contract renewal process was not as successful as
originally anticipated.
Risk business revenue is anticipated to decline approximately 40% in
1999 as a result of the Company's implementation of substantial price
increases. Consequently, the Company anticipates that certain current
clients will not renew their contracts.
Looking at each of the Company's products and services, management
foresees the following:
Total revenue in 1999 versus 1998 will decline with Group Health
revenue declining in excess of 10% driven by a decrease in the number
of clients served. However, growth in the workers' compensation and
public sector business is anticipated.
The remaining group health business is expected to be more
profitable due to the various actions that have been undertaken during
the last several months, including implementing an average price
increase of approximately 10% on claims administration, displacing
competitive PPO networks, streamlining operations and improving
efficiency.
<PAGE>
The projected decrease in group health revenue is driven by four
factors: 1) anticipated client losses; 2) fewer employers making new
managed care commitments in 1999 and reduced new business opportunities
resulting in increased price competition; 3) lower retention of the
traditional First Health block of business than originally anticipated;
and 4) delayed start-up and slower ramp-up of some new business.
On the positive side, the Company expects that the business it has
retained will be stable and more profitable than in 1998. The Company
has succeeded in narrowing the focus of the First Health business to
multi-sited national payers with more standardized requirements than
existed at the time of the acquisition. These changes are expected to
enable the Company to lower overall costs while improving service,
which is anticipated to result in increased profitability.
Workers' Compensation revenue is anticipated to grow in excess of
10%. The Company is negotiating several new contracts and forecasted
revenue growth is dependent on the successful completion and
implementation of these contracts.
Public Sector Business - Medicaid revenue growth is expected to
increase in excess of 10% as a result of numerous contracts the Company
is actively pursuing.
Year 2000 Matters.
General
The Company has made significant progress on its company-wide
Year 2000 ("Y2K") readiness project, and the project is currently on
target to have the Company's significant information technology
("IT") and non-IT systems Y2K ready by the end of 1999. The Company
defines a significant system as one which, if not Y2K ready, may
have a material adverse impact on its results of operations,
revenues, regulatory compliance or relationships with customers,
vendors or others. The Company is using both internal and external
resources to accomplish its Y2K project objectives. Modification of
the source code for the Company's primary group health medical
claims processing system has been completed and testing of the
modified system has begun. Modification of the source code for the
Company's pharmacy claims processing system is continuing and is
expected to be completed by early 1999. The Company believes that
significant IT systems are either currently Y2K ready, will be
replaced with systems designed to be Y2K ready, or retired by the
end of 1999. As a service provider, the Company's non-IT systems
consist primarily of equipment typically found in commercial office
buildings including electrical, fire alarm and suppression,
security, HVAC and elevator systems, and the Company does not
anticipate any material Y2K problems with the non-IT systems within
its control. As part of its Y2K project, the Company is assessing,
and developing contingency plans to address the most reasonably
likely worst case scenarios which may result from the failure of a
significant Company or a material third party system to be Y2K
ready.
Y2K Project
<PAGE>
The Company has instituted a corporate-wide Y2K readiness
project to identify its IT and non-IT systems which will require
modification or replacement and to establish appropriate
remediation and contingency plans to avoid an impact on its
ability to continue to provide its services. Current plans call
for any necessary modifications, replacements and testing to
support Year 2000 to be completed before the end of 1999, prior to
any anticipated potential impact on the Company's services and
operations. The Company's Y2K project is divided into three major
sections: 1) IT Software Systems, 2) IT Hardware Systems and, 3)
Non-IT Systems. For each major section, the Company has
implemented the following five-phase approach:
1. Inventory Phase. Inventory of significant systems.
2. Assessment Phase. Assessment of the vulnerability of
significant systems to the Y2K problem and development of
correction and contingency plans.
3. Modification/Replacement Phase. Modification of computer
source code, and software, hardware and equipment upgrade,
retirement or replacement.
4. Testing and Validation Phase. Testing (both internally
and with third parties) of all modified, upgraded or
replaced components and interfaces.
5. Implementation Phase. Modified, upgraded or replaced
components are put into operation.
The following chart graphically depicts the approximate current
state of completion for each phase:
<TABLE>
Modification Testing and
Inventory Assessment or Replacement Validation Implementation
Phase Phase Phase Phase Phase
- ------------- --------- ---------- -------------- ----------- --------------
<S> <C> <C> <C> <C> <C>
IT Software 100% 98% 90% 60% 50%
IT Hardware 100% 100% 90% 90% 80%
Non-IT Systems 100% 90% 75% 70% 65%
</TABLE>
<PAGE>
IT Software Systems
The Company's IT software systems are comprised of both
proprietary and commercial third party software applications which
can be generally be divided into three categories: 1) database
systems, 2) operational systems, and 3) claims administration
systems. The Company has completed the inventory and assessment
phases for all its IT software systems.
Database Systems. As part of its ongoing efforts to update and
enhance its IT resources, the majority of the Company's database
systems currently utilize four digits to represent the year in date
data (i.e., 02/02/1998). Consequently, nearly all database IT
systems presently being used by the Company were created with the
change of millennium in mind and no further modifications are
necessary. The testing and validation phase is expected to be
completed by the end of the third quarter of 1999. Concurrent with
the completion of testing and validation, the remediated database
systems will be implemented.
Operational Systems. Approximately 95% of the roughly 350
operational systems (consisting primarily of third party software
applications) have been assessed. Of those assessed, the Company
has received assurances from approximately 85% of the third party
vendors that their systems are currently Y2K ready. For those
systems that may have a Y2K problem, the Company is assessing
whether it will modify, upgrade, replace or retire such systems.
The assessment phase is expected to be completed in the first
quarter of 1999. The modification, testing, validation and
implementation is expected to be completed by the end of the third
quarter of 1999.
Claims Administration Systems. The Company utilizes a number of
different systems to process health benefits claims for its clients.
The Company's primary group health and Medicaid medical claims
administration system is proprietary to the Company. Utilizing both
internal and external resources, modification of the source code for
the group health system was completed in the third quarter of 1998.
Testing of the modified system also began in the third quarter of
1998. As part of the testing phase, the Company communicated with
clients and other third parties which interface with this system and
established time frames to complete necessary testing and
validation. The testing, validation and implementation phases are
expected to be completed by the end of the second quarter of 1999.
The Company also licenses medical claims administration systems
from third party vendors, which are used primarily to process claims
for specific clients. The Company has received written assurances
that these systems are designed and programmed with the Year 2000 in
mind, and that all updates and changes to the system continue to be
Year 2000 compliant.
<PAGE>
To process pharmacy claims for clients, the Company utilizes
Company-owned proprietary systems. Utilizing both internal and
external resources, modification of the source code for these
systems is continuing and is expected to be completed by the end of
the second quarter of 1999. The testing and implementation phases
are expected to be completed by the end of the third quarter of
1999.
The Company utilizes customized Medicaid claims processing
systems for its government (Medicaid) contracts. Utilizing both
internal and external services, modification of the source code for
these systems are estimated to be completed in early 1999. The
testing, validation and implementation phases are being conducted
consistent with the time frames required in Company contracts with
the respective states and are expected to be completed by the end of
the third quarter of 1999.
Additionally, the Company has an agreement with Electronic Data
Systems ("EDS") for access to certain EDS systems to enable the
Company and EDS to provide certain workers' compensation bill
repricing services to Company clients. The Company has received
assurances from EDS that it is taking appropriate measures to
ensure its systems will not be interrupted by a Y2K problem. The
Company and EDS are also working together to ensure Company clients
are notified of any EDS system changes and modifications that
clients will need to make, and to establish any necessary testing
and validation schedules. The testing, validation and
implementation phases are expected to be completed by the end of
the second quarter of 1999.
IT Hardware Systems
The Company has completed the inventory and assessment phases for
its IT hardware systems. The testing phase is on target to be
completed by the end of the second quarter of 1999. The majority of
the effort in the implementation phase relates to an upgrade of the
desktop environment, a process which is approximately 60% complete
and on target to be completed by the end of the third quarter of
1999.
<PAGE>
Non-IT Systems
The Company's non-IT systems are primarily comprised of systems
typically found in commercial office buildings including,
electrical, fire alarm and suppression, security, HVAC and elevator
systems. The inventory and assessment phases for non-IT systems are
almost complete with only a few small office sites remaining. The
Company is on target to complete its modification, replacement and
testing phases by third quarter of 1999. The Company has also
received written assurances from the vast majority of its
significant vendors and suppliers that the Y2K problem will not
materially adversely effect their ability to continue to provide
supplies or services, and continues to seek written assurances from
the remainder. Additionally, the Company is on target to upgrade,
by July 1999, its telecommunications equipment for which the Company
has not received assurances from its vendors that the Y2K problem
will not materially adversely effect their equipment. The Company
continues to evaluate responses from owners/landlords of office
spaces which the Company leases and from significant
vendors/suppliers to determine their Year 2000 readiness. To date,
no responses have indicated that any facilities or vendors/suppliers
will have a Year 2000 problem which would have a material adverse
effect on the Company.
Costs
The Company estimates the total cost of its Y2K readiness project
to be approximately $16,000,000 which will be funded through
operating cash flows. Of the total project cost, approximately
$6,000,000 is attributable to the purchase of new hardware and
software which will be capitalized. The remaining $10,000,000,
which will be expensed as incurred, is not expected to have a
material effect on the results of operations. As of December 31,
1998, the Company has incurred approximately $10,000,000 (63%) of
its total estimated Year 2000 costs. The Company expects to receive
reimbursement of at least 40% of the costs directly from a number of
its clients due to the nature of the contractual arrangements with
these entities.
Year 2000 remediation costs represent approximately 15% of the
Company's total IT budget and no material projects have been
deferred due to the Company's Year 2000 efforts.
<PAGE>
Contingency Plans
The Company's IT systems interface with numerous clients, medical
service providers and regulatory agencies, and failure to correct a
material Y2K problem could interrupt business activities and
operations and materially adversely affect the Company's results of
operations, revenues, regulatory compliance or relationships with
customers, vendors or others. Not only must the Company ensure that
its own IT and non-IT systems are Y2K ready, but it also must
ascertain that the systems of third parties with whom the Company
interfaces are both Y2K ready and that their solutions to the Y2K
problem are compatible with those of the Company. As the Company
assesses the Y2K readiness of its IT and non-IT systems, contingency
plans are also being developed to address the most reasonably likely
worst case scenarios which may result from the failure of a
significant Company or material third party system to be Y2K ready.
Contingency plans will continue to be modified and developed as the
Company progresses in its Y2K readiness project.
Projected completion dates for Y2K modifications, testing and
implementation are based on current best estimates, derived
utilizing numerous assumptions of future events, including the
continued availability of certain resources, third party
modification plans and other factors. The Company believes its Y2K
project will reduce the uncertainty about the Y2K readiness of its
significant customers, vendors and suppliers and, therefore, its
ability to continue to provide its services without significant
interruptions in its normal business operations. However, due to
the general uncertainty inherent in the Y2K problem, in particular
the uncertainty of the Y2K readiness of customers and third-party
suppliers such as utility and telecommunications companies, the
Company is unable to determine at this time whether actual results
will differ materially from those anticipated, whether third party
systems on which the Company's systems rely will be converted in a
timely manner, or that failure by a third party to convert its
systems, or a conversion that is incompatible with the Company's
systems, would not have a material adverse effect on the Company.
New Accounting Pronouncements. In March 1998, the Accounting
Standards Executive Committee of the American Institute of Certified
Public Accountants issued Statement of Position 98-1, ("SOP 98-1"),
"Accounting for the Costs of Computer Software Developed or Obtained for
Internal Use." SOP 98-1 provides guidance on accounting for the costs of
computer software developed or obtained for internal use. Specifically,
certain internal payroll and payroll related costs should be capitalized
during the application development stage of a project and depreciated
over the computer software's useful life. The Company currently expenses
these costs as incurred and is evaluating the effects of SOP 98-1 on its
results of operations and financial position. The Company will implement
SOP 98-1 as of January 1, 1999.
<PAGE>
In June 1998, the Financial Accounting Standards Board issued
Statement of Financial Accounting Standards No. 133, "Accounting for
Derivative Instruments and Hedging Activities" ("SFAS No. 133"). SFAS
No. 133 requires that all derivative instruments be recognized as either
assets or liabilities in the balance sheet and that derivative
instruments be measured at fair value. This statement also requires
changes in the fair value of derivatives to be recorded each period in
current earnings or comprehensive income depending on the intended use of
the derivatives. This statement is effective for all fiscal quarters of
fiscal years beginning after June 15, 1999. The Company has not yet
determined the impact of SFAS No. 133 on its results of operations and
financial position.
<PAGE>
REPORT OF INDEPENDENT AUDITORS
Board of Directors and Stockholders
First Health Group Corp.
Downers Grove, Illinois
We have audited the consolidated balance sheets of First Health Group
Corp. and Subsidiaries as of December 31, 1998 and 1997, and the related
consolidated statements of operations, of comprehensive income, of cash
flows and of stockholders' equity for each of the three years in the
period ended December 31, 1998. 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, such consolidated financial statements present fairly, in
all material respects, the financial position of First Health Group Corp.
and Subsidiaries as of December 31, 1998 and 1997, and the results of
their operations, their comprehensive income and their cash flows for
each of the three years in the period ended December 31, 1998 in
conformity with generally accepted accounting principles.
DELOITTE & TOUCHE LLP
Chicago, Illinois
February 19, 1999
*************************************************************************
<PAGE>
REPORT BY MANAGEMENT
Management is responsible for the preparation and integrity of the
consolidated financial statements and financial comments appearing in
this annual report. The financial statements were prepared in accordance
with generally accepted accounting principles and include certain amounts
based on management's best estimates and judgments. Other financial
information presented in the annual report is consistent with the
financial statements.
The Company maintains a system of internal accounting controls designed
to provide reasonable assurance that assets are safeguarded, and that
transactions are executed as authorized and are recorded and reported
properly. This system of controls is based upon written policies and
procedures, appropriate divisions of responsibility and authority, and
careful selection and training of personnel. Policies and procedures
prescribe that the Company and all employees are to maintain the highest
ethical standards and that business practices are to be conducted in a
manner which is above reproach.
Deloitte & Touche LLP, independent auditors, has audited the Company's
consolidated financial statements and its report is presented herein.
Management has made available to Deloitte & Touche LLP all the Company's
financial records and related data, as well as the minutes of the Board
of Directors' meetings. Management believes that all representations made
to Deloitte & Touche LLP during its audit were valid and appropriate. The
Board of Directors has an Audit Committee composed solely of outside
Directors. The independent auditors have direct access to the Audit
Committee and periodically meet with the Audit Committee to discuss
accounting, auditing and financial reporting matters.
First Health Group Corp.
Downers Grove, Illinois
February 19, 1999
<PAGE>
<TABLE>
CONSOLIDATED BALANCE SHEETS
ASSETS
December 31,
1997 1998
----------- -----------
<S> <C> <C>
Current assets:
Cash and cash equivalents $ 77,836,000 $ 50,264,000
Short-term investments 5,999,000 961,000
Accounts receivable, less allowance
for doubtful accounts of
$10,064,000 and $11,151,000,
respectively 65,979,000 63,582,000
Reinsurance recoverable 142,553,000 57,466,000
Deferred taxes 21,700,000 18,415,000
Other current assets 11,790,000 10,874,000
----------- -----------
Total current assets 325,857,000 201,562,000
Long-term investments:
Marketable securities 175,938,000 125,120,000
Other 26,394,000 23,431,000
----------- -----------
Total long-term investments 202,332,000 148,551,000
Property and equipment:
Land, building and improvements 51,914,000 59,228,000
Computer equipment and software 61,542,000 80,944,000
Office furniture and equipment 23,131,000 13,617,000
----------- -----------
136,587,000 153,789,000
Less accumulated depreciation
and amortization (63,567,000) (49,805,000)
----------- -----------
Total property and equipment, net 73,020,000 103,984,000
Goodwill, less accumulated
amortization of $1,937,000
and $5,513,000, respectively 104,729,000 100,151,000
----------- -----------
Other assets 1,940,000 3,631,000
----------- -----------
$707,878,000 $557,879,000
=========== ===========
</TABLE>
<PAGE>
<TABLE>
LIABILITIES AND STOCKHOLDERS' EQUITY
December 31,
1997 1998
----------- -----------
<S> <C> <C>
Current liabilities:
Accounts payable $ 49,342,000 $ 52,408,000
Treasury stock purchase payable -- 25,000,000
Accrued expenses 45,474,000 33,545,000
Claims reserves 150,517,000 72,589,000
Income taxes payable -- 2,611,000
----------- -----------
Total current liabilities 245,333,000 186,153,000
Long-term debt 200,000,000 225,000,000
Other non-current liabilities 2,938,000 8,599,000
----------- -----------
Total liabilities 448,271,000 419,752,000
Commitments and contingencies -- --
Stockholders' equity:
Preferred stock, par value $1.00;
authorized 1,000,000 shares;
none issued -- --
Common stock, par value $.01;
authorized 155,000,000 shares;
issued 75,134,000 and
76,482,000 shares, respectively 376,000 765,000
Additional paid-in capital 157,173,000 182,842,000
Retained earnings 296,140,000 384,143,000
Unrealized holding gain (loss)
on marketable securities 3,223,000 (3,099,000)
Treasury stock, at cost;
11,244,000 and 23,019,000 shares,
respectively (197,305,000) (426,524,000)
----------- -----------
Total stockholders' equity 259,607,000 138,127,000
----------- -----------
$707,878,000 $557,879,000
=========== ===========
See Notes to Consolidated Financial Statements.
</TABLE>
<PAGE>
<TABLE>
CONSOLIDATED STATEMENTS OF OPERATIONS
Years Ended December 31,
1996 1997 1998
----------- ----------- -----------
<S> <C> <C> <C>
Revenues $247,804,000 $388,975,000 $503,077,000
Operating expenses:
Cost of services 72,284,000 154,513,000 228,108,000
Selling and marketing 29,148,000 42,376,000 49,574,000
General and administrative 13,745,000 29,204,000 42,724,000
Health care benefits 5,479,000 8,870,000 18,542,000
In-process research and development -- 80,000,000 --
Depreciation and amortization 12,334,000 17,185,000 25,235,000
Interest income (13,581,000) (15,013,000) (20,470,000)
Interest expense -- 6,273,000 12,642,000
----------- ----------- -----------
119,409,000 323,408,000 356,355,000
----------- ----------- -----------
Income before income taxes 128,395,000 65,567,000 146,722,000
Income taxes (49,400,000) (58,492,000) (58,719,000)
----------- ----------- -----------
Net income $ 78,995,000 $ 7,075,000 $ 88,003,000
Weighted average shares
outstanding - basic 68,886,000 65,048,000 61,670,000
----------- ----------- -----------
Net income per common share - basic $ 1.15 $ .11 $ 1.43
=========== =========== ===========
Weighted average shares
outstanding - diluted 70,488,000 66,832,000 62,658,000
=========== =========== ===========
Net income per common share - diluted $ 1.12 $ .11 $ 1.40
=========== =========== ===========
</TABLE>
<PAGE>
<TABLE>
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
Years Ended December 31,
1996 1997 1998
---------- ---------- ----------
<S> <C> <C> <C>
Net income $78,995,000 $ 7,075,000 $88,003,000
---------- ---------- ----------
Other comprehensive income, before tax:
Unrealized gains (losses) on securities:
Unrealized holding gains (losses)
arising during period 1,599,000 3,331,000 (7,640,000)
Less: reclassification adjustment
for gains (losses) included in
net income (163,000) 41,000 (2,759,000)
---------- ---------- ----------
Other comprehensive income (loss),
before tax 1,436,000 3,372,000 (10,399,000)
Income tax benefit (expense) related
to items of other comprehensive
income (loss) (553,000) (1,274,000) 4,077,000
---------- ---------- ----------
Other comprehensive income (loss) 883,000 2,098,000 (6,322,000)
---------- ---------- ----------
Comprehensive income $79,878,000 $ 9,173,000 $81,681,000
========== ========== ==========
See Notes to Consolidated Financial Statements.
</TABLE>
<PAGE>
<TABLE>
CONSOLIDATED STATEMENTS OF CASH FLOWS
Years Ended December 31,
1996 1997 1998
----------- ----------- -----------
<S> <C> <C> <C>
Cash flows from operating activities:
Cash received from customers $244,504,000 $390,755,000 $508,355,000
Cash paid to suppliers and employees (116,302,000) (238,773,000) (335,923,000)
Health care benefits paid (4,660,000) (7,146,000) (10,230,000)
Interest paid (2,000) (5,738,000) (12,639,000)
Interest income received 13,029,000 16,570,000 17,010,000
Income taxes paid, net (39,135,000) (55,823,000) (35,550,000)
----------- ----------- -----------
Net cash provided by operating
activities 97,434,000 99,845,000 131,023,000
----------- ----------- -----------
Cash flows from investing activities:
Purchases of investments (174,379,000) (231,334,000) (284,961,000)
Sales or maturities of investments 146,178,000 242,389,000 337,915,000
Acquisition of businesses, net of
cash acquired (10,090,000) (202,423,000) (173,000)
Purchases of property and equipment (14,635,000) (31,372,000) (52,428,000)
----------- ----------- -----------
Net cash provided by (used in)
investing activities (52,926,000) (222,740,000) 353,000
----------- ----------- -----------
Cash flows from financing activities:
Proceeds from issuance of
long-term debt -- 200,000,000 25,000,000
Purchase of treasury stock (61,134,000) (100,802,000) (204,219,000)
Proceeds from issuance of
common stock 12,738,000 9,931,000 20,894,000
Exercises of put options on
common stock -- -- (1,763,000)
Proceeds from sales of put
options on common stock 6,728,000 14,163,000 1,140,000
----------- ----------- -----------
Net cash provided by (used in)
financing activities (41,668,000) 123,292,000 (158,948,000)
----------- ----------- -----------
Net increase (decrease) in cash and
cash equivalents 2,840,000 397,000 (27,572,000)
Cash and cash equivalents, beginning
of period 74,599,000 77,439,000 77,836,000
----------- ----------- -----------
Cash and cash equivalents, end
of period $ 77,439,000 $ 77,836,000 $ 50,264,000
=========== =========== ===========
<PAGE>
Supplemental cash flow data:
Acquisition of businesses:
Fair value of assets acquired $ 19,246,000 $361,850,000 $ --
Cost in excess of net assets acquired 3,048,000 103,206,000 173,000
Fair value of liabilities assumed (11,204,000) (342,633,000) --
In-process research and development -- 80,000,000 --
Future payments on acquisition (1,000,000) -- --
----------- ----------- -----------
Net cash paid $ 10,090,000 $202,423,000 $ 173,000
=========== =========== ===========
Non-cash financing activity:
Treasury stock purchase payable $ -- $ -- $ 25,000,000
=========== =========== ===========
See Notes to Consolidated Financial Statements.
</TABLE>
<PAGE>
<TABLE>
CONSOLIDATED STATEMENTS OF CASH FLOWS, continued
Years Ended December 31,
1996 1997 1998
----------- ----------- -----------
<S> <C> <C> <C>
Reconciliation of net income
to net cash provided by
operating activities:
Net income $ 78,995,000 $ 7,075,000 $ 88,003,000
Adjustments to reconcile net income
to net cash provided by
operating activities:
In-process research and development -- 80,000,000 --
Change in provision for
uncollectible accounts receivable (234,000) 519,000 1,087,000
Depreciation and amortization 12,334,000 17,185,000 25,235,000
Amortization of bond premiums 1,758,000 945,000 302,000
Provision for deferred income taxes 5,011,000 4,035,000 14,937,000
Tax benefits from stock
options exercised 4,726,000 3,936,000 5,787,000
Gains on sales of investments (1,106,000) (423,000) (3,857,000)
Other, net (359,000) (1,347,000) (1,383,000)
Changes in assets and liabilities (net
of effects from acquired businesses):
Accounts receivable (2,026,000) (3,257,000) 1,310,000
Other current assets (883,000) 8,111,000 916,000
Reinsurance recoverable -- 105,610,000 85,087,000
Accounts payable and accrued expenses (1,029,000) (17,672,000) (8,863,000)
Claims reserves 162,000 (106,396,000) (77,928,000)
Income taxes payable -- -- 2,611,000
Non-current assets and liabilities 85,000 1,524,000 (2,221,000)
----------- ----------- -----------
Total adjustments 18,439,000 92,770,000 43,020,000
----------- ----------- -----------
Net cash provided by operating
activities $ 97,434,000 $ 99,845,000 $131,023,000
=========== =========== ===========
See Notes to Consolidated Financial Statements.
</TABLE>
<PAGE>
<TABLE>
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
Unrealized
Holding
Gain
Common Stock Additional (Loss) On Treasury Stock
------------ Paid-In Retained Marketable --------------
Shares Amount Capital Earnings Securities Shares Amount
---------- -------- ----------- ----------- --------- --------- -----------
<S> <C> <C> <C> <C> <C> <C> <C>
Balance, January 1, 1996 36,608,000 $ 366,000 $104,961,000 $210,070,000 $ 242,000 1,973,000 $(35,369,000)
Issuance of Common Stock
Through Stock Option and
Purchase Plans 574,000 6,000 12,732,000 -- -- -- --
Purchase of Treasury Stock -- -- -- -- -- 1,512,000 (61,134,000)
Tax Benefit Related to Stock
Options Exercised -- -- 4,726,000 -- -- -- --
Change in Unrealized Holding
Gain on Marketable Securities -- -- -- -- 883,000 -- --
Sale of Put Options on Common
Stock -- -- 6,728,000 -- -- -- --
Net Income -- -- -- 78,995,000 -- -- --
---------- -------- ----------- ----------- --------- --------- -----------
Balance, December 31, 1996 37,182,000 372,000 129,147,000 289,065,000 1,125,000 3,485,000 (96,503,000)
Issuance of Common Stock
Through Stock Option and
Purchase Plans 385,000 4,000 9,927,000 -- -- -- --
Purchase of Treasury Stock -- -- -- -- -- 2,137,000 (100,802,000)
Tax Benefit Related to Stock
Options Exercised -- -- 3,936,000 -- -- -- --
Change in Unrealized Holding
Gain on Marketable Securities -- -- -- -- 2,098,000 -- --
Sale of Put Options on
Common Stock -- -- 14,163,000 -- -- -- --
Net Income -- -- -- 7,075,000 -- -- --
---------- -------- ----------- ----------- --------- --------- -----------
Balance, December 31, 1997 37,567,000 376,000 157,173,000 296,140,000 3,223,000 5,622,000 (197,305,000)
2-for-1 Stock Split
Effective June 23, 1998 37,567,000 376,000 (376,000) -- -- 5,622,000 --
Issuance of Common Stock
Through Stock Option and
Purchase Plans 1,348,000 13,000 20,881,000 -- -- -- --
Purchase of Treasury Stock -- -- -- -- -- 11,775,000 (229,219,000)
Tax Benefit Related to Stock
Options Exercised -- -- 5,787,000 -- -- -- --
Change in Unrealized Holding
Loss on Marketable Securities -- -- -- -- (6,322,000) -- --
Sale of Put Options on
Common Stock -- -- 1,140,000 -- -- -- --
Exercise of Put Options on
Common Stock -- -- (1,763,000) -- -- -- --
Net Income -- -- -- 88,003,000 -- -- --
---------- -------- ----------- ----------- --------- --------- -----------
Balance, December 31, 1998 76,482,000 $ 765,000 $182,842,000 $384,143,000 $(3,099,000) 23,019,000 $(426,524,000)
========== ======== =========== =========== ========== ========== ============
See Notes to Consolidated Financial Statements.
</TABLE>
<PAGE>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. Summary of Significant Accounting Policies:
The Company: First Health Group Corp. (the "Company") is a full-
service national health benefits company. The Company specializes in
serving large, national employers with a single source for their group
health programs -- providing comprehensive, cost-effective and innovative
solutions for all the health benefits needs of their employees
nationwide. Through its workers' compensation service line, the Company
provides a full range of auto managed care and workers' compensation
services for insurance carriers, state insurance funds, third party
administrators and large, self-insured national employers. Through its
First Health Services service line, the Company provides services to
various state Medicaid and entitlement programs for claims
administration, pharmacy benefit management programs and medical
management and quality review services.
Principles of consolidation: The financial statements include the
accounts of the Company and its wholly-owned subsidiaries. Material
intercompany balances and transactions have been eliminated.
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 reported
amounts of assets and liabilities, disclosure of contingent assets and
liabilities and reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates.
Cash and cash equivalents and investments: Cash and cash equivalents
are defined as all highly liquid investments with original maturities of
three months or less at date of purchase.
Investments with maturities between three months and twelve months
and other investments needed for current cash requirements are classified
as short-term investments. All remaining investments are classified as
long-term. Investments, which are classified as available-for-sale
securities, are reported at fair value. The fair value of marketable
securities is estimated based on quoted market prices, when available. If
a quoted price is not available, fair value is estimated using quoted
market prices for similar financial instruments. The difference between
amortized cost and fair value is recorded as an adjustment to
stockholders' equity and other comprehensive income, net of applicable
deferred taxes. Realized gains and losses from sales of investments are
based upon the specific identification method.
Property and equipment: Property and equipment are stated at cost.
Expenditures for the maintenance and repair of property and equipment are
charged to expense as incurred. Expenditures for major replacement or
betterment are capitalized. Land, buildings and improvements include
approximately $4.3 million in construction-in-progress amounts as of
December 31, 1998.
<PAGE>
Depreciation is provided over the estimated useful lives of the
related assets using the straight-line method. These lives range from 5
years to 31.5 years for buildings and improvements, 1.5 years to 5 years
for computer equipment and software and 3 years to 5 years for office
furniture and equipment. Leasehold improvements are amortized over the
shorter of the estimated useful life of the asset or the term of the
lease.
Long-lived assets: The carrying amount of all long-lived assets is
evaluated periodically to determine if adjustment to the depreciation and
amortization period or to the unamortized balance is warranted. Such
evaluation is based principally on the expected utilization of the long-
lived assets and the projected, undiscounted cash flows of the operations
in which the long-lived assets are deployed.
Fair value of financial instruments: The carrying amounts for cash
and cash equivalents, accounts receivable and accounts payable are
reasonable estimates of their fair value. The fair value of marketable
securities and investments is discussed in Note 3 to the consolidated
financial statements. The carrying value of long-term debt is a
reasonable estimate of its fair value as amounts are borrowed at current
market rates.
Revenue recognition: The Company receives revenues for PPO services,
claims administration services, fee schedule services, clinical cost
management and other services on a predetermined contractual basis (such
as a percentage of the derived savings) or hourly rate. Revenues on a
percentage of savings basis for PPO and fee schedule services are
recognized based upon client claims processed. Additionally, the Company
records revenues based upon a fixed fee per covered participant, and the
fee varies depending upon the programs selected or on a per-transaction
basis.
Insurance operations: Insurance premiums are earned on a pro rata
basis over the terms of the policies.
Claims Reserves - Claims reserves include traditional life
insurance, such as whole life insurance, term life insurance and accident
and health insurance, as well as universal life insurance policies and
annuity contracts which do not have significant mortality or morbidity
risk. Reserves for future policy benefits on traditional life insurance
policies are computed using a net level premium method based upon
historical experience of investment yields, mortality and withdrawals,
including provisions for possible adverse deviation. Reserves for
universal life-type and annuity contracts are equal to the accumulated
policyholder account values, determined in accordance with the terms of
the underlying policies.
Reinsurance Recoverable--Reinsurance recoverable represents the
amount due from other insurance companies as a result of the cession of a
portion of the Company's insurance risk to such companies. Substantially
all of this balance is due from National Farmers Union Life Insurance
Company ("National Farmers").
Reinsurance recoverable and the related claim reserves are reported
separately in the consolidated balance sheets.
<PAGE>
Net income per common share: Net income per common share-basic is
based on the weighted average number of common shares outstanding during
the period. Net income per common share-diluted is based on the weighted
average number of common shares and common share equivalents outstanding
during the period. In calculating earnings per share, earnings are the
same for the basic and diluted calculations. Weighted average shares
outstanding increased for diluted earnings per share by 1,602,000,
1,784,000 and 988,000 for 1996, 1997 and 1998, respectively, due to the
effect of stock options. Net income per share decreased by $0.03 for
1996, did not change in 1997 and decreased by $0.03 for 1998.
All historical common share data have been adjusted for a 2-for-1
stock split in the form of a 100% stock distribution paid on June 23,
1998 to stockholders of record on June 2, 1998.
New Accounting Pronouncements: In 1998, the Company adopted
Statement of Financial Accounting Standards No. 130, "Reporting
Comprehensive Income". Comprehensive income represents the change in
equity from transactions and other events from non-owner sources. The
Company's only component of other comprehensive income is unrealized
holding gains and losses on marketable securities. Total other
comprehensive income (loss) net of income taxes was $883,000 in 1996,
$2,098,000 in 1997 and $(6,322,000) in 1998. The Company has added the
statement of comprehensive income to its financial statements to present
the required disclosures regarding comprehensive income.
In 1998, the Company also adopted Statement of Financial Accounting
Standards No. 131, "Disclosures About Segments of an Enterprise and
Related Information" ("SFAS No. 131"). The Company has determined it
currently operates in one reportable segment as defined by SFAS No. 131.
Each of the Company's products and services have similar long-term
financial performance and have similar economic characteristics. All of
the Company's products and services relate to programs that provide the
Company's customers with a single source for all of their group health
programs, providing comprehensive, cost-effective and innovative
solutions for all the health benefits needs of their employees.
In March 1998, the Accounting Standards Executive Committee of the
American Institute of Certified Public Accountants issued Statement of
Position 98-1, ("SOP 98-1"), "Accounting for the Costs of Computer
Software Developed or Obtained for Internal Use." SOP 98-1 provides
guidance on accounting for the costs of computer software developed or
obtained for internal use. Specifically, certain internal payroll and
payroll related costs should be capitalized during the application
development stage of a project and depreciated over the computer
software's useful life. The Company currently expenses these costs as
incurred and is evaluating the effects of SOP 98-1 on its results of
operations and financial position. The Company will implement SOP 98-1
as of January 1, 1999.
<PAGE>
In June 1998, the Financial Accounting Standards Board issued
Statement of Financial Accounting Standards No. 133, "Accounting for
Derivative Instruments and Hedging Activities" ("SFAS No. 133"). SFAS
No. 133 requires that all derivative instruments be recognized as either
assets or liabilities on the balance sheet and that derivative
instruments be measured at fair value. This statement also requires
changes in the fair value of derivatives to be recorded each period in
current earnings or comprehensive income depending on the intended use of
the derivatives. This statement is effective for all fiscal quarters of
fiscal years beginning after June 15, 1999. The Company has not yet
determined the impact of SFAS No. 133 on its results of operations and
financial position.
2. Acquisitions:
The Company acquired American Life and Health Insurance Company
("American") and its subsidiary insurance company on February 1, 1996.
Under the terms of the acquisition, the Company paid a purchase price of
approximately $12 million. The acquisition was accounted for by the
purchase method of accounting with the excess of the purchase price over
the fair value of the net assets acquired being amortized over 20 years.
The purchase price and the results of operations of American prior to the
acquisition were not material to the consolidated financial statements.
This transaction was financed with cash on hand.
On July 1, 1997, the Company acquired all the outstanding shares of
capital stock of First Health Strategies, Inc. ("Strategies") and First
Health Services Corporation ("Services") (collectively, "FHC"), excluding
the stock of Viable Information Processing Systems, Inc., a wholly-owned
subsidiary of Services, from First Financial Management Corporation and
First Data Corporation for a purchase price of approximately $196
million. Strategies, based in Salt Lake City, Utah, and Services, based
in Richmond, Virginia, provide independent health care administration
services such as claims administration and associated health care
management services to the self-insured corporate and government markets.
The acquisition was financed with a $200 million credit agreement
underwritten by the Company's bank group.
<PAGE>
Based on the terms of the acquisition, the transaction was accounted
for as a purchase of FHC by the Company for financial reporting and
accounting purposes. Accordingly, the consolidated statements of
operations include FHC's results since the date of acquisition. The
Company revalued the basis of FHC's acquired assets and assumed
liabilities to fair value at the date of purchase. The purchase price of
FHC was calculated as the net cash paid plus the Company's transaction
costs. The difference between the purchase price and the fair value of
the identifiable tangible and intangible assets acquired, the amount
allocated to in-process research and development, and the liabilities
assumed and incurred was recorded as goodwill and will be amortized over
a period of 30 years. The allocation of the purchase price was as
follows:
Purchase price $196,430,000
Transaction costs 3,000,000
-----------
Total purchase price $199,430,000
============
Purchase price has been allocated as follows:
Fair value of assets acquired $ 87,214,000
Goodwill 95,317,000
In-process research and development 80,000,000
Liabilities assumed (40,039,000)
Liability for restructuring and
integration costs (23,062,000)
-----------
$199,430,000
===========
In-process research and development represents projects related to
the next generation of FHC's claims processing system. These projects
represent FHC's research and development efforts prior to the
acquisition, which had not yet reached the stage of technological
feasibility and had no alternative future use; therefore, the ultimate
revenue generating capability of these projects was uncertain. The
purchased research and development was valued by an independent appraiser
using a discounted, risk-adjusted future income approach taking into
account risks related to existing and future markets and an assessment of
the life expectancy of the technology. The discount rate used in the
appraisal was 12%, and the life expectancy of the technology was 10
years. The 1997 consolidated statement of operations included an $80
million charge for the purchased research and development which was not
deductible for income tax purposes. The research and development
acquired will require additional development efforts, estimated to cost
$15 million, to become commercially viable. Such modifications include
the enhancement of various modules to perform claims adjudication,
reporting, imaging and correspondence, and are expected to be completed
within the next year, with a substantial portion of the expenditures
being incurred by mid-1999.
<PAGE>
The following unaudited pro forma information reflects the results
of the Company's operations as if the acquisition had occurred at the
beginning of the periods presented adjusted for (i) the effect of
recurring charges related to the acquisition, primarily the amortization
of goodwill, recording of interest expense on the borrowings to finance
the acquisition and a reduction of depreciation expense due to the write-
down to fair value of fixed assets, (ii) the removal of revenues and
related cost of services and expenses for the portions of the acquired
businesses that were held for sale, and (iii) the exclusion of the
effects of the non-recurring charge of $80 million for purchased in-
process research and development recorded by the Company in fiscal 1997
following the consummation of the acquisition.
<TABLE>
Twelve Months Ended December 31
1996 1997
---- ----
<S> <C> <C>
Pro forma:
Revenue $506,321,000 $508,417,000
Net income 88,589,000 86,738,000
Net income per common share - basic 1.29 1.33
Net income per common share - diluted $ 1.26 $ 1.30
</TABLE>
These pro forma results have been prepared for comparative purposes
only and do not purport to be indicative of what operating results would
have been had the acquisition actually taken place at the beginning of
the periods presented, nor do they purport to represent results of future
operations of the merged companies.
On August 30, 1997 the Company acquired Loyalty Life Insurance
Company ("Loyalty"), which is licensed to conduct health insurance
business in 49 states for a purchase price of approximately $12 million
in cash. Based upon the terms of the acquisition, the transaction was
accounted for as a purchase of Loyalty by the Company for financial
reporting and accounting purposes. In 1998, Loyalty changed its name to
First Health Life and Health Insurance Company. This name change is
pending approval from a number of state insurance regulators.
<PAGE>
3. Marketable Securities and Investments:
Information related to the Company's marketable securities and
investments at December 31 is as follows:
<TABLE>
1997 1998
Amortized Cost Fair Value Amortized Cost Fair Value
----------- ----------- ----------- -----------
<S> <C> <C> <C> <C>
United States
Government securities $ 33,346,000 $ 33,612,000 $ 16,768,000 $ 17,324,000
State and municipal
securities 3,785,000 3,817,000 6,925,000 7,065,000
Foreign government
securities 954,000 972,000 1,709,000 1,732,000
Corporate securities 69,576,000 71,104,000 47,669,000 48,524,000
Mortgage and asset-
backed securities 9,430,000 9,560,000 9,074,000 9,074,000
----------- ----------- ----------- -----------
Total debt securities 117,091,000 119,065,000 82,145,000 83,719,000
Equity securities 59,210,000 62,872,000 48,381,000 42,362,000
----------- ----------- ----------- -----------
Total $176,301,000 $181,937,000 $130,526,000 $126,081,000
=========== =========== =========== ===========
Less-classified as current 5,999,000 961,000
----------- -----------
Classified as long-term $175,938,000 $125,120,000
=========== ===========
Gross unrealized gains and (losses) were $6,446,000 and $(810,000),
respectively, at December 31, 1997 and $3,231,000 and $(7,676,000),
respectively, at December 31, 1998.
Contractual maturities of marketable debt securities at December 31
are as follows:
1997 1998
Amortized Cost Fair Value Amortized Cost Fair Value
----------- ----------- ----------- -----------
<S> <C> <C> <C> <C>
Due in one year or less $ 6,042,000 $ 5,999,000 $ 879,000 $ 961,000
Due after one year
through five years 31,474,000 31,729,000 37,517,000 38,362,000
Due after five years
through ten years 55,084,000 56,103,000 22,223,000 22,415,000
Due after ten years 24,491,000 25,234,000 21,526,000 21,981,000
----------- ----------- ----------- -----------
Total debt securities $117,091,000 $119,065,000 $ 82,145,000 $ 83,719,000
=========== =========== =========== ===========
</TABLE>
<PAGE>
Gross realized gains and (losses) on sales or maturities of
marketable securities were $651,000 and $(518,000), respectively, for the
year ended December 31, 1996, $1,857,000 and $(1,186,000), respectively,
for the year ended December 31, 1997 and $5,717,000 and $(2,289,000),
respectively, for the year ended December 31, 1998.
Included in other long-term investments on the consolidated balance
sheet at December 31, 1997 was a $12,561,000 investment in a limited
partnership which, in turn, invests in a variety of marketable
securities. The investment was accounted for on the cost basis because
the Company owned less than 5% of the limited partnership's assets and
had no influence on the general partner's investment decisions. The
general partner reported to the Company that its cumulative share of the
unrealized gain in the investment assets, before any applicable income
taxes, was $3,083,000 at December 31, 1997. This investment was
liquidated in 1998. The Company received $13,131,000 in proceeds from
the sale and expects to receive additional funds after the completion of
the audit of the partnership books.
Included in other long-term investments at December 31, 1997 and
1998 is an investment in a limited partnership which invests in equipment
which is leased to third parties. The initial investment is accounted for
on the equity method since the Company owns 20% of a particular tranche
of the limited partnership. The partnership reported to the Company that
its share of income attributable to this tranche was $583,000 in 1997 and
$590,000 in 1998. The total investment in this tranche was $8,673,000 at
December 31, 1997 and $8,674,000 at December 31, 1998. In the second
quarter of 1997, the Company made an additional investment of
approximately $4.2 million in this limited partnership for a 25% interest
in another tranche of the limited partnership. This investment is also
accounted for on the equity method. The partnership reported to the
Company that its share of income attributable to this tranche was
$150,000 in 1997 and $339,000 in 1998. The total investment in this
tranche was $4,184,000 at December 31, 1997 and $4,013,000 at December
31, 1998. In 1998, the Company made an additional investment of
approximately $8.3 million in this limited partnership for a 20% interest
in another tranche of the limited partnership. The new investment is
also accounted for on the equity method. The partnership reported to the
Company that its share of income attributable to this tranche was
$293,000 in 1998. The total investment in this tranche was $8,328,000 at
December 31, 1998.
4. Reinsurance:
On October 1, 1996, in anticipation of the Company's acquisition,
Loyalty entered into a reinsurance agreement whereby it ceded 100 percent
of its life insurance and annuity contracts in force ("pre-acquisition
business") to a former affiliate, National Farmers. Under the terms of
the reinsurance agreement, all premiums and deposits received by Loyalty
which relate to pre-acquisition business are transferred to National
Farmers. Additionally, the cash and investments transferred by Loyalty
to National Farmers which support ceded insurance liabilities are held in
escrow for the benefit of Loyalty's policy holders.
<PAGE>
Premiums and policy benefits, which are not material in amount, are
ceded to National Farmers and shown net of such cessions in the
consolidated statements of operations. Loyalty is currently seeking
approvals from the insurance regulators and policy holders of each state,
as necessary, which would result in the legal replacement of Loyalty by
National Farmers. Such approvals would release Loyalty from future
liability for its pre-acquisition business and result in the removal of
such policy liabilities from the Company's consolidated balance sheets.
The Company anticipates receiving the remainder of the approvals in 1999,
although there can be no assurance that such approvals will be obtained.
The Company also assumes and cedes reinsurance with other insurance
companies in the normal course of business. Reinsurance is ceded
primarily to limit losses from large exposures and to permit recovery of
a portion of direct losses. The Company continues to have primary
liability as the direct insurer for all ceded risks. Reinsurance is
assumed to increase the Company's revenues and to provide additional
diversification of its insured risks. The effects of reinsurance on
premiums and contract charges earned are as follows:
<TABLE>
Years Ended December 31,
1996 1997 1998
---------- ---------- ----------
<S> <C> <C> <C>
Life and health premiums
and contract charges:
Direct $14,467,000 $18,470,000 $28,384,000
Assumed 1,231,000 2,241,000 2,093,000
Ceded (7,792,000) (9,963,000) (11,486,000)
---------- ---------- ----------
Net $ 7,906,000 $10,748,000 $18,991,000
========== ========== ==========
The recoverable amounts at December 31, 1998 include $193,000
related to losses paid by the Company and billed to reinsurers and
$57,273,000 estimated by the Company with respect to ceded unpaid losses
(including claims incurred but not reported) which are not billable until
the losses are paid. Estimating amounts of reinsurance recoverable is
impacted by the uncertainties involved in the establishment of loss
reserves. Management believes the recoverables are appropriately
established; however, the amount ultimately recoverable may vary from
amounts currently recorded.
5. Accrued Expenses:
Accrued expenses at December 31, 1997 include approximately
$28,166,000 for merger-related restructuring expenses; $4,966,000 for
accrued salaries, wages and benefits; and $1,903,000 for insurance
accruals. Accrued expenses at December 31, 1998 include approximately
$15,303,000 for merger-related restructuring expenses; $5,728,000 for
accrued salaries, wages and benefits; and $1,961,000 for insurance
accruals.
<PAGE>
6. Long-Term Obligations:
On July 1, 1997, the Company entered into a $200 million revolving
credit agreement (the "Agreement") to facilitate the acquisition of FHC.
In August 1997, the Agreement was amended to increase available
borrowings to $350 million. As of December 31, 1998, $225 million was
outstanding under the Agreement. The revolving credit facility is due on
June 30, 2002. The Agreement provides for interest at the LIBOR rate
adjusted for the ratio of outstanding debt to earnings before interest,
taxes, depreciation and amortization. As of December 31, 1998, the
interest rate was approximately 6% per annum. The credit facility also
has a compensating fee arrangement calculated at approximately .2% per
annum of the unused balance.
The Agreement contains provisions which require the Company to
maintain a specified level of net worth and comply with various financial
ratios and includes, among other provisions, restrictions on investments,
dividend payments and incurrence of additional indebtedness. At December
31, 1998, $350,000,000 was available for dividend distributions under
these provisions.
7. Income Taxes:
Components of the provision for income taxes are as follows:
</TABLE>
<TABLE>
Years Ended December 31,
1996 1997 1998
---------- ---------- ----------
<S> <C> <C> <C>
Current provision:
Federal $38,430,000 $44,582,000 $36,717,000
State 5,959,000 9,875,000 7,065,000
---------- ---------- ----------
44,389,000 54,457,000 43,782,000
---------- ---------- ----------
Deferred provision:
Federal 4,871,000 2,901,000 12,135,000
State 140,000 1,134,000 2,802,000
---------- ---------- ----------
5,011,000 4,035,000 14,937,000
---------- ---------- ----------
Provision for income taxes $49,400,000 $58,492,000 $58,719,000
========== ========== ==========
</TABLE>
<PAGE>
Deferred tax assets and (liabilities) comprise the following, as
of December 31, 1997 and 1998:
<TABLE>
1997 1998
---------- ----------
<S> <C> <C>
Current Assets:
Purchase accounting reserves $11,852,000 $ 6,100,000
Revenue adjustments 3,174,000 3,681,000
Allowance for doubtful accounts 4,154,000 4,460,000
Vacation accrual 1,679,000 2,414,000
Other, net 841,000 1,760,000
---------- ----------
Total current assets 21,700,000 18,415,000
---------- ----------
Non-current assets (liabilities):
Depreciation 10,260,000 8,584,000
Intangible assets 3,411,000 1,998,000
Tax benefit of limited partnership
investment (10,689,000) (19,623,000)
Market value adjustment (2,103,000) 1,974,000
Other, net (2,737,000) 15,000
---------- ----------
Total non-current liabilities (1,858,000) (7,052,000)
---------- ----------
Net deferred tax assets $19,842,000 $11,363,000
========== ==========
</TABLE>
Income tax benefits associated with the exercise of stock options
were $4,726,000 in 1996, $3,936,000 in 1997 and $5,787,000 in 1998. Such
amounts are credited to additional paid-in-capital.
<TABLE>
Years Ended December 31,
1996 1997 1998
---------- ---------- ----------
<S> <C> <C> <C>
Provision for income taxes
at federal statutory rate $44,938,000 $22,948,000 $51,353,000
State taxes, net of federal
benefit 6,822,000 3,410,000 7,336,000
Expenses not deductible for
income tax purposes 13,000 33,796,000 1,109,000
Non-taxable interest income and
dividends (2,373,000) (1,662,000) (1,079,000)
---------- ---------- ----------
Provision for income taxes $49,400,000 $58,492,000 $58,719,000
========== ========== ==========
</TABLE>
<PAGE>
8. Employment Agreements:
The Company has employment agreements which expire between 1999 and
2001 with certain officers and key employees. The agreements provide for,
among other things, annual base salaries aggregating $2,845,000 plus
additional incentive compensation. The incentive compensation is at the
discretion of the Board of Directors. The Company recorded discretionary
incentive compensation to certain key officers and employees in the
aggregate amount $706,000 in 1996, $1,050,000 in 1997 and $471,000 in
1998.
9. Stockholders' Equity:
Employee Stock Purchase Plan: The Company maintains an Employee
Stock Purchase Plan which allows employees of the Company and its
subsidiaries to purchase shares of common stock on the last day of two
six-month purchase periods (i.e., February 28 and August 31 of each year)
at a purchase price which is 85% of the closing sale price of the shares
as quoted on Nasdaq on the first or last day of such purchase period,
whichever is lower. A maximum of 2,000,000 shares has been authorized for
issuance under the plan. As of December 31, 1998, 1,241,000 shares had
been issued pursuant to the plan.
Stock options: The Company maintains an Employee Stock Option Plan
which provides for the granting of options to employees and consultants
of the Company and its subsidiaries to purchase up to 4,000,000 shares of
common stock at a price not less than 85% of fair market value at date of
grant. In 1998, the Company adopted a new Employee Stock Option Plan
which provides for the granting of additional options to employees and
consultants of the Company and its subsidiaries to purchase up to
2,800,000 shares of common stock at a price not less than 85% of fair
market value at date of grant. Outstanding options expire between 1999
and 2008 under the first plan. There are no outstanding options under
the 1998 plan.
The Company also maintains a Stock Option Plan which provides for
the granting of options to purchase 660,000 shares of common stock at
fair market value at date of grant, which expire between 2001 and 2008,
to non-employee members of its Board of Directors. In 1998, the Company
adopted a new Stock Option Plan which provides for the granting of
additional options to purchase 200,000 shares of common stock at fair
market value at date of grant to non-employee members of its Board of
Directors. Options granted under this new plan expire in 2008. The
Company has also granted options to certain of its employees and members
of its Board of Directors under individual option agreements, which
expire in 2000.
<PAGE>
The following table summarizes changes in common stock under option
plans.
<TABLE>
Years Ended December 31,
1996 1997 1998
------------------ --------------- -----------------
Wtd.Avg. Wtd.Avg. Wtd.Avg.
# of Exercise # of Exercise # of Exercise
Shares Price Shares Price Shares Price
---------- ----- --------- ---- ---------- -----
<S> <C> <C> <C> <C> <C> <C>
Number of Shares:
Outstanding at
beginning of the year 4,256,000 $11.95 3,788,000 $14.01 6,682,000 $18.95
Granted 758,000 21.21 3,756,000 22.79 845,000 23.26
Exercised (1,080,000) 10.72 (706,000) 12.42 (1,243,000) 15.14
Canceled (146,000) 15.41 (156,000) 20.97 (235,000) 24.60
---------- ----- --------- ---- ---------- -----
Outstanding at end
of the year 3,788,000 14.01 6,682,000 18.95 6,049,000 20.11
---------- ----- --------- ---- ---------- -----
Exercisable at
December 31 2,326,000 $12.89 2,816,000 $15.86 3,118,000 $18.73
Available for grant 3,578,000 732,000 3,111,000
---------- ----- --------- ---- ---------- -----
</TABLE>
The following table summarizes information about stock options outstanding
and exercisable at December 31, 1998:
<TABLE>
Options Outstanding Options Exercisable
----------------------------- -----------------
Wtd. Avg.
Range of Remaining Wtd. Avg. Wtd. Avg.
Exercise Contractual Exercise Exercise
Price Shares Life In Years Price Shares Price
----- ------ ------------- ----- ------ -----
<S> <C> <C> <C> <C> <C>
$ 1.00 to $10.00 280,000 3.91 $ 7.92 280,000 $ 7.92
$10.01 to $20.00 1,307,000 5.48 $13.89 1,087,000 $14.30
$20.01 to $30.00 4,462,000 5.46 $22.69 1,751,000 $23.20
</TABLE>
<PAGE>
The Company has adopted the disclosure-only provisions of Statement
of Financial Accounting Standards No. 123 ("SFAS No. 123"). The
following table presents pro forma financial results if compensation cost
had been recorded consistent with the provisions of SFAS No. 123:
Years ended December 31,
1996 1997 1998
---------- --------- ---------
[S] [C] [C] [C]
Compensation cost - pretax $ 4,136,000 $5,813,000 $11,923,000
Net income 76,450,000 3,599,000 80,849,000
Net income per common share - basic 1.11 .06 1.31
Net income per common share - diluted $ 1.09 $ .05 $ 1.29
The weighted average fair values at date of grant for options
granted during 1996, 1997 and 1998 were $9.86, $8.21 and $9.11,
respectively, and were estimated using the Black-Scholes option pricing
model with the following assumptions:
<TABLE>
Years ended December 31,
1996 1997 1998
------ ------ ------
<S> <C> <C> <C>
Risk-free interest rate 6.42% 6.27% 4.85%
Dividend yield -- -- --
Expected volatility 34.18% 29.57% 34.03%
Expected life in years 1 to 9 1 to 9 1 to 8
Treasury Stock: The Company's Board of Directors has approved the
repurchase of up to 30 million shares of the Company's outstanding common
stock. Purchases may be made from time to time depending on market
conditions and other relevant factors. The Company had approximately
13.2 million shares available for repurchase under its repurchase
authorizations as of December 31, 1998.
During 1996, the Company purchased 2,824,000 shares of its
outstanding common stock in the open market for a total cost of
$56,095,000. During 1997, the Company purchased 4,273,000 shares of its
outstanding common stock in the open market for a total cost of
$100,802,000. During 1998, the Company purchased 9,983,000 shares of its
outstanding common stock on the open market for a total cost of
approximately $184,919,000 or an average price of $18.52 (of which
$25,000,000 is payable on December 31, 1998). The stock purchased was
recorded as treasury stock, at cost, and is available for general
corporate purposes. In connection with the exercise of options to
purchase 486,000 shares of common stock, during 1996, certain employees
paid the exercise price by delivering to the Company 200,000 shares of
previously owned common stock. In connection with exercise of options to
purchase 850,000 shares of common stock during 1998, a certain employee
paid the exercise price by delivering to the Company approximately
492,000 shares of previously owned stock. These shares were also
recorded as treasury stock, at cost, and are available for general
corporate purposes.
<PAGE>
In connection with its stock repurchase program, at December 31,
1998, the Company had outstanding put options which obligate the Company,
at the election of the option holders, to repurchase up to 2,050,000
shares of common stock at prices ranging from $14.50 to $24.00 per share.
The outstanding options expire at various dates from March 17, 1999 to
December 17, 1999. During 1998, 1,300,000 shares were put to the Company
at a total cost of $30,675,000. These shares were recorded as treasury
stock, at cost, and are available for general corporate purposes. In
addition, the Company settled 200,000 puts by delivering $1,763,000 in
cash to the option holders.
Employee Benefit Plan: The Company maintains a Savings and
Investment Plan which allows eligible employees to allocate up to 15% of
their salary, through payroll deductions, among various mutual funds. The
Company matches 75% of the employee's contribution, up to 6% of his or
her salary. The cost of this plan (net of forfeitures) was $1,374,000 in
1996, $2,874,000 in 1997 and $3,970,000 in 1998.
10. Commitments and Contingencies:
Litigation: The Company and its subsidiaries are subject to various
claims arising in the ordinary course of business and are parties to
various legal proceedings which constitute litigation incidental to the
business of the Company and its subsidiaries. In the opinion of the
Company's management, only one matter is potentially material to the
business or the financial condition of the Company. On August 6, 1998,
amended counterclaims were asserted against the Company in a lawsuit
pending in the United States District Court for the Northern District of
Illinois. The Company had initiated a lawsuit against United Payors and
United Providers ("UP & UP"), a network of hospital and other medical
providers, on April 26, 1996 asserting claims for trademark infringement
and state law claims for deceptive trade practices, fraud and deceptive
business practices and for intentional interference with contracts.
At this time, the Company alleges that UP & UP has employed and
continues to employ false and misleading statements and practices
concerning the nature of its own services and relationships with payor
clients, as well as the nature of the Company's services and
relationships with its payor clients, among other related subjects.
Specifically, the Company alleges that UP & UP misled hospitals to
believe that the benefits of joining UP & UP's network would principally
include the likelihood of an increased market share of patient visits by
mandatory commitments from UP & UP's payor clients to implement financial
incentives and to otherwise influence its clients' covered beneficiaries
to select a provider in UP & UP's network. The Company further alleges
that UP & UP representatives made false representations claiming an
affiliation or association with the Company's own proprietary network,
The AFFORDABLE Medical Networks.
<PAGE>
In answering the Company's lawsuit, UP & UP denied the allegations
and asserted defenses. UP & UP also asserted counterclaims seeking
damages for alleged "false advertising" by the Company, unfair
competition and deceptive trade practices, defamation, commercial
disparagement, and seeking equitable cancellation of the Company's
service mark "AFFORDABLE." Among other specific allegations, UP & UP
alleges that various statements made by the Company concerning the acts
of UP & UP, which are the subject of the claims summarized above, and a
mailing by the Company attaching a letter from the Director of the Office
of Personnel Management in which UP & UP is identified as a "silent or
non-directed preferred provider organization" constitute defamation per
se and commercial disparagement and deceptive trade practices.
The Company replied to UP & UP's counterclaims denying the
allegations, and asserting defenses. The action at this time is
proceeding through the discovery phase. The Company is prosecuting and
defending its interests vigorously. At this time, the Company does not
believe that the counterclaims will have a probable material adverse
effect on the Company's financial position or future operating results.
Leases: The Company leases office facilities under leases through
2009. At December 31, 1998, future minimum annual rental commitments
under these leases were as follows:
Years Ending December 31, Amount
1999 $ 8,788,000
2000 6,107,000
2001 4,880,000
2002 3,743,000
2003 3,439,000
Thereafter 17,115,000
----------
Total $44,072,000
==========
Total rent expense, recognized under the straight-line method, was
$1,380,000 in 1996, $5,264,000 in 1997 and $7,908,000 in 1998.
Agreement with EDS: The Company has an agreement (the "EDS
Agreement") with Electronic Data Systems Corporation ("EDS"), primarily
for the purpose of developing and jointly marketing medical and
administrative cost management services to workers' compensation payers.
The initial term of the EDS Agreement is to January 1, 2005, and may be
extended until 2015 upon mutual agreement of the Company and EDS. EDS
provides data processing, electronic claims transmission and marketing
support services to the Company. Compensation paid by the Company to EDS
for its medical cost management services is based upon the greater of a
specified minimum annual payment ($1,875,000 subject to adjustments
computed from changes in the Consumer Price Index), or a percentage of
savings method.
EDS processes all of the workers' compensation fee schedule claims
for the Company. Although there are other data processing service
organizations available, a loss of EDS's services would adversely affect
the operating results of the Company's fee schedule service business.
<PAGE>
11. Major Customers:
During 1996, 1997 and 1998, the Company had no customers which
individually accounted for 10% or more of revenues.
12. Derivative Financial Instruments:
The use of derivatives by the Company has not been material although
they have been used to reduce interest rate risks, potentially increase
the return on invested funds and manage the cost of common stock
repurchase programs. During 1996 through 1998, the Company had invested
$12,561,000 in a limited partnership fund which uses long and short
positions, leverage, and certain derivative securities to manage
portfolio and interest rate risk. The investment was accounted for on the
cost basis as the Company owned less than 5% of the assets of the limited
partnership. The investment was liquidated in 1998 for $13,131,000, plus
expected additional proceeds after the partnership audit is complete.
Investments in derivative financial instruments are approved by either
the Audit Committee or the Board of Directors of the Company.
<PAGE>
13. Quarterly Financial Data (Unaudited):
The following is a summary of unaudited results of operations (in
thousands except per share data) for the years ended December 31, 1997
and 1998.
</TABLE>
<TABLE>
Year Ended December 31, 1997
First Second Third Fourth
Quarter Quarter Quarter Quarter
<S> <C> <C> <C> <C>
Revenue $ 64,921 $ 68,834 $126,194 $129,026
Net income (loss) $ 20,834 $ 21,444 $(57,888) $ 22,685
Net income (loss) per
common share - basic $ .31 $ .33 $ (.91) $ .36
Weighted average shares
outstanding - basic 67,052 65,228 63,556 63,828
Net income (loss) per common
share - diluted $ .31 $ .32 $ (.91) $ .34
Weighted average shares
outstanding - diluted 68,314 66,614 63,556 66,112
Year Ended December 31, 1998
First Second Third Fourth
Quarter Quarter Quarter Quarter
<S> <C> <C> <C> <C>
Revenue $127,758 $126,742 $125,962 $122,615
Net income $ 23,103 $ 23,322 $ 22,250 $ 19,328
Net income per common
share - basic $ .36 $ .37 $ .36 $ .33
Weighted average shares
outstanding - basic 63,710 63,095 62,468 58,075
Net income per common
share - diluted $ .36 $ .36 $ .35 $ .33
Weighted average shares
outstanding - diluted 64,884 64,195 63,573 58,552
<PAGE>
CORPORATE AND INVESTOR INFORMATION
Independent Auditors
Deloitte & Touche LLP
Chicago, Illinois
Corporate Counsel
Neal, Gerber & Eisenberg
Chicago, Illinois
Transfer Agent & Registrar
The LaSalle National Bank of Chicago
Chicago, Illinois
Form 10-K. The Company has filed an Annual Report on Form 10-K for the
year ended December 31, 1998 with the Securities and Exchange Commission.
Stockholders may obtain a copy of this report, without charge, by
writing: Joseph E. Whitters, Chief Financial Officer, First Health Group
Corp., 3200 Highland Avenue, Downers Grove, IL 60515.
Common Stock. First Health Group Corp. Common Stock is quoted on the
Nasdaq National Market under the symbol FHCC. The following tables show
the quarterly range of high and low sales prices of the Common Stock
during the calendar periods indicated:
</TABLE>
<TABLE>
High Low
------- -------
<S> <C> <C>
1997
First Quarter $22.3125 $19.375
Second Quarter 27.8125 18.8125
Third Quarter 32.0625 25.875
Fourth Quarter 32.7815 24.50
1998
First Quarter $28.00 $22.625
Second Quarter 30.875 27.00
Third Quarter 30.125 19.125
Fourth Quarter 24.5625 13.625
1999
Through March 8 $17.188 $13.625
As of March 8, 1999, the Company had 960 stockholders of record.
Dividend Policy. The Company has not paid any dividends on its Common
Stock and expects that its earnings will continue to be retained for use
in the operation and expansion of its business.
</TABLE>
EXHIBIT 22
SUBSIDIARIES OF FIRST HEALTH GROUP CORP.
First Health Strategies, Inc. Office Realty Investors, Inc.
Incorporated in Delaware Incorporated in Illinois
First Health Services Corporation COMPARE Leasing Corp.
Incorporated in Virginia Incorporated in Delaware
First Health Life & Health First Health Insurance Services, Inc.
Insurance Company Incorporated in Illinois
Incorporated in Texas
First Health Realty, Inc. HealthCare COMPARE Administrative
Incorporated in Utah Services, Inc.
Incorporated in Illinois
First Health Strategies American Life and Health
(TPA), Inc. Insurance Company
Incorporated in Delaware Incorporated in Missouri
PRIMExtra, Inc. Cambridge Life Insurance Company
Incorporated in Delaware Incorporated in Missouri
U. S. Administrators, Inc. CHP Administration, Inc.
Incorporated in California Incorporated in California
First Health of Canada, Inc. First Health Strategies of Utah, Inc.
Incorporated in Ontario Incorporated in Utah
First Health Strategies of First Health Review, Inc.
Texas, Inc. Incorporated in Utah
Incorporated in Texas
First Health Strategies of New First Health Insurance Agency, Inc.
Mexico, Inc. Incorporated in Massachusetts
Incorporated in New Mexico
First Health Strategies of First Health Strategies of Ohio, Inc.
Pennsylvania, Inc. Incorporated in Ohio
Incorporated in Pennsylvania
Midwest Benefits Corporation First Mental Health, Inc.
Incorporated in Michigan Incorporated in Tennessee
First Peer Review of New Mexico, First Peer Review of Florida, Inc.
Inc. Incorporated in Delaware
Incorporated in Delaware
First Peer Review of Tennessee, Inc. First Peer Review of Hawaii
Incorporated in Delaware Incorporated in Delaware
First Peer Review of Illinois First Peer Review of Oregon
Incorporated in Delaware Incorporated in Delaware
First Peer Review of Colorado
Incorporated in Delaware
Exhibit 23
INDEPENDENT AUDITORS' CONSENT
First Health Group Corp.:
We consent to the incorporation by reference in the Registration
Statements of First Health Group Corp. on Form S-8 (file numbers 33-
26639, 33-26640, 33-42902, 33-43806, 33-43807, 33-87986, 33-62747, 333-
31893, 333-68941 and 333-68943) of our reports dated February 19, 1999,
appearing in and incorporated by reference in the Annual Report on
Form 10-K of First Health Group Corp. for the year ended December 31,
1998.
DELOITTE & TOUCHE LLP
Chicago, Illinois
March 23, 1999
<TABLE> <S> <C>
<ARTICLE> 5
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> YEAR
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-END> DEC-31-1998
<CASH> 50,264
<SECURITIES> 126,081
<RECEIVABLES> 74,733
<ALLOWANCES> 11,151
<INVENTORY> 0
<CURRENT-ASSETS> 201,562
<PP&E> 153,789
<DEPRECIATION> 49,805
<TOTAL-ASSETS> 557,879
<CURRENT-LIABILITIES> 186,153
<BONDS> 0
0
0
<COMMON> 765
<OTHER-SE> 137,362
<TOTAL-LIABILITY-AND-EQUITY> 557,879
<SALES> 0
<TOTAL-REVENUES> 503,077
<CGS> 0
<TOTAL-COSTS> 338,051
<OTHER-EXPENSES> 25,235
<LOSS-PROVISION> 897
<INTEREST-EXPENSE> 12,642
<INCOME-PRETAX> 146,722
<INCOME-TAX> 58,719
<INCOME-CONTINUING> 88,003
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 88,003
<EPS-PRIMARY> 1.43
<EPS-DILUTED> 1.40
</TABLE>
