ITEM 1. BUSINESS
(A) GENERAL DESCRIPTION OF BUSINESS
Through its direct and indirect subsidiaries, FHP International Corporation, a Delaware corporation (the "Company"), delivers managed health care services and sells indemnity health, group life and workers' compensation insurance. The Company's oldest subsidiary, FHP, Inc., a California corporation ("FHP"), is a federally qualified multi-state licensed health maintenance organization ("HMO"), which has been operating managed health care programs since 1961. Unless the context otherwise requires, the term "Company" as used in this Form 10-K Annual Report refers to FHP International Corporation and its direct and indirect subsidiaries.
At June 30, 1995, the Company provided a broad range of managed health care services to more than 1,779,000 HMO members, comprised of commercial and governmental employees and Medicare beneficiaries, in 11 states and Guam. These managed health care services include ambulatory and outpatient physician care, hospital care, pharmacy, dental care, eye care, home health nursing, skilled nursing, physical therapy, psychological counseling and health education.
The Company also offers group term life and health insurance products through its insurance subsidiaries. At June 30, 1995, the Company provided group term life insurance coverage for more than 75,000 insureds and group health and accident indemnity insurance coverage for more than 55,000 insureds. In its 24 Hour Managed Care ProgramSM the Company offers in a single package workers' compensation coverage, HMO plans and group indemnity medical, dental and life insurance benefit plans through several of its subsidiaries. The Company also offers third party administration and utilization review services and several PPO networks.
As a result of its June, 1994, acquisition of TakeCare, Inc. ("TakeCare"), the Company owned three separately licensed HMOs in both Colorado and California. On December 31, 1994, the three separately licensed Colorado HMO subsidiaries were merged with each other and the sole surviving Colorado HMO subsidiary, Comprecare Health Care Services, Inc., changed its name to FHP of Colorado, Inc. On March 31, 1995, the three separately licensed California HMO subsidiaries merged with each other and the sole surviving California HMO subsidiary is FHP.
Restructuring of Staff Model Operations
At June 30, 1995, the Company provided staff model HMO services to over 350,000 enrollees in 58 medical centers and dental centers located in southern California, Arizona, Utah, New Mexico, Nevada and Guam. On June 27, 1995, the Company announced that its Board of Directors had approved a plan to restructure its staff model HMO operations by creating a physician practice management company (the "PPMC"). Subject to the receipt of requisite regulatory approvals, the PPMC will become the owner and manager of most of the Company's 58 medical and dental centers and will employ all the personnel in those centers, with the exception of the physicians, dentists and certain other licensed professionals. The physicians, dentists and other professionals will become employees of several newly formed professional corporations ("PCs") and the PCs will enter into long-term management agreements with the PPMC. Under the management agreements, the PPMC will provide the facilities, equipment and support personnel to enable the physicians and dentists to continue their practices with no interruption in service to patients. It is the intention of the Company that the PPMC and PCs will become fully operational on or around January 1, 1996, and that the PCs will continue to provide health care to the Company's HMO members. The PPMC and the PCs also will seek to do business with non-affiliated HMOs and other payors and will provide fee-for-service health care to patients.
Together, the PPMC and PCs will include all the Company's current staff model operations in California, Utah, Arizona, New Mexico and Nevada. In connection with the restructuring, the Company also announced its intention to sell the Company's two acute care hospitals and to sublease or otherwise dispose of the Company's two skilled nursing facilities.
As a part of the restructuring, the Company has reduced the number of its employees by approximately 700 positions. At September 1, 1995, the Company had approximately 13,000 full and part-time employees.
The Company's primary business activities consist of two business segments: HMO services and group life, health and accident and workers' compensation insurance. Information concerning revenue, operating profit or loss and identifiable assets of the Company's two business segments is set forth in the financial statements and related notes included in Part II of this Form 10-K.
(B) HMO DELIVERY MODELS
The Company delivers health care services through independent practice association and group model HMOs in which the Company contracts with individual medical and dental providers, provider networks and multi-specialty medical groups to provide health care in facilities not operated by the Company. The term "IPA" used hereafter in this Form 10-K Annual Report refers to both of these contract HMO models. Each IPA model centers around one or more contract hospitals where IPA physicians maintain practice privileges. The Company's members receive health care through the offices of approximately 51,000 independent contract providers and approximately 600 contract hospitals.
As described above, the Company is undergoing a restructuring of its staff model operation which will result in the redeployment of those operations through the PPMC and PCs. Currently, in its staff model, the Company delivers health care services through an employed staff of primary health care physicians, physician specialists, dentists, nurses and other health care providers. These providers deliver health care to members in Company-operated facilities rather than in the offices of private doctors and dentists. At June 30, 1995, the Company employed approximately 800 primary care physicians and physician specialists, 200 dentists and 5,000 other health care professionals. Company-operated facilities currently include 58 medical and dental centers ranging in size from approximately 2,000 to 95,000 square feet, three acute care hospitals and two sub-acute skilled nursing facilities. With the transfer of these assets and personnel to the PPMC and the PCs, the Company will cease to operate as a staff model. The Company's former staff model HMO members will continue to receive health care services from the PPMC and PCs.
(C) HMO MEMBERSHIP
Commercial Members. As used herein, the term commercial members means all HMO members except Senior Plan/SM/ members. The Company acquires most of its commercial members by contracting with employers that offer health benefits to their employees. These employers generally offer a selection of indemnity and managed health care plans, pay for all or part of the monthly costs thereof and make payroll deductions for any costs payable by the employee. Supplemental benefits such as dental and eye care are often included as part of employer health benefit plans. During a designated open enrollment period, employees may select their desired health care coverage. Monthly premiums are negotiated between the Company and the employers, and are typically fixed for a one-year period. Commercial members comprised approximately 79% of the Company's total membership at June 30, 1995.
Senior Plan Members. The Company also delivers managed health care services to Medicare beneficiaries under its Senior Plan pursuant to contracts with the Health Care Financing Administration ("HCFA") of the United States Department of Health and Human Services ("DHHS"). These contracts entitle the Company to a fixed fee per member premium, and are subject to adjustment annually based on certain demographic information relating to the Medicare population, and the cost of providing health care in a particular geographic area. Senior Plan membership comprised approximately 21% of the Company's total membership at June 30, 1995, but accounted for approximately 47% of the Company's total revenue for the fiscal year. The Company receives substantially more revenue for each Senior Plan member than it receives for each commercial member.
In addition to physician care, hospitalization and other benefits covered by Medicare, Senior Plan benefits also include prescription drugs, routine physical exams, hearing tests, immunizations, eye examinations, counseling and health education services. Senior Plan members are enrolled on an individual basis and may disenroll with 30 days notice. Medicare beneficiaries also can choose to enroll in the Senior Plan PlusSM program which offers more comprehensive medical and dental benefits. Seniors who enroll in this plan pay a monthly premium.
The Company anticipates further growth opportunities for its Senior Plan, based in part on demographic trends that show that the senior population is growing faster than any other segment of the nation's population. The Company is currently one of the largest providers of health care services to Medicare beneficiaries in the United States.
The following table shows an approximate breakdown of the Company's HMO membership at June 30, 1995:
- -------- (1) Includes government employees and Medicaid recipients. (2) Includes mixed model membership in Arizona, New Mexico, Nevada and portions of southern California, where members may choose to receive care in an IPA or staff model setting. (3) Includes approximately 6,000 members located in northwest Indiana. (4) Includes approximately 1,000 members located in southeast Indiana and approximately 16,000 members located in northern Kentucky.
(D) INSURANCE OPERATIONS
The Company also offers group health and life insurance products through its insurance subsidiaries. At June 30, 1995, the Company provided group term life insurance coverage for approximately 75,000 individuals and group health and accident indemnity coverage (including its preferred provider organization) for approximately 55,000 individuals.
24 Hour Managed Care Program. The Company operates a 24 Hour Managed Care Program, which provides HMO and preferred provider organization/indemnity medical coverage and workers' compensation coverage in one coordinated managed care system. Through this program, both occupational and nonoccupational injuries and illnesses are covered by products offered in a single package and administered on a coordinated basis. As of June 30, 1995, the 24 Hour Managed Care Program provided services to approximately 189 employer groups for approximately 24,000 insured employees.
(E) GOVERNMENT REGULATION
Most of the Company's HMO subsidiaries are qualified under the federal Health Maintenance Organization Act of 1973, as amended (the "HMO Act"). In addition, each of the states in which the Company does business has enacted statutes regulating or affecting the HMO subsidiaries. As a result, the
Company is subject to extensive regulation regarding the scope of benefits provided to HMO members and the terms of group benefit agreements, the Company's financial condition, including minimum tangible net equity, quality assurance and utilization review procedures, enrollment requirements, manner of structuring member premiums, member grievance procedures, provider contracts, marketing and advertising. Changes in governmental regulations could adversely affect the operations, profitability and business prospects of the HMO subsidiaries.
An example of such regulations is the Knox-Keene Health Care Service Plan Act of 1975, as amended (the "Knox-Keene Act"), under which the Company's California HMO is licensed. The Knox-Keene Act mandates that the Company's California HMO satisfy California regulatory authorities that it has fiscally sound operations, adequate provision for the risk of insolvency, and working procedures for the prompt payment or denial of claims for payment by health care providers. In addition, the Knox-Keene Act empowers California regulatory authorities to limit the administrative expense of the Company's California HMO to 15% of total revenue. Nearly all of the Company's HMOs outside of California are subject to state regulation similar to the Knox-Keene Act.
California law requires all HMOs and health insurers that offer health care benefit plans to "small groups" in California (employers with 5 to 50 employees) to offer such benefit plans to any small group seeking coverage, and to renew the health coverage of any small group that purchases coverage from the HMO or insurer and desires to renew it, regardless of the health status of the individuals in the group. This legislation also limits the amount by which the premium rates charged to a specific small group by an HMO or insurer can vary from the average community rate charged by such HMO or insurer to other small groups in California. The law also places various other requirements on HMOs and insurers participating in the California small group market, including a requirement to file premium rate information with the state and various restrictions on the terms under which health care coverage can be provided to small groups.
Certain minimum tangible net equity and other financial viability requirements are imposed on the Company's HMO and insurance subsidiaries by regulatory authorities in each state in which these subsidiaries operate and restrict the Company's ability to transfer cash and short-term investments from such subsidiaries to the Company. While the Company currently believes its regulated subsidiaries are in compliance with these minimum tangible net equity and other financial viability requirements, a change in these requirements or an adverse determination by one or more regulatory authorities could have a material adverse effect on the Company's ability to make timely payments on preferred stock dividend obligations and principal and interest obligations under its Credit Agreement and its 7% Senior Notes due 2003. In order to obtain approvals for HMO and insurance company expansions into additional states, the regulated subsidiaries are required to meet certain minimum capital, surplus and deposit requirements which may require the Company to make additional capital contributions to such subsidiaries.
The Company's Senior Plan services are provided under contracts with, and are subject to regulation by, HCFA and certain state agencies. HCFA requires that an HMO be federally qualified in order to be eligible for Medicare fixed fee per member contracts. Under the Company's Medicare contracts and HCFA regulations, if the premiums received for Medicare-covered health care services provided to Senior Plan members are more than the premiums received for the same health care services provided to non-Senior Plan members, then the Company must provide its Senior Plan members with additional benefits beyond those required by Medicare or reduce any of the premiums, deductibles or co-payments that it may charge. The Company's Senior Plan is not permitted to account for more than one-half of the Company's total HMO members in each of the Company's geographic markets as those markets are defined by HCFA. HCFA has the right to audit HMOs operating under Medicare contracts to determine the quality of care being rendered and the degree of compliance with HCFA's contracts and regulations.
The Company's Medicare contracts are renewed annually unless the Company or HCFA elects to terminate the contracts. HCFA also may unilaterally terminate the Company's Medicare contracts if the Company fails to continue to meet compliance and eligibility standards. While the federal government may
implement changes in the Medicare risk-based program, the Company believes that the HMO will continue to be an important factor in the federal government's overall efforts to control medical costs. However, the loss of Medicare contracts or termination or modification of the HCFA risk-based Medicare program could have a material adverse effect on the revenue, profitability and business prospects of the Company. The services reimbursed by Medicare and Medicaid are subject to various requirements and restrictions imposed by contract law and regulation. Non-compliance with government regulations could subject the Company to adverse action by the government. To maintain compliance, the Company will take such action, or modify its practices, as it deems necessary.
Section 9313(c) of the Omnibus Budget Reconciliation Act of 1986 ("OBRA '86") prohibits HMOs with Medicare risk contracts from knowingly making incentive payments to a physician as an inducement to reduce or limit services to Medicare beneficiaries. Sections 4204(a) and 4731 of OBRA '90 repealed the prohibition on all such physician incentive plans, and enacted requirements for regulating these plans. Under these sections, an HMO must: (1) not operate a physician incentive plan that directly or indirectly makes specific payments to a physician or physician group as an inducement to limit or reduce medically necessary services to a specific individual enrolled with the organization; (2) disclose to HCFA their incentive plan arrangements in such detail as to allow HCFA to determine compliance of the arrangements with the DHHS regulations; and (3) provide certain protections to physicians and enrollees where a physician incentive plan places a physician or physician group at "substantial financial risk" for services not provided directly by them.
The Company's Medicare contracts subject it to numerous other federal regulations governing the Medicare program, including the so-called "Medicare and Medicaid anti-kickback statute." The Medicare and Medicaid anti-kickback statute (Section 1128B of the Social Security Act, as amended) provides both civil and criminal penalties for individuals or entities that knowingly and willfully offer, pay, solicit or receive remuneration in return for referrals of business reimbursed under Medicare or Medicaid. Civil penalties include exclusion from participation in the Medicare or Medicaid programs. In 1991, DHHS promulgated a "safe harbor" regulation that defined certain payment practices between providers of Medicare or Medicaid covered services and entities or individuals in a position to refer patients or business to these providers, which would not constitute violations of the statute. On November 5, 1992, DHHS promulgated interim final regulations establishing two new safe harbors and amending one existing safe harbor to provide protection from criminal prosecution and civil sanctions for certain payment practices engaged in by health care plans, including HMOs. This new regulation provides that certain incentives offered to HMO enrollees, such as a reduction or waiver of Medicare coinsurance or deductible amounts paid by the HMO; the waiver of Part A deductible and coinsurance amounts pursuant to an agreement between a hospital and a Medicare insurer; and price reductions or discounts offered to HMOs by contracting health care providers as part of agreements by those providers to furnish Medicare covered services will be deemed not to violate the anti-kickback statute. The Company believes that its payment practices either come within one or more of the safe harbors promulgated in 1991 and 1992, or are not in violation of the anti-kickback statute in any event.
The HMO and insurance subsidiaries of the Company must file periodic reports with, and their operations are subject to periodic examination by, federal and state licensing authorities. To remain licensed and accredited, it is necessary for the Company's HMO and insurance subsidiaries to comply with various fiscal standards imposed by regulatory authorities and to make changes from time to time in their services, procedures, structure and marketing methods. Such changes may be required as a result of amendment to, or other significant modification of, federal and state laws and regulations controlling the subsidiaries' operations.
The Company contracts with the United States Office of Personnel Management ("OPM") to provide or arrange managed health care services under the Federal Employees Health Benefits Program ("FEHBP") for federal employees, annuitants and their dependents. These contracts with OPM and applicable government regulations establish premium rating requirements for the FEHBP. OPM conducts periodic audits of its contractors to, among other things, verify that the premiums established under the OPM contracts are established in compliance with the community rating and other requirements under the FEHBP.
In May 1993, after conducting a periodic audit of the Company's FEHBP contracts covering primarily the years 1988 through 1991, OPM sent a draft audit report to the Company alleging certain defects in the Company's rating practices under applicable regulatory and contractual requirements and invited the Company to comment. Following its evaluation of additional information and comments provided by the Company, the OPM auditors will issue a final report; the OPM Audit Resolution Division will then be responsible for resolving the audit findings. As part of the resolution process, the Audit Resolution Division may reconsider the findings of the auditors and the information provided by the Company.
It is likely that the final audit report will recommend that OPM seek a monetary recovery from the Company and that such recommended recovery could be a substantial amount. At this time, the Company's management and legal counsel are unable to determine the amounts that may be required to be refunded to OPM to resolve the audit findings. Management currently believes, however, that after application of available offsets and consideration of established reserves, amounts ultimately required to be refunded to OPM will not have a material adverse effect on the consolidated financial position or results of operations or cash flows of the Company. In addition, the Company's management currently does not believe that the audit will have a material effect on future relations with OPM.
HCFA has notified the Company and other risk-based contractors that HCFA believes it has erroneously made overpayments over the last three years for health care services provided to dually eligible Medicaid/Medicare ("Medi/Medi") beneficiaries. HCFA began to recoup the alleged overpayments on a quarterly basis from the Company beginning April 1, 1995. The aggregate withholds by HCFA are expected to be approximately $23.5 million. The Company is contesting HCFA's legal authority to recoup such sums as well as the amount of the purported Medi/Medi overpayments. Most of the Company's capitation contracts permit the Company to retroactively reduce payments to providers to reflect changes in payments from HCFA. The Company's contracted providers have been notified that the Company will be recouping overpayments from them as a result of HCFA's recoupments from the Company.
The Company has established reserves based on its best estimate of the amounts it will be unable to recoup from contracted providers. Management currently believes that after consideration of established reserves and the amounts of overpayments which are currently expected to be borne by the contracted providers, amounts ultimately to be recouped by HCFA will not have a material adverse effect on the consolidated financial position or results of operations or cash flows of the Company.
The Company's insurance subsidiaries are regulated by the department of insurance in each of the states in which they operate. These regulations relate to, among other things, the terms, administration and marketing of the products offered and the financial condition of these subsidiaries, and subject these subsidiaries to periodic audits and continuing oversight. In addition, the offering of certain new insurance products may require the approval of these regulatory agencies.
The Company believes that it is in substantial compliance with all governmental regulations affecting its business, the violation of which could have a material adverse effect on its consolidated financial position or results of operations or cash flows.
(F) HEALTH CARE REFORM
There have been diverse legislative and regulatory initiatives at both the federal and state levels to address, among other aspects of the nation's health care system, the continuing increases in health care costs and the lack of health care coverage for a significant segment of the population. Several bills have been introduced in Congress to reform the nation's health care system. These bills include elements such as guaranteed issuance and renewability of health insurance; subsidies for individuals who are uninsured or underinsured; mandates on employers to provide health coverage for their employees; medical savings accounts; mandatory or voluntary regional health alliances or purchasing cooperatives; minimum or standardized health benefit packages; limitations on premiums; medical liability reforms; amendment of the antitrust laws to benefit providers; mandatory or optional single-payer systems for all or part of the
population; and changes in federal tax, Medicare and Medicaid laws and the Employee Retirement Income Security Act of 1974. To varying degrees, many of the bills contemplate the involvement of state governments in the regulation and implementation of federal health care reform legislation.
Various states are considering forms of single-payer systems, restructuring of Medicaid programs and "any willing provider" legislation that could require managed care companies to contract with any medical provider who agrees to the terms of the company's standard provider contract and payment schedule. All or any of these potential forms of legislation could adversely affect the Company's business.
The Company is unable to predict how existing federal or state laws and regulations may be changed or interpreted, what additional laws or regulations affecting its businesses may be enacted or proposed, when and which of the proposed laws will be adopted or what effect the new laws and regulations will have on its businesses. However, certain of the proposals, if adopted, could have a material adverse effect on the Company's business, while others, if adopted, could potentially benefit the Company's business. Although the effects of these activities cannot yet be determined, the Company remains committed to participate in the debate over health care reform and in the restructuring of the health care system.
(G) COMPETITION
The health care and insurance industries are highly competitive. The Company believes that among the most significant competitive factors in the market are the quality and location of the health care providers, the comprehensiveness of coverage and the pricing of services. The Company has a number of competitors, including commercial insurance carriers and other HMOs, some of which have substantially larger memberships and are better capitalized than the Company. In addition to insurance carriers and other HMOs, the Company also competes with fee-for-service physicians, hospitals, and preferred provider organizations which contract directly with employers, thus by-passing HMOs.
The Company's largest HMO competitor in California is Kaiser Foundation Health Plan, Inc. ("Kaiser"), which served approximately 4.7 million members in California at January 1, 1995. In addition to Kaiser, there are at least two other HMOs with more members than the Company in California at January 1, 1995. At June 30, 1995, the Company served approximately 894,000 HMO members in California.
At June 30, 1995, the Company served approximately 314,000 and 179,000 HMO members in Colorado and Utah, respectively, more members than any other HMO in these States. The Company believes that Kaiser is its largest competitor in Colorado and that Intermountain Health Care is its largest competitor in Utah. At June 30, 1995, the Company served approximately 174,000, 47,000 and 40,000 HMO members in Arizona, Nevada and New Mexico, respectively. The Company believes that its largest competitors in Arizona are Intergroup Prepaid Health Services of Arizona and CIGNA Healthplan of Arizona-Phoenix, that its largest competitor in Nevada is Health Plan of Nevada and that its largest competitor in New Mexico is Lovelace Healthplan, Inc.
At June 30, 1995, the Company served approximately 48,000 and 42,000 HMO members in Illinois and Ohio, respectively. The Company believes its largest competitor in Illinois is United HealthCare of Illinois, Inc. and that its largest competitor in Ohio is ChoiceCare. At June 30, 1995, the Company served approximately 38,000 HMO members in Guam. The Company believes its largest competitor in Guam is Guam Memorial Health Plan. At June 30, 1995, the Company served approximately 3,000 members in Texas. The Company believes that Sanus Health Plan, Inc. is its largest competitor in Texas. The Company also believes that Blue Cross and Blue Shield carriers serve a substantial portion of the total health care markets in its service areas.
All membership data for other HMOs is obtained from "The InterStudy Competitive Edge, 1995 Volume 5.2, Number 1," published by InterStudy Center for Managed Care Research, a research organization.
ITEM 2.

ITEM 2. PROPERTIES
The Company currently operates medical and dental centers ranging in size from approximately 2,000 to 95,000 square feet.
The Company currently operates (i) 26 medical and dental centers in southern California, of which 10 are owned and 16 are leased; (ii) 7 medical and dental centers in Utah, of which 6 are owned and 1 is leased; (iii) 14 medical centers in Arizona, of which 4 are owned and 10 are leased; (iv) 3 owned and 2 leased medical centers in New Mexico; (v) 2 medical centers in Nevada, of which one is owned and one is leased; and (vi) 1 owned and 3 leased medical centers in Guam and a neighboring island. The Company also leases two 99-bed sub-acute skilled nursing facilities, owns a hospital licensed for 239 beds and manages another hospital licensed for 150 beds in southern California. The Company also owns a hospital currently licensed for 117 beds in Salt Lake City, Utah. As described in Item 1, the Company has announced its intention to sell the Company's two acute care hospitals and to sublease or otherwise dispose of its two sub-acute skilled nursing facilities.
The Company owns a 40,000 square foot administrative office building in southern California and a 58,000 square foot administrative office building in Utah. The Company also leases administrative offices in more than one dozen states and a public affairs office in California.
On June 30, 1995, the Company owned buildings totaling approximately 1.6 million square feet in size, all but one of which was free of outstanding encumbrances. The Company has a single medical center in southern California which is subject to an encumbrance of approximately $2.5 million. During the fiscal year ended June 30, 1995, the Company leased approximately 2.1 million square feet of buildings subject to annual lease obligations of approximately $27.4 million. In addition, the Company owns nonproductive acreage in California, Utah, Arizona, New Mexico, Nevada and Guam most of which it is planning to sell.
ITEM 3.

ITEM 3. LEGAL PROCEEDINGS
During the ordinary course of business, the Company has become a party to pending and threatened legal actions and proceedings, a significant number of which involve claims of medical malpractice. Management of the Company is of the opinion, taking into account its insurance coverage and reserves that have been established, that the outcome of currently known legal actions and proceedings will not, singly or in the aggregate, have a material effect on the consolidated financial position or results of operations or cash flows of the Company.
ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of security holders, through the solicitation of proxies or otherwise, during the three months ended June 30, 1995.
EXECUTIVE OFFICERS OF THE REGISTRANT
Set forth below are the names of the executive officers of the Company as of September 15, 1995. The executive officers of the Company are chosen annually to serve until the first meeting of the Board of Directors following the next annual meeting of stockholders and until their successors are elected and have qualified, or until death, resignation or removal, whichever is sooner.
Westcott W. Price III, age 56, has been Vice Chairman of the Board of Directors of the Company since 1986, and has been a Director of the Company since 1984. Mr. Price was a Vice President of the Company from 1987 to 1989 and was elected President in 1989. Mr. Price joined FHP in 1981, first serving as Senior Vice President and later as Executive Vice President, and was elected President in 1987. Mr. Price became Chief Executive Officer of the Company in 1990.
Gloria Austin, age 41, joined FHP in 1978 and served in several executive capacities in FHP's Utah and California regional operations, including Associate Vice President, Utah Region Administration and Regional Vice President, Los Angeles. In February 1995, Ms. Austin became the Company's Senior Vice President, Health Care Delivery. In July 1995, Ms. Austin was appointed Senior Vice President, California of the Company's PPMC Division.
Valerie A. Fletcher, age 48, joined FHP in 1989 as Associate Vice President, Finance. In 1992, Ms. Fletcher was appointed Corporate Vice President, Accounting of FHP and in 1993 was elected Controller of the Company. In 1994, Ms. Fletcher became Vice President, Accounting of the Company.
Nick Franklin, age 52, joined FHP in 1990 and served as Vice President, Government Affairs before being appointed Senior Vice President, Public Affairs in 1993. In 1994, Mr. Franklin became Senior Vice President, Public Affairs of the Company.
John F. Fritz, age 51, joined FHP in 1991 and served as Vice President and Chief Actuary of FHP and FHP Life Insurance Company before becoming President of FHP Life Insurance Company and a Senior Vice President of the Company in 1994. From 1976 to 1991, Mr. Fritz was a Vice President and Principal of Tillinghast, a Towers Perrin Co., in Irvine, California.
Gary E. Goldstein, M.D., age 45, joined FHP in 1982 from private practice and has held the positions of Regional Medical Director, Corporate Medical Director, and California Regional Vice President. He was appointed Corporate Vice President of Medical Affairs in 1990 and in 1992, a Senior Vice President of FHP. In 1994, Dr. Goldstein was appointed Senior Vice President, Medical Affairs of the Company. In July 1995, Dr. Goldstein was appointed Senior Vice President and Chief Medical Officer of the Company's PPMC Division.
Burke F. Gumbiner, age 44, has been a Director of the Company since 1984 and was a Vice President from 1986 to November 1989, when he was appointed Senior Vice President. He joined FHP in 1977 and served in several executive capacities before being appointed a Senior Vice President in 1986. In 1994, Burke Gumbiner was appointed Senior Vice President and Chief Operating Officer, Insurance and Support Services of the Company. In August 1995, Mr. Gumbiner was appointed President of the Company's Insurance Division.
R. Judd Jessup, age 47, joined the Company in 1994 as President of its Health Plans Division. In July 1995, Mr. Jessup was appointed President of the Company's HMO Division. Mr. Jessup was TakeCare Health Plan, Inc.'s Executive Director from June 1987 to January 1990 and was its President from January 1990 to March 1995. He served as President of TakeCare, Inc. from 1991 until June of 1994 when it was acquired by the Company.
Jeffrey H. Margolis, age 32, joined the Company in 1994 as Vice President, Information Services and Chief Information Officer. From 1993 to 1994, Mr. Margolis was Vice President and Chief Information Officer of TakeCare, Inc. From 1989 to 1991, Mr. Margolis was Director of Information Services of Comprecare, Inc. and from 1991 to 1993 he was Vice President and Chief Information Officer of Comprecare, Inc. In June 1995, Mr. Margolis was appointed a Senior Vice President of the Company.
Jack D. Massimino, age 46, first joined FHP in 1975 and served in several executive capacities, including Utah Regional General Manager, before leaving FHP in 1979 to join a health care consulting firm. He later served as President, CEO and a Director of Texas Health Plans from 1987 to 1988. In 1988, he returned to FHP as Vice President of Corporate Development and in 1990 was appointed a Senior Vice President of FHP. From 1994 to 1995 he served as the Company's Executive Vice President and Chief Operating Officer. In July 1995, Mr. Massimino was appointed President of the Company's PPMC Division.
Michael A. Montevideo, age 41, joined FHP in 1985, became Treasurer of the Company and FHP in 1989 and was appointed an Associate Vice President of FHP in 1990 and a Vice President of FHP in 1993. In 1994, Mr. Montevideo became a Vice President of the Company.
Kenneth S. Ord, age 49, joined the Company in 1994 as Senior Vice President and Chief Financial Officer. From 1982 to 1994, he was employed by Kelly Services, Inc. in Troy, Michigan most recently as Vice President of Finance, Controller and Treasurer.
Eric D. Sipf, age 46, joined the Company in 1994 as Senior Vice President of Health Plans of the Company's Eastern Division. From 1985 to 1993, he was President and Chief Executive Officer of Comprecare, Inc. and from 1993 to 1994 was President of Comprecare Health Care Services, Inc. and TakeCare of Colorado, Inc.
Michael J. Weinstock, age 54, has been General Counsel and Secretary of the Company and FHP since 1987. He became a Vice President of the Company and FHP in 1989 and a Senior Vice President of the Company and FHP in 1993.
PART II
ITEM 5.

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
(A) MARKET INFORMATION
The Company's Common Stock is traded over-the-counter on the National Association of Securities Dealers Automated Quotation ("NASDAQ") National Market System under the symbol "FHPC." The following table sets forth the range of high and low closing bid prices per share for the fiscal periods indicated, as reported on the NASDAQ National Market System. Quotations represent prices between dealers and do not reflect retail markups, mark-downs or commissions and may not necessarily represent actual transactions.
As of September 15, 1995, the reported closing bid price per share was $23.00.
(B) HOLDERS
The approximate number of holders of record of the Company's Common Stock as of August 31, 1995 was 730. This number did not include individual participants in security position listings. Based on available information, the Company believes there are several thousand beneficial holders of its Common Stock.
(C) DIVIDENDS
The Company has retained its fiscal year 1995 earnings for use in its business and anticipates, for the foreseeable future, that no cash dividends will be paid on its Common Stock. The Company's Amended Credit Agreement restricts the payment of cash dividends on the Company's Common Stock.
ITEM 6.

ITEM 6.SELECTED FINANCIAL DATA
Information with respect to this item is located at page 14 herein.
ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Information with respect to this item is located at pages 15 through 19 herein.
ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The following documents are filed as part of this Form 10-K Annual Report:
ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
There have been no changes in the Company's independent auditors or disagreements with such auditors on accounting principles or practices or financial statement disclosures.
PART III
ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Information with respect to Directors of the Company is incorporated by reference from the Company's 1995 Proxy Statement. Certain information relating to Executive Officers of the Company appears on pages 9 through 10 herein.
ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION
Information with respect to this item is incorporated by reference from the Company's 1995 Proxy Statement.
ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
Information with respect to this item is incorporated by reference from the Company's 1995 Proxy Statement.
ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Information with respect to this item is incorporated by reference from the Company's 1995 Proxy Statement.
PART IV
ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
The following documents are filed as part of this Form 10-K Annual Report:
(a) Exhibits:
See the Exhibit Index on pages 43 through 45 herein.
(b) Financial Statement Schedules:
None.
(c) Reports on Form 8-K:
None filed during the three months ended June 30, 1995.
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.
FHP INTERNATIONAL CORPORATION
By /s/ Westcott W. Price III ------------------------------ Westcott W. Price III, Chief Executive Officer and President
Date: September 27, 1995
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 and on the date indicated.
FHP INTERNATIONAL CORPORATION
SELECTED FINANCIAL DATA
- -------- (a) The Company acquired all of the outstanding common stock of TakeCare on June 17, 1994, as explained in Note 12 of the Notes to Consolidated Financial Statements. The Consolidated Financial Statements include the operations of TakeCare beginning June 17, 1994.
(b) Earnings per share were computed as explained in Note 11 of the Notes to Consolidated Financial Statements.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
BUSINESS RESTRUCTURING
In June, 1995, FHP International Corporation ("FHP" or the "Company") announced an internal restructuring (the "Restructuring Plan") of its operations. The Restructuring Plan was formulated in response to the intensely competitive environment in the HMO industry and continued declining membership in its Company-operated medical facilities. The Restructuring Plan consists of the sale of the Company's owned and operated hospitals, certain nonproductive real estate and other assets; a reduction in the Company's work force; and the creation of three distinct business segments: 1) a physician practice management company ("PPMC"); 2) the contract model health maintenance organization ("HMO"); and3) the Company's group life, health and accident and workers' compensation insurance and related products (collectively, the "Insurance Group").
The Restructuring Plan provides for sale of the Company's two acute care hospitals located in Fountain Valley, California and Salt Lake City, Utah (with a combined total of 356 licensed beds), sublease of two sub-acute facilities, disposal of certain nonproductive real estate and other assets, discontinuance of the Company's consulting product line and a reduction of the Company's work force. Accordingly, the Company recorded a pretax charge against earnings in the fourth quarter of $75.1 million. The charge primarily includes the write- down to the estimated net realizable value of the hospitals and other assets held for sale and costs associated with a reduction in work force of approximately 500 employees which took place in June, 1995. The Company further reduced its work force by approximately 200 employees in the first quarter of fiscal year 1996. Further reductions in the work force are likely. The costs of fiscal year 1996 work force reductions, together with costs associated with establishing the PPMC, will result in an additional provision for restructuring in fiscal year 1996 of up to $10 million. All asset sales that are part of the Restructuring Plan are expected to be completed by June 30, 1996. Net proceeds available from the sale of assets will be used to reduce indebtedness and for other corporate purposes.
The Restructuring Plan includes the creation of the PPMC, as a new subsidiary of the Company and the transfer of the Company's medical centers and related assets (located in California, Arizona, Utah, Nevada, and New Mexico) into the PPMC. Approximately 7,000 of the Company's employees, including health care professionals, will become employees of the PPMC or of several newly created professional corporations (the "PCs"). The PCs will enter into long-term practice management agreements with the PPMC, thereby enabling the PCs and PPMC to do business with other payors and HMOs, as well as with the Company's HMO. The PCs and PPMC are expected to be operational by January 1, 1996, subject to obtaining all necessary regulatory approvals.
The Company's HMO will be responsible for all the Company's HMO membership. The HMO will contract with the PCs to provide health care services for approximately 20% of the Company's HMO members who are already receiving health care in the Company's medical centers. The Company's contractual arrangements between the HMO and PCs will be financially similar to existing contracts between the HMO and other contract health care providers.
The Company will continue to operate its Insurance Group. The Insurance Group accounted for 3.7% of the Company's revenue and incurred an operating loss in fiscal year 1995. The products offered by the Insurance Group enable the Company to offer a full complement of health care products to employer groups.
TAKECARE ACQUISITION
The Company acquired TakeCare, Inc. and its subsidiaries ("TakeCare") on June 17, 1994. The Company acquired all of the outstanding stock of TakeCare, for approximately $1,054.4 million. The acquisition was paid for by the issuance of approximately 21 million shares of Series A Cumulative Convertible Preferred Stock, 6.3 million shares of Common Stock, 79.2 thousand shares of Series B Adjustable Rate Cumulative Preferred Stock and approximately $360 million of cash.
REVENUE AND MEMBERSHIP
The Company generates approximately 96% of its revenue from premiums received for health care services provided to the HMO members of its wholly-owned subsidiaries. The Company experienced significant revenue growth during the three-year period ended June 30, 1995, primarily due to the acquisition of TakeCare in June, 1994, and to growth in its HMO membership. Total revenue for the year endedJune 30, 1995, was $3,909.4 million, increasing 58.1% over revenue of $2,473.0 million for the previous year. The Company's year-over-year revenue growth was primarily due to the TakeCare acquisition. During fiscal year 1995, revenue growth was slowed by modest enrollment growth and intense pricing competition.
Total HMO membership grew 17.0%, 104.3%, and 3.9% in the three years ended June 30, 1993, 1994, and 1995, respectively. Membership growth in fiscal year 1994 was primarily due to the acquisition of TakeCare on June 17, 1994. Excluding TakeCare membership, total HMO membership growth in fiscal year 1994 was 10.5%. During fiscal year 1995, the Company experienced slower membership growth than in prior years, due primarily to intense competition in all its key markets. Membership growth in fiscal year 1995 resulted from contiguous expansion of HMO operations into new market areas, together with growth in existing markets. The Company's membership in fiscal year 1995 grew primarily in the Company's contract model plans. As FHP and TakeCare merged their California operations, the Company lost approximately 14,000 former TakeCare plan members in fiscal year 1995. Also, membership in Company-operated medical centers continued to decline. Continued slow membership growth may adversely impact the Company's operating results in fiscal year 1996.
Commercial HMO membership grew 15.4%, 152.6%, and 2.9% for the years ended June 30, 1993, 1994, and 1995, respectively. Commercial HMO membership growth in fiscal year 1994 was primarily due to the acquisition of TakeCare. Excluding TakeCare commercial membership, commercial HMO membership growth in fiscal year 1994 was 10.7%. Senior membership grew 20.2%, 16.8%, and 7.8% for the fiscal years ended June 30, 1993, 1994, and 1995, respectively. Excluding TakeCare senior membership, senior HMO membership growth in fiscal year 1994 was 10.1%. During fiscal year 1995, regulatory approvals necessary for senior membership expansion in northern California were delayed, causing lower than expected senior growth. Regulatory approvals were completed in the fourth quarter of fiscal year 1995.
The Company generates approximately 51% of its HMO revenue from sales to the commercial market. The Company's ability to increase its commercial membership and commercial premium rates during the fiscal years ended June 30, 1994 and 1995, was adversely impacted by intense competition in all the Company's major markets, particularly in California. In addition, certain large employer groups and other purchasers of health care services continue to demand minimal increases or reductions in premium rates. Downward pressure on premium rates is expected to continue into fiscal year 1996 in all of the Company's major service areas. A substantial portion of the Company's HMO commercial premium rate increases becomes effective in January of each year.
Almost all of the Company's senior HMO revenue is generated from premiums paid to the Company by the Health Care Financing Administration ("HCFA"). The Company receives senior premium rate increases from HCFA on January 1 of each year. For calendar year 1995, the Company received an average 5.8% rate increase. Revenue per senior member is substantially higher than revenue per commercial plan member because senior members use substantially more health care services. In September of each year, HCFA announces the annual Medicare rate increases that will become effective on January 1 of the subsequent year. These rate increases vary geographically and become the basis for determining the amounts that HCFA will pay to the Company. Based upon the September, 1995, announcement, the Company currently estimates that it will receive an average 3.5% senior premium rate increase on January 1, 1996.
For the year ended June 30, 1995, the Company generated approximately 3.7% of its revenue from the sale of indemnity health, group life and workers' compensation insurance, and related lines of business. This compares to 4.4% for the previous fiscal year. In fiscal year 1994, the Company increased its investment in
the Insurance Group by approximately $25.0 million. During fiscal year 1995, the Company was faced with rate deregulation for workers' compensation insurance in California resulting in substantial rate decreases and loss of business in the state. Also, the Company's indemnity health subsidiaries have been facing an increasingly competitive market. The Company does not anticipate that its Insurance Group will represent a material portion of revenues or profits in fiscal year 1996.
COST OF HEALTH CARE
A significant factor affecting the Company's profitability is its ability to manage and control its health care costs. Since the Company receives fixed monthly premiums, an unusually high number of catastrophic claims (such as organ transplants and costly premature births) may cause substantial additional health care costs. Periodically, the Company's results of operations may be affected by such costs. Management believes that the Company's cost control measures, which include risk-sharing arrangements with its contract medical providers along with administrative and medical review of its health care delivery services, help to mitigate the effects of rising health care costs.
During the last three years, certain Company-operated medical centers in California have experienced high operating costs relative to declining enrollment. The economic recession has resulted in permanent job losses in certain industries in southern California whose employees were traditionally enrolled in Company-operated medical centers. Also, the competitive environment and the proliferation of managed care health plan choices have contributed further to a decline in membership in Company-operated medical centers. This has created excess capacity and therefore, higher health care costs as a percentage of revenue.
The following table sets forth the percentage relationships of various income statement items to revenue for the periods indicated:
Fiscal Year 1995 Compared to Fiscal Year 1994
Revenue increased 58.1% to $3,909.4 million for fiscal year 1995 from $2,473.0 million for fiscal year 1994, primarily due to the acquisition of TakeCare.
Health care costs increased 57.4% to $3,238.5 million for fiscal year 1995 from $2,057.7 million for fiscal year 1994, primarily due to the TakeCare acquisition. Health care costs decreased to 82.8% of revenue in 1995 from 83.2% in 1994, primarily due to the lower average cost of health care in the former TakeCare health plans. Notwithstanding the year-over-year improvement, the Company's cost of health care was adversely impacted by excess capacity in Company-operated medical centers.
General, administrative, and marketing ("G&A") expenses increased 57.0% to $521.7 million for fiscal year 1995 from $332.2 million for fiscal year 1994, primarily as a result of the acquisition of TakeCare. G&A expenses as a percentage of revenue were 13.3% in fiscal year 1995, down slightly from 13.4% in fiscal year 1994. Fiscal year 1995 G&A expenses included approximately $26.7 million of goodwill amortization arising from the TakeCare transaction on June 17, 1994. In fiscal year 1994, goodwill amortization relating to the TakeCare transaction was approximately $1.0 million.
Net interest income was $6.1 million for fiscal year 1995 as compared to $13.8 million for the previous year. Net interest income declined year-over- year, primarily because of additional interest expense due to an increase in debt related to the acquisition of TakeCare.
Fiscal Year 1994 Compared to Fiscal Year 1993
Revenue increased 23.3% to $2,473.0 million for fiscal year 1994 from $2,005.9 million for fiscal year 1993. Approximately 67.3% of revenue was generated by contract model membership, and approximately 28.3% of revenue was generated by membership in Company-operated medical centers during fiscal year 1994. Approximately 4.4% of the Company's revenue was generated by the Insurance Group.
Health care costs increased 22.4% to $2,057.7 million for fiscal year 1994 from $1,681.1 million for fiscal year 1993, primarily due to membership growth during the period. Health care costs decreased to 83.2% of revenue in 1994 from 83.8% in 1993, primarily due to improvement in the Company's health administration and health operations costs. In addition, pharmacy costs in Arizona, as well as optometry costs in California and Nevada, were significantly reduced. The Company experienced certain health care cost increases during the year. In Utah, the Company opened its own acute care hospital in August, 1993. The hospital did not reach break-even occupancy by the end of the fiscal year. California and Nevada experienced higher physician services costs as a percent of revenue in fiscal year 1994 than in fiscal year 1993.
G&A expenses increased 23.2% to $332.2 million for fiscal year 1994 from $269.6 million for the fiscal year 1993, primarily as a result of growth in the Company's operations. G&A expenses as a percentage of revenue were 13.4% in fiscal year 1994, unchanged from 13.4% in fiscal year 1993. Cost control measures included hiring freezes, reductions in the Company's work force, and administrative reorganizations.
Net interest income was $13.8 million for fiscal year 1994 as compared to $14.7 million for the previous year. The decrease in net interest income was primarily the result of interest expense on $100 million of 7% Senior Notes due 2003 (the "Notes") issued in September, 1993, and a decrease in capitalized interest of approximately $2 million, due to the completion of several major construction projects including the Company's Utah hospital. The decreases were partially offset by higher average invested cash balances during the period.
LIQUIDITY AND CAPITAL RESOURCES
The Company's consolidated cash, cash equivalents, and short-term investments increased by $209.6 million to $456.4 million at June 30, 1995, from $246.8 million at June 30, 1994. The increase includes the early receipt in June, 1995, of approximately $152.0 million of premiums from HCFA due on July 1, 1995, for medical services to be provided to senior members in July, 1995. Other major sources of cash during the fiscal year ended June 30, 1995, included cash generated from operations (net of the early receipt of HCFA premiums) of $135.0 million and net transfers of $37.4 million from long-term investments. Uses of cash during fiscal year 1995 included $72.1 million for capital expenditures, $26.3 million for Preferred Stock dividends, and $35.2 million net reductions in borrowings.
In order to fund a major portion of the cash required for the TakeCare acquisition, the Company entered into a $350 million Credit Agreement (the "Credit Agreement") in March, 1994. The Credit Agreement originally provided for a $250 million five-year Term Loan facility (the "Term Loan") and a $100 million five-year Revolving Credit facility (the "Revolving Credit Loan"). The Credit Agreement was amended in March, 1995, and currently provides a $200 million Revolving Credit Loan and a $150 million Term Loan. The Term Loan and Revolving Credit Loan carry interest rates currently ranging from 6.1% to 6.9% based on LIBOR rate borrowings. The Term Loan is repayable at the rate of $15 million every six months, commencing on September 29, 1995. The final payment is due March 31, 2000. The Credit Agreement contains financial and other covenants, including limitations on indebtedness, liens, dividends, sale and lease-back transactions, and certain other transactions.
The Company's ability to make a payment on, or repayment of, its obligations under the Notes, the Credit Agreement, and dividends on its preferred stock is significantly dependent upon the receipt of funds by the Company from the Company's direct and indirect subsidiaries. These subsidiary payments represent: (a) fees for management services rendered by the Company to the subsidiaries; and (b) cash dividends by the subsidiaries to the Company. Nearly all of the subsidiaries are subject to HMO regulations or insurance regulations and may be subject to substantial supervision by one or more HMO regulators and insurance regulators (the "Regulated Subsidiaries"). Each of the Regulated Subsidiaries must meet or exceed various fiscal standards imposed by HMO regulations or insurance regulations. These fiscal standards may, from time to time, impact the amount of funds paid by one or more of the Regulated Subsidiaries to the Company.
The Company believes the payments referred to above by the Regulated Subsidiaries, together with other financing sources, including the Credit Agreement, should be sufficient to enable the Company to meet its payment obligations (totaling approximately $80 million annually) under the Notes, the Credit Agreement and the Company's Preferred Stock. The Company believes that cash flow from operations, the Credit Agreement and existing cash balances will be sufficient to continue to fund operations and capital expenditures for the foreseeable future. Also, sales of real property under the Restructuring Plan are expected to generate net cash to the Company in fiscal year 1996 which is intended to be used to reduce indebtedness and for other corporate purposes.
Effects of Regulatory Changes and Inflation
Recently, the Company has been informed by HCFA that effective January 1, 1996, it will receive an annual premium rate increase of approximately 3.5% for its Senior Plan members. Over calendar years 1994 and 1995, annual Senior Plan premium increases granted by HCFA were approximately 2.0% and 5.8%, respectively. Periodically, the Company evaluates the effects of HCFA premium adjustments on its liquidity and capital resources, and incorporates the actual and anticipated impact of such adjustments into its planning process.
The Company has been experiencing significant downward pressures on commercial HMO membership growth and premium rates due to competition and measures by large employer groups and other purchasers of health care services attempting to hold their costs down. The Company may not be able to obtain premium rate increases and may see some premium rate reductions in its commercial HMO business in the short term. Also in recent years health care costs have been rising at a rate higher than that for consumer goods as a whole, as a result of inflation, new technology, and medical advances. There can be no assurance that these trends will be reversed in the short term.
FHP INTERNATIONAL CORPORATION
CONSOLIDATED BALANCE SHEETS
ASSETS
See accompanying Notes to Consolidated Financial Statements.
FHP INTERNATIONAL CORPORATION
CONSOLIDATED STATEMENTS OF INCOME
See accompanying Notes to Consolidated Financial Statements.
FHP INTERNATIONAL CORPORATION
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
See accompanying Notes to Consolidated Financial Statements.
FHP INTERNATIONAL CORPORATION
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (CONTINUED)
See accompanying Notes to Consolidated Financial Statements.
FHP INTERNATIONAL CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
See accompanying Notes to Consolidated Financial Statements.
FHP INTERNATIONAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1--ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES
Organization
FHP International Corporation (the "Company"), through its direct and indirect subsidiaries, delivers managed health care services and sells indemnity medical, group life, and workers' compensation insurance.
On June 17, 1994, the Company completed its acquisition of TakeCare, Inc. ("TakeCare") in exchange for cash, Common Stock, and Preferred Stock. The acquisition was accounted for as a purchase business combination, and consequently, all balances and results of operations of TakeCare since the date of acquisition have been included in the accompanying financial statements (Note 12).
Most of the Company's subsidiaries are federally qualified, licensed health maintenance organizations ("HMO") which provide comprehensive health care to their members for a fixed monthly fee per member. In the course of providing health care services to commercial and governmental employees, the Company extends credit to various federal government agencies and hospitals, independent physician groups, and to other health care providers and intermediaries located in California, Colorado, Arizona, Utah, Guam, New Mexico, Texas, Illinois, Nevada, Ohio, Indiana, and Kentucky.
Principles of Consolidation
The accompanying consolidated financial statements include the accounts of the Company and its subsidiaries. All significant intercompany accounts and transactions have been eliminated.
Regulatory Requirements
The Company's regulated subsidiaries must comply with certain minimum capital or tangible net equity requirements in each of the states in which they operate. As of June 30, 1995, all of the Company's regulated subsidiaries were in compliance with these requirements.
Revenue Recognition and Health Care Costs
Medicare risk contracts with the Health Care Financing Administration ("HCFA") provided 45%, 63%, and 65% of revenue in fiscal years 1995, 1994, and 1993, respectively. The Company's HMOs are paid a prospectively determined per capita monthly payment for each Medicare beneficiary enrolled in the HMOs. This capitated payment is the projected actuarial equivalence of 95% of the amount Medicare would have paid for the Medicare beneficiaries if they had received services from a fee for service Medicare provider or supplier. The HMOs must absorb any difference between the Medicare prepaid amounts and the actual costs the HMOs incur for providing services and are therefore at risk.
Premiums from enrolled groups for prepaid health care are recognized as revenue in the month in which the enrollees are entitled to care. Unearned premiums represent cash received from employer groups and HCFA in advance of the applicable period of coverage. Health care costs are recorded in the period when services are provided to enrolled members, including estimates for contracted medical specialists and hospital costs which have been incurred as of the balance sheet date but not yet reported. The estimates for accrued health care costs are based on historical studies of claims paid. The methods for making such estimates and for establishing the resulting reserves are continually reviewed and updated, and any adjustments resulting therefrom are reflected in current operations. While the ultimate amount of claims and the related expenses paid are dependent on future developments, management is of the opinion that the liability for medical claims payable is adequate to cover such medical claims and expenses.
FHP INTERNATIONAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
Advertising Costs
The Company recognizes advertising costs in accordance with the American Institute of Certified Public Accountants' Statement of Position 93-7, "Reporting on Advertising Costs."
Advertising expense was $37,018,000, $23,800,000, and $17,018,000 for the fiscal years ended June 30, 1995, 1994, and 1993, respectively.
Cash Equivalents
The Company considers all highly-liquid investments with a maturity of three months or less when purchased to be cash equivalents. The carrying value of cash and cash equivalents approximates fair value based on their short-term maturity.
Short-term, Long-term, and Restricted Investments
Effective June 30, 1994, the Company adopted Statement of Financial Accounting Standards No. 115 ("SFAS 115"), "Accounting for Certain Investments in Debt and Equity Securities." The Company has classified all of its investment portfolio as "available-for-sale." In accordance with SFAS 115, investments classified as available-for-sale are carried at fair value, and unrealized gains or losses (net of applicable income taxes) are reported in a separate caption of stockholders' equity.
Short-term, long-term, and restricted investments consist of U.S. Treasury securities, certificates of deposit, and other marketable debt securities. Long-term investments have maturities in excess of one year. Restricted investments primarily include investments placed on deposit with various state regulatory agencies to comply with regulatory requirements.
Income Taxes
The Company utilizes the asset and liability method of accounting for income taxes. Under this method, income taxes are recognized for (a) the amount of taxes payable or refundable for the current year and (b) deferred tax liabilities and assets for the future tax consequences of events that have been recognized in the Company's financial statements or tax returns. The effects of income taxes are measured based on enacted tax law and rates. Deferred tax assets and liabilities are established for temporary differences between the financial reporting basis and tax basis of the Company's assets and liabilities at tax rates expected to be in effect when such assets or liabilities are realized or settled.
Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of
In March, 1995, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 121 ("SFAS 121"), "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of." As permitted by SFAS 121, the Company elected to adopt the statement as of June 30, 1995. In accordance with SFAS 121, long-lived assets to be held will be reviewed for events or changes in circumstances which would indicate that the carrying value may not be recoverable. Assets held for sale are accounted for at the lower of carrying amount or fair value, less costs to sell, since management has committed to a plan to dispose of the assets. The adoption of SFAS 121 had no effect on the consolidated financial statements for fiscal year 1995. In accordance with SFAS 121, prior period financial statements have not been restated.
FHP INTERNATIONAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
Property and Equipment
Property and equipment are recorded at cost. Depreciation and amortization are provided principally by the straight-line method over the estimated useful lives of the respective classes of assets as follows: buildings, 20 to 40 years; leasehold improvements, lesser of the useful lives (three to ten years) or the lease term; and equipment and fixtures, three to ten years. Property and equipment also includes capitalized interest expense of approximately $471,000, $596,000, and $2,597,000 in fiscal years 1995, 1994, and 1993, respectively, associated with the Company's major construction projects.
Goodwill and Other Intangibles
Goodwill arose primarily from the purchase of TakeCare (Note 12). Amortization is provided on a straight-line basis over periods not exceeding 40 years. In addition to goodwill, other intangible assets resulting from business acquisitions consist of the economic value of purchased membership, customer contracts, and covenants not-to-compete. Intangibles are amortized on a straight-line basis over their estimated useful lives ranging from 3 to 30 years. The Company periodically evaluates whether events and circumstances have occurred which may affect the estimated useful life or the recoverability of the remaining balance of its intangibles. At June 30, 1995, the Company's management believed that no material impairment of goodwill or other intangible assets existed. Amortization charged to continuing operations amounted to $31,506,000, $5,284,000, and $1,163,000 for fiscal years 1995, 1994, and 1993, respectively. Accumulated amortization was $34,738,000, $6,685,000, and $1,401,000 for the fiscal years ended June 30, 1995, 1994, and 1993, respectively.
Other Assets
The principal components of other assets are as follows:
Reclassifications
Certain prior year amounts have been reclassified to conform to the 1995 financial statement presentation.
FHP INTERNATIONAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 2--PROPERTY AND EQUIPMENT
Property and equipment consist of the following:
In June, 1995, the Company's Board of Directors authorized the sale of the Company's two acute care hospitals and other nonproductive real estate (Note 13). Property and equipment with an estimated net realizable value of $136,477,000 have been reclassified to assets held for sale in the Consolidated Balance Sheets as of June 30, 1995.
Total depreciation and amortization expense related to property and equipment was $48,559,000, $39,987,000, and $28,749,000 for fiscal years 1995, 1994, and 1993, respectively.
NOTE 3--OTHER LIABILITIES
From January, 1984, through March, 1986, the Company maintained commercial insurance on a claims occurrence basis with nominal deductibles. Since April, 1986, the Company has maintained commercial insurance on a claims made basis. The Company currently carries $50,000,000 of professional liability insurance with annual deductibles of $2,000,000 per occurrence and $12,000,000 in the aggregate.
An estimate of the Company's liability for professional liability claims, including deductibles, was actuarially computed on a present value basis using a discount rate of 7%, and amounted to approximately $35,525,000 and $31,400,000 at June 30, 1995 and 1994, respectively. Such amounts are allocated between other current liabilities and other liabilities based on estimates of the amounts of claims which will be paid during the subsequent fiscal year (Note 8).
Other liabilities also include approximately $30,001,000 and $40,785,000 of reserves for losses and loss adjustment expenses at June 30, 1995 and 1994, respectively, associated with the Company's insurance operations. These reserves are estimates based on actuarial computations and industry standards for the eventual costs of claims incurred but not settled, less reinsurance recoverable from other companies.
As claims are settled, as amounts required to settle become known, and as anticipated claims are actuarially revised, the professional liability and loss reserve expenses and liabilities are adjusted accordingly.
FHP INTERNATIONAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 4--LONG-TERM OBLIGATIONS
Long-term obligations consist of the following:
Scheduled maturities of long-term obligations are as follows:
In March, 1994, in connection with the acquisition of TakeCare (Note 12), the Company entered into a $350 million credit agreement with a group of banks which provided for a $250 million term loan facility and a $100 million revolving credit facility (the "Credit Agreement"). The Credit Agreement was amended in March, 1995, and currently provides a $200 million revolving credit facility and a $150 million term loan facility. The amended Credit Agreement expires March 31, 2000. Prime rate, LIBOR based, and competitive bid (revolving credit facility only) interest rate options are available for borrowings under the Credit Agreement. In addition, a facility fee of 0.125% is payable, regardless of usage, on the $200 million revolving credit facility portion of the Credit Agreement.
The Credit Agreement contains financial and other covenants. The Company was in compliance with these covenants as of June 30, 1995.
FHP INTERNATIONAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 5--INCOME TAXES
The components of the provision for income taxes are summarized as follows:
The deferred (benefit) provision for income taxes results from reporting the following items in different periods for financial statement and income tax purposes:
The provision for income taxes differs from the amount of tax determined by applying the Federal statutory rate to pretax income. The components of this difference are summarized as follows:
FHP INTERNATIONAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
The tax effects of significant items comprising the Company's net deferred tax assets are as follows:
There was no change in the valuation allowance during the years ended June 30, 1995 and 1994.
NOTE 6--INVESTMENTS AND FAIR VALUE OF OTHER FINANCIAL INSTRUMENTS
Gross unrealized gains and losses and a comparison of amortized cost and estimated fair value are presented in the table below:
FHP INTERNATIONAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
Realized gains or (losses) on available-for-sale investments are calculated on the specific identification method and were $5,232,000 and ($880,000), respectively, in fiscal year 1995.
The contractual maturities of short-term, long-term, and restricted investments at June 30, 1995, were as follows:
The Company also determined that investments, classified as short-term, are available for use in current operations and, accordingly, classified such investments as current assets without regard to the investments' contractual maturity dates.
The fair value of short-term, long-term, and restricted investments is estimated based on quoted market prices. The fair value of the Company's long- term obligations are estimated to be equivalent to its carrying value.
FHP INTERNATIONAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 7--EMPLOYEE BENEFITS
The Company has a defined contribution pension plan ("Pension Plan") and an Employee Stock Ownership Plan ("ESOP") covering substantially all employees. Under the provisions of these plans, the Company contributed into trusts for the benefit of employees an amount equal to 12% of eligible annual compensation, as defined, of all plan participants. Effective January 1, 1995, the contribution rate was reduced to 8% of eligible annual compensation, as defined. Participants do not vest until they have completed five years of service with the Company. Nonvested contributions, which are forfeited upon an employee's termination, are treated as a reduction in the amount of the Company's contribution. The combined contribution expenses for the Pension Plan and ESOP were $32,844,000, $35,020,000, and $32,970,000 for fiscal years 1995, 1994, and 1993, respectively.
Under an Executive Incentive Plan (the "Plan"), the Company is authorized to grant restricted stock awards, incentive stock options, nonqualified stock options, and bonus awards to directors, officers, key employees, consultants, and other agents. Under the terms of the Plan, the exercise price of the stock options must be equal to the fair market value of the Company's Common Stock at the date of grant. All stock options granted by the Company through June 30, 1995, were nonqualified.
Beginning July 1, 1992, the first of a series of four annual stock option grants were made to certain executives under the Plan. These grants are intended to provide a strong linkage between long-term incentives and the Company's financial performance. Accelerated vesting of each of these stock options is tied directly to growth in the Company's earnings per share ("EPS"). Total stock options for 300,000, 435,000, and 1,085,000 shares were granted under this plan on July 1, 1994, 1993, and 1992, respectively. Each year's stock option grant allows the optionee up to six consecutive annual opportunities for accelerated vesting of portions of the employee's stock options only if the Company's EPS exceeds both: (1) EPS for the previous fiscal year and (2) average EPS for the two previous fiscal years. The terms of accelerated vesting for 25% of the stock options granted on July 1, 1992, and 10% of the stock options granted on July 1, 1993, have been met. The terms of accelerated vesting for stock options granted July 1, 1994, have not been met. If a stock option in the series does not become subject to accelerated vesting by the sixth anniversary of its grant, the stock option automatically becomes vested on the seventh anniversary of its grant. The Company may periodically issue stock options under similar terms and conditions as those above.
In addition to the options described above, the Company has granted other options. All options granted are included in the following summary of stock option activity for fiscal years 1995, 1994, and 1993:
At June 30, 1995, 1,179,000 shares remained available under the Plan for future grants of stock awards and stock options. Outstanding stock options at June 30, 1995, expire at the earlier of the date the stock option holder ceases to be an employee or a director, or ten years after the date of grant, based on the date of grant of the original stock options.
FHP INTERNATIONAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
The Company established a deferred compensation plan in July, 1991, for certain of its executives and physicians which is designed to provide supplemental retirement income benefits by enabling the participants to defer receipt of up to 50% of their gross annual salaries and 100% of their gross annual bonuses. Amounts deferred by employees are included in other liabilities and these deferred amounts are deemed to be invested in one or more mutual funds selected by the participants. The Company pays premiums on individual life insurance policies whose policy benefits are equal to the deferred amounts. Account balances, including earnings from investments, are distributed to a participant upon two years' advance request or upon a participant's termination of employment, death, or disability. Such distributions are substantially offset by any values in the cash surrender value of the life insurance policies provided by the Company which are included in other assets.
In fiscal year 1995, the Company's Board of Directors and shareholders approved the Employee Stock Purchase Plan, effective January 1, 1995. The plan provides employees of the Company with an opportunity to purchase the Company's Common Stock once annually with after tax income set aside through payroll deductions. Eligible employees may defer up to a specified amount from annual compensation to purchase shares of the Company's Common Stock at 85% of the market price on the last day of each annual offering period. No shares were purchased in fiscal year 1995, as the first purchase date is December 18, 1995.
On November 1, 1989, 187,000 shares of Common Stock were issued as restricted stock awards at a purchase price of $0.02 per share. Compensation expense was determined based on the excess of the estimated market value of the stock over the purchase price on the date of the grant and was recognized ratably over the vesting period which ended on October 31, 1992.
NOTE 8--COMMITMENTS AND CONTINGENCIES
Operating Leases
The Company leases certain buildings and equipment under operating leases. Future minimum rental payments required under operating leases that have initial or remaining noncancellable lease terms in excess of one year as of June 30, 1995, are as follows:
Total rental expense on operating leases aggregated $34,956,000, $28,663,000, and $23,579,000 for fiscal years 1995, 1994, and 1993, respectively.
OPM Audit
The Company contracts with the United States Office of Personnel Management ("OPM") to provide or arrange managed health care services under the Federal Employees Health Benefits Program ("FEHBP") for federal employees, annuitants, and their dependents. OPM is the Company's largest commercial customer. These contracts with OPM and applicable government regulations establish premium rating requirements
FHP INTERNATIONAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
for the FEHBP. OPM conducts periodic audits of its contractors to, among other things, verify that the premiums established under the OPM contracts are established in compliance with the community rating and other requirements under the FEHBP. In May, 1993, after conducting a periodic audit of the Company's FEHBP contracts covering primarily the years 1988 through 1991, OPM sent a draft audit report to the Company alleging certain defects in the Company's rating practices under applicable regulatory and contractual requirements and invited the Company to comment. Following its evaluation of the additional information and comments provided by the Company, the OPM auditors will issue a final report; the OPM Audit Resolution Division will then be responsible for resolving the audit findings. As part of the resolution process, the Audit Resolution Division may reconsider the findings of the auditors and the information provided by the Company.
It is likely that the final audit report will recommend that OPM seek a monetary recovery from the Company and that such recommended recovery could be a substantial amount. At this time, the Company's management and legal counsel are unable to determine the amounts that may be required to be refunded to OPM to resolve the audit findings. Management currently believes, however, that after application of available offsets and consideration of established reserves, amounts ultimately required to be refunded to OPM will not have a material adverse effect on the consolidated financial position or results of operations or cash flows of the Company. In addition, the Company's management currently does not believe that the audit will have a material effect on future relations with OPM.
Litigation
During the ordinary course of business, the Company and its subsidiaries have become a party to pending and threatened legal actions and proceedings, a significant number of which involve alleged claims of medical malpractice. Management of the Company is of the opinion, taking into account its insurance coverage and reserves that have been established, that the outcome of the currently known legal actions and proceedings will not, singly or in the aggregate, have a material effect on the consolidated financial position or results of operations or cash flows of the Company and its subsidiaries.
NOTE 9--NOTES RECEIVABLE FROM EMPLOYEE STOCK OWNERSHIP PLAN
During fiscal year 1993, the ESOP repaid to the Company amounts previously loaned of $4,150,000. The loans were made to enable the ESOP to purchase the Company's Common Stock on a periodic basis and were repaid from periodic contributions to the ESOP received from the Company (Note 7).
The Company currently makes quarterly contributions (pursuant to the annual contribution described in Note 7) to the ESOP to fund quarterly purchases by the ESOP on the open market. For fiscal years 1995, 1994, and 1993, the Company contributed $9,315,000, $9,140,000, and $6,870,000, respectively for this purpose.
NOTE 10--STOCKHOLDERS' EQUITY
In June, 1994, the Company amended its Certificate of Incorporation to increase the authorized number of shares of Common Stock from 70,000,000 to 100,000,000 and the authorized number of shares of Preferred Stock from 5,000,000 to 40,000,000. As the Company issues Preferred Stock, it is designated as either Series A Cumulative Convertible Preferred Stock ("Series A Preferred Stock") or Series B Adjustable Rate Cumulative Preferred Stock ("Series B Preferred Stock"). The Company issued 6,311,781 shares of Common Stock, 21,031,733 shares of Series A Preferred Stock, and 32,850 shares of Series B Preferred Stock as merger consideration in the acquisition of TakeCare as of June 17, 1994 (Note 12). An additional 3,876 shares of Common Stock, 8,574 shares of Series A Preferred Stock, and 46,368 shares of Series B Preferred Stock were issued during fiscal year 1995 to TakeCare shareholders for shares unpresented at the acquisition date.
FHP INTERNATIONAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
Holders of the Series A Preferred Stock are entitled to receive cumulative cash dividends of 5.0% per annum. Dividends are payable quarterly in arrears when and if declared by the Company's Board of Directors. Dividends declared during fiscal year 1995 were $26,230,000. On or after the fourth anniversary of the acquisition, the Company may, at its option, redeem all or part of the outstanding shares of Series A Preferred Stock, at fixed redemption prices per share plus an amount equal to any accrued and unpaid dividends. Each share of Series A Preferred Stock may be convertible at the option of the holder into the Company's Common Stock at any time commencing six months after the acquisition date. The conversion price for the Series A Preferred Stock is $31 per share.
Holders of Series B Preferred Stock are entitled to receive cumulative cash dividends of not less than 5.0% per annum or greater than 11.0% per annum. The actual dividend rate is determined quarterly based upon prevailing market interest rates. During fiscal year 1995, the dividend rate ranged from 6.245% to 7.454%. Dividends are payable quarterly in arrears when and if declared by the Company's Board of Directors. Dividends declared during fiscal year 1995 were $139,000. The Company may, at its option, redeem all or part of the outstanding shares of Series B Preferred Stock at $25 per share plus an amount equal to accrued and unpaid dividends.
In June, 1990, the Board of Directors of the Company declared a dividend of one common share purchase right (a "Right") for each outstanding share of common stock to the holders of record on June 29, 1990, and authorized and directed the issuance of one Right with respect to each share of common stock that shall become outstanding prior to the occurrence of certain terminating events. Each Right entitles the registered holder to purchase from the Company one-fourth of a share of common stock at a price which varies based on the market price of a share of the Company's stock ($23.00 at June 30, 1995), subject to adjustment (the "Purchase Price"). Upon the occurrence of certain events associated with an unsolicited takeover attempt of the Company, the Rights will become exercisable and will cease to automatically trade with the common stock. Thereafter, upon the occurrence of certain further triggering events, each Right will become exercisable, at an adjusted Purchase Price (the "Adjusted Purchase Price") equal to four times the Purchase Price immediately prior to such adjustment, for that number of shares of common stock having a market value of two times such Adjusted Purchase Price. The Rights have certain anti-takeover effects that will cause substantial dilution to a person or group that attempts to acquire the Company in a manner which causes the Rights to become exercisable. The terms of the Rights may be amended by the Board of Directors of the Company without the consent of the holders of the Rights. At June 30, 1995, there was one Right outstanding for each share of common stock outstanding and a sufficient number of authorized but unissued shares of common stock available for issuance upon (i) the exercise of the Rights, (ii) the issuance of common stock (and associated Rights) in connection with the future exercise of outstanding stock options, and (iii) the issuance of common stock (and associated Rights) in connection with the future conversion of the Series A Preferred Stock.
NOTE 11--EARNINGS PER SHARE ATTRIBUTABLE TO COMMON STOCK
Earnings per share for fiscal years 1995, 1994, and 1993, were computed by dividing net income attributable to Common Stock by 41,057,000, 34,051,000, and 33,270,000 shares, respectively, which represent the weighted average number of outstanding common shares and common share equivalents during the respective periods. Common share equivalents include the effect of dilutive stock options calculated using the treasury stock method.
Primary and fully diluted earnings per share are the same for each year presented.
FHP INTERNATIONAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 12--ACQUISITIONS
The Company acquired all of the outstanding common stock of TakeCare on June 17, 1994, in a transaction treated as a purchase for accounting purposes. The consolidated financial statements include the operations of TakeCare beginning June 17, 1994. The purchase price was approximately $1,054.4 million, net of acquisition costs.
The following table summarizes the unaudited pro forma consolidated results of operations of the Company as though the acquisition of TakeCare had occurred on July 1, 1992. The unaudited pro forma consolidated results of operations shown below do not necessarily represent what the consolidated results of operations of the Company would have been if the acquisition had actually occurred on July 1, 1992, nor do they represent a forecast of the consolidated results of operations of the Company for any future period.
In January, 1995, the Company acquired a third party administrator located in Nevada for approximately $1.9 million. The acquisition, which has been accounted for as a purchase, was consummated through the issuance of approximately 73,000 shares of the Company's Common Stock. As a result of the purchase, the Company recorded goodwill of approximately $1.4 million.
In October, 1993, the Company acquired an approximately 4,700 member HMO located in Denver, Colorado, for approximately $3.5 million. The Company also obtained a covenant not-to-compete for which it paid $0.5 million (Note 1). The acquisition, which has been accounted for as a purchase, was financed through cash generated from operations of the Company. During fiscal year 1995, under a contract clause tied to retained membership on the first anniversary of the transaction, the Company made an additional payment of approximately $0.8 million. As a result of the purchase, the Company recorded goodwill of approximately $1.8 million.
In March, 1993, the Company acquired an insurance carrier and its subsidiaries for approximately $21.7 million, net of cash acquired. Through its subsidiaries, it offers workers' compensation insurance in California and Arizona and provides various claims administration services. The acquisition, which has been accounted for as a purchase, was financed through cash generated from operations of the Company. As a result of the purchase, the Company recorded goodwill of approximately $2.5 million. The Company also obtained a covenant not-to-compete for which it paid $4.0 million (Note 1).
NOTE 13--RESTRUCTURING CHARGE
In June, 1995, the Company's Board of Directors approved a restructuring plan involving the discontinuance of services and programs that do not meet the Company's strategic and economic return objectives, a reduction in workforce, and the creation of a physician practice management company ("PPMC"), which will be operated as a subsidiary of the Company. The PPMC will encompass all of FHP's Company-operated medical facilities in California, Utah, Arizona, New Mexico, and Nevada. In addition, the Board of Directors decided to sell the Company's two acute care hospitals and other nonproductive real
FHP INTERNATIONAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) estate. The formation of the PPMC, anticipated for January 1, 1996, will entail added operating costs during the first six months of fiscal 1996. These costs include duplicate employees during the transition period, separation expenses for displaced employees, and the cost of developing new computer systems to handle fee for service business and other HMO and preferred provider organization customers. The restructuring plan was announced to the affected employees prior to the Company's fiscal year end.
Accordingly, the Company recorded a pretax restructuring charge of $75.1 million ($46.6 million, net of tax) in the accompanying Consolidated Statements of Income for the fiscal year ended June 30, 1995. Included in this charge are the expected costs of employee separations ($6.8 million), asset write-downs to estimated net realizable values ($58.9 million), and certain other costs associated with the Company's restructuring of its operations ($9.4 million). Assets identified as those to be sold as part of the restructuring have been reclassified as assets held for sale in the accompanying Consolidated Balance Sheets as of June 30, 1995, and are expected to be disposed of by the end of fiscal year 1996 (Notes 1 and 2).
The restructuring charge is based on the Company's estimate and will continue to be refined until the restructuring plan is complete.
NOTE 14--INFORMATION REGARDING THE COMPANY'S OPERATIONS IN DIFFERENT SEGMENTS
The Company offers a full range of products to achieve its strategic goal of becoming a sole source provider of health care services. These products can be classified into two principal segments of business: HMO and insurance services. The HMO offers a full range of related products to consumers and employers in the direct delivery of managed health care services, either through contracted health care providers or through Company-operated medical centers. Complementing the operations of the HMO are the products offered by the insurance segment. These products include traditional indemnity health and life insurance, workers' compensation, and third party administration of self- insured employer programs. Often, the products offered by the HMO and insurance segments are sold to the same account; that is, an employer is able to offer a "dual choice" to employees of enrollment in either the HMO or the indemnity product provided through group health insurance coverage.
FHP INTERNATIONAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
Information regarding the two segments is summarized below:
FHP INTERNATIONAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 15--UNAUDITED QUARTERLY INFORMATION
- -------- (a) The net loss for the fourth quarter ended June 30, 1995, included an unfavorable net adjustment due to a restructuring charge of approximately $46.6 million, net of tax, relating primarily to the costs of employee separations, asset write-downs to estimated net realizable values, and certain other costs associated with the restructuring of the Company's operations (Note 13).
(b) Fully diluted earnings per share is not presented if it is anti-dilutive.
(c) Net income for the fourth quarter ended June 30, 1994, included TakeCare's operations from the date of acquisition (June 17, 1994) and other favorable net adjustments of approximately $838,000, resulting primarily from changes of estimates with respect to certain fiscal year 1994 compensation and benefit related accruals and reserves for professional liability claims. Management's estimates were based on the most recent information available, including events and changes in circumstances which occurred during the period.
INDEPENDENT AUDITORS' REPORT
FHP International Corporation:
We have audited the accompanying consolidated balance sheets of FHP International Corporation and its subsidiaries as of June 30, 1995 and 1994, and the related consolidated statements of income, stockholders' equity, and cash flows for each of the three years in the period ended June 30, 1995. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated 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 FHP International Corporation and its subsidiaries at June 30, 1995 and 1994, and the results of their operations and their cash flows for each of the three years in the period ended June 30, 1995, in conformity with generally accepted accounting principles.
Deloitte & Touche LLP
Costa Mesa, California September 7, 1995
INDEX TO EXHIBITS
- -------- * Document has previously been filed with the Commission and is incorporated by reference and made a part hereof.
The Registrant will furnish any of the foregoing exhibits upon the payment of a reasonable fee based upon the Registrant's expenses in furnishing such exhibit(s). Written inquiries should be addressed to FHP International Corporation, Investor Relations Department, 9900 Talbert Avenue, Fountain Valley, California 92708.