-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, VpV8huzM2Whk5uHlvunjC1LsnepMxKKjVf+PFid6JIylH1Pa0EQ5SwxSfkhV/3Rp wxTSUdXAyd/bc5i8KWZNpw== 0000950131-99-002011.txt : 19990402 0000950131-99-002011.hdr.sgml : 19990402 ACCESSION NUMBER: 0000950131-99-002011 CONFORMED SUBMISSION TYPE: 10-K PUBLIC DOCUMENT COUNT: 4 CONFORMED PERIOD OF REPORT: 19981231 FILED AS OF DATE: 19990331 FILER: COMPANY DATA: COMPANY CONFORMED NAME: FIRST COMMONWEALTH INC CENTRAL INDEX KEY: 0001001493 STANDARD INDUSTRIAL CLASSIFICATION: HOSPITAL & MEDICAL SERVICE PLANS [6324] IRS NUMBER: 752154228 STATE OF INCORPORATION: DE FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K SEC ACT: SEC FILE NUMBER: 000-27064 FILM NUMBER: 99583441 BUSINESS ADDRESS: STREET 1: 444 NORTH WELLS ST STREET 2: STE 600 CITY: CHICAGO STATE: IL ZIP: 60610 BUSINESS PHONE: 3126441800 MAIL ADDRESS: STREET 1: 444 NORTH WELLS ST STREET 2: STE 600 CITY: CHICAGO STATE: IL ZIP: 60610 10-K 1 FORM 10-K First Commonwealth, Inc. Form 10-K For the year ended December 31, 1998 INDEX ITEM No. Page - -------- ---- PART I 1 Business......................................................... 2 2 Properties....................................................... 19 3 Legal Proceedings................................................ 19 4 Submission of Matters to a Vote of Security Holders.............. 19 PART II 5 Market for the Registrant's Common Equity and Related Shareholder Matters.............................................. 20 6 Selected Financial Data.......................................... 21 7 Management's Discussion and Analysis of Financial Condition and Results of Operations........................................ 23 7A Quantitative and Qualitative Disclosures About Market Risk....... 29 8 Financial Statements and Supplementary Data...................... 30 9 Accounting and Financial Disclosure.............................. 51 PART III 10 Directors and Executive Officers of the Registrant............... 51 11 Executive Compensation........................................... 51 12 Security Ownership of Certain Beneficial Owners and Management................................................... 51 13 Certain Relationships and Related Transactions................... 51 PART IV 14 Exhibits, Financial Statement Schedules and Reports on Form 8-K.. 52 SPECIAL NOTE ON FORWARD-LOOKING STATEMENTS Certain statements included or incorporated by reference in this Form 10-K under the caption "Management's Discussion and Analysis of Financial Condition and Results of Operations" and elsewhere in this Form 10-K constitute "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. Such forward-looking statements involve known and unknown risks, uncertainties and other factors which may cause the actual results, performance, or achievements of the Company to be materially different from any future results, performance, or achievements expressed or implied by such forward-looking statements. Such factors include, among other things, increased competition in the markets in which the Company operates; changes in regulation affecting the Company; changes in the utilization of services; changes in arrangements relating to payments to providers; the level of the Company's Indemnity/PPO enrollment and the related Indemnity/PPO risk of Indemnity/PPO plans; the ability to integrate and successfully operate acquired businesses and the risks associated with such businesses; the possible need for, and ability to obtain if needed, financing on acceptable terms to finance the Company's growth strategy; the ability of the Company to operate within the limitations imposed by any such financing arrangements; and other factors referenced or incorporated by reference in this Form 10-K. - 1 - PART I Item 1. Business First Commonwealth, Inc. is a leading provider of managed dental benefits in the upper Midwest, including the metropolitan areas of Chicago, Milwaukee, Detroit, Indianapolis and St. Louis. As of December 31, 1998, the Company provided managed care and indemnity/PPO products to approximately 644,900 employees and dependents ("members") through more than 4,000 employer groups ("groups"). The Company markets a broad range of innovative dental benefit plans which are designed to meet the needs of large, medium and smaller- sized groups. The managed care and PPO plans offer dental benefits primarily through the Company's managed care and PPO network of approximately 2,425 general dentists and specialists ("providers"). The Company distributes its products through a network of over 1,400 independent insurance brokers which target medium and smaller-sized groups, and a direct sales unit which targets larger groups. Significant client groups served by the Company include Advocate Health Care, City of Milwaukee First Chicago/NBD and Inland Steel Industries, Inc. ("Inland"). The Company's managed care plans are provided on a stand-alone basis ("managed care products") and also in conjunction with the Company's indemnity and indemnity/PPO plans (collectively "indemnity/PPO plans") which provide benefits outside the Company's managed care network (the combined managed care/indemnity/PPO plans are referred to as "Managed ChoiceSM products"). The Company has integrated its PPO network with the indemnity plan component of its Managed ChoiceSM product to offer a point-of-service option to members, called "'Managed ChoiceSM Triple Option." The Company also provides a "network rental" product primarily to large Taft-Hartley funds and medical HMOs. Under the terms of this product offering, the Company provides access to the network of reduced fee arrangements with providers, but does not handle the claims administration. The Company charges an access fee for these arrangements. The Company also receives fee income for administrative services only ("ASO") arrangements whereby the Company pays claims for self funded employers but does not assume the underwriting risk of these claims. The Company receives a monthly premium for each employee who enrolls in its managed care or indemnity plans. If covered by a managed care plan, a member selects a provider (general dentist) from the Company's managed care network. The Company then pays a monthly fee ("capitation payment") to the provider selected by the member. Certain preventative and diagnostic services (e.g., cleanings and x-rays) are provided to members at no additional fee. The dentist provides other dental services for a reduced fee ("co-payment") paid by the member. If covered by an indemnity plan, the member pays fees set by the dentist for services rendered and submits claims for reimbursement. The Company was founded in 1986 by Christopher C. Multhauf, Chairman of the Board of Directors and Chief Executive Officer of the Company, David W. Mulligan, President and Chief Operating Officer of the Company, Richard M. Burdge, a Director of the Company and Philip N. Bredesen, a former Director of the Company. Mr. Bredesen was previously the founder and Chairman of the Board of HealthAmerica Corporation, which grew to operate HMOs in 17 states before being acquired by Maxicare Health Plans, Inc. in 1986. The Company commenced operations in 1988 with the goal of building a leading managed dental care market position in the Chicago metropolitan area. Since beginning operations in 1988, the Company has grown to become one of the upper Midwest's leading dental benefit organizations. During 1996, the Company completed acquisitions in Milwaukee and St. Louis, and began de novo start-ups in Detroit and Indianapolis. Effective July 18, 1996, the Company completed the acquisition of Smileage Dental Services, Inc. ("Smileage"), a Milwaukee, Wisconsin based dental HMO administrator which provides services to approximately 50,000 members, and an associated reinsurance transaction, for an aggregate purchase price (including transaction costs) of $5.6 million. The acquisition was financed through the issuance of the Company's common stock. Effective December 31, 1996, the Company completed the acquisition of Champion Dental Services, Inc. ("Champion"), a St. Louis, Missouri based prepaid dental plan which provides services to approximately 60,000 - 2 - members, for an aggregate purchase price (including transaction costs) of $5.6 million. The acquisition was financed through proceeds from the Company's initial public offering and was paid in cash on January 2, 1997. As of January 1, 1997, the Company had increased the available market population for the markets it serves from the Chicago metropolitan area, which is the country's third most populous metropolitan market, with a population of approximately 8.3 million, to include the metropolitan areas of Milwaukee, Detroit, Indianapolis and St. Louis, as well as Chicago, which have a combined population of approximately 18.4 million. The Company's revenues increased from $22.1 million in 1994 to $64.2 million in 1998. Over the same period, the Company's operating income grew from $2.3 million to $5.9 million. For the year ended December 31, 1998, the Company's revenues increased 13% to $64.2 million from $56.6 million in the prior year period and operating income increased 16% to $5.9 million from $5.1 million. From December 31, 1994 to December 31, 1998, the number of fully insured members covered by the Company's managed care and indemnity/PPO products increased from 227,300 to 557,800. Several key operating strategies, including the Company's regional focus, have contributed to the Company's growth. First, the Company has built the largest prepaid managed dental care provider network in the Chicago metropolitan area and maintains the quality of this network through credentialing, ongoing peer review and Company-sponsored continuing education seminars. Second, the Company has developed a wide range of innovative dental benefit products that it believes have contributed to its success in attracting and retaining large groups. For example, the Company's Managed ChoiceSM products provide it with the capability to completely replace a group's existing indemnity plan with the Company's combined managed care and indemnity/PPO plan. Furthermore, the Company's national account administration program provides its Chicago-based employers with managed care plan options outside the Company's managed care network service area through its relationships with independent provider networks. Third, the Company has built an efficient business development process that combines an extensive proprietary database with targeted direct mail and telemarketing to contact employers, independent insurance brokers and providers. Utilizing this process, the Company markets its products directly to large employers, distributes its products through brokers to medium and smaller-sized employers and continuously recruits new providers into its managed care network. Fourth, the Company has expanded its geographic service area and is implementing its operating strategy in other major metropolitan areas in contiguous states. This is intended to enable the Company to continue to achieve administrative operating efficiencies as it expands. The Company believes there are significant opportunities for the continued growth of its business both in the Chicago metropolitan area and through the expansion of its geographic service area. First, the Company intends to continue to seek to increase sales from medium and smaller-sized groups by increasing its sales staff, telemarketing and direct mail efforts towards brokers which sell to these market segments. The Company believes that these market segments are currently under-penetrated for managed care products. Second, the Company intends to continue to develop innovative products in response to group needs. With the introduction of its Managed ChoiceSM products in 1992 and its introduction of Managed ChoiceSM Triple Option and PPO network rental option products in 1996, the Company believes that it is well positioned to continue to expand its presence among large employers and to increase its sales to medium and smaller-sized employers. Third, the Company has expanded its managed care provider network in the markets it serves to service existing groups, and it intends to increase its marketing efforts in these areas and continue to expand to contiguous or proximate areas. Fourth, the Company is committed to building and maintaining large, quality provider networks in any major markets it serves. Fifth, the Company intends to continue to focus on achieving administrative operating efficiencies through increased use of voice and data technologies and by emphasizing efficient provider arrangements. First Commonwealth, Inc. was incorporated in Delaware in 1986. Its principal place of business is located at 444 North Wells Street, Suite 600, Chicago, Illinois 60610, and its telephone number is (312) 644-1800. Unless the context otherwise requires, all references to the "Company" shall mean First Commonwealth, Inc., together with its subsidiaries, First Commonwealth Limited Health Services Corporation, First Commonwealth of Illinois, Inc., First Commonwealth Insurance Company, First Commonwealth Reinsurance Company, First Commonwealth Limited Health Service Corporation, Smileage Dental Services, Inc. and First Commonwealth of Missouri, Inc. - 3 - (formerly Champion), and its affiliate, First Commonwealth Health Services Corporation. See "Business - Company's Corporate Structure." The Dental Benefit Marketplace According to the U.S. Office of National Health Statistics, total expenditures for dental care in the United States grew from approximately $14 billion in 1980 to an estimated $48 billion in 1996. The U.S. Health Care Financing Administration reports that expenditures for dental services account for approximately 4% of total national health care expenditures. According to the U.S. Department of Labor, the cost of dental services has been rising at a higher rate than that for consumer goods. The U.S. Department of Labor Statistics reported that, from 1987 to 1997, the Consumer Price Index for all Urban Consumers for dental services increased 5.39% annually whereas this index for all items increased only 3.22% annually. As a result, the Company believes that there has been increased interest by employers in managing dental care costs. Employer-sponsored dental benefits are one of the most common employee welfare benefits. The National Association of Dental Plans ("NADP") estimates that approximately 147 million persons, representing approximately 55% of the total United States population, were covered by some form of dental benefit coverage at the end of 1997. Historically, a substantial majority of dental coverage has been through traditional indemnity plans. In recent years, however, managed dental HMO care has achieved increasing market acceptance. National managed dental HMO enrollment has grown at an annual rate of approximately 13% between 1994 and 1997, from approximately 18.3 million covered lives in 1994 to approximately 26.5 million in 1997. The estimated rate of growth in dental HMOs for 1998 was approximately 9% in terms of enrollment. This compares to over 50 million Americans who were enrolled in medical HMOs in 1994 according to the Group Health Association of America. The Company believes the relatively high growth rate for managed dental care plans is attributable to (i) the greater acceptance of managed care by employers and employees; (ii) the significant price advantage relative to indemnity plans; (iii) the cost effectiveness to employers of managed dental care plans as an employee benefit; and (iv) the growing acceptance of prepaid dental plans by dentists, resulting in improved accessibility and convenience for members. Members of managed dental HMO benefit plans represent approximately 19% of the population with dental care coverage and approximately 9% of the total U.S. population. The Company believes that there will continue to be significant growth opportunities in the managed dental benefits industry. Historically, larger employers have been more likely to offer dental benefit coverage to their employees. According to the 1993 Foster Higgins Survey of Employer Sponsored Health Plans (the "Foster Higgins Survey"), nationally approximately 87% of employers with more than 200 employees offer some type of dental benefit to some or all employees and approximately 64% of these employers have a stand-alone dental plan, separate and distinct from other health and welfare benefits offered to employees. By comparison, this survey reported that only 47% of employers with less than 200 employees offer dental benefits. It has been the Company's experience that many employers that do not offer dental benefits are willing to consider offering a plan in which the employee pays the full cost of such benefits through payroll deductions. The managed dental care industry as a whole is currently fragmented and characterized by the participation of several large, national insurance companies and many smaller independent plan sponsors. As of December 31, 1997, the NADP estimated that there were over 140 managed dental companies in the United States, with no dominant market leader. According to the American Dental Association ("ADA"), the number of practicing dentists in the United States per 100,000 population increased from 53 in 1980 to 60 in 1991. Recently, however, the supply of new dentists has slowed due to the closing of some dental schools and smaller graduating classes. In addition, the dental marketplace is highly fragmented with approximately 90% of all dentists working in a one or two-dentist office, according to the ADA. Also, according to a survey of dental practices published by the ADA in 1996, the median of staff and other costs that are part of total overhead expenses was approximately 60-65% of the gross revenues of solo and group dental practices. The increase in the number of dentists as a proportion of the population, the fragmented dental marketplace, the high proportion of overhead costs for dentists and an improved level of overall - 4 - dental health has created a competitive environment among dentists, particularly in metropolitan areas. The Company believes that these factors have contributed to the willingness of qualified dentists to participate in managed care and PPO networks as dentists seek to increase practice revenues. As in the case of medical coverage, the substantial majority of dental coverage is provided through traditional fee-for-service indemnity dental plans. Under a traditional fee-for-service indemnity plan, coverage is provided based on a reimbursement formula of the usual and customary charges submitted by the dentist. Compared to medical coverage, the average cost of dental services is lower and the utilization of services is more predictable. Unlike medical coverage, dental coverage generally does not cover catastrophic risks. Dental care is provided almost exclusively on an outpatient basis and, according to a 1997 article in the Illinois Dental News, over 90% of all dental services are performed by general dentists. Also, dental plans generally do not include coverage for hospitalization, typically the most expensive component of medical services. Common features of dental indemnity plans include deductibles, maximum annual benefits of less than $2,000 per person and significant patient cost-sharing. Patient cost-sharing typically varies by type of dental procedure ranging from no cost sharing for preventive procedures to 50% cost-sharing for crowns and even greater cost-sharing for orthodontic care. This high patient cost-sharing and the relatively predictable nature of dental expenditures substantially limits the underwriting risk of a dental plan when compared to the underwriting risk of a medical plan which covers catastrophic illness and injuries. Furthermore, since most dental problems are neither life threatening nor represent serious impairments to overall health, there is a higher degree of patient cost sensitivity and discretion associated with obtaining dental services. Many dental conditions also have a range of appropriate courses of treatment, each of which has a different out-of-pocket cost for patients. For example, a deteriorated amalgam filling may be replaced with another amalgam filling (a low-cost alternative), a pin-retained crown build-up (a more costly alternative) or a gold crown with associated periodontal treatment (the most costly alternative). The level of coverage provided to the patient and the dental plan's reimbursement methodology may influence the type of services selected by the patient or rendered by the dentist. Under a traditional indemnity insurance plan or fee-for-service arrangement, the insurer and the patient each pays a percentage of the fee charged by the dentist, subject to cost-sharing, maximum benefit allowances and usual and customary limits. Under such an indemnity plan, dentists have little incentive to reduce total charges because they are compensated on a fee-for-service basis. By contrast, under a dental HMO plan the pre-determined payments, typically capitated payments, are fixed and co-payments for additional services are pre-negotiated by the Company. The co-payments generally are designed to exceed the dentist's variable costs, but are typically less than the dentist's usual and customary fee. Fixed capitation payments that do not vary with the frequency of services provided create an incentive for dentists to emphasize preventive care, control costs and maintain a long-term patient relationship that generates consistent capitation revenue. Fixed capitation payments also substantially reduce the underwriting risk to the Company associated with the high utilization of services. Markets Served by the Company Until July 1996, the Company had focused its efforts primarily on the Chicago metropolitan market and has grown to become one of the Chicago's leading managed dental care organizations. The Company began providing managed care products to employers in the Chicago area in 1988. From 1988 to July 1996, the Company had expanded into northwest Indiana and certain other areas in Illinois, initially to serve employees of Chicago-based employers. By the beginning of 1997, the Company had expanded into Milwaukee and St. Louis, and had initiated de novo activity in Detroit and Indianapolis. The Chicago area is the country's third most populous metropolitan market with a population of approximately 7.5 million. In addition, northwest Indiana has a population of approximately 750,000 and the other areas of Illinois into which the Company has expanded have an aggregate population of approximately 1.9 million. According to the NADP, Illinois is the fourth largest state in terms of enrollment in managed dental care plans and had approximately 1.4 million persons enrolled in managed dental care plans in 1997 which represented 11.5% of the state's population. As of December 31, 1994, virtually all of the Company's 216,000 managed care members were located in Illinois. Approximately 321,100 of the Company's 482,200 managed care members were located in - 5 - Illinois and northwest Indiana as of December 31, 1998. The Company believes that Illinois, and particularly the Chicago metropolitan area, offers significant opportunities for continued growth in sales of managed dental care products, especially to medium and smaller-sized employers who have historically been less likely to offer managed dental coverage. The Company believes that, in the Chicago metropolitan area, there are approximately 500 employers with 500 or more employees (employing an aggregate of approximately 1.3 million persons), and approximately 50,000 employers with 10 - 499 employees (employing an aggregate of approximately 1.5 million persons). Based on its database of contacts with employers in the Chicago metropolitan area, the Company believes that a higher percentage of larger employers have implemented managed care plans as compared to medium and smaller-sized employers. The Company believes that medium and smaller-sized employers have become increasingly receptive to managed dental care products in part because of their increasing satisfaction with managed care in their medical benefit plans. The metropolitan markets of Milwaukee, St. Louis, Detroit and Indianapolis have a combined population of approximately 10.1 million. According to the NADP, the combined states from these metropolitan areas had approximately 1.4 million people enrolled in dental HMO plans in 1997. Approximately 161,100 of the Company's 482,200 managed care members were primarily located in the greater metropolitan area of the cities listed above. The Company believes that these expansion markets continue to offer opportunities for continued growth in sales of managed dental care and indemnity/PPO products. The Company presently has limited marketing activity in Indianapolis and does not expect to generate significant enrollment growth from this market in 1999. Since the Company's operations are located primarily in the Chicago, Milwaukee, St. Louis, Detroit, and Indianapolis metropolitan areas, its operations may be more adversely affected by localized economic, regulatory or competitive conditions than more geographically diverse companies. The Company also markets its products to employers based in its service areas who have employees outside the Company's managed care network service area ("out-of-area employees"). If an employer wishes to offer a managed care product to its out-of-area employees, the Company has arrangements to provide this option through its relationships with independent provider networks in over 40 states. The Company collects the revenue for these plans, retains a small processing fee, and remits the premium to the out-of-area independent dental plan carrier. Consequently, this product provides negligible gross margin to the Company. The Company markets this product to employers based in its service areas in order to compete with national dental plans. As of December 31, 1998, approximately 7,900 members were enrolled with other dental care plans through such arrangements. The Company also provides its Managed ChoiceSM product to employers who have some out-of-area employees, which permits such employees to select the local managed dental care plan or indemnity coverage through the Company. Growth Strategy The Company plans to further expand its business through the following strategies: Emphasize Medium and Smaller-sized Employers. The Company believes that employers with 10-499 employees continue to represent an attractive market segment for managed care products in all markets. The Company intends to continue to build upon its current market position in Chicago, as well as in the other regional markets, and increase its sales staff and telemarketing efforts towards brokers which sell to medium and smaller-sized employers. Continue to Expand Product Line. The Company believes that it must continue to offer its clients and prospective clients a range of new products that vary in cost, coverage and network access to remain competitive. The Company believes it can expand the marketing of its Managed ChoiceSM Triple Option product by expanding its PPO provider network, reducing benefits for non-network utilization, and reducing the overall cost of the product to reflect the lower non-network benefit levels. Managed care products that vary in cost relative to the size of the managed care network also represent areas of growth for the Company. - 6 - Pursue Acquisition/Market Expansion Opportunities. Management believes there are significant opportunities to expand the Company's operations into new markets either through acquisitions or de novo start-ups. The Company has an extremely strong balance sheet with substantial leverage capacity to support attractive acquisition opportunities as well as the management experience in successfully integrating the operations into the Company's business model. The Company believes that there are several attractive markets for expansion that can successfully be developed on a start-up basis if acquisition opportunities are not available. Increase Size of Quality Provider Network. A key factor in the past success of the Company has been the size, accessibility and quality of the Company's managed dental care provider network. The Company plans to increase its provider recruitment staff to add new, quality providers to its dental HMO and PPO networks. The Company believes a large, accessible network of quality providers is an important component in attracting new enrollment into its managed care and PPO products, both in existing markets and in any new markets developed by the Company. Achieve Additional Cost Efficiencies. The Company believes that its strategy of focusing operations on a regional basis provides certain SG&A cost savings. The Company continues to enhance its management information systems and plans to introduce new voice and data technologies in the areas of billing and enrollment to improve service levels and achieve additional staffing economies. Products The Company offers a comprehensive range of flexible and innovative dental benefit products that are designed to offer flexibility to an employer, its eligible employees and their dependents. Each product is positioned to meet the needs of key market segments that the Company has identified. The Company primarily markets two categories of products: (i) stand-alone managed care products and (ii) managed care plans offered in combination with indemnity/PPO plans (marketed by the Company as Managed ChoiceSM products). The following table shows the enrollment growth in the Company's managed care and indemnity/PPO plans.
As of December 31, ------------------ 1996 1997 1998 ---- ---- ---- Members Managed Care(1).................. 341,600 450,400 482,200 Indemnity/PPO.................... 56,200 65,300 75,600 -------- ------- ------- Total................... 397,800 515,700 557,800 ======= ======= =======
- ---------- (1) Includes members who have selected the managed care option under the Company's Managed ChoiceSM products and excludes Champion members as of December 31, 1996. From 1988 to 1992, the Company primarily marketed its managed care plans on a stand-alone basis. Beginning in 1992, the Company combined its managed care plans with indemnity plans and began marketing this combination as its Managed Choice(SM) products. Since the introduction of Managed Choice(SM) products in 1992 and the addition of a PPO option in 1996, the Company has experienced significant enrollment growth in its indemnity products, particularly among large employers. The Company also receives fee income for providing access to its PPO network and for ASO services. As of December 31, 1998, approximately 87,100 participants were eligible to access the Company's PPO network and were covered under its ASO arrangements. See "Fee Income Products" below. Managed Care Products. The Company offers a range of managed care plans which are designed to meet the needs of target markets. These plans vary in coverage levels and cost, which allows the Company to tailor an appropriate managed care product to an employer's current overall benefit program. The Company offers its - 7 - managed care products on a stand-alone basis and as an alternative to traditional indemnity dental insurance. Managed care products generally are more cost effective to groups and members than traditional indemnity coverage. For example, the Company typically charges 20 to 40% less in monthly premiums for managed care plans than for its indemnity plans which provide comparable coverage. In addition, the Company's managed dental care products offer more comprehensive benefits than traditional dental indemnity plans. The following table compares certain features of the Company's managed care plans with the features of a typical indemnity dental plan. COMPARISON OF FIRST COMMONWEALTH'S MANAGED CARE PLANS WITH A TYPICAL DENTAL INDEMNITY PLAN
First Commonwealth Typical Dental Feature Managed Care Plans Indemnity Plan(1) ================================================================================ Deductible None $50 per person ------------------------------------------------------------------------------------- Annual dollar limitation None $1,000 per year on coverage ------------------------------------------------------------------------------------- Claim forms for Not required; member Required; member or dentist reimbursement makes co-payment directly may incur delays in to dentist obtaining reimbursement ------------------------------------------------------------------------------------- Member's Member co-payment fixed Member pays any excess charges out-of-pocket costs in advance of service above customary fee levels -------------------------------------------------------------------------------------
(1) These features are also representative of indemnity plans offered by the Company. The Company receives a monthly premium for each employee and eligible dependent enrolled in its managed care plans. The Company remits a portion of the premium as a capitation payment to the participating network dentist selected by the member to "pre-pay" for dental care to be rendered to that member. The capitation payment is a fixed, per-member payment which is made by the Company to the provider for each member who chooses that dentist, regardless of the frequency or nature of services rendered. Members covered under the Company's managed care plans obtain certain basic dental procedures such as exams, x-rays, cleanings and fluoride treatments at no additional charge other than, in some cases, a small office visit co-payment. The Company's managed care plans also establish co-payments for other services provided by the network dentist such as fillings, root canals and crowns. The amount of the co-payment varies in accordance with the complexity of the covered procedure but is designed to exceed the provider's variable cost related to the procedure. The network general dentist provides all dental care services except those specialized services that are more appropriately delivered by dental specialists. When a managed care network general dentist identifies the need for a specialist, the general dentist completes a referral request form and forwards it to the Company for review. Examples of dental services provided by a specialist include oral surgery, periodontics, endodontics, pedodontics and orthodontics. The Company's independent contractor dentist consultants review the referral request to determine the appropriateness of the requested treatment. If the dental consultant approves the referral request, the patient is then referred by the network general dentist to a network specialist. The specialist dentist receives a co-payment from the member, negotiated in advance by the Company, for the specialty services rendered. In addition, the Company makes monthly payments to the specialist dentists on a capitated or other basis negotiated by the Company and the specialist. Members pay the same amount as a co-payment for the same service whether it is delivered by a managed care network general dentist or a managed care network specialist. At the time of enrollment, members are provided a list which itemizes all covered procedures, the applicable co-payment and any limitations or exclusions. Members' specific out-of-pocket cost for each covered service is thus known in advance of the service being provided by the managed care network provider. These features make the Company's managed care plan coverage relatively simple - 8 - for the member to understand and for the managed care network provider to administer, particularly when compared to the features of a typical indemnity plan. Members directly pay their applicable co-payment to managed care network providers, typically at the time of service. The Company's managed care plans do not require the patient or provider to complete a claim form in order to obtain coverage, reducing administrative requirements for its managed care network providers. Moreover, the Company's fixed co-payment schedule also improves the provider's ability to collect the patient portion of the cost of services during the visit. This, combined with prepaid capitation, reduces collection costs and improves the managed care network provider's cash flow. When an employer first introduces the Company's managed care product to its employees, the employer offers an open enrollment period in which employees may join the managed care plan. Employees enroll for a one year period. Each year thereafter the employer offers an open enrollment period in which employees may join the managed care plan and existing enrollees may terminate their coverage under the plan. When employees enroll in the managed care plan, they select a participating dentist from the Company's managed care network for each family member. Unlike many competing plans, the Company's managed care plans permit each member of an employee's family to choose a different dentist. This choice allows an employee to select a dentist closer to work while other family members may choose a dentist closer to home. The Company has designed a range of products to market to employers that currently do not offer a dental plan and to employers that currently offer only a traditional dental indemnity plan. A description of these products and the manner in which they are offered to employer groups follows. Managed Care Plans Offered on a Voluntary Basis. The Company's managed care plans can be offered on a voluntary (employee-pays-all) basis, in which only those employees who wish to receive and pay for coverage do so. This product is attractive to many employers who do not presently offer dental benefits to their employees, because it does not require the employer to contribute toward the cost of the dental plan. The Company believes that the primary reasons many employers do not offer a dental plan are cost and the restrictive underwriting requirements of dental indemnity plans. These underwriting restrictions often include minimum financial contributions from the employer, a guaranteed minimum number of employees participating in the dental plans and significant coverage exclusions. Under the Company's managed care products offered on a voluntary basis, the employee pays for the cost of the plan through a payroll deduction, which may be made on a pre-tax basis if the employer has adopted a flexible spending plan under Section 125 of the Internal Revenue Code. Furthermore, unlike many traditional indemnity carriers, the Company does not require any minimum number of employees to enroll in order for this employee-pay-all dental plan to be implemented. The Company's managed care products also do not have the extensive coverage exclusions of dental indemnity plans. Managed Care Plans Offered as an Alternative to an Existing Indemnity Dental Plan. The Company also offers its managed care plans as an alternative to an employer's existing dental indemnity program. Employees have the choice of enrolling in the Company's managed care plan or remaining in the employer's existing indemnity dental plan. In offering the Company's managed care plan as an alternative, the employer does not have to change existing indemnity dental benefits or its existing dental claims processor. Unlike traditional indemnity plan designs, the Company's managed care plans have no deductible to satisfy, no annual limitation on benefits, no claim forms to file and are easier for many employees to understand because of the relatively simple co-payment structure. The managed care plans offered by the Company to employers as an alternative to existing indemnity plans typically offer more comprehensive coverage than the managed care plans offered to employees on a voluntary basis. The more comprehensive coverage of the managed care alternative is designed to encourage employees to move from the existing dental indemnity plan because the managed care product provides the employer with lower cost per employee. Employers hold an annual open enrollment period in which employees may transfer between the traditional dental indemnity alternative and the managed care alternative. The Company has generally experienced net growth at annual renewals in its managed care plan when offered on such a basis. Managed Care Plans Offered as a Replacement for an Existing Dental Indemnity Plan. In evaluating the Company's managed care plans, some employers have elected to implement the managed care plan as a replacement - 9 - for an existing dental indemnity plan. The Company believes that, typically, this decision is based on three considerations: (1) the lower cost to the employer of the Company's managed dental care plan compared with the traditional dental indemnity plan, (2) the improved coverage to employees available through the Company's managed care plans as compared with a typical indemnity dental plan and (3) the Company's large and accessible network of credentialed dentists. In addition to the Company's stand-alone managed care products, the Company also markets its managed care plans in combination with indemnity coverage. A discussion of these products follows. Managed Care Plans Combined with Indemnity Plans--Managed ChoiceSM Products. The Company has combined its managed care plans with indemnity dental coverage in its Managed ChoiceSM products which offer coverage from the dental HMO network and non-network dentists. Managed ChoiceSM products enable the Company to replace an employer's existing traditional dental indemnity plan offered by a third party insurance company. Upon enrollment, members select the managed care product or the indemnity plan provided by the Company. The Company provides the out-of-network coverage on a traditional dental indemnity basis and administers the claims for the out-of-network coverage. In marketing its Managed ChoiceSM products, the Company consults with prospective groups to identify potential areas of cost containment for the out-of-network coverage. Because the Company controls the design of both the managed care and indemnity plans, it can encourage greater participation levels in the less expensive managed care plan. Through a combination of plan design and claims administration, the Company has helped contain the aggregate cost of its groups' indemnity dental benefit programs through its Managed ChoiceSM products. The Company has experienced considerable demand for its Managed ChoiceSM products since their introduction in 1992. As of December 31, 1998, Managed ChoiceSM products accounted for approximately 176,500 (approximately 32%) of the Company's approximately 557,800 members. Of the 176,500 Managed ChoiceSM enrollees, approximately 118,100 are enrolled in the Company's managed care plans and approximately 58,400 are enrolled in the Company's indemnity plans. Managed Care Plans Combined with Indemnity/PPO Plans--Managed ChoiceSM "Triple Option" Products. The Company has integrated a PPO network with the indemnity plan component of the Managed ChoiceSM product to offer a point-of-service option to members. Called the Managed ChoiceSM Triple Option, members have a point-of-enrollment choice between the managed care and the indemnity/ PPO plans. If a member selects the indemnity/PPO plan, the member then has a point-of-service option to choose a participating PPO dentist or a non-participating dentist. The member's out-of -pocket cost is reduced by selecting a participating managed care or dental PPO provider over a non-participating provider. Under the Company's Managed ChoiceSM Triple Option product, members who select the indemnity/PPO plan will have a benefit incentive to select the participating PPO dentist. The reduced fee arrangements of the PPO are expected to assist groups in containing dental costs. As of December 31, 1998, the Company's PPO network of providers had approximately 600 more dentists than its network of managed care providers. The Company is actively recruiting other dentists to participate in its PPO network and intends to add more dentists to its PPO plan to support this triple option product. The Company has had limited success with its Managed ChoiceSM Triple Option products since their introduction in 1996. As of December 31, 1998, Managed ChoiceSM Triple products accounted for approximately 44,300 (approximately 8%) of the Company's approximately 557,800 members. Of the 44,300 Managed ChoiceSM Triple Option enrollees, approximately 27,100 are enrolled in the Company's managed care plans and approximately 17,200 are enrolled in the Company's indemnity/PPO plans. See "Fee Income Products" below for members covered under this product on a self-insured basis. Fee Income Products. For self-insured employers, the Company provides claims administration under an administrative services only ("ASO") arrangement whereby the Company does not assume the underwriting risk for - 10 - the indemnity claims. The Company receives an administrative fee to process the claims and the underwriting risk is retained by the employer sponsoring the self-insured plan. Also under self-insured plans, the Company has offered the integration of the PPO network into employer sponsored plans and can receive a PPO access fee for each member who selects the indemnity/PPO self-insured plan as well as an ASO fee for providing third party administration services. Pursuant to an agreement with Inland, effective January 1, 1996, the Company is receiving PPO access fees as well as ASO fees covering approximately 24,000 Inland employees and dependents, and the Company is actively marketing combined PPO/ASO arrangements to other employers as part of its Managed Choicesm Triple Option product, as discussed above. As of December 31, 1998, the Company had approximately 37,800 members in these two categories. The Company also provides access to its PPO network for a fee to clients. Under this program, PPO network providers offer a reduced fee schedule for services performed. Eligible participants pay reduced fees when they receive dental care services from a PPO network provider. The Company charges its PPO network clients a monthly fee for each participant eligible to access the Company's reduced fee arrangements. The Company does not make any payments to its PPO network providers on behalf of the participants eligible to access the reduced fee arrangements. In 1996, the Company introduced a new product called a PPO network "rental" option. Under the terms of this new product offering, the Company provides access to its reduced fee arrangements with providers, but does not handle the third party administration services. This product capability was developed in response to the opportunity to market to large union Taft-Hartley funds, many of which handle their own claims processing. The Company has been selected by a coalition of unions representing more than 50,000 members as the endorsed PPO vendor and enrolled the first union group on January 1, 1997. Although this PPO network "rental" option generates modest fee income, it enhances the Company's purchasing power in the dental community and opens up the organized labor market as a new opportunity for the Company's other managed care products. As of December 31, 1998, the Company had approximately 49,300 members in these two categories. Network Providers The Company believes that the size, quality and accessibility of its network of managed care dentists has been an essential element in its managed care enrollment growth. The Company maintains a proprietary database of dentist contacts throughout its service area which it utilizes to continuously recruit new providers into its network. The Company also believes that its ability to effectively market its network of managed care dentists to employers through its managed care products makes participation in its provider network attractive to many dentists. The Company regards its managed care network providers as customers and has implemented practices and procedures to attract and retain qualified providers. The Company attempts to compensate managed care providers primarily on a capitated basis because it believes that capitated compensation is the most effective method of containing dental benefit plan costs on an ongoing basis. The Company typically "prepays" the capitated amounts on the first business day of each month for those members who have selected that dentist, thereby creating attractive cash flow advantages to dentists who participate in the Company's managed care network. Dentists have relative high fixed costs associated with their practices. Many dentists are willing to negotiate their fees and find capitation an attractive revenue source to help them cover such costs. In addition to capitation, managed care dentists also receive co-payments for services (other than certain preventative/diagnostic procedures) at the time service is rendered. The Company attempts to price its members' co-payments so that they exceed a dentist's variable costs for the procedure, but are less than the dentist's usual and customary fee. The Company's benefit plans require a patient to make co-payments directly to the dentist at the time of service, which eliminates delays in payments and reduces the overhead associated with filing claims and attendant collection efforts. In addition, the Company also may negotiate other payment arrangements with managed care dentists under certain circumstances. This may involve, among other things, contributions by the Company toward costs for infection control or cost-sharing by the Company on a discounted fee-for-service basis. A significant portion of the - 11 - specialists with which the Company has managed care provider contracts are compensated by the Company on such a discounted fee-for-service basis and not on a capitated basis. Accordingly, the Company retains the risk of its share of the cost for services provided through such arrangements. Total payments to specialists represented approximately 14% of the Company's payments to providers in 1998. The Company believes that the large number of practicing dentists and the high proportion of solo practitioners make the Chicago metropolitan markets competitive for private practice dentists. It has been the Company's experience within the Chicago metropolitan marketplace that dental providers are willing to participate in its managed care network. The Company believes that providers find participation in its managed care network attractive for several reasons. The Company has established a record of delivering large volumes of new patients to participating providers. The Company regards its network providers as customers and believes that it provides higher levels of service and support than typically provided by its competitors. These factors, coupled with the fact that the Company's capitated payment arrangements provide attractive cash flow advantages to its managed care dentists, have enabled the Company to attract and retain qualified providers for its managed care network. The Company also believes that its managed care network must be of demonstrable quality. The Company has developed a multi-step quality assessment program which begins by initially qualifying interested dentists followed by a personal office visit with the dentists. Further credentialing involves verifying a dentist's license, the existence of professional liability coverage and reviewing any previous claims history. Additionally, the dental office itself is reviewed to determine if Company's managed care quality assessment program standards, which include proper infection control procedures, are being followed. After dentists are added to the managed care network, they and their practices are periodically recredentialed to ensure Company quality assessment standards are being maintained. This recredentialing also includes a periodic random chart audit of members who have received services from network dentists at that practice. Additionally, a comprehensive membership complaint/inquiry database is maintained by the Company, the contents of which are discussed with network dentists when considered necessary. The Company administers its continuing quality assessment program through its staff and through consulting dentists, under the supervision of a lead consulting dentist. The Company further demonstrates its commitment to maintaining a quality oriented managed care network through routine, on-site field visits and telephone service calls to dentists. Additionally, the Company provides an ongoing series of continuing education seminars covering such topics as infection control. The Company also maintains a working relationship with professional dental organizations in dealing with issues of common interest. The Company believes that its managed care network must be stable in order to offer long-term continuity of care. The Company views its providers as customers rather than vendors of care and, consequently, focuses significant resources upon assessing and addressing provider concerns and sources of dissatisfaction. The Company also provides an ongoing series of continuing education seminars, at no cost for its managed care network providers. Through these contacts, the Company proactively works to meet network dentists' expectations. In 1998, the Company's managed care provider annual retention rate was approximately 92%. Managed care network providers are independent contractors who provide services to members pursuant to contractual arrangements with the Company. The Company's relationships with its managed care network dentists generally are terminable at any time by either party upon short notice. The contracts do not require managed care network dentists to provide services exclusively to members of the Company's plans. The Company may, following any required regulatory approval, change the terms, capitation rates, benefits and conditions of the various plans serviced by its managed care network upon advance notice. The Company's contracts with managed care network dentists require the dentists to maintain their own malpractice insurance. The Company also carries insurance protecting it against liability relating to acts or omissions of managed care network dentists. Although no material malpractice or similar claims have been asserted against the Company in the past, there can be no assurance that the Company will not become involved in such litigation or otherwise become subject to material claims relating to its managed care or PPO network dentists in the future. In the event of litigation or claims against the Company for malpractice by one of the providers or for negligence in credentialing one of the providers in its networks, there is - 12 - no assurance that the Company's professional liability insurance will be sufficient to cover any liability which might result from such litigation or claims. The Company's policy is to permit dentists to participate in either its managed care network, its PPO network or both. Consistent with the practice of other dental PPOs, if a dentist elects to only participate in the Company's PPO network, the credentialing requirements are less extensive than those for the managed care network and currently there are no ongoing peer review requirements for PPO dentists. Presently, substantially all of the participating dentists in the Company's managed care network participate in the Company's PPO network. In addition, at December 31, 1998, the Company's PPO network had approximately 600 additional dentists that do not participate in the Company's managed care network. The Company is actively recruiting other dentists to participate in its PPO network and intends to add more dentists to its PPO network. Customer Groups The following table shows a breakdown of the Company's groups by size as of December 31, 1998:
Subscribers(2) Number of ---------------------- Size of Group by Number of Subscribers(1) Groups Total % of Total ----------------------------------------- ------ ----- ---------- Individuals.......................................... N/A 6,600 2.6% 2-10 ............................................ 2,105 10,600 4.2% 11-50 ............................................ 1,661 39,100 15.5% 51-100 ............................................ 380 27,000 10.7% 101-500 ............................................ 340 67,400 26.8% 500+ ............................................ 55 101,400 40.2% ------ -------- ------ Total....................................... 4,541 252,100 100.0% ====== ======== ======
- --------- (1) The number of subscribers represents the number of employees of an employer group who have enrolled in one of the Company's products but does not include dependents of such employees. (2) Amounts do not include subscribers in the Company's ASO, ASO/PPO, PPO network access, PPO network rental programs and fully insured Medicare members. The Company's 10 largest groups accounted for approximately 23% of the Company's revenues for the year ended December 31, 1998 and accounted for approximately 14% of total members for such period. None of the Company's groups accounted for more than 10% of the Company's revenues in 1998. The Company has been successful in obtaining dental benefit business from some of the largest employers in the metropolitan areas it serves, including Advocate Health Care, First Chicago Corporation/NBD, City of Milwaukee, Milwaukee Public Schools and Washington University (St. Louis). The Company believes that the size and prominence of its largest employer groups has been instrumental in attracting and retaining other employers. The Company's group contracts generally provide for a defined set of dental benefits to be delivered to members for a period of one year at specified monthly rates. The contracts normally have fixed terms of one year and provide for automatic renewal unless terminated by notice from either party provided a specified period (typically 60 days) prior to the end of the term thereof. Marketing and Sales The Company markets its dental benefit plans through a network of over 1,400 independent insurance brokers and a direct sales force consisting of 16 employees. This dual distribution system is designed to reach large - 13 - groups as well as smaller groups and individuals in an efficient and cost effective manner. The Company believes that this marketing strategy provides it with a competitive advantage by enabling it to market to a wider range of potential groups more efficiently than companies relying on a single distribution system. The Company's direct sales force targets larger employers and groups which are more likely to contribute towards the cost of dental benefits for their employees. In marketing to large groups, the Company's sales force focuses on stand-alone managed care products as an economical alternative to traditional indemnity coverage as well as Managed ChoiceSM products. The Company pays its direct sales force through a combination of salary and bonus based upon the number of members enrolled for new groups. As part of its growth strategy, the Company intends to increase its internal sales and marketing staff to recruit and manage its network of brokers and expand telemarketing efforts. The Company's independent insurance broker network focuses on offering primarily voluntary (employee-pays-all) managed care products to medium and smaller-sized employers which have not previously contributed toward or offered dental care benefits to their employees. The Company believes that there are significant opportunities for the Company to expand managed care coverage to medium and smaller-sized employers by expanding its network of independent brokers who can efficiently sell dental benefit products to the medium and smaller-sized market. Brokers typically do not market the Company's dental benefit plans on an exclusive basis. Brokers generally receive a flat percentage of the premium collected as commission for the initial sale of the Company's product as well as a commission for each annual renewal thereof. The Company has developed a proprietary business development process which is used in conjunction with the Company's direct and brokered sales efforts. This business development process relies heavily on a computerized prospect tracking system which contains detailed benefit and contact information on approximately 35,000 employers in the Chicago, Milwaukee, St. Louis and Detroit metropolitan areas. Using this database, the Company's business development representatives use direct mail to target employer decision makers and brokers and telemarketing to follow up with these employer decision makers and brokers. It has been the Company's experience that the sales cycle may be a multi-year process, particularly since employers tend to make decisions regarding dental coverage on an annual basis. The Company believes that the continuity of communication which it has established with these decision makers gives the Company a significant advantage over its competitors in the metropolitan markets it serves. This comprehensive database also links brokers with their clients which permits the Company's field staff to contact brokers at the time of their clients' annual renewal periods. Marketing generally is a two-step process in which presentations are made first to employers and then directly to employees. Once selected by an employer, the Company typically solicits potential subscribers from the employee base directly. During periodic "open enrollments," when employees are permitted to change dental benefit programs, the Company uses direct mail, work site presentations and other marketing methods to attract new subscribers. The Company stresses its ability to provide a flexible schedule of benefits, quality dental services oriented toward preventive care at reasonable prices and a large panel of dentists from which to choose in these marketing efforts. The Company also has a member services department which assists members on such matters as schedules of benefits, available network dentists, transfers from one network dentist to another, emergency dental services, billing issues and other administrative and group service matters. The member services department also handles complaints about providers and conducts member satisfaction surveys. The Company has a separate account management department that focuses on servicing the needs of benefit managers and groups. The Company believes that this service effort is important to group retention and enrollment growth among group members. The Company manages its groups with a long-term strategic goal to increasing participation in the Company's managed care plans. - 14 - Management Information Systems The management information systems used by the Company are designed to facilitate subscriber and provider service. The Company depends on these systems for comprehensive group service, premium collection and reconciliation, administration of capitation and commission payments, member eligibility processing, marketing support, corporate accounting and management reporting. The Company's management information systems allow it to offer multiple plans tailored to the needs of its groups and have the capability to interface directly with the systems of its groups, which can facilitate expeditious processing of changes in membership information. The Company periodically upgrades its hardware and software systems to (i) enhance its capability for electronic interchange with its groups, (ii) streamline the systems' ability to support both multi-state accounts and multiple products for the same group, (iii) enhance the integration between the Company's management information systems and its corporate accounting software, (iv) improve statistical and analytical capability with respect to various aspects of the Company's business and (v) make other technological changes to improve the efficiency of the Company's systems. The Company plans to increase the use of electronic methods for billing, enrollment and ongoing eligibility maintenance between employer groups and network dentists. The Company believes that these upgrades should help it to limit staff increases in the future and to increase the effectiveness and efficiency of its administrative operations. Competition The Company operates in a highly competitive environment. Its competitors principally include insurance companies, which often offer both managed dental care and indemnity dental products in the Company's market, and independent companies offering managed dental care products similar to those offered by the Company. The managed dental care industry as a whole is currently fragmented and characterized by the participation of several large, national insurance companies and many smaller independent plan sponsors. The Company also competes with numerous other types of businesses in the health care industry, including health maintenance organizations, limited health services corporations, self-funded plans which are administered by third party administrators, preferred provider organizations and other discount fee-for-service dental plans. The Company has experienced, and expects that it will continue to experience in the future, increased competition from all such sources. Many of the Company's competitors are larger and have substantially greater financial and other resources than the Company. Price considerations have been a significant competitive factor in the past and the Company believes pricing will continue to be a significant competitive factor in the future, especially with respect to large government and labor union contracts awarded on the basis of competitive bidding. Currently such contracts constitute less than 2% of the Company's total revenues. The Company believes that it competes principally on the basis of the pricing of managed care products in comparison to traditional indemnity plan coverage, the size, accessibility and quality of its provider network, its service reputation and the diversity of its products. Of these, the Company has found that provider network size, accessibility and quality, service reputation and cost are generally the factors most critical in employer decision-making. While the managed dental care business does not require substantial amounts of capital, the Company believes that certain factors may limit the number of new competitors that successfully enter its marketplace. These include the need for new competitors to comply with governmental licensing requirements and to establish provider and insurance broker networks in order to enter and compete in the market. The Company believes that it is well positioned to continue to compete in the Chicago, Detroit, Milwaukee and St. Louis metropolitan areas as a result of its growing network of providers and insurance brokers and the Company's service reputation and client base. While the Company believes that it has successfully established one of the leading market positions in the Chicago, Milwaukee and St. Louis metropolitan areas, there can be no assurance that the Company will be able to continue to increase or maintain its market share. Increased competition could adversely affect the Company's results of operations. - 15 - Government Regulation The business of the Company is subject to extensive regulation, by, as may be applicable, the insurance statutes and regulations of the states in which the Company operates with respect to the prepaid health plan, insurance, reinsurance, and related operations of the Company ("Insurance Regulation"). The Company is registered in Illinois, Indiana and in Michigan as a Third Party Administrator and in Illinois as an Insurance Firm; its subsidiary, First Commonwealth of Illinois, Inc., is registered in Illinois as a Preferred Provider Administrator; another subsidiary, First Commonwealth Limited Health Services Corporation, is licensed in Illinois as a Limited Health Service Organization and in Indiana as a Limited Service Health Maintenance Organization; another subsidiary, First Commonwealth Insurance Company, is licensed in Illinois as a domestic life, accident and health insurer with the intent to underwrite indemnity dental business and also licensed as a Limited Health Service Organization; another subsidiary, First Commonwealth Limited Health Service Corporation, is licensed in Wisconsin as a Limited Service Health Organization; another subsidiary, First Commonwealth of Missouri, Inc. (formerly Champion Dental Services, Inc.), is licensed in Missouri as a prepaid dental plan corporation; and an affiliate, First Commonwealth Health Services Corporation, is organized under Illinois law as a Voluntary Health Services Plan. Insurance Regulation, which may vary from state to state, establishes extensive operational, financial, reporting, and other requirements applicable to the Company's business in such state. Depending upon the nature and scope of regulatory requirements adopted from time to time in each of the states having jurisdiction over the legal entities or operations of the Company, Insurance Regulation may materially and adversely affect the business, operating results and financial condition of the Company. Insurance Regulation generally requires the Company to be licensed by the state insurance department in order to offer its dental care products, administrative services or preferred provider network in such state and otherwise conduct its operations in such state. In addition, Insurance Regulation generally prescribes minimum levels of net worth and reserves, limits the ability of the Company's subsidiaries to pay dividends to the extent required surplus would be impaired, requires filings for approval of products and services offered by the Company and its subsidiaries and the filing of rate schedules, certain product literature, forms of contracts with subscribers, dentists and others (which may entail substantial delay in implementing changes or introducing new products), establishes minimum benefit levels for the Company's dental products in some cases, provides for periodic examinations, including quality assessment review, establishes standards for the Company's management and other personnel, specifies measures for resolving grievances and requires prior approval if more than a certain percentage of the Company's outstanding voting securities are to be acquired. Changes in Insurance Regulation or the application thereof could involve, among other things, increased capitalization requirements, limitations on the payment of dividends, distributions, or principal or interest on subordinated debt, the imposition of guaranty fund assessments, mandated health benefits and other terms of enrollment contracts, restrictions on the use of "fronting arrangements" and reinsurance agreements, requirements for admission of or licensing as foreign reinsurance companies, limited health service organizations, limited service health organizations, prepaid dental plan corporations, preferred provider administrators and third party administrators, state health insurance reforms for groups and individuals, "any willing provider" requirements limiting the Company's right to restrict the size of its provider network, minimum loss ratio requirements, enterprise liability statutes, which may increase the Company's liability for the negligent acts of its providers, or other matters. There can be no assurance that changes in Insurance Regulation or the application of existing Insurance Regulation, including matters relating to the Company's limited operations outside its service areas, will not materially and adversely affect the business or financial condition of the Company. Failure of the Company to comply with the Insurance Regulation could subject the Company to financial penalties, cease and desist orders or the revocation of one or more licenses required to conduct its business. Any future expansion of the Company's business may subject the Company to additional regulation by the state or federal governments. The insurance statutes and regulations of certain states may limit the ability of the Company to expand its operations in or into such states, or may substantially delay the commencement of operations in such states as a result of the need to comply with the licensing requirements of such states. Expansion of the Company's business by acquisition of control of existing regulated entities may subject the Company to substantial filing and approval requirements. Furthermore, proposals have been made in the past, and may be made - 16 - again, for national and state health care reform which, if enacted, could materially and adversely affect the business and financial condition of the Company. It has been the Company's policy to maintain regular contact and productive working relationships with regulators in each jurisdiction in which it is licensed to conduct business. In general, Insurance Regulation of the states in which the Company and its subsidiaries operate require a person seeking to acquire control, directly or indirectly, of certain regulated entities or of any person controlling such entity to file with the relevant insurance regulatory authority an application for change of control (commonly known as a "Form A") containing certain information regarding the identity and background of the acquiror and its affiliates, the source and amount of funds to be used to effect the acquisition and certain other matters. For purposes of many of these statutes and regulations promulgated thereunder, a person that owns or controls, directly or indirectly, 10% or more of the outstanding voting securities of any other person is generally presumed to "control" that other person. Accordingly, any purchase of Common Stock that would result in the purchaser having beneficial ownership of Common Stock equal to or in excess of the specified threshold level, which may be lower than 10% in some states or, as a result of future regulatory action, in one or more of those states in which the Company currently operates, pursuant to the offering of Common Stock made hereby or otherwise (including through purchases in the open market), must file for and obtain prior approval from all applicable regulatory authorities. Such prior approval could also apply to the acquisition of proxies to vote specified percentages of the outstanding Common Stock and, therefore, could delay or prevent a stockholder from acquiring such proxies in a proxy contest. No assurance can be given that the Company would not seek to invoke these laws and regulations in a proxy contest or a tender offer or merger situation. Failure to comply with change of control provisions under applicable state insurance codes by an investor acquiring the Company's Common Stock at or above the specified threshold levels could result in a material adverse effect on such investor, including the possible entry of a divestiture order, and could also possibly result in adverse regulatory action against the Company and its subsidiaries. Prospective and current stockholders, and not the Company, are responsible for compliance with Form A and similar filing and prior approval requirements. The Company assumes no obligation with respect to these matters. The Company's business is not currently regulated at the federal level. During 1994, however, Congress considered legislation proposing comprehensive reform of the health care system in the United States. The Company cannot predict whether or when future health care reform initiatives at the federal or state level or other initiatives affecting insurance and/or managed care providers such as the Company may be proposed, enacted or implemented or what impact such initiatives may have on the Company's business, operating results or financial condition. Company's Corporate Structure The Company contracts to provide dental care benefits to groups and members in Illinois through First Commonwealth Limited Health Services Corporation ("FC-Limited"), a wholly-owned subsidiary, and First Commonwealth Insurance Company ("FC-Insurance"); in Indiana through FC-Limited; in Wisconsin through First Commonwealth Limited Health Service Corporation ("FC-Wisconsin"), a wholly-owned subsidiary; in Missouri through First Commonwealth of Missouri, Inc. ("FC-Missouri), a wholly-owned subsidiary; and in Michigan through a fronting arrangement described below. The Company provides administrative and marketing services for FC-Limited, FC-Wisconsin, and FC-Missouri. Another wholly-owned subsidiary, First Commonwealth of Illinois, Inc. ("FC-Illinois"), contracts with dentists and dental care specialists to provide dental care services to groups and to members for whom FC-Limited, FC-Wisconsin, and FC-Missouri provides dental benefits. Smileage, a wholly-owned subsidiary, is a Wisconsin based dental HMO administrator. As the Company has increased its indemnity business, it has entered into a reinsurance agreement with North American Insurance Company ("North American"), an Illinois licensed reinsurer, covering a portion of its indemnity business. North American, in turn, has entered into an agreement with another third party insurer, Capitol Indemnity ("Capitol"). Capitol has entered into an agreement with another subsidiary of the Company, First Commonwealth Reinsurance Company ("FC-RE"), whereby North American transfers most of this reinsured risk from FC-Limited to Capitol and onto FC-RE. The Company currently retains virtually all of the underwriting risk of its indemnity plans. FC-RE engages in no reinsurance activity that is not related to the Company's indemnity - 17 - products. In 1998, FC-Limited entered into an assumptive reinsurance transaction with FC-Insurance to reinsurance over all of this business rather than reinsure this business through North American and Capitol. In addition, in 1997, the Company, acting as agent for North American and according to a fronting arrangement, began selling managed care and indemnity dental insurance policies in the state of Michigan. According to the reinsurance agreement above, North American ceded all policies in Michigan to Capitol who ceded these policies to FC-RE. Effective July 1998, Capitol replaced North American in this fronting arrangement. First Commonwealth Health Services Corporation ("FCHSC") is consolidated with the Company and its subsidiaries for financial reporting purposes. FCHSC is not material to the financial condition or operating results of the Company. FCHSC is licensed under the Voluntary Health Services Plans Act (the "VHSP Act"). In accordance with the VHSP Act, FCHSC is operated and conducted as a not-for-profit and is also governed by the provision of the General Not-for-Profit Corporation Act. FCHSC was initially capitalized by First Commonwealth, Inc. ("FC Inc.") through the purchase of a subordinated note. Certain officers and trustees of FCHSC are common to the officers and directors of FC Inc. Consistent with its authority under the VHSP Act, FCHSC provides reimbursement to its members for covered dental care. The VHSP Act requires, among other provisions, that FCHSC not expend more than 20% of its annual subscriber revenue for administrative costs and 10% for marketing costs. FC Inc. provides administrative and marketing services to FCHSC pursuant to a management agreement. Risk Management The Company maintains general and professional liability insurance to cover the risk of operating its managed care dental plans. In addition, each dentist in the provider network is required to maintain malpractice insurance. The Company seeks to enter into capitation arrangements whenever possible as its primary means of managed care dentist compensation. In addition to capitation arrangements, the Company also may negotiate other payment arrangements with dentists and specialists. Such arrangements may involve, among other things, contributions by the Company toward costs for infection control or discounted fee-for-service pricing arrangements. Certain specialists with which the Company has provider contracts are compensated by the Company on such a discounted fee-for-service basis and not on a capitated basis. Accordingly, the Company retains the risk of its share of the cost for services provided by such specialists. If the number of managed care providers covered under other compensation requirements materially increase, or the cost of such arrangements becomes significantly higher than projected, including utilization of specialty care benefits, the Company's profitability could be materially and adversely affected. Total payments to specialists represented approximately 14% of the Company's payments to managed care providers in 1998. In addition, an increasing portion of the Company's business is the sale of indemnity/PPO plans as part of its Managed ChoiceSM product. The Company retains virtually all of the underwriting risk of its indemnity/PPO products. Although dental indemnity/PPO plans have limitations on coverage (including limits on procedures covered, amounts covered per procedure and annual and lifetime benefits), due to variability in both the utilization of services and the cost per service under an indemnity/PPO plan, increased indemnity/PPO enrollment increases the underwriting risk undertaken by the Company. The dental benefit costs associated with the Company's Managed ChoiceSM products include an estimate of dental expenses incurred by its members outside of the Company's provided network, but which have not yet been reported to the Company. If the utilization or cost per service incurred outside of the Company's network were to be greater than estimated, the Company's business, operating results or financial condition could be materially and adversely affected. The Company has not experienced any significant adverse variations between such estimated and actual expenses, but there can be no assurance that such variations will not occur in the future. The Company staffs its claims processing operation with individuals experienced in dental terminology and procedures such as hygienists, dental office assistants and dentist consultants, who review claims submitted for appropriateness. The Company also uses specific underwriting criteria as an integral part of its risk management - 18 - program for its indemnity/PPO plans. Utilizing specific underwriting criteria, the Company attempts to assure that each employer group's profile is consistent with relevant rating assumptions. In addition, high patient cost-sharing in dental plans substantially limits the underwriting risk of a dental plan, particularly when compared to the risk in a medical plan. Furthermore, unlike medical plans, dental plans typically do not cover catastrophic risks. Employees The Company had approximately 153 employees as of December 31, 1998. None of the Company's employees is covered by a collective bargaining agreement. The Company believes its relations with its employees are good. Officers and Directors of the Registrant Officers - -------- Christopher C. Multhauf Chairman and Chief Executive Officer David W. Mulligan President and Chief Operating Officer, Secretary Gregory D. Stobbe Senior Vice President, Operations Mark R. Lundberg Vice President, Sales Scott B. Sanders Chief Financial Officer and Treasurer, Assistant Secretary Directors - --------- Christopher C. Multhauf Chairman and Chief Executive Officer David W. Mulligan President and Chief Operating Officer, Secretary Richard M. Burdge, Sr. Executive Vice President-Retired, CIGNA Corporation William J. McBride Chairman, Novaeon, Inc.; President-Retired, Value Health, Inc., a managed healthcare company Jackson W. Smart, Jr. Chairman and Chief Executive Officer-Retired, MSP Communications, Inc., a radio broadcasting company Item 2. Properties The Company does not own any real estate; it leases approximately 24,000 feet of office space in Chicago. The lease has a term expiring in 2000, with an option for the Company to extend the lease through 2003. In addition, the Company leases approximately 1,700 feet of office space in Milwaukee with a term expiring in 1999; 1,700 feet of office space in St. Louis with a term expiring in 2002; and 500 feet of office space in Detroit on a month to month lease. Item 3. Legal Proceedings The Company is involved from time to time in routine legal and regulatory proceedings incidental to its business. The Company is not involved in any currently pending lawsuits or proceedings that it believes will have, individually or in the aggregate, a material adverse effect on the Company. Item 4. Submission of Matters to a Vote of Security Holders None. - 19 - PART II Item 5. Market for Registrant's Common Equity and Related Stockholder Matters Stock Trading and Common Stock Prices The Company's Common Stock trades on The Nasdaq Stock MarketSM under the symbol FCWI. At February 27, 1999, there were 175 registered shareholders and the Company believes there are at least 400 round lot shareholders of beneficial interest. The following table sets forth the high and low closing prices by quarter for 1998, 1997 and 1996.
Quarter -------------------------------------------------------------------- First Second Third Fourth ----- ------ ----- ------ Year ending December 31, 1998 High $15.375 $16.00 $16.125 $13.25 Low $9.625 $13.75 $11.375 $9.75 Year ending December 31, 1997 High $21.25 $19.50 $20.50 $15.25 Low $14.75 $11.25 $14.75 $11.25 Year ending December 31, 1996 High $27.00 $29.00 $29.00 $24.50 Low $24.00 $24.25 $20.75 $16.50
Dividend Policy The Company has never paid cash dividends on its Common Stock. The Company currently intends to retain earnings to finance the growth and development of its business and does not anticipate paying cash dividends on its Common Stock in the foreseeable future. Any payment of cash dividends in the future will depend upon the financial condition, capital requirements and earnings of the Company, limitations on dividend payments by subsidiaries of the Company under applicable state laws requiring the maintenance of specified levels of capital and surplus and such other factors as the Board of Directors may deem relevant. - 20 - Item 6. Selected Financial Data SELECTED CONSOLIDATED FINANCIAL AND OPERATING DATA The selected consolidated statement of income data and balance sheet data as of, and for, the years ended December 31, 1998, 1997 and 1996 are derived from, and are qualified by reference to, the consolidated financial statements of the Company audited by Arthur Andersen LLP, independent public accountants, appearing elsewhere herein. The selected consolidated statement of income data and balance sheet data as of, and for, the years ended December 31, 1995 and 1994 are derived from audited financial statements of the Company not included herein. The selected consolidated financial information set forth below should be read in conjunction with "Management's Discussion and Analysis of Results of Operations and Financial Condition" and the Company's consolidated financial statements and related notes appearing elsewhere herein. The selected operating data has been derived from the accounting records of the Company and has not been audited.
Year Ended December 31, ----------------------- 1998 1997 1996(3) 1995 1994 ---- ---- ------- ---- ---- (in thousands, except for per share and operating data) Consolidated Statement of Income Data: Subscriber revenue.......................... $ 64,170 $ 56,594 $ 44,099 $ 33,315 $ 22,077 Benefit coverage expenses................... 42,731 37,932 27,873 20,286 12,321 ---------- ---------- ---------- ---------- ---------- Gross margin................................ 21,439 18,662 16,226 13,029 9,756 Selling, general and administrative expense 15,496 13,550 12,273 9,883 7,458 ---------- ---------- ---------- ---------- ---------- Operating income............................ 5,943 5,112 3,953 3,146 2,298 Interest income, net........................ 693 495 642 194 59 ---------- ---------- ---------- ---------- ---------- Income before income taxes.................. 6,636 5,607 4,595 3,340 2,357 Provision for income taxes.................. 2,645 2,284 1,864 1,336 1,009 ---------- ---------- ---------- ---------- ---------- Net income.................................. $ 3,991 $ 3,323 $ 2,731 $ 2,004 $ 1,348 ========== ========== ========== ========== ========== Basic earnings per share (1)................ $ 1.10 $ 0.92 $ 0.79 $ 0.69 $ 0.48 ========== ========== ========== ========== ========== Diluted earnings per share (1).............. $ 1.07 $ 0.89 $ 0.76 $ 0.67 $ 0.47 ========== ========== ========== ========== ========== Selected Operating Data: Members at end of period: Managed Care.............................. 482,200 450,400 341,600 265,800 215,700 Indemnity/PPO............................. 75,600 65,300 56,200 36,700 11,600 Fee Income (2)............................ 87,100 76,600 34,000 6,100 NC ---------- ---------- ---------- ---------- ---------- Total Members........................... 644,900 592,300 397,800 308,600 227,300 Consolidated Balance Sheet Data (at end of period): Total current assets........................ $ 20,252 $ 16,554 $ 21,023 $ 16,889 $ 5,716 Total assets................................ 38,076 31,895 34,454 19,111 7,217 Total current liabilities................... 10,181 8,325 14,331 7,280 3,977 Total liabilities........................... 10,357 8,573 14,498 7,405 4,077 Preferred stock............................. -- -- -- -- 892 Stockholders' equity........................ 27,719 23,323 19,956 11,706 2,248
- 21 - (1) Earnings per share reflects the conversion of all outstanding shares of Series B Preferred Stock upon the consummation of initial public offering in November 1995. (2) 1994 members are not comparable. (3) Reflects results of the acquisition of Smileage Dental Services, Inc. from July 18, 1996. Balance sheet data (but not income or operating data) as of December 31, 1996 includes amounts relating to Champion Dental Services, Inc., which was acquired as of December 31, 1996. - 22 - Item 7. Managements's Discussion and Analysis of Financial Condition and Results of Operations MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion and analysis of the Company's consolidated results of operations and consolidated financial condition should be read in conjunction with the Selected Consolidated Financial and Operating Data and the Company's consolidated financial statements, including the notes thereto appearing elsewhere in this Form 10-K. Overview The Company began operations in the Chicago area in 1988 and has grown to be a leading provider of managed dental benefits in the upper Midwest, including the metropolitan areas of Chicago, Milwaukee, St. Louis, Detroit and Indianapolis. As of December 31, 1998, the Company had 482,200 members in its managed care plans, 75,600 members in its fully insured indemnity/PPO plans, and 87,100 members eligible to access the Company's PPO network and covered under its administrative services only ("ASO") arrangements. In 1992, the Company began marketing indemnity plans as part of its Managed ChoiceSM products. In January 1996, the Company introduced its new PPO product (Managed ChoiceSM Triple Option), which integrates a managed component, the PPO option, into the Company's indemnity plans. The Indemnity/PPO revenue line includes revenue from both indemnity business that includes the PPO component as well as indemnity business that does not include the PPO component. The PPO component was available to less than 23% of the Company's Indemnity/PPO members as of December 31, 1998. The Company's Managed ChoiceSM products enable the Company to completely replace an employer's existing indemnity plan with the Company's combined managed care and indemnity/PPO plan. Acquisitions Effective July 18, 1996, the Company completed the acquisition of Smileage Dental Services, Inc. ("Smileage"), a Wisconsin-based dental HMO administrator, which provided services to approximately 50,000 members, and an associated reinsurance transaction, for an aggregate purchase price (including transaction costs) of $5.6 million. The acquisition was financed through the issuance of the Company's common stock. Effective December 31, 1996, the Company completed the acquisition of Champion Dental Services, Inc. ("Champion"), a Missouri-based prepaid dental plan, which provided services to approximately 60,000 members, for an aggregate purchase price (including transaction costs) of $5.6 million. The acquisition was financed through proceeds from the Company's initial public offering and was paid in cash on January 2, 1997. Both acquisitions offer managed care products that are typically at a lower gross margin level than what the Company has experienced in the past. Revenues The Company's annual revenues have increased from $44.1 million in 1996 to $64.2 million in 1998. Revenues increased to $64.2 million for 1998 from $56.6 million for 1997. Revenue growth for 1998 has been strong both in dollar and percentage terms, primarily as the result of the addition of new managed care and indemnity/PPO members. The Company expects that subscriber revenue will continue to increase at a slower rate than in previous years throughout 1999. The Company's product pricing varies based on the type of plan, the services provided and the member copayment (or coinsurance). In addition, pricing varies by marketplace based on employer and employee preference and competition. Pricing also may vary as a result of different pricing terms of the plans in effect at companies when acquired by the Company. As a result, per member pricing can fluctuate based on product mix, shifting marketplace preferences and acquisition timing. As contracts are renewed, the Company will seek to improve profitability on lower margin plans by increasing pricing, by offering plans with additional services at higher prices and margins, and by offering higher margin plans with fewer services at lower costs. - 23 - The largest source of Company revenue is derived from members enrolled in managed care plans. From 1996 to 1998, the Company's revenue from its managed care products grew from $32.8 million to $47.9 million. This increase is primarily attributable to managed care enrollment growth and, to a lesser degree, a shift toward managed care products with higher benefit and premium levels, as well as the acquisition of Smileage and Champion in 1996. In 1996, 1997 and 1998, managed care revenue accounted for approximately 74%, 77%, and 75%, respectively, of total revenue. The second largest source of Company revenue is generated from indemnity/PPO plan premiums. From 1996 to 1998, the Company's revenue from its indemnity/PPO products grew from $10.6 million to $15.2 million. For 1998 and 1996, revenue from indemnity/PPO enrollment accounted for approximately 24% of total revenue. The Company believes that revenue from indemnity/PPO enrollment will continue to increase in the future. The third largest source of revenue is fee income which is generated from the Company's PPO network rental program and ASO arrangements. Under the network rental program, PPO network providers offer services according to a reduced fee schedule negotiated by the Company. The Company charges its PPO groups a monthly fee for each member eligible to access such reduced fee arrangements. The Company does not make any payments to its PPO network providers on behalf of the eligible members access such reduced fee arrangements. Under the Company's ASO arrangements, the Company provides claims payments and related services for self-insured employers' indemnity plans. Under these arrangements the Company does not assume any of the underwriting risk for the indemnity claims. Benefit Coverage Expenses From 1996 to 1998, total benefit coverage expenses increased from $27.9 million to $42.7 million. Between 1996 and 1998, total benefit coverage expenses as a percentage of revenues increased from 63.2% to 66.6% of total revenue. This increase is largely the result of increases in the benefit coverage expenses of the Company's managed care products (primarily associated with the Company's acquisitions) and increases in benefit coverage expenses associated with indemnity/PPO plans. Gross Margin From 1996 to 1998, gross margin increased from $16.2 million to $21.4 million. Between 1996 and 1998, gross margin as a percentage of total revenue decreased from 36.8% to 33.4% of total revenue. This change is due to a decline in the gross margin of the Company's managed care products, primarily due to the lower gross margin on the managed care products acquired in the Wisconsin and Missouri marketplaces and the decrease in the gross margin on the Company's indemnity/PPO products in 1998. During 1998, the Company successfully transitioned portions of its lower gross margin business acquired in Wisconsin and Missouri to its higher gross margin standard products. In addition, the Company transitioned substantially all of its Illinois managed care membership to its new "template plan" line of products which has improved the managed care gross margin. The Company expects the managed care gross margin to continue to improve in 1999 as a result of the full year effect of the rollout of the new template plan design as well as the price increases that went into effect during 1998. The Company also expects the indemnity/PPO gross margin percentage to remain fairly consistent with the 1998 level throughout 1999. Overall gross margin percentages will vary if the mix of the Company's indemnity/PPO and managed care business changes from current levels. Selling, general and administrative Selling, general and administrative ("SG&A") expenses as a percent of revenues declined from 27.8% in 1996 to 24.2% in 1998. The change is primarily the result of economies of scale in meeting the administrative needs of increased enrollment due to the relatively fixed nature of certain SG&A expenses, higher revenues relative to the SG&A expenses associated with indemnity/PPO plans. This decrease in SG&A expenses as a percentage of revenue from 1996 through 1998 to a large degree offsets the decreases in the gross margin percentage during that period. The Company expects SG&A as a percent of revenue to remain relatively constant in 1999 and management expects it to decline thereafter, as the Company continues to achieve economies of scale and operating efficiencies. - 24 - Year 2000 Disclosure Many existing computer systems and applications abbreviate dates using only two digits ("98") rather than four digits ("1998"). If not corrected, this shortcut may cause problems when the century date "2000" occurs. On that date, some computer operating systems and applications and embedded technology may recognize the date as January 1, 1900 instead of January 1, 2000. If the Company fails to correct any critical Year 2000 processing problems prior to January 1, 2000, the affected systems may either cease to function or produce erroneous data, which could have material adverse operational and financial consequences. Currently, the Company believes that the major risks associated with the inability of systems and software to process Year 2000 data correctly include a disruption in the operation of its core enterprise systems, telephony systems, accounting and financial systems, and desktop and support systems. A failure of such systems could materially and adversely affect the Company's results of operations, financial position and cash flows. Throughout 1998 the Company has been actively working on its plan to address year 2000 compliance. The plan consists of three phases. Phase 1 involves an assessment of the Company's internal systems. Phase 1 is completed. The Company has found as a result of the assessment process that its core enterprise systems have always contained the ability to store and process the full four-digit year. Although this capability exists, several functional points of the system have not fully utilized the capability. Phase 2, scheduled for completion by July 1999, is the development and execution of specific action plans to resolve known potential year 2000 issues. Phase 3, scheduled for the second and third quarters of 1999, is the final testing of each major area determined as critical to ongoing business operations. Phase 1 included the identification of core business areas and processes, analysis of systems and hardware supporting the core business areas and the prioritization of renovation or replacement of systems and hardware that are not Year 2000 compliant. Included in the assessment phase is an analysis of risk management factors such as contingency plans and legal matters. The internal systems assessment process of Phase 1 categorized internal systems into 4 functional areas: (1) Core Enterprise System, (2) Telephony Systems, (3) Accounting and Financial Systems, and (4) Desktop and Support Systems. The Core Enterprise System includes computer systems that support key business functions such as billing, finance, customer service, and network provider payments. Within each of these areas it has been determined that the main suppliers of the systems utilized by the Company are able to provide year 2000 compliant releases. The acquisition of the available releases will be accomplished either through existing support arrangements or through the purchase of upgraded products. A fifth area requiring additional investigation is the assessment of the Company's major third party relationships outside of the information technology arena. This process has been completed. Phase 2 will consist of the conversion or replacement of selected platforms, applications, databases and utilities. Phase 3 will include the testing, verifying and validating the renovated or replaced platforms, applications, databases and utilities. The Company's current schedule is subject to change depending on developments that may arise through unforeseen circumstances, and through execution of the Company's compliance efforts. The Company is dependent on its vendors for compliant hardware, systems and applications and upgrades by experts, both internal and external, and the availability of critical resources with the requisite skill sets. The Company's ability to meet its target dates is dependent upon the timely provision of necessary upgrades and modifications by its suppliers and internal resources. In addition, the Company cannot guarantee that third parties on whom it depends for essential services (such as utilities, telecommunications operators, etc.) will convert their critical systems and processes in a timely manner. Failure or delay by any of these parties could significantly disrupt the Company's business. The Company's contingency plans will address mechanisms for preventing or mitigating interruption caused by such third parties. The Company believes that it will spend approximately $100,000 in 1999 to finish upgrading and verifying all critical areas identified. This cost includes the purchase of required software and hardware as well as outside contracting services. The Company has already secured the necessary resources for 1999. - 25 - Based on the Company's current schedule for completion of Year 2000 tasks, the Company believes that its planning is adequate to secure Year 2000 readiness of its critical systems. Nevertheless, management cannot provide assurance that its plans to achieve Year 2000 compliance will be successful or that the cost of its efforts will not differ materially from estimates, as each is subject to various risks and uncertainties, many of which are described above. Accordingly, the Company's goal is to develop business continuity and contingency plans in 1999 to address high-risk areas as they are identified. These plans are expected to assess the potential for business disruption in various scenarios, and to provide for key operational back-up, recovery and restoration alternatives. However, if the Company, or third parties with whom it has significant business relationships, fails to achieve Year 2000 readiness with respect to critical systems, there could be a material adverse affect on the Company's results of operations, financial position and cash flows. The Company's Year 2000 most reasonably likely worst case scenario may involve interruption of data processing services and telecommunications services and/or interruption of customer billing, operating and other information systems. As part of its Year 2000 initiative, the Company is evaluating these worst-case scenarios and is in the process of developing contingency and business plans tailored for Year 2000-related occurrences. The contingency and business contingency plans are expected to assess the potential for business disruption in various scenarios, and to provide key operational back-up, recovery and restorational alternatives. The Company's contingency plan initiatives include the following: personnel to be on call during the Year 2000 change to monitor critical systems, telecommunications and other processes and to react promptly to facilitate repairs; back-up plans in the event of failure or information or telecommunications systems or other Year 2000 disruptions; identification of alternate suppliers and implementation of plans to be in place for third-party products/services that fail to meet Year 2000 compliance commitment schedules; and data retention and recovery procedures to be in place for customer and critical business data to provide backups with on-site as well as off-site data copies. The Company anticipates having these contingency plans in place before December 31, 1999. The above information, which contains statements that are "forward-looking" within the meaning of the Private Securities Litigation Reform Act of 1995, is based on the Company's current best estimates, which were derived using numerous assumptions of future events, including the availability and future costs of certain technological and other resources, third party modification actions and other factors. Given the complexity of these issues and the possibility of unidentified risks, actual results may vary materially from those anticipated and discussed above. Specific factors that might cause such differences include, among others, the availability and cost of personnel trained in this area, the ability to locate and correct all affected computer codes, the timing and success of remedial efforts of third party suppliers and similar uncertainties. Results of Operations The following tables set forth certain information from the Company's consolidated statement of income for the periods indicated. In the opinion of management, these tables have been prepared on the same basis as the audited consolidated financial statements appearing elsewhere in this Annual Report and fairly present the results of operations of the Company for the periods covered thereby. - 26 -
Year Ended December 31, ----------------------- 1998 1997 1996 ---- ---- ---- (in thousands) Consolidated Statement of Income Data: Subscriber revenue Managed care................................. $ 47,901 $ 43,509 $ 32,807 Indemnity/PPO................................ 15,162 12,204 10,629 Fee income................................... 1,107 881 663 ---------- --------- ---------- Total subscriber revenue................... 64,170 56,594 44,099 ---------- --------- ---------- Benefit coverage expenses Managed care................................. 29,790 27,468 19,555 Indemnity/PPO................................ 12,941 10,464 8,318 Fee income................................... -- -- -- ---------- --------- ---------- Total benefit coverage expenses............ 42,731 37,932 27,873 ---------- --------- ---------- Gross margin Managed care................................. 18,111 16,041 13,252 Indemnity/PPO................................ 2,221 1,740 2,311 Fee income................................... 1,107 881 663 ---------- --------- ---------- Total gross margin......................... $ 21,439 $ 18,662 $ 16,226 ========== ========= ==========
Year Ended December 31, 1998 Compared to Year Ended December 31, 1997 Total subscriber revenue increased by $7.6 million, or 13.4%, to $64.2 million in 1998 from $56.6 million in 1997. The $7.6 million increase was primarily attributable to increased enrollment in the Company's managed care and indemnity/PPO dental plans, as well as price increases that went into effect during 1998. Managed care revenue increased $4.4 million over the same period, primarily due to an increase in new members and price increases. Indemnity/PPO revenue increased $3.0 million to $15.2 million in 1998 from $12.2 million in 1997, primarily as a result of adding new indemnity/PPO plan members and price increases. Total gross margin increased by $2.8 million, or 14.9%, to $21.4 million in 1998 from $18.7 million in 1997. Total gross margin as a percentage of revenue was 33.4% in 1998 as compared to 33.0% in 1997. This percentage increase was the result of improved gross margins on both the managed care and indemnity/PPO lines of business. Managed care gross margin as a percentage of revenue was 37.8% in 1998 as compared to 36.9% in 1997. The improved managed care gross margin was the result of transitioning lower gross margin business acquired in Wisconsin and Missouri to the Company's higher gross margin standard products, and transitioning the Company's Illinois membership to the new higher gross margin "template plan" line of products, as well as price increases which were implemented throughout 1998. The level of indemnity/PPO gross margin as a percentage of revenue increased to 14.6% in 1998 from 14.3% in 1997. This increase in indemnity/PPO gross margin was the result of price increases which were passed on during 1998. SG&A expenses increased by $1.9 million, or 14.4%, to $15.5 million for 1998 from $13.6 million in 1997. As a percentage of revenue, SG&A expenses increased to 24.2% for 1998 from 23.9% for 1997. This increase is attributable primarily to staffing and salary increases that were deferred in 1997 due to the Company's cost containment efforts that year. The Company expects SG&A as a percent of revenue to remain relatively constant in 1999 and management expects it to decline thereafter, as the Company continues to achieve economies of scale and operating efficiencies. Included in the SG&A total is $265,000, for 1998 and 1997, for the amortization of goodwill associated with the acquisitions. - 27 - Operating income increased by $830,000, or 16.2%, to $5.9 million for 1998 from $5.1 million in 1997. As a percentage of revenue, operating income was 9.3% in 1998 and 9.0% in 1997. The Company expects its operating income percentage to continue to improve as a result of its improved managed care gross margin. The effective tax rate for 1998 was 39.9% compared to 40.7% for 1997. The decline in effective tax rate is primarily due to the purchase of federally tax exempt municipal bonds purchased during the 1998 as well as the purchase of United States Treasury Notes and Bills which are exempt from state tax. The Company expects to continue to hold and/or purchase federally tax exempt municipal bonds throughout 1999. Net income increased by $668,000, or 20.1%, to $4.0 million for 1998 from $3.3 million for 1997. Year Ended December 31, 1997 Compared to Year Ended December 31, 1996 Total subscriber revenue increased by $12.5 million, or 28.3%, to $56.6 million in 1997 from $44.1 million in 1996. Of this increase, $3.3 million, or 26.4%, was attributable to the operations added through the acquisition of Missouri based Champion. The remaining $9.2 million increase was a 20.9% increase in revenues and was primarily attributable to increased enrollment in the Company's managed care and indemnity/PPO dental plans, as well as a full year effect of the Wisconsin based Smileage transaction. Managed care revenue increased $10.7 million over the same period, primarily due to an increase in new members and $3.3 million from Champion. Indemnity/PPO revenue increased $1.6 million to $12.2 million in 1997 from $10.6 million in 1996, primarily as a result of adding new indemnity/PPO plan members. Total gross margin increased by $2.5 million, or 15.4%, to $18.7 million in 1997 from $16.2 million in 1996. Total gross margin as a percentage of revenue was 33.0% in 1997 as compared to 36.8% in 1996. This percentage decline was the result of the lower gross margin from the Champion and Smileage acquisitions as well as from a decrease in gross margin in the Company's indemnity/PPO plans. Managed care gross margin as a percentage of revenue was 36.9% in 1997 as compared to 40.4% in 1996. This percentage decline was primarily the result of revenue acquired through the two acquisitions which had a combined gross margin percentage of 28.0% as compared with the existing managed care business which had a gross margin percentage of 40.0%. The level of indemnity/PPO gross margin as a percentage of revenue decreased to 14.3% in 1997 from 21.7% in 1996. This decline in indemnity/PPO gross margin was the result of increased expenses in the Company's indemnity/PPO plans, primarily attributable to higher utilization patterns. SG&A expenses increased by $1.3 million, or 10.6%, to $13.6 million for 1997 from $12.3 million in 1996. As a percentage of revenue, SG&A expenses dropped to 23.9% for 1997 from 27.8% for 1996. The change is primarily the result of economies of scale in meeting the administrative needs of increased enrollment due to the relatively fixed nature of certain SG&A expenses, higher revenues relative to the SG&A expenses associated with indemnity/PPO plans, and cost containment moves by the Company in 1997 to offset the decline in gross margin. Included in the SG&A total is $265,000 and $64,000, respectively, for 1997 and 1996, for the amortization of goodwill associated with the acquisitions. Operating income increased by $1.2 million, or 29.3%, to $5.1 million for 1997 from $3.9 million in 1996. As a percentage of revenue, operating income was 9.0% in 1997 and 1996. The effective tax rate for 1997 was 40.7% compared to 40.6% for 1996. Net income increased by $592,000, or 21.9%, to $3.3 million for 1997 from $2.7 million for 1996. - 28 - Liquidity and Capital Resources The Company's historical operating cash requirements have been met principally through operating cash flows. The primary uses of cash have been for operating activities and capital investments in the business. The acquisition of Champion was financed through proceeds from the Company's initial public offering and was paid in cash on January 2, 1997. The Company believes that cash generated from operations will be adequate to finance its anticipated operating needs for the foreseeable future. Cash flow provided by (used in) operations was $5.7 million, ($0.6) million and $3.7 million for the years ended December 31, 1998, 1997 and 1996, respectively. The Company primarily receives premium payments in advance of disbursing managed care dentist capitation payments and indemnity/PPO claims payments. Cash balances in excess of current needs are invested in interest- bearing accounts or cash equivalents. Cash flow from operations consist primarily of subscriber premiums and investment income net of capitation payments to network dentists, claims paid, brokers' commissions, general and administrative expenses and income taxes. In 1997, $2.0 million was transferred to restricted cash for the formation of an insurance company. Capital expenditures were $748,000 for 1998 and $682,000 for 1997 mainly for computer system enhancements, furniture, and leasehold improvements. Capital expenditures were $745,000 for the year ended December 31, 1996, primarily for office furniture and new computer systems. Cash provided by (used in) financing activities was $99,000, $43,000, and ($45,000) for the years ended December 31, 1998, 1997 and 1996, primarily from issuance of common stock in 1998 and 1997. As of December 31, 1998, the Company had cash and cash equivalents of $6.2 million, short-term investments of $4.8 million, long term investments of $3.1 million, restricted cash of $3.0 million, and no long term debt outstanding, except as of December 31, 1996, included in other current liabilities is a payable to the parent of Champion for the $5.5 million purchase price. In addition, the Company has a committed unsecured line of credit (the "Credit Agreement") available which expires June 30, 1999, and to date has not been executed and utilized. Upon execution of this Credit Agreement, the Company may borrow up to $5 million at the rate of LIBOR plus one-half percent. To the extent the Company makes acquisitions, a portion of the purchase price may be financed through borrowings. Under applicable insurance laws of the states in which the Company conducts business, the Company's subsidiaries operating in the particular state are required to maintain a minimum level of net worth and reserves. The Company may be required from time to time to invest funds in one or more of its subsidiaries to meet regulatory requirements, or to expand its operations into new geographic areas. In addition, applicable laws generally limit the ability of the Company's subsidiaries to pay dividends to the extent that required regulatory capital or surplus would be impaired. Impact of Inflation The Company does not believe the impact of inflation has significantly affected the Company's operations. Item 7A. Quantitative and Qualitative Disclosures about Market Risk The Company has determined that its market risk exposures, which arise primarily from exposures to fluctuations in interest rates, are not material to its future earnings, fair value and cash flows. - 29 - Item 8. Financial Statements and Supplementary Data Page Financial Statements ---- Report of Independent Public Accountants............................ 31 Consolidated Balance Sheets as of December 31, 1998, 1997 and 1996.. 32 Consolidated Statements of Income and Comprehensive Income for the years ended December 31, 1998, 1997 and 1996.................... 34 Consolidated Statements of Changes in Stockholders' Equity for the years ended December 31, 1998, 1997 and 1996.................... 35 Consolidated Statements of Cash Flows for the years ended December 31, 1998, 1997 and 1996.............................. 37 Reconciliations of Net Income to Net Cash Provided by Operating Activities for the years ended December 31, 1998, 1997 and 1996..... 38 Notes to Consolidated Financial Statements.......................... 39 - 30 - REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Stockholders and Board of Directors of First Commonwealth, Inc.: We have audited the accompanying consolidated balance sheets of FIRST COMMONWEALTH, INC. (a Delaware corporation) AND SUBSIDIARIES as of December 31, 1998, 1997 and 1996, and the related consolidated statements of income and comprehensive income, changes in stockholders' equity and cash flows for the years then ended. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of First Commonwealth, Inc. and Subsidiaries as of December 31, 1998, 1997 and 1996, and the results of their operations and their cash flows for the years then ended, in conformity with generally accepted accounting principles. ARTHUR ANDERSEN LLP Chicago, Illinois February 10, 1999 - 31 - FIRST COMMONWEALTH, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS As of December 31, 1998, 1997 and 1996
ASSETS - ------ 1998 1997 1996 ---- ---- ---- CURRENT ASSETS: Cash and cash equivalents $ 6,188,672 $ 9,047,214 $15,817,498 Short-term investments 4,824,629 - - Accounts receivable, net of allowances of $410,224, $334,012 and $289,554 at December 31, 1998, 1997 and 1996, respectively 4,941,894 3,443,661 3,010,585 Other receivables 579,015 163,329 220,819 Deposit under reinsurance agreement 2,098 752,284 696,564 Prepaid expenses 2,733,817 2,288,559 408,447 Deferred tax asset 982,000 859,000 869,000 ------------ ------------ ------------ Total current assets 20,252,125 16,554,047 21,022,913 ------------ ------------ ------------ PROPERTY AND EQUIPMENT, at cost 4,778,118 4,029,771 3,347,829 Less- Accumulated depreciation (3,034,010) (2,319,790) (1,725,450) ------------ ------------ ------------ Property and equipment, net 1,744,108 1,709,981 1,622,379 ------------ ------------ ------------ OTHER ASSETS: Investments 3,075,616 - - Restricted cash equivalents and government securities on deposit, at market 2,966,676 3,263,820 1,222,022 Goodwill and other intangibles, net of accumulated amortization of $593,273, $328,442 and $63,814 at December 31, 1998, 1997 and 1996, respectively 9,999,467 10,264,298 10,482,110 Deposits and other 38,476 103,495 104,554 ------------ ------------ ------------ Total other assets 16,080,235 13,631,613 11,808,686 ------------ ------------ ------------ Total assets $38,076,468 $31,895,641 $34,453,978 ============ ============ ============
The accompanying notes to consolidated financial statements are an integral part of these balance sheets. - 32 - FIRST COMMONWEALTH, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS-continued As of December 31, 1998, 1997 and 1996
LIABILITIES AND STOCKHOLDERS' EQUITY 1998 1997 1996 - ------------------------------------ ---- ---- ---- CURRENT LIABILITIES: Accounts payable--trade $ 154,866 $ 88,399 $ 338,000 Accounts payable--dental service providers 1,130,521 394,946 347,529 Claims liability 1,669,388 1,604,329 1,579,669 Accrued payroll and related costs 1,128,745 485,166 739,292 Other accrued expenses 812,390 355,429 648,000 Deferred subscriber revenue 5,088,757 4,444,468 4,448,953 Payable under reinsurance agreement 87,146 752,427 627,789 Income taxes payable 109,541 200,327 101,472 Other current liabilities (Note 2) - - 5,500,000 --------------- -------------- -------------- Total current liabilities 10,181,354 8,325,491 14,330,704 DEFERRED TAX LIABILITY 176,000 247,300 167,157 --------------- -------------- -------------- Total liabilities 10,357,354 8,572,791 14,497,861 --------------- -------------- -------------- STOCKHOLDERS' EQUITY: Common stock ($.001 par value; 15,000,000 shares authorized, 3,684,525 shares in 1998, 3,636,951 shares in 1997 and 3,600,996 shares in 1996 issued and outstanding) 3,685 3,637 3,601 Capital in excess of par value 13,353,604 13,251,815 13,206,633 Retained earnings 14,071,846 10,080,858 6,757,451 Less- 735 shares, 495 shares and 425 shares of common stock held in treasury at December 31, 1998, 1997 and 1996, respectively, at cost (15,942) (13,460) (11,568) Accumulated other comprehensive income 305,921 - - --------------- -------------- -------------- Total stockholders' equity 27,719,114 23,322,850 19,956,117 --------------- -------------- -------------- Total liabilities and stockholders' equity $38,076,468 $31,895,641 $34,453,978 =============== ============== ==============
The accompanying notes to consolidated financial statements are an integral part of these balance sheets. - 33 - FIRST COMMONWEALTH, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME For the Years Ended December 31, 1998, 1997 and 1996
1998 1997 1996 ---- ---- ---- SUBSCRIBER REVENUE $64,170,121 $56,594,410 $44,098,529 BENEFIT COVERAGE EXPENSES 42,731,042 37,932,044 27,872,976 ------------- ------------- ------------- Gross margin 21,439,079 18,662,366 16,225,553 SELLING, GENERAL AND ADMINISTRATIVE EXPENSE 15,496,424 13,549,645 12,272,835 ------------- ------------- ------------- Operating income 5,942,655 5,112,721 3,952,718 INTEREST INCOME, net 693,333 494,686 642,828 ------------- ------------- ------------- Income before income taxes 6,635,988 5,607,407 4,595,546 PROVISION FOR INCOME TAXES 2,645,000 2,284,000 1,864,000 ------------- ------------- ------------- NET INCOME $ 3,990,988 $ 3,323,407 $ 2,731,546 ------------- ------------- ------------- COMPREHENSIVE INCOME, net of tax: UNREALIZED GAINS ON SECURITIES: Unrealized holding gains arising during period, net of taxes of $16,614 24,921 -- -- STOCK OPTION EXPENSE, recognized only for tax purposes 281,000 -- -- ------------- ------------- ------------- Other comprehensive income 305,921 -- -- ------------- ------------- ------------- COMPREHENSIVE INCOME $ 4,296,909 $ 3,323,407 $ 2,731,546 ============= ============= ============= BASIC EARNINGS PER SHARE $1.10 $0.92 $0.79 ============= ============= ============= DILUTED EARNINGS PER SHARE $1.07 $0.89 $0.76 ============= ============= =============
The accompanying notes to consolidated financial statements are an integral part of these statements. - 34 - FIRST COMMONWEALTH, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY For the Years Ended December 31, 1998, 1997 and 1996
Common Stock Capital ---------------------- in Excess Retained Shares Dollars of Par Earnings ------ ------- --------- -------- BALANCE, December 31, 1995 3,365,375 $3,365 $7,676,536 $4,025,905 COMPREHENSIVE INCOME Net income -- -- -- 2,731,546 Other comprehensive income, net of tax: Comprehensive income -- -- -- -- Stock issued 235,621 236 5,530,097 -- Treasury stock purchased -- -- -- -- ---------- --------- ---------- ---------- BALANCE, December 31, 1996 3,600,996 3,601 13,206,633 6,757,451 COMPREHENSIVE INCOME Net income -- -- -- 3,323,407 Other comprehensive income, net of tax: Comprehensive income -- -- -- -- Stock issued 35,955 36 45,182 -- Treasury stock purchased -- -- -- -- ---------- --------- ---------- ---------- BALANCE, December 31, 1997 3,636,951 3,637 13,251,815 10,080,858 COMPREHENSIVE INCOME Net income -- -- -- 3,990,988 Other comprehensive income, net of tax: Unrealized holding gains arising during period -- -- -- -- Stock option expense, recognized for tax purposes -- -- -- -- Other comprehensive income -- -- -- -- Comprehensive income -- -- -- -- Stock issued 47,574 48 101,789 -- Treasury stock purchased -- -- -- -- ---------- --------- ---------- ----------- BALANCE, December 31, 1998 3,684,525 $3,685 $13,353,604 $14,071,846 ========== ========= =========== ===========
The accompanying notes to consolidated financial statements are an integral part of these statements. - 35 - FIRST COMMONWEALTH, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY-continued For the Years Ended December 31, 1998, 1997 and 1996
Accumulated Treasury Stock Other Total ------------------------- Comprehensive Comprehensive Stockholders' Shares Dollars Income Income Equity ------ ------- ------ ------ ------ BALANCE, December 31, 1995 $ -- $ -- $ -- $11,705,806 COMPREHENSIVE INCOME Net income -- -- $ 2,731,546 -- 2,731,546 Other comprehensive income, net of tax: ------------ Comprehensive income -- -- 2,731,546 -- -- ============ Stock issued -- -- -- 5,530,333 Treasury stock purchased (425) (11,568) -- (11,568) ----- -------- ------------- ----------- BALANCE, December 31, 1996 (425) (11,568) -- 19,956,117 COMPREHENSIVE INCOME Net income -- -- 3,323,407 -- 3,323,407 Other comprehensive income, net of tax: ------------ Comprehensive income -- -- 3,323,407 -- -- ============ Stock issued -- -- -- 45,218 Treasury stock purchased (70) (1,892) -- (1,892) ---- -------- ------------- ----------- BALANCE, December 31, 1997 (495) (13,460) -- 23,322,850 COMPREHENSIVE INCOME Net income -- -- 3,990,988 -- 3,990,988 Other comprehensive income, net of tax: Unrealized holding gains arising during period -- -- 24,921 -- 24,921 Stock option expense, recognized for tax purposes -- -- 281,000 -- 281,000 ------------ Other comprehensive income -- -- 305,921 305,921 -- ------------ Comprehensive income -- -- $4,296,909 -- -- ============ Stock issued -- -- -- 101,837 Treasury stock purchased (240) (2,482) -- (2,482) ----- -------- ------------- ----------- BALANCE, December 31, 1998 (735) ($15,942) $305,921 $27,719,114 ===== ======== ============= ===========
The accompanying notes to consolidated financial statements are an integral part of these statements. - 36 - FIRST COMMONWEALTH, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS For the Years Ended December 31, 1998, 1997 and 1996
1998 1997 1996 ---- ---- ---- CASH FLOWS FROM OPERATING ACTIVITIES: Cash received from subscribers $63,879,276 $55,767,127 $43,124,110 Cash paid to providers of care (28,507,698) (26,593,902) (15,202,299) Cash paid to employees, brokers and suppliers (14,576,975) (15,887,165) (14,465,535) Claims paid (13,016,149) (10,300,714) (8,063,681) Interest paid - - (514) Interest received 631,198 459,212 624,373 Income taxes paid (2,457,912) (1,993,502) (1,911,500) Cash transferred to restricted funds (286,561) (2,035,911) (373,158) ----------- ----------- ----------- Net cash provided by (used in) operating activities 5,665,179 (584,855) 3,731,796 ----------- ----------- ----------- CASH FLOWS FROM INVESTING ACTIVITIES: Purchase of property and equipment, net (748,347) (681,939) (745,509) Purchase of short-term investments (4,807,612) (517,130) (5,161,968) Purchase of long-term investments (3,067,117) - - Proceeds from sale of short-term investments - 517,130 5,097,314 Cash received in acquisition - - 432,326 Cost of acquisitions - (5,546,816) (171,680) ----------- ----------- ----------- Net cash used in investing activities (8,623,076) (6,228,755) (549,517) ----------- ----------- ----------- CASH FLOWS FROM FINANCING ACTIVITIES: Issuance of common stock 101,837 45,218 7,010 Principal payments on capital leases - - (26,996) Purchase of treasury stock (2,482) (1,892) (11,568) Payments of preferred dividends - - (13,380) ----------- ----------- ----------- Net cash provided by (used in) financing activities 99,355 43,326 (44,934) ----------- ----------- ----------- Net (decrease) increase in cash and cash equivalents (2,858,542) (6,770,284) 3,137,345 CASH AND CASH EQUIVALENTS, beginning of year 9,047,214 15,817,498 12,680,153 ----------- ----------- ----------- CASH AND CASH EQUIVALENTS, end of year $ 6,188,672 $ 9,047,214 $15,817,498 =========== =========== ===========
The accompanying notes to consolidated financial statements are an integral part of these statements. - 37 - FIRST COMMONWEALTH, INC. AND SUBSIDIARIES RECONCILIATIONS OF NET INCOME TO NET CASH PROVIDED BY OPERATING ACTIVITIES For the Years Ended December 31, 1998, 1997 and 1996
1998 1997 1996 ---- ---- ---- Net income $3,990,988 $3,323,407 $2,731,546 Adjustments to reconcile net income to net cash provided by operating activities- Depreciation and amortization 979,050 858,965 648,247 (Increase) decrease in assets- Accounts receivable, net (1,498,233) (433,076) (1,109,339) Other receivables (415,686) 57,490 (149,728) Deposit under reinsurance agreement 750,186 (55,720) (265,042) Prepaid expenses (445,258) (1,880,112) 881,526 Deferred tax asset (123,000) 10,000 (154,000) Restricted cash equivalents and government securities on deposit 313,164 (2,041,798) (373,158) Deposits and other 65,019 1,059 (59,854) Increase (decrease) in current liabilities- Accounts payable--trade 66,467 (249,601) (26,349) Accounts payable--dental service providers 735,575 47,417 (67,676) Claims liability 65,059 24,660 321,988 Accrued payroll and related costs 643,579 (254,126) (78,972) Other accrued expenses 456,961 (292,571) (91,022) Deferred subscriber revenue 644,289 (4,485) 1,186,160 Payable under reinsurance agreement (665,281) 124,638 238,535 Income taxes payable (107,400) 98,855 56,934 (Decrease)/Increase in long-term liabilities- Deferred tax liability 209,700 80,143 42,000 ---------- ---------- ---------- Net cash provided by (used in) operating activities $5,665,179 $ (584,855) $3,731,796 ========== ========== ==========
The accompanying notes to consolidated financial statements are an integral part of these statements. - 38 - FIRST COMMONWEALTH, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 1998, 1997 and 1996 1. ORGANIZATION The accompanying consolidated financial statements include the accounts of First Commonwealth, Inc. ("FC Inc."), First Commonwealth of Illinois, Inc.("FCI"), First Commonwealth Limited Health Services Corporation ("LHSC"), First Commonwealth Health Services Corporation ("HSC"), First Commonwealth Reinsurance Company ("FCRC"), First Commonwealth Insurance Company ("FC Insurance"), First Commonwealth Limited Health Service Corporation ("LHSCWI"), Smileage Dental Services, Inc. ("SDS") and First Commonwealth of Missouri, Inc. ("FCMO"), formerly Champion Dental Services, Inc. ("CDS"). These companies are collectively referred to hereinafter as "the Company". As discussed in Note 15, FC Inc. completed the acquisitions of SDS on July 18, 1996, and CDS on December 31, 1996. Included in the consolidated statement of income for the year ended December 31, 1996, are the results of SDS since its acquisition. SDS's and CDS's balance sheets are also included in the accompanying consolidated balance sheets beginning December 31, 1996. The Company is a provider of managed dental benefits in the upper Midwest, including the metropolitan areas of Chicago, Milwaukee, Detroit and Indianapolis, and with the acquisition of CDS, St. Louis. The Company provides dental care coverage and/or arranges for dental care services to be provided to its subscribers primarily on a prepaid basis. The Company also provides indemnity/Preferred Provider Organization dental coverage and administrative claim services. FC Inc. operates as an Illinois and Michigan licensed Third Party Administrator ("TPA"). As a TPA, FC Inc. provides administrative and marketing services to certain subsidiaries pursuant to management agreements. It also provides claim processing services for self-funded employers. FCI is an Illinois corporation and is a wholly owned subsidiary of FC Inc. FCI operates as a Preferred Provider Administrator which directly contracts with general dentists and specialists. These provider arrangements are made available to LHSC, LHSCWI, FCMO and HSC, as well as health maintenance organizations and self-funded employers. In making these provider arrangements available, FCI does not undertake any underwriting risk. LHSC is an Illinois for-profit corporation and is a wholly owned subsidiary of FC Inc. LHSC is licensed under the Illinois Limited Health Service Organization Act ("LHSO Act"). LHSC is also licensed by the Indiana Department of Insurance as a Limited Service Health Maintenance Organization. LHSC has entered into a Provider Agreement with FCI whereby FCI arranges for dental care services to LHSC's subscribers through FCI's network of private practice dentists. Consistent with its authority under the LHSO Act, LHSC also provides reimbursement for covered dental care provided outside of this network. In providing such services, LHSC undertakes underwriting risk. The LHSO Act requires, among other provisions, that LHSC meet certain net worth and deposit requirements discussed in Note 4. It is management's opinion that LHSC was in compliance with these provisions as of December 31, 1998, 1997 and 1996. HSC is an affiliated Illinois corporation, licensed under the Voluntary Health Services Plans Act (the "VHSP Act"). In accordance with the VHSP Act, HSC is operated and conducted not for profit and is also governed by the provisions of the General Not for Profit Corporation Act. HSC was initially capitalized by FC Inc. through the purchase of a subordinated note. FCRC was incorporated in Arizona during 1994 and is a wholly owned subsidiary of FC Inc. It is licensed by the Arizona Department of Insurance as a domestic life and disability reinsurer. - 39 - FIRST COMMONWEALTH, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-continued December 31, 1998, 1997 and 1996 FC Insurance was incorporated in Illinois during 1997 and is a wholly owned subsidiary of FC Inc. It is licensed as a domestic life, accident and health insurer to underwrite indemnity dental business and also received licensure under the LHSO Act in November 1998, which will allow it to underwrite managed care dental business. Effective January 1, 1998, it consummated a reinsurance transaction with LHSC for the business that was previously reinsured to an independent party (see Reinsurance Activity) and onto FCRC. For the year ended December 31, 1998, its business was indemnity dental only. LHSCWI was incorporated in Wisconsin in 1996 and is a wholly owned subsidiary of FC Inc. LHSCWI is licensed to operate as a Limited Service Health Organization under Chapter 611 of the Wisconsin insurance statutes ("Statutes") and is registered with the Office of the Commissioner of Insurance of Wisconsin. The Statutes require, among other provisions, that LHSCWI meet certain net worth and deposit requirements discussed in Note 4. It is management's opinion that LHSCWI was in compliance with these provisions as of December 31, 1998, 1997 and 1996. SDS, a wholly owned subsidiary of FC Inc., is a Wisconsin based dental health maintenance organization administrator. FCMO is a Missouri corporation and is a wholly owned subsidiary of FC Inc. FCMO is a St. Louis, Missouri based prepaid dental plan corporation organized under Section 379.900 RSMo. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Principles of Consolidation The accompanying financial statements include all the accounts of the Company. All material intercompany transactions and balances have been eliminated in consolidation. HSC, a not-for-profit company managed by FC Inc., has been included in the accompanying consolidated financial statements. HSC's financial position and results of operations are not material to the Company's financial statements. Cash and Cash Equivalents For purposes of these statements, the Company considers all cash and short-term investments with original maturities of less than 90 days to be cash and cash equivalents. Investments The Company has invested funds in municipal bonds that are federally tax exempt as well as United States Treasury notes. Accounts Receivable and Deferred Subscriber Revenue The Company invoices most of its subscriber groups prior to the month in which the groups' members will be entitled to service. The Company records these invoices as accounts receivable on the date the invoices are sent and also records as deferred subscriber revenue those amounts either invoiced or received in advance of the period of service. - 40 - FIRST COMMONWEALTH, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-continued December 31, 1998, 1997 and 1996 Revenue Recognition Subscriber revenue collected for dental care is recognized as revenue in the period in which the member is entitled to service. Related costs for dental care are expensed in the period the Company is obligated to provide such service. Prepaid Expenses The Company pays its providers to render covered dental care to eligible enrolled subscribers and dependents. Payment is typically made during the month prior to the month in which the subscribers and dependents become eligible for coverage. This payment is recorded as a prepaid expense at December 31, 1998 and 1997. Property and Equipment Depreciation is calculated using the straight-line method over the assets' estimated useful lives which are as follows: Leasehold improvements 5 years or life of lease Furniture 10 years Office equipment 5 years Computer equipment and software 3 years Property and equipment consist of the following:
December 31 ---------------------------------- 1998 1997 1996 ---- ---- ---- Leasehold improvements $ 433,409 $ 433,409 $ 422,231 Furniture 840,871 830,220 780,967 Office equipment 588,354 567,954 513,566 Computer equipment and software 2,915,484 2,198,188 1,631,065 ---------- ---------- ---------- Total property and equipment $4,778,118 $4,029,771 $3,347,829 ========== ========== ==========
Goodwill The excess of cost over fair value of net assets acquired resulting from the SDS and CDS acquisitions, accounted for using the purchase method, is being amortized using the straight-line method over 40 years. Accounts Payable--Dental Service Providers The Company records payables to dental service providers for certain services not included in the monthly prepayment to such providers discussed above. Other Current Liabilities Other current liabilities at December 31, 1996, represents the Company's liability relating to its acquisition of CDS. This amount was paid on January 2, 1997. - 41 - FIRST COMMONWEALTH, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-continued December 31, 1998, 1997 and 1996 Claims Liability The Company provides indemnity dental coverage for certain customers and records a liability for incurred but not reported and unpaid claims related to this coverage. Generally, this liability is estimated based on the age of existing claims and the Company's historical lag with respect to the reporting and payment of such claims. Changes in these estimates are reflected in the results of operations in the period in which such changes occur. Reinsurance Activity Effective January 1, 1995, LHSC entered into an agreement with a third party insurer ("Insurer") whereby LHSC ceded certain losses on indemnity insurance policies to Insurer. Concurrent with the execution of this agreement, Insurer entered into an agreement with FCRC whereby Insurer ceded certain losses related to LHSC policies to FCRC. In 1997, a separate independent third party insurer was inserted into the agreement between Insurer and FCRC. The Company has effectively retained all insurance risk on these LHSC losses ceded to Insurer. Accordingly, LHSC accounts for net payments to Insurer as deposits and records a claims liability for all incurred and unpaid losses on such policies. FCRC records a payable to Insurer for amounts Insurer has deposited with FCRC. The Company does not recognize any revenue from these reinsurance arrangements. In addition, in 1997, FC Inc., acting as agent for Insurer and according to a fronting agreement, began selling managed care and indemnity dental insurance policies in the state of Michigan. According to the same agreement, Insurer ceded all managed care and indemnity dental insurance policies in Michigan to the same separate independent third party insurer who ceded these policies to FCRC. Effective January 1, 1998, LHSC, rather than reinsure the policies to the Insurer, assumptively reinsured the same policies to FC Insurance. Earnings Per Share In 1997, the Company adopted Financial Accounting Standards Board Statement of Financial Accounting Standards ("SFAS") No. 128, "Earnings per Share." Under SFAS No. 128, primary earnings per share is replaced by "Basic" earnings per share, which excludes dilution and is computed by dividing income available to common shareholders by the weighted-average number of common shares outstanding for the period. "Diluted" earnings per share, which is computed similarly to fully diluted EPS, reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock. All prior-period EPS information (including interim EPS) has been restated to conform with the provisions of SFAS No. 128. The following tables reconcile the numerators (net income) and denominators (shares) of the basic and diluted earnings per share computations.
1998 EPS 1997 EPS 1996 EPS ---- --- ---- --- ---- --- Net income 3,990,988 $3,323,407 $2,731,456 ========== ========== ========== Basic shares/EPS 3,643,953 $1.10 3,617,994 $0.92 3,470,871 $0.79 ===== ===== ===== Effect of dilutive common stock options 93,711 109,340 128,694 ---------- ---------- ---------- Diluted/EPS 3,737,664 $1.07 3,727,334 $0.89 3,599,565 $0.76 ========== ===== ========== ===== ========== =====
Options to purchase shares of common stock outstanding during 1998, 1997, and 1996 that were not included in the computation of diluted EPS because the options' exercise price was greater than the average market price of the common shares are summarized in the following table. - 42 - FIRST COMMONWEALTH, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-continued December 31, 1998, 1997 and 1996 1998 1997 1996 ---- ---- ---- Weighted average shares under option 62,500 17,875 31,167 Weighted average option price $15.51 $16.78 $23.10 Weighted average contractual life (in years) 7.4 8.6 9.4 Subsequent to December 31, 1998, the Company issued 68,500 options to various key employees at the option price of $11.94 per share. Segment Information The Company considers its managed care and indemnity/PPO products to be operating segments as defined in SFAS No. 131. However, due to the similar economic characteristics of these segments, management has aggregated these segments for purposes of complying with the disclosure requirements of SFAS No. 131. 3. USE OF ESTIMATES AND ASSUMPTIONS The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. 4. REGULATORY REQUIREMENTS AND RESTRICTED FUNDS The State of Illinois statutes and related regulations of the Illinois Department of Insurance require LHSC, which is licensed under the LHSO Act, to maintain a minimum net worth of $500,000. LHSC maintains a deposit with the State of $200,000 in accordance with the State of Illinois requirements. The State of Indiana statutes and related regulations of the Indiana Department of Insurance require LHSC, which is licensed as a Limited Service Health Maintenance Organization, to maintain a $50,000 deposit with the State. The State of Arizona statutes and related regulations of the Arizona Department of Insurance require FCRC, which is licensed as a domestic life and disability reinsurer, to maintain a minimum of $100,000 deposited in trust with the State and a minimum surplus of $25,000. FCRC is required to maintain a trust account equal to the amount of claims payable on all insurance ceded. At December 31, 1998, 1997 and 1996, balances of $94,889, $632,767 and $705,867, respectively, were required in the trust account. The State of Illinois statutes and related regulations of the Illinois Department of Insurance require HSC, which is licensed under the VHSP Act, to maintain a contingency reserve in contributed capital of $20,050, $19,037 and $15,674 at December 31, 1998, 1997 and 1996. The State of Wisconsin insurance statutes require, among other provisions, that LHSCWI maintain a minimum capital of $100,000, apply a ten percent compulsory surplus factor to Point of Service/Indemnity ("POS") premium, and limit POS business to ten percent of total premium volume. LHSCWI has a certificate of deposit for $111,071 at Wisconsin bank and had POS business of $735,201 in 1998, $189,788 in 1997 and none in 1996. The State of Missouri statutes and related regulations of the Missouri Department of Insurance require FCMO, which is licensed as a Prepaid Dental Plan Corporation, to maintain a $50,000 deposit with the state and to maintain a maximum net worth of $150,000. - 43 - FIRST COMMONWEALTH, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-continued December 31, 1998, 1997 and 1996 The State of Illinois statutes and related regulations of the Illinois Department of Insurance require FC Insurance to maintain a minimum net worth of $1.5 million. FC Insurance maintains a deposit with the State of $1.6 million in accordance with State requirements. It is management's opinion that the Company was in compliance with these provisions at December 31, 1998, 1997 and 1996. Interest income earned on restricted funds is included in interest income, net in the consolidated statements of income. 5. CLAIMS LIABILITY The Company's claims liability, claims incurred and payments related to indemnity/PPO policies for the years ended December 31, 1998, 1997 and 1996, are as follows:
December 31 --------------------------------------- 1998 1997 1996 ----------- ----------- ----------- Claims liability, beginning of year $ 1,604,329 $ 1,579,669 $ 1,257,681 Add- Claims incurred 13,043,382 10,506,867 8,341,669 Less- Claims payments- Current year (11,403,233) (9,042,693) (7,274,355) Prior years (1,575,090) (1,439,514) (745,326) ------------ ----------- ----------- Claims liability, end of year $ 1,669,388 $ 1,604,329 $ 1,579,669 ============ =========== ===========
6. LEASE OBLIGATIONS The Company leases office space and various office equipment which are accounted for as operating leases. Rental costs under the operating lease agreements approximated $617,000, $617,000 and $486,000 for the years ended December 31, 1998, 1997 and 1996, respectively. Minimum future obligations under operating leases in effect at December 31, 1998, are: Years ending December 31- 1999 $335,489 2000 93,999 2001 50,156 2002 and thereafter 67,792 -------- Total $547,436 - 44 - FIRST COMMONWEALTH, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-continued December 31, 1998, 1997 and 1996 7. INCOME TAXES The current and deferred components of the provision for taxes are as follows: December 31 -------------------------------------- 1998 1997 1996 ---------- ---------- ---------- Current provision $2,537,000 $2,195,000 $1,962,000 ---------- ---------- ---------- Deferred provision (benefit) 108,000 89,000 (98,000) ---------- ---------- ---------- Total tax provision $2,645,000 $2,284,000 $1,864,000 A reconciliation of the effective tax rate from statutory U.S. federal income tax rate of 34% for 1998, 1997 and 1996, is as follows: 1998 1997 1996 ---- ---- ---- Statutory rate 34% 34% 34% State tax, net of federal benefit 5 5 5 Goodwill and other permanent items 2 2 2 Income from municipal bond investments (1) -- -- ---- ---- ---- Effective tax rate 40% 41% 41% ==== ==== ==== As of December 31, 1998, 1997 and 1996, total net current deferred tax assets were $982,000, $859,000 and $869,000, respectively, and total net noncurrent deferred tax liabilities were $176,000, $247,300 and $167,157, respectively. The temporary differences that give rise to deferred tax assets and liabilities are as follows:
December 31 --------------------------------- 1998 1997 1996 --------- --------- --------- Claims liability $ 359,000 $ 608,804 $ 616,100 Allowance for doubtful accounts 160,000 130,265 112,900 Vacation accrual 71,000 52,566 54,700 Miscellaneous 392,000 67,365 85,300 --------- --------- --------- Total current tax asset 982,000 859,000 869,000 --------- --------- --------- Accumulated amortization (160,000) (80,103) - --------- --------- --------- Accumulated depreciation and other (16,000) (167,197) (167,157) --------- --------- --------- Total noncurrent tax liability (176,000) (247,300) (167,157) --------- --------- --------- Total $ 806,000 $ 611,700 $ 701,843 ========= ========= =========
- 45 - FIRST COMMONWEALTH, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-continued December 31, 1998, 1997 and 1996 8. SOURCES OF REVENUE (Unaudited) The following table shows the percentage of revenue attributable to each type of product offered: 1998 1997 1996 ---- ---- ---- Managed care 75% 77% 74% Indemnity/PPO 24 22 24 Fee income 1 1 2 --- --- --- Total 100% 100% 100% === === === 9. SIGNIFICANT CUSTOMERS There are no customers that accounted for a significant amount of the Company's subscriber revenue in the years ended December 31, 1998, 1997 and 1996. 10. LINE OF CREDIT The Company has a committed unsecured line of credit (the "Credit Agreement") available with a Chicago bank that expires June of 1999, which to date has not been utilized. Pursuant to this Credit Agreement, the Company may borrow up to $5 million at the rate of LIBOR plus one-half percent. 11. PREFERRED STOCK During 1995, the Board of Directors and stockholders of the Company approved an amendment and restatement of its Restated Certificate of Incorporation to, among other things, authorize 1,000,000 shares of preferred stock, $.001 par value, which may be issued from time to time in one or more series with such rights, preferences and qualifications as the Company's Board of Directors may determine. The Board of Directors has designated 150,000 shares of the preferred stock as Series A Junior Participating Preferred Stock. There are no shares issued or outstanding of the Series A Junior Participating Preferred Stock. 12. COMMON STOCK In November, 1995, the Company completed an initial public offering of 530,000 shares of its common stock at $15 per share. The holder of each share of common stock is entitled to one vote on each matter submitted to a vote to the stockholders of the Company. - 46 - FIRST COMMONWEALTH, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-continued December 31, 1998, 1997 and 1996 The Company has two incentive plans, a 1987 Statutory-Nonstatutory Stock Option Plan ("1987 Plan") and a 1995 Long-Term Incentive Plan ("1995 Plan"), which were approved by the Board of Directors and stockholders. The Company has adopted the disclosure-only provisions of Statement of Financial Accounting Standards ("SFAS") No. 123, "Accounting for Stock-Based Compensation." Accordingly, no compensation cost has been recognized for the stock option plans. Had compensation cost for the Company's two stock option plans been determined based on the fair value at the grant date for awards in 1998, 1997 and 1996 consistent with the provisions of SFAS No. 123, the Company's net income (in thousands) and diluted earnings per share would have been reduced to the pro forma amounts of $3,789 and $1.01 in 1998, $3,268 and $0.88 in 1997 and $2,645 and $0.73 in 1996. The weighted average grant-date fair values of options granted in 1998, 1997 and 1996 were $6.00, $6.80 and $12.25, respectively. The fair value of each option grant was estimated on the date of the grant using the Black-Scholes option pricing model with the following weighted average assumptions for options issued in 1998, 1997 and 1996, respectively: risk- free interest rates of 5.4%, 6.8% and 6.5%; expected lives of 7 years; expected volatility of 41% in 1998 and in 1997 and 42% in 1996; and no expected dividends. Under the 1987 Plan, the Company can award up to 250,000 options to key employees, granted at a price equal to the fair market value at the date of the grant as determined by the Board of Directors or the Stock Option Compensation Committee, and vesting ratably over a period of two to four years from the date of the grant. The Company had granted 248,125 total options as of December 31, 1998, 1997 and 1996, to key employees and directors at option prices ranging from $.50 to $15.00 per share. Of the total options granted, 109,240, 133,375 and 148,950 had vested and were exercisable as of December 31, 1998, 1997 and 1996, respectively, and 132,685, 87,925 and 60,675 of the total options, granted and vested had been exercised as of December 31, 1998, 1997 and 1996, respectively. In connection with the initial public offering, the Company adopted the 1995 Long-Term Incentive Plan (the "1995 Plan"). Under the 1995 Plan, the Company may grant incentive stock options or nonqualified stock options. The 1995 Plan also provides for the grant of stock appreciation rights, bonus stock awards which are vested upon grant, stock awards which may be subject to a restriction period and specified performance measures, and performance shares. A total of 350,000 shares of common stock have been reserved for issuance under the 1995. Under the 1995 Plan, options are granted at a price equal to the fair market value at the date of the grant as determined by the Board of Directors and vest ratably over a period of one to four years from the date of the grant. For the years ended December 31, 1998, 1997 and 1996, the Company had granted 64,000, 94,000 and 105,500, respectively, total options to key employees and directors at option prices ranging from $11.25 to $28.625 per share. Of the total options granted, 90,863, 38,813 and 11,000 had vested and were exercisable as of December 31, 1998, 1997 and 1996, respectively, and 2,750 of the total options, granted and vested had been exercised during the year ended December 31, 1998. In addition, 0, 77,238 and 42,000 options were rescinded during the years ended December 31, 1998, 1997 and 1996. A summary of the status of the Company's two stock option plans at December 31, 1998, 1997 and 1996 and changes during the years then ended is presented in the table below: - 47 - FIRST COMMONWEALTH, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-continued December 31, 1998, 1997 and 1996
1998 1997 1996 ---- ---- ---- Weighted Weighted Weighted Average Average Average Option Option Option Shares Price Shares Price Shares Price ------ -------- ------ -------- ------ -------- Outstanding at beginning of year 277,700 $ 7.08 289,950 $ 7.90 235,750 $ 4.15 Granted 64,000 11.41 94,000 12.26 105,500 22.06 Exercised (47,510) 1.98 (29,012) 1.56 (9,300) 0.75 Forfeited - - (16,238) 10.36 (2,000) 21.81 Cancelled - - (61,000) 20.47 (40,000) 24.12 -------- ----- -------- ------- -------- ------- Outstanding at end of year 294,190 $ 8.86 277,700 $ 7.08 289,950 $ 7.90 ======== ======= ======== ======= ======== ======= Exercisable at end of year 200,103 $ 7.29 172,188 $ 4.38 159,950 $ 2.43 ======== ======= ======== ======= ======== =======
Of the 294,190 total options outstanding at December 31, 1998, 101,740 have option prices between $.70 and $1.70, with a weighted average option price of $1.38 and a weighted average remaining contractual life of three years. 101,740 of these options are exercisable at December 31, 1998, with a weighted average option price of $1.38. Of the total options outstanding at December 31, 1998, 129,950 have option prices between $11.25 and $11.75 with a weighted average option price of $11.52 and with a weighted average remaining contractual life of nine years. 54,488 of these options are exercisable at December 31, 1998, with a weighted average option price of $11.51. Of the total options outstanding at December 31, 1998, 60,500 have option prices between $14.56 and $17.00, with a weighted average option price of $15.08 and a weighted average remaining contractual life of seven years. 41,875 of these options are exercisable at December 31, 1998, with a weighted average option price of $15.14. The remaining 2,000 options outstanding at December 31, 1998, have option prices of $28.625, with a weighted average remaining contractual life of eight years. These options are exercisable at December 31, 1998. During 1995, the Board of Directors adopted a stockholders rights plan. Under the stockholders rights plan, each share of common stock will have associated with it one preferred share purchase right (a "Right"). Under certain circumstances, each Right would entitle the holders thereof to purchase one one-hundredth of a share of Series A Junior Participating Preferred Stock for a price of $40 per one one-hundredth of a share. The Rights are not presently exercisable and are transferable only with the related shares of common stock. The Rights would become exercisable at the specified exercise price upon the occurrence of certain events, including the acquisition of 15% or more of the Company's common stock by a person or group, as defined. The Rights may be redeemed, as a whole, at a redemption price of $.01 per Right, subject to adjustment, at the direction of the Board of Directors, at any time prior to the occurrence of certain events. In addition, in certain circumstances, the Board of Directors may direct the exchange of shares of common stock (or preferred shares) for all or any part of the Rights at the exchange rate of one share of common stock (or one one-hundredth of a preferred share) per Right, subject to adjustment. - 48 - FIRST COMMONWEALTH, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-continued December 31, 1998, 1997 and 1996 13. QUARTERLY FINANCIAL DATA (Unaudited) (in thousands, except per share data) Quarter ------------------------------------ First Second Third Fourth ----- ------ ----- ------ 1998- Subscriber revenue $15,615 $15,961 $16,145 $16,449 Gross margin 5,165 5,292 5,387 5,596 Net income 913 952 1,018 1,107 Basic earnings per common share .25 .26 .28 .30 Diluted earnings per common share .24 .25 .27 .30 1997- Subscriber revenue $13,463 $13,856 $14,519 $14,756 Gross margin 4,700 4,733 4,573 4,656 Net income 760 798 882 883 Basic earnings per common share .21 .22 .24 .24 Diluted earnings per common share .20 .21 .24 .24 1996- Subscriber revenue $ 9,773 $10,019 $11,786 $12,521 Gross margin 3,747 3,799 4,220 4,460 Net income 669 698 667 697 Basic earnings per common share .20 .21 .19 .19 Diluted earnings per common share .19 .20 .18 .19 14. RETIREMENT PLAN The Company has a 401(k) salary deferral plan in which all employees of the Company who have completed at least ninety days of service are eligible to participate. Under the plan, the Company provides a matching contribution of $.50 for every dollar an employee invests in the plan up to an annual maximum of 2% of the employee's compensation for the year. The Company may make additional discretionary contributions to the plan. The Company incurred 401(k) contributions expense of $84,051, $91,949 and $58,937 during the years ended December 31, 1998, 1997 and 1996, respectively. 15. BUSINESS COMBINATIONS Effective July 18, 1996, the Company completed the acquisition of SDS and an associated reinsurance transaction, for an aggregate purchase price (including transaction costs) of $5.6 million. The acquisition was financed through the issuance of 231,399 shares of the Company's common stock. The acquisition resulted in the excess of cost over fair value of net assets acquired of approximately $5.6 million. Effective December 31, 1996, the Company completed the acquisition of CDS for an aggregate purchase price (including transaction costs) of $5.6 million. The acquisition was financed through proceeds from the Company's initial public offering and was paid in cash on January 2, 1997. The acquisition resulted in the excess of cost over fair value of net assets acquired of approximately $4.9 million. - 49 - FIRST COMMONWEALTH, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-continued December 31, 1998, 1997 and 1996 The acquisitions of SDS and CDS were accounted for using the purchase method of accounting with SDS's results of operations included in the accompanying consolidated statement of income for the year ended December 31, 1996 from the effective date of the acquisition. Unaudited pro forma combined results of operations of the Company for the year ended December 31, 1996 for the acquisitions are as follows: Revenues (in thousands) for the year ended December 31, 1996 would be $50,860; Net income (in thousands) for the year ended December 31, 1996 would be $2,856; and diluted Net Income per share for the year ended December 31, 1996 would be $0.77. This pro forma information has been prepared assuming the acquisitions of SDS and CDS and the Company's initial public offering had occurred as of January 1, 1995. The pro forma results include the historical accounts of the Company and the historical accounts of the acquired businesses and pro forma adjustments including the amortization of the excess purchase price over the fair value of the net assets acquired, the reduction of salaries and expenses which will not be incurred on an ongoing basis, and the applicable income tax effects of these adjustments. The pro forma results of operations are not necessarily indicative of actual results which may have occurred had the operations of the acquired companies been combined in prior periods. - 50 - Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure None. PART III Item 10. Directors and Executive Officers of the Registrant The information contained under the headings "Election of Directors" and "Executive Officers" in the Proxy Statement (which Proxy Statement will be filed with the Securities and Exchange Commission on or before April 30, 1999) is incorporated herein by reference. Item 11. Executive Compensation Except for information referred to in Item 402(a)(8) of Regulation S-K, the information contained under the headings "Election of Directors" and "Executive Compensation and Other Information" in the Proxy Statement (which Proxy Statement will be filed with the Securities and Exchange Commission on or before April 30, 1999) is incorporated herein by reference. Item 12. Security Ownership of Certain Beneficial Owners and Management The information contained under the heading "Security Ownership of Certain Beneficial Owners and Management" in the Proxy Statement (which Proxy Statement will be filed with the Securities and Exchange Commission on or before April 30, 1999) is incorporated herein by reference. Item 13. Certain Relationships and Related Transactions The information contained under the heading "Certain Relationships and Related Transactions" in the Proxy Statement (which Proxy Statement will be filed with the Securities and Exchange Commission on or before April 30, 1999) is incorporated herein by reference. - 51 - PART IV Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K (a)(1) Financial Statements Financial statements for First Commonwealth, Inc. listed in the Index to Financial Statements and Supplementary Data on page 29 are filed as part of this Annual Report. (a)(2) Financial Statement Schedules Financial statements for First Commonwealth, Inc. listed in the Index to Financial Statements and Supplementary Data on page 29 are filed as part of this Annual Report. Consent of Independent Accountants Page 30 Schedule II -- Valuation and Qualifying Accounts Page 54 All other schedules for which provision is made in the applicable accounting regulation of the Securities and Exchange Commission are not required under the related instructions or an inapplicable, and therefore have been omitted. (a)(3) Exhibits The following Exhibits are filed herewith or incorporated herein: Exhibit No. Description - ----------- ----------- 3.1 -- Second Restated Certificate of Incorporation of the Company, as amended (1) 3.2 -- Restated By-laws of the Company (2) 4.1 -- Stockholders Rights Agreement between the Company and First Chicago Trust Company of New York (1) 4.2 -- First Amendment to Stockholders Rights Agreement dated December 15, 1998 is hereby incorporated to Form 8-A/A dated February 5, 1999 10.1 -- Series A and Series B Preferred Stock Purchase Agreement dated September 18, 1987 by and among the Company and the Purchasers referred to therein (1) 10.2 -- Registration Agreement, dated September 18, 1987, by and among the Company and the Purchasers referred to therein (1) 10.3 -- Founders' Agreement, dated September 18, 1987, by and among the Company, the Purchasers referred to therein and each of Christopher C. Multhauf and David W. Mulligan (1) 10.4 -- First Amendment and Agreement, dated as of September 18, 1988, by and among the Company and the Purchasers referred to therein (1) 10.5 -- First Commonwealth, Inc. Management Bonus Plan (1)(3) 10.6 -- 1987 Statutory-Nonstatutory Stock Option Plan, as amended (1)(3) 10.7 -- 1995 Long-Term Incentive Plan, as amended as of February 18, 1998 (3) - 52 - Exhibit No. Description - ----------- ----------- 10.8 -- First Commonwealth, Inc. Salary Savings Plan (1)(3) 10.9 -- Employment Agreement between the Company and Christopher C. Multhauf (1)(3) 10.10-- Employment Agreement between the Company and David W. Mulligan (1)(3) 10.11-- Employment Agreement between the Company and Gregory D. Stobbe, as amended (1)(3) 10.12-- Employment Agreement between the Company and Mark R. Lundberg (1)(3) 10.13-- Employment Agreement between the Company and Scott B. Sanders (1)(3) 10.14-- Reinsurance Agreement between First Commonwealth Limited Insurance Company and First Commonwealth Reinsurance Company (1) 10.15-- Reinsurance Agreement between North American Insurance Company and First Commonwealth Reinsurance Company (1) 10.16-- Form of First Commonwealth Limited Health Services Corporation Group Master Contract (1) 10.17-- Form of First Commonwealth of Illinois, Inc. Dental Provider Agreement (1) 10.18-- Form of First Commonwealth of Illinois, Inc. Participating PPO Dentist Contract (1) 10.19-- Lease Agreement between 444 North Wells Limited Partnership as sole beneficiary of American National Bank & Trust Company of Chicago Trust No. 56647 as Landlord and the Company as Tenant, as amended (1) 10.20-- Administrative Master Contract, dated December 12, 1990, between First Commonwealth of Illinois, Inc. and First Commonwealth Limited Health Services Corporation (1) 10.21-- Administrative Contract, dated December 12, 1990, between First Commonwealth, Inc. and First Commonwealth Limited Health Services Corporation (1) 10.22-- Management Agreement, dated November 20, 1987, between First Commonwealth, Inc. and First Commonwealth Health Services Corporation (1) 10.23-- Administrative Master Contract, dated February 1, 1989, between First Commonwealth of Illinois, Inc. and First Commonwealth Health Services Corporation, as amended (1) - 53 - Exhibit No. Description - ----------- ----------- 11 -- Statement re: computation of per share earnings (included in Item 8 filed herewith) 21 -- Subsidiaries of the Registrant 23 -- Consent of Arthur Andersen LLP 24 -- Powers of Attorney (included on signature page) 27 -- Financial Data Schedule - --------- (1) Incorporated herein by reference to an exhibit with the same number as filed with the Company's Registration Statement on Form S-1, as amended (Registration No. 33-97426). (2) Incorporated herein by reference to an exhibit with the same number as filed with the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1996. (3) Represents management contract or compensatory plan or arrangement. (b) Reports on Form 8-K None - 54 - REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULE To the Stockholders and Board of Directors of First Commonwealth, Inc.: We have audited in accordance with generally accepted auditing standards the consolidated financial statements included in FIRST COMMONWEALTH, INC. AND SUBSIDIARIES' 1998 Annual Report to Stockholders incorporated by reference in this Form 10-K, and have issued our report thereon dated February 10, 1999. Our audit was made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedule included on page 56 is the responsibility of the Company's management and is presented for purposes of complying with the Securities and Exchange Commission's rules and is not part of the basic financial statements. This schedule has been subjected to the auditing procedures applied in the audit of the basic financial statements and, in our opinion, fairly states in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. ARTHUR ANDERSEN LLP Chicago, Illinois February 10, 1999 - 55 - FIRST COMMONWEALTH, INC. AND SUBSIDIARIES SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS
Additions Period ------------------------------- - ------ Balance at Charged to Year Ended Beginning of Costs and Charged to Other Deductions- Balance at December 31, Description of Period Expenses Accounts-Describe Describe End of Period ------------ ----------- ------------ --------- ----------------- ----------- ------------- 1996 Claims liability $1,257,681 $8,341,669 -- $8,019,681(1) $1,579,669 Allowance for doubtful accounts $197,316 $124,000 -- $31,762(2) $289,554 1997 Claims liability $1,579,669 $10,506,867 -- $10,482,207(1) $1,604,329 Allowance for doubtful accounts $289,554 $204,655 -- $160,197(2) $334,012 1998 Claims liability $1,604,329 $12,941,142 -- $12,876,083(1) $1,669,388 Allowance for doubtful accounts $334,012 $144,000 -- $67,788(2) $410,224
- -------- (1) Payment for claims (2) Write-off of bad debt - 56 - SIGNATURES Pursuant to the requirements of Section 13 or Section 15(d) of the Securities Exchange Act of 1934, this Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Date: March 31, 1999 FIRST COMMONWEALTH, INC By: /s/ Christopher C. Multhauf Christopher C. Multhauf Chairman of the Board of Directors and Chief Executive Officer POWER OF ATTORNEY AND SIGNATURES Each of the undersigned officers and directors of First Commonwealth, Inc. hereby severally constitutes and appoints Christopher C. Multhauf, David W. Mulligan and Scott B. Sanders, and each of them singly, our true and lawful attorneys, with full power to them and each of them singly, to sign for us in our names in the capacities indicated below, all amendments to this Annual Report on Form 10-K, and generally to do all things in our names and on our behalf in such capacities to enable First Commonwealth, Inc. to comply with the provisions of the Securities Act of 1934, as amended, and all requirements of the Securities and Exchange Commission. Pursuant to the requirements of the Securities Exchange Act of 1934, this Registration Statement has been signed by the following persons in the capacities indicated on this 31st day of March, 1999.
Name Capacity ---- -------- /s/ Christopher C. Multhauf Chairman of the Board of Directors and Chief Executive Officer - ----------------------------- (principal executive officer) Christopher C. Multhauf /s/ David W. Mulligan Director, President, Secretary and Chief Operating Officer - ----------------------------- David W. Mulligan /s/ Scott B. Sanders Chief Financial Officer and Treasurer (principal financial and - ----------------------------- accounting officer) Scott B. Sanders /s/ Richard M. Burdge, Sr. Director - ----------------------------- Richard M. Burdge, Sr. /s/ William J. McBride Director - ----------------------------- William J. McBride /s/ Jackson W. Smart, Jr. Director - ----------------------------- Jackson W. Smart, Jr.
EXHIBIT INDEX Exhibit No. Description ----------- ----------- 21 -- Subsidiaries of the Registrant 23 -- Consent of Arthur Andersen LLP 24 -- Powers of Attorney (included on signature page) 27 - Financial Data Schedule EX-21 2 SUBSIDIARIES OF THE REGISTRANT EXHIBIT 21 SUBSIDIARIES OF THE REGISTRANT
Jurisdiction Name of Subsidiary Of Incorporation Doing Business As ------------------ ---------------- ----------------- First Commonwealth Limited Health Illinois First Commonwealth, Inc. Services Corporation First Commonwealth of Illinois, Inc. Illinois First Commonwealth, Inc. First Commonwealth Insurance Illinois First Commonwealth, Inc. Company First Commonwealth Reinsurance Arizona First Commonwealth, Inc. Company First Commonwealth Limited Health Wisconsin First Commonwealth, Inc. Service Corporation Smileage Dental Services, Inc. Wisconsin First Commonwealth, Inc. First Commonwealth of Missouri, Missouri First Commonwealth, Inc. Inc.
EX-23 3 CONSENT OF ARTHUR ANDERSEN LLP EXHIBIT 23 CONSENT OF ARTHUR ANDERSEN LLP As independent public accountants, we hereby consent to the incorporation by reference in this Form 10-K of First Commonwealth, Inc., of our report, dated February 10, 1999, on the consolidated financial statements of First Commonwealth, Inc. and Subsidiaries (the "Company") included in the Company's 1998 Annual Report on Form 10-K, and to the incorporation of our report, dated February 10, 1999, on the financial statement schedule of the Company, and included in this Form 10-K, into the Company's previously filed S-3 Registration Statement, File No. 333-18379, and S-8 Registration Statement, File No. 333-00474. ARTHUR ANDERSEN LLP Chicago, Illinois March 31, 1999 EX-27 4 FINANCIAL DATA SCHEDULE
5 THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE CONSOLIDATED FINANCIAL STATEMENTS OF FIRST COMMONWEALTH, INC. AS OF DECEMBER 31, 1998 AND FOR THE TWELVE MONTHS THEN ENDED, AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS. 1,000 12-MOS DEC-31-1998 JAN-01-1998 DEC-31-1998 6,189 4,825 5,352 410 0 20,252 4,778 3,034 38,076 10,181 0 0 0 4 27,715 38,076 0 64,170 0 58,083 0 144 693 6,636 2,645 3,991 0 0 0 3,991 1.10 1.07
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