-----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, SrVOUyDKgFDpFa7AXaz9TSgJiMkZ2uz6K7vnq2IgLdkUTXP7KSaLiNYgpfUH83Q4 90lUwW+K0293vJYmiHFuHQ== 0000754009-99-000005.txt : 19990319 0000754009-99-000005.hdr.sgml : 19990319 ACCESSION NUMBER: 0000754009-99-000005 CONFORMED SUBMISSION TYPE: 10-K PUBLIC DOCUMENT COUNT: 8 CONFORMED PERIOD OF REPORT: 19981231 FILED AS OF DATE: 19990318 FILER: COMPANY DATA: COMPANY CONFORMED NAME: SIERRA HEALTH SERVICES INC CENTRAL INDEX KEY: 0000754009 STANDARD INDUSTRIAL CLASSIFICATION: HOSPITAL & MEDICAL SERVICE PLANS [6324] IRS NUMBER: 880200415 STATE OF INCORPORATION: NV FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K SEC ACT: SEC FILE NUMBER: 001-08865 FILM NUMBER: 99568255 BUSINESS ADDRESS: STREET 1: 2724 N TENAYA WAY CITY: LAS VEGAS STATE: NV ZIP: 89128 BUSINESS PHONE: 7022427000 MAIL ADDRESS: STREET 1: 2724 NORTH TENAYA WAY STREET 2: 2724 NORTH TENAYA WAY CITY: LAS VEGAS STATE: NV ZIP: 89128 10-K 1 UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K (Mark One) X ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended December 31, 1998 OR TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from to Commission file number: 1-8865 SIERRA HEALTH SERVICES, INC. (Exact name of Registrant as specified in its charter) NEVADA (State or other jurisdiction of incorporation or organization) 88-0200415 (I.R.S. Employer Identification Number) 2724 NORTH TENAYA WAY LAS VEGAS, NEVADA 89128 (Address of principal executive offices) (Zip Code) Registrant's telephone number, including area code: (702) 242-7000 Securities registered pursuant to Section 12(b) of the Act: Title of each class Name of each exchange on which registered Common Stock, par value $.005 New York Stock Exchange Securities Registered Pursuant to Section 12(g) of the Act: None Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES X NO Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [ ] The aggregate market value of the voting stock held by non-affiliates of the registrant on February 26, 1999 was $353,058,000. The number of shares of the registrant's common stock outstanding on February 26, 1999 was 27,141,000. DOCUMENTS INCORPORATED BY REFERENCE DOCUMENT WHERE INCORPORATED Registrant's Current Report on Form 8-K dated Part I March 17, 1999. Part II, Item 7 Portions of the registrant's definitive proxy statement for Part III its 1999 annual meeting to be filed with the SEC not later than 120 days after the end of the fiscal year. SIERRA HEALTH SERVICES, INC. 1998 FORM 10-K ANNUAL REPORT TABLE OF CONTENTS
Page PART I Item 1. Business ................................................................................. 1 Item 2. Properties................................................................................ 17 Item 3. Legal Proceedings......................................................................... 17 Item 4. Submission of Matters to a Vote of Security Holders....................................... 17 PART II Item 5. Market for Registrant's Common Stock and Related Stockholder Matters............................................................ 18 Item 6. Selected Financial Data................................................................... 19 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations ............................................................. 20 Item 7a. Quantitative and Qualitative Disclosures about Market Risk ............................... 32 Item 8. Financial Statements and Supplementary Data............................................... 33 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure.................................................... 62 PART III Item 10. Directors and Executive Officers of the Registrant........................................ 62 Item 11. Executive Compensation.................................................................... 62 Item 12. Security Ownership of Certain Beneficial Owners and Management............................ 62 Item 13. Certain Relationships and Related Transactions............................................ 62 PART IV Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K........................... 63
i PART I ITEM 1. BUSINESS GENERAL Sierra Health Services, Inc. ("Sierra") and its subsidiaries (collectively referred to as the "Company"), is a managed health care organization that provides and administers the delivery of comprehensive health care and workers' compensation programs with an emphasis on quality care and cost management. The Company's strategy has been to develop and offer a portfolio of managed health care and workers' compensation products to employer groups and individuals. The Company's broad range of managed health care services is provided through its federally qualified and non-qualified health maintenance organizations ("HMOs"), managed indemnity plans, a third-party administrative services program for employer-funded health benefit plans, workers' compensation medical management programs and a subsidiary that administers a managed care federal contact for the Department of Defense's TRICARE program in Region 1. This contract is currently structured as five one-year option periods. If all option periods are exercised by the Department of Defense ("DOD") and no extensions of the performance period are made, health care delivery will end on May 31, 2003 for Region 1. Ancillary products and services that complement the Company's managed health care and workers' compensation product lines are also offered. On October 31, 1998, Sierra and one of its subsidiaries, Texas Health Choice, L.C. ("TXHC"), (formerly HMO Texas L.C.) completed the acquisition of certain assets of Kaiser Foundation Health Plan of Texas ("Kaiser-Texas"), a health plan operating in Dallas/Ft. Worth with approximately 109,000 members, and Permanente Medical Association of Texas ("Permanente"), a medical group with approximately 150 physicians. The purchase price was $124 million, which is net $20 million in operating cost support to be paid to Sierra by Kaiser Foundation Hospitals in five quarterly installments following the closing of the transaction. The purchase price includes amounts for real estate and eight medical and office facilities with approximately 500,000 square feet. In December 1998, certain accreditation goals were met by the health plan resulting in a purchase price increase of $3.0 million, to $127 million. The purchase price may increase up to an additional $27 million over three years if certain growth and member retention goals are met by the health plan. Sierra assumed no prior liabilities for malpractice or other litigation, or for any unanticipated future adjustments to claims expenses for periods prior to closing. The transaction was financed with a five-year revolving credit facility and a $35.2 million note payable to Kaiser Foundation Health Plan of Texas. The note is secured by the acquired real estate. Approximately $110 million of the $200 million revolving credit facility was used to fund the transaction. On December 31, 1998, Sierra completed the acquisition of the Nevada health care business of Exclusive Healthcare, Inc. ("EHI"), United of Omaha Life Insurance Company and United World Life Insurance Company ("United"), all of which are subsidiaries of Mutual of Omaha Insurance Company. Sierra retained approximately 9,000 members (approximately 4,400 HMO members) subsequent to the acquisition. On January 27, 1999, Sierra signed a definitive agreement to purchase the Texas operations of EHI (6,900 HMO members) and United's related preferred provider organization ("PPO") that is part of the dual option HMO/PPO plan. The transaction is expected to be completed no later than April 30, 1999 and is subject to regulatory approvals. The purchase price of both transactions is contingent based on how many members are retained through 2000 and 2001. No cash will be paid until group renewals begin in 2000. On September 30, 1997, Sierra Military Health Services, Inc. ("SMHS") was awarded a TRICARE contract to provide managed health care coverage to eligible beneficiaries in Region 1. In June 1998, the Company began providing health care benefits to approximately 606,000 individuals in Connecticut, Delaware, Maine, Maryland, Massachusetts, New Hampshire, New Jersey, New York, Pennsylvania, Rhode Island, Vermont, Virginia, West Virginia and Washington, D.C. In 1998, the award resulted in a total of approximately $204.8 1 million of revenue for the final five-months of the implementation phase and seven months of health care delivery. SMHS was notified on February 13, 1998 that the United States General Accounting Office ("GAO") sustained a competitor's protest of the contract award for TRICARE Managed Care Support Region 1 and recommended that the contract be re-bid. In December 1998, the Company reached an agreement to settle the protest (See Note 14 of Notes to the Consolidated Financial Statements). As part of the settlement, the competitor will forego any and all rights it may have to challenge the contract award and seek a re-bid. The principal executive offices of the Company are located at 2724 North Tenaya Way, Las Vegas, Nevada 89128, and its telephone number is (702) 242-7000. Managed Care Products and Services The Company's primary types of health care coverage are HMO plans, HMO Point of Service ("POS") plans, and managed indemnity plans, which include a PPO option. As of December 31, 1998, the Company provided HMO products to approximately 182,000 members in Nevada, 112,000 in Dallas, 25,000 in Houston and 5,000 in Arizona. The POS products allow members to choose one of the various coverage options when medical services are required instead of one plan for the entire year. The Company also provides managed indemnity products to approximately 41,000 members, Medicare supplement products to approximately 26,000 members, and administrative services to approximately 318,000 members. Medical premiums account for approximately 59% of total revenues. Approximately 70% of such medical premiums were derived from southern Nevada in 1998. With the acquisition of Kaiser-Texas, medical premiums derived from southern Nevada in November and December of 1998 were approximately 57% of medical premium revenue. Health Maintenance Organizations. The Company operates mixed group network model HMOs in Las Vegas, Nevada and Dallas/Ft. Worth, Texas and a network model HMO in Reno, Nevada and Houston, Texas. Contracted primary care physicians and specialists for the HMOs are compensated on a capitation or modified fee-for-service basis. Contracts with their primary hospitals are on a capitation or discounted per diem basis. Members receive a wide range of coverage after paying a nominal co-payment and are eligible for preventive care coverage. The HMOs do not require deductibles or claim forms. Most of the Company's managed health care services in Nevada are provided through its independently contracted network of over 2,200 providers and 13 hospitals. These Nevada networks include the Company's multi-specialty medical group, which provides medical services to approximately 71% of the Company's Nevada HMO members and employs over 170 primary care and other providers in various medical specialties. The Company directly provides home health care, hospice care and behavioral health care services and operates a company that provides home infusion, oxygen and durable medical equipment services. In addition, the Company operates three 24-hour urgent care centers, a radiology department, a vision department, an occupational medicine department and two free-standing, state-licensed and Medicare-approved ambulatory surgery centers. The Company believes that this vertical integration of its health care delivery system in Nevada provides a competitive advantage as it has helped it to manage health care costs effectively while delivering quality care. On October 31, 1998, the Company acquired certain assets of Kaiser-Texas, a group model HMO with approximately 109,000 members and a 150 physician medical group in Dallas/Ft. Worth, Texas. The independently contracted medical group provides professional services from nine health centers; eight of which offer primary care services while two offer specialty care services. In addition, TXHC has contracts with 13 hospitals for inpatient care in Dallas/Ft. Worth. Shortly after the acquisition, the Company changed the provider model in Dallas/Ft. Worth from a group model to a mixed network model by overlaying individual practice association ("IPA") delivery systems on top of the existing group model to provide members with more choice. The first IPA was contracted in November 1998 and added approximately 2 1,500 physicians to the Dallas/Ft. Worth delivery system. The Houston HMO members are served by approximately 1,600 independent contracted providers and 30 hospitals. In addition to its commercial HMO plans, which involve traditional HMO benefits and POS benefits, the Company offers a Medicare risk product for Medicare-eligible beneficiaries called Senior Dimensions in Nevada and parts of Arizona and Golden Choice in Texas. Senior Dimensions is marketed directly to Medicare-eligible beneficiaries in the Company's Nevada service area as well as contiguous parts of Arizona. The monthly payment received from the Health Care Financing Administration ("HCFA") is determined by formula established by Federal law. The Balanced Budget Act of 1997 included legislative changes which affected the way health plans are compensated for Medicare members by eliminating over five years amounts paid for graduate medical education and by increasing the blend of national cost factors applied in determining local reimbursement rates over a six-year phase-in period. Both changes will have the effect of reducing reimbursement in high cost metropolitan areas with a large number of teaching hospitals; however, the legislation includes a provision for a minimum increase of 2% annually in health plan Medicare reimbursement for the next five years. Under the authority provided by the 1997 Balanced Budget Act (see "Government Regulation and Recent Legislation"), HCFA has begun to collect hospital encounter data from Medicare risk contractors. The data will be used to implement a new risk adjustment mechanism which will be phased in over a five-year period beginning January 1, 2000. Given the relatively high Medicare risk premium levels in certain of the Company's market areas, the Company is in jeopardy that the new risk adjustment mechanism to be developed could adversely affect the Company's Medicare premium rates going forward. The Company does not believe that the risk adjustment mechanism will be applied to Social HMO capitation payments. As of December 31, 1998, the Company had 47,000 Medicare members, of which 33,500 were located in Nevada, 8,300 in Texas and 5,200 in Arizona. Approximately 26,000 of the Nevada Medicare members were enrolled in a Social Health Maintenance Organization (see "Social Health Maintenance Organization" following). Social Health Maintenance Organization. Effective November 1, 1996, the Company entered into a Social HMO contract pursuant to which a large portion of the Company's Medicare risk enrollees will receive certain expanded benefits. Sierra was one of six HMOs nationally to be awarded this contract, and is currently the only company to have implemented the program as of December 31, 1998. The Company receives additional revenues for providing these expanded benefits. The additional revenues are determined based on health risk assessments that have been, and will continue to be, performed on the Company's eligible Medicare risk members. The additional benefits include, among other things, assisting the eligible Medicare risk members with typical daily living functions such as bathing, dressing and walking. These members, as identified in the health risk assessments, are those who currently have difficulty performing such daily living functions because of a health or physical problem. HCFA has expressed the intention to continue the current reimbursement methodology for the Social HMO contract through December 31, 2000. HCFA has considered adjusting the reimbursement factors for the Social HMO members. At this time, however, there can be no assurance as to what the final per member reimbursement will be or that the social HMO contract will be renewed. Preferred Provider Organizations. The Company also offers health insurance through its PPO. The Company's managed indemnity plans generally offer insureds the option of receiving their medical care from either non-contracted or contracted providers. Insureds pay higher deductibles and co-insurance or co-payments when they receive care from non-contracted providers. Out-of-pocket costs are lowered by utilizing contracted providers who are part of the Company's PPO network. As of December 31, 1998, approximately 41,000 members were enrolled in Sierra's managed indemnity plans. The Company currently provides managed indemnity and Medicare supplement services to individuals in Nevada, Arizona, Colorado, Texas, California, Louisiana, Iowa and South Carolina. The Company is also exploring further expansion in certain other states and currently provides other insurance services in Missouri, New Mexico, and Pennsylvania. As of December 31, 1998 the PPO is licensed in a total of 43 states and the District of Columbia. 3 Ancillary Medical Services. Among the ancillary medical services offered by the Company are outpatient surgical care, diagnostic tests, medical and surgical procedures, inpatient and outpatient laboratory tests, x-ray, CAT scans, nuclear medicine services, and mental health and substance abuse services. In Nevada, the Company also provides home health care services, a hospice program and vision services. These services are provided to members of the Company's HMOs, managed indemnity and administrative services plans. The mental health and substance abuse services are also provided to approximately 137,000 participants from non-affiliated employer groups and insurance companies. In addition, the Company offers home infusion, oxygen and durable medical equipment services. Administrative Services. The Company's administrative services products provide, among other things, utilization review and PPO services to large employer groups that are usually self-insured. As of December 31, 1998, approximately 318,000 members were enrolled in the Company's administrative services plans. The results of operations for these services are included in specialty product revenues and expenses in the Consolidated Statements of Operations. Workers' Compensation Operations Workers' Compensation Subsidiary. On October 31, 1995, the Company acquired CII Financial, Inc. ("CII"), for approximately $76.3 million of common stock in a transaction accounted for as a pooling of interests. CII writes workers' compensation insurance in the states of California, Colorado, Kansas, Missouri, Nebraska, New Mexico, Texas and Utah. CII has licenses in 31 states and the District of Columbia. California, Colorado, and Texas represent approximately 84%, 8%, and 5%, respectively, of CII's fully insured workers' compensation insurance premiums in 1998. Workers' compensation insurance premiums account for approximately 13% of the Company's total revenue. The workers' compensation subsidiary applies the discipline of managed care concepts to its operations. These concepts include, but are not limited to, the use of specialized preferred provider networks, utilization reviews by employed board certified occupational medicine and orthopedic surgeons as well as nurse case managers, medical bill reviewers and job developers who facilitate early return to work. Effective September 30, 1997, the Company terminated its workers' compensation administrative services contract with the state of Nevada. The contract served approximately 200,000 enrollees and provided approximately $3.2 million in revenues for the year ended December 31, 1997. The contract was terminated to allow the Company to participate in the Nevada workers' compensation insurance market when the state allows private insurance companies to begin offering products on July 1, 1999. Military Contract Services Sierra Military Health Services, Inc. On September 30, 1997, the Company was awarded a TRICARE contract to provide managed health care coverage to eligible beneficiaries in Region 1. This region includes approximately 606,000 eligible individuals in Connecticut, Delaware, Maine, Maryland, Massachusetts, New Hampshire, New Jersey, New York, Pennsylvania, Rhode Island, Vermont, Virginia, West Virginia and Washington, D.C. SMHS completed an eight month implementation phase in May 1998 and began providing health care benefits on June 1, 1998 under the TRICARE contract. Under the TRICARE contract, SMHS provides health care services to approximately 606,000 dependents of active duty military personnel and military retirees and their dependents through subcontractor partnerships and individual providers. Through such partnerships, SMHS also performs specific administrative services, such as health care appointment scheduling, enrollment, network management and health care advice line services. SMHS performs such services using DOD information systems. If all five option periods are exercised by the DOD and no extensions of the performance period are made, health care delivery will end on May 31, 2003, followed by an additional eight month phaseout of the Region 1 managed care support contract. 4 Marketing The Company's marketing efforts for its commercial managed care products involve a two-step process. The Company first makes presentations to employers and then provides information directly to employees once the employer has decided to offer the Company's products. Once a relationship with a group is established and a group agreement is negotiated and signed, the Company's marketing efforts focus on individual employees. During a designated "open enrollment" period each year, usually the month preceding the annual renewal of the agreement with the group, employees choose whether to remain with, join or terminate their membership with a specific health plan offered by the employer. New employees decide whether to join one of the employers' health insurance options at the time of their employment. Although contracts with employers are generally terminable on 60 days notice, changes in membership occur primarily during open enrollment periods. Medicare risk products are primarily marketed by the HMOs' sales employees. Retention of employer groups and membership growth is accomplished through print advertising directed to employers and through consumer media campaigns. Media communications convey the Company's emphasis on preventive care, ready access to health care providers and quality service. Other communications to customers include employer and member newsletters, member education brochures, prenatal information packets, employer/broker seminars and direct mail advertising to clients. Members' satisfaction with Company benefits and services is monitored by customer surveys. Results from these surveys and other primary and secondary research guide the sales and advertising efforts throughout the year. The Company's workers' compensation insurance policies are sold primarily through independent insurance agents and brokers, who may also represent other insurance companies. The Company believes that independent insurance agents and brokers choose to market the Company's insurance policies primarily because of the price the Company charges. Additional considerations include the quality of service that the Company provides and the commissions the Company pays. The Company employs full-time employees as marketing representatives to make personal contacts with agents and brokers, to maintain regular communication with them, to advise them of the Company's services and products, and to recruit additional agents and brokers. In addition, the Company employs full-time field underwriters who meet with agents and brokers and can provide an immediate quote on a policy. As of December 31, 1998, the Company had relationships with approximately 730 agents and 20 brokers and paid its agents and brokers commissions based on a percentage of the gross written premium produced by such agents and brokers. The Company also utilizes a number of promotional media, including advertising in publications and at trade fairs, to support the efforts of its independent agents. SMHS administers marketing initiatives in accordance with the TRICARE Region 1 managed care support contract. SMHS' dedicated Marketing Division uses a multi-faceted marketing approach to ensure that all beneficiaries within Region 1 have the opportunity to learn about the health care benefits under TRICARE and have the opportunity to make health care choices that best fit their specific needs. Marketing initiatives include direct beneficiary briefings, direct mail, newspaper advertising, newsletters and web page briefs. 5 Membership Period End Membership:
Years Ended December 31, 1998 1997 1996 1995 1994 HMO: Commercial.............................. 277,000 156,000 147,000 116,000 107,000 Medicare................................ 47,000 36,000 30,000 25,000 20,000 Managed Indemnity........................... 41,000 64,000 46,000 31,000 24,000 Medicare Supplement......................... 26,000 25,000 23,000 15,000 9,000 Administrative Services (1) ................ 318,000 328,000 338,000 117,000 65,000 TRICARE Eligibles........................... 606,000 _______ _______ _______ _______ Total Membership........................ 1,315,000 609,000 584,000 304,000 225,000
(1) For comparability purposes, enrollment information has been restated to reflect the September 30, 1997 termination of the Company's workers' compensation administrative services contract with the state of Nevada. Enrollment in the terminated plan was 163,000, 94,000 and 79,000 members at December 31, 1996, 1995 and 1994, respectively. For the years ended December 31, 1998 and 1997, the Company received approximately 23.0% and 23.7%, respectively, of its total revenues from its contract with HCFA to provide health care services to Medicare enrollees. The Company's contract with HCFA is subject to annual renewal at the election of HCFA, and requires the Company to comply with federal HMO and Medicare laws and regulations and may be terminated if the Company fails to so comply. The termination of the Company's contract with HCFA would have a material adverse effect on the Company's business. In addition, there have been, and the Company expects that there will continue to be, a number of legislative proposals to limit Medicare reimbursements and to require additional benefits. Future levels of funding of the Medicare program by the federal government cannot be predicted with certainty (See "Government Regulation and Recent Regulation"). The Company's ability to obtain and maintain favorable group benefit agreements with employer groups affects the Company's profitability. The agreements are generally renewable on an annual basis but are subject to termination on 60 days prior notice. For the fiscal year ended December 31, 1998, the Company's ten largest HMO employer groups were, in the aggregate, responsible for less than 10% of the Company's total revenues. Although none of such employer groups accounted for more than 2% of total revenues during that period, the loss of one or more of the larger employer groups would, if not replaced with similar membership, have a material adverse effect upon the Company's business. The Company has generally been successful in retaining these employer groups. However, there can be no assurance that the Company will be able to renew its agreements with such employer groups in the future or that it will not experience a decline in enrollment within its employer groups. Additionally, revenues received under certain government contracts are subject to audit and retroactive adjustment. Provider Arrangements and Cost Management HMO and Managed Indemnity Products. A significant distinction between the Company's health care delivery system and that of many other managed care providers is the fact that approximately 71% of the Company's Nevada HMO members and 80% of its Texas HMO members receive primary health care through the Company's affiliated multi-specialty medical groups. The Company makes health care available through independently contracted providers employed by the multi-specialty medical groups and other independently contracted networks of physicians, hospitals and other providers. Under the Company's HMOs, the member selects a primary care physician who provides or authorizes any non-emergency medical care given to that member. These primary care physicians and some specialists are compensated to a limited extent on the basis of how well they coordinate appropriate medical care. The Company has a system of limited incentive risk arrangements and utilization management with respect 6 to its independently contracted primary care physicians. The Company compensates its independently contracted primary care physicians and specialists by using both capitation and modified fee-for-service payment methods. In Nevada, under both the capitation and modified fee-for-service methods, an incentive risk arrangement is established for institutional services. Additional amounts may be made available to certain capitated physicians if hospital costs are less than anticipated for the Company's HMO members. For those primary care physicians receiving payments on a modified fee-for-service basis, portions of the payments otherwise due the physicians are withheld. The amounts withheld are available for payment to the physicians if, at year-end, the expenditures for both institutional and non-institutional medical services are within predetermined, contractually agreed upon ranges. It is believed that this method of limited incentive risk payment is advantageous to the physician, the Company and the members because all share in the benefits of managing health care costs. The Company has, however, negotiated capitation and reduced fee-for-service agreements with certain specialists and primary care providers who do not participate in the incentive risk arrangements. The Company monitors health care utilization, including evaluation of elective surgical procedures, quality of care and financial stability of its capitated providers to facilitate access to service and to ensure member satisfaction. The Company also believes that it has negotiated favorable rates with its contracted hospitals. The Company's contracts with its hospital providers typically renew automatically with both parties granted the right to terminate after a notice period ranging from between three and twelve months. Reimbursement arrangements with other health care providers, including pharmacies, generally renew automatically or are negotiated annually and are based on several different payment methods, including per diems (where the reimbursement rate varies and is based on a per day of service charge for specified types of care), capitation or modified fee-for-service arrangements. To the extent possible, when negotiating non-physician provider arrangements, the Company solicits competitive bids. The Company provides, or negotiates discounted contracts with hospitals for the provision of, inpatient and outpatient hospital care, including room and board, diagnostic tests and medical and surgical procedures. The Company believes that it currently has a favorable contract with its primary southern Nevada contracted hospital, Columbia Sunrise Hospital. Subject to certain limitations, the contract provides, among other things, guaranteed contracted per diem rate increases on an annual basis after December 31, 1997. The per diem rate increased 1% in 1998 and is scheduled for 2% in 1999. Since a majority of the Company's southern Nevada hospital days are at Columbia Sunrise Hospital, this contract assists the Company in managing a significant portion of its medical costs. The contract expires in the year 2012. In Texas, the Company has negotiated a capitation arrangement with Columbia Hospital, Inc. for hospital services provided in Houston and has contracts with 13 hospitals for inpatient care in Dallas/Ft. Worth. The Company utilizes two reimbursement methods for health care providers rendering services under the Company's indemnity plans. For services to members utilizing a PPO plan, the Company reimburses participating physicians on a modified fee-for-service basis which incorporates a limited fee schedule and reimburses hospitals on a per diem or discounted fee-for-service basis. For services rendered under a standard indemnity plan, pursuant to which a member may select a non-plan provider, the Company reimburses non-contracted physicians and hospitals at pre-established rates, less deductibles and co-insurance amounts. The Company manages health care costs through its large case management program, urgent care centers and by educating its members on how and when to use the services of its plans and how to manage chronic disease conditions. The Company also audits hospital bills to identify inappropriate charges. Further, in Nevada the Company utilizes its home health care agency and its hospice which helps to minimize hospital admissions and lengths of stay. Military Health Services. Under the TRICARE contract, dependents of active duty military personnel and military retirees and their dependents choose one of three option plans available to them for health care services: (1) TRICARE Prime (an HMO style option with a self-selected primary care manager and no deductibles), (2) TRICARE Extra (a PPO style option), or (3) TRICARE Standard (an indemnity style option with deductibles and cost shares). Approximately 30% of eligible beneficiaries receive their primary care 7 through existing Military Treatment Facilities. SMHS negotiated discounted contracts with approximately 20,000 individual providers, 1,200 institutions and 5,000 pharmacies to provide supplemental network access for TRICARE Prime and Extra beneficiaries. SMHS' contracts with providers are primarily on a discounted fee-for-service basis with renewal and termination terms similar to Sierra's commercial practice. SMHS is at-risk for and manages the health care service cost of all TRICARE Extra and Standard beneficiaries as well as a small percentage of TRICARE Prime beneficiaries. Risk Management The Company maintains general and professional liability, property and fidelity insurance coverage in amounts that it believes are adequate for its operations. The Company's multi-specialty medical groups maintain excess malpractice insurance for the providers presently employed by the group. In Nevada and Arizona, the Company has assumed the risk for the first $250,000 per malpractice claim, not to exceed $1.5 million in the aggregate per contract year up to its limits of coverage. In Texas, the Company has assumed no self-insured retention per claim. The aggregate maximum exposure for each of these policies is $30 million per year. In addition, the Company requires all of its independently contracted provider physician groups, individual practice physicians, specialists, dentists, podiatrists and other health care providers (with the exception of certain hospitals) to maintain professional liability coverage. Certain of the hospitals with which the Company contracts are self-insured. The Company also maintains stop-loss insurance that reimburses the Company between 50% and 90% of hospital charges for each individual member of its HMO or managed indemnity plans whose hospital expenses exceed, depending on the contract, $100,000 to $200,000, during the contract year and up to $2.0 million per member per lifetime. Effective July 1, 1997, the Company also maintains excess catastrophic coverage for one of the Company's wholly-owned HMOs, Health Plan of Nevada, Inc. ("HPN"), that reimburses the Company for amounts by which the ultimate net loss exceeds $400,000, but does not exceed the annual maximum of $19.6 million per accident and $39.2 million per contract. In the ordinary course of its business, however, the Company is subject to claims that are not insured, principally claims for punitive damages. Effective January 1, 1998, workers' compensation claims are reinsured between $500,000 and $100 million per occurrence. For claims occurring on and after July 1, 1998, that are below $500,000, the Company obtained quota share and excess of loss reinsurance. Under this agreement, the Company reinsures 30% of the first $10,000 of each claim, 75% of the next $40,000 and 100% of the next $450,000. The Company receives a ceding commission from the reinsurer as a partial reimbursement of operating expenses. Information System The Company has in place certain data systems which assist the Company in, among other things, pricing its services, monitoring utilization and other cost factors, providing bills on a timely basis, identifying accounts for collection and handling various accounting and reporting functions. Its imaging and workflow systems are used to process and track claims and coordinate customer service. Where it is cost efficient, the Company's system is connected to large provider groups, doctors' offices, payors and brokers to enable efficient transfer of information and communication. The Company views its information systems capability as critical to the performance of ongoing administrative functions and integral to quality assurance and to the coordination of patient care across care sites. The Company is continually modifying or improving its information systems capabilities in an effort to improve operating efficiencies. Year 2000 The Year 2000 issue exists because many computer systems and applications currently use two-digit date fields to designate a year. As the century date change occurs, date-sensitive systems will recognize the year 2000 as 1900, or not at all. This inability to recognize or properly treat the Year 2000 may cause systems to process critical financial and operational information incorrectly. 8 The Company is currently in the process of modifying or replacing its mission critical financial and operational computer systems. The Company is also in the process of testing its non-information system technology for Year 2000 compliance. The Year 2000 project has been broken down into five phases: (1) inventorying Year 2000 items; (2) assessing the Year 2000 items that are determined to be material to the Company; (3) renovating or replacing material items that are determined not to be Year 2000 compliant; (4) testing and validating material items; and (5) implementing renovated and validated systems. At December 31, 1998, the inventory and assessment phases are substantially complete as it relates to all material computer systems and approximately 50% complete as it relates to non-information system technology. The Company estimates that the replacement/renovation phases and the testing/validation phases will be 95% complete by October 31, 1999. The Company estimates that it is approximately 50% complete with the total project as of December 31, 1998. Contingency planning for the mission critical business operations is scheduled to be completed by the end of April 1999. These plans focus on business operations involving information systems and non-information systems technologies. The Company has initiated formal communications with entities with whom it does business to assess their Year 2000 issues. Evaluations of the most critical third parties have been initiated, and follow-up reviews will be conducted through 1999. Contingency plans are being developed based on these evaluations and are expected to be completed by the middle of 1999. There can be no assurances that the systems of other companies or governmental agencies, such as HCFA and the DOD, on which the Company relies will be timely modified for Year 2000, or that the failure to modify by another company would not have a material adverse effect on the Company. Based upon two separate reports issued by the United States General Accounting Office it is doubtful that the computer systems at both HCFA and the DOD will be fully Year 2000 compliant by the end of 1999. The Company does not currently have available data to predict the impact of such non-compliance on its business operations. Should there be any material delays caused by Year 2000 issues, the Company anticipates that the governmental entities will make estimated payments. The Company is in the process of implementing three major systems at an estimated cost of $36 million to $38 million, which includes the implementation costs related to the recently acquired Kaiser-Texas operations. To date, the Company has spent approximately $19.0 million on the new computer systems and other Year 2000 items. The Company is expensing the costs to make modifications to existing computer systems and non-computer equipment. Management currently estimates the remaining new computer system costs and other Year 2000 costs to be $13.0 million to $16.0 million for operations in existence prior to the Kaiser-Texas transaction and $6.0 million to $8.0 million for the Kaiser-Texas operations that were acquired on October 31, 1998. While this is a substantial effort, it will give the Company the benefits of new technology and functionality for many of its financial and operational computer systems and applications. The failure to correct a material Year 2000 problem could result in an interruption of, or a failure of, certain business activities or operations. Such failures could materially adversely affect the Company's operations, liquidity and financial condition. Due to the general uncertainty inherent in the Year 2000 problem, resulting in part from uncertainty of the Year 2000 readiness of third parties with which the Company does business, the Company is unable to determine at this time whether the consequences of potential Year 2000 failures will have a material adverse impact on the Company's results of operations, liquidity or financial condition. The Company's Year 2000 project is expected to significantly reduce the Company's level of uncertainty about the Year 2000 problem. The Company believes that, with the implementation of the new computer systems and completion of the entire project as scheduled, the possibility of significant interruptions of operations should be reduced. The above contains forward-looking statements including, without limitation, statements relating to the Company's plans, strategies, objectives, expectations, intentions, and adequate resources, that are made pursuant to the "safe harbor" provisions of the Private Securities Litigation Reform Act of 1995. Readers are cautioned that forward-looking statements contained in the Year 2000 disclosure should be read in conjunction with the following disclosure of the Company: 9 The costs of the project and the dates on which the Company plans to complete the necessary Year 2000 modifications are based on management's best estimates, which were derived utilizing numerous assumptions of future events including the continued availability of certain resources and other factors. However, there can be no guarantee that these estimates will be achieved and actual results could differ materially from those plans. Specific factors that might cause such material differences include, but are not limited to, the availability and cost of personnel trained in this area, the ability to locate and correct all relevant computer codes, the ability of the Company's significant suppliers, customers and others with which it conducts business, including federal and state governmental agencies, to identify and resolve their own Year 2000 issues and similar uncertainties. Quality Assurance and Improvement The Company has developed programs to help ensure that the health care services provided by its HMO and managed indemnity plans meet the professional standards of care established by the medical community. The Company believes that its emphasis on quality allows it to increase and retain its members. The Company monitors and evaluates the availability and quality of the medical care rendered by the providers in its HMO and insurance plans and periodically audits selected diagnoses, problems and referrals to determine adherence to appropriate standards of medical care. In addition, the Company has medical directors who, supported by a professional medical staff, monitor the quality and appropriateness of health care by analyzing a physician's utilization of diagnostic tests, laboratory and radiology procedures, specialty referrals, prescriptions and hospitals. Physicians and hospitals selected to provide services to the Company's members are subject to the Company's quality assurance programs including a formal credentialing process of all physicians. The Company also has internal quality assurance and improvement review committees that meet on a regular basis to review specialist referrals, monitor the performance of physicians and review practice patterns, complaints and other patient issues. Staff members regularly visit hospitals to review medical records, meet with patients and review treatment programs and discharge plans with attending physicians. In addition, the Company solicits information from both existing and former members as to their satisfaction with the care delivered. Complaints and grievances are responded to on both an informal and formal basis, depending on the nature of the complaint. Several independent organizations have been formed for the purpose of responding to external demands for accountability in the health care industry. The Company has voluntarily elected to be evaluated by these external organizations, including the National Committee for Quality Assurance ("NCQA") and the Joint Commission on Accreditation of Healthcare Organizations ("JCAHO"). NCQA is an independent, not-for-profit organization that evaluates managed care organizations. The NCQA accreditation process includes rigorous evaluations conducted by a team of physicians and managed care experts. No comparable evaluation exists for fee-for-service health care. The NCQA evaluates plans on approximately 50 quality standards that fall into six categories: Quality Management and Improvement; Physician Credentials; Members' Rights and Responsibilities; Preventive Health Services; Utilization Management; and, Medical Records. In 1998, Health Plan of Nevada ("HPN") earned a three-year, full accreditation from the NCQA for its HMO and Medicare products in the Las Vegas metropolitan area and Pahrump. TXHC in Dallas/Ft. Worth currently has a One-Year Accreditation from NCQA, pending a May 1999 acquisition review. The JCAHO reviews rights, responsibilities and ethics, continuum of care, education and communication, leadership, management of information, and human resources and network performance. The Company's home health care and hospice subsidiaries are JCAHO accredited. There can be no assurance, however, that the Company will maintain NCQA or other accreditations in the future and there is no basis to predict what effect, if any, the lack of NCQA or other accreditations could have on HPN's or TXHC's competitive positions in southern Nevada and Dallas/Ft. Worth, Texas respectively. 10 Underwriting HMO. The Company structures premium rates for its various health plans primarily through community rating and community rating by class method. Under the community rating method, all costs of basic benefit plans for the Company's entire membership population are aggregated. These aggregated costs are calculated on a "per member per month" basis and converted to premium rates for various coverage types, such as single or family coverage. The community rating by class method is based on the same principles as community rating, except that actuarial adjustments to premium rates are made for demographic variations specific to each employer group such as the average age and sex of their employees, group size and industry. All employees of an employer group are charged the same premium rate if the same coverage is selected. In addition to those premium charges paid by the employers with whom the Company's HMOs contract, members also pay co-payments at the time certain services are provided. The Company believes that such co-payments encourage appropriate utilization of health care services while allowing the Company to offer competitive premium rates. The Company also believes that the capitation method of provider compensation encourages physicians to provide only medically necessary and appropriate care. Managed Indemnity. Premium charges for the Company's managed indemnity products are set in a manner similar to the community rating by class method described above. This rate calculation utilizes similar demographic adjustment factors such as age, sex and industry factors to develop group-specific adjustments from a given per member per month base rate by plan. Actual health claims experience is used in whole or in part to develop premium rates for larger insurance member groups. This process includes the use of utilization experience, adjustments for incurred but not reported claims, inflationary factors, credibility and specific reinsurance pooling levels for large claims. Workers' Compensation. Prior to insuring a particular risk, the Company reviews, among other factors, the employer's prior loss experience and premium payment history. Additionally, the Company determines whether the employer's employment classifications are among the classifications that the Company has elected to insure generally and if the amounts of the premiums for the classifications are within the Company's guidelines. The Company reviews these classifications periodically to evaluate whether they are profitable. A member of the Company's loss control department may conduct an on-site safety inspection before the Company insures the employer. The Company generally initiates this inspection for enterprises with manufacturing or construction classifications. The Company may also initiate inspections if the enterprise previously has had a high loss ratio or frequent losses. If the on-site inspection reveals hazards that can be corrected, and an agreement can be reached with the employer that these hazards will be corrected in a time frame established by the Company's underwriting department, the Company may issue a policy subject to correction of those hazards. In the event the Company has issued a policy where no previous inspection has been conducted, and subsequently learns through an inspection the employer has hazards that must be corrected, the Company will request that the employer correct the hazards within a specified period of time. If these hazards are not corrected, the Company may cancel the policy for non-compliance of the hazard correction. With regard to new business, the agent or broker will usually submit the claims history on the prospective account. In those situations where the claims history is not supplied by the agent or broker, other sources (such as the prior insurer) are used to obtain the appropriate claims history if possible. Competition HMO and Managed Indemnity. Managed care companies and HMOs operate in a highly competitive environment. The Company's major competition is from self-funded employer plans, PPO networks, other HMOs, such as Humana Care Plus, Pacificare, Inc., Aetna and Harris Methodist and traditional indemnity carriers, such as Blue Cross/Blue Shield. Many of the Company's competitors have substantially larger total enrollments, have greater financial resources and offer a broader range of products than the Company. Additional competitors with greater financial resources than the Company may enter the Company's markets in the future. The Company believes that the most important competitive factors are the delivery of reasonably priced, quality medical benefits to members and the adequacy and availability of health care delivery services and facilities. The Company depends on a large PPO network and flexible benefit plans 11 to attract new members. Competitive pressures are expected to limit the Company's ability to increase premium rates and, to a lesser extent, to result in declining premium rates. Accordingly, the profitability of the Company will, to a large extent, depend on the Company's ability to manage the costs of providing health care benefits to its members. The inability of the Company to manage these costs would have an adverse impact on the Company's future results of operations by reducing margins. In addition, competitive pressures may also result in reduced membership levels. Any such reductions could materially affect the Company's results of operations. Workers' Compensation. The Company's workers' compensation business is concentrated in California, a state where the workers' compensation insurance industry is extremely competitive. Since open rating became effective for policyholders in 1995, there have been, and continue to be, substantial reductions in premiums. The Company believes that there are more than 200 insurance companies writing workers' compensation insurance in California. Many of the Company's competitors have been in business longer, have a larger volume of business, offer a more diversified line of insurance coverage, have greater financial resources and have greater distribution capability than the Company. The largest writer of workers' compensation insurance in California is the State Compensation Insurance Fund. In all states in which the Company is currently writing business, competition for workers' compensation insurance is primarily driven by price and secondarily by services provided to insureds and agents. In states other than California and Texas, the National Council on Compensation Insurance ("NCCI") is usually the designated rating organization. The NCCI accumulates statistical information and recommends pure loss costs to the state's Department of Insurance. The Company then selects loss cost multiplier, expense loads to derive premium rates. Rating plans in those states are more "standardized" and are usually based on plans developed by the NCCI. Losses and Loss Adjustment Expenses Often, in workers' compensation insurance, several years may elapse between the occurrence of a loss and the final settlement of the loss. To recognize liabilities for unpaid losses, the Company establishes reserves, which are balance sheet liabilities representing estimates of future amounts needed to pay claims and related expenses for insured events, including reserves for events that have been incurred but have not yet been reported to the Company ("incurred by not reported" or "IBNR"). When a claim is reported, the Company's claims personnel initially establish reserves on a case-by-case basis for the estimated amount of the ultimate payment. These estimates reflect the judgment of the claims personnel based on their experience and knowledge of the nature and value of the specific type of claim and the available facts at the time of reporting as to severity of injury and initial medical prognosis. Included in these reserves are estimates of the expenses of settling claims, including legal and other fees, and the general expenses of administering the claims adjustment process. Claims personnel adjust the amount of the case reserves as the claim develops and as the facts warrant. IBNR reserves are established for unreported claims and loss development relating to current and prior accident years. In the event that a claim that occurred during a prior accident year was not reported until the current accident year, the case reserve for such claim typically will be established out of previously established IBNR reserves for that prior accident year. The Company reviews the adequacy of its reserves on a monthly basis and considers external forces such as changes in the rate of inflation, the regulatory environment, the judicial administration of claims, medical costs and other factors that could cause actual losses and loss adjustment expenses ("LAE") to change. Reserves are reviewed with the Company's independent actuary at least annually. The actuarial projections include a range of estimates reflecting the uncertainty of projections. Management evaluates the reserves in the aggregate, based upon the actuarial indications, and makes adjustments where appropriate. The 12 consolidated financial statements of the Company provide for reserves based on the anticipated ultimate cost of losses. Once an employer is insured by the Company, the Company's loss control department may assist the insured in developing and maintaining safety programs and procedures to minimize on-the-job injuries and industrial health hazards. The safety programs and procedures vary from insured to insured. The Company's loss control department may recommend to the employer that a safety committee consisting of members of the employer's management staff and its general labor force be established. The Company's loss control department may then assist the committee members in isolating safety hazards, advising the committee on how to correct the hazards and assisting the employer in establishing procedures to enforce the corrections. The Company's loss control department may also revisit the employer to determine whether the recommended corrections and procedures have been implemented. Depending upon the size, classifications, and loss experience of the employer, the Company's loss control department will periodically inspect the employer's places of business and may recommend changes that could prevent industrial accidents. In addition, severe or recurring injuries may also warrant on-site inspections. In certain instances, members of the Company's loss control department may conduct special educational training sessions for insureds' employees to assist in the prevention of on-the-job injuries. For example, employers engaged in manufacturing may be offered a training session on how to prevent back injuries or employers engaged in contracting may be offered a training session on general first aid and prevention of injuries that may result from specific work exposures. Government Regulation and Recent Legislation HMOs and Managed Indemnity. Federal and state governments have enacted statutes extensively regulating the activities of HMOs. In addition, growing government concerns over increasing health care costs and quality could result in new or additional state or federal legislation that could affect health care providers, including HMOs, PPOs and other health insurers. Among the areas regulated by federal and state law are the scope of benefits available to members, premium structure, procedures for review of quality assurance, enrollment requirements, the relationship between an HMO and its health care providers and members, licensing and financial condition. Government regulation of health care coverage products and services is a changing area of law that varies from jurisdiction to jurisdiction. Changes in applicable laws and regulations are continually being considered and interpretation of existing laws and rules also may change from time to time. Regulatory agencies generally have broad discretion in promulgating regulations and in interpreting and enforcing laws and regulations. While the Company is unable to predict what regulatory changes may occur or the impact on the Company of any particular change, the Company's operations and financial results could be negatively affected by regulatory revisions. For example, any proposals affecting underwriting practices, limiting rate increases, requiring new or additional benefits or affecting contracting arrangements (including proposals to require HMOs and PPOs to accept any health care providers willing to abide by an HMO's or PPO's contract terms) may have a material adverse effect on the Company's business. The continued consideration and enactment of "anti-managed care" laws and regulations by federal and state bodies may make it more difficult for the Company to control medical costs and may adversely affect financial results. In addition to changes in applicable laws and regulations, the Company is subject to various audits, investigations and enforcement actions. These include possible government actions relating to the federal Employee Retirement Income Security Act, which regulates insured and self-insured health coverage plans offered by employers, the Federal Employees Health Benefit Plan, federal and state fraud and abuse laws, and laws relating to utilization management and the delivery of health care and payment or reimbursement therefor. Any such government action could result in assessment of damages, civil or criminal fines or 13 penalties, or other sanctions, including exclusion from participation in government programs. In addition, disclosure of any adverse investigation or audit results or sanctions could negatively affect the Company's reputation in various markets and make it more difficult for the Company to sell its products and services. The Company has HMO licenses in Nevada, Texas and Arizona. The Company's HMO operations are subject to regulation by the Nevada Division of Insurance, the Nevada Division of Health, the Texas Department of Insurance and the Arizona Department of Insurance. The Company's health insurance subsidiary is domiciled and incorporated in California and is licensed in 43 states and the District of Columbia, with current operations primarily in Nevada, Arizona, Colorado, Texas, California, Louisiana, Iowa and South Carolina. It is subject to licensing and other regulations of the California Department of Insurance as well as the insurance departments of other states in which it operates or holds licenses. The Company's premium rate increases are subject to various state insurance department approvals. The Company's HMO and insurance subsidiaries are also required by state regulatory agencies to maintain certain deposits and must also meet certain net worth and reserve requirements. The Company also has certain other deposit requirements. The Company has restricted assets on deposit in various states ranging from $20,000 to $2.0 million and totalling $17.8 million at December 31, 1998. The Company's HMO and insurance subsidiaries meet requirements to maintain minimum stockholder's equity ranging from $1.1 million to $5.2 million. In addition, in conjunction with the Kaiser-Texas acquisition, TXHC entered into a letter agreement with the Texas Department of Insurance whereby TXHC agreed to maintain a net worth of $20.0 million. The Company's Nevada HMO and health insurance subsidiaries currently maintain home offices and a regional home office, respectively, in Las Vegas and, accordingly, are eligible for certain premium tax credits in Nevada. The Company's HMO subsidiaries are also restricted by state law as to the amount of dividends that can be declared and paid. Moreover, insurance companies and HMOs domiciled in Texas, Nevada and California generally may not pay extraordinary dividends without providing the state insurance commissioner with 30 days prior notice, during which period the commissioner may disapprove the payment. An "extraordinary dividend" is generally defined as a dividend whose fair market value together with that of other dividends or distributions made within the preceding 12 months exceeds the greater of (i) ten percent of the insurer's surplus as of the preceding December 31 or (ii) the net gain from operations of such insurer for the 12-month period ending on the preceding December 31. The Company is not in a position to assess the likelihood of obtaining future approval for the payment of "extraordinary dividends" or dividends other than those specifically allowed by law in each of its subsidiaries' states of domicile. No prediction can be made as to whether any legislative proposals relating to dividend rules in the domiciliary states of the Company's subsidiaries will be made or adopted in the future, whether the insurance departments of such states will impose either additional restrictions in the future or a prohibition on the ability of the Company's regulated subsidiaries to declare and pay dividends or as to the effect of any such proposals or restrictions on the Company's regulated subsidiaries. The Company is subject to the Federal HMO Act and the regulations promulgated thereunder. Of the Company's three subsidiary HMOs, only MedOne Health Plan, acquired at the end of 1996, is not federally-qualified under this Act. In order to obtain federal qualification, an HMO must, among other things, provide its members certain services on a fixed, prepaid fee basis and set its premium rates in accordance with certain rating principles established by federal law and regulation. The HMO must also have quality assurance programs in place with respect to its health care providers. Furthermore, an HMO may not refuse to enroll an employee, in most circumstances, because of such person's health, and may not expel or refuse to re-enroll individual members because of their health or their need for health services. Under the "corporate practice of medicine" doctrine, in most states, business organizations, other than those authorized to do so, are prohibited from providing, or holding themselves out as providers of, medical care. Some states, including Nevada, exempt HMOs from this doctrine. The laws relating to this doctrine are subject to numerous conflicting interpretations. Although the Company seeks to structure its operations 14 to comply with corporate practice of medicine laws in all states in which it operates, there can be no assurance that, given the varying and uncertain interpretations of those laws, the Company would be found to be in compliance with those laws in all states. A determination that the Company is not in compliance with applicable corporate practice of medicine laws in any state in which it operates could have a material adverse effect on the Company if it were unable to restructure its operations to comply with the laws of that state. Medicare and Medicaid antifraud and abuse provisions are codified at 42 U.S.C. Sections 1320a-7(b) (the "Anti-kickback Statute") and 1395nn (the "Stark Amendments"). Many states have similar anti-kickback and anti-referral laws. These statutes prohibit certain business practices and relationships involving the referral of patients for the provision of health care items or services under certain circumstances. Sanctions for violations of the Anti-kickback Statute and the Stark Amendments include criminal penalties and civil sanctions, including fines and possible exclusion from the Medicare and Medicaid programs. Similar penalties are provided for violation of state anti-kickback and anti-referral laws. The Department of Health and Human Services ("HHS") has issued regulations establishing "safe harbors" with respect to the Antikickback Statute. The Office of the Inspector General recently proposed new rules to clarify those safe harbors. HHS has also recently proposed to establish certain safe harbors under the Stark Amendments. The Company believes that its business arrangements and operations are in compliance with the Antikickback Statute and the Stark Amendments and the exceptions set forth therein, regardless of the availability of regulatory safe harbor protection with respect to those statutes. There can, however, be no assurance that (i) government officials charged with responsibility for enforcing the prohibitions of the Antikickback Statute and the Stark Amendments will not assert that the Company or certain transactions in which it is involved are in violation of those statutes; and (ii) such statutes will ultimately be interpreted by the courts in a manner consistent with the Company's interpretation. In 1997, Congress passed the Balanced Budget Act ("Act") which revised the structure of and reimbursement for private health plan options for Medicare enrollees. The Act seeks to expand the options available to Medicare enrollees by permitting HCFA to contract with a variety of types of managed care plans, creating a new Medicare fee-for-service option and establishing a Medicare Medical Savings Account Demonstration Program. The legislation also encourages provider sponsored organizations to contract directly with HCFA to provide coverage for Medicare enrollees. Federal reimbursement was modified so that the premiums paid by HCFA will be adjusted to take into account, on an increasing basis, a blend of national and local health care cost factors, rather than only local costs--starting with a 10% national factor in 1998 and moving to a 50% national factor by 2003. Congress also provided for gradual removal of a graduate medical education factor in determining reimbursement. As a result, it is likely that premiums paid by HCFA will not match the rate of increase for medical costs. The legislation includes a provision for a minimum increase of 2% annually in health plan Medicare reimbursement for the next five years. The legislation also provides for expedited licensure of provider-sponsored Medicare plans and a repeal in 1999 of the rule requiring health plans to have one commercial enrollee for each Medicare or Medicaid enrollee. These changes could have the effect of increasing competition in the Medicare market. Further, effective January 1, 1999, the Company was required to implement new Medicare regulations including, but not limited to, regulations relating to discharge notices, additional provider contract language and extensive new quality improvement programs. These new regulations are likely to increase the burden of administering the Company's Medicare plans and may adversely impact the Company's operations. The Health Insurance Portability and Accountability Act of 1996 (the "Accountability Act") was passed by Congress and signed into law by President Clinton on August 21, 1996 and effective beginning July 1, 1997. While the Accountability Act contains provisions regarding health insurance or health plans, such as portability and limitations on pre-existing condition exclusions, guaranteed availability and renewability, it also contains several anti-fraud measures that significantly change health care fraud and abuse 15 provisions. Some of the provisions include (i) creation of an anti-fraud and abuse trust fund and coordination of fraud and abuse efforts by federal, state and local authorities; (ii) extension of the criminal anti-kickback statues to all federal health programs; (iii) expansion of and increase in the amount of civil monetary penalties and establishment of a knowledge standard for individuals or entities potentially subject to civil monetary penalties; and (iv) revisions to current sanctions for fraud and abuse, including mandatory and permissive exclusion from participation in the Medicare or Medicaid programs. Workers' Compensation. The Company is subject to extensive governmental regulation and supervision in each state in which it conducts workers' compensation business. The primary purpose of such regulation and supervision is to provide safeguards for policyholders and injured workers rather than protect the interests of shareholders. The extent and form of the regulation may vary, but generally has its source in statutes that establish regulatory agencies and delegate to the regulatory agencies broad regulatory, supervisory and administrative authority. Typically, state regulations extend to such matters as licensing companies; restricting the types or quality of investments; requiring triennial financial examinations and market conduct surveys of insurance companies; licensing agents; regulating aspects of a company's relationship with its agents; restricting use of some underwriting criteria; regulating rates, forms and advertising; limiting the grounds for cancellation or nonrenewal of policies, solicitation and replacement practices; and specifying what might constitute unfair practices. Moreover, the payment of dividends and the making of other distributions to the Company by its workers' compensation insurance company subsidiaries are contingent upon the earnings of those subsidiaries and are subject to various business considerations, applicable state corporate laws and regulations, the terms of agreements to which they may become a party and government regulations, which restrict in certain circumstances the payment of dividends and distributions, and the transfer of assets to the Company. In the normal course of business, the Company and the various state agencies that regulate the activities of the Company may disagree on interpretations of laws and regulations, policy wording and disclosures or other related issues. These disagreements, if left unresolved, could result in administrative hearings and/or litigation. The Company attempts to resolve all issues with the regulatory agencies, but is willing to litigate issues where it believes it has a strong position. The ultimate outcome of these disagreements could result in sanctions and/or penalties and fines assessed against the Company. Currently, there are no litigation matters pending with any department of insurance. Typically, states mandate participation in insurance guaranty associations, which assess solvent insurance companies in order to fund claims of policyholders of insolvent insurance companies. Under this arrangement, insurers can be assessed up to 1% (or 2% in certain states) of premiums written for workers' compensation insurance in that state each year to pay losses and LAE on covered claims of insolvent insurers. In California and certain other states, insurance companies are allowed to recoup such assessments from policyholders while several states allow an offset against premium taxes. Potential assessment expenses, net of recoupment, if any, for insolvencies are not accrued until after an insolvency has occurred since the likelihood and the amount of the assessment expense cannot be reasonably determined or estimated. In California, there have been no new assessments for insolvent workers' compensation insurance companies since 1990. California's Insurance Holding Company Act regulates the payment of shareholder dividends by insurance companies. To date, the workers' compensation insurance subsidiaries have not paid dividends to the Company. General. Besides state insurance laws, the Company is subject to general business and corporation laws, federal and state securities laws, consumer protection laws, fair credit reporting acts and other laws regulating the conduct and operation of its subsidiaries. 16 Employees The Company had approximately 4,700 employees as of December 31, 1998. None of these employees are covered by a collective bargaining agreement. The Company believes that its relations with its employees are good. ITEM 2. PROPERTIES The Company owns several administrative facilities in southern Nevada totalling approximately 406,000 square feet. Such facilities include an approximate 134,000 square foot six-story home office building and an approximate 43,000 square foot two-story corporate administrative headquarters. These buildings are subject to liens securing an $800,000 loan balance from Bank of America. Also included in this total is a 198,000 square foot six-story administrative headquarters building which became fully occupied in 1998. This building was financed in January 1998 and is subject to a $13.4 million loan balance. The Company also owns several clinical facilities in the southern Nevada area totalling approximately 396,000 square feet and consisting primarily of nine medical clinics and two surgery centers. The Company leases additional office and clinical space in Nevada totalling approximately 145,000 and 86,000 square feet, respectively. In conjunction with the Kaiser-Texas acquisition, the Company purchased eight medical facilities totalling approximately 323,000 square feet and administrative facilities totalling approximately 175,000 square feet. These buildings are subject to a deed of trust note securing a $35.2 million note. In addition, the Company leases additional office and clinical space in Texas totalling approximately 54,000 square feet and 77,000 square feet, respectively. The above properties are utilized primarily for the managed care operations. The workers' compensation subsidiary is headquartered in Nevada and occupies approximately 25% of the 198,000 square foot administrative building as well as leases approximately 67,000 square feet of office space in California. The Company leases approximately 150,000 square feet of office space in other various states as needed for other regional operations, for TRICARE service centers and for the military subsidiary's administrative headquarters. The Company believes that current and planned clinical space will be adequate for its present needs. Additional clinical space may be required, however, if membership continues to expand in southern Nevada. The Company owns real estate and a building in Park City, Utah purchased in 1996 to provide entertainment and a meeting environment for significant current and prospective clients, brokers and others who assist in the Company's marketing efforts. ITEM 3. LEGAL PROCEEDINGS The Company is subject to various claims and other litigation in the ordinary course of business. Such litigation includes claims of medical malpractice, claims for coverage or payment for medical services rendered to HMO members and claims by providers for payment for medical services rendered to HMO members. Also included in such litigation are claims for workers' compensation and claims by providers for payment for medical services rendered to injured workers. The litigation with Humana resulting from its acquisition of Physician Corporation of America that was discussed in previous filings has been settled. In the opinion of the Company's management, the ultimate resolution of pending legal proceedings should not have a material adverse effect on the Company's financial condition. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None 17 PART II ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS Market Information The Company's common stock, par value $.005 per share (the "Common Stock"), has been listed on the New York Stock Exchange under the symbol SIE since April 26, 1994 and, prior to that, was listed on the American Stock Exchange since the Company's initial public offering on April 11, 1985. The following table sets forth the high and low sales prices for the Common Stock for each quarter of 1998 and 1997.
Period High Low 1998 First Quarter........................................ $26 7/8 $20 9/16 Second Quarter....................................... 27 37/64 23 1/4 Third Quarter........................................ 26 15 7/8 Fourth Quarter....................................... 24 15/16 17 15/16 1997 First Quarter........................................ $18 1/2 $16 5/12 Second Quarter....................................... 21 5/12 16 1/12 Third Quarter........................................ 24 11/12 20 19/24 Fourth Quarter....................................... 26 2/3 20 19/24
On February 26, 1999, the closing sale price of the common stock was $14 3/8 per share. Note: The above stock prices have been adjusted to account for the three-for-two stock split of the Company's common stock to stockholders of record as of May 18, 1998. Holders The number of record holders of Common Stock at February 26, 1999 was 254. Based upon information available to it, the Company believes there are several thousand beneficial holders of the Common Stock. Dividends No cash dividends have been paid on the Common Stock since the Company's inception. The Company currently intends to retain its earnings for use in its business and does not anticipate paying any cash dividends in the foreseeable future. As a holding company, the Company's ability to declare and to pay dividends is dependent upon cash distributions from its operating subsidiaries. The ability of the Company's health maintenance organization ("HMO") and insurance subsidiaries to declare and to pay dividends is limited by state regulations applicable to the maintenance of minimum deposits, reserves and net worth. (See Management's Discussion and Analysis of Financial Condition and Results of Operations -- Liquidity and Capital Resources.) The declaration of any future dividends will be at the discretion of the Company's Board of Directors and will depend on, among other things, future earnings, debt covenants, operations, capital requirements and the financial condition of the Company and upon general business conditions. 18 ITEM 6. SELECTED FINANCIAL DATA The following selected consolidated financial data of Sierra Health Services, Inc., and subsidiaries (the "Company"), for each of the fiscal years in the five-year period ended December 31, 1998 should be read in conjunction with the Consolidated Financial Statements and the related Notes thereto, "Management's Discussion and Analysis of Financial Condition and Results of Operations" and other information which appears elsewhere in this Annual Report on Form 10-K. The selected consolidated financial data below has been derived from the audited Consolidated Financial Statements of the Company.
Years Ended December 31, 1998 1997 1996 1995 1994 (Amounts in thousands, except per share data) Statement of Operations Data: OPERATING REVENUES: Medical Premiums............................................. $ 609,404 $513,857 $386,968 $319,475 $269,382 Specialty Product Revenues .................................. 148,368 146,211 133,324 102,807 101,287 Military Contract Revenues .................................. 204,838 4,346 Professional Fees............................................ 45,363 31,238 28,836 19,417 12,331 Investment and Other Revenues................................ 29,230 26,072 26,283 25,310 19,081 Total...................................................... 1,037,203 721,724 575,411 467,009 402,081 OPERATING EXPENSES: Medical Expenses............................................. 513,209 419,272 315,915 245,135 200,229 Specialty Product Expenses................................... 142,258 143,082 130,758 102,859 96,600 General, Administrative and Marketing Expenses............... 110,687 93,919 72,237 63,562 53,671 Military Contract Expenses ................................. 196,625 4,193 Integration, Settlement and Other Costs (1) ................. 13,851 29,350 12,064 11,614 Total...................................................... 976,630 689,816 530,974 423,170 350,500 OPERATING INCOME ............................................... 60,573 31,908 44,437 43,839 51,581 INTEREST EXPENSE AND OTHER, NET................................. (7,181) (4,433) (2,823) (3,737) (6,401) INCOME FROM CONTINUING OPERATIONS BEFORE INCOME TAXES ....................................... 53,392 27,475 41,614 40,102 45,180 PROVISION FOR INCOME TAXES...................................... 13,796 3,234 10,471 12,198 8,236 INCOME FROM CONTINUING OPERATIONS............................... 39,596 24,241 31,143 27,904 36,944 LOSS FROM DISCONTINUED OPERATIONS .............................. (6,600) (2,501) NET INCOME ..................................................... $ 39,596 $ 24,241 $ 31,143 $ 21,304 $ 34,443 EARNINGS PER COMMON SHARE (2): Income from Continuing Operations Per Share ................. $1.45 $.90 $1.17 $1.07 $1.57 Loss Per Share from Discontinued Operations ................. (.25) (.11) Net Income Per Share ........................................ $1.45 $.90 $1.17 $ .82 $1.46 Weighted Average Number of Common Shares Outstanding ........................................ 27,391 27,013 26,589 26,121 23,517 EARNINGS PER COMMON SHARE ASSUMING DILUTION (2): Income from Continuing Operations Per Share ............. $1.43 $.88 $1.15 $1.05 $1.54 Loss Per Share from Discontinued Operations ............. ___ (.25) (.10) Net Income Per Share .................................... $1.43 $.88 $1.15 $ .80 $1.44 Weighted Average Number of Common Shares Outstanding Assuming Dilution ...................... 27,747 27,426 27,191 26,601 23,999
19
Years Ended December 31, 1998 1997 1996 1995 1994 (Amounts in thousands) Balance Sheet Data: Working Capital ............................................. $ 47,763 $ 88,377 $ 76,530 $ 18,157 $ 71,337 Total Assets................................................. 1,045,120 723,936 629,462 575,146 535,487 Long-term Debt (Net of Current Maturities)................... 242,398 90,841 66,189 71,257 75,209 Cash Dividends Per Common Share.............................. NONE NONE NONE NONE NONE Stockholders' Equity......................................... 303,714 265,682 234,482 207,715 168,157
(1) The Company recorded certain identifiable integration, settlement and other costs. See Note 14 of Notes to the Consolidated Financial Statements. (2) Adjusted to account for three-for-two stock split of the Company's common stock to stockholders of record as of May 18, 1998. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion and analysis provides information which management believes is relevant for an assessment and understanding of the Company's consolidated financial condition and results of operations. The discussion should be read in conjunction with the Consolidated Financial Statements and Related Notes thereto. Any forward-looking information contained in this Management's Discussion and Analysis of Financial Condition and Results of Operations and any other sections of this 1998 Annual Report on Form 10-K should be considered in connection with certain cautionary statements contained in the Company's Current Report on Form 8-K filing dated March 17, 1999, incorporated herein by reference. Such cautionary statements are made pursuant to the "safe harbor" provisions of the Private Securities Litigation Reform Act of 1995 and identify important risk factors that could cause the Company's actual results to differ materially from those expressed in any projected, estimated or forward-looking statements relating to the Company. Acquisitions On October 31, 1998, Sierra and one of its subsidiaries, Texas Health Choice, L.C. (formerly HMO Texas L.C.) completed the acquisition of certain assets of Kaiser Foundation Health Plan of Texas ("Kaiser- Texas"), a health plan operating in Dallas/Ft. Worth with approximately 109,000 members, and Permanente Medical Association of Texas ("Permanente"), a medical group with approximately 150 physicians. The purchase price was $124 million, which is net $20 million in operating cost support to be paid to Sierra by Kaiser Foundation Hospitals in five quarterly installments following the closing of the transaction. The purchase price allocation includes a premium deficiency reserve of $25 million for estimated losses on the contracts acquired from Kaiser-Texas. Of this amount, $6.8 million was reversed in 1998 to offset losses on the acquired contracts. The purchase price includes amounts for real estate and eight medical and office facilities with approximately 500,000 square feet. In December 1998, certain accreditation goals were met by the health plan resulting in a purchase price increase of $3.0 million to $127 million. The purchase price may increase up to an additional $27 million over three years if certain growth and member retention goals are met by the health plan. Sierra assumed no prior liabilities for malpractice or other litigation, or for any unanticipated future adjustments to claims expenses for periods prior to closing. The transaction was financed with a five-year revolving credit facility and a $35.2 million note payable to Kaiser Foundation Health Plan of Texas. The note is secured by the acquired real estate. Approximately $110 million of the $200 million revolving credit facility was used to fund the transaction. 20 On December 31, 1998, Sierra completed the acquisition of the Nevada health care business of Exclusive Healthcare, Inc., United of Omaha Life Insurance Company and United World Life Insurance Company, all of which are subsidiaries of Mutual of Omaha Insurance Company. The purchase price is contingent based on how many members are retained through 2000 and 2001. No cash will be paid until group renewals begin in 2000. Sierra retained approximately 9,000 members (approximately 4,400 HMO members) subsequent to the acquisition. In August 1997, the Company acquired the assets and operations of Total Home Care, Inc. ("THC") for approximately $3.1 million, net of cash acquired. THC provides home infusion, oxygen, and durable medical equipment services in Nevada and Arizona. The Company sold the Arizona operations in the first quarter of 1998 for approximately $1.5 million. Also, in the first quarter of 1998, the Company purchased three medical clinics in southern Nevada for approximately $7.3 million. Effective December 31, 1996, the Company purchased Prime Holdings, Inc. ("Prime") for approximately $32.2 million in cash. At December 31, 1996, Prime operated MedOne Health Plan, Inc., a 12,800 member HMO, and also served 215,000 people through preferred provider organizations, workers' compensation programs, and administrative services products for self-insured employers and union welfare funds, primarily in the state of Nevada. Overview The Company derives revenues from its health maintenance organizations, managed indemnity, military health care services and workers' compensation insurance subsidiaries. To a lesser extent, the Company also derives additional specialty product revenues from non-HMO and insurance products (consisting of fees for workers' compensation administration, utilization management services and ancillary products), professional fees (consisting primarily of fees for providing health care services to non-members and co-payment fees received from members), and investment and other revenue. Medical premium revenues accounted for approximately 58.8%, 71.2% and 67.3% of the Company's total revenues for 1998, 1997 and 1996, respectively. The decrease in medical premiums as a percentage of total revenues is primarily due to the addition of military contract revenues. Continued medical premium revenue growth is principally dependent upon continued enrollment in the Company's products and upon competitive and regulatory factors. The Company's principal expenses consist of medical expenses, military contract expense, specialty product expenses, and general, administrative and marketing expenses. Medical expenses represent the aggregate expenses of operating the Company's multi-specialty medical group and other provider subsidiaries as well as capitation fees and other fee-for-service payments paid to independently contracted physicians, hospitals and other health care providers. As a provider of managed care services, the Company seeks to manage medical expenses by employing or contracting with physicians, hospitals and other health care providers at negotiated price levels, by adopting quality assurance programs, by monitoring and managing utilization of physicians and hospital services and by providing incentives to use cost-effective providers. Military contract expenses represent the expenses of delivering health care as agreed to in the TRICARE contract with the federal government as well as administrative costs to operate the military health care subsidiary. Specialty product expenses primarily consist of losses and loss adjustment expenses, and underwriting expenses associated with the Company's workers' compensation insurance subsidiaries. General, administrative and marketing expenses generally represent operational costs other than those associated with the delivery of health care services and specialty product services. On September 30, 1997, Sierra Military Health Services, Inc. ("SMHS") was awarded a TRICARE contract to provide managed health care coverage to eligible beneficiaries in Region 1. In June 1998, the Company began providing health care benefits to approximately 606,000 individuals in Connecticut, Delaware, Maine, Maryland, Massachusetts, New Hampshire, New Jersey, New York, Pennsylvania, Rhode Island, Vermont, 21 Virginia, West Virginia and Washington, D.C. In 1998, the award resulted in a total of $204.8 million of revenue for the final five-months of the implementation phase and seven months of health care delivery. SMHS was notified on February 13, 1998 that the United States General Accounting Office ("GAO") sustained a competitor's protest of the contract award for TRICARE Managed Care Support Region 1 and recommended that the contract be re-bid. In December 1998, the Company reached an agreement to settle the protest. As part of the settlement, the competitor will forego any and all rights it may have to challenge the contract award and seek a re-bid (See Note 14 of Notes to the Consolidated Financial Statements). Integration, settlement and other expenses represent identifiable incremental costs the Company has incurred primarily in connection with various mergers, acquisitions and planned dispositions as well as expenses associated with the Company's proposal to serve TRICARE beneficiaries in Region 1 and the ultimate cost to settle a bid protest. Start-up expenses associated with the proposal to serve TRICARE beneficiaries were charged to operations upon notification of award. Results of Operations The following table sets forth selected operating data as a percentage of revenues for the periods indicated:
Years Ended December 31, 1998 1997 1996 OPERATING REVENUES: Medical Premiums........................................ 58.8% 71.2% 67.3% Specialty Product Revenues ............................. 14.3 20.3 23.2 Military Contract Revenues 19.7 .6 Professional Fees....................................... 4.4 4.3 5.0 Investment and Other Revenues .......................... 2.8 3.6 4.5 Total................................................ 100.0 100.0 100.0 OPERATING EXPENSES: Medical Expenses........................................ 49.5 58.1 54.9 Specialty Product Expenses.............................. 13.7 19.8 22.7 General, Administrative and Marketing Expenses.......... 10.7 13.0 12.6 Military Contract Expenses ............................. 19.0 .6 Integration, Settlement and Other Costs................. 1.3 4.1 2.1 Total................................................ 94.2 95.6 92.3 OPERATING INCOME ............................................ 5.8 4.4 7.7 INTEREST EXPENSE AND OTHER, NET.............................. (.7) (.6) (.5) INCOME FROM CONTINUING OPERATIONS BEFORE INCOME TAXES .................................... 5.1 3.8 7.2 PROVISION FOR INCOME TAXES................................... 1.3 .4 1.8 NET INCOME .................................................. 3.8% 3.4% 5.4%
22 1998 Compared to 1997 Revenues. The Company's total operating revenues for 1998 increased approximately 43.7% to $1.04 billion from $721.7 million for 1997. The increase was primarily due to military contract revenue of $204.8 million and an increase in premium revenue of $95.5 million. The military contract revenue is a result of the implementation of the TRICARE contract as well as the first seven months of health care delivery. Revenue under the TRICARE contract is recorded based on the contract price as agreed to by the federal government. The contract also contains provisions which adjust the contract price based on actual experience. The estimated effects of these adjustments are recognized on a monthly basis. Medical premium revenue from the Company's HMO and managed indemnity insurance subsidiaries increased $95.5 million, or 18.6%. Excluding the effect of the Kaiser-Texas acquisition in the fourth quarter of 1998, premium revenue increased $66.9 million, or 13.0%. The $66.9 million increase in premium revenue reflects a 3.4% increase in member months (the number of months of each year that an individual is enrolled in a plan). Medicare member months increased 20.1% which contributed to the increase in medical premium revenue. Such growth in Medicare member months contributes significantly to the increase in premium revenues as the Medicare per member premium rates are over three times higher than the average commercial premium rate. The Company's premium rates increased an average of 3% to 4% for its HMO commercial groups and in excess of 10% for managed indemnity commercial groups. The Company also realized a slight increase in its capitation rate established by Health Care Financing Administration ("HCFA"). Approximately 78% of the Company's Nevada Medicare members are enrolled in the Social HMO Medicare program. HCFA is considering adjusting the reimbursement factor for the Social HMO members in the future. If the reimbursement for these members decreases significantly and related benefit changes are not made timely, there could be a material adverse effect on the Company's business. Specialty product revenue increased $2.2 million, or 1.5%, for the year ended December 31, 1998 compared to the prior year. The increase was due to revenue growth of $5.1 million in the workers' compensation insurance operation offset in part by a decrease in administrative services and other revenue of $2.9 million due primarily to the termination of the Company's workers' compensation administrative services contract with the State of Nevada. The Company's workers' compensation subsidiary signed a reinsurance agreement whereby a greater portion of premium is ceded thus reducing revenue. The agreement results in a reduction of specialty product expense as discussed later in this section. Excluding the effect of the new reinsurance agreement, the workers' compensation subsidiaries' revenue would have increased $21.2 million compared to the prior year. Professional fee revenue increased approximately $14.1 million primarily due to the January 1998 acquisition of the operations of two medical clinics in southern Nevada and the clinics acquired in the Dallas/Ft. Worth area. In addition approximately $3.5 million of the increase in professional fees was due to the operations of Total Home Care, Inc. ("THC") which was acquired in August 1997. Investment and other revenue increased approximately $3.2 million over the comparable period in the prior year primarily due to an increase in invested balances and capital gains realized on the sale of investments. Medical and Specialty Product Expense. Medical expenses as a percentage of medical premiums and professional fees ("Medical Care Ratio") increased from 76.9% to 78.4% for the year ended December 31, 1998 compared to the prior period. The increase in the medical care ratio was due to an increase in Medicare members as a percentage of fully-insured members, continued expansion in Texas, northern Nevada and Arizona which have higher medical care ratios, higher pharmacy costs and the acquisitions of THC and two medical clinics for which costs of operations are included in medical expenses. The cost of providing medical care to Medicare members generally requires a greater percentage of the premiums received. Pharmacy costs increased as the management of the pharmacy benefit was transitioned from a capitated pharmacy benefits contract to in-house management in the third quarter of 1998. The costs 23 under such capitation contract were substantially below actual claims experience. The medical care ratio is expected to further increase in 1999 due to the changes in member mix and pharmacy costs noted above. Included in medical expenses is the reversal of $4.4 million of premium deficiency reserve that was used to offset losses on contracts from the Kaiser-Texas operations that were acquired on October 31, 1998. Specialty product expenses decreased approximately $800,000, or less than 1.0%, due primarily to the implementation of the reinsurance agreement as discussed previously. Specialty product revenue and expense is primarily related to the workers' compensation insurance business. Effective January 1, 1998, workers' compensation claims are reinsured between $500,000 and $100 million per occurrence. For claims occurring on and after July 1, 1998, that are below $500,000, the Company obtained quota share and excess of loss reinsurance. Under this agreement, the Company reinsures 30% of the first $10,000 of each claim, 75% of the next $40,000 and 100% of the next $450,000. The Company receives a ceding commission from the reinsurer as a partial reimbursement of operating expenses. Excluding the effect of the reinsurance agreement, specialty product expense would have increased $19.5 million compared to the prior year. The combined ratio for the workers' compensation insurance business was 98.7% compared to 101.9% for the comparable prior year period. The reduction was due to a 198 basis point decrease in the loss ratio and a 122 basis point decrease in the expense ratio. The decrease in the loss ratio was largely due to the new reinsurance agreement for losses occurring on and after July 1, 1998 and as a result of the Company's ability to overlay and implement managed care techniques to the workers' compensation claims. The combined ratio excluding the effect of the new reinsurance agreement was 101.6% for the year ended December 31, 1998. In addition, favorable loss development on prior accident years totalled $9.6 million for the year ended December 31, 1998, compared to net favorable loss development of $9.0 million for the comparable prior year period. The favorable loss development is largely due to actual paid losses being below projected losses. There can be no assurance that favorable development, or the magnitude thereof, will continue in the future. The reduction in the expense ratio was largely due to a reduction in agents' commissions, as a result of a ceding commission related to the new reinsurance agreement and from lower salaries and related benefits expenses. The losses and loss adjustment expense ratio for the year ended December 31, 1998 reflect the Company's current projection of the ultimate costs of claims occurring in the current as well as prior accident years. Such projections are subject to change and any change would be reflected in the income statement. Workers' compensation claims are paid over several years. Until payment is made, the Company invests the monies, earning a yield on the invested balance. Military Contract Expense. The military contract expense is comprised of those expenses incurred in 1998 for five months of contract implementation and seven months of health care delivery. This expense consists primarily of costs to provide managed health care services to eligible beneficiaries in accordance with the Company's TRICARE contract. Under the contract, SMHS provides health care services to approximately 606,000 dependents of active duty military personnel and military retirees and their dependents through subcontractor partnerships and individual providers. Health care costs are recorded in the period when services are provided to eligible beneficiaries, including estimates for provider costs which have been incurred but not reported to the Company. Also, included in military contract expense are costs incurred to perform specific administrative services, such as health care appointment scheduling, enrollment, network management and health care advice line services, and other administrative functions of the military health care subsidiary. General, Administrative and Marketing Expenses. General, administrative and marketing ("G&A") cost increased $16.8 million, or 17.9%, compared to 1997. As a percentage of revenues, G&A costs for 1998 decreased to 10.7% from 13.0% during 1997. The decrease in the G&A ratio is primarily due to the addition of military contract revenues offset in part by costs for additional infrastructure needed to support overall Company growth. Excluding military revenues, G&A as a percentage of revenues was 13.3% in 1998. Of the $16.8 million increase in G&A, $3.2 million was due to additional G&A related to the acquired HMO business in the Dallas/Ft. Worth area. The remaining increase of $13.6 million consisted of $3.8 24 million increased compensation expense, resulting primarily from additional employees supporting expanded services and new benefit programs for management. Broker, third party administration and premium tax expense increased approximately $900,000 due to increased membership. In addition, depreciation expense increased $1.7 million. Integration, Settlement and Other Costs. In the fourth quarter of 1998, the Company expensed approximately $13.9 million, $10.3 million after tax, of costs primarily associated with the settlement of the protest pertaining to its military services contract as well as costs associated with the integration of the Kaiser-Texas business acquired October 31, 1998 (see Note 14 to the Consolidated Financial Statements). On March 18, 1997, the Company announced it had terminated its merger agreement with Physician Corporation of America, Inc. and recorded expenses of $11.0 million, $8.4 million after tax, for merger- related costs. During the third quarter of 1997 SMHS was awarded a contract to serve TRICARE eligible beneficiaries in Region 1. Development expenses of $18.4 million, $10.6 million net of taxes, were recorded in the third quarter primarily for expenses associated with the Company's proposal to serve TRICARE Region 1. Such expenses had been deferred until award notification. Interest Expense and Other. Interest expense and other increased approximately $2.7 million for the year ended December 31, 1998, compared to the same period in the prior year due to an increase in debt as a result of the Kaiser-Texas acquisition. Income Taxes. For the period, the Company recorded approximately $13.8 million of tax expense for an effective tax rate of 25.8% compared to 23.9% in 1997, excluding the tax effects of identifiable integration, settlement and other costs. The Company's current low operating tax rate is primarily a result of tax-preferred investments and the change in the deferred tax valuation allowance, which is due primarily to the ability to use a portion of net operating loss carryovers. The effective tax rate will increase to the 32% to 34% range in 1999 as most of the valuation allowances for net operating loss carryforwards have been utilized as of December 31, 1998. 1997 Compared to 1996 Revenues. The Company's total operating revenues for 1997 increased 25.4% to $721.7 million from $575.4 million for 1996. The increase was primarily due to medical premium revenue increases of approximately $126.9 million, or 32.8%, from the Company's HMO and managed indemnity insurance subsidiaries. Such premium growth resulted principally from an approximate 30.3% increase in member months. The Company's HMO and insurance subsidiaries' premium rates increased approximately 2.5%, primarily due to an increase in its capitation rate for its Medicare members as established by HCFA. The increase was due in part to the Company's participation in HCFA's social HMO program. The Company realized 1% to 3% rate increases for its existing HMO subsidiaries' commercial groups and the managed indemnity subsidiary. However, these increases were offset in part by lower premium rates at MedOne Health Plan, an HMO acquired on December 31, 1996. The Company's specialty product revenue increased $12.9 million, or 9.7%, to $146.2 million in 1997 from $133.3 million in 1996. The increase was due to specialty product revenue growth in the workers' compensation insurance market of approximately $8.3 million and an increase in administrative services and other of $4.6 million due primarily to the acquisition of Prime Health, Inc., at the end of 1996. Some of this increase will be offset in the future by the loss of a portion of the state of Nevada's self-insured medical business. Also, effective September 30, 1997, the Company terminated its workers' compensation administrative services contract with the state of Nevada. The contract served approximately 200,000 enrollees and provided approximately $3.2 million in revenues for the year ended December 31, 1997. The contract was terminated to allow the Company to participate in the Nevada workers' compensation insurance market when the state allows private insurance companies to begin offering products, which is anticipated for 1999. Professional fees increased $2.4 million, or 8.3%, over 1996 to $31.2 million. This increase is due in part to the acquisition of the 25 assets and operations of THC during the third quarter of 1997. THC provides home infusion, oxygen and durable medical equipment services in Nevada and Arizona. During the fourth quarter of 1997, SMHS began the implementation period of its TRICARE contract. The military contract revenue of $4.3 million is a result of this contract. Investment and other revenue was consistent with the prior year. Medical and Specialty Product Expenses. Total medical expenses increased by $103.4 million in 1997 compared to 1996. This 32.7% increase resulted from the consolidated member month growth discussed previously. The Medical Care Ratio increased from 76.0% to 76.9% due primarily to member growth and expansion in areas with higher medical expenses, such as northern Nevada and Texas. In addition, MedOne Health Plan has a higher Medical Care Ratio, which further contributed to the increase in the Company's overall Medical Care Ratio. Specialty product expenses increased $12.3 million, or 9.4%, over 1996. This increase is due primarily to the increase in workers' compensation premiums noted above. Specialty product revenue and expense is primarily related to the workers' compensation insurance business. The combined ratio for the workers' compensation insurance business was 101.9% for the year ended December 31, 1997, compared to 103.2% for the comparable prior year period. The reduction was due to a 40 basis point decrease in the loss ratio along with a 90 basis point decrease in the expense ratio. Compared to the prior year period, incurred losses for the current accident year were reduced as a result of the Company's ability to overlay and implement managed care techniques to the workers' compensation claims. In addition, the Company had net favorable loss development on prior accident years totaling $9.0 million compared to net favorable loss development of $15.3 million for the comparable prior year period. The favorable development is largely due to actual paid losses being below projected losses. The majority of the favorable loss development occurred on the 1992 through 1995 accident years. There can be no assurances that favorable development, or the magnitude thereof, will continue in the future. The losses and loss adjustment expense ratio for the year ended December 31, 1997 reflects the Company's current projection of the ultimate costs of claims occurring in the current as well as prior accident years. Such projections are subject to change and any change would be reflected in the income statement. Workers' compensation claims are paid over several years. Until payment is made, the Company invests the monies, earning a yield on the invested balance. General, Administrative and Marketing Expenses. G&A costs increased $21.7 million, or 30.0%, for the twelve months ended December 31, 1997 compared to the twelve months ended December 31, 1996. As a percentage of revenues, G&A costs for the twelve months ended December 31, 1997 increased to 13.0% from 12.6% during the comparable period in 1996. Of the $21.7 million increase in G&A, $8.6 million was in compensation costs primarily resulting from additional employees supporting expanded services and increased incentive amounts for management. Broker, third-party administration, and premium tax expenses increased approximately $8.5 million due to increased membership. Amortization and depreciation costs increased approximately $1.9 million primarily due to the amortization of goodwill resulting from the Prime acquisition. The remaining G&A increase was due to additional expenses in several areas including data processing maintenance. Military Contract Expense. During the fourth quarter of 1997, SMHS began the implementation period of its TRICARE contract. The military contract expense is a result of this contract. Integration, Settlement and Other Costs. On March 18, 1997, the Company announced it had terminated its merger agreement with Physician Corporation of America, Inc. and recorded and paid expenses of approximately $11.0 million, $8.4 million after tax, for merger-related costs. During the third quarter of 1997, SMHS, a wholly owned subsidiary of the Company, was awarded a contract to serve TRICARE eligible beneficiaries in Region 1. This region includes approximately 606,000 TRICARE beneficiaries in 13 northeastern states and the District of Columbia. Development expenses of 26 $18.4 million, $10.6 million net of taxes, were recorded in the third quarter primarily for expenses associated with the Company's proposal to serve eligible beneficiaries in Region 1. During 1995, as part of the Company's clinical expansion and growth efforts, the Company acquired a medical facility in Mohave County, Arizona, across the border from Laughlin, Nevada. This medical facility included a 12-bed hospital. During 1996, the Company implemented a plan to exit the hospital business and has actively pursued buyers for this business. As a result of this plan, the Company recorded a charge of $3.8 million, ($2.9 million after tax) in the fourth quarter of 1996, primarily to recognize the estimated costs to dispose of the hospital. As of December 31, 1998, the Company has been unable to reach an agreement to sell the hospital. As a result of higher than expected claim and administrative costs relative to premium rates that can be obtained in certain regional insurance operations and the Company's inability to negotiate adequate provider contracts due to its limited presence in some of these markets, the Company adopted a plan to restructure certain insurance operations during the third quarter of 1996 and recorded a charge of $8.3 million, ($6.2 million after tax). These restructuring costs included cancellation of certain contractual obligations of $6.0 million, lease termination costs of $1.5 million and approximately $750,000 of other costs. Interest Expense and Other. Interest expense and other increased approximately $1.6 million over the prior year primarily due to the $2.1 million benefit for minority interests recorded in 1996, offset in part by an increase in capitalized interest related to various construction projects in 1997. In November 1996, the Company acquired complete ownership of a Texas HMO in which it had previously held a 50% interest. That HMO began business in March 1995 and experienced losses in both years. In the prior year, a portion of these losses resulted in a benefit from minority interests. Income Taxes. The Company's effective tax rate for the year ended December 31, 1997 was 11.8%, compared to 25.2% in 1996. The difference between the Company's effective tax rate and the current federal tax rate is due primarily to a $4.7 million tax benefit recorded as a result of a reduction of the deferred tax valuation allowance and the Company's portfolio of tax preferred investments. These benefits are more significant as a result of the charges related to the Physicians Corporation of America acquisition and start-up costs associated with the TRICARE contract. Excluding these costs, the effective tax rate for 1997 is 23.9%. See Note 9 of Notes to Consolidated Financial Statements. LIQUIDITY AND CAPITAL RESOURCES The Company's cash flow from operating activities of $50.1 million during the twelve months ended December 31, 1998 resulted primarily from $39.6 million of net income, $19.3 million in depreciation and amortization and $6.4 million in provision for doubtful accounts offset by a $15.2 million decrease in cash flows from changes in assets and liabilities. The decrease in cash flow resulting from the change in assets and liabilities was primarily due to an increase in reinsurance recoverable and military accounts receivable. The increase in reinsurance recoverable is primarily due to the new reinsurance agreement implemented by the Company's workers' compensation subsidiary for claims occurring on or after July 1, 1998 that are below $500,000 (see Note 6 to the Consolidated Financial Statements). Military accounts receivable increased due to the implementation of health care delivery in 1998. Military accounts receivable consists primarily of one month's contract payment from the government in arrears, estimates of bid price adjustments ("BPAs") under the contract based on actual experience and any change orders not originally specified in the contract. These cash outflows were offset in part by increases in military health care payable and other current liabilities. The increase in military health care payable is a result of health care delivery beginning June 1, 1998 for the Region 1 TRICARE contract. Military health care payable includes the estimated cost for unpaid claims for which health care services have been provided to TRICARE eligibles and a provision of the estimated costs for claims that have been incurred but have not been 27 reported. The increase in other current liabilities is primarily due to expenses related to operations of the military services subsidiary and reinsurance premiums payable due to the new reinsurance contract. SMHS receives monthly cash payments equivalent to one-twelfth of its annual contractual price with the Department of Defense ("DOD") and accrues health care revenue on a monthly basis for any monies owed above its monthly cash receipt based on the number of at-risk eligible beneficiaries. Approximately $34 million of the military accounts receivable balance is associated with monies owed to SMHS as a result of providing health care services for a larger than expected beneficiary population. SMHS expects to receive this amount at the completion of the first BPA. The BPA process serves to adjust the DOD's monthly payments to SMHS, because such payments are based in part on 1996 DOD estimates for: beneficiary population, beneficiary population baseline health care cost, inflation and military direct care system utilization. As actual information is made available for the above items, quarterly adjustments are made to SMHS' monthly health care payment in addition to a lump sum adjustment for past months. SMHS accrues for such adjustments on a monthly basis as actual information is made available. The first such adjustment did not occur as scheduled on February 28, 1999 (SMHS anticipates additional DOD delays of up to 6 months). If the timing or amount of the BPA reimbursement varies significantly from the Company's expectations, there could be a material adverse effect on the Company's business and cash flows. Net cash used for investing activities during 1998 included $40.7 million in capital expenditures for construction costs associated with office facilities, furniture and equipment for the newly constructed six-story administrative headquarters building, continued implementation of three new computer systems, computer and medical equipment, other capital needs to support the Company's growth, and a $24.2 million net increase in investments. In addition, approximately $111.4 million of cash was used to purchase the Dallas, Texas operations of Kaiser Foundation Health Plan. Cash flows from financing activities included net proceeds from long-term borrowings (proceeds less payments) of $113.1 million. The majority of net proceeds from long-term borrowings was used to fund the Kaiser-Texas acquisition. The transaction was financed with a five-year revolving credit facility. As of December 31, 1998, the Company had $139 million in borrowings on the $200 million line of credit. Interest under the credit facility is variable and based on the London Interbank Offering Rate ("LIBOR") plus a margin determined by reference to the Company's leverage ratio. In addition, $50 million of the outstanding balance is covered by interest-rate swap agreements. The average cost of borrowing on this line of credit for the fourth quarter of 1998, including the impact of the swap agreements, was approximately 8.0%. The terms of the credit facility contain a mandatory payment schedule that begins on June 30, 2001 and ends on September 30, 2003 if the principal balance exceeds certain thresholds. The terms of the credit facility contain certain covenants including a minimum fixed charge coverage ratio and a maximum leverage ratio. The remaining $61 million available balance on the line of credit as of December 31, 1998, may be used for general corporate purposes, including working capital. During 1998 and 1997, the Company used $9.2 million and $5.5 million, respectively, to buy back Company stock on the open market. In the second quarter of 1997, the Company's Board of Directors authorized a $3.0 million line of credit from the Company to the Company's Chief Executive Officer ("CEO"). The CEO borrowed a total of $650,000 in 1998 and $2 million in 1997 at an interest rate equal to the LIBOR Offering Rate plus 53 basis points. During the first quarter of 1999, the CEO repaid approximately $360,000 of the line of credit. The line of credit is collateralized by certain of the CEO's rights to compensation from the Company and is due and payable no later than August 15, 1999. In September 1991, CII issued convertible subordinated debentures (the "Debentures") due September 15, 2001. The Debentures bear interest at 7 1/2% which is due semi-annually on March 15 and September 15. 28 Each $1,000 in principal is convertible into 25.382 shares of the Company's common stock at a conversion price of $39.40 per share. Unamortized issuance costs of $500,000 are included in other assets on the balance sheet and are being amortized over the life of the Debentures. The Debentures are general unsecured obligations of CII only and are not guaranteed by Sierra Health Services, Inc. ("Sierra"). During the twelve months ended December 31, 1998, the Company purchased $3.2 million of the Debentures on the open market. The holding company may receive dividends from its HMO and insurance subsidiaries which generally must be approved by certain state insurance departments. The Company's HMO and insurance subsidiaries are required by state regulatory agencies to maintain certain deposits and must also meet certain net worth and reserve requirements. The Company had restricted assets on deposit in various states totaling $17.8 million as of December 31, 1998. The HMO and insurance subsidiaries must also meet requirements to maintain minimum stockholder's equity, on a statutory basis, ranging from $1.1 million to $5.2 million. In addition, in conjunction with the Kaiser-Texas acquisition, Texas Health Choice, L.C. ("TXHC") entered into a letter agreement with the Texas Department of Insurance whereby TXHC agreed to maintain a net worth of $20.0 million. Of the cash and cash equivalents held at December 31, 1998, $81.3 million is designated for use only by the regulated subsidiaries. Such amounts are available for transfer to the holding company from the HMO and insurance subsidiaries only to the extent that they can be remitted in accordance with the terms of existing management agreements and by dividends. Remaining amounts are generally available on an unrestricted basis. The National Association of Insurance Commissioners has adopted new minimum capitalization requirements for HMOs, health care insurance entities and other risk-bearing health care entities. Depending on the nature and extent of the new minimum capitalization requirements ultimately adopted by each state, there could be an increase in the capital required for certain of the Company's regulated subsidiaries. The Company intends to fund any increase from available parent company cash reserves; however, there can be no assurance that such cash reserves will be sufficient to fund these minimum capitalization requirements. The new requirements are expected to be effective on or before December 31, 1999 upon enactment by each state. The Company does not believe that any such required increase in the amount of funds to be contributed to the subsidiaries will be material. The holding company will not receive dividends from its regulated subsidiaries if such dividend payment would cause violation of statutory net worth and reserve requirements. The Company has a 1999 capital budget of approximately $60 million, primarily for computer hardware and software, furniture and equipment and other requirements due to the Company's computer system conversion and projected growth and expansion. The Company's liquidity needs over the next 12 months will primarily be for the capital items noted above, the Company's stock repurchase program, debt service and expansion of the Company's operations, including potential acquisitions. The Company believes that existing working capital, operating cash flow and, if necessary, mortgage financing, equipment leasing, and amounts available under its credit facility will be sufficient to fund its capital expenditures and debt service. Additionally, subject to unanticipated cash requirements, the Company believes that its existing working capital and operating cash flow and, if necessary, its access to new credit facilities, will enable it to meet its liquidity needs on a longer term basis. Year 2000 The Year 2000 issue exists because many computer systems and applications currently use two-digit date fields to designate a year. As the century date change occurs, date-sensitive systems will recognize the year 2000 as 1900, or not at all. This inability to recognize or properly treat the Year 2000 may cause systems to process critical financial and operational information incorrectly. 29 The Company is currently in the process of modifying or replacing its mission critical financial and operational computer systems. The Company is also in the process of testing its non-information system technology for Year 2000 compliance. The Year 2000 project has been broken down into five phases: (1) inventorying Year 2000 items; (2) assessing the Year 2000 items that are determined to be material to the Company; (3) renovating or replacing material items that are determined not to be Year 2000 compliant; (4) testing and validating material items; and (5) implementing renovated and validated systems. At December 31, 1998, the inventory and assessment phases are substantially complete as it relates to all material computer systems and approximately 50% complete as it relates to non-information system technology. The Company estimates that the replacement/renovation phases and the testing/validation phases will be 95% complete by October 31, 1999. The Company estimates that it is approximately 50% complete with the total project as of December 31, 1998. Contingency planning for the mission critical business operations is scheduled to be completed by April 1999. These plans focus on business operations involving information systems and non-information systems technologies. The Company has initiated formal communications with entities with whom it does business to assess their Year 2000 issues. Evaluations of the most critical third parties have been initiated, and follow-up reviews will be conducted through 1999. Contingency plans are being developed based on these evaluations and are expected to be completed by the middle of 1999. There can be no assurances that the systems of other companies or governmental agencies, such as HCFA and the Department of Defense ("DOD"), on which the Company relies will be timely modified for Year 2000, or that the failure to modify by another company would not have a material adverse effect on the Company. Based upon two separate reports issued by the United States General Accounting Office it is doubtful that the computer systems at both HCFA and the DOD will be fully Year 2000 compliant by the end of 1999. The Company does not currently have available data to predict the impact of such non-compliance on its business operations. Should there be any material delays caused by Year 2000 issues, the Company anticipates that the governmental entities will make estimated payments. The Company is in the process of implementing three major systems at an estimated cost of $36 million to $38 million, which includes the implementation costs related to the recently acquired Kaiser-Texas operations. To date the Company has spent approximately $19.0 million on the new computer systems and other Year 2000 items. The Company is expensing the costs to make modifications to existing computer systems and non-computer equipment. Management currently estimates the remaining new computer system costs and other Year 2000 costs to be $13.0 million to $16.0 million for operations in existence prior to the Kaiser-Texas transaction and $6.0 million to $8.0 million for the Kaiser-Texas operations that were acquired on October 31, 1998. While this is a substantial effort, it will give the Company the benefits of new technology and functionality for many of its financial and operational computer systems and applications. The failure to correct a material Year 2000 problem could result in an interruption of, or a failure of, certain business activities or operations. Such failures could materially adversely affect the Company's operations, liquidity and financial condition. Due to the general uncertainty inherent in the Year 2000 problem, resulting in part from uncertainty of the Year 2000 readiness of third parties with which the Company does business, the Company is unable to determine at this time whether the consequences of potential Year 2000 failures will have a material adverse impact on the Company's results of operations, liquidity or financial condition. The Company's Year 2000 project is expected to significantly reduce the Company's level of uncertainty about the Year 2000 problem. The Company believes that, with the implementation of the new computer systems and completion of the entire project as scheduled, the possibility of significant interruptions of operations should be reduced. The above contains forward-looking statements including, without limitation, statements relating to the Company's plans, strategies, objectives, expectations, intentions, and adequate resources, that are made pursuant to the "safe harbor" provisions of the Private Securities Litigation Reform Act of 1995. Readers 30 are cautioned that forward-looking statements contained in the Year 2000 disclosure should be read in conjunction with the following disclosure of the Company: The costs of the project and the dates on which the Company plans to complete the necessary Year 2000 modifications are based on management's best estimates, which were derived utilizing numerous assumptions of future events including the continued availability of certain resources and other factors. However, there can be no guarantee that these estimates will be achieved and actual results could differ materially from those plans. Specific factors that might cause such material differences include, but are not limited to, the availability and cost of personnel trained in this area, the ability to locate and correct all relevant computer codes, the ability of the Company's significant suppliers, customers and others with which it conducts business, including federal and state governmental agencies, to identify and resolve their own Year 2000 issues and similar uncertainties. Inflation Health care costs continue to rise at a faster rate than the Consumer Price Index. The Company uses various strategies to mitigate the negative effects of health care cost inflation, including setting commercial premiums based on its anticipated health care costs, risk-sharing arrangements with the Company's various health care providers, and other health care cost containment measures. There can be no assurance, however, that, in the future, the Company's ability to manage medical costs will not be negatively impacted by items such as technological advances, competitive pressures, applicable regulations, increases in pharmacy costs, utilization changes and catastrophic items, which could, in turn, result in medical cost increases equaling or exceeding premium increases. Government Regulation The Company's business, offering health care coverage, health care management services, workers' compensation programs and, to a lesser extent, the delivery of medical services, is heavily regulated at both the federal and state levels. Government regulation of health care coverage products and services is a changing area of law that varies from jurisdiction to jurisdiction. Changes in applicable laws and regulations are continually being considered and interpretation of existing laws and rules also may change from time to time. Regulatory agencies generally have broad discretion in promulgating regulations and in interpreting and enforcing laws and regulations. While the Company is unable to predict what regulatory changes may occur or the impact on the Company of any particular change, the Company's operations and financial results could be negatively affected by regulatory revisions. For example, any proposals affecting underwriting practices, limiting rate increases, requiring new or additional benefits or affecting contracting arrangements (including proposals to require HMOs and PPOs to accept any health care providers willing to abide by an HMO's or PPO's contract terms) may have a material adverse effect on the Company's business. The continued consideration and enactment of "anti-managed care" laws and regulations by federal and state bodies may make it more difficult for the Company to manage medical costs and may adversely affect financial results. In addition to changes in applicable laws and regulations, the Company is subject to various audits, investigations and enforcement actions. These include possible government actions relating to the federal Employee Retirement Income Security Act, which regulates insured and self-insured health coverage plans offered by employers, the Federal Employees Health Benefit Plan, federal and state fraud and abuse laws, and laws relating to utilization management and the delivery of health care. Any such government action could result in assessment of damages, civil or criminal fines or penalties, or other sanctions, including 31 exclusion from participation in government programs. In addition, disclosure of any adverse investigation or audit results or sanctions could negatively affect the Company's reputation in various markets and make it more difficult for the Company to sell its products and services. Recently Issued Accounting Standards In March 1998, the Accounting Standards Executive Committee of the American Institute of Certified Public Accountants ("AcSEC") issued Statement of Position 98-1 ("SOP 98-1"), "Accounting for the Costs of Computer Software Developed For or Obtained For Internal Use". SOP 98-1 requires certain computer software costs to be capitalized and amortized over the software's estimated useful life. In June 1998, the AcSEC issued Statement of Position 98-5 ("SOP 98-5"), "Reporting on the Costs of Start-Up Activities". This standard requires organization costs and costs associated with start-up activities to be expensed as incurred. Both statements are effective for years beginning after December 15, 1998. The Company will adopt SOP 98-1 and SOP 98-5 for the fiscal year ending December 31, 1999 and does not believe these statements will have a material impact on its financial statements. In June 1998, The Financial Accounting Standards Board issued "Accounting for Derivative Instruments and Hedging Activities" ("FAS 133"). FAS 133 is effective for fiscal years beginning after June 15, 1999. FAS 133 addresses the accounting for derivative instruments including certain derivative instruments embedded in other contracts, and hedging activities. The Company does not believe this statement will have a material impact on its financial statements. ITEM 7a. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK As of December 31, 1998, the Company has approximately $392 million in cash and cash equivalents, and short-term, long-term and restricted investments. Of the investments, approximately $254.6 million is classified as available-for-sale investments and $54.0 million is classified as held-to-maturity investments. These investments are primarily in fixed income, investment grade securities. The Company's investment policies emphasize return of principal and liquidity and are focused on fixed returns that limit volatility and risk of principal. Because of the Company's investment policies, the primary market risk associated with the Company's portfolio is interest rate risk. Assuming an immediate 10% increase in interest rates, the net hypothetical loss in fair value of shareholders' equity related to financial instruments is estimated to be approximately $7.5 million (after tax) (2.5% of total shareholders' equity). The Company believes that such an increase in interest rates would not have a material impact on future earnings or cash flows as it is unlikely that the Company would need or choose to substantially liquidate its investment portfolio. The effect of interest rate risk on potential near-term net income, cash flow and fair value was determined based on commonly used sensitivity analyses. The models project the impact of interest rate changes on a wide range of factors, including duration and prepayment. Fair value was estimated based on the net present value of cash flows or duration estimates, assuming an immediate 10% increase in interest rates. As of December 31, 1998, the Company had approximately $139 million in borrowings outstanding under a revolving credit facility that was entered into in October 1998. Interest under the credit facility is variable and based on the London Interbank Offering Rate plus a margin, except for $50 million of the outstanding balance that is covered by interest-rate swap agreements. The average cost of borrowing on this line of credit was approximately 8% for the fourth quarter of 1998. If the average cost of borrowing on the amount outstanding as of December 31, 1998, was to increase by 10%, annual income before tax would decrease by approximately $900,000. 32 ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
INDEX TO FINANCIAL STATEMENTS Page Management Report on Consolidated Financial Statements.................................................... 34 Independent Auditors' Report.............................................................................. 35 Consolidated Balance Sheets at December 31, 1998 and 1997................................................. 36 Consolidated Statements of Operations for the Years Ended December 31, 1998, 1997, and 1996...................................................................... 37 Consolidated Statements of Changes in Stockholders' Equity for the Years Ended December 31, 1998, 1997 and 1996................................................... 38 Consolidated Statements of Cash Flows for the Years Ended December 31, 1998, 1997, and 1996...................................................................... 39 Notes to Consolidated Financial Statements................................................................ 40
33 MANAGEMENT REPORT ON CONSOLIDATED FINANCIAL STATEMENTS The management of Sierra Health Services, Inc., is responsible for the integrity and objectivity of the accompanying Consolidated Financial Statements. The statements have been prepared in conformity with generally accepted accounting principles applied on a consistent basis and are not misstated due to fraud or material error. The statements include some amounts that are based upon the Company's best estimates and judgment. The accounting systems and controls of the Company are designed to provide reasonable assurance that transactions are executed in accordance with management's authorization, that the financial records are reliable for preparing financial statements and maintaining accountability for assets, and that assets are safeguarded against losses from unauthorized use or disposition. Management believes that for the year ended December 31, 1998, such systems and controls were adequate to meet the objectives discussed herein. The accompanying Consolidated Financial Statements have been audited by independent certified public accountants, whose audits thereof were made in accordance with generally accepted auditing standards and included a review of internal accounting controls to the extent necessary to design audit procedures aimed at gathering sufficient evidence to provide a reasonable basis for their opinion on the fairness of presentation of the Consolidated Financial Statements taken as a whole. The Audit Committee of the Board of Directors, comprised solely of directors from outside the Company, meets regularly with management and the independent auditors to review the work procedures of each. The independent auditors have free access to the Audit Committee, without management being present, to discuss the results of their opinions on the adequacy of the Company's accounting controls and the quality of the Company's financial reporting. The Board of Directors, upon the recommendation of the Audit Committee, appoints the independent auditors, subject to stockholder ratification. Anthony M. Marlon, M.D. Chairman and Chief Executive Officer Paul H. Palmer Vice President, Finance Chief Financial Officer, and Treasurer 34 INDEPENDENT AUDITORS' REPORT Board of Directors Sierra Health Services, Inc.: We have audited the accompanying consolidated balance sheets of Sierra Health Services, Inc., and its subsidiaries as of December 31, 1998 and 1997, and the related consolidated statements of operations, stockholders' equity, and cash flows for each of the three years in the period ended December 31, 1998. Our audits also included the financial statement schedules listed in the index at Item 14 (a)(2). These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Sierra Health Services, Inc. and its subsidiaries at December 31, 1998 and 1997, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1998 in conformity with generally accepted accounting principles. Also, in our opinion, such financial statement schedules when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information set forth therein. DELOITTE & TOUCHE LLP Las Vegas, Nevada February 8, 1999 35 SIERRA HEALTH SERVICES, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS December 31, 1998 and 1997 ASSETS
1998 1997 CURRENT ASSETS: Cash and Cash Equivalents.............................................. $ 83,910,000 $ 96,841,000 Short-term Investments................................................. 110,008,000 115,498,000 Accounts Receivable (Less: Allowance for Doubtful Accounts 1998 - $10,540,000 ; 1997 - $7,916,000)................... 44,100,000 37,695,000 Military Accounts Receivable........................................... 69,552,000 4,346,000 Current Portion of Deferred Tax Asset ................................. 14,311,000 15,496,000 Reinsurance Recoverable................................................ 32,076,000 5,159,000 Prepaid Expenses and Other Current Assets.............................. 39,974,000 25,571,000 Total Current Assets............................................... 393,931,000 300,606,000 PROPERTY AND EQUIPMENT, NET................................................ 229,164,000 148,831,000 LONG-TERM INVESTMENTS...................................................... 180,816,000 155,153,000 RESTRICTED CASH AND INVESTMENTS............................................ 17,758,000 16,540,000 REINSURANCE RECOVERABLE, Net of Current Portion............................ 34,946,000 20,245,000 GOODWILL (Less: Accumulated Amortization 1998 - $5,213,000; 1997 - $2,898,000)............................. 142,471,000 42,803,000 OTHER ASSETS............................................................... 46,034,000 39,758,000 TOTAL ASSETS............................................................... $1,045,120,000 $723,936,000 LIABILITIES AND STOCKHOLDERS' EQUITY CURRENT LIABILITIES: Accounts Payable and Accrued Liabilities.................................. $ 69,284,000 $ 43,601,000 Accrued Payroll and Taxes................................................. 19,942,000 14,838,000 Medical Claims Payable.................................................... 78,022,000 55,943,000 Current Portion of Reserve for Losses and Loss Adjustment Expense .................................. 79,869,000 63,358,000 Unearned Premium Revenue.................................................. 39,968,000 29,763,000 Military Health Care Payable.............................................. 53,820,000 Current Portion of Long-term Debt......................................... 5,263,000 4,726,000 Total Current Liabilities............................................ 346,168,000 212,229,000 RESERVE FOR LOSSES AND LOSS ADJUSTMENT EXPENSE (Less Current Portion) ........................... 132,394,000 139,341,000 LONG-TERM DEBT (Less Current Portion) ........................................ 242,398,000 90,841,000 OTHER LIABILITIES ............................................................ 20,446,000 15,843,000 TOTAL LIABILITIES............................................................. 741,406,000 458,254,000 STOCKHOLDERS' EQUITY: Preferred Stock, $.01 Par Value, 1,000,000 Shares Authorized; None Issued or Outstanding Common Stock, $.005 Par Value, 40,000,000 Shares Authorized; Shares Issued: 1998 -- 28,236,000; 1997 - 27,709,000.................................................... 141,000 139,000 Additional Paid-in Capital................................................ 173,583,000 164,247,000 Treasury Stock; 1998 - 966,900; 1997 - 426,800 Common Shares........................................................ (14,821,000) (5,601,000) Accumulated Other Comprehensive Income: Unrealized Holding (Loss) Gain on Available-for-Sale Investment...................................................... (1,027,000) 655,000 Retained Earnings......................................................... 145,838,000 106,242,000 Total Stockholders' Equity........................................... 303,714,000 265,682,000 TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY.................................... $1,045,120,000 $723,936,000
See the accompanying notes to consolidated financial statements. 36 SIERRA HEALTH SERVICES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS For the Years Ended December 31, 1998, 1997 and 1996
1998 1997 1996 OPERATING REVENUES: Medical Premiums............................................. $ 609,404,000 $513,857,000 $386,968,000 Specialty Product Revenues .................................. 148,368,000 146,211,000 133,324,000 Military Contract Revenues .................................. 204,838,000 4,346,000 Professional Fees............................................ 45,363,000 31,238,000 28,836,000 Investment and Other Revenues ............................... 29,230,000 26,072,000 26,283,000 Total..................................................... 1,037,203,000 721,724,000 575,411,000 OPERATING EXPENSES: Medical Expenses............................................. 513,209,000 419,272,000 315,915,000 Specialty Product Expenses................................... 142,258,000 143,082,000 130,758,000 General, Administrative and Marketing Expenses............... 110,687,000 93,919,000 72,237,000 Military Contract Expenses .................................. 196,625,000 4,193,000 Integration, Settlement and Other Costs...................... 13,851,000 29,350,000 12,064,000 Total..................................................... 976,630,000 689,816,000 530,974,000 OPERATING INCOME.................................................. 60,573,000 31,908,000 44,437,000 INTEREST EXPENSE AND OTHER, NET................................... (7,181,000) (4,433,000) (2,823,000) INCOME FROM OPERATIONS BEFORE INCOME TAXES ......................................... 53,392,000 27,475,000 41,614,000 PROVISION FOR INCOME TAXES........................................ 13,796,000 3,234,000 10,471,000 NET INCOME ....................................................... $ 39,596,000 $ 24,241,000 $ 31,143,000 EARNINGS PER COMMON SHARE: Net Income Per Share .................................... $1.45 $.90 $1.17 EARNINGS PER COMMON SHARE ASSUMING DILUTION: Net Income Per Share .................................... $1.43 $.88 $1.15
See the accompanying notes to consolidated financial statements. 37 SIERRA HEALTH SERVICES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY For the Years Ended December 31, 1998, 1997 and 1996 (Amounts in thousands)
Accumu- lated Addi- Other Total tional Compre- Compre- Stock- Common Stock Paid-In Treasury hensive hensive Retained holders' Shares Amount Capital Stock Income Income Earnings Equity BALANCE, JANUARY 1, 1996.............. 26,516 $133 $147,195 $ (130) $9,659 0 $50,858 $207,715 Comprehensive Income: Net Income....................... $31,143 31,143 31,143 Other Comprehensive Income, Net of Tax Unrealized Loss on Available-for-sale- Investments ................ (9,172) (9,172) (9,172) Comprehensive Income................. $21,971 Common Stock Issued in Connection With Stock Plans................. 349 1 3,637 3,638 Income Tax Benefit Realized Upon Exercise of Stock Options........ 1,158 ______ 1,158 BALANCE, DECEMBER 31, 1996 ........... 26,865 134 151,990 (130) 487 82,001 234,482 Comprehensive Income: Net Income....................... $24,241 24,241 24,241 Other Comprehensive Income, Net of Tax Unrealized Gain on Available-for-sale- Investments ............ 168 168 168 Comprehensive Income................. $24,409 Common Stock Issued in Connection with Stock Plans................. 844 5 10,253 10,258 Purchase of Treasury Stock ......... (5,471) (5,471) Income Tax Benefit Realized Upon Exercise of Stock Options........ 2,004 2,004 BALANCE, DECEMBER 31, 1997 ........... 27,709 139 164,247 (5,601) 655 106,242 265,682 Comprehensive Income: Net Income....................... $39,596 39,596 39,596 Other Comprehensive Income, Net of Tax Unrealized Holding Loss on Available- for-sale Investments Arising During Period. (3,960) (3,960) (3,960) Reclassification Adjustment for Gains Included in Net Income 2,278 2,278 2,278 Comprehensive Income................. $37,914 Common Stock Issued in Connection with Stock Plans................. 527 2 8,052 8,054 Purchase of Treasury Stock ......... (9,220) (9,220) Income Tax Benefit Realized Upon Exercise of Stock Options........ 1,284 1,284 BALANCE, DECEMBER 31, 1998 ......... 28,236 $141 $173,583 $(14,821) $(1,027) $145,838 $303,714
See the accompanying notes to consolidated financial statements. 38 SIERRA HEALTH SERVICES, 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: Net Income ........................................................ $ 39,596,000 $ 24,241,000 $ 31,143,000 Adjustments to Reconcile Net Income to Net Cash Provided by Operating Activities: Depreciation and Amortization.................................. 19,263,000 13,510,000 10,499,000 Provision for Doubtful Accounts................................ 6,379,000 4,283,000 3,057,000 Change in Assets and Liabilities, Net of Effects from Acquisitions: Other Assets................................................... (5,362,000) (5,851,000) (16,301,000) Reinsurance Recoverable ....................................... (41,618,000) (5,635,000) 10,164,000 Reserve for Losses and Loss Adjustment Expense ................ 9,564,000 14,923,000 5,458,000 Other Liabilities ............................................. 4,594,000 6,838,000 6,985,000 Minority Interests............................................. 9,000 (12,000) (1,746,000) Accounts Receivable............................................ (2,870,000) (7,944,000) (12,469,000) Other Current Assets........................................... (10,674,000) (11,853,000) (4,671,000) Military Accounts Receivable................................... (69,552,000) (4,346,000) Military Health Care Payable................................... 53,820,000 Medical Claims Payable......................................... 12,333,000 8,974,000 4,973,000 Other Current Liabilities...................................... 34,606,000 15,692,000 15,354,000 Net Cash Provided by Operating Activities ..................... 50,088,000 52,820,000 52,446,000 CASH FLOWS FROM INVESTING ACTIVITIES: Capital Expenditures............................................... (40,743,000) (55,642,000) (17,927,000) Property and Equipment Dispositions, Net........................... 772,000 172,000 Purchase of Available-for-Sale Investments......................... (901,542,000) (1,078,396,000) (712,503,000) Proceeds from Sales/Maturities of Available-for-Sale Investments................................. 884,288,000 1,046,523,000 752,279,000 Purchase of Held-to-Maturity Investments........................... (51,887,000) (7,523,000) (25,835,000) Proceeds from Maturities of Held-to-Maturity Investments........... 44,964,000 10,449,000 39,184,000 Corporate Acquisitions, Net of Cash Acquired....................... (111,408,000) (3,145,000) (36,310,000) Corporate Disposition, Net of Cash Disposed........................ 1,373,000 Net Cash Used for Investing Activities......................... (174,955,000) (86,962,000) (940,000) CASH FLOWS FROM FINANCING ACTIVITIES: Proceeds from Long-term Borrowing.................................. 172,200,000 25,000,000 1,000,000 Payments on Debt and Capital Leases................................ (59,098,000) (2,391,000) (9,601,000) Purchase of Treasury Stock ........................................ (9,220,000) (5,471,000) Exercise of Stock in Connection with Stock Plans................... 8,054,000 10,258,000 3,638,000 Net Cash Provided by (Used for) Financing Activities........... 111,936,000 27,396,000 (4,963,000) NET (DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS............................................... (12,931,000) (6,746,000) 46,543,000 CASH AND CASH EQUIVALENTS AT BEGINNING OF YEAR........................................................... 96,841,000 103,587,000 57,044,000 CASH AND CASH EQUIVALENTS AT END OF YEAR................................. $ 83,910,000 $ 96,841,000 $103,587,000
See the accompanying notes to consolidated financial statements. 39 SIERRA HEALTH SERVICES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS For the Years Ended December 31, 1998, 1997 and 1996 1. BUSINESS Business. The consolidated financial statements include the accounts of Sierra Health Services, Inc. ("Sierra") and its subsidiaries (collectively referred to as the "Company"). The Company is a managed health care organization that provides and administers the delivery of comprehensive health care and workers' compensation programs with an emphasis on quality care and cost management. The Company's broad range of managed health care services is provided through its health maintenance organizations ("HMOs"), managed indemnity plans, third-party administrative services programs for employer-funded health benefit plans, workers' compensation medical management programs and its military health services programs. Ancillary products and services that complement the Company's managed health care product lines are also offered. Acquisitions. On October 31, 1998, Texas Health Choice, L.C. ("TXHC") (formerly HMO Texas, L.C.), a subsidiary of Sierra, completed the acquisition of certain assets of Kaiser Foundation Health Plan of Texas ("Kaiser-Texas"), a health plan operating in Dallas/Ft. Worth with approximately 109,000 members, and Permanente Medical Association of Texas ("Permanente"), a 150 physician medical group operating in that area. The purchase price was $124 million, which is net of $20 million in operating cost support to be paid to Sierra by Kaiser Foundation Hospitals in five quarterly installments following the closing of the transaction. The purchase price allocation includes a premium deficiency reserve of approximately $25 million for estimated losses on the contracts acquired from Kaiser-Texas. The purchase price includes amounts for real estate and eight medical and office facilities encompassing approximately 500,000 square feet. During the first quarter of 1999 certain accreditation goals were met by the health plan resulting in a purchase price increase of $3.0 million, to $127 million. The purchase price may increase an additional $27 million over three years if certain growth and member retention goals are met by the health plan. The acquisition has been recorded using purchase accounting and the excess of the purchase price over the fair value of the assets acquired was recorded as goodwill. The goodwill, in the amount of $102.0 million, is being amortized on a straight line basis over 40 years. The following pro forma information (unaudited) has been prepared assuming that this acquisition had taken place at the beginning of the respective periods. The pro forma information includes adjustments for the amortization of goodwill arising from the transaction and interest expense that would have been incurred to finance the purchase. The pro forma financial information is not necessarily indicative of the results of operations had the transaction been effected on the assumed dates.
1998 1997 Total Revenue ....................................... $1,207,000,000 $923,797,000 Net Income (Loss).................................... (2,818,000) (20,239,000) Net Income (Loss) Per Common Share................... (.10) (.75) Net Income (Loss) Per Common Share Assuming Dilution............................... (.10) (.75)
On December 31, 1998, Sierra completed the acquisition of the Nevada health care business of Exclusive Healthcare, Inc., United of Omaha Life Insurance Company and United World Life Insurance Company, all of which are subsidiaries of Mutual of Omaha Insurance Company. The purchase price is contingent based on how many members are retained through 2000 and 2001. No cash will be paid until group renewals begin in 2000. Sierra retained approximately 9,000 members (approximately 4,400 HMO members) subsequent to the acquisition. In August 1997, the Company acquired the assets and operations of Total Home Care, Inc. ("THC") for approximately $3.1 million, net of cash acquired. THC provides home infusion, oxygen, and durable medical equipment services in Nevada and Arizona. The Company sold the Arizona operations in the first 40 SIERRA HEALTH SERVICES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS For the Years Ended December 31, 1998, 1997 and 1996 quarter of 1998 for approximately $1.5 million. Also, in the first quarter of 1998, the Company purchased three medical clinics in southern Nevada for approximately $7.3 million. Effective December 31, 1996 the Company purchased Prime Holdings, Inc. ("Prime"), for approximately $32 million in cash. At December 31, 1996 Prime operated MedOne Health Plan, Inc. ("MedOne"), a 12,800 member HMO. Prime also served 215,000 people through preferred provider organizations, workers' compensation programs and administrative service products for self-insured employers and union welfare trust funds, primarily in the state of Nevada. The acquisition resulted in goodwill of $31 million. In November 1996, the Company acquired complete ownership of TXHC for $5,040,000. The Company had previously held a 50 percent interest in the Houston-based health plan. The purchase resulted in goodwill of $5,040,000. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Principles of Consolidation. All significant intercompany transactions and balances have been eliminated. Sierra's wholly owned subsidiaries include: Health Plan of Nevada, Inc. ("HPN"), TXHC and MedOne, all licensed HMOs; Sierra Health and Life Insurance Company, Inc. ("SHL"), a health and life insurance company; Southwest Medical Associates, Inc. ("SMA"), and The Medical Group of Texas ("TMGT"), multi-specialty medical groups; CII Financial, Inc. ("CII"), a holding company primarily engaged in writing workers' compensation insurance through its wholly owned subsidiaries; Sierra Military Health Services, Inc., ("SMHS"), a company that has been contracted to provide and administer managed care services to certain TRICARE eligible beneficiaries from June 1, 1998 to May 31, 2003; administrative services companies; a home health care agency; a hospice; a home medical products subsidiary; and a company that provides and manages mental health and substance abuse services. Medical Premiums. Non-Medicare member enrollment is represented principally by employer groups. Medical premiums are billed to each employer group in accordance with negotiated contracts, and such premium revenue is recognized when earned. Unearned premium revenue includes payments under prepaid Medicare contracts with the Health Care Financing Administration ("HCFA") and prepaid HPN, TXHC and MedOne commercial and SHL indemnity premiums. HPN and TXHC offer a prepaid health care program to Medicare recipients. Revenues associated with these Medicare recipients were approximately $238,913,000, $186,105,000 and $140,611,000 in 1998, 1997 and 1996, respectively. Specialty Product Revenues. These revenues consist primarily of workers' compensation premiums. Premiums are calculated by formula such that the premium written is earned pro rata over the term of the policy. Also included in specialty product revenues are administrative services and certain ancillary product revenues. Such revenues are recognized in the period in which the service is performed or the period that coverage for services is provided. Premiums written in excess of premiums earned are recorded as an unearned premium revenue liability. Premiums earned include an estimate for earned but unbilled premiums. Also included in specialty product revenue are revenues associated with administrative services and certain ancillary products. Military Contract Revenues. Revenue under the TRICARE contract is recorded based on the contract price as agreed to by the federal government. The contract also contains provisions which adjust the contract price based on actual experience. The estimated effects of these adjustments are recognized on a monthly basis. In addition, the Company records revenue based on estimates of the earned portion of any contract change orders not originally specified in the contract. 41 SIERRA HEALTH SERVICES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS For the Years Ended December 31, 1998, 1997 and 1996 Professional Fees. Revenue for professional medical services is recorded on the accrual basis in the period in which the services are provided. Such revenue is recorded at established rates net of provisions for estimated contractual and charitable allowances. Medical Expenses. Sierra contracts with hospitals, physicians and other providers of health care under capitated or discounted fee-for-service arrangements including hospital per diems to provide medical care services to enrollees. Capitated providers are at risk for the cost of medical care services provided to the Company's enrollees in the relevant geographic areas; however, the Company is ultimately responsible for the provision of services to its enrollees should the capitated provider be unable to provide the contracted services. Health care costs are recorded in the period when services are provided to enrolled members, including estimates for provider costs which have been incurred as of the balance sheet date but not reported to the Company. Losses on specific contracts, if any, are accrued when measurable. Specialty Product Expenses. This expense consists primarily of losses and loss adjustment expense ("LAE") and policy acquisition costs associated with issued workers' compensation policies. Losses and LAE is based upon the accumulation of cost estimates for reported claims occurring during the period as well as an estimate for losses that have occurred but have not yet been reported. Policy acquisition costs consist of commissions, premium taxes and other underwriting costs, which are directly related to the production and retention of new and renewal business and are deferred and amortized as the related premiums are earned. Should it be determined that future policy revenues and earnings on invested funds relating to existing insurance contracts will not be adequate to cover related costs and expenses, deferred costs are expensed. Also included in specialty product expense are costs associated with administrative services and certain ancillary products. These costs are recorded when incurred. Military Contract Expenses. This expense consists primarily of costs to provide managed health care services to eligible beneficiaries in accordance with the Company's TRICARE contract. Under the contract, SMHS provides health care services to approximately 606,000 dependents of active duty military personnel and military retirees and their dependents through subcontractor partnerships and individual providers. Health care costs are recorded in the period when services are provided to eligible beneficiaries including estimates for provider costs which have been incurred as of the balance sheet date but not reported to the Company. Also included in military contract expense are costs incurred to perform specific administrative services, such as health care appointment scheduling, enrollment, network management and health care advice line services, and other administrative functions of the military health care subsidiary. Cash and Cash Equivalents. The Company considers cash and cash equivalents as all highly liquid instruments with a maturity of three months or less at time of purchase. The carrying amount of cash and cash equivalents approximates fair value because of the short maturity of these instruments. Investments. Short- and long-term investments consist principally of U.S. Government securities and municipal bonds, as well as corporate and mortgage backed securities. Short-term investments have maturities of one year or less. Long-term investments have maturities in excess of one year. Restricted Cash and Investments. Certain subsidiaries are required by state regulatory agencies to maintain certain deposits and must also meet certain net worth and reserve requirements. The Company and its subsidiaries are in compliance with the applicable minimum regulatory and capital requirements. Military Accounts Receivable. Amounts receivable under government contracts are comprised primarily of one month's contract payment from the government in arrears, estimates of adjustments under the contract based on actual experience, and estimates of the earned portion of any change orders not originally specified in the contract. 42 SIERRA HEALTH SERVICES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS For the Years Ended December 31, 1998, 1997 and 1996 Property and Equipment. Property and equipment are stated at cost. Maintenance and repairs that do not improve or extend the life of the respective assets are charged to operations. Depreciation and amortization is computed using the straight-line method over the estimated service lives of the assets or terms of leases if shorter. Estimated useful lives are as follows: Buildings and Improvements 30 years Leasehold Improvements 3 - 10 years Furniture, Fixtures and Equipment 3 - 5 years Data Processing Hardware and Software 3 - 5 years Goodwill. Goodwill has been recorded primarily as a result of various business acquisitions by the Company. Amortization is provided on a straight line basis over periods not exceeding 40 years. The Company evaluates the carrying value of its intangible assets at each balance sheet date. Medical Claims Payable and Military Health Care Payable. Medical claims payable and Military health care payable include the estimated cost for unpaid claims for which health care services have been provided to enrollees and TRICARE eligibles and a provision of the estimated costs for claims that have been incurred but have not been reported. Reserve for Losses and Loss Adjustment Expense. The reserve for losses and LAE consists of estimated costs of each unpaid claim reported to the Company prior to the close of the accounting period, as well as those incurred but not yet reported. The methods for establishing and reviewing such liabilities are continually reviewed and adjustments are reflected in current operations. Income Taxes. The Company accounts for income taxes using the liability method. Deferred income tax assets and liabilities result from temporary differences between the tax basis of assets and liabilities and the reported amounts in the consolidated financial statements that will result in taxable or deductible amounts in future years. The Company's temporary differences arise principally from certain net operating losses, accrued expenses, reserves and depreciation. Concentration of Credit Risk. The Company's financial instruments that are exposed to credit risk consist primarily of investments and accounts receivable. The Company maintains cash and cash equivalents, and short- and long-term investments with various financial institutions. These financial institutions are located in many different regions, and company policy is designed to limit exposure with any one institution. Credit risk with respect to accounts receivable is generally diversified due to the large number of entities comprising the Company's customer base, other than gaming, and their dispersion across many different industries. These customers are primarily located in the states in which the Company operates. Such operations are principally in California, Nevada and Texas. However, the Company is licensed and does business in several other states as well. As of December 31, 1998, the Company has receivables outstanding from the federal government related to its TRICARE contract in the amount of $69.6 million. The Company also has receivables from certain reinsurers. Reinsurance contracts do not relieve the Company from its obligations to enrollees or policyholders. Failure of reinsurers to honor their obligations could result in losses to the Company. The Company evaluates the financial condition of its reinsurers to minimize its exposure to significant losses from reinsurer insolvencies. All reinsurers that the Company has reinsurance contracts with are rated A- or better by the A.M. Best Company. Recently Issued Accounting Standards. In March 1998, the Accounting Standards Executive Committee of the American Institute of Certified Public Accountants ("AcSEC") issued Statement of Position 98-1 ("SOP 98-1"), "Accounting for the Costs of Computer Software Developed For or Obtained For Internal Use". SOP 98-1 requires certain computer software costs to be capitalized and amortized over the software's estimated useful life. In June 1998, the AcSEC issued Statement of Position 98-5 ("SOP 98-5"), "Reporting on the Costs of Start-Up Activities". This standard requires organization costs and costs 43 SIERRA HEALTH SERVICES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS For the Years Ended December 31, 1998, 1997 and 1996 associated with start-up activities to be expensed as incurred. Both statements are effective for years beginning after December 15, 1998. The Company will adopt SOP 98-1 and SOP 98-5 for the fiscal year ending December 31, 1999 and does not believe these statements will have a material impact on its financial statements. In June 1998, The Financial Accounting Standards Board issued "Accounting for Derivative Instruments and Hedging Activities" ("FAS 133"). FAS 133 is effective for fiscal years beginning after June 15, 1999. FAS 133 addresses the accounting for derivative instruments including certain derivative instruments embedded in other contracts, and hedging activities. The Company does not believe this statement will have a material impact on its financial statements. 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. Estimates and assumptions include, but are not limited to, medical and specialty product expenses and military revenue and expenses. Actual results may materially differ from estimates. Reclassifications. Certain amounts in the Consolidated Financial Statements for the years ended December 31, 1997 and 1996 have been reclassified to conform with the current year presentation. 3. EARNINGS PER SHARE The following table provides a reconciliation of basic and diluted earnings per share ("EPS"):
Dilutive Basic Stock Options Diluted For the Year Ended December 31, 1998: Net Income..................................... $39,596,000 0 $39,596,000 Shares......................................... 27,391,000 356,000 27,747,000 Per Share Amount............................... $1.45 $1.43 For the Year Ended December 31, 1997: Net Income..................................... $24,241,000 $24,241,000 Shares......................................... 27,013,000 413,000 27,426,000 Per Share Amount............................... $.90 $.88 For the Year Ended December 31, 1996: Net Income..................................... $31,143,000 $31,143,000 Shares......................................... 26,589,000 602,000 27,191,000 Per Share Amount............................... $1.17 $1.15
Stock Split. On May 5, 1998, the Company announced a three-for-two stock split. Each stockholder of record of the Company owning one share of common stock, par value of $.005, as of the close of business on the record date of May 18, 1998, received an additional one-half share on June 18, 1998. In lieu of any fractional share resulting from the stock split, a stockholder received a cash payment based on the closing price of the Company's common stock on the record date. The par value remains $.005 per share. Common stock and earnings per share amounts have been retroactively adjusted to account for the split. 44 SIERRA HEALTH SERVICES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS For the Years Ended December 31, 1998, 1997 and 1996 CII issued convertible subordinated debentures (the "Debentures") due September 15, 2001. Each $1,000 in principal is convertible into 25.382 shares of the Company's common stock at a conversion price of $39.40 per share. The Debentures were not included in the computation of EPS because their effect would be anti-dilutive. 4. PROPERTY AND EQUIPMENT Property and equipment at December 31 consists of the following:
Classification 1998 1997 Land................................................... $ 28,588,000 $ 14,296,000 Buildings and Improvements............................. 145,308,000 109,307,000 Furniture, Fixtures and Equipment...................... 57,261,000 38,692,000 Data Processing Equipment and Software................. 43,643,000 31,452,000 Software in Development and Construction in Progress......................................... 20,324,000 4,170,000 Less: Accumulated Depreciation ........................ (65,960,000) (49,086,000) Net Property and Equipment......................... $229,164,000 $148,831,000
The following is an analysis of property and equipment under capital leases by classification as of December 31:
Classification 1998 1997 Data Processing Equipment and Software ................ $4,736,000 $4,779,000 Furniture, Fixtures and Equipment...................... 3,783,000 728,000 Building............................................... 245,000 245,000 Less: Accumulated Depreciation......................... (2,185,000) (467,000) Net Property and Equipment.......................... $6,579,000 $5,285,000
The Company capitalizes interest expense as part of the cost of construction of facilities and the implementation of computer systems. Interest expense capitalized in 1998, 1997 and 1996 was $1,037,000, $1,621,000 and $245,000, respectively. 5. CASH AND INVESTMENTS Investments that the Company has the intention and ability to hold to maturity are stated at amortized cost and categorized as held-to-maturity. The remaining investments have been categorized as available-for-sale and as a result are stated at their fair value. Unrealized holding gains and losses on available-for-sale securities are included as a separate component of stockholders' equity until realized. Gross realized gains and losses on investments in 1998 were $4.8 million and $2.5 million, respectively. Realized gains and losses are calculated using the specific identification method and are included in net income. 45 SIERRA HEALTH SERVICES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS For the Years Ended December 31, 1998, 1997 and 1996 The following table summarizes the Company's short-term, long-term and restricted investments as of December 31, 1998:
Gross Gross Estimated Amortized Unrealized Unrealized Fair Cost Gains Losses Value Available-for-Sale Investments: Classified as Short-term: U.S. Government and its Agencies..................... $ 19,180,000 $ 52,000 $ 219,000 $ 19,013,000 Municipal Obligations................... 24,974,000 88,000 5,000 25,057,000 Corporate Bonds......................... 31,419,000 45,000 60,000 31,404,000 Other. . . . ........................... 13,795,000 41,000 548,000 13,288,000 Total Short-term..................... 89,368,000 226,000 832,000 88,762,000 Classified as Long-term: U.S. Government and its Agencies..................... 61,034,000 608,000 1,357,000 60,285,000 Mortgage Backed......................... 6,209,000 1,000 216,000 5,994,000 Municipal Obligations................... 33,086,000 229,000 408,000 32,907,000 Corporate Bonds......................... 51,198,000 714,000 769,000 51,143,000 Total Long-term...................... 151,527,000 1,552,000 2,750,000 150,329,000 Classified as Restricted: U.S. Government and its Agencies..................... 8,549,000 87,000 8,636,000 Municipal Obligations................... 2,594,000 124,000 2,718,000 Corporate Bonds......................... 2,071,000 19,000 2,090,000 Other. . . . . . . . . ................. 2,081,000 2,081,000 Total Restricted .................... 15,295,000 230,000 15,525,000 Total Available-for-Sale ......... $256,190,000 $2,008,000 $3,582,000 $254,616,000 Held-to-Maturity Investments: Classified as Short-term: U.S. Government and its Agencies..................... $ 8,468,000 $ 9,000 $ 432,000 $ 8,045,000 Mortgage Backed......................... 5,936,000 266,000 5,670,000 Municipal Obligations................... 1,570,000 44,000 1,614,000 Corporate Bonds......................... 5,272,000 66,000 5,338,000 Total Short-term..................... 21,246,000 119,000 698,000 20,667,000 Classified as Long-term: U.S. Government and its Agencies..................... 6,529,000 29,000 51,000 6,507,000 Mortgage Backed.......................... 14,331,000 672,000 13,659,000 Municipal Obligations.................... 4,154,000 259,000 4,413,000 Corporate Bonds.......................... 5,473,000 441,000 5,914,000 Total Long-term...................... 30,487,000 729,000 723,000 30,493,000 Classified as Restricted: U.S. Government and its Agencies..................... 495,000 9,000 504,000 Municipal Obligations................... 574,000 17,000 591,000 Corporate Bonds......................... 1,164,000 50,000 1,214,000 Total Restricted .................... 2,233,000 76,000 2,309,000 Total Held-to-Maturity ........... $ 53,966,000 $ 924,000 $1,421,000 $ 53,469,000
46 SIERRA HEALTH SERVICES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS For the Years Ended December 31, 1998, 1997 and 1996 The following table summarizes the Company's short-term, long-term and restricted investments as of December 31, 1997:
Gross Gross Estimated Amortized Unrealized Unrealized Fair Cost Gains Losses Value Available-for-Sale Investments: Classified as Short-term: U.S. Government and its Agencies........................... $ 7,577,000 $ 31,000 $ 1,000 $ 7,607,000 Municipal Obligations......................... 41,732,000 88,000 194,000 41,626,000 Corporate Bonds.....................48,945,000 345,000 74,000 49,216,000 Other . . . . . .............................. 6,163,000 9,000 99,000 6,073,000 Total Short-term........................... 104,417,000 473,000 368,000 104,522,000 Classified as Long-term: U.S. Government and its Agencies........................... 38,031,000 169,000 59,000 38,141,000 Municipal Obligations......................... 3,160,000 139,000 1,000 3,298,000 Corporate Bonds.....................81,299,000 776,000 43,000 82,032,000 Other . . . . . ............... 63,000 63,000 Total Long-term............................ 122,553,000 1,084,000 103,000 123,534,000 Classified as Restricted: U.S. Government and its Agencies........................... 8,639,000 34,000 12,000 8,661,000 Municipal Obligations......................... 3,166,000 104,000 3,270,000 Corporate Bonds........................497,000 1,000 498,000 Other. . . . . . . . . ....................... 2,373,000 2,373,000 Total Restricted .......................... 14,675,000 139,000 12,000 14,802,000 Total Available-for-Sale ............... $241,645,000 $1,696,000 $483,000 $242,858,000 Held-to-Maturity Investments: Classified as Short-term: U.S. Government and its Agencies........................... $ 2,884,000 $ 33,000 $ 2,917,000 Corporate Bonds .............................. 8,092,000 189,000 8,281,000 Total Short-term........................... 10,976,000 222,000 11,198,000 Classified as Long-term: U.S. Government and its Agencies........................... 14,313,000 20,000 $ 38,000 14,295,000 Municipal Obligations......................... 6,038,000 372,000 6,410,000 Corporate Bonds.................. 11,268,000 509,000 11,000 11,766,000 Total Long-term............................ 31,619,000 901,000 49,000 32,471,000 Classified as Restricted: Municipal Obligations......................... 575,000 26,000 601,000 Corporate Bonds.................. 1,163,000 22,000 1,185,000 Total Restricted .......................... 1,738,000 48,000 1,786,000 Total Held-to-Maturity ................. $ 44,333,000 $1,171,000 $ 49,000 $ 45,455,000
47 SIERRA HEALTH SERVICES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS For the Years Ended December 31, 1998, 1997 and 1996 The contractual maturities of available-for-sale short-term, long-term and restricted investments at December 31, 1998 are shown below. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations.
Amortized Estimated Cost Fair Value Due in one year or less...................................... $ 64,036,000 $ 63,497,000 Due after one year through five years........................ 54,609,000 55,362,000 Due after five years through ten years....................... 16,763,000 17,063,000 Due after ten years.......................................... 120,782,000 118,694,000 Total................................................... $256,190,000 $254,616,000
The contractual maturities of held-to-maturity short-term, long-term and restricted investments at December 31, 1998 were as follows:
Amortized Estimated Cost Fair Value Due in one year or less...................................... $12,563,000 $12,417,000 Due after one year through five years........................ 12,209,000 12,957,000 Due after five years through ten years....................... 2,954,000 2,988,000 Due after ten years.......................................... 26,240,000 25,107,000 Total................................................... $53,966,000 $53,469,000
Of the cash and cash equivalents that total $83,910,000 million in the accompanying Consolidated Balance Sheet at December 31, 1998, $81,328,000 million is limited for use only by the Company's regulated subsidiaries. Such amounts are available for transfer to Sierra from the regulated subsidiaries only to the extent that they can be remitted in accordance with terms of existing management agreements and by dividends which customarily must be approved by regulating state insurance departments. The remainder is available to Sierra on an unrestricted basis. 6. REINSURANCE In the normal course of business, the Company seeks to reduce potential losses that may arise from catastrophic events that cause unfavorable underwriting results by reinsuring certain levels of such risk with other reinsurers. Amounts recoverable from reinsurers are estimated in a manner consistent with the claim liability associated with the reinsurance policy. The Company is covered under medical reinsurance agreements that provide coverage for 50% - 90% of hospital and other costs in excess of, depending on the contract, $100,000 to $200,000, per case, up to a maximum of $2,000,000 per member per lifetime for both the managed indemnity and HMO subsidiaries. In addition, certain of the Company's HMO members are covered by an excess catastrophe reinsurance contract. Reinsurance premiums of $2,860,000, $3,156,000 and $3,235,000 net of reinsurance recoveries of $1,185,000, $1,729,000 and $2,276,000 are included in medical expense for 1998, 1997 and 1996, respectively. In addition, SHL maintains reinsurance on certain other insurance products. CII also has reinsurance treaties in effect. Effective January 1, 1998, workers' compensation claims between $500,000 and $100,000,000 per occurrence are reinsured. In 1997 and 1996, workers' compensation claims between $350,000 and $60,000,000 per occurrence were reinsured. In addition, effective July 1, 1998, workers' compensation claims below $500,000 per occurrence are reinsured under quota share and excess reinsurance agreements (referred to as "low level reinsurance") with an A+ rated carrier. Under this agreement, CII reinsures 30% of the first $10,000 of each loss, 75% of the next $40,000 48 SIERRA HEALTH SERVICES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS For the Years Ended December 31, 1998, 1997 and 1996 and 100% of the next $450,000. CII receives a ceding commission from the reinsurer as a partial reimbursement of its operating expenses. The low level reinsurance agreement contains both retroactive and prospective reinsurance coverage and CII has bifurcated the low level reinsurance agreement to account for the different accounting treatments. The amount by which the estimated ceded liabilities exceed the amount paid for the retroactive coverage is amortized to income over the estimated remaining settlement period using the interest method. For the year ended December 31, 1998, CII amortized a deferred gain of $1,038,000. Any subsequent changes in estimated or actual cash flows are accounted for by adjusting the previously recorded deferred gain to the balance that would have existed had the revised estimate been available at the inception of the reinsurance transactions, with a corresponding charge or credit to income. At December 31, 1998 and 1997, the amount of reinsurance recoverable under prospective reinsurance contracts for unpaid losses and loss adjustment expenses for CII was $37,797,000 and $21,056,000, respectively. At December 31, 1998, the amount of reinsurance recoverable under the retroactive reinsurance contract was $18,710,000. The amount of reinsurance receivable for paid losses and loss adjustment expenses was $1,917,000 and $358,000, at December 31, 1998 and 1997, respectively. Reinsurance contracts do not relieve the Company from its obligations to enrollees or policyholders. Failure of reinsurers to honor their obligations could result in losses to the Company. The Company evaluates the financial condition of its reinsurers to minimize its exposure to significant losses from reinsurer insolvencies. All reinsurers that the Company has reinsurance contracts with are rated A- or better by the A.M. Best company. The following table provides workers' compensation prospective reinsurance information for the three years ended December 31, 1998:
Change in Recoveries Recoverable on Paid on Unpaid Premiums Losses/LAE Losses/LAE Ceded 1998: Travelers Indemnity Company of Illinois............................... $1,379,000 $19,664,000 $16,095,000 General Reinsurance Corporation............... 3,292,000 (2,923,000) 3,533,000 Others ....................................... 202,000 Total ........................................ $4,671,000 $16,741,000 $19,830,000 1997: General Reinsurance Corporation................. $ 841,000 $ 5,380,000 $ 4,872,000 Others ......................................... 187,000 Total .......................................... $ 841,000 $ 5,380,000 $ 5,059,000 1996: General Reinsurance Corporation................. $3,076,000 $(10,195,000) $4,713,000 Others ......................................... 456,000 Total .......................................... $3,076,000 $(10,195,000) $5,169,000
49 SIERRA HEALTH SERVICES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS For the Years Ended December 31, 1998, 1997 and 1996 7. LOSSES AND LOSS ADJUSTMENT EXPENSES The following table provides a reconciliation of the beginning and ending reserve balances for unpaid losses and LAE. There can be no assurances that favorable development, or the magnitude of the development, will continue in the future.
Year ended December 31, 1998 1997 1996 Net Beginning Losses and LAE Reserve ..................... $181,643,000 $172,100,000 $156,447,000 Net Provision for Insured Events Incurred in: Current Year .......................................... 103,990,000 102,301,000 101,401,000 Prior Years............................................ (9,643,000) (8,970,000) (15,284,000) Total Net Provision.................................. 94,347,000 93,331,000 86,117,000 Net Payments for Losses and LAE Attributable to Insured Events Incurred in: Current Year .......................................... 29,592,000 26,811,000 24,733,000 Prior Years............................................ 71,932,000 56,977,000 45,731,000 Total Net Payments .................................. 101,524,000 83,788,000 70,464,000 Net Ending Losses and LAE Reserve ........................ 174,466,000 181,643,000 172,100,000 Reinsurance Recoverable .................................. 37,797,000 21,056,000 15,676,000 Gross Ending Losses and LAE Reserve ...................... $212,263,000 $202,699,000 $187,776,000
8. LONG-TERM DEBT Long-term debt at December 31 consists of the following:
1998 1997 Revolving Credit Facility............................................ $139,000,000 $ 25,000,000 7 1/2% Convertible Subordinated Debentures .......................... 51,251,000 54,467,000 6% Mortgage Note..................................................... 35,171,000 7 1/5% Mortgage Note................................................. 13,440,000 7 3/8% Mortgage Note ............................................... 821,000 5,833,000 Adjustable Rate Mortgage Note ....................................... 3,116,000 Other................................................................ 7,978,000 7,151,000 Total.............................................................. 247,661,000 95,567,000 Less Current Portion................................................. (5,263,000) (4,726,000) Long-term Debt....................................................... $242,398,000 $90,841,000
Revolving Credit Facility. On October 31, 1998, the Company replaced its prior line of credit with a $200 million credit facility under which it has $139 million in borrowings outstanding as of December 31, 1998. Interest under the credit facility is variable and based on the London Interbank Offering Rate plus a margin determined by reference to the Company's leverage ratio. Of the outstanding balance, $50.0 million is covered by interest-rate swap agreements. The average cost of borrowing on this line of credit for the fourth quarter of 1998, including the impact of the swap agreements, was approximately 8.0%. The terms of the credit facility contain a mandatory payment schedule that begins on June 30, 2001 and ends on September 30, 2003 if the principal balance exceeds certain thresholds. The terms of the credit facility 50 SIERRA HEALTH SERVICES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS For the Years Ended December 31, 1998, 1997 and 1996 contain certain covenants including a minimum fixed charge coverage ratio and a maximum leverage ratio. In November 1998, the Company borrowed approximately $110 million to fund the acquisition of Kaiser- Texas. 7 1/2% Convertible Subordinated Debentures. In September 1991 CII issued convertible subordinated debentures (the "Debentures") due September 15, 2001. The Debentures bear interest at 7 1/2% which is due semi-annually on March 15 and September 15. Each $1,000 in principal is convertible into 25.382 shares of the Company's common stock at a conversion price of $39.40 per share. Unamortized issuance costs of $509,000 are included in other assets on the balance sheet and are being amortized over the life of the Debentures. Accrued interest on the Debentures as of December 31, 1998 and 1997 was $1,117,000 and $1,191,000, respectively. The Debentures are redeemable by CII, in whole or in part, at redemption prices of 101.05% in 1999 and 100.75% thereafter, plus accrued interest. The Debentures are general unsecured obligations of CII only and were not assumed or guaranteed by Sierra. During the twelve months ended December 31, 1998 and 1997, the Company purchased $3,216,000 and $30,000, respectively, of the debentures on the open market. 6.0% Mortgage Note. In conjunction with the acquisition of Kaiser-Texas, TXHC executed a deed of trust note for $35,200,000. The note is secured by deeds of trust covering the underlying real estate and fixtures. The terms of the note include fixed monthly payments of $211,000 for five years at which time the remaining principal is due. 7 1/5% Mortgage Note. In January 1998, the Company obtained a $15,000,000 loan from Bank of America, Nevada at an interest rate of 7 1/5%. This loan is secured by a deed of trust, assignment of rents and leases, and a security agreement and fixture filing covering the newly constructed portion of the Company's administrative headquarters complex and underlying real property. 7 3/8% Mortgage Note. In December 1993, the Company obtained a loan from Bank of America, Nevada. This loan is secured by a deed of trust, assignment of rents and leases, and a security agreement and fixture filing covering a portion of the Company's administrative headquarters complex and underlying real property. Adjustable Rate Mortgage Note. In 1998, the Company repaid a mortgage which had an adjustable rate with an interest margin of 3% over the Federal Home Loan Bank Board 11th District Cost of Funds Index, a maximum interest rate of five percentage points above the initial rate of 11.85% and a minimum interest rate of 8%. Other. The Company has obligations under capital leases with interest rates from 6.3% to 13.4%. In addition, the Company has term loans with the City of Baltimore and the State of Maryland. 51 SIERRA HEALTH SERVICES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS For the Years Ended December 31, 1998, 1997 and 1996 Scheduled maturities of the Company's notes payable and future minimum payments under capital leases, together with the present value of the net minimum lease payments at December 31, 1998, are as follows:
Obligations Notes Under Capital Year ending December 31, Payable Leases 1999................................................. $ 2,761,000 $2,932,000 2000................................................. 2,310,000 1,967,000 2001................................................. 53,263,000 1,314,000 2002................................................. 2,150,000 1,278,000 2003 ................................................ 173,984,000 105,000 Thereafter........................................... 6,379,000 276,000 Total............................................. $240,847,000 7,872,000 Less: Amounts Representing Interest................. (1,058,000) Present Value of Minimum Lease Payments.............. $6,814,000
The fair value of the Debentures at December 31, 1998 was $48,176,000 which was determined based on the market price on January 7, 1999. Excluding the Debentures, the fair value of long-term debt, including the current portion, is $195,057,000 based on the borrowing rates currently available to the Company for bank loans with similar terms and average maturities. 9. INCOME TAXES A summary of the provision for income taxes for the years ended December 31, 1998, 1997, and 1996 is as follows:
1998 1997 1996 Provision for Income Taxes: Current..................................... $12,595,000 $5,528,000 $11,860,000 Deferred.................................... 1,201,000 (2,294,000) (1,389,000) $13,796,000 $3,234,000 $10,471,000
The following reconciles the difference between the 1998, 1997 and 1996 current and statutory provision for income taxes:
1998 1997 1996 Statutory Rate .................................. 35% 35% 35% Tax Preferred Investments ....................... (2) (5) (6) Change in Valuation Allowance ................... (9) (17) (6) Other ........................................... 2 (1) 2 Provision for Income Taxes ................. 26% 12% 25%
52 SIERRA HEALTH SERVICES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS For the Years Ended December 31, 1998, 1997 and 1996 The tax effects of significant items comprising the Company's net deferred tax assets are as follows:
1998 1997 Deferred Tax Assets: Medical and Losses and LAE Reserves ...................... $ 4,398,000 $ 7,428,000 Accruals Not Currently Deductible......................... 4,875,000 7,269,000 Compensation Accruals .................................... 4,569,000 2,344,000 Bad Debt Allowances....................................... 2,189,000 2,041,000 Loss Carryforwards and Credits............................ 9,878,000 11,543,000 Unearned Premiums......................................... 850,000 902,000 Deferred Reinsurance Gains................................ 2,188,000 Other .................................................... 551,000 29,498,000 31,527,000 Deferred Tax Liabilities: Deferred Policy Acquisition Costs ........................ 586,000 596,000 Depreciation and Amortization ............................ 6,249,000 4,872,000 Other .................................................... 558,000 1,096,000 7,393,000 6,564,000 Net Deferred Tax Asset Before Valuation Allowance.................................... 22,105,000 24,963,000 Valuation Allowance ...................................... (1,575,000) (6,266,000) Net Deferred Tax Asset ................................... $20,530,000 $18,697,000
At December 31, 1998, the Company had approximately $20,022,000 of regular tax net operating loss carryforwards which are limited to use at the rate of approximately $7,021,000 per year during the carryforward period. The net operating loss carryforwards can be used to reduce future taxable income until they expire through the year 2011. In addition to the net operating loss carryforwards, the Company has alternative minimum tax credits of approximately $848,000 which can be used to reduce regular tax liabilities in future years. There is no expiration date for the alternative minimum tax credits. The majority of the above items are subject to both annual and separate company limitations required by the Internal Revenue Code. A valuation allowance has been set up to reflect the Company's inability to use tax benefits from certain acquisitions currently or in the near future. For the years ended December 31, 1998 and 1997, the Company was able to realize a portion of the tax benefits for which a valuation allowance had been previously established. As a result, the Company reduced its valuation allowance by $4,691,000 and $4,663,000 for the years ended December 31, 1998 and 1997, respectively. 53 SIERRA HEALTH SERVICES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS For the Years Ended December 31, 1998, 1997 and 1996 10. COMMITMENTS AND CONTINGENCIES Leases. The Company is the lessee under several operating leases, most of which relate to office facilities and equipment. The rentals on these leases are charged to expense over the lease term as the Company becomes obligated for payment and, where applicable, provide for rent escalations based on certain costs and price index factors. The following is a schedule, by year, of the future minimum lease payments under existing operating leases:
Year Ending December 31, 1999................................................... $ 8,811,000 2000................................................... 6,896,000 2001................................................... 6,060,000 2002................................................... 5,665,000 2003 .................................................. 3,740,000 Thereafter............................................. 5,038,000 Total............................................. $36,210,000
Rent expense totaled $8,763,000, $5,827,000 and $4,945,000 in 1998, 1997 and 1996, respectively. Litigation and Legal Matters. The Company is subject to various claims and other litigation in the ordinary course of business. Such litigation includes claims of medical malpractice, claims for coverage or payment for medical services rendered to HMO members and claims by providers for payment for medical services rendered to HMO members. Also included in such litigation are claims for workers' compensation and claims by providers for payment for medical services rendered to injured workers. In the opinion of the Company's management, the ultimate resolution of pending legal proceedings should not have a material adverse effect on the Company's financial condition. 11. EMPLOYEE BENEFIT PLANS Defined Contribution Plan. The Company has a defined contribution pension and 401(k) plan (the "Plan") for its employees. The Plan covers all employees who meet certain age and length of service requirements. The Company contributes a maximum of 2% of eligible employees' compensation and matches 50% of a participant's elective deferral up to a maximum of either 10% of an employee's compensation or the maximum allowable under current IRS statute. Expense under the plan totaled $4,522,000, $3,929,000 and $3,216,000 in 1998, 1997 and 1996, respectively. Supplemental Retirement Plan. The Company has Supplemental Retirement Plans (the "SRPs") for certain officers, directors and highly compensated employees. The SRPs are non-qualified deferred compensation plans through which participants may elect to postpone the receipt and taxation of all or a portion of their salary and bonuses received from the Company. The Company also matches 50% of those contributions that participants are restricted from deferring, if any, under the Company's pension and 401(k) plan. As contracted with the Company, the participants or their designated beneficiaries may begin to receive benefits under the SRPs upon participant death, disability, retirement, termination of employment or certain other circumstances including financial hardship. Executive Life Insurance Plan. Effective July 1, 1997 the Company has funded and entered into split dollar life insurance agreements with certain officers and key executives (selected and approved by the Sierra Board of Directors). The premiums paid by the Company will be reimbursed upon the occurrence of certain events as specified in the contract. Supplemental Executive Retirement Plan (SERP). Effective July 1, 1997, the Company adopted a defined benefit retirement plan covering certain key employees. The Company is funding the benefits through the 54 SIERRA HEALTH SERVICES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS For the Years Ended December 31, 1998, 1997 and 1996 purchase of certain life insurance policies. Benefits are based on, among other things, the employee's average earnings over the five-year period prior to retirement or termination, and length of service. Benefits attributable to service prior to the adoption of the plan are amortized over the estimated remaining service period for those employees participating in the plan. In 1998, the Company expanded the SERP to include more participants. The effect of adding these participants is included in plan amendments in the reconciliation below. A reconciliation of ending year balances is as follows:
For the Year Ended December 31, 1998 1997 Change in Benefit Obligation: Projected Benefit Obligation at Beginning of Period (Inception for 1997) ...................................... $ 9,515,000 $ 9,008,000 Service Cost ................................................. 408,000 132,000 Interest Cost ................................................ 875,000 375,000 Plan Amendments............................................... 995,000 Actuarial Gains/Losses........................................ 1,925,000 Benefits Paid ................................................ (97,000) Benefit Obligation at End of Period........................... 13,621,000 9,515,000 Change in Plan Assets: Fair Value of Plan Assets at Beginning of Period.............. 1,872,000 Actual Return on Plan Assets ................................. (58,000) (308,000) Company Contributions ........................................ 2,679,000 2,180,000 Fair Value of Plan Assets at End of Period.................... 4,493,000 1,872,000 Funded Status of the Plan .................................... (9,128,000) (7,643,000) Unrecognized Actuarial Change................................. 1,858,000 Unrecognized Prior Service Credit ............................ 8,757,000 8,647,000 Unrecognized Net Loss ........................................ 748,000 394,000 Total Recognized ............................................. $ 2,235,000 $ 1,398,000 Total Recognized Amounts in the Financial Statements Consist of: Accrued Benefit Liability .................................... $(3,325,000) $(2,964,000) Intangible Asset ............................................. 5,560,000 4,362,000 Total ........................................................ $ 2,235,000 $ 1,398,000 Assumptions: Discount Rate ................................................ 7.0% 7.0% Expected Return on Plan Assets ............................... 8.0% 8.0% Rate of Compensation Increase ................................ 5.0% 5.0% Components of Net Periodic Benefit Cost: Service Cost.................................................. $ 408,000 $ 132,000 Interest Cost ................................................ 875,000 375,000 Expected Return on Plan Assets................................ (295,000) (87,000) Amortization of Prior Service Credits......................... 885,000 361,000 Recognized Actuarial Loss..................................... 68,000 Net Periodic Benefit Cost..................................... $1,941,000 $ 781,000
55 SIERRA HEALTH SERVICES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS For the Years Ended December 31, 1998, 1997 and 1996 12. CAPITAL STOCK PLANS Stockholders' Rights Plan. Each share of Sierra common stock, par value $.005 per share, contains one right (a "Right"). Each Right entitles the registered holder to purchase from Sierra a unit consisting of one one-hundredth of a share of the Series A Junior Participating Preferred Shares (a "Unit"), par value $.01 per share, of Sierra, or a combination of securities and assets of equivalent value, at a purchase price of $100.00 per Unit, subject to adjustment. The Rights have certain anti-takeover effects. The Rights will cause substantial dilution to a person or group that attempts to acquire Sierra on terms not approved by Sierra's Board of Directors, except pursuant to an offer conditioned on a substantial number of Rights being acquired. The Rights should not interfere with any merger or other business combination approved by the Board of Directors since Sierra may redeem the Rights at the price of $.02 per Right prior to the time that a person or group has acquired beneficial ownership of 20% or more of Sierra common stock. Stock Option Plans. The Company has several plans that provide common stock-based awards to employees and to non-employee directors. The plans provide for the granting of Options, Stock, and other stock-based awards. Awards are granted by a committee appointed by the Board of Directors. Options become exercisable at such times and in such installments as set by the committee. The exercise price of each option equals the market price of the Company's stock on the date of grant. Stock options generally vest at a rate of 20% - 25% per year. Options generally expire one year after the end of the vesting period. The following table reflects the activity of the stock option plans:
Number of Option Weighted Shares Price Average Price Outstanding January 1, 1996................. 2,790,000 $ 2.25 - $21.17 $14.36 Granted.................................. 480,000 16.67 - 23.33 17.43 Exercised................................ (249,000) 2.25 - 19.09 8.38 Canceled................................. (23,000) 7.13 - 21.17 14.47 Outstanding December 31, 1996 .............. 2,998,000 5.00 - 23.33 15.34 Granted.................................. 459,000 16.25 - 24.50 23.15 Exercised................................ (705,000) 5.00 - 21.17 11.81 Canceled................................. (97,000) 6.31 - 23.33 17.33 Outstanding December 31, 1997 .............. 2,655,000 6.31 - 24.50 17.53 Granted.................................. 468,000 16.94 - 24.83 22.49 Exercised................................ (386,000) 6.31 - 23.33 14.25 Canceled................................. (7,000) 7.13 - 24.50 17.01 Outstanding December 31, 1998............... 2,730,000 6.31 - 24.83 18.89 Exercisable at December 31, 1998 ........... 1,274,000 $6.31 $24.50 $17.16 Available for Grant at December 31, 1998 ....................... 3,002,000
56 SIERRA HEALTH SERVICES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS For the Years Ended December 31, 1998, 1997 and 1996 The following table summarizes information about stock options outstanding at December 31, 1998:
Weighted Average Weighted Average Range of Exercise Remaining Options Exercise Price Prices Contractual Life Outstanding Exercisable Outstanding Exercisable $ 6.31 - 6.311,264 days 16,000 16,000 $ 6.31 $ 6.31 9.91 - 12.083,068 days 189,000 136,000 11.10 11.11 16.25 - 21.171,081 days 1,678,000 1,034,000 17.53 17.52 22.17 - 24.831,986 days 847,000 88,000 23.57 24.30
Employee Stock Purchase Plan. The Company has an employee stock purchase plan (the "Purchase Plan") whereby employees may purchase newly issued shares of stock through payroll deductions at 85% of the fair market value of such shares on specified dates as defined in the Purchase Plan. As of December 31, 1998, the Company had 353,000 shares reserved for purchase under the Purchase Plan. During 1998, a total of 144,000 shares were purchased at prices of $17.75 and $19.06 per share. During January 1999, 72,000 shares were issued to employees at $17.85 per share in connection with the Purchase Plan. Accounting for Stock-Based Compensation. The Company uses the intrinsic value method in accounting for its stock-based compensation plans. Accordingly, no compensation cost has been recognized for its employee stock option plans nor the Stock Purchase Plan. Had compensation cost for the Company's stock-based compensation plans been determined based on the fair value at the grant dates for awards under those plans, the Company's net income and earnings per share would have been reduced to the pro forma amounts indicated below:
For the Years Ended 1998 1997 1996 Net Income As reported $39,596,000 $24,241,000 $31,143,000 Proforma 37,106,000 22,177,000 29,703,000 Net Income Per Share As reported $1.45 $.90 $1.17 Proforma 1.35 .82 1.12 Net Income Per Share Assuming Dilution As reported $1.43 $.88 $1.15 Proforma 1.34 .81 1.09
The fair value of each option grant is estimated on the date of grant using the Black-Scholes option pricing model with the following weighted average assumptions used for grants in 1998, 1997 and 1996, respectively: dividend yield of 0% for all years; expected volatility of 37%, 35% and 29%; risk-free interest rates of 4.46%, 5.89% and 5.92%; and expected lives of five years for all years. The weighted fair value of options granted in 1998, 1997 and 1996 was $9.92, $8.27 and $5.65, respectively. The fair value of the look-back option implicit in each offering of the Purchase Plan is estimated on the date of grant using the Black-Scholes option pricing model with the following weighted average assumptions used for grants in 1998, 1997 and 1996, respectively: dividend yield of 0% for all years; expected volatility of 32%, 35% and 29%; risk-free interest rates of 5.30%, 5.32% and 5.29%; and expected lives of six months for all years. 57 SIERRA HEALTH SERVICES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS For the Years Ended December 31, 1998, 1997 and 1996 Due to the fact that the Company's stock option programs vest over many years and additional awards are made each year, the above pro forma numbers are not indicative of the financial impact had the disclosure provisions of FAS 123 been applicable to all years of previous option grants. The above numbers do not include the effect of options granted prior to 1995. 13. STATEMENTS OF CASH FLOWS SUPPLEMENTAL INFORMATION Supplemental statements of cash flows information for the years ended December 31, is presented below:
1998 1997 1996 Cash Paid During the Year for Interest (Net of Amount Capitalized)............................... $ 8,737,000 $4,463,000 $5,275,000 Cash Paid During the Year for Income Taxes.................... 15,003,000 7,943,000 7,966,000 Noncash Investing and Financing Activities: Liabilities Assumed in Connection with Corporate Acquisitions................................. 53,461,000 195,000 7,890,000 Reductions to Funds Withheld by Ceding Insurance Company and Future Policy Benefits........................................ 8,471,000 773,000 Stock Issued for Exercise of Options and Related Tax Benefits............................... 1,284,000 2,004,000 1,158,000 Additions to Capital Leases............................... 3,070,000 4,574,000
14. INTEGRATION, SETTLEMENT AND OTHER COSTS 1998 During the fourth quarter of 1998, the Company incurred settlement expenses totaling $8 million, $5.9 million after tax, related to the settlement of a competitor's protest for the Region 1 TRICARE contract. All this amount was paid during fiscal year 1998. On September 30, 1997, SMHS was awarded a five-year, $1.2 billion contract to administer managed health care services to military families and retirees in 13 northeastern states and Washington, D.C. A competing bidder protested the contract award and claimed, among other issues, that the United States Department of Defense failed to adequately disclose the weights of the significant factors used to evaluate proposals. In December 1998, SMHS reached an agreement to settle the protest. As part of the settlement, the competitor has foregone any and all rights it may have to challenge the contract award and seek re-bid. During the fourth quarter of 1998, the Company incurred integration, transition and other charges totaling $3.1 million, $2.3 million after tax, related primarily to its acquisition of the Texas operations of Kaiser Foundation Health Plan. In addition, the Company incurred certain legal expenses totaling $2.7 million, $2.0 million after tax, resulting primarily from the TRICARE settlement and acquisition and integration activity. As of December 31, 1998, $2.8 million was included in accrued expenses for these integration, transition and legal costs incurred through December 31, 1998. 1997 During 1997, the Company recorded and paid expenses of approximately $11.0 million, $8.4 million after tax, for merger-related costs. On March 18, 1997, the Company announced it had terminated its merger agreement with Physician Corporation of America. The original agreement had been entered into in November 1996. 58 SIERRA HEALTH SERVICES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS For the Years Ended December 31, 1998, 1997 and 1996 During the third quarter of 1997, SMHS was notified it had been awarded a TRICARE managed care contract by the Department of Defense to serve eligible beneficiaries in Region 1. This region includes more than 600,000 beneficiaries in 13 northeastern states and the District of Columbia. Development expenses of $18.4 million $10.6 million net of taxes, were recorded in the third quarter, primarily for expenses associated with the Company's proposal to serve TRICARE beneficiaries in Region 1. Such expenses had been deferred until award notification. SMHS began health care delivery on June 1, 1998. SMHS subcontracts for health care delivery, including some of the risk, for parts of the TRICARE contract. 1996 During 1995, as part of the Company's clinical expansion and growth efforts, the Company acquired a medical facility in Mohave County, Arizona, across the border from Laughlin, Nevada. This medical facility included a 12-bed hospital. During 1996 the Company implemented a plan to exit the hospital business and has actively pursued buyers for this business. As a result of this plan, the Company recorded a charge of $3.8 million, $2.9 million after tax, in the fourth quarter of 1996, primarily to recognize the estimated costs to dispose of the hospital. As of December 31, 1998, the Company has been unable to reach an agreement to sell the hospital. As a result of higher than expected claim and administrative costs relative to premium rates that can be obtained in certain regional insurance operations and the Company's inability to negotiate adequate provider contracts due to its limited presence in some of these markets, the Company adopted a plan to restructure certain insurance operations during the third quarter of 1996 and recorded a charge of $8.3 million, $6.2 million after tax. These restructuring costs included cancellation of certain contractual obligations of $6.0 million, lease termination costs of $1.5 million and approximately $750,000 of other costs. 15. UNAUDITED QUARTERLY INFORMATION (Amounts in thousands, except per share data)
March June September December 31 30 30 31 Year Ended December 31, 1998: Operating Revenues.................................... $210,409 $244,545 $281,082 $301,167 Operating Income...................................... 17,663 18,550 18,213 6,147 Income Before Income Taxes ........................... 16,382 16,931 17,006 3,073 Net Income .....................................12,187 12,551 12,584 2,274 Earnings Per Share ................................... .44 .46 .46 .08 Earnings Per Share Assuming Dilution ................. .44 .45 .46 .08 Year Ended December 31, 1997: Operating Revenues.................................... $170,578 $176,321 $183,859 $190,966 Operating Income (Loss) .............................. 3,242 15,103 (2,765) 16,328 Income (Loss) From Continuing Operations Before Income Taxes ............................... 1,840 13,896 (3,705) 15,444 Net Income............................................ 1,398 10,561 495 11,787 Earnings Per Share ................................... .05 .39 .02 .43 Earnings Per Share Assuming Dilution ................. .05 .39 .02 .43
59 SIERRA HEALTH SERVICES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS For the Years Ended December 31, 1998, 1997 and 1996 16. SEGMENT REPORTING The Company has three reportable segments based on the products and services offered: managed care and corporate operations, workers' compensation operations and military health services operations. The managed care segment includes managed health care services provided through HMOs, managed indemnity plans, third-party administrative services programs for employer-funded health benefit plans, multi-specialty medical groups, other ancillary services and corporate operations. The workers' compensation segment assumes workers' compensation claims risk in return for premium revenues. The military health services segment administers a five-year, managed care federal contract for the Department of Defense's TRICARE program in Region 1. Sierra evaluates each segment's performance based on segment operating profit. The accounting policies of the operating segments are the same as those described in the summary of significant accounting policies. 60 SIERRA HEALTH SERVICES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS For the Years Ended December 31, 1998, 1997 and 1996 Information concerning the operations of the reportable segments is as follows: (Amounts in thousands)
Managed Care Workers' Military and Corporate Compensation Health Services Operations Operations Operations Total 1998 Medical Premiums.................................. $609,404 0 0 $ 609,404 Specialty Product Revenues........................ 12,843 $135,525 148,368 Professional Fees ................................ 45,363 45,363 Military Contract Revenues........................ $204,838 204,838 Investment and Other Revenues..................... 8,594 20,229 407 29,230 Total Revenue.................................. $676,204 $155,754 $205,245 $1,037,203 Depreciation and Amortization..................... $ 15,545 $ 1,551 $ 2,167 $ 19,263 Interest Expense and Other 2,610 3,998 573 7,181 Segment Profit. ....................... $ 40,704 $ 18,492 $ 8,047 $ 67,243 Integration, Settlement and Other Costs........... (4,869) (8,982) (13,851) Net Income (Loss) Before Income Taxes............. $ 35,835 $ 18,492 $ (935) $ 53,392 Segment Assets. ........................ $ 593,332 $377,911 $ 73,877 $1,045,120 Capital Expenditures.............................. 32,520 3,208 5,015 40,743 1997 Medical Premiums.................................. $513,857 $ 513,857 Specialty Product Revenues........................ 16,297 $129,914 146,211 Professional Fees ................................ 31,238 31,238 Military Contract Revenues........................ $ 4,346 4,346 Investment and Other Revenues..................... 8,711 17,361 26,072 Total Revenue.................................. $570,103 $147,275 $ 4,346 $ 721,724 Depreciation & Amortization....................... $ 12,491 $ 950 $ 69 $ 13,510 Interest Expense and Other 371 4,062 4,433 Segment Profit. ....................... $ 45,662 $ 11,010 153 $ 56,825 Integration, Settlement and Other Costs........... (12,600) (16,750) (29,350) Net Income (Loss) Before Income Taxes............. $ 33,062 $ 11,010 $(16,597) $ 27,475 Segment Assets. ........................ $373,652 $343,425 $ 6,859 $ 723,936 Capital Expenditures.............................. 43,825 11,178 639 55,642 1996 Medical Premiums.................................. $386,968 $ 386,968 Specialty Product Revenues........................ 11,983 $121,341 133,324 Professional Fees ................................ 28,836 28,836 Investment and Other Revenues..................... 7,595 18,688 26,283 Total Revenue.................................. $435,382 $140,029 $ 575,411 Depreciation & Amortization....................... $ 9,599 $ 900 $ 10,499 Interest Expense and Other (1,247) 4,070 2,823 Segment Profit. ....................... $ 42,930 $ 10,748 $ 53,678 Integration, Settlement and Other Costs........... (12,064) 12,064 Net Income Before Income Taxes.................... $ 30,866 $ 10,748 $ 41,614 Segment Assets. ....................... $313,463 $315,999 $ 629,462 Capital Expenditures.............................. 17,361 566 17,927
61 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 set forth under the caption "Election of Directors" in Sierra's Proxy Statement for its 1999 Annual Meeting of Stockholders, is incorporated herein by reference. ITEM 11. EXECUTIVE COMPENSATION The information set forth under the caption "Compensation of Executive Officers" in Sierra's Proxy Statement for its 1999 Annual Meeting of Stockholders, is incorporated herein by reference. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information set forth under the caption "Security Ownership of Certain Beneficial Owners and Management" in Sierra's Proxy Statement for its 1999 Annual Meeting of Stockholders, is incorporated herein by reference. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information set forth under the caption "Certain Relationships and Related Transactions" in Sierra's Proxy Statement for its 1999 Annual Meeting of Stockholders, is incorporated herein by reference. 62 PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a)(1) The following consolidated financial statements are included in Part II, Item 8 of this Report:
Page Independent Auditors' Report............................................................. 35 Consolidated Balance Sheets at December 31, 1998 and 1997................................ 36 Consolidated Statements of Operations for the Years Ended December 31, 1998, 1997 and 1996...................................................... 37 Consolidated Statements of Changes in Stockholders' Equity for the Years Ended December 31, 1998, 1997 and 1996.................................. 38 Consolidated Statements of Cash Flows for the Years Ended December 31, 1998, 1997 and 1996...................................................... 39 Notes to Consolidated Financial Statements............................................... 40 (a)(2) Financial Statement Schedules: Schedule I - Condensed Financial Information of Registrant................... S-1 Schedule V - Supplemental Information Concerning Property-Casualty Insurance .................................. S-4 Section 403.04 b - Reconciliation of Beginning and Ending Loss and Loss Adjustment Expense Reserves and Exhibit of Redundancies (Deficiencies) ................... S-5
All other schedules are omitted because they are not applicable, not required, or because the required information is in the consolidated financial statements or notes thereto. (a)(3) and (c) The following exhibits are filed as part of, or incorporated by reference into, this Report as required by Item 601 of Regulation S-K: (3.1) Articles of Incorporation, together with amendments thereto to date, incorporated by reference to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1990. (3.2) Certificate of Division of Shares into Smaller Denominations of the Registrant, incorporated by reference to Exhibit 3.3 to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1992. (3.3) Amended and Restated Bylaws of the Registrant, as amended through December 12, 1997, incorporated by reference to Exhibit 3.3 to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1997. (4.1) Rights Agreement, dated as of June 14, 1994, between the Registrant and Continental Stock Transfer & Trust Company, incorporated by reference to Exhibit 3.4 to the Registrant's Registration Statement on Form S-3 effective October 11, 1994 (Reg. No. 33- 83664). (4.2) Specimen Common Stock Certificate, incorporated by reference to Exhibit 4(e) to the Registrant's Registration Statement on Form S-8 as filed and effective on August 5, 1994 (Reg. No. 33-82474). (4.3) Form of Indenture, of 7 1/2% convertible subordinated debentures due 2001 from CII Financial, Inc. to Manufacturers Hanover Trust Company as Trustee dated September 15, 1991, incorporated by reference to Exhibit 4.2 of Post-Effective Amendment No. 1 on Form S-3 to Registration Statement on Form S-4 dated October 6, 1995 (Reg. No. 33-60591). 63 (4.4) First Supplemental Indenture between CII Financial, Inc., Sierra Health Services, Inc. and Chemical Bank as Trustee, dated as of October 31, 1995, to Indenture dated September 15, 1991, incorporated by reference to Exhibit 4.3 of Post-Effective Amendment No. 2 on Form S-3 to Registration Statement on Form S-4 dated October 31, 1995 (Reg. No. 33- 60591). (10.1) Administrative Services agreement between Health Plan of Nevada, Inc. and the Registrant dated December 1, 1987, incorporated by reference to Exhibit 10.17 to Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1991. (10.2) Administrative Services agreement between Sierra Health and Life Insurance Company, Inc. and the Registrant dated April 1, 1989, incorporated by reference to Exhibit 10.18 to Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1991. (10.3) Agreement between Health Plan of Nevada, Inc. and the United States Health Care Financing Administration dated July 24, 1992, incorporated by reference to Exhibit 10.18 to the Registrant's Annual Report on Form 10-K filed for the fiscal year ended December 31, 1992. (10.4) Credit Agreement dated as of October 30, 1998, among Sierra Health Services, Inc. as Borrower, Bank of America National Trust and Savings Association as Administrative Agent and Issuing Bank, First Union National Bank as Syndication Agent, and the Other Financial Institutions Party Thereto, dated as of October 30, 1998. (10.5) First Amendment to Credit Agreement among Sierra Health Services, Inc., as Borrower, Bank of America National Trust and Savings Association as Administrative Agent and Issuing Bank and the Other Financial Institutions Party Thereto, dated as of November 23, 1998. (10.6) Second Amendment to Credit Agreement among Sierra Health Services, Inc. as borrower, Bank of America National Trust and Savings Association as Administrative Agent and the Other Financial Institutions Party Thereto, dated as of January 15, 1999. (10.7) Compensatory Plans, Contracts and Arrangements. (1) Employment Agreement with Jonathon W. Bunker dated November 15, 1997, incorporated by reference to Exhibit 10.6 to Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1997. (2) Employment Agreement with Frank E. Collins dated November 15, 1997, incorporated by reference to Exhibit 10.6 to Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1997. (3) Employment Agreement with William R. Godfrey dated November 15, 1997, incorporated by reference to Exhibit 10.6 to Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1997. (4) Employment Agreement with Laurence S. Howard dated November 15, 1997, incorporated by reference to Exhibit 10.6 to Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1997. (5) Employment Agreement with Anthony M. Marlon, M.D. dated November 15, 1997, incorporated by reference to Exhibit 10.6 to Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1997. 64 (6) Employment Agreement with Erin E. MacDonald dated November 15, 1997, incorporated by reference to Exhibit 10.6 to Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1997. (7) Employment Agreement with Michael A. Montalvo dated November 15, 1997, incorporated by reference to Exhibit 10.6 to Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1997. (8) Employment Agreement with Marie H. Soldo dated November 15, 1997, incorporated by reference to Exhibit 10.6 to Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1997. (9) Employment Agreement with James L. Starr dated November 15, 1997, incorporated by reference to Exhibit 10.6 to Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1997. (10) Employment Agreement with Paul H. Palmer dated November 20, 1998. (11) Draft of Split Dollar Life Insurance Agreement effective as of July 1, 1997, by and between Sierra Health Services, Inc., and Jonathon W. Bunker, Ria Marie Carlson, Frank E. Collins, William R. Godfrey, Laurence S. Howard, Erin E. MacDonald, Anthony M. Marlon, M.D., Kathleen M. Marlon, Michael A. Montalvo, John A. Nanson, M.D., Marie H. Soldo, and James L. Starr, incorporated by reference to Exhibit 10.2 to the Registrant's Quarterly Report on Form 10-Q for the fiscal quarter ended June 30, 1997. (12) Sierra Health Services, Inc. Deferred Compensation Plan effective May 1, 1996 as Amended and Restated Effective July 1, 1997, dated as of July 1, 1997, incorporated by reference to Exhibit 10.3 to the Registrant's Quarterly Report on Form 10-Q for the fiscal quarter ended June 30, 1997. (13) Sierra Health Services, Inc. Supplemental Executive Retirement Plan effective as of July 1, 1997, dated as of July 7, 1997, incorporated by reference to Exhibit 10.4 to the Registrant's Quarterly Report on Form 10-Q for the fiscal quarter ended June 30, 1997. (14) Sierra Health Services, Inc. Supplemental Executive Retirement Plan effective as of March 1, 1998, incorporated by reference to Exhibit 10 to the Registrant's Quarterly Report on Form 10-Q for the fiscal quarter ended March 31, 1998. (15) The Registrant's Second Amended and Restated 1986 Stock Option Plan as amended to date, incorporated by reference to Exhibit 10.24 to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1992. (16) The Registrant's Second Restated Capital Accumulation Plan, as amended to date, incorporated by reference to Exhibit 10.24 to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1992. (17) Protocols for cash bonus awards, incorporated by reference to Exhibit 10.17 (5) to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1994. (18) Sierra Health Services, Inc. 1995 Long-Term Incentive Plan, as amended and restated through May 18, 1998, incorporated by reference to Exhibit 10.4 to the Registrant's Quarterly Report on Form 10-Q for the fiscal quarter ended June 30, 1998. 65 (19) Sierra Health Services, Inc. 1995 Non-Employee Directors' Stock Plan, as amended and restated through May 18, 1998, incorporated by reference to Exhibit 10.5 to the Registrant's Quarterly Report on Form 10-Q for the fiscal quarter ended June 30, 1998. (10.8) Agreement and Plan of Merger dated as of June 12, 1995 among the Registrant, Health Acquisition Corp., and CII Financial, Inc., incorporated by reference to the Report on Form 8-K dated June 13, 1995, as amended. (10.9) Loan Agreement dated August 11, 1997 between the Company and Anthony M. Marlon for a revolving credit facility in the maximum aggregate amount of $3,000,000, incorporated by reference to the Registrant's Quarterly Report on Form 10-Q for the fiscal quarter ended September 30, 1997. (10.10) Master Purchase and Sale Agreement between Kaiser Foundation Health Plan of Texas (as Seller) and HMO Texas, L.C. (as Buyer), dated June 5, 1998, incorporated by reference to Exhibit 10.1 to the Registrant's Quarterly Report on Form 10-Q for the fiscal quarter ended June 30, 1998.* (10.11) Asset Sale and Purchase Agreement between Kaiser Foundation Health Plan of Texas, A Texas Non-Profit Corporation and HMO Texas, L.C., a Texas Limited Liability Company, dated June 5, 1998, incorporated by reference to Exhibit 10.2 to the Registrant's Quarterly Report on Form 10-Q for the fiscal quarter ended June 30, 1998.* (10.12) Asset Sale and Purchase Agreement between Permanente Medical Association of Texas, a Texas Professional Association and HMO Texas, L.C., a Texas Limited Liability Company, dated June 5, 1998, incorporated by reference to Exhibit 10.3 to the Registrant's Quarterly Report on Form 10-Q for the fiscal quarter ended June 30, 1998.* (10.13) Amendment No. 2 to Asset Sale and Purchase Agreement between Kaiser Foundation Health Plan of Texas and Texas Health Choice, L.C. (formerly HMO Texas, L.C.)* 66 (21) Subsidiaries of the Registrant (listed herein): There is no parent of the Registrant. The following is a listing of the active subsidiaries of the Registrant: Jurisdiction of Incorporation Sierra Health and Life Insurance Company, Inc. California Health Plan of Nevada, Inc. Nevada Sierra Healthcare Options, Inc. and Subsidiary Nevada Behavioral Healthcare Options, Inc. Nevada Family Health Care Services Nevada Family Home Hospice, Inc. Nevada Southwest Medical Associates, Inc. Nevada Sierra Medical Management, Inc. and Subsidiaries Nevada Southwest Realty, Inc. Nevada Sierra Health Holdings, Inc. (Texas Health Choice, L.C.) Texas Sierra Texas Systems, Inc. Texas CII Financial, Inc., and Subsidiaries California Northern Nevada Health Network, Inc. Nevada Intermed, Inc. Arizona Prime Holdings, Inc. and Subsidiaries Nevada Sierra Military Health Services, Inc. Nevada Sierra Home Medical Products, Inc. Nevada Nevada Administrators, Inc. Nevada MedOne Health Plan, Inc. Nevada (23.1) Consent of Deloitte & Touche LLP (27.1) Financial Data Schedule - 1998 (99) Registrant's current report on Form 8-K dated March 17, 1999, incorporated herein. All other Exhibits are omitted because they are not applicable. (b) Reports on Form 8-K The Company filed a Current Report on Form 8-K, dated November 11, 1998, with the Securities and Exchange Commission to present pro forma financial information related to the acquisition of Kaiser-Texas and the required financial statements. (d) Financial Statement Schedules The Exhibits set forth in Item 14 (a)(2) are filed herewith. *The agreements contain certain schedules and exhibits which were not included in this filing. The Company will furnish supplementally a copy of any omitted schedule or exhibit to the Commission upon request. 67 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has caused this report to be signed on its behalf by the undersigned thereto duly authorized. SIERRA HEALTH SERVICES, INC. By: /S/ ANTHONY M. MARLON Anthony M. Marlon, M.D. Date: March 17, 1999 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
Signature Title Date /S/ ANTHONY M. MARLON, M.D. Chief Executive Officer March 17, 1999 Anthony M. Marlon, M.D. and Chairman of the Board (Chief Executive Officer) /S/ PAUL H. PALMER Vice President of Finance, March 17, 1999 Paul H. Palmer Chief Financial Officer, and Treasurer (Chief Accounting Officer) /S/ ERIN E. MACDONALD President and March 17, 1999 Erin E. MacDonald Chief Operating Officer Director /S/ CHARLES L. RUTHE Director March 17, 1999 Charles L. Ruthe /S/ WILLIAM J. RAGGIO Director March 17, 1999 William J. Raggio /S/ THOMAS Y. HARTLEY Director March 17, 1999 Thomas Y. Hartley
68 SIERRA HEALTH SERVICES, INC. AND SUBSIDIARIES SCHEDULE I - CONDENSED FINANCIAL INFORMATION OF REGISTRANT CONDENSED BALANCE SHEETS - Parent Company Only
December 31, 1998 1997 CURRENT ASSETS: Cash and Cash Equivalents .......................................... $ 7,945,000 $ 15,115,000 Short-term Investments.............................................. 2,831,000 2,090,000 Prepaid Expenses and Other Current Assets........................... 9,189,000 10,415,000 Total Current Assets.......................................... 19,965,000 27,620,000 PROPERTY AND EQUIPMENT - NET ............................................ 45,699,000 55,251,000 EQUITY IN NET ASSETS OF SUBSIDIARIES .................................... 375,910,000 204,204,000 NOTES RECEIVABLE FROM SUBSIDIARIES ...................................... 9,677,000 9,744,000 LONG-TERM INVESTMENTS ................................................... 1,088,000 86,000 GOODWILL AND OTHER INTANGIBLE ASSETS .................................... 2,275,000 2,362,000 OTHER ................................................................... 30,817,000 24,081,000 TOTAL ASSETS ............................................................ $485,431,000 $323,348,000 CURRENT LIABILITIES: Accounts Payable and Other Accrued Liabilities ..................... $ 24,422,000 $ 16,757,000 Current Portion of Long-term Debt .................................. 393,000 2,349,000 Total Current Liabilities .................................... 24,815,000 19,106,000 LONG-TERM DEBT (Less Current Portion).................................... 139,429,000 25,858,000 OTHER LIABILITIES ....................................................... 17,473,000 12,702,000 TOTAL LIABILITIES ....................................................... 181,717,000 57,666,000 STOCKHOLDERS' EQUITY: Capital Stock ...................................................... 141,000 139,000 Additional Paid-in Capital ......................................... 173,583,000 164,247,000 Treasury Stock ..................................................... (14,821,000) (5,601,000) Accumulated Other Comprehensive Income: Unrealized Holding (Loss) on Available-for-sale Investments ............................................. (1,027,000) 655,000 Retained Earnings .................................................. 145,838,000 106,242,000 Total Stockholders' Equity ................................... 303,714,000 265,682,000 TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY............................... $485,431,000 $323,348,000
Note:Scheduled maturities of long-term debt, including the principal portion of obligations under capital leases, are as follows:
Year Ending December 31, 1999........................................................... $ 393,000 2000........................................................... 429,000 2001........................................................... -- 2002........................................................... -- 2003 .......................................................... 139,000,000 Thereafter..................................................... -- Total...................................................... $139,822,000
S-1 SIERRA HEALTH SERVICES, INC. AND SUBSIDIARIES SCHEDULE I - CONDENSED FINANCIAL INFORMATION OF REGISTRANT (Continued) CONDENSED STATEMENT OF OPERATIONS - Parent Company Only
Year Ended December 31, 1998 1997 1996 OPERATING REVENUES: Management Fees........................................ $52,773,000 $47,303,000 $44,139,000 Subsidiary Dividends................................... 4,085,000 1,700,000 3,733,000 Investment and Other Income............................ 5,564,000 6,688,000 5,145,000 Total Operating Revenues............................ 62,422,000 55,691,000 53,017,000 GENERAL AND ADMINISTRATIVE EXPENSES: Payroll and Benefits................................... 22,238,000 17,616,000 11,579,000 Depreciation........................................... 5,329,000 3,707,000 3,433,000 Data Processing Maintenance............................ 2,556,000 2,370,000 1,115,000 Rent................................................... 620,000 615,000 649,000 Repairs and Maintenance................................ 879,000 459,000 408,000 Legal.................................................. 691,000 293,000 1,874,000 Consulting............................................. 1,242,000 769,000 827,000 Other.................................................. 6,489,000 4,677,000 4,030,000 Integration, Settlement and Other Costs ..... ......... 4,569,000 29,350,000 12,064,000 Total General and Administrative.................... 44,613,000 59,856,000 35,979,000 INTEREST EXPENSE AND OTHER, NET............................ (2,566,000) (676,000) (503,000) EQUITY IN UNDISTRIBUTED EARNINGS OF SUBSIDIARIES............................... 28,364,000 25,615,000 21,991,000 INCOME BEFORE INCOME TAXES................................. 43,607,000 20,774,000 38,526,000 (PROVISION FOR) BENEFIT FROM INCOME TAXES.......................................... (4,011,000) 3,467,000 (7,383,000) NET INCOME................................................. $39,596,000 $24,241,000 $31,143,000
S-2 SIERRA HEALTH SERVICES, INC. AND SUBSIDIARIES SCHEDULE I - CONDENSED FINANCIAL INFORMATION OF REGISTRANT (Continued) CONDENSED STATEMENTS OF CASH FLOWS - Parent Company Only
Year Ended December 31, 1998 1997 1996 CASH FLOWS FROM OPERATING ACTIVITIES: Net Income........................................................... $39,596,000 $24,241,000 $31,143,000 Adjustments to Reconcile Net Income to Net Cash Provided by Operating Activities: Depreciation and Amortization.................................... 5,416,000 3,885,000 3,611,000 Equity in Undistributed Earnings of Subsidiaries..................... (28,364,000) (25,615,000) (21,991,000) Change in Assets and Liabilities: Other Assets..................................................... (6,890,000) (1,177,000) (15,917,000) Current Assets................................................... 1,192,000 (2,312,000) (5,959,000) Current Liabilities.............................................. 8,949,000 5,493,000 4,712,000 Other Long-term Liabilities ..................................... 4,770,000 6,634,000 6,069,000 Net Cash Provided by Operating Activities........................ 24,669,000 11,149,000 1,668,000 CASH FLOWS FROM INVESTING ACTIVITIES: Capital Expenditures, Net ........................................... (22,294,000) (26,453,000) (9,292,000) (Increase) Decrease in Short-term Securities......................... (606,000) 9,732,000 14,136,000 (Increase) Decrease in Other Assets.................................. (886,000) 5,820,000 6,942,000 Dividends from Subsidiary............................................ 4,085,000 1,700,000 3,733,000 Acquisitions, Net of Cash Acquired .................................. (7,500,000) (3,145,000) (31,270,000) Dispositions, Net of Cash Disposed .................................. 1,373,000 (Increase) Decrease in Net Assets in Subsidiaries................... (125,488,000) (30,816,000) 14,321,000 Net Cash Used for Investing Activities .......................... (151,316,000) (43,162,000) (1,430,000) CASH FLOWS FROM FINANCING ACTIVITIES: Proceeds from Long-term Borrowing ................................... 166,000,000 25,000,000 Reductions in Long-term Obligations and Payments on Capital Leases....................................... (45,424,000) (480,000) (718,000) Proceeds from Note Receivable to Subsidiary.......................... 67,000 60,000 2,789,000 Purchase of Treasury Stock .......................................... (9,220,000) (5,471,000) Exercise of Stock in Connection with Stock Plans..................... 8,054,000 10,258,000 3,638,000 Net Cash Provided by Financing Activities........................ 119,477,000 29,367,000 5,709,000 Net (Decrease) Increase in Cash and Cash Equivalents....................... (7,170,000) (2,646,000) 5,947,000 Cash and Cash Equivalents at Beginning of Year............................. 15,115,000 17,761,000 11,814,000 Cash and Cash Equivalents at End of Year................................... $ 7,945,000 $15,115,000 $17,761,000 Supplemental condensed statements of cash flows information: Cash Paid During the Year for Interest (Net of Amount Capitalized).......................................... $ 2,030,000 $ 632,000 $ 443,000 Cash Paid During the Year for Income Taxes................................. 14,788,000 7,916,000 6,423,000 Noncash Investing and Financing Activities: Stock Issued for Exercise of Options and Related Tax Benefits......................................... 1,284,000 2,004,000 1,158,000 Liabilities Assumed in Connection with Corporate Acquisition....................................... 1,233,000
S-3 SIERRA HEALTH SERVICES, INC. SUPPLEMENTAL INFORMATION CONCERNING PROPERTY - CASUALTY INSURANCE (amounts in thousands)
Gross Reserves Deferred for Unpaid Policy Claims and Discount if any Gross Net Acquisition Adjustment Deducted in Unearned Earned Investment Affiliation With Costs Expenses Column C Premiums Premiums Income Registrant Column A Column B Column C Column D Column E Column F Column G Consolidated Property and Casualty Entities of CII Financial, Inc. for Years Ended: December 31, 1998........ $1,804 $212,263 -- $11,158 $154,104 $18,241 December 31, 1997........ 1,800 202,699 -- 11,285 134,262 16,780 December 31, 1996........ 1,832 187,776 -- 9,885 126,121 16,422
Table continued on next page SIERRA HEALTH SERVICES, INC. SUPPLEMENTAL INFORMATION CONCERNING PROPERTY - CASUALTY INSURANCE (amounts in thousands)
Claims & Claim Adjustment Amortization Expenses Incurred of Deferred Paid Claims Related to Policy and Claims Direct (1) (2) Acquisition Adjustment Premiums Affiliation With Current Prior Year Costs Expenses Written Registrant Column A Year Column H Column I Column J Column K Consolidated Property and Casualty Entities of CII Financial, Inc. for Years Ended: December 31, 1998........ $103,990 $(9,643) $28,243 $101,524 $153,914 December 31, 1997........ 102,301 (8,970) 26,211 83,788 135,580 December 31, 1996........ 101,401 (15,284) 21,968 70,464 126,497
S-4 SIERRA HEALTH SERVICES, INC. AND SUBSIDIARIES SECTION 403.04b RECONCILIATION OF BEGINNING AND ENDING LOSS AND LOSS ADJUSTMENT EXPENSE RESERVES AND EXHIBIT OF REDUNDANCIES (DEFICIENCIES) (in thousands) Year ended December 31
1998 1997 1996 1995 1994 1993 1992 1991 1990 1989 Losses and LAE Reserve............... $212,263 $202,699 $187,776 $182,318 $190,962 $200,356 $178,460 $112,749 $ 67,593 $ 37,466 Less Reinsurance Recoverables (1)...... 37,797 21,056 15,676 25,871 29,342 25,841 20,207 Net Loss and LAE Reserves ............. 174,466 181,643 172,100 156,447 161,620 174,515 158,253 Cumulative Net Paid as of: One Year Later ....... 71,933 56,977 45,731 44,519 50,210 50,360 57,611 39,118 14,820 Two Years Later ...... 91,765 70,854 68,619 79,788 84,465 89,177 65,165 28,657 Three Years Later .... 83,674 80,645 94,865 104,569 108,849 76,988 36,579 Four Years Later ..... 86,381 102,395 114,293 120,539 83,822 39,345 Five Years Later ..... 106,012 119,462 126,100 87,618 41,043 Six Years Later ...... 122,000 129,060 89,607 41,962 Seven Years Later .... 130,649 90,721 42,541 Eight Years Later .... 91,354 42,818 Nine Years Later ..... 43,054 Net Reserve Re-estimated as of: One Year Later ....... 172,000 163,130 141,163 139,741 160,562 154,388 140,815 83,841 37,463 Two Years Later ...... 146,987 132,193 125,279 141,100 147,167 142,447 96,011 39,753 Three Years Later .... 113,766 117,792 126,483 134,747 143,433 97,142 43,528 Four Years Later ..... 102,955 122,517 132,193 137,143 97,942 44,404 Five Years Later ..... 114,443 131,112 135,249 94,852 45,027 Six Years Later ...... 127,258 135,299 93,561 44,543 Seven Years Later .... 133,729 93,672 43,741 Eight Years Later .... 92,851 43,682 Nine Years Later ..... 43,682 Cumulative Redundancy (Deficiency) ......... 9,643 25,113 42,681 58,665 60,072 30,995 (20,980) (25,258) (6,216) Net Reserve.............. 174,466 181,643 172,100 156,447 161,620 174,515 Reinsurance Recoverables...... 37,797 21,056 15,676 25,871 29,342 25,841 Gross Reserve ......... $212,263 202,699 187,776 182,318 190,962 200,356 Net Re-estimated Reserve ..... 172,000 146,987 113,766 102,955 114,443 Re-estimated Reinsurance Recoverables ......... 17,856 14,154 15,000 14,502 12,523 Gross Re-Estimated Reserve .............. 189,856 161,141 128,766 117,457 126,966 Gross Cumulative Redundancy............ $ 12,843 $ 26,635 $ 53,552 $ 73,505 $ 73,390
(1) Amounts reflect reinsurance recoverable under prospective reinsurance contracts only. The Company adopted Financial Accounting Standards Board Statement No. 113 ("FAS 113"), "Accounting and Reporting for Short-Duration and Long-Duration Reinsurance Contracts" for the year ended December 31, 1992. As permitted, prior financial statements have not been restated. Reinsurance recoverables on unpaid losses and LAE are shown as an asset on the balance sheets at December 31, 1998 and 1997. However, for purposes of the reconciliation and development tables, loss and LAE information are shown net of reinsurance. See the notes to consolidated financial statements. S-5 EX-10 2 EXHIBIT 10.4 CREDIT AGREEMENT Dated as of October 30, 1998 among SIERRA HEALTH SERVICES, INC., as Borrower, BANK OF AMERICA NATIONAL TRUST AND SAVINGS ASSOCIATION, as Administrative Agent and Issuing Bank, FIRST UNION NATIONAL BANK, as Syndication Agent, and THE OTHER FINANCIAL INSTITUTIONS PARTY HERETO Lead Arranger: NATIONSBANC MONTGOMERY SECURITIES LLC TABLE OF CONTENTS
Section Page ARTICLE I DEFINITIONS.....................................................................................................1 1.01 Certain Defined Terms.....................................................................................1 1.02 Other Interpretive Provisions............................................................................24 1.03 Accounting Principles....................................................................................25 ARTICLE II THE CREDITS....................................................................................................26 2.01 Amounts and Terms of Commitments.........................................................................26 2.02 Loan Accounts............................................................................................26 2.03 Procedure for Borrowing..................................................................................27 2.04 Conversion and Continuation Elections....................................................................28 2.05 Voluntary Termination or Reduction of Commitments........................................................29 2.06 Optional Prepayments.....................................................................................30 2.07 Mandatory Prepayments of Loans; Mandatory Commitment Reductions and Repayments.........................................................................30 2.09 Interest.................................................................................................33 2.10 Fees ..................................................................................................34 (a) Agents' Fees..............................................................................34 (b) Commitment Fees...........................................................................34 2.11 Computation of Fees and Interest.........................................................................34 2.12 Payments by the Company..................................................................................35 2.13 Payments by the Banks to the Agent.......................................................................35 2.14 Sharing of Payments, Etc.................................................................................36 2.15 Security.................................................................................................37 ARTICLE III THE LETTERS OF CREDIT..........................................................................................37 3.01 The Letter of Credit Subfacility.........................................................................37 3.02 Issuance, Amendment and Renewal of Letters of Credit.....................................................38 3.03 Existing BofA Letters of Credit; Risk Participations, Drawings and Reimbursements.......................................................................41 3.04 Repayment of Participations..............................................................................43 3.05 Role of the Issuing Bank.................................................................................44 3.06 Obligations Absolute.....................................................................................44 3.07 Cash Collateral Pledge...................................................................................46 3.08 Letter of Credit Fees....................................................................................46 3.09 Uniform Customs and Practice.............................................................................46 ARTICLE IV TAXES, YIELD PROTECTION AND ILLEGALITY.........................................................................47 4.01 Taxes ..................................................................................................47 4.02 Illegality...............................................................................................48 4.03 Increased Costs and Reduction of Return..................................................................49 4.04 Funding Losses...........................................................................................50 4.05 Inability to Determine Rates.............................................................................50 4.06 Certificates of Banks....................................................................................51
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Section Page 4.07 Substitution of Banks....................................................................................51 4.08 Survival.................................................................................................51 ARTICLE V CONDITIONS PRECEDENT...........................................................................................51 5.01 Conditions of Initial Credit Extensions..................................................................51 (a) Credit Agreement and Notes................................................................52 (b) Resolutions; Incumbency...................................................................52 (c) Organization Documents; Good Standing.....................................................52 (d) Legal Opinions............................................................................52 (e) Payment of Fees...........................................................................52 (f) Certificate...............................................................................53 (g) Collateral Documents......................................................................53 (h) Regulatory Compliance.....................................................................54 (i) Prior Credit Agreement....................................................................54 (j) Kaiser Acquisition Agreements.............................................................54 (k) Litigation................................................................................55 (l) Financial Covenant Certificate............................................................55 (m) Other Documents...........................................................................55 5.02 Conditions to All Credit Extensions......................................................................55 (a) Notice, Application.......................................................................55 (b) Continuation of Representations and Warranties............................................56 (c) No Existing Default.......................................................................56 ARTICLE VI REPRESENTATIONS AND WARRANTIES.................................................................................56 6.01 Corporate Existence and Power............................................................................56 6.02 Corporate Authorization; No Contravention................................................................57 6.03 Authorization, Approval, etc.............................................................................57 6.04 Binding Effect...........................................................................................58 6.05 Litigation...............................................................................................58 6.06 No Default...............................................................................................58 6.07 Compliance with Laws and ERISA...........................................................................58 6.08 Use of Proceeds; Margin Regulations......................................................................60 6.09 Title to Property and Collateral; No Liens...............................................................60 6.10 As to Pledged Shares.....................................................................................60 6.11 Taxes ..................................................................................................60 6.12 Financial Condition......................................................................................60 6.13 Environmental Matters....................................................................................61 6.14 Collateral Documents.....................................................................................62 6.15 Regulated Entities.......................................................................................62 6.16 No Burdensome Restrictions...............................................................................62 6.17 Copyrights, Patents, Trademarks and Licenses, etc........................................................62 6.18 Subsidiaries.............................................................................................63 6.19 Insurance................................................................................................63 6.20 Swap Obligations.........................................................................................63 6.21 Full Disclosure..........................................................................................63 6.22 Business Activity........................................................................................63 6.23 Licensing, Etc...........................................................................................63
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Section Page 6.24 Kaiser Acquisition Agreements.............................................................................64 6.25 Year 2000 Representation.................................................................................64 ARTICLE VII AFFIRMATIVE COVENANTS..........................................................................................65 7.01 Financial Statements.....................................................................................65 7.02 Certificates; Other Information..........................................................................66 7.03 Notices..................................................................................................67 7.04 Preservation of Corporate Existence, Etc.................................................................68 7.05 Maintenance of Property..................................................................................68 7.06 Insurance................................................................................................68 7.07 Payment of Obligations...................................................................................69 7.08 Compliance with Laws.....................................................................................69 7.09 Compliance with ERISA....................................................................................69 7.10 Inspection of Property and Books and Records.............................................................70 7.11 Environmental Laws.......................................................................................70 7.12 Use of Proceeds..........................................................................................70 7.13 Further Assurances.......................................................................................70 7.14 Dividends of Subsidiaries During Default.................................................................71 7.15 Acquisitions.............................................................................................71 ARTICLE VIII NEGATIVE COVENANTS.............................................................................................72 8.01 Limitation on Liens......................................................................................72 8.02 Disposition of Assets....................................................................................74 8.03 Consolidations and Mergers...............................................................................74 8.04 Loans and Investments....................................................................................75 8.05 Limitation on Indebtedness...............................................................................76 8.06 Transactions with Affiliates.............................................................................76 8.07 Use of Proceeds..........................................................................................77 8.08 Contingent Obligations...................................................................................77 8.09 Lease Obligations........................................................................................77 8.10 Restricted Payments......................................................................................78 8.11 ERISA ..................................................................................................79 8.12 Change in Business.......................................................................................79 8.13 Accounting Changes.......................................................................................79 8.14 Financial Covenants......................................................................................79 8.15 Limitation on Payment Restrictions Affecting Subsidiaries......................................................................................80 8.16 Pledged Shares...........................................................................................80 8.17 Acquisitions.............................................................................................81 ARTICLE IX EVENTS OF DEFAULT..............................................................................................81 9.01 Event of Default.........................................................................................81 (a) Non-Payment...............................................................................81 (b) Representation or Warranty................................................................82 (c) Specific Defaults.........................................................................82 (d) Other Defaults............................................................................82
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Section Page (e) Cross-Default.............................................................................82 (f) Insolvency; Voluntary Proceedings.........................................................82 (g) Involuntary Proceedings...................................................................83 (h) ERISA.....................................................................................83 (i) Monetary Judgments........................................................................83 (j) Non-Monetary Judgments....................................................................83 (k) Change of Control.........................................................................83 (l) Loss of Licenses..........................................................................84 (m) HMO Event.................................................................................84 (n) Prospective Premium Default...............................................................84 (o) Adverse Change............................................................................84 (p) Invalidity of Subordination Provisions....................................................84 9.02 Remedies.................................................................................................84 9.03 Rights Not Exclusive.....................................................................................85 ARTICLE X THE AGENT......................................................................................................85 10.01 Appointment and Authorization; "Agent"..................................................................85 10.02 Delegation of Duties....................................................................................86 10.03 Liability of Agent......................................................................................86 10.04 Reliance by Agent.......................................................................................87 10.05 Notice of Default.......................................................................................87 10.06 Credit Decision.........................................................................................88 10.07 Indemnification of Agent................................................................................88 10.08 Agent in Individual Capacity............................................................................89 10.09 Successor Agent.........................................................................................89 10.10 Withholding Tax.........................................................................................90 10.11 Syndication Agent.......................................................................................91 ARTICLE XI MISCELLANEOUS..................................................................................................91 11.01 Amendments and Waivers..................................................................................91 11.02 Notices.................................................................................................92 11.03 No Waiver; Cumulative Remedies..........................................................................93 11.04 Costs and Expenses......................................................................................93 11.05 Company Indemnification.................................................................................94 11.06 Payments Set Aside......................................................................................95 11.07 Successors and Assigns..................................................................................95 11.08 Assignments, Participations, etc........................................................................95 11.09 Set-off.................................................................................................97 11.10 Automatic Debits of Fees................................................................................97 11.11 Notification of Addresses, Lending Offices, Etc.........................................................98 11.12 Counterparts............................................................................................98 11.13 Severability............................................................................................98 11.14 No Third Parties Benefited..............................................................................98 11.15 Governing Law and Jurisdiction..........................................................................98 11.16 Waiver of Jury Trial....................................................................................99 11.17 Entire Agreement.......................................................................................100
-iv- SCHEDULES Schedule 1.01 Specified Charges Schedule 2.01 Commitments Schedule 3.03 Existing BofA Letters of Credit Schedule 5.01(g) Excluded Subsidiaries Schedule 6.03 Required Approvals Schedule 6.05 Litigation Schedule 6.12 Permitted Liabilities Schedule 6.13 Environmental Matters Schedule 6.18 Subsidiaries and Minority Interests Schedule 6.19 Insurance Matters Schedule 8.01 Permitted Liens Schedule 8.04 Existing Investments Schedule 8.05 Permitted Indebtedness Schedule 8.08 Contingent Obligations Schedule 8.17 Permitted Acquisitions Schedule 11.02 Lending Offices; Addresses for Notices EXHIBITS Exhibit A Form of Notice of Borrowing Exhibit B Form of Notice of Conversion/Continuation Exhibit C Form of Compliance Certificate Exhibit D Form of Legal Opinion of Company's Counsel Exhibit E Form of Assignment and Acceptance Exhibit F Form of Promissory Note Exhibit G Form of Pledge Agreement Exhibit H Form of Kaiser Note Exhibit I Form of Joinder Agreement -v- CREDIT AGREEMENT This CREDIT AGREEMENT is entered into as of October 30, 1998, among SIERRA HEALTH SERVICES, INC., a Nevada corporation (the "Company"), the several financial institutions from time to time party to this Agreement (collectively, the "Banks"; individually, a "Bank"), Bank of America National Trust and Savings Association, as Issuing Bank and as administrative agent for the Banks and First Union National Bank, as syndication agent. WHEREAS, the Banks have agreed to make available to the Company a revolving credit facility with letter of credit subfacility upon the terms and conditions set forth in this Agreement; NOW, THEREFORE, in consideration of the mutual agreements, provisions and covenants contained herein, the parties agree as follows: ARTICLE I DEFINITIONS 1.01 Certain Defined Terms. The following terms have the following meanings: "Acquisition" means any transaction or series of related transactions for the purpose of or resulting, directly or indirectly, in (a)the acquisition of all or substantially all of the assets of a Person, or of any business or division of a Person, (b)the acquisition of in excess of 50% of the capital stock, partnership interests, membership interests or equity of any Person, or otherwise causing any Person to become a Subsidiary, or (c)a merger or consolidation or any other combination with another Person (other than a Person that is a Subsidiary) provided that the Company or the Subsidiary is the surviving entity. "Actual Knowledge" shall mean, as to any matter with respect to any Person, the actual knowledge of such matter by a Responsible Officer of such Person, it being understood in any event that "actual knowledge" shall be deemed to exist upon receipt of a notice of such matter by a Responsible Officer. "Affiliate" means, as to any Person, any other Person which, directly or indirectly, is in control of, is controlled by, or is under common control with, such Person. A Person shall be deemed to control another Person if the controlling Person possesses, directly or indirectly, the power to direct or cause the direction of the management and policies of the other Person, 1 whether through the ownership of voting securities, membership interests, by contract, or otherwise. "Agent" means BofA in its capacity as agent for the Banks hereunder, and any successor agent arising under Section 10.09. "Agent-Related Persons" means BofA and any successor agent arising under Section 10.09 and any successor letter of credit issuing bank hereunder, together with their respective Affiliates (including, in the case of BofA, the Arranger), and the officers, directors, employees, agents and attorneys-in-fact of such Persons and Affiliates. "Agent's Payment Office" means the address for payments set forth on Schedule 11.02 or such other address as the Agent may from time to time specify. "Agreement" means this Credit Agreement. "Applicable Regulatory Requirements" refers to any requisite filing or approval requirements of any state insurance regulatory authorities having jurisdiction over any of the Subsidiaries that must be satisfied or obtained by the Agent or the Lender Parties as a condition to exercising or transferring direct or indirect voting or other control over such Subsidiaries or transferring or otherwise disposing of the Pledged Shares, Pledged Property or Collateral with respect to such Subsidiaries. "Applicable Commitment Fee Rate" means a rate per annum determined by reference to the Leverage Ratio as follows:
Applicable Level Leverage Ratio Commitment Fee Rate Level 1 Less than or equal to 1.50 0.300% Level 2 Greater than 1.50 but less than or equal to 2.00 0.350% Level 3 Greater than 2.00 but less than or equal to 2.50 0.350% Level 4 Greater than 2.50 but less than or equal to 3.00 0.450% Level 5 Greater than 3.00 but less than or equal to 3.50 0.450% Level 6 Greater than 3.50 0.500%
From the Closing Date until the delivery of the Compliance Certificate for the fiscal quarter ending June 30, 1999, the Applicable Commitment Fee Rate shall be Level 5. Thereafter, the Applicable Commitment Fee Rate shall be effective from and including the date on which the Agent receives a Compliance Certificate to but excluding the date on which the Agent receives the next Compliance Certificate; provided, however, that if the 2 Agent does not receive a Compliance Certificate by the date required by subsection 7.02(b), the Applicable Commitment Fee Rate shall, effective as of such date, be Level 6 to but excluding the date the Agent receives such Compliance Certificate. "Applicable Letter of Credit Fee Rate" means a rate per annum equal to the Applicable Margin for LIBOR Rate Loans. "Applicable Margin" means in the case of Base Rate Loans and LIBOR Rate Loans a rate per annum determined by reference to the Leverage Ratio as follows:
Applicable Applicable LIBOR Base Level Leverage Ratio Rate Margin Rate Margin Level 1 Less than or equal to 1.50 1.000% 0.000% Level 2 Greater than 1.50 but less than or equal to 2.00 1.250% 0.250% Level 3 Greater than 2.00 but less than or equal to 2.50 1.625% 0.625% Level 4 Greater than 2.50 but less than or equal to 3.00 1.875% 0.875% Level 5 Greater than 3.00 but less than or equal to 3.50 2.125% 1.125% Level 6 Greater than 3.50 2.375% 1.375%
From the Closing Date until the delivery of the Compliance Certificate for the fiscal quarter ending June 30, 1999, the Applicable Margin shall be Level 5. Thereafter, the Applicable Margin shall be effective from and including the date on which the Agent receives a Compliance Certificate to but excluding the date on which the Agent receives the next Compliance Certificate; provided, however, that if the Agent does not receive a Compliance Certificate by the date required by subsection 7.02(b), the Applicable Margin shall, effective as of such date, be Level 6 to but excluding the date the Agent receives such Compliance Certificate. "Assignee" has the meaning specified in subsection 11.08(a). "Attorney Costs" means and includes all reasonable fees and disbursements of any law firm or other external counsel, the allocated reasonable cost of internal legal services and all disbursements of internal counsel. "Bank" has the meaning specified in the introductory clause hereto. References to the "Banks" shall include BofA, and shall 3 include any Bank acting in its capacity as Issuing Bank; for purposes of clarification only, to the extent that a Bank may have any rights or obligations in addition to those of the Banks due to its status as Issuing Bank, its status as such will be specifically referenced. "Bankruptcy Code" means the Federal Bankruptcy Reform Act of 1978 (11 U.S.C. Section 101, et seq.), as amended. "Base Rate" means, for any day, the higher of: (a) 0.50% per annum above the latest Federal Funds Rate; and (b)the rate of interest in effect for such day as publicly announced from time to time by BofA in San Francisco, California, as its "reference rate." (The "reference rate" is a rate set by BofA based upon various factors including BofA's costs and desired return, general economic conditions and other factors, and is used as a reference point for pricing some loans, which may be priced at, above, or below such announced rate.) Any change in the reference rate announced by BofA shall take effect at the opening of business on the day specified in the public announcement of such change. "Base Rate Loan" means a Revolving Loan, or an L/C Advance, that bears interest based on the Base Rate. "BofA" means Bank of America National Trust and Savings Association, a national banking association. "Borrowing" means a borrowing hereunder consisting of Revolving Loans of the same Type made to the Company on the same day by the Banks under Article II, and, other than in the case of Base Rate Loans, having the same Interest Period. Borrowing Date means any date on which a Borrowing occurs under Section 2.03. "Business Day" means any day other than a Saturday, Sunday or other day on which commercial banks in San Francisco are authorized or required by law to close and, if the applicable Business Day relates to any LIBOR Rate Loan, means such a day on which dealings are carried on in the applicable offshore dollar interbank market. "Capital Adequacy Regulation" means any guideline, request or directive of any central bank or other Governmental Authority, or any other law, rule or regulation, whether or not having the force of law, in each case, regarding capital adequacy of any bank or of any corporation controlling a bank. 4 "Capital Expenditures" means, for any period, the aggregate amount of all expenditures of the Company and its Subsidiaries for fixed or capital assets made during such period which, in accordance with GAAP, would be classified as capital expenditures. "Capital Lease" means any lease of property which in accordance with GAAP should be capitalized on the lessee's balance sheet or disclosed in a footnote thereto as a capitalized lease. "Cash Collateralize" means to pledge and deposit with or deliver to the Agent, for the benefit of the Agent, the Issuing Bank and the Banks, as additional collateral for the L/C Obligations, cash or deposit account balances pursuant to documentation in form and substance satisfactory to the Agent and the Issuing Bank (which documents are hereby consented to by the Banks). Derivatives of such term shall have corresponding meaning. The Company shall grant to the Agent, for the benefit of the Agent, the Issuing Bank and the Banks, a security interest in all such cash and deposit account balances. Cash collateral shall be maintained in blocked deposit accounts at BofA. "Change of Control" shall be deemed to have occurred if any Person or group (as defined in Section 13(d)(3) of the Exchange Act) acquires (beneficially or of record) 25% or more of the voting or economic interests in the fully diluted capital stock of the Company. "CII" means CII Financial, Inc., a wholly-owned Subsidiary of the Company. "Closing Date" means the date on or before November 30, 1998 on which all conditions precedent set forth in Section 5.01 are satisfied or waived by all Banks (or, in the case of subsection 5.01(e), waived by the Person entitled to receive such payment). "Code" means the Internal Revenue Code of 1986, and regulations promulgated thereunder. "Collateral" means all property and interests in property and proceeds thereof now owned or hereafter acquired by the Company and its Subsidiaries in or upon which a Lien now or hereafter exists in favor of the Banks, or the Agent on behalf of the Banks, whether under this Agreement or under any other documents executed by any such Person and delivered to the Agent or the Banks. 5 "Collateral Documents" means, collectively, (i)the Pledge Agreements and all other security agreements, mortgages, deeds of trust, patent and trademark assignments, lease assignments, guarantees and other similar agreements between the Company or any Subsidiary and the Banks or the Agent for the benefit of the Banks now or hereafter delivered to the Banks or the Agent pursuant to or in connection with the transactions contemplated hereby, and all financing statements (or comparable documents now or hereafter filed in accordance with the Uniform Commercial Code or comparable law) against the Company or any Subsidiary as debtor in favor of the Banks or the Agent for the benefit of the Banks as secured party, and (ii) any amendments, supplements, modifications, renewals, replacements, consolidations, substitutions and extensions of any of the foregoing. "Commitment", as to each Bank, has the meaning specified in Section 2.01. "Commitment Increase Date" has the meaning specified in Section 2.08. "Company" has the meaning specified in the introductory clause hereto. "Compliance Certificate" means a certificate substantially in the form of Exhibit C. "Consolidated Adjusted EBITDA" means, for any period, the Sierra Adjusted EBITDA plus the Kaiser-Texas Modified EBITDA. Consolidated Adjusted EBITDA shall be calculated as of the last day of the most recently ended fiscal quarter of the Company for the period of four consecutive full fiscal quarters then ended. "Consolidated Funded Debt" means, as of any date, when used with reference to any Person, without duplication, (i) Indebtedness of such Person which by its terms matures in, or at such Person's option can be extended for, one year or more from the date of the creation or incurrence thereof (including current portions of such long-term Indebtedness), including all hedging agreements and letters of credit entered into in connection with such Indebtedness, (ii) such Person's Capital Lease obligations classified as long-term liabilities under GAAP, (iii) Guaranty Obligations of such Person of Indebtedness of other Persons of the character referred to in clauses (i) and (ii) above and (iv) the amount by which CII's reserve liabilities exceed the sum of CII's cash and marketable securities. "Consolidated Net Worth" of any Person means the amount, if any, by which Total Assets exceed Total Liabilities. 6 "Consolidated Tangible Assets" means, at any time, (a) the Total Assets of the Company and its Subsidiaries, minus (b) the aggregate net book value at such time of all assets of the Company and its Subsidiaries that should be treated as intangible assets in accordance with GAAP, (including, without limitation, goodwill, patents, trade names, trade marks, copyrights, franchises, experimental expense, organization expense, unamortized debt discount and expense, deferred assets (other than prepaid insurance, prepaid taxes and deferred tax assets) treasury stock and the excess of cost of shares acquired over book value of related assets). "Contingent Obligation" means, as to any Person, any direct or indirect liability of that Person, with or without recourse, (a) with respect to any Indebtedness, lease, dividend, letter of credit or other obligation (the "primary obligations") of another Person (the "primary obligor"), including any obligation of that Person (i) to purchase, repurchase or otherwise acquire such primary obligations or any security therefor, (ii) to advance or provide funds for the payment or discharge of any such primary obligation, or to maintain working capital or equity capital of the primary obligor or otherwise to maintain the net worth or solvency or any balance sheet item, level of income or financial condition of the primary obligor, (iii) to purchase property, securities or services primarily for the purpose of assuring the owner of any such primary obligation of the ability of the primary obligor to make payment of such primary obligation, or (iv) otherwise to assure or hold harmless the holder of any such primary obligation against loss in respect thereof (each, a "Guaranty Obligation"); (b) with respect to any Surety Instrument issued for the account of that Person or as to which that Person is otherwise liable for reimbursement of drawings or payments; (c) to purchase any materials, supplies or other property from, or to obtain the services of, another Person if the relevant contract or other related document or obligation requires that payment for such materials, supplies or other property, or for such services, shall be made regardless of whether delivery of such materials, supplies or other property is ever made or tendered, or such services are ever performed or tendered, or (d) in respect of any Swap Contract. The amount of any Contingent Obligation shall, in the case of Guaranty Obligations, be deemed equal to the stated or determinable amount of the primary obligation in respect of which such Guaranty Obligation is made or, if not stated or if indeterminable, the maximum reasonably anticipated liability in respect thereof, and in the case of other Contingent Obligations other than in respect of Swap Contracts, shall be equal to the maximum reasonably anticipated liability in respect thereof and, in the case of 7 Contingent Obligations in respect of Swap Contracts, shall be equal to the Swap Termination Value. "Contractual Obligation" means, as to any Person, any provision of any security issued by such Person or of any agreement, undertaking, contract, indenture, mortgage, deed of trust or other instrument, document or agreement to which such Person is a party or by which it or any of its property is bound. "Conversion/Continuation Date" means any date on which, under Section 2.04, the Company (a) converts Loans of one Type to another Type, or (b) continues as Loans of the same Type, but with a new Interest Period, Loans having Interest Periods expiring on such date. "Convertible Debt" means the Indebtedness in respect of those certain 71/2% Convertible Subordinated Debentures Due 2001 of CII, in an outstanding principal amount of $51,456,000 as of September 30, 1998. "Credit Extension" means and includes (a) the making of any Revolving Loans hereunder, and (b) the Issuance of any Letters of Credit hereunder. "Default" means any event or circumstance which, with the giving of notice, the lapse of time, or both, would (if not cured or otherwise remedied during such time) constitute an Event of Default. "Dollars", "dollars" and "$" each mean lawful money of the United States. "Effective Amount" means (i) with respect to any Revolving Loans on any date, the aggregate outstanding principal amount thereof after giving effect to any Borrowings and prepayments or repayments of Revolving Loans occurring on such date; and (ii) with respect to any outstanding L/C Obligations on any date, the amount of such L/C Obligations on such date after giving effect to any Issuances of Letters of Credit occurring on such date and any other changes in the aggregate amount of the L/C Obligations as of such date, including as a result of any reimbursements of outstanding unpaid drawings under any Letters of Credit or any reductions in the maximum amount available for drawing under Letters of Credit taking effect on such date. "Eligible Assignee" means (a) a commercial bank organized under the laws of the United States, or any state thereof, and having a combined capital and surplus of at least $100,000,000; 8 b) a commercial bank organized under the laws of any other country which is a member of the Organization for Economic Cooperation and Development (the "OECD"), or a political subdivision of any such country, and having a combined capital and surplus of at least $100,000,000, provided that such bank is acting through a branch or agency located in the United States; (c) a Person that is primarily engaged in the business of commercial banking and that is (i) a Subsidiary of a Bank, (ii) a Subsidiary of a Person of which a Bank is a Subsidiary, or (iii) a Person of which a Bank is a Subsidiary; or (d) any insurance company, mutual fund or other financial institution or fund which has been approved in writing by the Company and the Agent as an Eligible Assignee for purposes of this Agreement, provided that in each such case such approval shall not be unreasonably withheld and shall not be required from the Company during the continuance of any Event of Default. "Environmental Claims" means all claims, however asserted, by any Governmental Authority or other Person alleging potential liability or responsibility for violation of any Environmental Law, or for release or injury to the environment or threat to public health, personal injury (including sickness, disease or death), property damage, natural resources damage, or otherwise alleging liability or responsibility for damages (punitive or otherwise), cleanup, removal, remedial or response costs, restitution, civil or criminal penalties, injunctive relief, or other type of relief, resulting from or based upon the presence, placement, discharge, emission or release (including intentional and unintentional, negligent and non-negligent, sudden or non- sudden, accidental or non-accidental, placement, spills, leaks, discharges, emissions or releases) of any Hazardous Material at, in, or from Property, whether or not owned by the Company. "Environmental Laws" means all federal, state or local laws, statutes, common law duties, rules, regulations, ordinances and codes, together with all administrative orders, directed duties, requests, licenses, authorizations and permits of, and agreements with, any Governmental Authorities, in each case relating to environmental, health, safety and land use matters; including, without limitation, the Comprehensive Environmental Response, Compensation and Liability Act of 1980 ("CERCLA"), the Clean Air Act, the Federal Water Pollution Control Act of 1972, the Solid Waste Disposal Act, the Federal Resource Conservation and Recovery Act, the Toxic Substances Control Act and the Emergency Planning and Community Right-to-Know Act. "ERISA" means the Employee Retirement Income Security Act of 1974, and regulations promulgated thereunder. 9 "ERISA Affiliate" means any trade or business (whether or not incorporated) under common control with the Company within the meaning of Section 414(b) or (c) of the Code (and Sections 414(m) and (o) of the Code for purposes of provisions relating to Section 412 of the Code). "ERISA Event" means (a) a Reportable Event with respect to a Pension Plan; (b) a withdrawal by the Company or any ERISA Affiliate from a Pension Plan subject to Section 4063 of ERISA during a plan year in which it was a substantial employer (as defined in Section 4001(a)(2) of ERISA) or a cessation of operations which is treated as such a withdrawal under Section 4062(e) of ERISA; (c) a complete or partial withdrawal by the Company or any ERISA Affiliate from a Multiemployer Plan or notification that a Multiemployer Plan is in reorganization; (d) the filing of a notice of intent to terminate, the treatment of a Plan amendment as a termination under Section 4041 or 4041A of ERISA, or the commencement of proceedings by the PBGC to terminate a Pension Plan or Multiemployer Plan; (e) an event or condition which might reasonably be expected to constitute grounds under Section 4042 of ERISA for the termination of, or the appointment of a trustee to administer, any Pension Plan or Multiemployer Plan; or (f) the imposition of any liability under Title IV of ERISA, other than PBGC premiums due but not delinquent under Section 4007 of ERISA, upon the Company or any ERISA Affiliate. "Eurodollar Reserve Percentage" has the meaning specified in the definition of "LIBOR Rate". "Event of Default means any of the events or circumstances specified in Section 9.01. "Exchange Act" means the Securities Exchange Act of 1934, and regulations promulgated thereunder. "Excluded Subsidiary" means the 2314 Partnership, any Subsidiary of the Company that has less than $500,000 of assets or the pledge of whose stock (i) is prohibited pursuant to applicable regulations of a Governmental Authority or (ii) would otherwise subject the Company or such Subsidiary to burdensome regulatory requirements (as reasonably determined by the Company and the Agent). "Existing BofA Letters of Credit" means the letters of credit described in Schedule 3.03. "Federal Funds Rate" means, for any day, the rate set forth in the weekly statistical release designated as H.15(519), or any 10 successor publication, published by the Federal Reserve Bank of New York (including any such successor, "H.15(519)") on the preceding Business Day opposite the caption "Federal Funds (Effective)"; or, if for any relevant day such rate is not so published on any such preceding Business Day, the rate for such day will be the arithmetic mean as determined by the Agent of the rates for the last transaction in overnight Federal funds arranged prior to 9:00 a.m. (New York City time) on that day by each of three leading brokers of Federal funds transactions in New York City selected by the Agent. "Fee Letter" has the meaning specified in subsection 2.10(a). "Fixed Charges" means, for any period of four consecutive fiscal quarters and without duplication, the sum of (i) cash Interest Expense and fees paid on, all Indebtedness during such period plus (ii) the aggregate principal amount of all current maturities of Consolidated Funded Debt (including the principal portion of rentals under Capital Leases) scheduled to be paid by the Company and its Subsidiaries during such period (excluding prepayments of principal not required under the loan documents relating to such Indebtedness and excluding the payment of the Convertible Debt upon the maturity thereof), all as determined for the Company and its Subsidiaries on a consolidated basis in accordance with GAAP. "Fixed Charges Coverage Ratio" means, at any date, the ratio of (i) Consolidated Adjusted EBITDA for the four consecutive fiscal quarters ending on or prior to such date minus cash Capital Expenditures and cash income taxes paid during such period to (ii) Fixed Charges for such period. "FRB" means the Board of Governors of the Federal Reserve System, and any Governmental Authority succeeding to any of its principal functions. "Further Taxes" means any and all present or future taxes, levies, assessments, imposts, duties, deductions, fees, withholdings or similar charges (including, without limitation, net income taxes and franchise taxes), and all liabilities with respect thereto, imposed by any jurisdiction on account of amounts payable or paid pursuant to Section 4.01. "GAAP" means generally accepted accounting principles set forth from time to time in the opinions and pronouncements of the Accounting Principles Board and the American Institute of Certified Public Accountants and statements and pronouncements of 11 the Financial Accounting Standards Board (or agencies with similar functions of comparable stature and authority within the U.S. accounting profession), which are applicable to the circumstances as of the Closing Date. "Governmental Authority" means any nation or government, any state or other political subdivision thereof, any central bank (or similar monetary or regulatory authority) thereof, any entity exercising executive, legislative, judicial, regulatory or administrative functions of or pertaining to government, and any corporation or other entity owned or controlled, through stock or capital ownership or otherwise, by any of the foregoing. "Guaranty Obligation" has the meaning specified in the definition of "Contingent Obligation." "Hazardous Materials" means all those substances that are regulated by, or which may form the basis of liability under, any Environmental Law, including any substance identified under any Environmental Law as a pollutant, contaminant, hazardous waste, hazardous constituent, special waste, hazardous substance, hazardous material, or toxic substance, or petroleum or petroleum derived substance or waste. "Health Care Business" shall mean (a) the provision, administration or arrangement of health care services, related ancillary products or both, directly or through an HMO, a provider, a regulated health care service contractor or any other business which in the ordinary course provides, administers or arranges for such services, products or both, (b) the provision, administration or arrangement of health, life and related insurance, (c) the provision or management of health care services (including medical management claims services and management through medical information services), (d) the provision, administration or arrangement of health care through a hospital, outpatient, urgent care, clinical, home health or hospice environment, (e) the provision, administration or arrangement of workers' compensation services both fully insured and administrative in nature, (f) any business activities directly related and incidental to any of the foregoing, and (g) any other business activity which is related, ancillary or incidental to any of the foregoing and in which the Company is engaged on the Closing Date. "HMO" shall mean any Person which operates as a health maintenance organization. 12 "HMO Event" shall mean failure by the Company or any of its HMO Subsidiaries to comply in any material respect with any of the terms and provisions of any applicable HMO Regulation pertaining to the fiscal soundness, solvency or financial condition of the Company or any of its HMO Subsidiaries, or the assertion in writing, after the Closing Date, by an HMO Regulator that it intends to take administrative action against the Company or any of its HMO Subsidiaries to revoke or modify any Governmental Approval of, or to enforce the fiscal soundness, solvency or financial provisions or requirements of such HMO Regulations against, the Company or any of its HMO Subsidiaries, if such action, modification or enforcement is reasonably likely to have a Material Adverse Effect. "HMO Regulations" shall mean all Requirements of Law applicable to any HMO Subsidiary under federal or state law and any regulations, orders and directives promulgated or issued pursuant to the foregoing. "HMO Regulator" means any Person charged with the administration, oversight or enforcement of an HMO Regulation, whether primarily, secondarily, or jointly. "HMO Subsidiary" shall mean any current or future Subsidiary of the Company that is either an HMO or a regulated health care service contractor. "HMO Texas" means HMO Texas, L.C., a Texas limited liability company which is an indirect Subsidiary of the Company. "Honor Date" has the meaning specified in subsection 3.03(b). "Indebtedness" of any Person means, without duplication, (a) all indebtedness for borrowed money; (b) all obligations issued, undertaken or assumed as the deferred purchase price of property or services (other than trade payables entered into in the ordinary course of business on ordinary terms); (c) all non- contingent reimbursement or payment obligations with respect to Surety Instruments; (d) all obligations evidenced by notes, bonds, debentures or similar instruments, including obligations so evidenced incurred in connection with the acquisition of property, assets or businesses; (e) all indebtedness created or arising under any conditional sale or other title retention agreement, or incurred as financing, in either case with respect to property acquired by the Person (even though the rights and remedies of the seller or bank under such agreement in the event of default are limited to repossession or sale of such property); 13 f) all obligations with respect to Capital Leases; (g) all Indebtedness referred to in clauses (a) through (f) above secured by (or for which the holder of such Indebtedness has an existing right, contingent or otherwise, to be secured by) any Lien upon or in property (including accounts and contracts rights) owned by such Person, even though such Person has not assumed or become liable for the payment of such Indebtedness; and (h) all Guaranty Obligations in respect of Indebtedness or obligations of others of the kinds referred to in clauses (a) through (g) above. For all purposes of this Agreement, the Indebtedness of any Person shall include all recourse Indebtedness of any partnership or joint venture in which such Person is a general partner or a joint venturer or a member. For purposes of calculating the amount of any Indebtedness described in clauses (e) and (g) above, to the extent that the rights and remedies of the obligee of such Indebtedness are limited to certain property and are nonrecourse to the Person owning or pledging such property, the amount of such Indebtedness shall not exceed the value of such property. "Indemnified Liabilities" has the meaning specified in Section 11.05. "Indemnified Person" has the meaning specified in Section 11.05. "Independent Auditor" has the meaning specified in subsection 7.01(a). "Insolvency Proceeding" means, with respect to any Person, (a) any case, action or proceeding with respect to such Person before any court or other Governmental Authority relating to bankruptcy, reorganization, insolvency, liquidation, receivership, dissolution, winding-up or relief of debtors, or (b) any general assignment for the benefit of creditors, composition, marshalling of assets for creditors, or other, similar arrangement in respect of its creditors generally or any substantial portion of its creditors; undertaken under U.S. Federal, state or foreign law, including the Bankruptcy Code. "Interest Expense" of the Company and its Subsidiaries for any period means the aggregate amount of interest paid, accrued or scheduled to be paid or accrued in respect of any Indebtedness (including the interest portion of rentals under Capital Leases) and all but the principal component of payments in respect of conditional sales, equipment trust or other title retention agreements or under a Capital Lease paid, accrued or scheduled to be paid or accrued by the Company and its Subsidiaries during such period, in each case determined in accordance with GAAP and 14 excluding periodic maintenance, insurance, taxes and similar charges not properly characterized as interest expense under GAAP. "Interest Payment Date" means, as to any LIBOR Rate Loan, the last day of each Interest Period applicable to such Loan and, as to any Base Rate Loan, the last Business Day of each calendar quarter and each date such Loan is converted into another Type of Loan, provided, however, that if any Interest Period for a LIBOR Rate Loan exceeds three months, the date that falls three months after the beginning of such Interest Period and after each Interest Payment Date thereafter is also an Interest Payment Date. "Interest Period" means, as to any LIBOR Rate Loan, the period commencing on the Borrowing Date of such Loan or on the Conversion/Continuation Date on which the Loan is converted into or continued as a LIBOR Rate Loan, and ending on the date one, two, three or six months thereafter as selected by the Company in its Notice of Borrowing or Notice of Conversion/Continuation; provided that: (i) if any Interest Period would otherwise end on a day that is not a Business Day, that Interest Period shall be extended to the following Business Day unless the result of such extension would be to carry such Interest Period into another calendar month, in which event such Interest Period shall end on the preceding Business Day; (ii) any Interest Period pertaining to a LIBOR Rate Loan that begins on the last Business Day of a calendar month (or on a day for which there is no numerically corresponding day in the calendar month at the end of such Interest Period) shall end on the last Business Day of the calendar month at the end of such Interest Period; and (iii) no Interest Period for any Loan shall extend beyond the Revolving Termination Date. "Investment" has the meaning specified in Section 8.04. "IRS" means the Internal Revenue Service, and any Governmental Authority succeeding to any of its principal functions under the Code. "Issuance Date" has the meaning specified in subsection 3.01(a). 15 "Issue" means, with respect to any Letter of Credit, to issue or to extend the expiry of, or to renew or increase the amount of, such Letter of Credit; and the terms "Issued," "Issuing" and "Issuance" have corresponding meanings. "Issuing Bank" means BofA in its capacity as issuer of one or more Letters of Credit hereunder, together with any replacement letter of credit issuer arising under subsection 10.01(b) or Section 10.09. "Joinder Agreement" means each of the Joinder Agreements which may be executed by additional Banks pursuant to Section 2.08, substantially in the form of Exhibit I. "Kaiser Acquisition Agreements" means those certain Asset Sale and Purchase Agreements dated June 5, 1998, one of which is between PMAT and HMO Texas and the other of which is between Kaiser-Texas and HMO Texas. "Kaiser Note" means that certain promissory note in the principal amount of $35,200,000 and otherwise substantially in the form of Exhibit H, from HMO Texas in favor of Kaiser Texas. "Kaiser Texas" means Kaiser Foundation Health Plan of Texas. "Kaiser-Texas Acquisition" means the transaction pursuant to which the Company will acquire certain assets of Kaiser Texas and PMAT. "Kaiser-Texas Modified EBITDA" means, for the four quarter period ending on December 31, 1998, a loss of [$5,641,000]; for the four quarter period ending on March 31, 1999, the product of (a) 4 times (b) the net income of HMO Texas and PMAT for the fiscal quarter ending on March 31, 1999 plus to the extent deducted therefrom, total book taxes, Interest Expense and depreciation and amortization expenses minus any non-cash extraordinary gains; for the four quarter period ending on June 30, 1999, the product of (a) 2 times (b) the net income of HMO Texas and PMAT for the two fiscal quarters ending on June 30, 1999 plus to the extent deducted therefrom, total book taxes, Interest Expense and depreciation and amortization expenses minus any non-cash extraordinary gains; for the four quarter period ending on September 30, 1999, the product of (a) 4/3 times (b) the net income of Texas and PMAT for the three fiscal quarters ending on September 30, 1999 plus to the extent deducted therefrom, total book taxes, Interest Expense and depreciation and amortization expenses minus any non-cash extraordinary gains; and for all periods ending after September 30, 1999, zero. 16 "L/C Advance" means each Bank's participation in any L/C Borrowing in accordance with its Pro Rata Share. "L/C Amendment Application" means an application form for amendment of outstanding standby letters of credit as shall at any time be in use at the Issuing Bank, as the Issuing Bank shall request. "L/C Application" means an application form for issuances of standby letters of credit as shall at any time be in use at the Issuing Bank, as the Issuing Bank shall request. "L/C Borrowing" means an extension of credit resulting from a drawing under any Letter of Credit which shall not have been reimbursed on the date when made nor converted into a Borrowing of Revolving Loans under subsection 3.03(c). "L/C Commitment" means the commitment of the Issuing Bank to Issue, and the commitment of the Banks severally to participate in, Letters of Credit from time to time Issued or outstanding under Article III, in an aggregate amount not to exceed on any date the amount of $50,000,000, as the same shall be reduced as a result of a reduction in the L/C Commitment pursuant to Section 2.05; provided that the L/C Commitment is a part of the combined Commitments, rather than a separate, independent commitment. "L/C Obligations" means at any time the sum of (a) the aggregate undrawn amount of all Letters of Credit then outstanding, plus (b) the amount of all unreimbursed drawings under all Letters of Credit, including all outstanding L/C Borrowings. "L/C-Related Documents" means the Letters of Credit, the L/C Applications, the L/C Amendment Applications and any other document relating to any Letter of Credit, including any of the Issuing Bank's standard form documents for letter of credit issuances. "Lead Arranger" means NationsBanc Montgomery Securities LLC, a Delaware limited liability company. "Lender Party" has the meaning specified in the Pledge Agreements. "Lending Office" means, as to any Bank, the office or offices of such Bank specified as its "Lending Office" or "Domestic Lending Office" or "Offshore Lending Office", as the case may be, on Schedule 11.02, or such other office or offices 39246619.6 11699 1000P 96246459 17 as such Bank may from time to time notify the Company and the Agent. "Letters of Credit" means any standby letters of credit Issued by the Issuing Bank pursuant to Article III. "Leverage Ratio" of any Person means the ratio of Consolidated Funded Debt to Consolidated Adjusted EBITDA. "LIBOR Rate" means, for any Interest Period, with respect to LIBOR Rate Loans comprising part of the same Borrowing, the rate of interest per annum (rounded upward to the next 1/100th of 1%) determined by the Agent as follows: LIBOR Rate = LIBOR 1.00 - Eurodollar Reserve Percentage Where, "Eurodollar Reserve Percentage" means for any day for any Interest Period the maximum reserve percentage (expressed as a decimal, rounded upward to the next 1/100th of 1%) in effect on such day (whether or not applicable to any Bank) under regulations issued from time to time by the FRB for determining the maximum reserve requirement (including any emergency, supplemental or other marginal reserve requirement) with respect to Eurocurrency funding (currently referred to as "Eurocurrency liabilities"); and "LIBOR" means the rate of interest per annum determined by the Agent to be the arithmetic mean (rounded upward to the next 1/16th of 1%) of the rates of interest per annum notified to the Agent by BofA as the rate of interest at which dollar deposits in the approximate amount of the amount of the Loan to be made or continued as, or converted into, a LIBOR Rate Loan by BofA and having a maturity comparable to such Interest Period would be offered to major banks in the London interbank market at their request at approximately 11:00 a.m. (London time) two Business Days prior to the commencement of such Interest Period. The LIBOR Rate shall be adjusted automatically as to all LIBOR Rate Loans then outstanding as of the effective date of any change in the Eurodollar Reserve Percentage. "LIBOR Rate Loan" means a Loan that bears interest based on the LIBOR Rate. 18 "Lien" means any security interest, mortgage, deed of trust, pledge, hypothecation, assignment, charge or deposit arrangement, encumbrance, lien (statutory or other) option, pre-emptive right or preferential arrangement of any kind or nature whatsoever having substantially the same effect as any of the foregoing in respect of any property (including those created by, arising under or evidenced by any conditional sale or other title retention agreement, the interest of a lessor under a Capital Lease, any financing lease having substantially the same economic effect as any of the foregoing, or the filing of any financing statement naming the owner of the asset to which such lien relates as debtor, under the Uniform Commercial Code or any comparable law), any contingent or other agreement to provide any of the foregoing (but not including the interest of a lessor under an operating lease), and including, in the case of stock, stockholder agreements, voting trust agreements and similar arrangements. "Loan" means an extension of credit by a Bank to the Company under Article II or Article III in the form of a Revolving Loan or L/C Advance. "Loan Documents" means this Agreement, any Notes, the Collateral Documents, the Fee Letter, the L/C-Related Documents, and all other letters and documents delivered to the Agent, Syndication Agent, Lead Arranger or any Bank in connection herewith. "Majority Banks" means at any time Banks then holding in excess of 50% of the then aggregate unpaid principal amount of the Loans, or, if no such principal amount is then outstanding, Banks then having in excess of 50% of the Commitments. "Margin Stock" means "margin stock" as such term is defined in Regulation T, U or X of the FRB. "Material Adverse Effect" means (a) a material adverse change in, or a material adverse effect upon, the operations, business, properties or condition (financial or otherwise) of the Company or the Company and its Subsidiaries taken as a whole; (b) a material impairment of the ability of the Company to perform under any Loan Document and to avoid any Event of Default; or (c) a material adverse effect upon (i) the legality, validity, binding effect or enforceability against the Company of any Loan Document, or (ii) the perfection or priority of any Lien granted under any of the Collateral Documents. 19 "Multiemployer Plan" means a "multiemployer plan", within the meaning of Section 4001(a)(3) of ERISA, to which the Company or any ERISA Affiliate makes, is making, or is obligated to make contributions or, during the preceding three calendar years, has made, or been obligated to make, contributions. "Net Cash Proceeds" shall mean cash payments received from any sale, lease, transfer or other disposition of equity securities of a Subsidiary of the Company or property or other assets of the Company or a Subsidiary thereof (including any cash payments received by way of deferred payment pursuant to a note or installment receivable or otherwise, but only as and when received), in each case net of (A) all accounting, appraisal, legal, title and recording tax expenses, (B) the amount of any Indebtedness (other than Indebtedness hereunder) secured by the property or assets being sold and/or required to be repaid by the Company or Subsidiaries of the Company on the occasion of such sale, (C) the amount of accrued employee benefits required to be paid on the occasion of such, (D) a reserve for amounts, if any, subject to recapture by Medicare as a consequence of such sale, (E) commissions and other reasonably estimated income taxes payable with respect to the fiscal year during which such sale occurs, as a consequence of such sale, lease, transfer or other disposition or as a consequence of any repatriation of such cash payments and (F) all distributions and other payments made to holders of minority interests in Subsidiaries as a result of such sale, lease, transfer or other disposition. "Note" means a promissory note executed by the Company in favor of a Bank pursuant to subsection 2.02(b), in substantially the form of Exhibit F. "Notice of Borrowing" means a notice in substantially the form of Exhibit A. "Notice of Conversion/Continuation" means a notice in substantially the form of Exhibit B. "Obligations" means all advances, debts, liabilities, obligations, covenants and duties arising under any Loan Document owing by the Company to any Bank, the Agent, or any Indemnified Person, whether direct or indirect (including those acquired by assignment), absolute or contingent, due or to become due, now existing or hereafter arising and any obligations owing by the Company to any Bank under any Swap Contracts permitted under the terms of this Agreement. "Organization Documents" means, for any corporation, the certificate or articles of incorporation, the bylaws, any certificate of determination or instrument relating to the rights 20 of preferred shareholders of such corporation, any shareholder rights agreement, and all applicable resolutions of the board of directors (or any committee thereof) of such corporation. "Other Taxes" means any present or future stamp, court or documentary taxes or any other excise or property taxes, charges or similar levies which arise from any payment made hereunder or from the execution, delivery, performance, enforcement or registration of, or otherwise with respect to, this Agreement or any other Loan Documents. "Participant" has the meaning specified in subsection 11.08(d). "PBGC" means the Pension Benefit Guaranty Corporation, or any Governmental Authority succeeding to any of its principal functions under ERISA. "Pension Plan" means a pension plan (as defined in Section 3(2) of ERISA) subject to Title IV of ERISA which the Company sponsors, maintains, or to which it makes, is making, or is obligated to make contributions, or in the case of a multiple employer plan (as described in Section 4064(a) of ERISA) has made contributions at any time during the immediately preceding five (5) plan years. "Permitted Acquisitions" means Acquisitions by the Company or any of its Subsidiaries of Persons and/or assets involved (or to be used) in connection with the Health Care Business; provided, that (i) any Acquisition involving a merger to which the Company or any of its Subsidiaries is a party must provide that the Company or such Subsidiary is the surviving corporation in such merger, (ii) immediately before and after giving effect to the consummation of each Acquisition, no Default has occurred and is continuing or will exist; (iii) for each such Acquisition, the prior, effective written consent or approval to such Acquisition of the board of directors or equivalent governing body of the acquiree has been obtained; and (iv) the Company shall have complied with the requirements of Section 7.15, if applicable. "Permitted Liens" has the meaning specified in Section 8.01. "Person" means an individual, partnership, corporation, limited liability company, business trust, joint stock company, trust, unincorporated association, joint venture or Governmental Authority. 21 "Plan" means an employee benefit plan (as defined in Section 3(3) of ERISA) which the Company sponsors or maintains or to which the Company makes, is making, or is obligated to make contributions and includes any Pension Plan. "Pledge Agreement" means each Pledge Agreement executed and delivered by the Company or a Pledgor Subsidiary pursuant to Section 5.0.1(g), substantially in the form of Exhibit G hereto, as amended, supplemented, restated or otherwise modified from time to time. "Pledged Collateral" has the meaning specified in the Pledge Agreements. "Pledged Property" has the meaning specified in the Pledge Agreements. "Pledged Shares" has the meaning specified in the Pledge Agreements. "Pledgor Subsidiary" means any Subsidiary of the Company or of another Subsidiary executing and delivering a Pledge Agreement. "PMAT" means Permanente Medical Association of Texas. "Prior Credit Agreement" means that certain Credit Agreement dated as of April 11, 1996, as amended, among the Company, the lenders party thereto and BofA, as agent. "Pro Rata Share" means, as to any Bank at any time, the percentage equivalent (expressed as a decimal, rounded to the ninth decimal place) at such time of such Bank's Commitment divided by the combined Commitments of all Banks. "Prospective Premium Default" shall mean the institution, with respect to the Company or any of its Subsidiaries by an HMO Regulator pursuant to applicable HMO Regulations, of a restriction on the fees or premiums that any HMO Subsidiary of the Company may charge that is likely to cause the Company to be in default of one or more of the financial covenants in Section 8.14 of this Agreement during one or more of the four fiscal quarters of the Company following the effective date of such restriction; provided that, in determining such likelihood, due consideration shall be given of actions the Company proposes to take, or to have any HMO Subsidiary take, in response to such restriction to the extent such actions have been communicated to the Banks within 30 days after such effective date and so long as 22 no other Default (whether or not related to such restriction) shall then have occurred and be continuing. "Regulatory Tangible Net Equity" shall mean, for any HMO, "tangible net equity," "net worth" or such similar financial concept as defined by any HMO Regulation promulgated by any HMO Regulator as shall be applicable to HMOs. "Regulatory Tangible Net Equity Requirement" shall mean, as to any HMO, the minimum level at which an HMO is required by any applicable HMO Regulation or HMO Regulator to maintain its Regulatory Tangible Net Equity. "Reportable Event" means, any of the events set forth in Section 4043(b) of ERISA or the regulations thereunder, other than any such event for which the 30-day notice requirement under ERISA has been waived in regulations issued by the PBGC. "Requirement of Law" means, as to any Person, any law (statutory or common), treaty, rule or regulation or determination of an arbitrator or of a Governmental Authority, in each case applicable to or binding upon the Person or any of its property or to which the Person or any of its property is subject. "Responsible Officer" means the chief executive officer or the president of the Company, the chief financial officer or any other officer having substantially the same authority and responsibility; or, with respect to compliance with financial covenants, the chief financial officer, the treasurer or the assistant treasurer of the Company, or any other officer having substantially the same authority and responsibility. "Revolving Loan" has the meaning specified in Section 2.01, and may be a Base Rate Loan or a LIBOR Rate Loan (each, a "Type" of Revolving Loan). "Revolving Termination Date" means the earlier to occur of: (a) September 30, 2003; and (b) the date on which the Commitments terminate in accordance with the provisions of this Agreement. "SEC" means the Securities and Exchange Commission, or any Governmental Authority succeeding to any of its principal functions. 23 "Sierra Adjusted EBITDA" means, for any period, the net income of the Company and its consolidated Subsidiaries (other than, for the fiscal quarters ending on December 31, 1998, March 31, 1999, June 30, 1999 and September 30, 1999, HMO Texas and PMAT) plus, to the extent deducted in determining net income, total book taxes, Interest Expense, depreciation and amortization expenses and solely for the first three fiscal quarters of 1999, the Specified Charges, minus any non-cash extraordinary gains. Sierra Adjusted EBITDA shall be calculated as of the last day of the most recently ended fiscal quarter of the Company for the period of four consecutive full fiscal quarters then ended (the "Measurement Period"), and such calculation shall include, on a pro forma basis, the Consolidated Adjusted EBITDA of any Person (other than Kaiser-Texas) acquired by the Company pursuant to an Acquisition during the Measurement Period, as if such Acquisition had occurred on the first day of the Measurement Period. "Significant Subsidiary" shall mean HMO Texas and any other Subsidiary of the Company of which (i) the revenues (directly and together with its Subsidiaries) for the most recent fiscal year of the Company were at least five percent (5%) of the Company's consolidated revenues for such fiscal year or (ii) the consolidated total assets as of the last day of the most recent fiscal year of the Company were at least five percent (5%) of the Company's consolidated total assets as of such date. "Specified Charges" means those charges set forth on Schedule 1.01 hereof. "Specified Percentage" means a percentage determined by reference to the Leverage Ratio set forth in the most recent Compliance Certificate received by the Agent, as follows:
Leverage Ratio Specified Percentage Greater than or equal to 3.00 100% Greater than or equal to 2.00 but less than 3.00 75% Less than 2.00 50%
"Subsidiary" of a Person means any corporation, association, partnership, limited liability company, joint venture or other business entity of which 50% or more of the voting stock, membership interests or other equity interests (in the case of Persons other than corporations), is owned or controlled directly or indirectly by the Person, or one or more of the Subsidiaries of the Person, or a combination thereof. Unless the context otherwise clearly requires, references herein to a "Subsidiary" refer to a Subsidiary of the Company. 24 "Surety Instruments" means all letters of credit (including standby and commercial), banker's acceptances, bank guaranties, shipside bonds, surety bonds and similar instruments. "Swap Contract" means any agreement, whether or not in writing, relating to any transaction that is a rate swap, basis swap, forward rate transaction, commodity swap, commodity option, equity or equity index swap or option, bond, note or bill option, interest rate option, forward foreign exchange transaction, cap, collar or floor transaction, currency swap, cross-currency rate swap, swaption, currency option or any other, similar transaction (including any option to enter into any of the foregoing) or any combination of the foregoing, and, unless the context otherwise clearly requires, any master agreement relating to or governing any or all of the foregoing. "Swap Termination Value" means, in respect of any one or more Swap Contracts, after taking into account the effect of any legally enforceable netting agreement relating to such Swap Contracts, (a) for any date on or after the date such Swap Contracts have been closed out and termination value(s) determined in accordance therewith, such termination value(s), and (b) for any date prior to the date referenced in clause (a) the amount(s) determined as the mark-to-market value(s) for such Swap Contracts, as determined by the Company based upon one or more mid-market or other readily available quotations provided by any recognized dealer in such Swap Contracts (which may include any Bank). "Taxes" means any and all present or future taxes, levies, assessments, imposts, duties, deductions, fees, withholdings or similar charges, and all liabilities with respect thereto, excluding, in the case of each Bank and the Agent, respectively, taxes imposed on or measured by its net income by the jurisdiction (or any political subdivision thereof) under the laws of which such Bank or the Agent, as the case may be, is organized or maintains a lending office. "Total Assets" of any Person means all property (whether real, personal, tangible, intangible or mixed) that, in accordance with GAAP should be included in determining total assets as shown on the asset portion of the balance sheet of such Person. "Total Liabilities" of any Person means all obligations that, in accordance with GAAP, would be included in determining total liabilities as shown on the liabilities side of the balance sheet of such Person. 25 "2314 Partnership" means 2314 West Charleston Partnership, a Nevada general partnership of which the general partner is Southwest Realty, Inc., a Nevada corporation which is a wholly- owned subsidiary of the Company. "Type" has the meaning specified in the definition of "Revolving Loan." "Unfunded Pension Liability" means the excess of a Plan's benefit liabilities under Section 4001(a)(16) of ERISA, over the current value of that Plan's assets, determined in accordance with the assumptions used for funding the Pension Plan pursuant to Section 412 of the Code for the applicable plan year. "United States" and "U.S." each means the United States of America. "Wholly-Owned Subsidiary" means any corporation in which (other than directors' qualifying shares required by law) 100% of the capital stock of each class having ordinary voting power, in each case, at the time as of which any determination is being made, is owned, beneficially and of record, by the Company, or by one or more of the other Wholly-Owned Subsidiaries, or both. 1.02 Other Interpretive Provisions. (a) The meanings of defined terms are equally applicable to the singular and plural forms of the defined terms. (b) The words "hereof", "herein", "hereunder" and similar words refer to this Agreement as a whole and not to any particular provision of this Agreement; and subsection, Section, Schedule and Exhibit references are to this Agreement unless otherwise specified. (c) (i) The term "documents" includes any and all instruments, documents, agreements, certificates, indentures, notices and other writings, however evidenced. (ii) The term "including" is not limiting and means "including without limitation." (iii) In the computation of periods of time from a specified date to a later specified date, the word "from" means "from and including"; the words "to" and "until" each mean "to but excluding", and the word "through" means "to and including." 26 (iv) The term "property" includes any kind of property or asset, real, personal or mixed, tangible or intangible. (d) Unless otherwise expressly provided herein, (i) references to agreements (including this Agreement) and other contractual instruments shall be deemed to include all subsequent amendments and other modifications thereto, but only to the extent such amendments and other modifications are not prohibited by the terms of any Loan Document, and (ii) references to any statute or regulation are to be construed as including all statutory and regulatory provisions consolidating, amending, replacing, supplementing or interpreting the statute or regulation. (e) The captions and headings of this Agreement are for convenience of reference only and shall not affect the interpretation of this Agreement. (f) This Agreement and other Loan Documents may use several different limitations, tests or measurements to regulate the same or similar matters. All such limitations, tests and measurements are cumulative and shall each be performed in accordance with their terms. Unless otherwise expressly provided, any reference to any action of the Agent or the Banks by way of consent, approval or waiver shall be deemed modified by the phrase "in its/their reasonable discretion." (g) This Agreement and the other Loan Documents are the result of negotiations among and have been reviewed by counsel to the Agent, the Company and the other parties, and are the products of all parties. Accordingly, they shall not be construed against the Banks or the Agent merely because of the Agent's or Banks' involvement in their preparation. 1.03 Accounting Principles. (a) Unless the context otherwise clearly requires, all accounting terms not expressly defined herein shall be construed, and all financial computations required under this Agreement shall be made, in accordance with GAAP, consistently applied. (b) References herein to "fiscal year" and "fiscal quarter" refer to such fiscal periods of the Company. 27 ARTICLE II THE CREDITS 2.01 Amounts and Terms of Commitments. Each Bank severally agrees, on the terms and conditions set forth herein, to make loans to the Company (each such loan, a "Revolving Loan") from time to time on any Business Day during the period from the Closing Date to the Revolving Termination Date, in an aggregate amount not to exceed at any time outstanding the amount set forth on Schedule 2.01 (such amount as the same may be reduced under Section 2.05 or increased under Section 2.08 or as a result of one or more assignments under Section 10.08, the Bank's "Commitment"); provided, however, that, after giving effect to any Borrowing of Revolving Loans, the Effective Amount of all outstanding Revolving Loans and the Effective Amount of all L/C Obligations, shall not at any time exceed the combined Commitments; and provided further, that the Effective Amount of the Revolving Loans of any Bank plus the participation of such Bank in the Effective Amount of all L/C Obligations shall not at any time exceed such Bank's Commitment. Within the limits of each Bank's Commitment, and subject to the other terms and conditions hereof, the Company may borrow under this section 2.01, prepay under Section 2.06 and reborrow under this section 2.01. 2.02 Loan Accounts. (a) The Loans made by each Bank and the Letters of Credit Issued by the Issuing Bank shall be evidenced by one or more accounts or records maintained by such Bank or Issuing Bank, as the case may be, in the ordinary course of business. The accounts or records maintained by the Agent, the Issuing Bank and each Bank shall be presumptive evidence of the amount of the Loans made by the Banks to the Company and the Letters of Credit Issued for the account of the Company, and the interest and payments thereon. Any failure to so maintain such accounts or records, or any error in doing so, shall not, however, limit or otherwise affect the obligation of the Company hereunder to pay any amount owing with respect to the Loans or any Letter of Credit. (b) Upon the request of any Bank made through the Agent, the Loans made by such Bank may be evidenced by one or more Notes, instead of or in addition to loan accounts. Each such Bank shall endorse on the schedules annexed to its Note(s) the date, amount and maturity of each Loan made by it and the amount of each payment of principal made by the Company with 28 respect thereto. Each such Bank is irrevocably authorized by the Company to endorse its Note(s) and each Bank's record shall be conclusive absent manifest error; provided, however, that the failure of a Bank to make, or an error in making, a notation thereon with respect to any Loan shall not limit or otherwise affect the obligations of the Company hereunder or under any such Note to such Bank. 2.03 Procedure for Borrowing. (a) Each Borrowing of Revolving Loans shall be made upon the Company's irrevocable written notice delivered to the Agent in the form of a Notice of Borrowing (which notice must be received by the Agent prior to 10:00 a.m. (San Francisco time) (i) three Business Days prior to the requested Borrowing Date, in the case of LIBOR Rate Loans, and (ii) one Business Day prior to the requested Borrowing Date, in the case of Base Rate Loans, specifying: (A) the amount of the Borrowing, which shall be, in the case of LIBOR Rate Loans, in an aggregate minimum amount of $5,000,000 or any multiple of $1,000,000 in excess thereof and, in the case of Base Rate Loans, in an aggregate minimum amount of $1,000,000 or any multiple of $100,000 in excess thereof; (B) the requested Borrowing Date, which shall be a Business Day; (C) the Type of Loans comprising the Borrowing; and (D) if such Borrowing is comprised of LIBOR Rate Loans, the duration of the Interest Period applicable to such Loans included in such notice. If the Notice of Borrowing fails to specify the duration of the Interest Period for any Borrowing comprised of LIBOR Rate Loans, such Interest Period shall be one month. (b) The Agent will promptly notify each Bank of its receipt of any Notice of Borrowing and of the amount of such Bank's Pro Rata Share of that Borrowing. (c) Each Bank will make the amount of its Pro Rata Share of each Borrowing available to the Agent for the account of the Company at the Agent's Payment Office by 11:00 a.m. (San 29 Francisco time) on the Borrowing Date requested by the Company in funds immediately available to the Agent. The proceeds of all such Loans will then be made available to the Company by the Agent by wire transfer in accordance with written instructions provided to the Agent by the Company of like funds as received by the Agent. (d) After giving effect to any Borrowing, unless the Agent shall otherwise consent, there may not be more than ten (10) different Interest Periods in effect. 2.04 Conversion and Continuation Elections. (a) The Company may, upon irrevocable written notice to the Agent in accordance with subsection 2.04(b): (i) elect, as of any Business Day, in the case of Base Rate Loans, to convert any such Loans (or any part thereof in an amount not less than $5,000,000, or that is in an integral multiple of $1,000,000 in excess thereof) into LIBOR Rate Loans; (ii) elect, as of the last day of the applicable Interest Period, in the case of LIBOR Rate Loans, to convert any such Loans (or any part thereof in an amount not less than $1,000,000, or that is in an integral multiple of $100,000 in excess thereof) into Base Rate Loans; or (iii) elect as of the last day of the applicable Interest Period, in the case of LIBOR Rate Loans, to continue any such Loans having Interest Periods expiring on such day (or any part thereof in an amount not less than $5,000,000, or that is in an integral multiple of $1,000,000 in excess thereof); provided, that if at any time the aggregate amount of LIBOR Rate Loans in respect of any Borrowing is reduced, by payment, prepayment, or conversion of part thereof to be less than $5,000,000, such LIBOR Rate Loans shall automatically convert into Base Rate Loans, and on and after such date the right of the Company to continue such Loans as, and convert such Loans into, LIBOR Rate Loans, shall terminate. (b) The Company shall deliver a Notice of Conversion/Continuation to be received by the Agent not later than 9:00 a.m. (San Francisco time) at least (i) three Business Days in advance of the Conversion/ Continuation Date, if the 30 Loans are to be converted into or continued as LIBOR Rate Loans, and (ii) one Business Day in advance of the Conversion/ Continuation Date, if the Loans are to be converted into Base Rate Loans, specifying: (A) the proposed Conversion/Continuation Date; (B) the aggregate amount of Loans to be converted or continued; (C) the Type of Loans resulting from the proposed conversion or continuation; and (D) other than in the case of conversions into Base Rate Loans, the duration of the requested Interest Period. (c) If upon the expiration of any Interest Period applicable to LIBOR Rate Loans, the Company has failed to select timely a new Interest Period to be applicable to such LIBOR Rate Loans, the Company shall be deemed to have elected to convert such LIBOR Rate Loans into Base Rate Loans effective as of the expiration date of such Interest Period. (d) The Agent will promptly notify each Bank of its receipt of a Notice of Conversion/ Continuation, or, if no timely notice is provided by the Company, the Agent will promptly notify each Bank of the details of any automatic conversion. All conversions and continuations shall be made ratably according to the respective outstanding principal amounts of the Loans with respect to which the notice was given held by each Bank. (e) Unless the Majority Banks otherwise consent, during the existence of a Default or Event of Default, the Company may not elect to have a Loan converted into or continued as a LIBOR Rate Loan. (f) After giving effect to any conversion or continuation of Loans, unless the Agent shall otherwise consent, there may not be more than ten (10) different Interest Periods in effect. 2.05 Voluntary Termination or Reduction of Commitments. The Company may, upon not less than three Business Days' prior notice to the Agent, terminate the Commitments, or permanently reduce the Commitments by an aggregate minimum amount of $5,000,000 or any multiple of $1,000,000 in excess thereof; unless, after 31 giving effect thereto and to any prepayments of Loans made on the effective date thereof, (i) the Effective Amount of all Revolving Loans and L/C Obligations together would exceed the amount of the combined Commitments then in effect, or (ii) the Effective Amount of all L/C Obligations then outstanding would exceed the L/C Commitment. Once reduced in accordance with this Section, the Commitments may not be increased. Any reduction of the Commitments shall be applied to each Bank according to its Pro Rata Share. If and to the extent specified by the Company in the notice to the Agent, some or all of the reduction in the combined Commitments shall be applied to reduce the L/C Commitment. All accrued commitment and letter of credit fees to, but not including, the effective date of any reduction or termination of Commitments, shall be paid on the effective date of such reduction or termination. 2.06 Optional Prepayments. Subject to Section 4.04, the Company may, at any time or from time to time, upon not less than (i) three Business Days' irrevocable notice to the Agent, ratably prepay LIBOR Rate Loans in whole or in part, in minimum amounts of $5,000,000 or any multiple of $1,000,000 in excess thereof, and (ii) one Business Day's irrevocable notice to the Agent, ratably prepay Base Rate Loans in whole or in part, in minimum amounts of $1,000,000 or any multiple of $100,000 in excess thereof. Such notice of prepayment shall specify the date and amount of such prepayment and the Type(s) of Loans to be prepaid. The Agent will promptly notify each Bank of its receipt of any such notice, and of such Bank's Pro Rata Share of such prepayment. If such notice is given by the Company, the Company shall make such prepayment and the payment amount specified in such notice shall be due and payable on the date specified therein, together with accrued interest to each such date on the amount prepaid and any amounts required pursuant to Section 4.04. Amounts so prepaid may be reborrowed subject to the applicable provisions of this Agreement. 2.07 Mandatory Prepayments of Loans; Mandatory Commitment Reductions and Repayments. (a) If on any date the Effective Amount of L/C Obligations exceeds the L/C Commitment, the Company shall Cash Collateralize on such date the outstanding Letters of Credit in an amount equal to the excess of the maximum amount then available to be drawn under the Letters of Credit over the Aggregate L/C Commitment. Subject to Section 4.04, if on any date after giving effect to any Cash Collateralization made on such date pursuant to the preceding sentence, the Effective Amount of all Revolving Loans then outstanding plus the Effective 32 Amount of all L/C Obligations exceeds the combined Commitments, the Company shall immediately, and without notice or demand, prepay the outstanding principal amount of the Revolving Loans and L/C Advances by an amount equal to the applicable excess. (b) On each date set forth below, the aggregate Commitments shall, without any further action, automatically and permanently be reduced to the amount set forth opposite such date: Date Amount June 30, 2001 $205,000,000*/ December 31, 2001 $185,000,000 June 30, 2002 $165,000,000 December 31, 2002 $145,000,000 June 30, 2003 $125,000,000 provided, however, that on the Revolving Termination Date, the aggregate Commitments shall be zero and on such date the Company shall repay to the Banks the aggregate principal amount of Loans outstanding on such date. (c) If the aggregate Commitments equal or exceed $100,000,000, the aggregate Commitments shall be automatically and permanently reduced (but not to an amount below $100,000,000) by an amount equal to seventy-five percent (75%) of the first $25,000,000 of Net Cash Proceeds and one hundred percent (100%) of all Net Cash Proceeds in excess thereof received by the Company or its Subsidiary from a sale or disposition of any asset (including, without limitation, any sale or disposition by the Company of any capital stock of any of its Subsidiaries) other than up to $10,000,000 in any fiscal year of Net Cash Proceeds from asset sales in the ordinary course of business; provided, however, that so long as no Default or Event of Default shall have occurred and then be continuing, the aggregate Commitments shall not be required to be reduced under this Section 2.07(c) if and to the extent the Company or one of its Subsidiaries has used such Net Cash Proceeds within 180 days of the receipt thereof for Capital Expenditures or Acquisitions (in accordance with the provisions of Article VI hereof) in the existing lines of business of the Company; provided, further, that in no event shall the Net Cash Proceeds used by the Company or its Subsidiaries in accordance with the previous proviso exceed $10,000,000 in any fiscal year or $25,000,000 during the term of this Agreement. The reduction in the aggregate Commitments - -------- */Applicable only if the commitments have been increased pursuant to Section 2.08. 33 contemplated by this Section 2.07(c) shall occur no later than the earlier of (i) the tenth day after receipt by the Company or its Subsidiary of Net Cash Proceeds, unless prior to such date the Company shall have provided the Agent with written notice of its intention to reinvest such proceeds in accordance with the terms of the preceding sentence, or (ii) the date which is 180 days from the date of receipt by the Company or its Subsidiary of such Net Cash Proceeds subject, in the case of asset sales by regulated Subsidiaries of the Company, to the compliance by such Subsidiaries with any applicable Requirements of Law. Any reduction in the aggregate Commitment pursuant to this Section 2.07(c) shall be applied to reduce any remaining scheduled installments in inverse order of maturity. 2.08 Increase to the Commitment. (a) On or before April 30, 1999, the Company may by written notice to the Agent, request proposed increases to the amount of the Commitments to be effective on a date to be specified by the Company (the "Commitment Increase Date"), provided that (i) as of the Commitment Increase Date, no Default or Event of Default shall have occurred, (ii) each such request shall be for an increase in the Commitments which is in an integral multiple of $5,000,000 and (iii) without the prior written consent of all of the Banks, no such increase shall result in the aggregate principal amount of the Commitments being in excess of $225,000,000. Nothing contained in this Section 2.08 shall be construed as a commitment on behalf of the Agent or any Bank to assume any increase in the Commitments. (b) Each Person which assumes any portion of an increase to the Commitments shall be a Bank or a willing financial institution which qualifies as an Eligible Assignee and which is designated by the Agent or the Syndication Agent. (c) The Borrower, each such Eligible Assignee or Bank and the Agent shall execute and deliver a Joinder Agreement, and Company shall deliver a Note to each such Eligible Assignee in the amount of its Commitment. Upon the Commitment Increase Date, the Eligible Assignee or Bank named therein shall become a Bank for all purposes of the Loan Documents, with the Commitment therein set forth. (d) By executing and delivering a Joinder Agreement, the Eligible Assignee or Bank named therein acknowledges and agrees as of the Commitment Increase Date that (i) it has received a copy of this Agreement, together with copies of the most recent financial statements delivered pursuant to Section 7.01 and such other documents and information as it has deemed 34 appropriate to make its own credit analysis and decision to enter into such Joinder Agreement; (ii) it will, independently and without reliance upon the Agent, the Syndication Agent or any Bank and based on such documents and information as it shall deem appropriate at the time, continue to make its own credit decisions in taking or not taking action under this Agreement; (iii) it appoints and authorizes the Agent to take such action and to exercise such powers under this Agreement as are delegated to the Agent by this Agreement; and (iv) it will perform in accordance with their terms all of the obligations which by the terms of this Agreement are required to be performed by it as a Bank. (e) The Agent shall maintain a copy of each Joinder Agreement, shall promptly inform the Banks of the identity of each Bank which executes a Joinder Agreement and provide each Bank and the Company with a revised Schedule 2.01 to this Agreement. 2.09 Interest. (a) Each Revolving Loan shall bear interest on the outstanding principal amount thereof from the applicable Borrowing Date at a rate per annum equal to the LIBOR Rate or the Base Rate, as the case may be (and subject to the Company's right to convert to other Types of Loans under Section 2.04), plus the Applicable Margin. (b) Interest on each Revolving Loan shall be paid in arrears on each Interest Payment Date. Interest shall also be paid on the date of any prepayment of LIBOR Rate Loans under Section 2.06 or 2.07 for the portion of the Loans so prepaid and upon payment (including prepayment) in full thereof and, during the existence of any Event of Default, interest on all Loans shall be paid on demand of the Agent at the request or with the consent of the Majority Banks. (c) Notwithstanding subsection (a) of this Section, while any Event of Default exists or after acceleration, the Company shall pay interest (after as well as before entry of judgment thereon to the extent permitted by law) on the principal amount of all outstanding Obligations, at a rate per annum which is determined by adding 2% per annum to the Applicable Margin then in effect for such Loans and, in the case of Obligations not subject to an Applicable Margin, at a rate per annum equal to the Base Rate plus 2%; provided, however, that, on and after the expiration of any Interest Period applicable to any LIBOR Rate Loan outstanding on the date of occurrence of such Event of 35 Default or acceleration, the principal amount of such Loan shall, during the continuation of such Event of Default or after acceleration, bear interest at a rate per annum equal to the Base Rate plus the Applicable Margin for Base Rate Loans plus 2%. (d) Anything herein to the contrary notwithstanding, the obligations of the Company to any Bank hereunder shall be subject to the limitation that payments of interest shall not be required for any period for which interest is computed hereunder, to the extent (but only to the extent) that contracting for or receiving such payment by such Bank would be contrary to the provisions of any law applicable to such Bank limiting the highest rate of interest that may be lawfully contracted for, charged or received by such Bank, and in such event the Company shall pay such Bank interest at the highest rate permitted by applicable law. 2.10 Fees. In addition to certain fees described in Section 3.08: (a) Agents' Fees. The Company shall pay fees to the Agent and the Syndication Agent for their own account, as required by the letter agreement ("Fee Letter") between the Company, the Agent and the Syndication Agent dated October 1, 1998. (b) Commitment Fees. The Company shall pay to the Agent for the account of each Bank a commitment fee on the average daily unused portion of such Bank's Commitment, computed on a quarterly basis in arrears on the last Business Day of each fiscal quarter, equal to the product of (i) the Applicable Commitment Fee Rate and (ii) the average daily unused portion of such Bank's Commitment during such fiscal quarter. For purposes of calculating utilization under this subsection, the Commitments shall be deemed used to the extent of the Effective Amount of Revolving Loans then outstanding, plus the Effective Amount of L/C Obligations then outstanding. Such commitment fee shall accrue from the Closing Date to the Revolving Termination Date and shall be due and payable quarterly in arrears on the last day of each March, June, September and December, commencing December 31, 1998 through the Revolving Termination Date, with the final payment to be made on the Revolving Termination Date; provided that, in connection with any reduction or termination of Commitments under Section 2.05 or Section 2.07, the accrued commitment fee calculated for the period ending on such date shall also be paid on the date of such reduction or termination, with the following quarterly payment being calculated on the basis of the period from such reduction or termination date to 36 such quarterly payment date. The commitment fees provided in this subsection shall accrue at all times after the above- mentioned commencement date, including at any time during which one or more conditions in Article V are not met. 2.11 Computation of Fees and Interest. (a) All computations of interest for Base Rate Loans when the Base Rate is determined by BofA's "reference rate" shall be made on the basis of a year of 365 or 366 days, as the case may be, and actual days elapsed. All other computations of fees and interest shall be made on the basis of a 360-day year and actual days elapsed (which results in more interest being paid than if computed on the basis of a 365-day year). Interest and fees shall accrue during each period during which interest or such fees are computed from the first day thereof to the last day thereof. (b) Each determination of an interest rate by the Agent shall be conclusive and binding on the Company and the Banks in the absence of manifest error. The Agent will, at the request of the Company or any Bank, deliver to the Company or the Bank, as the case may be, a statement showing the quotations used by the Agent in determining any interest rate and the resulting interest rate. 2.12 Payments by the Company. (a) All payments to be made by the Company shall be made without set-off, recoupment or counterclaim. Except as otherwise expressly provided herein, all payments by the Company shall be made to the Agent for the account of the Banks at the Agent's Payment Office, and shall be made in dollars and in immediately available funds, no later than 11:00 a.m. (San Francisco time) on the date specified herein. The Agent will promptly distribute to each Bank its Pro Rata Share (or other applicable share as expressly provided herein) of such payment in like funds as received. Any payment received by the Agent later than 11:00 a.m. (San Francisco time) shall be deemed to have been received on the following Business Day and any applicable interest or fee shall continue to accrue. (b) Subject to the provisions set forth in the definition of "Interest Period" herein, whenever any payment is due on a day other than a Business Day, such payment shall be made on the following Business Day, and such extension of time shall in such case be included in the computation of interest or fees, as the case may be. 37 (c) Unless the Agent receives notice from the Company prior to the date on which any payment is due to the Banks that the Company will not make such payment in full as and when required, the Agent may assume that the Company has made such payment in full to the Agent on such date in immediately available funds and the Agent may (but shall not be so required), in reliance upon such assumption, distribute to each Bank on such due date an amount equal to the amount then due such Bank. If and to the extent the Company has not made such payment in full to the Agent, each Bank shall repay to the Agent on demand such amount distributed to such Bank, together with interest thereon at the Federal Funds Rate for each day from the date such amount is distributed to such Bank until the date repaid. 2.13 Payments by the Banks to the Agent. (a) Unless the Agent receives notice from a Bank on or prior to the Closing Date or, with respect to any Borrowing after the Closing Date, at least one Business Day prior to the date of such Borrowing, that such Bank will not make available as and when required hereunder to the Agent for the account of the Company the amount of that Bank's Pro Rata Share of the Borrowing, the Agent may assume that each Bank has made such amount available to the Agent in immediately available funds on the Borrowing Date and the Agent may (but shall not be so required), in reliance upon such assumption, make available to the Company on such date a corresponding amount. If and to the extent any Bank shall not have made its full amount available to the Agent in immediately available funds and the Agent in such circumstances has made available to the Company such amount, that Bank shall on the Business Day following such Borrowing Date make such amount available to the Agent, together with interest at the Federal Funds Rate for each day during such period. A notice of the Agent submitted to any Bank with respect to amounts owing under this subsection (a) shall be conclusive, absent manifest error. If such amount is so made available, such payment to the Agent shall constitute such Bank's Loan on the date of Borrowing for all purposes of this Agreement. If such amount is not made available to the Agent on the Business Day following the Borrowing Date, the Agent will notify the Company of such failure to fund and, upon demand by the Agent, the Company shall pay such amount to the Agent for the Agent's account, together with interest thereon for each day elapsed since the date of such Borrowing, at a rate per annum equal to the interest rate applicable at the time to the Loans comprising such Borrowing. (b) The failure of any Bank to make any Loan on any Borrowing Date shall not relieve any other Bank of any obligation 38 hereunder to make a Loan on such Borrowing Date, but no Bank shall be responsible for the failure of any other Bank to make the Loan to be made by such other Bank on any Borrowing Date. 2.14 Sharing of Payments, Etc. If, other than as expressly provided elsewhere herein, any Bank shall obtain on account of the Loans made by it any payment (whether voluntary, involuntary, through the exercise of any right of set-off, or otherwise) in excess of its ratable share (or other share contemplated hereunder), such Bank shall immediately (a) notify the Agent of such fact, and (b) purchase from the other Banks such participations in the Loans made by them as shall be necessary to cause such purchasing Bank to share the excess payment pro rata with each of them; provided, however, that if all or any portion of such excess payment is thereafter recovered from the purchasing Bank, such purchase shall to that extent be rescinded and each other Bank shall repay to the purchasing Bank the purchase price paid therefor, together with an amount equal to such paying Bank's ratable share (according to the proportion of (i) the amount of such paying Bank's required repayment to (ii) the total amount so recovered from the purchasing Bank) of any interest or other amount paid or payable by the purchasing Bank in respect of the total amount so recovered. The Company agrees that any Bank so purchasing a participation from another Bank may, to the fullest extent permitted by law, exercise all its rights of payment (including the right of set-off, but subject to Section 11.10) with respect to such participation as fully as if such Bank were the direct creditor of the Company in the amount of such participation. The Agent will keep records (which shall be conclusive and binding in the absence of manifest error) of participations purchased under this Section and will in each case notify the Banks following any such purchases or repayments. 2.15 Security. All obligations of the Company under this Agreement, the Notes all other Loan Documents and any Swap Contract entered into with a Bank and permitted under this Agreement shall be secured in accordance with the Collateral Documents. ARTICLE III THE LETTERS OF CREDIT 3.01 The Letter of Credit Subfacility. (a) On the terms and conditions set forth herein (i) the Issuing Bank agrees, (A) from time to time on any Business 39 Day during the period from the Closing Date to the Revolving Termination Date to issue Letters of Credit for the account of the Company, and to amend or renew Letters of Credit previously issued by it, in accordance with subsections 3.02(c) and 3.02(d), and (B) to honor drafts under the Letters of Credit; and (ii) the Banks severally agree to participate in Letters of Credit Issued for the account of the Company; provided, that the Issuing Bank shall not be obligated to Issue, and no Bank shall be obligated to participate in, any Letter of Credit if as of the date of Issuance of such Letter of Credit (the "Issuance Date") (1) the Effective Amount of all L/C Obligations plus the Effective Amount of all Revolving Loans exceeds the combined Commitments, (2) the participation of any Bank in the Effective Amount of all L/C Obligations plus the Effective Amount of the Revolving Loans of such Bank exceeds such Bank's Commitment, or (3) the Effective Amount of L/C Obligations exceeds the L/C Commitment. Within the foregoing limits, and subject to the other terms and conditions hereof, the Company's ability to obtain Letters of Credit shall be fully revolving, and, accordingly, the Company may, during the foregoing period, obtain Letters of Credit to replace Letters of Credit which have expired or which have been drawn upon and reimbursed. (b) The Issuing Bank is under no obligation to Issue any Letter of Credit if: (i) any order, judgment or decree of any Governmental Authority or arbitrator shall by its terms purport to enjoin or restrain the Issuing Bank from Issuing such Letter of Credit, or any Requirement of Law applicable to the Issuing Bank or any request or directive (whether or not having the force of law) from any Governmental Authority with jurisdiction over the Issuing Bank shall prohibit, or request that the Issuing Bank refrain from, the Issuance of letters of credit generally or such Letter of Credit in particular or shall impose upon the Issuing Bank with respect to such Letter of Credit any restriction, reserve or capital requirement (for which the Issuing Bank is not otherwise compensated hereunder) not in effect on the Closing Date, or shall impose upon the Issuing Bank any unreimbursed loss, cost or expense which was not applicable on the Closing Date and which the Issuing Bank in good faith deems material to it; (ii) the Issuing Bank has received written notice from any Bank, the Agent or the Company, on or prior to the Business Day prior to the requested date of Issuance of such 40 Letter of Credit, that one or more of the applicable conditions contained in Article V is not then satisfied; (iii) the expiry date of any requested Letter of Credit is (A) more than 364 days after the date of Issuance, unless the Majority Banks have approved such expiry date in writing, or (B) later than thirty days prior to the Revolving Termination Date; (iv) any requested Letter of Credit does not provide for drafts, or is not otherwise in form and substance acceptable to the Issuing Bank, or the Issuance of a Letter of Credit shall violate any applicable policies of the Issuing Bank; (v) any requested Letter of Credit is for the purpose of supporting the issuance of any letter of credit by any other Person; or (vi) such Letter of Credit is in a face amount less than $500,000 or to be denominated in a currency other than Dollars. 3.02 Issuance, Amendment and Renewal of Letters of Credit. (a) Each Letter of Credit shall be issued upon the irrevocable written request of the Company received by the Issuing Bank (with a copy sent by the Company to the Agent) at least four days (or such shorter time as the Issuing Bank may agree in a particular instance in its sole discretion) prior to the proposed date of issuance. Each such request for issuance of a Letter of Credit shall be by facsimile, confirmed immediately in an original writing, in the form of an L/C Application, and shall specify in form and detail satisfactory to the Issuing Bank: (i) the proposed date of issuance of the Letter of Credit (which shall be a Business Day); (ii) the face amount of the Letter of Credit; (iii) the expiry date of the Letter of Credit; (iv) the name and address of the beneficiary thereof; 41 (v) the documents to be presented by the beneficiary of the Letter of Credit in case of any drawing thereunder; (vi) the full text of any certificate to be presented by the beneficiary in case of any drawing thereunder; and (vii) such other matters as the Issuing Bank may require. (b) At least two Business Days prior to the Issuance of any Letter of Credit, the Issuing Bank will confirm with the Agent (by telephone or in writing) that the Agent has received a copy of the L/C Application or L/C Amendment Application from the Company and, if not, the Issuing Bank will provide the Agent with a copy thereof. Unless the Issuing Bank has received notice on or before the Business Day immediately preceding the date the Issuing Bank is to issue a requested Letter of Credit from the Agent (A) directing the Issuing Bank not to issue such Letter of Credit because such issuance is not then permitted under subsection 3.01(a) as a result of the limitations set forth in clauses (1) through (3) thereof or subsection 3.01(b)(ii); or (B) that one or more conditions specified in Article V are not then satisfied; then, subject to the terms and conditions hereof, the Issuing Bank shall, on the requested date, issue a Letter of Credit for the account of the Company in accordance with the Issuing Bank's usual and customary business practices. (c) From time to time while a Letter of Credit is outstanding and prior to the Revolving Termination Date, the Issuing Bank will, upon the written request of the Company received by the Issuing Bank (with a copy sent by the Company to the Agent) at least four days (or such shorter time as the Issuing Bank may agree in a particular instance in its sole discretion) prior to the proposed date of amendment, amend any Letter of Credit issued by it. Each such request for amendment of a Letter of Credit shall be made by facsimile, confirmed immediately in an original writing, made in the form of an L/C Amendment Application and shall specify in form and detail satisfactory to the Issuing Bank: (i) the Letter of Credit to be amended; (ii) the proposed date of amendment of the Letter of Credit (which shall be a Business Day); (iii) the nature of the proposed amendment; and (iv) such other matters as the Issuing Bank may require. The Issuing Bank shall be under no obligation to amend any Letter of Credit if: (A) the Issuing Bank would have no obligation at such time to issue such Letter of Credit in its amended form under the terms of this Agreement; or (B) the 42 beneficiary of any such Letter of Credit does not accept the proposed amendment to the Letter of Credit. The Agent will promptly notify the Banks of the receipt by it of any L/C Application or L/C Amendment Application. (d) The Issuing Bank and the Banks agree that, while a Letter of Credit is outstanding and prior to the Revolving Termination Date, at the option of the Company and upon the written request of the Company received by the Issuing Bank (with a copy sent by the Company to the Agent) at least four days (or such shorter time as the Issuing Bank may agree in a particular instance in its sole discretion) prior to the proposed date of notification of renewal, the Issuing Bank shall be entitled to authorize the automatic renewal of any Letter of Credit issued by it. Each such request for renewal of a Letter of Credit shall be made by facsimile, confirmed immediately in an original writing, in the form of an L/C Amendment Application, and shall specify in form and detail satisfactory to the Issuing Bank: (i) the Letter of Credit to be renewed; (ii) the proposed date of notification of renewal of the Letter of Credit (which shall be a Business Day); (iii) the revised expiry date of the Letter of Credit; and (iv) such other matters as the Issuing Bank may require. The Issuing Bank shall be under no obligation so to renew any Letter of Credit if: (A) the Issuing Bank would have no obligation at such time to issue or amend such Letter of Credit in its renewed form under the terms of this Agreement; or (B) the beneficiary of any such Letter of Credit does not accept the proposed renewal of the Letter of Credit. If any outstanding Letter of Credit shall provide that it shall be automatically renewed unless the beneficiary thereof receives notice from the Issuing Bank that such Letter of Credit shall not be renewed, and if at the time of renewal the Issuing Bank would be entitled to authorize the automatic renewal of such Letter of Credit in accordance with this subsection 3.02(e) upon the request of the Company but the Issuing Bank shall not have received any L/C Amendment Application from the Company with respect to such renewal or other written direction by the Company with respect thereto, the Issuing Bank shall nonetheless be permitted to allow such Letter of Credit to renew, and the Company and the Banks hereby authorize such renewal, and, accordingly, the Issuing Bank shall be deemed to have received an L/C Amendment Application from the Company requesting such renewal. (e) The Issuing Bank may, at its election (or as required by the Agent at the direction of the Majority Banks), deliver any notices of termination or other communications to any Letter of Credit beneficiary or transferee, and take any other action as necessary or appropriate, at any time and from time to 43 time, in order to cause the expiry date of such Letter of Credit to be a date not later than the Revolving Termination Date. (f) This Agreement shall control in the event of any conflict with any L/C-Related Document (other than any Letter of Credit). (g) The Issuing Bank will also deliver to the Agent, concurrently or promptly following its delivery of a Letter of Credit, or amendment to or renewal of a Letter of Credit, to an advising bank or a beneficiary, a true and complete copy of each such Letter of Credit or amendment to or renewal of a Letter of Credit. 3.03 Existing BofA Letters of Credit; Risk Participations, Drawings and Reimbursements. (a) On and after the Closing Date, the Existing BofA Letters of Credit shall be deemed for all purposes, including for purposes of the fees to be collected pursuant to subsections 3.08(a) and 3.08(b), and reimbursement of costs and expenses to the extent provided herein, Letters of Credit outstanding under this Agreement and entitled to the benefits of this Agreement and the other Loan Documents, and shall be governed by the applications and agreements pertaining thereto and by this Agreement. Each Bank shall be deemed to, and hereby irrevocably and unconditionally agrees to, purchase from the Issuing Bank on the Closing Date or on the Commitment Increase Date a participation in each such Letter of Credit and each drawing thereunder in an amount equal to the product of such Bank's Pro Rata Share times the maximum amount available to be drawn under such Letter of Credit and the amount of such drawing, respectively. For purposes of subsection 2.01(b) and subsection 2.10(b), the Existing BofA Letters of Credit shall be deemed to utilize pro rata the Commitment of each Bank. (b) Immediately upon the Issuance of each Letter of Credit in addition to those described in subsection 3.3(a), each Bank shall be deemed to, and hereby irrevocably and unconditionally agrees to, purchase from the Issuing Bank a participation in such Letter of Credit and each drawing thereunder in an amount equal to the product of (i) the Pro Rata Share of such Bank, times (ii) the maximum amount available to be drawn under such Letter of Credit and the amount of such drawing, respectively. For purposes of subsection 2.01(b), each Issuance of a Letter of Credit shall be deemed to utilize the Commitment of each Bank by an amount equal to the amount of such participation. 44 (c) In the event of any request for a drawing under a Letter of Credit by the beneficiary or transferee thereof, the Issuing Bank will promptly notify the Company. The Company shall reimburse the Issuing Bank prior to 10:00 a.m. (San Francisco time), on each date that any amount is paid by the Issuing Bank under any Letter of Credit (each such date, an "Honor Date"), in an amount equal to the amount so paid by the Issuing Bank. In the event the Company fails to reimburse the Issuing Bank for the full amount of any drawing under any Letter of Credit by 10:00 a.m. (San Francisco time) on the Honor Date, the Issuing Bank will promptly notify the Agent and the Agent will promptly notify each Bank thereof, and the Company shall be deemed to have requested that Base Rate Loans be made by the Banks to be disbursed on the Honor Date under such Letter of Credit, subject to the amount of the unutilized portion of the Revolving Commitment and subject to the conditions set forth in Section 5.02. Any notice given by the Issuing Bank or the Agent pursuant to this subsection 3.03(c) may be oral if immediately confirmed in writing (including by facsimile); provided that the lack of such an immediate confirmation shall not affect the conclusiveness or binding effect of such notice. (d) Each Bank shall upon any notice pursuant to subsection 3.03(c) make available to the Agent for the account of the relevant Issuing Bank an amount in Dollars and in immediately available funds equal to its Pro Rata Share of the amount of the drawing, whereupon the participating Banks shall (subject to subsection 3.03(e)) each be deemed to have made a Loan consisting of a Base Rate Loan to the Company in that amount. If any Bank so notified fails to make available to the Agent for the account of the Issuing Bank the amount of such Bank's Pro Rata Share of the amount of the drawing by no later than 12:00 noon (San Francisco time) on the Honor Date, then interest shall accrue on such Bank's obligation to make such payment, from the Honor Date to the date such Bank makes such payment, at a rate per annum equal to the Federal Funds Rate in effect from time to time during such period. The Agent will promptly give notice of the occurrence of the Honor Date, but failure of the Agent to give any such notice on the Honor Date or in sufficient time to enable any Bank to effect such payment on such date shall not relieve such Bank from its obligations under this Section 3.03. (e) With respect to any unreimbursed drawing that is not converted into Loans consisting of Base Rate Loans to the Company in whole or in part, because of the Company's failure to satisfy the conditions set forth in Section 5.02 or for any other reason, the Company shall be deemed to have incurred from the Issuing Bank an L/C Borrowing in the amount of such drawing, 45 which L/C Borrowing shall be due and payable on demand (together with interest) and shall bear interest at a rate per annum equal to the Base Rate plus 2% per annum, and each Bank's payment to the Issuing Bank pursuant to subsection 3.03(d) shall be deemed payment in respect of its participation in such L/C Borrowing and shall constitute an L/C Advance from such Bank in satisfaction of its participation obligation under this Section 3.03. (f) Each Bank's obligation in accordance with this Agreement to make the Loans or L/C Advances, as contemplated by this Section 3.03, as a result of a drawing under a Letter of Credit, shall be absolute and unconditional and without recourse to the Issuing Bank and shall not be affected by any circumstance, including (i) any set-off, counterclaim, recoupment, defense or other right which such Bank may have against the Issuing Bank, the Company or any other Person for any reason whatsoever; (ii) the occurrence or continuance of a Default, an Event of Default or a Material Adverse Effect; or (iii) any other circumstance, happening or event whatsoever, whether or not similar to any of the foregoing; provided, however, that each Bank's obligation to make Loans under this Section 3.03 is subject to the conditions set forth in Section 5.02. 3.04 Repayment of Participations. (a) Upon (and only upon) receipt by the Agent for the account of the Issuing Bank of immediately available funds from the Company (i) in reimbursement of any payment made by the Issuing Bank under the Letter of Credit with respect to which any Bank has paid the Agent for the account of the Issuing Bank for such Bank's participation in the Letter of Credit pursuant to Section 3.03 or (ii) in payment of interest thereon, the Agent will pay to each Bank, in the same funds as those received by the Agent for the account of the Issuing Bank, the amount of such Bank's Pro Rata Share of such funds, and the Issuing Bank shall receive the amount of the Pro Rata Share of such funds of any Bank that did not so pay the Agent for the account of the Issuing Bank. (b) If the Agent or the Issuing Bank is required at any time to return to the Company, or to a trustee, receiver, liquidator, custodian, or any official in any Insolvency Proceeding, any portion of the payments made by the Company to the Agent for the account of the Issuing Bank pursuant to subsection 3.04(a) in reimbursement of a payment made under the Letter of Credit or interest or fee thereon, each Bank shall, on demand of the Agent, forthwith return to the Agent or the Issuing 46 Bank the amount of its Pro Rata Share of any amounts so returned by the Agent or the Issuing Bank plus interest thereon from the date such demand is made to the date such amounts are returned by such Bank to the Agent or the Issuing Bank, at a rate per annum equal to the Federal Funds Rate in effect from time to time. 3.05 Role of the Issuing Bank. (a) Each Bank and the Company agree that, in paying any drawing under a Letter of Credit, the Issuing Bank shall not have any responsibility to obtain any document (other than any sight draft and certificates expressly required by the Letter of Credit) or to ascertain or inquire as to the validity or accuracy of any such document or the authority of the Person executing or delivering any such document. (b) No Agent-Related Person nor any of the respective correspondents, participants or assignees of the Issuing Bank shall be liable to any Bank for: (i) any action taken or omitted in connection herewith at the request or with the approval of the Banks (including the Majority Banks, as applicable); (ii) any action taken or omitted in the absence of gross negligence or willful misconduct; or (iii) the due execution, effectiveness, validity or enforceability of any L/C-Related Document. (c) The Company hereby assumes all risks of the acts or omissions of any beneficiary or transferee with respect to its use of any Letter of Credit; provided, however, that this assumption is not intended to, and shall not, preclude the Company's pursuing such rights and remedies as it may have against the beneficiary or transferee at law or under any other agreement. No Agent-Related Person, nor any of the respective correspondents, participants or assignees of the Issuing Bank, shall be liable or responsible for any of the matters described in clauses (i) through (vii) of Section 3.06; provided, however, anything in such clauses to the contrary notwithstanding, that the Company may have a claim against the Issuing Bank, and the Issuing Bank may be liable to the Company, to the extent, but only to the extent, of any direct, as opposed to consequential or exemplary, damages suffered by the Company which the Company proves were caused by the Issuing Bank's willful misconduct or gross negligence or the Issuing Bank's willful failure to pay under any Letter of Credit after the presentation to it by the beneficiary of a sight draft and certificate(s) strictly complying with the terms and conditions of a Letter of Credit. In furtherance and not in limitation of the foregoing: (i) the Issuing Bank may accept documents that appear on their face to be in order, without responsibility for further investigation, 47 regardless of any notice or information to the contrary; and (ii) the Issuing Bank shall not be responsible for the validity or sufficiency of any instrument transferring or assigning or purporting to transfer or assign a Letter of Credit or the rights or benefits thereunder or proceeds thereof, in whole or in part, which may prove to be invalid or ineffective for any reason. 3.06 Obligations Absolute. The obligations of the Company under this Agreement and any L/C-Related Document to reimburse the Issuing Bank for a drawing under a Letter of Credit, and to repay any L/C Borrowing and any drawing under a Letter of Credit converted into Revolving Loans, shall be unconditional and irrevocable, and shall be paid strictly in accordance with the terms of this Agreement and each such other L/C-Related Document under all circumstances, including the following: (i) any lack of validity or enforceability of this Agreement or any L/C-Related Document; (ii) any change in the time, manner or place of payment of, or in any other term of, all or any of the obligations of the Company in respect of any Letter of Credit or any other amendment or waiver of or any consent to departure from all or any of the L/C-Related Documents; (iii) the existence of any claim, set-off, defense or other right that the Company may have at any time against any beneficiary or any transferee of any Letter of Credit (or any Person for whom any such beneficiary or any such transferee may be acting), the Issuing Bank or any other Person, whether in connection with this Agreement, the transactions contemplated hereby or by the L/C-Related Documents or any unrelated transaction; (iv) any draft, demand, certificate or other document presented under any Letter of Credit proving to be forged, fraudulent, invalid or insufficient in any respect or any statement therein being untrue or inaccurate in any respect; or any loss or delay in the transmission or otherwise of any document required in order to make a drawing under any Letter of Credit; (v) any payment by the Issuing Bank under any Letter of Credit against presentation of a draft or certificate that does not strictly comply with the terms of any Letter of Credit; or any payment made by the Issuing Bank under any Letter of Credit to any Person purporting to be a trustee in bankruptcy, debtor-in-possession, assignee 48 for the benefit of creditors, liquidator, receiver or other representative of or successor to any beneficiary or any transferee of any Letter of Credit, including any arising in connection with any Insolvency Proceeding; (vi) any exchange, release or non-perfection of any collateral, or any release or amendment or waiver of or consent to departure from any other guarantee, for all or any of the obligations of the Company in respect of any Letter of Credit; or (vii) any other circumstance or happening whatsoever, whether or not similar to any of the foregoing, including any other circumstance that might otherwise constitute a defense available to, or a discharge of, the Company or a guarantor. 3.07 Cash Collateral Pledge. Upon (i) the request of the Agent, (A) if the Issuing Bank has honored any full or partial drawing request on any Letter of Credit and such drawing has resulted in an L/C Borrowing hereunder, or (B) if, as of the Revolving Termination Date, any Letters of Credit may for any reason remain outstanding and partially or wholly undrawn, or (ii) the occurrence of the circumstances described in Section 2.07 requiring the Company to Cash Collateralize Letters of Credit, then, the Company shall immediately Cash Collateralize the L/C Obligations in an amount equal to such L/C Obligations. 3.08 Letter of Credit Fees. (a) The Company shall pay to the Agent for the account of each of the Banks a letter of credit fee on the average daily maximum amount available to be drawn of the outstanding Letters of Credit, computed on a quarterly basis in arrears on the last Business Day of each calendar quarter based upon Letters of Credit outstanding for that quarter as calculated by the Agent, at a rate per annum equal to the Applicable Letter of Credit Fee Rate. Such letter of credit fees shall be due and payable quarterly in arrears on the last Business Day of each calendar quarter during which Letters of Credit are outstanding, commencing on December 31, 1998, through the Revolving Termination Date (or such later date upon which the outstanding Letters of Credit shall expire), with the final payment to be made on the Revolving Termination Date (or such later expiration date). (b) The Company shall pay to the Issuing Bank, for its sole account, a letter of credit fronting fee for each Letter of 49 Credit Issued by the Issuing Bank equal to .125% of the face amount (or increased face amount, as the case may be) of such Letter of Credit. Such Letter of Credit fronting fee shall be due and payable on each date of Issuance of a Letter of Credit. (c) The Company shall pay to the Issuing Bank, for its sole account, from time to time on demand the normal issuance, presentation, amendment and other processing fees, and other standard costs and charges, of the Issuing Bank relating to letters of credit as from time to time in effect. 3.09 Uniform Customs and Practice. The Uniform Customs and Practice for Documentary Credits as published by the International Chamber of Commerce most recently at the time of issuance of any Letter of Credit shall (unless otherwise expressly provided in the Letters of Credit) apply to the Letters of Credit. ARTICLE IV TAXES, YIELD PROTECTION AND ILLEGALITY 4.01 Taxes. (a) Any and all payments by the Company to each Bank or the Agent under this Agreement and any other Loan Document shall be made free and clear of, and without deduction or withholding for, any Taxes. In addition, the Company shall pay all Other Taxes. (b) If the Company shall be required by law to deduct or withhold any Taxes or Other Taxes from or in respect of any sum payable hereunder to any Bank or the Agent, then: (i) the sum payable shall be increased as necessary so that, after making all required deductions and withholdings (including deductions and withholdings applicable to additional sums payable under this Section), such Bank or the Agent, as the case may be, receives and retains an amount equal to the sum it would have received and retained had no such deductions or withholdings been made; (ii) the Company shall make such deductions and withholdings; 50 (iii) the Company shall pay the full amount deducted or withheld to the relevant taxing authority or other authority in accordance with applicable law; and (iv) the Company shall also pay to each Bank or the Agent for the account of such Bank, at the time interest is paid, Further Taxes in the amount that the respective Bank specifies as necessary to preserve the after-tax yield the Bank would have received if such Taxes, Other Taxes or Further Taxes had not been imposed; provided, that the foregoing obligation of the Company to pay such additional amounts shall not apply (A) to any payment to any Bank that is subject to deduction for or withholding for taxes pursuant to the Code, unless, as of the Closing Date or the date it becomes a Bank pursuant to Section 11.08, such Bank is entitled to submit a Form 1001 (relating to such Bank and entitling it to a complete exemption from withholding on all interest to be received by it under this Agreement) or a Form 4224 (relating to all interest to be received by such Bank under this Agreement in respect of the Loans) (and, in that regard, each such Bank shall deliver to the Administrative Agent and the Company the documentation required by Section 10.10), or (B) to any taxes imposed solely by reason of the failure of such Bank to comply with applicable certification, information, documentation or other reporting requirements concerning the nationality, residence, identity or connections with the United States of such Bank if such compliance is required by statute or regulations of the United States as a precondition to relief or exemption from such Taxes. (c) The Company agrees to indemnify and hold harmless each Bank and the Agent for the full amount of (i) Taxes, (ii) Other Taxes, and (iii) Further Taxes in the amount that the respective Bank specifies as necessary to preserve the after-tax yield the Bank would have received if such Taxes, Other Taxes or Further Taxes had not been imposed, and any liability (including penalties, interest, additions to tax and expenses) arising therefrom or with respect thereto, whether or not such Taxes, Other Taxes or Further Taxes were correctly or legally asserted. Payment under this indemnification shall be made within 30 days after the date the Bank or the Agent makes written demand therefor. 51 (d) Within 30 days after the date of any payment by the Company of Taxes, Other Taxes or Further Taxes, the Company shall furnish to each Bank or the Agent the original or a certified copy of a receipt evidencing payment thereof, or other evidence of payment satisfactory to such Bank or the Agent. (e) If the Company is required to pay any amount to any Bank or the Agent pursuant to subsection (b) or (c) of this Section, then such Bank shall use reasonable efforts (consistent with legal and regulatory restrictions) to change the jurisdiction of its Lending Office so as to eliminate any such additional payment by the Company which may thereafter accrue, if such change in the sole judgment of such Bank is not otherwise disadvantageous to such Bank. 4.02 Illegality. (a) If any Bank determines that the introduction of any Requirement of Law, or any change in any Requirement of Law, or in the interpretation or administration of any Requirement of Law, has made it unlawful, or that any central bank or other Governmental Authority has asserted that it is unlawful, for any Bank or its applicable Lending Office to make LIBOR Rate Loans, then, on notice thereof by the Bank to the Company through the Agent, any obligation of that Bank to make LIBOR Rate Loans shall be suspended until the Bank notifies the Agent and the Company that the circumstances giving rise to such determination no longer exist. (b) If a Bank determines that it is unlawful to maintain any LIBOR Rate Loan, the Company shall, upon its receipt of notice of such fact and demand from such Bank (with a copy to the Agent), prepay in full such LIBOR Rate Loans of that Bank then outstanding, together with interest accrued thereon and amounts required under Section 4.04, either on the last day of the Interest Period thereof, if the Bank may lawfully continue to maintain such LIBOR Rate Loans to such day, or immediately, if the Bank may not lawfully continue to maintain such LIBOR Rate Loan. If the Company is required to so prepay any LIBOR Rate Loan, then concurrently with such prepayment, the Company shall borrow from the affected Bank, in the amount of such repayment, a Base Rate Loan. (c) If the obligation of any Bank to make or maintain LIBOR Rate Loans has been so terminated or suspended, the Company may elect, by giving notice to the Bank through the Agent that all Loans which would otherwise be made by the Bank as LIBOR Rate Loans shall be instead Base Rate Loans. 52 4.03 Increased Costs and Reduction of Return. (a) If any Bank determines that, due to either (i) the introduction of or any change in or in the interpretation by any Governmental Authority of any law or regulation or (ii) the compliance by that Bank with any guideline or request from any central bank or other Governmental Authority (whether or not having the force of law), there shall be any increase in the cost to such Bank of agreeing to make or making, funding or maintaining any LIBOR Rate Loans or participating in Letters of Credit, or, in the case of the Issuing Bank, any increase in the cost to the Issuing Bank of agreeing to issue, issuing or maintaining any Letter of Credit or of agreeing to make or making, funding or maintaining any unpaid drawing under any Letter of Credit, then the Company shall be liable for, and shall from time to time, upon demand (with a copy of such demand to be sent to the Agent), pay to the Agent for the account of such Bank, additional amounts as are sufficient to compensate such Bank for such increased costs. (b) If any Bank shall have determined that (i) the introduction of any Capital Adequacy Regulation, (ii) any change in any Capital Adequacy Regulation, (iii) any change in the interpretation or administration of any Capital Adequacy Regulation by any central bank or other Governmental Authority charged with the interpretation or administration thereof, or (iv) compliance by the Bank (or its Lending Office) or any corporation controlling the Bank with any Capital Adequacy Regulation, affects or would affect the amount of capital required or expected to be maintained by the Bank or any corporation controlling the Bank and (taking into consideration such Bank's or such corporation's policies with respect to capital adequacy and such Bank's desired return on capital) determines that the amount of such capital is increased as a consequence of its Commitment, loans, credits or obligations under this Agreement, then, upon demand of such Bank to the Company through the Agent, the Company shall pay to the Bank, from time to time as specified by the Bank, additional amounts sufficient to compensate the Bank for such increase. 4.04 Funding Losses. The Company shall reimburse each Bank and hold each Bank harmless from any loss or expense which the Bank may sustain or incur as a consequence of: (a) the failure of the Company to make on a timely basis any payment of principal of any LIBOR Rate Loan; 53 (b) the failure of the Company to borrow, continue or convert a Loan after the Company has given (or is deemed to have given) a Notice of Borrowing or a Notice of Conversion/ Continuation; (c) the failure of the Company to make any prepayment in accordance with any notice delivered under Section 2.06; (d) the prepayment (including pursuant to Section 2.07) or other payment (including after acceleration thereof) of a LIBOR Rate Loan on a day that is not the last day of the relevant Interest Period; or (e) the automatic conversion under Section 2.04 of any LIBOR Rate Loan into a Base Rate Loan on a day that is not the last day of the relevant Interest Period; including any such loss or expense arising from the liquidation or reemployment of funds obtained by it to maintain its LIBOR Rate Loans or from fees payable to terminate the deposits from which such funds were obtained. For purposes of calculating amounts payable by the Company to the Banks under this Section and under subsection 4.03(a), each LIBOR Rate Loan made by a Bank (and each related reserve, special deposit or similar requirement) shall be conclusively deemed to have been funded at the LIBOR used in determining the LIBOR Rate for such LIBOR Rate Loan by a matching deposit or other borrowing in the interbank eurodollar market for a comparable amount and for a comparable period, whether or not such LIBOR Rate Loan is in fact so funded. 4.05 Inability to Determine Rates. If the Agent determines that for any reason adequate and reasonable means do not exist for determining the LIBOR Rate for any requested Interest Period with respect to a proposed LIBOR Rate Loan, or that the LIBOR Rate applicable pursuant to subsection 2.09(a) for any requested Interest Period with respect to a proposed LIBOR Rate Loan does not adequately and fairly reflect the cost to the Banks of funding such Loan, the Agent will promptly so notify the Company and each Bank. Thereafter, the obligation of the Banks to make or maintain LIBOR Rate Loans hereunder shall be suspended until the Agent revokes such notice in writing. Upon receipt of such notice, the Company may revoke any Notice of Borrowing or Notice of Conversion/Continuation then submitted by it. If the Company does not revoke such Notice, the Banks shall make, convert or continue the Loans, as proposed by the Company, in the amount specified in the applicable notice submitted by the Company, but such Loans shall be made, converted or continued as Base Rate Loans instead of LIBOR Rate Loans. 54 4.06 Certificates of Banks. Any Bank claiming reimbursement or compensation under this Article IV shall deliver to the Company (with a copy to the Agent) a certificate setting forth in reasonable detail the amount payable to the Bank hereunder and the reasons therefor and such certificate shall be conclusive and binding on the Company in the absence of manifest error. 4.07 Substitution of Banks. If the Company shall receive notice from any Bank that LIBOR Rate Loans are no longer available from such Bank pursuant to Section 4.02 or that amounts are due to such Bank pursuant to Section 4.01 or 4.03, the Company may (but subject in any such case to the payments required by Section 4.04), upon at least five Business Days' prior written or telecopier notice to such Bank and the Agent, but not more than 90 days after receipt of written notice from such Bank, identify to the Agent a lending institution acceptable to the Company and the Agent, which will purchase the Commitments, the amount of outstanding Loans and any participations in Letters of Credit from the Bank providing such notice, and such Bank shall thereupon assign its Commitment, any Loans owing to such Bank, any participations in Letters of Credit and the Notes held by such Bank to such replacement lending institution pursuant to Section 11.08. 4.08 Survival. The agreements and obligations of the Company in this Article IV shall survive the payment of all other Obligations. ARTICLE V CONDITIONS PRECEDENT 5.01 Conditions of Initial Credit Extensions. The obligation of each Bank to make its initial Credit Extension hereunder is subject to the condition that the Agent shall have received on or before the Closing Date all of the following, in form and substance satisfactory to the Agent and each Bank, and in sufficient copies for each Bank: (a) Credit Agreement and Notes. This Agreement and the Notes executed by each party thereto; (b) Resolutions; Incumbency. (i) Copies of the resolutions of the board of directors of the Company and each Pledgor Subsidiary authorizing the transactions contemplated hereby, certified as of the Closing Date by the Secretary or an Assistant 55 Secretary of the Company and each such Pledgor Subsidiary; and (ii) A certificate of the Secretary or Assistant Secretary of the Company and each Pledgor Subsidiary certifying the names and true signatures of the officers of the Company or such Pledgor Subsidiary (as the case may be) authorized to execute, deliver and perform, as applicable, this Agreement, and all other Loan Documents to be delivered by it hereunder; (c) Organization Documents; Good Standing. Each of the following documents: (i) the articles or certificate of incorporation and the bylaws of the Company as in effect on the Closing Date, certified by the Secretary or Assistant Secretary of the Company as of the Closing Date; and (ii) a good standing and tax good standing certificate for the Company and each of its domestic Subsidiaries from the Secretary of State (or similar, applicable Governmental Authority) of its state of incorporation and each state where the Company or such Subsidiary (as the case may be) is qualified to do business as a foreign corporation as of a recent date, together with a bring-down certificate by facsimile, dated the Closing Date; (d) Legal Opinions. Opinions of (i) Morgan, Lewis & Bockius, special California counsel to the Company; (ii) internal Nevada counsel to the Company; and (iii) local counsel to the Company and its Subsidiaries in such other jurisdictions as the Agent may reasonably request, each addressed to the Agent and the Banks and collectively addressing the matters set forth in Exhibit D with respect to the Company and its Subsidiaries; (e) Payment of Fees. Evidence of payment by the Company of all accrued and unpaid fees, costs and expenses to the extent then due and payable on the Closing Date, other than costs associated with the Kaiser-Texas Acquisition, together with Attorney Costs of BofA to the extent invoiced prior to or on the Closing Date, plus such additional amounts of Attorney Costs as shall constitute BofA's reasonable estimate of Attorney Costs incurred or to be incurred by it through the closing proceedings (provided that such estimate shall not thereafter preclude final settling of accounts between the Company and BofA); including any 56 such costs, fees and expenses arising under or referenced in Sections 2.10 and 11.04; (f) Certificate. A certificate signed by a Responsible Officer, dated as of the Closing Date, stating that: (i) the representations and warranties contained in Article VI are true and correct on and as of such date, as though made on and as of such date; (ii) no Default or Event of Default exists or would result from the Credit Extension; (iii) there has occurred since December 31, 1997, no event or circumstance that has resulted or could reasonably be expected to result in a Material Adverse Effect; and (iv) to the best of such Responsible Officer's knowledge there has not occurred since December 31, 1997, a material adverse change in, or a material adverse effect upon, the operations, business, properties, or condition (financial or otherwise) of the business being acquired by HMO Texas from Kaiser Texas or PMAT; (g) Collateral Documents. The Pledge Agreements, executed by the Company and each Pledgor Subsidiary, covering the capital stock of all Subsidiaries other than those Excluded Subsidiaries listed on Schedule 5.01(g), in appropriate form for recording, where necessary, together with: (i) acknowledgment copies of all UCC-1 financing statements filed, registered or recorded to perfect the security interests of the Agent for the benefit of the Banks, or other evidence satisfactory to the Agent that there has been filed, registered or recorded all financing statements and other filings, registrations and recordings necessary and advisable to perfect the Liens of the Agent for the benefit of the Banks in accordance with applicable law; (ii) written advice relating to such Lien and judgment searches as the Agent shall have requested, and such termination statements or other documents as may be necessary to confirm that the Collateral is subject to no other Liens in favor of any Persons (other than Permitted Liens); 57 (iii) all certificates and instruments representing the Pledged Collateral, stock transfer powers executed in blank with signatures guaranteed as the Agent or the Banks may specify; (iv) evidence that all other actions necessary or, in the opinion of the Agent or the Banks, desirable to perfect and protect the first priority security interest created by the Pledge Agreements have been taken; (v) funds sufficient to pay any filing or recording tax or fee in connection with any and all UCC-1 financing statements; and (vi) evidence that all other actions necessary or, in the opinion of the Agent or the Banks, desirable to perfect and protect the first priority Lien created by the Collateral Documents, and to enhance the Agent's ability to preserve and protect its interests in and access to the Collateral, have been taken; (h) Regulatory Compliance. A certificate of a Responsible Officer on behalf of each of the HMO Subsidiaries to the effect that such HMO Subsidiary is in compliance in all material respects with the requirements of all applicable HMO Regulations, including such Regulatory Tangible Net Equity Requirements as are applicable to such HMO Subsidiary, and with all other Requirements of Law; (i) Prior Credit Agreement. Evidence that all commitments to lend under the Prior Credit Agreement have been terminated and that all principal, interest, fees and other sums then due and payable under the Prior Credit Agreement have been paid in full; (j) Kaiser Acquisition Agreements. A certificate signed by a Responsible Officer of the Company, dated as of the Closing Date, stating that: (i) the conditions precedent to the transactions contemplated by the Kaiser Acquisition Agreements have been satisfied without waiver or forbearance; (ii) to the best of such Responsible Officer's knowledge, the representations and warranties of HMO Texas, the Company, PMAT and Kaiser Texas set 58 forth in the Kaiser Acquisition Agreements are true and correct in all material respects; (iii) each of PMAT and Kaiser Texas has certified to HMO Texas that its representations and warranties set forth in the Kaiser Acquisition Agreements are true and correct in all material respects; and (iv) the Kaiser Acquisition Agreements have not been amended in any material respect adverse to the Company; (k) Litigation. Such evidence as the Agent shall reasonably require that (i) there exists no litigation challenging or seeking to restrain or prohibit the consummation of the transactions contemplated by the Kaiser Acquisition Agreements, the making of the Loans by the Banks or the performance of the Obligations and (ii) there exists no judgment, order, injunction, or other restraint prohibiting the consummation of the transactions contemplated by the Kaiser Acquisition Agreements, the making of the Loans by the Banks or the performance of the Obligations; (l) Financial Covenant Certificate. A certificate signed by a Responsible Officer of the Company, dated as of the Closing Date confirming that after giving effect to the Kaiser- Texas Acquisition, on a pro forma basis: (i) the Leverage Ratio, as of September 30, 1998 is not more than 3.50 to 1.00; and (ii) Sierra Adjusted EBITDA, as of September 30, 1998 is not less than $70,000,000. (m) Other Documents. Such other approvals, opinions, documents or materials as the Agent or any Bank may request. 5.02 Conditions to All Credit Extensions. The obligation of each Bank to make any Loan to be made by it (including its initial Loan) and the obligation of the Issuing Bank to Issue any Letter of Credit (including the initial Letter of Credit) is subject to the satisfaction of the following conditions precedent on the relevant Borrowing Date or Issuance Date: (a) Notice, Application. The Agent shall have received (with, in the case of the initial Loan only, a copy for each Bank) a Notice of Borrowing or, in the case of any Issuance 59 of any Letter of Credit, the Issuing Bank and the Agent shall have received an L/C Application or L/C Amendment Application, as required under Section 3.02; (b) Continuation of Representations and Warranties. The representations and warranties in Article IV hereof and in the Pledge Agreements shall be true and correct on and as of such Borrowing Date or Issuance Date (in all material respects if such date is a date subsequent to the Closing Date) with the same effect as if made on and as of such Borrowing Date or Issuance Date (except to the extent such representations and warranties expressly refer to an earlier date, in which case they shall be true and correct as of such earlier date); and (c) No Existing Default. No Default or Event of Default shall exist or shall result from such Borrowing or Issuance. Each Notice of Borrowing and L/C Application or L/C Amendment Application submitted by the Company hereunder shall constitute a representation and warranty by the Company hereunder, as of the date of each such notice and as of each Borrowing Date or Issuance Date, as applicable, that the conditions in this Section 5.02 are satisfied. ARTICLE VI REPRESENTATIONS AND WARRANTIES The Company represents and warrants to the Agent and each Bank that: 6.01 Corporate Existence and Power. The Company and each of its Subsidiaries: (a) is a corporation duly organized, validly existing and in good standing under the laws of the jurisdiction of its incorporation; (b) has the corporate power and authority and all governmental licenses, authorizations, consents and approvals to own or hold under lease its property and other assets, carry on its business as currently conducted by it and to execute, deliver, and perform its obligations under the Loan Documents; (c) is duly qualified as a foreign corporation and is licensed and in good standing under the laws of each jurisdiction where its ownership, lease or operation of property or the 60 conduct of its business requires such qualification or license, except where the failure to be so licensed or qualified would not have, individually or in the aggregate, a Material Adverse Effect; and (d) is in compliance with all Requirements of Law, except for such instances of non-compliance as would not have, individually or in the aggregate, a Material Adverse Effect. 6.02 Corporate Authorization; No Contravention. The execution, delivery and performance by the Company of this Agreement, the Pledge Agreements and each other Loan Document to which the Company or any Pledgor Subsidiary is party, have been duly authorized by all necessary corporate action, and do not and will not: (a) contravene the terms of any of the Company's or the Pledgor Subsidiaries' Organization Documents; (b) conflict with or result in any breach or contravention of, or the creation of any Lien under, any document evidencing any Contractual Obligation to which the Company is a party or any order, injunction, writ or decree of any Governmental Authority to which the Company or any Pledgor Subsidiary or any of their respective property is subject, except for such instances as would not have, individually or in the aggregate, a Material Adverse Effect; or (c) violate any Requirement of Law. 6.03 Authorization, Approval, etc. (a) Except as set forth on Schedule 6.03, no approval, consent, exemption, authorization, or other action by, or notice to, or filing with, any Governmental Authority or any other Person (except for recordings or filings in connection with the Liens granted to the Agent under the Collateral Documents) is necessary or required in connection with the execution, delivery or performance by, or enforcement against, the Company or any of its Subsidiaries of the Agreement, the Pledge Agreements or any other Loan Document including: (i) the pledge by the Company and the Pledgor Subsidiaries of any Collateral pursuant to the Pledge Agreements or the execution, delivery, and performance of the Pledge Agreements by the Company and the Pledgor Subsidiaries; and 61 (ii) the exercise by the Agent of the voting or other rights provided for in the Pledge Agreements, or, except with respect to any Pledged Shares, as may be required in connection with a disposition of such Pledged Shares by laws affecting the offering and sale of securities generally, the remedies in respect of the Collateral pursuant to the Pledge Agreements. (b) As of the Closing of the Kaiser-Texas Acquisition, no material approval, consent, exemption, authorization, or other action by, or notice to, or filing with, any Governmental Authority is necessary or required for the consummation of the Kaiser-Texas Acquisition, other than that which has been obtained. 6.04 Binding Effect. This Agreement, the Pledge Agreements and each other Loan Document to which the Company or any Pledgor Subsidiary is a party constitute the legal, valid and binding obligations of the Company or such Pledgor Subsidiary (as the case may be), enforceable against the Company or such Pledgor Subsidiary (as the case may be) in accordance with their respective terms, except as enforceability may be limited by applicable bankruptcy, insolvency, or similar laws affecting the enforcement of creditors' rights generally or by equitable principles relating to enforceability. 6.05 Litigation. Except as set forth on Schedule 6.05, there are no actions, suits, proceedings, claims or disputes pending which have been served, or to the best knowledge of the Company, otherwise pending, threatened or contemplated, at law, in equity, in arbitration or before any Governmental Authority, against the Company, or its Subsidiaries or any of their respective properties which: (a) purport to affect or pertain to this Agreement or any other Loan Document, or any of the transactions contemplated hereby or thereby; or (b) would reasonably be expected to have a Material Adverse Effect. No injunction, writ, temporary restraining order or any order of any nature has been issued by any court or other Governmental Authority purporting to enjoin or restrain the execution, delivery or performance of this Agreement or any other Loan Document, or directing that the transactions provided for herein or therein not be consummated as herein or therein provided. 62 6.06 No Default. No Default or Event of Default exists or would result from the incurring of any Obligations by the Company or any of its Subsidiaries or from the grant or perfection of the Liens of the Agent and the Banks on the Collateral. As of the Closing Date, neither the Company nor any Subsidiary is in default under or with respect to any Contractual Obligation in any respect which, individually or together with all such defaults, could reasonably be expected to have a Material Adverse Effect, or that would, if such default had occurred after the Closing Date, create an Event of Default under subsection 9.01(e). 6.07 Compliance with Laws and ERISA. (a) Except as set forth on Schedule 6.03, the Company and its Subsidiaries are in compliance with the requirements of all applicable laws, rules, regulations and orders of every governmental authority, the non-compliance with which might materially adversely affect the business, properties, assets, operations or condition (financial or otherwise) of the Company or the value of the Collateral or the worth of the Collateral as collateral security. (b) Each Plan is in compliance in all material respects with the applicable provisions of ERISA, the Code and other federal or state law. Each Plan which is intended to qualify under Section 401(a) of the Code has received a favorable determination letter from the IRS and to the best knowledge of the Company, nothing has occurred which would cause the loss of such qualification. The Company and each ERISA Affiliate has made all required contributions to any Plan subject to Section 412 of the Code, and no application for a funding waiver or an extension of any amortization period pursuant to Section 412 of the Code has been made with respect to any Plan. (c) There are no pending (and served) or, to the best knowledge of Company, otherwise pending or threatened claims, actions or lawsuits, or action by any Governmental Authority, with respect to any Plan which has resulted or could reasonably be expected to result in a Material Adverse Effect. There has been no prohibited transaction or violation of the fiduciary responsibility rules with respect to any Plan which has resulted or could reasonably be expected to result in a Material Adverse Effect. (d) (i) No ERISA Event has occurred or is reasonably expected to occur; 63 (ii) no Pension Plan has any Unfunded Pension Liability; (iii) neither the Company nor any ERISA Affiliate has incurred, or reasonably expects to incur, any liability under Title IV of ERISA with respect to any Pension Plan (other than premiums due and not delinquent under Section 4007 of ERISA); (iv) neither the Company nor any ERISA Affiliate has incurred, or reasonably expects to incur, any liability (and no event has occurred which, with the giving of notice under Section 4219 of ERISA, would result in such liability) under Section 4201 or 4243 of ERISA with respect to a Multiemployer Plan; and (v) neither the Company nor any ERISA Affiliate has engaged in a transaction that could be subject to Section 4069 or 4212(c) of ERISA. 6.08 Use of Proceeds; Margin Regulations. The proceeds of the Loans are to be used solely for the purposes set forth in and permitted by Section 7.12 and Section 8.07. Neither the Company nor any Subsidiary is generally engaged in the business of purchasing or selling Margin Stock or extending credit for the purpose of purchasing or carrying Margin Stock. 6.09 Title to Property and Collateral; No Liens. The Company and each Subsidiary have good record and marketable title in fee simple to, or valid leasehold interests in, all real property necessary or used in the ordinary conduct of their respective businesses, except for such defects in title as could not, individually or in the aggregate, have a Material Adverse Effect. The Company and the Pledgor Subsidiaries are the legal and beneficial owners of, and have good and marketable title to (and have full right and authority to pledge, hypothecate, mortgage and deliver) all the Collateral that is subject to their respective Pledge Agreements. As of the Closing Date, all the Collateral and other property of the Company and its Subsidiaries are subject to no Liens, other than Permitted Liens. Even after the Closing Date, the Collateral shall continue not to be subject to any Liens, other than Permitted Liens. 6.10 As to Pledged Shares. Except as disclosed in Schedule 6.10, all Pledged Shares are duly authorized and validly issued, fully paid, and non-assessable, and constitute all of the issued and outstanding shares of capital stock of the Subsidiaries whose shares have been pledged by the Company and the Pledgor 64 Subsidiaries under the Pledge Agreements. Other than the Pledged Shares, no Subsidiary whose shares have been pledged under the Pledge Agreements has outstanding any capital stock or other securities convertible into or exchangeable for any of its capital stock, nor will it have outstanding any rights to subscribe for or to purchase, or any warrants or options for the purchase of, or any agreements (contingent or otherwise) providing for the issuance of, or any calls, commitments or claims of any character relating to, any of its capital stock or any securities convertible into or exchangeable for any of its capital stock. 6.11 Taxes. The Company and its Subsidiaries have filed all Federal and other material tax returns and reports required to be filed, and have paid all Federal and other material taxes, assessments, fees and other governmental charges levied or imposed upon them or their properties, income or assets otherwise due and payable, except those which are being contested in good faith by appropriate proceedings and for which adequate reserves have been provided in accordance with GAAP. There is no proposed tax assessment against the Company or any Subsidiary that would, if made, have a Material Adverse Effect. 6.12 Financial Condition. (a) The audited consolidated financial statements of the Company and its Subsidiaries dated December 31, 1997, and the related consolidated statements of income or operations, shareholders' equity and cash flows for the fiscal year ended on that date: (i) were prepared in accordance with GAAP consistently applied throughout the period covered thereby, except as otherwise expressly noted therein; (ii) fairly present the financial condition of the Company and its Subsidiaries as of the date thereof and results of operations for the period covered thereby; and (iii) except as specifically disclosed in Schedule 6.12, show all material indebtedness and other liabilities, direct or contingent, of the Company and its consolidated Subsidiaries as of the date thereof, including liabilities for taxes, material commitments and Contingent Obligations. (b) The audited consolidated financial statements of Kaiser Texas and its Subsidiaries dated December 31, 1997, and the related consolidated statements of income of operations, 65 shareholders' equity and cash flows for the fiscal year ended on that date and the unaudited consolidated financial statements of Kaiser Texas and its Subsidiaries dated June 30, 1998, and the related consolidated statements of income or operations, shareholders' equity and cash flows for the six months ended on that date: (i) were prepared in accordance with GAAP consistently applied throughout the period covered thereby, except as otherwise expressly noted therein; (ii) fairly present the financial condition of Kaiser Texas and its Subsidiaries as of the dates thereof and results of operations for the period covered thereby; (iii) except as specifically disclosed in Schedule 6.12, show all material indebtedness and other liabilities, direct or contingent, of Kaiser Texas and its consolidated Subsidiaries as of the date thereof, including liabilities for taxes, material commitments and Contingent Obligations; except to the extent that departures from the representations in clauses (i), (ii) or (iii) above could not, individually or in the aggregate, reasonably be expected to have a Material Adverse Effect. (c) Since December 31, 1997, there has been no Material Adverse Effect. 6.13 Environmental Matters. The Company conducts in the ordinary course of business a review of the effect of existing Environmental Laws and existing Environmental Claims on its business, operations and properties, and as a result thereof the Company has reasonably concluded that, except as specifically disclosed in Schedule 6.13, such Environmental Laws and Environmental Claims could not, individually or in the aggregate, reasonably be expected to have a Material Adverse Effect. 6.14 Collateral Documents. (a) The provisions of the Pledge Agreements and the delivery of the Collateral pursuant thereto are effective to create in favor of the Agent for the benefit of the Banks, a legal, valid and enforceable first priority security interest in all right, title and interest of the Company and its Subsidiaries in the Collateral described therein and all proceeds thereof. 66 Except as contemplated by this Agreement, no filing or other action will be necessary to perfect or protect such security interest. (b) All representations and warranties of the Company and the Pledgor Subsidiaries contained in the Collateral Documents are true and correct. 6.15 Regulated Entities. None of the Company, any Person controlling the Company, or any Subsidiary, is an "Investment Company" within the meaning of the Investment Company Act of 1940. The Company is not subject to regulation under the Public Utility Holding Company Act of 1935, the Federal Power Act, the Interstate Commerce Act, any state public utilities code, or any other Federal or state statute or regulation limiting its ability to incur Indebtedness. 6.16 No Burdensome Restrictions. Neither the Company nor any Subsidiary is a party to or bound by any Contractual Obligation, or subject to any restriction in any Organization Document, or any Requirement of Law, which could reasonably be expected to have a Material Adverse Effect. 6.17 Copyrights, Patents, Trademarks and Licenses, etc. The Company or its Subsidiaries own or are licensed or otherwise have the right to use all of the patents, trademarks, service marks, trade names, copyrights, contractual franchises, authorizations and other rights that are reasonably necessary for the operation of their respective businesses, without conflict with the rights of any other Person. To the best knowledge of the Company, no slogan or other advertising device, product, process, method, substance, part or other material now employed, or now contemplated to be employed, by the Company or any Subsidiary infringes upon any rights held by any other Person. No claim or litigation regarding any of the foregoing is pending or threatened, and no patent, invention, device, application, principle or any statute, law, rule, regulation, standard or code is pending or, to the knowledge of the Company, proposed, which, in either case, could reasonably be expected to have a Material Adverse Effect. 6.18 Subsidiaries. As of the Closing Date, the Company has no Subsidiaries other than those specifically disclosed in part (a) of Schedule 6.18 hereto and has no equity investments in any other corporation or entity constituting 20% or more of the outstanding equity interests in such corporation or entity other than those specifically disclosed in part (b) of Schedule 6.18. 67 Set forth in part (c) of Schedule 6.18 is a list of all Excluded Subsidiaries as of the Closing Date. 6.19 Insurance. Except as specifically disclosed in Schedule 6.19, the properties of the Company and its Subsidiaries are insured with financially sound and reputable insurance companies not Affiliates of the Company, in such amounts, with such deductibles and covering such risks as are customarily carried by companies engaged in similar businesses and owning similar properties in localities where the Company or such Subsidiary operates. 6.20 Swap Obligations. Neither the Company nor any of its Subsidiaries has incurred any outstanding obligations under any Swap Contracts except in the ordinary course of business for bona fide hedging purposes. 6.21 Full Disclosure. None of the representations or warranties made by the Company or any Subsidiary in the Loan Documents as of the date such representations and warranties are made or deemed made, and none of the statements contained in any exhibit, report, statement or certificate furnished by or on behalf of the Company or any Subsidiary in connection with the Loan Documents (including the offering and disclosure materials delivered by or on behalf of the Company to the Banks prior to the Closing Date), contains any untrue statement of a material fact or omits any material fact required to be stated therein or necessary to make the statements made therein, in light of the circumstances under which they are made, not misleading as of the time when made or delivered. 6.22 Business Activity. Neither the Company nor any of its Subsidiaries is engaged in any line or lines of business activity other than the Health Care Business. 6.23 Licensing, Etc. Each HMO Subsidiary maintains (i) all licenses and certifications required pursuant to any HMO Regulation; (ii) all certifications and authorizations necessary to ensure that each of the HMO Subsidiaries is eligible for all reimbursements available under the HMO Regulations to the extent applicable to HMOs of their type; and (iii)all licenses, permits, authorizations and qualifications required under the HMO Regulations in connection with the ownership or operation of HMOs; except where the failure to maintain the items described in any of the preceding three clauses would not have a Material Adverse Effect. 6.24 Kaiser Acquisition Agreements. 68 (a) Consummation of the transactions contemplated by the Kaiser Acquisition Agreements by Kaiser Texas, the Company, PMAT and Kaiser Texas has not and will not: (i) contravene the terms of any of that Person's Organization Documents; (ii) conflict with in any material respect or result in a breach or contravention of, or the creation of any Lien under, any document evidencing any material Contractual Obligation to which such Person is a party or any order, injunction, writ or decree of any Governmental Authority to which such Person or its property is subject; or (iii) violate any material Requirement of Law. (b) The Kaiser Acquisition Agreements constitute the legal, valid and binding obligations of the Company and, to the Company's knowledge, PMAT and Kaiser Texas, enforceable against such Person in accordance with their respective terms, except as enforceability may be limited by applicable bankruptcy, insolvency, or similar laws affecting the enforcement of creditors' rights generally or by equitable principles relating to enforceability. 6.25 Year 2000 Representation. On the basis of a comprehensive review and assessment of the Company's and its Subsidiaries' systems and equipment and inquiry made of the Company's and its Subsidiaries' material suppliers, vendors and customers, the Company reasonably believes that the "Year 2000 problem" (that is, the inability of computers, as well as embedded microchips in non-computing devices, to perform properly date-sensitive functions with respect to certain dates prior to and after December 31, 1999), including costs of remediation, will not result in a Material Adverse Effect. The Company and its Subsidiaries have developed feasible contingency plans adequately to ensure uninterrupted and unimpaired business operation in the event of failure of their own or a third party's systems or equipment due to the Year 2000 problem, including those of vendors, customers, and suppliers, as well as a general failure of or interruption in its communications and delivery infrastructure. 69 ARTICLE VII AFFIRMATIVE COVENANTS So long as any Bank shall have any Commitment hereunder, or any Loan or other Obligation shall remain unpaid or unsatisfied, or any Letter of Credit shall remain outstanding, unless the Majority Banks waive compliance in writing: 7.01 Financial Statements. The Company shall deliver to the Agent, in form and detail satisfactory to the Agent and the Majority Banks, with sufficient copies for each Bank: (a) as soon as available, but not later than 90 days after the end of each fiscal year (commencing with the fiscal year ended December 31, 1998), a copy of the audited consolidated balance sheets of the Company and its Subsidiaries as at the end of such year and the related consolidated statements of income or operations, shareholders' equity and cash flows for such year, setting forth in each case in comparative form the figures for the previous fiscal year, and accompanied by the opinion of Deloitte & Touche or another nationally-recognized independent public accounting firm ("Independent Auditor") which report shall state that such consolidated financial statements present fairly the financial position for the periods indicated in conformity with GAAP applied on a basis consistent with prior years. Such opinion shall not be qualified or limited because of a restricted or limited examination by the Independent Auditor of any material portion of the Company's or any Subsidiary's records; (b) as soon as available, but not later than 45 days after the end of each of the first three fiscal quarters of each fiscal year (commencing with the fiscal quarter ended March 31, 1999), a copy of the unaudited consolidated balance sheets of the Company and its Subsidiaries as of the end of such quarter and the related consolidated statements of income and cash flows for the period commencing on the first day and ending on the last day of such quarter, and certified by a Responsible Officer as fairly presenting, in accordance with GAAP (subject to ordinary, good faith year-end audit adjustments), the financial position and the results of operations of the Company and the Subsidiaries; (c) as soon as available, but not later than 90 days after the end of each fiscal year (commencing with the fiscal year ended December 31, 1998), (i) a copy of an unaudited consolidating balance sheets of the Company and its Subsidiaries as at the end of such year and the related consolidating statements of income for such year, certified by a Responsible Officer as having been developed and used in connection with the 70 preparation of the financial statements referred to in subsection 7.01(a) and (ii) a copy of a statement of financial position for any of the Company's Subsidiaries for which the Company provides a guaranty of reserve liabilities, as of the end of such quarter, certified by a Responsible Officer; and (d) as soon as available, but not later than 45 days after the end of each of the first three fiscal quarters of each fiscal year (commencing with the fiscal quarter ended March 31, 1999), (i) a copy of the unaudited consolidating balance sheets of the Company and its Subsidiaries, and the related consolidating statements of income for such quarter, all certified by a Responsible Officer as having been developed and used in connection with the preparation of the financial statements referred to in subsection 7.01(b) and (ii) a copy of a statement of financial position for any of the Company's Subsidiaries for which the Company provides a guaranty of reserve liabilities, as of the end of such quarter, certified by a Responsible Officer. 7.02 Certificates; Other Information. The Company shall furnish to the Agent, with sufficient copies for each Bank: (a) concurrently with the delivery of the financial statements referred to in subsection 7.01(a), a certificate of the Independent Auditor stating that in making the examination necessary therefor no knowledge was obtained of any Default or Event of Default, except as specified in such certificate; (b) concurrently with the delivery of the financial statements referred to in subsections 7.01(a) and (b), a Compliance Certificate executed by a Responsible Officer; (c) promptly, copies of all financial statements and reports that the Company sends to its shareholders, and copies of all financial statements and regular, periodical or special reports (including Forms 10K, 10Q and 8K) that the Company or any Subsidiary may make to, or file with, the SEC; (d) promptly following the receipt of the same, a copy of each notice relating to the loss by the Company or any HMO Subsidiary of any material operating permit, license or certification by any HMO Regulator; (e) promptly following the receipt of the same, all material correspondence received by the Company or any Subsidiary (other than correspondence in draft form) from an HMO Regulator which asserts that the Company or any HMO Subsidiary is not in 71 substantial compliance with any HMO Regulation or which threatens the taking of any action against the Company or any Subsidiary under any HMO Regulation which would reasonably be expected to have a Material Adverse Effect; (f) from time to time upon receipt of a written request by the Agent or any Bank specifying in reasonable detail the types of documents to be provided, copies of any and all statements, audits, studies or reports submitted by or on behalf of the Company or any HMO Subsidiary to any HMO Regulator; and (g) promptly, such additional information regarding the business, financial or corporate affairs of the Company or any Subsidiary as the Agent, at the request of any Bank, may from time to time reasonably request in writing. 7.03 Notices. The Company shall promptly notify the Agent and each Bank: (a) of the occurrence of any Default or Event of Default, and of the occurrence or existence of any event or circumstance that could, with reasonable foreseeability, become a Default or Event of Default; (b) of any matter that has resulted or may reasonably be expected to result in a Material Adverse Effect, including (i) breach or non-performance of, or any default under, a Contractual Obligation of the Company or any Subsidiary; (ii) any dispute, litigation, investigation, proceeding or suspension between the Company or any Subsidiary and any Governmental Authority; or (iii) the commencement of, or any material development in, any litigation or proceeding affecting the Company or any Subsidiary; including pursuant to any applicable Environmental Laws; (c) of the occurrence of any of the following events affecting the Company or any ERISA Affiliate (but in no event more than 10 days after such event), and deliver to the Agent and each Bank a copy of any notice with respect to such event that is filed with a Governmental Authority and any notice delivered by a Governmental Authority to the Company or any ERISA Affiliate with respect to such event: (i) an ERISA Event, (ii) a material increase in the Unfunded Pension Liability of any Pension Plan, 72 (iii) the adoption of, or the commencement of contributions to, any Plan subject to Section 412 of the Code by the Company or any ERISA Affiliate, or (iv) the adoption of any amendment to a Plan subject to Section 412 of the Code, if such amendment results in a material increase in contributions or Unfunded Pension Liability; (d) of any material change in accounting policies or financial reporting practices by the Company or any of its consolidated Subsidiaries; and (e) of the creation or acquisition of Subsidiary and a statement as to whether or not such Subsidiary is an Excluded Subsidiary. Each notice under this Section shall be accompanied by a written statement by a Responsible Officer setting forth details of the occurrence referred to therein, and stating what action the Company or any affected Subsidiary proposes to take with respect thereto and at what time. Each notice under subsection 7.03(a) shall describe with particularity any and all clauses or provisions of this Agreement or other Loan Document that have been (or could with reasonable foreseeability be) breached or violated. 7.04 Preservation of Corporate Existence, Etc. The Company shall, and shall cause each Subsidiary to: (a) preserve and maintain in full force and effect its corporate existence and good standing under the laws of its state or jurisdiction of incorporation; (b) preserve and maintain in full force and effect all governmental rights, privileges, qualifications, permits, licenses and franchises necessary or desirable in the normal conduct of its business, including all licenses and certifications required pursuant to any HMO Regulation, all certifications and authorizations necessary to ensure that each of the HMO Subsidiaries is eligible for all reimbursements available under the HMO Regulation to the extent applicable to HMOs of their type, and all licenses, permits, authorization and qualifications required under the HMO Regulations in connection with the ownership or operation of HMOs; (c) use reasonable efforts, in the ordinary course of business, to preserve its business organization and goodwill; and 73 (d) preserve or renew all of its registered patents, trademarks, trade names and service marks, the non-preservation of which could reasonably be expected to have a Material Adverse Effect. 7.05 Maintenance of Property. The Company shall maintain, and shall cause each Subsidiary to maintain, and preserve all its property which is used or useful in its business in good working order and condition, ordinary wear and tear excepted and make all necessary repairs thereto and renewals and replacements thereof except where the failure to do so could not reasonably be expected to have a Material Adverse Effect. 7.06 Insurance. Except as specifically disclosed in Schedule 6.19, in addition to insurance requirements set forth in the Collateral Documents, the Company shall maintain, and shall cause each Subsidiary to maintain, with financially sound and reputable independent insurers, insurance with respect to its properties and business against loss or damage of the kinds customarily insured against by Persons engaged in the same or similar business, of such types and in such amounts as are customarily carried under similar circumstances by such other Persons, of such types and in such amounts as are customarily carried under similar circumstances by such other Persons; including workers' compensation insurance, public liability and property and casualty insurance which amount shall not be reduced by the Company in the absence of 30 days' prior notice to the Agent. Upon request of the Agent or any Bank, the Company shall furnish the Agent, with sufficient copies for each Bank, at reasonable intervals (but not more than once per calendar year) a certificate of a Responsible Officer of the Company (and, if requested by the Agent, any insurance broker of the Company) setting forth the nature and extent of all insurance maintained by the Company and its Subsidiaries in accordance with this Section or any Collateral Documents (and which, in the case of a certificate of a broker, were placed through such broker). 7.07 Payment of Obligations. The Company shall, and shall cause each Subsidiary to, pay and discharge as the same shall become due and payable, all their respective obligations and liabilities, including: (a) all tax liabilities, assessments and governmental charges or levies upon it or its properties or assets, unless the same are being contested in good faith by appropriate proceedings and adequate reserves in accordance with GAAP are being maintained by the Company or such Subsidiary; 74 (b) all lawful claims which, if unpaid, would by law become a Lien upon its property; and (c) all Indebtedness, as and when due and payable, but subject to any subordination provisions contained in any instrument or agreement evidencing such Indebtedness. 7.08 Compliance with Laws. The Company shall comply, and shall cause each Subsidiary to comply, in all material respects with all Requirements of Law of any Governmental Authority having jurisdiction over it or its business (including all HMO Regulations and the Federal Fair Labor Standards Act), except such as may be contested in good faith or as to which a bona fide dispute may exist. 7.09 Compliance with ERISA. The Company shall, and shall cause each of its ERISA Affiliates to: (a) maintain each Plan in compliance in all material respects with the applicable provisions of ERISA, the Code and other federal or state law; (b) cause each Plan which is qualified under Section 401(a) of the Code to maintain such qualification; and (c) make all required contributions to any Plan subject to Section 412 of the Code. 7.10 Inspection of Property and Books and Records. The Company shall maintain and shall cause each Subsidiary to maintain proper books of record and account, in which full, true and correct entries in conformity with GAAP consistently applied shall be made of all financial transactions and matters involving the assets and business of the Company and such Subsidiary. The Company shall permit, and shall cause each Subsidiary to permit, representatives and independent contractors of the Agent or any Bank to visit and inspect any of their respective properties, to examine their respective corporate, financial and operating records, and make copies thereof or abstracts therefrom, and to discuss their respective affairs, finances and accounts with their respective directors, officers, and independent public accountants, all at the expense of the Company and at such reasonable times during normal business hours and as often as may be reasonably desired, upon reasonable advance notice to the Company. 7.11 Environmental Laws. The Company shall, and shall cause each Subsidiary to, conduct its operations and keep and maintain its property in material compliance with all Environmental Laws. 75 7.12 Use of Proceeds. The Company shall use the proceeds of the Loans for the Kaiser-Texas Acquisition, for general working capital purposes and for general corporate purposes (other than for Acquisitions that are not Permitted Acquisitions) not in contravention of any Requirement of Law or of any Loan Document. 7.13 Further Assurances. (a) The Company shall ensure that all written information, exhibits and reports furnished to the Agent or the Banks do not and will not contain any untrue statement of a material fact and do not and will not omit to state any material fact or any fact necessary to make the statements contained therein not misleading in light of the circumstances in which made, and will promptly disclose to the Agent and the Banks and correct any defect or error that may be discovered therein or in any Loan Document or in the execution, acknowledgment or recordation thereof. (b) Promptly upon request by the Agent or the Majority Banks, the Company shall (and shall cause any of its Subsidiaries, including Pledgor Subsidiaries, to) do, execute, acknowledge, deliver, record, re-record, file, re-file, register and re-register, any and all such further acts, deeds, conveyances, security agreements, mortgages, assignments, estoppel certificates, financing statements and continuations thereof, termination statements, notices of assignment, transfers, certificates, assurances and other instruments the Agent or such Banks, as the case may be, may reasonably require from time to time in order (i) to carry out more effectively the purposes of this Agreement or any other Loan Document, (ii) to subject to the Liens created by any of the Collateral Documents any of the Collateral, properties, rights or interests covered by any of the Collateral Documents, (iii) to perfect, protect and maintain the validity, effectiveness and priority of any of the Collateral Documents and the Liens intended to be created thereby, and (iv) to better assure, convey, grant, assign, transfer, preserve, protect and confirm to the Agent and Banks the rights granted or now or hereafter intended to be granted to the Banks under any Loan Document or under any other document executed in connection therewith. 7.14 Dividends of Subsidiaries During Default. Promptly upon (but in no case more than five Business Days after) the occurrence of a Default, the Company shall cause each HMO Subsidiary of the Company to declare and pay dividends (in cash, property, or obligations) on, or to make payments or distributions on account of, the shares of all classes of stock 76 of such entity in an amount equal to the maximum amount permitted by applicable law at such time to such Subsidiary for the payment of dividends; provided, however, that no such Subsidiary shall be required to pay dividends under this Section 7.14 to the extent that doing so would cause the Regulatory Tangible Net Equity of such Subsidiary to be less than 105 percent of any Regulatory Tangible Net Equity Requirement applicable to such Subsidiary. 7.15 Acquisitions. Prior to consummating any Permitted Acquisition for aggregate consideration (whether consisting of cash, securities, other property, assumption of Indebtedness or other obligations, or any combination thereof) having a value in excess of $25,000,000, the Company shall have delivered to the Agent (in form and detail satisfactory to each Bank and in sufficient copies for each Bank) the following: (i) At least 15 days' prior written notice from a Responsible Officer of the Company, stating the Company's intention to consummate a Permitted Acquisition, together with a brief summary of the substantive terms thereof; (ii) At least 10 days prior to the consummation of such Permitted Acquisition, a certified copy of the executed purchase contract or merger agreement relating to such Permitted Acquisition; and (iii) An officer's certificate, executed by a Responsible Officer of the Company, dated the date of consummation of such Permitted Acquisition, certifying that immediately before and after giving effect to such Permitted Acquisition (A) no Default has occurred and is continuing or will exist after giving effect to the Permitted Acquisition and (B) that the Company will be in compliance on a pro forma basis with each of the financial ratios specified in Section 8.14 as of the end of the fiscal quarter immediately preceding such Acquisition for the twelve-month period preceding such fiscal quarter end, together with a reasonably detailed worksheet setting forth the calculations of such ratios, which calculations shall be acceptable to the Banks. ARTICLE VIII NEGATIVE COVENANTS So long as any Bank shall have any Commitment hereunder, or any Loan or other Obligation shall remain unpaid or unsatisfied, 77 or any Letter of Credit shall remain outstanding, unless the Majority Banks waive compliance in writing: 8.01 Limitation on Liens. The Company shall not, and shall not suffer or permit any Subsidiary to, directly or indirectly, make, create, incur, assume or suffer to exist any Lien upon or with respect to any part of its property, whether now owned or hereafter acquired, other than the following ("Permitted Liens"): (a) any Lien existing on property of the Company or any Subsidiary on the Closing Date and set forth in Schedule 8.01 securing Indebtedness outstanding on such date and any refinancing or refunding thereof; (b) any Lien created under any Loan Document; (c) Liens for taxes, fees, assessments or other governmental charges which are not delinquent or remain payable without penalty, or to the extent that non-payment thereof is permitted by Section 7.07, provided that no notice of lien has been filed or recorded under the Code; (d) carriers', warehousemen's, mechanics', landlords', materialmen's, repairmen's or other similar Liens arising in the ordinary course of business which are not delinquent or remain payable without penalty; (e) Liens (other than any Lien imposed by ERISA) consisting of pledges or deposits required in the ordinary course of business in connection with workers' compensation, unemployment insurance and other social security legislation; (f) easements, rights-of-way, restrictions and other similar encumbrances incurred in the ordinary course of business which, in the aggregate, are not substantial in amount, and which do not in any case materially detract from the value of the property subject thereto or interfere with the ordinary conduct of the businesses of the Company and its Subsidiaries; (g) purchase money security interests on any property acquired or held by the Company or its Subsidiaries in the ordinary course of business, securing Indebtedness incurred or assumed for the purpose of financing all or any part of the cost of acquiring such property; provided that (i) any such Lien attaches to such property concurrently with or within 20 days after the acquisition thereof, (ii) such Lien attaches solely to the property so acquired in such transaction, (iii) the principal amount of the Indebtedness secured thereby does not exceed 100% 78 of the cost of such property, and (iv) the principal amount of the Indebtedness secured by any and all such purchase money security interests shall not at any time exceed $25,000,000; (h) mortgage Liens in connection with the financing of existing, unencumbered real property of the Company or its Subsidiaries securing Indebtedness having an aggregate principal amount of up to $100,000,000 so long as the Specified Percentage of the net proceeds thereof are applied, within ten days after receipt thereof, by the Company to the scheduled reductions of the Commitment pursuant to Section 2.07(b), and such payments are applied to reduce the ratable reduction of the remaining installments under Section 2.07(b); (i) mortgage Liens on any real property acquired or constructed by the Company or its Subsidiaries subsequent to the Closing Date in the ordinary course of business, securing Indebtedness incurred or assumed for the purpose of financing all or any part of the cost of acquiring or constructing such property; provided that (i) any such Lien attaches to such property concurrently with or within 90 days after such property is placed in service by the Company, (ii) such Lien attaches solely to the property so acquired or constructed in such transaction, (iii) the principal amount of the Indebtedness secured thereby does not exceed 100% of the fair market value of such property, (iv) such Indebtedness is without recourse to the Company or any of its Subsidiaries and (v) the aggregate amount of all such Indebtedness does not exceed $25,000,000; (j) Liens securing obligations in respect of Capital Leases, limited to the assets subject to such leases, provided that such Capital Leases are otherwise permitted hereunder; (k) Liens on any property of HMO Texas, securing the Kaiser Note; provided that such Indebtedness is without recourse to the Company or any of its Subsidiaries (other than HMO Texas to the extent set forth in the Kaiser Note); (l) Liens securing letters of credit, each of which has an individual face amount less than $500,000 and the aggregate face amounts of which are less than $1,000,000; and (m) Liens securing obligations of the Company to a Subsidiary permitted pursuant to Section 8.05(g). 8.02 Disposition of Assets. The Company shall not, and shall not suffer or permit any Subsidiary to, directly or indirectly, sell, assign, lease, convey, transfer or otherwise dispose of (whether in one or a series of transactions) any 79 property (including accounts and notes receivable, with or without recourse) or enter into any agreement to do any of the foregoing, except: (a) dispositions of inventory, or used, worn-out or surplus equipment, all in the ordinary course of business; (b) the sale of equipment to the extent that such equipment is exchanged for credit against the purchase price of similar replacement equipment, or the proceeds of such sale are reasonably promptly applied to the purchase price of such replacement equipment; (c) sales by the Company in the ordinary course of business of marketable securities held in its investment portfolios; (d) dispositions of assets (including all, but not less than all of the capital stock of any Subsidiary) acquired subsequent to December 31, 1997, to the extent advisable in the best business judgment of the Company; and (e) dispositions not otherwise permitted hereunder of assets (including all, but not less than all, of the capital stock of any Subsidiary) listed on the balance sheet of the Company at December 31, 1997, which are made for fair market value; provided, that (i) at the time of any disposition, no Event of Default shall exist or shall result from such disposition, (ii) the aggregate sales price from such disposition shall be paid in cash, (iii) the aggregate value of all assets so sold by the Company and its Subsidiaries prior to the Revolving Loan Termination Date, together, shall not exceed 10% of the Consolidated Tangible Assets listed on the December 31, 1997 balance sheet. 8.03 Consolidations and Mergers. The Company shall not, and shall not suffer or permit any Subsidiary to, merge, consolidate with or into, or convey, transfer, lease or otherwise dispose of (whether in one transaction or in a series of transactions all or substantially all of its assets (whether now owned or hereafter acquired) to or in favor of any Person, except: (a) any Subsidiary may merge with the Company, provided that the Company shall be the continuing or surviving corporation, or with any one or more Subsidiaries, provided that if any transaction shall be between a Subsidiary and a Wholly- Owned Subsidiary, the Wholly-Owned Subsidiary shall be the continuing or surviving corporation; (b) any Subsidiary may sell all or substantially all of its assets (upon voluntary liquidation or otherwise), to the Company or another Wholly-Owned Subsidiary; and (c) Permitted Acquisitions. 8.04 Loans and Investments. The Company shall not purchase or acquire, or suffer or permit any Subsidiary to purchase or acquire, or make any commitment therefor, any capital stock, equity interest, or any obligations or other securities of, or any interest in, any Person, or make or commit to make any Acquisitions, or make or commit to make any advance, loan, extension of credit or capital contribution to or any other investment in, any Person including any Affiliate of the Company (together, "Investments"), except for: (a) Investments held by the Company or Subsidiary in the form of cash equivalents or marketable securities in the ordinary course of business; (b) extensions of credit in the nature of accounts receivable or notes receivable arising from the sale or lease of goods or services in the ordinary course of business; (c) extensions of credit by the Company to any of its Wholly-Owned Subsidiaries or by any of its Wholly-Owned Subsidiaries to another of its Wholly-Owned Subsidiaries; (d) Investments in Subsidiaries; (e) the Investments as of the Closing Date listed on Schedule 8.04; (f) loans or advances to officers and employees in an aggregate amount not to exceed $2,500,000; and (g) other Investments consisting of equity holdings in 2314 Partnership and Persons other than Subsidiaries in an aggregate amount not exceeding 15% of the Company's Net Worth at any one time outstanding. 8.05 Limitation on Indebtedness. The Company shall not, and shall not suffer or permit any Subsidiary to, create, incur, assume, suffer to exist, or otherwise become or remain directly or indirectly liable with respect to, any Indebtedness, except: 80 (a) Indebtedness incurred pursuant to this Agreement; (b) Indebtedness consisting of Contingent Obligations permitted pursuant to Section 8.08; (c) Indebtedness existing on the Closing Date and set forth in Schedule 8.05 (including, without limitation, the Indebtedness evidenced by the Kaiser Note); (d) Indebtedness secured by Liens permitted by subsections 8.01(g), (h) and (i); (e) Indebtedness incurred for the purpose of refinancing all (but not less than all) of any item of Indebtedness incurred pursuant to subsections (b) or (c) above; provided, that the aggregate outstanding principal amount of such Indebtedness shall not at any time exceed the aggregate outstanding principal amount thereof at the Closing Date, minus the aggregate amount of all payments and prepayments of principal which as of such time shall have been made after the date of this Agreement in respect of Indebtedness incurred pursuant to subsections (b) and (c) or pursuant to this subsection (e); and (f) loans or advances to officers and employees of the Company and its Subsidiaries permitted pursuant to Section 8.04(f); (g) loans from any Subsidiary of the Company to the Company; (h) Indebtedness in an aggregate principal amount at any one time outstanding not in excess of $25,000,000 in respect of Capital Leases; and (i) additional unsecured Indebtedness not otherwise permitted under this Section 8.05, in an aggregate principal amount not to exceed $15,000,000 at any one time outstanding; provided that not more than $7,500,000 of such Indebtedness may be Indebtedness of the Company's Subsidiaries. 8.06 Transactions with Affiliates. The Company shall not, and shall not suffer or permit any Subsidiary to, enter into any transaction with any Affiliate of the Company, except upon fair and reasonable terms no less favorable to the Company or such Subsidiary than would obtain in a comparable arm's-length transaction with a Person not an Affiliate of the Company or such Subsidiary. 81 8.07 Use of Proceeds. (a) The Company shall not, and shall not suffer or permit any Subsidiary to, use any portion of the Loan proceeds or any Letter of Credit, directly or indirectly, (i) to purchase or carry Margin Stock, (ii) to repay or otherwise refinance indebtedness of the Company or others incurred to purchase or carry Margin Stock, (iii) to extend credit for the purpose of purchasing or carrying any Margin Stock, (iv) to acquire any security in any transaction that is subject to Section 13 or 14 of the Exchange Act, or (v) for any purpose which violated Regulations T, U or X of the FRB. (b) The Company shall not, directly or indirectly, use any portion of the Loan proceeds or any Letter of Credit (i) knowingly to purchase Ineligible Securities from the Agent or any of its Affiliates during any period in which the Agent or any of its Affiliates makes a market in such Ineligible Securities, (ii) knowingly to purchase during the underwriting or placement period Ineligible Securities being underwritten or privately placed by the Agent or any of its Affiliates, or (iii) to make payments of principal or interest on Ineligible Securities underwritten or privately placed by the Agent or any of its Affiliates and issued by or for the benefit of the Company or any Affiliate of the Company. Certain Affiliates of the Agent are registered broker-dealers and permitted to underwrite and deal in certain Ineligible Securities; and "Ineligible Securities" means securities which may not be underwritten or dealt in by member banks of the Federal Reserve System under Section 16 of the Banking Act of 1933 (12 U.S.C. Section 24, Seventh), as amended. 8.08 Contingent Obligations. The Company shall not, and shall not suffer or permit any Subsidiary to, create, incur, assume or suffer to exist any Contingent Obligations except: (a) endorsements for collection or deposit in the ordinary course of business; (b) Contingent Obligations of the Company and its Subsidiaries existing as of the Closing Date and listed in Schedule 8.08; (c) Contingent Obligations under Swap Contracts; and (d) Contingent Obligations with respect to Surety Instruments incurred in the ordinary course of business; 82 (e) Guarantees by the Company of leases by its Subsidiaries of office and medical space; and (f) Guarantees by the Company of reserve obligations and similar obligations of its Subsidiaries under applicable Requirements of Law. 8.09 Lease Obligations. The Company shall not, and shall not suffer or permit any Subsidiary to, create or suffer to exist any obligations for the payment of rent for any property under lease or agreement to lease, except for: (a) leases of the Company and of Subsidiaries in existence on the Closing Date and any renewal, extension or refinancing thereof; (b) operating leases entered into by the Company or any Subsidiary after the Closing Date in the ordinary course of business; and (c) Capital Leases other than those permitted under clause (a) of this Section, entered into by the Company or any Subsidiary after the Closing Date to finance the acquisition of equipment, to the extent permitted pursuant to Section 8.05. 8.10 Restricted Payments. (a) So long as there are any Obligations outstanding, the Company shall not, and shall not suffer or permit any Subsidiary to, (x) purchase, redeem, retire or otherwise acquire for value, or set apart any money for a sinking, defeasance or other analogous fund for, the purchase, redemption, retirement or other acquisition of, or make any voluntary prepayment of, the principal of the Convertible Debt or the Kaiser Note prior to the scheduled maturity thereof, (y) declare or make any dividend payment or other distribution of assets, properties, cash, rights, obligations or securities on account of any shares of any class of its capital stock, or purchase, redeem or (z) otherwise acquire for value any shares of its capital stock or any warrants, rights or options to acquire such shares, now or hereafter outstanding (each, a "Restricted Payment") unless (i) at the time of, and immediately after giving effect to, such Restricted Payment, no Default or Event of Default shall have occurred and be continuing, (ii) after giving effect to such Restricted Payment, the aggregate amount of all Restricted Payments 83 made in any fiscal year does not exceed $15,000,000; provided, however that if the Company's Leverage Ratio as of the end of any fiscal quarter shall be less than 2.5 to 1.0, the annual limitation on Restricted Payments for the fiscal year in which such fiscal quarter falls and in each following fiscal year shall be $20,000,000, and (iii) after giving effect to such Restricted Payment, the aggregate amount of all Restricted Payments after the Closing Date does not exceed $50,000,000; notwithstanding the foregoing, the Company may refinance the Convertible Debt or the Kaiser Note with equity securities or with Indebtedness so long as, in the case of Indebtedness, the terms of the replacement Indebtedness (including, without limitation, interest rate, maturity, average life and collateral therefore) are no less favorable to the Company or the Banks than those of the Indebtedness so refinanced. (b) The Company shall not, and shall not suffer or permit any Subsidiary to make any regularly scheduled payment of the principal of or interest on, or any other amount owing in respect of the Convertible Debt unless both before and after giving effect thereof, no Default or Event of Default shall have occurred and be continuing. 8.11 ERISA. The Company shall not, and shall not suffer or permit any of its ERISA Affiliates to: (a) engage in a prohibited transaction or violation of the fiduciary responsibility rules with respect to any Plan which has resulted or could reasonably expected to result in liability of the Company in an aggregate amount in excess of $2,000,000; or (b) engage in a transaction that could be subject to Section 4069 or 4212(c) of ERISA. 8.12 Change in Business. The Company shall not, and shall not suffer or permit any Subsidiary to, engage in any material line of business other than the Health Care Business. 8.13 Accounting Changes. The Company shall not, and shall not suffer or permit any Subsidiary to, make any significant change in accounting treatment or reporting practices, except as required by GAAP, or change the fiscal year of the Company or of any Subsidiary. 84 8.14 Financial Covenants. The Company shall not: (a) permit its Leverage Ratio at the end of any fiscal quarter set forth below to exceed the ratio set forth below opposite such date: For the Quarter Ended: Ratio December 31, 1998 3.75 to 1.00 March 31, 1999 3.50 to 1.00 June 30, 1999 3.25 to 1.00 September 30, 1999 3.25 to 1.00 December 31, 1999 3.00 to 1.00 March 31, 2000 3.00 to 1.00 June 30, 2000 2.75 to 1.00 September 30, 2000 2.75 to 1.00 Thereafter 2.50 to 1.00 (b) permit its Consolidated Net Worth to be less than the sum of (i) 85% of its Consolidated Net Worth as of the Closing Date (after giving effect to the Kaiser-Texas Acquisition) plus (ii) 75% of cumulative consolidated net income (without giving effect to any consolidated net losses) for the period commencing on the Closing Date and ending on the date of determination, plus (iii) 75% of the amount by which its Consolidated Net Worth is increased by issuances of equity securities (except to the extent such issuance is made in connection with an Acquisition or securities issued pursuant to the Company's long term incentive plans, stock option plans and employee stock purchase plans); (c) permit its Fixed Charges Coverage Ratio at the end of any fiscal quarter set forth below to be less than the ratio set forth below opposite such date: For the Quarter Ended: Ratio December 31, 1998 1.50 to 1.00 March 31, 1999 1.50 to 1.00 June 30, 1999 1.50 to 1.00 September 30, 1999 1.50 to 1.00 December 31, 1999 1.50 to 1.00 March 31, 2000 1.75 to 1.00 June 30, 2000 2.00 to 1.00 September 30, 2000 2.25 to 1.00 December 31, 2000 2.50 to 1.00 Thereafter 3.00 to 1.00 (d) incur, make or enter into any contractual undertaking for Capital Expenditures in any fiscal year in excess of [6% of the Company's Consolidated Tangible Assets as of the last day of the most recently ended fiscal year.] 85 8.15 Limitation on Payment Restrictions Affecting Subsidiaries. Except as set forth in this Agreement, the Company shall not, and shall not permit any of its Subsidiaries, directly or indirectly, to create or suffer to exist or allow to become effective any consensual encumbrance or restriction on the ability of (i) any of the Subsidiaries of the Company to (a) declare and pay dividends on such Subsidiaries' stock or pay any obligation, liability or any Indebtedness owed to the Company or any of its other Subsidiaries, (b) make loans or advances to the Company or its other Subsidiaries or (c) transfer any of its properties or assets to the Company or any of its other Subsidiaries, or (ii) the Company or any of its Subsidiaries to receive or retain vis-a-vis the transferor any such amounts set forth in clauses (i)(a), (i)(b) or (i)(c) above, except for encumbrances or restrictions existing under or by reason of HMO Regulations and other applicable law. 8.16 Pledged Shares. The Company shall, and shall cause each of its Subsidiaries to, pledge to the Agent, for the benefit of the Banks, all of the shares of capital stock of each of their respective Subsidiaries (other than the shares of Excluded Subsidiaries) from time to time pursuant to a Pledge Agreement. 8.17 Acquisitions. The Company will not, nor will it permit any of its Subsidiaries to, make any Acquisition unless: (i) immediately before and after giving effect to the consummation of each Acquisition, no Default has occurred and is continuing or will exist; (ii) for each such Acquisition involving the purchase of a majority of the stock of another party, the prior, effective written consent or approval to such Acquisition of the board of directors or equivalent governing body of the other party or parties has been obtained; (iii) the aggregate value of the cash or other non-stock consideration (including Indebtedness assumed by the Company or its Subsidiaries in connection therewith) for all Acquisitions (other than those described in the following proviso) does not exceed $25,000,000 in any fiscal year or $50,000,000 after the Closing Date; and (iv) the aggregate value of all consideration (including Indebtedness assumed by the Company and its Subsidiaries in connection therewith) for all such Acquisitions (other than those described in the 86 following proviso) does not exceed $75,000,000 in any fiscal year or $150,000,000 after the Closing Date; provided, however, that notwithstanding the foregoing, any Subsidiary of the Company may be merged or consolidated with or into the Company if the Company shall be the continuing or surviving corporation or with or into any other Subsidiary of the Company. ARTICLE IX EVENTS OF DEFAULT 9.01 Event of Default. Any of the following shall constitute an "Event of Default": (a) Non-Payment. The Company fails to pay, (i) when and as required to be paid herein, any amount of principal of or interest on any Loan or of any L/C Obligation, or (ii) within three days after the same becomes due, any fee or any other amount payable hereunder or under any other Loan Document; or (b) Representation or Warranty. Any representation or warranty by the Company or any Subsidiary made or deemed made herein, in any other Loan Document, or which is contained in any certificate, document or financial or other statement by the Company, any Subsidiary, or any Responsible Officer, furnished at any time under this Agreement, or in or under any other Loan Document, is incorrect in any material respect on or as of the date made or deemed made; or (c) Specific Defaults. The Company fails to perform or observe any term, covenant or agreement contained in any of Section 7.01, 7.02, 7.03 or 7.09 or in Article VIII; or (d) Other Defaults. The Company fails to perform or observe any other term or covenant contained in this Agreement or any other Loan Document, and such default shall continue unremedied for a period of 20 days after the earlier of (i) the date upon which a Responsible Officer had Actual Knowledge of such failure or (ii) the date upon which written notice thereof is given to the Company by the Agent or any Bank; or (e) Cross-Default. The Company or any Subsidiary (A) fails to make any payment in respect of any Indebtedness or Contingent Obligation, having an aggregate principal amount of more than $10,000,000 when due (whether by scheduled maturity, required prepayment, acceleration, demand, or otherwise); or 87 (B) fails to perform or observe any other condition or covenant, or any other event shall occur or condition exist, under any agreement or instrument relating to any such Indebtedness or Contingent Obligation, and such failure continues after the applicable grace or notice period, if any, specified in the relevant document on the date of such failure if the effect of such failure, event or condition is to cause, or to permit the holder or holders of such Indebtedness or beneficiary or beneficiaries of such Indebtedness (or a trustee or agent on behalf of such holder or holders or beneficiary or beneficiaries) to cause such Indebtedness to be declared to be due and payable prior to its stated maturity, or such Contingent Obligation to become payable or cash collateral in respect thereof to be demanded; or (f) Insolvency; Voluntary Proceedings. The Company or any Significant Subsidiary (i) ceases or fails to be solvent, or generally fails to pay, or admits in writing its inability to pay, its debts as they become due, subject to applicable grace periods, if any, whether at stated maturity or otherwise; (ii) voluntarily ceases to conduct its business in the ordinary course; (iii) commences any Insolvency Proceeding with respect to itself; or (iv) takes any action to effectuate or authorize any of the foregoing; or (g) Involuntary Proceedings. (i) Any involuntary Insolvency Proceeding is commenced or filed against the Company or any Significant Subsidiary, or any writ, judgment, warrant of attachment, execution or similar process, is issued or levied against a substantial part of the Company's or any Significant Subsidiary's properties, and any such proceeding or petition shall not be dismissed, or such writ, judgment, warrant of attachment, execution or similar process shall not be released, vacated or fully bonded within 60 days after commencement, filing or levy; (ii) the Company or any Significant Subsidiary admits the material allegations of a petition against it in any Insolvency Proceeding, or an order for relief (or similar order under non-U.S. law) is ordered in any Insolvency Proceeding; or (iii) the Company or any Significant Subsidiary acquiesces in the appointment of a receiver, trustee, custodian, conservator, liquidator, mortgagee in possession (or agent therefor), or other similar Person for itself or a substantial portion of its property or business; or (h) ERISA. (i) An ERISA Event shall occur with respect to a Pension Plan or Multiemployer Plan which has resulted or could reasonably be expected to result in liability of the Company under Title IV of ERISA to the Pension Plan, 88 Multiemployer Plan or the PBGC in an aggregate amount in excess of $2,000,000; the aggregate amount of Unfunded Pension Liability among all Pension Plans at any time exceeds $2,000,000; or (iii) the Company or any ERISA Affiliate shall fail to pay when due, after the expiration of any applicable grace period, any installment payment with respect to its withdrawal liability under Section 4201 of ERISA under a Multiemployer Plan in an aggregate amount in excess of $2,000,000; or (i) Monetary Judgments. One or more non-interlocutory judgments, non-interlocutory orders, decrees or arbitration awards is entered against the Company or any Subsidiary involving in the aggregate a liability (to the extent not covered by independent third-party insurance as to which the insurer does not dispute coverage) as to any single or related series of transactions, incidents or conditions, of $5,000,000 or more, and the same shall remain unvacated and unstayed pending appeal for a period of 10 days after the entry thereof; or (j) Non-Monetary Judgments. Any non-monetary judgment, order or decree is entered against the Company or any Subsidiary which does or would reasonably be expected to have a Material Adverse Effect, and there shall be any period of 10 consecutive days during which a stay of enforcement of such judgment or order, by reason of a pending appeal or otherwise, shall not be in effect; or (k) Change of Control. There occurs any Change of Control; or (l) Loss of Licenses. Any HMO Regulator or any other Governmental Authority revokes or fails to renew any material license, permit or franchise of the Company or any Subsidiary, or the Company or any Subsidiary for any reason loses any material license, permit or franchise, or the Company or any Subsidiary suffers the imposition of any restraining order, escrow, suspension or impound of funds in connection with any proceeding (judicial or administrative) with respect to any material license, permit or franchise; or (m) HMO Event. An HMO Event shall have occurred and remain unremedied for the lesser of 30 days after the occurrence of such event or five days after the duration of any cure period imposed for the cure of such HMO Event by the HMO Regulator administering the pertinent HMO Regulations; or (n) Prospective Premium Default. A Prospective Premium Default shall have occurred; or 89 (o) Adverse Change. There occurs a Material Adverse Effect; or (p) Invalidity of Subordination Provisions. The subordination provisions of the Convertible Debt is for any reason revoked or invalidated, or otherwise cease to be in full force and effect, or any Person contests in any manner (with a reasonable likelihood of success) the validity or enforceability thereof or denies that it has any further liability or obligation thereunder, or the Indebtedness hereunder is for any reason subordinated or does not have the priority contemplated by this Agreement or such subordination provisions. 9.02 Remedies. If any Event of Default occurs, the Agent shall, at the request of, or may, with the consent of, the Majority Banks, (a) declare the commitment of each Bank to make Loans and any obligation of the Issuing Bank to Issue Letters of Credit to be terminated, whereupon such commitments and obligation shall be terminated; (b) declare an amount equal to the maximum aggregate amount that is or at any time thereafter may become available for drawing under any outstanding Letters of Credit (whether or not any beneficiary shall have presented, or shall be entitled at such time to present, the drafts or other documents required to draw under such Letters of Credit) to be immediately due and payable, and declare the unpaid principal amount of all outstanding Loans, all interest accrued and unpaid thereon, and all other amounts owing or payable hereunder or under any other Loan Document to be immediately due and payable, without presentment, demand, protest or other notice of any kind, all of which are hereby expressly waived by the Company; and (c) exercise on behalf of itself and the Banks all rights and remedies available to it and the Banks under the Loan Documents or applicable law; provided, however, that upon the occurrence of any event specified in subsection (f) or (g) of Section 9.01 (in the case of clause (i) of subsection (g) upon the expiration of the 60-day period mentioned therein), the obligation of each Bank to make Loans and any obligation of the Issuing Bank to Issue Letters of Credit shall automatically terminate and the unpaid principal amount of all outstanding Loans and all interest and other amounts as aforesaid shall automatically become due and payable without further act of the Agent, the Issuing Bank or any Bank. 90 NOTWITHSTANDING THE FOREGOING, THE AGENT AND THE BANKS EXPRESSLY ACKNOWLEDGE AND AGREE THAT ANY TRANSFER OF THE PLEDGED SHARES, OR ANY EXERCISE OF CONTROL WITH RESPECT THERETO, IS SUBJECT TO, AND SHALL BE EFFECTED SOLELY IN COMPLIANCE WITH, APPLICABLE REGULATORY REQUIREMENTS; PROVIDED THAT THIS ACKNOWLEDGMENT AND AGREEMENT IS MADE SOLELY FOR THE BENEFIT OF APPLICABLE GOVERNMENTAL AND REGULATORY AUTHORITIES AND SHALL NOT BE CONSTRUED AS A COVENANT AS BETWEEN THE AGENT AND THE BANKS, ON THE ONE HAND, AND THE COMPANY OR ANY OF ITS SUBSIDIARIES, ON THE OTHER HAND. 9.03 Rights Not Exclusive. The rights provided for in this Agreement and the other Loan Documents are cumulative and are not exclusive of any other rights, powers, privileges or remedies provided by law or in equity, or under any other instrument, document or agreement now existing or hereafter arising. ARTICLE X THE AGENT 10.01 Appointment and Authorization; "Agent". (a) Each Bank hereby irrevocably (subject to Section 10.09) appoints, designates and authorizes the Agent to take such action on its behalf under the provisions of this Agreement and each other Loan Document and to exercise such powers and perform such duties as are expressly delegated to it by the terms of this Agreement or any other Loan Document, together with such powers as are reasonably incidental thereto. Notwithstanding any provision to the contrary contained elsewhere in this Agreement or in any other Loan Document, the Agent shall not have any duties or responsibilities, except those expressly set forth herein, nor shall the Agent have or be deemed to have any fiduciary relationship with any Bank, and no implied covenants, functions, responsibilities, duties, obligations or liabilities shall be read into this Agreement or any other Loan Document or otherwise exist against the Agent. Without limiting the generality of the foregoing sentence, the use of the term "agent" in this Agreement with reference to the Agent is not intended to connote any fiduciary or other implied (or express) obligations arising under agency doctrine of any applicable law. Instead, such term is used merely as a matter of market custom, and is intended to create or reflect only an administrative relationship between independent contracting parties. (b) The Issuing Bank shall act on behalf of the Banks with respect to any Letters of Credit Issued by it and the 91 documents associated therewith until such time and except for so long as the Agent may agree at the request of the Majority Lenders to act for such Issuing Bank with respect thereto; provided, however, that the Issuing Bank shall have all of the benefits and immunities (i) provided to the Agent in this Article X with respect to any acts taken or omissions suffered by the Issuing Bank in connection with Letters of Credit Issued by it or proposed to be Issued by it and the application and agreements for letters of credit pertaining to the Letters of Credit as fully as if the term "Agent", as used in this Article X, included the Issuing Bank with respect to such acts or omissions, and (ii) as additionally provided in this Agreement with respect to the Issuing Bank. 10.02 Delegation of Duties. The Agent may execute any of its duties under this Agreement or any other Loan Document by or through agents, employees or attorneys-in-fact and shall be entitled to advice of counsel concerning all matters pertaining to such duties. The Agent shall not be responsible for the negligence or misconduct of any agent or attorney-in-fact that it selects with reasonable care. 10.03 Liability of Agent. None of the Agent-Related Persons shall (i) be liable for any action taken or omitted to be taken by any of them under or in connection with this Agreement or any other Loan Document or the transactions contemplated hereby (except for its own gross negligence or willful misconduct), or (ii) be responsible in any manner to any of the Banks for any recital, statement, representation or warranty made by the Company or any Subsidiary or Affiliate of the Company, or any officer thereof, contained in this Agreement or in any other Loan Document, or in any certificate, report, statement or other document referred to or provided for in, or received by the Agent under or in connection with, this Agreement or any other Loan Document, or the validity, effectiveness, genuineness, enforceability or sufficiency of this Agreement or any other Loan Document, or for any failure of the Company or any other party to any Loan Document to perform its obligations hereunder or thereunder. No Agent-Related Person shall be under any obligation to any Bank to ascertain or to inquire as to the observance or performance of any of the agreements contained in, or conditions of, this Agreement or any other Loan Document, or to inspect the properties, books or records of the Company or any of the Company's Subsidiaries or Affiliates. 10.04 Reliance by Agent. 92 (a) The Agent shall be entitled to rely, and shall be fully protected in relying, upon any writing, resolution, notice, consent, certificate, affidavit, letter, telegram, facsimile, telex or telephone message, statement or other document or conversation believed by it to be genuine and correct and to have been signed, sent or made by the proper Person or Persons, and upon advice and statements of legal counsel (including counsel to the Company), independent accountants and other experts selected by the Agent. The Agent shall be fully justified in failing or refusing to take any action under this Agreement or any other Loan Document unless it shall first receive such advice or concurrence of the Majority Banks as it deems appropriate and, if it so requests, it shall first be indemnified to its satisfaction by the Banks against any and all liability and expense which may be incurred by it by reason of taking or continuing to take any such action. The Agent shall in all cases be fully protected in acting, or in refraining from acting, under this Agreement or any other Loan Document in accordance with a request or consent of the Majority Banks and such request and any action taken or failure to act pursuant thereto shall be binding upon all of the Banks. (b) For purposes of determining compliance with the conditions specified in Section 5.01, each Bank that has executed this Agreement shall be deemed to have consented to, approved or accepted or to be satisfied with, each document or other matter either sent by the Agent to such Bank for consent, approval, acceptance or satisfaction, or required thereunder to be consented to or approved by or acceptable or satisfactory to the Bank. 10.05 Notice of Default. The Agent shall not be deemed to have knowledge or notice of the occurrence of any Default or Event of Default, except with respect to defaults in the payment of principal, interest and fees required to be paid to the Agent for the account of the Banks, unless the Agent shall have received written notice from a Bank or the Company referring to this Agreement, describing such Default or Event of Default and stating that such notice is a "notice of default". The Agent will notify the Banks of its receipt of any such notice. The Agent shall take such action with respect to such Default or Event of Default as may be requested by the Majority Banks in accordance with Article IX; provided, however, that unless and until the Agent has received any such request, the Agent may (but shall not be obligated to) take such action, or refrain from taking such action, with respect to such Default or Event of Default as it shall deem advisable or in the best interest of the Banks. 93 10.06 Credit Decision. Each Bank acknowledges that none of the Agent-Related Persons has made any representation or warranty to it, and that no act by the Agent hereinafter taken, including any review of the affairs of the Company and its Subsidiaries, shall be deemed to constitute any representation or warranty by any Agent-Related Person to any Bank. Each Bank represents to the Agent that it has, independently and without reliance upon any Agent-Related Person and based on such documents and information as it has deemed appropriate, made its own appraisal of and investigation into the business, prospects, operations, property, financial and other condition and creditworthiness of the Company and its Subsidiaries, and all applicable bank regulatory laws relating to the transactions contemplated hereby, and made its own decision to enter into this Agreement and to extend credit to the Company hereunder. Each Bank also represents that it will, independently and without reliance upon any Agent-Related Person and based on such documents and information as it shall deem appropriate at the time, continue to make its own credit analysis, appraisals and decisions in taking or not taking action under this Agreement and the other Loan Documents, and to make such investigations as it deems necessary to inform itself as to the business, prospects, operations, property, financial and other condition and creditworthiness of the Company. Except for notices, reports and other documents expressly herein required to be furnished to the Banks by the Agent, the Agent shall not have any duty or responsibility to provide any Bank with any credit or other information concerning the business, prospects, operations, property, financial and other condition or creditworthiness of the Company which may come into the possession of any of the Agent-Related Persons. 10.07 Indemnification of Agent. Whether or not the transactions contemplated hereby are consummated, the Banks shall indemnify upon demand the Agent-Related Persons (to the extent not reimbursed by or on behalf of the Company and without limiting the obligation of the Company to do so), pro rata, from and against any and all Indemnified Liabilities; provided, however, that no Bank shall be liable for the payment to the Agent-Related Persons of any portion of such Indemnified Liabilities resulting solely from such Person's gross negligence or willful misconduct. Without limitation of the foregoing, each Bank shall reimburse the Agent upon demand for its ratable share of any costs or out-of-pocket expenses (including Attorney Costs) incurred by the Agent in connection with the preparation, execution, delivery, administration, modification, amendment or enforcement (whether through negotiations, legal proceedings or otherwise) of, or legal advice in respect of rights or responsibilities under, this Agreement, any other Loan Document, 94 or any document contemplated by or referred to herein, to the extent that the Agent is not reimbursed for such expenses by or on behalf of the Company. The undertaking in this Section shall survive the payment of all Obligations hereunder and the resignation or replacement of the Agent. 10.08 Agent in Individual Capacity. BofA and its Affiliates may make loans to, issue letters of credit for the account of, accept deposits from, acquire equity interests in and generally engage in any kind of banking, trust, financial advisory, underwriting or other business with the Company and its Subsidiaries and Affiliates as though BofA were not the Agent or the Issuing Bank hereunder and without notice to or consent of the Banks. The Banks acknowledge that, pursuant to such activities, BofA or its Affiliates may receive information regarding the Company or its Affiliates (including information that may be subject to confidentiality obligations in favor of the Company or such Subsidiary) and acknowledge that the Agent shall be under no obligation to provide such information to them. With respect to its Loans, BofA shall have the same rights and powers under this Agreement as any other Bank and may exercise the same as though it were not the Agent or the Issuing Bank. 10.09 Successor Agent. The Agent may, and at the request of the Majority Banks shall, resign as Agent upon 30 days' notice to the Banks. If the Agent resigns under this Agreement, the Majority Banks shall appoint from among the Banks a successor agent for the Banks. If no successor agent is appointed prior to the effective date of the resignation of the Agent, the Agent may appoint, after consulting with the Banks and the Company, a successor agent from among the Banks. Upon the acceptance of its appointment as successor agent hereunder, such successor agent shall succeed to all the rights, powers and duties of the retiring Agent and the term "Agent" shall mean such successor agent and the retiring Agent's appointment, powers and duties as Agent shall be terminated. After any retiring Agent's resignation hereunder as Agent, the provisions of this Article X and Sections 11.04 and 11.05 shall inure to its benefit as to any actions taken or omitted to be taken by it while it was Agent under this Agreement. If no successor agent has accepted appointment as Agent by the date which is 30 days following a retiring Agent's notice of resignation, the retiring Agent's resignation shall nevertheless thereupon become effective and the Banks shall perform all of the duties of the Agent hereunder until such time, if any, as the Majority Banks appoint a successor agent as provided for above. Notwithstanding the foregoing, however, BofA may not be removed as the Agent at the request of the Majority Banks unless BofA shall also simultaneously be replaced as 95 "Issuing Bank" hereunder pursuant to documentation in form and substance reasonably satisfactory to BofA. 10.10 Withholding Tax. (a) If any Bank is a "foreign corporation, partnership or trust" within the meaning of the Code and such Bank claims exemption from, or a reduction of, U.S. withholding tax under Sections 1441 or 1442 of the Code, such Bank agrees with and in favor of the Agent and the Company, to deliver to the Agent: (i) if such Bank claims an exemption from, or a reduction of, withholding tax under a United States tax treaty, two properly completed and executed copies of IRS Form 1001 before the payment of any interest in the first calendar year and before the payment of any interest in each third succeeding calendar year during which interest may be paid under this Agreement; (ii) if such Bank claims that interest paid under this Agreement is exempt from United States withholding tax because it is effectively connected with a United States trade or business of such Bank, two properly completed and executed copies of IRS Form 4224 before the payment of any interest is due in the first taxable year of such Bank and in each succeeding taxable year of such Bank during which interest may be paid under this Agreement; and (iii) such other form or forms as may be required under the Code or other laws of the United States as a condition to exemption from, or reduction of, United States withholding tax. Such Bank agrees to promptly notify the Agent and the Company of any change in circumstances which would modify or render invalid any claimed exemption or reduction. (b) If any Bank claims exemption from, or reduction of, withholding tax under a United States tax treaty by providing IRS Form 1001 and such Bank sells, assigns, grants a participation in, or otherwise transfers all or part of the Obligations of the Company to such Bank, such Bank agrees to notify the Agent of the percentage amount in which it is no longer the beneficial owner of Obligations of the Company to such Bank. To the extent of such percentage amount, the Agent will treat such Bank's IRS Form 1001 as no longer valid. 96 (c) If any Bank claiming exemption from United States withholding tax by filing IRS Form 4224 with the Agent sells, assigns, grants a participation in, or otherwise transfers all or part of the Obligations of the Company to such Bank, such Bank agrees to undertake sole responsibility for complying with the withholding tax requirements imposed by Sections 1441 and 1442 of the Code. (d) If any Bank is entitled to a reduction in the applicable withholding tax, the Agent may withhold from any interest payment to such Bank an amount equivalent to the applicable withholding tax after taking into account such reduction. However, if the forms or other documentation required by subsection (a) of this Section are not delivered to the Agent, then the Agent may withhold from any interest payment to such Bank not providing such forms or other documentation an amount equivalent to the applicable withholding tax imposed by Sections 1441 and 1442 of the Code, without reduction. (e) If the IRS or any other Governmental Authority of the United States or other jurisdiction asserts a claim that the Agent or the Company did not properly withhold tax from amounts paid to or for the account of any Bank (because the appropriate form was not delivered or was not properly executed, or because such Bank failed to notify the Agent of a change in circumstances which rendered the exemption from, or reduction of, withholding tax ineffective, or for any other reason) such Bank shall indemnify the Agent and the Company fully for all amounts paid, directly or indirectly, by the Agent or the Company as tax or otherwise, including penalties and interest, and including any taxes imposed by any jurisdiction on the amounts payable to the Agent under this Section, together with all costs and expenses (including Attorney Costs). The obligation of the Banks under this subsection shall survive the payment of all Obligations and the resignation or replacement of the Agent. 10.11 Syndication Agent. The Bank identified on the facing page or signature pages of this Agreement as the "syndication agent" shall not have any right, power, obligation, liability, responsibility or duty under this Agreement other than those applicable to all Banks as such. Without limiting the foregoing, the Bank so identified as the "syndication agent" shall not have or be deemed to have any fiduciary relationship with any Bank. Each Bank acknowledges that it has not relied, and will not rely, on the Bank so identified in deciding to enter into this Agreement or in taking or not taking any action hereunder. 97 ARTICLE XI MISCELLANEOUS 11.01 Amendments and Waivers. No amendment or waiver of any provision of this Agreement or any other Loan Document, and no consent with respect to any departure by the Company therefrom, shall be effective unless the same shall be in writing and signed by the Majority Banks (or by the Agent at the written request of the Majority Banks) and the Company and acknowledged by the Agent, and then any such waiver or consent shall be effective only in the specific instance and for the specific purpose for which given; provided, however, that no such waiver, amendment, or consent shall, unless in writing and signed by all the Banks and the Company and acknowledged by the Agent, do any of the following: (a) increase or extend the Commitment of any Bank (or reinstate any Commitment terminated pursuant to Section 8.02); (b) postpone or delay any date fixed by this Agreement or any other Loan Document for any payment of principal, interest, fees or other amounts due to the Banks (or any of them) hereunder or under any other Loan Document; (c) reduce the principal of, or the rate of interest specified herein on any Loan, or (subject to clause (iii) below) any fees or other amounts payable hereunder or under any other Loan Document; (d) change the percentage of the Commitments or of the aggregate unpaid principal amount of the Loans which is required for the Banks or any of them to take any action hereunder; or (e) amend this Section, or Section 2.14, or any provision herein providing for consent or other action by all Banks; and, provided further, that (i) no amendment, waiver or consent shall, unless in writing and signed by the Issuing Bank in addition to the Majority Banks or all the Banks, as the case may be, affect the rights or duties of the Issuing Bank under this Agreement or any L/C-Related Document relating to any Letter of Credit Issued or to be Issued by it, (ii) no amendment, waiver or consent shall, unless in writing and signed by the Agent in addition to the Majority Banks or all the Banks, as the case may be, affect the rights or duties of the Agent under this Agreement or any other Loan Document, and (iii) the Fee Letters may be 98 amended, or rights or privileges thereunder waived, in a writing executed by the parties thereto. 11.02 Notices. (a) All notices, requests, consents, approvals, waivers and other communications shall be in writing (including, unless the context expressly otherwise provides, by facsimile transmission, provided that any matter transmitted by the Company by facsimile (i) shall be immediately confirmed by a telephone call to the recipient at the number specified on Schedule 11.02, and (ii) shall be followed promptly by delivery of a hard copy original thereof) and mailed, faxed or delivered, to the address or facsimile number specified for notices on Schedule 11.02; or, as directed to the Company or the Agent, to such other address as shall be designated by such party in a written notice to the other parties, and as directed to any other party, at such other address as shall be designated by such party in a written notice to the Company and the Agent. (b) All such notices, requests and communications shall, when transmitted by overnight delivery, or faxed, be effective when delivered for overnight (next-day) delivery, or transmitted in legible form by facsimile machine, respectively, or if mailed, upon the third Business Day after the date deposited into the U.S. mail, or if delivered, upon delivery; except that notices pursuant to Article II, III or X to the Agent shall not be effective until actually received by the Agent, and notices pursuant to Article III to the Issuing Bank shall not be effective until actually received by the Issuing Bank at the address specified for the "Issuing Bank" on the applicable signature page hereof. (c) Any agreement of the Agent and the Banks herein to receive certain notices by telephone or facsimile is solely for the convenience and at the request of the Company and the Pledgor Subsidiaries. The Agent and the Banks shall be entitled to rely on the authority of any Person purporting to be a Person authorized by the Company or any Pledgor Subsidiary to give such notice and the Agent and the Banks shall not have any liability to the Company, any Pledgor subsidiary or other Person on account of any action taken or not taken by the Agent or the Banks in reliance upon such telephonic or facsimile notice. The obligation of the Company to repay the Loans and L/C Obligations shall not be affected in any way or to any extent by any failure by the Agent and the Banks to receive written confirmation of any telephonic or facsimile notice or the receipt by the Agent and the Banks of a confirmation which is at variance with the terms 99 understood by the Agent and the Banks to be contained in the telephonic or facsimile notice. 11.03 No Waiver; Cumulative Remedies. No failure to exercise and no delay in exercising, on the part of the Agent or any Bank, any right, remedy, power or privilege hereunder, shall operate as a waiver thereof; nor shall any single or partial exercise of any right, remedy, power or privilege hereunder preclude any other or further exercise thereof or the exercise of any other right, remedy, power or privilege. 11.04 Costs and Expenses. The Company shall: (a) whether or not the transactions contemplated hereby are consummated, pay or reimburse BofA (including in its capacity as Agent and Issuing Bank) within five Business Days after demand (subject to subsection 5.01(e)) for all reasonable costs and expenses incurred by BofA (including in its capacity as Agent and Issuing Bank) in connection with the development, preparation, delivery, administration and execution of, and any amendment, supplement, waiver or modification to (in each case, whether or not consummated), this Agreement, any Loan Document and any other documents prepared in connection herewith or therewith, and the consummation of the transactions contemplated hereby and thereby, including reasonable Attorney Costs incurred by or on behalf of BofA (including in its capacity as Agent and Issuing Bank) with respect thereto; and (b) pay or reimburse the Agent and each Bank within five Business Days after demand (subject to subsection 5.01(e)) for all reasonable costs and expenses (including Attorney Costs) incurred by them in connection with the enforcement, attempted enforcement, or preservation of any rights or remedies under this Agreement or any other Loan Document during the existence of an Event of Default or after acceleration of the Loans (including in connection with any "workout" or restructuring regarding the Loans, and including in any Insolvency Proceeding or appellate proceeding). 11.05 Company Indemnification. Whether or not the transactions contemplated hereby are consummated, the Company shall indemnify, defend and hold the Agent-Related Persons, and each Bank and each of its respective officers, directors, employees, counsel, agents and attorneys-in-fact (each, an "Indemnified Person") harmless from and against any and all liabilities, obligations, losses, damages, penalties, actions, judgments, suits, costs, charges, expenses and disbursements (including of experts and agents and Attorney Costs which all 100 shall be paid upon demand by the Agent) of any kind or nature whatsoever which may at any time (including at any time following repayment of the Loans, the termination of the Letters of Credit and the termination, resignation or replacement of the Agent or replacement of any Bank) be imposed on, incurred by or asserted against any such Person in any way relating to or arising out of: this Agreement, the Pledge Agreements or any document contemplated by or referred to herein; the administration of the Loan Documents; the custody, preservation, use or operation of or the sale of, collection from, or other realization upon, any of the Collateral; the exercise or enforcement of any of the rights of the Agent under the Pledge Agreements or any other Loan Document; the failure by the Company to perform or observe any of the provisions of the Pledge Agreements or any other Loan Document; the transactions contemplated hereby; or any other action taken or omitted by any such Person under or in connection with any of the foregoing, including with respect to any investigation, litigation or proceeding (including any Insolvency Proceeding or appellate proceeding) related to or arising out of this Agreement or the Loans or Letters of Credit or the use of the proceeds thereof, whether or not any Indemnified Person is a party thereto (all the foregoing, collectively, the "Indemnified Liabilities"); provided, that the Company shall have no obligation hereunder to any Indemnified Person with respect to Indemnified Liabilities resulting solely from the gross negligence or willful misconduct of such Indemnified Person. The agreements in this Section shall survive payment of all other Obligations. 11.06 Payments Set Aside. To the extent that the Company makes a payment to the Agent or the Banks, or the Agent or the Banks exercise their right of set-off, and such payment or the proceeds of such set-off or any part thereof are subsequently invalidated, declared to be fraudulent or preferential, set aside or required (including pursuant to any settlement entered into by the Agent or such Bank in its discretion) to be repaid to a trustee, receiver or any other party, in connection with any Insolvency Proceeding or otherwise, then (a) to the extent of such recovery the obligation or part thereof originally intended to be satisfied shall be revived and continued in full force and effect as if such payment had not been made or such set-off had not occurred, and (b) each Bank severally agrees to pay to the Agent upon demand its pro rata share of any amount so recovered from or repaid by the Agent. 11.07 Successors and Assigns. The provisions of this Agreement shall be binding upon and inure to the benefit of the parties hereto and their respective successors and assigns, 101 except that the Company may not assign or transfer any of its rights or obligations under this Agreement without the prior written consent of the Agent and each Bank. 11.08 Assignments, Participations, etc. (a) Any Bank may, with the written consent of the Company at all times other than during the existence of an Event of Default and the Agent and the Issuing Bank, which consents shall not be unreasonably withheld, at any time assign and delegate to one or more Eligible Assignees (provided that no written consent of the Company, the Agent or the Issuing Bank shall be required in connection with any assignment and delegation by a Bank to an Eligible Assignee that is an Affiliate of such Bank) (each an "Assignee") all, or any ratable part of all, of the Loans, the Commitments, the L/C Obligations and the other rights and obligations of such Bank hereunder, in a minimum amount of $5,000,000; provided, however, that after giving effect thereto, such Bank shall either retain a Commitment in a minimum amount of $5,000,000 or have no ongoing Commitment and provided further that the Company and the Agent may continue to deal solely and directly with such Bank in connection with the interest so assigned to an Assignee until (i) written notice of such assignment, together with payment instructions, addresses and related information with respect to the Assignee, shall have been given to the Company and the Agent by such Bank and the Assignee; (ii) such Bank and its Assignee shall have delivered to the Company and the Agent an Assignment and Acceptance in the form of Exhibit E ("Assignment and Acceptance") together with any Note or Notes subject to such assignment and (iii) the assignor Bank or Assignee has paid to the Agent a processing fee in the amount of $3,500. (b) From and after the date that the Agent notifies the assignor Bank that it has received (and provided its consent with respect to) an executed Assignment and Acceptance and payment of the above-referenced processing fee, (i) the Assignee thereunder shall be a party hereto and, to the extent that rights and obligations hereunder have been assigned to it pursuant to such Assignment and Acceptance, shall have the rights and obligations of a Bank under the Loan Documents, and (ii) the assignor Bank shall, to the extent that rights and obligations hereunder and under the other Loan Documents have been assigned by it pursuant to such Assignment and Acceptance, relinquish its rights and be released from its obligations under the Loan Documents. 102 (c) Within five Business Days after its receipt of notice by the Agent that it has received an executed Assignment and Acceptance and payment of the processing fee, (and provided that it consents to such assignment in accordance with subsection 11.08(a)), the Company shall execute and deliver to the Agent, new Notes evidencing such Assignee's assigned Loans and Commitment and, if the assignor Bank has retained a portion of its Loans and its Commitment, replacement Notes in the principal amount of the Loans retained by the assignor Bank (such Nots to be in exchange for, but not in payment of, the Notes held by such Bank). Immediately upon each Assignee's making its processing fee payment under the Assignment and Acceptance, this Agreement shall be deemed to be amended to the extent, but only to the extent, necessary to reflect the addition of the Assignee and the resulting adjustment of the Commitments arising therefrom. The Commitment allocated to each Assignee shall reduce such Commitments of the assigning Bank pro tanto. (d) Any Bank may at any time sell to one or more commercial banks or other Persons not Affiliates of the Company (a "Participant") participating interests in any Loans, the Commitment of that Bank and the other interests of that Bank (the "originating Bank") hereunder and under the other Loan Documents; provided, however, that (i) the originating Bank's obligations under this Agreement shall remain unchanged, (ii) the originating Bank shall remain solely responsible for the performance of such obligations, (iii) the Company, the Issuing Bank and the Agent shall continue to deal solely and directly with the originating Bank in connection with the originating Bank's rights and obligations under this Agreement and the other Loan Documents, and (iv) no Bank shall transfer or grant any participating interest under which the Participant has rights to approve any amendment to, or any consent or waiver with respect to, this Agreement or any other Loan Document, except to the extent such amendment, consent or waiver would require unanimous consent of the Banks as described in the first proviso to Section 11.01. In the case of any such participation, the Participant shall be entitled to the benefit of Sections 4.01, 4.03 and 11.05 as though it were also a Bank hereunder, and if amounts outstanding under this Agreement are due and unpaid, or shall have been declared or shall have become due and payable upon the occurrence of an Event of Default, each Participant shall be deemed to have the right of set-off in respect of its participating interest in amounts owing under this Agreement to the same extent as if the amount of its participating interest were owing directly to it as a Bank under this Agreement. 103 (e) Notwithstanding any other provision in this Agreement, any Bank may at any time create a security interest in, or pledge, all or any portion of its rights under and interest in this Agreement and the Note held by it in favor of any Federal Reserve Bank in accordance with Regulation A of the FRB or U.S. Treasury Regulation 31 CFR Section 203.14, and such Federal Reserve Bank may enforce such pledge or security interest in any manner permitted under applicable law. 11.09 Set-off. In addition to any rights and remedies of the Banks provided by law, if an Event of Default exists or the Loans have been accelerated, each Bank is authorized at any time and from time to time, without prior notice to the Company, any such notice being waived by the Company to the fullest extent permitted by law, to set off and apply any and all deposits (general or special, time or demand, provisional or final) at any time held by, and other indebtedness at any time owing by, such Bank to or for the credit or the account of the Company against any and all Obligations owing to such Bank, now or hereafter existing, irrespective of whether or not the Agent or such Bank shall have made demand under this Agreement or any Loan Document and although such Obligations may be contingent or unmatured. Each Bank agrees promptly to notify the Company and the Agent after any such set-off and application made by such Bank; provided, however, that the failure to give such notice shall not affect the validity of such set-off and application. 11.10 Automatic Debits of Fees. With respect to any commitment fee, arrangement fee, letter of credit fee or other fee, or any other cost or expense (including Attorney Costs) due and payable to the Agent, the Issuing Bank, the Arranger or the Banks under the Loan Documents, the Company hereby irrevocably authorizes BofA to debit any deposit account of the Company with BofA in an amount such that the aggregate amount debited from all such deposit accounts does not exceed such fee or other cost or expense. If there are insufficient funds in such deposit accounts to cover the amount of the fee or other cost or expense then due, such debits will be reversed (in whole or in part, in BofA's sole discretion) and such amount not debited shall be deemed to be unpaid. No such debit under this Section shall be deemed a set- off. 11.11 Notification of Addresses, Lending Offices, Etc. Each Bank shall notify the Agent in writing of any changes in the address to which notices to the Bank should be directed, of addresses of any Lending Office, of payment instructions in respect of all payments to be made to it hereunder and of such 104 other administrative information as the Agent shall reasonably request. 11.12 Counterparts. This Agreement may be executed in any number of separate counterparts, each of which, when so executed, shall be deemed an original, and all of said counterparts taken together shall be deemed to constitute but one and the same instrument. 11.13 Severability. Wherever possible each provision of this Agreement, the Pledge Agreements or any other instrument agreement required hereunder shall be interpreted in such manner as to be effective and valid under applicable law, but if any provision of this Agreement, the Pledge Agreements or any other instrument or agreement required hereunder shall be prohibited by or invalid under such law, such provision shall be ineffective to the extent of such prohibition or invalidity, without invalidating the remainder of such provision or the remaining provisions of such agreement or instrument. 11.14 No Third Parties Benefited. This Agreement is made and entered into for the sole protection and legal benefit of the Company, the Banks, the Agent and the Agent-Related Persons, and their permitted successors and assigns, and no other Person shall be a direct or indirect legal beneficiary of, or have any direct or indirect cause of action or claim in connection with, this Agreement or any of the other Loan Documents. 11.15 Governing Law and Jurisdiction. (a) THIS AGREEMENT, THE PLEDGE AGREEMENTS AND THE NOTES SHALL BE GOVERNED BY, AND CONSTRUED IN ACCORDANCE WITH, THE LAW OF THE STATE OF CALIFORNIA EXCEPT TO THE EXTENT THAT THE VALIDITY OR PERFECTION OF ANY SECURITY INTERESTS OR REMEDIES UNDER ANY LOAN DOCUMENTS ARE GOVERNED BY THE LAWS OF A STATE OTHER THAN CALIFORNIA; PROVIDED THAT THE AGENT AND THE BANKS SHALL RETAIN ALL RIGHTS ARISING UNDER FEDERAL LAW. (b) ANY LEGAL ACTION, PROCEEDING OR LITIGATION BASED HEREON, OR ARISING OUT OF, UNDER, OR IN CONNECTION WITH, THIS AGREEMENT, THE PLEDGE AGREEMENTS OR ANY OTHER LOAN DOCUMENT, OR ANY COURSE OF CONDUCT, COURSE OF DEALING, STATEMENTS (WHETHER ORAL OR WRITTEN) OR ACTIONS OF THE AGENT, THE BANKS OR THE COMPANY MAY BE BROUGHT AND MAINTAINED IN THE COURTS OF THE STATE OF CALIFORNIA OR IN THE UNITED STATES DISTRICT COURT FOR THE CENTRAL DISTRICT OF CALIFORNIA; PROVIDED, HOWEVER, THAT ANY SUIT SEEKING ENFORCEMENT AGAINST ANY COLLATERAL OR OTHER PROPERTY MAY BE BROUGHT, AT THE AGENT'S OPTION, IN THE COURTS OF ANY 105 JURISDICTION WHERE SUCH COLLATERAL OR OTHER PROPERTY MAY BE FOUND. BY THE EXECUTION AND DELIVERY OF THIS AGREEMENT OR THE PLEDGE AGREEMENTS, EACH OF THE COMPANY, THE BANKS AND THE AGENT HEREBY CONSENTS FOR ITSELF AND IN RESPECT OF ITS PROPERTY AND EXPRESSLY AND IRREVOCABLY SUBMITS TO THE NON-EXCLUSIVE JURISDICTION OF THE COURTS OF THE STATE OF CALIFORNIA AND OF THE UNITED STATES DISTRICT COURT FOR THE CENTRAL DISTRICT OF CALIFORNIA FOR THE PURPOSE OF ANY SUCH LITIGATION AS SET FORTH ABOVE AND IRREVOCABLY AGREES TO BE BOUND BY ANY JUDGMENT RENDERED THEREBY IN CONNECTION WITH SUCH LITIGATION. THE AGENT, THE BANKS AND THE COMPANY FURTHER IRREVOCABLY CONSENT TO THE SERVICE OF PROCESS BY ANY MEANS PERMITTED BY CALIFORNIA LAW INCLUDING BY REGISTERED MAIL, POSTAGE PREPAID, OR BY PERSONAL SERVICE WITHIN OR WITHOUT THE STATE OF CALIFORNIA. THE AGENT, THE BANKS AND THE COMPANY HEREBY EXPRESSLY AND IRREVOCABLY WAIVE, TO THE FULLEST EXTENT PERMITTED BY LAW, ANY OBJECTION WHICH THEY MAY HAVE OR HEREAFTER MAY HAVE TO THE LAYING OF VENUE OF ANY SUCH LITIGATION BROUGHT IN ANY SUCH COURT REFERRED TO ABOVE AND ANY CLAIM THAT ANY SUCH LITIGATION HAS BEEN BROUGHT IN AN INCONVENIENT FORUM. TO THE EXTENT THAT THE AGENT, THE BANKS AND THE COMPANY HAVE OR HEREAFTER MAY ACQUIRE ANY IMMUNITY FROM JURISDICTION OF ANY COURT OR FROM ANY LEGAL PROCESS (WHETHER THROUGH SERVICE OR NOTICE, ATTACHMENT PRIOR TO JUDGMENT, ATTACHMENT IN AID OF EXECUTION OR OTHERWISE) WITH RESPECT TO THEM OR THEIR PROPERTY, THE AGENT, THE BANKS AND THE COMPANY HEREBY IRREVOCABLY WAIVE SUCH IMMUNITY IN RESPECT OF THEIR OBLIGATIONS UNDER THIS AGREEMENT, THE PLEDGE AGREEMENTS AND THE OTHER LOAN DOCUMENTS. 11.16 Waiver of Jury Trial. THE COMPANY, THE BANKS AND THE AGENT EACH WAIVE THEIR RESPECTIVE RIGHTS TO A TRIAL BY JURY OF ANY CLAIM OR CAUSE OF ACTION BASED UPON OR ARISING OUT OF OR RELATED TO THIS AGREEMENT, THE PLEDGE AGREEMENTS, THE OTHER LOAN DOCUMENTS, ANY COURSE OF CONDUCT, COURSE OF DEALING, STATEMENTS (WHETHER ORAL OR WRITTEN) OR ACTIONS OF THE COMPANY, THE PLEDGOR SUBSIDIARIES, THE BANKS OR THE AGENT, OR THE TRANSACTIONS CONTEMPLATED HEREBY OR THEREBY, IN ANY ACTION, PROCEEDING OR OTHER LITIGATION OF ANY TYPE BROUGHT BY ANY OF THE PARTIES AGAINST ANY OTHER PARTY OR ANY AGENT-RELATED PERSON, PARTICIPANT OR ASSIGNEE, WHETHER WITH RESPECT TO CONTRACT CLAIMS, TORT CLAIMS, OR OTHERWISE. THE COMPANY, THE BANKS AND THE AGENT EACH AGREE THAT ANY SUCH CLAIM OR CAUSE OF ACTION SHALL BE TRIED BY A COURT TRIAL WITHOUT A JURY. WITHOUT LIMITING THE FOREGOING, THE PARTIES FURTHER AGREE THAT THEIR RESPECTIVE RIGHT TO A TRIAL BY JURY IS WAIVED BY OPERATION OF THIS SECTION AS TO ANY ACTION, COUNTERCLAIM OR OTHER PROCEEDING WHICH SEEKS, IN WHOLE OR IN PART, TO CHALLENGE THE VALIDITY OR ENFORCEABILITY OF THIS AGREEMENT, THE PLEDGE AGREEMENTS, OR THE OTHER LOAN DOCUMENTS OR ANY PROVISION HEREOF OR THEREOF. THIS WAIVER SHALL APPLY TO ANY 106 SUBSEQUENT AMENDMENTS, RENEWALS, SUPPLEMENTS OR MODIFICATIONS TO THIS AGREEMENT, THE PLEDGE AGREEMENTS, AND THE OTHER LOAN DOCUMENTS. THE COMPANY ACKNOWLEDGES AND AGREES THAT IT HAS RECEIVED FULL AND SUFFICIENT CONSIDERATION FOR THIS PROVISION (AND EACH OTHER PROVISION OF EACH OTHER LOAN DOCUMENT TO WHICH IT IS A PARTY) AND THAT THIS PROVISION IS A MATERIAL INDUCEMENT FOR THE AGENT AND THE BANKS ENTERING INTO THIS AGREEMENT AND EACH SUCH OTHER LOAN DOCUMENT. 11.17 Entire Agreement. This Agreement, together with the Pledge Agreements and the other Loan Documents, embodies the entire agreement and understanding among the Company, the Pledgor Subsidiaries, the Banks and the Agent, and supersedes all prior or contemporaneous agreements and understandings of such Persons, verbal or written, relating to the subject matter hereof and thereof. [remainder of page intentionally left blank] 107 IN WITNESS WHEREOF, the parties hereto have caused this Agreement to be duly executed and delivered in Los Angeles, California by their proper and duly authorized officers as of the day and year first above written. SIERRA HEALTH SERVICES, INC. By:______________________________ Title:___________________________ 108 BANK OF AMERICA NATIONAL TRUST AND SAVINGS ASSOCIATION, as Agent By:______________________________ Title:___________________________ BANK OF AMERICA NATIONAL TRUST AND SAVINGS ASSOCIATION, as Issuing Bank By:______________________________ Title:___________________________ BANK OF AMERICA NATIONAL TRUST AND SAVINGS ASSOCIATION, as a Bank By:______________________________ Title:___________________________ 109 FIRST UNION NATIONAL BANK By:______________________________ Title:___________________________ 110 SCHEDULE 1.01 SPECIFIED CHARGES 1. Acquisition and integration expenses up to $10,000,000 recorded in the fourth quarter of 1998 related to the Kaiser-Texas Acquisition 2. Legal and related costs to settle the up to $12,000,000 TRICARE Region 1 bid protest. 3. Acquisition and integration expenses up to $2,000,000 related to the acquisition from Mutual of Omaha and subsidiaries 111 SCHEDULE 2.01 COMMITMENTS AND PRO RATA SHARES Bank Commitment Pro Rata Share Bank of America National Trust and Savings Association $120,000,000 60% First Union National Bank $ 80,000,000 40% TOTAL $200,000,000 100% 112 SCHEDULE 3.03 EXISTING BofA LETTERS OF CREDIT Letter of Credit Amount Expires 3001796 $4,242,000 March 3, 1999 113 SCHEDULE 5.01(G) EXCLUDED SUBSIDIARIES A. CII Financial, Inc. and its subsidiaries 1. CII Leasing, Inc. (California) 2. CII Premium Finance Company (California) 3. Direct Rehabilitation Services (California) 4. Finance Assurance Co., Ltd. (Cayman Islands) 5. K & L Insurance Services, Inc. (California) 6. CII Insurance Agency (California) 7. California Indemnity Insurance Company and its subsidiaries (California) a. E & E Insurance Agency, Inc. (Nevada) b. Sierra Insurance Company of Texas (Texas) c. Commerical Casualty Insurance Company (California) d. CII Insurance Company (California) B. Intermed, Inc. (Arizona) C. Midwest Health, Inc. (Illinois) D. Nevada Administrators, Inc. (Nevada) E. Northern Nevada Health Network, Inc. (Nevada) F. Elias F. Ghanem, Ltd. (Nevada) G. M.E.G.A., Inc. (Nevada) H. Sierra Behavioral Health, Inc. (Nevada) I. Sierra Health & Life Insurance Company, Inc. (California) J. Sierra Health Holdings, Inc. (Nevada) and its subsidiary 1. Texas Health Choice, L.C. (Texas LLC) K. 2314 West Charleston Partnership SCHEDULE 6.03 REQUIRED APPROVALS 1. The Company or certain of its Subsidiaries will be required, following the Closing, to notify applicable insurance regulators of the transaction evidenced by the Loan Documents by filing amendments to their Insurance Holding Company System Registration Statement or equivalent statement. 2. Prior to obtaining ownership and/or control, or transferring ownership and/or control of the Pledged Shares of Subsidiaries subject to regulation by state insurance regulatory authorities, the Agent and the Banks may need to make certain filings with those authorities and obtain requisite regulatory approval. Under apllicable anti-affiliation statutes, banks and certain other financial institutions may be prohibited from owning or controlling any subsidiary subject to state insurance legislation. 3. Section 18442 of the California Financial Code states that "(a)n industrial loan company shall not make any loan of money or property to or guarantee the obligation of any person upon the security of its capital (including the shares of capital stock) of the company, its holding company, or its affiliates." Although Section 18442 may be read to prohibit the pledge of shares of a corporation which owns an industrial loan company (such as in the case of CIIF and CII Premium Finance Company), a representative of the Industrial Loan Department of the Department of Corporations has taken the position in a telephonic conversation that Section 18442 is not intended to prohibit the pledge of shares of the parent company. SCHEDULE 6.05 LITIGATION PCA v. Sierra Health Services, Inc. (United States District Court, Southern District of Florida). PCA filed on March 18, 1997 and seeks specific performance of a terminated merger agreement and monetary damages exceeding $20,000,000. The court dismissed the action without prejudice for failure to join an indespensable party. Sierra Health Services, Inc. v. PCA (Court of Chancery of Delaware). The Company filed on March 27, 1997 and seeks damages and declaratory relief for breach of the merger agreement and fraud. On July 31, 1998, the Company filed a Second Amended Complaint that also alleges negligent misrepresentation. The action is currently pending. Harbor House Cafe, Inc. and other similarly situated v. California Indemnity Insurance Company and Does 1-20 (No. 787823-5, Superior Court of the State of California for the County of Alameda) Class action alleging non-disclosure of inability to pay policyholder dividends to certain policyholders. Harbor House Cafe, Inc. and other similarly situated v. California Indemnity Insurance Company and Does 1-100 (No. 7879920-9, Superior Court of the State of California for the County of Alameda) One of approximately 35 class actions against various insurers and the California state insurance fund seeking damages growing out of administration by the defendants of experience readjustments. SCHEDULE 6.12 PERMITTED LIABILITIES None. SCHEDULE 6.13 ENVIRONMENTAL MATTERS None SCHEDULE 6.18 SUBSIDIARIES & MINORITY INTERESTS (A) Subsidiaries of Sierra Health Services, Inc. A. Behavioral Healthcare Options, Inc. (Nevada) B. CII Financial, Inc. and its subsidiaries 1. CII Leasing, Inc. (California) 2. CII Premium Finance Company (California) 3. Direct Rehabilitation Services (California) 4. Finance Assurance Co., Ltd. (Cayman Islands) 5. K & L Insurance Services, Inc. (California) 6. CII Insurance Agency (California) 7. California Indemnity Insurance Company and its subsidiaries (California) a. California Indemnity Insurance Company (Nevada) b. Sierra Insurance Company of Texas (Texas) c. Commercial Casualty Insurance Company (California) d. CII Insurance Company (California) C. Family Healthcare Services (Nevada) D. Family Home Hospice, Inc. (Nevada) E. Health Plan of Nevada (Nevada) F. Intermed, Inc. (Arizona) G. Midwest Health, Inc. (Illinois) H. Nevada Administrators, Inc. (Nevada) I. Northern Nevada Health Network, Inc. (Nevada) J. Prime Holdings, Inc. (Nevada) and its subsidiaries 1. Med One Health Plan (Nevada) 2. Elias F. Ghanem, Ltd. (Nevada) 3. M.E.G.A., Inc. (Nevada) 4. Prime Health, Inc. (Nevada) K. Sierra Acquisition, Inc. (Delaware) L. Sierra Behavioral Health, Inc. (Nevada) M. Sierra Health & Life Insurance Company, Inc. (California) N. Sierra Health Holdings, Inc. (Nevada) and its subsidiary 1. Texas Health Choice, L.C. (Texas LLC) O. Sierra Health-Care Options, Inc. (Nevada) P. Sierra Home Medical Products, Inc. (Nevada) Q. Sierra Medical Management, Inc. (Nevada) and its subsidiaries 1. Mohave Valley Hospital, Inc. (Arizona) 2. Tolemac, Inc. (Arizona) R. Sierra Military Health Services, Inc. (Delaware) S. Sierra Texas Systems, Inc. (Texas) T. Southwest Medical Associates, Inc. (Nevada) U. Southwest Realty, Inc. (Nevada) 1. 2314 W. Charleston Partnership (B) Equity Investments: A. Integrated Health Services at Silvercrest, Inc. B. Triwest Healthcare Alliance Corp. (C) Excluded Subsidiaries See Schedule 5.01(g) SCHEDULE 6.19 INSURANCE MATTERS The Company does not carry a separate errors and omissions policy. SCHEDULE 8.01 PERMITTED LIENS See Schedule 8.05 SCHEDULE 8.04 EXISTING INVESTMENTS 1. Mortgage loans to former officers and employees of CII in a principal amount outstanding on the date hereof of approximately $4,954,000. 2. Loans to Dr. Anthony Marlon in a principal amount outstanding on the date hereof of approximately $2,650,000 secured by a pledge of options to purchase Company stock. 3. See Schedule 6.18(B). SCHEDULE 8.05 PERMITTED INDEBTEDNESS 1. 7.11% Mortgage Note in favor of BofA, Nevada secured by a deed of trust, assignment of rents and leases, and a security agreement covering the newly constructed portion of the Company's administrative headquarters complex and underlying real property. 2. 7.5% Convertible Subordinated Debentures due 2001 of CII. 3. 7 3/8% Mortgage Note in favor of BofA, Nevada secured by a deed of trust, assignment of rents and leases, and a security agreement covering a portion of the Company's administrative headquarters. 4. Master Lease and Security Agreement dated as of December 31, 1997 between Sumitomo Bank Leasing and Finance, Inc. as lessor and Sierra Health Services, Inc. as lessee. 5. The Kaiser Note. 6. Other existing debt of approximately $7,158,000 in principal. 7. Earn-out under the Kaiser Acquisition Agreement. 8. Earn-out in connection with the in-market acquisition of certain assets from Mutual of Omaha or affiliates not to exceed $15,000,000 over three years. SCHEDULE 8.08 CONTINGENT OBLIGATIONS None SCHEDULE 8.17 PERMITTED ACQUISITIONS The in-market acquisition of certain assets from Mutual of Omaha or affiliates for a price not to exceed $15,000,000 over three years. SCHEDULE 11.02 OFFSHORE AND DOMESTIC LENDING OFFICES, ADDRESSES FOR NOTICES BANK OF AMERICA NATIONAL TRUST AND SAVINGS ASSOCIATION, as Administrative Agent Notices (other than Borrowing Notices and Notices of Conversion/Continuation): Bank of America National Trust and Savings Association Agency Management Services #20529 555 South Flower Street, 11th Floor Los Angeles, CA 90071 Attention: Ms. Gina Meador Vice President Telephone: 213/228-5245 Facsimile: 213/228-2299 AGENT'S PAYMENT OFFICE: Notices for Extensions of Credit and Conversion/Continuation: Bank of America National Trust and Savings Association Agency Administrative Services #5596 1850 Gateway Boulevard, Fifth Floor Concord, CA 94520 Attention: Nicole Burish Telephone: 925/675-8437 Facsimile: 925/675-8500 BANK OF AMERICA NATIONAL TRUST AND SAVINGS ASSOCIATION, as a Bank Domestic and Offshore Lending Office: GPO-Domestic Account Administration #5693 1850 Gateway Boulevard, Third Floor Concord, CA 94520 1 Attention: Elvira Karpat Telephone: 925/675-8255 Facsimile: 925/675-7531/7532 Notices (other than Borrowing notices and Notices of Conversion/Continuation): Bank of America National Trust and Savings Association Health Care Finance #9173 555 South Flower Street, 11th Floor Los Angeles, CA 90071 Attention: J. Gregory Seibly Vice President Telephone: 213/228-2953 Facsimile: 213/228-2756 EX-10 3 EXHIBIT 10.5 FIRST AMENDMENT TO CREDIT AGREEMENT THIS FIRST AMENDMENT TO CREDIT AGREEMENT is made and dated as of November 23, 1998 (the "First Amendment") among SIERRA HEALTH SERVICES, INC. (the "Company"), the Banks now party to the Credit Agreement referred to below, the financial institutions listed on the signature page hereof that are joining the Credit Agreement as Banks (the "New Banks") and BANK OF AMERICA NATIONAL TRUST AND SAVINGS ASSOCIATION, a national banking association, as Administrative Agent (the "Agent"), and amends that certain Credit Agreement dated as of October 30, 1998 (as further amended or modified from time to time, the "Credit Agreement"). RECITALS WHEREAS, the Company has requested the Agent and the Banks to amend certain provisions of the Credit Agreement, and the Agent and the Banks are willing to do so, on the terms and conditions specified herein; WHEREAS, the New Banks wish to be added to the Credit Agreement as Banks, and the Company, the Agent and the existing Banks are willing to permit the New Banks to be so added; NOW, THEREFORE, for good and valuable consideration, the receipt and adequacy of which are hereby acknowledged, the parties hereby agree as follows: 1. Terms. All terms used herein shall have the same meanings as in the Credit Agreement unless otherwise defined herein. 2. Amendment. The Credit Agreement is hereby amended as follows: 2.1 Amendments to Section 1.01. (a) There shall be added to Section 1.01 of the Credit Agreement, in appropriate alphabetical sequence, the following definitions: "First Union" shall mean First Union National Bank. "Workers' Compensation Business" shall mean the business of underwriting workers' compensation insurance and performing administrative functions related thereto. "Workers' Compensation Event" shall mean failure by the Company or any of its Workers' Compensation Subsidiaries to comply in any material respect with any of the terms and provisions of any applicable Workers' 39251439.4 12199 1610P 96246459 1 Compensation Regulation pertaining to the fiscal soundness, solvency or financial condition of the Company or any of its Workers' Compensation Subsidiaries, or the assertion in writing, after the Closing Date, by a Workers' Compensation Regulator that it intends to take administrative action against the Company or any of its Workers' Compensation Subsidiaries to revoke or modify any Governmental Approval of, or to enforce the fiscal soundness, solvency or financial provisions or requirements of such Workers' Compensation Regulations against, the Company or any of its Workers' Compensation Subsidiaries, if such action, modification or enforcement is reasonably likely to have a Material Adverse Effect. "Workers' Compensation Regulations" shall mean all Requirements of Law applicable to any Workers' Compensation Subsidiary under federal or state law and any regulations, orders and directives promulgated or issued pursuant to the foregoing in connection with the operation of its Workers Compensation Business. "Workers' Compensation Regulator" means any Person charged with the administration, oversight or enforcement of a Workers' Compensation Regulation, whether primarily, secondarily, or jointly. "Workers' Compensation Subsidiary" shall mean any current or future Subsidiary of the Company that is primarily involved in the Workers' Compensation Business. (b) The second sentence following the chart in the definition of the term "Applicable Commitment Fee Rate" in Section 1.01 of the Credit Agreement is hereby amended and restated in its entirety to read as follows: "Thereafter, the Applicable Commitment Fee Rate shall be the actual Level reflected on the Compliance Certificate and shall be effective from and including the date on which the Agent receives such Compliance Certificate to but excluding the date on which the Agent receives the next Compliance Certificate; provided, however, that if the Agent does not receive a Compliance Certificate by the date required by subsection 7.02(b), the Applicable Commitment Fee Rate shall, effective as of such date, be Level 6 to but excluding the date the Agent receives such Compliance Certificate (on which such date the Applicable Commitment Fee Rate shall be the actual Level reflected on such Compliance Certificate)." (c) The second sentence following the chart in the definition of the term "Applicable Margin" in Section 1.01 of the Credit Agreement is hereby amended and restated in its entirety to read as follows: 39251439.4 12199 1610P 96246459 2 "Thereafter, the Applicable Margin shall be the actual Level reflected on the Compliance Certificate and shall be effective from and including the date on which the Agent receives a Compliance Certificate to but excluding the date on which the Agent receives the next Compliance Certificate; provided, however, that if the Agent does not receive a Compliance Certificate by the date required by subsection 7.02(b), the Applicable Margin shall, effective as of such date, be Level 6 to but excluding the date the Agent receives such Compliance Certificate (on which such date the Applicable Margin shall be the actual Level reflected on such Compliance Certificate)." (d) Clause (d) of the definition of the term "Eligible Assignee" in Section 1.01 of the Credit Agreement is hereby amended and restated in its entirety to read as follows: "(d) any insurance company, mutual fund or other financial institution or fund." (e) Clause (a) of the definition of the term "Health Care Business" in Section 1.01 of the Credit Agreement is hereby amended by adding "including without limitation the provision of Medicare and Medicaid services" at the end thereof. (f) The definition of the term "HMO Texas" in Section 1.01 of the Credit Agreement is hereby amended and restated in its entirety to read as follows: "HMO Texas" means Texas Health Choice L.C., a Texas limited liability company, formerly known as HMO Texas, L.C., which is an indirect Subsidiary of the Company. (g) The definition of the term "Honor Date" in Section 1.01 of the Credit Agreement is hereby amended by deleting "subsection 3.03(b)" and replacing it with "subsection 3.03(c)". (h) The definition of the term "L/C-Related Documents" in Section 1.01 of the Credit Agreement is hereby amended by adding "the Existing BofA Letters of Credit," after "Letters of Credit," in the first line thereof. (i) The definition of the term "Kaiser Acquisition Agreements" in Section 1.01 of the Credit Agreement is hereby amended and restated in its entirety to read as follows: "Kaiser Acquisition Agreements" means that certain Asset Sale and Purchase Agreement dated June 5, 1998 between PMAT and HMO Texas, as amended, that certain Asset Sale and Purchase Agreement dated June 5, 1998, as amended, between Kaiser-Texas and HMO Texas and that certain Master 39251439.4 12199 1610P 96246459 3 Sale and Purchase Agreement dated June 5, 1998 between Kaiser-Texas and HMO Texas, as amended. (j) The definition of the term "Majority Banks" in Section 1.01 of the Credit Agreement is hereby amended and restated in its entirety to read as follows: "Majority Banks" means at any time that BofA and First Union shall collectively hold in excess of 50% of the Commitments, Banks holding in excess of 75% of the then aggregate unpaid principal amount of the Loans, or, if no such principal amount is then outstanding, Banks having in excess of 75% of the Commitments; at any time that BofA and First Union shall collectively hold in excess of 42.5% of the Commitments but not more than 50% of the Commitments, Banks holding in excess of 66 2/3% of the then aggregate unpaid principal amount of the Loans, or, if no such principal amount is then outstanding, Banks having in excess of 66 2/3% of the Commitments; and at any time that BofA and First Union shall collectively hold 42.5% or less of the Commitments, Banks holding in excess of 60% of the then aggregate unpaid principal amount of the Loans, or, if no such principal amount is then outstanding, Banks having in excess of 60% of the Commitments. 2.2 Amendment to Section 2.07. (a) The first sentence of clause (c) of Section 2.07 of the Credit Agreement is hereby amended by inserting "excluding sales or dispositions in the ordinary course of business by the Company of securities in its investment portfolio" immediately after "in the existing lines of business of the Company" appearing in the eleventh line thereof. 2.3 Amendment to Section 3.01. (a) The first sentence of clause (a) of Section 3.01 of the Credit Agreement is hereby amended by inserting "to the day thirty days prior" immediately after "Closing Date" in the third line thereof. 2.4 Amendments to Section 3.03. (a) Clause (b) of Section 3.03 of the Credit Agreement is hereby amended by deleting "subsection 3.3(a)" and replacing it with "subsection 3.03(a)" in the second line thereof. 2.5 Amendments to Section 3.06. (a) Clause (iii) of Section 3.06 of the Credit Agreement is hereby amended by adding "(including without limitation any Bank)" after "Person" in the sixth line thereof. 39251439.4 12199 1610P 96246459 4 2.6 Amendments to Section 5.01. (a) Clause (i) of Section 5.01 of the Credit Agreement is hereby amended by adding "and the collateral thereunder has been released" to the end thereof. 2.7 Amendments to Section 6.01. (a) Clause (d) of Section 6.01 of the Credit Agreement is hereby amended by adding "including without limitation all Workers' Compensation Regulations," after "Requirements of Law" in the first line thereof. 2.8 Amendments to Section 6.02. (a) Clause (c) of Section 6.02 of the Credit Agreement is hereby amended by adding "including without limitation all Workers' Compensation Regulations," after "Requirement of Law" in the first line thereof. 2.9 Amendments to Section 6.05. (a) Clause (a) of Section 6.05 of the Credit Agreement is hereby amended by adding "or impair the Banks ability to effect rights and remedies" to the end thereof. 2.10 Amendments to Section 6.07. (a) Clause (a) of Section 6.07 of the Credit Agreement is hereby amended by deleting "the requirements of all applicable laws, rules, regulations and orders of every governmental authority" and replacing it with "Requirements of Law of every Governmental Authority". 2.11 Amendments to Section 6.21. (a) Section 6.21 of the Credit Agreement is hereby amended by adding "and the Kaiser Acquisition Agreements" after "Loan Documents" in the third line thereof and adding "or the Kaiser Acquisition Agreements" after "Closing Date)" in the ninth line thereof. 2.12 Amendments to Section 6.23. (a) Section 6.23 of the Credit Agreement is hereby amended and restated in its entirety to read as follows: "6.23 Licensing, Etc. Each HMO Subsidiary maintains in full force and effect (i) all licenses and certifications required pursuant to any HMO Regulation; (ii) all certifications and authorizations necessary to ensure that 39251439.4 12199 1610P 96246459 5 each of the HMO Subsidiaries is eligible for all reimbursements available under the HMO Regulations to the extent applicable to HMOs of their type; and (iii) all licenses, permits, authorizations and qualifications required under the HMO Regulations in connection with the ownership or operation of HMOs; except where the failure to maintain the items described in any of the preceding three clauses would not have a Material Adverse Effect. Each Workers' Compensation Subsidiary maintains in full force and effect (i) all licenses and certifications required pursuant to any Workers' Compensation Regulation; and (ii) all licenses, permits, authorizations and qualifications required under the Workers' Compensation Regulations in connection with the ownership or operation of a Workers' Compensation Business; except where the failure to maintain the items described in any of the preceding three clauses would not have a Material Adverse Effect." 2.13 Amendments to Section 6.25. (a) The first sentence of Section 6.25 of the Credit Agreement is hereby amended by adding "or Event of Default" after "Material Adverse Effect" in the tenth line thereof. (b) The second sentence of Section 6.25 of the Credit Agreement is hereby amended by adding the following clause prior to the end thereof: ", all to the extent necessary to insure that any such failure will not result in a Material Adverse Effect." 2.14 Amendments to Section 7.02. (a) Clauses (d), (e) and (f) of Section 7.02 of the Credit Agreement are hereby amended and restated in their entirety to read as follows: "(d) promptly following the receipt of the same, a copy of each notice relating to the loss or threatened loss by the Company, any Workers' Compensation Subsidiary or any HMO Subsidiary of any material operating permit, license or certification by any Workers' Compensation Regulator or any HMO Regulator; (e) promptly following the receipt of the same, all material correspondence received by the Company or any Subsidiary (other than correspondence in draft form) from (i) an HMO Regulator which asserts that the Company or any HMO Subsidiary is not in substantial compliance with any HMO Regulation or which threatens the taking of any action against the Company or any Subsidiary under any HMO Regulation which would reasonably be expected to have a Material Adverse Effect or (ii) a Workers' 39251439.4 12199 1610P 96246459 6 Compensation Regulator which asserts that the Company or any Workers' Compensation Subsidiary is not in substantial compliance with any Workers' Compensation Regulation or which threatens the taking of any action against the Company or any Subsidiary under any Workers' Compensation Regulation which would reasonably be expected to have a Material Adverse Effect; (f) from time to time upon receipt of a written request by the Agent or any Bank specifying in reasonable detail the types of documents to be provided, copies of any and all statements, audits, studies or reports submitted by or on behalf of (i) the Company or any HMO Subsidiary to any HMO Regulator or (ii) the Company and any Workers' Compensation Subsidiary to any Workers' Compensation Regulator (except to the extent that the delivery of such documents could result in the waiver by the Company of any privilege it might have under applicable law); and" 2.15 Amendments to Section 7.08. (a) Section 7.08 of the Credit Agreement is hereby amended by adding ", all Workers' Compensation Regulations" after "HMO Regulations" in the fifth line thereof. 2.16 Amendments to Section 7.16. (a) There shall be added to the Credit Agreement a new section 7.16 reading in its entirety as follows: 7.16 Accreditation. The Company will use reasonable commercial efforts to (i) maintain the current accreditation by the National Committee for Quality Assurance ("NCQA") for Health Plan of Nevada at the "Full Accreditation" level, and (ii) obtain within a reasonable period of time and thereafter maintain accreditation by NCQA for its Dallas area HMO operations at the "Provisional Accreditation", "One-Year Accreditation" or "Full Accreditation" levels. 2.17 Amendments to Section 8.02. (a) Subsection (c) of Section 8.02 of the Credit Agreement is hereby amended by deleting the date "December 31, 1997" and substituting therefor the date "November 2, 1998". (b) Subsection (d) of Section 8.02 of the Credit Agreement is hereby amended and restated to read in its entirety as follows: "(d) dispositions not otherwise permitted hereunder of assets (including all, but not less than all, of the capital stock of any Subsidiary) owned by 39251439.4 12199 1610P 96246459 7 the Company or any Subsidiary as of November 2, 1998, which are made for fair market value; provided, that (i) at the time of any disposition, no Event of Default shall exist or shall result from such disposition, (ii) the aggregate sales price from such disposition shall be paid in cash, (iii) the aggregate value of all assets so sold by the Company and its Subsidiaries prior to the Revolving Loan Termination Date, together, shall not exceed 10% of the Consolidated Tangible Assets of the Company and its Subsidiaries as of November 2, 1998." 2.18 Amendments to Section 8.17. (a) Subsections (iii) and (iv) of Section 8.17 of the Credit Agreement are hereby re-numbered as subsections (iv) and (v). (b) A new subsection (iii) shall be added to Section 8.17 of the Credit Agreement reading in its entirety as follows: "(iii) if the aggregate value of all consideration (including Indebtedness assumed by the Company and its Subsidiaries in connection therewith) for any single Acquisition exceeds $25,000,000, the Company shall have obtained the prior written approval of the Majority Banks." 2.19 Amendments to Section 9.02. (a) Clause (a) of Section 9.02 of the Credit Agreement is hereby amended by adding "and participate in Letters of Credit" after "Loans" in the first line thereof and replacing "commitments" with "Commitments" in the third line thereof. 2.20 Amendments to Section 10.07. (a) Section 10.07 of the Credit Agreement is hereby amended by deleting "solely" after "resulting" in line 9 thereof. 2.21 Amendments to Section 11.01. (a) Clause (a) of Section 11.01 of the Credit Agreement is hereby amended by replacing "Section 8.02" with "Section 9.02" in the second line thereof. (b) Clause (b) of Section 11.01 of the Credit Agreement is hereby amended by adding the following immediately prior to the end thereof: "or postpone or delay any date set forth in Section 2.07(b) for the reduction of the Commitments" 39251439.4 12199 1610P 96246459 8 (c) There shall be added to Section 11.01 of the Credit Agreement a new Clause (f) reading in its entirety as follows: "(f) release any portion of the Pledged Collateral;" 2.22 Amendment of Schedules. (a) Schedule 2.01 of the Credit Agreement is hereby amended and restated to read in its entirety as set forth on Schedule 2.01 hereto. (b) Schedule 5.01(g) of the Credit Agreement is hereby amended and restated to read in its entirety as set forth on Schedule 5.01(g) hereto. (c) Schedule 11.02 of the Credit Agreement is hereby amended and restated to read in its entirety as set forth on Schedule 11.02 hereto. 2.23 Addition of New Banks. (a) Upon the effectiveness of this First Amendment, each of the New Banks shall (i) be a party to the Credit Agreement; (ii) assume all of the rights and obligations of a Bank under the Credit Agreement with a Commitment in the amount set forth opposite such Bank's name in Schedule 2.01 attached hereto; and (iii) be secured by the Collateral. The Commitments of the New Banks and the revised Commitments of the existing Banks will be effective as of November 25, 1998 (the "New Commitment Effective Date"). As of the date of this First Amendment, there are three outstanding Borrowings of LIBOR Rate Loans (the "Outstanding Loans"). It is the intention of the parties that on the New Commitment Effective Date the New Banks shall purchase assignments in each of the Outstanding Loans in an amount equal to each such Bank's respective Pro Rata Share. The interest rate payable by the Company on the Outstanding Loans shall remain unchanged; however, the interest rate distributable to the New Banks on their portion of the New Loans shall be equal to the LIBOR Rate for an Interest Period of three months, determined as of November 23, 1998, plus the Applicable Margin for LIBOR Rate Loans. On the New Commitment Effective Date, each New Bank shall pay to the Agent (for delivery to BofA and First Union) its Pro Rata Share of the aggregate principal amount of the Outstanding Loans. The obligation of each New Bank to so provide its purchase price to the Agent shall be absolute and unconditional and shall not be affected by the occurrence of a Default or Event of Default. Each New Bank that has provided to the Agent the purchase price due for its assignment in such Loans shall thereupon acquire a pro rata participation, to the extent of such payment, in the claim of BofA and First Union against the Company for principal and shall share, in accordance with its Pro Rata Share, in any principal payment made by the Company with respect to such claim. (b) From and after the New Commitment Effective Date, the New Banks shall be entitled to their Pro Rata Share of all interest and fees thereafter accruing under this 39251439.4 12199 1610P 96246459 9 Credit Agreement (including, without limitation, interest on each such New Bank's Pro Rata Share of the Outstanding Loans). All Loans made after the New Commitment Effective Date shall be made by the Banks pursuant to the Pro Rata Shares set forth in Schedule 2.01 attached hereto. (c) Each of the New Banks hereby (i) warrants and represents that it is authorized to become a party to the Credit Agreement; (ii) appoints and authorizes the Agent to take such action, exercise such powers, and perform such duties under the Credit Agreement as are specifically delegated to or required of the Agent by the terms of the Credit Agreement, together with such other powers as are reasonably incidental thereto; and (iii) agrees that it will abide and be bound by all of the terms, covenants and agreements, and perform all of the obligations, which by the terms of the Credit Agreement are required to be abided and performed by it as a Bank and shall be entitled to all of the rights, benefits and privileges available or accruing to Banks under the Loan Documents. 3. Representations and Warranties. The Company represents and warrants to the Agent and the Banks that, on and as of the date hereof, and after giving effect to this First Amendment: 3.1 Authorization. The execution, delivery and performance by the Company of this First Amendment has been duly authorized by all necessary corporate action, and this First Amendment has been duly executed and delivered by the Company. 3.2 Binding Obligation. This First Amendment constitutes the legal, valid and binding obligation of the Company, enforceable against it in accordance with its terms, except as enforceability may be limited by applicable bankruptcy, insolvency, or similar laws affecting the enforcement of creditors' rights generally or by equitable principles relating to enforceability. 3.3 No Legal Obstacle to Amendment. The execution, delivery and performance of this First Amendment will not (a) contravene the Organization Documents of the Company; (b) constitute a breach or default under any contractual restriction or violate or contravene any law or governmental regulation or court decree or order binding on or affecting the Company which individually or in the aggregate does or could reasonably be expected to have a Material Adverse Effect; or (c) result in, or require the creation or imposition of, any Lien on any of the Company's properties. No approval or authorization of any governmental authority is required to permit the execution, delivery or performance by the Company of this First Amendment, or the transactions contemplated hereby. 3.4 Incorporation of Certain Representations. After giving effect to the terms of this First Amendment, the representations and warranties of the Company set forth in Article VI of the Credit Agreement are true and correct in all respects on and as of the date hereof as though made on and as of the date hereof, except as to such representations made as of an earlier specified date. 39251439.4 12199 1610P 96246459 10 3.5 Default. No Default or Event of Default under the Credit Agreement has occurred and is continuing. 4. Conditions, Effectiveness. The effectiveness of this First Amendment shall be subject to the compliance by the Company with its agreements herein contained, and to the delivery of the following to Agent in form and substance satisfactory to Agent of the following on or before November 30, 1998: 4.1 Authorized Signatories. A certificate, signed by the Secretary or an Assistant Secretary of the Company and dated the date of this First Amendment, as to the incumbency of the person or persons authorized to execute and deliver this First Amendment and any instrument or agreement required hereunder on behalf of the Company. 4.2 Organization Documents. The articles or certificate of incorporation and the bylaws of each Pledgor Subsidiary as in effect on the date of this First Amendment, and resolutions authorizing the transactions by the Pledgor Subsidiaries contemplated by the Credit Agreement, each certified by the Secretary or Assistant Secretary of the each Pledgor Subsidiary as of the date of this First Amendment. 4.3 Pledge Agreement Affirmations. The Agent shall have received affirmation letters in respect of the Pledge Agreement, substantially in the form of Exhibit A, from each Pledgor Subsidiary. 4.4 Notes. The Agent shall have received for each Bank, including without limitation each New Bank, a duly executed Note in the amount of such Bank's Commitment. 4.5 Regulatory Certificate. A certificate of a Responsible Officer on behalf of each of the Workers' Compensation Subsidiaries to the effect that such Workers' Compensation Subsidiary is in compliance in all material respects with the requirements of all applicable Workers' Compensation Regulations and with all other Requirements of Law. 4.6 Reliance Letters. Letters from Morgan, Lewis & Bockius and the internal counsel of the Company authorizing the New Banks to rely on the opinions delivered pursuant to the Credit Agreement. 4.7 Other Evidence. Such other evidence with respect to the Company or any other person as the Agent or any Bank may reasonably request to establish the consummation of the transactions contemplated hereby, the taking of all corporate action in connection with this First Amendment and the Credit Agreement and the compliance with the conditions set forth herein. 39251439.4 12199 1610P 96246459 11 5. Miscellaneous. 5.1 Effectiveness of the Credit Agreement and the Notes. Except as hereby expressly amended, the Credit Agreement and the Notes shall each remain in full force and effect, and are hereby ratified and confirmed in all respects on and as of the date hereof. 5.2 Waivers. This First Amendment is limited solely to the matters expressly set forth herein and is specific in time and in intent and does not constitute, nor should it be construed as, a waiver or amendment of any other term or condition, right, power or privilege under the Credit Agreement or under any agreement, contract, indenture, document or instrument mentioned therein; nor does it preclude or prejudice any rights of the Agent or the Banks thereunder, or any exercise thereof or the exercise of any other right, power or privilege, nor shall it require the Majority Banks to agree to an amendment, waiver or consent for a similar transaction or on a future occasion, nor shall any future waiver of any right, power, privilege or default hereunder, or under any agreement, contract, indenture, document or instrument mentioned in the Credit Agreement, constitute a waiver of any other right, power, privilege or default of the same or of any other term or provision. 5.3 Counterparts. This First Amendment may be executed in any number of counterparts, and all of such counterparts taken together shall be deemed to constitute one and the same instrument. All provisions of this First Amendment shall become effective when the Company, the Agent and the Majority Banks shall have signed a copy hereof and the same shall have been delivered to the Agent. 5.4 Governing Law. This First Amendment shall be governed by and construed in accordance with the laws of the State of California. 39251439.4 12199 1610P 96246459 12 IN WITNESS WHEREOF, the parties hereto have caused this First Amendment to be duly executed and delivered as of the date first written above. SIERRA HEALTH SERVICES, INC. By: Name: Title: BANK OF AMERICA NATIONAL TRUST AND SAVINGS ASSOCIATION, as Administrative Agent By: Name: Title: BANK OF AMERICA NATIONAL TRUST AND SAVINGS ASSOCIATION, as a Bank By: Name: Title: FIRST UNION NATIONAL BANK, as a Bank By: Name: Title: 39251439.4 12199 1610P 96246459 13 CREDIT LYONNAIS NEW YORK BRANCH, as a New Bank By: Name: Title: THE FIRST NATIONAL BANK OF CHICAGO, as a New Bank By: Name: Title: NORWEST BANK NEVADA N.A., as a New Bank By: Name: Title: UNION BANK OF CALIFORNIA, N.A., as a New Bank By: Name: Title: 39251439.4 12199 1610P 96246459 14 SCHEDULE 2.01 COMMITMENTS AND PRO RATA SHARES
Bank Commitment Pro Rata Share Bank of America National Trust and Savings Association $ 66,666,667 33.333333333% First Union National Bank $ 53,333,333 26.666666667% Credit Lyonnais New York Branch $ 20,000,000 10.000000000% The First National Bank of Chicago $ 20,000,000 10.000000000% Norwest Bank Nevada N.A. $ 20,000,000 10.000000000% Union Bank of California, N.A. $ 20,000,000 10.000000000% TOTAL $200,000,000 100%
39251439.4 12199 1610P 96246459 SCHEDULE 11.02 OFFSHORE AND DOMESTIC LENDING OFFICES, ADDRESSES FOR NOTICES BANK OF AMERICA NATIONAL TRUST AND SAVINGS ASSOCIATION, as Administrative Agent Notices (other than Borrowing Notices and Notices of Conversion/Continuation): Bank of America National Trust and Savings Association Agency Management Services #20529 555 South Flower Street, 11th Floor Los Angeles, CA 90071 Attention: Ms. Gina Meador Vice President Telephone: 213/228-5245 Facsimile: 213/228-2299 AGENT'S PAYMENT OFFICE: Notices for Extensions of Credit and Conversion/Continuation: Bank of America National Trust and Savings Association Agency Administrative Services #5596 1850 Gateway Boulevard, Fifth Floor Concord, CA 94520 Attention: Kathy Eddy Telephone: 925/675-8458 Facsimile: 925/675-8500 39251439.4 12199 1610P 96246459 BANK OF AMERICA NATIONAL TRUST AND SAVINGS ASSOCIATION, as a Bank Domestic and Offshore Lending Office: GPO-Domestic Account Administration #5583 The Harnor Building, 19th Floor 333 S. Beaudry Ave. Los Angeles, CA 90017-1486 Attention: Sandra Ibarra Telephone: 213/345-6536 Facsimile: 213/345-6550 Notices (other than Borrowing notices and Notices of Conversion/Continuation): Bank of America National Trust and Savings Association Health Care Finance #9173 555 South Flower Street, 11th Floor Los Angeles, CA 90071 Attention: J. Gregory Seibly Vice President Telephone: 213/228-2953 Facsimile: 213/228-2756 FIRST UNION NATIONAL BANK Domestic and Offshore Lending Office: One First Union Center Charlotte, North Carolina 28288 Attention: Sue Patterson Telephone: 704/374-7121 Facsimile: 704/374-6537 with a copy of all Notices (other than Borrowing Notices or Notices of Conversion/Continuation): 39251439.4 12199 1610P 96246459 First Union National Bank One First Union Center Charlotte, North Carolina 28288 Attention: Valerie Cline Telephone: 704/383-6237 Facsimile: 704/383-9144 CREDIT LYONNAIS NEW YORK BRANCH Domestic and Offshore Lending Office: 1301 Avenue of the Americas New York, New York 10019 Attention: Kenia A. Perez Telephone: 212/261-7788 Facsimile: 212/261-3440 THE FIRST NATIONAL BANK OF CHICAGO Domestic and Offshore Lending Office: One First National Plaza Chicago, Illinois 60670 Attention: Ken Fecko Telephone: 312/732-4616 Facsimile: 312-732-4303 NORWEST BANK NEVADA N.A. Domestic and Offshore Lending Office: 3300 West Sahara Avenue Las Vegas, Nevada 89102 Attention: Sue Norton Telephone: 702/765-3180 Facsimile: 702/765-3888 39251439.4 12199 1610P 96246459 UNION BANK OF CALIFORNIA, N.A. Domestic and Offshore Lending Office: Commercial Customer Service Unit 1980 Saturn Street Monterey Park, CA 91755 Attention: Gohar Karapetyan Telephone: 323/720-2679 Facsimile: 323/724-6198 39251439.4 12199 1610P 96246459 EXHIBIT A to First Amendment to Credit Agreement November 23, 1998 Sierra Health Services, Inc. Sierra Medical Management, Inc. Prime Holdings, Inc. c/o Sierra Health Services, Inc. 2724 North Tenaya Way Las Vegas, Nevada 89128 Re: Sierra Health Services, Inc. Gentlemen: Please refer to (1) the Credit Agreement, dated as of October 30, 1998 (the "Credit Agreement"), by and among Sierra Health Services, Inc., as the Borrower, the commercial lending institutions party thereto (collectively, the "Lenders") and Bank of America National Trust and Savings Association, as agent (herein, in such capacity, called the "Agent") and (2) the Pledge Agreements dated October 30, 1998 from each of the addressees in favor of the Lenders and the Agent (the "Pledge Agreements"). Pursuant to an amendment dated of even date herewith, a copy of which is attached hereto, certain terms of the Credit Agreement were amended. We hereby request that you (i) acknowledge and reaffirm all of your obligations and undertakings under your Pledge Agreement and (ii) acknowledge and agree that your Pledge Agreement is and shall remain in full force and effect in accordance with the terms thereof. Please indicate your agreement to the foregoing by signing in the space provided below, and returning the executed copy to the undersigned. BANK OF AMERICA NATIONAL TRUST AND SAVINGS ASSOCIATION, as Agent By:______________________________ 39251439.4 12199 1610P 96246459 Title: Acknowledged and Agreed to as of November 20, 1998 SIERRA HEALTH SERVICES, INC. SIERRA MEDICAL MANAGEMENT, INC. PRIME HOLDINGS, INC. By:____________________________ Its:________________________ 39251439.4 12199 1610P 96246459 EX-10 4 EXHIBIT 10.6 SECOND AMENDMENT TO CREDIT AGREEMENT THIS SECOND AMENDMENT TO CREDIT AGREEMENT is made and dated as of January 15, 1999 (the "Second Amendment") among SIERRA HEALTH SERVICES, INC. (the "Company"), the Banks now party to the Credit Agreement referred to below, DEUTSCHE BANK AG, New York and/or Cayman Island Branches (the "New Bank") and BANK OF AMERICA NATIONAL TRUST AND SAVINGS ASSOCIATION, a national banking association, as Administrative Agent (the "Agent"), and amends that certain Credit Agreement dated as of October 30, 1998, as amended by that certain First Amendment dated as of November 23, 1998 (as further amended or modified from time to time, the "Credit Agreement"). RECITALS WHEREAS, the Company has requested the Agent and the Banks to amend certain provisions of the Credit Agreement, and the Agent and the Banks are willing to do so, on the terms and conditions specified herein; WHEREAS, the New Bank wishes to be added to the Credit Agreement as a Bank, and the Company, the Agent and the existing Banks are willing to permit the New Bank to be so added; NOW, THEREFORE, for good and valuable consideration, the receipt and adequacy of which are hereby acknowledged, the parties hereby agree as follows: 1. Terms. All terms used herein shall have the same meanings as in the Credit Agreement unless otherwise defined herein. 2. Amendment. The Credit Agreement is hereby amended as follows: 2.1 Amendment to Section 8.10. (a) Section 8.10 of the Credit Agreement is hereby amended by adding the following clause immediately after the phrase "notwithstanding the foregoing," in the seventh line from the end of such Section: "(i) any Wholly-Owned Subsidiaries may declare and pay dividends to the Company and (ii) " 2.2 Amendment to Section 8.14. (a) Clause (ii) of subsection (b) of Section 8.14 of the Credit Agreement is hereby amended by replacing the phrase "for the period commencing on the Closing Date and 1 ending on the date of determination" and with the following phrase: "for each Fiscal Quarter ending after the Closing Date and on or before the date of determination,". 2.3 Amendment to Section 8.17. (a) The proviso at the end of Section 8.17 of the Credit Agreement is hereby amended by inserting the following clause immediately after the word "foregoing": "the Company may consummate any of the transactions set forth on Schedule 8.17 and". 2.4 Amendment to Section 9.02. (a) The following sentence shall be added to the end of the first sentence of Section 9.02: "Upon any acceleration of the Loans pursuant to the foregoing provisions, the Company shall deposit with the Agent cash collateral in an amount equal to the aggregate undrawn amount of all Letters of Credit then outstanding (the "Maximum Available Amount"); provided that in the event of any drawing under any Letter of Credit thereafter, the Agent shall use such cash collateral to reimburse such drawing and provided further that, in the event of any cancellation or expiration of any Letter of Credit, the Agent shall apply the difference between the Maximum Available Amount immediately prior to such cancellation or expiration and the Maximum Available Amount immediately after such cancellation or reduction, first, to the payment in full of any outstanding Obligations, and second, to the Company or to such other Person who may be lawfully entitled to receive such funds or as a court of competent jurisdiction may direct." 2.5 Amendment to Section 10.10. Section 10.10 of the Credit Agreement is hereby amended and restated in its entirety to read as follows: 10.10 Withholding Tax. (a) If any Bank is a "foreign corporation, partnership or trust" within the meaning of the Code and such Bank claims exemption from, or a reduction of, U.S. withholding tax under Sections 1441 or 1442 of the Code, such Bank agrees with and in favor of the Agent and the Company, to deliver to the Agent: (i) if such Bank claims an exemption from, or a reduction of, withholding tax under a United States tax treaty, two properly completed and executed copies of IRS Form 1001 before the payment of any interest in the first calendar year and before the payment of any interest in each third succeeding calendar year during which interest may be paid under this Agreement; (ii) if such Bank claims that interest paid under this Agreement is exempt from United States withholding tax because it is effectively connected with a United States trade or business of such Bank, two properly completed and executed copies of IRS Form 4224 before the payment of any interest is due in the first taxable year of 2 such Bank and in each succeeding taxable year of such Bank during which interest may be paid under this Agreement; and (iii) to the extent it is legally able to do so, such other form or forms as may be required under the Code or other laws of the United States as a condition to exemption from, or reduction of, United States withholding tax. Such Bank agrees to promptly notify the Agent and the Company of any change in circumstances which would modify or render invalid any claimed exemption or reduction. (b) If any Bank claims exemption from, or reduction of, withholding tax under a United States tax treaty by providing IRS Form 1001 and such Bank sells, assigns, grants a participation in, or otherwise transfers all or part of the Obligations of the Company to such Bank, such Bank agrees to notify the Agent of the percentage amount in which it is no longer the beneficial owner of Obligations of the Company to such Bank. To the extent of such percentage amount, the Agent will treat such Bank's IRS Form 1001 as no longer valid. (c) If any Bank claiming exemption from United States withholding tax by filing IRS Form 4224 with the Agent grants a participation in all or part of the Obligations of the Company to such originating Bank, such originating Bank agrees to undertake sole responsibility for complying with the withholding tax requirements imposed by Sections 1441 and 1442 of the Code with respect to its participant. (d) If any Bank is entitled to a reduction in the applicable withholding tax, the Agent may withhold from any interest payment to such Bank an amount equivalent to the applicable withholding tax after taking into account such reduction. However, if the forms or other documentation required by subsection (a) of this Section are not delivered to the Agent, then the Agent may withhold from any interest payment to such Bank not providing such forms or other documentation an amount equivalent to the applicable withholding tax imposed by Sections 1441 and 1442 of the Code, without reduction. (e) If the IRS or any other Governmental Authority of the United States or other jurisdiction asserts a claim that the Agent or the Company did not properly withhold tax from amounts paid to or for the account of any Bank (because such Bank failed to notify the Agent of a change in circumstances which rendered the exemption from, or reduction of, withholding tax ineffective) such Bank shall indemnify the Agent and the Company fully for all amounts paid, directly or indirectly, by the Agent or the Company as tax or otherwise, including penalties and interest, and including any taxes imposed by any jurisdiction on the amounts payable to the Agent under this Section, together with all costs and expenses (including Attorney Costs). The obligation of the Banks under this subsection shall survive the payment of all Obligations and the resignation or replacement of the Agent. 3 2.6 Amendment of Schedules. (a) Schedule 2.01 of the Credit Agreement is hereby amended and restated to read in its entirety as set forth on Schedule 2.01 hereto. (b) Schedule 11.02 of the Credit Agreement is hereby amended and restated to read in its entirety as set forth on Schedule 11.02 hereto. 2.7 Addition of New Bank. (a) Upon the date of effectiveness of this Second Amendment (the "Effective Date"), the New Bank shall (i) be a party to the Credit Agreement; (ii) assume all of the rights and obligations of a Bank under the Credit Agreement with a Commitment in the amount set forth opposite such Bank's name in Schedule 2.01 attached hereto; and (iii) be secured by the Collateral. On the Effective Date, the New Bank shall purchase and assume, and BofA and First Union shall each sell to the New Bank, 25% of its Commitment under the Credit Agreement, including 25% of each of the outstanding Loans of BofA and First Union (with such purchase, assumption and sale being deemed to have been completed upon payment of the purchase price in the manner referred to below). As of the date of this Second Amendment, there are four outstanding Borrowings of LIBOR Rate Loans, the terms of which are more particularly described on Exhibit A hereto. The interest rate payable by the Company on its outstanding Loans shall not change; however, the interest rate distributable to the New Bank on its portion of the Loans purchased from BofA and First Union shall be equal to the LIBOR Rate for an Interest Period of one or three months (as described on Exhibit A), determined as of January 15, 1999, plus the Applicable Margin for LIBOR Rate Loans. On the Effective Date, the New Bank shall assume the Commitment of, and pay to the Agent (for delivery to BofA and First Union) the purchase price for the Loans sold by, BofA and First Union. The obligation of the New Bank to so provide its purchase price to the Agent shall be absolute and unconditional and shall not be affected by the occurrence of a Default or Event of Default. Upon the delivery by the New Bank to the Agent of the purchase price due for such Loans, the New Bank shall thereupon hold an assignment, to the extent of such payment, in the claim of BofA and First Union against the Company for principal and shall share, in accordance with its Pro Rata Share, in any principal payment made by the Company with respect to such claim. (b) From and after the New Commitment Effective Date, the New Bank shall be entitled to its Pro Rata Share of all interest and fees thereafter accruing under this Credit Agreement (including, without limitation, interest on the New Bank's Pro Rata Share of the Outstanding Loans). All Loans made after the New Commitment Effective Date shall be made by the Banks pursuant to the Pro Rata Shares set forth in Schedule 2.01 attached hereto. (c) The New Bank hereby (i) warrants and represents that it is authorized to become a party to the Credit Agreement; (ii) appoints and authorizes the Agent to take such 4 action, exercise such powers, and perform such duties under the Credit Agreement as are specifically delegated to or required of the Agent by the terms of the Credit Agreement, together with such other powers as are reasonably incidental thereto; and (iii) agrees that it will abide and be bound by all of the terms, covenants and agreements, and perform all of the obligations, which by the terms of the Credit Agreement are required to be abided and performed by it as a Bank and shall be entitled to all of the rights, benefits and privileges available or accruing to Banks under the Loan Documents. 3. Representations and Warranties. The Company represents and warrants to the Agent and the Banks that, on and as of the date hereof, and after giving effect to this Second Amendment: 3.1 Authorization. The execution, delivery and performance by the Company of this Second Amendment has been duly authorized by all necessary corporate action, and this Second Amendment has been duly executed and delivered by the Company. 3.2 Binding Obligation. This Second Amendment constitutes the legal, valid and binding obligation of the Company, enforceable against it in accordance with its terms, except as enforceability may be limited by applicable bankruptcy, insolvency, or similar laws affecting the enforcement of creditors' rights generally or by equitable principles relating to enforceability. 3.3 No Legal Obstacle to Amendment. The execution, delivery and performance of this Second Amendment will not (a) contravene the Organization Documents of the Company; (b) constitute a breach or default under any contractual restriction or violate or contravene any law or governmental regulation or court decree or order binding on or affecting the Company which individually or in the aggregate does or could reasonably be expected to have a Material Adverse Effect; or (c) result in, or require the creation or imposition of, any Lien on any of the Company's properties. No approval or authorization of any governmental authority is required to permit the execution, delivery or performance by the Company of this Second Amendment, or the transactions contemplated hereby. 3.4 Incorporation of Certain Representations. After giving effect to the terms of this Second Amendment, the representations and warranties of the Company set forth in Article VI of the Credit Agreement are true and correct in all respects on and as of the date hereof as though made on and as of the date hereof, except to the extent such representations relate solely to an earlier specified date. 3.5 Default. No Default or Event of Default under the Credit Agreement has occurred and is continuing. 4. Conditions, Effectiveness. The effectiveness of this Second Amendment shall be subject to the compliance by the Company with its agreements herein contained, and to the 5 delivery of the following to Agent in form and substance satisfactory to Agent of the following on or before January 31, 1999: 4.1 Execution of Second Amendment. The Company, the Agent and the Majority Banks shall have signed a copy hereof and the same shall have been delivered to the Agent. 4.2 Pledge Agreement Affirmations. The Agent shall have received affirmation letters in respect of the Pledge Agreement, substantially in the form of Exhibit A, from each Pledgor Subsidiary. 4.3 Notes. The Agent shall have received for each of BofA, First Union and the New Bank, a duly executed Note in the amount of such Bank's Commitment. 4.4 Other Evidence. Such other evidence with respect to the Company or any other person as the Agent, the New Bank or any Bank may reasonably request to establish the consummation of the transactions contemplated hereby, the taking of all corporate action in connection with this Second Amendment and the Credit Agreement and the compliance with the conditions set forth herein. 5. Miscellaneous. 5.1 Effectiveness of the Credit Agreement and the Notes. Except as hereby expressly amended, the Credit Agreement and the Notes shall each remain in full force and effect, and are hereby ratified and confirmed in all respects on and as of the date hereof. 5.2 Waivers. This Second Amendment is limited solely to the matters expressly set forth herein and is specific in time and in intent and does not constitute, nor should it be construed as, a waiver or amendment of any other term or condition, right, power or privilege under the Credit Agreement or under any agreement, contract, indenture, document or instrument mentioned therein; nor does it preclude or prejudice any rights of the Agent or the Banks thereunder, or any exercise thereof or the exercise of any other right, power or privilege, nor shall it require the Majority Banks to agree to an amendment, waiver or consent for a similar transaction or on a future occasion, nor shall any future waiver of any right, power, privilege or default hereunder, or under any agreement, contract, indenture, document or instrument mentioned in the Credit Agreement, constitute a waiver of any other right, power, privilege or default of the same or of any other term or provision. 5.3 Counterparts. This Second Amendment may be executed in any number of counterparts, and all of such counterparts taken together shall be deemed to constitute one and the same instrument. 5.4 Governing Law. This Second Amendment shall be governed by and construed in accordance with the laws of the State of California. 6 IN WITNESS WHEREOF, the parties hereto have caused this Second Amendment to be duly executed and delivered as of the date first written above. SIERRA HEALTH SERVICES, INC. By: Name: Title: BANK OF AMERICA NATIONAL TRUST AND SAVINGS ASSOCIATION, as Administrative Agent By: Name: Title: BANK OF AMERICA NATIONAL TRUST AND SAVINGS ASSOCIATION, as a Bank By: Name: Title: FIRST UNION NATIONAL BANK, as a Bank By: Name: Title: 7 CREDIT LYONNAIS NEW YORK BRANCH, as a Bank By: Name: Title: THE FIRST NATIONAL BANK OF CHICAGO, as a Bank By: Name: Title: NORWEST BANK NEVADA N.A., as a BANK By: ___________________________________ Name: Title: UNION BANK OF CALIFORNIA, N.A., as a Bank By: Name: Title: 8 DEUTSCHE BANK AG, NEW YORK AND/OR CAYMAN ISLANDS BRANCHES, as a New Bank By: Name: _________________________ Title: By: Name: Title: 9 SCHEDULE 2.01 COMMITMENTS AND PRO RATA SHARES
Bank Commitment Pro Rata Share Bank of America National Trust and Savings Association $ 50,000,000 25% First Union National Bank $ 40,000,000 20% Deutsche Bank AG, New York $ 30,000,000 15% and/or Cayman Island Branches Credit Lyonnais New York Branch $ 20,000,000 10% The First National Bank of Chicago $ 20,000,000 10% Norwest Bank Nevada N.A. $ 20,000,000 10% Union Bank of California, N.A. $ 20,000,000 10% TOTAL $200,000,000 100%
SCHEDULE 11.02 OFFSHORE AND DOMESTIC LENDING OFFICES, ADDRESSES FOR NOTICES BANK OF AMERICA NATIONAL TRUST AND SAVINGS ASSOCIATION, as Administrative Agent Notices (other than Borrowing Notices and Notices of Conversion/Continuation): Bank of America National Trust and Savings Association Agency Management Services #20529 555 South Flower Street, 11th Floor Los Angeles, CA 90071 Attention: Ms. Gina Meador Vice President Telephone: 213/228-5245 Facsimile: 213/228-2299 AGENT'S PAYMENT OFFICE: Notices for Extensions of Credit and Conversion/Continuation: Bank of America National Trust and Savings Association Agency Administrative Services #5596 1850 Gateway Boulevard, Fifth Floor Concord, CA 94520 Attention: Kathy Eddy Telephone: 925/675-8458 Facsimile: 925/675-8500 BANK OF AMERICA NATIONAL TRUST AND SAVINGS ASSOCIATION, as a Bank Domestic and Offshore Lending Office: GPO-Domestic Account Administration #5583 The Harnor Building, 19th Floor 333 S. Beaudry Ave. Los Angeles, CA 90017-1486 Attention: Sandra Ibarra Telephone: 213/345-6536 Facsimile: 213/345-6550 Notices (other than Borrowing notices and Notices of Conversion/Continuation): Bank of America National Trust and Savings Association Health Care Finance #9173 555 South Flower Street, 11th Floor Los Angeles, CA 90071 Attention: J. Gregory Seibly Vice President Telephone: 213/228-2953 Facsimile: 213/228-2756 FIRST UNION NATIONAL BANK Domestic and Offshore Lending Office: One First Union Center Charlotte, North Carolina 28288 Attention: Sue Patterson Telephone: 704/374-7121 Facsimile: 704/374-6537 with a copy of all Notices (other than Borrowing Notices or Notices of Conversion/Continuation): First Union National Bank One First Union Center Charlotte, North Carolina 28288 Attention: Valerie Cline Telephone: 704/383-6237 Facsimile: 704/383-9144 DEUTSCHE BANK AG, New York and/or Cayman Islands Branches Domestic Lending Office: Operations: Richard Agnolet Deutsche Bank AG New York Branch 31 W. 52nd Street New York, NY 10019 Tel: 212-469-4113 Fax: 212-469-4138 Business/Credit Matters Sue Pearson Deutsche Bank AG 31 W. 52nd Street New York, NY 10019 Tel: 212-469-7140 Fax: 212-469-8701 Offshore Lending Office: Deutsche Bank AG Cayman Islands Branch c/o New York Branch Operations: Richard Agnolet Deutsche Bank AG New York Branch 31 W. 52nd Street New York, NY 10019 Tel: 212-469-4113 Fax: 212-469-4138 Business/Credit Matters Sue Pearson Deutsche Bank AG 31 W. 52nd Street New York, NY 10019 Tel: 212-469-7140 Fax: 212-469-8701 CREDIT LYONNAIS NEW YORK BRANCH Domestic and Offshore Lending Office: 1301 Avenue of the Americas New York, New York 10019 Attention: Kenia A. Perez Telephone: 212/261-7788 Facsimile: 212/261-3440 THE FIRST NATIONAL BANK OF CHICAGO Domestic and Offshore Lending Office: One First National Plaza Chicago, Illinois 60670 Attention: Ken Fecko Telephone: 312/732-4616 Facsimile: 312-732-4303 NORWEST BANK NEVADA N.A. Domestic and Offshore Lending Office: 3300 West Sahara Avenue Las Vegas, Nevada 89102 Attention: Sue Norton Telephone: 702/765-3180 Facsimile: 702/765-3888 UNION BANK OF CALIFORNIA, N.A. Domestic and Offshore Lending Office: Commercial Customer Service Unit 1980 Saturn Street Monterey Park, CA 91755 Attention: Gohar Karapetyan Telephone: 323/720-2679 Facsimile: 323/724-6198 EXHIBIT A to Second Amendment to Credit Agreement January 15, 1999 Sierra Health Services, Inc. Sierra Medical Management, Inc. Prime Holdings, Inc. c/o Sierra Health Services, Inc. 2724 North Tenaya Way Las Vegas, Nevada 89128 Re: Sierra Health Services, Inc. Gentlemen: Please refer to (1) the Credit Agreement, dated as of October 30, 1998, as amended by that certain First Amendment dated as of November 23, 1998 (the "Credit Agreement"), by and among Sierra Health Services, Inc., as the Borrower, the commercial lending institutions party thereto (collectively, the "Lenders") and Bank of America National Trust and Savings Association, as agent (herein, in such capacity, called the "Agent") and (2) the Pledge Agreements dated October 30, 1998 from each of the addressees in favor of the Lenders and the Agent (the "Pledge Agreements"). Pursuant to an amendment dated of even date herewith, a copy of which is attached hereto, certain terms of the Credit Agreement were amended. We hereby request that you (i) acknowledge and reaffirm all of your obligations and undertakings under your Pledge Agreement and (ii) acknowledge and agree that your Pledge Agreement is and shall remain in full force and effect in accordance with the terms thereof. Please indicate your agreement to the foregoing by signing in the space provided below, and returning the executed copy to the undersigned. BANK OF AMERICA NATIONAL TRUST AND SAVINGS ASSOCIATION, as Agent By:______________________________ Title: Acknowledged and Agreed to as of January 15, 1999 SIERRA HEALTH SERVICES, INC. SIERRA MEDICAL MANAGEMENT, INC. By:____________________________ Its:___________________________ PRIME HOLDINGS, INC. By:____________________________ Its:___________________________ EXHIBIT A OUTSTANDING BORROWINGS OF LIBOR RATE LOANS (as of January 15, 1999) LENGTH OF INTEREST BORROWING PERIOD FOR DETERMINING AMOUNT MATURITY PAYMENTS TO NEW BANK $101,000,000 February 5, 1999 One Month $ 18,000,000 February 9, 1999 One Month 8,000,000 February 10, 1999 One Month $ 12,000,000 March 3, 1999 Three Months EX-10 5 EXHIBIT 10.7(10) EMPLOYMENT AGREEMENT This Agreement is made this day of November 20, 1998, by and between SIERRA HEALTH SERVICES, Inc., a Nevada Corporation, of Las Vegas, Nevada (hereinafter referred to as "Employer"), and Paul H. Palmer , (hereinafter referred to as "Employee"). WITNESSETH WHEREAS, Employer is a publicly traded company engaged in the business of providing managed health care services through subsidiary companies; WHEREAS, Employee has expertise and experience in providing managed health care services; and, WHEREAS, Employee has made and is expected to continue to make a major contribution to the profitability, growth and financial strength of Employer; NOW, THEREFORE, in consideration of the mutual promises and agreements hereinafter set forth, Employer and Employee agree as follows: ARTICLE I EMPLOYMENT/DUTIES AND POWERS 1. Employer hereby employs, engages and hires Employee as Vice President, Treasurer and Chief Financial Officer , and Employee hereby accepts and agrees to such hiring, engagement and employment, subject to the general supervision and direction of Employer. 2. Employee shall perform such duties as are assigned by the CEO of Employer 1 or his/her designee, and shall at all times faithfully and to the best of his/her ability perform all the duties that may be required of Employee to the reasonable satisfaction of Employer. Employee shall exercise only those powers for signing contracts and conveyances in the ordinary course of business as are expressly authorized by Employer's CEO or the appropriate Board of Directors. Employee further agrees to participate in and assist in the development of quality improvement programs offered by Employer. ARTICLE II TERM OF EMPLOYMENT - TERM OF AGREEMENT 1. The term of employment governed by this Agreement shall be for approximately a 3 year period starting November 20, 1998 and terminating December 31,2001 subject, however, to prior termination as hereinafter provided in Article VII. Unless earlier terminated by the mutual agreement of the parties hereto, this Agreement shall terminate at December 31, 2001 or, if Employee has become entitled to any benefit under Article VII due to termination of employment on or before December 31, 2001, at such date as Employer has no further obligations to Employee under Article VII; provided, however, that the provisions of Article V and Article VI (and this clause of Article II) shall survive any termination of this Agreement. 2 ARTICLE III COMPENSATION AND REVIEW 1. Employer shall pay Employee and Employee shall accept from Employer as payment for Employee's services hereunder, compensation in the form of base salary in the amount as set forth in Attachment A of this Agreement, payable at such times as are deemed appropriate by Employer, but not less than twice a month, and other compensation payable under this Agreement. 2. (a) Employer shall reimburse Employee for all necessary and reasonable business expenses incurred by Employee while performing services pursuant to Employer's direction. (b) Employee agrees to maintain adequate records of expenses, in such detail as Employer may reasonably request. 3. (a) Employee shall also be eligible for those Employee fringe benefit programs, bonus plans, and stock option plans as are made available to other employees of Employer at the same organizational level, and as approved by the Board of Directors. (b) Except for Employee's vested benefits under the Supplemental Executive Retirement Plan ("SERP"), Employer may, at any time and at its sole discretion, amend any fringe benefit programs, bonus programs, or stock option programs without prior notice to Employee even though such an amendment may decrease the future benefits available under said programs. 3 4. Employee's performance shall be reviewed at least annually based on established job duties, goals and objectives and other reasonable standards as deemed necessary and appropriate by Employer. ARTICLE IV OTHER EMPLOYMENT Employee shall devote all of his time, attention, knowledge, and skills solely to the business and interest of Employer, unless otherwise authorized by Employer, and Employer shall be entitled to all of the income, benefits, or profits arising from or incident to all work, work associations, services, or advice of Employee, unless otherwise authorized in writing by Employer. Employee shall not, during the term hereof, be interested in any manner, as partner, officer, director, advisor, employee or in any other capacity in any other business similar to Employer's business or any allied trade, or obtain any interest adverse to Employer; provided, however, that Employee may provide advice and consultation to other entities with the written approval of Employer, and further provided, however, that nothing herein contained shall be deemed to prevent or limit the right of Employee to invest any of his/her surplus funds in the capital stock or other securities of any corporation whose stock or securities are publicly owned or are regularly traded on any public exchange, nor shall anything herein contained be deemed to prevent Employee from investing or limit Employee's right to invest his/her surplus funds in real estate. Employee shall complete a Conflict of Interest form by February 15 of each 4 calendar year and submit it to Employer for review. All conflicts of interest or any potential conflicts of interest which arise during the year must be immediately reported to Employer. All conflict of interest concerns must be resolved to the reasonable satisfaction of Employer as a condition of continuation of employment. ARTICLE V BUSINESS SECRETS 1. Employee shall not at any time or in any manner, either directly or indirectly, divulge, disclose or communicate to any person, firm or corporation, in any manner whatsoever, any proprietary or confidential information concerning any matter affecting or relating to the business of Employer or its subsidiaries, including without limiting the generality of the foregoing, any of their customers, the prices they obtain from providers or have obtained from the sale of, or at which they sell or have sold, its services, or any other information concerning the business of Employer or its subsidiaries, their manner of operation, or their plans, if such a disclosure would be detrimental to the business interests of Employer or its subsidiaries. 2. If Employee's employment hereunder is terminated by either party at any time hereafter, then Employee agrees to turn over to Employer all papers, documents, working papers, correspondence, memos and any and all other documents in Employee's possession relating to or concerning any matter affecting or relating to the business of Employer or its subsidiaries. 5 ARTICLE VI NONCOMPETITION AGREEMENT 1. Employee acknowledges that in Employee's employment hereunder, Employee will have continual contacts with the groups, members, and providers who are covered by or associated with the managed health care programs offered by Employer or its subsidiaries in Nevada and other states. In all of Employee's activities, Employee, through the nature of Employee's work, will have access to and will acquire confidential information related to the business and operations of Employer and its subsidiaries, including, without limiting the generality of the foregoing, member and group lists, and confidential information relating to processes, plans, methods of doing business and special needs of doctors, hospitals, members, groups, pharmacies, or other health care providers who contract with Employer or its subsidiaries. Employee acknowledges that all such information is the property of Employer or its subsidiaries solely and constitutes confidential information of such parties; that the disclosure thereof would cause substantial loss to the goodwill of Employer and its subsidiaries; that disclosure thereof to Employee is being made only because of the position of trust and confidence which Employee will occupy and because of Employee's agreement to the restrictions herein contained; that his knowledge of these matters would enable him, on termination of this Agreement, to compete with Employer or its subsidiaries in a manner likely to cause Employer and its subsidiaries irreparable harm, and disclosure of such matters would, likewise, cause such 6 harm; and that the restrictions imposed upon Employee herein would not prohibit Employee in earning a living. 2. It is understood and agreed by Employee and Employer that the essence of this Employment Agreement is the mutual covenants of the parties herein made, that the present and future members and groups of Employer or its subsidiaries will remain Employer's or its subsidiaries' members and groups during the term of this Agreement and following its termination for any reason. In consideration for the employment and continued employment of Employee by Employer, and also for the amount received by Employee as compensation, Employee hereby irrevocably warrants, covenants, and agrees as follows: (a) during the term of Employee's employment and after leaving the employment of Employer for any reason, whether involuntary or voluntary, Employee will not take any action whatsoever which may or might disturb any existing business relationship of Employer or its subsidiaries with any doctors, groups, members, hospitals, pharmacies or other health care providers in Nevada who contract with Employer or its subsidiaries; (b) for a period of one (1) year after leaving the employment of Employer, Employee will not solicit business from the members or groups of Employer or its subsidiaries in Nevada, or in any manner disrupt any business relationship Employer or its subsidiaries has with any contracted health care provider in Nevada with whom Employee came in contact as an employee of Employer. 7 (c) for a period of one (1) year after leaving the employment of Employer, Employee will not, either directly or indirectly, work for any present or future competitors of Employer operating in the state of Nevada who in any manner offer any managed health care programs, insurance coverage, or administer health care claims for employers. Such competitors shall include, but are not limited to, HMOs, PPOs, insurance companies, utilization management companies, or third party administrators. 3. The one (1) year period specified in this Article will be tolled during any period of breach of any of the terms of Article VI by Employee. 4. Employee agrees that in the event of a breach of any term of this Agreement, and more particularly, in the event of a breach of any of the terms and provisions of Article VI, Employer shall be entitled to secure an order in any suit brought for that purpose to enjoin Employee from violating any of the provisions of the Agreement and that, pending the hearing and the decision on the application for such order, Employer shall be entitled to a temporary restraining order without prejudice to any other remedy available to Employer, all at the expense of Employee should Employer prevail in such action. Employee understands that the covenants of this Article are the essence of this Employment Agreement, and without which no Employment Agreement with Employee would be entered into by Employer. 5. The provisions of Article VI shall in no event be construed to be an exclusive remedy and such remedy shall be held and construed to be cumulative and not 8 exclusive of any rights or remedies, whether in law or equity, otherwise available under the terms of this Agreement or under the laws of the United States or the state of Nevada. 6. The covenants and agreements made by Employee in this Article VI shall be construed as an agreement independent of any other provision in the Agreement and the existence of any claim or cause of action by Employee against Employer, whether predicated on this Agreement or otherwise, shall not constitute a defense to the enforcement by Employer, by injunctive relief or otherwise, of the provisions of Article VI. The invalidity of all or any part of any section or paragraph of this Article VI shall not render invalid the remainder of this Article or any section hereof. 7. No failure or failures on the part of Employer to enforce any violation by Employee of this Noncompetition agreement, shall constitute a waiver of Employer's rights thereafter to enforce all of the terms, covenants, provisions and agreements herein contained. ARTICLE VII TERMINATION OF EMPLOYMENT 1. Termination of employment by either Employer or Employee shall follow established Sierra Health Services Policies and Procedures including appropriate notice, except as otherwise specifically set forth in this Article. 2. Employee may terminate employment hereunder with sixty (60) days prior written notice. If Employee shall voluntarily terminate employment all eligible separation 9 compensation and benefits as are routinely made available to other employees of Employer at the same organizational level, shall be paid or made available to Employee. 3. If Employer shall terminate Employee's employment hereunder without cause, except as otherwise set forth in Paragraphs 6 and 7 of this Article, Employee shall be entitled to nine (9) months salary and all other separation compensation and benefits as are routinely made available to other employees of Employer at the same organizational level. 4. In the event Employee's employment hereunder terminates for any reason other than for cause, as set forth in Paragraph 6 of this Article, Employee and his/her family shall be eligible to remain covered under Employer's health care coverage program, at no expense, for a period of time equal to Employee's length of service or until Medicare eligible, whichever occurs first, following termination of such employment. 5. Notwithstanding any other provision in this Agreement to the contrary, Employee hereby agrees that any separation compensation due to Employee, other than accrued vacation, shall be paid out 25% after the first 90 days, 37 1/2% after the first 180 days, and the remaining 37 1/2% at the end of 365 days, except in the event of a change in control. Payment of such amounts shall fully release Employer from any and all liability of Employer relating to this Agreement or the employment hereunder. Any payments or such amounts which would otherwise be payable after a change in control, or arising as a result of a change in control, shall be made in a lump sum within five (5) 10 business days following the date of the change in control and shall, except as otherwise provided in any other benefit program or in this Agreement, fully release Employer from any and all liability of Employer relating to this Agreement or the employment hereunder. 6. If Employer shall terminate Employee's employment due to Employee's conduct that is materially detrimental to Employer's reputation, business relationships, or for misappropriation of Employer's funds, Employee shall be eligible for four (4) weeks salary and any other separation compensation and benefits as are routinely made available to other employees of Employer at the same organizational level, as full and final payment under this Agreement. Payment of such amounts shall fully release Employer from any and all liability of Employer relating to this Agreement or the employment hereunder. 7. (a) If Employee is unable to perform Employee's duties hereunder, by reason of illness or incapacity of any kind, for a period of more than six (6) months in excess of accrued sick leave, Employee's employment hereunder may be terminated by Employer at its absolute discretion with one week of prior written notice. (b) If Employee's illness or incapacity shall have ended, and Employee shall have assumed Employee's duties hereunder, prior to the date specified in the notice of termination, Employee shall be entitled to resume Employee's employment hereunder as if such notice had not been given. 8. In the event of a change in control of Employer, whereby any "person" (as such term is used in Sections 3(a)(9) and 13(d)(3) of the Securities Exchange Act of 1934) 11 is or becomes the beneficial owner, directly or indirectly, of securities of Employer representing 51% or more of the combined voting power of the then outstanding securities of Employer, and such change in control was not approved by a majority of the Board of Directors of Employer, Employee, at his/her sole option, shall be entitled to terminate his/her employment hereunder and, upon such termination, will be entitled to a cash amount equal to (2.0) times Employee's current salary and the target annual bonus for which Employee is eligible in the year of termination, together with any other separation compensation and benefits as are routinely made available to other employees of Employer at the same organizational level. Employee's right to terminate under this Paragraph 8 may be exercised at the time of the change in control or at any time within two years after the change in control, including upon receipt of any notice that Employer has elected to terminate Employee's employment without cause during such two-year period. Payment of such amounts shall be made in a lump sum within five (5) business days following the date such amounts become payable hereunder and shall, except as otherwise provided in any other benefit program or in this Agreement, fully release Employer from any and all liability of Employer relating to this Agreement or the employment hereunder. 9. In the event of a change in control of Employer, whereby any "person" (as such term is used in Sections 3(a)(9) and 13(d)(3) of the Securities Exchange Act of 1934) is or becomes the beneficial owner, directly or indirectly, of securities of Employer representing 51% or more of the combined voting power of the then outstanding securities 12 of Employer, and such change in control is approved by a majority of the Board of Directors of Employer, Employee, at his/her sole option, shall be entitled to terminate his/her employment hereunder and, upon such termination, will be entitled to a cash amount equal to (2.0) times Employee's current salary and the target annual bonus for which Employee is eligible in the year of termination, together with any other separation compensation and benefits as are routinely made available to other employees of Employer at the same organizational level, if, within two (2) years after the effective date of the change in control any one of the following occurs: (a) the assignment to Employee of any duties inconsistent with Employee's position (including status, offices, titles, and reporting requirements), authority, duties, or responsibilities or any other action by the Employer that results in a material diminution in such position, authority, duties, or responsibilities, excluding for this purpose an action not taken in bad faith and that is remedied by Employer within 10 days after receipt of written notice by Employee; (b) a reduction in Employee's annual base salary or target bonus; (c) the relocation of Employer's principle executive offices to a location more than 75 miles from the current location of such offices or (d), in the event such change in control occurs within the final two years prior to the calendar date stated as the termination date of the Agreement in Article II, and if, prior to such stated termination date and prior to termination of Employee's employment, Employer has not offered to enter into an extension of this employment agreement or a new employment agreement providing benefits substantially equal to those under this 13 agreement for a term to extend until at least two years after the date of such change in control. In addition, if Employee's employment hereunder is terminated for reasons other than those set forth in Paragraph 6 and 7 of this Article within two (2) years after the effective date of a change in control which was approved by a majority of Employer's Board of Directors, Employee shall be entitled to a cash amount equal to (2.0) times Employee's current salary and the target annual bonus for which Employee is eligible in the year of termination, together with all other separation compensation and benefits as are routinely made available to other employees of Employer at the same organizational level. Payment of such amounts shall be made in a lump sum within five (5) business days following the date such amounts become payable hereunder, and shall, except as otherwise provided in any other benefit program or in this Agreement, fully release Employer from any and all liability of Employer relating to this Agreement or the employment hereunder. 10. Anything contained herein to the contrary notwithstanding in the event that Employer shall discontinue operation of Employer other than as a result of a merger, consolidation or acquisition, then this Agreement shall terminate and the provisions of Article VI shall terminate as of the last day of the month in which Employer ceases operation with the same force and effect as if such last day of the month were originally set as the termination date hereof. 11. Any amounts payable under this Article VII shall also be payable to Employee 14 in the event Employee is terminated without cause during the 90-day period prior to a Change in Control. 12. Whether or not Employee becomes entitled to any payments under Paragraphs 1 through 11 of this Article VII, if any payments or benefits received, or to be received, by Employee (including the vesting of any option and other non-cash benefits and property), whether pursuant to any provision of this Agreement or any other plan, arrangement or agreement with Employer or any affiliated company, excluding the Gross- Up Payment described herein (such payments and benefits being the "Total Payments"), will be subject to any excise tax imposed under section 4999 of the Internal Revenue Code of 1986, as amended (such excise tax, including penalties and interest thereon, being the "Excise Tax"), Employer shall pay to Employee an additional amount (the "Gross-Up Payment") such that the net amount retained by Employee, after reduction for any Excise Tax on the Total Payments and any federal and Excise Tax on the Gross-Up Payment, shall be equal to the sum of (i) the Total Payments plus (ii) any deductions disallowed for federal income tax purposes because of the inclusion of the Gross-Up Payment in Executive's adjusted gross income multiplied by the Executive's highest marginal rate of federal income taxation for the calendar year in which the Gross-Up Payment is to be made. 15 ARTICLE VIII EFFECT OF WAIVER The waiver by either party of a breach of any provision of this agreement shall not operate or be construed as a waiver of any subsequent breach thereof. ARTICLE IX ACTUAL ATTORNEY'S FEES EXPENDED Employer and Employee agree that all attorneys fees expended by either party in any dispute, arbitration or litigation concerning this Agreement will be paid by the losing party in that dispute, arbitration or litigation. ARTICLE X NOTICE Any and all notices referred to herein shall be sufficient if furnished in writing, sent by registered mail to the representative parties at the addresses subscribed below their signatures to this Agreement. 16 ARTICLE XI ASSIGNMENT The rights, benefits and obligations of Employee under this Agreement shall be assignable, and all covenants and agreements hereunder shall inure to the benefit of and be enforceable by or against Employer's successors or assigns. ARTICLE XII ENTIRE AGREEMENT This Agreement contains the entire Agreement between the parties, and the parties hereby agree that no other oral representations or agreements have been entered into in connection with this transaction. ARTICLE XIII AMENDMENT No amendment or modification of this Agreement shall be deemed effective, unless or until, it is executed in writing by the parties hereto. 17 ARTICLE XIV VALIDITY This Agreement, having been executed and delivered in the State of Nevada, its validity, interpretation, performance and enforcement will be governed by the laws of that state. ARTICLE XV SEVERABILITY It is mutually agreed that all of the terms, covenants, provisions, and agreements contained herein are severable and that, in the event any of them shall be held to be invalid by any competent court, this Agreement shall be interpreted as if such invalid term, covenant, provision, or agreement were not contained herein. ARTICLE XVI FORUM The parties hereto consent and agree that any action to enforce this Agreement or any provision therein or any rights hereunder or any action relating to the employment of Employee with Employer shall be brought in the State of Nevada. 18 ARTICLE XVII INDEMNIFICATION Employer shall indemnify Employee whether or not then in office, to the fullest extent provided for in Employer's Articles of Incorporation or Bylaws, as in effect, or as may thereafter be amended, modified or revised from time to time (collectively, "Employer's Articles"), or permitted under the law of Nevada or such other state in which Employer may hereafter be domiciled, against any and all costs, claims, judgments, fines, settlements, liabilities, and fees or expenses (including, without limitation, reasonable attorneys' fees) incurred in connection with any proceedings (including without limitation, threatened actions, suits or investigations) arising out of, or relating to, Employee's actions or in actions as a director, officer or employee of Employer at any point during his employment by or service to Employer, whether under this Agreement, any prior employment agreements or otherwise. The indemnification contemplated under this Section shall be provided to Employee unless, at the time indemnification is sought, such indemnification would be prohibited under the law of Nevada or of the state in which Employer may then be domiciled; Employer may rely on the advice of its counsel in determining whether indemnification is so prohibited. 19 IN WITNESS WHEREOF, the parties have executed this Agreement at Las Vegas, Nevada, on the day of , 19 . SIERRA HEALTH SERVICES, INC. By:______________________________ Chief Executive Officer P. O. Box 15645 Las Vegas, NV 89114-5645 EMPLOYEE By:______________________________ Paul H. Palmer 1484 Flintrock Henderson, NV 89014 20 ATTACHMENT A COMPENSATION - Paul H. Palmer 1998 Subject to all the terms of this Agreement, the compensation for - ---- Employee shall be paid $________ per month ($____________ per annum). 21 EX-27 6
5 THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE STATEMENTS OF CONSOLIDATED OPERATIONS AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS. 12-MOS DEC-31-1998 DEC-31-1998 83,910,000 110,008,000 124,192,000 10,540,000 0 393,931,000 295,124,000 65,960,000 1,045,120,000 346,168,000 242,398,000 0 0 141,000 303,573,000 1,045,120,000 0 1,037,203,000 0 962,779,000 13,851,000 0 7,181,000 53,392,000 13,796,000 39,596,000 0 0 0 39,596,000 1.45 1.43 Identifiable integration, settlement, and other costs
EX-23 7 EXHIBIT 23.1 INDEPENDENT AUDITORS' CONSENT We consent to the incorporation by reference in Registration Statement Nos. 33-42222, 33-41542, 33-41543, 33-59187, 33-60901, 33-60591, 33-82474, and 333-68399 of Sierra Health Services, Inc. on Forms S-8 of our report dated February 8, 1999 appearing in this Annual Report on Form 10-K of Sierra Health Services, Inc. for the year ended December 31, 1998. DELOITTE & TOUCHE LLP Las Vegas, Nevada March 15, 1999 EX-10 8 EXHIBIT 10.13 AMENDMENT NO. 2 TO THE ASSET SALE AND PURCHASE AGREEMENT THIS AMENDMENT ("Amendment") is entered into as of October 31, 1998, by and between Kaiser Foundation Health Plan of Texas, a Texas non-profit corporation ("Seller"), and Texas Health Choice, L.C., f/k/a HMO Texas, L.C., a Texas limited liability company ("Buyer"). RECITAL The undersigned parties have entered into that certain Asset Sale and Purchase Agreement, dated June 5, 1998, as amended on August 7, 1998 ("Purchase Agreement"), and the parties desire to further amend the Purchase Agreement as set forth herein. NOW, THEREFORE, for and in consideration of the above recitals and the representations, warranties, mutual covenants, and agreements herein expressed, and for other good and valuable consideration, the receipt and sufficiency of which are hereby expressly acknowledged, the parties hereby agree as follows: 1. Identity of Buyer. The parties hereby agree to amend (i) the initial paragraph of the Purchase Agreement, (ii) Section 15.1 regarding notices, (iii) the signature blocks of Buyer, and (iv) any other place in the Purchase Agreement which references HMO Texas, L.C. as Buyer, to change the identity of the Buyer from HMO Texas, L.C., a Texas limited liability company, to Texas Health Choice, L.C., a Texas limited liability company. 2. Confidentiality Agreements. The parties hereby acknowledge that the references to the Confidentiality Agreements dated March 28, 1998 and March 30, 1998 in paragraph E of the Recitals in the Purchase Agreement are erroneous, and hereby agree to amend such paragraph to change such references to the Confidentiality Agreements dated March 24, 1998 and March 27, 1998. Copies of the Confidentiality Agreements dated March 24, 1998 and March 27, 1998 are attached as Exhibits A and B to this Amendment. 3. Texas Group 3000 Issues. The parties hereby acknowledge that Section 1.4.4 of the Purchase Agreement shall be interpreted to mean that the Texas Group 3000 Members shall not be counted in the Membership Base under the Earn-Out Accounts for the purpose of calculating any additional purchase price paid by Buyer to Seller thereunder. In addition, other members employed by the Group 3000 Members' employers (such employers to be determined as of the Closing Date) shall not be counted unless (i) such member is listed on Schedule 1.4.4 as a National Account or (ii) Seller brings new members to areas other than Dallas/Fort Worth in accordance with the provisions of Section 1.4.4. As an example of subsection (i), if XYZ Co. is listed as a National Account in Schedule 1.4.4 and an employee of XYZ Co. is listed as a Group 3000 Member but is not included in the membership count in Schedule 1.4.4, the employee shall never count in the Membership Base for purposes of calculating the Earn-Out Accounts; however, increases in the number of members employed by XYZ Co. and who are not a Group 3000 Member at Closing shall be counted in the Membership Base for purposes of calculating the Earn-out Accounts. 4. Old National Accounts. In addition to updating Schedule 1.4.4 to make it accurate as of the Closing, the parties agree (i) to delete intentionally Columbia Healthcare members from the Membership Base for purposes of Section 1.4.4, notwithstanding that Columbia Healthcare is an Old National Account, and (ii) to not count Columbia Healthcare members in the New Accounts or Earn-Out Accounts. This shall affect Section 1.4.4 of the Purchase Agreement only. 5. Closing. The parties hereby agree that Section 1.5 of the Purchase Agreement shall be amended to change the reference regarding the time of Closing from 12:01:01 a.m. to 11:59:59 p.m. on the Closing Date. 6. Columbia Hospital Contract. In order to simplify the process described in Section 1.6.3(b) of the Purchase Agreement relating to the Columbia Hospital Contract, the parties agree to delete the text of Section 1.6.3(b) of the Purchase Agreement in its entirety, and replace such text with the following: Buyer has arranged to amend and assume that certain contract between Seller and Columbia North Texas Division, Inc. ("Columbia"), dated January 1, 1995 ("Columbia Hospital Contract") pursuant to a letter dated September 17, 1998, from Larry S. Howard to Thomas O. Corley, which sets forth the agreement between Buyer and Columbia and the consent of Columbia to the assignment and assumption of the Columbia Hospital Contract. The following chart sets forth the change in Equivalent Per Diem rates resulting from the assignment of the Columbia Hospital Contract to Buyer: - -----------------------------------------------------------------------------------------------
Time Period 11/1/98 to 1/1/99 to 3/1/99 to 12/31/98 2/28/99 12/31/99 - ----------------------------------------------------------------------------------------------- Existing Columbia $1,059 $1,109 $1,109 Contract Equivalent Per Diem - ----------------------------------------------------------------------------------------------- Amended Columbia $1,143 $1,143 $1,170 Contract Assigned to Buyer Equivalent Per Diem - ----------------------------------------------------------------------------------------------- Difference in $84 $34 $61 Equivalent Per Diem - -----------------------------------------------------------------------------------------------
- 2 - For each Time Period set forth above, Seller shall reimburse Buyer 70% of the applicable Difference in Equivalent Per Diem multiplied by the number of Inpatient Hospital Days incurred under the Columbia Hospital Contract during that Time Period. In addition, Seller shall reimburse Buyer the amount by which 30% of the applicable Difference in Equivalent Per Diem multiplied by the number of Inpatient Hospital Days incurred under the Columbia Hospital Contract for all Time Periods cumulatively exceeds $350,000. Seller shall pay amounts due under this Section 1.6.3(b) on a monthly basis promptly upon receipt of an invoice from Buyer and shall be subject to later verification by Seller through a quarterly audit of Buyer's books and records necessary or reasonable to verify the number of Inpatient Hospital Days at Columbia facilities utilized under the Columbia Hospital Contract. This payment shall be the sole and exclusive payment by Seller to Buyer relating to the cost increases imposed by Columbia's condition to consent to the assignment of the Columbia Hospital Contract from Seller to Buyer. The parties agree that the language set forth above supersedes all discussions and agreements regarding the Columbia Hospital Contract among the parties since June 5, 1998, through the date hereof, including, but not limited to, that certain amendment among the parties dated August 7, 1998, and that the language as set forth above constitutes the sole, full and complete agreement among the parties relating to the Columbia Hospital Contract. 7. Adjustment to Purchase Price. Section 1.4.1 of the Purchase Agreement is amended to state as follows: The consideration for the transfer of the Assets from Seller and Seller's Affiliates to Buyer shall be One Hundred Twenty-Two Million, Nine Thousand, Three Hundred and Nine Dollars ($122,009,309.00), as adjusted as provided in this Section 1.4 (the "Purchase Price"). Ninety-Two Million, Nine Thousand, Three Hundred and Nine Dollars ($92,009,309.00) of the Purchase Price shall be paid by Buyer to Seller by Federal Reserve Bank wire transfer of good funds at Closing, as adjusted as provided in this Section 1.4. The remaining Thirty Million Dollars ($30,000,000.00) of the Purchase Price shall be paid in accordance with the earn-outs set forth in Sections 1.4.4 and 1.4.5. The parties acknowledge that the amount of Two Hundred Seventy Five Six Hundred Ninety-One ($ 275,691.00) is the purchase price associated with the Insurance Assumption Reinsurance Agreement and that such amount is not included in the term Purchase Price for purposes of this Agreement. In addition, Section 1.4.6 of the Purchase Agreement shall be deleted in its entirety, it being the intent of the parties that the sole adjustment to the Purchase Price as a result of any decrease in - 3 - Member Accounts as required by Section 1.4.6 is reflected in the Purchase Price set forth in the amended Section 1.4.1 set forth above. 8. Amendment to Section 10.8. Both Sections 10.8(a) and 10.8(b) of the Purchase Agreement shall each be amended to add the following: The parties shall meet within 30 days of the Closing Date to come to an agreement on the actuarially sufficient commercial rate to be charged for 1999. If the parties are unable to come to an agreement prior to January 1, 1999, each shall charge the other an amount equal to 4 % (2 % for Medicare) above the rate being charged for 1998 (the 1998 commercial and Medicare rates being described in the consolidated and amended Exhibits 10.8(a) & (b)) until they have reached an agreement as to the actuarially sufficient commercial rates for 1999, at which time, the amount previously provided for 1999 shall be adjusted accordingly with the final actuarially sufficient commercial rates. 9. Section Deleted. Section 10.9 is deleted in its entirety. 10. Amendments Relating to Personal Property. a. Section 11.3.1 of the Purchase Agreement is amended to add the following: This Section 11.3.1 shall not apply to the extent that the aggregate net book value of the personal property delivered to Buyer hereunder is less than $22,478,636. b. Section 11.3.2 of the Purchase Agreement is amended to add the following: This Section 11.3.2 shall not apply to the extent that the aggregate net book value of the personal property delivered to Buyer hereunder is less than $22,478,636. 11. Exhibits/Documents Amended. The parties agree to amend certain exhibits which were attached to the Purchase Agreement on June 5, 1998, and to replace such exhibits in their entirety with new versions of such exhibits, which shall be approved by the parties and signed at Closing, the signatures of the duly authorized officer(s) of each party to such exhibits to conclusively evidence the parties' approval thereof, including, without limitation, the following exhibits: Bill of Sale Exhibit 1.6.1(b) Transition Agreement Exhibit 1.6.1(m) Medical Services Agreement Exhibit 1.6.1(n) Opinion Letter of Seller's Counsel Exhibit 5.1 Opinion Letter of Buyer's Counsel Exhibit 6.1 12. Schedules Amended. The parties agree to amend certain schedules which were attached to the Purchase Agreement on June 5, 1998, and to replace such schedules in their entirety with restated versions of such schedules, as follows: - 4 - Schedule 1. l(b) Provider Agreements Schedule 1.1(c) Contracts Schedule 1.l(d) Tangible Personal Property Schedule 1.1(i) Assets of Seller's Affiliates Schedule 1.1(j) Software, Hardware and Related Data of Seller or Seller's Affiliates Schedule 1.2(m) Other Assets to be Excluded Schedule 1.4.4 Membership Base Schedule 2.1.6 Litigation Schedules 10.8(a)&(b) Seller's Group 3000 Rates & Seller's Affiliates Standard Group 3000 Rates (amended and combined) 13. HCFA and OPM. Notwithstanding the terms of the HCFA and OPM Novation Agreements, as such terms may come to be, Buyer and Seller agree that as between themselves, the relationship between Seller and Buyer shall be governed by Sections 10.2 and 10.3 of the Purchase Agreement and the following addition to Sections 11.1 and 11.2 of the Purchase Agreement: There shall be a new Section 11.1(f) that shall state: Any claim, obligation, or other liability arising from the current OPM or HCFA contracts (including, but not limited to, any legal obligations regarding the accuracy of the encounter data) with respect to any period prior to the Closing Date other than as described in Sections 10.2 or 10.3. There shall be a new Section 11.2(f) that shall state: Any claim, obligation, or other liability arising from the current OPM or HCFA contracts (including, but not limited to, any legal obligations regarding the accuracy of the encounter data) with respect to any period on or after the Closing Date other than as described in Sections 10.2 or 10.3. 14. Directors. The last sentence of Section 10.4.4 shall be deleted and replaced with the following: Buyer shall pay for the premiums of all such directors for the calendar year 1999. 15. National Accounts. Buyer and Seller agree that the fixtures, furniture and equipment used by Seller's Affiliates in connection with its National Accounts Program and which are located in Northpoint I, 9229 LBJ Freeway, Suite 202, Dallas, Texas 75243 are not Assets. 16. Other Provisions. All other provisions of the Purchase Agreement not explicitly amended by this Amendment shall remain in full force and effect. ************* [signature pages to follow] - 5 - IN WITNESS WHEREOF, the parties hereto have executed this Amendment as of October 31, 1998. BUYER: TEXAS HEALTH CHOICE, L.C. (F/K/A HMO TEXAS, L.C.) By: Name: Title: SELLER: KAISER FOUNDATION HEALTH PLAN OF TEXAS By: Name: Title: Sierra Health Services, Inc. and Kaiser Foundation Hospitals have executed this Amendment solely with respect to their respective guarantee obligations set forth in Section 14 of the Purchase Agreement. SIERRA HEALTH SERVICES, INC. By: Name: Title: [signature page 1 of 2 - Amendment No. 2 to Asset Sale and Purchase Agreement] - 6 - KAISER FOUNDATION HOSPITALS By: Name: Title: Attachments: Exhibit A Confidentiality Agreement dated March 24, 1998 Exhibit B Confidentiality Agreement dated March 27, 1998 Restated Schedule 1.1(b) Provider Agreements Restated Schedule 1.1(c) Contracts Restated Schedule 1.1(d) Tangible Personal Property Restated Schedule 1.1(i) Assets of Seller's Affiliates Restated Schedule 1.1(j) Software, Hardware and Related Data of Seller or Seller's Affiliates Restated Schedule 1.2(m) Other Assets to be Excluded Restated Schedule 1.4.4 Membership Base Restated Schedule 2.1.6 Litigation Restated Schedules 10.8 (a)&(b) Seller's Group 3000 Rates and Seller's Affiliates Standard Group 3000 Rates [signature page 2 of 2 - Amendment No. 2 to Asset Sale and Purchase Agreement] - 7 - -----END PRIVACY-ENHANCED MESSAGE-----