United HealthCare ("we," "us," "our") has completed several transactions affecting the year-to-year comparisons of our consolidated financial position and results of operations. The most significant transaction was our October 2, 1995, acquisition of The MetraHealth Companies, Inc. (MetraHealth). MetraHealth was formed in January 1995, when the group health care operations of Metropolitan Life Insurance Company and The Travelers Insurance Group were combined. At the time of acquisition, MetraHealth served over 10 million people, including 5.9 million in network-based care programs, 469,000 of whom were health plan members. We acquired two other companies with health plan operations during 1996. > On April 12, 1996, we acquired HealthWise of America, Inc. (HealthWise), a health care management company that owned or operated health plans in Maryland, Kentucky, Tennessee and Arkansas. HealthWise served 154,000 members at the time of acquisition. > On March 29, 1996, we acquired PHP, Inc. (PHP), a North Carolina-based health plan. PHP served 132,000 members at the time of acquisition. We accounted for the acquisition of HealthWise as a pooling of interests; however, we did not restate our consolidated financial results because the effects of the acquisition on our consolidated financial statements were not material. We accounted for the MetraHealth and PHP acquisitions as purchase transactions and, accordingly, only the post-acquisition results of these companies are included in our consolidated financial statements. This Financial Review should be read together with the accompanying Consolidated Financial Statements and notes. SUMMARY OPERATING INFORMATION 1997 1996 1 1995 3 Amount or Percent Percent Increase (Decrease) Amount or Percent Percent Increase (Decrease) Amount or Percent Revenues (in millions) $11,794 17% $10,074 78% $5,671 Net Earnings (in millions) $460 17% $392 2% $383 Medical Costs to Premium Revenues 84.3% 84.0% 79.7% SG&A Expenses to Total Revenues 20% 21.5% 18.2% Enrollment by Product (in thousands as of December 31) Health Plan Products Commercial 4,600 12% 4,100 36% 3,005 Medicare 352 53% 230 55% 148 Medicaid 526 0% 525 49% 352 Total Health Plan Products 5,478 13% 4,855 39% 3,005 Other Network-Based Products 5,556 2% 5,462 2 (3%) 5,628 2 Indemnity Products 2,030 (27%) 2,795 2 (27%) 3,803 2 Total Enrollment 13,064 0% 13,112 1% 12,936 Enrollment by Funding Arrangement (in thousands as of December 31) Fully Insured Health Plan Products 5,172 14% 4,542 39% 3,262 Other Network-Based Products 687 (4%) 719 3% 700 Indemnity Products 370 (37%) 585 (40%) 982 Total Fully Insured 6,229 7% 5,846 18% 4,944 Self-Funded Health Plan Products 306 (2%) 313 29% 243 Other Network-Based Products 4,869 3% 4,743 2 (4%) 4,928 2 Indemnity Products 1,660 (25%) 2,210 2 (22%) 2,821 2 Total Self-Funded 6,835 (6%) 7,266 (9%) 7,992 Total Enrollment 13,064 0% 13,112 1% 12,936 1 Amounts and percents include post-acquisition operating results of HealthWise and PHP. For comparability purposes, amounts and percents exclude merger costs associated with the acquisition of HealthWise of $15 million ($9 million after tax) and the provision for future losses on two large multi year contracts of $45 million ($27 million after tax). 2 For comparability purposes, amounts and percents exclude the self-funded other network-based and indemnity lives served by United HealthCare Administrators, Inc., of 666,000 in 1996 and 674,000 in 1995. We sold United HealthCare Administrators, Inc. on June 30, 1997. 3 Amounts and percents include post-acquisition operating results of MetraHealth. For comparability purposes, amounts and percents exclude restructuring charges of $154 million ($97 million after tax) associated with the MetraHealth acquisition. RESULTS OF OPERATIONS PREMIUM REVENUES Premium revenues in 1997 totaled $10.1 billion. This represents an increase of $1.6 billion, or 19%, compared to 1996 premium revenues. Excluding the effects of the HealthWise and PHP acquisitions, premium revenues in 1997 increased by 17% over 1996. The increase in premium revenues primarily is due to growth in year-over-year same-store health plan premium revenues of $1.5 billion, or 25%, in 1997. The increase in health plan premium revenues reflects same-store enrollment growth of 13% and an average year-over-year premium rate increase on renewing commercial groups exceeding 5%. Growth in our Medicare programs also contributed to the increase in premium revenues. Included in the total health plan same-store enrollment growth of 13% is a year-over-year same-store increase of 53% in Medicare enrollment. Significant growth in Medicare enrollment affects year-over-year comparability of premium revenues. The Medicare product generally has per member premium rates three to four times higher than average commercial premium rates because this population uses proportionately more medical care services. The year-over-year increase in premium revenues from health plan operations was partially offset by an expected decrease in premium revenues from fully insured non-network-based indemnity products of $218 million. Nearly $60 million of this decrease is because we discontinued our relationship with a broker who sold and administered small group indemnity business on our behalf, which led to the loss of 30,000 indemnity members effective July 1, 1997. The remaining decrease is from declining enrollment in these products, due to average 10% to 20% rate increases that started in 1996 and continued into 1997, as well as other business factors. We expect enrollment in the non-network-based indemnity products will continue to decline through 1998. To the extent possible, we will try to convert these enrollees to our network-based managed care products. Premium revenues in 1996 totaled $8.5 billion. This was an increase of $3.6 billion, or 72%, over 1995 premium revenues. Excluding the effects of the MetraHealth, HealthWise and PHP acquisitions, the increase in 1996 premium revenues over 1995 was 28%. Total same-store health plan enrollment grew 30%, and year-over-year premium rate increases on renewing commercial groups were 1% to 2% on average. Because of changes in our customer mix, we did not realize the full effect of same-store enrollment growth and average year-over-year premium rate increases in the percentage increase in 1996 premium revenues. This is because much of the enrollment growth in 1996 had been in health plan small group products, which generally have lower benefits (and therefore lower premiums) than other commercial health plan products. MEDICAL COSTS The combination of our pricing strategy and medical management efforts is reflected in the medical care ratio (the percent of premium revenues expensed as medical costs). We generally set new and renewal commercial health plan premium rates based on anticipated health care costs. Our health care cost trend was in the 3% to 4% range throughout 1996 and 1997, an increase over our 1995 trend of 1% to 2%. We have been increasing premium rates in excess of 5% on average for new and existing commercial health plan business beginning in the second half of 1996, throughout 1997 and into 1998. The medical care ratio increased from 84.0% in 1996 (before nonrecurring charges) to 84.3% in 1997. The increase in the medical care ratio is the result of several factors. > A few health plan markets had medical care ratios substantially higher than our other health plans in the aggregate. The reasons varied from plan to plan, but generally, medical cost controls and provider contracting initiatives were not being fully implemented and commercial premium yields were insufficient compared to corresponding medical costs. We expect performance will improve in these markets; however, we believe these health plans will continue to moderate our overall results through 1998. > Several markets had recently introduced Medicare products, which have been well received and are growing rapidly. We generally experience higher medical care ratios during the early stage of Medicare product introductions. > Medicaid premiums did not increase and, in fact, decreased in several markets. Further Medicaid premium reductions are possible in certain markets in 1998, which may inhibit our ability to improve the overall medical care ratio in the near term. The medical care ratio increased from 79.7% in 1995 to 84.0% in 1996 (before recurring charges). A portion of the increase in the medical care ratio was because of former MetraHealth products (included in the 1996 results, but only in one quarter of 1995), which historically have had a higher medical care ratio when compared to our other products. Had the MetraHealth products been included in our financial results for all of 1995, the medical care ratio would have been approximately 81.0%. The 1996 medical care ratio also reflects the increasing health care cost trend of 3% to 4% as previously discussed. In addition, in the second quarter of 1996, we recorded a provision of $45 million to cover estimated losses we expect to incur through the remaining terms of two large multi year contracts in our St. Louis health plan. Including the contract loss provision, the 1996 medical care ratio was 84.6%. MANAGEMENT SERVICES AND FEE REVENUES Management services and fee revenues in 1997 totaled $1.4 billion. This represents an increase of $30 million, or 2%, over management services and fee revenues in 1996. These revenues are primarily generated from self-funded products where we receive a fee for administrative services and generally assume no financial responsibility for health care costs associated with these products. In addition, we generate fee revenues from administrative services we perform on behalf of managed health plans and for services provided by our specialty businesses. The overall increase in management services and fee revenues is attributable to enrollment growth within the managed health plans and an increase in individuals served by our specialty services operations, most notably in United Behavioral Health and Optum®, our telephone- and Internet-based health information and personal care management business. Offsetting these increases, fee revenues from self-funded products decreased $15 million because of declining enrollment in these products. In addition, the June 30, 1997, sale of our subsidiary, United HealthCare Administrators, Inc., resulted in a $24 million decrease in these revenues in 1997 compared to 1996. Management services and fee revenues in 1996 of $1.4 billion were two times greater than the comparable 1995 revenues. Excluding the effect of the MetraHealth, HealthWise and PHP acquisitions, we generated management services and fee revenues in 1996 of $409 million, a 42% increase over 1995. Managed health plans and our behavioral health and health information and diversified care management businesses again accounted for the most notable increases. OTHER OPERATING EXPENSES Selling, general and administrative expenses as a percent of total revenues (the SG&A ratio) increased from 18.2% in 1995 to 21.5% in 1996. As expected, the MetraHealth acquisition had a significant impact on SG&A expenses (in total dollars as well as a percentage of revenue) because a greater proportion of the former MetraHealth business consisted of fee-based, self-funded products rather than products that generate full premium revenue. Since the MetraHealth acquisition, we have decreased the SG&A ratio from 24.2% in the fourth quarter of 1995 to 20.0% in 1997. The improvement in the SG&A ratio reflects ongoing operating efficiencies as well as our diligence in managing these expenses. On an absolute dollar basis, selling, general and administrative costs increased $199 million in 1997, or 9%, over 1996. This increase reflects the additional infrastructure needed to support the corresponding $1.6 billion increase in premium-based business, as well as the additional investment in new Medicare markets and increased support for our growing specialty services operations. Depreciation and amortization was $146 million in 1997, $133 million in 1996, and $94 million in 1995. Depreciation and amortization increased each year because of higher levels of capital expenditures to support business growth and amortization of goodwill and other intangible assets related to recent acquisitions. With the MetraHealth acquisition, we developed a comprehensive plan to integrate the business activities of the combined companies. The plan included, among other things, the disposition, discontinuance and restructuring of certain businesses and product lines, and the recognition of certain asset impairments. In the fourth quarter of 1995, we recorded $154 million in restructuring charges associated with the plan. The restructuring charges did not cover all integration costs. Such things as new information systems, anticipated operating losses from businesses to be discontinued, employee relocation, and training were not included. These costs are being recognized as they are incurred. MERGER COSTS In connection with the April 1996 acquisition of HealthWise, we recorded nonoperating merger costs of $15 million, consisting primarily of professional fees and other direct costs associated with the acquisition. GOVERNMENT REGULATION Our primary business, offering health care coverage and health care management services, is heavily regulated at the federal and state levels. We strive to comply in all respects with applicable federal and state regulations. To maintain compliance, we may need to make changes from time to time in our services, products, marketing methods or organizational or capital structure. 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. The interpretation of existing laws and rules also may change from time to time. Regulatory agencies generally have broad discretion to issue regulations and interpret and enforce laws and rules. While we are unable to predict regulatory changes, regulatory revisions could affect our operations and financial results negatively. Certain proposed changes in Medicare and Medicaid programs may improve opportunities to enroll people under products developed for these populations. Other proposed changes could limit available reimbursement and increase competition in those programs, with adverse affects on our financial results. Also, it could be more difficult for us to control medical costs if federal and state bodies continue to consider and enact "anti-managed care" laws and regulations, such as "any willing provider" laws. Many jurisdictions have enacted small group insurance and rating reforms, which generally limit the ability of insurers and health plans to use risk selection to control medical costs for small group business. Generally these laws may limit or eliminate use of preexisting conditions exclusions, experience rating and industry class rating, and may limit rate increases. Under these laws, medical cost control through amended provider contracts and improved preventive and chronic care management may become more important. We believe our experience in these areas will allow us to compete effectively. In addition to changes in applicable laws and rules, we are subject to governmental investigations and enforcement actions. Included are actions relating to the Federal Employee Retirement Income Security Act (ERISA), which regulates insured and self-insured health coverage plans offered by employers; the Federal Employees Health Benefit Plan (FEHBP); federal and state fraud and abuse laws; and laws relating to care management and health care delivery. Government actions could result in assessment of damages, civil or criminal fines or penalties, or other sanctions, including exclusion from participation in government programs. We are currently involved in various government audits, but we do not believe the results will have a material adverse effect on our financial position or results of operations. INFLATION Although the general rate of inflation has remained relatively stable and health care cost inflation has stabilized in recent years, the national health care cost inflation rate still exceeds the general inflation rate. We use various strategies to mitigate the negative effects of health care cost inflation, including setting commercial premiums based on anticipated health care costs, risk-sharing arrangements with various health care providers, and other health care cost containment measures. Specifically, health plans try to control medical and hospital costs through contracts with independent providers of health care services. Through these contracted care providers, our health plans emphasize preventive health care and appropriate use of specialty and hospital services. While we currently believe our strategies to mitigate health care cost inflation will continue to be successful, competitive pressures, new health care product introductions, demands from health care providers and customers, applicable regulations or other factors may affect our ability to control the impact of health care cost increases. In addition, certain non-network-based products do not have health care cost containment measures similar to those in place for network-based products. As a result, there is added health care cost inflation risk with these products. FINANCIAL CONDITION AND LIQUIDITY Our cash and investments increased from $3.5 billion at December 31, 1996, to $4.0 billion at December 31, 1997. The increase in cash and investments is primarily the result of cash generated from operations of $683 million, offset by purchases of property and equipment and capitalized software of $176 million. Under applicable state regulations, several subsidiaries are required to maintain specific capital levels to support their operations. After taking these regulations and certain business considerations into account, we had $960 million in cash and investments available for general corporate use at December 31, 1997. The National Association of Insurance Commissioners has an effort underway that would require new minimum capitalization limits for health care coverage provided by insurance companies, HMOs and other risk-bearing health care entities. The requirements would take the form of risk-based capital rules. Depending on the nature and extent of the new minimum capitalization requirements ultimately adopted, there could be an increase in the capital required for certain of our subsidiaries. Any increase would be funded from our corporate usable cash reserves. The new requirements are expected to be effective December 31, 1998. We continue to focus on expanding health care programs to the Medicare population. In the past 12 months, the number of sites offering a Medicare health plan product increased from 18 to 27 sites. Over the same period, health plan Medicare enrollment grew 53%. We continue to invest in new markets and expect to have approximately 39 sites offering Medicare programs by year-end 1998. Significant expenses are associated with introducing a Medicare health plan product. Start-up expenses include a lengthy and detailed regulatory approval process, product-specific provider contracting and network configuration, high up-front sales and marketing costs, and staffing of service areas in advance of product sales. We expect to incur operating losses from Medicare products in start-up markets, usually for the first 12 to 18 months. Once Medicare enrollment targets are met, we expect corresponding administrative costs to be covered. In November 1997, we announced a significant realignment of our operations, designed to take full advantage of opportunities to grow and succeed as we expand into the broad health and well-being marketplace. We have aligned our operations into six independent but strategically linked businesses, each focused on performance, growth and shareholder value. The realignment is dramatically changing the way we manage our business. We are realigning our resources and activities to more directly support the operations of our businesses. We are assessing the effectiveness of our core management processes and transaction processing systems. We are also evaluating each of our businesses for strategic fit, growth potential and operating performance and will be taking actions on business units that do not fit our new direction. Our realignment efforts will take several months to complete. Despite the vast undertaking, we do not expect our realignment efforts to negatively affect our product offerings, provider relations, billing and collection disciplines, and claims processing and payment activities. We are in the process of modifying our computer systems to accommodate the year 2000. We currently expect these modifications to be completed well in advance of the year 2000 with no adverse effect on our operations. We expect to incur associated expenses of approximately $20 million in 1998 and $15 million in 1999 to complete this effort. Our inability to complete year 2000 modifications on a timely basis or the inability of other companies with which we do business to complete their year 2000 modifications on a timely basis could adversely affect our operations. In February 1997, we completed a contract to deliver Medicare and hospital supplement insurance and develop an array of new products for the American Association of Retired Persons (AARP) beginning in January 1998. Under the terms of the l0-year contract, our portion of the AARP insurance offerings represents over $3.5 billion in annual premium revenue from over 4 million enrolled members. In November 1997, the board of directors authorized a stock repurchase program. Up to 10% of our outstanding common stock may be repurchased under the program. Purchases may be made from time to time at prevailing prices in the open market, subject to certain restrictions relating to volume, pricing and timing. The repurchased shares will be available for reissuance through employee stock option and purchase plans and for other corporate purposes. Activity under the program to date has not been significant. In January 1998, we filed a shelf registration statement with the Securities and Exchange Commission to sell as much as $200 million of debt securities, preferred or common shares. The shelf filing registers the securities and allows us to sell them from time to time as we need financing. Proceeds from sales of these securities will be used for a variety of general purposes, which may include working capital, securities repurchases, debt repayment and acquisitions. We recently established a $100 million capital fund from our corporate usable cash reserves that will allow us to make strategic investments in new and promising businesses as we see opportunities. We expect our available cash resources will be sufficient to meet our current operating requirements and internal development and realignment initiatives. In addition, based on our current financial condition and results of operations, we should be able to finance additional cash requirements in the public or private markets, if necessary. Currently, we do not have any other definitive commitments that require cash resources; however, we continually evaluate opportunities to expand our operations. This includes internal development of new products and programs and may include acquisitions.