10-Q/A 1 a2051915z10-qa.txt 10-Q/A FORM 10-Q/A (NO. 1) THIS REPORT IS BEING FILED BECAUSE THE REGISTRANT'S FORMER INDEPENDENT AUDITORS, ERNST & YOUNG LLP, HAVE ADVISED THE COMPANY THAT THEIR SAS 71 WAS INCOMPLETE AT THE TIME OF THE FILING OF THE FORM 10-Q. E&Y SUBSEQUENTLY RESIGNED AS THE COMPANY'S INDEPENDENT AUDITORS AND ADVISED THE COMPANY THAT THEIR AUDIT OPINION FOR 2000 CONTAINED IN THE COMPANY'S FORM 10-K MAY NOT BE RELIED UPON. THE COMPANY DOES NOT AGREE THAT THE SAS 71 REVIEW WAS INCOMPLETE IN ANY MATERIAL RESPECT AT THE TIME OF FILING OF THE ORIGINAL FORM 10-Q. SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended March 31, 2001 -------------- OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from ________ to ________ Commission file number 0-18902 ------- Health Risk Management, Inc. ---------------------------------------------------------- (Exact name of registrant as specified in its charter) Minnesota 41-1407404 ------------------------------- ----------------------- (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification Number) 10900 Hampshire Avenue South, Minneapolis, Minnesota 55438 ---------------------------------------------------------- (Address of principal executive offices, Zip Code) (952) 829-3500 -------------- (Registrant's telephone number, including area code) ------ ---------------------------------------------------------- (Former name, former address and former fiscal year, if changed since last report) 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 the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date. The number of shares of Common Stock par value $.01 per share, outstanding on May 12, 2001 was 4,915,950 (including 15,000 unregistered shares issued to Hamilton Health Center for the purchase of Pennsylvania HealthMATE, Inc, and 234,000 unregistered shares issued to HRM Health Plans (PA), Inc., a wholly-owned subsidiary). -2- When filing Form 10-Q for the quarter ended March 31, 2001, the Company did not include the Market Risk Factors (Risk Factors) under Part I./Item 3. As described in Part II./Item 5./Other Information, the Company's auditors have withdrawn its audit opinion relating to the Company's financial statements for fiscal year ended December 31, 2000, as filed on the Company's Form 10-K for fiscal year 2000, and have informed the Company that it was unable to complete its review of the Company's interim financial statements and medical services payable liability at the time of the filing of the Form 10-Q. It is possible that continuing review will indicate the need for an adjustment to the medical services payable liability. As described in Part II./Item 5. the Company's independent auditors have resigned and the Company has engaged a new independent actuary and is in the process of engaging new independent auditors. Finally, the "Subsequent Events" section of the Notes to the Financial Statements has been updated. HEALTH RISK MANAGEMENT, INC. INDEX

PART I. ITEM 1. FINANCIAL INFORMATION HEALTH RISK MANAGEMENT, INC. CONSOLIDATED BALANCE SHEETS (in thousands, except share data) ASSETS

See accompanying notes. -4- HEALTH RISK MANAGEMENT, INC. CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited) (in thousands, except per share data)

See accompanying notes. -5- HEALTH RISK MANAGEMENT, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited) (in thousands)

See accompanying notes. -6- HEALTH RISK MANAGEMENT, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. UNAUDITED FINANCIAL STATEMENTS The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the three month period ended March 31, 2001 will not be indicative of the results that may be expected for the year ended December 31, 2001 due in part to the Company rationalization activities that were initiated in April 2001. The consolidated balance sheet at December 31, 2000 has been derived from the audited consolidated financial statements at that date but does not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. The Company's independent auditors have withdrawn their audit opinion with respect to the December 31, 2000 financial statements. For further information, refer to the consolidated financial statements and footnotes thereto included in the Registrant Company and Subsidiaries' report on Form 10-K for the year ended December 31, 2000. 2. USES OF ESTIMATES The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Significant accounts which are largely determined based on management's estimates and assumptions include incurred but not yet reported claims included in medical services payable, amounts recoverable from providers included in accounts receivable, economic life of computer software capitalized for internal use and external sale, recoverability of goodwill, accrued severance obligations payable included in accrued expenses and the deferred tax asset valuation allowance. Such estimates and assumptions could change in the future as more information becomes known, which could impact the amounts reported and disclosed herein. 3. GOING CONCERN The following figures are based on the initial calculation of management and the initial actuarial figures provided by the Company's former independent actuaries, Ernst & Young LLP ("E&Y"). During the year ended December 31, 2000 and the three months ended March 31, 2001, the Company had a net loss of $27.6 million and $4.0 million, respectively. As of March 31, 2001, the Company has a working capital deficit of $29.5 million and total Shareholders' equity of $2.1 million. The Company's insurance subsidiary (the Plan) reported to the Commonwealth of Pennsylvania Insurance Department (the Department) a statutory net worth of $.6 million as of December 31, 2000. As of January 1, 2001, the Plan adopted revised statutory accounting principles regarding admitted and non-admitted assets. These new standards, referred to as Codification, resulted in an estimated statutory net worth deficit of approximately $12.5 million. These levels of net worth are below certain minimum statutory - based capital requirements. Unless resolved, the insurance regulators have the statutory authority to place the Plan into receivership. On June 7, 2001, the Company received a preliminary report from Milliman USA, its new independent actuaries, regarding the medical services payable liability as of December 31, 2000. The Company and Milliman have discussed the report, which is not final, and therefore may not be relied upon without independent verification. However, the Company believes that the medical services payable liability as of December 31 recommended by Milliman is highly likely to be greater, and possibly substantially greater, than that recommended by the Company's former actuary, E&Y. -7- Under its contracts with the Pennsylvania Department of Public Welfare (the "DPW"), the Plan is to provide Medicaid insurance coverage to covered members as defined in the HealthChoices Southeast Physical Health Agreement and the Voluntary Managed Care Organization Provider Agreement. These contracts require the Plan to meet certain minimum statutory-basis net worth requirements. Because these requirements were not met at December 31, 2000 or March 31, 2001 the DPW has the right to terminate its contracts with the Plan. These conditions raise substantial doubt about the Company's ability to continue as a going concern. The March 31, 2001 financial statements do not include any adjustments that might result from the outcome of these uncertainties. Accounts such as goodwill and other intangibles would require adjustment if the Company could not continue as a going concern. 4. SUBSEQUENT EVENTS Subsequent to March 31, 2001, the Company has undergone significant changes in management, has identified and implemented significant payroll and other operating expense reductions, obtained external financing was delisted by Nasdaq and submitted to the Commonwealth Pennsylvania Department of Insurance a capital plan for HRMPA (the Company's wholly owned Medicaid HMO). MANAGEMENT CHANGES The management changes announced by the Company were the retirement of each of the CEO and President in March 2001. Severance, insurance and other costs under terms of the employment agreements with the former CEO, President and a senior executive officer of approximately $1,539,000 have been accrued as of March 31, 2001 and have been included in selling, marketing and administration expense during the first quarter of 2001. The Company is disputing the payment obligations under terms of the Employment Agreement. However, on June 11, 2001, the Company was ordered to place these funds in escrow pending the outcome of litigation of the executives' claims against the Company. The Company is exploring its legal options regarding the June 11 order. The final amounts paid to these former executives may be more or less than the March 31, 2001 accrual. A management team, experienced in restructuring health care companies, is operating at the direction of the Board of Directors. Through April 27, 2001, payroll and other operating expense reductions, which are expected to yield $10.1 million on an annualized basis, have been identified and implemented. Severance obligations of approximately $300,000 will be incurred in the second quarter of 2001 as a result of the payroll reductions realized under the rationalization plan. Other expenses, including legal and consulting fees, will be incurred in the second quarter under the rationalization plan. On June 11, 2001, the Company engaged Kurron Shares of America, Incorporated ("KSA"), a New York based restructuring company, to assist in managing and improving the Company's financial functions, lead a process that is focused on cost reduction and improvement of the Company's operating performance, and assist the Company in developing a restructuring plan. The Company intends to explore all of its alternatives, including financings, recapitalizations and asset sales. As part of that engagement, Corbett A. Price was appointed as the Company's Chief Restructuring Officer and Steven L. Volla will be providing consulting services. Messrs. Price and Volla are affiliated with KSA. FINANCING On May 15, 2001, the Company, Loop Corp. and affiliates of Loop Corp. signed a Master Agreement, pursuant to which Loop Corp. agreed to fund $6.1 million (less expenses) to the Company, to be advanced by the Company to its HMO subsidiary. In this phase of the financing, the Company issued warrants for up to 1,000,000 shares of its common stock, exercisable at a price of $7.50 per share, and a debenture that is exchangeable, in certain circumstances, for preferred stock of the Company. The Company received a wire transfer in the amount of $3.0 million and a check in the amount of $3.0 million on May 15. -8- Following the resignation of the Company's former auditors, E&Y, and the Company's disclosure to Loop Corp. of the proposed increases to the medical services payable liability, Loop Corp. advised the Company that it would not make funds available for payment on the check. Loop Corp. and the Company are continuing discussions regarding this matter; and Loop Corp. has indicated to the Company that it believes that it may have claims for rescission as a result of the increase in the medical services payable liability. The Company and Loop Corp. are in negotiations regarding this matter. Because of the Company's dispute with Loop Corp., the Company cannot be assured that it will successfully retain the proceeds of the $6.1 million financing. Andrew Jahelka, a member of the Board of Directors of the Company, is president of Loop Corp. and Leon A. Greenblatt III, the indirect holder of a substantial equity stake in the Company, has a controlling interest in and is secretary of Loop Corp. Mr. Jahelka and Mr. Greenblatt are also significant equity holders of Persus, LLC. Because of these affiliations, the HRM warrants and the convertible debenture will not be exercisable until the issuance of the warrants are approved by HRM's shareholders. NASDAQ On April 18, 2001, the Company was advised by Nasdaq that it was not in compliance with the marketplace rules because it had failed to timely file its annual report on Form 10-K. The Company appealed the decision and attended a hearing before a listings qualifications panel on May 10, 2001 and filed its annual report on Form 10-K on May 11, 2001. On May 16, 2001, the Company received a notification from Nasdaq that the Listing Qualifications Panel would consider the existence of the "going concern" opinion, which the Company received from its independent auditors for fiscal year 2000, in the Panel's decision. The Company made a written submission to Nasdaq regarding the going concern opinion on May 23, 2001. Finally, the Company was informed by Nasdaq, by a telephone call on May 21, 2001, that Nasdaq considered the Company's 10-Q for the first quarter of 2001 to be delinquent because the Company's independent auditors had not yet completed their review of the Company's financial statements. On May 22, 2001, the Company received notification from Nasdaq that it was halting trading in the Company's securities pending receipt and review of more detailed information regarding the delinquency of the Company's Form 10-K. The Company has responded by letter to the Nasdaq's concerns. On Thursday, June 7, 2001, Nasdaq informed the Company that the Listing Qualifications Panel had ruled to delist the Company effective as of June 8, 2001. The Company is considering its options concerning this ruling. PENNSYLVANIA INSURANCE Under Pennsylvania Insurance statutes and its contracts with the DPW, the Plan must meet certain minimum statutory-basis capital requirements. Because these requirements were not met at December 31, 2000 and at March 31, 2001, the Department has the right to place the Plan into receivership and the Department of Public Welfare has the right to terminate its contracts with the Plan. In response to the lack of adequate capital, the Company's management presented a risk based capital plan to the Department on April 19, 2001, which the Department rejected on April 30, 2001. Management submitted a revised risk based capital plan to the Department on May 7, 2001. Management is in continuing discussions with the Department as a result of the increases proposed to be made in the medical services payable liability by E&Y. CHANGE IN AUDITORS On Friday, May 18, 2001, the Company was advised that Ernst & Young LLP ("E&Y") had resigned as the Company's independent auditors. RESIGNATION OF DIRECTORS On June 1, 2001, Steven L. Volla resigned from the Company's Board of Directors; effective June 7, 2001, Robert Montgomery resigned from the Board; and on June 7, 2001, Corbett A. Price resigned from the Board, effective June 8. None of the resigning directors informed the Company, in writing or otherwise, that he was resigning because of a disagreement with the Company on any matter relating to the Company's operations, policies or practices. 5. MEDICAL SERVICES PAYABLE -9- Medical services payable is estimated by management using a variety of techniques, including a per member per month cost analysis as well as the use of completion factors developed from historical payment patterns and industry-wide payment patterns. Since the acquisition of the Medicaid health plans, the ability of management to reliably estimate medical services payable has been affected by a lack of reliable paid claim data prior to their acquisition and inconsistent processing of claims and workflow inefficiencies since their acquisition date. These issues have caused overpayments or duplicate payments to providers and created claim backlogs. Through March 31, 2001, these issues continue to affect management's ability to estimate the ultimate cost of medical services. The assumptions made regarding provider recoveries, reduction in duplicate claim payments or overpayments and processing efficiencies may not be realized, which would adversely affect the ultimate cost of medical services. The estimates for medical services payable are continually reviewed and adjusted as experience develops or new information becomes known. Such adjustments are included in current operations. Accounts receivable at March 31, 2001 and December 31, 2000 includes $2,424,000 and $5,519,000, respectively, reflecting management's estimate of duplicate payments and overpayments to providers. Management believes that offset of identified recoveries against current payments to providers will not adversely affect relationships with those providers and that its estimate of identified recoveries is fully realizable. However, to the extent that the amounts recorded as an account receivable are not realized, the medical services cost will increase and will be reflected in current operations as changes in estimates occur. As of May 18, 2001 E&Y recommended that the Company increase the reserve for medical services payable at December 31, 2000 by $2.8 million, and at March 31, 2001 by $2.2 million. The Company has not accepted E&Y's latest determinations with respect to medical services payable. As discussed above, after E&Y's resignation as the Company's auditors, the Company retained Milliman USA as its independent actuaries. On June 7, 2001, the Company received a preliminary report from Milliman USA regarding the Medical Services Payable as of December 31, 2000. The Company and Milliman have discussed the report, which is not final, and therefore may not be relied upon without independent verification. However, the Company believes that the Medical Services payable liability as of December 31 recommended by Milliman is highly likely to be greater, and possibly substantially greater, than that recommended by the Company's former actuary, E&Y. 6. COMPUTER SOFTWARE COSTS

The Company capitalizes its internal-use software related to its Care Management software and Claim Administration software in accordance with the American Institute of Certified Public Accountants -10- (AICPA) Statement of Position (SOP) 98-1 "ACCOUNTING FOR COMPUTER SOFTWARE DEVELOPED FOR OR OBTAINED FOR INTERNAL USE" (the SOP). Effective January 1, 2001, the estimated remaining useful life of additions to Claim Administration software was reduced from ten years to five years. The Company capitalizes QualityFIRST(R) computer software costs in accordance with Statement of Financial Accounting Standards (SFAS) No. 86, ACCOUNTING FOR THE COSTS OF COMPUTER SOFTWARE TO BE SOLD, LEASED, OR OTHERWISE MARKETED. The capitalized costs are amortized based on the greater of the amount computed using (a) the ratio of current gross revenues for the product to the total of current and anticipated future gross revenues or (b) a straight-line basis over their estimated useful lives, ranging from three to seven years. In May, 2001, the current management team determined that it would not fund the development of a reporting project included within Care Management Software. The net book value of the software of $836,000 has been written off in the quarter ended March 31, 2001 and is included in "Amortization" in the consolidated statement of cash flows. 7. NET INCOME (LOSS) PER SHARE The following table sets forth the computation of basic and diluted earnings per share for the three months ended March 31, (in thousands, except per share data):

The effect of stock options were not included in the calculation of diluted earnings per share for the quarter ended March 31, 2001 because they were antidilutive. In addition, the 234,000 unregistered shares of stock issued to the Plan have been excluded from the shares outstanding for purposes of determining basic and diluted earnings per share. The Company has not accepted E&Y's May 18 determinations. However, if the May 18 recommendations of E&Y related to increases to the medical services payable are correct, the Company's net worth at December 31, 2000 and March 31, 2001 would be reduced from $6.1 million to $3.3 million and from $2.1 million to a deficit of $2.9 million, respectively. Net loss per share at these dates would be $6.52 and $1.32, respectively, rather than $5.92 and $.85. The impact of the recommendation on the net worth of the Company's Medicaid HMO would be a reduction to net worth of $1.9 million and $3.3 million as of December 31, 2000 and March 31, 2001, respectively. The impact on the HMO is less than on the Company due to the 33% quota share reinsurance agreement the HMO has in place. 8. COMPREHENSIVE INCOME -11- The comprehensive income for the Company for the three months ended March 31, 2000 was as follows (in thousands): Net income $ 104 Change in net unrealized loss on fixed maturity investments (10) ------------- Comprehensive income $ 94 =============

9. INVESTMENTS The Company held no fixed maturity investments at December 31, 2000 or March 31, 2001. There were no sales of fixed maturity investments during the three months ended March 31, 2001 and March 31, 2000. At March 31, 2001, U.S. Treasury Securities with a book value of $100,000 were on deposit with the Commonwealth of Pennsylvania Insurance Department to satisfy regulatory requirements. 10. REINSURANCE The quota share reinsurance agreements entered into by the Plan were for the purposes of reducing the risk of financial loss to the Plan and to generate statutory surplus. To the extent that the reinsurer is unable to meet its obligations under terms of the agreements, the Plan remains primarily liable. Effective July 1, 2000, the Plan entered into a 33% quota share reinsurance agreement under which the reinsurer has assumed 33% of the Medicaid medical cost risk and certain non-medical expenses in exchange for 33% of the related Medicaid premium. Under this agreement, on July 6, 2000, the Plan received a $4,000,000 ceding allowance from the reinsurer. The ceding allowance will be realized in relation to profits ceded to the reinsurer. The Plan realized $392,000 of the ceding allowance in the three months ended March 31, 2001, as a component of net revenues. Amounts ceded under the contract for premiums, medical costs, cost of services, and selling, marketing and administration expenses for the quarter ended March 31, 2001, were $16,317,000, $14,035,000, $1,170,000 and $585,000, respectively. Under terms of the 33% quota-share agreement, the Plan or reinsurer can terminate the agreement on December 31, 2004 or later with 180 days notice. Additionally, the Plan can recapture the business ceded after June 30, 2002 upon repayment of the ceding allowance and losses incurred on the business ceded, and payment of 18% interest per annum. The Plan can recapture the business ceded prior to June 30, 2002 for a fee of $25,000 for each month the recapture occurs prior to June 30, 2002. The Company did not have a quota share reinsurance agreement in place in the quarter ended March 31, 2000. The reinsurer has asked the Company to place in escrow cash and investments equal to approximately one-third of the medical services payable liability. The Company is continuing negotiations with the reinsurer. 11. NOTES PAYABLE The term loan is subject to debt covenants that are to be met on a quarterly basis. The Company did not meet certain bank covenants under the term loan agreement during the quarter ended March 31, 2001. Subsequent to March 31, 2001, the Company received a waiver for the covenant violations for the quarter ended March 31, 2001 and amended certain of the covenants. 12. COMMITMENTS AND CONTINGENCIES -12- As a risk contractor for Medicaid programs, the Plan is subject to regulations covering operating procedures. The laws and regulations governing risk contractors are complex and subject to interpretation. The Commonwealth of Pennsylvania and various regulatory bodies within the Commonwealth, monitor the Plan's operations to ensure compliance with the applicable laws and regulations. There can be no assurance that administrative or systems issues or the Plan's current or future provider arrangements will not result in adverse action by regulatory authorities. The Plan received in 2000 a demand letter (which also named the Company and PAHRM) from a current provider seeking payments totaling $8,400,000 under certain provisions of its provider contract. On January 26, 2001, the provider placed this matter in binding arbitration before the American Arbitration Association in Philadelphia, Pennsylvania. The Plan believes that amounts due to this provider are significantly less than the $8,400,000 demanded and any amounts unpaid at March 31, 2001, are included within its medical services payable. The Plan intends to contest this case vigorously while seeking an out-of-court settlement. The Company and PAHRM are contesting being named in the arbitration. In the quarter ended March 31, 2001, the Plan received a demand letter from a current provider seeking payments totaling $4,400,000 under certain provisions of its provider contract. Every effort is being made by both parties to resolve this matter without resorting to arbitration or litigation. The Plan believes that amounts due to this provider are less than the $4,400,000 demanded and any amounts owed are included within its medical claims payable liability. In the quarter ended March 31, 2001, the Plan received a demand letter from a current provider seeking payments totaling $600,000 for the difference between full billed charges and the state Medicaid fee for service rates. A similar dispute has been appealed by another Philadelphia HMO to the Pennsylvania Supreme Court. Until a definitive ruling is issued which compels the Plan to pay full billed charges, the Plan will continue to pay at the Pennsylvania Medicaid fee for service rates. If the provider's position is upheld by the Pennsylvania Supreme Court, the Plan and all other Medicaid plans in the state of Pennsylvania may be unable to operate profitably in the Pennsylvania Medicaid marketplace without a significant increase in premiums. Premiums are subject to renewal annually with the Department of Public Welfare. The Company has been sued on this claim and intends to contest the matter. Subsequent to March 31, 2001, the Company has received several demand letters from former employees affected by the rationalization of the Company. The demand letters seek immediate compensation under various agreements such as employment, severance or commission. The Company is currently in the process of assessing each demand letter. The Company expects to receive additional demand letters as the rationalization efforts continue. In addition to meeting the net worth requirements of the Department, under terms of its contracts with the DPW, effective July 1, 2001, the Plan may be required to maintain a net worth of $8.2 million. As discussed above, the Company has received notification from Loop Corp. that Loop Corp. may pursue litigation against the Company to rescind Loop Corp.'s investment of $6.1 million in the Company and possibly pursue other claims. 13. RECLASSIFICATION Certain items in the financial statements for the three months ended March 31, 2000 have been reclassified to conform to the 2001 presentations. 14. SEGMENT REPORTING Reportable segment information is as follows (in thousands):

-14-

(1) Intersegment 4YourCare Services unit revenues represent the amounts charged to the Health Plan unit under terms of an administrative services agreement. The revenue is eliminated in consolidation. Intersegment QUALITYFIRST unit revenues represents amounts charged by the QUALITYFIRST unit to the 4YourCare Services unit ($97,000 and $73,000 for the three months ended March 31, 2001 and 2000, respectively) and the Health Plan unit ($220,000 and $212,000 for the three months ended March 31, 2001 and 2000, respectively) for use of the QUALITYFIRST(R) software. The revenue is based upon covered members or employees and is eliminated in consolidation. (2) Investment income earned on Health Plan cash and cash equivalents is recorded in the Health Plan unit. All other investment income is recorded in the 4YourCare Services unit. (3) Interest expense for the Health Plan unit relates to the surplus note payable that was reversed in the quarter ended September 30, 2000 when the note was acquired from Oxford Health Plans, Inc. The remaining interest expense has been allocated between the 4YourCare Services unit and the QualityFIRST unit based upon segment assets. (4) Corporate amounts have been allocated back to the respective business units based upon estimated resource usage. -15- ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. OVERVIEW The Company's revenues consist primarily of insurance premiums related to the Health Plan Unit, management service fees for health plan management in the 4YourCare Business Unit, QualityFIRST revenues for software licenses and subscription fees in the QualityFIRST Business Unit, and investment income. The Company has been impacted by several events that occurred subsequent to March 31, 2001. See Note 4 to the financial statements above. In order to manage its insurance risk and generate statutory surplus, the HMO entered into quota share reinsurance agreement to cede 33% of the Health Plan premiums, medical costs, costs of services and selling, marketing and administration expenses in the last six months of 2000 and the quarter ended March 31, 2001. There was no quota share reinsurance agreement in effect during the quarter ended March 31, 2000. Under terms of the quota share agreement, the Health Plan received an advance ceding allowance of $4,000,000. For statutory accounting purposes, the ceding allowance was recognized as revenue upon receipt from the reinsurer. For GAAP, the ceding allowance is realized in relation to profits ceded to the reinsurer. The Company's operating expenses are comprised of medical costs related to the Health Plan operations (consisting of the costs of medical services incurred by the Health Plan members net of medical costs ceded to the reinsurer), cost of services (consisting of salaries, wages and benefits, telephone expenses, depreciation and amortization, rent, computer operations, customer service, and the development of new services), and selling, marketing and administration expenses (consisting of salaries, wages and benefits of sales staff and sales account management personnel, bad debts, professional services, insurance, litigation costs and depreciation). The net medical costs, net cost of services and net selling, marketing and administration expenses reflect the impact of the reinsurance agreement discussed above. For the quarter ended March 31, 2001, the Company had a net loss of $4.0 million. This loss had reduced the Company's net worth from $6.1 million at December 31, 2000 to $2.1 million at March 31, 2001. The working capital deficit was $29.5 million at March 31, 2001 compared to $28.1 million at December 31, 2000. The continuation of net losses from the prior year has led directly to the Company engaging in rationalization efforts at the end of the first quarter and continuing on into the second quarter of 2001. The prior CEO and President retired and have been replaced by a management team experienced in restructuring health care companies. To date, payroll and other operating expense reductions which are expected to yield approximately $10.1 million on an annualized basis have been identified and implemented. The Company's Health Plan is required to submit statutory financial statements with the Pennsylvania Department of Insurance and to maintain a statutory surplus level sufficient to meet or exceed risk-based capital calculations. The Health Plan filed its 2000 Annual Statement with the Department of Insurance, indicating the net worth was below a threshold control level as of December 31, 2000. As a result, the Department of Insurance required a Risk-Based Capital (RBC) Plan be submitted to the Department of Insurance within 90 days. On April 19, 2001, that Plan was submitted. On April 30, 2001, the Health Plan received notice that the Department required a re-submission of the RBC Plan by May 7, 2001. The Health Plan has prepared and submitted the revised RBC Plan to address the Department's issues. The Revised RBC Plan is under review by the Department. The Health Plan anticipates working with the Department to stabilize and strengthen its financial condition. In the year 2000, the NAIC and the Commonwealth of Pennsylvania adopted revised statutory accounting principles to further clarify and standardize admitted and non-admitted assets for statutory purposes. Referred to as Codification, the revised statutory accounting standards are effective January 1, 2001. Based upon a permitted practice letter received from the Department on May 14, 2001, the Health Plan surplus will exceed the threshold control level as of March 31, 2001. -16- Over 80% of the Company's total revenues are from the Health Plan Business Unit. Included in the results of the Health Plan are OakTree (serving Philadelphia and surrounding counties) and HealthMate (serving Harrisburg and surrounding counties). OakTree has experienced a continuing decline in membership while HealthMate has seen steady growth in membership. Future trends in membership are difficult to predict. This business is subject to regulatory risks such as re-negotiation of rates on an annual basis, changing and expanding reporting requirements, net worth requirements, government agendas and the general health of the membership served. Service utilization for contracted charges payable to providers of care, pharmacies, and other health care providers can significantly impact the profitability of the Health Plan. The Health Plan has a receivable of $6,910,000 from a reinsurance policy for aggregate coverage of excessive medical costs that is currently in the course of collection. The Health Plan fully expects to collect the receivable during 2001 once issues related to the reinsurance claim are fully resolved. To the extent that the reinsurer does not meet its obligations assumed under the reinsurance contract, the Health Plan remains primarily liable. RESULTS OF OPERATIONS The following table sets forth certain consolidated financial data as a percentage of revenues for the three months ended March 31, 2001, March 31, 2000 and the year ended December 31, 2000.

(1) Computed as a % of HMO premiums, net (gross premiums less ceded premiums). (2) Computed as a % of net revenues. * Less than 1% on a rounded basis REVENUES: Total revenues prior to the reduction for ceded premiums increased $4,063,000 (7.2%) for the quarter ended March 31, 2001 compared to the same period in 2000 (from $56,741,000 to $60,804,000). These increases are primarily attributable to the acquisition of HealthMate on February 1, 2000 and increases in rates under terms of the contracts with the DPW offset by a net decrease in members served under the DPW contract and lower 4YourCare and QualityFIRST revenues resulting from the loss of several clients. -17- Following is a breakout of revenues:

Premiums - gross are from insurance premiums related to the HMO operations of the Health Plan business unit. The premiums-gross increased 10.4% or $4.7 million, for the three months ended March 31, 2001 compared to the same period in 2000 (increasing from $44.8 million to $49.5 million). This increase is the net result of a $2.7 million increase for having three months of premiums for HealthMate in 2001 compared to two months of revenue in 2000 (the year of acquisition), approximately $3.0 million from the 6-7% rate increase from the Department of Public Welfare of the Commonwealth of Pennsylvania (DPW) under the Oaktree contract effective January 1, 2001, approximately $.6 million increase for from the 7% rate increase from the DPW under the HealthMATE contract, approximately $.6 million increase for increased HealthMATE membership less approximately $2.2 million due to the decrease in Oaktree membership. In order to manage its insurance risk and generate statutory surplus , the HMO entered into a quota share reinsurance agreement to cede off 33% of the Health Plan premiums, medical costs, costs of services and selling, marketing and administration expenses effective July 1, 2000. This agreement impacted the reported results of the Health Plan for the quarter ended March 31, 2001. Under terms of the quota share agreement, the Health Plan received an advance ceding allowance of $4,000,000. The ceding allowance is realized in relation to profits ceded to the reinsurer. The 4YourCare revenues decreased 7.2% or $.8 million, for the three months ended March 31, 2001 compared to the same period in 2000 (decreasing from $10.5 million to $9.7 million) which was the result of the loss of several self-insured clients offset by the addition of a significant number of covered lives through its contract with HCA, a client of many years, in January 2001. HCA represented 30.3% and 21.9% of 4YourCare revenues in the three months ended March 31, 2001 and 2000, respectively. Revenues from QualityFIRST(R) decreased 11.9% or $.1 million for the three months ended March 31, 2001 compared to the same period in 2000 (decreasing from $1.2 million to $1.1 million). The decreases were the result of a decrease in the number of clients utilizing the QualityFIRST(R) software. Investment income decreased 30.7% or $.1 million for the three months ended March 31, 2001 compared to the same period in 2000 (decreasing from $.3 million to $.2). This decrease is directly related to the sale of investments by the Health Plan, the proceeds of which were used to pay claims. MEDICAL COSTS, NET: Medical costs, net of amounts ceded, for the Health Plan decreased 22% or $8.2 million for the three months ended March 31, 2001 compared to the same period in 2000 (decreasing from $36.8 million to $28.6 million). Excluding the impact of the quota share reinsurance agreement, medical costs increased 22% or $8.2 million for the three months ended March 31, 2001 compared to the same period in 2000 (increasing from $36.8 million to $44.8 million). The increase in gross medical costs resulted from HealthMATE claims for the full quarter ended March 31, 2001 compared to two months of claims in 2000, an estimated 12% increase in pharmacy costs and other increases in medical costs. As a percentage of net Health Plan premiums, net medical costs was 86.2% for the three months ended March 31, 2001 compared to 82.1% for the same period in 2000. The increase in the loss ratio highlights the Health Plan's continued need to control medical costs though improved provider and pharmacy contracting, network management and utilization management. COST OF SERVICES, NET: Cost of services, net of amounts ceded, decreased 6.1% or $.9 million for the three months ended March 31, 2001 compared to the same period in 2000 (decreasing from $15.4 million to $14.5 million). -18- Excluding the impact of the quota share reinsurance agreement, cost of services increased 1.4% or $.2 million for the three months ended March 31, 2001 compared to the same period in 2000 (increasing from $15.4 million to $15.6 million). As a percentage of net revenues, cost of service was 32.6% and 27.2% for the three months ended March 31, 2001 and 2000. SELLING, MARKETING AND ADMINISTRATION, NET: Selling, marketing and administration, net of amounts ceded, increased 29.0% or $1.2 million for the three months ended March 31, 2001 compared to the same period in 2000 (increasing from $4.0 million to $5.1 million. Excluding the impact of the quota share reinsurance agreement, selling, marketing and administration increased 43.7% or $1.7 million for the three months ended March 31, 2001 compared to the same period in 2000 (increasing from $4.0 million to $5.7 million). The 2001 increase is primarily due to the accrual of severance costs of $1,500,000 and increased audit fees. This expense as a percentage of net revenues was 11.6% for the three months ended March 31,2001 and 7.0% for the same period in 2000. INTEREST EXPENSE: Interest expense decreased 16.0% or $53,000 for the three months ended March 31, 2001 compared to the same period in 2000 (decreasing from $332,000 to $279,000) and was .6% of net revenue for both periods. INCOME TAXES: Income taxes was an expense of $20,000 for the quarter ended March 31, 2001 compared to an expense of $100,000 for the same period in 2000. The decrease is due to fluctuations in levels of income or loss before income taxes. In 2001, the effective tax benefit is less than the statutory rate because the Company is not able to recognize deferred tax assets in excess of deferred tax liabilities in that the utilization of such assets is not reasonably assured. LIQUIDITY AND CAPITAL RESOURCES For the quarter ended March 31, 2001, the Company continued to be challenged by the reality that cash provided by operations is not sufficient to finance the Company's obligations. As was explained in the Overview section above, the magnitude of the net loss for the year ended December 31, 2000, had reduced the Company's net worth from $33.1 million at December 31, 1999 to $6.1 million at December 31, 2000. During the quarter ended March 31, 2001, the net worth declined to $2.1 million.. The cash flow provided by operations was $2.9 million for the three months ended March 31, 2001, compared to cash flow used in operations of $2.1 million for the same period in 2000. Cash flow from operations exceeded net loss for the quarter ended March 31, 2001 primarily due to non-cash charges such as depreciation ($806,000) amortization ($2,573,000), decrease in accounts receivable ($1,680,000), increase in accounts payable $1,638,000) and increase in accrued expenses ($1,396,000) offset by the reduction in the medical service payable ($1,396,000). Cash was used to invest in software and program enhancements ($1.1 million for the three months ended March 31, 2001 compared to $1.4 million for the same period in 2000). The Company also used cash to acquire property and equipment ($.8 million for the three months ended March 31, 2001 compared to $.2 million for the same period in 2000). The Company expects to continue to invest in software and program enhancements in 2001 on the core business units and will need to fund some of the prior year software and program enhancements. The Company used cash of $1.0 million for the three months ended March 31, 2001, compared to $1.2 million for the same period in 2000, to repay principal on notes payable and capital leases. The Company's term loan has a principal balance of $5.9 million as of March 31, 2001. The term loan is secured by liens on the assets of the Company and is payable in monthly installments of $225,000 (including interest) through October 31, 2001 when all other outstanding principal is due (or such later date to which the bank may agree). The Company had a working capital deficit of $29.5 million at March 31, 2001 compared to a deficit of $28.1 million at December 31, 2000. The major factors for the increased deficit relate to $.9 million increase in accounts payable, $1.5 million increase to accrued expenses, $1.7 decrease to accounts receivable offset by a decrease of $1.2 million to medical services payable, $.4 million decrease to unearned revenue, a $.8 million decrease to current maturities of notes payable and a $.1 million decrease to cash and cash equivalents. Through April 27, 2001, payroll and other operating expense reductions expected to yield approximately $10.1 million on an annualized basis have been identified and implemented. The loss for the quarter ended March 31, 2001 resulted in the Company not meeting certain bank covenants under the bank loan agreement. Subsequent to March 31, 2001, the Company and the bank have been in negotiations regarding the amendment of the loan agreement to waive the defaults that existed at March 31, 2001 and to amend the covenants going forward. -19- As a result of its financial position, the Pennsylvania Department of Insurance has required the Company to submit a risk based capital plan to the Department of Insurance. On April 19, 2001, the plan was submitted. On April 30, 2001, the plan was notified that the Department would require a resubmission of the plan. The plan has been prepared and resubmitted; however there can be no assurance that the health plan will be successful in obtaining approval of the revised plan. Failure to achieve approval may jeopardize the contracts for covered members with the DPW. In the year 2000, the NAIC and the Commonwealth of Pennsylvania adopted revised statutory accounting principles to further clarify and standardize admitted and non-admitted assets for statutory purposes. Referred to as Codification, the revised statutory accounting standards are effective January 1, 2001. Based upon a permitted practice letter received from the Department on May 14, 2001, the Health Plan surplus will exceed the threshold control level as of March 31, 2001. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK In the course of business, the Company is exposed to market risk from changes in interest rates. The Company does not enter into any derivative transactions. The Company's term loan obligation is subject to interest rate risk. A 100 basis point increase in interest rates related to the Company's term loan payable would result in an annual increase in the Company's then current interest expense of approximately $63,000. FORWARD LOOKING STATEMENTS The statements contained in this Report on Form 10-Q and the Management's Discussion and Analysis of Financial Condition and Results of Operations, include forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 (the "PSLRA"). When used in this Report on Form 10-Q and in future filings by the Company with the Securities and Exchange Commission, in its press releases, presentations to securities analysts or investors, and in oral statements made by or with the approval of one of its executive officers, the words or phrases "believes," "anticipates," "intends," "will likely result," "estimates," "projects" or similar expressions are intended to identify such forward-looking statements. Any of these forward-looking statements involve risks and uncertainties that may cause its actual results to differ materially from the results discussed in the forward-looking statements. The following discussion contains certain cautionary statements regarding its business that investors and others should consider. This discussion is intended to take advantage of the "safe harbor" provisions of the PSLRA. In making these cautionary statements, the Company is not undertaking to address or update each factor in future filings or communications regarding its business or results, and is not undertaking to address how any of these factors may have caused results to differ from discussions or information contained in previous filings or communications. In addition, any of the matters discussed below may have affected its past, as well as current, forward-looking statements about future results. Its actual results in the future may differ materially from those expressed in prior communications. THE COMPANY MAY NOT ACCOMPLISH ITS BUSINESS PLAN. As discussed above under the caption MANAGEMENT'S DISCUSSION AND ANALYSIS, the Company had a net loss of $27.6 million for the year ended December 31, 2000 and a loss of $3.9 million for the quarter ended March 31, 2001. The Company had a working capital deficit of $28.1 million at December 31, 2000 and $29.5 million at March 31, 2001. To address its financial condition, the Company has developed, and is continuing to develop, a rationalization plan, which involves, among other things, expense reductions, the obtaining of additional financing, the development of an RBC plan in order to comply with the capital requirements of the Pennsylvania Department of Insurance and a review of all of the Company's contractual relationships. As disclosed previously, Steven Volla part of the new Company's management team resigned as a Director, and is now a consultant to the Company. The Company is also addressing the it's ability to obtain sufficient financing, to manage its costs more effectively than it has in the past, and, possibly, to obtain new business. As a result of these considerations, no assurances can be given that the Company will be able to accomplish its plans. If it cannot do so, it is possible that the Company will cease operations. THE COMPANY FACES THE RISK THAT ITS ACTUARIES WILL UPON FURTHER REVIEW REACH A HIGHER CALCULATION OF REQUIRED RESERVES. As previously disclosed, E&Y has withdrawn its opinion with respect to the Company's financial reports and the Company has engaged Milliman USA as its new independent actuary to conduct a thorough review of the Company's reports. On June 7, 2001, the Company received a preliminary report from Milliman regarding the medical services payable liability as of December 31, 2000. This preliminary report, which is not Milliman's final report and therefore may not be relied upon without independent verification, indicates that the medical services payable liability as of December 31 may be greater than any of the reports the Company received from E&Y. The Company has not yet received the final report -20- from Milliman, however. As the result of this ongoing review it cannot be assured that the Company will not have to restate its financials. THE COMPANY HAS BEEN DELISTED FROM THE NASDAQ NATIONAL MARKET, WHICH RESTRICTS LIQUIDITY OF THE STOCK. On April 18, 2001, the Company was advised by Nasdaq that it was not in compliance with the Marketplace Rules of the Nasdaq National Market because it had failed to timely file its annual report on Form 10-K. The Company appealed the decision and attended a hearing before a Listing Qualifications Panel on May 10, 2001. On May 16, 2001, the Company received a notification from Nasdaq that the Listing Qualifications Panel would consider the existence of the "going concern" opinion, which the Company received from its independent auditors for Fiscal Year 2000, in the Panel's decision. The Company made a written submission to Nasdaq regarding the going concern opinion on May 23, 2001. Finally, the Company was informed by Nasdaq, by a telephone call on May 21, 2001, that Nasdaq considered the Company's 10-Q for the first quarter of 2001 to be delinquent because the Company's independent auditors had not yet completed their review of the Company's financial statements. On May 22, 2001, the Company received notification from Nasdaq that it was halting trading in the Company's securities pending receipt and review of more detailed information regarding the delinquency of the Company's Form 10-K. The Company has responded to the Nasdaq's concerns. On June 7, 2001 the Company was informed by Nasdaq that it had been delisted effective June 8. The Company intends to consider its options concerning Nasdaq's action, however, no assurance can be given that the Company will seek or will be successful in relisting its stock. As the Company's stock is delisted, the liquidity of its stock is impaired. The Company's stock may trade at a lower price than might otherwise be obtained. As the Company's stock is delisted, the Company's stock may be traded over-the-counter, more commonly known as the OTC market. OTC transactions involve risks in addition to those associated with transactions in securities traded on the Nasdaq National Market. Many OTC stocks trade less frequently and in smaller volume than Nasdaq-listed stocks and the values of these stocks may be more volatile than Nasdaq-listed stocks. If the Company's stock is traded in the OTC market and a market maker sponsors the Company, the Company may have the price of its stock electronically displayed on the OTC Bulletin Board, or OTCBB. However, if the Company lacks sufficient market maker support for display on the OTCBB, it must have its price published by the National Quotations Bureau LLP in a paper publication known as the "Pink Sheets." The marketability of the Company's stock will be even more limited if its price must be published on the "Pink Sheets." HEALTH CARE COSTS The Company uses a large portion of its revenue to pay the costs of health care services or supplies delivered to its members. Total health care costs are affected by the number of individual services rendered and the cost of each service. Much of its premium revenue is priced before services are delivered and the related costs are incurred, usually on a prospective annual basis. Although the Company bases the premiums it receives on the estimate of future health care costs over the fixed premium period, competition, regulations and other factors may and often do cause actual health care costs to exceed what was estimated and reflected in premiums. These factors may include increased use of services, increased cost of individual services, catastrophes, epidemics, the introduction of new or costly treatments, medical cost inflation, new mandated benefits or other regulatory changes, insured population characteristics and seasonal changes in the level of health care use. In addition, the financial results the Company reports for any particular period include estimates of claims incurred that have not yet been received or processed. Because of these estimates, the Company's earnings may be adjusted later to reflect the actual costs. Relatively insignificant changes in medical costs as a percentage of premium revenues, because of the narrow margins of its health plan business, can create significant changes in its financial results. INDUSTRY FACTORS The managed care industry receives significant negative publicity and has been the subject of large jury awards. This publicity has been accompanied by increased litigation, legislative activity, regulation and governmental review of industry practices. These factors may adversely affect the Company's ability to market its products or services, may require changes to its products and services, and may increase the regulatory burdens under which the Company operates, further increasing costs of doing business and adversely affecting profitability. COMPETITION In many geographic or product markets, the Company competes with a number of other entities, some of which may have certain characteristics or capabilities that give them a competitive advantage. The Company believes the barriers to entry in these markets are not substantial, so the addition of new competitors can occur relatively easily, and consumers enjoy significant flexibility in moving to new providers of health and well being services. Certain of the Company's customers may decide to perform for themselves functions or services that the Company provides, which -21- would decrease the Company's revenues. Certain of the Company's contracted providers may decide to market products and services to the Company's customers in competition with the Company. In addition, significant merger and acquisition activity has occurred in the industry in which the Company operates as well as in industries that act as suppliers to the Company, such as the hospital, physician, pharmaceutical, medical device and health information systems industries. To the extent that there is strong competition or that competition intensifies in any market, the Company's ability to retain or increase customers or providers, or maintain or increase revenue growth, pricing flexibility, control over medical cost trends and marketing expenses may be adversely affected. GOVERNMENT PROGRAMS AND REGULATION The business of the Company is heavily regulated at the state level. The laws and rules governing its business and interpretations of those laws and rules are subject to frequent change. Broad latitude is given to the agencies administering those regulations. Existing or future laws and rules could force us to change how the Company does business, restrict revenue and enrollment growth, increase the Company's health care and administrative costs and capital requirements, or other actions. Delays or failure to obtain approval at the state level could adversely affect the Company's revenue or could increase costs. The Company participates in state mandated Medicaid HMO programs which are subject to frequent change, including changes that may reduce the number of persons enrolled or eligible, reduce the amount of reimbursement or payment levels, or reduce or increase its administrative or health care costs under such programs. Such changes could adversely affect financial results. State legislatures and Congress continue to focus on health care issues. Congress is considering various forms of "Patients' Bill of Rights" legislation which, if adopted, could fundamentally alter ERISA's treatment of liability for noncompliance, fiduciary breach of contract and improper coverage denials. Additionally, there recently have been federal and state legislative attempts to limit ERISA's preemptive effect on state laws. If adopted, such limitations could increase the Company's liability exposure and could permit greater state regulation of the Company's operations. Other proposed bills and regulations at state and federal levels may impact certain aspects of its business including provider contracting, claims payments and process, confidentiality of health information and government-funded programs. Further, tax code changes considered from time to time by Congress may make it easier and more cost effective for employers to establish defined contribution plans. While the Company cannot predict if any of these initiatives will ultimately become binding law or regulation, or if enacted, what their terms will be, their enactment could increase costs, expose the Company to expanded liability, require the Company to revise the ways in which it conducts business or put the Company at risk for a loss of business to new health care funding arrangements. Further, as the Company's businesses continue to implement their e-commerce initiatives, uncertainty surrounding the regulatory authority and requirements in this area will make it difficult to ensure compliance. The Company is also subject to various governmental reviews and audits. Such oversight could result in the loss of licensure or the right to participate in certain programs, or the imposition of civil or criminal fines, penalties and other sanctions. In addition, disclosure of any adverse investigation or audit results or sanctions could damage its reputation in various markets and make it more difficult for us to sell the Company's products and services. The Company is currently involved in various governmental investigations, audits and reviews. The Company's operations are conducted through its wholly owned subsidiaries, which include a Medicaid HMO and a third party administrator. These operations are subject to state regulations that, among other things, may require the maintenance of minimum levels of statutory capital, as defined by each state, and may restrict the timing and amount of dividends and other distributions that may be paid to their respective parent companies. Generally, the amount of dividend distributions that may be paid by its regulated subsidiaries, without prior approval by state regulatory authorities, is limited based on the entity's level of statutory net income and statutory capital and surplus. PROVIDER RELATIONS One of the significant techniques the Company uses to manage health care costs and facilitate care delivery is contracting with physicians, hospitals and other providers. Because the Company's health plans are geographically diverse and most of those health plans contract with a large number of providers, the Company currently believes the aggregate exposure to provider relations issues is limited. A number of organizations are advocating for legislation that would exempt certain providers from federal and state antitrust laws, the adoption of which could impact this assessment. In any particular market, providers could refuse to contract, demand higher payments, or take other actions that could result in higher health care costs, less desirable products for customers and members, or difficulty meeting regulatory or accreditation requirements. In some markets, certain providers, particularly hospitals, physician/hospital organizations or multi-specialty physician groups, may have significant market positions or near monopolies. In addition, physician or practice management companies, which aggregate physician practices for administrative efficiency and marketing leverage, continue to expand. These providers may compete directly with the Company. If these providers refuse to contract with us, use their market position to negotiate favorable contracts, or place the -22- Company at a competitive disadvantage, those activities could adversely affect the Company's ability to market products or to be profitable in those areas. LITIGATION AND INSURANCE The Company may be a party to a variety of legal actions that affect any business, such as employment and employment discrimination-related suits, employee benefit claims, breach of contract actions, tort claims, shareholder suits, including securities fraud, and intellectual property related litigation. In addition, because of the nature of the business, the Company is subject to a variety of legal actions relating to business operations, including the design, management and offering of its products and services. These could include: claims relating to the denial of health care benefits; medical malpractice actions; allegations of anti-competition and unfair business activities; provider disputes over compensation and termination of provider contracts; disputes related to self-funded business, including actions alleging claim administration errors and the failure to disclose network rate discounts and other fee and rebate arrangements; disputes over copayment calculations; claims related to the failure to disclose certain business practices; and claims relating to customer audits and contract performance. As disclosed above, the Company has received a letter from Loop Corp. indicating that Loop Corp. may pursue litigation against the Company for rescission of Loop Corp.'s investment of $6.1 million among other claims. INFORMATION SYSTEMS The Company's businesses depend significantly on effective information systems. The Company's information systems require an ongoing commitment of significant resources to maintain and enhance existing systems and develop new systems in order to keep pace with continuing changes in information processing technology, evolving industry and regulatory standards, and changing customer preferences. For example, HIPAA's administrative simplification provisions and the federal claim processing regulations may ultimately require significant changes to current systems. In addition, the Company may from time to time obtain significant portions of its systems-related or other services or facilities from independent third parties, which may make its operations vulnerable to such third parties' failure to perform adequately. Failure to maintain effective and efficient information systems could cause the loss of existing customers, difficulty in attracting new customers, issues in determining medical cost estimates, customer and provider disputes, regulatory problems, increases in administrative expenses or other adverse consequences. ADMINISTRATION AND MANAGEMENT Efficient and cost-effective administration of the Company's operations is essential to profitability and competitive positioning. While the Company is attempting to effectively manage expenses, staff-related and other administrative expenses may arise from time to time due to business or product start-ups or expansions, growth or changes in business, acquisitions, regulatory requirements or other reasons. These expense increases are not clearly predictable and may adversely affect results. Further, the Company believes it currently has an experienced, capable management and technical staff. The market for management and technical personnel, including information systems professionals, in the health care industry is very competitive. Loss of certain key employees or a number of managers or technical staff could adversely affect the Company's ability to administer and manage its business. DATA AND PROPRIETARY INFORMATION Many of the products that are part of its knowledge and information-related business depend significantly on the integrity of the data on which they are based. If the information contained in its databases were found or perceived to be inaccurate, or if such information were generally perceived to be unreliable, commercial acceptance of its database-related products would be adversely and materially affected. Furthermore, the use of individually identifiable data by its businesses is regulated at federal, state and local levels. These laws and rules are changed frequently by legislation or administrative interpretation. These restrictions could adversely affect revenues from certain of its products or services and, more generally, affect its business, financial condition and results of operations. There are various legislative and regulatory proposals currently under consideration that address the use and maintenance of individually identifiable health data, including regulations promulgated pursuant to HIPAA. Compliance with these proposals could result in cost increase due to necessary systems changes and the development of new administrative processes. Additionally, if enacted, some of these proposals may impose restrictions on its use of patient data. The success of knowledge and information-related business activities also depends significantly on the Company's ability to maintain proprietary rights to its products. The Company relies on its agreements with customers, confidentiality agreements with employees, and its trade secrets, copyrights and patents to protect its proprietary rights. The Company cannot assure that these legal protections and precautions will prevent misappropriation of its proprietary -23- information. In addition, substantial litigation regarding intellectual property rights exists in the software industry, and the Company expects software products to be increasingly subject to third-party infringement claims as the number of products and competitors in this industry segment grows. Such litigation could have an adverse effect on the ability of the Company's knowledge and information-related business to market and sell its products and on its business, financial condition and results of operations. FINANCIAL OUTLOOK From time to time in press releases and otherwise, the Company may publish forecasts or other forward-looking statements regarding its future results, including estimated revenues or net earnings. Any forecast of its future performance reflects various assumptions. These assumptions are subject to significant uncertainties, and as a matter of course, any number of them may prove to be incorrect. Further, the achievement of any forecast depends on numerous risk and other factors (including those described in this discussion), many of which are beyond its control. As a result, the Company cannot assure that its performance will be consistent with any management forecasts or that the variation from such forecasts will not be material and adverse. Current and potential shareholders are cautioned not to base their entire analysis of the Company's business and prospects upon isolated predictions, but instead are encouraged to utilize the Company's entire publicly available mix of historical and forward-looking information, as well as other available information affecting the Company and its services, when evaluating its prospective results of operations. PART II. OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS The Company may be a party to a variety of legal actions that affect any business, such as employment and employment discrimination-related suits, employee benefit claims, breach of contract actions, tort claims, shareholder suits, including securities fraud, and intellectual property related litigation. In addition, because of the nature of the business, the Company is subject to a variety of legal actions relating to business operations, including the design, management and offering of its products and services. These could include: claims relating to the denial of health care benefits; medical malpractice actions; allegations of anti-competition and unfair business activities; provider disputes over compensation and termination of provider contracts; disputes related to self-funded business, including actions alleging claim administration errors and the failure to disclose network rate discounts and other fee and rebate arrangements; disputes over copayment calculations; claims related to the failure to disclose certain business practices; and claims relating to customer audits and contract performance. The Company maintains general and professional liability insurance coverages. The Plan received in 2000 a demand letter (which also named the Company and Pennsylvania HRM (PAHRM)) from a current provider seeking payments totaling $8,400,000 under certain provisions of its provider contract. On January 26, 2001, the provider placed this matter in binding arbitration before the American Arbitration Association in Philadelphia, Pennsylvania. The Plan believes that amounts due to this provider are significantly less than the $8,400,000 demanded and any amounts owed are included within its medical services payable. The Plan intends to contest this case vigorously while seeking an out-of-court settlement. The Company and PAHRM are contesting being named in the arbitration. In the quarter ended March 31, 2001, the Plan received a demand letter from a current provider seeking payments totaling $4,400,000 under certain provisions of its provider contract. Every effort is being made by both parties to resolve this matter without resorting to arbitration or litigation. The Plan believes that amounts due to this provider is less than the $4,400,000 demanded and any amounts owed are included within its medical claims payable liability. In the quarter ended March 31, 2001, the Plan received a demand letter from a current provider seeking payments totaling $600,000 for the difference between fully billed charges and the state Medicaid fee for service rates. A similar dispute has been appealed by another Philadelphia HMO to the Pennsylvania Supreme Court. Until a definitive ruling is issued which compels the Plan to pay full billed charges, the Plan will continue to pay at the Pennsylvania Medicaid fee for service rates. If the provider's position is upheld by the Pennsylvania Supreme Court, the Plan, as well as other Pennsylvania Medicaid HMO's, may be unable to operate profitably in the Pennsylvania Medicaid marketplace without a significant increase in premiums. Premiums are subject to renewal annually with the Department of Public Welfare. The Company has been sued on this matter and intends to conduct the matter. Subsequent to the quarter ended March 31, 2001, the Company has received several demand letters from former employees, including some management, affected by the rationalization of the Company. The demand letters seek immediate compensation under various agreements such as employment, severance or commission. The Company is -24- currently in the process of assessing each demand letter. The Company expects to receive additional demand letters as the rationalization efforts continue. As disclosed above, the Company has received a letter from Loop Corp. indicating that Loop Corp. may pursue litigation against the Company for rescission of Loop Corp.'s investment of $6.1 million, among other claims. ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS Since March 31, 2001, the Company has entered into a letter of intent pursuant to which it anticipates receiving additional equity and other financing. On May 15, 2001, the Company executed a Master Agreement with Loop Corp. and certain affiliates of Loop Corp. In connection with the financing contemplated in the Master Agreement, the Company issued warrants exercisable at a price of $7.50 per share for up to 1,000,000 shares of its common stock and a convertible debenture exchangeable, in certain circumstances, for preferred stock of the Company convertible into common stock. The warrants (and, if issued, the preferred stock) will not become exercisable for or convertible into common stock prior to March 23, 2002 and except in compliance with the applicable rules under the Minnesota Business Corporation Act and the applicable rules and regulations of the National Association of Securities Dealers. The financing is being provided by affiliates of the Company's largest shareholder. As disclosed above, Loop Corp. has announced that it seeks to rescind this transaction and may initiate litigation to do so. ITEM 3. DEFAULTS UPON SENIOR SECURITIES None. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. ITEM 5. OTHER INFORMATION None. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K Subsequent to March 31, 2001, the Company filed the following reports on Form 8-K: 1. On May 25, 2001, the Company disclosed on Form 8-K that its independent accountants had resigned. 2. On June 7, 2001, the Company amended the May 25 Form 8-K by filing a Form 8-K/A, including the response of the Company's former independent accountants to the Company's Form 8-K. 3. On June 11, 2001, the Company disclosed on Form 8-K the recent developments concerning its financing, that certain directors had resigned and that it had engaged restructuring advisors. -25- SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. HEALTH RISK MANAGEMENT, INC. Dated: June 13, 2001 By: /s/ Leland G. LeBlanc -------------------------------------- Leland G. LeBlanc Chief Financial Officer and Member of the Executive Committee (principal financial officer and principal accounting officer) -26- SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 EXHIBIT INDEX to FORM 10-Q For Quarter Ended March 31, 2001 HEALTH RISK MANAGEMENT, INC. (SEC File No. 0-18902) Exhibit Number Exhibit Description ------- ------------------- None. -27-

HEALTH RISK MANAGEMENT INC /MN/ 10-Q/A