10-Q 1 fchn10q-0603.txt 1 UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10 - Q [ X ] QUARTERLY REPORT UNDER SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended JUNE 30, 2003 [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from to Commission File No. 0-23998 FIRST CHOICE HEALTH NETWORK, INC. (Exact name of Registrant as specified in its charter) Washington 91-1272766 (State or other jurisdiction of (I.R.S. employer incorporation or organization) identification number) 600 University Street Suite 1400 Seattle, Washington 98101 (Address of principal executive offices) (206) 292-8255 (Registrant's telephone number, including area code) Indicate by checkmark whether the Registrant (1)has filed all reports required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes __X___ No ______ Indicate by checkmark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act) Yes ______ No __X___ The aggregate number of Registrant's shares of Class A Common Stock and Class B Common Stock outstanding on June 30, 2003, was 538 shares and 40,600 shares, respectively. 1 2 FIRST CHOICE HEALTH NETWORK, INC. INDEX TO FORM 10-Q Page Part I Financial Information Item 1 Financial Statements Condensed Consolidated Balance Sheets (Unaudited) at June 30, 2003 and December 31, 2002 3 Condensed Consolidated Statements of Income (Unaudited) for the Three and Six Months Ended June 30, 2003 and 2002 5 Condensed Consolidated Statements of Cash Flows (Unaudited) for the Six Months Ended June 30, 2003 and 2002 6 Notes to Condensed Consolidated Financial Statements (Unaudited) 7 Item 2 Management's Discussion and Analysis of Financial Condition and Results of Operations 11 Item 3 Quantitative and Qualitative Disclosures About Market Risk 14 Item 4 Controls and Procedures 14 Part II Other Information Item 1 Legal Proceedings 15 Item 4 Submission of Matters to the Vote of Security Holders 15 Item 6 Exhibits and Reports 16 Signatures 17 2 3 FIRST CHOICE HEALTH NETWORK, INC. AND SUBSIDIARY CONDENSED CONSOLIDATED BALANCE SHEETS (UNAUDITED) JUNE 30, 2003 AND DECEMBER 31, 2002

See Notes to Condensed Consolidated Financial Statements. 3 4 FIRST CHOICE HEALTH NETWORK, INC. AND SUBSIDIARY CONDENSED CONSOLIDATED BALANCE SHEETS (UNAUDITED) JUNE 30, 2003 AND DECEMBER 31, 2002

See Notes to Condensed Consolidated Financial Statements. 4 5 FIRST CHOICE HEALTH NETWORK, INC. AND SUBSIDIARY CONDENSED CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED) FOR THE THREE MONTHS AND SIX MONTHS ENDED JUNE 30, 2003 AND 2002

See Notes to Condensed Consolidated Financial Statements. 5 6 FIRST CHOICE HEALTH NETWORK, INC. AND SUBSIDIARY CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED) FOR THE SIX MONTHS ENDED JUNE 30, 2003 AND 2002

See Notes to Condensed Consolidated Financial Statements. 6 7 FIRST CHOICE HEALTH NETWORK, INC. AND SUBSIDIARY NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) FOR THE SIX MONTHS ENDED JUNE 30, 2003 AND 2002 NOTE 1 PRESENTATION OF INTERIM INFORMATION The accompanying unaudited interim condensed consolidated financial statements and related notes have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission and in accordance with accounting principles generally accepted in the United States of America. In the opinion of the management of First Choice Health Network, Inc. and Subsidiary, the accompanying unaudited interim condensed consolidated financial statements include all normal adjustments considered necessary to present fairly the financial position as of June 30, 2003, and the results of operations for the three and six months ended June 30, 2003 and 2002, and cash flows for the six months ended June 30, 2003 and 2002. The condensed consolidated financial statements include the segregation of the discontinued operations of the insured health plan business which required a restatement of the prior year's financial statements to be comparative. (See Note 5.) The results of interim operations are not necessarily indicative of operating results for the entire year. NOTE 2 INVESTMENTS During the six months ended June 30, 2003, the Company purchased $2.9 million of bonds available for sale. The amortized cost, unrealized gains or losses and fair values of investments in debt securities as of June 30, 2003 and December 31, 2002 are as follows:

In determining fair value, management obtains quotations from independent sources who make markets in similar securities, generally broker dealers. These quotes are generally estimates of fair value based on an evaluation of appropriate facts such as trading in similar securities, yields, credit quality, coupon rate, maturity, type of issue, and other market data. Principal paydowns on investments in debt securities during the first six months of 2003 were $1,206,748. 7 8 NOTE 3 RECENTLY ISSUED ACCOUNTING STANDARDS In June 2002, the Financial Accounting Standards Board (FASB) issued Statement No. 146, Accounting for Costs Associated with Exit or Disposal Activities. This Statement requires that a liability for costs associated with an exit or disposal activity be recognized when the liability is incurred and be measured at fair value and adjusted for changes in estimated cash flows. Previously, generally accepted accounting principles provided for the recognition of such costs at the date of management's commitment to an exit plan. Under Statement No. 146, management's commitment to an exit plan would not be sufficient, by itself, to recognize a liability. The Statement is effective for exit or disposal activities initiated after December 31, 2002. In 2003 the Plan will undertake an orderly exit from its commercial insurance product offerings. This exit will be complete by December 31, 2003 by the non-renewal of all remaining commercial business during 2003. Disclosure regarding the discontinuance of the insurance segment of the business is included in Note 5. In January 2003, the FASB issued Interpretation No. 46, Consolidation of Variable Interest Entities (VIE). This interpretation will require VIE to be consolidated by a company if that company is subject to a majority of the risk of loss from the VIE's activities or entitled to receive a majority of the entity's residual return. The provisions of Interpretation No. 46 are required to be applied immediately to VIEs created after January 31, 2003. The Company does not have any VIEs and accordingly the implementation of the Interpretation did not result in an impact on its financial position or results of operations. In May 2003, FASB issued Statement No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity. This Statement establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances). Many of those instruments were previously classified as equity. This Statement is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003, except for mandatory redeemable financial instruments of nonpublic entities. Adoption of the Statement did not result in an impact on the Company's statement of financial position or results of operations. NOTE 4 REPORTABLE OPERATING SEGMENTS Factors management used to identify the enterprise's reportable segments: As the Company exits the commercial insurance market, the Company will re-direct these resources to a new line of business that is intended to leverage the Company's technological and staff capabilities for health benefits administration. The resulting segments of the Company are defined on the basis of products and services offered and will require distinct tracking capabilities in the areas of revenue accumulation, expense reporting, marketing strategies, and customer service requirements. As a result of the exit from the commercial insurance market, the segment reported as of December 31, 2002 as the Plan, which offered a variety of fully insured health insurance plans to employer groups, is being reported as a discontinued operation and will no longer be included as an operating segment for ongoing operations. Disclosures for June 30, 2002 have been restated as required. 8 9 Description of the types of products and services from which each reportable segment derives its revenue: The Network operations have two primary products which have been aggregated into one reportable segment: network access fees and hospital administrative fees. Network access fees arise from the rental of the Company's large PPO network while hospital administrative fees arise from charges to the network hospitals based on claims incurred by members. The other reportable segment, third party administration fees (TPA), is the outcome of the new business strategy of offering benefits administration services to employers self-funding their company health insurance plans. Measurement of segment profit or loss and segment assets: The accounting policies of the segments are the same as those described in the summary of significant accounting policies. The Company evaluates performance based on profit and loss from operations before income taxes not including nonrecurring gains and losses. The following information has been restated for the three and six months ended June 30, 2002, to exclude the discontinued operations. Information about profit or loss and assets of reportable segments:

9 10 NOTE 5 DISCONTINUED OPERATIONS As the Plan's business model shifted from capitated contracts to fee for service contract arrangements over the past three (3) years, management and the Board of Directors have reevaluated the strategic importance of the Plan. As a result, the Plan's existing commercial insured business is being wound down in an orderly manner with a complete exit of the commercial insured business. This exit will be complete by December 31, 2003 by the non-renewal of all remaining commercial business during 2003. At the Balance Sheet date the following assets included in the condensed consolidated balance sheet apply to the discontinued operations of the Plan:

10 11 Item 2 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Overview The Company's operations have historically consisted of two business segments. The parent company, First Choice Health Network (the "Network), operates a PPO rental network and the subsidiary company, First Choice Health Plan (the "Plan"), operates as a health care service contractor that accepts insurance risk. As a result of the decision by the Plan's Board of Directors authorizing management to exit the insured health care business by no later than December 2003, the Plan business is presented as a discontinued segment in the financial statements. The exit is proceeding in an orderly manner and no business will be renewed beginning in February 2003. As a result of the exit, the Plan's insured membership has declined from 28,715 at December 31, 2002 to 12,808 at June 30, 2003. As the Plan ceases to offer its commercial insurance products, a new business strategy of offering benefits administration services to self-funded employers ("TPA" business) is being implemented. This strategy allows the Company to take advantage of its extensive technological and staff capabilities for health benefits administration that were developed for the commercial insurance business. Development of this TPA business will help to mitigate some of the administrative costs of exiting the commercial insurance business by utilizing current infrastructure. TPA membership is 9,568 at June 30, 2003. As a result, the TPA business has now replaced the discontinued insurance business as a business segment for the Company. The Network's revenues consist primarily of access fees paid to utilize the PPO network, but also includes fees generated from medical management services, Employee Assistance Programs and a complementary and alternative medicine provider network. The TPA revenues consist primarily of fees paid for administrative services provided by the TPA. FORWARD-LOOKING STATEMENTS This quarterly report on Form 10-Q includes forward-looking statements about the future operations of the Company, including discussion of the effects of the Company's exit from the insured health care business, the prospects for the Company's entry into the TPA business, and the adequacy of the Company's reserves for claims expenses and unreported claims. These forward-looking statements involve certain risks and uncertainties that could cause actual results to differ materially from those in the forward-looking statements. Such factors include the Company's ability to attract new TPA customers, the cost of maintaining technological and staff capabilities for health benefits administration, and the risk associated with potential claim volatility and adverse selection as a result of the reduced membership in the Plan due to the Company's decision to exit the insured health care business. Because of these uncertainties, actual future results, performance or achievements may be materially different from the results, performance or achievements expressed or implied by these forward-looking statements. 11 12 RESULTS OF OPERATIONS THREE MONTHS ENDED JUNE 30, 2003 COMPARED TO THREE MONTHS ENDED JUNE 30, 2002 Operating revenue, net of discontinued operations, increased $.4 million (8.4%) from 2002 to 2003. The increase in 2003 resulted principally from the launch of the Company's TPA business segment ($.5 million). Hospital administration fees experienced a decrease of $.3 million while network access fee revenue increased by $.2 million. Selling, general and administrative expenses of the ongoing business segments increased $.3 million (22.2%) from 2002 to 2003. The increase resulted primarily from the redirection of costs from the insured business to the new TPA business. Payroll and related expenses of the ongoing business segments experienced a similar fluctuation with a $.5 million increase (28.5%) from 2002 to 2003 resulting from the same redirection of costs from the insured business to the TPA business. The Plan's net income and loss as shown on the discontinued operations line on the statements of income for the three months ended June 30, 2003 and 2002 is $513,713 and ($2,391,547), respectively. The swing from a net loss in 2002 to net income in 2003 results from a combination of the following factors: reduced exposure as member months decreased by 61.7% to 40,987 in 2003, reduced operating expenses as a result of the decreasing membership and corresponding start up of TPA services in the Network, and an improvement in the medical loss ratio from 97.7% in 2002 to 85.1% in 2003. SIX MONTHS ENDED JUNE 30, 2003 COMPARED TO SIX MONTHS ENDED JUNE 30, 2002 Operating revenue, net of discontinued operations, increased $1.3 million (13.8%) from 2002 to 2003. The increase in 2003 resulted principally from the launch of the Company's TPA business segment ($.9 million) and the impact of a rate increase on PPO rental network fees ($.6 million) offset by a decrease in hospital administration fees of $.3 million. Selling and administrative expenses of the ongoing business segments increased $.7 million (30.0%) from 2002 to 2003. The increase resulted primarily from the redirection of costs from the insured business to the new TPA business. Payroll and related expenses of the ongoing business segments experienced a similar fluctuation with a $.8 million increase (27.2%) from 2002 to 2003 resulting from the same redirection of costs from the insured business to the TPA business. The Plan's net income and loss as shown on the discontinued operations line on the statements of income for the six months ended June 30, 2003 and 2002 is $328,416 and ($3,035,239), respectively. The swing from a net loss to net income results from a combination of the following factors: reduced exposure as member months decreased by 56.7% to 96,378 in 2003, reduced operating expenses as a result of the decreasing membership and corresponding start up of TPA services in the Network, and an improvement in the medical loss ratio from 97.7% in 2002 to 85.1% in 2003. Related Party Transactions The Company's related party transactions consist of four components. One component is the premium revenue that is received from the Company's owner hospitals for their employee groups that are members of the Plan. The second component is the administrative fee received from the Company's owner hospitals for TPA services. The third component is the Company's payment to the owner hospitals in the form of claims payments for medical services rendered to any member of the Plan. These three components are independent of each other and have no relationship for analytical purposes. A fourth component, hospital administrative fees from owner hospitals, is unrelated to the other components. 12 13 MARKET RISK The Company offers its PPO, TPA and Plan products in a highly competitive environment. The Company has numerous competitors, including for-profit and not-for-profit HMOs, TPAs, preferred provider organizations ("PPOs"), and indemnity insurance carriers, some of which have substantially larger enrollments and greater financial resources than the Company. The Company's ability to retain existing PPO clients and attract new clients is largely dependent on its ability to offer competitive provider contract value and maintain a network of high quality, efficient, fully credentialed providers who agree to accept competitive reimbursement rates. The TPA will compete with numerous other insurance carriers and TPAs operating in Washington, many of which are significantly larger and have greater financial resources than the Company. Competition for TPA clients is based primarily on price and operational performance. As discussed above, the Plan's existing commercial insured business will be wound down in an orderly manner with a complete exit of the commercial insured business by December 2003. The resulting reduction in membership may subject the Plan to various risks including adverse selection, claim volatility and administrative costs that may result in losses. This decision to exit the insured business required the Company to evaluate the carrying value of its investment in the Plan. The contractually required capital contribution of $213,009 was made into the Plan in the second quarter of 2003. This investment was written down by 20% ($43,000) to reflect the 20% interest not owned by the Company. LIQUIDITY AND CAPITAL RESOURCES Since inception in 1986, the Company has financed its operations from equity investments from over 870 physicians, from the seven hospitals comprising the Company's Class B shareholders, non-equity capital contributions from four additional hospitals pursuant to their respective participation agreements, and funds from operations. As indicated on the Company's Condensed Consolidated Balance Sheet at June 30, 2003, the Company had cash and cash equivalents of approximately $.3 million compared to approximately $2.3 million at December 31, 2002. The decrease in cash resulted from activity as shown in the Condensed Consolidated Statements of Cash Flows on page six. The Company anticipates that the revenue generated by operations, cash and cash equivalents and investment securities available for sale as of June 30, 2003 will be sufficient to meet its cash requirements throughout 2003. The reduction in the Plan's insured membership is expected to be funded by the Plan's cash and investments totaling $15.5 million at June 30, 2003. Following are explanations of significant balance sheet account fluctuations: Cash and cash equivalents deceased 86.1%, or $2.0 million, while investment securities available for sale increased 37.0%, or $1.7 million. The decrease in cash resulted from activity as shown in the Condensed Consolidated Statements of Cash Flows on page six. Federal income tax payable due to subsidiary of $1.6 million was repaid in the first quarter. The income tax receivable from subsidiary of $.5 million as of June 30, 2003 is a result of current year tax accruals. The Company has not historically paid cash dividends, but is currently reevaluating this policy given the reduced capital needs as insurance operations are exited. 13 14 CRITICAL ACCOUNTING POLICIES AND ESTIMATES As a result of the decision to exit the insured health care business by December 31, 2003, the Company's 80% ownership in the Plan was written down by $1,237,486 at December 31, 2001 to the expected net realizable value, which is 80% of the Plan's book value. Management believes this measurement of the expected net realizable value is still valid as of June 30, 2003. The reserve for unpaid claims and claims adjustment expenses represents reported and unreported claims which have been incurred but have not been paid at the date of the financial statements. The reserve for unreported claims is determined actuarially using prior experience and the nature of current health insurance contracts and volume. Included in the liability is an estimate of the future expenses necessary to settle claims. Due to the uncertainties inherent in the estimation process, actual costs may differ from the estimated amounts in the near term, and these differences may be significant. As a result of the decreasing membership in the Plan, management has increased the level of conservatism in the estimate due to increased risk associated with potential claim volatility resulting from a lower membership base. Item 3 QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK There have been no material changes in the reported market risks faced by the Company since the end of its most recent fiscal year. Item 4 CONTROLS AND PROCEDURES (a) Evaluation of Disclosure Controls and Procedures: An evaluation of the Registrant's disclosure controls and procedures (as defined in Rule 13(a)-15e under the Securities Exchange Act of 1934 (the "Act")) was carried out under the supervision and with the participation of the Registrant's Chief Executive Officer, Executive Vice President of Finance and several other members of the registrant's senior management as of the end of the period covered by this report. Based on that evaluation, the Registrant's Chief Executive Officer and Executive Vice President of Finance concluded that the Registrant's disclosure controls and procedures are effective in ensuring that the information required to be disclosed by the Registrant in the reports it files or submits under the Act is (i) accumulated and communicated to the Registrant's management (including the Chief Executive Officer and Executive Vice President of Finance) as appropriate to allow timely decisions regarding required disclosure, and (ii) recorded, processed, summarized and reported within the time periods specified in the SEC's rules and forms. (b) Changes in Internal Control over financial reporting: In the quarter ended June 30, 2003, there has been no change in the Registrant's internal control over financial reporting that has materially affected, or is reasonably likely to materially affect, it's internal control over financial reporting. Disclosure Controls and Internal Controls. Disclosure controls are procedures that are designed with the objective of ensuring that information required to be disclosed in the Registrant's reports filed under the Securities Exchange Act of 1934 (Exchange Act) is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission's (SEC) rules and forms. Disclosure controls are also designed with the objective of ensuring that such information is accumulated and communicated to our management, as appropriate to allow timely decisions regarding required disclosure. Internal Controls are procedures which are designed with the objective of providing reasonable assurance that (1) transactions are properly authorized; 14 15 (2) assets are safeguarded against unauthorized or improper use; and (3) transactions are properly recorded and reported, all to permit the preparation of financial statements in conformity with accounting principles generally accepted in the United States of America. Limitations on the Effectiveness of Controls. The Registrant's management does not expect that our disclosure controls or our internal controls will prevent all errors and all fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of the control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Registrant have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the control. The design of any system of controls also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions; over time, controls may become inadequate because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected. Part II Other Information Item 1 Legal Proceedings In the normal course of business, the Company may encounter claims, assessments, and litigation brought against the Company. If and when these situations arise, the Company assesses the situation and accrues for financial exposure, if appropriate. As of June 30, 2003, the Company is not aware of any such material situations. Item 4 Submission of Matters to the Vote of Security Holders The Company held its 2003 annual meeting of shareholders on June 26, 2003. The following directors were elected at the annual meeting:

15 16 The other matters presented for action at the annual meeting were approved by the following vote:

Item 6 Exhibits and Reports The following exhibits are filed with this report: Exhibit 31.1 Certification of Gary Gannaway pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 Exhibit 31.2 Certification of Kenneth A. Hamm pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 Exhibit 32.1 Sarbanes-Oxley Section 906 Certification for Gary Gannaway, Chief Executive Officer Exhibit 32.2 Sarbanes-Oxley Section 906 Certification for Kenneth A. Hamm, Executive Vice President of Finance 17 SIGNATURES In accordance with the requirements of the Exchange Act, the registrant has caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. FIRST CHOICE HEALTH NETWORK, INC. Date: August 14, 2003 By: / s /Kenneth A. Hamm Kenneth A. Hamm Executive Vice President of Finance (Principal Financial and Accounting Officer and Duly Authorized Officer)

FIRST CHOICE HEALTH NETWORK INC 10-Q