Hawaii Medical Service Assoc. Outlook Updated to Negative; ‘A+’ Ratings Affirmed

October 20, 2003

Standard & Poor’s has revised its outlook on Hawaii Medical Service Assoc. (HMSA) to negative from stable. Standard & Poor’s also affirmed its ‘A+’ counterparty credit and financial strength ratings on HMSA.

The negative outlook reflects the company’s recently diminished profitability and pricing flexibility stemming in part from legislation recently enacted in Hawaii that subjects HMSA’s rates for all underwritten products to review and approval by the insurance department. If HMSA were unable to stabilize current earnings and maintain capital adequacy near its present level by year-end 2004, Standard & Poor’s would likely lower the ratings.

The ratings affirmation reflects HMSA’s very strong capitalization and liquidity and leading market position. Offsetting factors include its marginal earnings profile, narrow geographic scope and exposure to recently enacted rate regulation.

By year-end 2003, Standard & Poor’s expects HMSA’s member base to remain stable and be 665,000-675,000 members. Standard & Poor’s also expects HMSA to incur a modest underwriting loss relative to premium (1%-2%) and achieve pretax income of $10 million-$20 million. The company’s capital adequacy and liquidity are expected to diminish somewhat but remain very strong.

By year-end 2004, Standard & Poor’s expects HMSA’s enrollment to exceed 665,000 members, pretax income to exceed $10 million and its capital adequacy and liquidity to remain very strong.

Major Rating Factors
— Very strong capitalization and liquidity. HMSA’s capital adequacy was 303% as of Dec. 31, 2002, which is considered very strong but lower than the prior year due in part to a 5% reduction in surplus attributed to underwriting losses and portfolio devaluation. HMSA has a negligible amount of long-term debt as it paid off a $40 million loan in 2002 and maintains a very modest level of intangibles on its GAAP balance sheet. Standard & Poor’s believes that HMSA maintains a very sound liquidity position as reflected by its year-end 2002 liquidity ratio of 247%, which is considered very strong. In addition to HMSA’s strong cash position, the company’s investment portfolio is conservatively invested and highly liquid. The bond portfolio consists mainly of very high-quality investment-grade industrial securities of short and intermediate term maturities.

— Strong business position in Hawaii. HMSA is the leading provider of health insurance and related services in Hawaii. As of Dec. 31, 2002, HMSA’s member base exceeded 668,000 members (more than 50% of Hawaii’s population) compared with about 629,000 members in the prior year. The company offers a broad spectrum of products across all market segments in the private and public sectors. Standard & Poor’s also believes that HMSA’s brand equity remains strong and is well supported by its broad networks, servicing capabilities, distribution relationships, and strong knowledge of its core Hawaii marketplace.

— Marginal earnings profile. Standard & Poor’s considers HMSA’s profitability to be marginal as reflected by the company’s earnings adequacy ratio (excluding realized gains) of 67% for the five-year period ended Dec. 31, 2002. In 2002, HMSA incurred a pretax loss of about $50 million (negative 3.7% ROR). The weak performance was driven by a combination of generally higher than anticipated medical cost trends, the booking of a premium deficiency reserve ($15 million), write-off of information technology development costs ($21.3 million) and portfolio related losses ($22 million). HMSA has lost money on an underwriting basis for the previous five-year period due in part to a pricing strategy influenced by its strong capital position and a desire to deliver affordable health care to its members. Before 2002, HMSA achieved bottom line profitability because of its low administrative expense ratio and significant investment gains. Through August 2003, HMSA incurred a very modest underwriting loss (less than 1% of premium revenue) but was profitable ($5.2 million) on a pretax basis.

— Narrow geographic scope/exposure to rate regulation. HMSA operates in only one state, which exposes the company to adverse developments on the legislative, regulatory, and economic fronts. These events could include–but are not limited to–provider contracting restrictions, pricing constraints, and deterioration of general business conditions. In addition, the State of Hawaii enacted legislation (effective Jan. 1, 2003) that provided for rate regulation of medical insurance carriers, which applies to all underwritten products regardless of market segment or product type. The rate filings are reviewed for appropriateness and to determine if they are excessive, inadequate, or unfairly discriminatory.

Standard & Poor’s believes that HMSA’s pricing flexibility has been somewhat constrained by this legislation and the company could be exposed to further erosion of its underwriting margin for 2003 and 2004.

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