Advocate Health Care Network and Subsidiaries FINANCIAL REPORT

Transcription

1 Advocate Health Care Network and Subsidiaries FINANCIAL REPORT For the Fourth Quarter and Year Ended December 31, 2014

2 Cautionary Statement Regarding Forward Looking Statements in this Quarterly Financial Report This Quarterly Report contains forward looking statements within the meaning of the federal securities laws. Forwardlooking statements are those statements that do not relate solely to historical or current fact, and can often be identified by use of words including but not limited to may, believe, will, expect, project, estimate, anticipate, plan, or continue. These forward looking statements are based on the current plans and expectations of Advocate Health Care Network and Subsidiaries ( Advocate ) that, although believed to be reasonable, are subject to a number of known and unknown uncertainties and risks inherent in the operation of health care facilities, many of which are beyond Advocate s control, that could significantly affect current plans and expectations and Advocate s future financial position and results of operations. These factors include, but are not limited to, the following: potential federal or state reform of health care, implementation of the Patient Protection and Affordable Care Act (the Affordable Care Act ) and related rules and regulations, and any potential modifications or challenges to Affordable Care Act or any other such legislation; the highly competitive nature of the health care business; pressures to contain costs by managed care organizations, insurers, health care providers and Advocate s ability to negotiate acceptable terms with third party payors; changes in the Medicare and Medicaid programs that may impact reimbursements to health care providers and insurers, as well as possible additional changes in such programs; Advocate s ability to attract and retain qualified management and other personnel, including affiliated physicians, nurses and medical support personnel; liabilities and other claims asserted against Advocate; changes in accounting standards and practices; changes in general economic conditions; future divestitures or acquisitions; changes in revenue mix or delays in receiving payments from third party payors, as has recently been the case in Illinois as a result of state budget constraints; the availability and cost of capital to fund future expansion plans of Advocate and to provide for ongoing capital expenditure needs; changes in business strategy or development plans; Advocate s ability to implement shared services and other initiatives and realize decreases in administrative, supply and infrastructure costs; the outcome of pending and any future litigation; the ability to achieve expected levels of patient volumes and control the costs of providing services; results of reviews of Advocate s cost reports; and increased costs from further government regulation of health care and Advocate s failure to comply, or allegations of any failure to comply, with applicable laws and regulations, including without limitation, laws, regulations, policies and procedures relating to the status of Advocate and certain of its subsidiaries as taxexempt organizations as well as its ability to comply with the requirements of Medicare and Medicaid programs. These forward looking statements speak only as of the date made. Except as required by law, Advocate has undertaken no obligation to publicly update or revise any forward looking statement contained in this Quarterly Report, whether as a result of new information, future events or otherwise. As a consequence, current plans, anticipated actions and future financial position and results of operations may differ from those expressed in any forward looking statements made by or on behalf of Advocate. Investors are cautioned not to unduly rely on such forward looking statements when evaluating the information presented in this Quarterly Report.

3 Advocate Health Care Network and Subsidiaries For the Fourth Quarter and Year Ended December 31, 2014 C O N T E N T S Page Interim Condensed Consolidated Financial Statements for the Fourth Quarter and Year Ended December 31, 2014: Interim Condensed Consolidated Balance Sheets... 1 Interim Condensed Consolidated Statements of Operations and Changes in Net Assets... 3 Interim Condensed Consolidated Statements of Cash Flows... 5 Notes to Interim Condensed Consolidated Financial Statements... 6 Management Discussion and Analysis of Financial Condition and Results of Operations 22 Sources of System Net Patient Service Revenue, Utilization Statistics and Ratios Liquidity Summary... 56

4 Advocate Health Care Network and Subsidiaries Interim Condensed Consolidated Balance Sheets (dollars in thousands) Note 1 December 31, December 31, Assets Current assets: Cash and cash equivalents $ 272,912 $ 563,229 Short term investments 19,456 19,401 Assets limited as to use: Internally designated for self insurance programs 91,747 89,660 Patient accounts receivable less allowances for uncollectible accounts of $219,447 and $181, , ,033 Amounts due from primary third party payors 16,850 10,107 Prepaid expenses, inventories and other current assets 267, ,322 Collateral proceeds received under securities lending program 19,768 19,165 Total current assets 1,322,268 1,524,917 Assets limited as to use: Externally designated under debt agreements, net of amounts required to meet current obligations 7, ,656 Internally designated for capital improvement 4,413,827 3,777,538 Internally designated for self insurance programs, less current portion 687, ,485 Externally designated for capital improvement, medical education and health care programs 60,544 58,840 Investments under securities lending program 19,145 19,013 5,188,244 4,734,532 Interests in health care and related entities 150, ,103 Reinsurance receivable 161, ,318 Deferred costs and intangible assets, less allowances for amortization 44,236 51,231 Other noncurrent assets 116, ,382 5,660,887 5,242,566 Property and equipment at cost: Property and equipment 4,883,957 4,437,891 Less allowances for depreciation 2,332,932 2,155,428 2,551,025 2,282,463 $ 9,534,180 $ 9,049,946 Note 1: December 31, 2014 financial statement information was derived from and should be read in conjunction with the Advocate Health Care Network and Subsidiaries 2014 Audited Consolidated Financial Statement, available on the Electronic Municipal Market Access ( EMMA ) website. The Condensed Consolidated Financial Statements were prepared on March 6,

5 Advocate Health Care Network and Subsidiaries Interim Condensed Consolidated Balance Sheets (continued) Note 1 December 31, December 31, Liabilities and net assets Current liabilities: Current portion of long term debt $ 20,042 $ 17,810 Long term debt subject to short term remarketing arrangements 130, ,130 Accounts payable 335, ,306 Accrued salaries and employee benefits 373, ,192 Accrued expenses 130, ,526 Amounts due to primary third party payors 309, ,780 Current portion of accrued insurance and claims costs 119, ,412 Obligations to return collateral under securities lending program 19,768 19,440 Total current liabilities 1,439,058 1,380,596 Noncurrent liabilities: Long term debt, less current portion 1,458,375 1,452,109 Pension plan liability 37,441 23,737 Accrued insurance and claims costs, less current portion 712, ,470 Accrued losses subject to insurance recovery 161, ,318 Obligations under swap agreements, net of collateral posted 86,246 47,908 Other noncurrent liabilities 186, ,373 Total noncurrent liabilities 2,642,729 2,540,915 Total liabilities 4,081,787 3,921,511 Net assets: Unrestricted 5,284,721 4,968,578 Temporarily restricted 118, ,335 Permanently restricted 48,019 47,566 5,451,731 5,127,479 Non controlling interest Total net assets 5,452,393 5,128,435 $ 9,534,180 $ 9,049,946 Note 1: December 31, 2014 financial statement information was derived from and should be read in conjunction with the Advocate Health Care Network and Subsidiaries 2014 Audited Consolidated Financial Statements, available on the Electronic Municipal Market Access ( EMMA ) website. See accompanying notes to interim condensed consolidated financial statements. The Condensed Consolidated Financial Statements were prepared on March 6,

6 Advocate Health Care Network and Subsidiaries Interim Condensed Consolidated Statements of Operations and Changes in Net Assets (dollars in thousands) Unaudited Note 1 For the Quarter Ended December 31, For the Year Ended December 31, Unrestricted revenues and other support Net patient service revenue $ 1,203,902 $ 1,156,014 $ 4,583,607 $ 4,244,386 Proceeds from Medicaid assessment 50,648 50, , ,082 Provision for uncollectible accounts (65,689) (97,689) (289,597) (253,989) 1,188,861 1,108,777 4,496,600 4,214,479 Capitation revenue 102,004 96, , ,516 Other revenue 86,205 97, , ,007 1,377,070 1,302,987 5,231,393 4,938,002 Expenses Salaries, wages and employee benefits 674, ,314 2,637,606 2,510,470 Purchased services and operating supplies 352, ,082 1,313,401 1,211,483 Contracted medical services 34,717 33, , ,570 Insurance and claims costs (680) (7,807) 118, ,349 Other 68,083 86, , ,115 Medicaid assessment 35,557 35, , ,873 Depreciation and amortization 63,395 57, , ,648 Interest 13,199 14,782 56,811 55,299 1,241,220 1,216,145 4,900,793 4,637,807 Operating income 135,850 86, , ,195 Nonoperating income (loss) Investment (losses) income (19,955) 129, , ,727 Change in the fair value of interest rate swaps (21,888) 10,220 (38,338) 41,236 Other nonoperating items, net (5,713) (9,368) (14,130) (15,455) Fair value of net assets acquired 151,663 Loss on refinancing of debt (45,470) (45,470) (46) (93,026) 130,591 39, ,125 Revenues in excess of expenses $ 42,824 $ 217,433 $ 369,607 $ 765,320 Note 1: December 31, 2014 financial statement information was derived from and should be read in conjunction with the Advocate Health Care Network and Subsidiaries 2014 Audited Consolidated Financial Statements, available on the Electronic Municipal Market Access ( EMMA ) website. See accompanying notes to interim condensed consolidated financial statements. The Condensed Consolidated Financial Statements were prepared on March 6,

7 Advocate Health Care Network and Subsidiaries Interim Condensed Consolidated Statements of Operations and Changes in Net Assets (continued) (dollars in thousands) Unaudited Note 1 For the Quarter Ended For the Year Ended December 31, December 31, Unrestricted net assets Revenues in excess of expenses $ 42,824 $ 217,433 $ 369,607 $ 765,320 Contributions received from a supporting foundation and grants used for capital purposes 2, ,558 4,201 Post retirement benefit plan adustments (64,018) 70,912 (64,018) 70,912 Other (4) (21) (Decrease) increase in unrestricted net assets (18,378) 289, , ,412 Temporarily restricted net assets Contributions for medical education programs, capital purchases, and other purposes 8,685 4,184 24,388 27,778 Realized gains on investments 1,608 1,294 5,325 2,959 Unrealized (losses) gains on investments (239) 1,538 (1,106) 3,768 Contribution of net assets of Sherman Hospital 719 Net assets released from restrictions and used for operations, for capital purposes, for medical education programs and other purposes (6,933) (3,868) (20,951) (14,240) Increase in temporarily restricted net assets 3,121 3,148 7,656 20,984 Permanently restricted net assets Contribution of net assets of Sherman Hospital 263 Contributions for medical education programs, capital purchases, and other purposes ,889 Increase in permanently restricted net assets ,152 (Decrease) increase in net assets (14,937) 293, , ,548 Change in non controlling interest (264) 321 (294) (26) Net assets at beginning of period 5,467,594 4,834,732 5,128,435 4,264,913 Net assets at end of period $ 5,452,393 $ 5,128,435 $ 5,452,393 $ 5,128,435 Note 1: December 31, 2014 financial statement information was derived from and should be read in conjunction with the Advocate Health Care Network and Subsidiaries 2014 Audited Consolidated Financial Statements, available on the Electronic Municipal Market Access ( EMMA ) website. See accompanying notes to interim condensed consolidated financial statements. The Condensed Consolidated Financial Statements were prepared on March 6,

8 Advocate Health Care Network and Subsidiaries Interim Condensed Consolidated Statements of Cash Flows (dollars in thousands) Unaudited Note 1 For the Quarter Ended For the Year Ended December 31, December 31, Operating activities (Decrease) increase in net assets $ (15,201) $ 293,703 $ 323,958 $ 863,522 Adjustments to reconcile increase (decrease) in net assets to net cash provided by operating activities: Depreciation, amortization and accretion 62,475 56, , ,828 Provision for uncollectible accounts 65,689 97, , ,989 Deferred income taxes (3,835) (5,893) (3,835) (5,893) Losses (gains) on disposal of property and equipment 479 4,370 (1,297) 5,909 Loss on refinancing of debt 45,470 45, Contribution of certain net assets of Sherman Hospital (152,645) Change in fair value of interest rate swaps 21,888 (10,220) 38,338 (41,236) Postretirement benefit plan adjustments 64,018 (70,912) 64,018 (70,912) Restricted contributions and gains on investments, net of assets released from restrictions used for operations (4,118) (3,010) (10,393) (10,039) Change in operating assets and liabilities: Trading securities (105,702) (213,515) (629,369) (476,014) Patient accounts receivable (135,771) (181,562) (356,307) (243,799) Amounts due to/from primary third party payors (22,099) 37,320 28,068 5,035 Accounts payable, accrued salaries, employee benefits, accrued expenses and other noncurrent liabilities 46, ,730 (7,608) 160,561 Other assets (17,461) (11,295) (10,929) 409 Accrued insurance and claims costs (29,763) (53,504) 40,874 9,393 Net cash (used in) provided by operating activities (27,878) 93,135 46, ,154 Investing activities Purchases of property and equipment (157,743) (119,082) (507,788) (385,695) Proceeds from sale of property and equipment 1, ,349 2,590 Cash acquired in the acquistion of Sherman Hospital 12,280 Net sales and purchases of investments designated as nontrading 58,351 46, ,576 78,332 Other 15,073 (43,876) 13,615 (66,043) Net cash used in investing activities (83,261) (115,340) (333,248) (358,536) Financing activities Proceeds from issuance of debt 341, , ,956 Payment of long term debt (361,419) (8,747) (374,509) (144,014) Collateral returned under interest rate swap agreements 4,330 Proceeds from restricted contributions and gains on investments 10,374 7,853 29,060 36,394 Net cash (used in) provided by financing activities (9,486) (894) (3,890) 16,666 (Decrease) increase in cash and cash equivalents (120,625) (23,099) (290,317) 165,284 Cash and cash equivalents at beginning of period 393, , , ,945 Cash and cash equivalents at end of period $ 272,912 $ 563,229 $ 272,912 $ 563,229 Note 1: December 31, 2014 financial statement information was derived from and should be read in conjunction with the Advocate Health Care Network and Subsidiaries 2014 Audited Consolidated Financial Statements, available on the Electronic Municipal Market Access ( EMMA ) website. See accompanying notes to interim condensed consolidated financial statements. The Condensed Consolidated Financial Statements were prepared on March 6,

9 Note A Basis of Presentation Advocate Health Care Network and Subsidiaries Notes to Interim Condensed Consolidated Financial Statements As of and for the Fourth Quarter and Year Ended December 31, 2014 (dollars shown in tables are in thousands except as noted) The accompanying interim condensed consolidated financial statements for the fourth quarters and years ended December 31, 2014 and 2013 have been prepared in accordance with accounting principles generally accepted in the United States applied on a basis substantially consistent with that of the 2014 audited consolidated financial statements of Advocate Health Care Network and Subsidiaries ( Advocate ). In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. The interim condensed consolidated financial statements do not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. On June 1, 2013, Sherman Hospital and Advocate completed an affiliation agreement pursuant to which Advocate became the sole corporate member of Sherman Hospital ( Sherman or ASH ). ASH owns and operates a 255 bed acute care hospital and is located in Elgin, Illinois. ASH is the sole member of various not for profit corporations, the shareholder of various business corporations engaged in the delivery of health care services, the provision of goods and services ancillary thereto, which include a nursing home ( Sherman West Court ), home health care company and an approximately 35 employed physician medical group. Additionally, on June 1, 2013 the name of Sherman Hospital was changed to Advocate Sherman Hospital. The affiliation was accounted for as an acquisition in accordance with the authoritative guidance on not for profit mergers and acquisitions. Accordingly, no goodwill was recorded in connection with this transaction and the operations of ASH have been included in Advocate s consolidated financial statements since the acquisition date. See Note M for additional information related to this affiliation. Note B Accounting Pronouncements New Accounting Pronouncements In May 2014, the Financial Accounting Standards Board ( FASB ) issued guidance related to recognizing revenue from contracts with customers. This new guidance dictates that the standard be applied either retrospectively to each prior reporting period presented or retrospectively with the cumulative effect of initially applying the revenue recognition standard recognized at the date of initial application. This new guidance is effective for fiscal years and interim periods within those fiscal years beginning after December 15, Advocate is evaluating the effect this guidance will have on its consolidated financial statements. The Condensed Consolidated Financial Statements were prepared on March 6,

10 Note C Reclassifications in the Condensed Consolidated Financial Statements Certain reclassifications were made to the 2013 consolidated financial statements to conform to the classifications used in There was no impact on net assets or revenues in excess of expenses. Note D Use of Estimates The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates, assumptions and judgments that affect the reported amounts of assets and liabilities and amounts disclosed in the notes to the financial statements at the date of the financial statements. Estimates also affect the reported amounts of revenues and expenses during the reporting period. Although estimates are considered to be fairly stated at the time made, actual results could differ materially from those estimates. Advocate considers critical accounting policies to be those that require the more significant judgments and estimates in the preparation of its financial statements, including, but not limited to, the following: recognition of patient service revenue, which includes, contractual allowances, third party payor settlements, contracted medical service expense recognition and reserves for incurred but not reported claims; accounting for asset impairment or disposal of long lived assets; provisions for uncollectible accounts and charity care allowances; reserves for losses and expenses related to health care professional, general and other selfinsured liability risks; analysis of potential other than temporary declines in fair value of non trading investments; accounting for swap valuations; and pension plan actuarial assumptions. Management relies on historical experience and on other assumptions believed to be reasonable under the circumstances in making its judgments and estimates. Although estimates are considered to be reasonable at the time made, actual results could differ materially from those estimates. Changes in estimates that relate to prior years payment arrangements resulted in increases to net patient service revenue of $2.2 million and $0.2 million for the quarters ended December 31, 2014 and 2013, respectively; $6.4 million and $20.9 million for the years ended December 31, 2014 and 2013, respectively. Note E Patient Service Revenue and Accounts Receivable Patient accounts receivable are stated at net realizable value. Advocate evaluates the collectability of its accounts receivable based on the length of time the receivable is outstanding, major payor sources of revenue, historical collection experience and trends in health care insurance programs to estimate the appropriate allowance for uncollectible accounts and provision for uncollectible accounts. For receivables associated with services provided to patients who have third party coverage, Advocate analyzes contractually due amounts and provides an allowance for contractual discounts and a provision for uncollectible accounts for the patient portion. For receivables associated with self pay patients, Advocate records a significant provision for uncollectible accounts in the period of service on the basis of its past experience, which indicates that many patients do not pay the portion of their bill for which they are financially responsible. These adjustments are accrued on an estimated basis and are adjusted as needed in future periods. Accounts receivable are charged to the allowance for uncollectible accounts when they are deemed uncollectible. The Condensed Consolidated Financial Statements were prepared on March 6,

11 The allowance for uncollectible accounts as a percentage of accounts receivable was 26% and 24% at December 31, 2014 and 2013, respectively. Advocate s combined allowance for uncollectible accounts receivable, uninsured discounts and charity care covered 100% of self pay accounts receivable at both December 31, 2014 and Note F Retirement Plans Advocate maintains defined benefit pension plans ( Plans ) that cover substantially all of its employees ( associates ). The Advocate Health Care Network Pension Plan had a liability of $29.1 million at December 31, 2014 and a prepaid pension expense of $25.8 million at December 31, 2013, included in other noncurrent assets on the Interim Condensed Consolidated Balance Sheets. The Condell Health Network Retirement Plan s had a liability of $8.4 million and $23.7 million at December 31, 2014 and 2013, respectively. Plans expense included in the interim condensed consolidated statements of operations and changes in net assets is as follows: For the Quarter Ended December 31, For the Year Ended December 31, Service cost $ 11,337 $ 10,996 $ 45,224 $ 43,989 Interest cost 10,176 8,226 40,346 32,909 Expected return on plan assets (14,667) (13,933) (58,131) (55,734) Amortization of: Actuarial loss 2,595 4,353 10,284 17,412 Prior service cost (credit) (1,217) (1,205) (4,823) (4,823) Settlement/curtailment Net pension expense $ 9,127 $ 9,208 $ 33,803 $ 34,524 Amounts funded into the Plans were paid from employer assets and were as follows (there were no contributions other than cash to the Plans): For the Quarter Ended December 31, For the Year Ended December 31, Cash contributions $ 20,269 $ 8,190 $ 56,266 $ 31,950 At this time Advocate anticipates making $32.9 million in contributions to the Plans during Expected associate benefit payments from the Plans assets are $54.3 million in 2015; $62.8 million in 2016; $63.0 million in 2017; $67.9 million in 2018; $72.5 million in 2019 and $387.9 million for the years 2020 through The Condensed Consolidated Financial Statements were prepared on March 6,

12 The Plans asset allocation and investment strategies are designed to earn returns on plan assets consistent with a reasonable and prudent level of risk. Investments are diversified across classes, economic sectors, and manager style to minimize the risk of loss. Advocate uses investment managers specializing in each asset category and, where appropriate, provides the investment manager with specific guidelines that include allowable and/or prohibited investment types. Advocate regularly monitors manager performance and compliance with investment guidelines. Advocate s target and actual allocation of the Plans assets are as follows: Target Actual Target Actual Domestic and international equity securities 35.0% 37.8% 42.5% 47.5% Alternative investments Cash and fixed income securities % 100.0% 100.0% 100.0% Assumptions used to determine benefit obligations are as follows: December 31, 2014 December 31, 2013 Discount rate 3.90% 4.70% Assumed rate of return on assets 7.25% 7.25% The assumed rate of return on Plan assets is based on historical and projected rates of return for asset classes in which the portfolio is invested. The expected return for each asset class was then weighted based on the target asset allocation to develop the overall expected rate of return on assets for the portfolio. This resulted in the selection of the 7.25% assumption for 2014 and In addition to the Plans, Advocate sponsors various defined contribution plans for its associates. Contributions to these plans, which are included in salaries, wages and employee benefits expense in the interim condensed consolidated statements of operations and changes in net assets, were as follows: For the Quarter Ended December 31, For the Year Ended December 31, Contribution plan expense $ 9,163 $ 10,465 $ 39,708 $ 40,641 The Condensed Consolidated Financial Statements were prepared on March 6,

13 Note G Long Term Debt Advocate s outstanding bonds are secured by obligations issued under the Amended and Restated Master Trust Indenture dated as of September 1, 2011, with Advocate Health Care Network, Advocate Health and Hospitals Corporation, Advocate Condell, and Advocate North Side (the Obligated Group or Restricted Affiliates) and U.S. Bank National Association, as master trustee (the Advocate Master Indenture). Under the terms of the bond indentures and other arrangements, various amounts are to be on deposit with trustees, and certain specified payments are required for bond redemption and interest payments. The Advocate Master Indenture and other debt agreements, including a bank credit agreement, also place restrictions on Advocate and require Advocate to maintain certain financial ratios. Prior to the issuance of the Series 2014 Bonds, ASH and Sherman West Court were members of an obligated group (Sherman Obligated Group) created pursuant to a master trust indenture dated as of August 1, 1991, as supplemented and amended (Sherman Master Indenture) with The Bank of New York Mellon Trust Company, N.A., as master trustee. In connection with the issuance of the Series 2014 Bonds, ASH became a member of the Obligated Group under the Advocate Master Indenture and the Sherman Master Indenture was discharged. Advocate s unsecured variable rate revenue bonds, Series 2003A of $19.7 million, Series 2003C of $19.0 million, Series 2008C 3B of $22.0 million, and Series 2011B of $70.0 million, while subject to a long term amortization period, may be put to Advocate at the option of the bondholders in connection with certain remarketing dates. To the extent that bondholders may, under the terms of the debt, put their bonds within a maximum of 12 months after December 31, 2014, the principal amount of such bonds has been classified as a current obligation in the accompanying consolidated balance sheets. Management believes the likelihood of a material amount of bonds being put to Advocate is remote. However, to address this possibility, Advocate has taken steps to provide various sources of liquidity, including assessing alternate sources of financing, including lines of credit and/or unrestricted assets as a source of self liquidity. Advocate has standby bond purchase agreement ( SBPA ) with banks to provide liquidity support for the Series 2008C Bonds. In the event of a failed remarketing of a Series 2008C Bond upon its tender by an existing holder and subject to compliance with the terms of the standby bond purchase agreement, the standby bank would provide the funds for the purchase of such tendered bonds, and Advocate would be obligated to repay the bank for the funds it provided for such bond purchase (if such bond is not subsequently remarketed), with the first installment of such repayment commencing on the date one year and one day after the bank purchases the bond. As of December 31, 2014 and 2013, there were no bank purchased bonds outstanding. The following table provides the outstanding par value at December 31, 2014 and associated SBPAs expiration dates for these bonds. Series Par Outstanding (dollars in millions) SBPA Expiration 2008C 1 $ August 1, C 2A 49.8 August 1, C 2B 58.2 August 1, C 3A 87.7 August 1, 2017 The Condensed Consolidated Financial Statements were prepared on March 6,

14 On July 5, 2013, ASH retired $105,700 of the Sherman Bonds (Series 1997 bonds). On August 8, 2013, the Illinois Finance Authority, for the benefit of the Advocate, issued its Revenue Bonds, Series 2013A, in the amount of $96.9 million. The proceeds of the Series 2013A Bonds were used, together with other funds available to Advocate, to finance, refinance, or reimburse Advocate for a portion of the costs related to the acquisition, construction, renovation, and equipping of certain capital projects and to pay certain costs of issuing the Series 2013A Bonds. In 2013, the Series 2008A 1 Bonds and Series 2008A 2 Bonds, which currently bear interest at a fixed interest rate set for a specified period, were remarketed at a premium for an approximate seven year period, and a portion of the outstanding par was redeemed in the amount of $9.1 million and $7.7 million, respectively. On December 18, 2014, the Illinois Finance Authority, for the benefit of Advocate, issued its Revenue Bonds, Series 2014, in the amount of $304.8 million. The proceeds of the Series 2014 Bonds were used to advance refund the Series 2007A Sherman Bonds and a portion of the Series 2008D Bonds, and to pay certain costs of issuing the Series 2014 Bonds. Advocate has in place certain interest rate swaps associated with its variable rate Series 2008C Bonds; these swaps effectively convert these Series 2008C Bonds to a fixed rate of 3.605%. Additional information about the Advocate interest rate swap program relating to certain of Advocate s variable rate debt is described in Note J Derivatives, and also in the Guarantees of Debt, Swaps and Other Derivatives and Financing Arrangements section of the Management Discussion and Analysis of Financial Condition and Results of Operations. Interest paid, net of capitalized interest, amounted to $62.7 million and $56.0 million for the year ended December 31, 2014 and 2013, respectively. Advocate capitalized interest of $7.5 million and $5.1 million for the year ended December 31, 2014 and 2013, respectively. Maturities of long term debt, capital leases, and sinking fund requirements, assuming remarketing of the variable rate demand revenue refunding bonds, for the five years ending December 31, 2019, are as follows: 2015 $20.0 million; 2016 $19.7 million; 2017 $20.9 million; 2018 $22.3 million; and 2019 $30.3 million. At December 31, 2014, Advocate had lines of credit with banks aggregating to $250.0 million. These lines of credit provide for various interest rates and payment terms and expire as follows: $25.0 million in February 2015, $75.0 million in March 2015, $50.0 million in November 2016 and $100.0 million in December These lines of credit may be used to redeem bonded indebtedness, to pay costs related to such redemptions, for capital expenditures, or for general working capital purposes. At December 31, 2014, no amounts were outstanding on these lines of credit. In February 2015, the $25.0 million line of credit was extended to February 2016 and the $75.0 million line of credit was extended to March 2018 and increased to $100.0 million. The Condensed Consolidated Financial Statements were prepared on March 6,

15 Note H Investments Substantially all investments and assets limited as to use are classified as trading. Investments in debt and equity securities with readily determinable fair values are measured at fair value using quoted market prices. Investments in limited partnerships that invest in marketable securities and derivative products ( hedge funds ) are reported using the equity method of accounting based on information provided by the respective partnership. Investments in private equity limited partnerships with ownership percentages over 5% are recorded on the equity method of accounting, while those with ownership percentages of 5% or less are recorded using the cost method of accounting. For private equity investments carried at cost, Advocate regularly compares the net asset value (NAV), which is a proxy for the fair value, to the recorded cost of these investments for potential other than temporary impairment. The cost of these investments is $384.4 million and $292.2 million and the NAV of these based on estimates determined by the investments management was $443.9 million and $335.6 million at December 31, 2014 and 2013, respectively. For the year ended December 31, 2014 and 2013, Advocate identified and recorded $15.0 million and $5.4 million, respectively, of impairment losses that are included in investment income in the interim condensed consolidated statements of operations and changes in net assets. Investment income or loss (including realized gains and losses, interest, dividends, changes in equity of limited partnerships, and unrealized gains and losses) is included in investment income unless the income or loss is restricted by donor or law or is related to assets designated for self insurance programs. Investment income on self insurance trust funds is reported in other revenue. Gains and losses which are restricted by donor or law are reported as a change in temporarily restricted net assets. Investment returns for assets limited as to use, cash and cash equivalents and short term investments are comprised of the following: For the Quarter For the Year Ended Ended December 31, December 31, Interest and dividend income $ 15,344 $ 47,815 $ 167,822 $ 151,877 Net realized gains 22,126 40, , ,330 Net change in unrealized gains (losses) (40,597) 57,960 (99,803) 69,520 $ (3,127) $ 146,107 $ 188,052 $ 342,727 Investment returns are included in the consolidated statements of operation and changes in net assets as follows: For the Quarter For the Year Ended Ended December 31, December 31, Other revenue $ 15,459 $ 13,535 $ 46,888 $ 48,273 Investment income (loss) (19,955) 129, , ,727 Temporarily resticted net assets realized and change in unrealized gains (losses) 1,369 2,833 4,219 6,727 $ (3,127) $ 146,107 $ 188,052 $ 342,727 Investments in hedge funds totaled $1,661.6 million and $895.2 million at December 31, 2014 and 2013, respectively. Investments in private equity limited partnerships totaled $444.8 million and $336.9 million at December 31, 2014 and 2013, respectively. At December 31, 2014, Advocate had commitments to The Condensed Consolidated Financial Statements were prepared on March 6,

16 fund an additional $491.8 million to private equity limited partnerships over approximately the next six years. Additional allocations of investments are anticipated to be made to private equity limited partnerships in the future as opportunities arise. Note I Fair Value Measurements Advocate accounts for certain assets and liabilities at fair value. The hierarchy below lists three levels of fair value based on the extent to which inputs used in measuring fair value is observable in the market. Advocate categorizes each fair value measurement in one of three levels based on the lowest level input that is significant to the fair value measurement in its entirety. These levels are: Level 1: Quoted prices in active markets for identified assets or liabilities. Level 2: Inputs, other than the quoted process in active markets that are observable either directly or indirectly. Level 3: Unobservable inputs in which there is little or no market data, which then requires the reporting entity to develop its own assumptions about what market participants would use in pricing the asset or liability. The following section describes the valuation methodologies Advocate uses to measure financial assets and liabilities at fair value. In general, where applicable, Advocate uses quoted prices in active markets for identical assets and liabilities to determine fair value. This pricing methodology applies to Level 1 investments such as domestic and international equities, United States Treasuries, exchange traded funds, and agency securities. If quoted prices in active markets for identical assets and liabilities are not available to determine fair value then quoted prices for similar assets and liabilities or inputs other than quoted prices that are observable either directly or indirectly are used. These investments are included in Level 2 and consist primarily of corporate notes and bonds, foreign government bonds, mortgage backed securities, commercial paper, and certain agency securities. The fair value for the obligations under swap agreements included in Level 2 is estimated using industry standard valuation models. These models project future cash flows and discount the future amounts to a present value using market based observable inputs, including interest rate curves. The fair values of the obligation under swap agreements include adjustments related to Advocate s credit risk. The Sherman Series 2007A Bonds required a debt service reserve fund that was invested in a guaranteed investment contract (GIC) that was included as a Level 2 investment. This investment represented a privately negotiated agreement between ASH and various banks. Although the investment was not traded on any market and was nontransferable for the duration of the bonds, the underlying assets were traded in active markets. As described in Note G, the Sherman Series 2007A Bonds were advanced refunded in December 2014 and the GIC was terminated. Advocate s investments are exposed to various kinds and levels of risk. Equity securities and equity funds expose Advocate to market risk, performance risk and liquidity risk for both domestic and international investments. Market risk is the risk associated with major movements of the equity markets. Performance risk is that risk associated with a company s operating performance. Fixed income securities and fixed income mutual funds expose Advocate to interest rate risk, credit risk and liquidity risk. As interest rates change, the value of many fixed income securities is affected, including those with fixed interest rates. Credit risk is the risk The Condensed Consolidated Financial Statements were prepared on March 6,

17 that the obligor of the security will not fulfill its obligations. Liquidity risk is affected by the willingness of market participants to buy and sell particular securities. Liquidity risk tends to be higher for equities related to small capitalization companies and certain alternative investments. Due to the volatility in the capital markets, there is a reasonable possibility of subsequent changes in fair value resulting in additional gains and losses in the near term. The carrying values of cash and cash equivalents, accounts receivable and payable, accrued expenses and short term borrowings are reasonable estimates of their fair values due to the short term nature of these financial instruments. The Condensed Consolidated Financial Statements were prepared on March 6,

18 Fair Value Measurements at Reporting Date Using Quoted Prices in Active Significant Other Significant Markets for Identical Observable Unobservable Assets Inputs Inputs Description December 31, 2014 (Level 1) (Level 2) (Level 3) Assets Cash and short term investments $ 362,473 $ 348,076 $ 14,397 $ Corporate Bonds and other debt securities 498, ,086 United States goverment obligations 254, ,478 Government mutual funds 310, ,075 Bond and other debt security mutual funds 300,017 8, ,429 Commodity mutual funds 3,497 3,497 Equity securities 1,201,133 1,201,133 Equity funds 536,151 97, ,881 Investment at fair value $ 3,465,910 $ 1,968,639 $ 1,497,271 $ Investment not at fair value 2,106,449 Total investments $ 5,572,359 Collateral proceeds received under securities lending program $ 19,768 $ 19,768 Liabilities Derivatives: Obligations under swap agreements $ (86,246) $ (86,246) Obligations to return capital under securities lending program $ (19,768) $ (19,768) Fair Value Measurements at Reporting Date Using Quoted Prices in Active Significant Other Significant Markets for Identical Observable Unobservable Assets Inputs Inputs Description December 31, 2013 (Level 1) (Level 2) (Level 3) Assets Cash and short term investments $ 956,883 $ 952,558 $ 4,325 $ Corporate Bonds and other debt securities 326, ,163 United States goverment obligations 199, ,689 Government mutual funds 502, ,257 80,815 Bond and other debt security mutual funds 479, , ,145 Commodity mutual funds 4,631 4,631 Equity securities 1,083,000 1,083,000 Equity funds 605, , ,080 Guaranteed investment contract 17,218 17,218 Investment at fair value $ 4,175,064 $ 3,246,629 $ 928,435 $ Investment not at fair value 1,231,758 Total investments $ 5,406,822 Collateral proceeds received under securities lending program $ 19,165 $ 19,165 Liabilities Derivatives: Obligations under swap agreements $ (47,908) $ (47,908) Obligations to return capital under securities lending program $ (19,440) $ (19,440) The Condensed Consolidated Financial Statements were prepared on March 6,

19 Investments not at fair value include hedge funds and private equity limited partnerships ( alternative investments ). The fair values of the alternative investments that do not have readily determinable fair values are determined by the general partner or fund manager taking into consideration, among other things, the cost of the securities or other investments, prices of recent significant transfers of like assets and subsequent developments concerning the companies or other assets to which the alternative investments relate. Based on the inputs in determining the estimated fair value of these investments these assets would be considered a Level 3. The valuation for the estimated fair value of long term debt is completed by a third party service and takes into account a number of factors including, but not limited to, any one or more of the following: (i) general interest rate and market conditions; (ii) macroeconomic and/or deal specific credit fundamentals; (iii) valuations of other financial instruments which may be comparable in terms of rating, structure, maturity and/or covenant protection; (iv) investor opinions about the respective deal parties; (v) size of the transaction; (vi) cash flow projections, which in turn are based on assumptions about certain parameters that include, but are not limited to, default, recovery, prepayment and reinvestment rates; (vii) administrator reports, asset manager estimates, broker quotations and/or trustee reports, and (viii) comparable trades, where observable. Based on the inputs in determining the estimated fair value of debt this liability would be considered a Level 2. The estimated fair value of long term debt was $1,632.1 million and $1,573.4 million at December 31, 2014 and 2013, respectively. The carrying value of long term debt was $1,609.1 million and $1,605.0 million at December 31, 2014 and 2013, respectively. Note J Derivatives Advocate has interest rate related derivative instruments to manage exposure of its variable rate debt instruments and does not enter into derivative instruments for any purpose other than risk management. By using derivative financial instruments to manage the risk of changes in interest rates, Advocate exposes itself to credit risk and market risk. Credit risk is the failure of the counterparty to perform under the terms of the derivative contracts. When the fair value of a derivative contract is positive, the counterparty owes Advocate, which creates credit risk for Advocate. When the fair value of a derivative contract is negative, Advocate owes the counterparty, and therefore, it does not possess credit risk. Advocate minimizes the credit risk in derivative instruments by entering into transactions that may require the counterparty to post collateral for the benefit of Advocate based on the credit rating of the counterparty and the fair value of the derivative contract. Market risk is the adverse effect on the value of a financial instrument that results from a change in interest rates. The market risk associated with interest rate changes is managed by establishing and monitoring parameters that limit the types and degree of market risk that may be undertaken. Advocate also mitigates risk through periodic reviews of its derivative positions in the context of its total blended cost of capital. At December 31, 2014, Advocate maintains an interest rate swap program on its Series 2008C variable rate demand revenue bonds. These bonds expose Advocate to variability in interest payments due to changes in interest rates. Advocate believes that it is prudent to limit the variability of its interest payments. To meet this objective and to take advantage of low interest rates, Advocate entered into various interest rate swap agreements to manage fluctuations in cash flows resulting from interest rate risk. These swaps convert the variable rate cash flow exposure on the variable rate demand revenue bonds to synthetically fixed cash flows. The Condensed Consolidated Financial Statements were prepared on March 6,

20 The notional amount under each interest rate swap agreement is reduced over the term of the respective agreement to correspond with reductions in the principal outstanding under various bond series. The following is a summary of the outstanding positions under these interest rate swap agreements at December 31, 2014 and 2013: Bond Series Notional Amount Maturity Date Rate Received Rate Paid 2008C 1 $129,900 11/1/ % of LIBOR + 26 bps 3.605% 2008C 2 $108,425 11/1/ % of LIBOR + 26 bps 3.605% 2008C 3 $ 88,000 11/1/ % of LIBOR + 26 bps 3.605% The swaps are not designated as hedging instruments, and therefore, hedge accounting has not been applied. As such, unrealized changes in fair value of the swaps are included as a component of nonoperating income (loss) in the interim condensed consolidated statements of operations and changes in net assets as changes in the fair value of interest rate swaps. The net cash settlement payments, representing the realized changes in fair value of the swaps, are included as interest expense in the interim condensed consolidated statements of operations and changes in net assets. The fair value of the interest rate swap agreements at December 31, 2014 and 2013 was as follows: December 31, 2014 December 31, 2013 Obligations under swap agreements $ (86,246) $ (47,908) Collateral posted under swap agreements Obligations under swap agreements, net $ (86,246) $ (47,908) Amounts recorded in the interim condensed consolidated statements of operations and changes in net assets for the swaps agreements are as follows: For the Quarter For the Year Ended Ended December 31, December 31, Net cash payments on interest rate swap agreements (interest expense) $ 2,820 $ 2,519 $ 10,734 $ 10,518 Change in the fair value of interest rate swap agreements (nonoperating) $ (21,888) $ 10,220 $ (38,338) $ 41,236 Advocate's interest rate swap instruments contain provisions that require Advocate to maintain an investment grade credit rating on its tax exempt bonds from certain major credit rating agencies. If Advocate's tax exempt bonds were to fall below investment grade on the valuation date, it would be in violation of these provisions, and the counterparty to the derivative instruments could request immediate payment or demand immediate and ongoing full overnight collateralization on derivative instruments in net liability positions. The Condensed Consolidated Financial Statements were prepared on March 6,

21 Note K Contingencies and Health Care Regulations Advocate is self insured for substantially all general and professional liability risks. The self insurance programs combine various levels of self insured retention with excess commercial insurance coverage. In addition, various umbrella insurance policies have been purchased to provide coverage in excess of the selfinsured limits. Revocable trust funds, administered by a trustee and a captive insurance company, have been established for the self insurance programs. Actuarial consultants have been retained to determine the estimated cost of claims, as well as to determine the amount to fund into the irrevocable trust and captive insurance company. Advocate is a defendant in certain litigation related to professional and general liability risks. Although the outcome of the litigations cannot be determined with certainty, management believes, after consultation with legal counsel, that the ultimate resolution of the litigations will not have a material adverse effect on Advocate s operations or financial condition. Note L Legal, Regulatory, and Other Contingencies The health care industry is subject to significant regulatory requirements of federal, state and local governmental agencies and independent professional organizations and accrediting bodies, technological advances and changes in treatment modes, various competitive factors and changes in third party reimbursement programs. Certain of these factors include: licensing, surveys, audits and investigations; privacy laws; Fraud and Abuse laws and regulations; the Federal False Claims Act; restrictions on referrals; environmental laws and regulations; and other Federal, state and local laws and regulations. Laws and regulations governing the Medicare and Medicaid programs are extremely complex and subject to interpretation. During the last few years, as a result of nationwide investigations by governmental agencies, various health care organizations have received requests for information and notices regarding alleged noncompliance with those laws and regulations, which, in some instances, have resulted in organizations entering into significant settlement agreements. Compliance with such laws and regulations may also be subject to future government review and interpretation, as well as significant regulatory action, including fines, penalties, exclusion from the Medicare and Medicaid programs, and revocation of federal or state tax exempt status. Moreover, Advocate expects that the level of review and audit to which it and other health care providers are subject will increase. Various federal and state agencies have initiated investigations, which are in various stages of discovery, relating to reimbursement, billing practices and other matters of Advocate. There can be no assurance that regulatory authorities will not challenge Advocate s compliance with these laws and regulations, and it is not possible to determine the impact, if any, such claims or penalties would have on Advocate. As a result, there is a reasonable possibility that recorded amounts will change by a material amount in the near term. To foster compliance with applicable laws and regulations, Advocate maintains a compliance program designed to detect and correct potential violations of laws and regulations related to its programs. In 2013 four desktop computers were stolen during a burglary at one of Advocate s administrative support locations. The computers did not contain patient medical records, but did contain certain patient The Condensed Consolidated Financial Statements were prepared on March 6,

22 information, including names, addresses, Social Security numbers and limited billing and clinical information. Affected patients were notified and offered free credit monitoring and identity theft protection. This matter is under investigation by various government agencies and Advocate has received notice that it has been named in numerous lawsuits regarding this matter. Advocate continues to monitor and investigate these matters. Although the outcome of these investigations and litigation cannot be determined with certainty, management is not in possession of any information to suggest that the costs relating to the resolution of this incident will have a material adverse effect on Advocate s operations or financial condition. On March 17, 2014, Advocate and certain of its subsidiaries were named as defendants to litigation surrounding the Church Plan status of one of Advocate s defined benefit plans. On December 31, 2014, the United States District Court for the Northern District of Illinois issued its Decision and Order denying the Defendants Motion to Dismiss. Advocate filed a Motion for Interlocutory Appeal, which was granted on January 13, 2015 and has subsequently filed its Petition for Appeal with the Seventh Circuit on January 23, The appeal remains pending. Regardless of the outcome of such appeal, Advocate does not believe that this matter will have a material adverse effect on Advocate s financial position or results of operations. Note M Sherman Affiliation The fair value of assets and liabilities of ASH contributed at June 1, 2013 consisted of the following: Cash and cash equivalents $ 12,280 Investments 123,355 Other current assets 65,949 Property and equipment 318,398 Other long term assets 29,601 Total assets 549,583 Current liabilities, excluding current portion of long term debt 69,412 Long term debt 284,217 Other long term liabilities 43,309 Total liabilities 396,938 Increase in net assets $ 152,645 After the September 30, 2013 unaudited interim condensed consolidated financial statements were issued, additional fair value adjustments were made during the fourth quarter of 2013 related to the ASH affiliation that resulted in a decrease of $19.0 million to the net assets contributed as originally reported at September 30, In the September 31, 2014 unaudited interim condensed consolidated statements of operations and changes in net assets and interim condensed consolidated statement of cash flows, for the quarter and nine months ended September 30, 2013 were restated to reflect these adjustments. In the unaudited interim condensed consolidated statements of operations and changes in net assets, depreciation and amortization for the nine months ended September 30, 2013 was reduced by $1.2 million from what was originally reported resulting in operating income being increased by $1.2 million. The fair value of assets acquired for the nine months ended September 30, 2013 was reduced by $19.3 million from what was The Condensed Consolidated Financial Statements were prepared on March 6,

23 originally reported. This reduction along with the aforementioned decrease in depreciation and amortization resulted in revenues in excess of expenses being reduced by $18.1 million from what was originally reported for the nine months ended September 30, In the unaudited interim condensed consolidated statement of cash flows the aforementioned changes impacted the following lines but resulted in no change to cash and cash equivalents at end of period. Increase in net assets for the nine months ended September 30, 2013 decreased by $18.1 million, depreciation, amortization and accretion decreased by $1.2 million, and fair value of net assets acquired was increased by $19.3 million. As the September 30, 2013 statements were adjusted in the aforementioned manner, there were corresponding adjustments to the quarter ended December 31, 2013 in the accompanying unaudited interim condensed consolidated statements of operations and changes in net assets and interim condensed consolidated statement of cash flows. In the unaudited interim condensed consolidated statements of operations and changes in net assets, depreciation and amortization for the quarter ended December 31, 2013 was increased by $1.2 million from what was originally reported resulting in operating income being decreased by $1.2 million. The fair value of assets acquired for the quarter ended December 31, 2013 was increased by $19.3 million from what was originally reported, resulting in zero being reported for the quarter ended. This reduction along with the aforementioned increase in depreciation and amortization resulted in revenues in excess of expenses being increased by $18.1 million from what was originally reported for the quarter ended December 31, In the unaudited interim condensed consolidated statement of cash flows the aforementioned changes impacted the following lines but resulted in no change to cash and cash equivalents at end of period. Decrease in net assets for the quarter ended December 31, 2013 increased by $18.1 million, depreciation, amortization and accretion increased by $1.2 million, and fair value of net assets acquired was decreased by $19.3 million. There were no changed for the year ended December 31, Total 2013 operating revenue and operating loss from the date of affiliation for ASH of $170.3 million and $5.0 million, respectively, are included in the accompanying unaudited Interim Condensed Consolidated Statements of Operations and Changes in Net Assets. Following are the unaudited pro forma results for the year ended December 31, These results reflect the addition of ASH s unaudited results for the period January 1, 2013 to May 31, 2013 to Advocate s results for the year ended December 31, December 31, 2013 Total operating revenue $ 5,062,920 Operating income 301,479 Revenues in excess of expenses 771,600 The pro forma information provided is a compilation of results only and should not be construed to accurately reflect what the actual results would have been had the affiliation been consummated on January 1, 2013 and is not intended to project Advocate s results of operations for any future periods. The Condensed Consolidated Financial Statements were prepared on March 6,

24 Note N Affiliation and Merger On September 11, 2014, Advocate and NorthShore University Health System entered into a definitive merger and affiliation agreement (the Agreement ) to form Advocate NorthShore Health Partners ( ANHP ), an integrated delivery system to be comprised of sixteen hospitals, a broad network of clinically integrated employed and affiliated physicians, outpatient centers and home health services across northern and central Illinois. The transaction is anticipated to be completed in 2015, subject to the required regulatory approval of the Federal Trade Commission. Advocate can provide no assurance that the transaction will, or will not, occur. Note O Subsequent Events Advocate evaluated events occurring between January 1, 2015 and March 25, 2015, which is the date when the interim condensed consolidated financial statements were issued. The Condensed Consolidated Financial Statements were prepared on March 6,

25 Advocate Health Care Network and Subsidiaries Management Discussion and Analysis of Financial Condition and Results of Operations This Management Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with the Interim Condensed Consolidated Financial Statements for the fourth quarter and year ended December 31, Organizational Overview Advocate Health Care Network and Subsidiaries, ( Advocate ), based in Downers Grove, Illinois, is the largest health care provider in the State of Illinois. Advocate Health Care Network ( AHCN ) is the sole member of Advocate Health and Hospitals Corporation ( AHHC ) and Advocate Sherman Hospital ( ASH ). AHHC is the sole member of Advocate North Side Health Network ( North Side ) and Advocate Condell Medical Center ( ACMC ), each of which are Illinois not for profit corporations. AHCN, ASH, AHHC, North Side and ACMC are also the sole members of various not for profit corporations or the shareholders of various business corporations, the primary activities of which are the delivery of health care services or the provision of goods and services ancillary thereto. These controlled corporations, along with AHCN, ASH, AHHC, ACMC and North Side, constitute Advocate. As the parent of Advocate, AHCN currently has no material operations or activities of its own, apart from its ability to control ASH, AHHC, ACMC, North Side and other controlled organizations compromising Advocate. All of Advocate s hospitals, except for Advocate Illinois Masonic Medical Center (owned by North Side), Advocate Condell Medical Center (owned by ACMC) and Advocate Sherman Hospital (owned by ASH) are owned by AHHC. Advocate s not for profit corporations, including AHCN, ASH, AHHC, North Side and ACMC, are exempt from federal income taxation pursuant to Section 501(c)(3) of Internal Revenue Code of 1986, as amended. Advocate provides a continuum of care to over 1.1 million individuals throughout northern and central Illinois through its twelve acute care hospitals and an integrated children s hospital, which in total have approximately 3,600 licensed beds, primary and specialty physician services, outpatient centers, physician office buildings and home health and hospice care in northern and in central Illinois. Advocate has approximately 6,400 physicians on the medical staffs of its hospitals. Through a long term academic and teaching affiliation with the University of Illinois at Chicago Health Sciences Center, Advocate trains more resident physicians than any other non university teaching hospital in Illinois. Advocate makes strategic, operating and financial decisions on a system wide basis to provide for complete financial integration of Advocate hospitals and other health services. Further, Advocate s overall management is centralized to allow for a streamlined decision making process and the ability to respond quickly to market forces. Advocate s management believes it has the greatest geographic coverage in northern and central Illinois with over 250 sites of care. Advocate owns and is affiliated with two large physician groups. Advocate Medical Group ( AMG ) is an unincorporated physician group that is a division of both AHHC. As of December 31, 2014 AMG employed approximately 973 full time equivalent ( FTE ) physicians. Advocate also has a management and professional service agreement with Dreyer Medical Group, Ltd., which as of December 31, 2014 employed approximately 165 FTE physicians. 22

26 Strategic Direction Advocate is among national industry leaders in the transformation of care delivery from fee for service to fee for value. Consistent with its mission of serving the health needs of individuals, families and communities Advocate has established a vision and set of strategies to become a population health management organization. This strategy includes three key components: Align Physicians Through its affiliate, Advocate Health Partners, d/b/a Advocate Physician Partners ( APP ), Advocate has clinically integrated with over 4,500 physicians, approximately 3,000 of whom are independent practitioners. APP provides single signature contracting with payors, all of whom provide financial incentives to APP to reward physicians for improvements in quality, safety, service and cost. As a pioneer of clinical integration, Advocate has the ability to align large numbers of physicians to accept risk for improving the health of the population and for reducing the cost of care. Migrate Reimbursement to Value and Risk Based Contracts Through APP, Advocate has successfully executed contracts with commercial and governmental payors that reward the organization for quality and reducing the total cost of care. Advocate currently participates in the Medicare Shared Savings Program ( MSSP ), Medicare Advantage contracts, capitation based contracts for several commercial health management organizations, and a shared savings contract with Blue Cross of Illinois. Advocate has recently signed a contract with the State of Illinois to serve as an Accountable Care Entity and to provide care for Medicaid managed care enrollees. In total, Advocate has over 650,000 covered and attributed lives for whom it is responsible for improving quality and reducing the total cost of care. Advocate is exploring additional strategies and opportunities to increase this number while appropriately managing financial risk. Invest in Care Management and Care Coordination Advocate has established a robust care management and care coordination capability to effectively improve the health of and reduce the total cost of care for the population served. This strategy has allowed Advocate to beat market benchmarks for trend in the cost of care and to perform successfully under value and risk based reimbursement. Advocate foresees continued investment in its care delivery assets to ensure that safety, quality, service and cost are optimized. The creation of a tightly integrated and scaled care delivery network is a critical enabler of the population health management strategy. Advocate may also continue to invest in its network to increase access and affordability through new outpatient locations, continued growth of its employed physician group and integration of its home health, hospice and palliative care services. 23

27 Mission and Community Benefit As a faith based health care organization, affiliated with the United Church of Christ ( UCC ) and the Evangelical Lutheran Church in America ( ELCA ), the mission, values and philosophy of Advocate form the foundation for its strategic priorities. Advocate s mission is to serve the health care needs of individuals, families and communities through a wholistic philosophy rooted in the fundamental understanding of human beings as created in the image of God. Consistent with its mission, Advocate is committed to providing each patient with quality care and service and treating each patient with respect, integrity and dignity. Through its values of compassion and stewardship, Advocate provides free or discounted care to uninsured and underinsured patients who are eligible for assistance. If the patient does not qualify for any public assistance programs, such as Medicaid or KidCare, then the patient will be considered for charity care. This program provides free care for patients with annual incomes up to 200% of the federal poverty level, and discounts for the uninsured with annual incomes between 200% and 600% of the federal poverty level. Discounts are available for insured patients with annual incomes between 200% and 400% of the federal poverty level. Each hospital has a multi disciplinary charity care committee, some with community representatives participating, to oversee the application of Advocate s charity care program. Ninety nine percent of completed charity care applications are approved. The cost to Advocate of providing uncompensated care to the uninsured, underinsured and unreimbursed cost of government sponsored programs is as follows: Year Ended December 31, 1 (dollars in thousands) Charity care $ 123,234 $ 103,638 Uncollectible accounts 68,681 57,560 Unreimbursed government sponsored indigent health care 335, ,485 Total Costs of Uncompensated Care $ 527,133 $ 491, Filed with the State of Illinois Attorney General s office in accordance with the State of Illinois Community Benefits Act. The total cost of uncompensated care represents the largest portion of the total of all community benefits provided by Advocate. Total uncompensated care costs increased from 2012 to 2013 due to the affiliation with ASH and the continued challenging economy which forced more individuals to seek charity care or else resulted in uncollectible accounts. These increases were partially offset by expense management and lower insurance costs. Advocate is involved in numerous activities and programs reaching beyond the walls of its hospitals and into the community. These activities are wide ranging and include providing community health education, 24

28 immunizations for children and seniors, support groups, health screenings, health fairs, pastoral care and parish nursing, home delivered meals, transportation services, seminars and speakers, community meeting space, crisis lines, spirituality newsletters, newspaper and magazine articles regarding current health issues, medical residency and internships, education to other health professionals such as nurses and pharmacy technicians, research and language assistance, dental van for special needs patients, counseling for hospice patients and their families, and many other subsidized health services. The cost of these programs and activities are provided either free of charge or for a fee less than the cost of providing them. The cost of providing these other community benefits totaled $133.6 million in The Affordable Care Act, described below, imposes requirements on tax exempt hospitals to develop, implement and monitor charity care policies and procedures. In addition, one of the objectives of the Affordable Care Act has been to extend the availability and affordability of health care insurance to those segments of the population who have not been able to afford health care insurance or who have not had access to health care services. This is likely to result in a reduction in the volume of patients who have historically been afforded care under Advocate s charity care program starting with the federal fiscal year beginning October 1, Employees As of December 31, 2014, Advocate employed approximately 33,300 individuals (approximately 28,700 FTEs). Advocate s management believes that the salary levels and benefits packages for its employees are competitive and that Advocate s managers generally have good relationships with their employees. Less than one tenth of one percent (0.1%) of Advocate employees are represented by collective bargaining groups. Advocate, along with other healthcare providers, has been the target of unions attempting to organize associates. Unions have employed various tactics to either directly attract associates or engage in corporate campaign strategies that are designed to undermine the credibility and integrity of the targeted healthcare providers. Management cannot predict with any certainty whether union organizing related activities will have any material adverse effect on the financial condition or operations of Advocate. In recent years, the health care industry has suffered from a scarcity of nursing and other qualified health care technicians and personnel. This scarcity may intensify if utilization of health care services increases as a consequence of the expansion of the number of insured consumers occurs as anticipated as a consequence of the Affordable Care Act. This trend could force Advocate to pay higher salaries to nursing and other qualified health care technicians and personnel as competition for such employees intensifies. Environment and Competition In the Chicago metropolitan area, which includes the counties of Cook, DuPage, Will, Kane, Lake and McHenry, nine hospitals and/or health care systems had a market share (based on the sum of inpatient admissions and observation cases) of 3.0% or higher at the end of the rolling year ended September 30, 2014 or years ended December 31, 2013 or For the rolling year ended September 30, 2014, Advocate s market share was 17.8%, and for the years ended December 31, 2013 and 2012, 17.8% and 17.8%, respectively. Market share data is derived from Advocate s analysis of the most recently available statistics from COMPdata, the Illinois Hospital Association s health information database. The market share of Advocate 25

29 and these other hospitals or health care systems for the rolling year ended September 30, 2014 and the years ended December 31, 2013 and 2012 are as follows: Rolling Year Ended September 30, 2014 Year Ended December 31, 2013 Year Ended December 31, 2012 Advocate (1) 17.8% 17.8% 17.8% Presence Health (2) 9.4% 9.6% 9.8% Northwestern Medicine (3) 9.2% 9.1% 9.0% Adventist Alexian Health System (4) 7.2% 7.4% 7.0% NorthShore University Health System (5) 4.9% 4.9% 4.8% Rush System for Health 4.5% 4.5% 4.3% Edward Elmhurst Healthcare (6) 4.2% 4.1% 4.0% Trinity Health (7) 4.1% 4.4% 4.4% Tenet Healthcare System (8) 3.6% 3.6% 3.8% (1) (2) (3) (4) (5) (6) (7) (8) Reflects the affiliation with Advocate Sherman Hospital in June 2013 for all periods presented. Our Lady of the Resurrection was sold by Presence in June 2014 and has been removed from all time periods. Reflects the June 2014 merger with Cadence Health for all periods presented. Affiliated with Ascension Health, a national Catholic health system based in St. Louis, Missouri. In June 2014, Alexian and Adventist Health System Sunbelt Health Corporation agreed to create a joint operating company, and data for all time periods reflects this joint operation, assuming the completion of the transaction. As described herein under Potential for New Corporate Affiliations, in September 2014, Advocate entered into an affiliation agreement with NorthShore University HealthSystem to form a 16 hospital system to be called Advocate NorthShore Health Partners. The completion of this transaction, currently targeted for 2015, is subject to the required approval from the Federal Trade Commission. Reflects the merger of Edward Hospital and Health Services and Elmhurst Memorial Healthcare effective July 1, Market share includes Edward Hospital, Elmhurst Memorial Hospital, and Linden Oaks Hospital at Edward for all periods presented. Loyola University Health System and Mercy Health System are both part of the health care system known as Trinity Health, which is headquartered in Novi, Michigan Tenet Healthcare System acquired Vanguard Health Systems in October As reflected in the preceding table, the Chicago metropolitan market is fragmented with the nine largest hospitals/health care systems comprising approximately 66% of the market. Over the past several years, affiliation, acquisition and merger activity has increased, which includes activity between existing hospitals and health systems in the Chicago metropolitan market and the introduction of organizations new to this market. With the acquisition of BroMenn Medical Center and Eureka Hospital (described below) in January 2010, Advocate has a presence in the central Illinois market place. For the rolling year ended September 30, 2014 and the years ended December 31, 2013 and 2012, Advocate s market share in the thirteen counties comprising the central Illinois market, based on an analysis of COMPdata statistics, was 7.3%, 6.9% and 6.8%, respectively. In its primary service area of McLean County, Illinois, BroMenn Medical Center had a 48.4% 26

30 market share for the rolling year ended September 30, 2014 and a 47.7% and 47.9% market share, respectively, for the years ended December 31, 2013 and In addition to the increased hospital affiliation, acquisition and merger activity affecting the markets in which Advocate operates physician group acquisitions and affiliations with the various hospitals and health care systems in these markets also have increased. Management cannot predict with any certainty whether the hospital and physician group acquisition, merger and affiliation activities occurring within Advocate s markets will have any material effect on the financial condition or operations of Advocate. Summary of Significant Accounting Policies and Use of Estimates Advocate s accounting policies are fundamental to understanding management s discussion and analysis of results of operations and financial condition. Many of Advocate s accounting policies require significant judgment regarding valuation of assets and liabilities and/or significant interpretation of specific accounting guidance. Advocate s significant accounting policies are described in Note 1 of Advocate s 2014 audited consolidated financial statements and are summarized in the notes to the interim condensed consolidated financial statements for the fourth quarter and year ended December 31, There have been no significant changes in accounting policies from the 2013 audited consolidated financial statements. Refer to Notes C and D of the notes to the interim condensed consolidated financial statements for the fourth quarter and year ended December 31, 2014 for information related to the adoption of new accounting standards and the use of estimates, respectively. Management relies on historical experience and on other assumptions believed to be reasonable under the circumstances in making its judgments and estimates. Although estimates are considered to be reasonable at the time made, actual results could differ materially from those estimates. Internal Control Environment Advocate has an established independent Audit Committee of the Board of Directors and an Internal Audit Department. Advocate has adopted the Committee of Sponsoring Organizations of the Treadway Commission ( COSO ) Internal Control Integrated Framework (2013). The Internal Audit Department carries out an annual audit program that assesses Advocate s design and operation of internal controls to achieve efficient and effective operations, accurate and reliable financial reporting, compliance with policies, laws and regulations, and the proper safeguarding of assets. General Economic Conditions and Investment Performance The disruption of the credit and financial markets several years ago led to volatility in the securities markets, significant losses in investment portfolios, increased business failures and consumer and business bankruptcies, and was a major cause of the economic recession in 2008 and As a direct consequence, the financial condition of Advocate and its operating results were materially adversely affected. In response to that disruption, the Dodd Frank Wall Street Reform and Consumer Protection Act (the Financial Reform Act ) was enacted in The Financial Reform Act included broad changes to the existing financial regulatory structure, including the creation of new federal agencies to identify and respond to risks to 27

31 the financial stability of the United States. Additional legislation is pending or under active consideration by Congress and regulatory action is being considered by various federal agencies and the Federal Reserve Board and foreign governments, which are intended to increase the regulation of domestic and global credit markets. The effects of the Financial Reform Act and of these legislative, regulatory and other governmental actions, if implemented, are unclear. The health of the economy has a direct impact on Advocate and also increases stress on the budgets of the states. Hospitals continue to feel the impact of higher unemployment, reduced personal income earning expectations and diminished access to private insurance. Unemployment remains high within the service areas in which Advocate operates and in certain of those areas remains higher than the national average. Effects of a weaker economy on hospitals and physician practice operations have also resulted in (but are not limited to) lower patient volumes as patients defer elective health care services; rising charity care and bad debt expense; budget pressures on federal and state governments intensifying reviews of Medicare and Medicaid reimbursement rates; unfavorable changes in payor mix away from commercial payors; financial pressures and decreasing membership at health care insurers, contributing to lower commercial rate increases for health care providers; and increased difficulty attracting philanthropy. The American Recovery and Reinvestment Act of 2009 ( ARRA ) included several provisions that were intended to provide financial relief to the health care sector, including a requirement that states promptly reimburse healthcare providers. ARRA also established a framework for the implementation of a nationallybased health information technology program, including incentive payments to eligible healthcare providers to encourage implementation of health information technology and electronic health records. Assuming federal funding is available, such incentive payments are payable to eligible healthcare providers that comply with the applicable federal requirements, including demonstrating "meaningful use" of electronic health records, in each period over a four year period. Pursuant to ARRA, commencing in 2015, Medicare eligible providers that do not demonstrate meaningful use of electronic health records will receive a downward adjustment in federal reimbursement. Advocate demonstrated stage one "meaningful use" of electronic health records at the majority of its health care facilities, and has received incentive payments available under ARRA. Impact of Investment Performance Advocate has significant holdings in a broad range of investments. Investment income (including both realized and unrealized gains on investments) has contributed significantly to Advocate s financial results over recent years. Market fluctuations have affected and will likely continue to materially affect the value of those investments and those fluctuations may be and historically have been material. The state of the economy and market disruptions has exacerbated the market fluctuations. Reduction in investment income and the market value of its investments may have a negative impact on Advocate s financial condition, including its ability to provide its own liquidity for variable rate debt or to fund capital expenditures from cash and investments. 28

32 Results of Operations Quarter to quarter and year to date comparison of payor mix and utilization information is included in Attachment 1 of this document. Set forth below is the quarter to quarter and year to date comparison of operating income and net income. Quarter to Quarter Comparison Quarter ended December 31 Year To Date Comparison Year Ended December 31 in millions Operating income Net income in millions Operating income Net income FY13 FY14 FY13 FY14 Management s Discussion of Financial Performance Medicaid Assessment: In 2008 CMS approved a Medicaid assessment system, and in 2013 CMS approved an enhanced Medicaid assessment system, each of which is scheduled to be in effect through June 30, For the fourth quarters and years ended December 31, 2014 and 2013, Advocate s revenues from the Medicaid assessment system amounted to $38.7 and $38.5 million and $154.9 and $149.6 million, respectively, and assessment expenses were $28.5 million and $32.2 million and $113.8 million and $114.4 million, respectively, for a net benefit of $10.3 and $6.4 million and $41.1 and $35.1 million, respectively. For the fourth quarter and year ended December , Advocate recorded revenues from the enhanced Medicaid assessment system of $11.9 million and $47.7 million, respectively, and enhanced Medicaid assessment expenses of $7.1 million and $28.4 million, respectively, for a net benefit of $4.8 million and $19.3 million, respectively. For the fourth quarter and year ended December 31, 2013, Advocate recorded revenues from the enhanced Medicaid assessment system of $11.9 million and $74.5 million, respectively, for a net benefit of $8.7 million and $34.1 million, respectively. Because the enhanced Medicaid assessment program was approved in September 2013 and was retroactive to June 10, 2012, $26.8 million of these revenues and $15.9 million of these expenses (net benefit of $20.5 million) recorded in September 2013 was for the period of June 10, 2012 through December 31, In January 2015, CMS approved this extension and also approved The Patient Protection and Affordable Care Act and the Health Care and Education Reconciliation Act of 2010 (collectively referred to as 29

33 the Affordable Care Act ), providing the State of Illinois with funds retroactive to March 2014 to assist Illinois hospitals with the expansion of Medicaid per the Affordable Care Act. Management anticipates initially receiving approximately $48.0 million annually in expansion funds. This amount will change depending on the growth of Medicaid in the State of Illinois. Quarters Ended December 31, 2014 and 2013: Operating income of $135.9 million was generated during the fourth quarter of 2014, an increase of $49.0 million from the comparable period of This resulted in an operating margin of 9.9% for the quarter ended December 31, 2014 compared to an operating margin of 6.8% for the quarter ended December 31, 2013 and 6.3% for the year ended December 31, Total revenue for the fourth quarter of 2014 of $1,377.1 million increased $74.1 million (5.7%) from the comparable period of the prior year. Patient service revenue net of the provision for uncollectible accounts was $1,138.2 million for the fourth quarter of 2014, an increase of $79.9 million (7.5%) from the comparable period of the prior year. The increase is a result of a 2.4% increase in inpatient volumes, higher non acute care volumes, and a decrease in the provision for uncollectible accounts. Capitation revenue, which amounted to $102.0 million, increased $5.0 million (5.2%) for the fourth quarter of 2014 compared to the fourth quarter of The increase in capitation revenue reflects an increase in rates due to higher acuity and an increase in membership participating in full risk capitated plans, partially offset by a decrease in membership participating in partial risk plans at Advocate s affiliated physician groups. Total expenses for the fourth quarter of 2014 amounted to $1,241.2 million, an increase of $25.1 million (2.1%) from the fourth quarter of The increase in operating expenses reflects inflationary increases, partially offset by focused expense management. Insurance and claims costs in both the fourth quarters of 2014 and 2013 were credits to expense. These credits to expense reflect changes in the actuarial derived estimated reserves on Advocate s self insurance program. The fourth quarter of 2014 depreciation and amortization expense increased $6.2 million (11.0%) compared to the fourth quarter of 2013 due to the completion of a hospital ambulatory pavilion project in Net income of $42.8 million was generated in the fourth quarter of 2014, a decrease of $174.6 million from the comparable period of This resulted in a net margin of 6.6% for the quarter ended December 31, 2014 compared to a net margin of 15.3% for the quarter ended December 31, Market volatility adversely impacted investment returns and the mark to market on Advocate s interest rate swap agreements. Also in December 2014, the Series 2014 Bond issuance was completed. Proceeds from this issuance were used to advance refund for savings the Series 2007A Sherman Bonds and a portion of the Series 2008D Bonds, and to pay certain costs of issuing the Series 2014 Bonds. This transaction resulted in an accounting or book loss of $45.5 million. Years Ended December 31, 2014 and 2013: Operating income of $330.6 million was generated during 2014, an increase of $30.4 million from This resulted in an operating margin of 6.3% for the year ended December 31, 2014 compared to an operating margin of 6.1% for the year ended December 31,

34 Total revenue for 2014 of $5,231.4 million increased $293.4 million (5.9%) from the prior year. Patient service revenue net of provision for uncollectible accounts and including proceeds from Medicaid assessment was $4,496.6 million for 2014, an increase of $282.1 million (6.7%) from the prior year. The increase is the result of the merger with ASH ($129.8 million), higher non acute care volumes, higher patient acuity and lower charity care, partially offset by a 2.3% decrease in same store (excluding ASH) inpatient volumes and an increase in the provision for uncollectable accounts. The increase in the provision for uncollectible accounts includes the effect of ASH ($3.6 million) being included for all of 2014 compared to seven months of Excluding the aforementioned effect of ASH, the provision for uncollectible accounts increased $32.0 million from 2013 to This increase was offset by a decrease in charity care reflecting a shift of patients with no insurance to having insurance coverage but with a high patient responsibility. Capitation revenue, which amounted to $413.5 million, increased $24.0 million (6.2%) for 2014 compared to 2013, which reflects an increase in rates due to higher acuity and an increase in membership participating in full risk capitated plans, partially offset by a decrease in membership participating in partial risk plans at Advocate s affiliated physician groups. Total expenses for 2014 amounted to $4,900.8 million, an increase of $263.0 million (5.7%) from The increase in operating expenses reflects the addition of ASH ($130.4 million) and inflationary increases, partially offset by focused expense management. In 2014 depreciation and amortization expense increased $28.0 million (13.2%) compared to 2013 primarily due to the addition of ASH ($9.9 million) and the completion and opening of a hospital ambulatory pavilion project in Interest expense of $56.8 million increased $1.5 million (2.7%) compared to 2013 due to the addition of ASH ($4.7 million). Contracted medical services of $152.6 million increased $17.1 million (12.6%) compared to 2013 primarily due to an increase in utilization of external medical services for patients participating in capitated plans. Net income of $369.9 million was generated during 2014, a decrease of $395.7 million from This resulted in a net margin of 7.8% for the year ended 2014 compared to a net margin of 11.7% for the year ended A weaker investment market in 2014 compared to 2013 resulted in lower investment returns and a decrease in the mark to market on Advocate s interest rate swap agreements. During 2013 $151.6 million was recorded for the fair value of unrestricted assets acquired from the ASH affiliation. As explained above, the Series 2014 Bond issuance was completed, which resulted in an accounting or book loss of $45.5 million in General and Professional Liability Insurance Advocate has a comprehensive insurance program designed to conserve and protect its assets and properties. Risk transfer is utilized to shift exposures and losses to a third party indemnifier when it is deemed prudent and appropriate. Certain components of the insurance program, including hospital professional and general liability risks, are self insured on a claims made basis. Advocate purchases excess liability insurance in amounts it deems necessary to cover losses that may exceed its self insured portion. Limits of excess liability insurance are commensurate with health care industry standards and are placed with insurance carriers that are currently financially sound. Actuarial consultants are retained to determine funding requirements as well as to assist in the estimation of outstanding general and professional liabilities for retained risks. Accruals for general and professional liability claims are actuarially determined on a discounted basis (utilizing a 3.25% and 3.5% rate as 31

35 of and for the years ended December 31, 2014 and 2013, respectively). The estimated cost of claims is actuarially determined based on past experience as well as other considerations, including the nature of each claim or incident and relevant trend factors. Accrued insurance and claims costs would have been approximately $48.7 million greater at December 31, 2014 had these liabilities not been discounted. Advocate targets to fund its self insured general and professional liabilities, on a claims made basis, at the discounted, expected range into an irrevocable trust that is administered by a bank trustee and a captive insurance company. Reinsurance receivables are recognized in a manner consistent with the liabilities relating to the underlying reinsured contracts. Advocate maintains commercial insurance policies for additional lines of coverage relevant to the operation of an integrated health care delivery system. Some policies carry deductibles. All insurance coverage, lines and self insured programs have been reviewed annually by an independent insurance auditor. Independent physicians that are credentialed to be a member of an Advocate hospital medical staff must maintain specified insurance levels to practice at Advocate hospitals. Costs of general and professional liability claims can make it difficult for physicians to maintain such coverage. These market forces may exert further upward pressure on Advocate s insurance expense and/or affect its relations with medical staff members. Advocate is a defendant in certain litigation related to professional and general liability risks. Although the outcome of the litigation cannot be determined with certainty, management believes, after consultation with legal counsel, that the ultimate resolution of this litigation will not have any material adverse effect on Advocate s operations or financial condition. Liquidity and Capital Resources Unrestricted cash and investment balances (including amounts reported as part of assets limited to use, and investments under securities lending program) was $4,725.3 million at December 31, 2014 and $4,379.2 million at December 31, At December 31, 2014, $2,233.7 million of the $4,725.3 million of unrestricted cash and investment balances had either daily or weekly liquidity. Attachment 2 of this report provides a summary of available liquidity at December 31, Cash and cash equivalents were $272.9 and $563.2 million at December 31, 2014 and 2013, respectively. The decrease of $290.3 million from December 31, 2013 to December 31, 2014 was primarily due a change made in Advocate s asset allocation policy. This change, which is intended to improve the overall investment program s return, reduced the allocation of investment assets to fixed income and cash and cash equivalents and resulted in a corresponding increase in real asset and hedge funds. For more information on Advocate s Investment Program see the Investment Program section of this report. Cash provided by operating activities during 2014 amounted to $46.8 million compared to $507.2 million of cash provided during The change of $460.4 million between years was primarily related to higher working capital uses in 2014 related to the funding of accrued 2013 payroll and retirement savings liabilities in the first quarter of 2014, and increased investments in trading securities. 32

36 Days cash and investments on hand were 383 as of December 31, 2014, a decrease of 3 days from December 31, The decrease is primarily driven by an increase in the value of one day s operating expenses, increased capital spending and higher working capital uses, partially offset by higher operating income. As described in Note G, at December 31, 2014, Advocate had lines of credit with banks aggregating $250.0 million. These lines of credit provide for various interest rates, payment terms and expire as follows: $25.0 million in February 2015, $75.0 million in March 2015, $50.0 million in November 2016 and $100.0 million in December These lines of credit may be used to redeem or purchase bonds, pay costs related to such redemptions or purchases, for capital expenditures or for general working capital purposes. Management currently intends to request that the banks renew these agreements prior to expiration. In February 2015, the $25.0 million line of credit was extended to February 2016 and the $75.0 million line of credit was extended to March 2018 and increased to $100.0 million. At both December 31, 2014 and December 31, 2013, and from January 1, 2015 through the date of this document, there were no amounts drawn on these lines of credit. Net capital expenditures amounted to $507.8 million and $385.7 million for the years ended December 31, 2014 and 2013, respectively. The increase in capital expenditures in 2014 compared to 2013 primarily reflects expenditures made towards a bed tower project and ambulatory pavilion projects on two of the hospital campuses. Capital spending in 2013 and 2014 was made from cash generated from operations, investment returns and proceeds from the 2012 and 2013A bond issuances. In the fourth quarter of 2014, Advocate s Board of Directors authorized approximately $345 million of new capital projects. These capital projects include various infrastructure improvement, clinical technology, information technology projects and routine capital needs, the majority of which expenditures are anticipated to be paid for between 2014 and Management anticipates funding these additional projects from unrestricted cash and investments. As described in Note G, Advocate is a party to four separate standby bond purchase agreements (the SBPAs ) with three banks to provide liquidity support for the four separate subseries of the Series 2008C Bonds (other than the $22.0 million Series 2008 C 3B Bonds, which were converted to long term rate bonds in 2009) in the event of a failed remarketing of any of such subseries of the Series 2008C Bonds. The SBPAs require various reporting, operating and financial covenants to be maintained. These covenants may be waived, modified or amended by the bank in its sole discretion and without notice to or consent by any bond trustee, the Master Trustee or the holders of any outstanding bonds. Violation of any of such covenants may result in an Event of Default under the Advocate Master Indenture, which could result in acceleration of all of the Obligations issued under the Advocate Master Indenture. Unless extended, the SBPA for the Series 2008C 1 Bonds will terminate on August 1, 2016, the SBPA for the Series 2008C 2A Bonds will terminate on August 1, 2019 and the SBPAs for the Series 2008C 2B Bonds and the Series 2008C3 A Bonds will terminate on August 1, In the event that any Bank Bonds are not remarketed within one year from the date they are purchased by a bank pursuant to an SBPA, Advocate has agreed to cause such Bank Bonds to be redeemed pursuant to the related bond indenture such that the unpaid principal balance of all then outstanding Bank Bonds shall amortize in sixteen approximately equal quarterly installments, with the first installment commencing on the date that is one year and one day after the date on which such Series 2008C Bond became a Bank Bond, and 33

37 the final installment payable on the date that is five years from the date on which such Series 2008C Bond became a Bank Bond. At December 31, 2014, December 31, 2013, and the date of this report, there were no Bank Bonds outstanding. Advocate is party to additional covenants agreements (the ACAs ) with a bank, relating to the $50 million Series 2011C Bonds and $50 million Series 2011D Bonds issued in September 2011 and purchased by the bank. The ACAs require various reporting, operating and financial covenants to be maintained. These covenants may be waived, modified or amended by the bank in its sole discretion and without notice to or consent by any bond trustee, the Master Trustee or any holders of outstanding bonds. Violation of any of such covenants may result in an Event of Default under the Advocate Master Indenture, which could result in acceleration of all of the Obligations issued under the Advocate Master Indenture. The Series 2011C Bonds currently bear interest at an indexed rate for a seven year period and the Series 2011D Bonds currently bear interest at an indexed rate for a ten year period. At the end of their respective initial periods, the Series 2011C Bonds and the Series 2011D Bonds will be subject to mandatory tender, unless waived by the holders thereof, and Advocate presently anticipates that the Series 2011C Bonds and Series 2011D Bonds will be remarketed to new holders in one of the interest rate modes available under the related bond indenture. In the event the Series 2011C Bonds or the Series 2011D Bonds are not remarketed on their respective mandatory tender dates, then, as long as no default or event of default (as defined in the ACAs) has occurred and is continuing, the Series 2011C Bonds or Series 2011D Bonds, as applicable, may either be repaid over a three year period or remarketed during that time. The Series 2003A and the Series 2003C Bonds and the Series 2008A 1, Series 2008A 2 and Series 2008 A 3 Bonds were originally issued as long term rate bonds with stated sinking fund redemptions through 2022 and 2030, respectively. On May 1, 2012, a portion of the Series 2008A 3 Bonds ($42.8 million) was remarketed at a premium for a new seven year interest rate period and the remaining principal amount of the Series 2008A 3 Bonds ($8.4 million) was retired. On January 24, 2013, a portion of the Series 2008A 1 Bonds ($ million) was remarketed at a premium for a new seven year interest rate period and the remaining principal amount of the Series 2008A 1 Bonds ($9.095 million) was retired. On February 1, 2013, a portion of the Series 2008A 2 Bonds ($35.5 million) was remarketed at a premium for a new seven year interest rate period and the remaining principal amount of the Series 2008A 2 Bonds ($7.735 million) was retired. On April 25, 2014, the outstanding Series 2003C Bonds ($21.2 million) were remarketed for a new approximately oneyear interest rate period. On July 1, 2014, the Series 2003A Bonds and the Series 2008C 3B Bonds were both remarketed for a new approximately one year interest rate period. As described in the preceding paragraph, certain of Advocate s outstanding bonds bear interest at long term rates for a particular interest rate period, and are subject to mandatory tender at the end of each particular interest rate period. The following table summarizes the next scheduled mandatory tender dates for these bonds as of the date of this document. In the event these bonds are not remarketed upon mandatory tender at the end of their current interest rate period, management anticipates utilizing marketable unrestricted investments and/or available lines of credit to meet the purchase obligations. 34

38 Series Principal Amount Next Mandatory Tender Date Series 2003C $19.0 million May 1, 2015 Series 2003A $19.7 million July 16, 2015 Series 2008C 3B $22.0 million July 16, 2015 Series 2008A 3 $42.8 million May 1, 2019 Series 2008A 1 $42.0 million January 15, 2020 Series 2008A 2 $35.5 million February 12, 2020 The Series 2003A, 2003C and 2008C 3B Bonds were classified as current liabilities in the interim condensed consolidated balance sheets as of December 31, 2014 and December 31, 2013 due to the fact that these bonds were subject to mandatory tender within approximately one year of the balance sheet date. The Series 2011B Bonds issued for Advocate s benefit in September 2011 bear interest at Windows Interest Rates (the Windows Variable Rate Bonds ) and are subject to optional and mandatory tender for purchase. The Windows Variable Rate Bonds are not supported by any external dedicated liquidity facility. Holders of Windows Variable Rate Bonds have a right to optionally tender their Bonds for purchase. If the tendered Windows Variable Rate Bonds are not successfully remarketed within the 30 day period that follows the date that notice of such optional tender is received by the Remarketing Agent (the Remarketing Window ), then all Windows Variable Rate Bonds are required to be purchased on the day that is 210 days after notice of such optional tender is received by the Remarketing Agent (the Windows Mandatory Tender Date ). The period from the end of the Remarketing Window until the Windows Mandatory Tender Date (initially, 180 days) is referred to as the Funding Window. During the Funding Window, Advocate expects that it would analyze the then current market conditions and availability and relative cost of any refinancing or restructuring alternatives for those Windows Variable Rate Bonds that are required to be purchased on the Windows Mandatory Tender Date (including, without limitation, conversion of those bonds to another interest mode or the refinancing or repayment of those bonds). The Series 2011B Bonds are classified as current liabilities in the interim condensed consolidated balance sheets. Under regulatory rules of the State of Illinois, Advocate is required to post a letter of credit with a State agency to operate a self insured workers compensation program. At December 31, 2014 and December 31, 2013, the stated amount of the letter of credit totaled $16.0 million and $15.3 million, respectively. A separate letter of credit related to Advocate Condell s self insured workers compensation program was outstanding at December 31, 2014 and December 31, 2013 in the amount of $0.5 million. ASH had letter of credit agreements totaling $1.4 million and $2.6 million at December 31, 2014 and December 31, 2013, respectively, related to various construction projects. Additionally, in 2004, Advocate established a letter of credit in connection with a building lease arrangement, which was outstanding in the amount of $0.0 and $0.8 million at December 31, 2014 and December 31, 2013, respectively. No amounts were drawn on these letters of credit as of December 31, 2014 or December 31, Management believes that Advocate s financial condition is generally good. Advocate s cash, other liquid assets, operating cash flow, borrowing capacity and ability to lease certain medical equipment, taken 35

39 together are believed to provide adequate resources to fund ongoing operating requirements, debt service and maintenance capital requirements. Investment Program Advocate s investment program is strategically structured to maximize long term growth over a full market cycle through a meaningful commitment to equity, fixed income and alternative investments. Advocate s Board of Directors has adopted an investment policy that regulates the allocation of substantially all of Advocate s investment assets and further defines investment vehicles utilized among other guidelines. In addition to the projected investment market environment the allocation of assets in the investment portfolio reflects the capital and working capital requirements, earning power and debt structure of Advocate. On November 20, 2013, Advocate s Board of Directors approved changes to Advocate s Investment Policy including revisions to the allocation of investment assets. The revised policy is intended to increase the investment yield while maintaining the current return/risk ratio of the portfolio. The primary changes are a reduction in the allocation of investment assets to fixed income and cash and cash equivalents and a corresponding increase in real asset and hedge funds. The asset allocation at December 31, 2013, excluding cash and cash equivalents maintained for operating purposes provided for a commitment to equity securities (30.0%), fixed income investments (25.0%), and select alternative investment classes (45.0%). For each of the above categories, the policy establishes allocation targets among the following investment styles: 15% domestic equities; 15.0% international equities; 25% fixed income; 10.0% private equity; 20.0% hedge funds; and 15.0% real assets. Additionally, there are specific ranges for each asset class. Further, limitations are placed on investment managers as to the overall amount that can be invested in one issuer (except for U.S. government obligations and its agencies) or economic sector. Management began reallocating the portfolio to the new asset allocation in November 2013 and the reallocation was completed in mid Assets of the program will continue to be managed by a number of external investment professionals. Further, Advocate utilizes the services of an independent investment consultant to assist in the evaluation of the performance of investment managers and the total portfolio. At December 31, 2014, Advocate had approximately 13% of its investment assets invested in domestic equities, 19% in international equities, 24% in fixed income, 7% in private equity, 22% in hedge funds and 15% in real assets. At December 31, 2014, Advocate was committed to fund $491.8 million to various private equity and real assets limited partnerships over the next seven years. The overall yields (not annualized) on Advocate s investment portfolio for the quarters ended December 31, 2014 and 2013 were 0.2% and 2.6%, respectively; for the years ended December 31, 2014 and 2013 were 3.6% and 7.1%, respectively. Additionally, Advocate held $335.8 million in a cash operating pool at December 31, Managed Care and Capitation Revenue Managed care payors accounted for approximately 44% of hospital admissions and 57% of net patient service revenue for the year ended December 31, Advocate continues to attempt to secure reasonable reimbursement rates. In the first quarter of 2015, Advocate finalized a two year contract, through December 31, 2016, with a significant payor, Health Care Service Corporation, d/b/a Blue Cross and Blue Shield of Illinois ( Blue Cross ), which represented approximately 29% of Advocate s net patient service revenue for the year ended December 31, Since June 1998, Advocate has been party to a capitated physician provider 36

40 agreement with Humana Health Plan, Inc. and Humana Insurance Company and their affiliates ( Humana ). The commercial and Medicare HMO products of this capitated agreement are with Advocate s wholly owned medical groups and as of July 1, 2012 also include Humana s Medicare PPO product. Advocate also has hospital agreements with Humana. All of these agreements automatically renew for one year terms commencing on each January 1 unless either party provides a notice of termination. All of the agreements were automatically renewed for Capitation revenue received under the commercial and Medicare HMO agreements with Humana amounted to 42% and 38% of total capitation revenue for the years ended December 31, 2014 and 2013, respectively. Contracts with other managed care payors are generally no more than two years in length and subject to automatic renewal, renegotiation or termination at end of term. Negotiations related to contract renewals can be acrimonious and such contracts may or may not be renewed. Advocate cannot predict with any certainty the ultimate outcome of future negotiations with managed care payors as contracts expire. As of the date of this document, there are no managed care contracts under termination notice. Management anticipates that the Affordable Care Act will continue to alter the commercial health care insurance industry. The Affordable Care Act imposes, over time, increased regulation of the industry, the use and availability of state based exchanges in which health insurance can be purchased by certain groups and segments of the population, the extension of subsidies and tax credits for premium payments by some consumers and employers and the imposition upon commercial insurers of certain terms and conditions that must be included in contracts with providers. In addition, the Affordable Care Act imposes many new obligations on states related to health care insurance. It is unclear how the increased federal oversight of state health care may affect future state oversight or affect Advocate. The effects of these changes upon the financial condition of any third party payor that offers health care insurance, rates paid by third party payors to providers and thus the revenues of Advocate, and upon the operations, results of operations and financial condition of Advocate cannot be predicted. Guarantees of Debt, Swaps and Other Derivatives and Financing Arrangements Interest Rate Swaps: As described in Note J, Advocate entered into multiple floating to fixed interest rate swap arrangements with respect to the Series 2008C Bonds (collectively, the Series 2008C Swaps ) pursuant to ISDA Master Agreements. Pursuant to the Series 2008C Swaps, Wells Fargo Bank, National Association ( Wells Fargo ) and PNC Bank, National Association ( PNC ) pay AHCN the sum of a percentage of the one month London Interbank Offered Rate ( LIBOR ) plus a spread, and AHCN pays Wells Fargo and PNC amounts based on a fixed rate (approximately 3.605%). All Wells Fargo, PNC and AHCN payments are made on a same day net payment basis with reference to a notional amount that declines over the term of the Series 2008C Swaps. Unless terminated earlier in accordance with their terms, the Series 2008C Swaps scheduled termination date is November 1, Under certain circumstances, however, the Series 2008C Swaps are subject to termination prior to the scheduled termination date. See Note I Fair Value Measurements and Note J Derivatives to the Interim Condensed Consolidated Financial Statements for the fair value and a description of the accounting treatment of Advocate s interest rate swap arrangements. 37

41 Debt Guarantees: Advocate has agreed to provide a $1.0 million loan to a third party under the terms of a management service organization agreement. At December 31, 2014 and December 31, 2013, $1.0 million has been loaned under this agreement. In connection with certain Advocate joint ventures, Advocate has guaranteed $1.0 million of those joint ventures outstanding debt as of December 31, Securities Lending: As part of the management of the investment portfolio, Advocate has entered into an arrangement whereby securities owned by Advocate are loaned, primarily to brokers and investment banks. The loans are arranged through a bank. Borrowers are required to post collateral in the form of cash or highly rated securities for securities borrowed equal to approximately 102% 105% of the value of the security loaned on a daily basis. The bank is responsible for reviewing the credit worthiness of the borrowers. Advocate has also entered into an arrangement whereby the bank is responsible for the risk of borrower bankruptcy and default. At December 31, 2014, Advocate loaned approximately $19.1 million in securities and accepted collateral for these loans in the amount of $19.8 million, of which $19.8 million represented cash collateral. The collateral received under the securities lending program has been reflected as a current asset and a current obligation payable in the interim condensed consolidated balance sheets presented. The balance of securities loaned and accepted collateral fluctuates on a daily basis. Potential for New Corporate Affiliations Health care is currently a very dynamic market. Advocate is actively exploring new opportunities for affiliations with, and acquisitions of, other institutions and organizations. Advocate will continue to consider any potential affiliations that may be in the best interest of Advocate. In September 2014 Advocate entered into an affiliation agreement (the Affiliation Agreement ) with NorthShore University HealthSystem ( NorthShore ) to form a 16 hospital system to be called Advocate NorthShore Health Partners ( ANHP ). If completed, AHCN would become the sole corporate member of NorthShore. ANHP would be the largest integrated health care delivery system in Illinois and the 11 th largest not for profit health care system in the United States, serving three million patients annually. Advocate believes that combining the two organizations will create a preeminent health care system, focused on a patient centered, fully integrated population health delivery model. The Affiliation Agreement outlines plans to consolidate balance sheets of the two organizations, with governance by a single Board of Directors, as well as a unified mission, vision and strategy. The ANHP Board of Directors would be made up of an equal number of members from Advocate and NorthShore. The completion of this transaction, currently targeted for 2015, is subject to the receipt of regulatory approval from the Federal Trade Commission. Advocate and NorthShore are reviewing the optimal debt 38

42 structure for ANHP, and no decisions have been made at this time regarding any debt restructuring for either of the entities. NorthShore cares for patients at four hospitals Evanston Hospital, Glenbrook Hospital, Highland Park Hospital and Skokie Hospital and through a multispecialty physician practice, NorthShore Medical Group, comprised of approximately 900 primary and specialty care physicians located in 100 plus offices across Chicago and many of the northern suburbs. NorthShore also supports the NorthShore Research Institute, the NorthShore Philanthropic Foundation and NorthShore Home & Hospice Services. As of and for the year ended September 30, 2014, NorthShore s audited year end results posted on EMMA reported approximately $2,177.9 million of total net assets and $1,927.5 million in total unrestricted revenues. At September 30, 2014, NorthShore had approximately $367.2 million of long term indebtedness outstanding, including current maturities. There were no other significant affiliations, acquisitions or divestitures completed during the year ended December 31, 2014 or from January 1, 2015 through the date of this document. Commitments Advocate has various commitments to construct additions and renovations to its medical facilities and future minimum rental commitments under the terms of non cancellable leases. Obligations entered into prior to January 1, 2015 are described in Note 11 to the Advocate Health Care Network and Subsidiaries 2014 Audited Consolidated Financial Statements. Executive Management There were no changes to executive management in 2014 and from January 1, 2015 through the date of this document. Ratings Moody s Investors Services, Inc. ( Moody s ), Standard and Poor s Rating Services ( S&P ) and Fitch Ratings ( Fitch ) have assigned long term ratings of Aa2, AA and AA, respectively, to the long term debt of Advocate. There were no changes to Advocate s assigned long term ratings during 2013, 2014 or from January 1, 2015 through the date of this document. In connection with various bond issues Advocate has obtained short term credit ratings from each of the three rating agencies. Moody s, S&P and Fitch have assigned short term ratings of Aa2/VMIG1, A 1+ and F1+, respectively. There were no changes to Advocate s assigned short term ratings during 2013, 2014 or from January 1, 2015 through the date of this document. The aforementioned ratings reflect only the view of the rating agency providing the same and an explanation of the significance of such ratings may be obtained only from the rating agency furnishing the same. Certain information and materials not included in this unaudited quarterly report may have been furnished to the rating agencies. Generally, rating agencies base their ratings on the information and materials 39

43 so furnished and on investigations, studies and assumptions performed or made by the rating agencies. There is no assurance that the ratings will continue for any given period of time or that these ratings will not be revised downward or withdrawn entirely by any of such rating agencies if, in the judgment of such rating agency, circumstances so warrant. Any downward revision or withdrawal of such ratings may have a material adverse effect on the market price of Advocate s outstanding tax exempt bonds. Budget Control Act of 2011 The Budget Control Act of 2011 (the Budget Control Act ) limits the federal government s discretionary spending caps at levels necessary to reduce expenditures by $917 billion from the current federal budget baseline through fiscal year Medicare, Social Security, Medicaid and other entitlement programs will not be affected by the limit on discretionary spending caps. The Budget Control Act also created a Joint Select Committee on Deficit Reduction (the Super Committee ), which was tasked with making recommendations, on or before November 23, 2011, to further reduce the federal deficit by $1.5 trillion. After several months of negotiations, the Committee was unable to reach agreement on spending reductions, putting into motion $1.2 trillion in spending cuts (known as sequestration). Provisions of the Budget Control Act, as modified by the Taxpayer Relief Act, set in place a protocol for the sequestration resulting in an automatic 2% reduction in Medicare program payments for all healthcare providers and Medicare Advantage insurers that would have gone into effect on March 27, However, on March 26, 2013, President Obama signed into law the Consolidated and Further Continuing Appropriations Act of 2013, which provided funds for operation of the federal government through December 31, 2013 and offset some of the sequestration mandated reductions for federal fiscal year The spending reductions for federal fiscal year 2013 were approximately $85.4 billion with similar cuts for federal fiscal years 2014 through In December 2013, the President signed the Bipartisan Budget Act of 2013 that increased the sequestration caps for federal fiscal years 2014 and 2015 by $45 billion and $18 billion, respectively, but extended the caps into 2022 and Because Congress may make changes to the budget in the future, it is impossible to predict the impact any spending cuts that are approved may have on Advocate. Further, with no long term resolution in place for federal deficit reduction, hospital and physician reimbursement are likely to continue to be targets for reductions with respect to any interim or long term federal deficit reduction efforts. These and any additional reductions in Medicare spending could have a material adverse effect upon the financial condition or operations of Advocate. Jobs Creation Act The Middle Class Tax Relief and Job Creation Act of 2012 (the Jobs Creation Act ), as amended by the Taxpayer Relief Act, delayed through the end of 2013 the implementation of certain scheduled cuts to physician payments mandated by the sustainable growth rate ( SGR ) formula that ties physician reimbursement to the gross domestic product. In 2013, Medicare physician reimbursement would have been cut by 26.5% but for this extension. The Jobs Creation Act provides that the approximately $17 billion cost of delaying the scheduled cuts for physician payments be achieved by providing for cuts in other areas of health care, including reductions in Medicaid payments to hospitals with a disproportionate share of uninsured 40

44 patients, as well as reducing Medicare s reimbursement to providers for beneficiaries unpaid coinsurance and deductible amounts after reasonable collection efforts. Prior to the enactments of the Jobs Creation Act, Medicare reimbursed hospital providers 70 percent of beneficiary bad debt. The Jobs Creation Act reduces that reimbursement level to 65 percent. In 2014, the Protecting Access to Medicare Act of 2014 was passed which delayed scheduled SGR reductions of 24% until March On March 24, 2015, U.S. House of Representative Republican and Democratic leadership released legislation to permanently replace the SGR formula. The proposed legislation included details to pay for the approximately $210 billion cost associated with eliminating the SGR formula. Structural changes to the Medicare program account for $70 billion of this cost. Reductions in payments for treating Medicare beneficiaries may have a material adverse effect on the financial condition or operations of Advocate. The Taxpayer Relief Act also continues a number of Medicare policies known as extenders. Those extenders include a wide variety of policies, including special provisions for some low volume hospitals and charges for ambulance and physical therapy costs. The $30 billion cost of these provisions is expected to be partially offset by a reduction of payments to hospitals over the next decade, including an estimated $10.5 billion reduction in the projected Medicare hospital payments over 10 years for inpatient or overnight care (through a downward adjustment in annual base payment increases), and a reduction in the Medicaid disproportionate share payments to hospitals by an additional $4.2 billion over the same period. These cuts are in addition to those made with respect to hospitals as part of the Affordable Care Act. As noted above, reductions in payments for treating Medicare beneficiaries may have a material adverse effect on the operating results, cash flow and financial condition of Advocate. Debt Limit Increase The federal government has through legislation created a debt ceiling or limit on the amount of debt that may be issued by the United States Treasury. In the past several years, political disputes have arisen within the federal government in connection with discussions concerning the authorization for an increase in the federal debt ceiling. Any failure by Congress to increase the federal debt limit may impact the federal government s ability to incur additional debt, pay its existing debt instruments and to satisfy its obligations relating to the Medicare and Medicaid programs. Management is unable to determine at this time what impact any failure to increase the federal debt limit may have on the operations and financial condition of Advocate, although such impact may be material. Additionally, the market price or marketability of Advocate s outstanding bonds in the secondary market may be materially adversely impacted by any failure to increase the federal debt limit. Health Care Reform The Affordable Care Act was enacted in 2010 to overhaul the United States health care system and regulate many aspects of health care delivery and financing. Some of the provisions of the Affordable Care Act took effect immediately, or were phased in over time. The remaining provisions are expected to take effect or be phased in over the next one to five years. The Affordable Care Act also requires the promulgation of substantial regulations with significant effects on the health care industry and third party payors. In response, third party payors and suppliers and vendors of goods and services to health care providers are expected to 41

45 impose new and additional contractual terms and conditions. Thus, the health care industry will continue to be subjected to significant new statutory and regulatory requirements and contractual terms and conditions, and consequently to structural and operational changes and challenges, for a substantial period of time. The constitutionality of the Affordable Care Act has been challenged in courts around the country. On June 28, 2012, the U.S. Supreme Court in its decision in National Federation of Independent Business v. Sebelius issued a ruling upholding certain provisions of the Affordable Care Act, including an individual mandate (which began in 2014, generally requiring individuals to have a certain amount of health insurance coverage or pay a penalty), thus allowing implementation of the law to go forward. As of January, 2014, the Affordable Care Act provided for the expansion of Medicaid programs to a broader population with incomes up to 133% of federal poverty levels. In its decision in National Federation of Independent Business v. Sebelius, the U.S. Supreme Court determined that any expansion of Medicaid must be at the option of individual states, and not a mandatory obligation. The Court reasoned that permitting the federal government to condition the availability of current Medicaid funding on participation in the expanded Medicaid program equated to a mandate that States participate in the expanded Medicaid program. Although the federal government is expected to almost entirely fund the expanded Medicaid program through 2020, some state officials have expressed reluctance to participate, citing concerns that the administrative and other costs associated with enrolling and managing potentially millions of new individuals would add further stress to already depleted state resources. In the event a state chooses not to participate in the expanded Medicaid program, the net effect of the reforms contained in the Affordable Care Act could be significantly reduced. Illinois is currently participating in the expanded Medicaid program. Attempts to amend and repeal provisions of the Affordable Care Act were introduced in previous Congressional sessions and certain amendments to the Affordable Care Act were contained in the American Taxpayer Relief Act of 2012 (the Taxpayer Relief Act ) signed into law by President Obama on January 3, There are also challenges to other provisions of the Health Care Reform Act in pending litigation. In March 2015, the United States Supreme Court heard oral arguments in a case regarding the federal government s right to subsidize health insurance premiums in states that use the federal health insurance exchange rather than a state run exchange. A decision on this case is expected in June or July of If this challenge is successful, individuals who obtained health care insurance through the federal health insurance exchange may lose their tax credit subsidies. Attempts to amend and repeal provisions of the Health Care Reform Act were introduced in previous Congressional sessions and certain amendments to the Health Care Reform Act were contained in the Taxpayer Relief Act. The ultimate outcome of any legislative efforts to repeal, amend, eliminate or reduce funding for the Health Care Reform Act are unknown. Results of recent Congressional elections and of the Presidential election in 2016 could affect the outcome of those efforts. A significant component of the Affordable Care Act is reformation of the sources and methods by which consumers will pay for health care for themselves and their families and by which employers will procure health insurance for their employees and dependents of their employees and, as a consequence, expansion in the overall number of consumers of health care services. The Affordable Care Act was designed, in substantial part, to make available, or subsidize the premium costs of, health care insurance for some of the millions of currently uninsured (or underinsured) consumers, in particular, those who fall below certain 42

46 income levels. The Affordable Care Act proposed to accomplish that objective through various provisions, summarized as follows: (i) the creation of active markets (referred to as exchanges) in which individuals and small employers can purchase health care insurance for themselves and their families or their employees and dependents, (ii) the provision of means tested subsidies for premium costs to certain individuals and families based upon their income relative to federal poverty levels, (iii) the requirement that individual consumers obtain and certain employers provide a minimum level of health care insurance, and the provision of a penalty in the form of taxes on consumers and employers that do not comply with these mandates, (iv) the expansion of private commercial insurance coverage generally through such reforms as prohibitions on denials of coverage for pre existing conditions and elimination of lifetime or annual cost caps, and (v) the expansion of existing public programs for individuals and families, including Medicaid. To the extent any of all of those provisions produce the expected result, an increase in utilization of health care services by those who are currently avoiding or rationing their health care can be expected. Although bad debt expenses and/or charity care provided may be reduced, increased utilization will be associated with increased variable and fixed costs of providing health care services, which costs may or may not be offset by increased revenues. In March 2012, the Congressional Budget Office ( CBO ) estimated that by 2012, as a result of the Affordable Care Act, some million people will receive coverage through the new insurance exchanges, and over 17 million additional people will be enrolled in Medicaid and the Children s Health Insurance Program ( CHIP ). However, approximately 6 million fewer people are projected to purchase individual coverage directly from insurers or obtain coverage through their employers, resulting in an estimated net increase in the number of people with private insurance coverage of about 16 million. Importantly, the CBO estimates do not reflect the Supreme Court s decision in National Federation of Independent Business v. Sebelius, which precludes the HHS Secretary from penalizing states that choose not to participate in the Medicaid expansion. It is anticipated that providers operating in markets with large Medicaid and uninsured populations will benefit from increased revenues resulting from increased utilization and reductions in bad debt or uncompensated care. Such increase in utilization can also be expected to increase the cost of providing that care, which may or may not be balanced by increased revenues. To the extent the provisions of the Affordable Care Act remaining after the Supreme Court s decision in National Federation of Independent Business v. Sebelius produce the intended result, an increase in utilization of health care services by those who are currently avoiding or rationing their health care can be expected. Bad debt expenses may be reduced because reimbursement for otherwise uncompensated care will be received; however, the net impact of such an increase in utilization of health care services is difficult to predict, due to the rates of reimbursement under the Medicaid and Medicare programs, which could be further reduced. Increased variable and fixed costs of providing health care services will be associated with increased utilization, which may or may not be offset by increased revenues, as well as a risk of physician shortages, especially in specialties necessary to provide critical intervention or chronic disease management (e.g., primary care). The Affordable Care Act also contains more than thirty two sections related to health care fraud and abuse and program integrity as well as significant amendments to existing criminal, civil and administrative anti fraud statutes. The potential for increased legal exposure due to the Affordable Care Act s enhanced compliance and regulatory requirements, disclosure and transparency obligations, quality of care expectations and extraordinary enforcement provisions could increase Advocate s operating expenses. 43

47 With respect to charity care, the Affordable Care Act contains many features from previous tax exemption reform proposals, including a set of sweeping changes applicable to charitable hospitals exempt under Section 501(c)(3) of the Internal Revenue Code. The Affordable Care Act: (a) imposes new eligibility requirements for 501(c)(3) hospitals, coupled with an excise tax for failures to meet certain of those requirements; (b) requires mandatory IRS review of the hospitals entitlement to exemption; (c) sets forth new reporting requirements including information related to community health needs assessments and audited financial statements; (d) requires hospitals to adopt and publicize a financial assistance policy, limit charges to patients who qualify for financial assistance to the lowest amount charged to insured patients, and control the billing and collection processes; and (e) imposes further reporting requirements on the Secretary of the Treasury regarding charity care levels. Failure to satisfy these conditions may result in the imposition of fines and the loss of tax exempt status. The Affordable Care Act reduces the growth in Medicare payments. For example, the annual Medicare market basket updates for hospitals will be reduced through September 30, The market basket updates are subject to productivity adjustments. The reductions in market basket updates and the productivity adjustments will have a disproportionately negative effect on providers that rely more upon Medicare. Moreover, certain reductions in market basket updates take effect prior to the expansion of insurance coverage and the number of insured consumers. This sequence of events is expected to have an interim negative effect on revenues and operating income. The combination of reductions to the market basket updates and the imposition of the productivity adjustments may, in some cases and in some years, result in reductions in Medicare payments per discharge on a year to year basis. Additionally, payments under Medicare Advantage programs (Medicare managed care) will be periodically reduced through September 30, 2019, which may result in increased premiums or out of pocket costs to Medicare beneficiaries enrolled in Medicare Advantage plans. Those beneficiaries may terminate their participation in such plans opting instead for the traditional Medicare fee for service program. The reduction in payments to Medicare Advantage programs may also lead to decreased payments to providers by managed care companies operating Medicare Advantage programs. All or any of these outcomes will have a disproportionately negative effect upon those providers that rely more upon Medicare managed care revenues. On October 1, 2012, a value based purchasing program was established under the Medicare program designed to provide incentive payments to hospitals based on performance on quality and efficiency measures. These incentive payments are to be funded through a pool of money collected from all hospital providers. Depending on the performance of the Advocate s hospitals, their respective Medicare revenues could decrease under a value based purchasing program. As of October 1, 2013, and continuing through 2020, a state s Medicare disproportionate share hospital ( DSH ) payments allotment from federal funds will be reduced. Initially, Medicare DSH payments will be reduced by 75%. DSH payments will be increased thereafter to account for the national rate of consumers who do not have health care insurance and received uncompensated care. The Taxpayer Relief Act is expected to further reduce Medicare DSH payments to hospitals by $4.2 billion over the next 10 years, by rebasing future allocations. 44

48 The Hospital Readmissions Reduction program, which began in October 2012, reduces by specified percentages, Medicare payments to hospitals that have a high rate of potentially preventable readmissions of Medicare patients with certain clinical conditions to account for such excessive and preventable costs associated with hospital readmissions. As of October 1, 2014, Medicare payments to certain hospitals that experience high levels of hospitalacquired conditions are being reduced by 1%. As of July 1, 2011, federal payments to states for Medicaid services related to health care acquired conditions are prohibited. The Affordable Care Act also introduced a requirement that health care insurers include quality improvement covenants in their contracts with hospital providers and report the progress on such actions to the United States Department of Health and Human Service ( HHS ). Commencing January 1, 2015, health care insurers participating in the health insurance exchanges will be allowed to contract only with hospitals that have implemented programs designed to ensure patient safety and enhance quality of care. The effect of these provisions upon the process of negotiating contracts with insurers or the costs of implementing such programs cannot be predicted. With varying effective dates, the Affordable Care Act enhances the ability to detect and reduce waste, fraud, and abuse in public programs through provider enrollment screening, enhanced oversight periods for new providers and suppliers, and enrollment moratoria in areas identified as being at elevated risk of fraud in all public programs, and by requiring Medicare and Medicaid program providers and suppliers to establish compliance programs. The Affordable Care Act requires the development of a database to capture and share health care provider data across federal health care programs and provides for increased penalties for fraud and abuse violations and increased funding for anti fraud activities. The Affordable Care Act further provides for the establishment of an Independent Payment Advisory Board (the Board ) responsible for proposing policies to Congress to help both improve the quality of care under Medicare and lower costs. Beginning January 15, 2019, unless Congress enacts legislation related to the Board s recommendations, should the Medicare growth rate exceed the target growth rate and require (as determined by the CMS Office of the Actuary) the Secretary of HHS is required to implement the Board s proposals. The Affordable Care Act also creates a Center for Medicare and Medicaid Innovation to test innovative payment and service delivery models and to implement various demonstration programs and pilot projects designed to test, evaluate, encourage and expand new payment structures and methodologies to reduce health care expenditures while maintaining or improving quality of care. Such programs and projects include bundled payments under Medicare and Medicaid, as well as comparative effectiveness research programs that compare the clinical effectiveness of medical treatments and develop recommendations concerning practice guidelines and coverage determinations. Other provisions encourage the creation of new health care delivery programs, such as Accountable Care Organizations ( ACOs ) or combinations of provider organizations that voluntarily meet quality thresholds in order to either share in the cost savings they achieve for the Medicare program, or pay a penalty should quality of care decline or costs increase. Advocate has been selected to participate in the Medicare Shared Savings Program ( Shared Savings Program ) ACO, a multifaceted new program sponsored by CMS. The Shared Savings Program, one of three federal ACO 45

49 programs, is intended to provide financial incentives for providers to better coordinate patient care through use of electronic medical records and performance metrics that lead to savings if patients health outcomes, safety and care experience improve. The outcomes of these projects and programs, including Advocate s participation in a Shared Savings Program ACO, and their effect on payments to providers and financial performance, cannot be predicted. As a result of the foregoing, health care providers such as Advocate could face additional strains on their operations, financial performance and condition. Management and its professional advisors continue to analyze the Affordable Care Act to assess its effects on current and projected operations, financial performance and financial condition. However, management cannot predict with any reasonable degree of certainty or reliability any interim or ultimate effects of the law and/or regulations. The Affordable Care Act has made several changes to the Medicare program, ranging from changes to amounts payable to providers through imposition, directly or indirectly, of quality assurance measures. The Affordable Care Act also amended certain provisions of the Federal False Claims Act regarding the timing of the obligation to reimburse overpayments. Further, the Affordable Care Act authorizes the Secretary of HHS to exclude a provider s participation in the Medicare, Medicaid and Children s Health Insurance Program ( CHIP ) programs as well as to suspend payments to a provider pending an investigation of a credible allegation of fraud against the provider. Continued Pressures on and changes to State Funded Programs In Illinois, Medicaid is administered by the Illinois Department of Healthcare and Family Services ( IDHFS ). The State of Illinois continues to be adversely affected by fiscal considerations that affect its budget for programs such as Medicaid. Historically, federal payments and amounts appropriated by the Illinois General Assembly for payment of Medicaid claims have not been sufficient to reimburse hospitals for their actual costs in providing services to Medicaid patients. Also, the State of Illinois has routinely failed to pay Medicaid claims on a timely basis. The Save Medicaid Access and Resources Together Act ( SMART Act ), passed in 2012, includes approximately $1.6 billion in cuts to the state s Medicaid funding, representing approximately $1.36 billion in program reductions and $240 million in reimbursement rate cuts. Separately, Public Act provides that the maximum amounts of unpaid Medicaid Assistance bills received and recorded on or before June 30 of a particular fiscal year that may be paid by IDHFS from future fiscal year Medicaid Assistance appropriations is $100 million for fiscal year 2014 and each fiscal year thereafter. This amount was $700 million in fiscal year On March 23, 2015, Illinois legislative leaders and Governor reached a deal on addressing the fiscal year 2015 state budget shortfall. House Bills 317 and 318 call for $1.3 billion in fund sweeps and across the board funding cuts of 2.25% to address the $1.6 billion budget shortfall. On March 24, 2015 the Illinois House of Representatives passed both bills and the Illinois Senate is expected to vote on these bills by the end of March The targeted savings from Medicaid to address this budget shortfall amount to $160 million. The impact on Illinois hospitals is estimated to be $27 million and will come from a temporary three month increase of the provider assessment tax. The reduction in Medicaid services and programs, as well as any failure by the State of Illinois to pay Medicaid claims on a timely basis, may have an adverse effect on Advocate s operating results, cash flow and financial condition. 46

50 The Omnibus Medicaid Bill, Senate bill 741, as amended by House Amendment #1 (SB 741), passed in May 2014, authorizes a new hospital payment system and extends both the existing Medicaid assessment system and enhanced Medicaid assessment system to July 1, The new hospital payment system became effective July 1, The goal of the new payment system is to better align the payment for services rendered to Medicaid patients with the hospitals providing the services. Under the new hospital payment system, rates paid will be based on more current utilization data with a greater emphasis on accurate coding of claims. Quarterly fixed payments are being replaced with increased payments on a per claim basis. Outpatient rates are also being increased. SB 741 also provides that IDHFS will request from CMS approval for new federal dollars for hospitals serving newly eligible Medicaid recipients under the Affordable Care Act. IDHFS estimates this will provide approximately $400 million of new annual federal funding to be distributed to hospitals across Illinois. The distribution of this new funding is designed to mirror the two current hospital assessment systems distributions. The additional funding from CMS was approved in January Laws, Regulations and Related Litigation As a health care provider, Advocate and its subsidiaries and affiliates are subject to extensive and frequently changing federal, state and local laws and regulations governing various aspects of our business. In particular, Advocate and its subsidiaries provide a broad range of services, many of which are regulated by different government agencies, subject to differing regulatory schemes and subject to contractual reviews and program audits in the normal course of business. Many operations that Advocate and its subsidiaries undertake are subject to significant governmental certification and licensing regulations, as well as federal and state laws, including those relating to: fraud and abuse; billing and pricing practices; kickbacks, referrals, rebates and fee splitting; antitrust; tax exempt status, including intermediate sanctions; tax exempt financing including the use of bond proceeds; marketing, sales, and pricing practices; privacy and security of personal health care information; human subject research; the handling and disposal of medical specimens, hazardous waste and controlled substances; and occupational safety and consumer protection. Government agencies and private whistleblowers have made enforcement of the provisions relating to false claims, kickbacks, physician self referral and various other fraud and abuse laws a major priority in recent years. Potential sanctions for violation of these statutes and regulations include significant fines and criminal penalties and the loss of various licenses, certificates and authorizations and loss of tax exempt status. On March 17, 2014, Advocate, certain of its subsidiaries, and certain of its board members and employees were named as defendants in a lawsuit challenging the church plan status of one of Advocate s defined benefit plans. Stapleton, et al v Advocate Health Care Network, et al, Civil No 14 cv (N. District 47

51 of Illinois). The complaint alleges that one of Advocate s defined benefit plans (i) does not meet the definition of a church plan under the Employee Retirement Income Security Act ( ERISA ); (ii) was underfunded; and (iii) violated various provisions of ERISA applicable to covered defined benefit plans; or, alternately, if Advocate s defined benefit plan qualifies for church plan status, the church plan exemption is an unconstitutional accommodation under the Establishment Clause of the First Amendment. Advocate and the other named defendants intend to oppose the certification of a class of plaintiffs and to vigorously defend the suit. Advocate has relied upon an Internal Revenue Service ruling issued to it that its Plan is a Church Plan and is confident that the Plan meets the Church Plan definition under the statute. On January 21, 2015, the U.S. Federal District Court denied Advocate s Motion to Dismiss and the Court ruled that a Church must establish a Church Plan. The Court further found that Advocate s Pension Plan was not established by a Church, and therefore, is not exempt from ERISA and the Church Plan exemption. Advocate filed a Motion for Interlocutory Appeal to the 7 th Circuit Court of Appeals. The 7 th Circuit granted Advocate s Motion and the case is now on appeal before the 7 th Circuit Court of Appeals. Although the outcome of this litigation cannot be determined with certainty, Management is not in possession of any information to suggest that the costs relating to the defense and resolution of this lawsuit will have a material adverse effect on Advocate s operating results, cash flow or financial condition. The Civil Division of the Department of Justice ( DOJ ) has contacted Advocate in connection with the DOJ s nationwide review of whether, in certain cases, hospital charges to the federal government relating to implantable cardio defibrillators met the CMS criteria. In connection with this nationwide review, the DOJ reviewed certain ICD billing and medical records at certain of Advocate s hospitals for the period from October 1, 2003 through September 30, In the interest of avoiding the delay, uncertainty, inconvenience and expense of protracted litigation, and without any admission of liability, Advocate and the DOJ agreed in December 2014 to settle this matter. This settlement did not have a material effect on the operating results, cash flow or financial condition of Advocate. The Affordable Care Act has made several changes to the Medicare program, ranging from changes to amounts payable to providers through imposition, directly or indirectly, of quality assurance measures. The Affordable Care Act also amended certain provisions of the Federal False Claims Act and added provisions respecting the timing of the obligation to reimburse overpayments. Further, the Affordable Care Act authorizes the Secretary of HHS to exclude a provider s participation in the Medicare, Medicaid and CHIP programs as well as to suspend payments to a provider pending an investigation of a credible allegation of fraud against the provider. Advocate expects that the level of review and audit to which it and other health care providers are subject will increase. To foster compliance with applicable laws, Advocate has a compliance program that is designed to detect and correct potential violations of laws and regulations related to its programs. Advocate also tracks enforcement trends, closely reviews government advisories concerning suspect practices, and regularly undertakes to educate its officers, associates and vendors concerning applicable laws and regulations. However, many of the laws and regulations affecting Advocate and its subsidiaries and affiliates have not been interpreted by regulators or the courts or have been subject to varying interpretations. As a result, regulators may contend that they have broad authority to assert claims for noncompliance and assert claims or penalties based upon their interpretation of those requirements. It is not possible to determine the impact, if any, such claims or penalties would have upon Advocate and its subsidiaries. 48

52 The Health Insurance Portability and Accountability Act of 1996 ( HIPAA ) added two prohibited practices, the commission of which may lead to civil monetary penalties: (1) the practice or pattern of presenting a claim for an item or service on a reimbursement code that the person knows or should know will result in greater payment than appropriate, i.e., upcoding, and (2) the practice of submitting claims for payment for medically unnecessary services. Violation of such prohibited practices due to civil neglect could amount to civil monetary penalties ranging from $50,000 to $1.5 million for all identical violations in a calendar year and/or imprisonment. Advocate management does not expect that the prohibited practices provisions of HIPAA will affect Advocate in a material respect. HIPAA also includes administrative simplification provisions intended to facilitate the processing of health care payments by encouraging the electronic exchange of information and the use of standardized formats for health care information. Congress recognized, however, that standardization of information formats and greater use of electronic technology presents additional privacy and security risks due to the increased likelihood that databases of personally identifiable health care information will be created and the ease with which vast amounts of such data can be transmitted. Therefore, HIPAA requires the establishment of distinct privacy and security protections for individually identifiable health information ( Protected Health Information or PHI ). HHS promulgated privacy regulations under HIPAA (the Privacy Rule ) that protect the privacy of PHI maintained by health care providers (including hospitals), health plans, and health care clearinghouses (collectively, Covered Entities ) and provides individuals with certain rights regarding their PHI (including, for example, access to PHI, amending PHI, and receiving an accounting of disclosures of PHI). Security regulations also have been promulgated under HIPAA (the Security Rule ). The Security Rule requires Covered Entities to have certain administrative, technical, and physical safeguards in place to ensure the confidentiality, integrity, and availability of all electronic PHI they create, receive, maintain, or transmit. Additionally, HHS promulgated regulations to standardize the electronic transfer of information pursuant to certain enumerated transactions (the Transactions and Code Sets Rule ). The 2009 Health Information Technology for Economic and Clinical Health Act (the HITECH Act ) significantly changed the landscape of federal privacy and security laws regarding PHI. The HITECH Act (i) extended the reach of HIPAA, certain provisions of the Privacy Rule, and the Security Rule, (ii) imposed a breach notification requirement on HIPAA covered entities and their business associates, (iii) limited certain uses and disclosures of PHI, (iv) increased individuals rights with respect to PHI, and (v) increased enforcement of, and penalties for, violations of the privacy and security of PHI. The HITECH Act also created a federal breach notification requirement that mirrors protections that many states have passed in recent years. This requirement provides that the System must notify patients of any unauthorized access, acquisition, or disclosure of their unsecured PHI that poses significant risk of financial, reputational or other harm to a patient. In addition, a new breach notification requirement was established requiring reporting to the Secretary of HHS and, in some cases, local media outlets, of certain unauthorized access, acquisition, or disclosure of unsecured PHI that poses significant risk of financial, reputational or other harm to a patient. In January 2013, HHS issued an omnibus final rule interpreting and implementing various provisions of the HITECH Act, including a final breach notification rule. In addition, Advocate s facilities are also subject to 49

53 any state law that is related to the reporting of data breaches and more restrictive than the regulations and/or requirements issued under HIPAA and the requirements of the HITECH Act. Any violation of HIPAA and, the HITECH Act or regulations promulgated thereunder is subject to HIPAA civil and criminal penalties, including monetary penalties and/or imprisonment. Advocate believes that all of its health care facilities are in substantial compliance with HIPAA, the HITECH Act, and the rules promulgated thereunder; however, in 2013, four password protected computers were stolen in a break in at one of Advocate s administrative support locations. Certain patient information was contained on the computers. Advocate has determined that while the computers did not contain patient medical records, they did house patient information, including names, addresses, dates of birth and Social Security numbers. The computers also had limited clinical information, such as the treating physicians and/or departments, diagnoses, medical record numbers, medical service codes, and health insurance data. Affected patients were notified and offered free credit monitoring and identity theft protection. The data breach is being investigated by HHS s Office for Civil Rights (the OCR ) and the Illinois Attorney General s office for possible HIPAA and Illinois privacy law violations. Advocate is cooperating with these agencies in their investigations. Numerous class action lawsuits and one individual complaint have been initiated on behalf of the affected patients. As of the date of this Report, three of the class action cases (Tierney vs. Advocate filed in U.S. District Court, Vides vs. Advocate filed in Lake County Court and Maglio vs. Advocate filed in Kane County court) have been dismissed with prejudice. Plaintiff s counsel for these cases is considering their options with regard to the appeal of these decisions. Based upon Advocate s investigation, while partnering with both local and federal authorities, there is no reason to believe that any of the information contained on the stolen computers has been misused or compromised. However, due to the significant concern related to this event Advocate will continue to monitor and investigate these matters and related complaints in regard to any incident involving patient information. While no assurance can be given that the outcome of these investigations and this litigation will be favorable to Advocate, at this time management believes that because of Advocate s privacy policies and practices, the costs relating to the resolution of this incident will not have a material adverse effect on Advocate s operating results, cash flow and financial condition. Billing Practices for Uninsured and Under Insured Patients Both Federal and State authorities have opened investigations into the health care industry s billing practices for uninsured and underinsured patients. Billing and collection practices of hospitals continue to be subject to the intense scrutiny of federal, state and local governmental agencies. Billing and collection practices and procedures are governed by a detailed and complex array of federal Medicare statutes, regulations and policy pronouncements. Advocate believes that its billing and collection practices are consistent with federal and state policies and regulations and intends to vigorously defend its practices if challenged. Advocate management believes that its billing and collection practices comply with current law, though as indicated in the section above entitled Laws, Regulations and Related Litigation, laws and regulations related to billing practices have not been interpreted by the courts or regulators or have been subject to varying interpretations. 50

54 As a faith based health care organization, the mission, values and philosophy of Advocate form the foundation for its strategic plan. Advocate s mission is to serve the health care needs of individuals, families and communities through a wholistic philosophy rooted in the fundamental understanding of human beings as created in the image of God. The number of uninsured and underinsured individuals is a national issue and the State of Illinois has a significant number of uninsured and underinsured individuals. Families with income levels of up to six hundred percent of the federal poverty level are eligible for free or discounted care. Additionally, Advocate does not place liens on primary residences and considers employment status and financial resources of insured and uninsured patients before taking legal action in its accounts receivable collection efforts. As community needs evolve Advocate periodically reviews and revises its policies and procedures relating to charity care. Tax Exempt Status Due to budget deficits and declining tax revenues and the growing numbers of uninsured and underinsured individuals in the United States, federal, state and local governments are increasingly scrutinizing the tax status of not for profit hospitals. Over the past several years, various hearings and studies have been undertaken by the federal government related to the tax status of entities exempt from federal income tax under Section 501(c)(3) of the Internal Revenue Code. Some of these hearings and studies were designed to address the question of equating tax exempt status with community benefits provided. Other issues addressed included executive compensation levels and corporate compliance. Management cannot predict whether these hearings or studies will ultimately lead to new or changed legislation or regulations that will affect Advocate s tax exempt status. The status of real property and sales tax exemptions for nonprofit health care providers has been under scrutiny in the State of Illinois for a number of years. As a result, in June 2012, the State of Illinois enacted legislation (the Illinois Property and Sales Tax Act ) creating new standards for real property and sales tax exemptions for health care providers operating in the State. The Illinois Property and Sales Tax Act provides that a hospital owner or hospital affiliate satisfies the conditions for an exemption from real property taxation if the value of qualified services or activities for the hospital year equals or exceeds the relevant hospital entity's estimated property tax liability for the calendar year in which exemption or renewal of exemption is sought. Nonprofit hospitals that satisfy this test will also be exempt from the State s sales and use tax. The Illinois Property and Sales Tax Act includes a list of the items that are included within the definition of qualified services and activities, including charity care (free or discounted services pursuant to the hospital s financial assistance policy, measured at cost); health services to low income or underserved individuals (including, without limitation, financial or in kind support relating to the care and treatment of low income or underserved individuals); subsidies provided to State or local governments for programs related to health care for low income or underserved individuals; support for State health care programs for low income individuals; and the portion of unreimbursed costs attributed to providing, paying for, or subsidizing goods, activities or services that relieve the burden of government relating to health care for low income individuals, including, without limitation, the provision of medical education and training of health care professionals as well as the provision of emergency, trauma, burn, neonatal, psychiatric, rehabilitation or other special services. 51

55 Prior to the passage of the Illinois Property and Sales Tax Act, Illinois law required organizations exempt from sales and use tax to request renewal of their exemption every five years. Certain Advocate entities applied for renewal of their exemptions, and subsequently received letters from IDOR indicating that their applications were under review. In these letters, the Illinois Department of Revenue ( IDOR ) indicated that these entities could continue to operate under their current exemptions (provisional extensions) until a final determination is made. In July 2013, IDOR began notifying hospital companies with expired sales tax exemption certificates and who were operating under provisional extensions, including certain Advocate entities that in order to renew their sales tax exempt status they had to complete and submit a newly released exemption application form by September 3, 2013 unless an extension of time to complete was requested and approved. Management submitted exemption application forms for each of the affected Advocate entities, and has received exemption approvals for all the affected entities. In March 2014, Management filed an exemption application for Advocate Condell as the current exemption expired in May 2014, and is awaiting a decision from IDOR. Until a decision is rendered Advocate Condell continues to qualify under its prior exemption. A lawsuit against IDOR is pending challenging the constitutionality of the Illinois Property and Sales Tax Act. Management cannot predict whether that lawsuit will be successful or not. Management cannot predict whether the Illinois Property and Sales Tax Act will have a material impact on the operating results, cash flow and financial condition of Advocate in regards to future property or sales tax exemption applications if an adverse ruling(s) is received. As set forth elsewhere in this report, a variety of Advocate s practices are under examination by a number of governmental agencies and private parties. Moreover, some commentators have suggested that the Affordable Care Act (see discussion above) will result in additional scrutiny of tax exempt health care providers, including expanding the requirements for maintenance of Section 501(c)(3) status by hospitals to include maintenance and monitoring of charity care policies and procedures. Although no government entity has yet challenged Advocate s tax exempt status, the increased government scrutiny could lead federal, state or local agencies to challenge Advocate s tax exempt status. Charity Care and Patient Billing Legislation In addition to the increased scrutiny that tax exempt hospitals have faced in the past few years through federal and state charity care litigation, congressional hearings and Internal Revenue Service examinations, the Office of the Illinois Attorney General (the Attorney General ) has also directed its attention toward state legislative and regulatory initiatives relating to tax exempt hospitals. Under current Illinois law, tax exempt hospitals are required annually to submit audited financial statements and detailed community benefits reports to the Attorney General. The Fair Patient Billing Act relates to Illinois Hospitals billing and collection procedures and the Hospital Uninsured Patient Discount Act requires all hospitals to provide discounts to uninsured patients meeting certain eligibility requirements and to establish a maximum collectible amount of 25% of annual family income for eligible individuals. Also, the Uninsured Charity Care Act, which was passed in June 2012, strengthened Illinois hospitals charity care obligations that are detailed in the Hospital Uninsured Patient 52

56 Discount Act to require, among other things (i) the Attorney General to develop standard provisions in applications for financial assistance, together with rules for determining presumptive eligibility and (ii) hospitals, other than rural hospitals or critical access hospitals to provide a charitable discount for all medically necessary health care services exceeding $300 to uninsured individuals who apply for such a discount and who have a family income of not more than 200% of the federal poverty guidelines and rural hospitals or critical access hospitals to provide medically necessary free care to individuals with family income of up to 125% of the federal poverty guidelines. The Illinois Attorney General s rules, which became effective on January 1, 2014, require specific disclosures in financial assistance applications and limit the information that a hospital may require on its forms used to determine eligibility for assistance. The new rules also require each hospital to develop and implement a presumptive eligibility policy identifying specific eligibility criteria by which a patient may be deemed eligible for financial assistance as soon as possible after receiving health care services and prior to the issuance of any bill for such services. Management believes that Advocate is in substantial compliance with these rules. Corporate Compliance Advocate has established a Business Conduct Program (the Compliance Program ) intended to assist Advocate Board members, associates, physicians and vendors to conform their actions to comply with the numerous laws and regulations applicable to the healthcare industry. As part of this program, Advocate has developed and implemented Business Conduct Guidelines, a Conflict of Interest Policy and a Code of Business Conduct to describe such laws and regulations and to give clear guidance as to the manner in which Advocate associates are to conduct their day to day activities. The Compliance Program is overseen by the Vice President, Chief Compliance Officer, who reports functionally and administratively to Advocate s Senior Vice President and General Counsel as well as functionally to the President and Chief Executive Officer, Executive Management Team and Advocate Business Conduct Committee. Each major site within Advocate has established a Site Business Conduct Committee in an effort to ensure that it is incorporating the Compliance Program into its operations. The Compliance Program is primarily concerned with the following areas: patient confidentiality, information privacy, information systems security, discrimination, harassment, safety and health, conflicts of interest, Medicare/Medicaid fraud and abuse laws, Stark anti referral legislation, and Medicare and Medicaid coding and billing procedures. In addition, a Business Conduct Hotline provides associates with an anonymous means to report violations of the program or seek guidance and clarification on issues or concerns they might have with respect to their own conduct or the conduct of other Advocate associates. Advocate has educated its Board, employees, physicians and vendors as to the elements of the Compliance Program. The Compliance Program undergoes periodic review and updates based on new developments. Dates of the Condensed Consolidated Financial Statements and Management Discussion and Analysis of Financial Condition and Results of Operations The interim condensed consolidated financial statements and the sources of system net patient service revenue, utilization statistics and ratios (Attachment 1) and liquidity worksheet (Attachment 2) were prepared as of March 6, The management discussion and analysis of financial condition and results of operations were prepared as of March 25,

57 Contact Person: James W. Doheny Vice President of Finance and Corporate Controller Advocate Health Care 3075 Highland Parkway Downers Grove, IL E mail: [email protected] P: F:

58 Attachment 1 Sources of System Net Patient Service Revenue, Utilization Statistics and Ratios For the quarter ended For the year ended December 31, December 31, SOURCES OF SYSTEM NET PATIENT SERVICE REVENUE Medicare 24 % 27 % 24 % 25 % Medicaid Managed Care Self pay, workers' compensation and other % 100 % 100 % 100 % UTILIZATION STATISTICS Acute Care Hospitals: Admissions Same Store 38,724 37, , ,852 Sherman (a) 3,659 3,637 14,623 8,703 Subtotal 42,383 41, , ,555 Observation Cases Same Store 12,562 12,318 49,360 45,068 Sherman (a) 1,510 1,246 5,633 2,615 Subtotal 14,072 13,564 54,993 47,683 Total Admissions and Observation Cases 56,455 54, , ,238 Average Length of Stay (days) Same Store Sherman (a) Total Outpatient Visits Same Store 440, ,495 1,685,105 1,678,229 Sherman (a) 48,891 49, , ,170 Total 489, ,609 1,878,528 1,793,399 Home Health: Home Health Care Admissions Same Store 6,226 5,790 24,412 23,259 Sherman (a) , Total 6,594 6,109 25,843 24,119 Physician Practices Physician Visits 831, ,872 3,142,350 2,870,055 Covered Lives Full Risk 31,615 26,154 31,615 26,154 Partial Risk 84,194 88,961 84,194 88,961 (a) Represents activity for Sherman Hospital after June 1, 2013, the effective date of the affiliation with Advocate. FINANCIAL RATIOS Operating Margin 9.9% 6.8% 6.3% 6.1% Net Margin 6.6% 15.3% 7.8% 11.7% Operating Cash Flow Margin 15.4% 12.2% 12.0% 11.5% EBITDA Margin 11.0% 21.2% 13.1% 17.1% OTHER FINANCIAL INDICATORS Days Cash on Hand (b) Debt Service Coverage (c) 9.4x 9.5x Debt to Capitalization Ratio (c) 23.3% 24.2% Cash to Debt 294.3% 281.6% (b) The days cash on hand calculation includes assets limited to use and investments under securities lending program, and excludes the Medicaid assessment payable/expense for all periods presented as such amounts are not payable until the additional Medicaid revenue is received. (c) Calculated as required by the terms of the Master Trust Indenture (Amended and Restated). The Sources of Net Patient Service Revenue, Utilization Statistics and Ratios was prepared on March 6,

59 Attachment 2 Advocate Health Care Network and Subsidiaries Liquidity Summary as of December 31, 2014 (dollars in thousands) ASSETS (Gross) Daily Liquidity Money Market Funds (Moody's rated Aaa) $52,633 Dedicated bank lines (of credit) 0 Operating Cash 328,644 Overnight Repurchase Agreements (Collateralized by Treasuries; P-1 Counterparty) 0 US Treasuries & Aaa-rated Agencies (<3 year maturity) 54,036 US Treasuries & Aaa-rated Agencies (>3 year maturity) 52,924 Subtotal Daily Liquidity (Cash & Securities) $488,237 General Purpose Line of Credit 250,000 Subtotal Daily Liquidity 738,237 Weekly Liquidity Publicly Traded Fixed Income Securities (Aa3 or higher) and P-1 Commercial Paper 822,161 Other Investment Grade Publicly Traded Fixed Income Holdings 0 Exchange Traded Equities (Stock and Mutual Funds) 923,288 Subtotal Weekly Liquidity 1,745,450 TOTAL DAILY AND WEEKLY LIQUIDITY $2,483,686 Monthly Liquidity Funds, vehicles, investments that allow withdrawals with one month notice or less 472,298 Longer-Term Liquidity Funds, vehicles, investments that allow withdrawals with greater than one month notice (Hedge & Private Equity) 2,019,355 LIABILITIES (Self-Liquidity Debt Shorter than 13 Months & CP) Scheduled Mandatory Tender VRDBs Within 13 months Mandatory tenders scheduled on: 05/1/ ,980 Mandatory tenders scheduled on: 07/16/ ,655 Subtotal Other Liabilities 60,635 TOTAL LIABILITIES (Self-Liquidity Debt & CP Shorter Than 13 months) $60,635 The Liquidity Summary was prepared on March 6,