Subject

This memo outlines California legal requirements for a group for a group managed care health plan that desires a financial device on California lives. This informational document explains the requirements involved in Knox Keene Act compliance and the financial devices known as a "Flexible Funding Agreement" and an "Adjustment Payment" rider.

The California Department of Corporations requires separate financial accounting for California lives subject to these agreements. Copies of financial records associated with such plans with California lives must be located and readily available for Department of Corporations (DOC) auditors' inspection within the state of California, even for cases where the ASO contract was entered in to in another state. The Underwriting Division located in Woodland Hills, California is the location for maintaining such files.

To satisfy these and other DOC requirements, Woodland Hills underwriting requires the assistance of the selling Regional office to obtain the following documents:

1. Copy of signed ASO contract page;
2. Original copy of executed Flexible Funding Agreement Rider.
3. Original copy of executed Adjustment Payment Modification Rider.
4. Maximum Contractual Premium Rate Calculation and notification to client, including support documentation.
5. Year end calculations including supporting documentation, and
6. Copies of any reimbursement vouchers, if applicable,
7. An original of the Flexible Funding Rider or Adjustment Payment Rider shall be housed in the Woodland Hills corporate office of Prudential Health Care Plan of California, Inc.

At the time of a proposal, underwriters should include language explaining the California flexible funding features. Please refer to the attached Exhibit 4 for an example of the language that can be included in your proposal.

To expedite the drafting of either Rider by the Woodland Hills Regional Benefits, Communications and Compliance Departments, send an e-mail message requesting a draft agreement to WO15272 or "IREIB" with the case name, control number, proposal effective date and whether the case requires a Flexible Funding Agreement or if a dividend participating employer group, an Adjustment Payment Modification Rider.

Table of Contents

I. Background of Knox Keene Act 1975

The Knox-Keene Act of 1975 defined regulations for HMOs operating in the state of California and established the California Department of Corporations (DOC) as the HMO regulator overseeing licensure and compliance. The PruCare Plus and DMO products in California prior to 1990, were filed with and approved by the California State Insurance Department, regulators of insurance companies. However, in 1990, the DOC once again reviewed the PruCare Plus and DMO products and concluded that these products should be under their jurisdiction. In order to utilize capitation in California, which we believe are essential to effective cost containment and management, Prudential was required to file with the DOC. HMO licensure was granted effective July, 1990 to PruCare of California, Inc.

DOC approval has a significant impact on the way Prudential handles California managed business. The regulations incorporate in to Knox Keene necessitating change in financial reporting, funding, plan design, contracts, descriptive materials, etc. With reference to healthcare, it is important to note that only the in-network portion of PruCare Plus is subject to DOC regulation.

The DOC requires that Prudential Health Care be at full financial risk on a prospective basis.

The focus of this memorandum is primarily underwriting, regulatory compliance and year end accounting consideration with regard to PruCare plans.

1. Flexible Funding PruCare Plus;
2. Participating PruCare Plus;
3. Minimum Premium Plans (MMP);
4. Non-Participating PruCare Plus;
5. Non-Participating HMOs;
6. Participating HMOs.

II. Flexible Funding PruCare Plus Accounts with California Members

II. A. In-Network benefits in California

The In-Network benefits for California members must be provided through an insured contract with a Flexible Funding Rider. Flexible Funding (Flex) essentially duplicates the cash flow advantages of an Administrative Services Only (ASO) plan. The DOC filing requires this arrangement only be offered to employers with a minimum of 1,000 employees nationwide, however, we recommend it be reserved for cases with a minimum of 1,000 employees of which there are no less than 500 California members.

1. Maximum Contractual Premium must be established and communicated to the client and to the Woodland Hills Underwriting Flex Coordinator. The Maximum Contractual Premium Rates are established by the underwriter, annually, prior to the effective date of the contract period and are based on an estimate of incurred in-network claims (including capitations/bulk bills) and the following:
-- In-network portion of the pool charge (if applicable)
-- In-network portion of the ASO fee
-- Any HMO individual conversions (other conversions would be included under out-of-network plan, i.e. Major Medical).

Margin is also included in the Maximum Contractual Premium rate. It is extremely important that there be a transfer of risk to PruCare under the Flexible Funding; therefor a maximum premium must be set for the in-network benefits and reasonable margin assumptions included in the Maximum Contractual Premium. The following margin requirements have been filed with the Department of Corporations; margins included in the Maximum Contractual Premium should not exceed these limits:

Maximum Contractual Premium rates are incorporated in to our contract and are used to limit the contract holder's liability for PruCare Plus in-network benefits. Please refer to the Sample Cases calculation, Exhibit 1, for an example of how the Maximum Contractual Premium Rate should be set.

2. The in-network "Premium" paid is generally considered to be the sum of the first three items mentioned above under II.A. Similarities above, plus, the conversion and pooling charges (if applicable).

3. A reconciliation of "Premium" paid to the Maximum Contractual Premiums as defined in the contract, is performed at the end of the contractual period.

4. ERISA Form 5500 must be completed and sent to the client and the Woodland Hills Underwriting Flex Coordinator along with copies of any voucher necessary due to tripping of the Maximum Contractual Premium for that policy period.

5. In additional to the standard Prudential HealthCare credit worthiness criteria, the California Department of Corporations requires a Flexible Funding candidate meet the following minimum standards:

5. a. The Quick Ratio, Sales/Receivable Ratio and Debt Ratio must be no less than standard ratios for that employer's industry; see Exhibit 6;

5. b. The employers Dunn & Bradstreet rating must be one of the following: 1A1 - 5A1, 1A2 - 5A2, or 1A3 - 5A3.

At the end of the contract period, a reconciliation of "Premium" paid relative to the Maximum Contractual Premium is completed by the underwriter. This reconciliation should be no later than 5 months after the end of the contract period. For a canceled account, the preliminary year end reconciliation is conducted at the end of the 5th month following the end of the contract period. The final reconciliation is standardly deferred for 18 months.

Please refer to the enclosed Supplementary Memo 21 of the Dividend formula for instructions on how to complete year end calculations.

If the "Premium" should exceed the amount defined in the contract as the Maximum Contractual Premium, we need to refund this amount to the client. The refund would be viewed as a deficit which may be carried forward provided in the contract. <-p>Cross-application of any carry forward deficit to offset a deficit in other coverages, such as life, medical indemnity coverage or vice versa is prohibited on a prospective contractual basis. However, on a retrospective basis, PruCare can suggest, and a contract holder can request in writing the use of any refundable amounts to offset a deficit or to pay due and unpaid premium on any participating products. This contract holder requests would apply to that specific year end settlement only.

If the "Premium" is less than the Maximum Contractual Premium, there is no dividend generated and there is no due and unpaid amount generated by the difference between the Maximum Contractual Premium and the amount defined as "Premium" paid, as defined above. However, if the case has an accumulated deficit, the surplus or excess generated between the Maximum Contractual Premium and the "Premium" would be callable in order to recoup the deficit.

Benefit Plan Design

Due to Knox Keene requirements, there are some limits on flexibility for in-network plan design. Plan features required by the Department of Corporations are:
No Actively-at-Work provision
Employee must live in the service area to be eligible
No pre-existing condition exclusion provisions
Coinsurance is handled as co-pays
Non-duplication Coordination of Benefits (COB) may not apply

VII. Out-of-Network Benefits in California