The following tables present selected historical financial data and other information for the company and its predecessor, NewQuest, LLC. We derived the selected historical statement of income, cash flow, and balance sheet data for each of the four years ended December 31, 2009 and as of and for the period from March 1, 2005 to December 31, 2005 from the audited consolidated financial statements of the company and for the period from January 1, 2005 to February 28, 2005 from the audited consolidated financial statements of NewQuest, LLC. We derived the selected balance sheet data as of February 28, 2005 from the unaudited consolidated financial statements of NewQuest, LLC.
HealthSpring, Inc. (the “company” or “HealthSpring”) is a managed care organization whose primary focus is Medicare, the federal government-sponsored health insurance program for U.S. citizens aged 65 and older, qualifying disabled persons, and persons suffering from end-stage renal disease. As of December 31, 2009, we operated Medicare Advantage plans in Alabama, Florida, Illinois, Mississippi, Tennessee, and Texas. As of January 1, 2010, we also commenced operations of Medicare Advantage plans in three counties in Northern Georgia. We also offer a national stand-alone Medicare prescription drug plan. We refer to our Medicare Advantage plans, including plans providing prescription drug benefits, or MA-PD, as “Medicare Advantage” plans and our stand-alone prescription drug plan as our “PDP.” For purposes of additional analysis, the company provides membership and certain financial information, including premium revenue and medical expense, for our Medicare Advantage (including MA-PD) and PDP plans. We report our business in four segments: Medicare Advantage; PDP; Commercial; and Corporate. The following discussion of our results of operations includes a discussion of revenue and certain expenses by reportable segment. See “-Segment Information” below for additional information related thereto.
The Centers for Medicare and Medicaid Services (“CMS”) is the federal agency responsible for overseeing the Medicare program. The company’s Tennessee Medicare Advantage plan is currently undergoing an audit by CMS relating to compliance with CMS’s risk score coding requirements. The company is in the process of responding to CMS’s information request, including retrieving and providing medical records that support diagnosis codes and risk scores relating to 2006 dates of service and 2007 plan premiums. The company is currently unable to predict the outcome of CMS’s audit, calculate a payment error rate, or predict the amount of premiums, if any, that may be subject to repayment by the Tennessee plan to CMS. No assurance can be provided at this time as to the outcome of the current CMS audit or whether other company plans will be selected or targeted for such audits.
Net income increased $14.6 million, or 12.3%, in 2009 to $133.6 million compared to 2008.
Our diluted earnings per share, or EPS, was $2.41 for 2009 compared with $2.12 for 2008.
Medicare Advantage membership at 2009 year-end increased 16.8% over the prior year. PDP membership at 2009 year-end increased 10.8% over the prior year.
Medicare (including Medicare Advantage and PDP) premium revenue for 2009 was approximately $2.6 billion; an increase of 22.5% over 2008 results.
Medicare Advantage (including MA-PD) premiums were $2.3 billion for 2009, reflecting an increase of 22.5% over the prior year. Stand-alone PDP premiums increased $59.9 million, or 22.6%, to $325.4 million in 2009.
As with our traditional Medicare Advantage plans, we provide written bids to CMS for our Part D plans, which include the estimated costs of providing prescription drug benefits over the plan year. Premium payments from CMS are based on these estimated costs. The amount of CMS payments relating to the Part D standard coverage for our MA-PD plans and PDP is subject to adjustment, positive or negative, based upon the application of risk corridors that compare our prescription drug costs in our bids to CMS to our actual prescription drug costs. Variances exceeding certain thresholds may result in CMS making additional payments to us or our refunding to CMS a portion of the premium payments we previously received. We estimate and recognize adjustments to premium revenue related to estimated risk corridor payments as of each quarter end based upon our actual prescription drug costs for each reporting period as if the annual contract were to end at the end of each reporting period. We account for estimated risk corridor settlements with CMS on our consolidated balance sheet and as an operating activity in our consolidated statement of cash flows. Actual risk corridor payments upon final settlement with CMS could differ materially, favorably or unfavorably, from our estimates.
Because of the Part D product benefit design, the company incurs prescription drug costs unevenly throughout the year, resulting in fluctuations in quarterly MA-PD and PDP earnings. As a result of product features such as co-payments and deductibles, the coverage gap, risk corridors, and reinsurance, we generally expect to incur a disproportionate amount of prescription drug costs in the first half of the year. As a result, our Part D-related earnings are generally expected to increase in the second half of the year as compared to the first half of the year.
One of our primary tools for managing our business and measuring our profitability is our medical loss ratio, or MLR, the ratio of our medical expenses to the premiums we receive. Small changes in the ratio of our medical expenses relative to the premium we receive can result in significant changes in our financial results. Changes in the MLR from period to period result from, among other things, changes in Medicare funding, changes in benefits offered by our plans, our ability to manage medical expense, changes in accounting estimates related to incurred but not reported claims, or IBNR, and our Part-D-related earnings relative to CMS’ risk corridors. We use MLRs both to monitor our management of medical expenses and to make various business decisions, including what plans or benefits to offer, what geographic areas to enter or exit, and our selection of healthcare providers. We analyze and evaluate our Medicare Advantage and PDP MLRs separately.
Medicare Advantage. Our Medicare Advantage membership increased in each of our markets for 2009 and in the aggregate by 16.8% to 189,241 members at December 31, 2009 from 162,082 members at December 31, 2008. The increase in 2009 was primarily the result of organic growth in our markets through increased penetration in existing service areas and to a lesser extent our expansion into additional service areas in the states where we operate. Our Alabama and Tennessee membership decreased slightly as of December 31, 2008 compared to membership at December 31, 2007 as a result of the company exiting certain counties and discontinuing and changing certain products. Effective as of January 1, 2010, we also began operating Medicare Advantage plans in three counties in Northern Georgia. Medicare Advantage (including MA-PD) membership as of January 1, 2010 was approximately 193,320, reflecting increases in each of our markets except Texas whose membership decreased approximately 2,600 members.
The company’s Medicare premium revenue is subject to adjustment based on the health risk of its members. We refer to this process for adjusting premiums as the CMS risk adjustment payment methodology. Under the risk adjustment payment methodology, managed care plans must capture, collect, and report diagnosis code information to CMS. After reviewing the respective submissions, CMS establishes the payments to Medicare plans generally at the beginning of the calendar year and then adjusts premiums on two separate occasions on a retroactive basis.
The following schedule includes premiums, medical costs, and medical loss ratio statistics as adjusted to reflect changes in estimates (both for premium revenue and related risk-sharing costs) resulting from Final CMS Settlements in the fiscal year which corresponds with the CMS plan year for which the amounts pertain (for example, adjustments to reflect in 2008, premium amounts of $6.5 million and the related risk-sharing costs, which were recorded in 2009, but pertain to the 2008 CMS plan year).
Subject to adjustment based on changes in estimated risk adjustment payments related to final settlements in 2010.
Because we did not estimate and accrue for the risk adjustment payments in the manner assumed in the pro-forma table, this pro-forma presentation is not in accordance with U.S. generally accepted accounting principles (GAAP). We believe that these non-GAAP measures are useful to investors and management in analyzing financial trends regarding our operating and financial performance. These non-GAAP measures should be considered in addition to, but not as a substitute for, the corresponding GAAP as reported items shown in the table above.
In October 2009, the Company received notification from CMS that the Company’s obligation to CMS for all Part D activity for the 2008 plan year totaled $36.6 million. The Company settled such amounts from 2008 with CMS in the fourth quarter of 2009. There was no material impact on the Company’s financial condition and results of operations as a result of adjusting our estimates to final settlement amounts.
Premium Revenue: Total premium revenue for the year ended December 31, 2009 was $2,619.5 million as compared with $2,140.7 million in 2008, representing an increase of $478.8 million, or 22.4%. The components of premium revenue and the primary reasons for changes were as follows:
Medicare Advantage: Medicare Advantage (including MA-PD) premiums were $2,291.1 million for the year ended December 31, 2009 as compared to $1,870.1 million in 2008, representing an increase of $421.0 million, or 22.5%. The increase in Medicare Advantage premiums in 2009 is primarily attributable to increases in membership and in PMPM premium rates in substantially all of our plans. PMPM premiums for the current year averaged $1,050.48, which reflects an increase of 4.9% as compared to 2008, as adjusted to exclude retroactive risk adjustments associated with prior years. The PMPM premium increase in the current year is the result of rate increases in CMS-calculated base rates as well as rate increases related to risk scores. Member months increased 16.9% for 2009 as compared to 2008.
Investment Income. Investment income was $4.3 million for 2009 as compared to $15.0 million in 2008, reflecting a decrease of $10.7 million, or 71.5%. The decrease is primarily attributable to a decrease in the average yield on invested and cash balances. We have implemented a new investment strategy in 2010 and expect to reallocate a substantial portion of our cash in money market funds to high-quality fixed income assets. We expect this change to increase the average yield on our invested cash and securities relative to that which we would earn if we continued to rely primarily on money market funds.
Medicare Advantage. Medicare Advantage (including MA-PD) medical expense for the year ended December 31, 2009 increased $391.0 million, or 26.7%, to $1,855.9 million from $1,464.9 million for 2008, which is primarily attributable to membership increases in 2009 as compared to 2008 and increases in PMPM medical expense. For the year ended December 31, 2009, the Medicare Advantage MLR was 81.1% as compared to 79.0% for 2008, as adjusted to exclude favorable final CMS settlement adjustments associated with prior years (see “-Risk Adjustment Payments” above). The increase in the MLR for the current year was primarily attributable to increases in inpatient procedure costs in our Tennessee health plan and increases in outpatient expenses in our Alabama, Tennessee, and Texas health plans. The MLR increase in 2009 was partially offset by improvements in our Florida plan’s MLR attributable primarily to hospital recontracting efforts.
Interest expense was $15.6 million for the year ended December 31, 2009, compared with $19.1 million in 2008. The decrease in the current year was the result of lower effective interest rates and lower average principal balances outstanding. The weighted average interest rate incurred on our borrowings during the year ended December 31, 2009 and 2008 was 6.0% and 6.6%, respectively (4.8% and 5.6%, respectively, exclusive of amortization of deferred financing costs).
Medicare Advantage: As reported, Medicare Advantage premiums were $1,870.1 million for 2008 as compared to $1,363.6 million for 2007, representing an increase of $506.5 million or 37.1%. On an as-adjusted basis (see “-Risk Adjustment Payments” table above), Medicare Advantage premiums were $1,847.3 million for 2008 as compared to $1,378.1 million for 2007, representing an increase of $469.2 million, or 34.0%. The increase in Medicare Advantage premiums in 2008 is primarily attributable to the inclusion of a full year of LMC Health Plans’ results, increased membership, and increases in PMPM premium rates. Member months increased 18.9% for 2008 as compared to 2007. PMPM premiums increased 12.8% to $989.66 for 2008 from $877.47 for 2007 on an as-adjusted basis to exclude the additional 2007 final retroactive risk premiums recorded in 2008 (see “-Risk Adjustment Payments” above). As adjusted, the PMPM premium increase in 2008 is primarily the result of rate increases in base rates as well as rate increases associated with increases in risk scores and the inclusion of LMC Health Plans’ full year results in 2008, as LMC Health Plans has historically experienced higher PMPM premiums than our other markets. Adjusting this statistic as if the LMC Health Plans’ were included in the full year of 2007, PMPM premiums for 2008 would have increased 9.3% compared to 2007.
Fee Revenue. Fee revenue was $32.6 million for 2008 compared to $25.0 million for 2007, an increase of $7.6 million. The increase in 2008 was attributable to increased management fees as a result of new IPAs under contract since 2007 and higher premiums in managed IPAs compared to 2007.
Medicare Advantage. For the year ended December 31, 2008, the Medicare Advantage (including MA-PD) MLR was 79.0% compared to 79.2% for 2007, both on an as-adjusted basis (see “- Risk Adjustment Payments” above). As reported, Medicare Advantage (including MA-PD) medical expense for the year ended December 31, 2008 increased $377.6 million, or 34.7%, to $1,464.9 million from $1,087.2 million for 2007, primarily as a result of the medical expense incurred by LMC Health Plans for the full year 2008 and as a result of increased per member per month medical costs in all of our existing health plans.
Our Medicare Advantage (including MA-PD) medical expense calculated on a PMPM basis was $782.13 for the year ended December 31, 2008, compared with $695.22 for 2007 (adjusted to exclude the portion of risk sharing with providers associated with final CMS risk adjustment payments relating to prior periods, net (see “- Risk Adjustment Payments” above)), reflecting an increase of 12.5%, primarily as a result of medical cost inflation in addition to the factors discussed above. Adjusting this statistic as if LMC Health Plans’ were included in the full year of 2007, PMPM medical expense for 2008 would have increased 8.8% compared to 2007 primarily as a result of increases in in-patient utilization in our Florida health plan, PMPM increases in the prescription drug component of our Medicare Advantage plans and medical cost inflation.
Commercial. Commercial medical expense decreased by $33.6 million, or 86.7%, to $5.1 million in 2008 as compared to $38.7 million for 2007. The decrease in 2008 was primarily attributable to the reduction in membership versus 2007.
SG&A for 2008 was $246.3 million as compared with $186.2 million for 2007, an increase of $60.1 million, or 32.3%. The increase in 2008 as compared to the prior year is the result of the inclusion of LMC Health Plans for the full year 2008, personnel and other administrative costs increases in 2008, and costs related to PDP membership increases. As a percentage of revenue, SG&A expense was 11.3% for 2008 compared to 11.8% in the prior year. The decrease in SG&A as a percentage of revenue in 2008 was primarily the result of improved operating leverage and the inclusion of LMC Health Plans for the full year 2008, which has historically operated at a substantially lower SG&A percentage than our company as a whole.
Depreciation and amortization expense was $28.5 million in 2008 as compared with $16.2 million in 2007, representing an increase of $12.3 million, or 76.0%. The increase in 2008 was primarily the result of $9.7 million in incremental amortization expense associated with intangible assets recorded as part of the acquisition of LMC Health Plans and incremental depreciation on property and equipment additions made in 2007 and 2008.
Interest expense was $19.1 million in 2008 as compared with $7.5 million in 2007. Interest expense recognized in 2008 was the result of the company incurring interest for a full year on the $300.0 million of indebtedness incurred on October 1, 2007 in connection with the purchase of LMC Health Plans. The weighted average interest rate incurred on our borrowings during 2008 and 2007 was 6.6% and 9.7%, respectively (5.6% and 7.4%, respectively, exclusive of amortization of deferred financing costs).
We report our business in four segments: Medicare Advantage, stand-alone Prescription Drug Plan, Commercial, and Corporate. Medicare Advantage (“MA-PD”) consists of Medicare-eligible beneficiaries receiving healthcare benefits, including prescription drugs, through a coordinated care plan qualifying under Part C and Part D of the Medicare Program. Stand-alone Prescription Drug Plan (“PDP”) consists of Medicare-eligible beneficiaries receiving prescription drug benefits on a stand-alone basis in accordance with Medicare Part D. Commercial consists of our commercial health plan business. The Commercial segment was insignificant as of December 31, 2009 and 2008. The Corporate segment consists primarily of corporate expenses not allocated to the other reportable segments. These segment groupings are also consistent with information used by our chief executive officer in making operating decisions.
In connection with the company moving a large number of employees from its markets to its corporate operations effective January 1, 2009, the company revised its methodology for allocating certain corporate expenses to its segments, which resulted in its allocating a greater share of such expenses to its operating segments. Additionally, as of January 1, 2009, the company revised its methodology for allocating the SG&A expenses within its prescription drug operations, which resulted in its allocating a greater share of such expenses to its MA-PD segment. As a result of these revisions, the segment EBITDA amounts for the 2008 and 2007 periods include reclassification adjustments between segments such that the periods presented are comparable.
Cash flows related to 2007 investing and financing activities were significantly affected by the acquisition of the LMC Health Plans.
The increase in cash flow provided by operating activities to $170.0 million for 2009 from $162.0 for 2008 is primarily attributable to increases in earnings, the amount and timing of risk corridor settlements with CMS, and other changes in working capital items.
During the year ended December 31, 2009, the company’s financing activities consisted primarily of $36.2 million of funds received in excess of funds withdrawn from CMS for the benefit of members, and $31.0 million for the repayment of long-term debt. Funds due for the benefit of members are recorded as an asset on our consolidated balance sheets at both December 31, 2009 and 2008. We settled approximately $36.6 million of such Part D related amounts relating to 2008 with CMS during the second half of 2009 as part of the final settlement of Part D payments for the 2008 plan year. We anticipate settling approximately $1.9 million of such Part D related amounts relating to 2009 with CMS during the second half of 2010 as part of the final settlement of Part D payments for the 2009 plan year. We expect cash flows in 2010 to include receipts and withdrawals for similar subsidies (or funds) from CMS related to the 2010 Medicare year.
For the year ended December 31, 2008, the company’s primary investing activities consisted of $11.7 million in property and equipment additions, expenditures of $59.8 million to purchase investment securities, $71.2 million in proceeds from the maturity of investment securities, and the expenditure of $7.2 million for the Valley Plans acquisition. Our 2008 capital expenditures were primarily related to our technology initiatives and the development of medical clinics as part of our advanced medical home initiatives.
Effective July 31, 2009, we novated our PDP members and transferred the related assets and liabilities of the PDP business from the company’s Tennessee HMO subsidiary to our accident and health insurance subsidiary. We obtained approvals for the transaction from CMS, the Tennessee Department of Commerce and Insurance, and the Texas Department of Insurance. In connection with the novation, we were required to infuse $2.5 million of capital into our accident and health subsidiary in the second quarter and agree to other financial measures relating to such subsidiary’s net worth and capital in order to comply with various state regulatory requirements. As a result of the novation and corresponding asset transfer, our Tennessee HMO’s statutory capital requirements will no longer be impacted by the PDP business segment’s operating results and financial position.
The company’s regulated insurance subsidiaries are restricted from making distributions without appropriate regulatory notifications and approvals or to the extent such distributions would put them out of compliance with statutory net worth requirements. At December 31, 2009, $424.2 million of our $530.7 million of cash, cash equivalents, investment securities, and restricted investments were held by our regulated insurance subsidiaries, and subject to these dividend restrictions.
Subsidiary distributions to the parent company (other than tax-related distributions) for 2009, 2008, and 2007 were as follows:
Long-term debt at December 31, 2009 and 2008 consists of the following (in thousands):
In connection with funding the acquisition of LMC Health Plans, on October 1, 2007, we entered into agreements with respect to a $400.0 million, five-year credit facility (the “2007 Credit Agreement”) which provided for $300.0 million in term loans and a $100.0 million revolving credit facility. Borrowings under the 2007 Credit Agreement accrued interest on the basis of either a base rate or a LIBOR rate plus, in each case, an applicable margin (225 basis points for LIBOR advances at December 31, 2009) depending on our debt-to-EBITDA leverage ratio. The weighted average interest rates incurred on borrowings under the 2007 Credit Agreement during the years ended December 31, 2009, and 2008 were 6.0% and 6.6%, respectively (4.8% and 5.6%, respectively, exclusive of amortization of deferred financing costs). The 2007 Credit Agreement was scheduled to mature on October 1, 2012. The company made early principal payments of $2.3 million and $10.0 million in 2009 and 2008, respectively.
On February 11, 2010, the company entered into a $350.0 million credit agreement (the “New Credit Agreement”), which, subject to the terms and conditions set forth therein, provides for a five-year, $175.0 million term loan credit facility and a four-year, $175.0 million revolving credit facility, including a $25.0 million sublimit for the issuance of standby letters of credit and a $25.0 million sublimit for swingline loans (the “New Credit Facilities”). Proceeds from the New Credit Facilities, together with cash on hand, were used to fund the repayment of $237.0 million in term loans outstanding under the company’s 2007 Credit Agreement as well as transaction expenses related thereto. As of February 11, 2010, there was $200.0 million of indebtedness outstanding under the New Credit Facilities.
Borrowings under the New Credit Agreement accrue interest on the basis of either a base rate or a LIBOR rate plus, in each case, an applicable margin depending on the company’s debt-to-EBITDA leverage ratio (initially 325 basis points for LIBOR borrowings). The company will also pay a commitment fee of 0.500% per annum, which may be reduced to 0.375% if certain leverage ratios are achieved, on the actual daily unused portions of the New Credit Facilities. The revolving credit facility under the New Credit Agreement matures, the commitments thereunder terminate, and all amounts then outstanding thereunder will be payable on February 11, 2014.
Interest includes the estimated interest payments under our credit facility assuming no change in the LIBOR rate applicable to the portion of our debt outstanding not subject to interest rate swap agreements as of December 31, 2009.
Medical expense is recognized in the period in which services are provided and includes an estimate of the cost of medical expense that has been incurred but not yet reported, or IBNR. Medical expense includes claim payments, capitation payments, risk sharing payments and pharmacy costs, net of rebates, as well as estimates of future payments of claims incurred, net of reinsurance. Capitation payments represent monthly contractual fees disbursed to physicians and other providers who are responsible for providing medical care to members. Pharmacy costs represent payments for members’ prescription drug benefits, net of rebates from drug manufacturers. Rebates are recognized when earned, according to the contractual arrangements with the respective vendors. Premiums we pay to reinsurers are reported as medical expense and related reinsurance recoveries are reported as deductions from medical expense.
The IBNR component of total medical claims liability is based on our historical claims data, current enrollment, health service utilization statistics, and other related information. Estimating IBNR is complex and involves a significant amount of judgment. Accordingly, it represents our most critical accounting estimate. The development of the IBNR includes the use of standard actuarial developmental methodologies, including completion factors and claims trends, which take into account the potential for adverse claims developments, and considers favorable and unfavorable prior period developments. Actual claims payments will differ, however, from our estimates. A worsening or improvement of our claims trend or changes in completion factors from those that we assumed in estimating medical claims liabilities at December 31, 2009 would cause these estimates to change in the near term and such a change could be material.
Completion factors estimate liabilities for claims based upon the historical lag between the month when services are rendered and the month claims are paid and takes into consideration factors such as expected medical cost inflation, seasonality patterns, product mix, and membership changes. The completion factor is a measure of how complete the claims paid to date are relative to the estimate of the total claims for services rendered for a given reporting period. Although the completion factor is generally reliable for older service periods, it is more volatile, and hence less reliable, for more recent periods given that the typical billing lag for services can range from a week to as much as 90 days from the date of service.
Amounts incurred related to prior years vary from previously estimated claims liabilities as the claims ultimately are settled. As discussed previously, medical claims liabilities are generally settled and paid within several months of the member receiving service from the provider. Accordingly, the 2009, 2008, and 2007 prior year favorable development relates primarily to fee-for-service claims incurred in previous calendar year. The negative amounts reported in the table above for incurred related to prior periods result from fee-for-service claims estimates being ultimately settled for amounts less than originally anticipated (a favorable development). A positive amount reported for incurred related to prior periods would result from claims estimates being ultimately settled for amounts greater than originally anticipated (an unfavorable development).
Actual claims trends ultimately being lower than original estimates resulting in $3.0 million of favorable development, primarily attributable to lower than anticipated cost increases and utilization in both our Medicare and commercial lines of business;
Actual completion factors ultimately being higher than completion factors used to estimate IBNR at December 31, 2008 based on historical patterns resulting in $3.1 million of favorable development, which increase was primarily attributable to a shortening of the time between when claims are submitted by providers and paid by our plans.
As reflected in the immediately preceding table, claims estimates at December 31, 2007 ultimately settled during 2008 for $11.6 million (or 0.9% of total 2007 medical expense) less than the amounts originally estimated. This favorable prior period reserve development was primarily as a result of the following factors:
Actual claims trends ultimately being lower than original estimates resulting in $9.6 million of favorable development, primarily attributable to lower than anticipated cost increases and utilization in both our Medicare and commercial lines of business;
Actual completion factors ultimately being higher than completion factors used to estimate IBNR at December 31, 2007 based on historical patterns resulting in $1.7 million of favorable development, which increase was primarily attributable to a shortening of the time between when claims are submitted by providers and paid by our plans.
We generally receive premiums on a monthly basis in advance of providing services. Premiums collected in advance are deferred and reported as deferred revenue. We recognize premium revenue during the period in which we are obligated to provide services to our members. Any amounts that have not been received are recorded on the consolidated balance sheet as accounts receivable.
All such estimated amounts are periodically updated as additional diagnosis code information is reported to CMS and adjusted to actual amounts when the ultimate adjustment settlements are either received from CMS or the company receives notification from CMS of such settlement amounts.
Long lived assets, such as property and equipment and purchased intangibles subject to amortization, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to estimated future undiscounted cash flows expected to be generated by the asset. If the carrying amount of an asset exceeds its estimated fair value, an impairment charge is recognized by the amount of the excess. Assets to be disposed of would be separately presented in the consolidated balance sheet and reported at the lower of the carrying amount or fair value less costs to sell, and no longer depreciated.
Goodwill represents the excess of cost over fair value of assets of businesses acquired. Goodwill and intangible assets acquired in a purchase business combination and determined to have an indefinite useful life are not amortized, but instead are tested for impairment at least annually. An impairment loss is recognized to the extent that the carrying amount exceeds the asset’s fair value. This determination is made at the reporting unit level and consists of two steps. First, the company determines the fair value of the reporting unit and compares it to its carrying amount. Second, if the carrying amount of the reporting unit exceeds its fair value, an impairment loss is recognized for any excess of the carrying amount of the unit’s goodwill over the implied fair value of that goodwill. The implied fair value of goodwill is determined by allocating the fair value of the reporting units in a manner similar to a purchase price allocation. The residual fair value after this allocation is the implied fair value of the reporting unit’s goodwill. Goodwill exists at four of our reporting units - Alabama, Florida, Tennessee and Texas.
We report a liability for unrecognized tax benefits resulting from uncertain tax positions taken or expected to be taken in a tax return. We recognize interest and penalties, if any, related to unrecognized tax benefits in income tax expense.
In June 2009, the Financial Accounting Standards Board issued new guidance for determining whether an entity is a variable interest entity (“VIE”) and requires an enterprise to perform an analysis to determine whether the enterprise’s variable interest or interests give it a controlling financial interest in a VIE. Under the new guidance, an enterprise has a controlling financial interest when it has a) the power to direct the activities of a VIE that most significantly impact the entity’s economic performance and b) the obligation to absorb losses of the entity or the right to receive benefits from the entity that could potentially be significant to the VIE. The guidance also requires an enterprise to assess whether it has an implicit financial responsibility to ensure that a VIE operates as designed when determining whether it has power to direct the activities of the VIE that most significantly impact the entity’s economic performance. The guidance also requires ongoing assessments of whether an enterprise is the primary beneficiary of a VIE, requires enhanced disclosures and eliminates the scope exclusion for qualifying special-purpose entities. The adoption of the new guidance on January 1, 2010 did not impact our financial statements.
In our opinion, HealthSpring, Inc. and subsidiaries maintained, in all material respects, effective internal control over financial reporting as of December 31, 2009, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of HealthSpring, Inc. and subsidiaries as of December 31, 2009 and 2008, and the related consolidated statements of income, stockholders’ equity and comprehensive income, and cash flows for each of the years in the three-year period ended December 31, 2009, and our report dated February 11, 2010 expressed an unqualified opinion on those consolidated financial statements.
HealthSpring, Inc, a Delaware corporation (the “Company”), was organized in October 2004 and began operations in March 2005. The Company is a managed care organization that focuses primarily on Medicare, the federal government sponsored health insurance program for U.S. citizens aged 65 and older, qualifying disabled persons, and persons suffering from end-stage renal disease. Through its health maintenance organization (“HMO”) and regulated insurance subsidiaries, the Company operates Medicare Advantage health plans in the states of Alabama, Florida, Illinois, Mississippi, Tennessee, and Texas and offers Medicare Part D prescription drug plans to persons in 24 of the 34 CMS regions. Effective as of January 1, 2010, the Company also began operating Medicare Advantage plans in three counties in Northern Georgia. The Company also provides management services to healthcare plans and physician partnerships.
Debt and equity securities are classified in three categories: trading, available for sale, or held to maturity. Trading securities are bought and held principally for the purpose of selling them in the near term. Held to maturity securities are those securities that the Company does not intend to sell, nor expect to be required to sell, prior to maturity. All securities not included in trading or held to maturity are classified as available for sale. The Company holds no trading securities.
The Company periodically evaluates whether any declines in the fair value of its available for sale investments are other than temporary. This evaluation consists of a review of several factors, including, but not limited to: length of time and extent that a security has been in an unrealized loss position; the existence of an event that would impair the issuer’s future earnings potential; the near term prospects for recovery of the market value of a security; the intent of the Company to sell the impaired security; and whether the Company will be required to sell the security prior to the anticipated recovery in market value. Declines in value below cost for debt securities where it is considered probable that all contractual terms of the security will be satisfied, where the decline is due primarily to changes in interest rates (and not because of increased credit risk), and where the Company does not intend to sell the investment prior to a period of time sufficient to allow a market recovery, are assumed to be temporary. If management determines that an other-than-temporary impairment exists, the carrying value of the investment will be reduced to the current fair value of the investment and if such impairment results from credit-related matters, the Company will recognize a charge in the consolidated statements of income equal to the amount of the carrying value reduction. Other-than-temporary impairment write-downs resulting from non-credit-related matters are recognized in other comprehensive income.
The Company reviews its deferred tax assets for recoverability and establishes a valuation allowance based on historical taxable income, projected future taxable income, applicable tax strategies, and the expected timing of the reversals of existing temporary differences. A valuation allowance is provided when it is more likely than not that some portion or all of the deferred tax assets will not be realized.
The Company conducted its annual impairment test as of October 1, 2009 and concluded that the carrying value of the reporting units did not exceed their fair value. In addition, no events have occurred subsequent to the 2009 testing date which would indicate any impairment may have occurred.
Medical claims liability represents the Company’s liability for services that have been performed by providers for its Medicare Advantage and commercial HMO members that have not been settled as of any given balance sheet date. The liability consists of medical claims reported to the plans as well as an actuarially determined estimate of claims that have been incurred but not yet reported to the plans, or IBNR. In addition, the medical claims liability includes liabilities for prescription drug benefits and for amounts owed to providers under risk-sharing and quality management arrangements.
The Company recognizes prescription drug costs as incurred, net of estimated rebates from drug companies. The Company has subcontracted the prescription drug claims administration to two third-party pharmacy benefit managers.
In April 2009, the Financial Accounting Standards Board, or the FASB, issued new guidance to address concerns about (1) measuring the fair value of financial instruments when the markets become inactive and quoted prices may reflect distressed transactions and (2) recording impairment charges on investments in debt securities. The FASB also issued guidance to require disclosures of fair values of certain financial instruments in interim financial statements to provide financial statement users with more timely information about the effects of current market conditions on their financial instruments. The new guidance highlights and expands on the factors that should be considered in estimating fair value when the volume and level of activity for a financial asset or liability has significantly decreased and requires new disclosures relating to fair value measurement inputs and valuation techniques (including changes in inputs and valuation techniques). In addition, new guidance regarding recognition and presentation of other-than-temporary impairments changed (1) the trigger for determining whether an other-than-temporary impairment exists and (2) the amount of an impairment charge to be recorded in earnings. The adoption of this guidance in the second quarter of 2009 did not impact the Company’s financial statements.
In June 2009, the FASB codified existing accounting standards. The new guidance establishes only two levels of U.S. GAAP, authoritative and nonauthoritative. The FASB Accounting Standards Codification (the “Codification”) became the source of authoritative, nongovernmental GAAP, except for rules and interpretive releases of the SEC, which are sources of authoritative GAAP for SEC registrants. All other non-grandfathered, non-SEC accounting literature not included in the Codification became nonauthoritative. This guidance is effective for financial statements for interim or annual reporting periods ending after September 15, 2009. The Company began to use the new guidelines and numbering system prescribed by the Codification when referring to GAAP in the quarter ended September 30, 2009. As the Codification was not intended to change or alter existing GAAP, it did not impact the Company’s financial statements.
Certain amounts in previously issued financial statements were reclassified to conform to the 2009 presentation.
Effective October 1, 2008, the Company acquired a Medicare Advantage contract from Valley Baptist Health Plans (“Valley Plans”), operating in the Texas Rio Grande Valley counties of Hidalgo, Willacy, and Cameron, for approximately $7.2 million in cash. Valley Plans had approximately 2,700 members as of the acquisition date. Additional cash consideration of $0.9 million was paid to the seller in 2009 and additional cash consideration of up to $0.7 million (net of the subsequent return of $0.2 million related to membership retroactivity) is potentially payable to the seller in 2010, in both cases based upon membership levels retained. The final allocation of the purchase price in 2009 resulted in the Company recording additional accounts receivable acquired of approximately $0.7 million and recording an equal reduction in the amount of intangible assets acquired. As part of the transaction, the Company entered into a provider contract with Valley Baptist Health System. The contract, with an initial term of five years, includes two hospitals and 12 out-patient facilities. The Company accounted for this acquisition as an asset acquisition and therefore 100% of the purchase price was allocated to the identified assets acquired as follows:
On October 1, 2007, the Company completed the acquisition of all of the outstanding capital stock of Leon Medical Centers Health Plans, Inc. (“LMC Health Plans”) pursuant to the terms of a Stock Purchase Agreement, dated as of August 9, 2007 (the “Stock Purchase Agreement”). The results of LMC Health Plans are included in the Company’s results from the date of acquisition. LMC Health Plans is a Miami, Florida-based Medicare Advantage HMO with approximately 32,050 members at December 31, 2009. Pursuant to the Stock Purchase Agreement, the Company acquired LMC Health Plans for $355.0 million in cash and contingent consideration of 2.67 million shares of HealthSpring common stock, which share consideration was released in November 2009 to the former stockholders of LMC Health Plans as a result of Leon Medical Centers, Inc. (“LMC”) completing the construction of two additional medical centers in accordance with the timetable set forth in the Stock Purchase Agreement. The released shares are included in the computation of basic and diluted earnings per share for 2009 on a weighted-average basis and as issued and outstanding shares on the Company’s balance sheet at December 31, 2009. The Company recorded additional purchase price of $34.7 million in the 2009 fourth quarter associated with the release of such shares.
Accounts receivable at December 31, 2009 and 2008 consists of the following:
The allowance for doubtful accounts is the Company’s best estimate of the amount of probable losses in the Company’s existing accounts receivable and is based on a number of factors, including a review of past due balances, with a particular emphasis on past due balances greater than 90 days old. Account balances are charged off against the allowance after all means of collection have been exhausted and the potential for recovery is considered remote.
There were no investment securities classified as trading as of December 31, 2009 or 2008.
Investment securities classified as available for sale as of December 31, 2009 and 2008 consist of municipal bonds and corporate debt securities. Investment securities classified as held to maturity consist of United States Treasury securities, municipal bonds, corporate debt securities and securities issued by other government agencies.
There have been no realized gains or losses on maturities of investment securities for the years ended December 31, 2009, 2008 and 2007.
Gross unrealized losses on investment securities and the fair value of the related securities, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at December 31, 2009, are as follows:
Municipal Bonds and Government Agencies: The unrealized losses on investments in municipal bonds were caused by an increase in investment yields as a result of a widening of credit spreads. The contractual terms of these investments do not permit the issuer to settle the securities at a price less than the amortized cost of the investment. The Company determined that it did not intend to sell these investments and that it was not more-likely-than-not to be required to sell these investments prior to their recovery, thus these investments are not considered other-than-temporarily impaired.
A summary of property and equipment at December 31, 2009 and 2008 is as follows:
Depreciation expense on property and equipment for the year ended December 31, 2009, 2008, and 2007 was $12,401, $9,369, and $6,175, respectively.
A breakdown of the identifiable intangible assets, their assigned value and accumulated amortization at December 31, 2009 and 2008 is as follows:
Changes to the carrying value of identifiable intangible assets during 2009 and 2008 are as follows:
At December 31, 2009, all intangible assets are amortized using a straight-line method except for member network intangible assets which are amortized using an accelerated method. Also see Note 1(f).
The provider contract comprising 92% of the provider network intangible asset balance at December 31, 2009 comes up for renewal in October 2017. This contract includes a five-year renewal term at the Company’s option. Such renewal has been assumed in the amortization period of the provider network intangible asset.
Amortization expense expected to be recognized during fiscal years subsequent to December 31, 2009 is as follows:
In November 2009, the Company released contingent consideration of 2.67 million shares of HealthSpring common stock, which was held in escrow, to the former stockholders of LMC Health Plans. The released shares are included in the computation of basic and diluted earnings per share for the fourth quarter of 2009 and as issued and outstanding on the Company’s consolidated balance sheet at December 31, 2009. See Note 2 - “Acquisitions”.
The weighted average fair value of options granted in 2009, 2008, and 2007 is provided below. The fair value for all options as determined on the date of grant was estimated using the Black-Scholes option-pricing model with the following assumptions:
The expected volatility used in 2009 is based on the Company’s actual volatility rates. During 2007 and 2008, the Company estimated a blended rate for volatility based on the Company’s actual volatility rates experienced and the volatility rates of its peer group. Additionally, because of the Company’s limited history of employee exercise patterns, the expected term assumption is based on industry peer information. The risk-free interest rate was based on a traded zero-coupon U.S. Treasury bond with a term substantially equal to the option’s expected term. The Company recognized a deferred income tax benefit of approximately $3,631, $3,368, and $3,001 for the years ended December 31, 2009, 2008, and 2007, respectively, related to the share-based compensation expense. The actual tax (expense) benefit realized from stock options exercised during 2009, 2008, and 2007 was $(18), $(199) and, $2, respectively. There was no capitalized stock-based compensation expense in 2009, 2008, or 2007.
Computed intrinsic value per share amounts are based upon the amount by which the fair market value of the Company’s common stock at December 31, 2009 of $17.61 per share exceeded the weighted average exercise price. The aggregate value amounts are calculated using the actual exercise prices and including only those options which were exercisable and whose intrinsic value was positive at the end of the period.
Restricted stock awards in 2009, 2008, and 2007 were granted with a fair value equal to the market price of the Company’s common stock on the date of grant. Compensation expense related to the restricted stock awards is based on the market price of the underlying common stock on the grant date and is recorded straight-line over the vesting period, generally ranging from one to four years from the date of grant. The weighted average grant date fair value of the Company’s restricted stock awards was $12.70, $19.16, and $21.66 for the years ended December 31, 2009, 2008, and 2007, respectively.
During the year ended December 31, 2009, the Company awarded 60,516 shares of restricted stock to non-employee directors pursuant to the 2006 Plan, all of which were outstanding at December 31, 2009. The restrictions relating to the restricted stock awarded in 2009 lapse one year from the grant date. In the event a director resigns or is removed prior to the lapsing of the restriction, or if the director fails to attend 75% of the board and applicable committee meetings during the one-year period, shares will be forfeited unless resignation or failure to attend is caused by death or disability.
During the year ended December 31, 2009, 67,089 restricted shares were purchased by certain executives pursuant to the Management Stock Purchase Program (the “MSPP”), 23,804 of which were cancelled in accordance with the terms of the MSPP due to the termination of certain employees. The restrictions on shares purchased under the MSPP generally lapse on the second anniversary of the issue date. At December 31, 2009, 456,715 shares were available for issuance under the MSPP.
The following table presents the calculation of the Company’s net income per common share available to common stockholders - basic and diluted, for the years ended December 31, 2009, 2008, and 2007:
Diluted earnings per share (“EPS”) reflects the potential dilution that could occur if stock options or other share-based awards were exercised or converted into common stock. The dilutive effect is computed using the treasury stock method, which assumes all share-based awards are exercised and the hypothetical proceeds from exercise are used by the Company to purchase common stock at the average market price during the period. The incremental shares (difference between shares assumed to be issued versus purchased), to the extent they would have been dilutive, are included in the denominator of the diluted EPS calculation. Options to purchase 4.0 million shares, 3.8 million shares, and 3.3 million shares were antidilutive and therefore excluded from the computation of EPS for the years ended December 31, 2009, 2008, and 2007, respectively.
For the years ended December 31, 2009, 2008, and 2007, GulfQuest, L.P. earned management and other fees from RPO of approximately $20,355, $18,883, and $16,313, respectively. These amounts are reflected in management and other fee income in the accompanying consolidated statements of income.
Texas HealthSpring, LLC incurred medical expense to RPO of approximately $140,241, $126,583, and $109,489 for the years ended December 31, 2009, 2008, and 2007, respectively, related to medical services provided to its members by RPO. The 50%/50% risk sharing mechanism with respect to the common membership pool of RPO and Texas HealthSpring, LLC resulted in the Company accruing for amounts to RPO of approximately $15, $2,934, and $4,204 for the years ended December 31, 2009, 2008 and 2007, respectively. GulfQuest, L.P.’s 25% share of RPO’s profits were approximately $11,616, $12,907, and $10,285 for those same respective periods. These amounts are reflected as components of medical expense in the accompanying consolidated statements of income. Amounts receivable (payable) from the Company’s subsidiaries from (to) RPO in connection with these various relationships were $293 and $(3,206) as of December 31, 2009 and 2008, respectively.
In December 2007, Herbert A. Fritch, the Company’s Chairman of the Board of Directors, and Chief Executive Officer, acquired a 15.8% membership interest in Predators Holdings, LLC (“Predators Holdings”), the owner of the Nashville Predators National Hockey League team. In addition, in December 2007 Mr. Fritch loaned Predators Holdings $2,000 and, in January 2009, collateralized a letter of credit in the amount of $3,400 in favor of Predators Holdings. Mr. Fritch is a member of the executive committee of Predators Holdings. A subsidiary of Predators Holdings manages the Sommet Center in Nashville, Tennessee where the hockey team plays its home games. The Company is a party to a suite license agreement with another subsidiary of Predators Holdings pursuant to which the company leases a suite for Predators games and other functions. In 2009 and 2008, the Company paid $134 and $135, respectively, under the license agreement for the use of the suite (including 16 tickets, but not food and beverage concessions, for each Predators’ home game).
On October 1, 2007, the Company completed the acquisition of all the outstanding capital stock of LMC Health Plans. Prior to the closing, Benjamin Leon, Jr., who was subsequently elected as a director of the Company, owned a majority of LMC Health Plans’ outstanding capital stock. The acquisition of LMC Health Plans included the release of contingent consideration of 2.67 million shares of HealthSpring common stock in November 2009 to the former stockholders of LMC Health Plans (see Note 2).
On October 1, 2007, LMC Health Plans entered into an Office Space Agreement with LMC whereby LMC Health Plans was permitted to use certain space under lease by LMC. In lieu of reimbursing LMC for its portion of the leased space, LMC Health Plans paid the landlord directly. Such lease expense totaled $736 and $127 for the years ended December 31, 2008 and 2007, respectively. The Office Space Agreement terminated on December 31, 2008.
At December 31, 2009 and 2008, the Company had current assets of $2,760 and $753, respectively, recorded on its consolidated balance sheets for amounts due from the sellers of LMC Health Plans under settlement provisions included in the Stock Purchase Agreement regarding working capital and risk adjustment premiums related to the period prior to the acquisition date.
Future non-cancellable payments under these lease obligations as of December 31, 2009 are as follows:
Proceeds from the $300.0 million in term loans, together with the Company’s available cash on hand, were used to fund the acquisition of LMC Health Plans and transaction expenses related thereto. The $100.0 million revolving credit facility, which is available for working capital and general corporate purposes including capital expenditures and permitted acquisitions, was undrawn as of December 31, 2009. As a result of covenant restrictions, available borrowings under the credit facility at December 31, 2009 were limited to $94.0 million.
Borrowings under the Credit Agreement accrue interest on the basis of either a base rate or the London InterBank Offered Rate (“LIBOR”) plus, in each case, an applicable margin (225 basis points for LIBOR advances at December 31, 2009) depending on the Company’s debt-to-EBITDA leverage ratio. The LIBOR rate plus the applicable margin as of December 31, 2009 was 3.18%. The Company also pays commitment fees on the unfunded portion of the lenders’ commitments under the revolving credit facility, the amounts of which will also depend on the Company’s leverage ratio. The Credit Agreement matures, the commitments thereunder terminate, and all amounts then outstanding thereunder are payable on October 1, 2012.
The term loans are payable in quarterly principal installments. Maturities of long-term debt under the Credit Agreement are as follows:
On February 11, 2010, the Company entered into a new $350.0 million Credit Agreement, the proceeds of which, together with cash on hand, were used to fund the repayment of $237.0 million in term loans outstanding under the Credit Agreement. The new credit agreement replaced the Company’s Credit Agreement previously discussed herein. See further discussion of the Company’s new $350.0 million Credit Agreement in Note 24: Subsequent Event.
The Company’s medical claims liabilities at December 31, 2009 and 2008 consists of the following:
A reconciliation of the U.S. federal statutory rate (35%) to the effective tax rate is as follows for the periods presented:
The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and liabilities at December 31, 2009 and 2008 is as follows:
The above amounts are classified as current or long-term in the consolidated balance sheets in accordance with the asset or liability to which they relate or, when applicable, based on the expected timing of the reversal. Current deferred tax assets at December 31, 2009 and 2008 were $6,973 and $4,198, respectively. Non-current deferred tax liabilities at December 31, 2009 and 2008 were $80,434 and $89,615, respectively.
The Company records a valuation allowance to reduce its net deferred tax assets to the amount that is more likely than not to be realized. As of December 31, 2009 and 2008, the Company carried a valuation allowance against deferred tax assets of $327 and $330, respectively. To the extent the valuation allowance is reduced that was previously recorded as a result of business combinations, the offsetting credit will be recognized first as a reduction to goodwill, then to other intangible assets, and lastly as a reduction in the current period’s income tax provision. As of December 31, 2009, the Company had $327 of valuation allowance remaining from the 2005 recapitalization which could potentially result in future reductions to goodwill.
Income taxes payable of $6,277 and $2,938 at December 31, 2009 and 2008, respectively, are included in other current liabilities on the Company’s consolidated balance sheets. In addition, income taxes payable of $750 and $1,183 at December 31, 2009 and 2008, respectively, are included in other long-term liabilities on the Company’s consolidated balance sheets. The balance in other long-term liabilities relates to certain tax matters associated with the acquisition of LMC Health Plans which were recorded through goodwill, as well as certain unrecognized tax benefits.
The Company’s continuing accounting policy is to recognize interest and/or penalties related to income tax matters as a component of tax expense in the condensed consolidated statements of income. Accrued interest and penalties were approximately $0.1 million and $0.1 million as of December 31, 2009 and December 31, 2008, respectively. The Company had unrecognized tax benefits of $0.5 million and $0.3 million as of December 31, 2009 and December 31, 2008, respectively, all of which, if recognized, would affect the Company’s effective income tax rate. In addition, the Company does not anticipate that unrecognized tax benefits will significantly increase or decrease within the next 12 months.
The Company entered into the two interest rate swap derivatives to convert floating-rate debt to fixed-rate debt. The Company’s interest rate swap agreements involve agreements to pay a fixed rate and receive a floating rate, at specified intervals, calculated on an agreed-upon notional amount. The Company’s objective in entering into these financial instruments is to mitigate its exposure to significant unplanned fluctuations in earnings caused by volatility in interest rates. The Company does not use any of these instruments for trading or speculative purposes.
A summary of the aggregate notional amounts, balance sheet location and estimated fair values of derivative financial instruments as of the dates indicated is as follows:
In connection with the Company moving a large number of employees from its markets to its corporate operations effective January 1, 2009, the Company revised its methodology for allocating certain corporate expenses to its segments, which resulted in its allocating a greater share of such expenses to its operating segments. Additionally, as of January 1, 2009, the Company revised its methodology for allocating the selling, general, and administrative expenses within its prescription drug operations, which resulted in its allocating a greater share of such expenses to its MA-PD segment. As a result of these revisions, the segment EBITDA amounts for the 2008 and 2007 periods include reclassification adjustments between segments such that the periods presented are comparable.
Asset and equity details by reportable segment have not been disclosed, as the Company does not internally report such information.
The Company’s regulated insurance subsidiaries are required to maintain satisfactory minimum net worth requirements established by their respective state departments of insurance. At December 31, 2009, the statutory minimum net worth requirements and actual statutory net worth were $18.5 million and $90.4 million for the Tennessee HMO; $1.1 million and $41.9 million for the Alabama HMO; $9.9 million and $27.4 million for the Florida HMO; and $28.0 million (at 200% of authorized control level) and $76.1 million for the Texas HMO, and $12.1 million (at 200% of authorized control level) and $41.2 million for the accident and health subsidiary, respectively. Each of these subsidiaries were in compliance with applicable statutory requirements as of December 31, 2009. Notwithstanding the foregoing, the state departments of insurance can require the Company’s regulated insurance subsidiaries to maintain minimum levels of statutory capital in excess of amounts required under the applicable state law if they determine that maintaining additional statutory capital is in the best interest of the Company’s members. In addition, as a condition to its approval of the LMC Health Plans acquisition, The Florida Office of Insurance Regulation has required the Florida plan to maintain 115% of the statutory surplus otherwise required by Florida law until September 2010.
The Company and its health plans are subject to periodic and routine audits by federal and state regulatory authorities. In connection with its continuing statutory obligation to review risk score coding practices by Medicare Advantage plans, CMS announced that it would audit Medicare Advantage plans, primarily targeted based on risk score growth, for compliance by the plans and their providers with proper coding practices. The Company’s Tennessee Medicare Advantage plan has been selected by CMS for an audit for compliance by the plan and its providers with proper coding practices (sometimes referred to as “RADV Audits”). Specifically, the RADV Audit of the plan pertains to the 2006 risk adjustment data used to determine 2007 premium rates. In late 2009, the Company’s Tennessee plan received from CMS the RADV Audit member sample, which CMS will use to calculate a payment error rate for 2007 Tennessee plan premiums. The Company is in the process of responding to the RADV Audit request, including retrieving and providing medical records supporting diagnoses codes and risk scores and, where appropriate, provider attestations, all of which are due to CMS on February 18, 2010. CMS has indicated that payment adjustments resulting from its RADV Audits will not be limited to risk scores for the specific beneficiaries for which errors are found but will be extrapolated to the relevant plan population. CMS’s methodology for extrapolation remains unclear, however. The Company is in the process of gathering records responsive to the RADV Audit and is currently unable to calculate a payment error rate or predict the impact of extrapolating that error rate to 2007 Tennessee plan premiums.
The following are the levels of the fair value hierarchy and a brief description of the type of valuation information (“inputs”) that qualifies a financial asset for each level:
When quoted prices in active markets for identical assets are available, the Company uses these quoted market prices to determine the fair value of financial assets and classifies these assets as Level I. In other cases where a quoted market price for identical assets in an active market is either not available or not observable, the Company obtains the fair value from a third party vendor that uses pricing models, such as matrix pricing, to determine fair value. These financial assets would then be classified as Level II. In the event quoted market prices were not available, the Company would determine fair value using broker quotes or an internal analysis of each investment’s financial statements and cash flow projections. In these instances, financial assets would be classified based upon the lowest level of input that is significant to the valuation. Thus, financial assets might be classified in Level III even though there could be some significant inputs that may be readily available.
Loans under the New Credit Agreement are secured by a first priority lien on substantially all assets of the Company and its non-HMO subsidiaries, including a pledge by the Company and its non-HMO subsidiaries of all of the equity interests in each of their domestic subsidiaries (including HMO subsidiaries).
The New Credit Agreement contains conditions precedent to extensions of credit and representations, warranties and covenants, including financial covenants, customary for transactions of this type. The New Credit Agreement also contains customary events of default as well as restrictions on undertaking certain specified corporate actions.