Closed four acquisitions across all business divisions deploying $1.2 billion of capital.
We have capitation arrangements for certain ancillary heath care services, such as mental health care, and a small percentage of our membership is covered by global capitation arrangements. Under the typical arrangement, the provider receives a fixed percentage of premium to cover costs of all medical care or of the specified ancillary services provided to the globally capitated members. Under some capitated arrangements, physicians may also receive additional compensation from risk sharing and other incentive arrangements. Global capitation arrangements limit our exposure to the risk of increasing medical costs, but expose us to risk as to the adequacy of the financial and medical care resources of the provider organization. We are ultimately responsible for the coverage of our members pursuant to the customer agreements. To the extent that the respective provider organization faces financial difficulties or otherwise is unable to perform its obligations under the capitation arrangements, we will be required to perform such obligations. Consequently, we may have to incur costs in doing so in excess of the amounts we would otherwise have to pay under the original global or ancillary capitation through our contracted network arrangements. Medical costs associated with capitation arrangements made up approximately 4.9% of the Company’s total medical costs for the year ended December 31, 2007.
We incur cost of sales expense for prescription drugs provided by our workers’ compensation pharmacy benefit manager and for the independent medical examinations performed by physicians on injured workers. Both businesses were acquired with the acquisition of the workers’ compensation managed care services business from Concentra, Inc. (“Concentra”). These costs are associated with fee-based products.
We generate cash through operations. As a profitable company in an industry that is not capital equipment intensive, we have not needed to use financing methods to fund operations. While we have incurred debt (as described in Note I to our consolidated financial statements in this Form 10-K), the proceeds have been used to finance acquisitions and were not used to fund operations. Our primary use of cash is to pay medical claims. Any excess cash has historically been used for acquisitions, to prepay indebtedness and for repurchases of our common stock.
We contract with the United States Office of Personnel Management (“OPM”) and with various federal employee organizations to provide health insurance benefits under the Federal Employees Health Benefits Program. These contracts are subject to government regulatory oversight by the Office of the Inspector General (“OIG”) of OPM who perform periodic audits of these benefit program activities to ensure that contractors meet their contractual obligations with OPM. For our managed care contracts, the OIG conducts periodic audits to, among other things, verify that premiums established under its contracts are in compliance with community rating requirements under the FEHB Program. The OPM may seek premium refunds or institute other sanctions against health plans that participate in the program. For our experience-rated plans, the OIG focuses on the appropriateness of contract charges, the effectiveness of claims processing, financial and cost accounting systems, and the adequacy of internal controls to ensure proper contract charges and benefits payments. The OIG may seek refunds of costs charged under these contracts or institute other sanctions against health plans. These audits are generally a number of years in arrears. We estimate and record reserves for audit and other contract adjustments based on appropriate guidelines. Any differences between actual results and estimates are recorded in the year the audits are finalized.
Actuarial standards of practice generally require the actuarially developed medical claims estimates to cover obligations under an assumption of moderately adverse conditions. Adverse conditions are situations in which the actual claims are expected to be higher than the otherwise estimated value of such claims. In many situations, the claims paid amount experienced will be less than the estimate that satisfies the actuarial standards of practice. Medical claims liabilities are recorded at an amount we estimate to be appropriate. Adjustments of prior years estimates may result in additional medical costs or, as we have experienced during the last several years, a reduction in medical costs in the period an adjustment was made. Our reserve models have historically developed favorably suggesting that the accrued liabilities calculated from the models were more than adequate to cover our ultimate liability for unpaid claims. We believe that this favorable development is a result of good communications between our health plans and our actuarial staff regarding medical utilization, mix of provider rates and other components of medical cost trend.
The negative medical cost amounts noted as “prior year” developments are favorable adjustments for claim estimates being settled for amounts less than originally anticipated. As noted above, these favorable restatements from original estimates occur due to changes in medical utilization, mix of provider rates and other components of medical cost trends. Medical claim liabilities are generally paid within several months of the member receiving service from the provider. Accordingly, the 2007 prior year developments relate almost entirely to claims incurred in calendar year 2006 and the increase in prior year medical cost was driven primarily by growth in the medical cost base of our Company.
Changes in the completion factors, trend factors and utilization factors can have a significant effect on the claim liability. The following example (in thousands, except percentages) provides the estimated effect to our December 31, 2007 unpaid claims liability assuming hypothetical changes in the completion, trend, and inpatient day factors. While we believe the selection of factors and ranges provided are reasonable, certain factors and actual results may differ.
We also establish reserves, if required, for the probability that anticipated future health care costs and contract maintenance costs under our existing provider contracts will exceed anticipated future premiums and reinsurance recoveries on those contracts.
Additionally, due primarily to long standing conservative investment guidelines, we have a de minimis sub prime investment and auction rate security exposure. With our municipal bond investments, they remain at an investment grade status based on their own merits. Although we do not rely on bond insurers exclusively to maintain our high level of investment credit quality, $523.0 million of our $880.1 million state and municipal bond holdings are insured. For our mortgaged-backed and asset-backed securities, our holdings remain at investment grade with a AAA rating. We participate in only the higher level investment tranches. For our asset-backed securities, we only participate in offerings that are over collateralized to further protect our principal investment.
Goodwill and other intangible assets that have indefinite lives are subject to a periodic assessment for impairment by applying a fair-value-based test. For our impairment analysis we relied primarily on the income approach and secondarily on the market approach. The income approach is based on the present value of expected future cash flows. The income approach involves estimating the present value of our estimated future cash flows, and discounting these cash flows at a given rate of return. The market approach estimates a business’s fair value by analyzing the recent sales of similar companies. The approaches were reviewed together for consistency and commonality.
We account for share based compensation in accordance with the provisions of Statement of Financial Accounting Standards No. 123 (revised 2004), “Shared-Based Payment” (“SFAS 123R”). Under the fair value recognition provisions of SFAS 123R, determining the appropriate fair value model and calculating the fair value of share-based payment awards require the input of subjective assumptions, including the expected life of the share-based payment awards and stock price volatility. We believe that a blend of the implied volatility of our tradeable options and the historical volatility of our share price is a better indicator of expected volatility and future stock price trends than historical volatility alone. Therefore, the expected volatility in 2006 and 2007 was based on a blend of market-based implied volatility and the historical volatility of our stock. The assumptions used in calculating the fair value of share-based payment awards represent our best estimates. In addition, we are required to estimate the expected forfeiture rate and recognize expense only for those shares expected to vest. If our actual forfeiture rate is materially different from our estimate, the stock-based compensation expense could be significantly different from what we have recorded in the current period. See Note F to the Consolidated Financial Statements in Item 8 for a further discussion on stock-based compensation.
In July 2006, the Financial Accounting Standards Board (“FASB”) issued “Interpretation No. 48 (“FIN 48”), Accounting for Uncertainty in Income Taxes--an Interpretation of FASB Statement No. 109”, which clarifies the accounting for uncertainty in income taxes recognized in the financial statements in accordance with SFAS No. 109. FIN 48 prescribes a more likely than not threshold for financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. For a tax benefit to be recognized, a tax position must be more likely than not to be sustained upon examination by applicable taxing authorities. The benefit recognized is the amount that has a greater than 50% likelihood of being realized upon final settlement of the tax position. The Company adopted FIN 48 effective January 1, 2007. The change in net assets, because of applying this pronouncement, is considered a change in accounting principle with the cumulative effect of the change required to be treated as an adjustment to the opening balance of retained earnings. The cumulative effect of implementing FIN 48 was an increase of $3.4 million to the beginning balance of retained earnings.
In May 2007, the Financial Accounting Standards Board (FASB) issued FASB Staff Position (“FSP”) FIN 48-1 Definition of Settlement in FASB Interpretation No. 48 (FSP FIN 48-1). FSP FIN 48-1 provides guidance on how to determine whether a tax position is effectively settled for the purpose of recognizing previously unrecognized tax benefits. FSP FIN 48-1 is effective retroactively to January 1, 2007. The implementation of this standard did not have a material effect on our consolidated financial position or results of operations.
First Health is a full service national health benefits services company that serves the group health, workers’ compensation and state public program markets. Provider Synergies manages preferred drug lists and negotiates rebates on behalf of state government and commercial clients. The businesses acquired from Concentra include a preferred provider organization, provider bill review, pharmacy benefit management, field case management, telephonic case management and independent medical exam businesses. The businesses acquired from Mutual include Mutual’s commercial employer group health business in Nebraska and Iowa, as well as its national Federal Employees Health Benefits administration business, representing approximately 233,000 members in total. Vista is a Florida-based diversified health plan serving approximately 294,000 members consisting of 150,000 commercial employer group members, 32,000 individual members, 28,000 Medicare Advantage HMO members and 84,000 state program members. Approximately 85% of the membership is in the south Florida market with the remainder in north central Florida and the state’s panhandle. In addition to the acquired businesses discussed above, we completed a purchase of approximately 26,500 members from FirstGuard Health Plan Missouri, Inc., a wholly-owned subsidiary of Centene Corporation. For additional information regarding our acquisitions, please refer to Note B to our consolidated financial statements.
The following table presents our membership as of December 31, 2007 and 2006 (in thousands).
(2) “Other ASO” membership includes active National Accounts and FEHBP administrative services business.
Commercial group risk membership increased 123,000 over the prior year end due primarily to the members acquired through the acquisition of Vista and of certain group health businesses from Mutual of Omaha, which together added 168,000 members. Health plan ASO membership increased 129,000 due to acquisitions, which added 99,000 members, and due to new sales and certain groups changing from a risk product to a non-risk product. Other ASO membership declined due to losses in our National Accounts business which was partially offset by FEHBP members obtained through the group health business acquired from Mutual of Omaha.
Individual Consumer & Government membership increased 397,000 from the prior year end, primarily due to our new Medicare Private-Fee-for-Service (“PFFS”) product. Commencing January 1, 2007, we offered Medicare PFFS plans to individuals in 43 states under the name Advantra Freedom. The increase in membership related to PFFS was 166,000. Membership also increased from the prior year due to the members acquired through the acquisition of Vista and FirstGuard which together added 170,000 members. Additionally, we had organic growth in our Individual, Medicare Advantage HMO and PPO and our Part D businesses.
Managed care premium revenue increased in both our Individual Consumer & Government and Commercial divisions. The growth is a result of our new Medicare PFFS product, growth in existing products as well as from the acquisitions; each of which is described above. Partially offsetting the increase was a decline in same store Commercial risk membership over the prior year period.
Interest expense increased primarily as a result of the issuance of debt during the current year, details of which are discussed below in our discussion of liquidity. The increase is also a result of the redemption during the first quarter of 2007 of our $170.5 million of outstanding 8.125% senior notes due February 15, 2012. We redeemed the notes at a redemption price equal to 104.1% of the principal amount plus interest accrued on the redemption date. As a result of the redemption, we recognized $6.9 million of interest expense for the premium paid on redemption and wrote off $2.2 million of deferred financing costs related to the senior notes.
Other income increased primarily as a result of a larger investment portfolio and higher interest rates.
Managed care premium revenue increased as a result of business related to our Medicare Part D products, which was new in 2006, and as a result of rate increases that occurred throughout all markets. Medicare Part D business accounted for $669.9 million of managed care premium revenue in 2006.
Commercial premium yields (premium per member per month) increased as a result of rate increases that occurred throughout all markets. The reported commercial premium yield increase of 5.3% is lower than the rate increases on renewing business due to a mix change in the types of plans being purchased as new business (such as a change to lower benefit plans); the types of plans being selected by renewing members when they have a choice among multiple options (such as a change to higher deductible, lower premium plans); and the termination of certain large groups which had high costs and high premium yields. Medicare Advantage premium yields increased as a result of the rate increases from the annual competitive bid filings. Medicaid premium yields increased as a result of rate increases effective January 1 and July 1, 2006 in Missouri, our largest Medicaid market.
Management services revenue decreased partially as a result of declines in membership in the National Accounts and Federal Employees Health Benefit Plan businesses. Additionally, the implementation of Medicare Part D resulted in a decline of Medicaid/Public pharmacy administration fee based revenue during 2006 compared to 2005, although this decline was more than offset by the increased revenue from our new Medicare Part D business discussed above in the managed care premium revenue section. These decreases were also partially offset by reporting a full year of First Health results in 2006. First Health was acquired on January 28, 2005 and therefore only results from January 28, 2005 through December 31, 2005 are included in our 2005 results of operations.
Selling, general and administrative expense increased primarily as a result of costs related to the new Medicare Part D business in 2006, reporting a full year of the First Health results in 2006, recognizing stock option expense related to the adoption of SFAS 123(R) and increased salary expenses due to annual compensation increases. However, these increases are partially offset by synergies gained subsequent to the acquisition of First Health. Selling, general and administrative expenses as a percentage of revenue have improved as a result of these achieved synergies, continuing revenue growth and success in controlling overall administrative costs.
Interest expense was higher in 2005 as a result of the refinancing of our credit facilities during the second quarter of 2005. As a result of the refinancing, we wrote off $5.4 million of deferred financing costs in the second quarter of 2005 related to the original credit facilities associated with the First Health acquisition. Additionally, our debt has declined during 2005 and 2006 and, as a result, interest expense related to the indebtedness has also declined.
Our provision for income taxes increased almost exclusively due to an increase in earnings. Our effective tax rate remained relatively flat at 37.5% in 2006 compared to 37.3% in 2005.
(2) Data excludes a small group PPO insurance block which was previously reported within First Health.
(3) “Medicare Advantage” data includes Medicare Advantage HMO, Medicare Advantage PPO, and Medicare Advantage PFFS results.
Individual Consumer & Government revenue increased from 2006 as a result of membership from our new Medicare PFFS business, as well as the increased Part D, Medicaid and Individual membership, both organic and acquired. Part D revenue includes adjustments attributable to the estimation of CMS risk sharing payments.
Medicare Advantage risk premium yields per member per month decreased as a result of the addition of our new Medicare Private-Fee-For-Service business, which has a lower premium yield than our existing Medicare Advantage business, since our individually distributed PFFS products generally did not include a pharmacy benefit in 2007. This average premium yield decrease was partially offset by the rate increases from the annual competitive bid filings for our Medicare Advantage products, as well as from increases in risk factor adjustment scores for certain of our Medicare products. Part D premium yields have declined in 2007 compared to 2006 primarily due to the lower CMS risk sharing accruals as well as the annual competitive bid filings for our Part D products. This change is a result of the improved profitability of the Part D program, which is discussed below. Medicaid premium yields increased as a result of rate increases in Missouri, our largest Medicaid market, effective July 1, 2006 and July 1, 2007.
The increase in gross margin was driven by the increased business discussed above and was partially offset by the increased medical costs associated with this increased business. Part D medical costs as a percentage of premium revenue have decreased over the prior year quarter as a result of favorable pharmacy cost trend due to re-negotiated pharmaceutical contracts resulting from higher enrollment and as a result of members moving to generic drugs. Medicaid medical costs as a percentage of premium revenue increased over the prior year as a result of an increase in large claims incurred in our Missouri market.
Our investment guidelines require our fixed income securities to be investment grade in order to provide liquidity to meet future payment obligations and minimize the risk to the principal. Our fixed income portfolio includes government and corporate securities with an average quality rating of “AA+” and an average contractual duration of 3.6 years as of December 31, 2007. Typically, the amount and duration of our short-term assets are more than sufficient to pay for our short-term liabilities and we do not anticipate that sales of our long-term investment portfolio will be necessary to fund our claims liabilities.
Our cash and investments, consisting of cash, cash equivalents, short-term investments, and long-term investments, but excluding deposits of $64.4 million restricted under state regulations, increased $57.5 million to $2.8 billion at December 31, 2007 from $2.7 billion at December 31, 2006.
Net cash from operating activities is primarily driven by net earnings and by an increase in medical liabilities of approximately $194.8 million related to the new Medicare PFFS business. The nature of Medicare PFFS is such that premium revenues are generally received up to two months prior to the cash payment for the related medical costs. Accordingly, this results in strong cash inflows upon the implementation of a new benefit program. These inflows are partially offset by the $363.7 million payment to CMS, which was expected, related to the 2006 Medicare Part D contract year which was the primary driver for the decrease in medical claims liabilities, and other accrued liabilities. The decrease in cash flows from other receivables was primarily a result of an increase in pharmacy rebate receivables related to the Medicare Part D business and the CMS payment previously mentioned. Additionally, accounts payable and other accrued liabilities decreased primarily due to a decrease in income taxes payable, attributable largely to tax payments for the year exceeding the tax provision, offset by other normal operating activities.
During 2007, we made acquisitions for a total cost of approximately $1.2 billion, net of cash acquired, which was paid in cash, including $34.2 million paid into an escrow account pending final settlement.
On August 27, 2007, we completed the sale of $400 million aggregate principal amount of our 6.30% Senior Notes due 2014 (the “7-year Notes”) at the issue price of 99.575% per Note. The 7-year Notes are our senior unsecured obligations and rank equally with all of our other senior unsecured indebtedness. As of December 31, 2007, the fair value was $410.0 million.
Our Board of Directors has approved a program to repurchase our outstanding common stock. Stock repurchases may be made from time to time at prevailing prices on the open market, by block purchase or in private transactions. In February 2007, our Board of Directors approved an increase to the share repurchase program of 7.9 million shares. As a part of this program, no shares were purchased in 2005, 4.6 million shares of our common stock were purchased in 2006 at an aggregate cost of $256.1 million and 7.5 million shares of our common stock were purchased in 2007 at an aggregate cost of $429.0 million. As of December 31, 2007, the total remaining common shares we are authorized to repurchase under this program is 6.5 million.
The increase in capital and surplus for our regulated subsidiaries is a result of net earnings as well as the inclusion of the Vista and Mutual of Omaha acquisitions. This was partially offset by dividends paid to the parent company.
Although the provisions of any future legislation adopted at the state or federal level can not be accurately predicted at this time, management believes that the ultimate outcome of currently proposed legislation should not have a material adverse effect on the results of our operations in the short-term. Nevertheless, it is possible that future legislation or regulation could have a significant effect on our operations.
We expect to add at least 125,000 net Part D members from our 2007 year end results. A majority of these new members will be in Low Income Subsidy products. As a result of this growth and the overall program’s wider risk sharing corridor in 2008, our Part D business is expected to have a steeper medical loss ratio (“MLR”) slope, resulting in a greater seasonal effect on the progression of quarterly earnings per share. More specifically, in the fourth quarter of 2007, we reported a Part D MLR of 58%. For the first quarter of 2008, we are expecting a loss ratio of 104% (vs. a 95% and 98% MLR in the first quarter of 2007 and 2006, respectively). Despite the better than previously expected membership growth and quarterly MLR progression referred to above, our expectations of the full year Part D MLR have not changed.
We expect investment income to decrease in 2008 due to lower market interest rates.
We have audited the accompanying consolidated balance sheets of Coventry Health Care, Inc. and subsidiaries as of December 31, 2007 and 2006, and the related consolidated statements of operations, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2007. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Coventry Health Care, Inc. and subsidiaries at December 31, 2007 and 2006, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2007, in conformity with U.S. generally accepted accounting principles.
Coventry Health Care, Inc. (together with its subsidiaries, the “Company” or “Coventry”) is a diversified national managed health care company based in Bethesda, Maryland operating health plans, insurance companies, network rental and workers’ compensation services companies. Through its Commercial Business, Individual Consumer & Government Business and Specialty Business divisions, the Company provides a full range of risk and fee-based managed care products and services to a broad cross section of individuals, employer and government-funded groups, government agencies, and other insurance carriers and administrators.
The following table shows the components of the change in medical liabilities for the years ended December 31, 2007, 2006 and 2005, respectively (in thousands):
Comprehensive Income - Comprehensive income includes net income and the unrealized net gains and losses on investment securities. Other comprehensive income is net of reclassification adjustments to adjust for items currently included in net income, such as realized gains and losses on investment securities. The deferred tax provision for unrealized holding gains arising from investment securities during the year ended December 31, 2007 was $6.3 million. The deferred tax benefit for unrealized holding losses arising from investment securities during the years ended December 31, 2006 and 2005 was $0.02 million and $6.9 million, respectively. The deferred tax provision for reclassification adjustments for gains included in net income on investment securities during the years ended December 31, 2007 and 2005 was $0.5 million and $0.8 million, respectively. The deferred tax benefit for reclassification adjustments for losses included in net income on investment securities during the years ended December 31, 2006 was $0.2 million.
Revenue Recognition - Managed care premiums are recorded as revenue in the month in which members are entitled to service. Premiums are based on a per subscriber contract rate and the subscribers in the Company’s records at the time of billing. Premium billings are generally sent to employers in the month proceeding the month of coverage. Premium billings may be subsequently adjusted to reflect changes in membership as a result of retroactive terminations, additions, or other changes. The Company also receives premium payments from Centers for Medicare & Medicaid Services (“CMS”) on a monthly basis for its Medicare membership. Membership and category eligibility are periodically reconciled with CMS and such reconciliations could result in adjustments to revenue. The Company also receives premium payments on a monthly basis from the state Medicaid programs with which the Company contracts for the Medicaid members for whom it provides health coverage. Membership and category eligibility are periodically reconciled with the state Medicaid programs and such reconciliations could result in adjustments to revenue. Premiums collected in advance are recorded as deferred revenue. Employer contracts are typically on an annual basis, subject to cancellation by the employer group or by the Company upon 30 days notice.
A reconciliation of the final risk sharing, low-income subsidy, and reinsurance subsidy amounts is performed following the end of contract year. For both contract years of 2006 and 2007, as of December 31, 2007, the CMS risk sharing payable was $52.5 million and is included in accounts payable and other accrued liabilities and the CMS risk sharing receivable was $4.0 million and is included in other receivables. As of December 31, 2007, the subsidy amounts payable totaled $62.0 million and is included in medical liabilities and the subsidy amounts receivable totaled $29.4 million and is included in other receivables.
Cost of Sales - This is a new line on the Company’s statements of operations this year and is a direct result of the Worker’s Compensation business acquired from Concentra, Inc. (“Concentra”). Cost of sales consists of the expense for prescription drugs provided by the Company’s workers’ compensation pharmacy benefit manager and for the independent medical examinations performed by physicians on injured workers. These costs are associated with fee-based products and exclude the cost of drugs related to the risk products recorded in medical costs.
Other Income - Other income includes interest income, net of fees, of approximately $138.7 million, $101.5 million, and $59.8 million for the year ended December 31, 2007, 2006, and 2005 respectively.
In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities. SFAS No. 159 permits companies to choose to measure many financial instruments and certain other items at fair value. SFAS No. 159 is effective for financial statements issued for fiscal years beginning after November 15, 2007. The Company does not expect the adoption of SFAS No. 159 to have a material impact on the Company’s consolidated financial statements.
In December 2007, the FASB issued SFAS No. 141 (R), Business Combinations. SFAS No. 141 (R) requires an acquirer to measure the identifiable assets acquired, the liabilities assumed and any noncontrolling interest in the acquiree at their fair values on the acquisition date, with goodwill being the excess value over the net identifiable assets acquired. SFAS No. 141 (R) is effective for financial statements issued for fiscal years beginning after December 15, 2008. Early adoption is prohibited. The Company has not yet determined the effect on the Company’s consolidated financial statements, if any, upon adoption of SFAS No. 141 (R).
First Health is a full service national health benefits services company that serves the group health, workers’ compensation and state public program markets. Provider Synergies manages preferred drug lists and negotiates rebates on behalf of state government and commercial clients. The businesses acquired from Concentra include a preferred provider organization (“PPO”), provider bill review, pharmacy benefit management, field case management, telephonic case management and independent medical exam businesses. The businesses acquired from Mutual include Mutual’s commercial employer group health business in Nebraska and Iowa, as well as its national Federal Employees Health Benefits administration business, representing approximately 233,000 members in total. Vista is a Florida-based diversified health plan serving approximately 294,000 members consisting of 150,000 commercial employer group members, 32,000 individual members, 28,000 Medicare Advantage HMO members and 84,000 state program members. Approximately 85% of the membership is in the south Florida market with the remainder in north central Florida and the state’s panhandle.
The Company completed its impairment test of goodwill and has determined that there was no impairment of goodwill as of October 1, 2007, the Company’s annual impairment test date. The changes in the carrying amount of goodwill for the years ended December 31, 2007 and 2006 were as follows (in thousands):
Other intangible amortization expense for the years ended December 31, 2007, 2006 and 2005 was $48.2 million, $35.4 million and $31.1 million, respectively. The increase during the year ended December 31, 2007 in other intangible assets and the related amortization expense is a result of the other intangible assets obtained with the acquisitions of Concentra, Mutual of Omaha and Vista. Estimated intangible amortization expense is $63.0 million for the year ending December 31, 2008, $61.4 million for the year ending December 31, 2009, $61.2 million for the year ending December 31, 2010, $61.1 million for the year ending December 31, 2011 and $60.9 million for the year ending December 31, 2012. The weighted-average amortization period is approximately 10 years for other intangible assets.
Depreciation expense for the years ended December 31, 2007, 2006 and 2005 was $94.4 million, $77.9 million and $55.1 million, respectively. Included in the depreciation expense for the year ended December 31, 2007, 2006 and 2005 is $32.9 million, $26.9 million and $13.1 million, respectively, of expense for developed software.
The amortized cost, gross unrealized gain or loss and estimated fair value of short-term and long-term investments by security type were as follows at December 31, 2007 and 2006 (in thousands):
The amortized cost and estimated fair value of short-term and long-term investments by contractual maturity were as follows at December 31, 2007 and December 31, 2006 (in thousands):
The following table shows the Company’s investments’ gross unrealized losses and fair value, at December 31, 2007, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position (in thousands).
Under the Stock Incentive Plan, the terms and conditions of option grants are established on an individual basis with the exercise price of the options being equal to not less than 100% of the fair value of the underlying stock at the date of grant. Options generally become exercisable after one year in 25% increments per year and expire ten years from the date of grant. At December 31, 2007, the Stock Incentive Plan had outstanding options representing 10.9 million shares of common stock.
The Company continues to use the Black-Scholes-Merton option pricing model and amortizes compensation expense over the requisite service period of the grant. The methodology used in 2007 to derive the assumptions used in the valuation model is consistent with that used in 2006. The following average values and weighted-average assumptions were used for option grants.
The Company granted 2.3 million stock options during the twelve months ended December 31, 2007. The Black-Scholes-Merton weighted-average value of options granted was $ 16.79, $17.24 and $14.96 per share for the years ended December 31, 2007, 2006 and 2005, respectively. The Company recorded compensation expense related to stock options of approximately $36.1 million and $30.7 million for the year ended December 31, 2007 and 2006, respectively. The total intrinsic value of options exercised was $77.9 million, $52.4 million and $83.8 million for the years ended December 31, 2007, 2006 and 2005, respectively. As of December 31, 2007, there was $70.6 million of total unrecognized compensation cost (net of expected forfeitures) related to nonvested stock option grants which is expected to be recognized over a weighted average period of 2.5 years.
The following table summarizes stock option activity for the year ended December 31, 2007:
The following table summarizes restricted stock award activity for the year ended December 31, 2007:
No valuation allowance is needed for 2007 and 2006 deferred tax assets because the Company believes that the realization of the deferred tax assets, including net operating losses, is likely due to the future reversals of existing taxable temporary differences, and expected future positive taxable income as a result of planned business and tax initiatives.
Current income taxes payable of $0.1 million and $84.1 million are included in “Other Accrued Liabilities” on the consolidated balance sheets as of December 31, 2007 and December 31, 2006, respectively.
The Company’s current income taxes payable have been reduced by tax benefits resulting from equity based compensation transactions. These benefits were credited to shareholder’s equity and amounted to $31.5 million and $21.9 million for the years ended December 31, 2007 and December 31, 2006, respectively.
A tabular reconciliation of the total amounts of unrecognized tax benefits at the beginning and end of 2007 is as follows:
Gross decreases due to a lapse of a statute of limitations
Penalties and tax-related interest expense are reported as a component of income tax expense. As of December 31, 2007, the total amount of income tax-related accrued interest and penalties, net of related tax benefit, recognized in the statement of financial position was $10.2 million. For the year ended December 31, 2007, the total amount of income tax-related accrued interest and penalties, net of related tax benefit, recognized in the statement of operations was $4.5 million.
The Company is regularly audited by federal, state and local tax authorities, and from time to time these audits result in proposed assessments. Tax years 2004-2006 remain open to examination by these tax jurisdictions. The Company believes appropriate provisions for all outstanding issues have been made for all jurisdictions and all open years.
The Company previously had other 401(k) plans that it sponsored. These plans arose from acquisitions of other companies and these plans have either since been terminated or merged into the Savings Plan. The cost of the Savings Plan, including the acquired plans, for 2007, 2006 and 2005 was approximately $21.6 million, $18.9 million, and $14.5 million, respectively.
As of December 31, 2007, the Company was the sponsor of a 401(k) Restoration and Deferred Compensation Plan (“RESTORE”). Under the RESTORE, participants may defer up to 75% of their base salary and up to 100% of any bonus awarded. The Company makes matching contributions equal to 100% of the participant’s contribution on the first 3% of the participant’s compensation and 50% of the participant’s contribution on the second 3% of the participant’s compensation. Participants vest in the Company’s matching contributions ratably over two years. All costs of the RESTORE are funded by the Company as they are incurred.
The Company’s outstanding debt was as follows at December 31, 2007 and 2006 (in thousands):
On January 28, 2005, the Company completed the private placement of $250 million aggregate principal amount of 5.875% senior notes due 2012 and $250 million aggregate principal amount of 6.125% senior notes due 2015. The senior notes are general unsecured obligations of the Company and rank equal in right of payment to all of the Company’s existing and future senior debt. As of December 31, 2007, the fair value of the 5.875% senior notes and the 6.125% senior notes was $253.1 million and $250.0 million, respectively.
On August 27, 2007, the Company completed the sale of $400 million aggregate principal amount of its 6.30% Senior Notes due 2014 (the “7-year Notes”) at the issue price of 99.575% per Note. The 7-year Notes are senior unsecured obligations of Coventry and rank equally with all of its other senior unsecured indebtedness. As of December 31, 2007, the fair value was $410.0 million.
As of December 31, 2007, the Company is contractually obligated to make the following minimum lease payments within the next five years and thereafter (in thousands):
The Company operates in leased facilities with original lease terms of up to thirteen years with options for renewal. Total rent expense was $33.1 million, $30.3 million and $30.2 million, for the years ended December 31, 2007, 2006 and 2005, respectively.
Seven defendants entered into settlement agreements with the plaintiffs, which received final approval from the trial court. On June 16, 2006, the trial court filed an order in the Shane lawsuit which granted summary judgment on all claims in favor of Coventry. The trial court also granted summary judgment on all claims in favor of two other defendants. The plaintiffs appealed the trial court’s summary judgment order to the Eleventh Circuit Court of Appeals. By an order dated June 13, 2007, the Eleventh Circuit affirmed the trial court’s order granting summary judgment in favor of the Company. The plaintiffs did not request reconsideration of the decision from the Eleventh Circuit nor did they seek to appeal the decision to the U.S. Supreme Court. The Shane lawsuit has triggered the filing of copycat class action complaints by other health care providers such as chiropractors, podiatrists, acupuncturists and other licensed health care professionals. Each of these actions has been transferred to the MDL and have been designated as “tag-along” actions The Company has been named as a defendant in seven of these tag-along actions however, four of these actions have been subsequently dismissed/withdrawn against the Company. The trial court has entered an order which has stayed all proceedings in the tag-along actions. Although the Company can not predict the outcome, it believes that the tag-along actions will not have a material adverse effect on its financial position or results of operations. Management also believes that the claims asserted in these lawsuits are without merit and the Company intends to defend its position.
A small percentage of the Company’s membership is covered by global capitation arrangements. Under the typical arrangement, the provider receives a fixed percentage of premium to cover all the medical costs provided to the globally capitated members. Under some capitated arrangements, physicians may also receive additional compensation from risk sharing and other incentive arrangements. Global capitation arrangements limit the Company’s exposure to the risk of increasing medical costs, but expose the Company to risk as to the adequacy of the financial and medical care resources of the provider organization. In addition to global capitation arrangements, the Company has capitation arrangements for ancillary services, such as mental health care. The Company is ultimately responsible for the coverage of its members pursuant to the customer agreements. To the extent that the respective provider organization faces financial difficulties or otherwise is unable to perform its obligations under the capitation arrangements, the Company will be required to perform such obligations. Consequently, the Company may have to incur costs in excess of the amounts it would otherwise have to pay under the original global or ancillary capitation arrangements. Medical costs associated with capitation arrangements made up approximately 4.9%, 6.1%, and 6.5% of the Company’s total medical costs for the years ended December 31, 2007, 2006 and 2005, respectively. Membership associated with global capitation arrangements was approximately 110,000, 110,000 and 116,000 as of December 31, 2007, 2006 and 2005, respectively.
Concentration of credit risk with respect to receivables is limited due to the large number of customers comprising the Company’s customer base and their breakdown among geographical locations. The Company believes the allowance for doubtful accounts adequately provides for estimated losses as of December 31, 2007. The Company has a risk of incurring losses if such allowances are not adequate.
The majority of states in which the Company operates health plans have adopted a RBC policy that recommends the health plans maintain statutory reserves at or above the “Company Action Level,” which is currently equal to 200% of their RBC. The State of Florida does not currently use RBC methodology in its regulation of HMOs. Some states, in which the Company’s regulated subsidiaries operate, require deposits to be maintained with the respective states’ departments of insurance. The table below summarizes the Company’s statutory reserve information as of December 31, 2007 and 2006 (in millions, except percentage data).
The increase in capital and surplus for the Company’s regulated subsidiaries is a result of net earnings as well as the inclusion of the Vista and Mutual of Omaha acquisitions. This was partially offset by dividends paid to the parent company.
Other income for the years ended December 31, 2007, 2006 and 2005 includes interest income, net of fees, of approximately $138.7 million, $101.5 million and $59.8 million, respectively.
The Company’s Board of Directors has approved a program to repurchase its outstanding common stock. Stock repurchases may be made from time to time at prevailing prices on the open market, by block purchase or in private transactions. In February 2007, its Board of Directors approved an increase to the share repurchase program in an amount equal to 5% of the Company’s outstanding common stock, thus increasing its repurchase authorization by 7.9 million shares. Under the share repurchase program, the Company purchased 7.5 million shares of the Company’s common stock during 2007, at an aggregate cost of $429.0 million, 4.6 million shares during 2006, at an aggregate cost of $256.1 million and no shares were purchased in 2005. The total remaining common shares the Company is authorized to repurchase under this program is 6.5 million as of December 31, 2007. Excluded from these amounts are shares purchased in exchange for employee payroll taxes on vesting of restricted stock awards as these purchases are not part of the program.
The Individual Consumer & Government Division provides comprehensive health benefits to members participating in the Medicare Advantage HMO, Medicare Advantage PPO, Medicare Advantage Private-Fee-For-Service, Medicare Prescription Drug, and Medicaid programs and receives premium payments from federal and state governments. This division also provides commercial fully-insured managed care services on an individual basis and offers products and services more specialized to the needs of state governments such as pharmacy benefit management, clinical management and fiscal intermediary services on a fee-for-service basis.
The following is a summary of unaudited quarterly results of operations (in thousands, except per share data) for the years ended December 31, 2007 and 2006. Due to rounding of quarterly results, total amounts for each year may differ immaterially from the annual results.