As of December 31, 2011, we leased approximately 66,000 square feet of space for our corporate office in Bethesda, Maryland. We also leased approximately 1,946,000 aggregate square feet for office space, subsidiary operations and customer service centers for the various markets where our health plans and other subsidiaries operate, of which approximately 2.4% is subleased. Our leases expire at various dates from 2012 through 2022. We also own eight buildings throughout the country with approximately 643,000 square feet, which is used for administrative services related to our subsidiaries’ operations, of which approximately 3.5% is subleased. We believe that our facilities are adequate for our operations.
Implemented a Medicaid contract with the Commonwealth of Kentucky effective November 1, 2011.
Medicare Part D membership decreased by 485,000 members due to a loss of auto assign regions and a reduction in the 2011 product offerings.
Diluted earnings per share (“EPS”) from continuing operations of $3.70, an increase of 24.6% from 2010 diluted EPS from continuing operations.
We operate health plans, insurance companies, managed care services companies and workers’ compensation services companies and generate our operating revenues from premiums and fees for a broad range of managed care and management service products. Managed care premiums for our commercial risk products, for which we assume full underwriting risk, can vary. For example, premiums for our preferred provider organization (“PPO”) and point of service (“POS”) products are typically lower than our health maintenance organization (“HMO”) premiums due to medical underwriting and higher deductibles and co-payments that are typically required of the PPO and POS members. Managed care premium rates for our government programs, Medicare and state-sponsored managed Medicaid, are largely established by governmental regulatory agencies. These government products are offered in select markets where we believe we can achieve profitable growth based upon favorable reimbursement levels, provider costs and regulatory climates.
Revenue for our management services products (“non-risk”) is generally derived from a fixed administrative fee, provided on a predetermined contractual basis or on a percentage-of-savings basis, for access to our health care provider networks and health care management services, for which we do not assume underwriting risk. The management services we provide typically include health care provider network management, clinical management, pharmacy benefit management (“PBM”), bill review, claims repricing, claims processing, utilization review and quality assurance.
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 (“FEHBP”). These contracts are subject to government regulatory oversight by the Office of the Inspector General (“OIG”) of OPM, which performs 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 FEHBP. 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 benefit 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 for both our managed care contracts and our experience rated plans based on appropriate guidelines and historical results. Any differences between actual results and estimates are recorded in the year the audits are finalized.
Effective in 2011, as required by the Patient Protection and Affordable Care Act, as amended by the Health Care and Education Reconciliation Act of 2010 (collectively, “PPACA”), commercial health plans with medical loss ratios (“MLRs”) on fully insured products are required to issue rebates to policyholders if the actual loss ratio falls below the target. The mandated minimum MLR targets for health plans (as calculated under the definitions in PPACA and related regulations), such that the percentage of health coverage premium revenue spent on health care medical costs and quality improvement expenses, are set at 85% for large employer groups, 80% for small employer groups and 80% for individuals, subject to state-specific exceptions. The potential for and size of the rebates are measured by regulated subsidiary, state and market segment (individual, small group and large group). Accordingly, in the current year, we have recorded a rebate estimate in the “accounts payable and other accrued liabilities” line in the accompanying balance sheet and as contra-revenue in “managed care premiums” in the accompanying statements of operations. We estimate the rebate liability based on judgments and estimated information, including utilization, unit cost trends, quality improvement costs, and product pricing, features and benefits. If actual experience varies from our estimates or future regulatory guidance differs from our current judgments, the actual rebate liability could differ from our estimates.
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 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 has been 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 following table presents the components of the change in medical claims liabilities for the years ended December 31, 2011, 2010 and 2009, respectively (in thousands).
A regular element of our unpaid medical claim liability estimation process is the examination of actual results and, if appropriate, the modification of assumptions and inputs related to the process based upon past experience. Our reserve setting methodologies have taken these changes into consideration when determining the factors used in calculating our medical claims liabilities as of December 31, 2011 by choosing factors that reflect more recent experience.
any changes to the rating of the security by a rating agency;
For debt securities, if we intend to either sell or determine that we will more-likely-than-not be required to sell a debt security before recovery of the entire amortized cost basis or maturity of the debt security, we recognize the entire impairment in earnings. If we do not intend to sell the debt security and we determine that we will not more-likely-than-not be required to sell the debt security but we do not expect to recover the entire amortized cost basis, the impairment is bifurcated into the amount attributed to the credit loss, which is recognized in earnings, and all other cases, which are recognized in other comprehensive income. Realized gains and losses on the sale of investments are determined on a specific identification basis.
the fair value of a reporting unit refers to the amount at which the unit as a whole could be bought or sold in a current transaction between willing parties;
quoted market prices in active markets are the best evidence of fair value and shall be used as the basis for the measurement, if available;
As of October 1, 2011 our market capitalization was below our book value. We concluded that this did not affect the overall goodwill impairment analysis, as we believe our suppressed market capitalization to be primarily attributed to negative economic conditions and the enactment of health care reform. We will continue to monitor our market capitalization as a potential impairment indicator considering overall market conditions and managed care industry events. Any impairment charges that may result will be recorded in the period in which the impairment is identified.
Also in accordance with ASC Topic 350-30 we review intangible assets that are subject to amortization for recoverability whenever events or changes in circumstances indicate that its carrying amount may not be recoverable. An impairment loss shall be recognized if the carrying amount of an intangible asset is not recoverable and its carrying amount exceeds its fair value. In 2011, we did not incur an impairment charge related to our other intangible assets. Our intangible assets that are subject to amortization consist of our customer lists, licenses, and provider networks.
See Note A, Organization and Summary of Significant Accounting Policies, to the consolidated financial statements for information and disclosures related to new accounting standards, which is incorporated herein by reference.
Total Health Plan membership increased 218,000 compared to December 31, 2010, primarily due to the new contract with the Commonwealth of Kentucky to provide services for the Commonwealth’s Medicaid program, effective in the fourth quarter of 2011. Other National ASO membership decreased 86,000 primarily due to a decline of our FEHBP membership. The decrease in Medicare Part D membership of 485,000 was a result of the loss of auto assign regions as well as a reduction in product offerings from five in 2010 to two in 2011.
Cost of sales increased due to continued growth of our pharmacy benefit management program in the Workers’ Compensation division.
During the second quarter of 2010, a $278.0 million charge for a provider class action was recorded resulting from the Court of Appeal, Third Circuit for the State of Louisiana decision to affirm the trial court’s decision to grant summary judgment against a wholly-owned subsidiary of Coventry in provider class action litigation in Louisiana state court. On May 27, 2011, the court entered an order of final approval of a settlement and, accordingly, we recorded a non-recurring pre-tax adjustment to earnings of $159.3 million in the second quarter of 2011. For additional information regarding the provider class action, refer to Note M, Commitments and Contingencies, to the consolidated financial statements, which is incorporated herein by reference.
Depreciation and amortization expense was lower during the current year primarily due to certain assets becoming fully depreciated.
Managed care premium revenue decreased as a result of our exit from the Medicare PFFS product line. This exit accounted for a decline of $2.9 billion in revenue in 2010. Partially offsetting this decrease was an increase in revenue as a result of the acquisitions of Preferred Health Systems, Inc. (“PHS”) and MHP in 2010, an increase in revenue from Medicare Advantage Coordinated Care Plans (“Medicare Advantage CCP”) due to an increase in membership, and an increase in Medicare Part D revenue due to a slightly higher premium yield in 2010.
Medical costs decreased primarily as a result of not renewing our Medicare PFFS product. Partially offsetting this decrease was an increase in medical costs as a result of the acquisitions of PHS and MHP in 2010. Total MLR decreased 6.0% over the prior year to 79.4% from 85.4% as a result of the change in the mix of business resulting from the non-renewal of the Medicare PFFS product, which had a higher MLR of 92.0%. Additionally, we experienced lower than expected medical trend levels in 2010 which resulted in improved MLR percentages in all lines of business.
Cost of sales increased due to the growth of our pharmacy benefit management program in the Workers’ Compensation Division.
Selling, general and administrative expense decreased primarily due to lower salaries and benefits costs as well as decreased broker commissions. The salaries and benefits costs decrease resulted from a reduction in the number of full-time employees associated with the non-renewal of the Medicare PFFS product and continued general headcount reductions. Additionally, salaries and benefits declined as a result of executive severance accruals that occurred during the prior year that did not occur in the current year. Broker commissions decreased primarily as a result of the non-renewal of the Medicare PFFS product. Although lower in absolute terms, selling, general and administrative expense as a percentage of operating revenues increased as a result of the large decrease in operating revenues in the current year associated with the non-renewal of the Medicare PFFS product which had a high premium rate and a low relative expense level.
During the second quarter of 2010, a $278.0 million charge for a provider class action was recorded resulting from the Court of Appeal, Third Circuit for the State of Louisiana decision to affirm the trial court’s decision to grant summary judgment against a wholly-owned subsidiary of Coventry in provider class action litigation in Louisiana state court. For additional information regarding the provider class action, refer to Note M, Commitments and Contingencies, to the consolidated financial statements, which is incorporated herein by reference.
The provision for income taxes increased due to the increase in earnings. The effective tax rate on continuing operations decreased to 36.1% as compared to 37.5% for the prior year due primarily to the proportion of our earnings in states with lower tax rates.
Excludes the Medicare PFFS product, which was not renewed effective January 1, 2010.
Health Plan and Medical Services division revenue increased for its Commercial risk, Medicare Advantage and Medicaid risk products. This increase in Commercial risk and Medicare Advantage is primarily due to the acquisition of MHP in October 2010. The increase in Medicaid Risk revenue is due to entering new markets in August 2010 in the State of Nebraska and in November 2011 in the Commonwealth of Kentucky. Partially offsetting this increase in revenue was a decrease in Commercial Management Services revenue due to a decline of our FEHBP membership.
There was an increase in the average realized premium per member per month for the Commercial Risk business due to renewal rate increases. The increase in Commercial Risk revenue was partially offset by the accruals for the minimum MLR rebates, discussed above. Medicare Advantage revenues increased primarily due to the acquisition of MHP, as well as a general increase in premiums per member per month. The increase in Medicaid Risk revenue is primarily due to the two new markets, previously described. The Medicaid risk premiums per member per month increased as a result of a rate increase effective July 1, 2011, in Missouri, our largest Medicaid market, the implementation of the Kentucky contract which has a higher than average premium per member per month and due to a change in member mix in our Nebraska market.
Specialized Managed Care division revenue decreased for the year primarily due to lower Medicare Part D membership as a result of the loss of auto assign regions as well as a reduction in product offerings from five in 2010 to two in 2011. Including the effect of the CMS risk sharing premium adjustments as well as ceded revenue, the premium per member per month was $88.80 in 2011 compared to $82.86 in 2010. Excluding the effect of CMS risk sharing premium adjustments and revenue ceded to external parties, Medicare Part D premium per member per month for 2011 increased to $92.41 compared to $87.96 in 2010, primarily due to pharmacy cost trends and the loss of the lower priced premium products.
When reviewing the premium yield for the Medicare Part D business, we believe that adjusting for the ceded revenue is useful for comparisons to competitors that may not have similar ceding arrangements. When reviewing the Medicare Part D business, adjusting for the risk sharing amounts is useful to understand the results of the Part D business because of our expectation that the risk sharing revenue is insignificant on a full year basis.
Workers' Compensation division revenue increased for the year primarily due to the growth of our pharmacy benefit management program, which was partially offset by a decline in volume and rates in our network products.
Workers’ Compensation gross margin decreased slightly for the year primarily due to decline in volume and rates in our network products offset by increased volume in our pharmacy benefit management program. The decrease was partially offset by the growth of our pharmacy benefit management program.
The increase in Medicare Advantage CCP revenue was attributable to the acquisition of MHP as well as the increase in organic membership associated with that product. The Medicare Advantage premium per member per month increased in 2010 as a result of the exit from the Medicare PFFS product which had a lower premium rate than the Medicare Advantage CCP product. The Medicare PFFS premium yield was lower than the Medicare Advantage CCP premium rate since Medicare PFFS typically did not include a pharmacy benefit. The increase in Medicaid revenue was attributable to commencing operations during 2010 in the Nebraska and Pennsylvania markets. The Medicaid premium per member per month decreased in 2010 as a result of program benefit changes in Missouri, our largest Medicaid market. Effective October 1, 2009, the pharmacy benefit was removed from the program and thus was no longer included in the Missouri Medicaid rate payment.
Revenue in the Workers’ Compensation Division decreased slightly primarily due to a decline in volume in our network and clinical programs, partially offset by the growth of our pharmacy benefit management program.
Workers’ Compensation gross margin decreased due to declines in our network and clinical program volumes, which are higher margin products, partially offset by increases attributable to the growth of our pharmacy benefit management program which operates at a lower margin.
The nature of a majority of our operations is such that cash receipts from premium revenues are typically received up to two months prior to the expected cash payment for related medical costs. Premium revenues are typically received at the beginning of the month in which they are earned, and the corresponding incurred medical expenses are paid in a future time period, typically 15 to 60 days after the date such medical services are rendered. The lag between premium receipts and claims payments creates positive cash flow and overall cash growth. As a result, we typically hold approximately one to two months of “float.” In addition, accumulated earnings provide further liquidity.
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. The fixed income portfolio includes government and corporate securities with an average quality rating of “AA-” and an effective duration of 3.66 years as of December 31, 2011. 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.
Net cash from operating activities for the year ended December 31, 2011 was an inflow as a result of net earnings generated by our normal operations during the period, net of adjustments to earnings, an increase in medical liabilities primarily due to the implementation of our Kentucky Medicaid contract and an increase in accounts payable and other accrued liabilities related to minimum MLR rebate accruals. Offsetting these inflows is an increase in other receivables related to the timing of settlement of current year subsidy receivables for our Medicare business due from CMS that we expect to receive in 2012. Additionally, offsetting these inflows was $150.5 million paid to settle the provider class action litigation in Louisiana. For additional information regarding the provider class action matter, refer to Note M, Commitments and Contingencies, to the consolidated financials statements, which is incorporated herein by reference.
Our net cash from operating activities in 2010 was $609.6 million lower than the 2009 period as 2010 period reflected the medical claim payments associated with the Medicare PFFS product run out. During 2009, we experienced large positive cash flows from operating activities primarily due to membership growth across the Medicare products.
As of December 31, 2011, we were contractually obligated to make the following payments during the next five years and thereafter (in thousands):
The table above does not reflect the timing of cash payments related to income taxes or legal contingencies. For additional information related to our income taxes, operating leases and other contingencies refer to Note J, Income Taxes, and Note M, Commitments and Contingencies, to the consolidated financial statements, which is incorporated herein by reference.
On June 22, 2011, we entered into a five-year revolving credit facility agreement in the principal amount of $750.0 million. As of December 31, 2011, there were no amounts outstanding under this credit facility. For additional information, refer to Note L, Debt, to the consolidated financial statements, which is incorporated herein by reference.
We have typically paid 90% to 95% of medical claims within six months of the date incurred and approximately 99% of medical claims within nine months of the date incurred. We believe medical claims liabilities are short-term in nature and therefore do not meet the listed criteria for classification as contractual obligations and, accordingly, have been excluded from the table above. As of December 31, 2011, we had $85.4 million of unrecognized tax benefits. The above table excludes these amounts due to uncertainty of timing and amounts regarding future payments.
For our Medicare Advantage CCP product, we anticipate growth of approximately 25,000 members in early 2012, as compared to year-end 2011. We expect the 2012 Medicare Advantage MLR to be in the low to mid 80%s, consistent with the 2011 MLR of 82.9%.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Coventry Health Care, Inc. at December 31, 2011 and 2010, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2011, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule referred to above, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Coventry Health Care, Inc.’s internal control over financial reporting as of December 31, 2011, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 27, 2012 expressed an unqualified opinion thereon.
Investments - The Company accounts for investments in accordance with the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Codification (“ASC”) Topic 320-10, “Accounting for Certain Investments in Debt and Equity Securities,” ASC Topic 320-10-35-35, “Accounting for Debt Securities After an Other-than-Temporary Impairment,” and Accounting Standards Update (“ASU”) 2010-06, “Improving Disclosures about Fair Value Measurements.” The Company has adopted the disclosure provisions of ASU 2010-06. The Company invests primarily in fixed income securities and classifies all of its investments as available-for-sale. Investments are evaluated on an individual security basis at least quarterly to determine if declines in value are other-than-temporary. In making that determination, the Company considers all available evidence relating to the realizable value of a security. This evidence is reviewed at the individual security level and includes, but is not limited to, the following:
Other Receivables - Other receivables include pharmacy rebate receivables of $280.5 million and $310.7 million at December 31, 2011 and 2010, respectively. Other receivables also include Medicare Part D program related risk share and subsidy receivables (discussed below under “Revenue Recognition”), Medicare risk adjuster receivables, Office of Personnel Management (“OPM”) receivables, interest receivables, and any other receivables that do not relate to premiums. The increase in other receivables during 2011 primarily resulted from the net Medicare Part D subsidy receivables (reinsurance subsidy, low-income subsidy and coverage gap subsidy) related to the 2011 plan year that we expect to collect when the plan year is settled in 2012.
Other Current Assets - Other Current Assets primarily include deferred tax assets and also includes prepaid expenses. See Note J, Income Taxes, to the consolidated financial statements for additional information.
Business Combinations, Accounting for Goodwill and Other Intangibles - The Company accounts for Business Combinations in accordance with ASC Topic 805-10, “Business Combinations” and accounts for goodwill and other intangibles in accordance with ASC Topic 350-10, “Intangibles - Goodwill and Other” and ASU 2011-08, “Intangibles - Goodwill and Other (Topic 350): Testing Goodwill for Impairment.” Goodwill and other intangible assets that have indefinite lives are subject to a periodic assessment for impairment by applying a fair-value-based test. The Company’s annual impairment test date is October 1 of each fiscal year. The Company has five reporting units: Health Plans, Workers’ Compensation, MHNet, Medicare Part D, and Network Rental. For goodwill, the Company performs a multi-step impairment test. First, the Company measures the fair value of each reporting unit and compares it to its carrying value. The Company determines the fair value of its reporting units based on a weighting of income and market approaches. The market approach estimates the reporting unit’s fair value by utilizing market multiples of revenue or earnings for comparable companies. The income approach is based on the present value of estimated future cash flows. If the fair value of the reporting unit exceeds the carrying value of the net assets assigned to that unit, goodwill is not impaired and no further testing is performed. If the carrying value of the net assets assigned to the reporting unit exceeds the fair value of the reporting unit, then the Company must perform the second step of the impairment test in order to determine the implied fair value of the reporting unit’s goodwill. If the carrying value of a reporting unit’s goodwill exceeds its implied fair value, the Company records an impairment charge equal to the difference. Impairment charges are recorded in the period incurred. See Note E, Goodwill and Other Intangible Assets, to the consolidated financial statements for disclosure related to these assets.
The following table presents the components of the change in medical claims liabilities for the years ended December 31, 2011, 2010 and 2009, respectively (dollars in thousands).
The change in Medicare Part D related subsidy liabilities identified in the table above represent subsidy amounts received from Centers for Medicare & Medicaid Services (“CMS”) for reinsurance, coverage gap and for cost sharing related to low-income individuals. These subsidies are recorded in medical liabilities and the Company does not recognize premium revenue or claims expense for these subsidies.
Comprehensive Income - Comprehensive income includes net earnings and unrealized net gains and losses on investment securities. Other comprehensive income is net of reclassification adjustments to adjust for items currently included in net earnings, such as realized gains and losses on investment securities. The deferred tax provision for holding gains arising from investment securities during the years ended December 31, 2011, 2010 and 2009 was $18.3 million, $4.1 million, and $25.3 million, respectively. The deferred tax provision for reclassification adjustments for gains included in net earnings on investment securities during the years ended December 31, 2011, 2010 and 2009 was $6.5 million, $4.3 million, and $4.5 million, respectively.
Subsidy amounts received from CMS for coverage gap, reinsurance and for cost sharing related to low-income individuals are recorded in medical liabilities and will offset medical costs when paid. The Company does not recognize premium revenue or claims expense for these subsidies as the Company does not incur any risk with this part of the program. A reconciliation of the final risk sharing, low-income subsidy and reinsurance subsidy amounts is performed following the end of each contract year. A reconciliation of the coverage gap discount subsidies is performed quarterly.
CMS periodically performs audits and may seek return of premium payments made to the company if risk adjustment factors are not properly supported by medical record data. The Company estimates and records reserves for CMS audits based on information available at the time the estimates are made. The judgements and uncertainties affecting the application of these policies include, among other things, significant estimates related to the amount of hierarchical condition category (“HCC”) revenue subject to audit, anticipated error rates, sample methodologies, confidence intervals, enrollee selection, and payment error extrapolation methodology. The Company has recorded risk adjustment data validation (“RADV”) reserves, for contract years 2007 through 2011, of $155.2 million at December 31, 2011. The total RADV liability includes $125.6 million associated with the 2007 through 2010 contract years. Although the Company maintains reserves for RADV audits, actual results could differ materially from those estimates.
Cost of Sales - 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.
Contract Acquisition Costs - Costs related to the acquisition of customer contracts, such as commissions paid to outside brokers, are paid on a monthly basis and expensed as incurred. For the Medicare Advantage Coordinated Care Plans (“Medicare Advantage CCP”) business, the Company advances commissions and defers amortization of these costs to the period in which revenue associated with the acquired customer is earned, which is generally not more than one year.
Earnings Per Share - Basic earnings per share are based on the weighted average number of common shares outstanding during the year. Diluted earnings per share assume the exercise of all options and the vesting of all restricted stock using the treasury stock method. Potential common stock equivalents to purchase 6.5 million, 10.3 million and 12.2 million shares for the years ended December 31, 2011, 2010 and 2009, respectively, were excluded from the computation of diluted earnings per share because the potential common stock equivalents were anti-dilutive.
In May 2011, the FASB issued ASU 2011-04, “Fair Value Measurement (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and International Financial Reporting Standards.” ASU 2011-04 requires additional fair value measurement disclosures, including: (a) quantitative information about the significant unobservable inputs used for Level 3 fair value measurements, a qualitative discussion about the sensitivity of the measurements to changes in the unobservable inputs, and a description of a company’s valuation process, (b) any transfers between Level 1 and 2, (c) information about when the current use of a non-financial asset measured at fair value differs from its highest and best use, and (d) the hierarchy classification for items whose fair value is not recorded on the balance sheet but is disclosed in the notes. ASU 2011-04 is effective for fiscal periods beginning after December 15, 2011. The Company will adopt the disclosure requirements beginning in fiscal year 2012. The adoption of ASU 2011-04 is not expected to materially affect the Company’s financial position or results of operations.
In June and December 2011, the FASB issued ASU 2011-05, “Comprehensive Income (Topic 220): Presentation of Comprehensive Income” and ASU 2011-12, “Comprehensive Income (Topic 220): Deferral of the Effective Date for Amendments to the Presentation of Reclassifications of Items Out of Accumulated Other Comprehensive Income in ASU 2011-05,” respectively. ASU 2011-05 allows an entity the option to present the total of comprehensive income, the components of net income, and the components of other comprehensive income either in one continuous statement of comprehensive income or in two separate but consecutive statements. Also, ASU 2011-05 requires that reclassification adjustments between comprehensive income and net income must be presented on the face of the financial statements. ASU 2011-12 defers until further notice the requirement that reclassification adjustments between other comprehensive income and net income be presented on the face of the financial statements. Both ASU 2011-05 and ASU 2011-12 are effective for fiscal years and interim periods beginning after December 15, 2011, with early adoption permitted. The Company will adopt the disclosure requirements beginning in fiscal year 2012. The adoptions of ASU 2011-05 and ASU 2011-12 are not expected to affect the Company’s financial position or results of operations.
During the three years ended December 31, 2011, the Company completed two business combinations. These business combinations were accounted for using the acquisition method of accounting and therefore the operating results of each acquisition have been included in the Company’s consolidated financial statements since the date of their acquisition. The purchase price for each business combination was allocated to the assets, including the identifiable intangible assets and liabilities based on estimated fair values. The excess of the purchase price over the net identifiable assets acquired was allocated to goodwill.
The following table summarizes the business combinations for the year ended December 31, 2010. The purchase price, inclusive of all retroactive balance sheet settlements to date, is presented below (in millions):
The Company completed its 2011 annual impairment test of goodwill in accordance with ASC Topic 350 and determined that there were no impairments. In performing its impairment analysis the Company identified its reporting units in accordance with the provisions of ASC Topic 350 and ASC Topic 280, “Segment Reporting.”
In order to determine the fair value of its reporting units, the Company weighted the income approach and the market approach. Under the income approach, the Company assumed certain growth rates, capital expenditures, discount rates and terminal growth rates in its calculations. The key assumptions used to determine the fair value of the Company’s reporting units included terminal values based upon long term growth rates and a discount rate based on the Company’s weighted average cost of capital adjusted for the risks associated with the operations. The market approach estimates the Company’s fair value by utilizing market multiples.
The Company will continue to monitor its market capitalization in relation to aggregate fair values of its reporting units to determine if events and circumstances warrant the performance of an interim impairment analysis.
The Company entered into a sale-leaseback transaction in the fourth quarter of 2011. The sale of a building and associated land resulted in an immaterial gain, which will be amortized over the life of the new lease (10 years).
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, 2011 and 2010 (in thousands):
The Company acquired eight separate investments (tranches) in a limited liability company that invests in equipment leased to third parties, through its acquisition of First Health Group Corp. on January 28, 2005. The total investment as of December 31, 2011 was $20.1 million and is accounted for using the equity method. The Company’s proportionate share of the limited liability company’s income is included in other income in the Company’s statements of operations. The Company has between a 20% and 25% interest in the limited liability company's share of each individual tranche of the limited liability company (approximately 10% of the total limited liability company).
The amortized cost and estimated fair value of available for sale debt securities by contractual maturity were as follows at December 31, 2011 and 2010 (in thousands):
Gross investment gains of $17.4 million and gross investment losses of $0.4 million were realized on sales of investments for the year ended December 31, 2011. This compares to gross investment gains of $15.5 million and gross investment losses of $4.5 million realized on sales of investments for the year ended December 31, 2010, and gross investment gains of $14.0 million and gross investment losses of $2.4 million realized on sales for the year ended December 31, 2009. The Company’s realized gains and losses are recorded in other income, net in the Company's consolidated statements of operations.
The Company continues to review its investment portfolios under its impairment review policy. Given the current market conditions and the significant judgments involved, there is a continuing risk that declines in fair value may occur and that other-than-temporary impairments may be recorded in future periods.
The Company’s Level 2 securities primarily consist of government-sponsored enterprise securities, state and municipal bonds, mortgage-backed securities, asset-backed securities, corporate debt and money market funds. The Company determines the estimated fair value for its Level 2 securities using the following methods: quoted prices for similar assets/liabilities in active markets, quoted prices for identical or similar assets in non-active markets (few transactions, limited information, non-current prices and high variability over time), inputs other than quoted prices that are observable for the asset/liability (e.g. interest rates, yield curves volatilities and default rates, among others), and inputs that are derived principally from or corroborated by other observable market data.
Cash Equivalents: Level 2 cash equivalents are valued using inputs that are principally from, or corroborated by, observable market data, primarily quoted prices for like or similar assets.
Government-Sponsored Enterprises: These securities primarily consist of bonds issued by government-sponsored enterprises, such as the Federal Home Loan Bank, the Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation. The fair value of government-sponsored enterprises is based upon observable market inputs such as quoted prices for like or similar assets, benchmark yields, reported trades and credit spreads.
The Company’s Level 3 securities primarily consisted of corporate financial holdings and mortgage-backed and asset-backed securities that were thinly traded due to market volatility and lack of liquidity. The Company determined the estimated fair value for its Level 3 securities using unobservable inputs that cannot be corroborated by observable market data including, but not limited to, broker quotes, default rates, benchmark yields, credit spreads and prepayment speeds.
Transfers between levels, if any, are recorded as of the end of the reporting period. During the year ended December 31, 2011, there were no transfers between Level 1 and Level 2. The following table provides a summary of changes in the fair value of the Company’s Level 3 financial assets for the years ended December 31, 2011 and 2010 (in thousands):
During 2010, one investment previously classified as Level 3 was reclassified to Level 2 because observable market data became available.
The carrying value of the revolving credit facility approximated the fair value due to the short maturity dates of the draws. The Company had no outstanding borrowings under its current credit facility at December 31, 2011.
The Company has one stock incentive plan, the Amended and Restated 2004 Incentive Plan (the “Incentive Plan”) under which shares of the Company’s common stock are authorized for issuance to key employees, consultants and directors in the form of stock options, restricted stock and other stock-based awards. Shares available for issuance under the Incentive Plan were 4.3 million as of December 31, 2011.
Under the 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 but not less than the fair value of the underlying stock at the date of grant. Options generally become exercisable after one year in either 33% or 25% increments per year and expire ten years from the date of grant.
The total intrinsic value of options exercised was $20.9 million, $11.3 million, and $1.5 million for the years ended December 31, 2011, 2010 and 2009, respectively. The tax benefit realized from stock option exercises was $7.7 million, $4.1 million and $0.5 million, for the years ended December 31, 2011, 2010 and 2009, respectively. As of December 31, 2011, there was $20.0 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 2.0 years.
The Company’s effective tax rate differs from the federal statutory rate of 35% as a result of the following:
The effect of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities at December 31, 2011 and 2010 are presented below (in thousands):
The total amount of unrecognized tax benefits, as of December 31, 2011 and 2010 that, if recognized, would affect the effective tax rate was $38.2 million and $43.3 million, respectively. Further, the Company is unaware of any positions for which it is reasonably possible that the total amounts of unrecognized tax benefits will significantly increase or decrease within the next twelve months.
Penalties and tax-related interest expense are reported as a component of income tax expense. As of December 31, 2011 and 2010, the total amount of income tax-related accrued interest and penalties, net of related tax benefit, recognized in the statement of financial position was $10.4 million and $9.2 million, respectively.
Under the Savings Plan, participants may defer up to 75% of their eligible compensation, limited by the maximum compensation deferral amount permitted by applicable law. The Company makes matching contributions in the Company’s common stock equal to 100% of the participant’s contribution on the first 3% of the participant’s eligible compensation and equal to 50% of the participant’s contribution on the second 3% of the participant’s eligible compensation. Participants vest immediately in all safe harbor matching contributions. The Savings Plan permits all participants, regardless of service, to sell the employer match portion of the Coventry common stock in their accounts, during certain times of the year, and transfer the proceeds to other Coventry 401(k) funds of their choosing. All costs of the Savings Plan are funded by the Company and participants as they are incurred.
As a result of corporate acquisitions and transactions, the Company has acquired entities that have sponsored other qualified plans. All qualified plans sponsored by the acquired subsidiaries of the Company have either terminated or merged with and into the Savings Plan. The cost of the Savings Plan, including the acquired plans, for 2011, 2010 and 2009 was approximately $29.7 million, $27.4 million and $30.3 million, respectively.
The Company was the sponsor of a deferred compensation plan that was designed to promote the retention of key senior management and to recognize their strategic importance to the Company. The fixed dollar and stock equivalent allocations charged to operations for this plan were $1.6 million in 2009. This plan was settled and paid out during 2010 for $1.4 million.
During 2011, the Company completed the sale of $600.0 million aggregate principal amount of its 5.450% Senior Notes due 2021 (the “2021 Notes”) at the issue price of 99.800% per note. The 2021 Notes are senior unsecured obligations of Coventry and rank equally with all of its other senior unsecured indebtedness.
During 2011, the Company repaid in full the $380.0 million outstanding balance of the revolving credit facility due July 11, 2012 and the associated credit agreement was terminated.
During 2011, the Company entered into a new Credit Agreement (the “Credit Facility”). The Credit Facility provides for a five-year revolving credit facility in the principal amount of $750.0 million, with the Company having the ability to request an increase in the facility amount up to an aggregate principal amount not to exceed $1.0 billion. Advances under the Credit Facility bear interest at (1) a rate per annum equal to the Administrative Agent’s base rate (the “Base Rate”) or (2) the one-, two-, three-, six-, nine-, or twelve-month rate per annum for Eurodollar deposits (the “Eurodollar Rate”) plus an applicable margin, as selected by the Company. The applicable margin for Eurodollar Rate advances depends on the Company’s debt ratings and varies from 1.050% to 1.850%. The Company pays commitment fees on the Credit Facility ranging from 0.200% to 0.400%, per annum, regardless of usage and dependent on the Company’s debt ratings. The obligations under the Credit Facility are general unsecured obligations of the Company. As of December 31, 2011, there were no amounts outstanding under the Credit Facility.
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, 2011. The Company has a risk of incurring losses if such allowances are not adequate.
The Company’s regulated health maintenance organizations (“HMO”) and insurance company subsidiaries are required by state regulatory agencies to maintain minimum surplus balances, thereby limiting the dividends the parent may receive from its regulated entities. During 2011, the Company received $489.4 million in dividends from its regulated subsidiaries and paid $122.0 million in capital contributions to these subsidiaries.
Excluding funds held by entities subject to regulation and excluding the equity method investments, the Company had cash and investments of approximately $1.4 billion and $1.1 billion at December 31, 2011 and 2010, respectively. The increase primarily resulted from the issuance of the 2021 Notes discussed previously, dividends received from the Company’s regulated subsidiaries, and earnings generated from its non-regulated entities. This increase was partially offset by share repurchases, repayment of debt related to our revolving credit facility, a cash payment related to the provider class action litigation in Louisiana and capital contributions made by the parent.
The Company’s Board of Directors has approved a program to repurchase its outstanding common shares. Share repurchases may be made from time to time at prevailing prices on the open market, by block purchase, or in private transactions. The Company’s Board of Directors approved increases in November 2011 and March 2011 to the share repurchase program in amounts equal to 10% and 5% of the Company’s then outstanding common stock, thus increasing the Company’s repurchase authorization by 14.4 million and 7.5 million shares, respectively. Under the share repurchase program, the Company purchased 10.7 million shares and 1.5 million shares of its common stock, at an aggregate cost of $327.7 million and $30.0 million during 2011 and 2009, respectively. During 2010, the Company made no repurchases of its common stock. As of December 31, 2011, the total remaining common shares the Company is authorized to repurchase under this program is 16.5 million. Excluded from these amounts are shares purchased in connection with the vesting of restricted stock awards to satisfy employees’ minimum statutory tax withholding obligations as these purchases are not part of the program.
On May 27, 2011, the court entered an order of final approval of a settlement and, accordingly, the Company recorded a non-recurring pre-tax adjustment to earnings of $159.3 million in the second quarter of 2011. See Note M, Commitments and Contingencies, to the consolidated financial statements for additional information.
Mr. Joseph R. Swedish, a director of the Company since 2010, is the President and Chief Executive Officer of Trinity Health, a not-for-profit, integrated health care delivery system which operates 47 hospitals and other health care facilities in eight states. Trinity Health has entered into market based provider contracts with subsidiaries of the Company in these eight states. During 2011 and 2010, the Company paid approximately $14.4 million and $18.9 million respectively to Trinity Health for health care services provided to its members. Consistent with the Company’s Related Person Transactions Policy, disinterested members of the Board’s Nominating/Corporate Governance Committee as well as disinterested members of the entire Board determined that the level of reimbursement paid to Trinity Health for services provided to its members were market based and that the total amount paid was immaterial to both Trinity Health and the Company. Since Trinity Health is a not-for-profit organization, Mr. Swedish derives no additional income as a result of the transaction between Trinity Health and the Company.