square foot sales office in Utah and two clinical offices totaling approximately 4,500 square feet in Arizona. We also own several parcels of land in Las Vegas. One parcel is currently up for sale.
The table below presents our selected consolidated financial information for the years indicated. The table should be read in conjunction with the Consolidated Financial Statements and the related Notes thereto, “Management's Discussion and Analysis of Financial Condition and Results of Operations” and other information which appears elsewhere in this Annual Report on Form 10-K. The selected consolidated financial data below has been derived from our audited Consolidated Financial Statements and related notes.
The following discussion and analysis provides information which management believes is relevant for an assessment and understanding of our consolidated financial condition and results of operations. The discussion should be read in conjunction with the Consolidated Financial Statements and related Notes thereto. The information contained below may be subject to risk factors. We urge you to review carefully the section “Forward-Looking Statements” in Part 1, Item 1 and “Risk Factors” in Part 1, Item 1A of this Annual Report on Form 10-K for a more complete discussion of forward looking statements and the risks associated with an investment in our securities.
Our highlights for the year ended December 31, 2006 compared to the year ended December 31, 2005 include:
Total operating revenues increased by 24.1%. This improvement was primarily driven by a 25.7% increase in medical premiums due to our participation in the new Medicare Part D prescription drug program (PDP), an increase in our HMO membership and premium rate increases. Also contributing to the improvement in operating revenues was a 26.0% increase in investment and other revenues, which increased due to an increase in yield during and higher average invested balances.
General and administrative (G&A) expenses as a percentage of medical premiums decreased to 12.7% in 2006 from 13.4% in 2005. G&A expenses increased 19.1% primarily due to PDP related expenses, higher employee compensation related expenses, premium taxes, and brokers’ fees.
Operating income from our managed care and corporate operations improved 24.3% primarily driven by our participation in the PDP, medical premium revenue growth from new members and premium rate increases. Our operating margin from our managed care and corporate operations, which is operating income divided by total revenues, decreased 10 basis points as a result of the lower operating margin for the PDP.
We repurchased 6.6 million shares of our common stock during 2006. Our weighted average common shares outstanding assuming dilution has decreased from 67.1 million in 2005 to 62.7 million in 2006, or 6.6%.
Cash flows from operating activities increased to $190.4 million from $166.8 million during 2005. This increase is mostly due to the fact that we had a $13.5 million increase in income taxes payable due to the timing of tax payments, recorded an $11.8 million payable to the Centers for Medicare and Medicaid Services (CMS) as a result of favorable pharmacy utilization in our Medicare Advantage PDP, and had an increase in our non-PDP medical claims payable during 2006 compared to 2005. This was partially offset by negative cash flow of $7.9 million related to our stand-alone PDP. The negative cash flow is primarily due to insufficient funding from CMS for our reimbursable low-income subsidy and reinsurance costs. These costs should be fully reimbursed after CMS performs their year-end reconciliation, which is currently expected to be completed by the third quarter of 2007.
The increase in medical premiums for 2006 includes $197.1 million from our stand-alone PDP described below, which was effective January 1, 2006. We recognize medical premiums from the PDP as earned over the contract period. The increase in medical premiums for 2006 also reflects the annual Medicare increase described below and a 3.5% increase in HMO Medicare member months. The growth in Medicare member months contributes significantly to the increase in medical premiums as the Medicare per member premium rates are more than three times the
In 2007, SHL, for the first time, will offer an enhanced benefit plan, which provides brand name and generic prescription drug benefits through the coverage gap or “donut hole”. At January 31, 2007, we had 41,900 members enrolled in our enhanced benefit plan. We do not expect many new members to enroll the rest of the year as Medicare beneficiaries cannot change stand alone PDP plans during the year unless unusual circumstances exist. The premium structure for the enhanced benefit plan was based on a projected level of utilization per member. We engaged independent actuarial consultants in developing the enhanced benefit plan who used their national database in this process. Our experience so far in 2007 leads us to believe we will experience increased costs from what the actuarial projections anticipated. One cause of this may be unanticipated levels of adverse selection. Based on the data available to date, and without giving effect to any success our efforts at mitigation may have, we anticipate that expected 2007 pharmacy and maintenance costs will exceed the expected 2007 premiums; however, given the limited data we have, we are unable to reasonably estimate the amount of premium deficiency at this time. We believe that over the course of the next 45 to 60 days we will be able to obtain additional information that will allow us to reasonably estimate the amount of the premium deficiency. We are currently developing and implementing strategies in an effort to mitigate expected losses on this product. This product will not be offered in 2008. Certain strategies may be subject to approval from CMS. See Note 13, “Commitments and Contingencies”, in the Notes to Consolidated Financial Statements for further discussion of our enhanced benefit plan.
CMS shares in a portion of the risk of pharmacy costs related to the basic coverage in our stand-alone and Medicare Advantage PDP. The Company recognizes a risk sharing payable or receivable based on the year-to-date activity and a corresponding increase or decrease to medical premiums. The risk sharing payable or receivable is accumulated for each contract and recorded in the prepaid expenses and other current assets or accrued and other current liabilities depending on the net contract balance at the end of the reporting period.
In 2007, SHL will continue to offer its local and regional Medicare Advantage PPO plans and for the first time, SHL will offer a Medicare Advantage Private Fee-For-Service plan. The plan will be available in 28 states and the District of Columbia. The plan does not include Medicare Part D prescription drug coverage but does provide hospital and physician coverage. Members will pay a monthly premium, co-payments and coinsurance, with reasonable out-of-pocket maximum amounts. Members will also have unlimited network access.
Effective January 2004, CMS adopted a new risk adjustment payment methodology for Medicare beneficiaries
Pursuant to an existing contract with the Division of Healthcare Financing and Policy of the state of Nevada (DHCFP), we provide health care coverage to certain Medicaid eligible individuals and uninsured children who do not qualify for Medicaid. At December 31, 2006, we had approximately 44,300 members enrolled in our HMO Medicaid risk program. To enroll in this program, an individual must be eligible for the Temporary Assistance for Needy Families or the Children's Health Assurance Program categories of the state’s Medicaid program. At December 31, 2006, we also had approximately 16,200 Nevada Check Up members. Nevada Check Up is the state’s Children's Health Insurance Program, which covers certain uninsured children who do not qualify for Medicaid. We receive a monthly fee for each Medicaid and Nevada Check Up member enrolled by the state's Managed Care Division and we also receive a per case fee for each Medicaid and Nevada Check Up eligible newborn delivery. We received a 0.9% decrease on January 1, 2006, due in large part to our mix of Medicaid members; however, we received a 2.6% rate increase on July 1, 2006. We expect a 1% rate increase retroactive to January 1, 2007 and an additional 1.0% increase on July 1, 2007.
Investment and Other Revenue. Higher average invested balances and an increase in yield during 2006 primarily contributed to the increase in investment and other revenues. See Note 3, "Cash and Investments", in the Notes to Consolidated Financial Statements.
medical expenses are the operating expenses of the Company’s medical provider subsidiaries and certain claims-related administrative expenses, which accounted for 28.4% and 32.9% of our total medical expenses for 2006 and 2005, respectively.
Interest Expense. Debenture holders converted $63.0 million of our senior convertible debentures during 2005. This conversion resulted in a decrease in interest expense in compared to 2005. This decrease was partially offset by using our credit facility to repurchase shares. At December 31, 2006, we had $75 million outstanding on our credit facility.
Provision for Income Taxes. Our effective tax rate is slightly less than the statutory rate due primarily to tax-preferred investments. The 2006 tax rate was higher than 2005 primarily due to a favorable state tax settlement during 2005.
HMO and POS premium rates for renewing commercial groups increased approximately 6.0% while the overall
Professional Fees. The increase in professional fees is a result of increased visits to our clinical subsidiaries and a new contract to provide anesthesiology services to a local hospital.
Offsetting the decrease of $9.4 million in administrative services revenue, we had an increase in investment and other revenues of $6.5 million due to an increase in yield during 2005 and higher average invested balances, partially offset by a loss on a short sale of U.S. Treasury bonds.
Our medical claims payable liability requires us to make significant estimates. Any changes to the estimates would be reflected in the year the adjustments are made. Included in medical expenses is favorable development on prior years’ estimates of $13.3 million and $12.1 million for the years ended December 31, 2005 and 2004, respectively. The favorable development is a result of claims being settled for amounts less than originally estimated. For a further description of the estimate for our medical claims payable liability, see below in “Critical Accounting Policies and Estimates”.
We contract with hospitals, physicians and other independent providers of health care under capitated or discounted fee-for-service arrangements, including hospital per diems, to provide medical care services to members. Capitated providers are at risk for a portion of the cost of medical care services provided to our members in the relevant geographic areas; however, we are ultimately responsible for the provision of services to our members should the
capitated provider be unable to provide the contracted services. We incurred capitation expenses with non-affiliated providers of $128.3 million and $114.1 million, or 12.6% and 13.0%, of our total medical expenses for 2005 and 2004, respectively. Also included in medical expenses are the operating expenses of the Company’s medical provider subsidiaries and certain claims-related administrative expenses, which accounted for 32.9% and 32.3% of our total medical expenses for 2005 and 2004, respectively.
Discontinued Operations. On January 15, 2003, we announced that we were exploring strategic alternatives to dispose of CII Financial, Inc. (CII). Our Board of Directors authorized the sale of the operations on December 31, 2002. Accordingly, beginning in the fourth quarter of 2002, we reclassified our workers’ compensation insurance business as discontinued operations.
On November 25, 2003, we announced that we had reached an agreement to sell California Indemnity Insurance Company (Cal Indemnity), and its subsidiaries. Cal Indemnity and its subsidiaries were CII’s only significant asset. In the fourth quarter of 2003, we recorded a charge of $15.6 million, gross and net of tax, to write down the investment in Cal Indemnity to its estimated net sales proceeds.
On March 31, 2004, we completed the sale of Cal Indemnity. Cal Indemnity's subsidiaries, which were included in the sale, were Commercial Casualty Insurance Company, Sierra Insurance Company of Texas, and CII Insurance Company.
Net cash used for investing activities during 2006 included capital expenditures associated with the continued implementation of new computer systems, leasehold improvements on facilities, furniture and equipment and other capital purchases to support our growth. The net cash change in investments for the period was a decrease in investments, as investments were sold to fund operations.
In March 2003, we issued $115.0 million aggregate principal amount of 2¼% senior convertible debentures due March 15, 2023. The debentures pay interest, which is due semi-annually on March 15 and September 15 of each year. Each $1,000 principal amount of debentures is convertible, at the option of the holders, into 109.3494 shares of our common stock before March 15, 2023 if (i) the market price of our common stock for at least 20 trading days
During 2005, we received offers and entered into five separate and privately negotiated transactions with debenture holders (holders) pursuant to which the holders converted an aggregate of $63.0 million of debentures they owned into approximately 6.9 million shares of our common stock in accordance with the indenture governing the debentures. During the first quarter of 2006, a holder converted $500,000 in debentures for approximately 54,000 shares of common stock. During the third quarter of 2006, we entered into a privately negotiated transaction with a holder pursuant to which the holder converted $8,000,000 in debentures for approximately 875,000 shares of common stock in accordance with the indenture governing the debentures. In January 2007, we entered into a privately negotiated transaction with a holder pursuant to which the holder converted $21.7 million in debentures for approximately 2.4 million shares of common stock in accordance with the indenture governing the debentures.
On March 3, 2003, we entered into a revolving credit facility. Effective June 26, 2006, this facility was amended to extend the expiration from December 31, 2009 to June 26, 2011, increase the availability from $140.0 million to $250.0 million and reduce the drawn and undrawn fees. The current incremental borrowing rate is LIBOR plus 0.60%. The facility is available for general corporate purposes and at December 31, 2006, we had $75.0 million outstanding on this facility.
Our HMO and insurance subsidiaries are required by state regulatory agencies to maintain certain deposits and must also meet certain net worth and reserve requirements. The HMO and insurance subsidiaries had restricted assets on deposit in various states totaling $18.7 million at December 31, 2006. The HMO and insurance subsidiaries must also meet requirements to maintain minimum stockholders’ equity, on a statutory basis, as well as minimum risk-based capital requirements, which are determined annually. In conjunction with the exit from the Texas HMO health care market, the Texas Department of Insurance approved a plan of withdrawal and Texas Health Choice, L.C., is now required to maintain deposits of $1.5 million and net worth of at least $3.5 million. We believe we are in material compliance with our regulatory requirements.
Of the $58.9 million in cash and cash equivalents held at December 31, 2006, $38.6 million was designated for use only by the regulated subsidiaries. Amounts are available for transfer to the parent company from the HMO and insurance subsidiaries only to the extent that they can be remitted in accordance with the terms of existing management agreements and by dividends. The parent company will not receive dividends from its regulated subsidiaries if such dividend payment would cause a violation of statutory net worth and reserve requirements.
Our long-term debt consists of our 2¼% senior convertible debentures issued in March 2003 and our credit facility. We occupy space and lease equipment under leases that are accounted for as capital leases, where the property and equipment and related lease obligations are recorded on our balance sheet.
We also occupy premises and utilize equipment under operating leases that expire at various dates through 2016. In accordance with generally accepted accounting principles, the obligations under these operating leases are not recorded on our balance sheet.
We also have a $3.4 million long-term liability for transition services related to our sale of CII that we are required to provide through December 31, 2009.
Health care costs continue to rise at a rate faster than the Consumer Price Index. We use various strategies to mitigate the negative effects of health care cost inflation, including setting commercial premiums based on our anticipated health care costs, risk-sharing arrangements with our various health care providers and other health care cost containment measures including member co-payments. There can be no assurance, however, that in the future, our ability to manage medical costs will not be negatively impacted by items such as technological advances, competitive pressures, applicable regulations, change in provider contracts, increases in pharmacy and other medical costs, utilization changes and catastrophic items, which could, in turn, result in medical cost increases equaling or exceeding premium increases.
Our business, offering health care coverage, health care management services and, to a lesser extent, the delivery of medical services, is heavily regulated at both the federal and state levels.
Government regulation of health care coverage products and services is a dynamic area of law that varies from jurisdiction to jurisdiction. Amendments to existing laws and regulations are continually being considered and interpretation of the existing laws and rules changes from time to time. Regulatory agencies generally exercise broad discretion in interpreting laws and promulgating regulations to enforce their interpretations.
While we are unable to predict what legislative or regulatory changes may occur or the impact of any particular change, our operations and financial results could be negatively affected by any legislative or regulatory requirements. For example, any proposals to eliminate or reduce the Employee Retirement Income Security Act (ERISA), which regulates insured and self-insured health care coverage plans offered by employers, pre-emption of state laws that would increase potential managed care litigation exposure, affect underwriting practices, limit rate increases, require new or additional benefits or affect contracting arrangements (including proposals to require HMOs and PPOs to accept any health care provider willing to abide by an HMO's or PPO's contract terms or commission arrangements) may have a material adverse effect on our business. The continued consideration and enactment of “anti-managed care” laws and regulations by federal and state bodies may make it more difficult for us to manage medical costs and may adversely affect financial results.
In September 2006, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 108 (SAB 108) addressing how the effects of prior-year uncorrected financial statement misstatements should be considered in current-year financial statements. SAB 108 requires registrants to quantify misstatements using both balance-sheet and income-statement approaches in evaluating whether or not a misstatement is material. SAB 108 is effective for fiscal years ending after November 15, 2006. We have adopted SAB 108 and it did not have a material impact on our year ended December 31, 2006 consolidated financial position or results of operations.
In February 2007, the FASB issued Statement of Financial Accounting Standards No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities- Including an Amendment of FASB Statement No. 115” (SFAS 159).
(PMPM) costs to the current membership. The estimated PMPM costs are derived from historical paid claims (with completion factors as described above), trend assumptions and current utilization reports. This methodology is consistently applied from period to period.
The completion factors and estimated PMPM costs are the most significant factors we use in estimating our IBNR claims. The following table illustrates the sensitivity of these factors and the estimated potential impact on our medical claims payable balance as a result of these factors:
The table below provides historical information regarding the accrual and payment of our medical claims payable. Components of the total incurred claims for each year include amounts accrued for current year estimated claims expense as well as adjustments to prior year estimated accruals. The impact of any “changes in prior periods’ estimates” may be offset as we establish the estimate for the current year. Our accounting practice is to consistently recognize the actuarial best estimate of our ultimate liability for our claims within a reasonable level of confidence required by actuarial standards. Thus, only when the release of a prior year reserve is not offset with the same level of conservatism in estimating the current year reserve will the redundancy create a net reduction in current period medical expenses. The evaluation of medical claims payable at December 31, 2006 is comparable to prior years and we have applied our methodology in a consistent manner in determining our best estimate for medical claims payable at each reporting date.
Our provision for provider disputes is based on a separate evaluation of each dispute. We recognize a liability for such
Litigation and Legal Accruals. We are subject to various claims and other litigation in the ordinary course of business. Such litigation includes, but is not limited to, claims of medical malpractice, claims for coverage or payment for medical services rendered to HMO members and claims by providers for payment for medical services rendered to HMO and other members. We may also face claims for punitive damages that are not covered by insurance. In addition, under the terms of the note receivable due from the sale of Cal Indemnity, which is subject to adjustment for loss development, we can be indirectly affected by claims for workers’ compensation and claims by providers for payment of medical services rendered to injured workers. With respect to certain pending actions, we maintain commercial insurance coverage with varying deductibles for which we maintain estimated reserves for our self-insured portion based upon our current assessment of such litigation. In addition, we accrue estimated legal defense and other settlement costs based on our assessment of the available information, including our outside legal counsel’s assessment of the case. We also assess potential legal exposure, based on currently available information, to determine if a precautionary notice of potential claim should be reported to our insurers and if an accrual should be established.
Note Receivable From the Sale of Cal Indemnity. On March 31, 2004, we completed the sale of Cal Indemnity and its insurance subsidiaries. We received a note for $62.0 million, which is subject to certain adjustments including development that occurs on the loss and allocated loss adjustment expense (ALAE) reserves from the closing date through December 31, 2009. Included in the development is, if applicable, any uncollectible reinsured losses. We are also obligated to perform, be responsible for the performance of, or be financially obligated to pay for, certain transition services through December 31, 2009 for which we received a limited amount of funds for these services.
Based on our new actuary’s analyses as well as considering the historical adverse loss development trend, we recorded a valuation allowance of $15.0 million in December 2004. Partially offsetting this was a reduction in accrued liabilities related to the sale. As noted above, we are contractually obligated for the performance of certain transition services through December 31, 2009. We previously accrued net liabilities for the then projected deficiency in the revenues to be received to perform the services. In 2004, due to actual revenues exceeding estimates and actual expenses being less than projected expenses, we re-evaluated the remaining liabilities, which resulted in a $5.5 million reduction.
Any future adverse loss development could have a material effect on our financial results. For example, a 1% increase in the projected loss and ALAE ratios for all of the 2000 through 2005 accident years would increase the adverse development by approximately $6.4 million. If the loss and ALAE ratios for all accident years since Cal Indemnity’s inception (1988) increased by 1%, the adverse development would increase by approximately $17.6 million.
Other. In addition to the critical accounting policies and estimates discussed above, other areas requiring us to use judgment, assumptions and estimates include, but are not limited to, allowance for retroactive premium adjustments, potential investment impairments, deferred tax assets and liabilities, legal reserves, contractual discounts on professional fee revenue, allowances for doubtful receivables, other accrued liabilities, amounts related to our PDP, accrued payroll and taxes, post-employment benefit liabilities, unearned premium revenue and contingent assets and liabilities. See Note 2, "Summary of Significant Accounting Policies", in the Notes to Consolidated Financial Statements.
We have audited the accompanying consolidated balance sheets of Sierra Health Services, Inc. and subsidiaries (the “Company”) as of December 31, 2006 and 2005, and the related consolidated statements of income, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2006. Our audits also included the financial statement schedules listed in the Index at Item 15 (a)(2). These financial statements and financial statement schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on the financial statements and financial statement schedules based on our audits.
As discussed in Note 9 to the consolidated financial statements, on January 1, 2006, the Company adopted the provisions of Statement of Financial Accounting Standard No. 123(R), Share-Based Payment, and on December 31, 2006, the Company adopted the provisions of Statement of Financial Accounting Standard No. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the Company’s internal control over financial reporting as of December 31, 2006, based on the criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 27, 2007 expressed an unqualified opinion on management’s assessment of the effectiveness of the Company’s internal control over financial reporting and an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting.
Business. The consolidated financial statements include the accounts of Sierra Health Services, Inc. and its subsidiaries (collectively referred to as “Sierra” or the “Company”). Sierra is a managed health care organization that provides and administers the delivery of comprehensive health care programs with an emphasis on quality care and cost management. Sierra’s broad range of managed health care services are provided through its health maintenance organization (“HMO”), managed indemnity plans, third-party administrative services programs for employer-funded health benefit plans and medical management programs. Ancillary products and services that complement the Company's managed health care product lines are also offered. In addition, the Company had a subsidiary that administered a managed care federal contract for the Department of Defense’s (“DoD”) TRICARE program in Region 1. Health care services under the Company's TRICARE contract for Region 1 ended on August 31, 2004. On September 1, 2004, the Company entered a phase-out period at substantially reduced revenues. During 2005, the Company reached a negotiated settlement with the DoD for certain outstanding change orders and bid price adjustments related to option period six and the phase-out of the Company's military health care operations.
Medical Premiums. Commercial membership contracts are generally established on an annual basis subject to cancellation by the employer group or Sierra upon 60 days written notice. Premiums, including premiums from both commercial and governmental programs, are due monthly and are recognized as revenue during the period in which members are entitled to receive services and are net of estimated retroactive adjustments of members and groups. Commercial member enrollment is represented principally by employer groups or individuals. HPN offers a prepaid health care program to Medicare and Medicaid recipients and SHL offers a prepaid health care and pharmacy program to Medicare recipients. Revenues associated with Medicare recipients were approximately $751.3 million, $505.1 million and $455.0 million in 2006, 2005 and 2004, respectively. Revenues associated with Medicaid recipients were approximately $108.9 million, $98.0 million and $88.0 million in 2006, 2005 and 2004, respectively. Premiums collected in advance of the period that coverage for services is provided are recorded as unearned premium revenue and can include payments under prepaid Medicare contracts with the Centers for Medicare and Medicaid Services (“CMS”) and prepaid HPN and SHL commercial premiums.
In 2007, the Company will offer its stand-alone PDP in 30 states and the District of Columbia. The Company will remain eligible as a PDP sponsor for its current auto-enrolled CMS subsidized beneficiaries in California and Nevada,
and for its current and 2007 auto-enrolled beneficiaries in Arizona, Colorado, Idaho, Oregon, Utah and Washington. The Company will no longer be a PDP sponsor for auto-enrolled beneficiaries in New Mexico and Texas. For 2007, the Company, for the first time, will offer an enhanced benefit plan in the same 30 states and the District of Columbia. The enhanced benefit plan had approximately 41,900 members at January 31, 2007. See Note 13 for further discussion of the Company’s 2007 enhanced PDP offering.
The Company recognizes premium revenue as earned over the contract period; however, pharmacy and administrative costs are recognized as incurred with no allocation or annualized estimation of the impact of deductibles, the coverage gap or “donut hole,” prior to it being reached by the member, or reinsurance. This method of recognizing revenues and expenses results in a disproportionate amount of expense in the first part of each contract year when the plan is responsible for a larger portion of the drug cost.
CMS shares in the risk of certain pharmacy costs related to the basic benefits covered in our PDP. The Company recognizes a risk sharing payable or receivable based on the year-to-date activity. The risk sharing payable or receivable is accumulated for each contract and recorded in the Consolidated Balance Sheet in prepaid expenses and other current assets or accrued and other current liabilities depending on the net contract balance at the end of the reporting period.
Certain of the Company's HMO members are covered by an excess catastrophe reinsurance contract and SHL maintains reinsurance on certain of its insurance products. Reinsurance premiums of $2.1 million, $1.8 million and $1.9 million, net of reinsurance recoveries of $3.2 million, $4.0 million and $3.1 million, are included in medical expenses for 2006, 2005 and 2004, respectively.
Premium Deficiency Reserves. Premium deficiency expenses are recognized when it is probable that the future costs associated with a group of existing contracts will exceed the anticipated future premiums on those contracts. For purposes of analyzing premium deficiencies, contracts are grouped in a manner consistent with its method of acquiring, servicing, and measuring the profitability of such contracts. The Company calculates expected premium deficiency expense based on estimated revenues and expenses. Once established, premium deficiency reserves are evaluated quarterly for adequacy. In 2006, the Company has recorded $1.1 million in premium deficiency related to its new local and regional Medicare PPO business. See Note 13 for further discussion of premium deficiency relative to the Company’s enhanced PDP offering for 2007.
Concentration of Credit Risk. The Company's financial instruments that are exposed to credit risk consist primarily of cash equivalents, investments and accounts receivable. The Company maintains cash and cash equivalents and investments with various financial institutions. These financial institutions are located in many different regions and Company policy is designed to limit exposure with any one institution. The Company’s investments in trust deed mortgage notes are with numerous independent borrowers and are secured by real estate in several states. Loan to value ratios for these investments are typically based on appraisals or other market data obtained at the time of loan origination and may not reflect subsequent changes in value estimates. As a result, there may be less security than anticipated at the time the loan was originally made. If the value of the underlying assets decrease and default occurs, the Company may not recover the full amount of the loan or any interest due. The Company believes that no further adjustments are required to its recorded amounts of investments in trust deed mortgage notes at December 31, 2006.
Company from its obligations to enrollees or policyholders. Failure of reinsurers to honor their obligations would result in losses to the Company. The Company evaluates the financial condition of its reinsurers to minimize its exposure to significant losses from reinsurer insolvencies. All reinsurers with whom the Company has reinsurance contracts are rated A- or better by A.M. Best Company (3rd highest out of 16).
Recently Issued Accounting Standards. In July 2006, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes - an Interpretation of FASB Statement No. 109” (“FIN 48”). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with Statement of Financial Accounting Standards No. 109, “Accounting for Income Taxes”. FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. FIN 48 is effective for fiscal years beginning after December 15, 2006. The Company will be required to apply the provisions of FIN 48 to all tax positions upon initial adoption with any cumulative effect adjustment to be recognized as an adjustment to retained earnings. The Company estimates that, upon adoption, the cumulative effect adjustment charged to retained earnings to increase reserves for uncertain tax positions will be less than $5.0 million. This estimate is subject to revision as the Company finalizes its analysis.
In September 2006, the FASB issued Statement of Financial Accounting Standards No. 157 “Fair Value Measurements” (“SFAS 157”). SFAS 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements. SFAS 157 applies only to other accounting pronouncements that require or permit fair value measurements. SFAS 157 is effective for fiscal years beginning after November 15, 2007. The Company does not believe the adoption of SFAS 157 will have a material impact on its consolidated financial position, results of operations or cash flows.
In September 2006, the FASB issued Statement of Financial Accounting Standards No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans” (“SFAS 158”). SFAS 158 requires the recognition of the unfunded status of pension and other postretirement benefit plans on the balance sheet. SFAS 158 is effective for fiscal years ending after December 15, 2006. The Company has adopted SFAS 158 and it did not have a material impact on its consolidated financial position or results of operations for the year ended December 31, 2006. See Note 9 - "Employee and Director Benefit Plans".
In September 2006, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 108 (“SAB 108”) addressing how the effects of prior-year uncorrected financial statement misstatements should be considered in current-year financial statements. SAB 108 requires registrants to quantify misstatements using both balance-sheet and income-statement approaches in evaluating whether or not a misstatement is material. SAB 108 is effective for fiscal years ending after November 15, 2006. The Company has adopted SAB 108 and it did not have a material impact on its consolidated financial position or results of operations for the year ended December 31, 2006.
medical expenses and reserves, military revenue and expenses, legal reserves, fair values of investments, amounts receivable or payable under government contracts, deferred income taxes, goodwill, asset allowances, accrued liabilities, malpractice reserves and amounts collectable from notes receivable. Actual results may materially differ from estimates.
Trust deed mortgage notes and real estate joint ventures are stated at amortized cost and categorized as other investments. These investments are classified as current assets if expected maturity is within one year of the balance sheet date. Otherwise, they are classified as long-term investments. The remaining investments have been categorized as available-for-sale and are stated at their fair value. Fair value is estimated primarily from published market values at the balance sheet date. Gross realized gains on investments, from continuing operations, for 2006, 2005 and 2004 were $1.5 million, $1.3 million and $601,000, respectively. Gross realized losses on investments, from continuing operations, for 2006, 2005 and 2004 were $835,000, $242,000 and $535,000, respectively.
The following table summarizes the Company's available-for-sale investments at December 31, 2006:
The following table summarizes the Company's other investments at December 31, and 2005:
mortgage backed securities and corporate bonds are due to interest rate increases. It is expected that the securities would not be realized at a price less than the amortized cost of the Company’s investment. Based on the immaterial severity of the impairments and the ability and intent of the Company to hold these investments until recovery of fair value, which may be maturity, the investments were not considered to be other than temporarily impaired at December 31, 2006.
The Company’s effective tax rate is based on actual or expected income, statutory tax rates and available tax planning opportunities. The Company may use significant estimates and judgments in determining its effective tax rate. The Company is occasionally audited by federal, state or local jurisdictions regarding compliance with federal, state and local tax laws and the recognition of income and deductibility of expenses. Tax assessments may not arise until several years after tax returns are filed. While there is an element of uncertainty in predicting the outcome of tax audits, the Company believes that the recorded tax assets and liabilities are appropriately stated based on its analyses of probable outcomes, including interest and other potential adjustments. The tax assets and liabilities are adjusted based on the most current facts and circumstances, including the progress of audits, case law and emerging legislation and interpretations and any adjustments are included in the effective tax rate in the period of adjustment.
Included in loss carryforwards and credits is the unrealized capital loss on the sale of Cal Indemnity of $43.1 million. There is no tax benefit for the capital loss due to the nature of the contingent note receivable associated with the sale of Cal Indemnity. This loss will not be realized for tax purposes until December 31, 2009. The Company cannot be assured that it can generate sufficient capital gains during the applicable carry-over periods to recognize the tax benefit of this capital loss. During 2006, the Company generated approximately $700,000 of capital gains which has resulted in a $240,000 reduction in the valuation allowance. Otherwise, the remaining unrealized capital loss has a full valuation allowance at December 31, 2006. Also, the Company had approximately $700,000 and $13.3 million of regular state tax operating loss carryforwards in the years 2006 and 2005, respectively. The net operating loss carryforwards can be used to reduce future state taxable income until they expire in the years ending in through 2013. The Company does not expect to derive any benefit from these state operating loss carryforwards, and a full valuation allowance has been established. Deferred tax liabilities of $360,000 and $2.0 million at December 31, 2006 and December 31, 2005, respectively, are included in other liabilities.
Current income tax receivables were $5.1 million at December 31, 2005 and are included in prepaid expenses and other current assets. The Company does not have an income tax receivable at December 31, 2006. Current income tax payables total $18.9 million at December 31, 2006, and $5.4 million at December 31, 2005 and are included in accrued and other current liabilities.
The following table reconciles the beginning and ending balances of military health care payable:
During 2005, the Company received offers and entered into five separate and privately negotiated transactions with debenture holders (“holders”) pursuant to which the holders converted an aggregate of $63.0 million of debentures they owned into approximately 6.9 million shares of Sierra common stock in accordance with the indenture governing the debentures. During the first quarter of 2006, a holder converted $500,000 in debentures for approximately 54,000 shares of common stock. During the third quarter of 2006, the Company entered into a privately negotiated transaction with a holder pursuant to which the holder converted $8,000,000 in debentures for approximately 875,000 shares of common stock in accordance with the indenture governing the debentures. As a result of these transactions, the Company expensed prepaid interest of $176,000 and $1.5 million in 2006 and 2005, respectively, and deferred financing costs of $91,000 and $1.2 million in 2006 and 2005, respectively. In January 2007, the Company entered into a privately negotiated transaction with a holder pursuant to which the holder converted $21.7 million in debentures for approximately 2.4 million shares of common stock in accordance with the indenture governing the debentures. As a result of this transaction, the Company expensed accrued and prepaid interest of $601,000 and deferred financing costs of $176,000.
Revolving Credit Facility - On March 3, 2003, the Company entered into a revolving credit facility. Effective June 26, 2006, the current facility was amended to extend the maturity from December 31, 2009 to June 26, 2011, increase the availability from $140.0 million to $250.0 million and reduce the drawn and undrawn fees. The current incremental borrowing rate is LIBOR plus .60%. The facility is available for general corporate purposes and at December 31, 2006, the Company had $75.0 million outstanding on this facility.
The fair value of long-term debt, including the current portion, is estimated to be approximately $118.9 million based on the borrowing rates currently available to the Company.
Stock-Based Compensation - The Company's employee stock plan and non-employee director stock plan provide common stock-based awards to employees and to non-employee directors. The plans provide for the granting of restricted stock units, options, and other stock-based awards. At December 31, 2006, the employee plan and the non-employee director plan permit the granting of share options and shares of up to 4.0 million and 232,000 shares, respectively, of common stock. Shares are issued using either treasury shares, or newly issued shares of common stock. A committee appointed by the Board of Directors grants awards. Awards become exercisable at such times and in such increments as set by the committee.
In December 2004, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 123 (revised 2004), "Share-Based Payment" (“SFAS 123R”), which replaced Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation” ("SFAS 123") and superseded Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” ("APB 25") as amended. SFAS 123R requires all share-based payments, including grants of employee stock options, to be recognized in the financial statements based on their fair values. The pro forma disclosures previously permitted under SFAS are no longer an alternative
to financial statement recognition. On January 1, 2006, the Company adopted SFAS 123R using a modified prospective application. Accordingly, prior period amounts have not been restated. Under this application, the Company is required to record compensation expense for all awards granted after the date of adoption and for the unvested portion of previously granted awards that remain outstanding at the date of adoption. The Company has also elected under Financial Accounting Standards Board Staff Position 123(R)-3, “Transition Election Related to Accounting for the Tax Effects of Share-Based Payment Awards” to use the alternative transition method to compute the pool of excess tax benefits available to absorb tax deficiencies recognized subsequent to the adoption of SFAS 123R as of the effective date of SFAS 123R.
The application of SFAS 123R had the following effect on reported amounts relative to the amounts that would have been reported using the intrinsic value method prescribed by APB 25, which the Company used before adopting SFAS 123R.
The following table represents the effect on net income and earnings per share if the Company had applied the fair
The Company's Purchase Plan allows employees to purchase newly issued shares of common stock through payroll deductions at 85% of the fair market value of such shares on the lower of the first trading day of the plan period or the last trading day of the plan period as defined in the Purchase Plan. During 2006, 158,000 and 49,000 shares were purchased at prices of $30.67 and $34.43 per share, respectively. At December 31, 2006, the Company had 770,000 shares reserved for purchase under the Purchase Plan of which 49,000 shares were purchased by employees at $30.63 per share in January 2007.
Excludes 172,000 and 164,000 shares at January 1, 2006 and December 31, 2006, respectively, which vested in 2005, but are not exercisable until 2008.
Restricted Stock Units - The Company has issued units of restricted stock (“Units”) to certain members of its management. Each Unit represents a nontransferable right to receive one share of Sierra common stock and there is no cost by the recipient to exercise the Units. The Units are included in total outstanding common shares. In the calculation of earnings per share, the unvested Units are not included in the common shares outstanding but are included in the calculation of common shares outstanding assuming dilution. Compensation expense is recognized over the vesting period.
The Company issued 250,000 performance-based Units in 2004 to certain members of its management. The first third of the Units vested in 2004 with the remainder vesting in January 2005. The value of the transaction was based on the number of Units issued and the Company's common stock price on the date the performance criteria was met. The stock price on the date the first performance criteria was met was $20.65. For the Units vesting in 2005, the price used to value the Units was $26.69. Total expense associated with the plan was $6.0 million for 2004 and $100,000 for 2005.
The Company issued 156,000 performance-based Units in 2005. The first 10% of these Units vested in the second quarter of 2005 with the remainder vesting in the fourth quarter of 2005. The value of the transaction was based on the number of Units issued and the Company's common stock price on the date the performance criteria was met. The stock price on the date the first performance criteria was met was $35.73. The stock price on the date the second performance criteria was met was $38.41. Total expense recognized during 2005 for the Units was $6.2 million.
In January 2006, the Company issued 4,000 non-performance based Units to each of the six non-employee Directors. The Units vest on the fourth anniversary of the grant date or earlier based on the occurrence of certain events. The fair value of the transaction was based on the number of Units issued and the Company's common stock price on the date of grant, which was $38.49. Total expense associated with the Units during 2006 was $336,000, which represents the fair value of vested Units during the year.
In August 2006, the Company issued 210,000 Units to certain members of its management. The Units vest according to a variety of vesting schedules, or earlier based on the occurrence of certain events. The majority of Units have a three year holding period from the date of grant. The fair value of the transaction was based on the number of Units issued, the Company stock price on the date of issuance, which was $43.60, and an estimated forfeiture rate. A discount was applied to the Units with a holding period as a result of the lack of marketability between the vesting dates and settlement dates. The fair value of Units granted with a holding period includes a discount that was estimated at the date of grant using the Black-Scholes option-pricing model with the following weighted average assumptions: expected volatility of 32.3%, risk-free interest rate of 4.8% and dividend rate of 0%. Total expense associated with the Units was $5.2 million for 2006, which approximates the fair value of vested Units during the year.
Defined Contribution Plan - The Company has a defined contribution pension and 401(k) plan (the “Plan”) for its employees. The Plan covers all employees who meet certain age and length of service requirements. The Company matches 50%-100% of an employee’s elective deferral up to a maximum of 6% of a participant’s annual compensation, subject to IRS limits. The Plan does not require additional Company contributions. Expense under the Plan totaled $6.9 million, $4.9 million and $5.1 million for the years ended December 31, 2006, 2005 and 2004, respectively.
Supplemental Retirement Plans - The Company has Supplemental Retirement Plans (the “SRPs”) for certain officers, directors and highly compensated employees. The SRPs are non-qualified deferred compensation plans through which participants may elect to postpone the receipt and taxation of a portion of their salary and bonuses received from the Company. As contracted with the Company, the participants or their designated beneficiaries may begin to receive benefits under the SRPs upon a participant’s death, disability, retirement, termination of employment or certain other circumstances including financial hardship. The Company had a liability of $21.6 million and $18.4 million for the SRPs at December 31, 2006 and 2005, respectively. While the SRPs are unfunded plans, the Company is informally funding the plans through life insurance contracts on certain Company employees. The life insurance contracts had cash surrender values of $20.5 million and $17.3 million at December 31, 2006 and 2005, respectively.
The application of SFAS 158 had the following effect on the individual items in the Consolidated Balance Sheets at December 31, 2006. There was no effect on the Consolidated Statement of Income for the Year ended December 31, 2006.
Stock Split - On December 6, 2005, the Company's Board of Directors approved a two-for-one split of shares of its common stock, which was effected in the form of a 100% common stock dividend. All shareholders of record on December 16, 2005, received one additional share of Sierra common stock for each share of common stock held on that date. The additional shares of common stock were distributed to shareholders of record in the form of a stock dividend on December 30, 2005. Since the common stock dividend was issued on outstanding shares, the shares held as treasury stock were not adjusted to reflect the two-for-one split.
The following table provides a reconciliation of basic and diluted earnings per share (“EPS”):
On January 15, 2003, the Company announced that it was exploring strategic alternatives for its workers’ compensation company, CII. Sierra’s Board of Directors approved the sale of the operations on December 31, 2002. Accordingly, beginning in the fourth quarter of 2002, the Company reclassified its workers’ compensation insurance business as discontinued operations.
the final closing date balance sheet. The $2.7 million adjustment was a timing difference and has since been repaid. The transaction also includes a note receivable of $62.0 million, plus accrued interest, payable to the Company in January 2010. The note receivable can be increased or decreased depending on favorable or adverse claim and expense development from the date of closing through December 31, 2009, and other offsets and additions based on certain agreements between the parties. The note receivable can be increased on a dollar for dollar basis for the first $15.0 million in positive loss reserve development and $0.50 per dollar on any favorable development in excess of $15.0 million. The note receivable can also be decreased on a dollar for dollar basis for the first $58.0 million in adverse loss development.
During the fourth quarter of 2004, the Company engaged a new independent actuary to evaluate the loss development. Based on the independent actuarial projections, the Company recorded a $15.0 million valuation allowance as of December 31, 2004. The Company was required to engage a new actuary to avoid a potential conflict of interest with its former actuary, who was still engaged by Cal Indemnity, and the impact such a potential conflict would have on internal controls. Based on subsequent actuarial evaluations, there have been no changes to the valuation allowance in 2005 and 2006.
Certain other contractual assets and liabilities were recorded in conjunction with the sale including a current asset of $15.8 million and a non-current asset of $7.1 million that represent Cal Indemnity’s unallocated loss adjustment expense (“ULAE”) reserves to be paid to Sierra. Offsetting these assets was a current liability of $15.8 million and a non-current liability of $7.1 million, which represent the contractual services to be performed by Sierra. Including the cash proceeds, net assets of $68.3 million were recorded in conjunction with the sale of Cal Indemnity. Previously, CII had recorded valuation adjustments to reduce the business to its estimated net realizable value upon disposition. No further adjustments were required upon final disposition; therefore, no gain or loss on the sale was recorded.
A third-party claims administrator was engaged to administer claims for a period of 15 years. Under the terms of this agreement, the administrator will provide certain claims services for Cal Indemnity and its subsidiaries. Sierra will be responsible for this administrator's costs and for providing certain transition services for varying terms to Cal Indemnity. The purchaser of Cal Indemnity will pay Sierra for these costs from an account consisting of the ULAE reserves and accrued liabilities as of the closing, a percentage of premiums earned after the closing, plus accrued interest on the ULAE reserves. In addition, Sierra is providing workers’ compensation managed care services at market rates to Cal Indemnity. The Company recorded $1.5 million, $2.7 million and $12.1 million in administrative services revenue and $1.5 million, $2.5 million and $21.7 million in operating expenses to provide the contractually administrative services for 2006, 2005 and 2004, respectively. The $21.7 million in operating expenses for 2004 includes the $15.0 million valuation allowance on the note receivable.
The Company had previously estimated that the revenues and funds the Company expected to receive would not cover the expected cost to provide the contractual administrative services so the Company accrued additional liabilities at March 31, 2004 to cover the expected deficiency. Due to actual revenues exceeding estimates and actual expenses being less than projected expenses, the Company reduced the accrued liabilities by $5.5 million during the year ended December 31, 2004.
The Company’s Consolidated Statement of Income for the year ended December 31, 2004 reflects the activity of the discontinued operations through the disposal date, March 31, 2004. Any subsequent activity related to this disposal has been reflected in continuing operations.
Litigation and Legal Matters. Although the Company has not been sued, Sierra was identified in discovery submissions in pending class action litigation against major managed care companies, as having allegedly participated in an unlawful conspiracy to improperly deny, diminish or delay payments to physicians. In Re: Managed Care Litigation, MDL No. 1334 (S.D.Fl.).
Subsequent lower court rulings have further resolved which of the plaintiffs' claims are subject to arbitration. In 2004, the Court of Appeals for the Eleventh Circuit upheld a district court ruling certifying a plaintiff class in the Shane case. In February 2005, the district court determined to bifurcate the case, holding a trial phase limited to liability issues, and a second, if necessary, regarding damages.
Aetna, Inc., CIGNA Corporation, the Prudential Insurance Company of America, Wellpoint Inc., Health Net Inc. and Humana Inc. have entered into settlement agreements which have been approved by the district court. On January 31, 2006, the trial court granted summary judgment on all claims to defendant PacifiCare Health Systems, Inc. (“PacifiCare”), finding that plaintiffs had failed to provide documents or other evidence showing that PacifiCare agreed to participate in the alleged conspiracy. On June 19, 2006, the trial court granted summary judgment on all remaining claims against the two remaining defendants, UnitedHealth Group, Inc. and Coventry Health Care, Inc., because the plaintiffs had not submitted evidence that would allow a jury to reasonably find that either had been part of a conspiracy to underpay doctors or that either had aided or abetted alleged RICO violations. Plaintiffs have appealed this decision. Plaintiffs in the Shane proceeding had stated their intention to introduce evidence at trial concerning Sierra and other parties not named as defendants in the litigation.
For all claims that are considered probable and for which the amount of loss can be reasonably estimated, the Company accrued amounts it believes to be appropriate, based on information presently available. With respect to certain pending actions, the Company maintains commercial insurance coverage with varying deductibles for which the Company maintains estimated reserves for its self-insured portion based upon its current assessment of such litigation. Due to recent unfavorable changes in the commercial insurance market, the Company has for certain risks, purchased coverage with higher deductibles and lower limits of coverage. In the opinion of management, based on information presently available, the amount or range of any potential loss for certain claims and litigation cannot be reasonably estimated or is not considered probable. However, the ultimate resolutions of these pending legal proceedings are not expected to have a material adverse effect on the Company’s financial condition, operating results and cash flows.
Subsequent Events. Effective January 1, 2007, the Company offered a new enhanced benefit PDP stand alone product, which provides brand name and generic prescription drug benefits thoughout the coverage gap or “donut hole”. The Company engaged independent actuarial consultants in developing the enhanced benefit PDP stand alone offering. These actuaries used their national database in this process. The Company’s proposal to CMS for the enhanced benefit product relied upon actuarial assumptions regarding membership characteristics, drug utilization and the cost of prescription drugs. These actuarial assumptions were considered reasonable based on the facts and circumstances known at the time the Company submitted its bid to CMS.
The actual utilization in this program in January 2007 was much higher than the actuarial assumptions had projected. Based on the January 2007 utilization data and other limited information, the Company now believes that a premium deficiency is probable as expected benefit and maintenance costs are projected to exceed the expected future premiums. The Company is currently developing and implementing strategies to help mitigate expected losses on this product.
On February 11, 2004, the Company purchased 1,000,000 shares at $16.00 per share from its Chief Executive Officer ("CEO") for a total of $16.0 million. The closing price of the Company’s common stock on February 11, 2004, was $16.18. On May 27, 2004, the Company purchased an additional 1,000,000 shares at $21.60 per share from its CEO for a total of $21.6 million. The closing price of the Company’s common stock on May 27, 2004, was $21.63. The independent directors of the Company’s Board of Directors approved both of the purchases.
The Company has two reportable segments based on the products and services offered: managed care and corporate operations, and military health services operations. The managed care and corporate operations segment includes managed health care services provided through our HMO, managed indemnity plans, third-party administrative services programs for employer-funded health benefit plans and self-insured workers’ compensation plans, multi-specialty medical groups, other ancillary services and corporate operations. The military health services operations (“SMHS”) segment administered a managed care federal contract for the Department of Defense's TRICARE program in Region 1.
Through participation in Medicare, TRICARE and the Federal Employees Health Benefit Plan programs, the Company generated approximately 44%, 38% and 53% of its total consolidated revenues from agencies of the U.S. government for the years ended December 31, 2006, 2005 and 2004, respectively. The TRICARE revenue is presented below in the military health services operations segment and the remainder of the revenue described above is included in the managed care and corporate operations segment.