As of December 31, 2008, we leased approximately 89,000 square feet of space for our corporate office in Bethesda, Maryland. We also leased approximately 2,315,000 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 6% is subleased. Our leases expire at various dates from 2009 through 2019. We also own nine buildings throughout the country with approximately 798,000 square feet, which is used for administrative services related to our subsidiaries’ operations, of which approximately 6% is subleased. We believe that our facilities are adequate for our operations.
Medicare Advantage growth of 97,000 members from the prior year, an increase of 34%
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 PPO and POS products are typically lower than our 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 selected markets where we believe we can achieve profitable growth based upon favorable reimbursement levels, provider costs and regulatory climates.
We have capitation arrangements for certain ancillary heath care services, such as mental health care, and a small percentage of our membership is covered by global capitation arrangements. Under the typical arrangement, the provider receives a fixed percentage of premium to cover costs of all medical care or of the specified ancillary services provided to the globally capitated members. Under some capitated arrangements, physicians may also receive additional compensation from risk sharing and other incentive arrangements. Global capitation arrangements limit our exposure to the risk of increasing medical costs, but expose us to risk as to the adequacy of the financial and medical care resources of the provider organization. We are ultimately responsible for the coverage of our members pursuant to the customer agreements. To the extent that the respective provider organization faces financial difficulties or otherwise is unable to perform its obligations under the capitation arrangements, we will be required to perform such obligations. Consequently, we may have to incur costs in doing so in excess of the amounts we would otherwise have to pay under the original global or ancillary capitation through our contracted network arrangements. Medical costs associated with capitation arrangements made up approximately 4.1% of the Company’s total medical costs for the year ended December 31, 2008.
We have established systems to monitor the availability, appropriateness and effectiveness of the patient care we provide. We collect utilization data in each of our markets that we use to analyze over-utilization or under-utilization of services and assist our health plans in arranging for appropriate care for their members and improving patient outcomes in a cost efficient manner. Medical directors also monitor the utilization of diagnostic services and encourage the use of outpatient surgery and testing where appropriate. Each health plan collects data showing each physician’s utilization profile for diagnostic tests, specialty referrals and hospitalization and presents such data to the health plan’s physicians. The medical directors monitor these results in an effort to ensure the use of medically, cost-effective appropriate services.
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 negative medical cost amounts noted as “prior year development” are favorable adjustments for claim estimates being settled for amounts less than originally anticipated. As noted above, these favorable developments from original estimates occur due to changes in medical utilization, mix of provider rates and other components of medical cost trends. Medical claim liabilities are generally paid within several months of the member receiving service from the provider. Accordingly, the 2008 prior year development relates almost entirely to claims incurred in calendar year 2007.
The significant favorable / (unfavorable) factors driving the overall favorable prior year developments include:
Lower than anticipated medical cost increases of $47.6 million favorable development
Lower than anticipated other specific case liabilities of $10.5 million favorable development
Changes in the completion factors, trend factors and utilization factors can have a significant effect on the claim liability. The following example (in thousands, except percentages) provides the estimated effect to our December 31, 2008 unpaid claims liability assuming hypothetical changes in the completion, trend, and inpatient day factors. While we believe the selection of factors and ranges provided are reasonable, certain factors and actual results may differ.
We account for investments in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 115 - “Accounting for Certain Investments in Debt and Equity Securities.” We invest primarily in fixed income securities and classify all of our 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, we consider all available evidence relating to the realizable value of a security. This evidence includes, but is not limited to, the following:
adverse financial conditions of a specific issuer, monoline bond insurer, segment, industry, region or other variables;
the length of the time and the extent to which the fair value has been less than cost;
elimination or reduction in dividend payments, or scheduled interest and principal;
Generally, we do not adjust prices received from pricing services or brokers, unless it is evident from our verification procedures the fair value measurement is not consistent with SFAS No. 157. Based upon our internal price verification procedures and review of fair value methodology documentation provided by independent pricing services, we have concluded that the fair values provided by pricing services and brokers are consistent with the guidance in SFAS No. 157.
The following table includes only our investments in an unrealized loss position at December 31, 2008. For these investments, the table shows the gross unrealized losses and fair value aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position (in thousands).
Our municipal bond investments remain at an investment grade status based on their own merits (excluding monoline insurers). Although we do not rely on bond insurers exclusively to maintain our high level of investment credit quality, $498.6 million of our $841.3 million total state and municipal bond holdings are insured through a monoline insurer. For our mortgaged-backed and asset-backed securities, our holdings remain at investment grade with a AAA rating. We participate in only the higher level investment tranches. For our asset-backed securities, we only participate in offerings that are over collateralized to further protect our principal investment.
Subsequent to our 2008 annual impairment test, we experienced a decline in the market capitalization of our Company to an amount below book value. As a result, we reconsidered our analysis, incorporating new information that became available after the annual impairment date. This new information included operating results for the quarter ended December 31, 2008 as well as revised expectations for fiscal year 2009.
While we believe we have made reasonable estimates and assumptions to calculate the fair values of the reporting units and other intangible assets, it is possible a material change could occur. Under the income approach, we assumed certain growth rates, capital expenditures, discount rates and terminal growth rates in our calculations. If the assumptions used in our fair-value-based tests differ from actual results, the estimates underlying our goodwill impairment tests could be adversely affected.
In accordance with SFAS No. 142, we test intangible assets not subject to amortization for impairment annually or more frequently if events or changes in circumstances indicate that the asset might be impaired. The impairment test consists of a comparison of the fair value of an intangible asset with its carrying amount. If the carrying amount of the intangible asset exceeds its fair value, an impairment loss shall be recognized in an amount equal to that excess. We have chosen October 1 as our impairment testing date. Our only intangible asset that is not subject to amortization consists of a trade name.
We have not incurred an impairment charge related to our other intangible assets. See Note D, Goodwill and Other Intangible Assets, to the consolidated financial statements for additional disclosure related to these assets.
Our other long-lived assets consist of property and equipment which are depreciated or amortized over their estimated useful life, and are subject to impairment reviews. In accordance with Statement of Position (“SOP”) 98-1, “Accounting for the Costs of Computer Software Developed or Obtained for Internal Use,” the cost of internally developed software is capitalized and included in property and equipment. We capitalize costs incurred during the application development stage for the development of internal-use software. These costs primarily relate to payroll and payroll-related costs for employees along with costs incurred for external consultants who are directly associated with the internal-use software project. We have not incurred an impairment charge related to our long-lived assets. See Note E, Property and Equipment, to the consolidated financial statements for additional disclosure related to these assets.
For this information, refer to Note C, Acquisitions, to the Notes to the Consolidated Financial Statements herein.
(1)“Commercial Group Risk” membership includes our health plan commercial group business and a small group PPO insurance block which was previously imbedded within our First Health segment.
(2)“Other ASO” membership includes active National Accounts and FEHBP administrative services business.
Commercial group risk membership decreased 103,000 due to terminations and due to certain groups changing from a risk product to a non-risk product. Health plan ASO membership decreased 36,000 primarily due to the loss of a large group in our Utah market partially offset by a shift of certain groups from a risk product to a non-risk product. Other ASO membership decreased 150,000 due to losses of National Accounts business.
Individual Consumer & Government membership increased 244,000 from the prior year end, primarily due to organic growth in all Medicare products and expansion into new areas. Medicaid risk membership decreased 109,000 primarily due to the termination of our Pennsylvania Medicaid behavioral health contract representing approximately 107,000 members, effective July 1, 2008. This was a capitated pass-through arrangement we had with a local provider group. Given the nature of this globally capitated contract, we earned a low single digit operating margin.
The following table is provided to facilitate a more meaningful discussion regarding the comparison of our operations for each of the three years in the period ended December 31, 2008 (in thousands, except earnings per share and percentage data).
Management services revenue increased compared to the prior year primarily as a result of the acquisition of Concentra, Inc. (“Concentra”) and organic growth in our workers’ compensation services business. This increase was partially offset by the Other ASO membership decline described above.
Selling, general and administrative expense increased primarily due to normal operating costs associated with our prior year acquisitions of Concentra, Mutual and Vista, as well as costs related to growth of our Medicare business.
Selling, general and administrative expense increased primarily due to operating costs associated with our acquisitions of Concentra, Mutual and Vista, as well as costs related to our new Medicare PFFS business in 2007. The increase in total selling, general and administrative expense was also attributable to increased salary and benefit expense as we position ourselves for future growth initiatives and as we incur normal annual compensation increases.
Other income, net increased primarily as a result of a larger investment portfolio and higher interest rates.
We have three reportable segments: Commercial, Individual Consumer & Government, and Specialty. Each of these segments, which the Company also refers to as “Divisions,” is separately managed and provides separate operating results that are evaluated by the chief operating decision maker. Beginning in 2008, in order to reflect a change in the manner in which we manage our operations, our network rental business operations were reclassified from our Commercial Division to our Specialty Division. Our network rental business results for the 2007 period have been reclassified to conform to the 2008 presentation. The Commercial Division is comprised of all of our commercial employer-focused businesses, including the traditional health plan group risk and ASO products as well as the National Accounts and FEHBP. The Individual Consumer & Government Division contains our individual consumer products and all Medicare and Medicaid products. The Specialty Division includes our workers’ compensation services businesses, network rental business, mental-behavioral health benefits business of MHNet and the dental benefits business of GDS.
(2) Revenue PMPM excludes the impact of CMS risk share adjustments and revenue ceded to external parties.
Commercial ASO revenue declined from the prior year due to membership losses in our National Accounts non-risk business as well as due to fee negotiations related to the long-term renewal of our contract as plan administrator of the Mail Handler’s Benefit Plan. These declines were partially offset by an increase in our Commercial health plan ASO revenue.
Medicare Advantage risk premium yields, excluding the impact of revenue ceded to external parties, per member per month increased as a result of the rate increases from the annual competitive bid filings for our Medicare Advantage products as well as from increases in risk factor adjustment scores for our Medicare Advantage products. With the impact of the ceded revenue being included in the premium yield, the Medicare Advantage risk premium yields, per member per month decreased to $742.07 in 2008 compared to $771.81 in 2007. The decrease was a result of a larger portion of our Medicare PFFS business in 2008 being ceded to external parties through quota share arrangements. This average premium yield decrease was partially offset by the annual competitive bid filings and risk factor scores noted above.
Part D premium yields, excluding the impact of CMS risk sharing premium adjustments and revenue ceded to external parties, were $88.34 in 2008 compared to $99.57 in 2007 primarily due to the annual competitive bid filings for our Part D products as well as the mix of products sold. Including the impact of the CMS risk sharing premium adjustments as well as the ceded revenue, the yields were $78.84 in 2008 compared to $82.53 in 2007.
Medicaid premium yields increased as a result of rate increases in Missouri, our largest Medicaid market, effective July 1, 2007 and July 1, 2008. The yields also increased due to the termination of our Pennsylvania Medicaid behavioral health contract, which had a lower premium yield.
The decrease in gross margin in our Individual Consumer & Government Division was driven by lower gross margins in our Medicare PFFS business as a result of increased medical costs in 2008. This decrease was partially offset by growth from our Medicare Advantage HMO and PPO business, as well as increased Medicaid and Individual business, both organic and acquired. Medicare Part D medical costs as a percentage of premium revenue have increased as a result of a widening of the risk corridors and growth in our low-income auto-assign population in 2008. Medicaid medical costs as a percentage of premium revenue decreased over the prior year period as a result of the premium yield increases discussed above.
Specialty Division revenue increased primarily as a result of the acquisition of certain business from Concentra during the second quarter of 2007, as well as organic growth in our workers’ compensation services business. The increase was also a result of the acquisition of MHNet in the first quarter of 2008 and to a lesser extent the acquisition of GDS in the second quarter of 2008.
Our investment guidelines require our fixed income securities to be investment grade in order to provide liquidity to meet future payment obligations and minimize the risk to the principal. Our fixed income portfolio has an average quality rating of “AA+” and a modified duration of 3.3 years as of December 31, 2008. Typically, the amount and duration of our short-term assets are more than sufficient to pay for our short-term liabilities and we do not anticipate that sales of our long-term investment portfolio will be necessary to fund our claims liabilities.
Our cash and investments, consisting of cash, cash equivalents, short-term investments, and long-term investments, but excluding deposits of $66.5 million restricted under state regulations, increased $309.7 million to $3.1 billion at December 31, 2008 from $2.8 billion at December 31, 2007.
Our net cash from operating activities in 2008 was $47.3 million higher than 2007. Contributing to this was a larger increase in medical liabilities in 2008 than in 2007 due to the reasons described above but also due to the growth in our Medicare PFFS business in 2008. The nature of our business is such that premium revenues are generally received up to two months prior to the expected cash payment for the related medical costs. This results in strong cash inflows upon the implementation of a benefit program. The increase in medical liabilities was partially offset by a decline in net earnings in 2008 compared to 2007 and a larger increase in other receivables during 2008, primarily related to pharmacy rebate and Medicare accruals.
During November and December 2008, we repurchased a total of $10.0 million of our remaining outstanding 5.95% Senior Notes due March 15, 2017.
Our Board of Directors has approved a program to repurchase our outstanding common stock. Stock repurchases may be made from time to time at prevailing prices on the open market, by block purchase or in private transactions. In May 2008, the Company’s Board of Directors approved an increase to the share repurchase program in an amount equal to 5% of the Company’s then outstanding common stock, thus increasing the Company’s repurchase authorization by 7.5 million shares. As a part of this program, 4.6 million shares were purchased in 2006 at an aggregate cost of $256.1 million, 7.5 million shares of our common stock were purchased in 2007 at an aggregate cost of $429.0 million and 7.3 million shares of our common stock were purchased in 2008 at an aggregate cost of $318.0 million. As of December 31, 2008, the total remaining common shares we are authorized to repurchase under this program is 6.7 million.
(b) As mentioned above, the State of Florida does not have a RBC requirement for its regulated HMOs. Accordingly, the statutory reserve information provided for Vista is based on the actual statutory minimum capital required by the State of Florida.
The increase in capital and surplus for our regulated subsidiaries is a result of net earnings and capital contributions made by the parent company, partially offset by dividends paid to the parent company.
(a) Interest payable on credit facilities has been estimated based on interest rates as of February 2009 and assumes no additional changes in the principal amount.
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. Accordingly, we believe medical claims liabilities are short-term in nature and therefore do not meet the listed criteria for classification as contractual obligations and have been excluded from the table above. As of December 31, 2008, we had $51.8 million of unrecognized tax benefits. The above table excludes these amounts due to uncertainty of timing and amounts regarding future payments.
Refer to Legal Proceedings in Note K, Commitments and Contingencies, which is incorporated herein by reference.
We expect to add in excess of 75,000 net Medicare Advantage members during 2009 from both individual and group sales.
We expect to add in excess of 420,000 net Part D members compared to our 2008 year end membership. A majority of these new members will be in our Advantra Rx Mainstream products.
We expect to remain conservatively invested in high-quality securities, with approximately $1.6 billion in cash, cash equivalents, and treasury securities as of the beginning of the year. Accordingly, given the current interest rate environment, we expect investment income to decrease in 2009.
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, 2008, 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, 2009 expressed an unqualified opinion thereon.
Coventry Health Care, Inc. (together with its subsidiaries, the “Company” or “Coventry”) is a diversified national managed health care company based in Bethesda, Maryland operating health plans, insurance companies, network rental and workers’ compensation services companies. Through its Commercial Business Division, Individual Consumer & Government Business Division and Specialty Business Division, the Company provides a full range of risk and fee-based managed care products and services to a broad cross section of individuals, employer and government-funded groups, government agencies, and other insurance carriers and administrators.
Since the Company began operations in 1987 with the acquisition of the American Service Companies entities, including Coventry Health and Life Insurance Company (“CH&L”), the Company has grown substantially through acquisitions. See Note C to these consolidated financial statements for information on the Company’s 2008 acquisitions.
Significant Customers - The Company’s commercial business is diversified across a large customer base and there are no commercial groups that make up 10% or more of Coventry’s managed care premiums. The Company received 38.1%, 33.1% and 21.6% of its managed care premiums for the years ended December 31, 2008, 2007 and 2006, respectively, from the federal Medicare program throughout its various markets. The Company also received 10.3%, 10.7% and 11.1% of its managed care premiums for the years ended December 31, 2008, 2007 and 2006, respectively, from its state-sponsored Medicaid programs throughout its various markets. For the years ended December 31, 2008, 2007 and 2006, the State of Missouri accounted for almost half the Company’s Medicaid premiums. These revenues from the Medicare and Medicaid Programs are included in the Individual Consumer & Government Business Division. The Company received 9.2%, 14.7% and 19.3% of its management services revenue from a single customer, Mail Handlers Benefit Plan, for the years ended December 31, 2008, 2007 and 2006, respectively and is included in the Commercial Business Division.
Cash and Cash Equivalents - Cash and cash equivalents consist principally of money market funds, commercial paper, certificates of deposit, and treasury bills. The Company considers all highly liquid securities purchased with an original maturity of three months or less to be cash equivalents.
Temporary declines in value of investments classified as available-for-sale are netted with unrealized gains and reported as a net amount in a separate component of stockholders’ equity. A decline in fair value below amortized cost that is judged to be other-than-temporary is accounted for as a realized loss and the impairment is included in earnings. Realized gains and losses on the sale of investments are determined on a specific identification basis.
Long-term Assets - Long-term assets primarily include assets associated with the 401(k) Restoration and Deferred Compensation Plan, senior note issuance costs and reinsurance recoveries. The reinsurance recoveries were obtained with the acquisition of First Health Group Corp. (“First Health”) and are related to certain life insurance receivables from a third party insurer for liabilities that have been ceded to that third party insurer.
Business Combinations, Accounting for Goodwill and Other Intangibles - The Company accounts for business combinations, goodwill and other intangibles in accordance with SFAS No. 141, “Business Combinations,” SFAS No. 142, and SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.” Acquired intangible assets are separately recognized upon meeting certain criteria. Such intangible assets include, but are not limited to, trade and service marks, non-compete agreements, customer lists and licenses. An intangible asset that is subject to amortization is tested for recoverability whenever events or changes in circumstances indicate that its carrying amount may not be recoverable. 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 considers multiple approaches to identifying the fair value of its goodwill and other intangible assets. Those approaches include the market approach and the income approach. The market approach estimates a business’s fair value by utilizing market multiples. The income approach is based on the present value of expected future cash flows. Impairment charges will be recorded in the period in which the impairment took place. See Note D, Goodwill and Other Intangible Assets, to consolidated financial statements for disclosure related to goodwill and other intangible assets.
(2) Prior year reported medical costs in the current year as a percentage of prior year reported medical costs.
Other Long-term Liabilities - Other long-term liabilities consist primarily of liabilities associated with the 401(k) Restoration and Deferred Compensation Plan, the deferred tax liabilities associated with acquired intangible assets, a limited partnership investment, property, plant, and equipment, policy / claims payable, funds held on deposit, and the liability for unrecognized tax benefit.
Comprehensive Income - Comprehensive income includes net earnings, unrealized net gains and losses on investment securities, and other than temporary impairments on its investments. 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 unrealized holding gains arising from investment securities during the years ended December 31, 2008 and 2007 was $3.0 million and $6.3 million, respectively. The deferred tax benefit for unrealized holding losses arising from investment securities during the year ended December 31, 2006 was $0.02 million. The deferred tax provision for reclassification adjustments for gains included in net earnings on investment securities during the years ended December 31, 2008 and 2007 was $1.6 million and $0.5 million, respectively. The deferred tax benefit for reclassification adjustments for losses included in net earnings on investment securities during the years ended December 31, 2006 was $0.2 million.
The Company enters into performance guarantees with employer groups where it pledges to meet certain standards. These standards vary widely and could involve customer service, member satisfaction, claims processing, claims accuracy, telephone response time, etc. The Company also enters into financial guarantees which can take various forms including, among others, achieving an annual aggregate savings threshold, achieving a targeted level of savings per-member, per-month or achieving overall network penetration in defined demographic markets. For each guarantee, the Company estimates and records performance based revenue after considering the relevant contractual terms and the data available for the performance based revenue calculation. Pro-rata performance based revenue is recognized on an interim basis pursuant to the ultimate rights and obligations of the parties upon termination of the contracts.
Revenue for pharmacy benefit management services in both the National Accounts business and the Public Sector is derived on a pre-negotiated contractual amount per claim. Revenue related to the administration of these transactions is recorded when the pharmacy transaction is processed by the Company but does not include revenue or expense related to the sale of pharmaceuticals. Revenue for pharmacy benefit management services for Workers’ Compensation business is derived on a pre-negotiated amount per pharmacy claim which includes the cost of the pharmaceutical. Revenue and a corresponding cost of sales to a third party vendor related to the sale of pharmaceuticals is recorded when a pharmacy transaction is processed by the Company. Revenue associated with pharmacy rebates from the National Accounts business is recorded based on the contractual rebates received from the formulary less the pre-negotiated rebates paid to clients. No rebate revenue is collected or recorded related to the Company’s Public Sector or Worker’s Compensation business.
Income Taxes - The Company files a consolidated federal tax return for the Company and its subsidiaries. The Company accounts for income taxes in accordance with SFAS No. 109 - “Accounting for Income Taxes.” The deferred tax assets and/or liabilities are determined by multiplying the differences between the financial reporting and tax reporting bases for assets and liabilities by the enacted tax rates expected to be in effect when such differences are recovered or settled. The effect on deferred taxes of a change in tax rates is recognized in income in the period that includes the enactment date. The realization of total deferred tax assets is contingent upon the generation of future taxable income in the tax jurisdictions in which the deferred tax assets are located. Taxable income includes the impact of the reversal of deferred tax liabilities. Valuation allowances are provided to reduce such deferred tax assets to amounts more likely than not to be ultimately realized. No such valuation allowances have been recorded.
Earnings Per Share - Basic earnings per share 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 8.3 million, 3.2 million and 0.7 million shares for the years ended December 31, 2008, 2007 and 2006, respectively, were excluded from the computation of diluted earnings per share because the potential common stock equivalents were anti-dilutive.
During the years ended December 31, 2008 and 2007, the Company completed five business combinations and one membership purchase. These business combinations are all accounted for using the purchase 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 purchase price of the Company’s membership purchases is allocated to identifiable intangible assets and is being amortized over a useful life of ten to fifteen years.
The acquisitions made during the year ended December 31, 2007 were individually insignificant but were significant when aggregated. As a result of these acquisitions, the Company recorded $952.8 million of goodwill, of which, $289.1 million is expected to be deductible for tax purposes. The following table lists the assigned value of the intangible assets as of the acquisition date (in millions) and the associated amortization period:
The following unaudited pro forma consolidated results of operations assume the acquisitions made during the years ended December 31, 2007 and 2006 occurred on January 1, 2007 and 2006, respectively (in millions, except per share data):
In accordance with SFAS No. 142, for the purpose of testing goodwill for impairment, acquired assets and assumed liabilities were assigned to a reporting unit as of the acquisition date if both of the following criteria were met: (1) the asset will be employed in or the liability relates to the operations of a reporting unit and (2) the asset or liability will be considered in determining the fair value of the reporting unit. Corporate assets (i.e. information technology) or liabilities (i.e. debt) were also assigned to a reporting unit if both of these criteria were met.
As an overall test of the reasonableness of the estimated fair values of the reporting units, the Company compared the aggregate fair values of its reporting units to its market capitalization as of October 1, 2008. The comparison confirmed that the fair values were reasonably representative of market views when applying a reasonable control premium to the market capitalization.
Depreciation expense for the years ended December 31, 2008, 2007 and 2006 was $84.6 million, $94.4 million and $77.9 million, respectively. Included in the depreciation expense for the years ended December 31, 2008, 2007 and 2006 was $29.9 million, $32.9 million and $26.9 million, respectively, of expense for developed software.
The Company considers all of its investments as available-for-sale securities and, accordingly, records unrealized gains and losses, except for those determined to be other-than-temporary impairments, as other comprehensive income (loss) in the stockholders’ equity section of its consolidated balance sheets.
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, 2008 and 2007 (in thousands):
Gross investment gains of $7.6 million and gross investment losses of $37.0 million were realized on sales and the other than temporary impairment of investments for the year ended December 31, 2008. This compares to gross investment gains of $1.7 million and gross investment losses of $0.5 million on these sales for the year ended December 31, 2007, and gross investment gains of $0.2 million and gross investment losses of $0.7 million on these sales for the year ended December 31, 2006.
The unrealized losses presented in this table do not meet the criteria for an other-than-temporary impairment. The unrealized losses are the result of interest rate movements and significant increases in volatility and liquidity concerns in the securities and credit markets. We intend to hold these investments for a period of time sufficient to allow for a recovery in market value, which may be maturity.
During the year ended December 31, 2008, the Company recognized a charge of $36.2 million that consisted of $33.5 million for the other-than-temporary impairment of investment securities and $2.7 million in realized losses on the sale of securities. The other-than-temporary impairment charge related to its investments in Lehman Brothers Holdings, Inc. (“Lehman”), certain corporate financial holdings, auction rate securities and mortgage backed and asset-backed securities. The Company evaluates its investment securities for other-than-temporary declines in value based on quantitative and qualitative factors. The cost of investment securities is based upon specific identification. In analyzing individual securities for other-than-temporary impairments, the Company considers factors affecting the issuer, factors affecting the industry the issuer operates within, and general debt and equity market trends. The Company also considers the length of time an investment’s fair value has been below its carrying value, the severity of the decline, the near-term prospects for recovery to cost, and the Company’s intent and ability to hold the investment until maturity or market recovery is realized.
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 further declines in fair value may occur and additional 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, high variability over time), inputs other than quoted prices that are observable for the asset/liability (e.g. interest rates, yield curves volatilities, default rates, etc.), and inputs that are derived principally from or corroborated by other observable market data.
The Company’s Level 3 securities primarily consist of corporate financial holdings, auction rate securities and mortgage backed and asset-backed securities that were thinly traded due to market volatility and lack of liquidity. The Company determines the estimated fair value for its Level 3 securities using unobservable inputs that can not be corroborated by observable market data including, but not limited to, broker quotes, default rates, benchmark yields, credit spreads and prepayment speeds.
During the year ended December 31, 2008, the Company’s investments in Lehman, certain corporate financial holdings, auction rate securities and mortgage backed and asset-backed securities were transferred into Level 3 from Level 2. The transfer in occurred because as of September 30, 2008, some of the inputs used for determining the fair value of these investments were not readily available, primarily quoted prices for similar assets in an active market. Therefore the fair value of these securities was determined using observable inputs, interest rates and unobservable inputs such as credit spreads and non-binding broker quotes.
As of December 31, 2008, the Company had one stock incentive plan, the Amended and Restated 2004 Stock Incentive Plan (the “Stock Incentive Plan”) under which shares of the Company’s common stock were 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 Stock Incentive Plan were 4.6 million as of December 31, 2008.
The Company granted 2.1 million stock options during the twelve months ended December 31, 2008. The Black-Scholes-Merton weighted-average value of options granted was $13.16, $16.79 and $17.24 per share for the years ended December 31, 2008, 2007 and 2006, respectively. The Company recorded compensation expense related to stock options of approximately $35.3 million, $36.1 million, and $30.7 million for the years ended December 31, 2008, 2007, and 2006, respectively. The total intrinsic value of options exercised was $10.4 million, $77.9 million and $52.4 million for the years ended December 31, 2008, 2007 and 2006, respectively. As of December 31, 2008, there was $57.7 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 2.4 years.
The Company awarded 1.6 million shares of restricted stock in the twelve months ended December 31, 2008. Of the total restricted stock issued, approximately 0.7 million shares included performance criteria which were not met and therefore these shares were cancelled. The value of the Company’s restricted shares is amortized over various vesting periods through 2012. The Company recorded compensation expense related to restricted stock grants, including restricted stock granted in prior periods, of approximately $25.3 million, $28.1 million and $25.0 million for the years ended December 31, 2008, 2007 and 2006, respectively. The total unrecognized compensation cost (net of expected forfeitures) related to the restricted stock was $44.0 million at December 31, 2008, and is expected to be recognized over a weighted average period of 2.7 years. The weighted-average fair value of restricted stock granted was $39.06, $59.42 and $50.75 per share for the years ended December 31, 2008, 2007 and 2006, respectively. The total fair value of shares vested during the years ended December 31, 2008, 2007 and 2006 was $17.3 million, $39.2 million and $36.1 million, respectively.
The following table summarizes restricted stock award activity for the year ended December 31, 2008:
The effect of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities at December 31, 2008 and 2007 are presented below (in thousands):
(1) Includes $94.0 million and $119.9 million classified as current assets at December 31, 2008 and 2007, respectively, and ($217.7) million and ($229.2) million classified as noncurrent assets (liabilities) at December 31, 2008 and 2007, respectively.
The Company adopted “Interpretation No. 48 (“FIN 48”), Accounting for Uncertainty in Income Taxes--an Interpretation of FASB Statement No. 109,” which clarifies the accounting for uncertainty in income taxes recognized in the financial statements in accordance with SFAS No. 109 on January 1, 2007. FIN 48 prescribes a more likely than not threshold for financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. For a tax benefit to be recognized, a tax position must be more likely than not to be sustained upon examination by applicable taxing authorities. The benefit recognized is the amount that has a greater than 50% likelihood of being realized upon final settlement of the tax position. The change in net assets, because of applying this pronouncement, is considered a change in accounting principle with the cumulative effect of the change required to be treated as an adjustment to the opening balance of retained earnings. The cumulative effect of implementing FIN 48 was an increase of $3.4 million to the beginning balance of retained earnings for the year ended December 31, 2007.
The Company is regularly audited by federal, state and local tax authorities, and from time to time these audits result in proposed assessments. Tax years 2005-2007 remain open to examination by these tax jurisdictions. The Company believes appropriate provisions for all outstanding issues have been made for all jurisdictions and all open years.
During the year ended December 31, 2008, the Internal Revenue Service (“IRS”) completed its examination of the income tax returns of First Health Group Corporation (“FHGC”) for all years through 2004. As of December 31, 2008, the IRS was in the process of examining FHGC’s income tax returns for the short year ended January 28, 2005, the date of FHGC’s merger with the Company.
As of December 31, 2008, the IRS is examining the Company’s income tax returns for the years ended December 31, 2005 and December 31, 2006. Additionally, the Company settled certain income tax examinations with various state and local tax authorities. Tax assessed as a result of these examinations, if any, was not material. FHGC is also subject to ongoing examinations by state tax authorities for pre-acquisition years. The Company believes that adequate accruals have been provided for all FHGC open tax years.
As of December 31, 2008, the Company sponsored one defined contribution retirement plan qualifying under the Internal Revenue Code Section 401(k): the Coventry Health Care, Inc. Retirement Savings Plan (the “Savings Plan”). All employees of Coventry Health Care, Inc. and employees of its subsidiaries can elect to participate in the Savings Plan. T. Rowe Price is the custodial trustee of all Savings Plan assets, participant loans and the Coventry Health Care, Inc. common stock in the Savings Plan. The Coventry Health Care Workers Compensation, Inc. 401(k) and Profit Sharing (the “Workers Compensation Plan”) had merged with and into the Savings Plan effective January 1, 2008. Fidelity Investments was the custodial trustee of all Workers Compensation Plan assets and participant loans until January 2, 2008 when the assets were wired to T. Rowe Price. T. Rowe Price became the custodial trustee of the Workers Compensation Plan assets and participant loans on January 2, 2008 when the Workers Compensation Plan assets merged with and into the Savings Plan upon receipt from Fidelity.
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 Plans 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.
Under the Workers Compensation Plan, participants could defer up to 25% of their eligible compensation, limited by the maximum compensation deferral amount permitted by applicable law. The Company will make a discretionary employer matching contributions for the 2008 plan year. Participants are 100% vested in the Company’s matching contributions. All costs of the Workers Compensation 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 2008, 2007 and 2006 was approximately $31.5 million, $21.6 million, and $18.9 million, respectively.
For information regarding the Company’s stock-based compensation, please refer to Note G, Stock-Based Compensation, to the notes to the consolidated financial statements.
On July 11, 2007, the Company executed an Amended and Restated Credit Agreement (the “Credit Facility”). The Credit Facility provides for a five-year revolving credit facility in the principal amount of $850.0 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. The obligations under the Credit Facility are general unsecured obligations of the Company. The Company drew $80.0 million under the Credit Facility to pay off the Company’s remaining $80.0 million balance on its five-year term loan that was originally entered into during 2005 and drew an additional $285.0 million to help fund the Vista acquisition payment.
On August 27, 2007, the Company completed the sale of $400 million aggregate principal amount of its 6.30% Senior Notes due 2014 (the “7-year Notes”) at the issue price of 99.575% per Note. The 7-year Notes are senior unsecured obligations of Coventry and rank equally with all of its other senior unsecured indebtedness. As of December 31, 2008, the fair value was $244.5 million.
On January 28, 2005, the Company completed the private placement of $250 million aggregate principal amount of 5.875% senior notes due 2012 and $250 million aggregate principal amount of 6.125% senior notes due 2015. The senior notes are general unsecured obligations of the Company and rank equal in right of payment to all of the Company’s existing and future senior debt. As of December 31, 2008, the fair value of the 5.875% senior notes and the 6.125% senior notes was $194.1 million and $150.0 million, respectively.
Loans under the new credit facilities bear interest at a margin or spread in excess of either (1) the one-, two-, three-, six-, nine-, or twelve- month rate for Eurodollar deposits (the “Eurodollar Rate”) or (2) the greater of the federal funds rate plus 0.5% or the base rate of the Administrative Agent (“Base Rate”), as selected by the Company. The margin or spread depends on the Company’s non-credit-enhanced long-term senior unsecured debt ratings and varies from 0.350% to 1.000% for Eurodollar Rate advances and from 0.000% to 0.500% for Base Rate advances.
As of December 31, 2008, the aggregate maturities of debt based on their contractual terms, including unamortized discount, are as follows (in thousands):
The Company operates in leased facilities with original lease terms of up to thirteen years with options for renewal. Total rent expense was $40.8 million, $33.1 million and $30.3 million, for the years ended December 31, 2008, 2007 and 2006, respectively.
The Company has received a subpoena from the U.S. Attorney for the District of Maryland, Northern Division, requesting information regarding the operational process for confirming Medicare eligibility for the Workers Compensation set-aside product. The Company is fully cooperating and is providing the requested information. The Company can not predict what, if any, actions may be taken by the U.S. Attorney. However, based on the information known to date, the Company does not believe that the outcome of this inquiry will have a material adverse effect on its financial position or results of operations.
The Company’s financial instruments that are exposed to credit risk consist primarily of cash equivalents, investments in fixed income securities and accounts receivable. The Company invests its excess cash in state and municipal bonds, U.S. Treasury and agency securities, mortgage-backed securities, asset-backed securities, corporate debt and other securities. Investments in marketable securities are managed within guidelines established by the Board of Directors, which only allow for the purchase of investment-grade fixed income securities and limits exposure to any one issuer. The fair value of the Company’s financial instruments is equivalent to their carrying value. There is some credit risk associated with these instruments.
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, 2008. The Company has a risk of incurring losses if such allowances are not adequate.
Other income for the years ended December 31, 2008, 2007 and 2006 includes interest income, net of fees, of approximately $104.6 million, $138.7 million and $101.5 million, respectively. For the year ended December 31, 2008, other income included a charge of $36.2 million that consisted of $33.5 million for the other-than-temporary impairment of investment securities and $2.7 million in realized losses on the sale of securities.
The Company’s Board of Directors has approved a program to repurchase its outstanding common stock. Stock repurchases may be made from time to time at prevailing prices on the open market, by block purchase or in private transactions. In May 2008, the Company’s Board of Directors approved an increase to the share repurchase program in an amount equal to 5% of the Company’s then outstanding common stock, thus increasing the Company’s repurchase authorization by 7.5 million shares. Under the share repurchase program, the Company purchased 7.3 million shares of the Company’s common stock during 2008, at an aggregate cost of $318.0 million, 7.5 million shares during 2007, at an aggregate cost of $429.0 million and 4.6 million shares at an aggregate cost of $256.1 million were purchased in 2006. The total remaining common shares the Company is authorized to repurchase under this program is 6.7 million as of December 31, 2008. Excluded from these amounts are shares purchased in exchange for employee payroll taxes on vesting of restricted stock awards as these purchases are not part of the program.
The following is a summary of unaudited quarterly results of operations (in thousands, except per share data) for the years ended December 31, 2008 and 2007. Due to rounding of quarterly results, total amounts for each year may differ immaterially from the annual results.