Expense ratio. The expense ratio is defined as underwriting, policy acquisition costs and insurance expenses as a percentage of earned premiums (excludes Life Insurance Division).
We offer insurance (primarily health and life) to niche consumer and institutional markets. Through our subsidiaries we issue primarily health insurance policies, covering individuals and families, to the self-employed, association groups and small businesses, and life insurance policies to markets that we believe are underserved. We believe we have one of the largest direct selling organizations in the health insurance field, with approximately 1,900 independent writing agents per week in the field selling health insurance to the self employed market in 44 states.
The Company’s expenses consist primarily of insurance claims expense and expenses associated with the underwriting and acquisition of insurance policies. Claims expenses consist primarily of payments to physicians, hospitals and other healthcare providers under health policies and include an estimated amount for incurred but not reported and unpaid claims. Underwriting, policy acquisition costs and insurance expenses consist of direct expenses incurred across all insurance lines in connection with issuance, maintenance and administration of in-force insurance policies, including amortization of deferred policy acquisition costs, commissions paid to agents, administrative expenses and premium taxes. The Company also incurs other direct expenses in connection with generating income derived by the Self-Employed Agency Division from ancillary services and membership marketing and administrative services provided to the membership associations that make available to their members the Company’s health insurance products.
In connection with various stock-based compensation plans that we maintain for the benefit of our independent agents, we record non-cash variable stock-based compensation expense in amounts that depend and fluctuate based upon the fair value (as determined by the Company’s Board of Directors since the Merger) of the Company’s common stock. See discussion below under the caption “Variable Stock-Based Compensation” and Note 14 of Notes to Financial Statements.
The Company’s business segments for financial reporting purposes include (i) the Insurance segment, which includes the businesses of the Company’s Self-Employed Agency Division, the Life Insurance Division and Other Insurance; (ii) the Other Key Factors segment, which includes investment income not otherwise allocated to the Insurance segment, realized gains and losses on sale of investments, interest expense on corporate debt, variable stock-based compensation, pre-operational costs associated with the Company’s Medicare Advantage PFFS market initiative, general expenses relating to corporate operations and in 2006, the incremental costs associated with the acquisition of the Company by a group of private equity investors, and (iii) the Disposed Operations segment, which includes the Company’s former Star HRG Division and former Student Insurance Division.
Following adoption of SEC Staff Accounting Bulletin No. 108 (SAB 108), Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in the Current Year Financial Statements, the Company performed an analysis to determine the appropriate portion of commissions to be deferred over the lives of the underlying policies. Generally, first year and second year commission rates are higher than the renewal year commission rates, and the Company has determined that the preferred approach is to capitalize the excess commissions associated with those earlier years and amortize the capitalized costs ratably over the estimated life of the policy. Accordingly, effective January 1, 2006, the Company has elected to change its accounting methodology by amortizing the first and second year excess commissions ratably over the average life of the policy which approximates a two year period .
The Company has elected to utilize the one time special transition provisions of SAB 108 and recorded an adjustment to retained earnings effective January 1, 2006 to reflect this change in accounting policy with respect to the capitalization and amortization of deferred acquisition costs associated with excess first and second year
Revenues and income from continuing operations before federal income taxes (“operating income”) for each of the Company’s business segments and divisions in 2007, 2006 and 2005 was as follows:
Loss Ratio. The Loss ratio is defined as Benefits expense as a percentage of Earned premium revenue.
Earned premium revenue at the SEA Division decreased to $1.282 billion in 2007 compared to $1.330 billion in 2006, a decrease of $48.0 million or 4%. This decrease in earned premium revenue was primarily attributable to a slight increase in policy lapse rates, a decline in submitted annualized premium volume, and a decrease in the conversion rate of submitted policies to issue policies. The period over period decrease in submitted annualized premium volume was due to a decrease in the average number of writing agents in the field from 2,143 during 2006 to 1,874 during 2007 and a 6% decrease in the productivity per agent based on the average number of weekly applications submitted per writing agent. The decrease in conversion experience on submitted policies was at least partly expected as it reflects the implementation of more rigorous underwriting procedures.
Underwriting, policy acquisition costs and insurance expenses increased to $478.1 million in 2007 from $444.0 million in 2006, an increase of $34.1 million or 8%. In 2007, the Company recognized a $20.0 million expense associated with the potential settlement of the multi-state market conduct examination; see Note 17 of Notes to Financial Statements. This increase also resulted from an $8.0 million asset impairment charge in 2007 associated with two technology assets that we determined were no longer of value to the Company and additional consulting and professional fees incurred for various operational and technology focused initiatives.
The Life Insurance Division reported operating income in 2007 of $2.6 million compared to operating income of $5.3 million in 2006, a decrease of $2.7 million. This decrease was largely attributable to a $9.6 million increase in benefits expenses partially offset by a $4.2 million increase in premium and a $2.6 million decrease in underwriting and acquisition expenses.
Earned premium revenue at the Life Insurance Division increased to $69.9 million in 2007 compared to $65.7 million in 2006, an increase of $4.2 million or 6%. This increase reflects a greater level of renewal premiums from sales that originated in 2006 and prior years through our relationships with two independent marketing companies. The number of policies in force grew during 2007 as new sales exceeded the deterioration in existing blocks of business of older products.
Benefits expenses increased substantially in 2007 to $54.0 million from $44.5 million in 2006. This $9.6 million or 22% increase resulted from unusually adverse mortality experience. Underwriting, policy acquisition costs and insurance expenses decreased in 2007 to $35.4 million from $38.1 million in 2006, a decrease of $2.7 million or 7%. This reduction in expenses reflects a decrease in new sales and a decrease in the amortization of deferred acquisition costs based on more current actuarial assumptions.
In 2007, the Company’s Life Insurance Division generated annualized paid premium volume (i.e., the aggregate annualized life premium amount associated with new life insurance policies issued by the company) in the amount of $18.4 million compared to $20.0 million in 2006.
Set forth below is certain summary financial and operating data for the Company’s Other Insurance Division for each of the three most recent fiscal years:
Operating Margin. Operating margin is defined as Operating income as a percentage of Earned premium revenue.
The Other Insurance Division consists of the operations of ZON Re-USA, LLC (an 82.5%-owned subsidiary), which underwrites, administers and issues accidental death, AD&D, accident medical and accident disability insurance products, both on a primary and on a reinsurance basis. In 2007, ZON Re generated operating income of $7.9 million compared to $5.5 million in 2006, an increase of $2.4 million or 44%. This increase in operating income largely resulted from a substantial decrease in benefits expenses.
Earned premium revenue decreased by $3.9 million or 11% to $30.0 million in 2007 compared to $33.9 million in 2006. During 2007, we experienced an increase in competitive pressure, which impacted new and renewal business.
The Company’s Other Key Factors segment includes investment income not otherwise allocated to the Insurance segment, realized gains and losses on sale of investments, interest expense on corporate debt, variable stock-based compensation, costs associated with the Company’s Medicare Advantage PFFS market initiative and general expenses relating to corporate operations. In 2006, the incremental costs associated with the acquisition of the Company by a group of private equity investors were reported in the Other Key Factors segment.
The Other Key Factors segment reported an operating loss in 2007 of $42.2 million, compared to operating income of $90.5 million in 2006. On a comparative basis, the 2006 results were particularly impacted by the total $201.7 million of gains resulting from the sales of the Star HRG and Student Insurance Divisions partially offset by the $48.0 million of Merger costs.
Interest expense on corporate debt of $43.6 million in 2007 represents an $8.8 million or 25% increase over the $34.8 million incurred in 2006. This increase in interest expense is a function of a greater average outstanding debt balance in 2007 associated with the additional borrowings undertaken in connection with the Merger transaction in 2006. See Note 8 of Notes to the Financial Statements.
In 2007, we incurred $12.4 million of expenses associated with our decision to enter the Medicare Advantage PFFS market beginning with the calendar year 2008 enrollment period. These expenses included compensation costs, lead generation expense, marketing, printing and other costs.
General corporate expenses of $25.2 million in 2007 represented a $14.5 million decrease from the $39.7 million spent in 2006. The 2006 results included substantially more costs for a corporate branding initiative and other professional fees incurred for various special projects that were undertaken following the Merger.
On July 11, 2006 and December 1, 2006, the Company completed the sales of the assets formerly comprising its Star HRG and Student Insurance Divisions, respectively. See Note 2 of Notes to Financial Statements.
Set forth below is certain summary financial and operating data for the Company’s former Star HRG Division (which designed, marketed and administered limited benefit health insurance plans for entry level, high turnover and hourly employees) for each of the three most recent fiscal years:
In 2006 HealthMarkets reported consolidated revenues and income from continuing operations of $2.147 billion and $216.6 million, respectively, compared to revenues and income from continuing operations in 2005 of $2.121 billion and $203.0 million, respectively. Reflecting results from discontinued operations, the Company reported overall 2006 net income of $237.7 million, compared to 2005 net income of $203.5 million.
Revenues. HealthMarkets’ revenues increased to $1.831 billion in 2006 from $1.684 billion in 2005, an increase of $146.9 million, or 9%. The Company’s revenues were particularly impacted by the following factors:
Other income (consisting primarily of income derived by the SEA Division from ancillary services and membership marketing and administrative services provided to the membership associations that make available to their members the Company’s health insurance products) decreased by 2% to $101.8 million in 2006 from $103.6 million in 2005. The decrease in other income was primarily attributable to a decrease in fee and other income earned by the Company’s former real estate subsidiary, the activities of which were immaterial and which the Company dissolved in the first quarter of 2007.
Benefits and Expenses. HealthMarkets’ total benefits and expenses increased to $1.493 billion in 2006 from $1.364 billion in 2005, an increase of $129.8 million, or 10%. The Company’s benefits and expenses were particularly impacted by the following factors:
Benefits, claims and settlement expenses increased nominally to $784.9 million in 2006 from $777.7 million in 2005, primarily as a result of an increase in the claim benefits as a percentage of earned premium associated with business written at the SEA Division. See Self-Employed Agency discussion below.
Total interest expense on corporate debt and the Company’s student loan credit facilities increased to $41.1 million in 2006 from $6.0 million in 2005, primarily due to the incremental indebtedness incurred in connection with the Merger and the increase in borrowing rates on the student loan debt.
The decrease in operating margin to 17.8% in 2006 compared to 22.3% in 2005 was attributable primarily to the increase in loss ratio and increase in underwriting, policy acquisition costs and insurance expenses in the amount of $15.5 million associated with a change in accounting policy with respect to amortization of a portion of deferred acquisition costs. See Note 1 of Notes to Financial Statements.
The Company’s Life Insurance Division reported operating income in 2006 of $5.3 million compared to operating income of $7.1 million in 2005. The year-over-year decrease in operating income was attributable to an increase in death claims during the first half of 2006 and an increase in administrative expenses The increase in administrative expenses is due to a decrease in capitalized deferred acquisition costs (administration costs) related to a decline in first year sales volume.
The Other Insurance Division consists of the operations of ZON Re (an 82.5%-owned subsidiary), which underwrites, administers and issues accidental death, AD&D, accident medical and accident disability insurance products, both on a primary and on a reinsurance basis. In 2006, ZON Re generated revenues and operating income of $35.3 million and $5.5 million, respectively, compared to revenues and operating income of $34.8 million and $4.7 million, respectively, in 2005.
The Other Key Factors segment reported income in 2006 of $90.5 million, compared to a loss of $1.6 million in 2005.
reporting purposes, the Company reflects all non-cash variable stock based compensation associated with its agent stock plans in its “Other Key Factors” business segment. See Note 14 of Notes to Financial Statements.
The accounting treatment of the Company’s agent plans has resulted and will continue to result in unpredictable non-cash stock-based compensation charges, primarily dependent upon future fluctuations in the prevailing fair value of HealthMarkets common stock. These unpredictable fluctuations in stock based compensation charges may result in material non-cash fluctuations in the Company’s results of operations. Unvested benefits under the agent plans vest in January of each year; accordingly, in periods of general appreciation in the price of HealthMarkets common stock, the Company’s cumulative liability, and corresponding charge to income, for unvested stock-based compensation is expected to be greater in each successive quarter during any given year.
At December 31, 2007 and 2006, HealthMarkets, Inc. and HealthMarkets LLC at the holding company level held cash and cash equivalents (including short-term investments) in the amount of $63.0 million and $311.5 million, respectively. Set forth below is a summary statement of aggregate cash flows for HealthMarkets, Inc and HealthMarkets LLC for each of the three most recent years:
During 2007, the Company received an aggregate of $176.2 million in cash dividends from our subsidiaries compared to $221.7 million in 2006. Prior approval by insurance regulatory authorities is required for the payment by a domestic insurance company of dividends that exceed certain limitations based on statutory surplus and net income. During 2008, the Company’s domestic insurance companies can pay, without prior approval of the regulatory authorities, aggregate dividends in the ordinary course of business to the holding company of approximately $153.6 million ($76.3 million was paid in January 2008). However, as it has done in the past, the Company will assess the results of operations of the regulated domestic insurance companies
On April 5, 2006, the Company received $985.0 million for the purchase of common stock by the group of private equity firms in connection with the Merger.
During 2006, the Company received a total of $144.3 million in distributions from the non-consolidated qualifying special purpose entity, Grapevine Finance LLC. Of this total $72.4 million resulted from a principal repayment by CIGNA on the $150.8 million note issued as consideration in the sale of Star HRG. The other $71.9 million resulted from Grapevine’s issuance of senior secured notes.
In 2007, the Company received $54.2 million in proceeds from other financing activities largely consisting of $50.4 million in proceeds from subsidiaries to acquire shares in the agent stock plans. The corresponding amount in 2006 was $20.4 million. The 2007 activity was unusually greater in large part due to a $27.9 million reinvestment of the extraordinary cash dividend in May 2007.
During 2007 and 2006, the Company made voluntary principal prepayments of $75.0 million and $62.5 million, respectively, on the $500.0 million term loan facility.
During 2007, the holding company paid an extraordinary cash dividend of $317.0 million.
During 2007, the Company paid $41.5 million mostly to repurchase shares of its common stock from subsidiaries in connection with the agent stock plans and also to purchase common stock from officers.
Set forth below is a summary of the Company’s contractual obligations (on a consolidated basis) at December 31, 2007:
Investments are selected based upon the parameters established in the Company’s investment policies. Emphasis is given to the selection of high quality, liquid securities that provide current investment returns. Maturities or liquidity characteristics of the securities are managed by continually structuring the duration of the investment portfolio to be consistent with the duration of the policy liabilities. Consistent with regulatory
requirements and internal guidelines, the Company invests in a range of assets, but limits its investments in certain classes of assets, and limits its exposure to certain industries and to single issuers.
Corporate bonds included in the fixed maturity portfolio consist primarily of short term and medium term investment grade bonds. The Company’s investment policy with respect to concentration risk limits individual investment grade bonds to 3% of assets and non-investment grade bonds to 2% of assets. The policy also limits the investments in any one industry to 20% of assets. As of December 31, 2007, the largest concentration in any one investment grade corporate bond was $92.4 million, which represented 6.3% of total invested assets. This security was received as payment on the sale of the Student Insurance Division. To limit its credit risk, the Company has taken out $75.0 million of credit default insurance on this bond, reducing its default exposure to $19.8 million, or 1.3% of total invested assets. The largest concentration in any one non-investment grade corporate bond was $4.6 million, which represented less than 1% of total invested assets. The largest concentration to any one industry was less than 10%. Additionally, due primarily to long standing conservative investment guidelines, our direct exposure to sub prime investments and auction rate securities is limited to 3.5% of investments.
Included in the fixed maturity portfolio are mortgage-backed securities, including collateralized mortgage obligations, mortgage-backed pass-through certificates and commercial mortgage-backed securities. To limit its credit risk, the Company invests in mortgage-backed securities that are rated investment grade by the public rating agencies. The Company’s mortgage-backed securities portfolio is a conservatively structured portfolio that is concentrated in the less volatile tranches, such as planned amortization classes and sequential classes. The Company seeks to minimize prepayment risk during periods of declining interest rates and minimize duration extension risk during periods of rising interest rates. The Company has less than 1% of its investment portfolio invested in the more volatile tranches.
The Company continually monitors these investments and believes that, as of December 31, 2007, the unrealized loss in these investments is temporary.
The Company regularly monitors its investment portfolio to attempt to minimize its concentration of credit risk in any single issuer. Set forth in the table below is a schedule of all investments representing greater than 1% of the
The Company’s discussion and analysis of its financial condition and results of operations are based upon the Company’s consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires the Company to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and related disclosure of contingent assets and liabilities. On an on-going basis, the Company evaluates its estimates, including those related to health and life insurance claims, bad debts, investments, intangible assets, income taxes, financing operations and contingencies and litigation. The Company bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.
The completion factors and loss ratio estimates in the most recent incurred months are the most significant factors affecting the estimate of the claim liability. The Company believes that the greatest potential for variability from estimated results is likely to occur at its SEA Division. The following table illustrates the sensitivity of these factors and the estimated impact to the December 31, 2007 unpaid claim liability for the SEA Division. The scenarios selected are reasonable based on the Company’s past experience, however future results may differ.
With respect to business at its Disposed Operations segment, the Company assigned incurred dates based on the date of service. This definition estimated the liability for all medical services received by the insured prior to the end of the applicable financial period. Appropriate adjustments were made in the completion factors to account for pending claim inventory changes and contractual continuation of coverage beyond the end of the financial period.
As indicated in the table above, incurred losses developed in amounts less than originally anticipated.
Set forth in the table below is a summary of the claims liability development experience (favorable) unfavorable by business unit in the Company’s Insurance segment for each of the years ended December 31, 2007, 2006 and 2005:
The total favorable claims liability development experience for 2007, 2006 and 2005 in the amount of $75.6 million, $85.8 million and $121.4 million, respectively, represented 18.1%, 19.5% and 24.6% of total claim liabilities established for the SEA Division as of December 31, 2006, 2005 and 2004, respectively.
Development in the most recent incurral months and Development in completion factors
The Accumulated Covered Expense (“ACE”) rider is an optional benefit rider available with certain scheduled/basic health insurance products that provides for catastrophic coverage for covered expenses under the contract that generally exceed $100,000 or, in certain cases, $75,000. This rider pays benefits at 100% after the stop loss amount is reached up to the aggregate maximum amount of the contract for expenses covered by the rider. Development in the ACE rider is presented separately due to the greater level of volatility in the ACE product resulting from the nature of the benefit design where there are less frequent claims but larger dollar value claims. The development experience presented in the table above is partially attributable to development in the most recent incurral months and development in the completion factors. The favorable development also reflects changes in the assumptions used to calculate the estimate of the claim liability. See discussion below regarding Changes in the SEA Claim Liability Estimates.
In 2007, the SEA Division benefited from favorable development in its claim liability of $6.7 million related to its reserve for benefits provided through group blanket contracts to the members of certain associations. These contracts were not renewed and the Company’s subsequent actual experience was favorable in comparison to the reserve estimates established prior to the termination of the contracts.
The Company experienced favorable development of $8.5 million during 2005 in its reserve for large claims as a result of lower frequency and severity of large claims than anticipated. During 2006, the Company determined that sufficient provision for large claims could be made within its normal reserve process, thus eliminating the need for the separate large claim reserve and producing favorable development in the amount of $10.6 million. Since this reserve was eliminated in 2006, there is no subsequent development in 2007, either favorable or unfavorable.
The remaining favorable experience in the claim liability development was $4.7 million, $4.2 million and $4.5 million in 2007, 2006 and 2005, respectively, which in each year, represented less than 1.1% of total claim liability established at the end of each preceding year.
Impact on Other Insurance. Through our 82.5%-owned subsidiary, ZON Re, we underwrite, administer and issue accidental death, AD&D, accident medical and accident disability insurance products, both on a primary and on a reinsurance basis. The unfavorable claim liability development experience at ZON Re in 2007 in the amount of $734,000 was due to certain large claims reported in 2007 associated with claims incurred in prior years. The favorable claim liability experience of $2.5 million in 2006 is due to the release of reserves held at December 31, 2005 for catastrophic excess of loss contracts expiring during 2006.
As presented in the table above, the SEA Division has reported particularly favorable development experience for the last several years. In response to these results, the Company has endeavored and will continue in its efforts to refine its estimates and assumptions in calculating the claim liability estimate. To the extent the changes in estimates described below related to prior year incurral months at the time the change was implemented, that portion or amount of the change is included in the development experience table. The Company made the following changes in estimate, by year, as described below:
In 2007, the Company made certain refinements to reduce its estimate of the claim liability for the ACE rider totaling $10.9 million. The refinement of $5.9 recorded in the third quarter was attributable to an update of the completion factors used in estimating the claim liability for the ACE rider. A benefit recorded in the second quarter of $5.0 million reflected an increasing reliance on actual historical data for the ACE rider in lieu of large claim data derived from other products.
During the third quarter of 2007, the claim liability was reduced by $12.3 million resulting from a refinement to the estimate of unpaid claim liability specifically for the most recent incurral months. In particular, the Company reassessed its claim liability estimates among product lines between the more mature scheduled benefit products that have more historical data and are more predictable, and the newer products that are less mature, have less historical data and are more susceptible to adverse deviation.
During 2006, the Company reduced the claim liability estimate by a total of $25.1 million for the ACE rider, $10.5 million was recorded in the third quarter and $14.6 million was recorded in the fourth quarter. These reductions were attributable to an update of the completion factors used in estimating the claim liability, reflecting both actual historical data for the ACE rider and historical data derived from other products. In 2005, the completion factors were calculated with more emphasis placed on historical data derived from other products since there was insufficient data related to the ACE product rider to provide accurate and reliable completion factors.
In the third quarter, the Company reduced the claim liability estimate by $21.0 million. This reduction was attributable to a refinement of the estimate of the unpaid claim liability for the most recent incurral months. The Company utilizes anticipated loss ratios to calculate the estimated claim liability for the most recent incurral months. Despite negligible premium rate increases implemented on the most popular scheduled health insurance products, the SEA Division has continued to observe favorable claims experience and, as a result, loss ratios have not increased as rapidly as anticipated. This favorable claims experience has been reflected in the refinement of the anticipated loss ratios used in estimating the unpaid claim liability for the most recent incurral months.
In addition, in the third quarter, an additional $12.3 million reduction was made as a result of updates to the completion factors used in the developmental method of estimating the unpaid claim liability, reflecting more current claims administration practices.
In the first quarter, the Company made certain refinements to its claim liability calculations related to the ACE rider, the effect of which decreased claim liabilities by $7.6 million. Prior to January 1, 2005, the Company utilized a technique that is commonly used to estimate claims liabilities with respect to developing blocks of business, until sufficient experience is obtained to allow more precise estimates. The Company believed that the technique produced appropriate reserve estimates in all prior periods. During the first quarter of 2005, the Company believed that there were sufficient claims paid on this benefit to produce a reserve estimate utilizing the completion factor technique. As a result, effective January 1, 2005, the Company refined its technique used to estimate claim liabilities to utilize completion factors for older incurral dates. The technique utilizes anticipated loss ratios in the most recent incurral months. This completion factor technique utilized historical data derived from other products since there was insufficient data related to the ACE product rider to provide accurate and reliable completion factors.
At December 31, 2006, the Company changed its accounting policy, effective January 1, 2006, with respect to the amortization of a portion of deferred acquisition costs associated with commissions paid to agents. Generally, the first year and second year commission rates on policies issued by the Company’s SEA Division are higher than renewal year commission rates. Commencing in 2006, the Company changed its accounting methodology with respect to the first year and second year excess commissions and now amortizes those excess commissions over a two year period, which approximates the average life of the policy. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations - 2006 Change in Accounting Policy.”
The Company incurs various costs in connection with the origination and initial issuance of its life insurance policies, including underwriting and policy issuance costs. The Company defers those costs that vary with production. The Company capitalizes commission and issue costs primarily associated with the new business of its Life Insurance Division. Deferred acquisition costs consist primarily of sales commissions and other underwriting costs of new life insurance sales. Policy acquisition costs associated with traditional life business are capitalized and amortized over the estimated premium-paying period of the related policies, in proportion to the ratio of the annual premium revenue to the total premium revenue anticipated. Such anticipated premium revenue,
which is modified to reflect actual lapse experience, is estimated using the same assumptions as are used for computing policy benefits. For universal life-type and annuity contracts, capitalized costs are amortized at a constant rate based on the present value of the estimated gross profits expected to be realized on the book of contracts.
Investments are reviewed quarterly (or more frequently if certain indicators arise) to determine if they have suffered an impairment of value that is considered other than temporary. Management’s review considers the following indicators of impairment: fair value significantly below cost; decline in fair value attributable to specific adverse conditions affecting a particular investment; decline in fair value attributable to specific conditions, such as conditions in an industry or in a geographic area; decline in fair value for an extended period of time; downgrades by rating agencies from investment grade to non-investment grade; financial condition of the issuer deterioration and situations where dividends have been reduced or eliminated or scheduled interest payments have not been made. Management monitors investments where two or more of the above indicators exist. The Company also identifies investments in economically challenged industries. If investments are determined to be other than temporarily impaired, a loss is recognized at the date of determination.
Grapevine is a non-consolidated qualifying special purpose entity as defined in FASB 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities. As a qualifying special purpose entity, HealthMarkets does not consolidate the financial results of Grapevine and accounts for its residual interest in Grapevine as an investment in fixed maturity securities pursuant to EITF 99-20, Recognition of Interest Income and Impairment on Purchase and Retained Beneficial Interests in Securitized Financial Assets.
In 2003, the Company realized net capital losses that were carried forward and available to offset future capital gains, if any, realized in the following 5 years. In 2003, the Company established a valuation allowance for the deferred tax asset resulting from the capital loss carryforward reflecting the uncertainty in the Company’s ability to realize that asset in subsequent years through the generation of sufficient capital gains. In 2006, the sales of the
The Company is subject to proceedings and lawsuits related to insurance claims and other matters. See Note 17 of Notes to Financial Statements. The Company is required to assess the likelihood of any adverse judgments or outcomes to these matters, as well as potential ranges of probable losses. A determination of the amount of accruals required, if any, for these contingencies is made after careful analysis of each individual issue. The required accruals may change in the future due to new developments in each matter or changes in approach, such as a change in settlement strategy in dealing with these matters.
The state of domicile of each of the Company’s domestic insurance subsidiaries imposes minimum risk-based capital requirements that were developed by the NAIC. The formulas for determining the amount of risk-based capital specify various weighting factors that are applied to financial balances and premium levels based on the perceived degree of risk. Regulatory compliance is determined by a ratio of a company’s regulatory total adjusted capital, as defined, to its authorized control level risk-based capital, as defined. Companies’ specific trigger points or ratios are classified within certain levels, each of which requires specified corrective action. At December 31, 2007, the risk-based capital ratio of each of the Company’s domestic insurance subsidiaries significantly exceeded the ratios for which regulatory corrective action would be required.
In December 2007, FAS No. 160, Noncontrolling Interests in Consolidated Financial Statements - an amendment of ARB No. 51, was issued. The objective of FAS 160 is to improve the relevance, comparability, and transparency of the financial information related to minority interest that a reporting entity provides in its consolidated financial statements. This Statement is effective for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2008. The Company believes this statement will not have a material impact on its financial position or results of operations.
In February 2007, FAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities was issued. FAS 159 permits an entity to elect fair value as the initial and subsequent measurement attribute for many financial assets and liabilities. Entities electing the fair value option would be required to recognize changes in fair value in earnings. Entities electing the fair value option are required to distinguish on the face of the statement of financial position, the fair value of assets and liabilities for which the fair value option has been elected and similar assets and liabilities measured using another measurement attribute. FAS 159 is effective for fiscal year 2008. The adjustment to reflect the difference between the fair value and the carrying amount would be accounted for as a cumulative-effect adjustment to retained earnings as of the date of initial adoption. The Company believes this statement will not have a material impact on its financial position or results of operations.
On January 1, 2007, the Company adopted the provisions of the FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes - an interpretation of FAS No. 109, (FIN 48). FIN 48 clarifies the accounting for income taxes by prescribing a minimum recognition threshold that a tax position is required to meet before being recognized in the financial statements. FIN 48 also provides guidance on derecognition, measurement, classification, interest and penalties, disclosure and transition. The adoption of FIN 48 did not impact the Company’s financial condition or results of operations.
In February 2006, the FASB issued FAS No. 155, Hybrid Instruments. SFAS No. 155 amends FAS No. 133 and FAS No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities. FAS No. 155 also resolves issues addressed in Statement 133 Implementation Issue No. D1, Application of Statement 133 to Beneficial Interests in Securitized Financial Assets. FAS No. 155: a) permits fair value remeasurement for any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation, b) clarifies which interest-only strips and principal-only strips are not subject to the requirements of SFAS No. 133, c) establishes a requirement to evaluate interests in securitized financial assets to identify interests that are freestanding derivatives or that are hybrid financial instruments that contain an embedded derivative requiring bifurcation, d) clarifies that concentrations of credit risk in the form of subordination are not embedded derivatives, and e) amends FAS No. 140 to eliminate the prohibition on a qualifying special purpose entity from holding a derivative financial instrument that pertains to a beneficial interest other than another derivative financial instrument. The Company adopted FAS No. 155 effective January 1, 2007; however, there was no material impact.
fair value and expands disclosures about fair value measurements. FAS 157 is effective for fiscal year 2008. The Company is currently evaluating the impact of this pronouncement on its financial position and results of operations.
In 2005, the American Institute of Certified Public Accountants issued Statement of Position (SOP) 05-1, Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection With Modifications or Exchanges of Insurance Contracts, for implementation in the first quarter of 2007. The SOP requires that deferred acquisition costs be expensed in full when the original contract is substantially changed by election or amendment of an existing contract feature or by replacement with a new contract. The Company implemented the SOP for contract changes beginning in the first quarter of 2007 with no material effects to the financial statements at implementation.