We lease office space for our principal executive offices in Woodland Hills, California. Our executive offices, comprising approximately 115,448 square feet, are occupied under a lease that was renewed in 2004 with new terms and conditions. As part of the lease renewal, we amended our existing lease, which was scheduled to expire on December 31, 2004, and entered into a new lease with a ten-year term. The new lease commenced on January 1, 2005 and expires December 31, 2014. A significant portion of our California HMO operations are also housed in Woodland Hills, in a separate 333,954 square foot leased facility. This new two-building facility was occupied at the end of 2001, under a lease that expires December 31, 2011. Combined rent and rent related obligations for our Woodland Hills facilities were approximately $13.1 million in 2004.
Severance, Asset Impairment and Restructuring Charges and other Miscellaneous Expenses. We recorded $18 million of miscellaneous items as part of the fourth quarter 2004 pre-tax earnings charge, including severance and related benefit costs, lease terminations, the write-off of certain investments and IT assets and other balance sheet items. For information regarding these balance sheet items, see “-Results of Operations-Severance, Asset Impairments and Restructuring Costs.”
Total health plan membership decreased 3% to approximately 3.8 million members at December 31, 2003 from approximately 4.0 million members at December 31, 2002.
Enrollment in our commercial health plans, including ASO members, decreased 3% at December 31, 2003 compared to the same period in 2002. The decrease in commercial membership was primarily due to planned exits from unprofitable large employer group accounts during 2003, in particular the planned loss of the California Public Employees’ Retirement System (“CalPERS”) account effective January 1, 2003. The CalPERS account had more than 175,000 members. This loss was partially offset by a membership increase in our small group and individual market as a result of sales efforts targeted at this portion of the market, improved relationships with the distribution system, including insurance brokers and general agents, pricing consistently with the market and health care cost trends and new and improved products.
Membership in our state Medicaid programs decreased 3% at December 31, 2003 compared to the same period in 2002, primarily due to the State of California’s efforts to disenroll Medi-Cal members no longer eligible for this program, with Los Angeles County experiencing the majority of the decrease.
Region 6, covering Arkansas, Oklahoma, most of Texas, and most of Louisiana
referred to as the Mid-Atlantic and Heartland sub-regions) and September 1, 2004 for the area that was previously TRICARE Region 1 (now referred to as the National Capital and Northeast sub-regions). We ended the delivery of health care under our existing Region 11 contract on May 31, 2004, our existing Region 9, 10 and 12 contract on June 30, 2004, and our existing Region 6 contract on October 31, 2004.
From January 1, 2004 through May 31, 2004 (the expiration date for the old Region 11 TRICARE contract), enrollment of TRICARE beneficiaries in TRICARE Prime for the Region 11 contract increased by 2.0% to 153,062, while the total estimated number of eligible beneficiaries, based on data from the Department of Defense, decreased by 4.5% to 236,834. From January 1, 2004 through October 31, 2004, (the expiration date for the old Region 6 TRICARE contract), enrollment of TRICARE beneficiaries in TRICARE Prime for the Region 6 contract increased by 1.3% to 393,674, while the total estimated number of eligible beneficiaries, based on data from the Department of Defense, decreased by 5.3% to 612,611. From January 1, 2004 through June 30, 2004 (the expiration date for the old Regions 9, 10 and 12 TRICARE contract), enrollment of TRICARE beneficiaries in TRICARE Prime for the Regions 9, 10 and 12 contract increased by 1.1% to 387,906 while the total estimated number of eligible beneficiaries, based on data from the Department of Defense and excluding Alaska, decreased by 0.1% to 595,626. Department of Defense estimated numbers of eligible beneficiaries are subject to revision when actual numbers become available. TRICARE beneficiaries do not “enroll” in either TRICARE Extra or TRICARE Standard, rather, they select, on a case-by-case basis, to utilize either, both or neither of these options during any given year. As such, there is no enrollment data available for the TRICARE Extra and TRICARE Standard options.
Commercial premiums increased by $430.9 million or 6.6% for the year ended December 31, 2004 compared to the same period in 2003. This increase is attributable to our implementation of higher rates (including renewal rates) in our large and small group markets in all of our health plans to account for higher health care costs, partially offset by membership losses in all states except Arizona and Oregon.
Medicaid premiums decreased by $66.5 million or 5.7% for the year ended December 31, 2004 compared to the same period in 2003, primarily due to membership losses in all states.
Medicare Risk premium decreased by $42.3 million or 3.0% for the year ended December 31, 2003 compared to the same period in 2002. This decrease was the result of our planned exit from certain counties in California and Arizona. The increase in Medicare risk premiums reflects annual rate increases from CMS and was seen across all states.
Medicaid premiums increased by $40.3 million or 3.6% for the year ended December 31, 2003 compared to the same period in 2002. This increase was due to rate increases and increased reimbursement rates for maternity charges in New Jersey. Rates in California were relatively flat with a 1.1% decrease in the Department of Health Services’ rates offset by an increase in the Healthy Families program rates.
A rate/volume analysis showing the impact of these commercial, Medicare and Medicaid premium and membership changes for the year ended December 31, 2003 compared to the same period in 2002 is summarized in the following table.
the receipt of an additional $206.7 million from higher change order and bid price adjustments.
Other income decreased by $40.3 million for the year ended December 31, 2004 as compared to the same period in 2003 due to the sale of our employer services group division effective October 31, 2003. We deferred approximately $15.9 million of the gains on the October 2003 sales of our employer services group division and dental and vision plans related to non-compete and network access agreements. The deferred amounts are recognized as other income over the terms of the agreements. We recognized other income of $2.8 million during 2004 related to the amortization of these agreements.
Health Plan Services costs increased by $896.8 million or 12.0% to $8,413.6 million for the year ended December 31, 2004 from $7,516.8 million for the same period in 2003 due to the following:
Health Plan Services MCR increased to 88.0% for the year ended December 31, 2004 as compared to 82.7% for the same period in 2003. The increase is primarily due to higher commercial health care costs that outpaced the premium revenue growth.
A rate/volume analysis showing the impact of these commercial, Medicare and Medicaid health care cost changes for the year ended December 31, 2004 compared to the same period in 2003 is summarized in the following table.
Government contracts costs increased by $138.1 million, or 7.7%, for the year ended December 31, 2004 compared to the same period in 2003 due to an increase in costs of $672.1 million from the start of providing health care services under the new TRICARE contract for the North Region, partially offset by $528.2 million from the expiration of the old TRICARE contracts.
The changes in general and administrative (“G&A”), selling, amortization and depreciation and interest expense for the year ended December 31, 2004 compared to the same period in 2003 and for the year ended December 31, 2003 compared to the same period in 2002 are as follows:
The selling costs ratio (selling costs as a percentage of Health Plan Services premiums) decreased to 2.5% for the year ended December 31, 2004 from 2.6% for the same period in 2003, primarily due to lower broker commissions as a result of the decline in small group and individual enrollment in 2004.
Interest expense for the year ended December 31, 2004 decreased by $6.0 million, or 15.3%, compared to the same period in 2003 primarily due to the current favorable impact of $7.1 million in settlements on our interest rate swap contracts (“Swap Contracts”) for our Senior Notes, partially offset by an increase in our interest expense of $1.9 million as a result of the downgrade of our senior unsecured debt rating. See Note 6 to our consolidated financial statements for further information on our Swap Contracts and information on the downgrade of our senior unsecured debt rating.
G&A costs increased by $56.4 million, or 6.6%, for the year ended December 31, 2003 compared to the same period in 2002 due to continued investment in our operations and systems consolidation projects. Our administrative expense ratio remained at 10.6% for the year ended December 31, 2003 as compared to the same period in 2002.
Interest expense decreased by $1.1 million, or 2.7%, for the year ended December 31, 2003 as compared to the same period in 2002 due to lower average balance outstanding from repayment of the entire balance of $120 million on our revolving credit facility balance as of June 30, 2002.
We recorded a $1.7 million pre-tax charge for lease termination expenses associated with the exit of certain properties as part of the transition from our old TRICARE contracts to the new TRICARE contract for the North Region.
See Note 14 to our consolidated financial statements for further information on the severance and related benefits, asset impairments and lease termination costs.
During 2003, we recorded a $1.9 million pre-tax impairment on a corporate facility building located in Carmichael, California consisting entirely of non-cash write-downs of building and building improvements. On April 12, 2004, we sold this asset for $1.3 million in cash and recognized a pre-tax gain of $0.2 million in our consolidated statement of operations for the year ended December 31, 2004.
During the fourth quarter ended December 31, 2003, we assessed the probability and concluded it was unlikely that we would realize any of the earnout shares to which we may be entitled under the marketing and stock issuance agreement with NaviMedix. Accordingly, we recognized an asset impairment of $13.8 million on our $15 million asset related to the CSMS-IPA e-business connectivity services contract.
As part of our ongoing G&A expense reduction efforts, we implemented an enterprise-wide staff reduction in 2001. This formal plan was completed as of September 30, 2002 and we recorded a modification of $1.5 million to reflect an increase in the severance and related benefits in connection with this staff reduction.
million in cash and $1.6 million in notes. Accordingly, we wrote off the original investments of $13.4 million less the $1 million cash received and recognized an impairment charge of $12.4 million on December 31, 2002 which included an allowance against the full value of the notes received in exchange.
Net Gain (Loss) on Sale of Businesses and Assets Held for Sale
The gains and (losses) recognized from divestitures made during the years ended December 31, 2004, 2003 and 2002 are summarized in the following table.
On March 1, 2004, we completed the sale of two subacute subsidiaries, American VitalCare, Inc. and Managed Alternative Care, Inc., to a subsidiary of Rehabcare Group, Inc. We received a payment of approximately $11 million, subject to certain post-closing adjustments, and a $3 million subordinated promissory note for which we recorded a full reserve.
On October 31, 2003, we consummated the sale of our workers’ compensation services subsidiary, Health Net Employer Services, Inc., along with its subsidiaries Health Net Plus Managed Care Services, Inc. and Health Net CompAmerica, Inc., collectively known as our employer services group subsidiary, to First Health Group Corp. In connection with this sale, we received $79.5 million in cash.
During 2002, we recorded an estimated pre-tax loss of $2.6 million on assets held for sale related to a corporate facility building in Trumbull, Connecticut consisting entirely of non-cash write-downs of a building and building improvements.
The 2004, 2003 and 2002 divestitures described above did not have a material impact on our financial condition, results of operations or liquidity. See Note 3 to our consolidated financial statements for more information on these divestitures.
(1) The effective income tax rate differs from the statutory federal tax rate of 35.0% in each year due primarily to state income taxes, tax-exempt investment income, business divestitures and tax return examination settlements. The effective income tax rate decreased from 2003 to 2004 due to an increase in the impact of tax benefits associated with tax return examination settlements. The effective income tax rate increased from 2002 to 2003 primarily due to the reduction in the impact of tax benefits associated with tax return examination settlements.
share, as a result of our settlement agreement with SNTL Litigation Trust, to settle all outstanding claims under the Superior National Insurance Group, Inc v. Foundation Health Corporation, et. al. litigation. See “Item 3. Legal Proceedings” and Note 12 to our consolidated financial statements for additional information regarding the Superior settlement.
A description of the cumulative effect of a change in accounting principle from adopting SFAS No. 142 is contained in Note 2 to our consolidated financial statements.
We believe that cash flow from operating activities, existing working capital, lines of credit, and funds from any potential divestitures of business are adequate to allow us to fund existing obligations, introduce new products and services, and continue to develop health care-related businesses. We regularly evaluate cash requirements for current operations and commitments, and for capital acquisitions and other strategic transactions. We may elect to raise additional funds for these purposes, either through issuance of debt or equity, the sale of investment securities or otherwise, as appropriate.
Our cash flow from investing activities is primarily impacted by the sales, maturities and purchases of our available-for-sale investment securities and restricted investments. Our investment objective is to maintain safety and preservation of principal by investing in high-quality, investment grade securities while maintaining liquidity in each portfolio sufficient to meet our cash flow requirements and attaining the highest total return on invested funds.
Net decrease in net income plus amortization, depreciation and other net non-cash charges of $199.7 million,
Net decrease in cash flows from amounts receivable/payable under government contracts of $175.3 million, primarily due to the transition to the new TRICARE contract for the North Region, and
Delayed receipt of the December 2004 Medicare payment of $66 million for our California and New York health plans.
Net cash from operating activities decreased by $33.7 million for the year ended December 31, 2003 compared to the same period in 2002 due to the following:
Net decrease in net income plus amortization, depreciation and other net non-cash charges of $72.1 million,
Net decrease in cash flows from premiums receivable and unearned premiums of $9.1 million primarily from enrollment decreases, and
Net decrease in cash collections from other assets of $3.2 million, partially offset by
Net increase in cash flows of $2.5 million from the tax benefits on stock option exercises.
Increases in cash flows from investing activities for the year ended December 31, 2004 compared to the same period in 2003 and for the year ended December 31, 2003 compared to the same period in 2002 are as follows:
Net cash from investing activities increased by $91.3 million for the year ended December 31, 2004 compared to the same period in 2003 due to the following:
Net decrease in purchases of property and equipment of $17.0 million, partially offset by
Cash proceeds of $90.3 million from the sale of our employer services subsidiary and dental and vision subsidiaries in 2003, partially offset by
Increases in cash flows from financing activities for the year ended December 31, 2004 compared to the same period in 2003 and for the year ended December 31, 2003 compared to the same period in 2002 are as follows:
repurchase program. In August 2003, our Board of Directors authorized us to repurchase up to an additional $200 million (net of exercise proceeds and tax benefits from the exercise of employee stock options) of our common stock under our stock repurchase program. Based on the authorization we received from our Board of Directors to repurchase up to an aggregate of $450 million, our total authority under our stock repurchase program through 2004 was estimated at $593 million, including the realized exercise proceeds and tax benefits. Share repurchases are made under our stock repurchase program from time to time through open market purchases or through privately negotiated transactions. We used net free cash available to the parent company to fund the share repurchases. As a result of Moody’s downgrade in September 2004 and S&P’s downgrade in November 2004 with respect to our senior unsecured debt rating, we discontinued our repurchases of common stock under our stock repurchase program through the end of 2004. Our stock repurchase program currently remains on hold. Our decision to resume the repurchase of shares under our stock repurchase program will depend on a number of factors, including, without limitation, any future ratings action taken by Moody’s or S&P on our senior unsecured debt rating. See Note 6 to our consolidated financial statements for additional information regarding the Moody’s and S&P downgrades.
Our Senior Notes consist of $400 million in aggregate principal amount of 8.375% senior notes due 2011. The Senior Notes were issued pursuant to an indenture dated as of April 12, 2001. The interest rate payable on our Senior Notes is subject to adjustment from time to time if either Moody’s or S&P downgrades the rating ascribed to the Senior Notes below investment grade (as defined in the indenture governing the Senior Notes). On September 8, 2004, Moody’s announced that it had downgraded our senior unsecured debt rating from Baa3 to Ba1, which triggered an adjustment to the interest rate payable by us on our Senior Notes. As a result of the Moody’s downgrade, effective September 8, 2004, the interest rate on the Senior Notes increased from the original rate of 8.375% per annum to an adjusted rate of 9.875% per annum, resulting in an increase in our interest expense of $6 million on an annual basis. On November 2, 2004, S&P announced that it had downgraded our senior unsecured debt rating from BBB- to BB+. The adjusted interest rate of 9.875% per annum will remain in effect for so long as the Moody’s rating on our senior unsecured debt remains below Baa3 (or the equivalent) or the S&P rating on our senior unsecured debt remains below BBB- (or the equivalent). During any period in which the Moody’s rating on our senior unsecured debt is Baa3 (or the equivalent) or higher and the S&P rating on our senior unsecured debt is BBB- (or the equivalent) or higher, the interest rate payable on the Senior Notes will be equal to the original rate of 8.375% per annum.
The Senior Notes are redeemable, at our option, at a price equal to the greater of:
100% of the principal amount of the Senior Notes to be redeemed; and
On June 30, 2004, we entered into a new five-year revolving credit agreement with Bank of America, N.A., as Administrative Agent, Swing Line Lender and L/C Issuer, JP Morgan Chase Bank, as Syndication Agent, and the other lenders party thereto. The senior credit facility refinanced and replaced our previous $175 million 364-
day credit facility (which matured June 22, 2004) and $525 million revolving five-year credit facility (which was scheduled to mature June 28, 2006).
Borrowings under our senior credit facility may be used for general corporate purposes, including acquisitions, and to service our working capital needs. We must repay all borrowings, if any, under our senior credit facility by June 30, 2009, unless the maturity date under the senior credit facility is extended. Interest on any amount outstanding under the senior credit facility is payable monthly at a rate per annum of (a) LIBOR plus a margin ranging from 50 to 112.5 basis points or (b) the higher of (1) the Bank of America prime rate and (2) the federal funds rate plus 0.5%, plus a margin of up to 12.5 basis points. We have also incurred and will continue to incur customary fees in connection with the senior credit facility. As of December 31, 2004, no amounts were outstanding under our senior credit facility and the maximum commitment level under our senior credit facility was $700 million.
We can obtain letters of credit in an aggregate amount of $200 million under our senior credit facility. We transferred all existing letters of credit under our previous five-year credit facility to the new senior credit facility. As of December 31, 2004, these letters of credit totaled $13.2 million in the aggregate. No amounts had been drawn on any of these letters of credit as of December 31, 2004. As a result of issuing these letters of credit, the maximum amount that can be drawn under our senior credit facility is $686.8 million as of December 31, 2004. In January 2005, we secured additional letters of credit under our senior credit facility of $4.7 million to guarantee workers’ compensation claim payments to certain external third-party insurance companies in the event that we do not pay our portion of the workers’ compensation claims. Due to the additional letters of credit secured, the maximum amount that can be drawn under our senior credit facility as of the date of the filing of this Annual Report on Form 10-K was $682.1 million.
Our senior credit facility requires us to comply with certain covenants that impose restrictions on our operations, including the maintenance of a maximum leverage ratio, a minimum consolidated fixed charge coverage ratio and minimum net worth and a limitation on dividends and distributions. On September 8, 2004, Moody’s downgraded our senior unsecured debt rating from Baa3 to Ba1 and on November 2, 2004, S&P downgraded our senior unsecured debt rating from BBB- to BB+. Because the Moody’s rating on our senior unsecured debt is below Baa3 and the S&P rating is below BBB-, we are currently prohibited under the terms of the senior credit facility from making dividends, distributions or redemptions in respect of our capital stock in excess of $75 million in any consecutive four-quarter period, are subject to a minimum borrower cash flow fixed charge coverage ratio rather than the consolidated fixed charge coverage ratio, are subject to additional reporting requirements to the lenders, and are subject to increased interest and fees applicable to any outstanding borrowings and any letters of credit secured under the senior credit facility. The minimum borrower cash flow fixed charge coverage ratio calculates the fixed charge on a parent company only basis. In the event either Moody’s or S&P upgrades our senior unsecured debt rating to at least Baa3 or BBB-, respectively, our coverage ratio will revert back to the consolidated fixed charge coverage ratio.
Our significant contractual obligations as of December 31, 2004 and their impact on our cash flows and liquidity are summarized below for the years ending December 31:
Other purchase obligations include payments due under agreements for goods or services that are enforceable and legally binding on us and that specify all significant terms, including: fixed or minimum quantities to be purchased; fixed, minimum or variable price provisions; and the approximate timing of the transaction. We have included in the table set forth under the heading “Contractual Obligations” above, obligations related to a three-year pharmacy benefit services agreement, a five-year agreement for a nurse advice line and other related services, and a five-year agreement for a disease and condition management services.
As of December 31, 2004, we had no off-balance sheet arrangements as defined under Regulation S-K 303(a)(4).
recognition, health care costs, reserves for contingent liabilities, amounts receivable or payable under government contracts, goodwill and recoverability of long-lived assets and investments. Accordingly, we consider accounting policies on these areas to be critical in preparing our consolidated financial statements. A significant change in any one of these amounts may have a significant impact on our consolidated results of operations and financial condition. A more detailed description of the significant accounting policies that we use in preparing our financial statements is included in the notes to our consolidated financial statements which are included elsewhere in this Annual Report on Form 10-K.
Reserves for claims and other settlements and health care and other costs payable under government contracts include reserves for claims (incurred but not reported claims (“IBNR”) and received but unprocessed claims), and other liabilities including capitation payable, shared risk settlements, provider disputes, provider incentives and other reserves for our two reporting segments, Health Plan Services and Government Contracts. As of December 31, 2004, Health Plan Services reserves for claims comprised approximately 68% of reserves for claims and other settlements, and Government Contracts reserves for claims comprised approximately 81% of health care and other costs payable under government contracts. See Note 16 to our accompanying consolidated financial statements for a reconciliation of changes in the reserve for claims.
Other relevant factors include exceptional situations that might require judgmental adjustments in setting the reserves for claims, such as system conversions, processing interruptions or changes, environmental changes or other factors. In California, there were significant improvements in the claims processing that had a material impact upon the reserve levels as of December 31, 2004. None of the other factors had a material impact on the development of our claims payable estimates during any of the periods presented in this Annual Report on Form 10-K. All of these factors are used in estimating reserves for claims and are important to our reserve methodology in trending the claims per member per month for purposes of estimating the reserves for the most recent months. In developing its best estimate of reserves for claims, we consistently apply the principles and methodology listed above from year to year, while also giving due consideration to the potential variability of these factors. Because reserves for claims includes various actuarially developed estimates, our actual health care services expense may be more or less than our previously developed estimates. Claim processing expenses are also accrued based on an estimate of expenses necessary to process such claims. Such reserves are continually monitored and reviewed, with any adjustments reflected in current operations.
HN of California, our California HMO, generally contracts with various medical groups to provide professional care to certain of its members on a capitated, or fixed per member per month fee basis. Capitation contracts generally include a provision for stop-loss and non-capitated services for which we are liable. Professional capitated contracts also generally contain provisions for shared risk. We have risk-sharing arrangements with certain of our providers related to approximately 1,140,000 members, primarily in the California commercial market. Shared- risk arrangements provide for us to share with our providers the variance
We assess the profitability of contracts for providing health care services when operating results or forecasts indicate probable future losses. Significant factors that can lead to a change in our profitability estimates include margin assumptions, risk share terms and non-performance of a provider under a capitated agreement resulting in membership reverting to fee-for-service arrangements with other providers. Contracts are grouped in a manner consistent with the method of determining premium rates. Losses are determined by comparing anticipated premiums to estimates for the total of health care related costs less reinsurance recoveries, if any, and the cost of maintaining the contracts. Losses, if any, are recognized in the period the losses are determined and are classified as Health Plan Services. We held a premium deficiency reserve of $0.1 million as of December 31, 2004.
The TRICARE North Region contract is made up of two major revenue components, health care and administrative services. Health care services revenue includes health care costs, including paid claims and estimated IBNR expenses, for care provided for which we are at risk and underwriting fees earned for providing the health care and assuming underwriting risk in the delivery of care. Administrative services revenue encompasses all other services provided to both the government customer and to beneficiaries, including services such as medical management, claims processing, enrollment, customer services and other services unique to the managed care support contracts with the government. Revenues associated with the transition to the new TRICARE contract for the North Region are recognized over the entire term of the contract.
Under our new TRICARE contract for the North Region we recognize amounts receivable and payable under the government contracts related to estimated health care IBNR expenses which are reported separately on the accompanying consolidated balance sheet as of December 31, 2004. These amounts are the same since all of the estimated health care IBNR expenses incurred are offset by an equal amount of revenues earned.
Health care costs and associated revenues are recognized as the costs are incurred and the associated revenue is earned. Revenue related to administrative services is recognized as the services are provided and earned.
We recognize an estimated loss from such loss contingencies when we believe it is both probable that a loss will be incurred and that the amount of the loss can be reasonably estimated. Our loss estimates are based in part on an analysis of potential results, the stage of the proceedings, our relevant insurance coverage, consultation with outside counsel and any other relevant information available. While the final outcome of these proceedings cannot be determined at this time, based on information presently available we believe that the final outcome of such proceedings will not have a material adverse effect upon our financial condition, results of operations or liquidity. However, our belief regarding the likely outcome of such proceedings could change in the future and an unfavorable outcome could have a material adverse effect upon our financial condition, results of operations or liquidity. In addition, the ultimate outcome of these loss contingencies cannot be predicted with certainty and it is difficult to measure the actual loss, if any, that might be incurred.
We test goodwill for impairment annually based on the estimated fair value of the reporting units which comprise our Health Plan Services and Government Contracts reportable segments. We test for impairment on a more frequent basis in cases where events and changes in circumstances would indicate that we might not recover the carrying value of goodwill. Our measurement of fair value is based on utilization of both the income and market approaches to fair value determination. As a part of assessing impairments of goodwill and other intangible assets, we perform fair value measurements and utilize an independent third-party professional services firm to assist with this assessment. The income approach is based on a discounted cash flow methodology. The discounted cash flow methodology is based upon converting expected cash flows to present value. Annual cash flows are estimated for each year of a defined multi-year period until the growth pattern becomes stable. The expected interim cash flows expected after the growth pattern becomes stable are calculated using an appropriate capitalization technique and then discounted. The market approach uses a market valuation methodology which includes the selection of companies engaged in a line (or lines) of business similar to ours to be valued and an analysis of our comparative operating results and future prospects in relation to those of the guideline companies selected. The market price multiples are selected and applied to us based on our relative performance, future prospects and risk profiles in comparison to those of the guideline companies. Methodologies for selecting guideline companies include the exchange methodology and the acquisition methodology. The exchange methodology is based upon transactions of minority-interests in publicly traded companies engaged in a line (or lines) of business similar to ours. The public companies selected are defined as guideline companies. The acquisition methodology involved analyzing the transaction involving similar companies that have been bought and sold in the public marketplace. There are numerous assumptions and estimates underlying the determination of the estimated fair value of our reporting units, including certain assumptions and estimates related to future earnings based on current and future plans and initiatives. If these planned initiatives do not accomplish their targeted objectives, the assumptions and estimates underlying the goodwill impairment tests could be adversely affected and have a material effect upon our financial condition, results of operations or liquidity.
Long-lived assets are classified as held for sale when certain criteria are met, which include: management commitment to a plan to sell the assets, the availability of the assets for immediate sale in their present condition, whether an active program to locate buyers and other actions to sell the assets have been initiated, whether the sale of the assets is probable and their transfer is expected to qualify for recognition as a completed sale within one year, whether the assets are being marketed at reasonable prices in relation to their fair value and how unlikely it is that significant changes will be made to the plan to sell the assets.
We measure long-lived assets to be disposed of by sale at the lower of carrying amount or fair value less cost to sell. Fair value is determined using quoted market prices or the anticipated cash flows discounted at a rate commensurate with the risk involved.
We record deferred tax assets and liabilities based on differences between the book and tax bases of assets and liabilities. The deferred tax assets and liabilities are calculated by applying enacted tax rates and laws to taxable years in which such differences are expected to reverse. We establish a valuation allowance and continually review the adequacy of the valuation allowance and recognize the benefits from our deferred tax assets only when an analysis of both positive and negative factors indicate that it is more likely than not that the benefits will be realized. In addition, we maintain a reserve for the estimated amount of potential assessments by taxing authorities upon their examination. The reserve is comprised of amounts for potential specific issues
arising in periods subject to examination. These amounts are released from the reserve upon closure of such examinations and new amounts are added for specific issues for new tax years.
As necessary, we make contributions to and issue standby letters of credit on behalf of our subsidiaries to meet risk-based capital or other statutory capital requirements under state laws and regulations. Health Net, Inc.
contributed $32 million to certain of its subsidiaries to meet capital requirements during the year ended December 31, 2004. Of the $32 million, we contributed $20 million to our New Jersey health plan, $9 million to our Bermuda subsidiary and $3 million to our insurance company in New York. Except for the $32 million in capital contributions, our parent company did not make any capital contributions to its subsidiaries to meet risk-based capital or other statutory capital requirements under state laws and regulations during the year ended December 31, 2004 or thereafter through the date of the filing of this Annual Report on Form 10-K.