Basic weighted average shares outstanding (3) 88,126 88,113 88,802 97,485 89,282
All historical common share data have been adjusted for a 3-for-2 stock split in the form of a stock distribution paid on January 30, 2004 to stockholders of record on January 9, 2004.
: Management’s Discussion and Analysis of Financial Condition and Results of Operations The following discussion should be read in conjunction with the accompanying audited consolidated financial statements and notes thereto. The organization of our Management’s Discussion and Analysis of Financial Condition and Results of Operations is as follows.
We are a leading publicly traded managed health care company with approximately 2.5 million members as of December 31, 2004. We operate a diversified portfolio of local market health plans, insurance companies and provider networks serving 15 markets. Our operations are based in Bethesda, Maryland with our local markets primarily covering the Mid-Atlantic, Midwest and Southeast regions of the United States. Our primary focus has been owning and operating health plans with a concentration on risk business with mid-sized employer groups.
diversifies our product offerings and client base and enables us to serve a full spectrum of healthcare clients nationwide, ranging from national accounts to small businesses and including corporate, federal government, state government, Medicaid and Medicare clients;
Medical loss ratio of 80.5% improved 70 basis points over the prior year.
During the three years ended December 31, 2004, we experienced substantial growth in operating revenues due in part to membership increases from acquisitions. Acquisitions must have a manageable regulatory and business climate and have the ability to add value to our company. Additionally, membership growth was achieved organically through marketing efforts, geographic expansion and increased product offerings. Our ability to introduce products quickly to each market has helped us to expand our customer base. In particular, we have been able to add a large variety of lower cost products, which has proven especially attractive to customers.
Our medical costs include medical claims paid under contractual relationships with a wide variety of providers and capitation arrangements. Medical costs also include an estimate of claims incurred but not reported.
Our health plans maintain provider networks that furnish health care services through contractual arrangements with physicians, hospitals and other health care providers. Prescription drug benefits are provided through a formulary comprised of an extensive list of drugs. Drug prices are negotiated through a national network of pharmacies at discounted rates.
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 arrangements.
We operate four regional service centers that perform claims processing, premium billing and collection, enrollment and customer service functions for our health plans. Our regional service centers enable us to take advantage of economies of scale, implement standardized management practices at each of our plans and capitalize on the benefits of our integrated information technology systems. We centralize the underwriting and product pricing functions for our health plans, which allows us to utilize our underwriting expertise and a disciplined pricing strategy at each of our health plans.
Critical Accounting Policies We consider the accounting policies described below critical in preparing our consolidated financial statements. Critical accounting policies are ones that require difficult, subjective, or complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain. The judgments and uncertainties affecting the application of these policies include significant estimates and assumptions made by us using information available at the time the estimates are made. Actual results could differ materially from those estimates.
Managed care premiums are recorded as revenue in the month in which members are entitled to service. Premiums are based on both a per subscriber contract rate and the number of subscribers in our records at the time of billing. Premium billings are generally sent to employers in the month preceding the month of coverage. Premium billings may be subsequently adjusted to reflect changes in membership as a result of retroactive terminations, additions, or other changes. Due to early timing of the premium billing, we are able to identify the retroactive adjustments for two subsequent months billings. Current period revenues are adjusted to reflect these retroactive adjustments.
As of December 31, 2004, we maintained allowances for retroactive billing adjustments of approximately $6.7 million compared with approximately $7.2 million at December 31, 2003. We also maintained allowances for doubtful accounts of approximately $0.9 million and $1.4 million as of December 31, 2004 and 2003, respectively. The calculation for these allowances is based on a percentage of the gross accounts receivable with the allowance percentage increasing for the older receivables. The allowances have declined as a result of an improvement in the aging of our premium receivables.
We enter into performance guarantees with employer groups where we pledge that we will meet certain standards. These standards vary widely and could involve customer service, member satisfaction, claims processing, claims accuracy, telephone on-hold time, etc. Under these performance guarantees, we could be at risk and may incur penalties for not maintaining the standards established in the contracts. The risk level varies by agreement with penalties based on a variety of calculations including per member per month, percentage of premium, or percentage of administration fees. Risk levels are evaluated at least quarterly. We estimate our potential exposure and record appropriate reserves. The penalties that we have incurred have been immaterial and, although, we can not predict with precision the future effect on our results of operations of these penalties, we expect them to remain immaterial.
Changes in the completion factors, trend factors and utilization factors can have a significant effect on the claim liability. The following example provides the estimated effect to our December 31, 2004 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.
The following table presents the components of the change in medical claims liabilities for the years ended December 31, 2004, 2003 and 2002, respectively (in thousands).
Medical liabilities, end of period $ 660,475 $ 597,190 $ 558,599
Acquisition balances represent medical liabilities of the acquired company as of the applicable acquisition date. Subsequent changes in estimates related to the acquired balances are recorded as adjustments to the settlement account with the acquired entity’s previous owner.
The following table shows our investments’ gross unrealized losses and fair value, at December 31, 2004, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position (in thousands).
Goodwill and other intangible assets that have indefinite lives are subject to a periodic assessment for impairment by applying a fair-value-based test. We use three approaches to identifying the fair value of our goodwill and other intangible assets: a market approach, a market capitalization approach and an income approach. The market approach estimates a business’s fair value by analyzing the recent sales of similar companies. The market capitalization approach is based on the market value of our total shares outstanding. The income approach is based on the present value of expected future cash flows. All three approaches are reviewed together for consistency and commonality. Any impairment charges that may result will be recorded in the period in which the impairment took place as recalculated on October 1, our annual impairment test date. We have not incurred an impairment charge related to goodwill or indefinite intangibles. See Note C to the consolidated financial statements for additional disclosure related to intangible assets.
SFAS No. 123(R) must be adopted no later than July 1, 2005. Early adoption will be permitted in periods in which financial statements have not yet been issued. We expect to adopt SFAS No. 123(R) on July 1, 2005 using the modified-prospective method.
Total operating revenues $ 5,311,969 $ 4,535,143 17.1% $ 4,535,143 $ 3,576,905 26.8%
Operating earnings $ 496,671 $ 366,197 35.6% $ 366,197 $ 200,670 82.5%
Net earnings $ 337,117 $ 250,145 34.8% $ 250,145 $ 145,603 71.8%
Diluted earnings per share $ 3.72 $ 2.75 35.3% $ 2.75 $ 1.58 74.1%
Commercial $ 226.59 $ 206.08 10.0% $ 206.08 $ 183.78 12.1%
Medicare $ 695.96 $ 629.52 10.6% $ 629.52 $ 593.29 6.1%
Medicaid $ 145.23 $ 139.69 4.0% $ 139.69 $ 137.54 1.6%
Medicare $ 579.92 $ 527.84 9.9% $ 527.84 $ 509.60 3.6%
as a percentage of revenue 11.5% 12.0% (0.5%) 12.0% 12.2% (0.2%)
Comparison of 2004 to Managed care premium revenue increased as a result of rate increases that occurred throughout all markets, acquisitions and organic growth. Commercial yields (premium per member per month) increased as a result of rate increases on renewals that occurred throughout all markets. Medicare yields increased as a result of the rate increases from the annual Adjusted Community Rating filings and from the Medicare Modernization Act. The rate increases from the Medicare Modernization Act were required to be used for enhanced member benefits and/or network access and thus did not affect profitability. The acquisition of Altius effective September 1, 2003 and OmniCare effective October 1, 2004 accounted for $208.7 million of the increase in managed care premium revenue over the prior year.
Medical costs have increased due to medical trend, acquisitions and organic growth. However, total medical expense as a percentage of managed care premium revenue has improved to 80.5% over the prior year. This favorable change was attributable mostly to our commercial business and is a result of the commercial premium rate increases mentioned above outpacing commercial medical trend. Reported commercial medical trend, net of benefit buy downs, was 8.9%. Our Medicare business medical loss ratio improved compared to the prior year as a result of the increase in premium yields discussed above. Our overall Medicaid medical loss ratio was essentially flat compared to prior year. Excluding OmniCare, the Medicaid medical loss ratio would have improved to 86.9%. The same store improvement is as a result of rate increases across our markets and as a result of much improved performance in our Medicaid Virginia market. The Virginia market benefited from lower utilization, lower drug costs and favorable provider contract renegotiations.
Management services revenue increased due to the increase in non-risk membership discussed earlier.
Other income increased due to a larger investment portfolio in 2003 offset by a decrease in interest income as a result of lower interest rates. Additionally, the current year included a gain from our single derivative investment compared to a loss in the prior year. This derivative investment was sold during the second quarter of 2003.
The nature of our operations is such that cash receipts from premium revenues are typically received up to two months prior to the expected cash payment for related medical costs. Premium revenues are typically received at the beginning of the month in which they are earned, and the corresponding incurred medical expenses are paid in a future time period, typically 30 to 60 days after the date such medical services are rendered. The lag between premium receipts and claims payments creates positive cash flow and overall cash growth. As a result, we typically hold approximately two months of “float”. In addition, accumulated earnings provide further positive cash flow. In addition to ample current liquidity, our long-term investment portfolio is available for further liquidity needs.
Our investment guidelines emphasize investment grade fixed income instruments in order to provide liquidity to meet future payment obligations and minimize the risk to the principal. The fixed income portfolio includes government and corporate securities with an average quality rating of “AA” and an average contractual duration of 2.5 years, as of December 31, 2004. 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 total cash and investments, consisting of cash and cash equivalents and short-term and long-term investments, but excluding deposits of $23.1 million restricted under state regulations, increased $321.8 million to $1.7 billion at December 31, 2004 from $1.4 billion at December 31, 2003.
We will continue to fund our working capital requirements from our cash flow from operations. We believe that because our long-term investments are available-for-sale, the amount of such investments should be considered when assessing our liquidity. On such basis, current assets plus long-term investments available-for-sale less current liabilities increased to $1.0 billion at December 31, 2004 from $730.5 million at December 31, 2003.
The demand for our products and services are subject to many economic fluctuations, risks and uncertainties that could materially affect the way we do business. Please refer to the section entitled “Risk Factors” in this Form 10-K for more information. Management believes that the combination of our ability to generate cash flows from operations, cash and investments on hand and the excess funds held in certain of our regulated subsidiaries will be sufficient to fund continuing operations, capital expenditures, debt interest costs and any other reasonably likely future cash requirements.
Cash Flows Net cash from operating activities is primarily driven by net earnings. For the year ended December 31, 2004, operating cash flow was positively affected by an increase in medical claims liabilities and an increase in accounts payable and other liabilities. Medical liabilities were unusually low at December 31, 2003 due to an effort to pay down medical claims inventory at year-end. The medical liabilities increased in 2004 as claim inventory levels returned to more normal levels and due to medical liabilities recorded for the new members brought on with the OmniCare membership purchase in October of 2004. Accounts payable and other liabilities increased as a result of an increase in taxes payable and an increase in the deferred compensation liability. Offsetting these operating cash inflows was a decrease in deferred revenue. As a result of the timing of CMS payments for Medicare beneficiaries, we only received eleven monthly CMS payments in 2004 versus twelve monthly CMS payments in 2003. Partially offsetting the one less CMS payment was an increase in commercial deferred revenue collections. Cash flow from operating activities has improved over the prior year as a result of higher earnings, an increase in unpaid medical liabilities and a larger increase in accounts payable and other accrued liabilities. Offsetting these improvements was a change in deferred revenue, the reasons for which are noted above. Prior year operating cash flows included a decrease in other receivables due to accelerated collections of our pharmacy rebate receivable as a result of improved procedures implemented in 2003. The pharmacy rebate receivable remained consistent at December 31, 2004 compared to December 31, 2003 and thus did not change operating cash flow year over year.
The additional indebtedness also includes the private placement of $250 million aggregate principal amount of 5 7/8% senior notes due 2012 and $250 million aggregate principal amount of 6 1/8% senior notes due 2015. These senior notes have since been registered with the Securities and Exchange Commission. The senior notes are general unsecured obligations of ours and rank equal in right of payment to all of our existing and future senior debt, including our existing 8.125% senior notes due 2012 and our new credit facilities.
We used the proceeds from the new credit facilities and senior notes, together with approximately $221 million of cash on hand, to fund the First Health acquisition, including the repayment of First Health’s outstanding bank debt and related transaction expenses.
Projected cash payments for the final payment for the OmniCare purchase are $6.2 million in the first quarter of 2005.
Projected capital payments in 2005 of approximately $65 million to $80 million consist primarily of computer hardware, software and related equipment costs associated with the development and implementation of improved operational and communication systems.
Our regulated HMO and insurance company subsidiaries are required by state regulatory agencies to maintain minimum surplus balances, thereby limiting the dividends the parent may receive from our regulated entities. During 2004, we received $173.6 million in dividends and $12.6 million for note repayments from our regulated subsidiaries.
We believe that all subsidiaries which incur medical claims maintain more than adequate liquidity and capital resources to meet these short-term obligations as a matter of both Company policy and multiple Department of Insurance regulations.
Excluding funds held by entities subject to regulation, we had cash and investments of approximately $383.1 million and $209.5 million at December 31, 2004 and December 31, 2003, respectively. The increase in non-regulated cash and investments is primarily a result of dividends received from our regulated subsidiaries, as mentioned above, and ordinary operating activities offset by stock repurchases made and payments for acquisitions. During the year ended December 31, 2004, we made capital contributions of approximately $20.0 million to our HMO subsidiaries. Of this total, $16.0 million was made to our newly formed Michigan subsidiary to meet statutory capital requirements.
The United States Department of Health and Human Services has issued rules, as mandated by the Health Insurance Portability and Accountability Act of 1996, which, among other things, impose security and privacy requirements with respect to individually identifiable patient data, including a member’s transactions with health care providers and payors, as well as requirements for the standardization of certain electronic transaction code sets and provider identifiers. We have spent approximately $2.2 million, $4.2 million and $4.1 million on compliance matters for the years ended December 31, 2004, 2003 and 2002, respectively. We do not anticipate future spending related to these rules to be material.
As of December 31, 2004, we were contractually obligated to make the following payments within the next five years and thereafter (in thousands):
Interest payable on new senior notes 255,938 30,000 60,000 60,000 105,938
Total additional contractual obligations $ 1,174,905 $ 74,938 $ 175,469 $ 318,560 $ 605,938
In the normal course of business, we have been named as a defendant in various legal actions such as actions seeking payments for claims denied by the Company, medical malpractice actions, employment related claims and other various claims seeking monetary damages. The claims are in various stages of proceedings and some may ultimately be brought to trial. Incidents occurring through December 31, 2004 may result in the assertion of additional claims. We maintain general liability, professional liability and employment practices liability insurances in amounts that we believe are appropriate, with varying deductibles for which we maintain reserves. The professional liability and employment practices liability insurances are carried through our captive subsidiary.
In 2005, we have received Medicare premium rate increases of seven to ten percent. Additionally, we have received a Medicaid rate increase of 6.5% effective January 1, 2005 in Missouri, our largest Medicaid market.
competition in premium or plan benefits from other health care benefit companies;
price of benefits offered and cost and risk of alternatives such as self-insurance;
The Mail Handlers Benefit Plan, which is administered by First Health, competes against a number of national carriers and local health plans for Federal employee membership. First Health has sought through plan design changes, including premium increases, changes in employee cost-sharing and benefit changes, to create a more attractive and competitive Mail Handlers product offering to attract new members as well as retain existing members. As these new products are introduced for 2005, it is expected that there will be some loss of existing membership as the new benefit plans may be more attractive to potential members than existing members. In addition, the new plan design changes for the 2005 benefit plan year may result in a greater than expected loss of membership if these products are not as attractive or competitive as we anticipate.
Competition in the multi-site, national account business may limit our ability to grow revenues which could adversely affect our results of operations.
We depend on the services of independent agents and brokers to market our managed care products and services, particularly to small employer group members. We do not have long term contracts with independent agents and brokers, who typically are not dedicated exclusively to us and frequently market the health care products of our competitors. We face intense competition for the services and allegiance of independent agents and brokers, and we can not assure you that agents and brokers will continue to market our products in a fair and consistent manner.
Over the last several years, the managed health care industry has been subject to negative publicity. Negative publicity regarding the managed health care industry generally or our company in particular may result in increased regulation and legislative review of industry practices further increase our costs of doing business and adversely affect our results of operations by:
We depend on our information technology systems for timely and accurate information. Failure to maintain effective and efficient information technology systems or disruptions in our information technology systems could cause disruptions in our business operations, loss of existing customers, difficulty in attracting new customers, disputes with customers and providers, regulatory problems, increases in administrative expenses and other adverse consequences.
potential difficulty in leveraging the value of the separate technologies of the combined company;
perceived adverse changes in product offerings available to customers and customer services standards, whether or not these changes do, in fact, occur;
potential charges to earnings resulting from the application of purchase accounting to the transaction;
reduction or loss of customer orders due to the potential for market confusion, hesitation and delay;
retaining and integrating management and other key employees of the combined company; and
impose fines or other penalties for the failure to pay claims promptly;
limit contractual terms with providers, including audit, payment and termination provisions;
We also may be subject to governmental investigations or inquiries from time to time. For example, several companies in the insurance industry have received subpoenas for information from the New York Attorney General and the Connecticut Attorney General with respect to an industry wide investigation into certain insurance brokerage practices, including broker compensation arrangements, bid quoting practices and potential antitrust violations. Insurance regulators in several states, including states in which our subsidiaries are domiciled, have sent letters of inquiry concerning similar matters to the companies subject to this jurisdiction, including our subsidiaries. We have furnished the information requested and have cooperated with the insurance regulatory authorities. The existence of such investigations in our industry could negatively impact the market value of all companies in our industry including our stock price. Any similar governmental investigations of Coventry could have a material adverse effect on our financial condition, results of operations or business or result in significant liabilities to the Company, as well as adverse publicity.
refunding of amounts we have been paid pursuant to our government contracts;
loss of one or more of our licenses to act as an insurer or HMO or to otherwise provide a service.
We are subject to litigation in the ordinary course of our business, including litigation based on new or evolving legal theories, that could adversely affect our results of operations.
We have, and expect to maintain, liability insurance coverage for some of the potential legal liabilities we may incur. Currently, professional liability and employment practices liability insurance is covered through our captive subsidiary. Potential liabilities that we incur may not, however, be covered by insurance, our insurers may dispute coverage or may be unable to meet their obligations or the amount of our insurance coverage may be inadequate. We can not assure you that we will be able to obtain insurance coverage in the future, or that insurance will continue to be available on a cost effective basis, if at all.
Our ability to generate sufficient cash to service our indebtedness will depend on numerous factors beyond our control.
Changes in economic conditions could adversely affect our business and results of operations. The state of the economy could adversely affect our employer group renewal prospects and our ability to collect or increase premiums. The state of the economy could also adversely affect the states’ budgets, which could result in the states attempting to reduce payments to Medicaid plans in those states in which we offer Medicaid plans, and increase taxes and assessments on our activities. Although we could attempt to mitigate or cover our exposure from such increased costs through, among other things, increases in premiums, there can be no assurance that we will be able to mitigate or cover all of such costs resulting from any budget cuts in states in which we operate. Although we have attempted to diversify our product offerings to address the changing needs of our membership, the effects of economic conditions could cause our existing membership to seek health coverage alternatives that we do not offer or could result in significant membership loss, lower average premium yields or decreased margins on continuing membership.
We have audited the accompanying consolidated balance sheets of Coventry Health Care, Inc. and subsidiaries as of December 31, 2004 and 2003, and the related consolidated statements of operations, shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2004. Our audits also included the financial statement schedule listed in the Index at Item 15(a)(2). These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
Treasury stock, at cost; 15,925 in 2004; 14,226 in 2003 (291,054)
Stock Split - On December 23, 2003, the Company’s Board of Directors approved a three-for-two stock split of the Company’s common stock. The stock split, in the form of a stock dividend, was distributed January 30, 2004 for stockholders of record on January 9, 2004. The stock split is reflected retroactively in the Company’s consolidated financial statements and notes thereto for all periods presented.
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 10.9%, 10.8% and 12.3% of its managed care premiums for the years ended December 31, 2004, 2003 and 2002, respectively, from the federal Medicare program throughout its various markets. The Company also received 11.7%, 11.8% and 13.1% of its managed care premiums for the years ended December 31, 2004, 2003 and 2002, respectively, from its state-sponsored Medicaid programs throughout its various markets. For the year ended December 31, 2004, the State of Missouri accounted for over half the Company’s Medicaid premiums.
Investments - The Company accounts for investments in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 115 - “Accounting for Certain Investments in Debt and Equity Securities.” The Company invests primarily in fixed income securities and classifies all of its investments as available-for-sale. Investments are evaluated at least quarterly to determine if declines in value are other-than-temporary. In making that determination, the Company considers all available evidence relating to the realizable value of a security. This evidence includes, but is not limited to, the following:
Long-term Assets - Long-term assets primarily include assets associated with the Supplemental Executive Retirement Plan (“SERP” ) and deferred tax assets.
Acquisition balances represent medical liabilities as of the applicable acquisition date. Subsequent changes in estimates related to the acquired balances are recorded as adjustments to the settlement account with the acquired entity’s previous owner.
Premiums for services to federal employee groups are subject to audit and review by the Office of Personnel Management (“OPM”) on a periodic basis. Such audits are usually a number of years in arrears. Adjustments are recorded as additional information regarding the audits and reviews becomes available. Any differences between actual results and estimates are recorded in the year the audits are finalized.
The Company enters into performance guarantees with employer groups where the Company guarantees that it will meet certain standards. These standards vary widely and could involve customer service, member satisfaction, claims processing, claims accuracy and telephone on-hold time. Under these performance guarantees, the Company could be at risk for not maintaining the standards agreed upon in the contracts. The risk level varies by agreement with penalties based on a variety of calculations including per member per month, percentage of premium, or percentage of administration fees. Performance levels are evaluated at least quarterly. The Company estimates its potential exposure and records the appropriate reserves.
EPS, basic - pro forma $ 3.73 $ 2.78 $ 1.60
EPS, diluted - pro forma $ 3.63 $ 2.70 $ 1.54
SFAS No. 123(R) must be adopted no later than July 1, 2005. Early adoption will be permitted in periods in which financial statements have not yet been issued. The Company expects to adopt SFAS No. 123(R) on July 1, 2005 using the modified-prospective method.
The following table summarizes all business combinations and membership purchases for the three years ended December 31, 2004. The purchase price of each business combination includes the payment for net worth and estimated transition costs. The estimated transition costs may be adjusted as actual expenses are incurred, thereby affecting the final purchase price of the acquisition. In addition, most of the Company’s acquisition agreements contain a provision for a final retroactive balance sheet settlement which may result in adjustments to the purchase price. The purchase price, inclusive of all retroactive balance sheet settlements to date and transaction cost adjustments, is presented below (in thousands):
C. GOODWILL AND OTHER INTANGIBLE ASSETS Goodwill and other intangible assets consist of costs in excess of the fair value of the net tangible assets of subsidiaries or operations acquired through December 31, 2004.
D. PROPERTY AND EQUIPMENT Property and equipment is comprised of the following (in thousands):
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, 2004 and 2003 (in thousands):
State and municipal bonds $ 361,969 $ 8,095 $ (778) $ 369,286
The amortized cost and estimated fair value of short-term and long-term investments by contractual maturity were as follows at December 31, 2004 and December 31, 2003 (in thousands):
The following table shows the Company’s investments’ gross unrealized losses and fair value, at December 31, 2004, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position (in thousands).
F. INCOME TAXES At December 31, 2004, the Company had approximately $53 million of federal and $93 million of state tax net operating loss carryforwards. The net operating losses were primarily acquired through various acquisitions. The net operating loss carryforwards can be used to reduce future taxable income until they expire through the year 2024.
The effect of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities at December 31, 2004 and 2003 are presented below (in thousands):
The valuation allowance at December 31, 2003 for deferred tax assets was due to the Company’s belief that the realization of the deferred tax asset resulting from net operating losses associated with certain acquisitions was unlikely. There is no valuation allowance at December 31, 2004 because now that these acquired companies are consistently profitable, the Company believes that the realization of the deferred tax asset is more likely than not.
As of December 31, 2004, 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.
The Stock Incentive Plan is authorized to grant either incentive stock options or nonqualified stock options, stock appreciation rights, restricted stock and other stock-based awards at the discretion of the Compensation and Benefits Committee of the Board of Directors. At the annual meeting of shareholders held on June 3, 2004, the Company’s shareholders voted to increase the shares of common stock authorized for issuance under the Stock Incentive Plan from an aggregate of 16.5 million shares to an aggregate of 22.5 million shares. Shares available for issuance under the Stock Incentive Plan were 4.7 million and 1.8 million as of December 31, 2004 and 2003, respectively.
During 2004, the Company awarded 563,000 shares of restricted stock. The weighted average fair value, at the measurement date, of the restricted stock awards was $52.78. The fair value of the restricted shares is amortized over various vesting periods through 2008. The Company recorded compensation expense related to restricted stock grants, including restricted stock granted in prior periods of approximately $15.5 million, $9.6 million and $5.7 million for the years ended December 31, 2004, 2003 and 2002, respectively. The deferred portion of the restricted stock is reported as a reduction to additional paid in capital and was $37.2 million at December 31, 2004.
The Company’s Employee Stock Purchase Plan (“ESPP”), implemented in 1994, allows substantially all employees who meet length of service requirements to set aside a portion of their salary for the purchase of the Company’s common stock. At the end of each plan year, the Company issues the stock to participating employees at an issue price equal to 85% of the lower of the stock price at the end of the plan year or the average stock price, as defined. The Company has reserved 1.4 million shares of stock for this plan and has issued 25,900, 25,700 and 16,500 shares in 2004, 2003 and 2002, respectively. Remaining shares available for issuance under the ESPP were 1.2 million as of December 31, 2004.
Under the Savings Plan, participants may defer up to 15% 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 will vest in the Company’s matching contributions in 50% increments annually on their anniversary date over a period of two years of service with the Company. Effective January 1, 2004, the Savings Plan was amended to permit divestiture, whereby employees with three or more years of service were eligible 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.
The cost, principally employer matching contributions, of the Savings Plan and the SERP charged to operations for 2004, 2003 and 2002 was $7.5 million, $7.3 million and $5.4 million, respectively.
In August 2003, the Company repurchased a portion of its senior notes with a face value of $4.5 million and a weighted average premium of 8.9%. The Company recorded a loss on the repurchase in accordance with SFAS No. 145 which requires gains and losses on extinguishments of debt to be classified as income or loss from continuing operations. The loss of $0.5 million was included as additional senior notes interest expense. The carrying value of the senior notes is equal to the face value and the fair value is based on the quoted market prices. As of December 31, 2004, the carrying value was $170.5 million and the fair value was $185.2 million. As of December 31, 2003, the carrying value was $170.5 million and the fair value was $189.7 million.
I. COMMITMENTS AND CONTINGENCIES As of December 31, 2004, the Company is contractually obligated to make the following payments within the next five years and thereafter (in thousands):
Net contractual obligations $ 337,563 $ 27,617 $ 51,360 $ 43,585 $ 215,001
The Company operates primarily in leased facilities with original lease terms of up to ten years with options for renewal. Through its acquisitions, the Company has office equipment leases with terms of approximately three years.
Several companies in the insurance industry have received subpoenas for information from the New York Attorney General and the Connecticut Attorney General with respect to an industrywide investigation into certain insurance brokerage practices, including broker compensation arrangements, bid quoting practices and potential antitrust violations. Coventry has not been served with any such subpoenas.
As a consequence of the Attorney General investigations in New York and Connecticut, Coventry, like most other companies in the insurance industry, has received Letters of Inquiry from the departments of insurance in several states in which it does business. These Letters, which are very similar, if not identical, seek information regarding broker compensation arrangements, bid quoting practices and conduct which may potentially constitute antitrust violations. Coventry has provided the information requested by these Letters and currently does not anticipate any additional follow up or requests for additional information.
A small percentage of the Company’s membership is covered by global capitation arrangements. Under the typical arrangement, the provider receives a fixed percentage of premium to cover all the medical costs 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 the Company’s exposure to the risk of increasing medical costs, but expose the Company to risk as to the adequacy of the financial and medical care resources of the provider organization. In addition to global capitation arrangements, the Company has capitation arrangements for ancillary services, such as mental health care. The Company is ultimately responsible for the coverage of its 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, the Company will be required to perform such obligations. Consequently, the Company may have to incur costs in excess of the amounts it would otherwise have to pay under the original global or ancillary capitation arrangements. Medical costs associated with capitation arrangements made up approximately 7.1%, 9.9%, and 8.9% of the Company’s total medical costs for the years ended December 31, 2004, 2003 and 2002, respectively. Membership associated with global capitation arrangements was approximately 127,000, 145,000 and 116,000 as of December 31, 2004, 2003 and 2002, respectively.
HealthAmerica Pennsylvania, Inc. (“HealthAmerica”), the Company’s Pennsylvania HMO subsidiary, received audit reports from the OPM that questioned approximately $31.1 million of subscription charges that were paid to HealthAmerica under the FEHBP for contract years 1993 - 1999. In the fourth quarter of 2003, HealthAmerica settled this dispute with the OPM and the U.S. Department of Justice. The final settlement payment of $29.0 million was fully reserved by HealthAmerica and therefore had no impact on 2003 earnings, the regulated capital of HealthAmerica, or its consolidated stockholders’ equity.
J. CONCENTRATIONS OF CREDIT RISK 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 require investment-grade fixed income securities and limit the amount that may be invested in any one issuer. The fair value of the Company’s financial instruments is equivalent to their carrying value and, although there is some credit risk associated with these instruments, the Company believes this risk to be minimal.
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, 2004. The Company has a risk of incurring losses if such allowances are not adequate.
Excluding funds held by entities subject to regulation, the Company had cash and investments of approximately $383.1 million and $209.5 million at December 31, 2004 and December 31, 2003, respectively. The increase in non-regulated cash and investments is primarily a result of dividends received from subsidiaries mentioned above and ordinary operating activities offset by stock repurchases made and payments for acquisitions. During the year ended December 31, 2004, Coventry made capital contributions of approximately $20.0 million to the Company’s HMO subsidiaries. Of this total, $16.0 million was made to the Company’s newly formed Michigan subsidiary to meet statutory capital requirements.
M. SHARE REPURCHASE PROGRAM The Company’s Board of Directors has approved a program to repurchase up to 10% of 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. As a part of this program, the Company purchased 3.3 million shares of its common stock in 2002 at an aggregate cost of $65.5 million, no shares in 2003 and 2.0 million shares during the first quarter of 2004 at an aggregate cost of $84.6 million. The total remaining common shares the Company is authorized to repurchase under the program is approximately 1.8 million as of December 31, 2004. 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.
N. SEGMENT INFORMATION The Company has three reportable segments: Commercial, Medicare and Medicaid products. The products are provided to a cross section of employer groups and individuals throughout the Company’s health plans. Commercial products include HMO, PPO and POS products. HMO products provide comprehensive health care benefits to members through a primary care physician. PPO and POS products permit members to participate in managed care but allow them the flexibility to utilize out-of-network providers in exchange for increased out-of-pocket costs. The Company provides comprehensive health benefits to members participating in Medicare and Medicaid programs and receives premium payments from federal and state governments.
O. QUARTERLY FINANCIAL DATA (UNAUDITED) The following is a summary of unaudited quarterly results of operations (in thousands, except per share data) for the years ended December 31, 2004 and 2003.
P. SUBSEQUENT EVENTS On January 28, 2005, the Company completed the acquisition of First Health Group Corporation (“First Health”). First Health is a full service national health benefits services company, headquartered in Downers Grove, Illinois, that serves the group health, workers’ compensation and state public program markets. Each outstanding share of First Health common stock was converted into a right to receive $9.375 cash and 0.1791 shares of Coventry common stock. As a result of the merger, the Company paid $863.2 million in cash and issued approximately 16.5 million shares of its common stock to stockholders of First Health.
The Credit Agreement contains covenants, including, among other things, covenants that restrict the Company’s ability and the ability of its subsidiaries to: incur additional indebtedness; incur guarantee obligations; create or permit liens on assets, engage in mergers or consolidations; dispose of assets; pay dividends or other distributions, purchase or redeem the Company’s equity securities or those of its subsidiaries and make other restricted payments; make loans, advances or other investments (including acquisitions); engage in certain transactions with affiliates; agree with others to limit their ability to grant liens on assets; agree with others to limit the ability of the Company’s subsidiaries to pay dividends or other restricted payments or to make loans or transfer assets to the Company or another of its subsidiaries. The new senior credit facilities also require compliance with specified financial ratios and tests, including a maximum leverage ratio, a minimum fixed charge coverage ratio and a minimum net worth requirement.