The following selected consolidated financial data as of and for each of the five years in the period ended December 31, 2006 has been derived from the audited Consolidated Financial Statements of the Company. The following data should be read in conjunction with the Consolidated Financial Statements and the notes thereto and Management’s Discussion and Analysis of Financial Condition and Results of Operations included herein.
Excludes the unrealized gains (losses) on securities available for sale, which gains are reported in “accumulated other comprehensive income (loss)” as a separate component of stockholders’ equity.
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 that we have the largest direct selling organization in the health insurance field, with approximately 2,100 independent writing agents per week in the field selling health insurance to the self employed market in 44 states.
The Company’s revenues have historically consisted primarily of premiums derived from sales of its indemnity, PPO, student group and voluntary employer group health plans and from life insurance policies. Revenues also include investment income derived from our investment portfolio and other income, which consists primarily of 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.
marketing and administrative services provided to the membership associations that make available to their members the Company’s health insurance products.
The Company establishes liabilities for benefit claims that have been reported but not paid and claims that have been incurred but not reported under health and life insurance contracts. These claim liabilities are developed using actuarial principles and assumptions that consider a number of items, including historical and current claim payment patterns, product variations, the timely implementation of appropriate rate increases and seasonality. See discussion below under the caption “Critical Accounting Policies and Estimates - Claims Liabilities” and Note G of Notes to Consolidated Financial Statements.
In connection with various stock-based compensation plans that we maintain for the benefit of our employees and independent agents, we record non-cash variable stock-based compensation expense in amounts that depend and fluctuate based upon the fair market 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 Q of Notes to Consolidated Financial Statements. The accounting treatment of the Company’s agent plans has resulted and will continue to result in unpredictable stock-based compensation charges, primarily dependent upon future fluctuations in the fair value of HealthMarkets Class A-2 common stock.
In July 2006 and December 2006, the Company sold in two separate transactions substantially all of the assets comprising its former Star HRG unit and its former Student Insurance Division. In connection with these sales, in 2006 the Company recorded an aggregate pre-tax gain in the amount of $201.7 million, of which $101.5 million was attributable to the Star HRG transaction and $100.2 million was attributable to the Student Insurance transaction.
The Company’s 2006 results of operations reflected significant one-time gains recognized in connection with the sales of the Company’s Star HRG unit and Student Insurance Division, which were sold by the Company in July and December of 2006, respectively. In particular, the Company recorded an aggregate pre-tax gain associated with these sales in the amount of $201.7 million, of which $101.5 million was attributable to the Star HRG transaction and $100.2 million was attributable to the Student Insurance transaction.
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 recently 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, rather than in the year the commissions were paid. 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 a two year period (based on recent persistency studies showing that SEA policies have an average life of 2.09 years).
Over time, the Company’s prior accounting policy with respect to amortization of the excess first and second year commissions resulted in an understatement of an asset (by 4% in 2004 and by 3% in 2005) and shareholders’ equity (by 8% in 2004 and by 6% in 2005). In addition, had the Company in prior periods properly deferred and amortized excess first and second year commissions over the average policy life of two years, the Company’s previously reported 2005 net income would have been reduced by $8.5 million (or by less than 4%) and the Company’s previously reported 2004 net income would have been reduced by $698,000 (or by less than 1%). Prior to the adoption of SAB 108, the Company considered the guidance contained in SEC Staff Accounting Bulletin No. 99, Materiality, using the “roll-over” method (which has as its primary focus the income statement, including the reversing effect of prior year misstatements) and concluded that its previously reported results of operations for the SEA Division for the years ending 2003 through 2005 were not materially distorted.
Revenues and income from continuing operations before federal income taxes (“operating income”) for each of the Company’s business segments and divisions in 2006, 2005 and 2004 was as follows:
Includes the incremental costs associated with the acquisition of the Company by a group of private equity investors.
In 2006 HealthMarkets reported consolidated revenues and income from continuing operations of $2.147 billion and $216.6 million ($6.07 per diluted share), respectively, compared to revenues and income from continuing operations in 2005 of $2.121 billion and $203.0 million ($4.31 per diluted share), respectively. Reflecting results from discontinued operations, the Company reported overall 2006 net income of $237.7 million $6.66 per diluted share), compared to 2005 net income of $203.5 million ($4.32 per diluted share).
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 is dissolving in the first quarter of 2007.
In 2006, the Company recognized net gains on sale of investments of $200.5 million compared to losses on sales of investments of $(760,000) in 2005. The increase in 2006 was primarily attributable to gains realized from the sales of the Company’s Star HRG Division and the Student Insurance Division in 2006.
Other expenses (consisting primarily of direct expenses incurred by the Company in connection with providing 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 and general expenses relating to corporate operations) increased to $158.7 million in 2006 from $81.2 million in 2005. The majority of the increase is attributed to incremental costs in the amount of $48.0 million associated with the Merger, $9.4 million of advisory fees incurred since the Merger date for services provided by the Private Equity Investors and additional overhead expenses incurred in connection with the previously announced corporate name change and branding initiative.
Our operating segments for financial reporting purposes include (a) the Insurance segment, which includes the businesses of the Company’s Self-Employed Agency (SEA) Division, the Life Insurance Division and Other Insurance, (b) Other Key Factors, which includes investment income not otherwise allocated to the Insurance segment, realized gains and losses, interest expense on corporate debt, general expenses relating to corporate operations, variable stock compensation and other unallocated items, and (c) Disposed Operations, which includes the Company’s former Star HRG Division and former Student Insurance Division (which operations were sold on July 11, 2006 and December 1, 2006, respectively).
Set forth below is certain summary financial and operating data for the Company’s Self-Employed Agency (“SEA”) Division for each of the three most recent fiscal years:
For 2006, the SEA Division reported operating income of $236.5 million compared to operating income of $310.5 million in 2005. Operating income at the SEA Division as a percentage of earned premium revenue (i.e., operating margin) in 2006 was 17.8% compared to 22.3% in 2005.
During 2005, the Company recorded a benefit in the amount of $40.9 million attributable to various refinements to the Company’s estimate of its claim liability.
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 A of Notes to Consolidated Financial Statements.
Total submitted annualized premium volume at the SEA Division increased by 10%, to $791.2 million in 2006 from $720.4 million in 2005. The increase in submitted annualized premium volume can be attributed primarily to an increase in the average number of writing agents per week in the field (from 2,039 in 2005 to 2,143 in 2006) and an increase in writing agent productivity. During 2006, the amount of weekly submitted annualized premium volume per writing agent increased by 4.5%, even as the average premium per policy decreased by 4.5%.
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, due to a decrease in capitalized deferred acquisition costs (administration costs) related to a decline in first year sales volume.
In 2006, 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 $20.0 million compared to $32.9 million in 2005. Annualized paid premium volume for 2006 was negatively impacted by service issues associated with an outside vendor that assists the Company in gathering key underwriting information, and a delay in production due to the introduction of redesigned products that are expected to improve return on capital.
Set forth below is a summary of the components of operating income at the Company’s Other Key Factors segment for each of the three most recent fiscal years:
Other significant items affecting the 2006 results in the Other Key Factors segment included a $9.4 million increase in variable stock-based compensation and an increase in general corporate expenses for the period to $39.8 million compared to $11.0 million incurred in the comparable period in 2005. These additional overhead expenses were principally associated with the change of the Company’s corporate name, the Company’s corporate branding initiative and monitoring fees paid to the Private Equity Investors. See Note O of Notes to Consolidated Financial Statements.
The Student Insurance Division was sold on December 1, 2006. Except for some minor transition expenses recorded in December 2006, the 2006 amounts represent eleven months of activity.
Operating margin is defined as operating income as a percentage of earned premium revenue.
The Star HRG Division was sold on July 11, 2006. Except for some minor transition expenses recorded after July 1, 2006, the 2006 results represent six months of activity.
The Company’s Star HRG Division reported operating income in 2006 in the amount of $2.3 million, compared to operating income of $1.4 million in 2005. The loss ratio associated with the Star HRG business decreased slightly to 62.6% in 2006 from 63.7% in 2005, and the underwriting and acquisition expense ratio decreased slightly to 36.0% in 2006 from 36.7% in 2005 from initiatives established in the fourth quarter of 2005. Earned premium revenue at the Star HRG Division was $74.1 million in 2006, compared to $144.6 million in 2005, reflecting the sale of the division effective July 11, 2006.
primarily because management did not anticipate realizing before its expiration the tax benefits of the capital loss carryover from the 2003 sale of the Company’s former student finance subsidiary.
Unless the context indicates otherwise, the following discussion comparative of our 2005 and 2004 results of operations excludes the operations of the Company’s Star HRG Division and Student Insurance Division which were sold in July and December 2006, respectively.
Life premiums and other considerations increased by 34%, to $61.6 million in 2005 from $45.9 million in 2004. This increase was attributable primarily to sales of newly-designed life products through its relationships with its two independent marketing companies.
Due to a 6% year over year increase in the book value of invested assets and an increase in the yield on short-term and other investments, investment income increased to $91.0 million in 2005 compared to $79.0 million in 2004.
The Company recognized losses on sale of investments of $(760,000) in 2005 compared to gains on sales of investments of $6.7 million in 2004. The 2005 losses were primarily attributable to the impairment of certain fixed maturities written down in the fourth quarter of 2005.
Expenses. HealthMarkets’ total expenses increased to $1.364 billion in 2005 from $1.345 billion in 2004, an increase of $18.6 million, or 1%. The Company’s expenses were particularly impacted by the following factors:
Other expenses (consisting primarily of direct expenses incurred by the Company in connection with providing 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 and general expenses relating to corporate operations) increased by 17%, to $81.2 million in 2005 from $69.6 million in 2004. The majority of the increase is attributed to incremental costs in the amount of $9.1 million associated with the then pending acquisition of the Company by a group of private equity investors.
Operating Income. Operating income increased by 20%, to $320.6 million in 2005 from $267.3 million in 2004. As discussed more fully below, the Company’s 2005 results from continuing operations benefited from a significant year-over-year increase in operating income at its SEA Division (from $260.7 million in 2004 to $310.5 million in 2005).
Operating income at the SEA Division in 2005 was positively impacted by an increase in earned premium revenue, a lower loss ratio (from 54.4% in 2004 to 51.5% in 2005) resulting from favorable claims experience, and a decrease in commission expenses as a percentage of earned premium. Earned premium revenue at the SEA Division increased to $1.395 billion in 2005, compared to earned premium revenue of $1.355 billion in 2004. However, the increase in premium is primarily attributable to the assumption during the fourth quarter of 2004 of small group policies originally issued by a wholly owned insurance subsidiary of HealthMarket Inc. (The Company acquired substantially all of the operating assets of HealthMarket Inc. on October 8, 2004 - see Note C of Notes to Consolidated Financial Statements). During 2005, the premium from the traditional health products issued by the SEA Division decreased approximately 1% due to the decline in submitted annualized premium volume.
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. The remaining portion of the adjustment to the claim liability (approximately $12.3 million) was attributable to an update of the completion factors used in the developmental method of estimating the unpaid claim liability to reflect more current claims administration practices.
The Company’s Life Insurance Division reported operating income in 2005 of $7.1 million compared to operating income of $4.7 million in 2004. The year-over-year increase in operating income was attributable to an increase in revenue and a decrease in fixed administrative costs as a percentage of earned premium revenue.
(from $7.6 million in net realized gains in 2004 to $(760,000) in net realized losses in 2005), an increase in general corporate expenses of $6.3 million and incremental costs in the amount of $9.1 million associated with the pending acquisition of the Company by a group of private equity investors. These unfavorable factors were partially offset by a $14.7 million increase in investment income on equity and a $7.1 million year-over-year decrease in variable stock-based compensation expense associated with the various stock accumulation plans established by the Company for the benefit of its independent agents (from $14.3 million in 2004 to $7.2 million in 2005).
The Company’s former Star HRG Division reported operating income in 2005 in the amount of $1.4 million, compared to operating income of $3.3 million in 2004. The loss ratio associated with the Star HRG business increased slightly to 63.7% in 2005 from 63.6% in 2004, and the underwriting and acquisition expense ratio decreased slightly to 36.7% in 2005 from 37.4% in 2004. The decrease in “Other income” from 2004 to 2005 was associated with the decrease in administrative fees on business underwritten by a third party insurance carrier and a decrease in fees received on ancillary products. Earned premium revenue at the Star HRG Division was $144.6 million in 2005, compared to $145.7 million in 2004.
Change in Claims and Future Benefit Liability Estimates - Self-Employed Agency Division
Results for the year ended December 31, 2006, reflected a benefit in the amount of $47.1 million attributable to refinements of the Company’s estimate for its claim liability on its health insurance products. For financial reporting purposes, these refinements are considered to be changes in estimate, resulting from additional information and subsequent developments from prior periods. Accordingly, the financial impact of these refinements was accounted for in the respective periods that the refinements occurred. Of the $47.1 million of refinements to the estimated claim liability, $44.5 million is attributable to prior years. The refinements to the estimate for the Company’s claim liability are more particularly described below:
An additional adjustment to the claim liability (approximately $25.1 million of which $10.5 million was recorded in the third quarter and $14.6 million was recorded in the fourth quarter) was attributable to an update of the completion factors used in estimating the claim liability for the Accumulated Covered Expense (“ACE”) rider, 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. This adjustment reflects 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. Had these refinements been made at December 31, 2005, the claim liability estimate would have been reduced by $19.1 million.
Results at the SEA Division for the year ended December 31, 2005 reflected a benefit in the amount of $33.3 million recorded in the third quarter of 2005 attributable to a refinement of the Company’s estimate for its claim liability on its health insurance products. The largest portion of the adjustment (approximately $21.0 million) 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 its most popular scheduled health insurance products, the SEA Division has continued to observe favorable claims experience and, as a result, loss ratios have
Computation of earnings (loss) per share for each quarter is made independently of earnings (loss) per share for the year.
On a consolidated level, the Company’s primary sources of liquidity have been premium revenues from policies issued, investment income, fees and other income, proceeds from corporate borrowings and borrowings to fund student loans. The primary uses of cash have been payments for benefits, claims and commissions under those policies, operating expenses, cash dividends to shareholders, stock repurchases and the funding of student loans. During 2006, the Company generated on a consolidated basis net cash from operations in the amount of $42.8 million, compared to net cash from operations of $185.4 million in 2005 and $254.2 million in 2004. The decrease in cash flow from operations in 2006 is due to the cash used to transfer the net liabilities of the Student Insurance Division and the Star HRG Division of $85.5 million. In addition, income from continuing operations before tax, excluding realized gains recorded on the sale of the Student Insurance Division and the Star HRG Division, decreased $162.6 million in 2006 from 2005.
The Company’s consolidated short and long-term indebtedness (exclusive of indebtedness secured by student loans) was $556.1 million and $15.5 million at December 31, 2006 and 2005, respectively.
In connection with the Merger completed on April 5, 2006, HealthMarkets, LLC, a direct wholly-owned subsidiary of the Company, entered into a credit agreement, providing for a $500.0 million term loan facility and a $75.0 million revolving credit facility (which includes a $35.0 million letter of credit sub-facility). The full amount of the term loan was drawn at closing, and the proceeds thereof were used to fund a portion of the consideration paid in the Merger. At December 31, 2006, the Company had an aggregate of $437.5 million of indebtedness outstanding under the term loan facility, which indebtedness bore interest at the London inter-bank offered rate (“LIBOR”) plus a borrowing margin (1.00%). The Company has not drawn on the $75.0 million revolving credit facility. During the six months ended December 31, 2006, the Company made its regularly scheduled quarterly principal payment in the amount of $2.5 million and a voluntary prepayment in the amount of $60.0 million on the term loan facility.
and thereafter at a floating rate equal to three-month LIBOR plus 3.05%. Distributions on the Trust Securities will be paid at the same interest rates paid on the Notes.
At December 31, 2006 and 2005, the Company had an aggregate of $119.0 million and $130.9 million, respectively, of indebtedness outstanding under a secured student loan credit facility, which indebtedness is represented by Student Loan Asset-Backed Notes (the “SPE Notes”) issued by a bankruptcy-remote special purpose entity (the “SPE”). At December 31, 2006 and 2005, indebtedness outstanding under the secured student loan credit facility was secured by alternative (i.e., non-federally guaranteed) student loans and accrued interest in the carrying amount of $111.2 million and $115.3 million, respectively, and by a pledge of cash, cash equivalents and other qualified investments in the amount of $14.2 million and $20.5 million, respectively. At December 31, 2006, $7.2 million of such cash, cash equivalents and other qualified investments was available to fund the purchase from the Company of additional student loans generated under the Company’s College First Alternative Loan program, which purchases may be made in accordance with the terms of the agreements governing the securitization until February 2007. After February 1, 2007, the Company will fund loans with cash on hand from HealthMarkets LLC.
The SPE Notes were issued by the SPE in three tranches ($50.0 million of Series 2001A-1 Notes and $50.0 million of Series 2001A-2 Notes issued on April 27, 2001, and $50.0 million of Series 2002A Notes issued on April 10, 2002). The Series 2001A-1 Notes and Series 2001A-2 Notes have a final stated maturity of July 1, 2036;
the Series 2002A Notes have a final stated maturity of July 1, 2037. However, the SPE Notes are subject to mandatory redemption in whole or in part (a) on the first interest payment date which is at least 45 days after February 1, 2007, from any monies then remaining on deposit in the acquisition fund not used to purchase additional student loans and (b) on the first interest payment date which is at least 45 days after July 1, 2005, from any monies then remaining on deposit in the acquisition fund received as a recovery of the principal amount of any student loan securing payment of the SPE Notes, including scheduled, delinquent and advance payments, payouts or prepayments. After July 1, 2005, the SPE Notes are also subject to mandatory redemption in whole or in part on each interest payment date from any monies received as a recovery of the principal amount of any student loan securing payment of the SPE Notes, including scheduled, delinquent and advance payments, payouts or prepayments. During 2006 and 2005 the Company made principal payments in the aggregate amount of $11.9 million and $19.1 million, respectively, on the Notes.
At December 31, 2006 and 2005, HealthMarkets, Inc. and HealthMarkets LLC at the holding company level held cash and cash equivalents in the amount of $311.5 million and $151.4 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:
Includes in 2004 $25.0 million of dividends from a non-insurance subsidiary related to the sale of the remaining uninsured student loans retained by the Company upon the sale of AMS.
Includes in 2006 proceeds from the term loan facility in the amount of $500 million and proceeds from the floating rate Junior Subordinated Notes of $100 million.
Includes distribution from a special purpose subsidiary of the principal payment received in 2006 in the amount of $72.4 million on the $150.8 million promissory note received in July 2006. See Notes C and L of Notes to Consolidated Financial Statements.
Reflects net proceeds of issuance by a non-consolidated qualifying special purpose subsidiary of $72.4 million principal amount of senior secured notes, which notes are secured by a pledge of the $150.8 million promissory note received in July 2006. HealthMarkets LLC received the promissory note as a non-cash dividend from its subsidiary, MEGA, and subsequently assigned the note to the special purpose subsidiary. See Notes C and L of Notes to Consolidated Financial Statements.
Includes repurchase of HealthMarkets common stock under the Company’s stock repurchase program in the amount of $-0- (-0- shares), $7.0 million (310,900 shares) and $16.3 million (1,043,400 shares) in 2006, 2005 and 2004, respectively. Also includes in 2006, 2005 and 2004 the amounts of $8.7 million, $6.4 million and $19.9 million, respectively, representing repurchases of HealthMarkets common stock for agent stock accumulation plans and purchases from officers or employees of the Company.
Includes the costs associated with the acquisition of the Company by a group of private equity investors.
Includes the repurchase of 43,567,252 shares of HealthMarkets common stock at $37.00 per share in connection with the Merger.
During 2006, 2005 and 2004, the Company’s cash and liquidity at the holding company were positively impacted by the following significant factors and developments:
During 2006, the Company received an aggregate of $221.7 million in cash dividends from its subsidiaries, compared to $164.0 million of cash dividends received in 2005.
During 2006 the Company received net cash proceeds in the amount of $71.9 million from the issuance by a non-consolidated qualifying special purpose subsidiary of $72.4 million principal amount of senior secured notes.
As described above, to finance the Merger the Company utilized the proceeds of additional indebtedness incurred in April 2006 in the amount of $600.0 million, consisting of $500.0 million under a term loan credit facility and $100.0 million of Floating Rate Junior Subordinated Notes.
On March 31, 2004, the Company completed the sale of all of the remaining uninsured student loan assets formerly held by the Company’s former Academic Management Services Corp. subsidiary. The sale of the uninsured student loans generated gross cash proceeds in the amount of approximately $25.0 million.
During 2006 and 2005, the holding company expended significant amounts of cash for expenses related to the Merger, of which approximately $120.9 million was expended during 2006 and approximately $8.4 million was expended during the fourth quarter of 2005.
During 2006, the holding company paid interest and principal on its $500.0 million term loan facility in the amount of $16.4 million and $62.5 million, respectively. The Company’s $62.5 million repayment of principal on the facility included a voluntary prepayment in the amount of $60.0 million.
During 2005 and 2004, the Company paid aggregate dividends to holders of its common stock in the amount of $34.7 million and $11.5 million, respectively.. On August 18, 2004, the Company’s Board of Directors adopted a policy of issuing a regular semi-annual cash dividend on shares of its common stock. Dividends paid in 2005 also included a $0.25 per share special dividend ($11.6 million in the aggregate) paid in March 2005. Since the execution on September 15, 2005 of a definitive agreement contemplating the acquisition of the Company in a cash merger by a group of private equity firms, the Company has not declared or paid additional dividends on shares of its common stock.
In June 2004, the Company paid in full the final payment due in the amount of $4.0 million on its 8.75% Senior Notes due June 2004, which the Company had issued in 1994 in the original aggregate issuance amount of $27.7 million.
Interest rates on the above commitments are principally variable (prime plus 2%).
Through February 1, 2007, the Company has funded its College Fund Life Division student loan commitments with the proceeds of indebtedness issued by a bankruptcy-remote special purpose entity (the “SPE Notes”). The indenture governing the terms of the SPE Notes provided that the proceeds of such SPE Notes could be used to fund
At each of December 31, 2006 and 2005, the Company had $9.6 million and $5.2 million, respectively, of letters of credit outstanding relating to its insurance operations.
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. Managements’ 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 deterioration of the issuer 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 impaired, a loss is recognized at the date of determination.
Set forth below is a summary of the Company’s investments by category at December 31, 2006 and 2005:
Fixed maturity securities represented 76.3% and 83.5% of the Company’s total investments at December 31, 2006 and 2005, respectively. Fixed maturity securities at December 31, 2006 consisted of the following:
As of December 31, 2006 and 2005, $1.356 billion or (98.7%) and $1.457 billion (or 98.1%), respectively, of the fixed maturity securities portfolio was rated BBB or better (investment grade), and $18.2 million or (1.3%) and $27.6 million (or 1.9%), respectively, of the fixed maturity securities portfolio was invested in below investment grade securities (rated less than BBB).
A quality distribution for fixed maturity securities at December 31, 2006 is set forth below:
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 Company’s aggregate investment portfolio at December 31, 2006 and 2005, excluding investments in U.S. Government securities:
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 Company establishes liabilities for benefit claims that have been reported but not paid and claims that have been incurred but not reported under health and life insurance contracts. Consistent with overall company philosophy, the claim liability estimate is determined which is expected to be adequate under reasonably likely circumstances. This estimate is developed using actuarial principles and assumptions that consider a number of items as appropriate, including but not limited to historical and current claim payment patterns, product variations, the timely implementation of appropriate rate increases and seasonality. The Company does not develop ranges in the setting of the claims liability reported in the financial statements
The Company’s claim liabilities are estimated using the developmental method, which involves the use of completion factors for most incurral months, supplemented with additional estimation techniques, such as loss ratio estimates, in the most recent incurral months. This method applies completion factors to claim payments in order to estimate the ultimate amount of the claim. These completion factors are derived from historical experience and are dependent on the incurred dates of the claim payments. The completion factors are selected so that they are equally likely to be redundant as deficient.
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, 2006 unpaid claim liability for the SEA Division. The scenarios selected are reasonable based on the Company’s past experience, however future results may differ.
Set forth below is a summary of claim liabilities by business unit at each of December 31, 2006, 2005 and 2004:
Set forth in the table below is the summary of the incurred but not reported claim liability by business unit at each of December 31, 2006, 2005 and 2004:
Over time, the developmental method replaces anticipated experience with actual experience, resulting in an ongoing re-estimation of the claims liability. Since the greatest degree of estimation is used for more recent periods, the most recent prior year is subject to the greatest change.
The total favorable claims liability development experience for 2005 in the amount of $121.4 million represented 24.6% of total claim liabilities established for the SEA Division at December 31, 2004. The favorable claims liability development experience in 2005 reflected a benefit of $33.3 million recorded in the third quarter of 2005 attributable to a refinement of the Company’s estimate for its claim liability on its health insurance products, which adjustment resulted from a refinement of the estimate of the unpaid claim liability for the most recent incurral months ($20.9 million, included in the table above as part of the development in the most recent incurral months) and an update of the completion factors used in the developmental method of estimating the unpaid claim liability to reflect more current claims administration practices ($12.3 million, included in the table above as part of the development in the completion factors). The favorable claims liability development experience at the SEA Division in 2005 also reflected the effects of a favorable adjustment in the amount of $7.6 million recorded in the first quarter of 2005 attributable to a refinement of an estimate for the Company’s claim liability established with respect to the ACE (accumulated covered expense) rider that provides for catastrophic coverage on the SEA Division’s scheduled health insurance products. Excluding the impact of the refinements discussed above, the remaining favorable experience in 2005 in the claims liability was $80.5 million, or 16.3% of total claim liabilities established for the SEA Division at December 31, 2004. Most of the remaining redundancy ($51.8 million in addition to the refinement described above) is attributable to experience in the five most recent incurral months developing more favorably than anticipated (as discussed above) and unanticipated improvements on certain closed blocks that appeared to have been deteriorating based on experience available at the end of 2004. The Company experienced an additional redundancy in the completion factors of $8.8 million (in addition to the redundancy from the refinement previously described in the third quarter of 2005) as the result of claims developing in amounts less than anticipated by the completion factors used at December 31, 2004. The Company also experienced favorable development of $8.5 million in its reserve for large claims as a result of lower frequency and severity of large claims than anticipated. In addition, the Company experienced favorable development of approximately $7.0 million associated with its reserves for regulatory and legal matters due to settlements of certain matters on terms more favorable than originally anticipated.
The total favorable claims liability development experience for 2004 in the amount of $91.7 million represented 20.2% of total claim liabilities established for the SEA Division at December 31, 2003. The favorable claims liability development experience at the SEA Division in 2004 reflected the effect of $47.8 million in claim liabilities established during 2003 in response to a rapid pay down during 2003 of an excess pending claims inventory. In particular, during 2003 the Company observed a change in the distribution of paid claims by incurred date; more paid claims were assigned to recent incurred dates than had been the case on paid claims in prior years. Assignment of paid claims with more recent incurred dates typically results in an understatement of the claim development liability, resulting in the need for augmented claim liabilities. The Company believes that the deviation from historical experience in incurred date assignment was a natural consequence of the effort required to reduce a claims backlog, which the Company was experiencing at the SEA Division during the course of 2003. However, as
In response to the redundancies reflected in 2004 and 2005, the Company elected in the third quarter of 2005 for the SEA Division to modify the assumptions used in the most recent incurral months to rely less on loss ratios assumed in the establishment of premium rates and more on historical experience, reducing the claim liability estimate in the most recent incurral months by $20.9 million. In addition, in response to observed changes in the pattern of claim payments, the Company elected in the third quarter of 2005 to update the completion factors used in the developmental method to estimate the claim liabilities at the SEA Division in a manner designed to produce new completion factors that were anticipated to be equally likely to be redundant as deficient. As a result of the new completion factors, the claims liability estimate was reduced by $12.3 million. These two adjustments in 2005 resulted in an aggregate reduction in the claim liability estimate in the amount of $33.3 million.
Impact on Disposed Operations. The products of the Student Insurance and Star HRG Divisions consisted principally of medical insurance. In general, medical insurance business, for which incurred dates are assigned
The favorable claims liability development experience at Star HRG Division of $1.4 million in 2006 includes the effects of claims in 2006 developing more favorably than indicated by the loss trends in 2005 used to determine the claim liability at December 31, 2005. The unfavorable claim liability development at the Star HRG Division in 2005 of $410,000 is within the normal statistical variation in the model used to develop the reserve. The actual development of prior years’ claims exceeded the expected development of the claims liability. The favorable claims liability development experience of $3.0 million in 2004 includes the effects of claims in 2004 developing more favorably than indicated by the loss trends in 2003 used to determine the claim liability at December 31, 2003.
The Company monitors and assesses the recoverability of deferred health and life policy acquisition costs on a quarterly basis.
The Company sponsors a series of stock accumulation plans (the “Agent Plans”) established for the benefit of the independent insurance agents and independent sales representatives associated with UGA - Association Field Services, New United Agency and Cornerstone America. The Company has established a liability for future unvested benefits under the Agent Plans and adjusts the liability based on the fair value of the Company’s Common Stock. The accounting treatment of the Company’s Agent Plans has resulted and will continue to result in unpredictable stock-based compensation charges, dependent upon fluctuations in the fair value of HealthMarkets Class A-2 common stock. These unpredictable fluctuations in stock based compensation charges may result in material non-cash fluctuations in the Company’s results of operations. See discussion above under the caption “Variable Stock-Based Compensation” and Note Q of Notes to Consolidated Financial Statements.
The Company seeks to match the cash flows of invested assets with the payment of expected liabilities. By doing this, the Company attempts to make cash available as payments become due. If a significant mismatch of the maturities of assets and liabilities were to occur, the impact on the Company’s results of operations could be significant.
On August 3, 2006, Grapevine Finance LLC (“Grapevine”) was incorporated in the State of Delaware as a wholly owned subsidiary of HealthMarkets, LLC. On August 16, 2006, the Company distributed and assigned to Grapevine the $150.8 million promissory note (“CIGNA Note”) and related Guaranty Agreement issued by Connecticut General Corporation in the Star HRG sale transaction (see Note C of Notes to Consolidated Financial Statements). On August 16, 2006, Grapevine issued $72.4 million of its senior secured notes to an institutional purchaser collateralized by Grapevine’s assets including the CIGNA Note. The net proceeds from the senior secured notes were distributed to HealthMarkets, LLC
The Company records deferred tax assets to reflect the impact of temporary differences between the financial statement carrying amounts and tax bases of assets. Realization of the net deferred tax asset is dependent on generating sufficient future taxable income. The amount of the deferred tax asset considered realizable, however, could be reduced in the near term if estimates of future taxable income during the carryforward period are reduced.
Beginning 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 five years. The Company determined in 2003 that it likely would not generate sufficient capital gains to realize the deferred tax benefits of the capital loss carryforwards and certain investment impairment losses realized in 2003. Management did not in 2003 anticipate selling appreciated assets to generate capital gains (and impair future investment return) solely for the purpose of utilizing the capital loss carryover. Accordingly, the Company did not recognize the tax benefits of these 2003 losses but, rather established a valuation allowance during 2003. The sales of the Student Insurance and the Star HRG divisions during 2006, however, generated capital gains in excess of the capital loss carryover and the investment impairment
The Company is subject to proceedings and lawsuits related to insurance claims and other matters. See Note P of Notes to Consolidated 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, 2006, 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 September 2006, the Securities and Exchange Commission Staff issued Staff Accounting Bulletin No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements,” or SAB 108, in an effort to address diversity in the accounting practice of quantifying misstatements and the potential for improper amounts on the balance sheet. Prior to the issuance of SAB 108, the two methods used for quantifying the effects of financial statement errors were the “roll-over” and “iron curtain” methods. Under the “roll-over” method, the primary focus is the income statement, including the reversing effect of prior year misstatements. The criticism of this method is that misstatements can accumulate on the balance sheet. On the other hand, the “iron curtain” method focuses on the effect of correcting the ending balance sheet, with less importance on the reversing effects of prior year errors in the income statement. SAB 108 establishes a “dual approach,” which requires the quantification of the effect of financial statement errors on each financial statement, as well as related disclosures. Public companies are required to record the cumulative effect of initially adopting the “dual approach” method in the first year ending after November 16, 2006 by recording any necessary corrections to asset and liability balances with an offsetting adjustment to the opening balance of retained earnings. The use of this cumulative effect transition method also requires detailed disclosures of the nature and amount of each error being corrected and how and when they arose. The Company adopted SAB 108 in the fourth quarter of 2006 and applied the provisions of SAB 108 in connection with the change in accounting policy with respect to the capitalization and amortization of excess first and second year commissions associated with the business of the Company’s SEA Division. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations - - 2006 Change in Accounting Policy.” The adoption of SAB 108 did not have a material impact on the Company’s financial position, results of operations or cash flows.
In September 2006, the Financial Accounting Standards Board (“FASB”) issued Statement 157 Fair Value Measurements, which defines fair value as the price that would be received to sell an asset or that would be paid to transfer a liability in an orderly transaction between market participants at the measurement date. SFAS 157 establishes a framework for measuring fair value and expands disclosures about fair value measurements. Statement 157 will be effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. The Company believes this statement will not have a material effect upon the financial condition or results of operations of the Company.
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
The following table illustrates the effect on net income as if the fair-value-based method had been applied to all outstanding and unvested option awards in each period.
This report and other documents or oral presentations prepared or delivered by and on behalf of the Company contain or may contain “forward-looking statements” within the meaning of the safe harbor provisions of the United States Private Securities Litigation Reform Act of 1995. Forward-looking statements are statements based upon management’s expectations at the time such statements are made. The Company undertakes no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. Forward-looking statements are subject to risks and uncertainties that could cause the Company’s actual results to differ materially from those contemplated in the statements. Readers are cautioned not to place undue reliance on the forward-looking statements. When used in written documents or oral presentations, the terms