(1) Balance Sheet Data includes acquisition balances as of December 31 of the year of acquisition. Operating Data includes the results of operations of acquisitions from the date of the respective acquisition. See the notes to the consolidated financial statements for information about our acquisitions.
(2) Unless noted as discontinued operations, Operating Data excludes First Health Services Corporation (“FHSC”) operating results for each year presented due to the sale of this business in July 2009. Balance Sheet Data does not exclude FHSC balances for 2008 and prior as amounts are immaterial. See the notes to the consolidated financial statements for additional information about our discontinued operations presentation.
Medicare Part D membership growth of 752,000 from the prior year, an increase of 81%
We incur cost of sales expense for prescription drugs provided by our workers’ compensation pharmacy benefit manager and for the independent medical examinations performed by physicians on injured workers. These costs are associated with fee-based products.
We generate cash through operations. As a profitable company in an industry that is not capital equipment intensive, we have generally not needed to use external financing to fund operations. Our primary use of cash is to pay medical claims. Any excess cash has historically been used for acquisitions, to prepay indebtedness and for repurchases of our common stock.
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 in the current month the retroactive adjustments included on two subsequent months billings. Current period revenues are adjusted to reflect these retroactive adjustments.
We receive premium payments from the Centers for Medicare and Medicaid Services (“CMS”) on a monthly basis for our Medicare membership to provide healthcare benefits to our Medicare members. Premiums are fixed (subject to retroactive risk adjustment) on an annual basis by contracts with CMS. Membership and category eligibility are periodically reconciled with CMS and can result in adjustments to revenue. CMS uses a risk adjustment model that incorporates the use of HCC codes to determine premium payments to health plans. We estimate risk adjustment revenues based on the diagnosis data submitted to CMS. Changes in revenue from CMS resulting from the periodic changes in risk adjustments scores for our membership are recognized when the amounts become determinable and the collectibility is reasonably assured.
CMS periodically performs audits and may seek return of premium payments made to the company if risk adjustment factors are not properly supported by medical record data. We estimate and record reserves for CMS audits based on information available at the time the estimates are made. The judgments and uncertainties affecting the application of these policies include significant estimates related to the amount of HCC revenue subject to audit and anticipated error rates. Although we believe the Company maintains appropriate reserves for its exposure to the risk adjustment data validation (“RADV”) audits, actual results could differ materially from those estimates.
We contract with the United States Office of Personnel Management (“OPM”) and with various federal employee organizations to provide health insurance benefits under the Federal Employees Health Benefits Program (“FEHBP”). These contracts are subject to government regulatory oversight by the Office of the Inspector General (“OIG”) of OPM, which performs periodic audits of these benefit program activities to ensure that contractors meet their contractual obligations with OPM. For our managed care contracts, the OIG conducts periodic audits to, among other things, verify that premiums established under its contracts are in compliance with community rating requirements under the FEHBP. The OPM may seek premium refunds or institute other sanctions against health plans that participate in the program. For our experience-rated plans, the OIG focuses on the appropriateness of contract charges, the effectiveness of claims processing, financial and cost accounting systems, and the adequacy of internal controls to ensure proper contract charges and benefits payments. The OIG may seek refunds of costs charged under these contracts or institute other sanctions against health plans. These audits are generally a number of years in arrears. We estimate and record reserves for audit and other contract adjustments for both our managed care contracts and our experience rated plans based on appropriate guidelines. Any differences between actual results and estimates are recorded in the year the audits are finalized.
The following table presents the components of the change in medical claims liabilities for the years ended December 31, 2009, 2008 and 2007, respectively (in thousands).
Lower than anticipated medical cost increases of $105.4 million favorable development
Within the reserve setting methodologies for inpatient and non-inpatient services, we use certain assumptions. For inpatient services, authorized days are used for utilization factors, while cost trend assumptions are incorporated into per diem amounts. The per diem estimates reflect anticipated effects of changes in reimbursement structure and severity mix. For non-inpatient services, a composite trend assumption is applied which reflects anticipated changes in cost per service, provider contracts, utilization and other factors.
Changes in the completion factors, trend factors and utilization factors can have a significant effect on the claim liability. The following example (in thousands, except percentages) provides the estimated effect to our December 31, 2009 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.
Generally, we do not adjust prices received from pricing services or brokers, unless it is evident from our verification procedures the fair value measurement is not consistent with ASC Topic 820. Based upon our internal price verification procedures and review of fair value methodology documentation provided by independent pricing services, we have concluded that the fair values provided by pricing services and brokers are consistent with the guidance in ASC Topic 820.
The unrealized losses presented in this table do not meet the criteria for an other-than-temporary impairment. The unrealized losses are the result of interest rate movements and significant increases in volatility and liquidity concerns in the securities and credit markets. The Company does not intend to sell and it is not more-likely-than not that the Company will be required to sell before a recovery of the amortized cost basis of these securities.
The goodwill impairment test compares the fair value of a reporting unit with its carrying amount, including goodwill. If the fair value of a reporting unit exceeds its carrying amount, goodwill of the reporting unit is considered not impaired. For our impairment analysis we relied on both the income approach and the market approach. The income approach is based on the present value of expected future cash flows. The income approach involves estimating the present value of our estimated future cash flows utilizing a risk adjusted discount rate. The market approach estimates a business’s fair value by comparing our Company to similar publicly traded entities and also by analyzing the recent sales of similar companies. The approaches were reviewed together for consistency and commonality.
In the case of a publicly traded company, the objective of the market capitalization approach is to determine whether the quoted market price is indicative of the fair value of its reporting units. In addressing the relationship of the determined fair value of our reporting units to our market capitalization, we considered factors outlined in ASC Topic 350, “Intangibles - Goodwill and Other” including:
As discussed in Note E, Goodwill and Other Intangible Assets, to the consolidated financial statements, we recorded an impairment charge of $72.4 million during 2009 related to the sale of FHSC.
Also in accordance with ASC 350-30 we review intangible assets that are subject to amortization for recoverability whenever events or changes in circumstances indicate that its carrying amount may not be recoverable. An impairment loss shall be recognized if the carrying amount of an intangible asset is not recoverable and its carrying amount exceeds its fair value. Our intangible assets that are subject to amortization consist of our customer lists, licenses, and provider networks. Based on events and circumstances, primarily lower than expected customer retention levels, we recorded $5.5 million in impairment charges to certain customer list balances in 2009.
The increases in Medicare Part D membership of 752,000 and Medicare Advantage PFFS of 86,000 were primarily the result of our successful annual election period and open enrollment period for 2009. In the second quarter of 2009, we decided not to renew our PFFS product effective for the 2010 plan year. Our PFFS product represented $2.9 billion in revenue for the year ended December 31, 2009.
The following table is provided to facilitate a discussion regarding the comparison of our consolidated results of continuing operations for each of the three years in the period ended December 31, 2009 (dollars in thousands, except diluted earnings per share amounts):
Cost of sales increased due to the growth of the pharmacy benefit management program revenues in the Workers’ Compensation Division as noted above.
Management services revenue increased compared to the prior year primarily as a result of the acquisition of business from Concentra, Inc. (“Concentra”) and organic growth in our workers’ compensation services business. This increase was partially offset by the Other National ASO membership decline described above.
Medical costs increased as a result of new business as discussed above. Medical costs also increased due to increased Commercial and Medicare PFFS medical cost trends as well as unfavorable IBNR reserve development with respect to our Medicare PFFS business. The Medicare Part D medical loss ratio increase was a result of the premium rate changes from the annual competitive bid filings for our Medicare Part D products and growth in our low-income auto-assign population in 2008.
Depreciation and amortization expense primarily increased as a result of the expense associated with the amortizable intangible assets identified with our recent acquisitions.
Other income decreased due to a charge of $36.2 million that consisted of $33.5 million for the other-than-temporary impairment of investment securities and $2.7 million in realized losses on the sale of securities. The decrease also resulted from lower interest rates during 2008.
(2) Revenue per member per month excludes the effect of CMS risk-share premium adjustments and revenue ceded to external parties.
Medicaid premium yields increased as a result of rate increases in Missouri, our largest Medicaid market, effective July 1, 2008 and July 1, 2009 as well as rate increases in Virginia and West Virginia effective July 1, 2009. The yields also increased due to the termination of our Pennsylvania Medicaid behavioral health contract, which had a lower premium yield. These increases in premium yield were offset by declines in the membership of the Medicaid Risk product. Membership declines also contributed to the reduction in revenue for Commercial Risk products.
Specialized Managed Care revenue experienced a significant increase over the prior year due to the large increase in membership for the Medicare Part D product. Medicare Part D premium yields for 2009, excluding the effect of CMS risk sharing premium adjustments and revenue ceded to external parties, decreased compared to 2008, primarily due to the mix of products sold in 2009. The majority of the Medicare Part D growth was in the lower cost, leaner benefit plans, which have a lower premium. Including the effect of the CMS risk sharing premium adjustments as well as the ceded revenue, the premium yields were $80.98 for 2009 compared to $78.84 in 2008. The increase is a result of a smaller portion of our Medicare Part D business in 2009 being ceded to external parties through quota share arrangements.
When reviewing the premium yield for Medicare Part D business, we believe that adjusting for the ceded revenue is useful for comparisons to competitors that may not have similar ceding arrangements. When reviewing the Medicare Part D business, adjusting for the risk share amounts is useful to understand the results of the Part D business because of our expectation that the risk sharing revenue will eventually be insignificant on a full year basis.
Our cash and investments, consisting of cash, cash equivalents, short-term investments, and long-term investments, but excluding deposits of $75.3 million restricted under state regulations, increased $675.8 million to $3.8 billion at December 31, 2009 from $3.1 billion at December 31, 2008.
Net cash from operating activities for the year ended December 31, 2009, was a result of net earnings plus non-cash adjustments to earnings including the impairment of FHSC goodwill and an increase in both medical liabilities and other payables. The increase in medical liabilities during 2009 is primarily related to the growth in membership across the Medicare business. Other payables increased primarily due to accruals for annual incentive compensation programs, an increase in taxes payable, and Medicare payables.
We repaid a total of $68.9 million principal amount of our remaining outstanding Senior Notes for payments of $59.9 million, resulting in a gain of $8.4 million, net of the write off of deferred financing costs.
Our credit facility requires compliance with a leverage ratio. All of our senior notes and credit facility contain certain covenants and restrictions regarding additional debt, dividends or other restricted payments, transactions with affiliates, disposing of assets and in some cases provide for debt repayment upon consolidations or mergers. As of December 31, 2009, we were in compliance with applicable covenants under the senior notes and credit facility.
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 2009, we received $121.0 million in dividends from our regulated subsidiaries and infused $293.8 million in capital contributions into our subsidiaries, due primarily to the significant growth of PFFS and Part D in 2009.
The National Association of Insurance Commissioners (“NAIC”) has proposed that states adopt risk-based capital (“RBC”) standards that would generally require higher minimum capitalization requirements for HMOs and other risk-bearing health care entities. RBC is a method of measuring the minimum amount of capital appropriate for a managed care organization to support its overall business operations in consideration of its size and risk profile. The managed care organization’s RBC is calculated by applying factors to various assets, premiums and reserve items. The factor is higher for those items with greater underlying risk and lower for less risky items. The adequacy of a managed care organization’s actual capital can then be measured by a comparison to its RBC as determined by the formula. Our health plans are required to submit a RBC report to the NAIC and their domiciled state’s department of insurance with their annual filing.
The increase in capital and surplus for our regulated subsidiaries primarily resulted from net earnings and capital contributions made by the parent company, partially offset by dividends paid to the parent company.
Excluding funds held by entities subject to regulation and excluding our equity method investments, we had cash and investments of approximately $713.0 million and $549.9 million at December 31, 2009 and 2008, respectively. The increase resulted from the proceeds received from the disposal of FHSC, earnings from non-regulated businesses, and dividends from our regulated subsidiaries. These were partially offset by capital infusions into our subsidiaries, payments made for share repurchases, and debt repayments.
(a) Interest payable on credit facilities has been estimated based on interest rates as of February 2010 and assumes no additional changes in the principal amount.
Refer to Note L, Commitments and Contingencies, to our consolidated financial statements for additional information related to our operating leases.
In recent years, health care cost inflation has exceeded the general inflation rate. To reduce the effect of health care cost inflation on our business operations, in which we assume underwriting risk, we have, where possible, increased premium rates and implemented cost control measures in our patient care management and provider contracting. We cannot be certain that we will be able to increase future premium rates at a rate that equals or exceeds the health care cost inflation rate or that our other cost control measures will be effective.
Health Plan and Medical Services Division - We expect our Commercial Group Risk membership will be down for the year in the low to mid single digit range, excluding the addition of the announced acquisition of Preferred Health Systems (PHS) on February 1, 2010 and its commercial risk membership of approximately 100,000 members. For same store Commercial membership, the forecasted health plan MLR is expected to be in the range of 81.5% to 82.0%, compared to 81.9% for 2009. Including the effect of the PHS acquisition, we expect the total Commercial Group MLR to be in a range of 82.25% to 82.75%. Overall, we expect the acquisition of PHS to be neutral to earnings for the year.
As previously announced, we have decided not to renew our national PFFS product for the 2010 plan year. There will be a claims run out period for this product in 2010, which we believe has been adequately reserved for as of the 2009 year end.
Specialized Managed Care Division - After our significant membership growth in 2009, we expect our Medicare Part D product to be down slightly to approximately 1.6 million members for 2010. This slight decrease reflects the loss of some auto assign regions along with some State Pharmacy Assistance Program members. Our MLR expectation for 2010 will be similar to our actual results in 2009, which was in the mid 80%s.
Workers' Compensation Division - We believe our Workers' Compensation Division will remain stable compared to 2009, with continued focus on the supporting administrative cost structure.
Regarding our balance sheet and liquidity, we ended the year with approximately $510 million in free cash at the parent level, and approximately $1.8 billion in cash, cash equivalents and U.S. Treasury securities on a consolidated basis. After a $110 million payment during the fourth quarter in 2009, we have a net balance owing on our revolving line of credit of $380 million. As usual, our first priority with our free cash will be to support the regulatory capital needs of our subsidiaries, and to maintain liquidity.
We have audited the accompanying consolidated balance sheets of Coventry Health Care, Inc. and subsidiaries as of December 31, 2009 and 2008, and the related consolidated statements of operations, stockholders' equity, and cash flows for each of the three years in the period ended December 31, 2009. Our audits also included the financial statement schedule listed in the Index at Item 15(a)(2). These financial statements and schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Coventry Health Care, Inc.’s internal control over financial reporting as of December 31, 2009, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 26, 2010 expressed an unqualified opinion thereon.
Basis of Presentation - The consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States and include the accounts of the Company and its subsidiaries. All inter-company transactions have been eliminated.
Investments - The Company accounts for investments in accordance with ASC 320-10 “Accounting for Certain Investments in Debt and Equity Securities,” ASC 320-10-35-35 “Accounting for Debt Securities After an Other-than-Temporary Impairment,” and with ASC 320-10-65 related to its fixed maturities securities as of April 1, 2009. The Company invests primarily in fixed income securities and classifies all of its investments as available-for-sale. Investments are evaluated on an individual security basis at least quarterly to determine if declines in value are other-than-temporary. In making that determination, the Company considers all available evidence relating to the realizable value of a security. This evidence is reviewed at the individual security level and includes, but is not limited to, the following:
Temporary declines in value of investments classified as available-for-sale are netted with unrealized gains and reported as a net amount in a separate component of stockholders’ equity, net of taxes. When we determine that a decline in fair value below amortized cost is judged to be other-than-temporary we are required to recognize the credit loss component as a charge in net earnings. Realized gains and losses on the sale of investments are determined on a specific identification basis.
Other Receivables - Other receivables include pharmacy rebate receivables of $314.9 million and $220.9 million at the December 31, 2009 and 2008, respectively. Other receivables also include Medicare Part D program related, risk share and subsidy receivables, Medicare risk adjuster receivables, Office of Personnel Management (“OPM”) receivables, receivables from providers and suppliers, interest receivables, and any other receivables that do not relate to premiums. The decrease in other receivables during 2009 primarily resulted from a decrease in the Medicare Part D related receivables, other receivables, and due from seller, partially offset by an increase in the pharmacy rebate receivables.
Other Current Assets - Other Current Assets primarily includes deferred tax assets and also includes prepaid expenses. For more information see Note I., Income Taxes, to consolidated financial statements.
The change in Medicare Part D related subsidy liabilities identified in the table above represent subsidy amounts received from CMS for reinsurance and for cost sharing related to low income individuals. These subsidies are recorded in medical liabilities and we do not recognize premium revenue or claims expense for these subsidies.
Other Long-term Liabilities - Other long-term liabilities consist primarily of deferred tax liabilities, liability for unrecognized tax benefits, and liabilities associated with the 401(k) Restoration and Deferred Compensation Plan.
Comprehensive Income - Comprehensive income includes net earnings and unrealized net gains and losses on investment securities. Other comprehensive income is net of reclassification adjustments to adjust for items currently included in net earnings, such as realized gains and losses on investment securities. The deferred tax provision for unrealized holding gains arising from investment securities during the years ended December 31, 2009, 2008 and 2007 was $25.3 million, $3.0 million, and $6.3 million respectively. The deferred tax provision for reclassification adjustments for gains included in net earnings on investment securities during the years ended December 31, 2009, 2008 and 2007 was $4.5 million, $1.6 million, and $0.5 million, respectively.
Revenue Recognition - Managed care premiums are recorded as revenue in the month in which members are entitled to service. Premiums are based on a per subscriber contract rate and the subscribers in the Company’s records at the time of billing. Premium billings are generally sent to employers in the month proceeding 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. The Company also receives premium payments from Centers for Medicare & Medicaid Services (“CMS”) on a monthly basis for its Medicare membership. Membership and category eligibility are periodically reconciled with CMS and such reconciliations could result in adjustments to revenue. CMS uses a risk adjustment model to determine premium payments to health plans. This risk adjustment model apportions premiums paid to all health plans according to health severity based on diagnosis data provided to CMS. The Company estimates risk adjustment revenues based on the diagnosis data submitted to CMS. Changes in revenue from CMS resulting from the periodic changes in risk adjustments scores for our membership are recognized when the amounts become determinable and the collectibility is reasonably assured.
The Medicare Part D program gives beneficiaries access to prescription drug coverage. Coventry has been awarded contracts by CMS to offer various Medicare Part D plans on a nationwide basis, in accordance with guidelines put forth by the agency. Payments from CMS under these contracts include amounts for premiums, amounts for risk corridor adjustments and amounts for reinsurance and low-income cost subsidies.
The Company has quota share arrangements on business with certain individual and employer groups with two of its Medicare distribution partners covering portions of the Company’s Medicare Part D and Medicare Private Fee for Service products. As a result of the quota share sharing arrangements, for the years ended December 31, 2009, 2008, and 2007, the Company ceded premium revenue of $416.5 million, $574.1 million, and $250.2 million, respectively, and the associated medical costs to these partners. The ceded amounts are excluded from the Company’s results of operations. The Company is not relieved of its primary obligation to the policyholder under this ceding arrangement.
Revenue for pharmacy benefit management services for Workers' Compensation business is derived on a pre-negotiated amount per pharmacy claim which includes the cost of the pharmaceutical. Revenue and a corresponding cost of sales to a third party vendor related to the sale of pharmaceuticals is recorded when a pharmacy transaction is processed by the Company. No pharmacy rebate revenue is collected or recorded related to the Company’s Worker’s Compensation business.
Cost of Sales - Cost of sales consists of the expense for prescription drugs provided by the Company’s workers’ compensation pharmacy benefit manager and for the independent medical examinations performed by physicians on injured workers. These costs are associated with fee-based products and exclude the cost of drugs related to the risk products recorded in medical costs.
Contract Acquisition Costs - Costs related to the acquisition of customer contracts, such as commissions paid to outside brokers, are paid on a monthly basis and expensed as incurred. For the Medicare Advantage business, the Company advances commissions and defers amortization of these costs to the period in which revenue associated with the acquired customer is earned, which is generally not more than one year.
Income Taxes - The Company files a consolidated federal tax return for the Company and its subsidiaries. The Company accounts for income taxes in accordance with ASC Topic 740 “Income Taxes.” The deferred tax assets and/or liabilities are determined by multiplying the differences between the financial reporting and tax reporting bases for assets and liabilities by the enacted tax rates expected to be in effect when such differences are recovered or settled. The effect on deferred taxes of a change in tax rates is recognized in income in the period that includes the enactment date. The realization of total deferred tax assets is contingent upon the generation of future taxable income in the tax jurisdictions in which the deferred tax assets are located. Taxable income includes the impact of the reversal of deferred tax liabilities. Valuation allowances are provided to reduce such deferred tax assets to amounts more likely than not to be ultimately realized.
In June 2009, the FASB established the FASB ASC, or Codification, which on July 1, 2009 became the single official source of authoritative, nongovernmental GAAP, superseding existing FASB, AICPA, EITF, and related literature. Prospectively, only one level of authoritative GAAP will exist, excluding the guidance issued by the SEC. All other literature will be non-authoritative. The Codification does not change GAAP but instead reorganizes the U.S. GAAP pronouncements into accounting topics, and displays all topics using a consistent structure. As the Codification does not change GAAP, it did not have a material effect on the Company’s financial statements. Previous references to applicable literature via the Company’s disclosures have been updated with references to the new Codification section.
In May 2009, the FASB issued ASC Topic 855, “Subsequent Events,” which required the Company to evaluate subsequent events through the date the financial statements are issued. This standard requires an entity to recognize in its financial statements the effects of all subsequent events that provide additional evidence about conditions that existed at the balance sheet date (recognized subsequent events) and prohibits an entity from recognizing the effects of subsequent events that provide evidence about conditions that did not exist at the balance sheet date (non-recognized subsequent events). The Company adopted the provisions of this standard as of June 30, 2009. The adoption of this standard did not impact the Company’s financial position or results of operations. The disclosures required by this standard are presented in Note S, Subsequent Events, to the consolidated financial statements.
In April 2009, the FASB issued ASC 320-10-65-1, “Transition Related to FASB Staff Position FAS 115-2 and FAS 124-2, Recognition and Presentation of Other-Than-Temporary Impairments.” This guidance relates to fixed maturity securities and requires that other-than-temporary impairment losses related to credit deterioration be included in the statements of operations and that losses related to other market factors be included as a component of other comprehensive income. The Company adopted the provisions of this update as of April 1, 2009. The portion of the Company’s impairment charge that was recorded prior to 2009 that was not either related to credit deterioration or to securities that the Company had made the decision to sell was insignificant. Accordingly, the Company did not record a cumulative effect transition adjustment and therefore the adoption of pronouncement did not impact the Company’s financial position or results of operations. The disclosures required by this update are presented in Note G, Investments, to the consolidated financial statements.
In April 2009, the FASB issued ASC 820-10-65-4, “Transition Related to FASB Staff Position FAS 157-4, Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly.” This guidance reaffirms that fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date under current market conditions. This update also reaffirms the need to use judgment in determining if a formerly active market has become inactive and in determining fair values when the market has become inactive. The adoption of this update did not impact the Company’s financial position or results of operations.
In December 2007, the FASB issued ASC 810-10, "Noncontrolling Interests in Consolidated Financial Statements - an Amendment of ARB No. 51," which clarifies that a noncontrolling interest in a subsidiary is an ownership interest in the consolidated entity that should be reported as equity in the consolidated financial statements. ASC 810-10 is effective for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2008. Early adoption is prohibited. The adoption of ASC 810-10 did not impact the Company's financial position or results of operations.
As a result of the change in its executive leadership, the Company realigned its organizational structure during 2009. The Company’s new organizational structure brings enhanced focus to areas of anticipated growth opportunities. As a result, the Company’s reportable segments have changed to the following three reportable segments: Health Plan and Medical Services, Specialized Managed Care, and Workers’ Compensation. Each of these segments, which the Company also refers to as “Divisions,” is separately managed and provides separate operating results that are evaluated by the Company’s chief operating decision maker.
The Specialized Managed Care Division is comprised of its Medicare Part D program, its network rental business (“Network Rental”) and its mental-behavioral health benefits business. As discussed in Note D, Discontinued Operations, to the consolidated financial statements, on July 31, 2009 the Company sold its Medicaid/Public entity business, First Health Services Corporation (“FHSC”). FHSC was a reporting unit within the Specialized Managed Care Division. FHSC operations are recognized within the line item “(Loss) income from discontinued operations, net of tax” in the Company’s consolidated statements of operations and have been excluded from the continuing operations segment results presented below.
The table below summarizes the results from continuing operations of the Company’s reportable segments through the gross margin level, as that is the measure of profitability used by the chief operating decision maker to assess segment performance and make decisions regarding the allocation of resources. A reconciliation of gross margin to operating earnings at a consolidated continuing operations level is also provided. Total assets by reportable segment are not disclosed as these assets are not reviewed separately by the Company’s chief operating decision maker. The dollar amounts in the segment tables are presented in thousands. The Company’s segment results for the prior years have been reclassified to conform to the 2009 presentation.
The following table summarizes the business combinations for the year ended December 31, 2008. The purchase price of each business combination includes the payment for net worth and estimated transition costs. The purchase price, inclusive of all retroactive balance sheet settlements to date and transaction cost adjustments, is presented below (in millions):
On February 13, 2008, the Company completed its acquisition of MHNet, a mental-behavioral health company based in Austin, Texas. On May 14, 2008, the Company completed its acquisition of a majority ownership interest in GDS, a dental company based in Rockville, Maryland. As a result of these acquisitions the Company recorded $111.2 million of goodwill, none of which is expected to be deductible for tax purposes.
The following unaudited pro forma consolidated results of operations assume the acquisitions made during the year ended December 31, 2007 occurred on January 1, 2007 (in millions, except per share data):
The pro forma amounts represent the historical operating results of the Company and its 2007 acquisitions. Excluded from the pro forma are the discontinued operations of FHSC, which was sold in July 2009. Included in the pro forma is the effect of the amortization of finite lived intangible assets arising from the purchase price allocation, interest expense related to financing the acquisitions and the associated income tax effects of the pro forma adjustments. The pro forma amounts assume that debt issuance and debt refinancing that occurred in 2007, which coincided with the acquisitions, would have occurred at the beginning of the year. In addition, the pro forma amounts exclude $35.0 million in acquisition related costs that were incurred as a result of the acquisition. The pro forma amounts are presented for comparison purposes and are not necessarily indicative of the operating results that would have occurred if the acquisitions had been completed at the beginning of the periods presented, nor are they necessarily indicative of operating results in future periods.
As discussed in Note D, Discontinued Operations, to the consolidated financial statements, the Company considered the pending sale of FHSC a potential indicator of impairment and in accordance with ASC Topic 350, it was determined that the carrying value of the reporting unit was in excess of fair value. Fair value was based on the sales price, which is Level 1 in the fair value hierarchy. Accordingly, the Company performed an estimate of the probable impairment loss and recorded a gross impairment charge of $72.4 million during the year ended December 31, 2009.
The Company completed its 2009 annual impairment test of goodwill in accordance with ASC Topic 350 and determined that there were no further impairments. In performing its impairment analysis the Company identified its reporting units in accordance with the provisions of ASC Topic 350 and ASC Topic 280 “Segment Reporting.”
The Company considers all of its investments as available-for-sale securities and, accordingly, records unrealized gains and losses within accumulated other comprehensive income (loss) in the stockholders’ equity section of its consolidated balance sheets. Certain prior year investment balances have been reclassified in the tables below to conform to the 2009 presentation requirements.
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, 2009 and 2008 (in thousands):
The amortized cost and estimated fair value of available for sale debt securities by contractual maturity were as follows at December 31, 2009 and 2008 (in thousands):
Investments with long-term option adjusted maturities, such as residential and commercial mortgage-backed securities, are included in the over 10 year category. Actual maturities may differ due to call or prepayment rights.
Gross investment gains of $14.0 million and gross investment losses of $2.4 million were realized on sales of investments for the year ended December 31, 2009. This compares to gross investment gains of $7.6 million and gross investment losses of $37.0 million that were realized on sales and the other-than-temporary impairment of investments for the year ended December 31, 2008, and gross investment gains of $1.7 million and gross investment losses of $0.5 million that were realized on investment sales for the year ended December 31, 2007. The Company's other-than-temporary impairment charge and its realized gains and losses are recorded in other income, net in the Company's consolidated statements of operations.
During the year ended December 31, 2008, we recognized a $33.5 million other-than-temporary impairment charge related to 31 securities, including our investments in Lehman Brothers Holdings, Inc., certain corporate financial holdings, auction rate securities and mortgage backed and asset-backed securities. This other-than-temporary impairment charge was representative of credit losses and therefore was recognized in earnings.
The Company’s Level 1 securities primarily consist of US Treasury securities and cash. The Company determines the estimated fair value for its Level 1 securities using quoted (unadjusted) prices for identical assets or liabilities in active markets.
The following table presents the fair value hierarchy for the Company’s financial assets measured at fair value on a recurring basis at December 31, 2009 and 2008 (in thousands):
The following table provides a summary of changes in the fair value of the Company’s Level 3 financial assets for the years ended December 31, 2009 and 2008 (in thousands):
Under the Stock Incentive Plan, the terms and conditions of option grants are established on an individual basis with the exercise price of the options being equal to not less than 100% of the fair value of the underlying stock at the date of grant. Options generally become exercisable after one year in either 33% or 25% increments per year and expire ten years from the date of grant. At December 31, 2009, the Stock Incentive Plan had outstanding options representing 13.0 million shares of common stock.
The Company continues to use the Black-Scholes-Merton option pricing model and amortizes compensation expense over the requisite service period of the grant. The methodology used in 2009 to derive the assumptions used in the valuation model is consistent with that used in prior years. The following average values and weighted-average assumptions were used for option grants.
The Company has not paid dividends in the past nor does it expect to pay dividends in the future. As such, the Company used a dividend yield percentage of zero. The Company uses a risk-free interest rate consistent with the yield available on a U.S. Treasury note with a term equal to the expected term of the underlying grants. The expected volatility was estimated based upon a blend of the implied volatility of the Company’s tradeable options and the historical volatility of the Company’s share price. The expected life was estimated based upon exercise experience of option grants made in the past to Company employees.
The Company awarded 1.7 million shares of restricted stock in the twelve months ended December 31, 2009. The value of the Company’s restricted shares is amortized over various vesting periods through 2013. The Company recorded compensation expense related to restricted stock grants, including restricted stock granted in prior periods, of approximately $16.5 million, $25.3 million, and $28.1 million for the years ended December 31, 2009, 2008 and 2007, respectively. The total unrecognized compensation cost (net of expected forfeitures) related to the restricted stock was $36.3 million at December 31, 2009, and is expected to be recognized over a weighted average period of 2.2 years. The weighted-average fair value of restricted stock granted was $16.43, $39.06, and $59.42 per share for the years ended December 31, 2009, 2008 and 2007, respectively. The total fair value of shares vested during the years ended December 31, 2009, 2008 and 2007 was $8.5 million, $17.3 million, and $39.2 million, respectively.
During the twelve months ended December 31, 2009, the Company granted performance share units (“PSUs”) to key employees pursuant to the Stock Incentive Plan. The PSUs represent hypothetical shares of the Company’s common stock. The holders of PSUs have no rights as shareholders with respect to the shares of the Company’s common stock to which the awards relate. The PSUs will vest based upon the achievement of certain performance goals and vest over various periods through 2011. All PSUs that vest will be paid out in cash based upon the price of the Company’s common stock and therefore are classified as a liability by the Company. The liability on the Company’s books at December 31, 2009 was $13.8 million, of which $10.9 million was paid out in February 2010.
The Company adopted ASC 740-10 “Accounting for Uncertainty in Income Taxes,” effective January 1, 2007 which clarifies the accounting for uncertainty in income taxes recognized in the financial statements in accordance with ASC Topic 740 “Income Taxes” on January 1, 2007. ASC 740-10 prescribes a more likely than not threshold for financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. For a tax benefit to be recognized, a tax position must be more likely than not to be sustained upon examination by applicable taxing authorities. The benefit recognized is the amount that has a greater than 50% likelihood of being realized upon final settlement of the tax position. The change in net assets, because of applying this pronouncement, is considered a change in accounting principle with the cumulative effect of the change required to be treated as an adjustment to the opening balance of retained earnings. The cumulative effect of implementing ASC 740-10 was an increase of $3.4 million to the beginning balance of retained earnings for the year ended December 31, 2007.
A reconciliation of the total amounts of unrecognized tax benefits for the years ended December 31, 2009, 2008 and 2007 is as follows (in thousands):
The Company is regularly audited by federal, state and local tax authorities, and from time to time these audits result in proposed assessments. Tax years 2006-2008 remain open to examination by these tax jurisdictions. The Company believes appropriate provisions for all outstanding issues have been made for all jurisdictions and all open years.
During the year ended December 31, 2009, the Internal Revenue Service (“IRS”) completed its examination of the income tax returns of the Company for the years ended December 31, 2005 and 2006. Tax assessed as a result of this examination was not material. During the year ended December 31, 2008, the IRS completed its examination of the income tax returns of First Health Group Corporation ("FHGC") for all years through 2004. Additionally, the Company settled certain income tax examinations with various state and local tax authorities. Tax assessed as a result of these examinations, if any, was not material. FHGC is also subject to ongoing examinations by certain state tax authorities for pre-acquisition years. The Company believes that appropriate provisions have been provided for all FHGC open tax years.
The cost, principally employer matching contributions, of RESTORE charged to operations for 2009, 2008 and 2007 was $0.9 million, $0.2 million, and $1.8 million, respectively.
The Company’s outstanding debt was as follows at December 31, 2009 and 2008 (in thousands):
5.95% Senior notes due 3/15/17, net of repurchases and unamortized discount of $1,022 at December 31, 2009
During 2009 the Company repaid a total of $68.9 million principal of outstanding senior notes for payments of $59.9 million, resulting in a gain of $8.4 million. These gains were net of the write off of deferred financing costs. The funds for the repayments were provided by cash from operations.
During November and December 2008, the Company repaid a principal total of $10 million of its outstanding 5.95% Senior Notes due March 15, 2017.
During 2008 the Company drew down $543.5 million from its Revolving Credit Facility and repaid $103.5 million of this amount. The remaining outstanding balance of $615.0 million was used to optimize the Company’s liquidity position during the current uncertain macroeconomic environment and for general corporate purposes. Also, from time to time throughout 2008 the Company drew down amounts as needed and repaid certain amounts on its Revolving Credit Facility for general corporate purposes.
As of December 31, 2009, the aggregate maturities of debt based on their contractual terms, gross of unamortized discount, are as follows (in thousands):
As of December 31, 2009, the Company is contractually obligated to make the following minimum lease payments within the next five years and thereafter (in thousands):
The Company operates in leased facilities with original lease terms of up to thirteen years with options for renewal. Total rent expense was $35.6 million, $40.8 million, and $33.1 million, for the years ended December 31, 2009, 2008 and 2007, respectively.
The Company has received a subpoena from the U.S. Attorney for the District of Maryland, Northern Division, requesting information regarding the operational process for confirming Medicare eligibility for its Workers Compensation set-aside product. The Company is fully cooperating and is providing the requested information. The Company cannot predict what, if any, actions may be taken by the U.S. Attorney. However, based on the information known to date, the Company does not believe that the outcome of this inquiry will have a material adverse effect on its financial position or results of operations.
First Health Group Corp, Inc. (“FHGC”), a subsidiary of the Company, is a party to various lawsuits filed in the state and federal courts of Louisiana involving disputes between providers and workers compensation payors who access FHGC’s contracts with these providers to reimburse them for services rendered to injured workers. FHGC has written contracts with providers in Louisiana which expressly state that the provider agrees to accept a specified discount off their billed charges for services rendered to injured workers. The discounted rate set forth in the FHGC provider contract is less than the reimbursement amount set forth in the Louisiana Workers Compensation Fee Schedule. For this reason, workers compensation insurers and third party administrators (“TPAs”) for employers who self insure worker compensation benefits, contract with FHGC to access the FHGC provider contracts. Thus, when a FHGC contracted provider renders services to an injured worker, the workers compensation insurer or the TPA reimburses the provider for those services in accordance with the discounted rate in the provider’s contract with FHGC. These workers compensation insurers and TPAs are referred to as “payors” in the FHGC provider contract and the contract expressly states that the discounted rate will apply to those payors who access the FHGC contract. Thus, the providers enter into these contracts with FHGC knowing that they will be paid the discounted rate by every payor who chooses to access the FHGC contract. So that its contracted providers know which payors are accessing their contract, FHGC sends regular written notices to its contracted providers and maintains a provider website which lists each and every payor who is accessing the FHGC contract.
On September 3, 2009, a shareholder, who owns less than 5,000 shares, filed a putative securities class action against the Company and three of its current and former officers in the federal district court of Maryland. Subsequent to the filing of the complaint, three other shareholders and/or investor groups filed motions with the court for appointment as lead plaintiff and approval of selection of lead and liaison counsel. By agreement, the four shareholders submitted a stipulation to the court regarding appointment of lead plaintiff and approval of selection of lead and liaison counsel. In December, 2009, the court approved the stipulation and ordered the lead plaintiff to file a consolidated and amended complaint. To date, no consolidated and amended complaint has been filed. The purported class period is February 9, 2007 to October 22, 2008. The complaint alleges that the Company’s public statements contained false, misleading and incomplete information regarding the Company’s profitability, particularly the profit margins for its Medicare PFFS products. The Company will vigorously defend against the allegations in the lawsuit. Although it cannot predict the outcome, the Company believes this lawsuit will not have a material adverse effect on its financial position or results of operations.
There are several lawsuits filed against Vista Health Plan by non-participating providers seeking to be paid their full billed charges for services rendered to Vista's members. Vista reimburses non-participating providers at rates which are usual and customary for similar services in the same geographical area. Based on the various stages of development of these lawsuits, including discussions of settlement, the Company has recognized reserves for estimates of probable loss. Although it cannot predict the outcome, the Company believes these lawsuits will not have a material adverse effect on its financial position or results of operations.
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 2.9%, 4.1%, and 4.9% of the Company’s total medical costs for the years ended December 31, 2009, 2008 and 2007, respectively.
The Company contracts with a pharmacy benefit manager (“PBM”) to manage our pharmacy benefits for our members and to provide rebate administration services on behalf of the Company. As of December 31, 2009, the Company had pharmacy rebate receivables of $314.9 million due from the PBM resulting from the normal cycle of rebate processing, data submission and collection of rebates. The Company has credit risk due to the concentration of receivables with this single vendor. The Company only records the pharmacy rebate receivables to the extent that the amounts are deemed probable of collection.
Excluding funds held by entities subject to regulation and excluding our equity method investments, the Company had cash and investments of approximately $713.0 million and $549.9 million at December 31, 2009 and 2008, respectively. The increase resulted from the proceeds received from the disposal of FHSC, earnings from non-regulated businesses, and dividends from the Company’s regulated subsidiaries. These were partially offset by capital infusions into the Company’s subsidiaries, and payments made for share repurchases.
Other income, net for the years ended December 31, 2009, 2008 and 2007 includes interest income, net of fees, of approximately $65.5 million, $104.6 million, and $138.7 million, respectively. Other income, net also includes gains of $8.4 million and $4.6 million on the repayment of outstanding debt for the years ended December 31, 2009 and 2008, respectively. For the year ended December 31, 2009, other income, net included a gain on disposal of investments of $11.6 million. For the year ended December 31, 2008, other income, net included a charge of $33.5 million for the other-than-temporary impairment of investment securities.
The Company’s Board of Directors has approved a program to repurchase its outstanding common shares. Share repurchases may be made from time to time at prevailing prices on the open market, by block purchase, or in private transactions. Under the share repurchase program the Company purchased 1.5 million shares of its common stock during 2009 at an aggregate cost of $30.0 million, 7.3 million shares during 2008 at an aggregate cost of $318.0 million, and 7.5 million shares during 2007 at an aggregate cost of $429.0 million. As of December 31, 2009, the total remaining common shares the Company is authorized to repurchase under this program is 5.2 million. Excluded from these amounts are shares purchased in exchange for employee payroll taxes on vesting of restricted stock awards as these purchases are not part of the program.
The following is a summary of unaudited quarterly results of operations (in thousands, except per share data) for the years ended December 31, 2009 and 2008. Due to rounding of quarterly results, total amounts for each year may differ immaterially from the annual results.
On February 1, 2010 the Company completed its previously announced acquisition of Preferred Health Systems, Inc. (“PHS”), a commercial health plan based in Wichita, Kansas serving more than 100,000 commercial group risk members and 20,000 commercial self-funded members.