Our executive offices are located in White Plains, New York, with regional offices for various administrative and operations staff in Lake Mary, Florida, Houston, Texas, Brookfield, Wisconsin, Columbia, Maryland, Mechanicsburg, Pennsylvania and San Juan, Puerto Rico. Our Medicare Advantage operations occupy office space in Houston, Texas, Dallas, Texas, and Oklahoma City, Oklahoma. In addition, we maintain other smaller, local offices to support Medicaid contracts, as well as a number of mental health clinics under our Medicaid contract in Puerto Rico. We lease a total of approximately 596,000 square feet of office space. Management considers its office facilities suitable and adequate for the current level of operations. Additional information regarding our lease obligations is included in Note 24-Commitments and Contingencies in the Notes to Consolidated Financial Statements included in this Annual Report on Form 10-K.
The following discussion and analysis presents a review of our financial condition as of December 31, 2013 and our results of operations for the years ended December 31, 2013, 2012 and 2011. As used in this report, except as otherwise indicated, references to the "Company," "Universal American," "we," "our," and "us" are to Universal American Corp., a Delaware corporation and its subsidiaries.
Universal American, through our health insurance and managed care subsidiaries, primarily serves the growing Medicare population by providing Medicare Advantage products. Approximately 30% of the Medicare population in the United States is currently enrolled in Medicare Advantage plans, a type of Medicare health plan offered by private companies that contract with the federal government to provide enrollees with health insurance. Our current focus is to grow our Medicare Advantage business in our core markets, which largely consists of our health plans offered in the Southwest and Upstate New York markets. In addition, we believe there is an opportunity to address the high cost of health care for the remaining 70% of the Medicare population enrolled in traditional fee-for-service Medicare and have joined primarily with primary-care and multi-specialty provider groups to form thirty-four Accountable Care Organizations, or ACOs, pursuant to the Medicare Shared Saving Program, or Shared Savings Program. We also provide Medicaid services to Medicaid agencies through APS Healthcare and recently acquired the Total Care Medicaid health plan serving approximately 35,000 members in Upstate New York.
•Expand our relationships with health care providers both within and outside our Medicare Advantage footprint to further develop existing and additional ACOs.
•Employ our medical management capabilities to improve the health and well-being of those we serve and reduce healthcare costs.
•Develop additional capabilities to participate in the growing dual eligible and long-term care sectors.
CMS assigns a beneficiary to the preliminary roster of an ACO if the ACO physicians billed for a "plurality" of services during the calendar year preceding the performance period. A plurality means the ACO physicians provided a greater proportion of primary care services, measured in terms of allowed charges, than the physicians in any other ACO or Medicare-enrolled tax- identification number. CMS sets the benchmark for each ACO using the historical medical costs of the beneficiaries assigned to an ACO. At the end of the ACO performance period, CMS applies the same plurality definition but to a different time period, the actual performance period. CMS does not fully update the benchmark to reflect the new mix of beneficiaries assigned during the performance period. As a result, many beneficiaries originally assigned to an ACO at the beginning of a performance year (i.e. January 1) may
no longer be on the ACOs roster at the end of a performance year (i.e. December 31) if they did not see a physician in the ACO during the performance year. As a result, many ACOs may experience a significant attrition of healthier patients in their ACO rosters that were included in the original benchmark set by CMS but had not received care during the performance period itself. This can have a significant adverse impact on an ACOs ability to achieve shared savings. Accordingly, it will be important for ACOs to ensure that all the assigned beneficiaries to an ACO continue to receive wellness and other services during the year to ensure they are assigned to the ACO at the end of the performance period.
Due to the Medicaid expansion provisions under the Affordable Care Act, CMS projects that Medicaid expenditures will increase from approximately $420 billion in 2012 to approximately $740 billion by 2020. In addition, as part of the Affordable Care Act, approximately 15 million additional people are expected to qualify for Medicaid in 2015.
A portion of Medicaid beneficiaries are dual eligibles, low-income seniors and people with disabilities who are enrolled in both Medicaid and Medicare. Based on CMS and Kaiser Family Foundation data, we estimate there are approximately 10 million dual eligible enrollees with annual spending of approximately $400 billion. Only a small portion of the total spending on dual eligibles is
Health Insurance Exchanges are a key component of the Affordable Care Act. The Exchanges offer individuals and small businesses the opportunity to obtain health insurance through private companies. Each State has the option of operating its own Exchange, partnering with the federal government or defaulting to a federally-run Exchange. Insurers are required to offer a minimum level of benefits with three levels of coverage that vary based on premiums and out-of-pocket costs. On January 1, 2014, we launched an Exchange product in Upstate New York. As of March 1, 2014, we have less than 300 members in our Exchange product.
In March 2010, President Obama signed into law the Affordable Care Act, legislating broad-based changes to the U.S. health care system. Certain provisions of the health reform legislation have already taken effect, and others become effective at various dates over the next several years. Due to the complexity of the health reform legislation, including yet to be promulgated implementing regulations, lack of interpretive guidance, and gradual implementation, the impact of the health reform legislation remains difficult to predict and quantify. In addition, we believe that any impact from the health reform legislation could potentially be mitigated by certain actions we may take in the future including modifying future Medicare Advantage bids to compensate for such changes. For example, the anticipation of additional revenues from STAR bonuses or reduced CMS reimbursement rates are factored into the anticipated level of benefits included in our Medicare Advantage bids for the upcoming year.
•implementation of a quality bonus for STAR ratings, beginning in 2012;
•limitation on the federal tax deductibility of compensation earned by individuals, beginning in 2013; and
Reduced Medicare Advantage reimbursement rates-Beginning in 2012, the Medicare Advantage "benchmark" rates began the transition to target Medicare fee-for-service cost benchmarks of 95%, 100%, 107.5% or 115% of the calculated Medicare fee-for-service costs. The transition period is 2, 4 or 6 years depending upon the applicable county. The counties are divided into quartiles based on each county's fee-for-service Medicare costs. We estimate that approximately 58% of our current membership resides in counties where the Medicare Advantage benchmark rate will equal 95% of the calculated Medicare fee-for-service costs, with approximately 95% of these members having a 6 year transition period. Under the law, the premiums for such members commenced the transition to 95% of Medicare fee-for-service costs beginning in 2012. This followed the freezing of Medicare Advantage reimbursement rates in 2011 based on our 2010 levels.
Implementation of quality bonus for STAR ratings-Beginning in 2012, Medicare Advantage plans with an overall "STAR rating" of three or more stars (out of five) based on 2011 performance are eligible for a "quality bonus" in their basic premium rates. Plans receiving STAR bonus payments are required to use the additional dollars to provide "extra benefits" for the plans' enrollees, to comply with required minimum loss ratios, resulting in a competitive advantage for those plans rather than a direct financial impact. The Affordable Care Act limits these quality bonuses to the plans that achieve 4 or more stars as their overall rating, but CMS is using demonstration authority to expand the quality bonus to 3 STAR plans for a three year period that will end December 31, 2014. In addition, beginning in 2012, Medicare Advantage STAR ratings affect the rebate percentage available for plans to provide additional member benefits (plans with quality ratings of 3.5 stars or above will have their rebate percentage increased from a base rate of 50% to 65% or 70%). In all cases, this rebate percentage is lower than the pre-Affordable Care Act rebate percentage of 75%. Our Medicare Advantage plans for 2014 are rated from 3.0 to 4.0 stars out of 5.0, with approximately 75% of our core membership now in
Stipulated minimum MLRs-Beginning in 2014, the new healthcare reform legislation will stipulate a minimum medical loss ratio, or MLR, of 85% for Medicare Advantage plans. This MLR takes into account benefit costs, quality initiative expenses, the ACA fee and taxes. Financial and other penalties may result from failing to achieve the minimum MLR ratio. Our reported Medicare Advantage MLR was 83.4% for the year ended December 31, 2013 and 80.6% for the year ended December 31, 2012. Although the methodology for defining medical costs and for calculating MLRs was recently defined by CMS, it remains subject to interpretation and we are continuing to evaluate its impact. Complying with such minimum ratio by increasing our medical expenditures or refunding any shortfalls to the federal government could have a material adverse effect on our operating margins, results of operations, and our statutory required capital.
annually. This fee will first be expensed and paid in 2014 and will affect the profitability of our Medicare Advantage business and could have a material adverse effect on our results of operations. We have estimated that the fee to be paid in 2014, based on 2013 net written premiums, will be approximately $22 million. Pursuant to the guidance issued by the FASB in July 2011, for reporting in accordance with U.S generally accepted accounting principles (GAAP), the liability for the fee will be estimated and recorded in full once the entity provides qualifying health insurance in the corresponding period with a corresponding deferred cost that is to be amortized to expense on a straight-line basis over the applicable calendar year. For statutory reporting purposes, the fee will be expensed on January 1 in the year of payment, rather than amortized to expense over the year. The ACA fee will be included in other operating costs, however, will be factored in when calculating the stipulated minimum MLR.
Limitation on the federal tax deductibility of compensation earned by individuals-Beginning in 2013, with respect to services performed during 2010 and afterward, for health insurance companies, the federal tax deductibility of compensation will be limited under Section 162(m)(6) of the Code to $500,000 per individual and will not contain an exception for "performance-based compensation." This limitation has increased our effective tax rate by approximately 60 basis points for the year ended December 31, 2013 and 200 basis points for the year ended December 31, 2012.
In addition, CMS, the US Office of Inspector General, the Internal Revenue Service, the Federal Trade Commission, the US Department of Justice, and various states have adopted or are considering adopting new legislation, rules, regulations and guidance relating to formation and operation of ACOs. Such laws may, among other things, require ACOs to become subject to financial regulation such as maintaining deposits of assets with the states in which they operate, the filing of periodic reports with the insurance department and/or department of health, or holding certain licenses or certifications in the jurisdictions in which the ACOs operate. Failure to comply with legal or regulatory restrictions may result in CMS terminating an ACO's agreement with CMS and/or subjecting an ACO to loss of the right to engage in some or all business in a state, payment of fines or penalties, or may implicate federal and state fraud and abuse laws relating to anti-trust, physician fee-sharing arrangements, anti-kickback prohibitions or prohibited referrals, any of which may adversely affect our operations and/or profitability.
All of the 2013 distribution was a return of capital for federal tax purposes and will not be currently taxable. The return of capital distribution reduces the holder's basis in their Universal American stock. For example, if you owned 100 shares of Universal American Corp. common stock on the record date, August 12, 2013, you received a $160 distribution. Of that distribution no amount is currently taxable; the entire $160 is a return of capital that reduces your basis in each share of stock by $1.60.
A portion of the 2012 special cash dividend was a return of capital for federal tax purposes and was not considered taxable. The return of capital portion reduced the holder's basis in their Universal American Corp. common stock. The breakdown is as follows:
The following table presents our membership in Medicare Advantage products as of December 31:
On March 2, 2012, we acquired APS Healthcare at a purchase price of $222.3 million. The allocation of the purchase price resulted in goodwill of $164.8 million and other intangible assets of $29.2 million. During calendar year 2013, we recorded an impairment of $189.4 million, which included impairments to goodwill of $164.8 million, amortizing intangibles of $16.1 million and tangible assets of $8.5 million. See Critical Accounting Policies elsewhere in this section and Note 8-Goodwill and Other Intangible Assets of Notes to consolidated financial statements for further information.
(1)We evaluate the results of operations of our segments based on income (loss) before realized gains and losses and income taxes. We believe that realized gains and losses are not indicative of overall operating trends. This differs from U.S. generally accepted accounting principles, which reflects the effect of realized gains and losses in the determination of net income (loss). The schedule above reconciles our segment income (loss), to net (loss) income in accordance with U.S. generally accepted accounting principles.
Our effective tax rate on continuing operations was 5.4% for 2013 compared with 31.7% for 2012. The variance in the 2013 effective tax rate compared with the 35% federal rate was driven by permanent items relating primarily to non-deductible goodwill impairment, the limitation on the deductibility of executive compensation for health insurers enacted in the Affordable Care Act, interest on the mandatorily redeemable preferred stock, foreign and state income taxes and non-recurring tax expenses. The effective tax rate in 2012 was favorably impacted by the recognition of certain state tax benefits, partially offset by permanent items, including non-deductible executive compensation and interest.
Our Traditional Insurance segment generated income before taxes of $18.1 million for 2012; an increase of $2.4 million compared to 2011. The increase in earnings is driven by an improvement in the underwriting performance of the Medicare Supplement business and a reduction in commissions and general expenses, which was partially offset by the continued decline of our insurance-in-force, particularly in the Senior Market and Specialty Health lines.
Our effective tax rate on continuing operations was 31.7% for 2012, compared with 72.6% for 2011. The effective tax rate in 2012 was favorably impacted by the recognition of certain state tax benefits, partially offset by the limitation on the deductibility of executive compensation for health insurers enacted in the Affordable Care Act. The effective tax rate in 2011 was driven by our low pre-tax income that magnified the effective rate impact of revenue based state taxes on lines of business for which revenues were relatively constant year-over-year and permanent non-deductible items. Excluding non-recurring tax benefits (discussed below), revenue-based state taxes and certain items that arose in connection with the 338(h)(10) election, the effective tax rate was 41.1% in 2012, compared with 44.0% in 2011, with permanent items of $1.2 million contributing 11.9% to the rate in 2011.
Our Senior Managed Care-Medicare Advantage segment includes the operations of our Medicare coordinated care HMO, PPO, network-based PFFS and non-network (Rural) PFFS Plans (collectively, the "Plans"), which provides coverage to Medicare beneficiaries in 34 states. Our HMOs offer coverage to Medicare beneficiaries primarily in Southeastern Texas, the area surrounding Dallas/Ft. Worth, 16 counties in Oklahoma and 3 counties in Indiana.
Net investment and other income. Net investment and other income decreased $4.7 million due to the payment of dividends to the parent in 2013 and due to the maturity of higher yielding assets with the proceeds being reinvested in lower yielding securities in this low interest rate environment.
Commissions and general expenses. Commissions and general expenses for the year ended December 31, 2013 decreased $11.2 million compared to the year ended December 31, 2012, primarily as the result of the decreased level of membership. Our administrative expense ratio improved to 14.3% for the year ended December 31, 2013 from 15.0% in 2012 primarily as a result of our cost reduction efforts. Included in our 2013 general expenses are $28.7 million of expenses, or 1.8% of premium, that are considered quality initiative expenses, which will be reported in medical expenses in 2014.
Net premiums. Net premiums for the Senior Managed Care-Medicare Advantage segment decreased by $340.9 million compared to the year ended December 31, 2011, primarily due to the decline in membership. In 2012, net premiums included $34.4 million of net favorable prior year items compared to $26.9 million in 2011.
Net investment income. Net investment income decreased by $1.2 million, primarily due to the maturity of higher yielding assets with the proceeds being reinvested in lower yielding securities in this low interest rate environment, as well as a lower invested asset base due to the payment of dividends in 2013 and the declining blocks of business.
Change in deferred acquisition costs. The change in deferred acquisition costs increased $7.2 million compared to 2012. This was primarily caused by the lower capitalization in 2013 due to the decision to discontinue marketing and selling Traditional insurance products in mid-2012.
Our Traditional Insurance segment generated income before taxes of $18.1 million for 2012, an increase of $2.4 million compared to 2011. The increase in earnings is driven by an improvement in the underwriting performance of the Medicare Supplement business and a reduction in commissions and general expenses, which was partially offset by the continued decline of our insurance-in-force, particularly in the Senior Market and Specialty Health lines.
Net investment income. Net investment income decreased by $2.1 million, primarily due to the maturity of higher yielding assets with the proceeds being reinvested in lower yielding securities in this low interest rate environment, as well as a lower invested asset base on the declining blocks of business.
The loss before income taxes from our Corporate & Other segment increased by $231.7 million for the year ended December 31, 2013 compared to 2012. This was due primarily to asset impairment charges related to APS Healthcare totaling $189.4 million, with $97.7 million taken in the fourth quarter of 2013 and $91.7 million taken in the second quarter of 2013, as well as a $19.9 million increase in total ACO costs in 2013, an increase in business development costs, and lower profitability of our APS Healthcare business.
Fee and other income. Fee and other income decreased by $23.6 million for the year ended December 31, 2013 compared to 2012 primarily due to lower levels of fee for service business at APS Healthcare, partially offset by including a full year of APS Healthcare results in 2013, compared with ten months in 2012.
Claims and other benefits. Claims and other benefits increased by $40.6 million for the year ended December 31, 2013 compared to 2012, primarily related to 2013 including a full year of APS Healthcare results compared to ten months in 2012 as well as higher utilization levels in our APS Puerto Rico business. In addition, 2013 included one month of Total Care benefits, amounting to $11.7 million.
Commissions and general expenses. Total commissions and general expenses decreased by $6.8 million for the year ended December 31, 2013 compared to 2012. This was driven by an $11.2 million decrease at APS Healthcare primarily related to expense reduction initiatives and lower levels of business. In addition, operating expenses of our CHS subsidiary declined by $3.4 million, as more ACO development costs were incurred in 2012 as compared to 2013 (see further discussion below). General corporate expenses increased $6.3 million compared with 2012, primarily related to business development activities. 2013 also included one month of Total Care results amounting to $1.5 million.
Equity in losses of unconsolidated subsidiaries. This line represents our share of losses on our unconsolidated ACO subsidiaries. Including the ACO operating expenses of our CHS subsidiary reported in commissions and general expenses above, total ACO costs were $41.6 million for the year ended December 31, 2013 compared with $21.7 million for 2012 and represent the start-up and operating costs of our ACO business. The increase of $19.9 million is driven by increased operating costs, as there were thirty-one ACO entities in operation in 2013 compared to sixteen at December 31, 2012. We did not recognize any ACO revenue for the year ended December 31, 2013. We expect that any revenue for the initial program periods ending December 31, 2013 will be reported in 2014. Based on the ACO operating agreements, we bear all costs of the ACO operations until revenue is
Fee and other income. Fee and other income increased by $120.6 million for the year ended December 31, 2012 primarily due to ten months of results related to APS Healthcare, acquired on March 2, 2012.
Interest expense. This represents interest related to the credit facility entered into in connection with our acquisition of APS Healthcare on March 2, 2012 and dividends on the Mandatorily Redeemable Preferred Shares, which was issued on April 29, 2011.
Restructuring costs. These costs represent charges we took in connection with several initiatives to realign our organization and consolidate certain functions to increase efficiency and responsiveness to customers and reduce costs. The 2012 cost represents charges for severance and other benefits related to a workforce reduction plan. In 2011, the $22.0 million of charges include the write-off of $11.8 million invested in the development of a commission administration system for our Career agents, charges of $5.8 million to reduce agent balances to the amount we expect to recover, $4.2 million for severance and other benefits related to a workforce reduction plan and $0.2 million related to lease termination.
Asset impairment charges. Asset impairment charges of $15.6 million in 2011 represents the write-off of an intangible asset related to our acquisition of a Career agency sales force. As a result of our closure of our Career Agency operations, we reviewed the recoverability of that asset and determined that its carrying value was greater than its fair value.
Commissions and general expenses. Total commissions and general expenses increased by $128.6 million for the year ended December 31, 2012 primarily due to ten months of operating expense of APS Healthcare, acquired on March 2, 2012. In addition, operating expenses of our CHS subsidiary were $11.5 million in 2012, as we incurred ACO development costs (see further discussion below). These increases were partially offset by a $5.5 million decrease in general corporate expenses as compared to 2011, primarily due to insurance recoveries in 2012 related to litigation settled in prior years and reimbursement from CVS Caremark for certain services provided under a transition services agreement in connection with the Medicare Part D sale, partially offset by $3.7 million of costs incurred in connection with the acquisition of APS Healthcare. 2011 included $4.8 million related to
Equity in losses of unconsolidated subsidiaries. This line represents our share of losses on our unconsolidated ACO subsidiaries. Including the ACO operating expenses of our CHS subsidiary reported in commissions and general expenses above, total ACO costs were $21.7 million for year ended December 31, 2012 and represent the start-up and operating costs of our ACO business. There we no such costs recognized in 2011. Based on the ACO operating agreements, we bear all costs of the ACO operations until revenue is recognized. At that point, we share in 100% of the revenue up to our costs incurred. Any remaining profit is generally shared equally with our ACO provider partners.
•the cash flows of our other subsidiaries, including our management service organization and APS Healthcare-Net cash flows from our management service organization and APS Healthcare available to our parent company amounted to approximately $1.3 million during the year ended December 31, 2013.
•payment of dividends to shareholders-We do not currently pay a regular dividend to our shareholders, however, we have paid special dividends in the past. On August 1, 2013, the Board of Directors of the Company approved the payment of a special cash dividend of $1.60 per share, payable on August 19, 2013 to shareholders of record as of August 12, 2013. The total dividend payment was $142.1 million of which $139.9 million was paid on August 19, 2013, with the balance to be paid in the future to holders of our restricted stock as such shares vest. Payment of any future dividends would be dependent upon an evaluation of excess capital, as discussed below.
•payment of dividends to holders of our mandatorily redeemable preferred shares-Dividends to holders of our mandatorily redeemable preferred shares amount to $3.4 million per year and we have paid $3.4 million during the year ended December 31, 2013. The $40 million face value of those shares cannot be redeemed prior to 2017, unless there is a change of control of the Company.
•payment of debt principal, interest and fees required under our 2012 Credit Facility-During the year ended December 31, 2013, we made principal payments of $28.5 million, which included prepayment of all mandatory 2014 principal payments totaling $14.3 million in connection with our November 2013 amendment interest payments of $3.2 million and other fee payments totaling $0.5 million. There is a bullet payment of $74.9 million due in 2017.
•payment of certain corporate overhead costs and public company expenses-Payments of certain corporate overhead costs and public company expenses amounted to $28.5 million for the year ended December 31, 2013.
Our insurance and HMO subsidiaries are required to maintain minimum amounts of statutory capital and surplus as required by regulatory authorities and each currently exceeds its respective minimum requirement at levels we believe are sufficient to support their current levels of operation. Additionally, the National Association of Insurance Commissioners, known as the NAIC, imposes regulatory risk-based capital, known as RBC, requirements on insurance companies. The level of RBC is calculated and reported annually. A number of remedial actions could be enforced if a company's total adjusted capital is less than 200% of authorized control level RBC. However, we generally consider target surplus to be 350% of authorized control level RBC. At December 31, 2013, all but one of our insurance subsidiaries had total adjusted capital in excess of our target of 350% of authorized control level RBC. One insurance company fell slightly below our target surplus with a 310% ratio, but still has total adjusted capital well in excess of the NAIC's 200%. Excess capital can be used by the insurance and HMO subsidiaries to make dividend payments to their respective holding companies, subject to certain restrictions, and from there to our parent company.
At December 31, 2013, we held cash and invested assets of approximately $900 million at our insurance and HMO subsidiaries that could readily be converted to cash. We believe that this level of liquidity is sufficient to meet our obligations and pay expenses.
$148.9 million paid in June, $51.5 million paid in July and the balance of $43 million paid in the fourth quarter of 2013. These are summarized in the following table:
At December 31, 2013, cash and cash equivalents represent approximately 7% of our total cash and invested assets, approximately 25% of cash and invested assets were held in securities backed by the U.S. government or its agencies and the average credit quality of our total investment portfolio was AA-.
The average book yield of our total investment portfolio was 3.3% at December 31, 2013 and December 31, 2012.
The 2012 Credit Facility contains customary representations and warranties as well as customary affirmative and negative covenants. Negative covenants include, among others, limitations on the incurrence of indebtedness, limitations on the incurrence of liens and limitations on acquisition, dispositions, investments and restricted payments. In addition, the 2012 Credit Facility contains certain financial covenants relating to minimum risk-based capital, consolidated leverage ratio, and consolidated debt service ratio. The 2012 Credit Facility also contains customary events of default. Upon the occurrence and during the continuance of an event of default, the Lenders may declare the outstanding advances and all other obligations under the 2012 Credit Facility immediately due and payable. As of December 31, 2013, and throughout the year then ended, we were in compliance with all financial covenants, as amended.
The 2012 Credit Facility bears interest at rates equal to, at our election, LIBOR or the base rate, plus an applicable margin that varies based on our consolidated leverage ratio from 1.75% to 2.50%, in the case of LIBOR loans, and from 0.75% to 1.50% in the case of base rate loans. Effective December 31, 2013, the interest rate on the term loan portion of the 2012 Credit Facility was 2.67%, based on a spread of 2.50% above LIBOR.
Our consolidated financial statements have been prepared in accordance with U.S. Generally Accepted Accounting Principles, known as GAAP. The preparation of our financial statements in conformity with GAAP requires us to make estimates and assumptions that affect the amounts of reported by us in our consolidated financial statements and the accompanying notes. Critical accounting policies are ones that require significant subjective or complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain. These estimates are based on information available at the time the estimates are made, as well as anticipated future events. Actual results could differ materially from these estimates. We periodically evaluate our estimates, and as additional information becomes available or actual amounts become determinable, we may revise the recorded estimates and reflect them in operating results. We believe that the following accounting policies are critical, as they involve the most significant judgments and estimates used in the preparation of our consolidated financial statements:
Policyholder account balances represent the balance that accrues to the benefit of the policyholder, otherwise known as the account value, as of the financial statement date. Account values increase to reflect additional deposits received and interest credited based on the account value. Account values decline to reflect surrenders and other withdrawals, including withdrawals relating to the cost of insurance and expense charges. We review the interest crediting rates periodically and adjust them with minimum levels below which the crediting rate cannot fall as we deem necessary. The liability for future policy benefits represents the present value of estimated future benefits to be paid to or on
•the inflationary effect on the cost per unit of each of these expense components.
The claim reserve balances at December 31, 2012 settled during 2013 for $5.9 million more than originally estimated. This prior year development represents less than 0.4% of the incurred claims recorded in 2012 and was primarily due to unfavorable development in our Medicare Advantage PFFS Plans.
The following table illustrates the sensitivity of our health IBNR payable at December 31, 2013 to identified reasonably possible changes to the estimated weighted average completion factors and healthcare cost trend rates. However, it is possible that the actual completion factors and healthcare cost trend rates will develop differently from our historical patterns and therefore could be outside of the ranges illustrated below.
•incremental direct costs of a successful contract acquisition, such as non-level commissions, and
We test for the recoverability of DAC at least annually. To the extent that we determine that the present value of future policy premiums and investment income or the net present value of expected gross profits would not be adequate to recover the unamortized costs, we would write off the excess deferred policy acquisition costs. Based on our annual tests, we determined that DAC was recoverable in 2013 and 2012.
Goodwill. Goodwill represents the amount of the purchase price in excess of the fair values assigned to the underlying identifiable net assets of acquired businesses. Goodwill is not amortized, but is subject to an annual impairment test. ASC 350, Goodwill and Other Intangible Assets, requires that goodwill balances be reviewed for impairment at the reporting unit level at least annually or more frequently if events occur or circumstances change that would indicate that a triggering event, as defined in ASC 350, has occurred. A reporting unit is defined as an operating segment or one level below an operating segment. Our reporting units are equivalent to our operating segments. We have goodwill assigned to our Senior Managed Care-Medicare Advantage, APS Healthcare and Total Care reporting units. The goodwill related to the acquisition of APS Healthcare and the assets of Total Care is included in our Corporate and Other segment.
We estimate the fair values of our reporting units using discounted cash flows, which include assumptions about a wide variety of internal and external factors. Significant assumptions used in the impairment analysis include financial projections of cash flow (including significant assumptions about operations and target capital requirements), long term growth rates for determining terminal value, and discount rates. Forecasts and long term growth rates used for our reporting units are consistent with, and use inputs from, our internal long term business plan and strategy. During our forecasting process, we assess revenue trends, medical cost trends, operating cost levels and target capital levels. Significant factors affecting these trends include changes in membership, premium yield, medical cost trends, contract renewal expectations and the impact and expectations of regulatory environments.
Although we believe that the financial projections used are reasonable and appropriate, the use of different assumptions and estimates could materially impact the analysis and resulting conclusions. In addition, due to the long term nature of the forecasts there is significant uncertainty inherent in those projections. That uncertainty is increased by the impact of healthcare reforms as discussed in Item 1, "Business-Regulation." For additional discussions regarding how the enactment or implementation of healthcare reforms and how other factors could affect our business and the related long term forecasts, see Item 1A, "Risk Factors" in Part I of this Annual Report on Form 10 K.
Future events that could have a negative impact on the levels of excess fair value over carrying value of our reporting units include, but are not limited to:
During the quarter ended June 30, 2013, certain events occurred and circumstances changed which indicated that it was more likely than not that goodwill for APS Healthcare was impaired, including the following:
•APS Healthcare failed to win certain new contracts that had previously been anticipated;
•APS Healthcare's Puerto Rico contract to provide managed behavioral health services under the Mi Salud program (the "APS Puerto Rico Contract"), which represented a significant portion of APS Healthcare's historical revenue was renewed, but at a lower rate than had previously been anticipated;
pricing source and monitoring the change in prices from month to month and upon sale of the security. Significant changes or variances are investigated and explained. To date, we have modified one price provided by the advisor.
•the effects of changes in interest rates or credit spreads, and
•the financial condition, credit rating and near-term prospects of the issuer,
Part A-Hospitalization benefits are provided under Part A. These benefits are financed largely through Social Security taxes. Beneficiaries are not required to pay any premium for Part A benefits. However, they are still required to pay out-of-pocket deductibles and coinsurance.
Part B-Benefits for medically necessary services and supplies including outpatient care, doctor's services, physical or occupational therapists and additional home healthcare are provided under Part B. These benefits are financed through premiums paid to the federal government by those eligible beneficiaries who choose to enroll in the program. The beneficiaries are also required to pay out-of- pocket deductibles and coinsurance.
Part D-Under Part D, prescription drug benefits may be provided by private Plans to individuals eligible for benefits under Part A and/or enrolled in Part B. These benefits are provided on both a stand-alone basis and also in connection with certain HMO, PPO and PFFS plans.
Medicare Risk Adjustment Provisions. CMS uses risk-adjusted rates per member to determine the monthly payments to Medicare Plans. CMS has implemented a risk adjustment model which apportions premiums paid to all health Plans according to health diagnoses. The risk adjustment model uses health status indicators, or risk scores, to improve the accuracy of payment. The CMS risk adjustment model pays more for members with increasing health severity. Under this risk adjustment methodology, diagnosis data from inpatient and ambulatory treatment settings are used by CMS to calculate the risk adjusted premium payment to Medicare Plans. The monthly risk-adjusted premium per member is determined by CMS based on normalized risk scores of each member from the prior year. Annually, CMS provides the updated risk scores to the Plans and revises premium rates prospectively, beginning with the July remittance for current Plan year members. CMS will also calculate the retroactive adjustments to premium related to the revised risk scores for the current year for current Plan year members and for the prior year for prior Plan year members.
Coverage Gap Discount Program. We receive advance payments from CMS as subsidies for members of our Plans with Part D coverage who reach the coverage gap. The Medicare Coverage Gap Discount Program, or CGDP, makes manufacturer discounts available to eligible Medicare beneficiaries receiving applicable, covered Part D drugs, while in the coverage gap. In general, the discount on each applicable covered Part D drug is fifty percent of an amount equal to the negotiated price. Members will continue to receive these discounts and they will grow until the coverage gap is closed in 2020.
a catastrophic reinsurance subsidy. Catastrophic reinsurance subsidies are paid by CMS prospectively as a fixed amount per member per month, and are determined based upon the Plan year bid we submitted to CMS. After the close of the annual Plan year, CMS reconciles actual experience compared to catastrophic reinsurance subsidies paid to the Plan and any differences are settled between CMS and the Plan. The catastrophic reinsurance subsidy is accounted for as deposit accounting and therefore not recognized in operations.
For members of our network-based and rural PFFS Plans with Part D benefits, CMS makes prospective monthly catastrophic reinsurance payments to the Plans based on estimated average reinsurance payments to other Medicare Advantage-Prescription Drug (MA-PD) Plans that provide Part D benefits. Based upon the current guidelines from CMS, these Plans are at risk for the variance between their actual expense and the CMS payments. As a result, we do not follow deposit accounting for these payments.
In accordance with ASC Topic 740-10, Income Taxes (ASC 740), a valuation allowance is deemed necessary when, based on the weight of the available evidence, it is more likely than not (a likelihood of more than 50%) that some portion or all of a deferred tax asset will not be realized. The future realization of the tax benefit depends on the existence of sufficient taxable income within the carryback and carryforward periods.
We believe that the negative evidence of our cumulative loss is not indicative of future projected income or our ability to realize the deferred tax assets existing as of December 31, 2013. The remaining deferred tax assets, for which a valuation allowance was not established, relate to amounts that can be realized through future reversals of existing taxable temporary differences, available and prudent tax planning strategies and the Company's estimates of future taxable income. Any 2013 U.S. tax losses can be carried back to 2011 and 2012 subject to certain limitations.
For the year ended December 31, 2013 we will file a consolidated federal income tax return that includes most corporate subsidiaries but excludes any subsidiary that qualifies as a life insurance company, is taxed as a partnership under the Internal Revenue Code as well as our subsidiaries domiciled in Puerto Rico. Subsidiaries that qualify as life insurance companies and partnerships will file separate federal income tax returns and the Puerto Rico subsidiaries will file tax returns in Puerto
At December 31, 2013, we had unrecognized tax benefits of $1.4 million, net of federal income tax, primarily related to refund claims filed in various state jurisdictions during 2010 and various pre-acquisition benefits related to APS Healthcare. During 2013 and 2012 we recognized $1.3 million and $8.9 million, respectively, of refund claims filed in 2010. We recognize interest and penalties related to unrecognized state tax benefits in federal and state tax expense.
During the years ended December 31, 2013 and 2012, we recognized $0.5 million and $0.6 million of accrued interest expense and penalties. During the year ended December 31, 2011, we recognized no such interest expense and penalties.