As of December 31, 2007, our membership has increased by 395,000 members or 30.0% to 1,711,000 members, which includes approximately 183,000 members for which ASO services are provided. The membership growth is due primarily to our entry into the Tennessee market in the Middle-Grand region in April 2007 and the Western region with our acquisition of MMCC effective November 1, 2007. Premium revenues increased approximately $1,076.4 million or 38.5%. This increase is due primarily to (1) commencement of operations in Middle Tennessee; (2) a full year impact of operations in Georgia which began serving members in June 2006 in Atlanta and in the remaining regions we serve in the fall of 2006; (3) expansion of services to ABD members in two new Texas markets, Austin and San Antonio beginning in 2007; and (4) the initiation of services to ABD members in Ohio in February 2007. The remaining growth in 2007 is a result of premium rate increases and yield increases resulting from changes in membership mix across many of our markets.
Investment income and other increased $34.1 million from $39.3 million for the year ended December 31, 2006 to $73.4 million for the year ended December 31, 2007 primarily as a result of higher interest rates and an increase in the average balance of invested assets over the prior year. The increase in the average invested balances was largely driven by the establishment of restricted assets held as collateral in 2007.
On January 28, 2008 we submitted our response to a request for proposal for expanded markets and reprocurement of our existing markets for the Florida Healthy Kids program. We anticipate the state will award contracts in early-to-mid-2008 with an implementation date of fall of 2008.
AMERIGROUP Texas, Inc. is required to pay an experience rebate to the State of Texas in the event profits exceed established levels. The experience rebate calculation reports that we filed for the state fiscal years (SFYs) 2000 through 2005 have been audited by a contracted auditing firm retained by the State. In their report, the auditor challenged the inclusion in the experience rebate calculation of certain expenses incurred by the Company in providing services to AMERIGROUP Texas, Inc. for services obtained from AMERIGROUP Corporation under an administrative services agreement. The audits of experience rebate calculation reports for SFYs 2006 and 2007 are in process.
In February 2008, we resolved all of the open audit issues with respect to the experience rebate calculation reports for SFYs 2005 and prior and those experience rebate reports are now final. With respect to the experience rebate calculation reports for SFYs 2006 and 2007, we also reached agreement on the nature and amount of the administrative expenses incurred by AMERIGROUP Texas, Inc., for services provided by AMERIGROUP Corporation under the administrative services agreement that can be included in the experience rebate calculation. The impact of this resolution has been fully recognized in our consolidated financial statements for the year ended
December 31, 2007 which resulted in an increase to selling, general and administrative expenses of approximately $7.4 million.
In the Fort Worth service area, AMERIGROUP Texas, Inc. had an exclusive risk-sharing arrangement with Cook Children’s Health Care Network (“CCHCN”) and Cook Children’s Physician Network (“CCPN”), which includes Cook Children’s Medical Center (“CCMC”) that was terminated as of August 31, 2005. Under the risk-sharing arrangement the parties have an obligation to perform annual reconciliations and settlements of the risk pool for each contract year. We have recorded a receivable in the accompanying Condensed Consolidated Financial Statements for the 2005 contract year, in the amount of $10.6 million, as of December 31, 2007. The contract with CCHCN prescribes reconciliation procedures which have been completed. CCHCN subsequently engaged external auditors to review all medical claims payments made for the 2005 contract year and has provided the preliminary results to us. We are currently in discussions with the parties regarding resolution of this matter. Although we continue to believe this to be a valid receivable, if we are unable to resolve this matter resulting in payment in full to us, our results of operations may be adversely affected, and we may incur significant costs in our efforts to reach a final resolution of this matter.
In December 2006, AMERIGROUP New Jersey, Inc., our New Jersey subsidiary, received a notice of deficiency for failure to meet provider network requirements in several New Jersey counties as required by our Medicaid contract with New Jersey. To date, we have not received notice of any final determination regarding our compliance with provider network requirements or possible fines and penalties. If we are unable to materially satisfy the provider network requirements, the State of New Jersey could impose fines and penalties that could have a material impact on our financial results.
We generate revenues primarily from premiums and ASO fees we receive from the states in which we operate to arrange for health benefit services for our members. We receive premiums from CMS for our Medicare Advantage members. We recognize premium and ASO fee revenue during the period in which we are obligated to provide services to our members. A fixed amount per member per month is paid to us to arrange for healthcare benefit services for our members pursuant to our contracts in each of our markets. These premium payments are
based upon eligibility lists produced by our government partners. Errors in this eligibility determination on which we rely can result in positive and negative revenue adjustments to the extent this information is adjusted by the state. Adjustments to eligibility data received from our government partners result from retroactive application of enrollment or disenrollment of members or classification changes of members between rate categories that were not known by us in previous months due to timing of the receipt of data or errors in processing by our government partners. These changes while common are not generally large. Retroactive adjustments to revenue for corrections in eligibility data are recorded in the period in which the information becomes known. We estimate the amount of outstanding retroactivity each period and adjust premium revenue accordingly, if appropriate. Historically, the impact of these adjustments has represented less than 1% of annual revenue, which results in a negligible impact on annual earnings as changes in revenue are typically accompanied by corresponding changes in the related health benefits expense. We believe this historical experience represents what is reasonably likely to occur in future periods.
In developing our medical claims payable estimates, we apply different estimation methods depending on the month for which incurred claims are being estimated. For mature incurred months (generally the months prior to the most recent three months), we calculate completion factors using an analysis of claim adjudication patterns over the most recent 39-month period. A completion factor is an actuarial estimate, based upon historical experience, of the percentage of incurred claims during a given period that have been adjudicated as of the date of estimation. We apply the completion factors to actual claims adjudicated-to-date in order to estimate the expected amount of ultimate incurred claims for those months.
Medical cost PMPM trend factors are the most significant factors we use in estimating our medical claims payable for the most recent three months. The following table illustrates the sensitivity of these factors and the
estimated potential impact on our medical claims payable estimates for the most recent three months as of December 31, 2007:
Health benefits expenses incurred during the year, related to prior years for the year ended December 31, 2007 of approximately $68.2 million were comparable to that in the prior year of approximately $62.8 million. As our medical claims payable estimate increases in amount due to increases in our membership base and inflationary increases in medical costs, the absolute dollar amount of subsequent changes to that estimate will increase even if the accuracy of our medical claims payable estimate remains consistent as a percentage of our original estimate.
Health benefits expenses incurred during the year, related to prior years for the year ended December 31, 2006 increased approximately $37.1 million from approximately $25.7 million for the year ended December 31, 2005 to approximately $62.8 million for the year ended December 31, 2006. This increase was primarily a result of medical claims payments which increased at a more modest rate than estimated at the end of 2005. Claims payments for dates of service occurring in the early portion of 2005 increased significantly, based on available claims payment information as of December 31, 2005. We estimated health benefits expenses would continue to increase significantly through the remainder of 2005. As claims for medical services delivered in the second half of 2005 were paid during 2006, it became apparent that the elevated cost trends we anticipated did not continue throughout 2005.
As noted above, actuarial standards of practice generally require that the liabilities established for IBNR are sufficient to cover obligations under an assumption of moderately adverse conditions. In many situations, the claims amounts ultimately settled will be less than the estimate that satisfies the actuarial standards of practice. When this occurs, health benefits expenses incurred during a year, related to prior years, may be reduced.
We account for income taxes in accordance with the provisions of FASB Statement No. 109, Accounting for Income Taxes. On a quarterly basis, we estimate our required tax liability based on enacted tax rates, estimates of book to tax differences in income, and projections of income that will be earned in each taxing jurisdiction. Deferred tax assets and liabilities representing the tax effect of temporary differences between financial reporting net income and taxable income are measured at the tax rates enacted at the time the deferred tax asset or liability is recorded.
The valuation of goodwill and intangible assets at acquisition requires assumptions regarding estimated discounted cash flows and market analyses. These assumptions contain uncertainties because they require management to use judgment in selecting the assumptions and applying the market analyses to the individual acquisitions. Additionally, impairment evaluations require management to use judgment to determine if impairment of goodwill and intangible assets is apparent. We have applied a consistent methodology in both the original valuation and subsequent impairment evaluations for all goodwill and intangible assets resulting from acquisitions occurring since the adoption FASB Statement No. 142 Goodwill and Other Intangible Assets. We do not anticipate any changes to that methodology, nor has any impairment loss resulted from our analyses. If the assumptions used to evaluate the value of goodwill and intangible assets change in the future, an impairment loss may be recorded and it could be material to our results of operations in the period in which the impairment loss occurs.
In December 2007, the FASB issued FASB Statement No. 141 (revised 2007), Business Combinations (“FASB Statement No. 141(R)”). FASB Statement No. 141(R) establishes principles and requirements for how an acquirer determines and recognizes in its financial statements the identifiable assets acquired, the liabilities assumed, any noncontrolling interest in the acquiree and the goodwill acquired. FASB Statement No. 141(R) also establishes disclosure requirements to enable the evaluation of the nature and financial effects of the business combination. FASB Statement No. 141(R) is effective for any transaction occurring in fiscal years beginning after December 15, 2008; therefore, it will have no impact on our current results of operations and financial condition; however, future acquisitions will be accounted for under this guidance.
The following table sets forth selected operating ratios for the years ended December 31, 2007, 2006 and 2005. All ratios, with the exception of the health benefits ratio, are shown as a percentage of total revenues.
Premium revenue for the year ended December 31, 2007 increased $1,076.4 million, or 38.5%. The increase was primarily due to entry into Tennessee, expansion regions in Georgia and ABD expansion in San Antonio and Austin, Texas and the Southwest Region of Ohio. Additionally, our existing products and markets contributed further to revenue growth from premium rate increases and yield increases resulting from changes in membership mix. Total membership increased 30.0% to 1,711,000 as of December 31, 2007 from 1,316,000 as of December 31, 2006.
Premium revenue for the year ended December 31, 2006 increased $484.2 million, or 20.9%. The increase was primarily due to entry into the Georgia market, commencement of operations as a Medicare Advantage plan in our Houston, Texas market and premium rate increases. Total membership increased 16.6% to 1,316,000 as of December 31, 2006 from 1,129,000 as of December 31, 2005.
a growth in salaries and benefits expenses due to a 19.6% increase in the number of employees;
an increase in premium taxes from revenue growth in markets where the tax is levied; and
an increase in salaries and benefits as a result of a 30% increase in employees, stock compensation expense related to the adoption of FASB Statement No. 123(R) and earnings-based compensation not provided for in the preceding year;
an increase in operational and technological initiatives and recruiting expenses to support the Company’s growth.
Income tax expense for 2007 and 2006 was $70.1 million and $66.0 million, respectively, with an effective tax rate of 37.6% in 2007 and 38.1% in 2006. Income tax expense for 2005 was $33.1 million with an effective tax rate
of 38.1%. The decrease in effective tax rate from 2007 to 2006 is primarily a result of the decrease in the blended state income tax rate. The effective tax rate remained unchanged between 2006 and 2005 as the increase in the blended state income tax rate was offset by increases in federal tax exempt interest income.
Net income increased from 2005 to 2006 as a result of actuarially sound premium rate increases in excess of medical trend, favorable prior period development and commencement of operation as a Medicare Advantage plan in Texas.
We believe that existing cash and investment balances, internally generated funds and available funds under our Credit Agreement will be sufficient to support continuing operations, capital expenditures and our growth strategy for at least 12 months. Our debt-to-total capital ratio at December 31, 2007 was 29.9%. As a result of significant borrowings under the Credit Agreement and the related debt service and issuance of the 2.0% Convertible Senior Notes, our access to additional capital may be limited which could restrict our ability to acquire new businesses or enter new markets and could impact our ability to maintain statutory net worth requirements in the states in which we do business.
Our operations are conducted through our wholly-owned subsidiaries, which include HMOs, one HIC and one PHSP. HMOs, HICs and PHSPs are subject to state regulations that, among other things, require the maintenance of minimum levels of statutory capital, as defined by each state, and restrict the timing, payment and amount of dividends and other distributions that may be paid to their stockholders. Additionally, certain state regulatory agencies may require individual regulated entities to maintain statutory capital levels higher than the state regulations.
As of December 31, 2007, we believe our subsidiaries were in compliance with all minimum statutory capital requirements. We anticipate the parent company will be required to fund minimum net worth shortfalls during 2008 using unregulated cash, cash equivalents and investments. We believe as a result that we will continue to be in compliance with these requirements at least through the end of 2008.
The National Association of Insurance Commissioners (“NAIC”) has defined risk-based capital (“RBC”) standards for HMOs and other entities bearing risk for healthcare coverage that are designed to identify weakly capitalized companies by comparing each company’s adjusted surplus to its required surplus (“RBC ratio”). The RBC ratio is designed to reflect the risk profile of HMOs. Within certain ratio ranges, regulators have increasing authority to take action as the RBC ratio decreases. There are four levels of regulatory action, ranging from requiring insurers to submit a comprehensive plan to the state insurance commissioner to requiring the state insurance commissioner to place the insurer under regulatory control. At December 31, 2007, the RBC ratio of each of the Company’s health plans was at or above the level that would require regulatory action. Although not all states
had adopted these rules at December 31, 2007, at that date, each of the Company’s active health plans had a surplus that exceeded either the applicable state net worth requirements or, where adopted, the levels that would require regulatory action under the NAIC’s RBC rules.
Cash from operations was $350.7 million for the year ended December 31, 2007 compared to $235.7 million for the year ended December 31, 2006. The increase in cash from operations is primarily due to an increase in net income prior to depreciation, amortization and other noncash items of $28.2 million as well as an increase of approximately $81.1 million in cash flows generated from working capital changes. We generated operating cash flows from working capital changes of $187.4 million in 2007 and $106.3 million in 2006. The year-over-year increase primarily resulted from an increase in claims payable of $156.0 million driven by growth of the business, offset by an increase in premium receivables and a decline in the growth of accounts payable, accrued expenses and other current liabilities between the years.
Cash used in investing activities was $431.5 million for the year ended December 31, 2007 compared to cash used in investing activities of $342.2 million for the year ended December 31, 2006. This increase in cash used in investing activities results primarily from net purchases of restricted investments held as collateral of $351.3 million to fund the irrevocable letter of credit required to stay the execution of the judgment in the Qui Tam Litigation and net purchases of hedge and warrant instruments of $27.0 million offset by lower net investment purchases of $295.2 million. We currently anticipate total capital expenditures for 2008 of approximately $45.0 million to $50.0 million related to technological infrastructure development and the expansion of our medical management system.
Our investment policies are designed to provide liquidity, preserve capital and maximize total return on invested assets. As of December 31, 2007, our investment portfolio consisted primarily of fixed-income securities. The weighted average maturity is less than twelve months. We utilize investment vehicles such as money market funds, commercial paper, certificates of deposit, municipal bonds, debt securities of government sponsored entities, corporate securities, corporate bonds, auction rate securities and U.S. Treasury instruments. The states in which we operate prescribe the types of instruments in which our subsidiaries may invest their cash. The weighted average taxable equivalent yield on consolidated investments as of December 31, 2007 was approximately 5.02%.
As of December 31, 2007, $104.6 million of our $199.9 million in short-term investments were comprised of municipal notes investments with an auction reset feature (“auction rate securities”). These notes are issued by various state and local municipal entities for the purpose of financing student loans, public projects and other activities; they carry a AAA credit rating. Subsequent to December 31, 2007 all of the $104.6 million of auction rate securities that we held at the balance sheet date were either sold or had their interest rate reset through a successful auction. As of February 20, 2008, $104.4 million of our investments were comprised of auction rate securities. Liquidity for these auction rate securities is typically provided by an auction process which allows holders to sell their notes and resets the applicable interest rate at pre-determined intervals, usually every 28 or 35 days. As of February 20, 2008, auctions had failed for $39.2 million of our auction rate securities and there is no assurance that auctions on the remaining auction rate securities in our investment portfolio will continue to succeed. An auction failure means that the parties wishing to sell their securities could not be matched with an adequate volume of buyers. In the event that there is a failed auction the indenture governing the security requires the issuer to pay interest at a contractually defined rate that is generally above market rates for other types of similar short-term instruments. The securities for which auctions have failed will continue to accrue interest at the contractual rate and be auctioned every 28 or 35 days until the auction succeeds, the issuer calls the securities, or they mature. As a result, our ability to liquidate and fully recover the carrying value of our remaining auction rate securities in the near term may be limited or not exist. These developments may result in the classification of some or all of these securities as long-term investments in our consolidated financial statements for the first quarter of 2008 or in other future periods. In addition, while all of our auction rate securities are currently rated AAA, if the issuers are unable to successfully close future auctions and their credit ratings deteriorate, we may in the future be required to record an impairment charge on these investments.
We believe we will be able to liquidate our auction rate securities without significant loss, and we currently believe these securities are not impaired, primarily due to government guarantees or municipal bond insurance; however, it could take until the final maturity of the underlying securities to realize our investments’ recorded value. The final maturity of the underlying securities could be as long as 33 years. The weighted-average life of the underlying securities for our auction rate securities portfolio is 25.3 years. We currently have the ability and intent to hold the remaining $104.6 million of auction rate securities, until market stability is restored with respect to these securities. We believe that, even allowing for the reclassification of these securities to long-term and the possible requirement to hold all such securities for an indefinite period of time, our remaining cash and cash equivalents and short-term investments will be sufficient to support continuing operations, capital expenditures and our growth strategies.
Cash provided by financing activities was $391.7 million and $11.1 million for the years ended December 31, 2007 and 2006, respectively. The increase in cash provided by financing activities was primarily related to proceeds received from the issuance of $260.0 million in aggregate principal amount of 2.0% Convertible Senior Notes and borrowings under the Credit Agreement of $351.3 million net of repayments of outstanding amounts under the Credit Agreement of $222.3 million and payment of debt issuance costs of $11.7 million.
As of December 31, 2007, we had $129.0 million outstanding under the senior secured synthetic letter of credit facility of our Credit Agreement. These funds are held in restricted investments as partial collateral for an irrevocable letter of credit in the amount of $351.3 million, issued to the Clerk of Court for the U.S. District Court for the Northern District of Illinois, Eastern Division. The irrevocable letter of credit was provided to the court for the purpose of staying the enforcement of the judgment in the Qui Tam Litigation pending resolution of our appeal. As of December 31, 2007, we had no outstanding borrowings but have caused to be issued irrevocable letters of credit in the aggregate face amount of $35.6 million under the senior secured revolving credit facility of our Credit
Agreement. We incurred offering expenses totaling $4.8 million in connection with the Credit Agreement which are included in other long-term assets in the Condensed Consolidated Financial Statements and are being amortized over the term of the Credit Agreement.
Effective March 28, 2007, we issued an aggregate of $260.0 million in principal amount of 2.0% Convertible Senior Notes due May 15, 2012 (the “Notes’’). In May 2007, we filed an automatic shelf registration statement on Form S-3 with the SEC covering the resale of the Notes and common stock issuable upon conversion of the Notes. The total proceeds from the offering of the Notes, after deducting underwriting fees and estimated offering expenses, were approximately $253.1 million. We incurred offering expenses totaling $6.9 million in connection with the offering of the Notes which are included in other long-term assets in the accompanying Consolidated Financial Statements and are being amortized over the term of the Notes. As of December 31, 2007, approximately $221.3 million of these proceeds plus $1.0 million funded by the Company, are held as restricted investments as the balance of the collateral required for the irrevocable letter of credit which totals $351.3 million, as discussed above. The remainder of the proceeds of the Notes were used in connection with the purchase of convertible note hedges and sold warrants that were established concurrent with the issuance of the Notes as discussed below.
Subject to certain exceptions, if we undergo a “designated event” (as defined in the Indenture) holders of the Notes will have the option to require us to repurchase all or any portion of their Notes. The designated event repurchase price will be 100% of the principal amount of the Notes to be purchased plus any accrued and unpaid
interest (including special interest, if any) up to but excluding the designated event repurchase date. We will pay cash for all Notes so repurchased. We may not redeem the Notes prior to maturity.
Concurrent with the issuance of the Notes, we purchased convertible note hedges covering, subject to customary anti-dilution adjustments, 6,112,964 shares of our common stock. The convertible note hedges allow us to receive shares of our common stock and/or cash equal to the amounts of common stock and/or cash related to the excess conversion value that we would pay to the holders of the Notes upon conversion. These convertible note hedges will terminate at the earlier of the maturity dates of the Notes or the first day on which none of the Notes remain outstanding due to conversion or otherwise. The cost of the convertible note hedges aggregated approximately $52.7 million.
Also concurrent with the issuance of the Notes, we sold warrants to acquire 6,112,964 shares of our common stock at an exercise price of $53.77 per share. If the average price of our common stock during a defined period ending on or about the settlement date exceeds the exercise price of the warrants, the warrants will be settled, at our option, in cash or shares of our common stock. Proceeds received from the issuance of the warrants totaled approximately $25.7 million.
On May 23, 2005, our shelf registration statement was declared effective with the SEC covering the issuance of up to $400.0 million of securities including common stock, preferred stock and debt securities. No securities have been issued under the shelf registration. Under this shelf registration, we may publicly offer such registered securities from time-to-time at prices and terms to be determined at the time of the offering.
The following table summarizes our material contractual obligations, including both on- and off-balance sheet arrangements, and our commitments at December 31, 2007 (in thousands):
Operating Lease Obligations. Our operating lease obligations are primarily for payments under non-cancelable office space leases.
We have no investments, loans or any other known contractual arrangements with special-purpose entities, variable interest entities or financial partnerships. During the year ended December 31 2007, the Company obtained three letters of credit through our Credit Agreement. A letter of credit for $351.3 million was obtained in March 2007 for the benefit of the clerk of the United States District Court for the Northern District of Illinois on behalf of the Company and AMERIGROUP Illinois, Inc. to stay the enforcement of a judgment in Qui Tam Litigation in the United States District Court for the Northern District of Illinois pending the resolution of the appeal to the United States Court of Appeals for the Seventh Court. See Part I, Item 3, Legal Proceedings. A letter of credit for $18.2 million was obtained in connection with the November 1, 2007 MMCC acquisition to secure the contingent payment under the purchase agreement. Lastly, a letter of credit for the benefit of the State of Georgia Department of Community Health for $17.4 million was obtained in compliance with requirements of the Georgia Medicaid contract.
AMERIGROUP Corporation (the “Company”), a Delaware corporation, is a multi-state managed healthcare company focused on serving people who receive healthcare benefits through publicly sponsored programs, including Medicaid, State Children’s Health Insurance Program (“SCHIP”), FamilyCare and Medicare Advantage.
The consolidated financial statements include the financial statements of AMERIGROUP Corporation and its wholly-owned subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation.
We consider all highly liquid investments with original maturities of three months or less to be cash equivalents. We had cash equivalents of $436,280 and $142,291 at December 31, 2007 and 2006, respectively, which consist of commercial paper, money market funds, U.S. Treasury Securities, debt securities of government sponsored entities and municipal bonds.
Available-for-sale securities are recorded at fair value. Changes in fair value are reported in other comprehensive income until realized through the sale or maturity of the security. As of December 31, 2007 and 2006, the Company had no unrealized gains or losses related to available-for-sale securities.
Included in short-term investments are auction rate securities totaling $104,575 and $121,090 at December 31, 2007 and 2006, respectively. Auction rate securities are comprised of municipal note investments with an auction reset feature. These notes are issued by various state and local municipal entities for the purpose of financing student loans, public projects and other activities; they carry a AAA credit rating. Liquidity for these auction rate securities is typically provided by an auction process which allows holders to sell their notes and resets the applicable interest rate at pre-determined intervals, usually every 28 or 35 days. An auction failure may occur if parties wishing to sell their securities cannot be matched with an adequate volume of buyers. In the event that there is a failed auction the indenture governing the security requires the issuer to pay interest at a contractually defined rate that is generally above market rates for other types of similar short-term instruments.
Goodwill represents the excess of cost over fair value of businesses acquired. In accordance with Financial Accounting Standards Board (“FASB”) Statement No. 142, Goodwill and Other Intangible Assets (“FASB Statement No. 142”), goodwill and intangible assets acquired in a purchase business combination and determined to have an indefinite useful life are not amortized, but instead tested for impairment at least annually. FASB Statement No. 142 also requires that intangible assets with estimable useful lives be amortized over their respective estimated useful lives to their estimated residual values, and reviewed for impairment in accordance with FASB Statement No. 144, Accounting for Impairment or Disposal of Long-Lived Assets.
Similar to other companies, we sometimes face challenges from the tax authorities regarding the amount of taxes due. Positions taken on our tax returns are evaluated and benefits are recognized only if it is more likely than not that our position will be sustained on audit. Based on our evaluation of tax positions, we believe that we have appropriately accrued for potential tax exposures.
Taxes based on premium revenues are currently paid by our plans in the States of Texas, New Jersey, Maryland (beginning April 1, 2005), New York, Ohio, Georgia and Tennessee. Premium tax expense totaled $85,218, $47,100 and $25,903 in 2007, 2006 and 2005, respectively, and is included in selling, general and administrative expenses. As of December 31, 2007, premium taxes range from 2% to 6% of revenues or are calculated on a per member per month basis.
On August 10, 2005, the Compensation Committee approved the immediate and full acceleration of vesting of approximately 909,000 “out-of-the-money” stock options awarded on February 9, 2005 to employees, including its executive officers, under the Company’s annual bonus program pursuant to its 2003 Equity Incentive Plan (the “Grant”). No other option grants were affected. Each stock option issued as a part of the Grant has an exercise price which is greater than the closing price per share on the date of the Compensation Committee’s action. The purpose of the acceleration was to enable the Company to avoid recognizing compensation expense associated with these options in future periods in its consolidated income statements, as a result of FASB Statement No. 123(R). The pre-tax charge avoided totals approximately $8,900 which would have been recognized over the years 2006 and 2007. This amount has been reflected in the proforma disclosures of the 2005 consolidated year-end financial statements. Because the options that were accelerated had a per share exercise price in excess of the market value of a share of the Company’s common stock on the date of acceleration, the Compensation Committee determined that the expense savings outweighs the objective of incentive compensation and retention.
We record premium revenue based on membership and premium information from each government partner. Premiums are due monthly and are recognized as revenue during the period in which we are obligated to provide services to members. In all of our states except Tennessee and Virginia, we are eligible to receive supplemental payments for newborns and/or obstetric deliveries. Each state contract is specific as to what is required before payments are generated. Upon delivery of a newborn, each state is notified according to our contract. Revenue is recognized in the period that the delivery occurs and the related services are provided to our member. Additionally, in some states we receive supplemental payments for certain services such as high cost drugs and early childhood prevention screenings. Any amounts that have been earned and have not been received from the state by the end of the period are recorded on our balance sheet as premium receivables.
Experience rebate payable, included in accrued expenses and other current liabilities, consists of estimates of amounts due under contracts with the State of Texas. These amounts are computed based on a percentage of the contract profits as defined in the contract with the state. The profitability computation includes premium revenue earned from the state less actual medical and administrative costs incurred and paid and less estimated unpaid claims payable for the applicable membership. The unpaid claims payable estimates are based on historical
Health benefits expenses incurred during the year, related to prior years for the year ended December 31, 2007 of approximately $68,232 were comparable to that in the prior year of approximately $62,846. As our medical claims payable estimate increases in amount due to increases in our membership base and inflationary increases in medical costs, the absolute dollar amount of subsequent changes to that estimate will increase even if the accuracy of our medical claims payable estimate remains consistent as a percentage of our original estimate.
Health benefits expenses incurred during the year, related to prior years or the year ended December 31, 2006 increased approximately $37,162 from approximately $25,684 for the year ended December 31, 2005 to approximately $62,846 for the year ended December 31, 2006. This increase was primarily a result of medical claims
Stop-loss premiums, net of recoveries, are included in health benefits expenses in the accompanying consolidated income statements.
On July 13, 2006, the FASB issued Interpretation No. 48 (“FIN 48”), Accounting for Uncertainty in Income Taxes. FIN 48 clarifies the accounting for uncertainty in income taxes recognized in the financial statements in accordance with FASB Statement No. 109. This interpretation provides guidance on the 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. We adopted the provisions of FIN 48 on January 1, 2007. As a result of the adoption of FIN 48, we recorded a $9,185 increase to retained earnings as of January 1, 2007. As of the date of adoption, the total gross amount of unrecognized tax benefits was $298 excluding interest. The gross amount of unrecognized tax benefits is $901 (excluding interest) as of December 31, 2007. Of this total, $610 (net of the federal benefit on state issues) represents the total amount of tax benefits that, if recognized, would impact the effective rate.
Our profitability depends in large part on accurately predicting and effectively managing health benefits expense. We continually review our premium and benefit structure to reflect its underlying claims experience and revised actuarial data; however, several factors could adversely affect the health benefits expense. Certain of these factors, which include changes in healthcare practices, cost trends, inflation, new technologies, major epidemics, natural disasters and malpractice litigation, are beyond any health plan’s control and could adversely affect our ability to accurately predict and effectively control healthcare costs. Costs in excess of those anticipated could have a material adverse effect on our results of operations.
The carrying amount, gross unrealized holding gains, gross unrealized holding losses and fair value for available-for-sale and held-to-maturity short-term investments are as follows at December 31, 2007 and 2006:
The following table shows the fair value of our held-to-maturity investments with unrealized losses that are not deemed to be other-than-temporarily impaired, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at December 31, 2007:
The temporary declines in value as of December 31, 2007 and 2006, are primarily due to fluctuations in short-term market interest rates.
Property and equipment, net at December 31, 2007 and 2006 is summarized as follows:
Additionally, as a result of the contingent nature of any future payments, purchase price adjustments may arise as those amounts become known.
Goodwill and acquired intangible assets for the years ended December 31, 2007 and 2006 are as follows:
Amortization expense for the years ended December 31, 2007, 2006 and 2005 was $2,279, $4,541 and $7,940, respectively, and the estimated aggregate amortization expense for the five succeeding years is as follows:
Income tax expense (benefit) for the years ended December 31, 2007, 2006 and 2005 consists of the following:
The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities at December 31, 2007 and 2006 are presented below:
Income tax payable was $5,945 at December 31, 2006 and is included in accrued expenses and other current liabilities. Prepaid income tax was $14,277 at December 31, 2007, and is included in prepaid expenses, provider receivables and other current assets.
Of the total unrecognized tax benefits of $901, $610 (net of the federal benefit on state issues) represents the total amount of tax benefits that, if recognized, would reduce our annual effective rate. The Company recognizes interest and any penalties accrued related to unrecognized tax benefits in income tax expense. We accrued potential interest of $120 related to these unrecognized tax benefits during 2007. As of December 31, 2007, the Company has recorded a liability for potential gross interest of $243. We do not expect our unrecognized tax benefits to change significantly over the next 12 months.
On March 26, 2007, we entered in to a Credit and Guaranty Agreement (the “Credit Agreement”) which provides, among other things, for commitments of up to $401,300 consisting of (i) up to $351,300 of financing under a senior secured synthetic letter of credit facility and (ii) up to $50,000 of financing under a senior secured revolving credit facility. The Credit Agreement terminates on March 15, 2012. We initially borrowed $351,300 under the senior secured synthetic letter of credit facility of the Credit Agreement. Shortly thereafter, we repaid $221,300 of such borrowings with the proceeds from the issuance of the Notes (described below). As a result, pursuant to the terms of the Credit Agreement, unless later amended by the parties, the commitments under the senior secured synthetic letter of credit facility were permanently reduced to $130,000 and total commitments under the Credit Agreement were permanently reduced to $180,000.
The proceeds of the Credit Agreement are available to (i) facilitate an appeal, payment or settlement of the judgment in the Qui Tam Litigation (as defined below), (ii) repay in full certain existing indebtedness, (iii) pay related transaction costs, fees, commissions and expenses, and (iv) provide for the ongoing working capital requirements and general corporate purposes, including permitted acquisitions. The borrowings under the Credit Agreement accrue interest at our option at a percentage, per annum, equal to the adjusted Eurodollar rate plus 2.0% or the base rate plus 1.0%. The applicable interest rate was 7.0% at December 31, 2007. We are required to make payments of interest in arrears on each interest payment date (to be determined depending on interest period elections made by the Company) and at maturity of the loans, including final maturity thereof.
As of December 31, 2007, we had $129,025 outstanding under the senior secured synthetic letter of credit facility portion of our Credit Agreement. These funds are held in restricted investments as partial collateral for an irrevocable letter of credit in the amount of $351,300, issued to the Clerk of Court for the U.S. District Court for the Northern District of Illinois, Eastern Division. The irrevocable letter of credit was provided to the court for the purpose of staying the enforcement of the judgment in the Qui Tam Litigation pending resolution of our appeal. As of December 31, 2007, we had no outstanding borrowings but have caused to be issued irrevocable letters of credit in the aggregate face amount of $35,600 under the senior secured revolving credit facility portion of our Credit Agreement. We incurred offering expenses totaling approximately $4,800 in connection with the Credit Agreement which are included in other long-term assets in the Consolidated Financial Statements and are being amortized over the term of the Credit Agreement.
Upon conversion of the Notes, we will pay cash up to the principal amount of the Notes converted. With respect to any conversion value in excess of the principal amount of the Notes converted, we have the option to settle the excess with cash, shares of our common stock, or a combination of cash and shares of our common stock based on a
daily conversion value, as defined in the Indenture. If an “accounting event” (as defined in the Indenture) occurs, we have the option to elect to settle the converted notes exclusively in shares of our common stock. The initial conversion rate for the Notes will be 23.5114 shares of common stock per one thousand dollars of principal amount of Notes, which represents a 32.5% conversion premium based on the closing price of $32.10 per share of our common stock on March 22, 2007 and is equivalent to a conversion price of approximately $42.53 per share of common stock. The conversion rate is subject to adjustment in some events but will not be adjusted for accrued interest. In addition, if a “fundamental change” (as defined in the Indenture) occurs prior to the maturity date, we will in some cases increase the conversion rate for a holder of Notes that elects to convert its Notes in connection with such fundamental change.
Subject to certain exceptions, if we undergo a “designated event” (as defined in the Indenture) holders of the Notes will have the option to require us to repurchase all or any portion of their Notes. The designated event repurchase price will be 100% of the principal amount of the Notes to be purchased plus any accrued and unpaid interest (including special interest, if any) up to but excluding the designated event repurchase date. We will pay cash for all Notes so repurchased. We may not redeem the Notes prior to maturity.
The convertible note hedges are expected to reduce the potential dilution upon conversion of the Notes in the event that the market value per share of our common stock, as measured under the convertible note hedges, at the time of exercise is greater than the strike price of the convertible note hedges, which corresponds to the initial conversion price of the Notes and is subject to certain customary adjustments. If, however, the market value per share of our common stock exceeds the strike price of the warrants (discussed below) when such warrants are exercised, we will be required to issue common stock. Both the convertible note hedges and warrants provide for net-share settlement at the time of any exercise for the amount that the market value of our common stock exceeds the applicable strike price.
Maturities of long-term debt for the five years ending December 31 are as follows:
In 1994, we established the 1994 Stock Plan (“1994 Plan”), which provides for the granting of either incentive stock options or non-qualified options to purchase shares of our common stock by employees, directors and consultants of the Company for up to 4,199,000 shares of common stock as of December 31, 1999. On February 9, 2000, we increased the number of options available for grant to 4,499,000.
Stock option activity during the year ended December 31, 2007 was as follows:
The fair value of each option grant is estimated on the date of grant using the Black-Scholes-Merton option pricing model with the following weighted-average assumptions for the year ended December 31, 2007, 2006 and 2005:
For the years ended December 31, 2007 and 2006, assumptions used in estimating the fair value at date of grant were based on the following:
the expected life of each award granted was calculated using the “simplified method” in accordance with Staff Accounting Bulletin No. 107;
Non-vested restricted stock for the twelve months ended December 31, 2007 is summarized below:
Non-vested restricted stock includes grants with both service and performance condition based vesting. Service-based awards generally vest annually over a period of four years contingent only on the employees’ continued employment. Performance based shares contingently vest over a period of four years from the date of grant based upon the extent of achievement of certain operating goals relating to the Company’s earnings per share, with up to 25% vesting on the first anniversary of the grant date and up to an additional 25% vesting on each of the second, third and fourth anniversaries of the grant date. The shares in each of the respective four tranches vest in full if earnings per share for each of the four calendar years after the date of grant equals or exceeds 115% of earnings per share for the preceding calendar year, as adjusted for any changes in measurement methods; provided that 50% of each tranche will vest if earnings per share for the year is between 113.50% and 114.24% (inclusive) of adjusted earnings per share for the preceding year, and 75% of each tranche will vest if earnings per share for the year is between 114.25% and 114.99% (inclusive) of adjusted earnings per share for the preceding year. Performance based awards represent 37,201 shares of outstanding non-vested restricted stock awards.
dilutive for the periods presented. Potential common stock equivalents representing 1,774,397 shares with a weighted-average exercise price of $40.85 for the year ended December 31, 2005, were not included in the computation of diluted net income per share because to do so would have been anti-dilutive for the periods presented.
Cash surrender value of life insurance policies: The carrying amount approximates fair value.
The carrying value of the current and long-term debt, with the exception of the convertible notes, approximates fair value, as the interest rate is variable and reflects current market conditions. The estimated fair value of the convertible notes is determined based upon quoted market prices. As of December 31, 2007, the fair value of convertible notes was $282,808.
We also lease office space under operating leases which expire at various dates through 2019. Future minimum payments by year and in the aggregate under all non-cancelable leases are as follows at December 31, 2007:
Certain employees have the option to participate in a non-qualified deferred compensation plan sponsored by the Company. Participants may contribute a percentage of their income subject to maximum plan limits. The Company does not match any employee contributions; however, the Company’s obligation to the employee is equal to the employees’ deferrals plus or minus any return on investment the employee earns through self-selected
investment allocations. Included in other long-term liabilities at December 31, 2007 and 2006, respectively was $6,336 and $4,382 related to this plan.
During 2003, we added a long-term cash incentive award designed to retain certain key executives. Each eligible participant is assigned a cash target, the payment of which is deferred for three years. The amount of the target is dependent upon the participant’s performance against individual major job objectives in the first year of the program. The target award amount is funded over the three-year period, with the funding at the discretion of the Compensation Committee of the Board of Directors. An executive is eligible for payment of a long-term incentive earned in any one year only if the executive remains employed with the Company and is in good standing at the beginning of the third following year. The expense recorded for the long-term cash incentive awards was $5,542 and $1,766 in 2007 and 2006, respectively. No expense was recorded in 2005 as the Company did not meet its financial goals required for the long-term cash incentive award to be awarded for the current year therefore, there is no current portion of the liability at December 31, 2007. The related current portion of the liability of $1,620 at December 31, 2006 is included in accrued payroll and related liabilities. The related long-term portion of the liability of $7,007 and $1,465 at December 31, 2007 and 2006, respectively, is included in other long-term liabilities.
The trial began on October 4, 2006, and the case was submitted to the jury on October 27, 2006. On October 30, 2006, the jury returned a verdict against us and AMERIGROUP Illinois, Inc. in the amount of $48,000, which under applicable law would be trebled to $144,000, plus penalties, and attorney’s fees, costs and expenses. The jury also found that there were 18,130 false claims. The statutory penalties allowable under the False Claims Act range between $5.5 and $11.0 per false claim. The statutory penalties allowable under the Illinois Whistleblower Reward and Protection Act, 740 ILC 175/3, range between $5.0 and $10.0 per false claim. On November 22, 2006, the Court entered an initial judgment in the amount of $48,000 and we subsequently filed motions for a new trial and remittur and for judgment as a matter of law and the plaintiffs filed motions to treble the civil judgment, impose the maximum fines and penalties and to assess attorney’s fees, costs and expenses against us.
we do not control this timeline, it is possible the Court of Appeals could render a decision as early as summer 2008, but there is no assurance that the decision will not occur at an earlier or later date.
Although it is possible that the ultimate outcome of the Qui Tam Litigation judgment will not be favorable to us, the amount of loss, if any, is uncertain. Accordingly, we have not recorded any amounts in the Condensed Consolidated Financial Statements for unfavorable outcomes, if any, as a result of the Qui Tam Litigation judgment. There can be no assurances that the ultimate outcome of this matter will not have a material adverse effect on our financial position, results of operations or liquidity.
It is also possible that plaintiffs in other states could bring similar litigation against us. While we believe that the practices at issue in the Qui Tam Litigation have not occurred outside of the operations of our former Illinois subsidiary, AMERIGROUP Illinois, Inc., a verdict in favor of a plaintiff in similar litigation in another state could have a material adverse effect on our financial position, results of operations or liquidity.
In the Fort Worth service area, AMERIGROUP Texas, Inc. had an exclusive risk-sharing arrangement with Cook Children’s Health Care Network (“CCHCN”) and Cook Children’s Physician Network (“CCPN”), which includes Cook Children’s Medical Center (“CCMC”) that was terminated as of August 31, 2005. Under the risk-sharing arrangement the parties have an obligation to perform annual reconciliations and settlements of the risk pool for each contract year. We have recorded a receivable in the accompanying Condensed Consolidated Financial Statements for the 2005 contract year, in the amount of $10,600, as of December 31, 2007. The contract with CCHCN prescribes reconciliation procedures which have been completed. CCHCN subsequently engaged external auditors to review all medical claims payments made for the 2005 contract year and has provided the preliminary results to us. We are currently in discussions with the parties regarding resolution of this matter. Although we continue to believe this to be a valid receivable, if we are unable to resolve this matter resulting in payment in full to us, our results of operations may be adversely affected, and we may incur significant costs in our efforts to reach a final resolution of this matter.
In December 2006, AMERIGROUP New Jersey Inc., our New Jersey subsidiary, received a notice of deficiency for failure to meet provider network requirements in several New Jersey counties as required by our Medicaid contract with New Jersey. To date, we have not received notice of any final determination regarding our compliance with provider network requirements or possible fines and penalties. If we are unable to materially satisfy the provider network requirements, the State of New Jersey could impose fines and penalties that could have a material impact on our financial results.
A Florida Statute (the “Statute”) gives the Florida Agency for Health Care Administration (“AHCA”) the right to contract with entities to provide comprehensive behavioral healthcare services, including mental health and substance abuse services. The Statute further requires the contractor to use at least 80% of the capitation for the provision of behavioral healthcare services, with any shortfall in the 80% expenditure being refunded to the State. In April 2007, our Florida subsidiary, AMERIGROUP Florida Inc., and AHCA resolved the disagreement regarding this matter for the 2004 and 2005 contract years and AMERIGROUP Florida, Inc. paid approximately $5,300 to AHCA.