The following selected consolidated financial data as of and for each of the five years in the year ended December 31, 2011 has been derived from the audited consolidated financial statements of the Company. The following data should be read in conjunction with the consolidated financial statements and the notes thereto and Management’s Discussion and Analysis of Financial Condition and Results of Operations included herein.
Through our insurance subsidiaries, we issue primarily health insurance policies, covering individuals, families, the self-employed and small businesses, and supplemental products. MEGA is an insurance company domiciled in Oklahoma and is licensed to issue health, life and annuity insurance policies in the District of Columbia and all states except New York. Mid-West is an insurance company domiciled in Texas and is licensed to issue health, life and annuity insurance policies in Puerto Rico, the District of Columbia, and all states except Maine, New Hampshire, New York and Vermont. Chesapeake is an insurance company domiciled in Oklahoma and is licensed to issue health and life insurance policies in the District of Columbia and all states except New Jersey, New York and Vermont.
The Company has recently experienced significant strategic changes, primarily in connection with the launch of its Insphere insurance agency in 2009 and the development of Insphere since that time. Insphere serves as an authorized insurance agency in 50 states and the District of Columbia, specializing in the distribution to the small business and middle-income market. Insphere distributes life, health, long-term care and retirement insurance through a portfolio of products from nationally recognized insurance carriers. As of December 31, 2011, Insphere had offices in 36 states with approximately 2,900 independent agents, of which approximately 1,800 agents on average write health insurance applications each month. Insphere distributes products underwritten by the Company’s insurance subsidiaries, as well as non-affiliated insurance companies.
The majority of our 2011 revenue was earned on health premiums derived from our inforce block of our indemnity and preferred provider organization (“PPO”) policies in our Commercial Health Division. Premiums on health insurance contracts are recognized as earned over the period of coverage on a pro rata basis. We also earned revenue on premiums from traditional life insurance polices, which are recognized as revenue when due. The decrease in premium reflects the change in the Company’s strategic focus, in connection with the launch of Insphere, on selling products underwritten by third-party carriers. The Company currently markets its health benefit plans in only a limited number of states in which Insphere does not have access to third-party health insurance products. The Company continues to offer supplemental insurance products underwritten by the Company’s insurance subsidiaries.
Commission and other income consists primarily of commission and bonus revenue generated from the sale of third-party insurance products, association memberships and ancillary services.
Revenue from continuing operations and income (loss) from continuing operations before federal income taxes (“Operating income”) for each of our business segments and divisions were as follows:
these products to the self-employed and individual markets through independent agents contracted with our insurance subsidiaries. Beginning in 2010, these products were primarily marketed through independent agents contracted with Insphere.
Loss Ratio. The loss ratio is defined as benefits expense as a percentage of earned premium revenue.
Submitted Annualized Volume. Submitted annualized premium volume in any period is the aggregate annualized premium amount associated with health insurance applications submitted by the Company’s agents in such period for underwriting by the Company.
The Commercial Health Division reported earned premium revenue of $544.7 million in 2011 compared to $736.8 million in 2010, a decrease of $192.1 million or 26.1%, which is primarily due to a decrease in policies in force. Total policies in force decreased by 21.5% to approximately 117,000 during 2011 as compared to approximately 149,000 during 2010. The decrease in policies in force is primarily due to the Company’s decision to discontinue the marketing of its health benefit plans in all but a limited number of states in which Insphere does not currently have access to third-party health insurance products. The Company continues to offer its supplemental products underwritten by Chesapeake and is focused on growing this line of business. However, the premium generated by the supplemental business has not been enough to offset the decline in premium associated with the Company’s health benefit plans. The decrease in premium in 2011 also reflects the accrual of $26.9 million for the medical loss ratio rebate.
The Commercial Health Division reported operating income of $101.9 million in 2011 compared to operating income of $236.8 million in 2010, a decrease of $134.9 million or 57.0%. The decrease in operating income during the current year period is generally attributable to an increase in the loss ratio as discussed more fully below, partially offset by a reduction in underwriting acquisition and insurance expenses.
The Commercial Health Division reported operating income of $236.8 million in 2010 compared to operating income of $117.5 million in 2009, an increase of $119.3 million or 102%. The increase in operating income during the current year period is generally attributable to a loss ratio reflecting better claims experience and a reduction in underwriting acquisition and insurance expenses.
Underwriting, acquisition and insurance expense decreased by $153.5 million, or 46% to $177.9 million in 2010 from $331.4 million in 2009. This decrease reflects the variable nature of commission expenses and premium taxes included in these amounts which generally vary in proportion to earned premium revenue and, in addition certain cost reduction programs initiated in the fourth quarter of 2008, which are being reflected as a decrease in the expense ratio. Other factors contributing to the decrease in underwriting, acquisition and insurance expenses include a decrease in the overall effective commission rate as a result of the decrease in new business. Generally, first year commission rates paid to agents are higher than renewal year commission rates. Additionally, with the formation of Insphere and the sale of third-party health insurance products underwritten by non-affiliated insurance carriers, the Commercial Health Division has significantly decreased the amount of marketing and acquisition costs.
The Company continues to evaluate new distribution opportunities and continues efforts to expand its portfolio and the size of its field force by developing additional marketing arrangements. We believe the implementation of these new opportunities, along with the current cost reduction program, will help mitigate future operating losses.
Corporate includes investment income not otherwise allocated to the other segments, realized gains and losses on sales, interest expense on corporate debt, the Company’s Student Loan business, general expense relating to corporate operations and operations that do not constitute reportable operating segments.
Corporate reported an operating loss in 2010 of $76.4 million compared to $73.3 million in 2009 for a small increase in operating expenses of $3.1 million. The changes for the period are primarily due to the following items:
Investment income increased by $4.8 million due to a reduction in the amount of investment income allocated to the Commercial Health Division in 2010 compared to 2009. Overall, investment income was comparable to prior year; however, the amount of investment income allocated to the Commercial Health Division was significantly lower than the prior year. The basis for the allocation was consistently applied for both years.
Net investment impairment losses recognized in earnings decreased by $3.7 million as we recognized impairment losses on other-than-temporary impairments of $765,000 in 2010 on one security, compared to $4.5 million on four securities during 2009. These impairment charges resulted from other than temporary reductions in the fair value of these investments compared to our cost basis.
Interest expense on corporate debt decreased by $1.5 million in 2010 compared to 2009, primarily due to the lower interest rate environment experienced in 2010 and the maturity of one of our interest rate swaps in April 2010. Partially offsetting these decreases, the 2010 results include $4.9 million of interest expense associated with our Grapevine Finance LLC (“Grapevine”) subsidiary. Pursuant to the Company’s adoption of ASU 2009-16 Accounting for Transfers of Financial Assets and Servicing Assets and Liabilities, the Company began to include the activities of Grapevine into its consolidated financial statements effective January 1, 2010.
In connection with the ISOP plan, we record a non-cash variable stock-based compensation benefit or expense based on the performance of the fair value of our common stock. Variable stock-based compensation decreased by $2.5 million as a result of the decrease in share price during 2010.
General corporate expenses and other increased by $18.8 million from the prior year. The 2010 results include approximately $11.7 million of additional severance expense and $10.6 million of additional stock compensation compared to the prior year. These charges are primarily related to reductions in the Company’s work force and the previously announced changes to the Company’s executive management team.
Disposed Operations includes the remaining run out of the former Medicare Division and the former Other Insurance Division as well as the residual operations from the disposition of other businesses prior to 2009.
The table below sets forth income (loss) from continuing operations for our Disposed Operations for the years ended December 31, 2011, 2010 and 2009:
As disclosed in the table above, we recognized positive experience related to benefits expense as a result of favorable claims experience on the expired policies maturing during the periods, which policies were not renewed. We also recognized positive results as favorable claims experience was realized on contracts expiring prior to or during the period. Underwriting, acquisition and insurance expenses continue to decline reflecting our exit from this line of business.
Cash flows from investing activities primarily consist of net investment purchases or sales and net purchases of property and equipment, including capitalized software. Investing activities for 2010 includes the redemption of invested assets used to pay a dividend in the amount of $118.5 million to shareholders during the year.
Cash flows used in financing activities primarily consist of repurchases of treasury stock, repayment of the student loan credit facility and dividends to shareholders. Cash flows provided by financing activities primarily consist of proceeds from shares issued to the ISOP. In 2010, cash flows used in financing activities were primarily related to dividend payments to shareholders of $118.5 million.
During 2011, 2010 and 2009, the holding company paid $10.6 million, $9.7 million and $21.1 million, respectively, to repurchase shares of its common stock from former officers and former and current participants of the ISOP or its predecessor plans.
In 2011, 2010 and 2009, the holding company paid $12.5 million, $18.8 million and $25.1 million, respectively in interest on outstanding debt.
During 2011, 2010 and 2009, the holding company used $30.4 million, $91.7 million and $23.1 million, respectively, in financing activities of which approximately $30.4 million, $90.7 million and $19.5 million, respectively, was used to fund Insphere operations.
Grapevine Finance LLC issued $72.4 million of senior secured notes to an institutional purchaser which matures in July 2021. The net proceeds were distributed to HealthMarkets, LLC. The note bears interest at an annual rate of 6.712%. The interest is to be paid semi-annually on January 15th and July 15th of each year.
In April 2004, UICI Capital Trust I completed the private placement of $15.0 million amount of floating rate trust preferred securities and $470,000 of floating rate common securities and invested the proceeds in an equivalent face amount of the Company’s floating rate junior subordinated notes due 2034. The notes will mature on April 29, 2034 and accrue interest at a floating rate equal to three-month LIBOR plus 3.50%, payable quarterly.
Set forth below is a summary of our consolidated contractual obligations at December 31, 2011:
(1) In connection with various reinsurance agreements the Company entered into coinsurance arrangements pursuant to which the reinsurers agreed to assume liability for $337.5 million of future policy benefits and $19.5 million of claim liabilities associated with such businesses.
Our discussion and analysis of the consolidated financial condition and results of operations are based upon the consolidated financial statements, which have been prepared in accordance with generally accepted accounting principles in the United States of America (“GAAP”). The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates, including those related to health and life insurance claims, bad debts, investments, intangible assets, income taxes, financing operations and contingencies and litigation. We base our estimates on historical experience, as well as various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.
Where possible, we utilize quoted market prices to measure fair value. For investments that have quoted market prices in active markets, we use the quoted market price as fair value and include these prices in the amounts disclosed in Level 1 of the hierarchy. When quoted market prices in active markets are unavailable, we determine fair values using various valuation techniques and models based on a range of observable market inputs including pricing models, quoted market price of publicly traded securities with similar duration and yield, time value, yield curve, prepayment speeds, default rates and discounted cash flow. In most cases, these estimates are determined based on independent third party valuation information, and the amounts are disclosed in Level 2 of the fair value hierarchy. Generally, we obtain a single price or quote per instrument from independent third parties to assist in establishing the fair value of these investments.
service data is unavailable, we may rely on bid/ask spreads from dealers in determining the fair value. When dealer quotations are used to assist in establishing the fair value, we generally obtain one quote per instrument. The quotes obtained from dealers or brokers are generally non-binding. When dealer quotations are used, we use the mid-mark as fair value. When broker or dealer quotations are used for valuation or price verification, greater priority is given to executable quotes. As part of the price verification process, valuations based on quotes are corroborated by comparison both to other quotes and to recent trading activity in the same or similar instruments.
To the extent we determine that a price or quote is inconsistent with actual trading activity observed in that investment or similar investments, or if we do not think the quote is reflective of the market value for the investment, we will internally develop a fair value using this observable market information and disclose the occurrence of this circumstance.
Investments are reviewed at least quarterly, using both quantitative and qualitative factors, to determine if they have experienced an impairment of value that is considered other-than-temporary. In its review, management considers the following indicators of impairment: fair value significantly below cost; decline in fair value attributable to specific adverse conditions affecting a particular investment; decline in fair value attributable to specific conditions, such as conditions in an industry or in a geographic area; decline in fair value for an extended period of time; downgrades by rating agencies from investment grade to non-investment grade; financial condition deterioration of the issuer and situations where dividends have been reduced or eliminated or scheduled interest payments have not been made. Additionally, we assess whether the amortized cost basis will be recovered by comparing the present value of cash flows expected to be collected with the amortized cost basis of the investment. When the determination is made that an other-than-temporary impairment (“OTTI”) exists but we do not intend to sell the security and it is not more likely than not that we will be required to sell the security before the recovery of its remaining amortized cost basis, we determine the amount of the impairment related to a credit loss and the amount related to other factors. OTTI losses attributed to a credit loss are recorded in “Net impairment losses recognized in earnings” on the statement of operations. OTTI losses attributed to other factors are reported in “Accumulated other comprehensive income (loss)” as a separate component of stockholders’ equity and accordingly have no effect on our net income (loss).
Premiums on traditional life insurance are recognized as revenue when due. Benefits and expenses are matched with premiums so as to result in recognition of income over the term of the contract. This matching is accomplished by means of the provision for future policyholder benefits and expenses and the deferral and amortization of acquisition costs.
We incur various costs in connection with the origination and initial issuance of its health insurance policies, including underwriting and policy issuance costs, costs associated with lead generation activities and distribution costs (i.e., sales commissions paid to agents). We defer these costs and amortize the deferred expense over the expected premium paying period of the policy, which approximates five years. Additionally, certain
underwriting and policy issuance costs, which we determined to be more variable than fixed in nature are capitalized and amortized over the expected premium paying period of the policy. We also defer commissions paid to agents and premium taxes with respect to the portion of health premium collected but not yet earned.
Prior to 2011, the majority of health insurance products offered through the Commercial Health Division establish the claims liabilities using the modified incurred date. Under the modified incurred date methodology, claims liabilities for the cost of all medical services related to the accident or sickness are recorded at the earliest date of diagnosis or treatment, even though the medical services associated with such accident or sickness might not be rendered to the insured until a later financial reporting period. A break in service of more than six months will result in the establishment of a new incurred date for subsequent services. A new incurred date will be established if claims payments continue for more than thirty-six months without a six month break in service. See Change in Accounting Principle on Claim Liabilities below for discussion on the change in methodology from the modified incurred date to service date.
Beginning in 2008, the Commercial Health Division began using date of service as opposed to the modified incurred date to establish the claims liabilities for new contracts introduced or updated in or after 2008.
The following table illustrates the sensitivity of these factors and the estimated impact to the December 31, 2011 unpaid claim liability for the Commercial Health Division. The scenarios selected are reasonable based on the Company’s past experience, however future results may differ.
The Company continues to update its completion factors to reflect more recent patterns of claim payments. Throughout 2010, we saw an ongoing decrease in the time period from incurral to payment of a claim, resulting in higher completion factors and lower reserves. In response to these trends, we used more recent experience to develop the completion factors, resulting in a decrease in claim liabilities of $30.6 million recognized during the three months ended September 30, 2010. During 2011, the Company again updated its completion factors to
reflect the more recent patterns of claim payments resulting in a decrease in the claim liabilities of $7.8 million in the three months ended September 30, 2011. We will continue to evaluate and update completion factors on an ongoing basis, as appropriate, and will evaluate the impact, if any, that Health Care Reform Legislation may have on the completion factors.
During 2010, we adjusted the estimated claim liability established in the fourth quarter of 2009 related to the review of claims processing for state mandated benefits based upon actual results from reprocessing approximately 81% of these claims. As a result of this refinement, during 2010, we recognized a decrease in the claims liabilities of $19.6 million.
As previously disclosed, in March 2010, Health Care Reform Legislation was signed into law. The Health Care Reform Legislation requires, beginning in 2011, a mandated minimum loss ratio (“MLR”) of 80% for the individual and small group markets. If MLR is below the mandated minimum, the Health Care Reform Legislation generally requires that the insurer return the amount of premium that is in excess of the required MLR to the policyholder in the form of rebates. The MLR is calculated for each of our insurance subsidiaries on a state-by-state basis in each state where the Company has issued major medical business. Department of Health and Human Services (“HHS”) rules indicate that the MLR calculation shall utilize data on incurred claims for the calendar year, paid through March of the following year.
Effective January 1, 2011, as a result of this change, the Company recorded the following: (i) a decrease in the amount of $77.9 million to claims and claims administration liabilities, (ii) an increase in the amount of $35.1 million to future policy and contract benefits, (iii) an increase in the amount of $15.0 million to deferred federal income tax liability and (iv) an increase in the amount of $27.8 million to retained earnings.
effective January 1, 2010, these plans were superseded and replaced by the HealthMarkets, Inc. InVest Stock Ownership Plan (the “ISOP”). Generally, unvested benefits under the ISOP vest in January of each year. We have established a liability for future unvested benefits under the ISOP, and we adjust such liability based on the fair value of our common stock. As such, we have experienced, and will continue to experience, unpredictable stock-based compensation charges, depending upon fluctuations in the fair value of HealthMarkets common stock. These unpredictable fluctuations in stock-based compensation charges may result in material non-cash fluctuations in our earnings (see Note 13 of Notes to Consolidated Financial Statements).
Our assets and liabilities, including financial instruments, are subject to the risk of potential loss arising from adverse changes in market rates and prices. Market risk is directly influenced by the volatility and liquidity in the markets in which the related underlying assets are traded.
The sensitivity analysis model decreases the gain in fair value of market sensitive instruments by $10.4 million based on a 100 basis point increase in interest rates as of December 31, 2011. This decreased value only reflects the impact of an interest rate increase on the fair value of our financial instruments.
At December 31, 2011, the Company had $481.1 million of debt exposed to the fluctuation of the three-month London Inter-bank Offer Rate (LIBOR) and is comprised of the term loan, UICI Capital Trust I note and the HealthMarkets Capital Trust I and II notes. The sensitivity analysis shows that if the three-month LIBOR rate changed by 100 basis points (1%), our interest expense would change by approximately $4.8 million.
Our Investment Committee monitors the investment portfolio of the Company and its subsidiaries. The Investment Committee receives investment management services from our in-house investment management team. The internal investment management team directly manages the investment assets.
Fixed maturity securities represented 40.6% and 64.6% of our total investments at December 31, 2011 and 2010, respectively. At December 31, 2011, fixed maturity securities consisted of the following:
Corporate bonds, included in the fixed maturity portfolio, consist primarily of short term and medium term investment grade bonds. The Company’s investment policy with respect to concentration risk limits individual investment grade bonds held by its insurance company subsidiaries to 3% of assets and non-investment grade bonds to 2% of assets. The policy also limits the investments in any one industry to 20% of assets. As of December 31, 2011, the largest concentration in any one investment grade corporate bond held by an insurance company subsidiary was $105.6 million ($94.8 million face value), which represented 10.0% of total invested assets. This security was received as payment on the sale of our Student Insurance Division. To limit its credit risk, we have taken out $75.0 million of credit default insurance on this bond, reducing our default exposure to $19.8 million, or 1.9% of total invested assets. The largest concentration in any one non-investment grade corporate bond was $4.9 million, which represented less than 1% of total invested assets. The largest concentration to any one industry was less than 10%. Additionally, due primarily to long standing conservative investment guidelines, our direct exposure to sub prime investments is 0.1% of investments.
A quality distribution for fixed maturity securities at December 31, 2011 is set forth below:
(3) Funds are diversified institutional money market funds that invest solely in United States dollar denominated money market securities.
Inflation historically has had a significant impact on the health insurance business. In recent years, inflation in the costs of medical care covered by such insurance has exceeded the general rate of inflation. Under basic hospital medical insurance coverage, established ceilings for covered expenses limit the impact of inflation on the amount of claims paid. Under catastrophic hospital expense plans and preferred provider contracts, covered expenses are generally limited only by a maximum lifetime benefit and a maximum lifetime benefit per accident or sickness. Therefore, inflation may have a significantly greater impact on the amount of claims paid under catastrophic hospital expense and preferred provider plans as compared to claims under basic hospital medical coverage. As a result, trends in healthcare costs must be monitored and rates adjusted accordingly. Under the health insurance policies issued in the self-employed market, the primary insurer generally has the right to increase rates upon 30-60 days written notice and subject to regulatory approval in some cases.
The annuity and universal life-type policies issued directly and assumed by HealthMarkets are significantly impacted by inflation. Interest rates affect the amount of interest that existing policyholders expect to have credited to their policies. However, we believe that our annuity and universal life-type policies are generally competitive with those offered by other insurance companies of similar size, and the investment portfolio is managed to minimize the effects of inflation.
The business of insurance is primarily regulated by the states and is affected by a range of legislative developments at both the state and federal levels. Legislation and regulations governing the use and security of individuals’ nonpublic personal data by financial institutions, including insurance companies, may have a significant impact on the financial condition and results of operations. See Item 1. Business - Regulatory and Legislative Matters.
See Recent Accounting Pronouncements in Note 2 of Notes to Consolidated Financial Statements for information regarding new accounting pronouncements.