As of December 31, 2006, we leased approximately 60,000 square feet of space for our corporate office in Bethesda, Maryland. We also leased approximately 1,696,000 aggregate square feet for office space, subsidiary operations and customer service centers for the various markets where our health plans and other subsidiaries operate, of which approximately 7% is subleased. Our leases expire at various dates from 2007 through 2018. We also own eight buildings throughout the country with approximately 727,000 square feet, which is used for administrative services related to our health plan and other operations, of which less than one percent is subleased. We believe that our facilities are adequate for our operations.
We are a national managed health care company based in Bethesda, Maryland operating health plans, insurance companies, network rental/managed care services companies, and workers’ compensation services companies. We provide a full range of risk and fee-based managed care products and services, including health maintenance organization (“HMO”), preferred provider organization (“PPO”), point of service (“POS”), Medicare Advantage, Medicare Prescription Drug Plans, Medicaid, Workers’ Compensation and Network Rental to a broad cross section of individuals, employer and government-funded groups, government agencies, and other insurance carriers and administrators in all 50 states as well as the District of Columbia and Puerto Rico.
Total cash and investments was $2.8 billion, a 35.4% increase over the prior year.
We generate our operating revenues from premiums and fees from a broad range of managed care and management service products. Premiums for our risk products, for which we assume full underwriting risk, can vary. For example, premiums for our commercial PPO and commercial POS products are typically lower than our commercial HMO premiums due to medical underwriting and higher deductibles and co-payments that are typically required of the commercial PPO and commercial POS members. Premium rates for our government programs, Medicare and state-sponsored managed Medicaid, are largely established by governmental regulatory agencies in conjunction with competitive bidding processes. Medicare products, including Part D, have risk adjusted premium rates at the member level to help align expected cost and reimbursement. These government products are offered in selected markets where we believe we can achieve profitable growth based upon favorable reimbursement levels, provider costs and regulatory climates.
We maintain provider networks that furnish health care services through contractual arrangements with physicians, hospitals and other health care providers. Prescription drug benefits are provided through a formulary comprised of an extensive list of drugs. Drug prices are negotiated at discounted rates through a national network of pharmacies.
We have capitation arrangements for certain ancillary heath care services, such as mental health care, and a small percentage of our membership is covered by global capitation arrangements. Under the typical arrangement, the provider receives a fixed percentage of premium to cover costs of all medical care or of the specified ancillary services provided to the globally capitated members. Under some capitated arrangements, physicians may also receive additional compensation from risk sharing and other incentive arrangements. Global capitation arrangements limit our exposure to the risk of increasing medical costs, but expose us to risk as to the adequacy of the financial and medical care resources of the provider organization. We are ultimately responsible for the coverage of our members pursuant to the customer agreements. To the extent that the respective provider organization faces financial difficulties or otherwise is unable to perform its obligations under the capitation arrangements, we will be required to perform such obligations. Consequently, we may have to incur costs in doing so in excess of the amounts we would otherwise have to pay under the original global or ancillary capitation through our contracted network arrangements.
We generate cash through operations. As a profitable company in an industry that is not capital equipment intensive, we have not needed to use financing methods to fund operations. While we did incur debt (as described in Note I to our consolidated financial statements in this Form 10-K), the entire proceeds were used to finance an acquisition and were not used to fund operations. Our primary use of cash is to pay medical claims. Any excess cash has historically been used for acquisitions, to prepay indebtedness and for repurchases of our common stock.
We also receive premium payments from the Centers for Medicare and Medicaid Services (“CMS”) on a monthly basis for our Medicare membership. Membership and category eligibility are periodically reconciled with CMS and can result in adjustments to revenue. Premiums collected in advance are recorded as deferred revenue.
Medical liabilities consist of actual claims reported but not paid and estimates of health care services incurred but not reported. Medical liabilities estimates are developed using actuarial principles and assumptions that consider, among other things, historical claims payment patterns, provider reimbursement changes, historical utilization trends, current levels of authorized inpatient days, other medical cost inflation factors, membership levels, benefit design changes, seasonality, demographic mix change and other relevant factors.
The following table presents the components of the change in medical claims liabilities for the years ended December 31, 2006, 2005 and 2004, respectively (in thousands).
The negative amounts noted as “prior year” medical costs are favorable adjustments for claim estimates being settled for amounts less than originally anticipated. As noted above, these favorable restatements from original estimates occur due to changes in medical utilization, mix of provider rates and other components of medical cost trends. Medical claim liabilities are generally paid within several months of the member receiving service from the provider. Accordingly, the 2006 prior year medical costs relate almost entirely to claims incurred in calendar year 2005 and the increase in prior year medical cost was driven primarily by lower than anticipated medical cost increases, growth in the medical cost base and uncertainties at the prior year-end regarding our Louisiana operations and the effects of Hurricane Katrina.
Changes in the completion factors, trend factors and utilization factors can have a significant effect on the claim liability. The following example provides the estimated effect to our December 31, 2006 unpaid claims liability assuming hypothetical changes in the completion, trend, and inpatient day factors. While we believe the selection of factors and ranges provided are reasonable, certain factors and actual results may differ.
The following table shows our investments’ gross unrealized losses and fair value, at December 31, 2006, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position (in thousands).
We account for share based compensation in accordance with the provisions of Statement of Financial Accounting Standards No. 123 (revised 2004), "Shared-Based Payment" ("FAS 123R"). Under the fair value recognition provisions of FAS 123R, determining the appropriate fair value model and calculating the fair value of share-based payment awards require the input of subjective assumptions, including the expected life of the share-based payment awards and stock price volatility. We have determined that a blend of the implied volatility of our tradeable options and the historical volatility of the Company’s share price is a better indicator of expected volatility and future stock price trends than historical volatility alone. Therefore, the expected volatility in 2006 was based on a blend of market-based implied volatility and the historical volatility of our stock. The assumptions used in calculating the fair value of share-based payment awards represent our best estimates. In addition, we are required to estimate the expected forfeiture rate and recognize expense only for those shares expected to vest. If our actual forfeiture rate is materially different from our estimate, the stock-based compensation expense could be significantly different from what we have recorded in the current period. See Note F to the Consolidated Financial Statements in Item 8 for a further discussion on stock-based compensation.
In July 2006, the Financial Accounting Standards Board (FASB) issued "Interpretation No. 48 (FIN 48), Accounting for Uncertainty in Income Taxes--an Interpretation of FASB Statement No. 109", which clarifies the accounting for uncertainty in income taxes recognized in the financial statements in accordance with SFAS No. 109. FIN 48 prescribes a recognition threshold and measurement attribute for the financial position already 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. FIN 48 was effective for the Company as of January 1, 2007. The change in net assets as a result of applying this pronouncement will be a change in accounting principle with the cumulative effect of the change required to be treated as an adjustment to the opening balance of retained earnings. The Company’s evaluation of the impact of adoption of FIN 48 is ongoing, and it is anticipated that the adoption of FIN 48 will not have a material impact on the Company’s January 1, 2007 balance of retained earnings.
Effective January 1, 2006, we completed the acquisition of Provider Synergies, an Ohio limited liability company. Provider Synergies manages preferred drug lists and negotiates rebates on behalf of state government and commercial clients. The acquisition was accounted for using the purchase method of accounting and, accordingly, the operating results of Provider Synergies have been included in our consolidated financial statements since the date of acquisition. The pro forma effects of this acquisition were not material to the Company’s consolidated financial statements.
(1) Excludes Medicare Part D; (2) Results of Operations includes First Health since January 28, 2005, the date of acquisition; and (3) Company is still providing services to terminated customers.
Commercial premium yields (premium per member per month) increased as a result of rate increases that occurred throughout all markets. The reported commercial premium yield increase of 5.3% is lower than the rate increases on renewing business due to a mix change in the types of plans being purchased as new business (such as a change to lower benefit plans); the types of plans being selected by renewing members when they have a choice among multiple options (such as a change to higher deductible, lower premium plans); and the termination of certain large groups which had high costs and high premium yields. Medicare Advantage premium yields increased as a result of the rate increases from the annual Competitive Bid filings. Medicaid premium yields increased as a result of rate increases effective January 1 and July 1, 2006 in Missouri, our largest Medicaid market.
Depreciation and amortization increased as a result of reporting a full year of First Health results in 2006 and as a result of an increase in property and equipment over the past two years, primarily computer equipment and software related to our First Health business.
Interest expense was higher in the prior year as a result of the refinancing of our credit facilities during the prior year second quarter. As a result of the refinancing, we wrote off $5.4 million of deferred financing costs in the prior year second quarter related to the original credit facilities associated with the First Health acquisition. Additionally, our debt has declined over the last two years and, as a result, interest expense related to the indebtedness has also declined.
Management services revenue increased almost entirely due to the acquisition of First Health. The acquisition of First Health accounted for $764.0 million of the increase in management services revenue over the prior year.
Coventry submitted bids as a Medicare Private Fee For Service (“PFFS”) sponsor in 2006 for the 2007 benefit year. The bids are designed to provide solutions for individuals and employer group populations. Our primary distribution strategy for the Medicare PFFS program is through marketing alliances with other insurers and brokerage channels.
Our investment guidelines require our fixed income securities to be investment grade in order to provide liquidity to meet future payment obligations and minimize the risk to the principal. The fixed income portfolio includes government and corporate securities with an average quality rating of “AA+” and an average contractual duration of 2.8 years as of December 31, 2006. Typically, the amount and duration of our short-term assets are more than sufficient to pay for our short-term liabilities and we do not anticipate that sales of our long-term investment portfolio will be necessary to fund our claims liabilities.
On February 15, 2007, we redeemed all $170.5 million of our outstanding 8.125% Senior Notes. We redeemed the Senior Notes at a redemption price equal to 104.1% of the principal amount plus interest accrued on the redemption date. We will record a charge, including the write-off of previously paid unamortized issuance costs, of approximately $9.1 million before tax, or $0.04 per diluted share in the first quarter of 2007. The funds for payment of the redemption price were provided by existing cash.
Proceeds from the issuance of debt include indebtedness incurred in 2005 related to the acquisition of First Health, less payments made for debt issuance costs. The issuance of debt includes $500 million of new senior notes, unsecured credit facilities consisting of a $300 million five-year term loan and $65 million from a revolving credit facility drawn at closing on January 28, 2005. Proceeds also include new credit facilities the Company entered into on June 30, 2005 providing for a revolving credit facility in the principal amount of $350 million, of which $117.5 million was drawn at closing, and a term loan in the principal amount of $100 million. Payments for retirement of debt include the repayment of a $200 million long-term credit facility assumed from the acquisition of First Health, repayment of the $365 million original credit facilities and the $117.5 million repayment of the new revolving credit facility.
Our Board of Directors has approved a program to repurchase our outstanding common stock. Stock repurchases may be made from time to time at prevailing prices on the open market, by block purchase or in private transactions. In February 2006, our Board of Directors approved an increase to the share repurchase program in an amount equal to 5% of our outstanding common stock, thus increasing our repurchase authorization by 8.1 million shares. As a part of this program, 3.0 million shares were purchased during the first quarter of 2004 at an aggregate cost of $84.6 million, no shares were purchased in 2005 and 4.6 million shares of our common stock were purchased in 2006 at an aggregate cost of $256.1 million. As of December 31, 2006, the total remaining common shares we are authorized to repurchase under this program is 6.2 million. We intend to repurchase approximately $200 million of our shares during the first quarter of 2007 under this program.
Our regulated HMO and insurance company subsidiaries are required by state regulatory agencies to maintain minimum surplus balances, thereby limiting the dividends the parent may receive from our regulated entities. During 2006, we received $297 million in dividends from our regulated subsidiaries.
We are a defendant in the provider track of the In Re: Managed Care Litigation filed in the United States District Court for the Southern District of Florida, Miami Division, Multi-District Litigation (“MDL”), No. 1334, in the action captioned, Charles B. Shane., et al., vs. Humana, Inc., et al. This lawsuit was filed by a group of physicians as a class action against Coventry and nine other companies in the managed care industry. The plaintiffs alleged violations of the Racketeer Influenced and Corrupt Organizations Act (“RICO”), conspiracy to violate RICO and aiding and abetting a scheme to violate RICO. In addition to these federal law claims, the complaint included state law claims for breach of contract, violations of various state prompt payment laws and equitable claims for unjust enrichment and quantum meruit. The trial court dismissed several of the state law claims and ordered all physicians who had an arbitration provision in their provider contracts to submit their direct RICO claims and their remaining state law claims to arbitration. As a consequence of this ruling, the plaintiffs who had arbitration provisions voluntarily dismissed their claims that were subject to arbitration. In its order, the trial court also held that the plaintiffs’ claims of (1) conspiracy to violate RICO and (2) aiding and abetting violations of RICO were not subject to arbitration. The trial court then certified various subclasses of plaintiffs with respect to these two federal law claims.
Seven defendants have entered into settlement agreements with the plaintiffs, which have received final approval from the trial court. On June 16, 2006, the trial court filed an order in the Shane lawsuit which granted summary judgment on all claims in favor of Coventry. The trial court also granted summary judgment on all claims in favor of two other defendants. The plaintiffs have appealed the trial court’s summary judgment order to the Eleventh Circuit Court of Appeals. The Shane lawsuit has triggered the filing of copycat class action complaints by other health care providers such as chiropractors, podiatrists, acupuncturists and other licensed health care professionals. Each of these actions has been transferred to the MDL and have been designated as “tag-along” actions. The court has entered an order which stays all proceedings in the tag-along actions until all pre-trial proceedings in the Shane action have been concluded. Although we can not predict the outcome, we believe that the Shane and the tag-along actions will not have a material adverse effect on our financial position or our results of operations. Management also believes that the claims asserted in these lawsuits are without merit and the Company intends to defend its position.
In 2007, we are expecting our total Health Plan commercial risk membership to ultimately remain approximately flat with 2006 year-end results. We expect Health Plan non-risk membership to be up 5% to 6% compared to 2006 year-end membership. We expect Medicare Advantage (excluding PFFS) membership to grow in the range of 5% to 10% during 2007, and expect Health Plan Medicaid membership to be up over 10% for the year, the majority of which resulting from the acquisition of approximately 31,000 members in our Missouri market in February 2007. In the aggregate, we expect total Health Plan membership to be flat to slightly down in Q1 2007, including the impact of the Medicaid acquisition.
We have audited the accompanying consolidated balance sheets of Coventry Health Care, Inc. and subsidiaries as of December 31, 2006 and 2005, and the related consolidated statements of operations, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2006. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Coventry Health Care, Inc.’s internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 28, 2007 expressed an unqualified opinion thereon.
As discussed in Note F to the consolidated financial statements, on January 1, 2006, Coventry Health Care, Inc. changed its method of accounting for stock-based compensation in accordance with guidance provided in Statement of Financial Accounting Standards No. 123(R), “Share-Based Payment.”
Basis of Presentation - The consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States and include the accounts of the Company and its subsidiaries, all of which are 100% owned. All significant inter-company transactions have been eliminated.
Significant Customers - The Company’s commercial business is diversified across a large customer base and there are no commercial groups that make up 10% or more of Coventry’s managed care premiums. The Company received 21.6%, 11.8% and 10.9% of its managed care premiums for the years ended December 31, 2006, 2005 and 2004, respectively, from the federal Medicare program throughout its various markets. The Company also received 11.1%, 13.2% and 11.7% of its managed care premiums for the years ended December 31, 2006, 2005 and 2004, respectively, from its state-sponsored Medicaid programs throughout its various markets. For the years ended December 31, 2006 and 2005, the State of Missouri accounted for almost half the Company’s Medicaid premiums. The Company received 19.3% and 22.1% of its management services revenue from a single customer, Mail Handlers Benefit Plan, for the years ended December 31, 2006 and 2005, respectively. The Company’s contract with the Mail Handlers Benefit Plan is up for renewal on December 31, 2007.
Other Receivables - Other receivables include interest receivables, pharmacy rebate receivables, Office of Personnel Management (“OPM”) receivables, receivables from providers and suppliers and any other receivables that do not relate to premiums.
Revenue Recognition - Managed care premiums are recorded as revenue in the month in which members are entitled to service. Premiums are based on a per subscriber contract rate and the subscribers in the Company’s records at the time of billing. Premium billings are generally sent to employers in the month proceeding the month of coverage. Premium billings may be subsequently adjusted to reflect changes in membership as a result of retroactive terminations, additions, or other changes. The Company also receives premium payments from CMS on a monthly basis for its Medicare membership. Membership and category eligibility are periodically reconciled with CMS and such reconciliations could result in adjustments to revenue. The Company also receives premium payments on a monthly basis from the state Medicaid programs with which we contract for the Medicaid members for whom we provide health coverage. Membership and category eligibility are periodically reconciled with the state Medicaid programs and such reconciliations could result in adjustments to revenue. Premiums collected in advance are recorded as deferred revenue. Employer contracts are typically on an annual basis, subject to cancellation by the employer group or by the Company upon 30 days notice.
Subsidy amounts received for reinsurance and for cost sharing related to low income individuals are recorded in medical liabilities and will offset medical costs when paid. We do not recognize premium revenue or claims expense for these subsidies as the Company does not incur any risk with this part of the program.
A reconciliation of the final risk sharing, low-income subsidy, and reinsurance subsidy amounts is performed following the end of the contract year. As of December 31, 2006, the CMS risk sharing payable was $32.6 million and is included in accounts payable and other accrued liabilities and the CMS risk sharing receivable was $3.8 million and is included in other receivables. As of December 31, 2006, the subsidy amounts payable totaled $323.3 million and is included in medical liabilities.
Revenue for pharmacy benefit management services in both the Group Health and Medicaid/Public sectors is derived on a pre-negotiated contractual amount per claim. Revenue is recorded when a pharmacy transaction is processed by the Company. The Company does not record any revenue or expense related to the sale of pharmaceuticals. In the Group Health business, revenue associated with pharmacy rebates is recorded based on the contractual rebates received from the formulary less the pre-negotiated rebates paid to clients. No rebate revenue is collected or recorded related to the Company’s Medicaid/Public business.
Contract Acquisition Costs - Costs related to the acquisition of customer contracts, such as commissions paid to outside brokers, are paid on a monthly basis and expensed as incurred. Regarding the Company’s new Medicare Private Fee for Service business, we advance funded commissions and have deferred amortization of these costs until 2007, when this new business begins.
Income Taxes - The Company files a consolidated federal tax return for the Company and its subsidiaries. The Company accounts for income taxes in accordance with SFAS No. 109 - “Accounting for Income Taxes.” The deferred tax assets and/or liabilities are determined by multiplying the differences between the financial reporting and tax reporting bases for assets and liabilities by the enacted tax rates expected to be in effect when such differences are recovered or settled. The effect on deferred taxes of a change in tax rates is recognized in income in the period that includes the enactment date. See Note G to consolidated financial statements for disclosures related to income taxes.
Other Income - Other income includes interest income, net of fees, of approximately $101.5 million, $59.8 million and $44.1 million for the years ended December 31, 2006, 2005 and 2004, respectively.
In July 2006, the Financial Accounting Standards Board (FASB) issued "Interpretation No. 48 (FIN 48), Accounting for Uncertainty in Income Taxes--an Interpretation of FASB Statement No. 109", which clarifies the accounting for uncertainty in incomes taxes recognized in the financial statements in accordance with SFAS No. 109. FIN 48 prescribes a recognition threshold and measurement attribute for the financial position already 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. FIN 48 was effective for the Company as of January 1, 2007. The change in net assets as a result of applying this pronouncement will be a change in accounting principle with the cumulative effect of the change required to be treated as an adjustment to the opening balance of retained earnings. The Company’s evaluation of the impact of adoption of FIN 48 is ongoing, and it is anticipated that the adoption of FIN 48 will not have a material impact on the Company’s January 1, 2007 balance of retained earnings.
The following table summarizes all business combinations and membership purchases for the three years ended December 31, 2006. The purchase price of each business combination includes the payment for net worth and estimated transition costs. The purchase price, inclusive of all retroactive balance sheet settlements to date and transition cost adjustments, is presented below (millions):
Effective January 28, 2005, the Company completed the acquisition of First Health. First Health is a full service national health benefits services company that serves the group health, workers’ compensation and state public program markets. The Company believes the combination of Coventry and First Health creates a leading health benefits company with the size, scale and product breadth to be a market leader with significant growth opportunities. The Company paid a premium (i.e., goodwill) over the fair value of the net tangible and identifiable intangible assets acquired for a number of reasons, including but not limited to:
Each outstanding share of First Health common stock was converted into a right to receive $9.375 cash and 0.2687 shares of Coventry common stock. As a result of the merger, the Company paid $863.1 million in cash and issued approximately 24.7 million shares of its common stock to stockholders of First Health. A value of $784.2 million was assigned to the shares issued based on the average closing price of Coventry common stock for the two days before, the day of and the two days after the acquisition announcement date of October 14, 2004.
The Company has allocated the excess purchase price over the fair value of the net assets acquired of approximately $1.3 billion to goodwill. The acquired goodwill is not deductible for income tax purposes. The intangible assets acquired, which are subject to amortization, consist of customer lists, tradenames, and a provider network and have a weighted-average useful life of approximately 10.8 years. The following table lists the Company’s estimate of the fair value of the tangible assets and liabilities as of the acquisition date (in millions):
The pro forma amounts represent historical operating results of the Company and First Health and include the pro forma effect of Coventry shares issued in the acquisition, the amortization of finite lived intangible assets arising from the purchase price allocation, interest expense related to financing the acquisition and the associated income tax effects of the pro forma adjustments. The 2004 pro forma amounts assume that debt pay down and debt cost write-offs related to debt refinancing would have occurred at the same period in 2004 as they occurred in 2005. The pro forma amounts exclude material, nonrecurring items including the expense related to the purchase of outstanding options of $27.2 million net of tax. The pro forma amounts are presented for comparison purposes and are not necessarily indicative of the operating results that would have occurred if the acquisition had been completed at the beginning of the periods presented nor are they necessarily indicative of operating results in future periods.
Effective January 1, 2006, the Company completed the acquisition of Provider Synergies, L.L.C. (“Provider Synergies”), an Ohio limited liability company. Provider Synergies manages preferred drug lists and negotiates rebates on behalf of state government and commercial clients. The acquisition was accounted for using the purchase method of accounting and, accordingly, the operating results of Provider Synergies have been included in the Company’s consolidated financial statements since the date of acquisition. The pro forma effects of this acquisition were not material to the Company’s consolidated financial statements.
Other intangible amortization expense for the years ended December 31, 2006, 2005 and 2004 was $35.4 million, $31.1 million and $2.7 million, respectively. The increase in other intangible assets and the related amortization is a result of the other intangible assets obtained with the acquisition of First Health. Estimated intangible amortization expense is $34.3 million for the year ending December 31, 2007, $33.9 million for the year ending December 31, 2008, $32.4 million for the year ending December 31, 2009, $32.2 million for the year ending December 31, 2010 and $32.1million for the year ending December 31, 2011. The weighted-average amortization period is approximately 11 years for other intangible assets.
The amortized cost and estimated fair value of short-term and long-term investments by contractual maturity were as follows at December 31, 2006 and December 31, 2005 (in thousands):
Gross investment gains of $0.2 million and gross investment losses of $0.7 million were realized on sales of investments for the year ended December 31, 2006. This compares to gross investment gains of $3.0 million and gross investment losses of $1.1 million on these sales for the year ended December 31, 2005, and gross investment gains of $2.0 million and gross investment losses of $1.3 million on these sales for the year ended December 31, 2004.
In accordance with SFAS 123R, for the period beginning January 1, 2006, excess tax benefits from stock awards are presented as financing cash flows. The excess tax benefits totaled $21.9 million for the year ended December 31, 2006. Such benefits were $38.0 million and $21.4 million for the years ended December 31, 2005 and 2004, respectively, and are presented as a component of operating cash flows.
The following table summarizes stock option activity for the year ended December 31, 2006:
The Black-Scholes-Merton weighted-average value of options granted was $ 17.24, $14.96 and $13.37 per share for the years ended December 31, 2006, 2005 and 2004, respectively. The total intrinsic value of options exercised was $52.4 million, $83.8 million and $50.0 million for the years ended December 31, 2006, 2005 and 2004, respectively. As of December 31, 2006, there was $73.1 million of total unrecognized compensation cost (net of expected forfeitures) related to nonvested stock option grants which is expected to be recognized over a weighted average period of 2.6 years.
Information with respect to stock options outstanding and stock options exercisable at December 31, 2006 was as follows:
The value of the restricted shares is amortized over various vesting periods through 2010. The Company recorded compensation expense related to restricted stock grants, including restricted stock granted in prior periods, of approximately $25.0 million, $21.9 million and $15.5 million for the years ended December 31, 2006, 2005 and 2004, respectively. The total unrecognized compensation cost related to the restricted stock was $39.9 million at December 31, 2006, and is expected to be recognized over a weighted average period of 2.4 years. The total fair value of shares vested during the years ended December 31, 2006, 2005 and 2004 was $36.1 million, $42.7 million and $ 29.4 million, respectively.
The following table summarizes restricted stock award activity for the year ended December 31, 2006:
At December 31, 2006, the Company had approximately $75 million of federal and $177 million of state tax net operating loss carryforwards. The Federal net operating losses were primarily acquired through various acquisitions. The net operating loss carryforwards can be used to reduce future taxable income and expire over varying periods through the year 2026.
Current income taxes payable of $84.1 million and $46.3 million are included in "other accrued liabilities" on the consolidated balance sheets as of December 31, 2006 and December 31, 2005, respectively.
As of December 31, 2006, the Company had one stock incentive plan, the Amended and Restated 2004 Stock Incentive Plan (the “Stock Incentive Plan”) under which shares of the Company’s common stock were authorized for issuance to key employees, consultants and directors in the form of stock options, restricted stock and other stock-based awards. In May 2006, the Stock Incentive Plan was amended to increase the number of shares authorized for issuance by an additional 9.0 million shares.
Effective January 1, 2006, the Company terminated the Employee Stock Purchase Plan. The Company’s Employee Stock Purchase Plan, implemented in 1994, allowed substantially all employees who meet length of service requirements to set aside a portion of their salary for the purchase of the Company’s common stock. At the end of each plan year, the Company issued the stock to participating employees at an issue price equal to 85% of the lower of the stock price at the end of the plan year or the average stock price, as defined in the plan. The Company issued 86,800 and 38,900 shares in 2005 and 2004, respectively.
The Company previously had other 401(k) plans that it sponsored. These plans arose from acquisitions of other companies and these plans have either since been terminated or merged into the Savings Plan. The cost of the Savings Plan, including the acquired plans, for 2006, 2005 and 2004 was approximately $18.9 million, $14.5 million, and $6.3 million, respectively.
The Company’s outstanding debt was as follows at December 31, 2006 and 2005 (in thousands):
On February 1, 2002, the Company completed a transaction to sell $175.0 million original 8.125% senior notes due February 15, 2012 in a private placement. These senior notes were then registered with the Securities and Exchange Commission. Interest on the notes is payable on February 15 and August 15 each year. In August 2003, the Company repurchased a portion of its senior notes with a face value of $4.5 million and a weighted average premium of 8.9%. The carrying value of the senior notes is equal to the face value and the fair value is based on the quoted market prices. As of December 31, 2006, the fair value of the 8.125% senior notes was $176.5 million. See Note Q for subsequent event information related to these senior notes.
On January 28, 2005, the Company completed the private placement of $250 million aggregate principal amount of 5 7/8% senior notes due 2012 and $250 million aggregate principal amount of 6 1/8% senior notes due 2015. These senior notes have since been exchanged and are now registered with the Securities and Exchange Commission. The senior notes are general unsecured obligations of the Company and rank equal in right of payment to all of the Company’s existing and future senior debt, including its 8 1/8% senior notes due 2012 and its new credit facilities as described below. As of December 31, 2006, the fair value of the 5 7/8% senior notes and the 6 1/8% senior notes was $245.6 million and $247.2 million, respectively.
On June 30, 2005, the Company entered into new credit facilities providing for a five-year revolving credit facility in the principal amount of $350 million, of which $117.5 million was drawn at closing, and a five-year term loan in the principal amount of $100 million. The new term loan facility requires regularly scheduled annual payments of principal in the amount of $10 million per year. The first payment under this agreement was made during the quarter ended June 30, 2006. Unless terminated earlier, the revolving credit facility will mature five years after closing and is payable in full upon its maturity on the termination date. The Company used the net proceeds of the borrowings under the new credit facilities to pay down and terminate its original term loan and revolving credit facility. On July 29, 2005, the Company paid off the outstanding balance of $117.5 million on its revolving credit facility.
Loans under the new credit facilities bear interest at a margin or spread in excess of either (1) the one-, two-, three-, six-, nine-, or twelve- month rate for Eurodollar deposits (the “Eurodollar Rate”) or (2) the greater of the federal funds rate plus 0.5% or the base rate of the Administrative Agent (“Base Rate”), as selected by the Company. The margin or spread depends on the Company’s non-credit-enhanced long-term senior unsecured debt ratings and varies from 0.450% to 1.750% for Eurodollar Rate advances and from 0.000% to 0.500% for Base Rate advances.
The Company’s senior notes and credit facilities require compliance with specified financial ratios and contain certain covenants and restrictions regarding incurring additional debt, limiting dividends or other restricted payments, restricting transactions with affiliates, disposing of assets and consolidations or mergers. The Company has complied with all ratios and covenants under the senior notes and credit facilities.
As of December 31, 2006, the aggregate maturities of debt based on their contractual terms, are as follows (in thousands):
As of December 31, 2006, the Company is contractually obligated to make the following minimum lease payments within the next five years and thereafter (in thousands):
The Company operates in leased facilities with original lease terms of up to thirteen years with options for renewal. Total rent expense was $30.3 million, $30.2 million and $19.0 million, for the years ended December 31, 2006, 2005 and 2004, respectively.
Seven defendants have entered into settlement agreements with the plaintiffs, which have received final approval from the trial court. On June 16, 2006, the trial court filed an order in the Shane lawsuit which granted summary judgment on all claims in favor of the Company. The trial court also granted summary judgment on all claims in favor of two other defendants. The plaintiffs have appealed the trial court’s summary judgment order to the Eleventh Circuit Court of Appeals. The Shane lawsuit has triggered the filing of copycat class action complaints by other health care providers such as chiropractors, podiatrists, acupuncturists and other licensed health care professionals. Each of these actions has been transferred to the MDL and have been designated as “tag-along” actions. The court has entered an order which stays all proceedings in the tag-along actions until all pre-trial proceedings in the Shane action have been concluded. Although the Company can not predict the outcome, management believes that the Shane and the tag-along actions will not have a material adverse effect on its financial position or its results of operations. Management also believes that the claims asserted in these lawsuits are without merit and the Company intends to defend its position.
A small percentage of the Company’s membership is covered by global capitation arrangements. Under the typical arrangement, the provider receives a fixed percentage of premium to cover all the medical costs provided to the globally capitated members. Under some capitated arrangements, physicians may also receive additional compensation from risk sharing and other incentive arrangements. Global capitation arrangements limit the Company’s exposure to the risk of increasing medical costs, but expose the Company to risk as to the adequacy of the financial and medical care resources of the provider organization. In addition to global capitation arrangements, the Company has capitation arrangements for ancillary services, such as mental health care. The Company is ultimately responsible for the coverage of its members pursuant to the customer agreements. To the extent that the respective provider organization faces financial difficulties or otherwise is unable to perform its obligations under the capitation arrangements, the Company will be required to perform such obligations. Consequently, the Company may have to incur costs in excess of the amounts it would otherwise have to pay under the original global or ancillary capitation arrangements. Medical costs associated with capitation arrangements made up approximately 6.1%, 6.5%, and 7.1% of the Company’s total medical costs for the years ended December 31, 2006, 2005 and 2004, respectively. Membership associated with global capitation arrangements was approximately 110,000, 116,000 and 127,000 as of December 31, 2006, 2005 and 2004, respectively.
Concentration of credit risk with respect to receivables is limited due to the large number of customers comprising the Company’s customer base and their breakdown among geographical locations. The Company believes the allowance for doubtful accounts adequately provides for estimated losses as of December 31, 2006. The Company has a risk of incurring losses if such allowances are not adequate.
The increase in capital and surplus for our regulated subsidiaries is a result of net earnings partially offset by dividends paid to the parent company.
Excluding funds held by entities subject to regulation and excluding our investment in an equipment leasing limited liability company, we had cash and investments of approximately $563.1 million and $347.2 million at December 31, 2006 and 2005, respectively. The increase was primarily due to the dividends received from our regulated subsidiaries and earnings from our non-regulated First Health business offset, in part, by the share repurchases discussed previously.
Other income for the years ended December 31, 2006, 2005 and 2004 includes interest income, net of fees, of approximately $101.5 million, $59.8 million and $44.1 million, respectively.
The First Health segment provides services to the Group Health and Specialty sectors. The Group Health business offers its managed care and administrative products to commercial payors in three customer classifications:
Federal Employees Health Benefits Program - a variety of managed care and administrative services available to federal employees and annuitants
The Specialty business offers network managed care and administrative services to two customer classifications:
(A) Includes results since January 28, 2005, the date of acquisition.
The Health Plan operations are aligned in several insured products. The Company believes identifying the gross margin and medical loss ratio (“MLR”) calculation from each of these products is useful in understanding the Company’s results of operations and is summarized in the table below (in thousands):
(1) Represents the Medicare Part D Prescription Drug Plan and excludes the health plan Medicare Advantage business.
(1) Includes results since January 28, 2005, the date of acquisition
The following is a summary of unaudited quarterly results of operations (in thousands, except per share data) for the years ended December 31, 2006 and 2005. Due to rounding of quarterly results, total amounts for each year may differ immaterially from the annual results.
On February 1, 2007, the Company purchased certain assets, including membership of approximately 31,000 members, from FirstGuard Health Plan Missouri, Inc., a wholly owned subsidiary of Centene Corporation.
On February 15, 2007, the Company redeemed all $170.5 million of its outstanding 8.125% senior notes. The Company redeemed the senior notes at a redemption price equal to 104.1% of the principal amount plus interest accrued on the redemption date. The funds for payment of the redemption price were provided by existing cash.