Financial Highlights should be read with the accompanying Management’s Discussion and Analysis of Financial Condition and Results of Operations and Consolidated Financial Statements and Notes.
(2) UnitedHealth Group acquired PacifiCare Health Systems, Inc. (PacifiCare) in December 2005 for total consideration of approximately $8.8 billion, Oxford Health Plans, Inc. (Oxford) in July 2004 for total consideration of approximately $5.0 billion and Mid-Atlantic Medical Services, Inc. (MAMSI) in February 2004 for total consideration of approximately $2.7 billion. The results of operations and financial condition of PacifiCare, Oxford and MAMSI have been included in UnitedHealth Group’s Consolidated Financial Statements since the respective acquisition dates.
Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with our Consolidated Financial Statements and Notes thereto included elsewhere in this Form 10-K.
Diluted net earnings per common share of $3.42, an increase of 15% over 2006.
Consolidated revenues of $75.4 billion, an increase of 5% over 2006.
Cash flows from operations of $5.9 billion, representing 126% of 2007 net earnings.
Revenues are comprised of premium revenues from risk-based products; service revenues, which primarily include fees for management, administrative and consulting services; product revenues; and investment and other income.
Product Revenues. Consolidated product revenues in 2007 totaled $898 million, an increase of $161 million, or 22%, over 2006. The increase was driven by pharmacy sales growth at Prescription Solutions primarily due to providing prescription drug benefit services to an additional four million Ovations Medicare Advantage and Part D members.
Medical costs for 2007 increased $2.1 billion, or 4%, to $55.4 billion, primarily due to an annual medical cost trend of 7% to 8% on commercial risk-based business due to medical cost inflation and increased utilization, as well as growth in Ovations Medicare programs, partially offset by a decrease in the number of individuals served by commercial risk-based products.
As previously disclosed, in December 2006, the Company entered into agreements with individuals who were executive officers of the Company at the time of grant of an applicable stock option to increase the exercise price of certain outstanding stock options. No compensation was payable to any of those individuals as a result of the increase in the exercise price of their stock options.
Cost of products sold in 2007 totaled $768 million, an increase of $169 million, or 28%, over 2006. This was primarily due to costs associated with increased pharmacy sales at Prescription Solutions as a result of providing prescription drug benefit services to an additional four million Ovations Medicare Advantage and Part D members in 2007.
Our effective income tax rate was 36.3% in both 2007 and 2006.
During the fourth quarter of 2007, we completed the transition to our new segment reporting structure which reflects how our chief operating decision maker now manages our business. Our new reporting structure has four reporting segments:
Health Care Services had revenues of $71.2 billion in 2007, representing an increase of $3.4 billion, or 5%, over 2006. Commercial Markets revenues of $40.3 billion in 2007 increased by $821 million, or 2%, over 2006. This increase was driven mainly by average net premium rate increases of 7% to 8% on UnitedHealthcare’s renewing commercial risk-based products, an increase in the number of individuals served by commercial fee-based products and businesses acquired since the beginning of 2006. This was partially offset by a 4% decrease in the number of individuals served by commercial risk-based products in 2007 primarily due to the Company’s internal pricing decisions in a competitive commercial risk-based pricing environment and the conversion of certain groups to commercial fee-based products. Ovations revenues of $26.5 billion in 2007 increased by approximately $1.8 billion, or 7%, over 2006. The increase was primarily driven by an increase in individuals served by standardized Medicare supplement and Evercare products, and rate increases on Medicare Advantage products as well as continued growth in our Medicare Part D program. The remaining Health Care Services revenue increase resulted from an increase in AmeriChoice revenues of $750 million, or 20%, over 2006 primarily due to an increase in the number of individuals served by Medicaid products as well as rate increases.
The number of individuals served with commercial products as of December 31, 2007 decreased by 175,000, or 1%, from the prior year. The number of individuals served with commercial fee-based products as of December 31, 2007 increased by 305,000, or 2%, over 2006 driven by new customer relationships and customers converting from risk-based products to fee-based products, partially offset by employment attrition at continuing customers. The number of individuals served with commercial risk-based products decreased by 480,000, or 4%, primarily due to a competitive pricing environment and the conversion of individuals to fee-based products.
OptumHealth earnings from operations in 2007 of $895 million increased $86 million, or 11%, over 2006 primarily due to the membership growth and rate increases discussed above. The OptumHealth operating margin declined from 18.6% in 2006 to 18.2% in 2007 due to a continued business mix shift toward higher revenue, lower margin products, partially offset by effective operating cost management.
Ingenix offers solutions to a spectrum of health care market participants on a national and international basis, including data management services, software products, publications, consulting and actuarial services, business process outsourcing services, clinical research outsourcing, pharmaceutical data and consulting services, and revenue cycle management solutions. Ingenix revenues for 2007 of $1.3 billion increased by $348 million, or 36%, over 2006. This was primarily driven by new business growth in the health information and contract research businesses as well as from businesses acquired since the beginning of 2006.
Ingenix earnings from operations in 2007 were $266 million, up $90 million, or 51%, from 2006. This increase in earnings from operations was primarily due to growth in the health information and contract research businesses, businesses acquired since the beginning of 2006 and effective operating cost management. The operating margin
was 20.4% in 2007, up from 18.4% in 2006. This increase in operating margin was largely driven by business growth and operating cost management described above.
Consolidated revenues in 2006 of $71.5 billion increased by $25.1 billion, or 54%, over 2005. Excluding the impact of businesses acquired since the beginning of 2005, consolidated revenues increased by approximately 21% in 2006 principally driven by the successful launch of the Medicare Part D program on January 1, 2006, rate increases on premium-based and fee-based services and growth in individuals served across our business segments. Following is a discussion of our 2006 consolidated revenue for each of our revenue components.
Premium Revenues. Consolidated premium revenues totaled $65.7 billion in 2006, an increase of $23.6 billion, or 56%, over 2005. Excluding the impact of acquisitions since the beginning of 2005, consolidated premium revenues increased by $8.8 billion, or 21%, over 2005. The increase was primarily driven by premium rate increases and the successful launch of the Medicare Part D program, partially offset by a slight decrease in the number of individuals served by our commercial risk-based products.
Commercial Markets premium revenues in 2006 totaled $35.6 billion, an increase of $7.5 billion, or 27%, over 2005. Excluding premium revenues from businesses acquired since the beginning of 2005, Commercial Markets premium revenues were essentially flat compared to 2005. This was primarily due to average net premium rate increases of approximately 8% or above on UnitedHealthcare’s renewing commercial risk-based products, offset by lower premium yields from new business primarily due to a larger portion of new customer sales generated from high-deductible lower-premium products (with correspondingly lower medical costs), and a 5% decrease in the number of individuals served by commercial risk-based products primarily due to the Company’s internal pricing decisions in a competitive commercial risk-based pricing environment and the conversion of certain groups to fee-based products. Ovations premium revenues in 2006 totaled $24.4 billion, an increase of $15.2 billion, or 165%, over 2005. Excluding the impact of acquisitions since the beginning of 2005, Ovations premium revenues increased by approximately $8.3 billion, or 92%, over 2005. The increase was primarily driven by the successful launch of the Medicare Part D program, which had premium revenues of $5.7 billion for 2006, and an increase in the number of individuals served by Medicare Advantage and standardized Medicare supplement products, as well as rate increases on these products. OptumHealth premium revenues increased by approximately $1.0 billion over 2005. This was primarily due to the acquisition of PacifiCare Health Systems, Inc. (PacifiCare) and strong growth in the number of individuals served by several OptumHealth businesses under premium-based arrangements. The remaining premium revenue increase primarily resulted from membership growth and premium revenue rate increases in AmeriChoice’s Medicaid programs, which contributed premium revenue increases of approximately $278 million, or 8%, over 2005.
Service Revenues. Service revenues in 2006 totaled $4.3 billion, an increase of $602 million, or 16%, over 2005. Excluding the impact of acquisitions since the beginning of 2005, service revenues increased by approximately 12% over 2005. The increase in service revenues was primarily driven by aggregate growth of 8% in the number of individuals served by commercial fee-based arrangements during 2006, as well as annual rate increases. In addition, Ingenix service revenues increased by approximately 22% due to new business growth in the health information and contract research businesses and from businesses acquired since the beginning of 2005.
Product Revenues. Product revenues in 2006 totaled $737 million, an increase of $579 million over 2005. This was primarily due to increased pharmacy sales at Prescription Solutions, which was acquired in December 2005 with the purchase of PacifiCare.
The operating cost ratio for 2006 of 14.0%, improved from 15.4% in 2005. This decrease was primarily driven by revenue mix changes, with premium revenues growing at a faster rate than service revenues primarily due to the new Medicare Part D program and the PacifiCare acquisition. Operating costs as a percentage of premium revenues are generally considerably lower than operating costs as a percentage of fee-based revenues. The decrease in the operating cost ratio reflected productivity gains from technology deployment and other cost management initiatives, including cost savings associated with the PacifiCare acquisition integration, and an insurance recovery of $43 million. These items were partially offset by a $22 million charitable contribution to the United Health Foundation and approximately $44 million of additional cash expenses related to the stock option review, exclusive of share-based compensation expense.
Cost of products sold in 2006 totaled $599 million, an increase of $510 million over 2005. This increase was primarily due to increased pharmacy sales at Prescription Solutions, which was acquired in December 2005 with the purchase of PacifiCare.
Depreciation and amortization in 2006 was $670 million, an increase of $217 million, or 48%, over 2005. Approximately $85 million of this increase was related to intangible assets from PacifiCare and other businesses acquired since the beginning of 2005. The remaining increase was primarily due to additional depreciation and amortization from higher levels of computer equipment and capitalized software as a result of technology enhancements, business growth and businesses acquired since the beginning of 2005.
Our effective income tax rate was 36.3% in 2006 and in 2005.
The following summarizes the operating results of our business segments for the years ended December 31:
products and a 5% decrease in the number of individuals served by commercial risk-based products in 2006 primarily due to the Company’s internal pricing decisions in a competitive commercial risk-based pricing environment and the conversion of certain groups to fee-based products. Ovations revenues of $24.6 billion in 2006 increased by approximately $15.2 billion, or 162%, over 2005. Excluding the impact of acquisitions since the beginning of 2005, Ovations revenues increased by $7.8 billion, or 85%, over 2005. The increase was primarily driven by the successful launch of the Medicare Part D program, which had premium revenues of $5.7 billion for 2006, and an increase in the number of individuals served by Medicare Advantage and standardized Medicare supplement products, as well as rate increases on these products. The remaining increase in Health Care Services revenues is attributable to a 8% increase in AmeriChoice revenues, excluding the impact of businesses acquired since the beginning of 2005, primarily driven by membership growth and premium revenue rate increases on Medicaid products.
Health Care Services earnings from operations in 2006 were $5.9 billion, representing an increase of $1.5 billion, or 34%, over 2005. This increase was principally driven by acquisitions and increases in the number of individuals served by Ovations’ Medicare and Part D products and Commercial Markets’ fee-based products. The segment also benefited by productivity gains from technology deployment and other cost management initiatives, including cost savings associated with the PacifiCare acquisition integration. These initiatives also reduced labor and occupancy costs in the transaction processing and customer service, billing and enrollment functions. The Commercial Markets medical care ratio increased to 80.5% in 2006 from 79.6% in 2005 and the UnitedHealthcare medical care ratio increased to 79.8% in 2006 from 78.6% in 2005, mainly due to the impact of the PacifiCare acquisition and changes in product, business and customer mix. Health Care Services’ operating margin for 2006 was 8.6%, a decrease from 9.9% in 2005. This decrease was driven mainly by the acquisition of PacifiCare and the new Medicare Part D program, which have lower operating margins than historic UnitedHealth Group businesses.
Excluding businesses acquired since the beginning of 2005, the number of individuals served by Medicare Advantage products increased by 230,000 from 2005 primarily due to new customer relationships, while individuals served by standardized Medicare supplement products increased by 125,000, or 6%, due to new
Earnings from operations in 2006 of $809 million increased $235 million, or 41%, over 2005. OptumHealth operating margin was 18.6% in 2006, up from 18.4% in 2005. Realized improvements in operating cost structure and benefits from the integration of PacifiCare specialty operations in 2006 were partially offset by a business mix shift toward higher revenue, lower margin products.
We manage our cash, investments and capital structure so we are able to meet the short and long-term obligations of our business while maintaining strong financial flexibility and liquidity. We forecast, analyze and monitor our cash flows to enable prudent investment management and financing within the confines of our financial strategy.
Our non-regulated businesses also generate significant cash from operations for general corporate use. Cash flows generated by these entities, combined with the issuance of commercial paper, long-term debt and the
Net cash flows from operating activities totaled $5.9 billion, $6.5 billion and $4.1 billion for 2007, 2006 and 2005, respectively. Cash from operating activities in 2007 decreased from 2006 by $649 million, or 10%, due to a reduction in working capital cash flows of $1.5 billion partially offset by an increase of $495 million in net income. The decrease in working capital cash flows was driven by lower medical costs payable growth primarily related to Ovations Medicare programs as the 2006 operating cash flows benefited from the initial establishment of the medical costs payable balance related to the Medicare Part D program, fewer income tax refunds received in 2007 as well as larger income tax payments and the timing of certain government payments and receipts. Overall, our receivables and related days sales outstanding increased primarily as a result of these governmental timing differences, while our commercial business receivables remained relatively flat.
notional amounts of $5.6 billion as of December 31, 2007, with variable rates that are benchmarked to the LIBOR. As of December 31, 2007, the aggregate asset, recorded at fair value, for all existing interest rate swaps was approximately $151 million. These interest rate swap agreements qualify as fair value hedges and are accounted for using the short-cut method under Statement of Financial Accounting Standards No. 133, “Accounting for Derivative Instruments and Hedging Activities” (FAS 133), whereby the hedges are reported in our Consolidated Balance Sheets at fair value, and the carrying value of the long-term debt is adjusted for an offsetting amount representing changes in fair value attributable to the hedged risk. Since these amounts completely offset, we have reported both the swap asset and the debt liability within debt in our Consolidated Balance Sheets and there have been no net gains or losses recognized in our Consolidated Statements of Operations. At December 31, 2007, the rates used to accrue interest expense on these agreements ranged from 4.1% to 6.1%.
Stock Repurchases. Under our Board of Directors’ authorization, we maintain a common stock repurchase program. Repurchases may be made from time to time at prevailing prices, subject to certain restrictions on volume, pricing and timing. During 2007, we repurchased 125.3 million shares which were settled for cash on or before December 31, 2007 at an average price of approximately $53 per share and an aggregate cost of approximately $6.6 billion. During 2006, we repurchased 40.2 million shares which were settled for cash on or before December 31, 2006 at an average price of approximately $56 per share and an aggregate cost of approximately $2.2 billion. As of December 31, 2007, we had Board of Directors’ authorization to purchase up to an additional 171.9 million shares of our common stock. Our common stock repurchase program is discretionary as we are under no obligation to repurchase shares. We expect to repurchase approximately $5 billion of our common stock in 2008.
As of December 31, 2007 and 2006, we had commercial paper and debt outstanding of approximately $11.0 billion and $7.5 billion, respectively. Our debt-to-total-capital ratio was 35.4% and 26.4% as of December 31, 2007 and 2006, respectively. Commercial paper consisted of senior unsecured debt sold on a discounted basis with maturities up to 270 days.
Cash and Investments. We maintained a strong liquidity position, with cash and investments of $22.3 billion and $20.6 billion at December 31, 2007 and 2006, respectively. Total cash and investments increased by $1.7 billion since December 31, 2006, primarily due to strong operating cash flows, the issuance of debt, and proceeds received from common stock issuances related to exercises of share-based awards, partially offset by common stock repurchases, repayments of debt, capital expenditures, and funds paid to Centers for Medicare & Medicaid Services (CMS) under the Medicare Part D program.
As further described under “- Dividend Restrictions,” many of our subsidiaries are subject to various government regulations that restrict the timing and amount of dividends and other distributions that may be paid to their parent companies. At December 31, 2007, approximately $2.4 billion of our $22.3 billion of cash and investments was held by non-regulated subsidiaries and was available for general corporate use, including acquisitions and common stock repurchases.
Shelf Registration. In February 2008, we filed a universal S-3 shelf registration statement with the SEC registering an unlimited amount of debt securities.
Debt Covenants. Our debt arrangements and credit facilities contain various covenants, the most restrictive of which require us to maintain a debt-to-total-capital ratio (calculated as the sum of commercial paper and debt divided by the sum of commercial paper, debt and shareholders’ equity) below 50%. We were in compliance with the requirements of all debt covenants as of December 31, 2007. On August 28, 2006, we received a purported notice of default from persons claiming to hold our 5.8% Senior Unsecured Notes due March 15, 2036 alleging a violation of the indenture governing those debt securities. This followed our announcement that we would delay filing our quarterly report on Form 10-Q for the quarter ended June 30, 2006. See Note 13 of Notes to the Consolidated Financial Statements for details.
In 2007 and 2006, based on the previous years’ statutory net income and statutory capital and surplus levels, the maximum amounts of dividends which could be paid without prior regulatory approval were $2.5 billion and $2.2 billion, respectively. For the years ended December 31, 2007 and 2006, the Company’s regulated subsidiaries paid approximately $2.9 billion and $2.5 billion in dividends to their parent companies, including approximately $400 million and $300 million of special dividends approved by state insurance regulators, respectively.
(2) Calculated using stated rates from the debt agreements and related interest rate swap agreements and assuming amounts are outstanding through their contractual term. For variable-rate obligations, we used the rates in place as of December 31, 2007 to estimate all remaining contractual payments. Includes unamortized discounts from par values.
(3) Includes fixed or minimum commitments under existing purchase obligations for goods and services, including agreements which are cancelable with the payment of an early termination penalty. Excludes agreements that are cancelable without penalty and also excludes liabilities to the extent recorded in our Consolidated Balance Sheets at December 31, 2007.
(6) Includes remaining capital commitments for equity investment funds and the investment commitment related to the PacifiCare acquisition discussed below.
(7) Includes future payments to optionholders related to the application of Section 409A, as well as obligations associated with certain employee benefit programs and charitable contributions related to the PacifiCare acquisition discussed below, which have been classified as “Thereafter” due to uncertainty regarding payment timing.
California’s health care infrastructure to further health care services to the underserved populations of the California marketplace, of which $8 million was invested at December 31, 2007. The timing and amount of individual contributions and investments are at our discretion subject to the advice and oversight of the local regulatory authorities; however, our goal is to have the investment commitment fully funded by the end of 2010. The investment commitment remains in place for 20 years after funding. The unfunded charitable commitment and investment commitment have been included in the above table.
At December 31, 2007, we had pending cash acquisitions. See Note 4 of Notes of the Consolidated Financial Statements for further detail.
We do not have any other material contractual obligations, off-balance sheet arrangements or commitments that require cash resources; however, we continually evaluate opportunities to expand our operations. This includes internal development of new products, programs and technology applications, and may include acquisitions.
These changes result in an increase in the amount of losses or profits that we may realize from this contract in 2008 as the amount of risk retained by CMS has diminished.
The underwriting gains or losses related to the AARP Medicare Supplement Insurance business are directly recorded as an increase or decrease to a rate stabilization fund (RSF). The primary components of the underwriting results are premium revenue, medical costs, investment income, administrative expenses, member service expenses, marketing expenses and premium taxes. Underwriting gains and losses are recorded as an increase or decrease to the RSF and accrue to the overall benefit of the AARP policyholders, unless cumulative net losses were to exceed the balance in the RSF. To the extent underwriting losses exceed the balance in the RSF, we would have to fund the deficit. Any deficit we fund could be recovered by underwriting gains in future periods of the contract. To date, we have not been required to fund any underwriting deficits. As further described in Note 12 of Notes to the Consolidated Financial Statements, the RSF balance is reported in Other Policy Liabilities in the Consolidated Balance Sheets. We believe the RSF balance is sufficient to cover potential future underwriting and other risks and liabilities associated with the contract.
Each reporting period, we estimate our obligations for medical care services that have been rendered on behalf of insured consumers but for which claims have either not yet been received or processed, and for liabilities for physician, hospital and other medical cost disputes. We develop estimates for medical care services incurred but
Each period, we re-examine previously established medical costs payable estimates based on actual claim submissions and other changes in facts and circumstances. As more complete claim information becomes available, we adjust the amount of the estimates, and include the changes in estimates in medical costs in the period in which the change is identified. In every reporting period, our operating results include the effects of more completely developed medical costs payable estimates associated with previously reported periods. If the revised estimate of prior period medical costs is less than the previous estimate, we will decrease reported medical costs in the current period (favorable development). If the revised estimate of prior period medical costs is more than the previous estimate, we will increase reported medical costs in the current period (unfavorable development). Historically, the net impact of estimate developments has represented less than 1% of annual medical costs, less than 5% of annual earnings from operations and less than 4% of medical costs payable.
In developing our medical costs payable estimates, we apply different estimation methods depending on the month for which incurred claims are being estimated. For example, we actuarially calculate completion factors using an analysis of claim adjudication patterns over the most recent 36-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 by us as of the date of estimation. For months prior to the most recent three months, 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. We do not believe that completion factors are a reliable basis for estimating claims incurred for the most recent three months as there is typically insufficient claim data available for those months to calculate credible completion factors. Accordingly, for the most recent three months, we estimate claim costs incurred primarily by applying observed medical cost trend factors to the average per member per month (PMPM) medical costs incurred in prior months for which more complete claim data is available, supplemented by a review of near-term completion factors. Medical cost trend factors are developed through a comprehensive analysis of claims incurred in prior months for which more complete claim data is available and by reviewing a broad set of health care utilization indicators including, but not limited to, pharmacy utilization trends, inpatient hospital census data and incidence data from the National Centers for Disease Control, as well as through a review of near-term completion factors. This approach is consistently applied from period to period.
Completion factors are the most significant factors we use in developing our medical costs payable estimates for older periods, generally periods prior to the most recent three months. The following table illustrates the sensitivity of these factors and the estimated potential impact on our medical costs payable estimates for those periods as of December 31, 2007:
The analyses above include those outcomes that are considered reasonably likely based on our historical experience in estimating liabilities for incurred but not reported benefit claims.
Revenues are principally derived from health care insurance premiums. We recognize premium revenues in the period eligible individuals are entitled to receive health care services. Customers are typically billed monthly at a contracted rate per eligible person multiplied by the total number of people eligible to receive services, as recorded in our records. Employer groups generally provide us with changes to their eligible population one month in arrears. Each billing includes an adjustment for prior period changes in eligibility status that were not reflected in our previous billing. We estimate and adjust the current period’s revenues and accounts receivable accordingly. Our estimates are based on historical trends, premiums billed, the level of contract renewal activity and other relevant information. We revise estimates of revenue adjustments each period and record changes in the period they become known.
As of December 31, 2007, we had approximately $13.4 billion of investments, primarily held in marketable debt securities. Our investments are principally classified as available for sale and are recorded at fair value. We exclude unrealized gains and losses on investments available for sale from earnings and report them together, net of income tax effects, as a separate component in shareholders’ equity. We continually monitor the difference between the cost and fair value of our investments. As of December 31, 2007, our investments had gross unrealized gains of $182 million and gross unrealized losses of $27 million. If any of our investments experience a decline in fair value that is determined to be other than temporary, based on analysis of relevant factors, we record a realized loss in our Consolidated Statements of Operations. Management judgment is involved in evaluating whether a decline in an investment’s fair value is other than temporary. We analyze relevant factors individually and in combination including the length of time and extent to which market value has been less than cost, the financial condition and near-term prospects of the issuer as well as specific events or circumstances that may influence the operations of the issuer, and our intent and ability to hold the investment for a sufficient time in order to enable recovery of our cost. New information and the passage of time can change these judgments. We revise impairment judgments when new information becomes known or when we do not anticipate holding the investment until recovery and record any resulting impairment charges at that time. We manage our investment portfolio to limit our exposure to any one issuer or industry and largely limit our investments to U.S. Government and Agency securities, state and municipal securities, and corporate debt obligations that are investment grade.
Matters relating to or arising out of our historical stock option practices, including regulatory inquiries, litigation matters, and potential additional cash and noncash charges could have a material adverse effect on the Company.
As previously disclosed, the SEC and the U.S. Attorney for the Southern District of New York are conducting investigations into the Company’s historical stock option practices and the Company has received requests for documents from the Minnesota Attorney General and various Congressional committees in connection with these issues and the Company’s executive compensation practices. We have not resolved these matters. We cannot provide assurance that the Company will not be subject to adverse publicity, regulatory or criminal fines, penalties, or other sanctions or contingent liabilities or adverse customer reactions in connection with these matters. In addition, we may be subject to additional regulatory inquiries arising out of the review of the Independent Committee, the review of a special litigation committee, consisting of two former Minnesota Supreme Court Justices, appointed by our Board of Directors to review claims asserted in federal and state shareholder derivative claims relating to our historical stock option practices (Special Litigation Committee), and the related restatement of our historical financial statements. Regulatory inquiries may be time consuming, expensive and distracting from the conduct of our business. The adverse resolution of any regulatory inquiry could have a material adverse effect on our business, financial condition and results of operations.
We and certain of our current and former directors and officers are defendants in a consolidated federal securities class action, an Employment Retirement Income Security Act of 1974, as amended (ERISA) class action, and state and federal shareholder derivative actions relating to our historical stock option practices. We also have received shareholder demands relating to those practices.
While we believe we have made appropriate judgments in our restated financial statements in determining the financial impacts of our historical stock option practices, we cannot provide assurance that the SEC will agree with the manner in which we have accounted for and reported, or not reported, the financial impacts, including the adjustments that we made based on our determination of the measurement dates for our historical stock option grants. If the SEC disagrees with our financial adjustments and such disagreement results in material changes to our historical financial statements, we may have to further restate our prior financial statements, amend prior filings with the SEC, or take other actions not currently contemplated.
In addition, other adjustments for non-operating cash charges may be required in connection with the resolution of stock option-related matters arising under litigation and the above-referenced regulatory reviews, the amount and timing of which are uncertain but which could be material.
State legislatures and Congress continue to focus on health care issues. Legislative and regulatory proposals at state and federal levels may affect certain aspects of our business, including contracting with physicians, hospitals and other health care professionals; physician reimbursement methods and payment rates; coverage determinations; mandated benefits and minimum medical expenditures; claim payments and processing; drug utilization and patient safety efforts; use and maintenance of individually identifiable health information; medical malpractice litigation; consumer-driven health plans and health savings accounts and insurance market reforms; confidentiality of health information; and government-sponsored programs. For example, from time to time, Congress has considered various forms of managed care reform legislation which if adopted, could fundamentally alter the treatment of coverage decisions under ERISA. Additionally, there have been legislative attempts to limit ERISA’s preemptive effect on state laws. If adopted, such limitations could increase our liability exposure and could permit greater state regulation of our operations. We cannot predict if any of these initiatives will ultimately become law, or, if enacted, what their terms or the regulations promulgated pursuant to such laws will be, but their enactment could increase our costs, expose us to expanded liability and require us to revise the ways in which we conduct business or put us at risk for loss of business.
We are also involved in various governmental investigations, audits and reviews. These regulatory activities include routine, regular and special investigations, audits and reviews by CMS, state insurance and health and welfare departments and state attorneys general, the Office of the Inspector General, the Office of Personnel Management, the Office of Civil Rights, the U.S. Department of Justice, U.S. Attorneys, the SEC and other governmental authorities. Reviews and investigations of this sort can lead to government actions, which can result in the assessment of damages, civil or criminal fines or penalties, or other sanctions, including restrictions or changes in the way we conduct business, loss of licensure or exclusion from participation in government programs. For example, in 2007, the California Department of Managed Health Care and the California Department of Insurance examined our PacifiCare health plans in California. As a result of these examinations, the California Department of Managed Health Care has assessed a penalty of $3.5 million related to its findings. The California Department of Insurance, however, has not yet levied a financial penalty related to its findings. In addition, public perception or publicity surrounding routine governmental investigations may adversely affect our stock price, damage our reputation in various markets or make it more difficult for us to sell products and services.
Our business providing PBM services are subject to federal and state regulations associated with the PBM industry and if we fail to comply with these regulations, our business, financial condition and results of operations could be materially adversely affected.
In connection with the PacifiCare merger, we acquired a PBM business, Prescription Solutions. We also provide PBM services through UnitedHealth Pharmaceutical Solutions. Prescription Solutions and UnitedHealth Pharmaceutical Solutions are subject to federal and state anti-kickback and other laws that govern their relationships with pharmaceutical manufacturers, customers and consumers. In addition, federal and state legislatures regularly consider new regulations for the industry that could adversely affect current industry practices, including the receipt or required disclosure of rebates from pharmaceutical companies. In the event a court were to determine that our PBM business acts as a fiduciary under ERISA, we could be subject to claims for alleged breaches of fiduciary obligations in implementation of formularies, preferred drug listings and drug management programs, contracting network practices, specialty drug distribution and other transactions. Our PBM business also conducts business as a mail order pharmacy, which subjects it to extensive federal, state and local laws and regulations. The failure to adhere to these laws and regulations could expose our PBM subsidiary to civil and criminal penalties. We also face potential claims in connection with purported errors by our mail order pharmacy, including in connection with the risks inherent in the packaging and distribution of pharmaceuticals and other health care products.
A reduction or less than expected increase in Medicare and Medicaid program funding and/or our failure to retain and acquire Medicare, Medicaid and State Medicaid Children’s Health Insurance Programs (SCHIP) enrollees could adversely affect our revenues and financial results.
We participate as a payer in Medicare Advantage, Medicare Part D, and various Medicaid and SCHIP programs and receive revenues from the Medicare, Medicaid and SCHIP programs to provide benefits under these programs. Our participation in these programs is through bids that are submitted periodically. Revenues for these programs are dependent upon periodic funding from the federal government or applicable state governments and allocation of the funding through various payment mechanisms. Funding for these programs is dependent upon
If we fail to develop and maintain satisfactory relationships with physicians, hospitals and other health care providers, our business could be adversely affected.
Our relationship with AARP is important and the loss of such relationship could have an adverse effect on our business and results of operations.
Under our agreements with AARP, we provide AARP-branded Medicare Supplement insurance, hospital indemnity insurance and other products to AARP members and Medicare Part D prescription drug plans to AARP members and non-members. One of our agreements with AARP expands the relationship to include AARP-branded Medicare Advantage plans for AARP members and non-members. Our agreements with AARP contain commitments regarding corporate governance, corporate social responsibility, diversity and measures intended to improve and simplify the health care experience for consumers. The AARP agreements may be terminated early under certain circumstances, including, depending on the agreement, a material breach by either party, insolvency of either party, a material adverse change in the financial condition of the Company, material changes in the Medicare programs, material harm to AARP caused by the Company, and by mutual agreement. The success of our AARP arrangements depends, in part, on our ability to service AARP and its members, develop additional products and services, price the products and services competitively, meet our corporate governance, corporate social responsibility, and diversity commitments, and respond effectively to federal and state regulatory changes. The loss of our AARP relationship could have an adverse effect on our business and results of operations.
Because of the nature of our business, we are routinely subject to various litigation actions, which, if resolved unfavorably to us, could result in substantial monetary damages.
Periodically, we become a party to the types of legal actions that can affect any business, such as employment and employment discrimination-related suits, employee benefit claims, breach of contract actions, tort claims, shareholder suits, and intellectual property-related litigation. In addition, because of the nature of our business, we are routinely made party to a variety of legal actions related to the design and management of our service offerings. These matters include, among others, claims related to health care benefits coverage and payment (including disputes with enrollees, customers, and contracted and non-contracted physicians, hospitals and other health care professionals), medical malpractice actions, contract disputes and claims related to disclosure of certain business practices. We are also party to certain class action lawsuits brought by health care professional groups.
We are largely self-insured with regard to litigation risks. Although we maintain excess liability insurance with outside insurance carriers for claims in excess of our self-insurance, certain types of damages, such as punitive damages in some circumstances, are not covered by insurance. We record liabilities for our estimates of the probable costs resulting from self-insured matters, however, it is possible that the level of actual losses may exceed the liabilities recorded.
A description of material legal actions in which we are currently involved is included in Note 13 of Notes to the Consolidated Financial Statements. We cannot predict the outcome of these actions with certainty, and we are incurring expenses in resolving these matters. Therefore, these legal actions could have a material adverse effect on our financial position, results of operations and cash flows.
We rely on our agreements with customers, confidentiality agreements with employees, and our trademarks, trade secrets, copyrights and patents to protect our proprietary rights. These legal protections and precautions may not prevent misappropriation of our proprietary information. In addition, substantial litigation regarding intellectual property rights exists in the software industry, and we expect software products to be increasingly subject to third-party infringement claims as the number of products and competitors in this industry segment grows. Such litigation and misappropriation of our proprietary information could hinder our ability to market and sell products and services and our revenues and results of operations could be adversely affected.
If the value of our intangible assets is materially impaired, our results of operations, shareholders’ equity and debt ratings could be materially adversely affected.
Due largely to our recent acquisitions, goodwill and other intangible assets represent a substantial portion of our assets. Goodwill and other intangible assets were approximately $18.6 billion as of December 31, 2007, representing approximately 37% of our total assets. If we make additional acquisitions, it is likely that we will record additional intangible assets on our books. We periodically evaluate our goodwill and other intangible assets to determine whether all or a portion of their carrying values may no longer be recoverable, in which case a charge to earnings may be necessary. Any future evaluations requiring an asset impairment of our goodwill and other intangible assets could materially affect our results of operations and shareholders’ equity in the period in which the impairment occurs. A material decrease in shareholders’ equity could, in turn, negatively impact our debt ratings or potentially impact our compliance with existing debt covenants.
Downgrades in our debt ratings, should they occur, may adversely affect our business, financial condition and results of operations.
Any failure by us to manage acquisitions and other significant transactions successfully could harm our financial results, business and prospects.
Fluctuations in the fixed income or equity markets could impair our profitability and capital position. Volatility in interest rates affects our returns on, and the market value of, fixed income and short term investments, which comprise the majority of the fair value of our investments at December 31, 2007. In addition, defaults by issuers, primarily from investments in liquid corporate and municipal bonds, who fail to pay or perform on their obligations could reduce our investment income and net realized investment gains or result in investment losses as we may be required to write down the value of our investments, which would adversely affect our profitability and shareholders’ equity.
We also invest a smaller proportion of our investments in equity investments, which are subject to greater volatility than fixed income investments. General economic conditions, stock market conditions, and many other factors beyond our control can adversely affect the value of our equity investments and may result in investment losses.
These Consolidated Financial Statements include certain amounts that are based on our best estimates and judgments. These estimates require us to apply complex assumptions and judgments, often because we must make estimates about the effects of matters that are inherently uncertain and will likely change in subsequent periods. The most significant estimates relate to medical costs, medical costs payable, revenues, intangible asset valuations, asset impairments, investment valuation and contingent liabilities. We adjust these estimates each period, as more current information becomes available. The impact of any changes in estimates is included in the determination of earnings in the period in which the estimate is adjusted.
claims processing and formulary design and management. Product revenues include ingredient costs (net of rebates), a negotiated dispensing fee and customer co-payments for drugs dispensed through our mail-service pharmacy. In all retail pharmacy transactions, revenues recognized always exclude the member’s applicable co-payment. Product revenues are recognized upon sale or shipment. Service revenues are recognized when the prescription claim is adjudicated. The Company has entered into retail service contracts that separately obligate us to pay our network pharmacy providers for benefits provided to its customers, whether or not we are paid. We are also involved in establishing the prices charged by retail pharmacies, determining which drugs will be included in formulary listings and selecting which retail pharmacies will be included in the network offered to plan sponsors’ members. As a result, revenues are reported on a gross basis in accordance with Emerging Issues Task Force (EITF) Issue No. 99-19, “Reporting Gross Revenue as a Principal versus Net as an Agent.” Product revenues also include sales of Ingenix syndicated content products which are recognized as revenue upon shipment.
Medical costs and medical costs payable include estimates of our obligations for medical care services that have been rendered on behalf of insured consumers but for which we have either not yet received or processed claims, and for liabilities for physician, hospital and other medical cost disputes. We develop estimates for medical costs incurred but not reported using an actuarial process that is consistently applied, centrally controlled and automated. The actuarial models consider factors such as time from date of service to claim receipt, claim backlogs, care professional contract rate changes, medical care consumption and other medical cost trends. We estimate liabilities for physician, hospital and other medical cost disputes based upon an analysis of potential outcomes, assuming a combination of litigation and settlement strategies. Each period, we re-examine previously established medical costs payable estimates based on actual claim submissions and other changes in facts and circumstances. As the liability estimates recorded in prior periods become more exact, we adjust the amount of the estimates, and include the changes in estimates in medical costs in the period in which the change is identified. In every reporting period, our operating results include the effects of more completely developed medical costs payable estimates associated with previously reported periods.
Property, equipment and capitalized software are stated at cost, net of accumulated depreciation and amortization. Capitalized software consists of certain costs incurred in the development of internal-use software, including external direct costs of materials and services and payroll costs of employees devoted to specific software development.
Goodwill represents the amount by which the purchase price of businesses we have acquired exceeds the estimated fair value of the net tangible assets and separately identifiable intangible assets of these businesses. Goodwill and intangible assets with indefinite useful lives are not amortized, but are tested at least annually for impairment. Intangible assets with discrete useful lives are amortized on a straight-line basis over their estimated useful lives. There was no impairment at December 31, 2007.
Other policy liabilities include the RSF associated with the AARP program (See Note 12), deposits under the Medicare Part D program (See Note 3), customer balances related to experience-rated insurance products and the current portion of future policy benefits for life insurance and annuity contracts. Customer balances represent excess customer payments and deposit accounts under experience-rated contracts. At the customer’s option, these balances may be refunded or used to pay future premiums or claims under eligible contracts.
Future policy benefits for life insurance and annuity contracts represent account balances that accrue to the benefit of the policyholders, excluding surrender charges, for universal life and investment annuity products. As a result of the October 2005 sale of the life and annuity business within our subsidiary Golden Rule Financial Corporation (Golden Rule) under an indemnity reinsurance arrangement, we have maintained a liability associated with the reinsured contracts, as we remain primarily liable to the policyholders, and have recorded a corresponding reinsurance receivable due from the purchaser in Other Assets in the Consolidated Balance Sheets. We evaluate the financial condition of the reinsurer and only record the reinsurance receivable to the extent of probable recovery.
The carrying amounts reported in the Consolidated Balance Sheets for cash and cash equivalents, premium and other receivables, unearned premiums, accounts payable and accrued expenses, income taxes payable, and certain other current liabilities approximate fair value because of their short-term nature.
Current and long-term investments, available-for-sale, at fair value: The carrying amount is stated at fair value, based on quoted market prices, where available. For securities not actively traded, fair values were estimated using values obtained from independent pricing services or quoted market prices of comparable instruments.
In June 2006, the FASB issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109” (FIN 48). FIN 48 clarifies the accounting for income taxes by prescribing a minimum recognition threshold that a tax position is required to meet before being recognized in the financial statements. FIN 48 also provides guidance on derecognition, measurement, classification, interest and penalties, disclosure and transition. We adopted FIN 48 as of January 1, 2007 (See Note 11).
In December 2007, the FASB issued FAS No. 141 (Revised 2007), “Business Combinations” (FAS 141R) which replaces FAS No. 141, “Business Combinations”. FAS 141R establishes principles and requirements for how an acquirer recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, any noncontrolling interest in the acquiree and the goodwill acquired. The statement also establishes disclosure requirements that will enable users to evaluate the nature and financial effects of the business combination. FAS 141R is effective for our fiscal year 2009 and must be applied prospectively to all new acquisitions closing on or after January 1, 2009. Early adoption of this standard is not permitted. We are currently evaluating the impact, if any, of FAS 141R on our Consolidated Financial Statements.
In December 2007, the FASB issued FAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements - An Amendment of ARB No. 51” (FAS 160). FAS 160 requires that accounting and reporting for minority interests be recharacterized as noncontrolling interests and classified as a component of equity. The standard is effective for our fiscal year 2009 and must be applied prospectively. We do not expect that the adoption of FAS 160 will have a material impact on our Consolidated Financial Statements.
In February 2007, the FASB issued FAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities - Including an amendment of FASB Statement No. 115” (FAS 159). FAS 159 expands the use of fair value accounting but does not affect existing standards that require assets or liabilities to be carried at fair value. Under FAS 159, a company may elect to use fair value to measure various assets and liabilities including accounts receivable, available-for-sale and held-to-maturity securities, equity method investments, accounts payable, guarantees and issued debt. If the use of fair value is elected, any upfront costs and fees related to the item must be recognized in earnings and cannot be deferred. The fair value election is irrevocable and generally made on an instrument-by-instrument basis, even if a company has similar instruments that it elects not to measure based on fair value. At the adoption date, unrealized gains and losses on existing items for which fair value has been elected are reported as a cumulative adjustment to beginning retained earnings. Subsequent to the adoption of FAS 159, changes in fair value are recognized in earnings. FAS 159 is effective for our fiscal year 2008. We are currently evaluating the impact, if any, of FAS 159 on our Consolidated Financial Statements.
Catastrophic Reinsurance Subsidy - CMS pays the Company a cost reimbursement estimate monthly to fund the CMS obligation to pay approximately 80% of the costs incurred by individual members in excess of the individual annual out-of-pocket maximum of $3,850. A settlement is made based on actual cost experience subsequent to the end of the plan year.
Low-Income Member Cost Sharing Subsidy - For qualifying low-income members, CMS pays on the member’s behalf, some or all of a member’s cost sharing amounts, such as deductibles and coinsurance. The
cost sharing subsidy is funded by CMS through monthly payments to the Company. The Company administers and pays the subsidized portion of the claims on behalf of CMS, and a settlement payment is made between CMS and the Company based on actual claims experience, subsequent to the end of the plan year.
The CMS Premium, the Member Premium, and the Low-Income Premium Subsidy represent payments for the Company’s insurance risk coverage under the Medicare Part D program and therefore are recorded as Premium Revenues in the Consolidated Statements of Operations. Premium revenues are recognized ratably over the period in which eligible individuals are entitled to receive prescription drug benefits. We record premium payments received in advance of the applicable service period in Unearned Premiums in the Consolidated Balance Sheets.
The risk-share payable due to CMS for the 2007 contract year through December 31, 2007 was approximately $145 million. This final risk-share amount is expected to be settled approximately six months after the contract year-end. The risk-share payable due to CMS as of December 31, 2007 for the 2006 contract year was approximately $135 million, subject to the reconciliation process with CMS, and was paid in January 2008. These risk-share payables, totalling $280 million are recorded in Other Policy Liabilities in the Consolidated Balance Sheets.
The risk-share provisions take effect if actual costs are more than 5% above or below expected costs.
On January 10, 2008, we acquired all of the outstanding shares of Fiserv Health, Inc. (Fiserv Health), a subsidiary of Fiserv, Inc., for $730 million in cash. Fiserv Health is a leading administrator of medical benefits and also provides care facilitation services, specialty health solutions and PBM services. The acquired businesses will each align with our Health Care Services, OptumHealth, Ingenix and Prescription Solutions segments. We expect that this transaction will allow us to expand the capacity of our existing benefits administration businesses and enable existing and new Fiserv Health customers to leverage our full range of assets, including ancillary services, our national network and technology tools. The pro forma effects of this acquisition on our Consolidated Financial Statements were not material.
price and the associated income tax effects of the pro forma adjustments. The following unaudited pro forma results have been prepared for comparative purposes only and do not purport to be indicative of the results of operations that would have occurred had the acquisition been consummated at the beginning of the period.
We record liabilities related to integration activities in connection with business combinations when integration plans are finalized and approved by management within one year of the acquisition date in accordance with the requirements of EITF Issue No. 95-3, “Recognition of Liabilities in Connection with a Purchase Business Combination.” Liabilities recorded relate to activities that have no future economic benefit to the Company and represent contractual obligations. These liabilities result in an increase to goodwill acquired. At each reporting date, we evaluate our liabilities associated with integration activities and make adjustments as appropriate. Integration activities relate primarily to severance costs for certain workforce reductions largely in the Health Care Services segment, costs of terminated or vacated leased facilities and other contract termination costs. The following table illustrates the changes in employee termination benefit costs and other integration costs related to the PacifiCare acquisition as of December 31, 2007:
For the years ended December 31, 2007, 2006 and 2005, aggregate consideration paid, net of cash assumed and other effects, for smaller acquisitions was $262 million, $276 million and $196 million, respectively. These acquisitions were not material to our Consolidated Financial Statements.
At December 31, 2007, the fair value of debt securities had the following maturity dates:
becomes known or when we do not anticipate holding the investment until recovery. If any of our investments experience a decline in fair value that is determined to be other-than-temporary, based on analysis of relevant factors, we record a realized loss in our Consolidated Statements of Operations. We do not consider the unrealized losses on each of the investments described above to be other-than-temporarily impaired at December 31, 2007.
We recorded realized gains and losses on sales of investments, as follows:
Included in the realized losses above are impairment charges of $6 million, $4 million and $8 million for 2007, 2006 and 2005, respectively.
The gross carrying value, accumulated amortization and net carrying value of other intangible assets as of December 31, 2007 and 2006, were as follows:
Amortization expense relating to intangible assets was $192 million in 2007, $181 million in 2006 and $94 million in 2005. Estimated full year amortization expense relating to intangible assets for each of the next five years is as follows: $185 million in 2008, $167 million in 2009, $158 million in 2010, $153 million in 2011, and $151 million in 2012.
Medical costs and medical costs payable include estimates of our obligations for medical care services that have been rendered on behalf of insured consumers but for which we have either not yet received or processed claims, and for liabilities for physician, hospital and other medical cost disputes. We develop estimates for medical costs incurred but not reported using an actuarial process that is consistently applied, centrally controlled and automated. The actuarial models consider factors such as time from date of service to claim receipt, claim backlogs, care professional contract rate changes, medical care consumption and other medical cost trends. We estimate liabilities for physician, hospital and other medical cost disputes based upon an analysis of potential outcomes, assuming a combination of litigation and settlement strategies. Each period, we re-examine previously established medical costs payable estimates based on actual claim submissions and other changes in facts and circumstances. As the liability estimates recorded in prior periods become more exact, we adjust the amount of the estimates, and include the changes in estimates in medical costs in the period in which the change is identified. For example, in every reporting period, our operating results include the effects of more completely developed medical costs payable estimates associated with previously reported periods.
As of December 31, 2007, our outstanding commercial paper had interest rates ranging from 5.1% to 5.5%.
Maturities of commercial paper and debt for the years ending December 31 are as follows: $1.9 billion in 2008, $1.4 billion in 2009, $750 million in 2010, $749 million in 2011, $448 million in 2012 and $5.8 billion thereafter.
In November 2007, we issued $500 million of zero coupon notes due November 2022. These zero coupon notes are original issue discount notes with an aggregate principal amount due at maturity of approximately $1.1
In November 2007, we entered into a $1.5 billion 364-day revolving credit facility in order to expand our access to liquidity. The credit facility supports our commercial paper program and is available for general working capital purposes. As of December 31, 2007, we had no amounts outstanding under this bank credit facility.
On December 1, 2006, our Health Care Services business segment acquired the Student Insurance Division (Student Resources) of The MEGA Life and Health Insurance Company through an asset purchase agreement. Under the terms of the asset purchase agreement, we issued a 10-year, 5.4% promissory note for approximately $95 million and paid approximately $1 million in cash in exchange for the net assets of Student Resources.
On February 24, 2006, our Health Care Services business segment acquired John Deere Health Care, Inc. (JDHC). Under the terms of the purchase agreement, we paid approximately $515 million in cash, including transaction costs, in exchange for all of the outstanding equity of JDHC. We issued commercial paper to finance the JDHC purchase price. JDHC has been renamed UnitedHealthcare Services Company of the River Valley, Inc.
Instruments and Hedging Activities” (FAS 133), whereby the hedges are reported in our Consolidated Balance Sheets at fair value, and the carrying value of the long-term debt is adjusted for an offsetting amount representing changes in fair value attributable to the hedged risk. Since these amounts completely offset, we have reported both the swap asset and the debt liability within debt in our Consolidated Balance Sheets and there have been no net gains or losses recognized in our Consolidated Statements of Operations. At December 31, 2007, the rates used to accrue interest expense on these agreements ranged from 4.1% to 6.1%.
Our debt arrangements and credit facilities contain various covenants, the most restrictive of which require us to maintain a debt-to-total-capital ratio (calculated as the sum of commercial paper and debt divided by the sum of commercial paper, debt and shareholders’ equity) below 50%. We were in compliance with the requirements of all debt covenants as of December 31, 2007. On August 28, 2006, we received a purported notice of default from persons claiming to hold our 5.8% Senior Unsecured Notes due March 15, 2036 alleging a violation of the indenture governing those debt securities. This followed our announcement that we would delay filing our quarterly report on Form 10-Q for the quarter ended June 30, 2006 (See Note 13).
PacifiCare had approximately $100 million par value of 3% convertible subordinated debentures (convertible notes) which were convertible into approximately 5.2 million shares of UnitedHealth Group’s common stock and $102 million of cash as of December 31, 2005. In December 2005, we initiated a consent solicitation to all of the holders of outstanding convertible notes pursuant to which we offered to compensate all holders who elected to convert their notes in accordance with existing terms and consent to an amendment to a covenant in the indenture governing the convertible notes. The compensation consisted of the present value of interest through October 18, 2007, the earliest mandatory redemption date, plus a pro rata share of $1 million. On January 31, 2006, approximately $91 million of the convertible notes were tendered pursuant to the offer, for which we issued 4.8 million shares of UnitedHealth Group common stock, valued at $282 million, and cash of $93 million and amended the indenture governing these notes. During 2007, approximately $9 million of convertible notes were tendered for conversion, for which we issued 470,119 shares of UnitedHealth Group common stock, valued at approximately $24 million, and cash of approximately $10 million. In September 2007, we notified the remaining holders of our intent to fully redeem all outstanding convertible notes on October 18, 2007, the earliest redemption date. As of October 16, 2007, all convertible notes were tendered pursuant to this redemption notice.
We conduct a significant portion of our operations through subsidiaries that are subject to standards established by the National Association of Insurance Commissioners. These standards, among other things, require these subsidiaries to maintain specified levels of statutory capital, as defined by each state, and restrict the timing and amount of dividends and other distributions that may be paid to their parent companies. Generally, the amount of dividend distributions that may be paid by a regulated subsidiary, without prior approval by state regulatory authorities, is limited based on the entity’s level of statutory net income and statutory capital and surplus. At December 31, 2007, approximately $2.4 billion of our $22.3 billion of cash and investments was held by non-regulated subsidiaries and was available for general corporate use, including acquisitions and common stock repurchases.
At December 31, 2007, we had 10 million shares of $0.001 par value preferred stock authorized for issuance, and no preferred shares issued and outstanding.
Stock options and SARs generally vest ratably over four to six years and may be exercised up to 10 years from the date of grant. Stock option and SAR activity for the year ending December 31, 2007 is summarized in the table below:
Restricted stock awards generally vest ratably over two to five years. Compensation expense related to restricted stock awards is determined based upon the fair value of each award on the date of grant. Restricted stock award activity for the year ending December 31, 2007 is summarized in the table below:
For 2007, 2006 and 2005, the income tax benefit realized from share-based awards was $399 million, $287 million and $311 million, respectively.
We have provided Supplemental Executive Retirement Plan benefits (SERPs), which are non-qualified defined benefit plans, for our current CEO and our former CEO, as well as for certain nonexecutive officers under a plan that was assumed in an acquisition. No additional amounts are accruing to the SERPs of our current CEO and former CEO. The SERPs are non-contributory, unfunded and provide benefits based on years of service and compensation during employment. Pension expense is determined using various actuarial methods to estimate the total benefits ultimately payable to executives, and is allocated to service periods. The actuarial assumptions used to calculate pension costs are reviewed annually. Pension expense was not significant for the years 2007, 2006 and 2005. The total SERP liability was $139 million and $131 million as of December 31, 2007 and 2006, respectively, and is recorded within Other Long Term Liabilities in the Consolidated Balance Sheets.
In addition, the Company maintains non-qualified, unfunded deferred compensation plans, which allow certain members of senior management and executives to defer portions of their salary or bonus and receive certain Company contributions on such deferrals, subject to plan limitations. The deferrals are recorded within
Long-Term Investments with an equal amount in Long-Term Other Liabilities in the Consolidated Balance Sheets. The total deferrals are distributable based upon termination of employment or other periods, as elected under each plan and are $225 million and $212 million as of December 31, 2007 and 2006, respectively.
Valuation allowances are provided when it is considered more likely than not that deferred tax assets will not be realized. The valuation allowances primarily relate to future tax benefits on certain federal and state net operating loss carryforwards. Federal net operating loss carryforwards expire beginning in 2008 through 2027, and state net operating loss carryforwards expire beginning in 2008 through 2027.
We classify interest and penalties associated with uncertain income tax positions as income taxes within our Consolidated Financial Statements. During the year ended December 31, 2007, the Company recognized approximately $28 million in interest expense. The Company had approximately $54 million of accrued interest at December 31, 2007, which is reported in Accounts Payable and Accrued Liabilities in the Consolidated Balance Sheets. This amount is not included in the reconciliation above. No amount was accrued for penalties. As of December 31, 2007, the total amount of unrecognized tax benefits that, if recognized, would affect the effective tax rate was $131 million.
We currently file income tax returns in the U.S. federal jurisdiction, various states, and foreign jurisdictions. The U.S. Internal Revenue Service (IRS) has completed exams on the consolidated income tax returns for fiscal years 2006 and prior. Our 2007 tax return is under advance review by the IRS under its Compliance Assurance Program (CAP). With the exception of a few states, we are no longer subject to income tax examinations prior to 2002 in major state and foreign jurisdictions. We do not believe any adjustments that may result from these examinations will be significant.
We believe it is reasonably possible that our liability for unrecognized tax benefits will decrease in the next twelve months by $75 million or less as a result of audit settlements and the expiration of statutes of limitations in certain major jurisdictions.
On October 3, 2007, we entered into four agreements with AARP that amended our existing AARP arrangements and incorporated many of the terms of the April 13, 2007 AARP agreement. These agreements extended our arrangements with AARP on the Supplemental Health Insurance Program to December 31, 2017, extended our arrangement with AARP on the Medicare Part D business to December 31, 2014, and gave us an exclusive right to use the AARP brand on our Medicare Advantage offerings until December 31, 2014, subject to certain limited exclusions.
Pursuant to our agreement, AARP assets under management are managed separately from our general investment portfolio and are used to pay costs associated with the AARP program. These assets are invested at our discretion, within investment guidelines approved by the Supplemental Health Insurance Program. We do not guarantee any rates of investment return on these investments and, upon transfer of this AARP agreement to another entity, we would transfer cash equal in amount to the fair value of these investments at the date of transfer to that entity. Interest earnings and realized investment gains and losses on these assets accrue to the overall benefit of the AARP policyholders through the RSF and, thus, are not included in our earnings. Interest income and realized gains and losses related to assets under management are recorded as an increase to the AARP RSF and were $108 million, $94 million and $90 million in 2007, 2006 and 2005, respectively. Assets under management are reported at their fair market value, and unrealized gains and losses are included directly in the RSF associated with the AARP program. As of December 31, 2007 and 2006, the amortized cost, gross unrealized gains and losses, and fair value of cash, cash equivalents and investments associated with the AARP insurance program, included in Assets Under Management, were as follows:
As of December 31, 2007, we had investments with an aggregate fair value of $151 million under the AARP agreement in an unrealized loss position of $2 million for 12 months or greater. These investments are subject to the same processes and reviews as the rest of our investment portfolio, including impairment analyses. As a result of these reviews, as is further discussed in Note 5, we did not identify any other-than-temporary impairments. Interest earnings and realized investment gains and losses on these assets accrue to the overall benefit of the AARP policyholders through the RSF and are, therefore, not included in our earnings.
In conjunction with the PacifiCare acquisition we committed to make $50 million in charitable contributions for the benefit of California health care consumers, which has been accrued in our Consolidated Balance Sheets. We have committed to specific projects totaling approximately $18 million of the $50 million charitable commitment at December 31, 2007, of which $6 million was paid. Additionally, we agreed to invest $200 million in California’s health care infrastructure to further health care services to the underserved populations of the California marketplace, of which $8 million was invested at December 31, 2007. The timing and amount of individual contributions and investments are at our discretion subject to the advice and oversight of the local regulatory authorities; however, our goal is to have the investment commitment fully funded by the end of 2010. The investment commitment remains in place for 20 years after funding.
We have various outstanding, undrawn letters of credit with financial institutions with an aggregate commitment of approximately $39 million at December 31, 2007.
In March 2006, we received an informal inquiry from the Securities and Exchange Commission (SEC) relating to our historical stock option practices. On December 19, 2006, we received from the SEC staff a formal order of investigation into the Company’s historical stock option practices.
On June 6, 2006, we received a Civil Investigative Demand from the Minnesota Attorney General requesting documents from January 1, 1997 to the date of the response concerning our executive compensation and historical stock option practices. We filed an action in Ramsey County Court, State of Minnesota, captioned UnitedHealth Group Incorporated vs. State of Minnesota, by Lori Swanson, Attorney General, seeking a
We have also received requests for documents from U.S. Congressional committees relating to our historical stock option practices and compensation of executives. At the conclusion of these regulatory inquiries, we could be subject to regulatory or criminal fines or penalties as well as other sanctions or other contingent liabilities, which could be material.
A consolidated derivative action, reflecting a consolidation of two actions, is also pending in Hennepin County District Court, State of Minnesota. The consolidated complaint is captioned In re UnitedHealth Group Incorporated Derivative Litigation. The action was brought by two individual shareholders and names certain of our current and former officers and directors as defendants, as well as the Company as a nominal defendant. On February 6, 2007, the state court judge entered an order staying the action pending resolution of the Special Litigation Committee process. On June 25, 2007, the state court judge entered an order modifying the stay to allow plaintiffs counsel to access documents produced in the federal derivative action described above.
Beginning in 1999, a series of class action lawsuits were filed against UnitedHealthcare, PacifiCare, and virtually all major entities in the health benefits business. These lawsuits were consolidated in a multi-district litigation in the Southern District Court of Florida. The health care provider plaintiffs alleged statutory violations, including violations of the Racketeer Influenced Corrupt Organization Act (RICO) in connection with alleged undisclosed reimbursement policies. Other allegations included breach of state prompt payment laws and breach of contract claims for failure to timely reimburse health care providers for medical services rendered. The consolidated suits seek injunctive, compensatory and equitable relief as well as restitution, costs, fees and interest payments. The trial court granted the health care providers’ motion for class certification. The Eleventh Circuit Court of Appeals affirmed the class action status of certain of the RICO claims, but reversed as to the breach of contract, unjust enrichment and prompt payment claims. Most of the co-defendents have settled. On January 31, 2006, the trial court dismissed all claims against PacifiCare, and on June 19, 2006, the trial court dismissed all claims against UnitedHealthcare brought by the lead plaintiffs. On June 13, 2007, the Eleventh Circuit Court of Appeals affirmed those decisions. Included in the multidistrict litigation are tag-along lawsuits which contain claims against the Company similar to the claims dismissed in the lead case. The tag-along cases were stayed pending resolution of the lead case. That stay has not been lifted, but it is anticipated that the trial court will now lift the stay and address the continuing viability of the tag-along claims. The plaintiffs in a number of the tag-along cases have sought to remand the cases to alternate forums. We have opposed these efforts and have moved the court to apply its June 2006 summary judgment ruling, and its other applicable pretrial rulings, to those cases. On February 12, 2008, the court denied all pending motions without prejudice and set a briefing schedule for future motions, including motions for summary judgment. We are vigorously defending against the remaining claims.
We have been and are currently involved in various governmental investigations, audits and reviews. These include routine, regular and special investigations, audits and reviews by CMS, state insurance and health and welfare departments, state attorneys general, the Office of the Inspector General, the Office of Personnel Management, the Office of Civil Rights, U.S. Congressional committees, the U.S. Department of Justice, U.S. Attorneys, the SEC and other governmental authorities. Such government actions can result in assessment of damages, civil or criminal fines or penalties, or other sanctions, including loss of licensure or exclusion from participation in government programs. For example, in 2007, the California Department of Managed Health Care and the California Department of Insurance examined our PacifiCare health plans in California. The examinations identified concerns that were largely administrative and provider related. The examination findings related to claims processing accuracy and timeliness, accurate and timely interest payments, timely implementation of provider contracts, timely, accurate provider dispute resolution, and other related matters. The California Department of Managed Health Care has assessed a penalty of $3.5 million related to its findings. The California Department of Insurance, however, has not yet levied a financial penalty related to its findings. While there is a theoretical maximum penalty that could be substantial, we believe the California Department of Insurance Commissioner will take into consideration the fact that the vast majority of the violations were administrative in nature and did not result in harm to our members. We are working closely with both departments to resolve any outstanding issues arising from the findings of the examinations of our PacifiCare health plans in California.
Our accounting policies for business segment operations are the same as those described in the Summary of Significant Accounting Policies (See Note 2). Transactions between business segments principally consist of customer service and transaction processing services that Health Care Services provides to OptumHealth, certain product offerings sold to Health Care Services customers by OptumHealth, sales of pharmacy benefit products and services to Health Care Services by Prescription Solutions and sales of medical benefits cost, quality and utilization data and predictive modeling to Health Care Services by Ingenix. These transactions are recorded at management’s estimate of fair value. All intersegment transactions are eliminated in consolidation. Assets and liabilities that are jointly used are assigned to each segment using estimates of pro-rata usage. Cash and investments are assigned such that each segment has at least minimum specified levels of regulatory capital or working capital for non-regulated businesses.
Substantially all of our operations are conducted in the United States. In accordance with accounting principles generally accepted in the United States, segments with similar economic characteristics may be combined. The financial results of Commercial Markets, Ovations and AmeriChoice have been aggregated in the Health Care Services segment column in the following tables because these businesses have similar economic characteristics and have similar products and services, types of customers, distribution methods and operational processes, and operate in a similar regulatory environment. These businesses also share significant common assets, including our contracted networks of physicians, health care professionals, hospitals and other facilities, information technology infrastructure and other resources.
The following table presents segment financial information as of and for the years ended December 31, 2007, 2006 and 2005:
(1) The corporate amount reflects the Section 409A charge recorded in the first quarter of 2007 as discussed in Note 10 of Notes to the Consolidated Financial Statements.
The following tables present selected quarterly financial information for all quarters of 2007 and 2006.
We have audited the accompanying consolidated balance sheets of UnitedHealth Group Incorporated and Subsidiaries (the “Company”) as of December 31, 2007 and 2006, and the related consolidated statements of operations, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2007. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.