We are an integrated managed care organization that delivers managed health care services through health plans and government sponsored managed care plans. We are among the nation’s largest publicly traded managed health care companies. Our mission is to help people be healthy, secure and comfortable. Our health maintenance organizations (HMOs), preferred provider organizations (PPOs) and point-of-service (POS) and government contracts subsidiaries provide health benefits to approximately 6.3 million individuals in 27 states and the District of Columbia through group, individual, Medicare, Medicaid, TRICARE and Veterans Affairs
programs. Our behavioral health services subsidiary, MHN, provides behavioral health, substance abuse and employee assistance programs to approximately 7.3 million individuals, including our own health plan members, in all 50 states. Our subsidiaries also offer managed health care products related to prescription drugs, and offer managed health care product coordination for multi-region employers and administrative services for medical groups and self-funded benefits programs.
On January 5, 2006, we announced that we entered into a definitive agreement to acquire certain health plan assets of Universal Care, Inc., a California-based health care company. This transaction is expected to close in the first half of 2006, subject to customary closing conditions, including regulatory approval. Upon closing of this acquisition, we expect to add approximately 20,000 Medi-Cal and Healthy Families beneficiaries to the approximately 700,000 Medi-Cal and Healthy Families beneficiaries that we already serve in nine California counties. Further, we will have the opportunity to enroll an additional 20,000 Medi-Cal and Healthy Families beneficiaries in Orange County. In addition, upon closing, we expect to add approximately 5,000 Medicare Advantage beneficiaries and approximately 75,000 commercial members that have received coverage through contracts with Universal Care’s health plans.
We believe we are the nation’s fifth-largest Medicare Advantage contractor based on membership with 174,040 members in 43 counties in five states as of December 31, 2005 compared to membership of 170,943 as of December 31, 2004. In connection with the passage of the Medicare Prescription Drug, Improvement and Modernization Act of 2003 (MMA), we have significantly expanded our Medicare health plans. For example, in 2005, we extended our participation in Medicare Advantage by adding new service areas and increasing participation in regional and local PPOs. As a result of this expansion we are now offering 98 new plans and are a major participant in the new “Part D” stand-alone drug benefit. On January 1, 2006, we began offering the new Part D prescription drug benefit to seniors in 10 states. U.S. citizens who are at least 65 years old, or who are disabled, or who are dual-eligible members in both Medicare and Medicaid are able to enroll in our Part D coverage plans.
We now offer prescription drug coverage under Medicare Advantage in Arizona, California, Connecticut, New York and Oregon, states where we had already been offering Medicare services. Medicare Advantage members in these states are generally permitted to sign up for the new benefit and receive prescription drug medications at no additional premium. We are also offering the new “Part D” stand-alone prescription drug benefit in these states. In addition, we offer the stand-alone Part D prescription drug benefit to seniors in five states where we do not have Medicare Advantage membership: Massachusetts, New Jersey, Rhode Island, Vermont and Washington.
We participate as a Special Needs plan provider in Arizona, California, Connecticut and New York. Special Needs plans are designed to ensure that Medicare beneficiaries with limited financial means and disabled Medicare beneficiaries have additional health care and prescription drug coverage. Our plan targets beneficiaries who are eligible for both Medicare and Medicaid in these four states and beneficiaries with chronic obstructive pulmonary disease and congestive heart failure in two California counties.
Our profitability depends in large part on our ability to effectively price our health care products; manage health care costs, including pharmacy costs; contract with health care providers; attract and retain members; and manage our G&A and selling expenses. In addition, factors such as regulation, competition and general economic conditions affect our operations and profitability. The potential effect of escalating health care costs, as well as any changes in our ability to negotiate competitive rates with our providers, may impose further risks to our ability to profitably underwrite our business, and may have a material impact on our business, financial condition or results of operations.
General and administrative expenses include those costs related to employees and benefits, consulting and professional fees, marketing, premium taxes and assessments and occupancy costs. Such costs are driven by membership levels, introduction of new products, system consolidations and compliance requirements for changing regulations. These expenses also included expenses associated with corporate shared services and other costs to reflect the fact that such expenses are incurred primarily to support Health Plan Services segment. Selling expenses consist of external broker commission expenses and generally vary with premium volume.
(b) The selling costs ratio is computed as selling expenses divided by health plan premium revenues.
(c) Premiums per member per month (PMPM) is calculated based on total at-risk member months and excludes administrative services only (ASO) member months.
Before the start of 2005, our objectives were to remain focused on disciplined pricing; contain the growth in health care costs; eliminate prior period reserve restatements (e.g., actual liability is different than previously estimated); stabilize or reverse the decline in commercial membership, improve pretax profit margins; increase statutory capital and strengthen the balance sheet; complete the transition to our TRICARE contract for the North Region; and to successfully prepare for the Medicare Part D drug benefit opportunity. The results of our efforts to meet these objectives are discussed below.
Net income improved to $229.8 million in 2005, or $1.99 per diluted share, from $42.6 million, or $0.38 per diluted share, in 2004. Results in 2005 reflect the impact of $83.3 million in litigation, asset impairment and restructuring charges. Included in the charges are $65.6 million related to the May 2005 settlement agreement to resolve the lead physician provider track action in the multidistrict class action lawsuit, and $15.9 million of estimated legal defense costs to appeal a Louisiana state court jury verdict related to the 1999 sale of three health plan subsidiaries. See “Item 3. Legal Proceedings” for additional information on these litigation matters. Results for the year ended December 31, 2004 included a $169 million pretax charge recorded in the fourth quarter ended December 31, 2004, which is discussed in more detail below.
Commercial health plan membership declined 9% at December 31, 2005 when compared to December 31, 2004, however, the rate of membership decline has begun to slow.
The Health Plan Services MCR declined to 83.9% for the year ended December 31, 2005 compared to 88% for the year ended December 31, 2004, primarily driven by a $158 million provider dispute charge recorded in the fourth quarter ended December 31, 2004. Favorable commercial health care cost trends also contributed to the improvement. The commercial health care cost trend for 2005, after adjusting for the provider dispute charge recorded in the fourth quarter ended December 31, 2004, was approximately 10%, and we believe this indicates that the health care cost trend is abating. We believe it also demonstrates that our focus on medical management basics, including prior authorization, concurrent review and discharge planning is showing results.
As of December 31, 2005, we had settled approximately 87% of the provider disputes related to the $169 million charge recorded in the fourth quarter ended December 31, 2004. We believe that the remaining liability amount of $35 million is sufficient to settle the remaining disputes.
Cash flow from operations for the year ended December 31, 2005 improved to $191.4 million compared to ($54.9) million for the year ended December 31, 2004, which was consistent with our expectations.
We believe that the decline in commercial health plan membership will continue to slow in 2006. However, because of some large group departures, we expect commercial health plan membership to decline between 3% and 4% in the first quarter of 2006. In addition, the task of stabilizing New Jersey and California small group membership continues to be challenging, but the prospect of increasing membership enrollment in other markets and areas of our business are more encouraging. We expect membership to stabilize by the end of the second quarter of 2006 and start to grow in the latter part of 2006. Therefore, we believe that commercial health plan membership at December 31, 2006 will be relatively flat when compared to December 31, 2005, including the new commercial membership that we expect to receive upon closing of our Universal Care acquisition.
$18 million in severance, asset impairment and restructuring charges and other expenses.
Reserve Developments. The fourth quarter 2004 pretax earnings charge also included amounts recorded for prior period adverse reserve developments, most of which related to revisions to reserve estimates for the second and third quarters of 2004. Approximately $56 million of the $65 million recorded for prior period adverse reserve developments relate to 2004. For information regarding our reserve restatements for December 31, 2003 and prior, see Note 16 to our consolidated financial statements. The 2004 adverse reserve developments are directly related to management’s decision in 2004 to accelerate claims payment practices and disengage from the claims review practices, both designed to improve relations with providers. As a result of deliberate actions to accelerate claims payments, we experienced higher level of paid claims in the first quarter of 2004 compared with 2003. These higher levels of paid claims persisted through the balance of 2004 and contributed to the increase in commercial health care costs. This had the impact of masking the increasing trend in health care costs until the fourth quarter of 2004 when higher levels of paid claims than were previously estimated emerged. The reserves established at December 31, 2004 assume a permanent increase in claims costs because of these changes.
Severance, Asset Impairment and Restructuring Charges and other Miscellaneous Expenses. We recorded $18 million of miscellaneous items as part of the fourth quarter 2004 pretax earnings charge, including severance and related benefit costs, lease terminations, the write-off of certain investments and IT assets and other balance sheet items. For information regarding these balance sheet items, see “-Results of Operations-Litigation, Severance and Related Benefit Costs and Asset Impairments.”
We expect enrollment to stabilize during 2006. The new commercial enrollment we expect to receive upon the closing of our Universal Care acquisition will be offset by certain large group departures. See “-Summary of Operating Results-Year Ended December 31, 2005 Compared to Year Ended December 31, 2004.”
Total health plan membership decreased 6% to approximately 3.6 million members at December 31, 2004 from approximately 3.8 million members at December 31, 2003.
membership losses from our planned withdrawal in selected counties in California. Medicare enrollment in our Oregon health plan increased from 392 to 8,594 members during 2004, primarily as a result of our Oregon health plan’s participation in a Medicare PPO demonstration project.
The following table summarizes the operating results for Health Plan Services for the last three fiscal years:
Medicare Risk premiums increased by $90.9 million, or 6.1%, for the year ended December 31, 2005 as compared to the same period in 2004. The increase in Medicare Risk premiums was primarily attributable to rate increases seen in all states due to increases in the per-member rates paid to us by CMS as a result of demographic and risk factor adjustments and favorable Medicare rate adjustments from 2003 and 2004 in our Arizona, California, Connecticut and New York plans totaling $17.2 million, which were recognized in the three months ended September 30, 2005 (see “-Health Plan Services Costs” for detail regarding the increase in capitation expense related to the 2003 and 2004 Medicare rate adjustment). The increase in the Medicare revenue yield PMPM was 5.4% for the year ended December 31, 2005 over the same period in 2004.
Medicaid premiums increased by $43.1 million, or 4.0%, for the year ended December 31, 2005 as compared to the same period in 2004. The increase in the Medicaid premium PMPM was 3.4% for the year ended December 31, 2005 over the same period in 2004, primarily due to rate increases for the Healthy Families and Access for Infants and Mothers (AIM) programs. These programs account for approximately 12% of total Medicaid membership.
Medicare Risk premiums increased by $102.6 million, or 7.4%, for the year ended December 31, 2004 compared to the same period in 2003. Rate increases, which were seen in all states due to increases in the per-member rates paid to us by CMS as a result of the adoption of the MMA in December 2003, increased premiums by 8.7%. This was partially offset by membership losses in all states except Oregon with an impact of (1.3)%.
Medicaid premiums decreased by $66.5 million, or 5.7%, for the year ended December 31, 2004 compared to the same period in 2003, primarily due to membership losses in all states, with an impact of (4.6)% and rate decreases with an impact of (1.1)%.
Medicaid health care costs increased by $36.5 million, or 4.1%, for the year ended December 31, 2005 as compared to the same periods in 2004. The increase in Medicaid health care costs was primarily driven by higher hospital inpatient claims expense. The increase in the Medicaid Risk health care cost PMPM was 3.5% for the year ended December 31, 2005 over the same period in 2004.
The comparison of health care costs above were substantially impacted by the $158 million of provider dispute costs recorded in the fourth quarter of 2004.
Health Plan Services MCR decreased to 83.9% for the year ended December 31, 2005 as compared to 88.0% for the same period in 2004. The decrease was primarily seen in our commercial business due to provider dispute settlements recorded in 2004. Excluding this, the favorable improvement in our MCR is primarily due to continued pricing discipline and moderating health care cost trends in our commercial market reflecting, in part, improvement in our hospital cost experience due to lower inpatient utilization resulting from enhanced medical management activities.
Medicare Risk health care costs increased by $126.3 million, or 10.2%, for the year ended December 31, 2004 compared to the same period in 2003. Medicare risk health care costs increased primarily as a result of higher hospital costs from higher bed day utilization, higher pharmacy cost trend for HMO products and provider settlements of $14.6 million relating to claims processing and payment issues that had been or were being resolved in the fourth quarter of 2004. The increase in the Medicare Risk health care cost PMPM was 11.5% for the year ended December 31, 2004 over the same period in 2003.
Health Plan Services MCR increased to 88.0% for the year ended December 31, 2004 as compared to 82.7% for the same period in 2003 primarily due to higher commercial health care costs that outpaced the premium revenue growth.
Net investment income increased by $14.7 million, or 25.3%, for the year ended December 31, 2005 as compared to the same period in 2004, primarily due to an increase in interest rates and an increase in the average balance of investments, partially offset by lower net realized gains. Included in net investment income was $(0.6) million and $4.2 million of net realized (loss) gain on sale of investments for 2005 and 2004, respectively.
Net investment income decreased slightly by $1.2 million for the year ended December 31, 2004 due to a decline in net realized gains and lower average cash balances, partially offset by the impact of higher interest rates. Included in net investment income was $4.2 million and $12.0 million of net realized gain on sale of investments for 2004 and 2003, respectively.
G&A costs increased by $68.3 million, or 7.7%, for the year ended December 31, 2005 as compared to the same period in 2004. Our administrative ratio (G&A and depreciation expenses as a percentage of Health Plan Services premiums and other income) also increased to 10.3% for the year ended December 31, 2005 from 9.7% for the same period in 2004. The increase is primarily due to our increased spending in preparation for our Medicare Advantage and Part D expansion plans and an increase in health plan marketing activities, partially offset by $10.6 million in legal costs associated with the provider settlements that was recognized in 2004.
Interest expense increased by $11.5 million, or 34.7%, for the year ended December 31, 2005 as compared to the same period in 2004. A $4.5 million increase in interest expense resulted primarily from a 150 basis point increase in the interest rate on our Senior Notes due to the downgrade of our senior unsecured debt rating effective September 2004, and a $6.8 million increase in interest expense resulted from higher variable interest rate we paid on the swap contract settlements. See “