Diluted net earnings per share from continuing operations of $2.12, including $(0.10) of debt extinguishment costs.
Florida. In December 2010, we completed the conversion of non-risk managed care membership from Access Health Solutions LLC to our subsidiary, Sunshine State Health Plan. Additionally, in December 2010, we completed the acquisition of Citrus Health Care, Inc., a Medicaid and long-term care health plan.
Kentucky. In November 2011, our subsidiary, Kentucky Spirit Health Plan, began providing managed care services under a three-year contract with the Kentucky Finance and Administration Cabinet to serve Medicaid beneficiaries.
Ohio. In October 2011, Buckeye Community Health Plan began operating under an amended contract with the Ohio Department of Job and Family Services which includes the management of the pharmacy benefit for Buckeye’s members.
South Carolina. In June 2010, we completed the acquisition of Carolina Crescent Health Plan.
In August 2011, we were awarded renewed and expanded contracts by the Texas Health and Human Services Commission. The contracts expand Superior’s STAR, STAR+PLUS and CHIP product offerings to include the new 10 county Hidalgo Service Area (STAR and STAR+PLUS), Medicaid RSA West Texas, Medicaid RSA Central Texas, Medicaid RSA North-East Texas and Lubbock (STAR+PLUS). All of the service areas and products will now include the management of the pharmacy benefit for Superior’s members. In addition, the state has added inpatient facility services to the managed care structure for the STAR+PLUS program. Operations in the expanded areas are expected to commence late in the first quarter of 2012.
In 2012, we announced that we were selected to contract with the Washington Health Care Authority to serve Medicaid beneficiaries in the state. Operations are expected to commence in the third quarter of 2012.
In March 2010, the Patient Protection and Affordable Care Act and the accompanying Health Care and Education Affordability Reconciliation Act, or the Acts, were enacted in the United States. The Acts contain provisions we expect will have a significant effect on our business in coming years including expanding Medicaid eligibility beginning in 2014 to recipients with incomes below 133% of the federal poverty level, retaining the CHIP program in its current form, and requiring state-based exchanges similar to our experience in Massachusetts in the future. The Acts allow states to receive the same level of rebates from pharmaceutical companies for their Medicaid programs, whether or not the states participate in managed care. The Acts also impose an excise tax on health insurers beginning in 2014 based upon relative market share. Effective in 2011, minimum health benefit cost ratios became mandated for commercial, fully-insured major medical health plans in the individual market, such as our Celtic subsidiary. The minimum health benefit cost ratio for these commercial plans will be set at 80% of premium revenue, adjusted for certain taxes, fees, assessments, risk premium and a credibility factor based upon both the number of covered life years and an average plan cost sharing adjustment calculated for each state. Certain states have filed and been granted waivers allowing for minimum heath benefit cost ratios at levels below 80%. If the actual health benefit cost ratios do not meet the minimum calculated for any state, rebates will be paid to those policyholders. Celtic expects to pay minimal rebates based on its 2011 results. Due to its complexity and lack of comprehensive interpretive guidance and implementation regulations, the ultimate impact of the Acts on Celtic is not yet fully known. The health benefit cost ratio minimum does not apply to other Centene subsidiaries.
From December 31, 2009 to December 31, 2011, we increased our at-risk managed care membership by 24.5%. The following table sets forth our membership by state for our managed care organizations:
Our health plans generate revenues primarily from premiums we receive from the states in which we operate. We receive a fixed premium per member per month pursuant to our state contracts. We generally receive premium payments and recognize premium revenue during the month in which we are obligated to provide services to our members. In some instances, our base premiums are subject to an adjustment, or risk score, based on the acuity of our membership. Generally, the risk score is determined by the state analyzing submissions of processed claims data to determine the acuity of our membership relative to the entire state’s membership. Some contracts allow for additional premium associated with certain supplemental services provided such as maternity deliveries.
Cost of services expense includes the pharmaceutical costs associated with our pharmacy benefit manager’s external revenues and certain direct costs to support the functions responsible for generation of our services revenues. These expenses consist of the salaries and wages of the professionals who provide the services and associated expenses.
Other income (expense) consists principally of investment income from cash and investments, earnings in equity method investments, and interest expense on debt.
Year Ended December 31, 2011 Compared to Year Ended December 31, 2010
Premium and service revenues increased 20.9% in 2011 over 2010 as a result of membership growth discussed under the heading “Membership”. The premium rates specified in our state contracts are generally updated on an annual basis through contract amendments. In 2011, we received premium rate adjustments which yielded a net 0.9% composite decrease across all of our markets.
The consolidated G&A expense ratio for the years ended December 31, 2011 and 2010 was 11.3% and 11.2%, respectively. The increase in the ratio in 2011 primarily reflects increased business expansion costs to support new business in Illinois, Kentucky, Louisiana and Texas, partially offset by the leveraging of our expenses over higher revenues.
Impairment of investment. During 2010, we determined we had an other-than-temporary impairment of our cost method investment in Casenet, LLC, and recorded an impairment charge of $5.5 million.
Gain on Reserve Primary Fund distributions. In 2010, we received distributions from the Reserve Primary Fund of $5.7 million resulting in a gain of $3.3 million recorded for the distributions received in excess of our adjusted basis.
Interest expense. Interest expense for 2011 increased by $2.3 million from 2010 primarily due to borrowings on the mortgage loan associated with the real estate development including our corporate headquarters. The real estate development was placed in service in the third quarter of 2010 and, accordingly, we ceased capitalizing interest on the project. The increase in interest expense was partially offset by reduced interest expense reflecting the refinancing our Senior Notes and lower interest rate as a result of the execution of the associated interest rate swap agreements in 2011.
Year Ended December 31, 2010 Compared to Year Ended December 31, 2009
Premium and service revenues increased 10.5% in 2010 over 2009 as a result of membership growth discussed under the heading “Membership”, and net premium rate increases in 2010. In 2010, we received premium rate adjustments in certain markets which yielded a net 2.3% composite increase across all of our markets. The increase in premium and service revenues was moderated by the removal of pharmacy services in two states in 2010. These pharmacy carve outs had the effect of reducing revenue by approximately $185.0 million during 2010.
The consolidated HBR of 85.5% for 2010 represented a 0.2% increase from the 2009 consolidated HBR of 85.3%. The increase is mainly due to a member mix shift to less favorable HBR categories, partially offset by provider network and utilization management initiatives.
Investment income. The decrease in investment income in 2010 reflects the decline in market interest rates.
Net gain on sale of investments. As a result of tightening our investment criteria for municipal securities, we sold municipal securities resulting in net gains of $2.5 million during 2010.
Impairment of investment. During 2010, we determined we had an other-than-temporary impairment of our cost method investment in Casenet, LLC, and recorded an impairment charge of $5.5 million, including $3.5 million of convertible promissory notes.
Interest expense. Interest expense increased reflecting the borrowings on the loans associated with the construction of our corporate headquarters. The real estate development was placed in service in the third quarter 2010 and accordingly we ceased capitalizing interest on the project. The increase was partially offset by the reduction in debt outstanding under our revolving credit agreement as a result of the equity offering completed during the first quarter of 2010.
Excluding the amounts attributable to noncontrolling interest, our effective tax rate in 2010 was 39.7% compared to 36.2% in 2009. The increase in 2010 was primarily driven by legislation enacted in May 2010 in the state of Georgia which replaced the state income tax with a premium tax for Medicaid managed care organizations effective July 1, 2010. Accordingly, a deferred tax asset of $1.7 million related to Georgia state net operating loss carry forwards was written off during 2010. Additionally, the increase in the effective tax rate in 2010 was also related to a decrease in tax exempt interest and an increase in state income taxes.
The following table summarizes our operating results by segment ($ in millions):
Investing activities used cash of $129.1 million in 2011, $210.6 million in 2010 and $270.1 million in 2009. Cash flows for each year primarily consisted of additions to the investment portfolio of our regulated subsidiaries, including transfers from cash and cash equivalents to long-term investments, and capital expenditures. In 2009, cash flows from investing activities also included membership conversion fees in Florida and acquisitions in Florida and South Carolina.
We spent $64.4 million, $31.7 million and $23.2 million in 2011, 2010 and 2009 respectively, on capital expenditures for system enhancements, a new datacenter and market expansions. We also spent $4.6 million, $31.6 million, and $0.5 million in 2011, 2010 and 2009, respectively, for costs associated with our headquarters development including land, tenant improvements and furniture. We anticipate spending approximately $55 million on capital expenditures in 2012 primarily associated with system enhancements and market expansions.
Our financing activities provided cash of $6.9 million in 2011, $72.1 million in 2010 and $46.6 million in 2009. During 2011, our financing activities primarily related to repayments and proceeds of long term debt as discussed below. During 2010, our financing activities primarily related to proceeds from our stock offering and resulting payoff of our revolving credit facility discussed below, as well as borrowings for the construction of the real estate development discussed above. During 2009, our financing activities primarily related to proceeds from borrowings under our $300 million credit facility and construction financing of the real estate development discussed above.
In June 2009, Centene Center LLC executed a $95 million construction loan associated with the real estate development that included our corporate headquarters. In December 2010, we refinanced the $95 million construction loan with an $80 million 10 year mortgage note payable. The mortgage note is non-recourse to the Company, bears a 5.14% interest rate and has a financial covenant requiring a minimum debt service coverage ratio.
In May 2011, we exercised our option to redeem the $175 million 7.25% Senior Notes due April 1, 2014 ($175 million Notes). We redeemed the $175 million Notes at 103.625% and wrote off unamortized debt issuance costs, resulting in a pre-tax expense of $8.5 million.
At December 31, 2011, we had working capital, defined as current assets less current liabilities, of $102.4 million, as compared to $(108.4) million at December 31, 2010. We manage our short-term and long-term investments with the goal of ensuring that a sufficient portion is held in investments that are highly liquid and can be sold to fund short-term requirements as needed. Our working capital is negative from time to time due to our efforts to increase investment returns through purchases of investments that have maturities of greater than one year and, therefore, are classified as long-term.
We have a stock repurchase program authorizing us to repurchase up to four million shares of common stock from time to time on the open market or through privately negotiated transactions. No duration has been placed on the repurchase program. We reserve the right to discontinue the repurchase program at any time. We did not make any repurchases under this plan during 2011 or 2010.
1 Includes $7,868 separate account liabilities from third party reinsurance that will not be settled in cash.
Our operations are conducted through our subsidiaries. As managed care organizations, these subsidiaries are subject to state regulations that, among other things, require the maintenance of minimum levels of statutory capital, as defined by each state, and restrict the timing, payment and amount of dividends and other distributions that may be paid to us. 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.
The National Association of Insurance Commissioners has adopted rules which set minimum risk-based capital requirements for insurance companies, managed care organizations and other entities bearing risk for healthcare coverage. As of December 31, 2011, each of our health plans were in compliance with the risk-based capital requirements enacted in those states.
Our significant accounting policies are more fully described in Note 2, Summary of Significant Accounting Policies, to our consolidated financial statements included elsewhere herein. Our accounting policies regarding medical claims liability and intangible assets are particularly important to the portrayal of our financial position and results of operations and require the application of significant judgment by our management. As a result, they are subject to an inherent degree of uncertainty. We have reviewed these critical accounting policies and related disclosures with the Audit Committee of our Board of Directors.
The paid and received completion factors, claims per member per month and per diem cost trend factors are the most significant factors affecting the IBNR estimate. The following table illustrates the sensitivity of these factors and the estimated potential impact on our operating results caused by changes in these factors based on December 31, 2011 data:
The change in medical claims liability is summarized as follows (in thousands):
Medical claims are usually paid within a few months of the member receiving service from the physician or other healthcare provider. As a result, the liability generally is described as having a “short-tail,” which causes less than 5% of our medical claims liability as of the end of any given year to be outstanding the following year. We believe that substantially all the development of the estimate of medical claims liability as of December 31, 2011 will be known by the end of 2012.
We have made several acquisitions that have resulted in our recording of intangible assets. These intangible assets primarily consist of customer relationships, purchased contract rights, provider contracts, trade names and goodwill. At December 31, 2011, we had $282.0 million of goodwill and $27.4 million of other intangible assets.
Intangible assets are amortized using the straight-line method over the following periods:
Goodwill is reviewed annually during the fourth quarter for impairment. In addition, an impairment analysis of intangible assets would be performed based on other factors. These factors include significant changes in membership, state funding, medical contracts and provider networks and contracts. The fair value of all reporting units with material amounts of goodwill was substantially in excess of the carrying value as of our annual impairment testing date.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Centene Corporation and subsidiaries as of December 31, 2011 and 2010, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2011, in conformity with U.S. generally accepted accounting principles.
The Company’s health plans generate revenues primarily from premiums received from the states in which it operates health plans. The Company receives a fixed premium per member per month pursuant to its state contracts. The Company generally receives premium payments during the month it provides services and recognizes premium revenue during the period in which it is obligated to provide services to its members. In some instances, the Company’s base premiums are subject to an adjustment, or risk score, based on the acuity of its membership. Generally, the risk score is determined by the State analyzing submissions of processed claims data to determine the acuity of the Company’s membership relative to the entire state’s Medicaid membership. Some states enact premium taxes, similar assessments and provider pass-through payments, collectively premium taxes, and these taxes are recorded as a separate component of both revenues and operating expenses. Some contracts allow for additional premium related to certain supplemental services provided such as maternity deliveries.
The Company’s specialty companies generate revenues under contracts with state programs, individuals, healthcare organizations and other commercial organizations, as well as from the Company’s own subsidiaries. Revenues are recognized when the related services are provided or as ratably earned over the covered period of service.
Premium and service revenues collected in advance are recorded as unearned revenue. For performance-based contracts the Company does not recognize revenue subject to refund until data is sufficient to measure performance. Premiums and service revenues due to the Company are recorded as premium and related receivables and are recorded net of an allowance based on historical trends and management’s judgment on the collectibility of these accounts. As the Company generally receives payments during the month in which services are provided, the allowance is typically not significant in comparison to total revenues and does not have a material impact on the presentation of the financial condition or results of operations. Activity in the allowance for uncollectible accounts for the years ended December 31, is summarized below:
As of December 31, 2011, premium and related receivables included $20,742 of notes receivable.
During 2011, the National Association of Insurance Commissioners (NAIC) issued new definitions which clarified the classification of medical costs for statutory reporting. In light of these new definitions, the Company reclassified certain Medical Costs and General & Administrative Expenses beginning with its financial results for the year ended December 31, 2011 to more closely align to the new NAIC definition. The following costs were reclassified from General & Administrative Expense to Medical Costs:
Carolina Crescent Health Plan. In June 2010, the Company acquired certain assets of Carolina Crescent Health Plan, a South Carolina Medicaid managed care organization for $17,993 in total consideration. The Company’s allocation of fair value resulted in goodwill of $16,543 and other identifiable intangible assets of $1,450. The acquisition is recorded in the Medicaid Managed Care segment. All of the goodwill is deductible for income tax purposes.
Access Health Solutions, LLC. In December 2010, the Company exercised its right to obtain the remaining assets and ownership interest in Access Health Solutions, LLC, or Access, for zero dollars. Subsequent to the acquisition of the remaining interest, Access continues to be consolidated in the Company’s Medicaid Managed Care segment results as a wholly owned subsidiary of the Company. During 2011, the Company made a conversion payment to the former owners of Access resulting in additional goodwill of $1,773. All of the goodwill is deductible for income tax purposes.
Centene Center LLC. In December 2010, the Company acquired the remaining ownership interest in Centene Center LLC for $48,250. The excess purchase price over the noncontrolling interest was recorded to additional paid in capital, net of the related deferred tax asset of $12,779. Centene Center LLC is a real estate development entity created for the construction of a real estate development that includes the Company’s corporate headquarters. The Company previously reported its investment in Centene Center as a consolidated VIE. Subsequent to the acquisition of the remaining interest, Centene Center LLC continues to be consolidated as a wholly owned subsidiary of the Company. The operating results of Centene Center LLC are included in general and administrative expense of the Company’s Medicaid Managed Care segment.
Additional 2009 Acquisitions. The Company acquired assets of the following entities: Pediatric Associates LLC, effective February 2009, Amerigroup Community Care of South Carolina, Inc., effective March 2009 and InSpeech, Inc., effective July 2009. The Company paid a total of approximately $12,500 in cash for these acquisitions. Goodwill of approximately $9,500 and other identifiable intangible assets of approximately $1,500 were included in the Medicaid Managed Care segment and other identifiable intangible assets of $1,700 were included in the Specialty Services segment, all of which is deductible for income tax purposes.
Pro forma disclosures related to these acquisitions have been excluded as immaterial.
As of December 31, 2011, the gross unrealized losses were generated from 31 positions out of a total of 410 positions. The decline in fair value of fixed income securities is a result of movement in interest rates subsequent to the purchase of the security.
Realized gains and losses are determined on the basis of specific identification or a first-in, first-out methodology, if specific identification is not practicable. The Company’s gross recorded realized gains and losses on investments for the years ended December 31, were as follows:
Investment and other income in 2010 included a net realized gain of $2,479 related to sales of fixed income investments and also included realized gains of $3,287 related to the Reserve Primary money market fund for distributions made during 2010. Investment amortization of $10,335, $10,750 and $7,209 was recorded in the years ended December 31, 2011, 2010 and 2009, respectively.
The following table summarizes fair value measurements by level at December 31, 2011, for assets and liabilities measured at fair value on a recurring basis:
The Company periodically transfers U.S. Treasury securities and obligations of U.S. government corporations and agencies between Level I and Level II fair value measurements dependent upon the level of trading activity for the specific securities at the measurement date. The Company utilizes matrix pricing services to estimate fair value for securities which are not actively traded on the measurement date. The Company designates these securities as Level II fair value measurements. The aggregate carrying amount of the Company’s life insurance contracts and other non-majority owned investments, which approximates fair value, was $24,094 and $21,451 as of December 31, 2011 and December 31, 2010, respectively.
As of December 31, 2011 and 2010, the Company had assets acquired under capital leases of $6,316 and $6,339, net of accumulated amortization of $1,285 and $1,041, respectively. Amortization on assets under capital leases charged to expense is included in depreciation expense. Depreciation expense for the years ended December 31, 2011, 2010 and 2009 was $42,249, $37,131 and $33,103, respectively.
Goodwill acquisitions and other adjustments were related to the acquisitions and finalization of fair value allocations discussed in Note 4, Acquisitions.
Amortization expense was $5,561, $4,119 and $3,692 for the years ended December 31, 2011, 2010 and 2009, respectively.
The December 31, 2011 reserve balance of $13,552 would decrease income tax expense, if recognized. The December 31, 2010 reserve balance of $3,036 would have decrease income tax expense, if recognized.
The federal income tax returns for 2008 through 2011 are open tax years. The Internal Revenue Service (IRS) performed an examination of the Company’s 2006 and 2007 tax returns and initially denied a tax benefit related to the abandonment of the FirstGuard stock in 2007. In 2011, the Company agreed to a settlement for the open tax years of 2006 and 2007. The settlement did not have a material impact on the consolidated financial statements.
The Company files in numerous state jurisdictions with varying statutes of limitation. The unrecognized state tax benefits are related to returns open from 2006 to 2011.
The Company had reinsurance recoverables related to medical claims liability of $5,313 and $6,180 at December 31, 2011 and 2010, respectively, included in premium and related receivables.
In December 2010, the Company refinanced a $95,000 construction loan with an $80,000 10 year mortgage note payable. The balance of the mortgage note payable was $77,847 at December 31, 2011. The mortgage note is non-recourse to the Company, bears a 5.14% interest rate and has a financial covenant requiring a minimum debt service coverage ratio. The collateralized property had a net book value of $165,106 at December 31, 2011.
The Company also has a mortgage note of $9,100 collateralized by another building and parking garage. The collateralized properties had a net book value of $23,898 at December 31, 2011. The mortgage is due August 31, 2014 and bears interest at the LIBOR rate plus 3% or the bank’s certificate of deposit rate plus 2%. The mortgage includes a financial covenant requiring a minimum fixed charge coverage ratio. The weighted average interest rate of outstanding borrowings was 3.12% at December 31, 2011.
The interest rate swaps are formally designated and qualify as fair value hedges. The interest rate swaps are recorded at fair value in the Consolidated Balance Sheet in other assets or other liabilities. Gains and losses due to changes in fair value of the interest rate swaps completely offset changes in the fair value of the hedged portion of the underlying debt. Therefore, no gain or loss has been recognized due to hedge ineffectiveness. Offsetting changes in fair value of both the interest rate swaps and the hedged portion of the underlying debt both were recognized in interest expense in the Consolidated Statement of Operations.
Various state laws require Centene’s regulated subsidiaries to maintain minimum capital levels specified by each state and restrict the amount of dividends that may be paid without prior regulatory approval. At December 31, 2011 and 2010, Centene’s subsidiaries, had aggregate statutory capital and surplus of $619,900 and $516,100, respectively, compared with the required minimum aggregate statutory capital and surplus of $342,000 and $308,000, respectively.
The Company’s stock incentive plans allow for the granting of restricted stock or restricted stock unit awards and options to purchase common stock. Both incentive stock options and nonqualified stock options can be awarded under the plans. No option will be exercisable for longer than ten years after the date of grant. The plans have 1,000,141 shares available for future awards. Compensation expense for stock options and restricted stock unit awards is recognized on a straight-line basis over the vesting period, generally three to five years for stock options and one to ten years for restricted stock or restricted stock unit awards. Certain restricted stock unit awards contain performance-based as well as service-based provisions. Certain awards provide for accelerated vesting if there is a change in control as defined in the plans. The total compensation cost that has been charged against income for the stock incentive plans was $18,171, $13,874 and $14,634 for the years ended December 31, 2011, 2010 and 2009, respectively. The total income tax benefit recognized in the income statement for stock-based compensation arrangements was $5,804, $4,713 and $3,945 for the years ended December 31, 2011, 2010 and 2009, respectively.
For the years ended December 31, 2011, 2010 and 2009, the Company used a projected expected life for each award granted based on historical experience of employees’ exercise behavior. The expected volatility is primarily based on historical volatility levels along with the implied volatility of exchange traded options to purchase Centene common stock. The risk-free interest rates are based on the implied yield currently available on U.S. Treasury instruments with a remaining term equal to the expected life.
The total fair value of restricted stock and restricted stock units vested during the years ended December 31, 2011, 2010 and 2009, was $22,280, $13,012 and $17,213, respectively.
As of December 31, 2011, there was $53,072 of total unrecognized compensation cost related to non-vested share-based compensation arrangements granted under the plans; that cost is expected to be recognized over a weighted-average period of 1.8 years. The actual tax benefit realized for the tax deductions from stock option exercises totaled $955, $883 and $395 for the years ended December 31, 2011, 2010 and 2009, respectively.
The Company maintains an employee stock purchase plan and has issued 34,966 shares, 37,048 shares, and 34,306 shares in 2011, 2010 and 2009, respectively.
Centene and its subsidiaries lease office facilities and various equipment under non-cancelable operating leases which may contain escalation provisions. The rental expense related to these leases is recorded on a straight-line basis over the lease term, including rent holidays. Tenant improvement allowances are recorded as a liability and amortized against rent expense over the term of the lease. Rent expense was $22,734, $21,393 and $20,211 for the years ended December 31, 2011, 2010 and 2009, respectively. Annual non-cancelable minimum lease payments over the next five years and thereafter are as follows:
The calculation of diluted earnings per common share for 2011, 2010 and 2009 excludes the impact of 106,219 shares, 2,010,183 shares and 2,351,679 shares, respectively, related to anti-dilutive stock options, restricted stock and restricted stock units.
Centene operates in two segments: Medicaid Managed Care and Specialty Services. The Medicaid Managed Care segment consists of Centene’s health plans including all of the functions needed to operate them. The Specialty Services segment consists of Centene’s specialty companies offering products for behavioral health, care management software, health insurance exchanges, individual health insurance, life and health management, long-term care programs, managed vision, telehealth services, and pharmacy benefits management. The health plans in Arizona, operated by our long-term care company, and Massachusetts, operated by our individual health insurance provider, are included in the Specialty Services segment.
Centene Corporation’s parent company only financial statements should be read in conjunction with Centene Corporation’s audited consolidated financial statements and the notes to consolidated financial statements included in this Form 10-K.