In addition to the office space referenced above, we lease approximately 102 sites in 26 states, totaling approximately 1,388,750 square feet of space.
The following discussion of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and the related notes included elsewhere in this Annual Report on Form 10-K. The following discussion contains forward-looking statements that involve known and unknown risks and uncertainties, including those set forth in the section entitled “Risk Factors” in this Annual Report on Form 10-K. This Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in its entirety, since it contains detailed information that is important to understanding Health Net, Inc. and its subsidiaries’ results and financial condition.
In 2004, our overall financial results did not meet our expectations. Earnings per share fell by 81% to $0.38 per basic and diluted share for 2004, compared with $2.02 per basic share and $1.98 per diluted share in 2003, primarily as a result of higher than anticipated commercial health care costs and lower enrollment. In addition, as described below, we recorded a $252 million pre-tax earnings charge in the fourth quarter ended December 31, 2004, which had a significant impact on our overall 2004 financial results.
Beginning in the latter part of the first quarter ended March 31, 2004, we began to implement a plan designed to improve financial performance (the “2004 Financial Performance Improvement Plan”). As part of the 2004 Financial Performance Improvement Plan, we increased prices in our commercial health plans and commenced a series of initiatives designed to reduce the growth rate of our commercial health care costs. Following implementation of the 2004 Financial Performance Improvement Plan, the rate of increase in commercial per member per month (“PMPM”) premium yields climbed from a 6.9% increase in the first quarter ended March 31, 2004 compared with the first quarter ended March 31, 2003, to a 10.7% increase in the fourth quarter ended December 31, 2004 compared with the fourth quarter ended December 31, 2003. We expect that the rate of growth in PMPM premium yields will continue to increase in the first quarter of 2005.
In the fourth quarter ended December 31, 2004, we recorded a $252 million pre-tax earnings charge which was comprised of the following:
$169 million of expenses associated with provider settlements, including legal costs, relating to claims processing and payment issues that have been or are being resolved;
$65 million of expenses for adverse reserve developments, most of which relates to the second and third quarters of 2004; and
Provider Settlement Expenses. Following a thorough review of outstanding provider disputes and management’s decision in the fourth quarter ended December 31, 2004 to settle a large number of provider disputes, we recorded an amount for provider settlements that reflects what we believe is a reasonable estimate to bring all of these matters to closure. These provider disputes were primarily in our California health plan and related to claims issues extending as far back as 2001. For additional information regarding our provider disputes, see “Item 3. Legal Proceedings-Provider Disputes” and “-Results of Operations-Health Plan Services Costs.”
Reserve Developments. The fourth quarter 2004 pre-tax 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.
Our success in 2005 will depend, in part, on our ability to maintain prices of our health plan products at a rate equal to or greater than the rate of growth in health care costs, as well as our ability to contain growth in our health care costs, especially hospital costs, by employing a range of medical management, pharmaceutical management and provider contracting strategies. We must also begin to reverse the decline in commercial membership in the second half of 2005 and prepare for the substantial changes that will occur in Medicare beginning January 2006 as a result of the implementation of various features of the MMA. In addition, we must sustain our focus on containing general and administrative costs while proceeding with the implementation of our Health Net One systems consolidation project. As previously announced, we are delaying the conversion of the claims systems in California and Oregon until 2006.
The table below and the discussion that follows summarize our results of operations for the last three fiscal years.
(3) PMPM is calculated based on total at-risk member months and excludes ASO member months.
Enrollment in our commercial health plans, including ASO members, decreased 8% at December 31, 2004 compared to the same period in 2003. This decrease was primarily attributable to the premium pricing increases implemented in early 2004 to address higher health care costs and network provider issues. The enrollment decline was seen in the large and small group markets in all of our commercial health plans except our Arizona and Oregon plans. Overall, small group and individual enrollment declined 12% from 2003 to 2004 and large group enrollment declined 6%. We expect enrollment declines to persist at least through the first half of 2005 as we continue to maintain higher premiums.
We participate in state Medicaid programs in California, Connecticut and New Jersey. California membership, where the program is known as Medi-Cal, comprised 84% of our Medicaid membership at December 31, 2004. Overall Medicaid membership decreased 2% at December 31, 2004 compared to the same period in 2003, primarily as a result of competition in New Jersey, a change in law that eliminated certain members eligibility in Connecticut and the State of California’s efforts to tighten eligibility requirements for participation in the Medi-Cal and Healthy Families program. In the third quarter of 2004, we added a new county in California, accounting for approximately 33,000 new members. Despite ongoing concerns about the states’ ability to adequately fund these Medicaid programs, we believe that the significant savings generated by Medicaid managed care will provide ongoing future growth opportunities, as states may move more Medicaid enrollees into managed care plans.
The following table below summarizes our health plan membership information by program and by state at December 31, 2004 and 2003 and the change in membership by program and by state between 2004 and 2003.
Membership in our federal Medicare Risk program decreased 4% at December 31, 2003 compared to the same period in 2002, primarily due to changes in benefit levels offered by us and planned withdrawal of participation and cancellation of the PPO/POS plan in selected counties.
The table below summarizes our health plan membership information by program and by state at December 31, 2003 and 2002 and the change in membership by program and by state between 2003 and 2002.
Regions 9, 10 and 12, covering California, Hawaii, Alaska and part of Arizona
Under our TRICARE contract for the North Region, we provide health care services to approximately 2.9 million Military Health System (“MHS”)-eligible beneficiaries, including 1.8 million TRICARE eligibles for whom we provide health care and administrative services and 1.1 million other MHS-eligible beneficiaries for whom we provide administrative services only. As of December 31, 2004, there were 1,350,153 TRICARE eligibles enrolled in TRICARE Prime under our North Region contract. The total estimated number of eligible beneficiaries for the North Region contract as of December 31, 2004 was 2,928,627 based on data provided by the Department of Defense. Our old TRICARE contracts covered approximately 1.5 million TRICARE eligibles as of December 31, 2003.
In addition to the 2.9 million eligible beneficiaries that we service under the TRICARE contract for the North Region, we administer 17 contracts with the U.S. Department of Veterans Affairs to manage community based outpatient clinics in 12 states covering approximately 33,000 enrollees. We also manage two behavioral health services subcontracts which support prime contracts issued by the Department of Defense’s Quality of Life Office. For additional information regarding our TRICARE contract for the North Region and the other government contracts we manage and administer, see “Item 1. Business-Segment Information-Government Contracts Segment.”
Health Plan Services premiums increased by $467.0 million or 5.1% to $9,560.2 million for the year ended December 31, 2004 from $9,093.2 million for the same period in 2003 due to the following:
Medicare Risk premium increased by $102.6 million or 7.4% for the year ended December 31, 2004 compared to the same period in 2003. Rate increases 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. This was partially offset by membership losses in all states except Oregon.
A rate/volume analysis showing the impact of these commercial, Medicare and Medicaid premium and membership changes for the year ended December 31, 2004 compared to the same period in 2003 is summarized in the following table.
Health Plan Services premiums increased by $511.6 million or 6.0% to $9,093.2 million for the year ended December 31, 2003 from $8,581.6 million for the same period in 2002 due to the following:
The increases in Government Contracts revenue for the year ended December 31, 2004 compared to the same period in 2003 and for the year ended December 31, 2003 compared to the same period in 2002 are as follows:
Government Contracts revenues increased by $156.1 million for the year ended December 31, 2004 as compared to the same period in 2003. This increase was primarily due to a $684.1 million increase in revenues in the second half of 2004 when we began providing health care services under the new TRICARE contract for the North Region, partially offset by a decrease in revenues of $526.7 million from the expiration of the old TRICARE contracts.
Government Contracts revenues increased by $367.1 million for the year ended December 31, 2003 as compared to the same period in 2002. This increase was primarily due to
a $143.4 million increase in risk sharing revenue resulting from increased health care cost estimates following the call-up of reservists in support of the nation’s heightened military activity and an increased number of enrollees seeking care in the private sector as many military health care professionals were deployed abroad, and
The decreases in net investment and other income for the year ended December 31, 2004 compared to the same period in 2003 and for the year ended December 31, 2003 compared to the same period in 2002 are as follows:
Net investment income generally remained consistent from 2003 to 2004 with only a slight decrease of $1.2 million for the year ended December 31, 2004 as a result of lower average cash balances.
Net investment income decreased by $5.9 million for the year ended December 31, 2003 as compared to the same period in 2002, primarily as a result of declines in interest rates applicable to our cash and cash equivalent balances as the Federal Reserve lowered the Fed Funds target by 25 basis points. This impacted our investment income in 2003 because the Fed Funds target rates track closely with cash yields, and a significant portion of our total balances available for investment is cash and cash equivalents. The decline was partially offset by higher average cash and investment balances.
Other income decreased by $2.8 million for the year ended December 31, 2003 compared to the same period for 2002, primarily due to the sale of our employer services group subsidiary effective October 31, 2003.
Commercial health care costs increased by $828.3 million, or 15.7%, for the year ended December 31, 2004 compared to the same period in 2003. Commercial health care costs increased primarily due to our decision to accelerate claim payments in early 2004 and provider settlements of $143.5 million relating to claims processing and payment issues that had been or were being resolved in the fourth quarter of 2004. These higher levels of paid claims persisted through the balance of 2004 and contributed to the increase in overall commercial health care costs. See “Item 3. Legal Proceedings-Provider Disputes” for additional information on the provider settlements. In addition, physician costs on PMPM basis increased by 7.2% in 2004, consistent with our expectations, and pharmaceutical costs on a PMPM basis for our health plans rose by 5.2% in 2004.
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.
Medicaid health care costs decreased by $57.8 million, or 6.0%, for the year ended December 31, 2004 compared to the same period in 2003. Medicaid health care costs decreased as a result of lower physician costs combined with membership losses.
Health Plan Services costs increased by $355.3 million or 5.0% to $7,516.8 million for the year ended December 31, 2003 from $7,161.5 million for the same period in 2003 due to the following:
Commercial health care costs increased by $376.8 million, or 7.6%, for the year ended December 31, 2003 compared to the same period in 2002. Commercial health care costs increased primarily due to higher hospital and physician costs and moderating trends in pharmacy costs attributable to benefit changes, increased generic usage and the conversion of two popular prescribed pharmaceuticals to over-the-counter status.
Medicare Risk health care costs decreased by $66.2 million, or 5.1%, for the year ended December 31, 2003 compared to the same period in 2002. Medicare risk health care costs decreased primarily due to a decrease in member months as a result of our planned exit from certain counties in California, Arizona and Connecticut. The increases in health care costs on a PMPM basis were primarily in California and Connecticut, which experienced higher physician capitation rates and increased inpatient and outpatient utilization. These trends were also consistent with revenue increases and limited Medicare fee schedule increases in 2003.
Medicaid health care costs increased by $44.7 million, or 4.9%, for the year ended December 31, 2003 compared to the same period in 2002. Medicaid health care costs increased primarily due to limited Medicaid fee schedule increases and a significant portion of providers in California being paid capitation on a percentage of premium basis.
Health Plan Services MCR decreased to 82.7% for the year ended December 31, 2003 from 83.5% for the same period in 2002 due to a continued focus on pricing discipline combined with pricing increases above the health care cost trend for our commercial and Medicare Risk products.
A rate/volume analysis showing the impact of these commercial, Medicare and Medicaid health care cost changes for the year ended December 31, 2003 compared to the same period in 2002 is summarized in the following table.
The increases in Government Contracts costs for the year ended December 31, 2004 compared to the same period in 2003 and for the year ended December 31, 2003 compared to the same period in 2002 are as follows:
The Government contracts ratio improved by 60 basis points to 95.3% for the year ended December 31, 2004 from 95.9% for the same period in 2003.
Government Contracts costs increased by $336.6 million, or 23.2%, for the year ended December 31, 2003 compared to the same period in 2002, primarily due to the increase in health care cost estimates of $196.8 million resulting from the call-up of reservists in support of the nation’s heightened military activity and $119.4 million from higher change order and bid price adjustments.
Our Government Contracts cost ratio decreased to 95.9% for the year ended December 31, 2003 from 96.9% for the same period in 2002.
Amortization and depreciation expense for the year ended December 31, 2004 decreased by $14.4 million, or 24.5%, compared to the same period in 2003 due to asset retirements and assets becoming fully depreciated. Amortization expense remained relatively flat from 2004 to 2003 at approximately $2.8 million.
The selling costs ratio increased to 2.6% for the year ended December 31, 2003 from 2.3% for the same period in 2002. This increase reflects the continued shift of our commercial health plan mix to small group with its higher selling costs.
Amortization and depreciation expense decreased $10.2 million, or 14.8%, for the year ended December 31, 2003 as compared to the same period in 2002. This decrease was primarily due to certain intangible assets (primarily comprised of employer groups) reaching the end of their useful lives in July 2002 and thus becoming fully amortized as well as from asset impairments recorded during the fourth quarter ended December 31, 2002 as a result of our systems consolidation project.
We recorded severance and related benefits, asset impairments and restructuring costs for the years ended December 31, 2004, 2003 and 2002. Set forth below, is a chart summarizing these charges and details regarding the summary information contained in the chart.
On May 4, 2004, we announced that, in order to enhance efficiency and reduce administrative costs, we would commence an involuntary workforce reduction of approximately 500 positions, which included reductions resulting from an intensified performance review process, throughout many of our functional groups and divisions, most notably in the Northeast. We recorded pre-tax severance and related benefit costs of $17.4 million, $5.2 million and $2.7 million in the second, third and fourth quarters of 2004, respectively, associated with the workforce reduction. We currently anticipate that we will record additional severance and benefit related costs of $3 million during the year ended December 31, 2005, and that an additional $12.6 million will be paid out during the year ending December 31, 2005. We plan to use cash flows from operations to fund these payments.
We recorded a $3.0 million pre-tax impairment on internally developed software and purchased computer hardware that were rendered obsolete as a result of changes to our operations and systems consolidation process. We also recorded a pre-tax $2.9 million impairment on investments in other companies in the fourth quarter of 2004.
During 2002, we recorded a $2.4 million pre-tax estimated loss on assets held for sale related to a corporate facility building located in Trumbull, Connecticut consisting entirely of non-cash write-downs of building and building improvements. On January 26, 2004, we sold this asset for $6.9 million in cash and recognized a pre-tax loss of $0.7 million as an asset impairment charge in our consolidated statement of operations for the year ended December 31, 2003.
During the fourth quarter ended December 31, 2002, pursuant to SFAS No. 144, we recognized $35.8 million of impairment charges stemming from purchased and internally developed software that were rendered obsolete as a result of our operations and systems consolidation process.
During the third quarter ended September 30, 2002, pursuant to SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities” (“SFAS No. 115”), we evaluated the carrying value of our investments available for sale in CareScience, Inc. The common stock of CareScience, Inc. had been consistently trading below $1.00 per share since early September 2002 and was at risk of being delisted. As a result, we determined that the decline in the fair value of CareScience’s common stock was other than temporary. The fair value of these investments was determined based on quotations available on a securities exchange registered with the SEC as of September 30, 2002. Accordingly, we recognized a $3.6 million pre-tax write-down in the carrying value of these investments which was classified as asset impairments and restructuring charges during the third quarter ended September 30, 2002.
Pursuant to SFAS No. 115 and SFAS No. 118, “Accounting by Creditors for Impairment of a Loan-Income Recognition and Disclosures,” we evaluated the carrying value of our investments in convertible preferred stock and subordinated notes of AmCareco, Inc. arising from the 1999 divestiture of our health plans in Louisiana, Oklahoma and Texas. Since August 2002, authorities in these states have taken various actions, including license denials and liquidation-related processes, that caused us to determine that the carrying value of these assets was no longer recoverable. Accordingly, we wrote off the total carrying value of our investment of $7.1 million which was included as a charge in asset impairments and restructuring charges during the third quarter ended September 30, 2002.
Effective September 30, 2004, we entered into agreements (the “Settlement Agreements”) to settle certain true-up adjustments under a stock purchase agreement and reinsurance agreement entered into in 2001 in connection with the sale of our Florida health plan (the “Florida Plan”). The Settlement Agreements also provided for the recovery of certain legal fees and legal settlements that we had paid on behalf of the Florida Plan. In connection with the Settlement Agreements, we recorded $0.4 million in additional pre-tax loss on sale of the Florida Plan related to the other true-up adjustments in our consolidated statements of operations in 2004.
As part of the Settlement Agreements, all of our indemnification obligations under the stock purchase agreement were terminated and the Florida Plan agreed to indemnify us against any current or future litigation relating to our prior ownership of the Florida Plan. In addition, effective September 30, 2004, we entered into agreements to amend the two existing notes that we received from the sale of the Florida Plan and the related corporate facility building. The amendments had no significant impact on our financial position or results of operations. See Note 3 to our consolidated financial statements for more information on the sale of the Florida Plan.
On October 31, 2003, we completed the sales of our dental and vision subsidiaries, Health Net Dental and Health Net Vision, to SafeGuard Health Enterprises, Inc. During the fourth quarter of 2004, we entered into a settlement agreement to settle the true-up adjustments related to the sale of our dental and vision subsidiaries. In connection with these sales, we received approximately $14.8 million in cash.
Our income tax expense and the effective income tax rate for the years ended December 31, 2004, 2003 and 2002 are as follows:
During the third quarter ended September 30, 2003, we recognized an $89.1 million loss on settlement from disposition of discontinued operations, net of tax of $47.9 million, or $0.77 per basic share and $0.75 per diluted
Our cash flow from operating activities is impacted by, among other things, the timing of collections on our amounts receivable from our TRICARE contract for the North Region. Health care receivables related to TRICARE are best estimates of payments that are ultimately collectible or payable. The timing of collection of such receivables is impacted by government audit and negotiation and can extend for periods beyond a year. Amounts receivable under government contracts were $129.5 million and $90.9 million as of December 31, 2004 and 2003, respectively. Cash flows from operating activities for 2004 were impacted by the effects of the transition to the new TRICARE contract. Under the old TRICARE contracts, we are required to set aside cash for the payment of run-out claims, which is expected to continue through 2005. We have set aside $38.9 million in cash as of December 31, 2004 as required under those TRICARE contracts to pay the run-out claims.
During the fourth quarter of 2004, we recorded $158.1 million of health care costs and $10.6 million of legal costs related to provider settlements. Most of the settlements involve California hospitals, and the claims at issue date back to 2001. These provider settlements will be funded by cash flow from operating activities. For additional information regarding the provider settlements, see “Health Plan Services Costs-2004 Compared to 2003” and “Item 3. Legal Proceedings-Provider Disputes.”
Decreases in our operating cash flows for the year ended December 31, 2004 compared to the same period in 2003 and for the year ended December 31, 2003 compared to the same period in 2002 are as follows:
Net cash from operating activities decreased by $434.7 million for the year ended December 31, 2004 compared to the same period in 2003 due to the following:
Net decrease in cash flows from accounts payable and other liabilities of $22.2 million primarily due to an increase in accruals resulting from timing of payments,
Net increase in cash flows from amounts receivable/payable under government contracts of $40.6 million, primarily resulting from the increases in health care revenue and cost attributable to reservist activation to support increased military activity,
Net increase in cash flows of $29.7 million from reserves for claims and other settlements, and
Net decrease in maturities and sales of available for sale securities of $168.5 million,
Net increase in purchases of restricted investments of $14.9 million as required under our old TRICARE contracts in connection with the run-out claims, and
An increase in maturities and sales of available for sale securities of $159.7 million primarily due to an increase in prepayments of mortgage-backed securities and called security holdings attributable to a decline in interest rates, and
An increase in the purchase of available for sale securities and restricted investments of $168.6 million.
Net cash used in financing activities decreased by $176.6 million for the year ended December 31, 2004 compared to the same period in 2003 due to a decrease in repurchases of our common stock. We repurchased 3,179,400 shares of our common stock for $83.7 million in 2004 under our stock repurchase program compared to 10,129,655 shares for $288.3 million in 2003. In addition, we paid $5.0 million for 150,000 shares repurchased in 2003 and settled in 2004. Cash proceeds from the exercise of stock options and employee stock purchases declined by $23.2 million.
Net cash used in financing activities was $246.2 million for the year ended December 31, 2003 as compared to $305.6 million for the same period in 2002. Under our stock repurchase program more fully described above, we repurchased and paid for 10,129,655 shares of our common stock for $288.3 million during the year ended December 31, 2003 compared to 6,519,600 shares for $159.7 million during the same period in 2002. We paid down the entire outstanding balance of our revolving credit facility as of December 31, 2002. Accordingly, the repayment of our credit facility decreased by $195 million, net of $50 million in borrowings, during the year ended December 31, 2003 as compared to the same period in 2002.
In April 2002, our Board of Directors authorized us to repurchase up to $250 million (net of exercise proceeds and tax benefits from the exercise of employee stock options) of our common stock under a stock
the sum of the present values of the remaining scheduled payments on the Senior Notes to be redeemed consisting of principal and interest, exclusive of interest accrued to the date of redemption, at the rate in effect on the date of calculation of the redemption price, discounted to the date of redemption on a semiannual basis (assuming a 360-day year consisting of twelve 30-day months) at the applicable yield to maturity (as specified in the indenture governing the Senior Notes) plus 40 basis points plus, in each case, accrued interest to the date of redemption.
On February 20, 2004, we entered into Swap Contracts to hedge against interest rate risk associated with our fixed rate Senior Notes. See “Quantitative and Qualitative Disclosures About Market Risk” for additional information regarding the Swap Contracts.
On March 1, 2005, we entered into an amendment to our senior credit facility. The amendment, among other things, amends the definition of Consolidated EBITDA to exclude from the calculation of Consolidated EBITDA during the five fiscal quarter periods commencing with the fiscal quarter ended December 31, 2004 and ending with the fiscal quarter ended December 31, 2005, up to $375 million relating to cash and non-cash, non-recurring charges in connection with litigation and provider settlement payments, any increase in medical claims reserves and any premiums relating to the repayment or refinancing of our Senior Notes to the extent such charges cause a corresponding reduction in Consolidated Net Worth (as defined in the senior credit facility).
We have excluded from such table amounts already recorded in our current liabilities on our consolidated balance sheet as of December 31, 2004. We have also excluded from such table various contracts we have entered into with our health care providers, health care facilities, the federal government and other contracts that we have entered into for the purpose of providing health care services. We have excluded those contracts that allow for cancellation without significant penalty, obligations that are contingent upon achieving certain goals and contracts for goods and services that are fulfilled by vendors within a short time horizon and within the normal course of business.
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America (“GAAP”) requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Principal areas requiring the use of estimates include revenue
We estimate the amount of our reserves for claims primarily by using standard actuarial developmental methodologies. This method is also known as the chain-ladder or completion factor method. The developmental method estimates reserves for claims based upon the historical lag between the month when services are rendered and the month claims are paid while taking into consideration, among other things, expected medical cost inflation, seasonality patterns, product mix, benefit plan changes and changes in membership. A key component of the developmental method is the completion factor which is a measure of how complete the claims paid to date are relative to the estimate of the claims for services rendered for a given period. While the completion factors are reliable and robust for older service periods, they are more volatile and less reliable for more recent periods since a large portion of health care claims are not submitted to us until several months after services have been rendered. Accordingly, for the most recent months, the incurred claims are estimated from a trend analysis
based on per member per month claims trends developed from the experience in preceding months. This method is applied consistently year over year while assumptions may be adjusted to reflect changes in medical cost inflation, seasonality patterns, product mix, benefit plan changes and changes in membership.
An extensive degree of actuarial judgment is used in this estimation process, considerable variability is inherent in such estimates, and the estimates are highly sensitive to changes in medical claims submission and payment patterns and medical cost trends. As such, the completion factors and the claims per member per month trend factor are the most significant factors used in estimating our reserves for claims. Since a large portion of the reserves for claims is attributed in the most recent months, the estimated reserves for claims is highly sensitive to these factors. The following table illustrates the sensitivity of these factors and the estimated potential impact on our operating results caused by these factors:
between actual costs and predetermined goals. Our health plans in Connecticut, New Jersey and New York market to small employer groups through a marketing agreement with The Guardian. We have approximately 260,000 members under this agreement. In general, we share equally with The Guardian in the profits of the marketing agreement, subject to certain terms of the marketing agreement related to expenses.
Other government contracts revenues are recognized in the month in which the eligible beneficiaries are entitled to health care services or in the month in which the administrative services are performed or the period that coverage for services is provided. Revenue under the expired former Region 11, Region 6 and Regions 9, 10 and 12 contracts is subject to price adjustments attributable to inflation and other factors. The effects of these adjustments are recognized on a monthly basis, although the final determination of these amounts could extend significantly beyond the period during which the services were provided.
Amounts receivable under government contracts are comprised primarily of price adjustments and change orders for services not originally specified in the contracts. Change orders arise because the government often directs us to implement changes to our contracts before the scope and/or value is defined or negotiated. We start to incur costs immediately, before we have proposed a price to the government. In these situations, we make no attempt to estimate and record revenue. Our policy is to collect and defer the costs incurred. Once we have submitted a cost proposal to the government, we will record the costs and the appropriate value for revenue, using our best estimate of what will ultimately be negotiated.
In the course of our operations, we are involved on a routine basis in various disputes with members, health care providers, and other entities, as well as audits by government agencies that relate to our services and/or business practices. We and several of our competitors were named as defendants in a number of significant class action lawsuits alleging violations of various federal statutes, including the Employee Retirement Income Security Act of 1974 and the Racketeer Influenced Corrupt Organization Act. See “Item 3.-Legal Proceedings” for additional information regarding these class actions.
We test long-lived assets or asset groups for recoverability when events or changes in circumstances indicate that their carrying amount may not be recoverable. Circumstances which could trigger a review include, but are not limited to: significant decreases in the market price of the asset, significant adverse changes in the business climate or legal factors, current period cash flow or operating losses combined with a history of losses or a forecast of continuing losses associated with the use of the asset and current expectation that the asset will more likely than not be sold or disposed of significantly before the end of its estimated useful life.
Recoverability is assessed based on the carrying amount of the asset and the sum of the undiscounted cash flows expected to result from the remaining period of use and the eventual disposal of the asset. An impairment loss is recognized when the carrying amount is not recoverable and exceeds the fair value of the asset.
Certain of our subsidiaries must comply with minimum capital and surplus requirements under applicable state laws and regulations, and must have adequate reserves for claims. Certain subsidiaries must maintain ratios of current assets to current liabilities pursuant to certain government contracts. Management believes that as of December 31, 2004, all of our health plans and insurance subsidiaries met their respective regulatory requirements.
By law, regulation and governmental policy, our health plan and insurance subsidiaries, which we refer to as our regulated subsidiaries, are required to maintain minimum levels of statutory net worth. The minimum statutory net worth requirements differ by state and are generally based on balances established by statute, a percentage of annualized premium revenue, a percentage of annualized health care costs, or risk based capital (“RBC”) requirements. The RBC requirements are based on guidelines established by the National Association of Insurance Commissioners (“NAIC”). The RBC formula, which calculates asset risk, underwriting risk, credit risk, business risk and other factors, generates the authorized control level (“ACL”), which represents the minimum amount of net worth believed to be required to support the regulated entity’s business. For states in which the RBC requirements have been adopted, the regulated entity typically must maintain the greater of the Company Action Level RBC, calculated as 200% of the ACL, or the minimum statutory net worth requirement calculated pursuant to pre-RBC guidelines. Because our regulated subsidiaries are also subject to their state regulators’ overall oversight authority, some of our subsidiaries are required to maintain minimum capital and surplus in excess of the RBC requirement, even though RBC has been adopted in their states of domicile. We generally manage our aggregate regulated subsidiary capital against 300% of ACL, although RBC standards are not yet applicable to all of our regulated subsidiaries. In addition to the foregoing requirements, our regulated subsidiaries are subject to restrictions on their ability to make dividend payments, loans and other transfers of cash or other assets to the parent company.
The reported and required statutory net worth for our regulated subsidiaries as of December 31, 2004 are summarized as follows:
(1) Includes Gem Insurance Company (sold effective February 28, 2005), Health Net Services (Bermuda) Ltd., and Health Net of Pennsylvania, Inc.