HealthSpring, Inc. (the “Company” or “HealthSpring”) is a managed care organization whose primary focus is Medicare, the federal government-sponsored health insurance program primarily for U.S. citizens aged 65 and older, qualifying disabled persons, and persons suffering from end-stage renal disease. As of December 31, 2010, we operated Medicare Advantage plans in Alabama, Delaware, Florida, Georgia, Illinois, Maryland, Mississippi, New Jersey, Pennsylvania, Tennessee, Texas, and the District of Columbia. We also offer national and regional stand-alone Medicare prescription drug plans. We refer to our Medicare Advantage plans, including plans providing prescription drug benefits, or MA-PD, as “Medicare Advantage” plans and our stand-alone prescription drug plans as our “PDPs.” For purposes of additional analysis, the Company provides membership and certain financial information, including premium revenue and medical expense, for our Medicare Advantage (including MA-PD) and PDP. We report our business in three segments: Medicare Advantage; PDP; and Corporate. The following discussion of our results of operations includes a discussion of revenue and certain expenses by reportable segment. See “-Segment Information” below for additional information related thereto.
Medicare Advantage membership at 2010 year-end increased 61.0% over the prior year. PDP membership at 2010 year-end increased 131.4% over the prior year.
On November 30, 2010, HealthSpring acquired all of the outstanding stock of Bravo Health, Inc. (“Bravo Health”), an operator of Medicare Advantage coordinated care plans in Pennsylvania, the Mid-Atlantic region, and Texas, and a Medicare Part D stand-alone prescription drug plan in 43 states and the District of Columbia. HealthSpring acquired Bravo Health for approximately $545.0 million in cash, subject to a post-closing positive or negative adjustment based on a calculation relating to, among other things, the statutory net worth of Bravo Health’s regulated subsidiaries as of the closing. Any such positive adjustment, which is expected to be paid by HealthSpring in June 2011, will not exceed $10.0 million. As of November 30, 2010, Bravo Health had 105,455 Medicare Advantage members and 300,969 PDP members.
At the closing of the acquisition, a $55.0 million escrow was established from the merger consideration to fund Bravo Health’s stakeholders’ post-closing indemnification obligations, if any, $23.0 million of which will be held in escrow for three years following closing with respect to certain specified claims, including the OIG matter discussed above. Consequently, although no assurance can be made, we do not expect the liability resulting from the RADV OIG Audit, if any, to have a material adverse effect on the results of operations, cash flows, or financial condition of the Company. No escrow-related liabilities or assets are included in the Company’s balance sheet at December 31, 2010.
The Company incurred approximately $11.4 million, or $0.14 per share, of transaction-related expenses relating to the acquisition of Bravo Health. Such expenses are included in selling, general and administrative expenses and interest expense in our results of operations for the year ended December 31, 2010.
As with our traditional Medicare Advantage plans, we provide written bids to CMS for our Part D plans, which include the estimated costs of providing prescription drug benefits over the plan year. Premium payments from CMS are based on these estimated costs. The amount of CMS payments relating to the Part D standard coverage for our MA-PD plans and PDPs is subject to adjustment, positive or negative, based upon the application of risk corridors that compare our prescription drug costs in our bids to CMS to our actual prescription drug costs. Variances exceeding certain thresholds may result in CMS making additional payments to us or our refunding to CMS a portion of the premium payments we previously received. We estimate and recognize adjustments to premium revenue related to estimated risk corridor payments as of each quarter end based upon our actual prescription drug costs for each reporting period as if the annual contract were to end at the end of each reporting period. We account for estimated risk corridor settlements with CMS on our consolidated balance sheet and as an operating activity in our consolidated statement of cash flows. Actual risk corridor payments upon final settlement with CMS could differ materially, favorably or unfavorably, from our estimates.
Certain Part D-related payments we receive from CMS, primarily relating to low income and reinsurance subsidies for qualifying members of our plans, represent payments for claims that we administer on behalf of CMS and for which we assume no risk. We account for these payments as funds held for (or due for) the benefit of members on our consolidated balance sheet and as a financing activity in our consolidated statement of cash flows. We do not recognize premium revenue or claims expense for these payments as these amounts represent pass-through payments from CMS to fund deductibles, co-payments, and other member benefits.
Management and Other Fee Revenue. Management and other fee revenue primarily include amounts paid to us for management services provided to independent physician associations and health plans. Our management subsidiaries typically generate fee revenue on one of two bases: (1) as a percentage of revenue collected by the relevant health plan; or (2) as a fixed PMPM payment or percentage of revenue for members serviced by the relevant independent physician association, or IPA. Fee revenue is recognized in the month in which services are provided. In addition, pursuant to certain of our management agreements with IPAs, we receive fees based on a share of the profits of the IPAs. To the extent these fees relate to members of our HMO and regulated insurance subsidiaries, the fees are recognized as a credit to medical expense. Management fees calculated based on profits are recognized, as fee revenue or as a credit to medical expenses, if applicable, when we can readily determine that such fees have been earned, which determination is typically made on a monthly basis.
The following table sets forth consolidated statements of income data expressed in dollars (in thousands) and as a percentage of revenues for each period indicated. Data for the year ended December 31, 2010 includes the results of Bravo Health from November 30, 2010.
Our primary source of revenue is monthly premium payments we receive based on membership enrolled in our managed care plans. The following table summarizes our Medicare Advantage (including MA-PD), and stand-alone PDP membership, by state, as of the dates indicated.
The Company’s Medicare premium revenue is subject to adjustment based on the health risk of its members. We refer to this process for adjusting premiums as the CMS risk adjustment payment methodology. Under the risk adjustment payment methodology, managed care plans must capture, collect, and report diagnosis code information to CMS. After reviewing the respective submissions, CMS establishes the payments to Medicare plans generally at the beginning of the calendar year and then adjusts premiums on two separate occasions on a retroactive basis.
The first retroactive risk premium adjustment for a given year generally occurs during the third quarter of such year. This initial settlement represents the updating of risk scores for the current year based on updated diagnoses from the prior year. CMS then issues a final retroactive risk premium adjustment settlement for that year in the following calendar year. We estimate and record on a monthly basis both the initial and final settlements with CMS. The impact of the Company updating its estimated final CMS settlement amounts (in the following calendar year) as a result of additional diagnoses code information and ultimately upon receiving notification of the final CMS settlement amounts were as follows:
Total revenue was $3.1 billion for the year ended December 31, 2010 as compared with $2.7 billion in 2009, representing an increase of $0.4 billion, or 17.6%. The components of revenue were as follows:
Premium Revenue: Total premium revenue for the year ended December 31, 2010 was $3.1 billion as compared with $2.6 billion in 2009, representing an increase of $0.5 billion, or 17.8%. The components of premium revenue and the primary reasons for changes were as follows:
PDP: PDP premiums (after risk corridor adjustments) were $472.9 million in the year ended December 31, 2010 compared to $325.4 million in 2009, an increase of $147.5 million, or 45.3%. The increase in premiums for the current year is primarily the result of increases in membership in our existing national PDP. Our average PMPM premiums (after risk corridor adjustments) were $93 in the current year, compared with $91 in 2009.
Investment Income: Investment income was $7.0 million for 2010 as compared to $4.3 million in 2009, reflecting an increase of $2.7 million, or 63.9%. The increase is primarily the result of increases in invested balances, as the Company has moved substantial amounts out of cash and cash equivalents into investments since 2009, and in the average duration and yield on invested assets in the portfolio.
Medicare Advantage. Medicare Advantage (including MA-PD) medical expense for the year ended December 31, 2010 increased $0.2 billion, or 10.8%, to $2.1 billion from $1.9 billion for 2009, which is primarily attributable to membership increases in the 2010 period as compared to the 2009 period and the inclusion of medical expenses incurred by Bravo Health from November 30, 2010. For the year ended December 31, 2010, the Medicare Advantage MLR was 78.7% versus 81.0% for 2009. The MLR improvement in the current period is primarily attributable to changes in benefit design and lower inpatient utilization, combined with premium revenue increases. Favorable utilization trends experienced in 2010 may not be sustainable in future periods. To the extent future utilization levels exceed any relative increases in premium revenue our MLR levels would deteriorate. Our Medicare Advantage medical expense calculated on a PMPM basis was $833 for the year ended December 31, 2010, compared with $851 for 2009.
PDP. PDP medical expense for the year ended December 31, 2010 increased $118.5 million to $389.4 million, compared to $270.9 million in 2009, which is primarily attributable to membership increases in our existing national PDP plan in the 2010 period. PDP MLR for 2010 was 82.3%, compared to 83.3% in 2009. The decrease in PDP MLR for the current period was primarily attributable to changes in formularies and favorable levels of pharmacy rebates in 2010. The Company currently expects MLR for the PDP segment to increase in 2011 as a result of increases in membership in 2011 in PDP regions with higher PMPM medical expenses than in 2010.
Selling, general and administrative (SG&A) expense for the year ended December 31, 2010 was $324.3 million as compared with $279.8 million for the prior year, an increase of $44.5 million, or 15.9%. The increase in 2010 as compared to the prior year is primarily the result of the inclusion of SG&A expense for Bravo Health for the one month in 2010 under the Company’s ownership, and additional personnel and selling costs related to membership growth in the Company’s existing health plans. Additionally, SG&A expense for the year ended December 31, 2010 includes transaction-related expenses of $9.7 million related to the acquisition of Bravo Health in 2010. As a percentage of revenue, SG&A expense decreased approximately 20 basis points for the year ended December 31, 2010 compared to the prior year.
Premium Revenue: Total premium revenue for the year ended December 31, 2009 was $2.6 billion as compared with $2.1 billion in 2008, representing an increase of $0.5 billion, or 22.4%. The components of premium revenue and the primary reasons for changes were as follows:
Medicare Advantage: Medicare Advantage (including MA-PD) premiums were $2.3 billion for the year ended December 31, 2009 as compared to $1.9 billion in 2008, representing an increase of $0.4 billion, or 22.5%. The increase in Medicare Advantage premiums in 2009 is primarily attributable to increases in membership and in PMPM premium rates in substantially all of our plans. PMPM premiums for 2009 averaged $1,050, which reflects an increase of 4.9% as compared to 2008, as adjusted to exclude retroactive risk adjustments associated with prior years. The PMPM premium increase in 2009 is the result of rate increases in CMS-calculated base rates as well as rate increases related to risk scores. Member months increased 16.9% for 2009 as compared to 2008.
PDP: PDP premiums (after risk corridor adjustments) were $325.4 million in the year ended December 31, 2009 compared to $265.5 million in 2008, an increase of $59.9 million, or 22.6%. The increase in premiums for 2009 is primarily the result of increases in membership and PDP PMPM premium rates. Our average PMPM premiums (after risk corridor adjustments) increased 10.2% to $91 in 2009 from $83 during 2008.
Fee Revenue. Fee revenue was $42.3 million in 2009 compared to $32.6 million for 2008, an increase of $9.7 million. The increase in 2009 is attributable to increased management fees as a result of higher membership in managed IPAs as compared to 2008.
Our Medicare Advantage medical expense calculated on a PMPM basis was $849 for the year ended December 31, 2009, compared with $782 for 2008, as adjusted to exclude final CMS retroactive risk adjustments associated with prior years.
Interest expense was $15.6 million for the year ended December 31, 2009, compared with $19.1 million in 2008. The decrease in 2009 was the result of lower effective interest rates and lower average principal balances outstanding. The weighted average interest rate incurred on our borrowings during the year ended December 31, 2009 and 2008 was 6.0% and 6.6%, respectively (4.8% and 5.6%, respectively, exclusive of amortization of deferred financing costs).
For the year ended December 31, 2009, income tax expense was $76.3 million, reflecting an effective tax rate of 36.4%, as compared with $67.5 million, reflecting an effective tax rate of 36.2%, for 2008. The higher rate in 2009 was the result of a number of factors, including greater concentration of the Company’s profitability in entities taxed at a higher state tax rate.
As of January 1, 2010, the Company revised its methodology for allocating SG&A expenses within its prescription drug operations to its MA-PD and PDP segments, which resulted in allocating a greater share of such expenses to its PDP segment. As a result of these revisions, the segment EBITDA amounts for 2009 and 2008 include reclassification adjustments between segments such that the periods presented are comparable.
We use segment EBITDA as an analytical indicator for purposes of assessing segment performance, as is common in the healthcare industry. Segment EBITDA should not be considered as a measure of financial performance under generally accepted accounting principles and segment EBITDA, as presented, may not be comparable to other companies.
A reconciliation of reportable segment EBITDA to net income included in the consolidated statements of income for the last three years ended December 31 is as follows:
The reported changes in cash and cash equivalents for the years ended December 31, 2010, 2009 and 2008 were as follows:
Our primary sources of liquidity are cash flow provided by our operations, available cash on hand, proceeds from the sale or maturities of our investment securities, and our revolving credit facility. We generated cash from operating activities of $221.1 million during 2010, compared to $170.0 million during 2009 and $162.0 million during 2008.
2009 Compared With 2008. The increase in cash flow provided by operating activities to $170.0 million for 2009 from $162.0 million for 2008 is primarily attributable to increases in earnings, the amount and timing of risk corridor settlements with CMS, and other changes in working capital items.
For the year ended December 31, 2010, the Company’s primary investing activity consisted of net expenditures of $461.7 million used to acquire Bravo Health on November 30, 2010. Other investing activities consisted of expenditures of $434.1 million to purchase investment securities and restricted investments, the receipt of $187.6 million in proceeds from the sale or maturity of investment securities and restricted investments, and $11.2 million spent on property and equipment additions.
For the year ended December 31, 2009, the Company’s primary investing activities consisted of $15.8 million in property and equipment additions, expenditures of $59.5 million to purchase investment securities, and $57.7 million in proceeds from the maturity of investment securities.
During the year ended December 31, 2009, the Company’s financing activities consisted primarily of $36.2 million of funds received in excess of funds withdrawn from CMS for Medicare Part D claim subsidies for which we do not assume risk, and $31.0 million for the repayment of long-term debt.
For the year ended December 31, 2008, the Company’s primary investing activities consisted of $11.7 million in property and equipment additions, expenditures of $59.8 million to purchase investment securities, $71.2 million in proceeds from the maturity of investment securities, and the expenditure of $7.2 million for the Valley Plans acquisition.
Minimum statutory net worth calculated at 200% of authorized control level.
Subsidiary distributions to the parent Company (other than tax-related distributions) for 2010, 2009, and 2008 were as follows (in thousands):
On February 11, 2010, the Company entered into a $350.0 million credit agreement (the “Prior Credit Agreement”), which, subject to the terms and conditions set forth therein, provided for a five-year, $175.0 million term loan credit facility and a four-year, $175.0 million revolving credit facility (the “Prior Credit Facilities”). Proceeds from the Prior Credit Facilities, together with cash on hand, were used to fund the repayment of $237.0 million in term loans outstanding under the Company’s 2007 credit agreement as well as transaction expenses related thereto.
In connection with entering into the Prior Credit Agreement, the Company wrote-off unamortized deferred financing costs of approximately $5.1 million incurred in connection with the 2007 credit agreement. The Company also terminated its interest rate swap agreements, which resulted in a payment of approximately $2.0 million to the swap counterparties. Such amounts are classified as interest expense and are reflected in the financial results of the Company for the year ended December 31, 2010.
In connection with the acquisition of Bravo Health, the Company and its existing lenders and certain additional lenders amended and restated the Prior Credit Agreement in the form of the Amended and Restated Credit Agreement (“Restated Credit Agreement”) on November 30, 2010 to provide for, among other things, the acquisition financing. As amended, the Restated Credit Agreement provides for the following:
$180.0 million of new term loan A indebtedness as “New Term Loan A” (funded at the closing of the acquisition);
The Revolving Credit Facility, Existing Term Loan A, New Term Loan A, and New Term Loan B are sometimes referred to herein as the “Credit Facilities.”
Borrowings under the Restated Credit Agreement accrue interest on the basis of either a base rate or LIBOR plus, in each case, an applicable margin depending on the Company’s total debt to adjusted EBITDA leverage ratio (initially 450 basis points for LIBOR borrowings under New Term Loan B and 375 basis points for LIBOR borrowings under the other Credit Facilities). With respect to New Term Loan B indebtedness, the Restated Credit Agreement includes a minimum LIBOR of 1.5%. The Company also is required to pay a commitment fee of 0.500% per annum, which may be reduced to 0.375% per annum if the Company’s total debt to adjusted EBITDA leverage ratio is 0.75 to 1.0 or less, on the daily unused portions of the Revolving Credit Facility. The Revolving Credit Facility matures, the commitments thereunder terminate, and all amounts then outstanding thereunder are payable on February 11, 2014. The $175.0 million revolving credit facility, which is available for working capital and general corporate purposes including capital expenditures and permitted acquisitions, was drawn in the amount of $100.0 million as of December 31, 2010.
The Restated Credit Agreement also contains conditions precedent to extensions of credit thereunder as well as representations, warranties, and covenants, including financial covenants, customary for transactions of this type. Financial covenants include (i) a maximum total debt to adjusted EBITDA ratio of 2.25 to 1.00 (reducing to 2.00 at December 31, 2011 and 1.75 to 1.00 on June 30, 2012), (ii) minimum net worth requirements for each regulated insurance subsidiary calculated by reference to applicable regulatory requirements, and (iii) maximum capital expenditures, in each case as more specifically provided in the Restated Credit Agreement. The Company believes it is currently in compliance with its financial and other covenants under the Restated Credit Agreement.
The Restated Credit Agreement also contains customary events of default as well as restrictions on undertaking certain specified actions including, among others, asset dispositions, acquisitions and other investments, dividends, changes in control, issuance of capital stock, fundamental corporate changes such as mergers and consolidations, incurrence of additional indebtedness, creation of liens, transactions with affiliates, and certain subsidiary regulatory restrictions. Under the Restated Credit Agreement, the Company is permitted to repurchase $100.0 million of the Company’s common stock in any calendar year (which annual amount increases as the Company’s leverage ratio improves). If an event of default occurs that is not otherwise waived or cured, the lenders may terminate their obligations to make loans and other extensions of credit under the Restated Credit Agreement and the obligations of the issuing banks to issue letters of credit and may declare the loans outstanding under the Restated Credit Agreement to be due and payable.
In connection with entering into the Prior Credit Agreement, the Company incurred financing costs of approximately $7.3 million which were recorded in February 2010. In connection with entering into the Restated Credit Agreement, the Company incurred financing costs of approximately $19.5 million, which were paid in November 2010. These amounts have been accounted for as deferred financing fees and are being amortized over the term of the Restated Credit Agreement using the interest method. The unamortized balance of such costs at December 31, 2010 totaled $24.8 million, and is included in other assets on the accompanying consolidated balance sheet.
Pharmacy costs represent payments for members’ prescription drug benefits, net of rebates from drug manufacturers. Rebates are recognized when earned, according to the contractual arrangements with the respective vendors. Estimation of rebates is a complex process and involves a number of assumptions and variables, including with respect to brand name and generic utilization; adherence to formularies; member volumes both on an absolute basis and relative to the markets; and new drug entrants during the period, among others.
The completion and claims trend factors are the most significant factors impacting the IBNR estimate. The following table illustrates the sensitivity of these factors and the impact on our operating results caused by changes in these factors that management believes are reasonably likely based on our historical experience and December 31, 2010 data:
The following table provides a reconciliation of changes in medical claims liability for the years ended December 31, 2010, 2009 and 2008:
Approximately $2.0 million paid to providers under risk sharing and capitation arrangements related to 2009 premiums is included in the incurred related to current period amounts in 2010. Such amount does not relate to fee-for-service medical claims estimates. Similarly, $2.2 million and $10.1 million paid to providers under risk sharing and capitation arrangements related to prior year premiums are included in the 2009 and 2008 incurred related to current period, respectively. Most of these amounts are the result of additional retroactive risk adjustment premium payments recorded that pertain to the prior year’s premiums (see - “Risk Adjustment Payments”).
Paid amounts related to the prior period for the 2010 period include $76.1 million of payments on acquired liabilities ($149.5 million as shown in the table herein) resulting from the Bravo Health acquisition on November 30, 2010.
As reflected in the immediately preceding table, claims estimates at December 31, 2009 ultimately settled during 2010 for $15.8 million (or 0.7% of total 2009 medical expense) less than the amounts originally estimated. This favorable prior period reserve development was primarily as a result of the following factors:
Actual completion factors ultimately being higher than completion factors used to estimate IBNR at December 31, 2009 based on historical patterns resulting in $4.0 million of favorable development, which increase was primarily attributable to a shortening of the time between when claims are submitted by providers and paid by our plans.
All such estimated amounts are periodically updated as additional diagnosis code information is reported to CMS and adjusted to actual amounts when the ultimate adjustment settlements are either received from CMS or the Company receives notification from CMS of such settlement amounts.
The Company recognizes premium revenue for the Part D payments received from CMS for which it assumes risk. Certain Part D payments from CMS represent payments for claims the Company pays for which it assumes no risk. The Company accounts for these payments as funds held for (or due for) the benefit of members on its consolidated balance sheets and as a financing activity in its consolidated statements of cash flows. The Company does not recognize premium revenue or claims expense for these payments as these amounts represent pass-through payments from CMS to fund deductibles, co-payments, and other member benefits.
To participate in Part D, the Company is required to provide written bids to CMS that include, among other items, the estimated costs of providing prescription drug benefits. Payments from CMS are based on these estimated costs. The monthly Part D payment the Company receives from CMS for Part D plans generally represents the Company’s bid amount for providing insurance coverage, both standard and supplemental, and is recognized monthly as premium revenue. The amount of CMS payments relating to the Part D standard coverage for MA-PD plans and PDPs is subject to adjustment, positive or negative, based upon the application of risk corridors that compare the Company’s prescription drug costs in its bids to the Company’s actual prescription drug costs. Variances exceeding certain thresholds may result in CMS making additional payments to the Company or the Company’s refunding to CMS a portion of the premium payments it previously received. The Company estimates and recognizes an adjustment to premium revenue related to estimated risk corridor payments based upon its actual prescription drug cost for each reporting period as if the annual contract were to end at the end of each reporting period. Risk corridor adjustments do not take into account estimated future prescription drug costs. The Company records a risk corridor receivable or payable and classifies the amount as current or long-term in the consolidated balance sheet based on the expected settlement with CMS. The liabilities on the Company’s consolidated balance sheets at December 31, 2010 and 2009 arise as a result of the Company’s actual costs to date in providing Part D benefits being lower than its bids. The risk corridor adjustments are recognized in the consolidated statements of income as a reduction of or increase to premium revenue.
The Company recognizes prescription drug costs as incurred, net of estimated rebates from drug companies. The Company has subcontracted the prescription drug claims administration to three third-party pharmacy benefit managers.
Goodwill valuations have been determined using an income approach based on the present value of expected future cash flows of each reporting unit. In assessing the recoverability of goodwill, we consider historical results, current operating trends and results, and we make estimates and assumptions about premiums, medical cost trends, margins and discount rates based on our budgets, business plans, economic projections, anticipated future cash flows and regulatory data. Each of these factors contains inherent uncertainties and management exercises substantial judgment and discretion in evaluating and applying these factors.
Effective January 1, 2010, the Company adopted the Financial Accounting Standards Board’s (FASB’s) updated guidance related to fair value measurements and disclosures, which requires a reporting entity to disclose separately the amounts of significant transfers in and out of Level 1 and Level 2 fair value measurements and to describe the reasons for the transfers. In addition, in the reconciliation for fair value measurements using significant unobservable inputs, or Level 3, a reporting entity should disclose separately information about purchases, sales, issuances and settlements. The updated guidance also requires that an entity should provide fair value measurement disclosures for each class of assets and liabilities and disclosures about the valuation techniques and inputs used to measure fair value for both recurring and non-recurring fair value measurements for Level 2 and Level 3 fair value measurements. The guidance is effective for interim or annual financial reporting periods beginning after December 15, 2009, except for the disclosures about purchases, sales, issuances and settlements in the roll forward activity in Level 3 fair value measurements, which are effective for fiscal years beginning after December 15, 2010 and for interim periods within those fiscal years. The adoption of the updated guidance for fair value measurements did not have an impact on the Company’s consolidated results of operations or financial condition.
In October 2010, the FASB issued amended guidance regarding the accounting for costs associated with acquiring or renewing insurance contracts. The amended guidance covers life and property and casualty insurers and other insurance companies and specifies the accounting treatment for the costs they incur in acquiring new customers and renewing old policies, including details on the types of costs that should be capitalized. The amended guidance will be effective for fiscal years that start after December 15, 2011. This guidance is effective for the Company beginning with its interim period ended March 31, 2012 with either prospective or retrospective application permitted. Early adoption is permitted. We are currently evaluating the impact this guidance will have on our consolidated financial statements.
In 2010, the FASB issued amended guidance regarding recognition and disclosure requirement of subsequent events. This guidance removed contradictions between the requirements of U.S. GAAP and the SEC’s filing rules. The amendments discharge the requirement that public companies disclose the date through which subsequent events are evaluated in both issued and revised financial statements.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of HealthSpring, Inc. and subsidiaries as of December 31, 2010 and 2009, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2010, in conformity with U.S. generally accepted accounting principles. Also in our opinion, the related financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein.
HealthSpring, Inc. acquired Bravo Health, Inc. on November 30, 2010. Management excluded from its assessment of the effectiveness of HealthSpring Inc.’s internal control over financial reporting as of December 31, 2010, Bravo Health, Inc.’s internal control over financial reporting associated with total assets of $806.1 million and total revenues of $144.6 million included in the consolidated financial statements of HealthSpring, Inc. and subsidiaries as of and for the year ended December 31, 2010. Our audit of internal control over financial reporting of HealthSpring, Inc. also excluded an evaluation of the internal control over financial reporting of Bravo Health, Inc.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of HealthSpring, Inc. and subsidiaries as of December 31, 2010 and 2009, and the related consolidated statements of income, stockholders’ equity and comprehensive income, and cash flows for each of the years in the three-year period ended December 31, 2010, and our report dated February 25, 2011 expressed an unqualified opinion on those consolidated financial statements.
The accompanying consolidated financial statements also include the accounts of variable interest entities (VIEs) of which the Company is the primary beneficiary. As of November 30, 2010, in connection with the acquisition of Bravo Health, Inc. (Bravo Health), the Company holds interest in certain physician practices that are considered VIEs because the physician practices may not have sufficient capital to finance their activities separate from the revenue received from the Company. The Company is deemed to be the primary beneficiary and, under the VIE accounting rules, is deemed to “control” the physician entities, which have been consolidated. Revenues, net income, and total assets of VIEs were $1.3 million, $79,000, and $4.5 million, respectively, as of and for the year ended December 31, 2010. The Company held no variable interests requiring consolidation prior to November 30, 2010.
The preparation of the consolidated financial statements requires management of the Company to make a number of estimates and assumptions relating to the reported amount of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the period. The most significant item subject to estimates and assumptions is the actuarial calculation for obligations related to medical claims. Other significant items subject to estimates and assumptions include the Company’s estimated risk adjustment payments receivable from The Centers for Medicare and Medicaid Services (CMS), the valuation of goodwill and intangible assets, the useful lives of definite-life intangible assets, the valuation of debt securities carried at fair value, and certain amounts recorded related to the Part D program, including rebates receivables from drug manufacturers. Actual results could differ from these estimates.
Debt and equity securities are classified in three categories: trading, available for sale, and held to maturity. Trading securities are bought and held principally for the purpose of selling them in the near term. Held to maturity securities are those securities that the Company does not intend to sell, nor expects to be required to sell, prior to maturity. All securities not included in trading or held to maturity are classified as available for sale. The Company holds no trading securities.
Trading securities and available for sale securities are recorded at fair value. Held to maturity debt securities are recorded at amortized cost, adjusted for the amortization or accretion of premiums or discounts. Unrealized gains and losses on trading securities are included in earnings. Unrealized gains and losses (net of applicable deferred taxes) on available for sale securities are included as a component of stockholders’ equity and comprehensive income until realized from a sale or other than temporary impairment. Realized gains and losses from the sale of securities are determined on a specific identification basis. Purchases and sales of investments are recorded on their trade dates. Dividend and interest income are recognized when earned.
The Company periodically evaluates whether any declines in the fair value of its available for sale investments are other than temporary. This evaluation consists of a review of several factors, including, but not limited to, length of time and extent that a security has been in an unrealized loss position; the existence of an event that would impair the issuer’s future earnings potential; the near term prospects for recovery of the market value of a security; the intent of the Company to sell the impaired security; and whether the Company will be required to sell the security prior to the anticipated recovery in market value. Declines in value below cost for debt securities where it is considered probable that all contractual terms of the security will be satisfied, where the decline is due primarily to changes in interest rates (and not because of increased credit risk), and where the Company does not intend to sell the investment prior to a period of time sufficient to allow a market recovery, are assumed to be temporary. If management determines that an other-than-temporary impairment exists, the carrying value of the investment will be reduced to the current fair value of the investment and if such impairment results from credit-related matters, the Company will recognize a charge in the consolidated statements of income equal to the amount of the carrying value reduction. Other-than-temporary impairment write-downs resulting from non-credit-related matters are recognized in other comprehensive income.
Property and equipment, consisting of land, a building, hardware, software, leasehold improvements, and furniture and equipment are stated at cost less accumulated depreciation. Depreciation on property and equipment is calculated on the straight line method over the estimated useful lives of the assets. The estimated useful life of property and equipment ranges from 1 to 15 years. The Company owns one building with an estimated useful life of 39 years. Leasehold improvements for assets under operating leases are amortized over the lesser of their useful life or the remaining term of the lease. Maintenance and repairs are charged to operating expense when incurred. Major improvements that extend the lives of the assets are capitalized.
Long lived assets, such as property and equipment and purchased intangibles subject to amortization, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to the estimated future undiscounted cash flows expected to be generated by the asset. If the carrying amount of an asset exceeds its estimated fair value, an impairment charge is recognized by the amount of the excess. Assets to be disposed of would be separately presented in the balance sheet and reported at the lower of the carrying amount or fair value less costs to sell, and no longer depreciated.
The Company records a liability for unrecognized tax benefits resulting from uncertain tax positions taken or expected to be taken in a tax return. The Company recognizes interest and penalties, if any, related to unrecognized tax benefits in income tax expense.
Goodwill represents the excess of cost over fair value of assets of businesses acquired. Goodwill and intangible assets acquired in a purchase business combination and determined to have an indefinite useful life are not amortized, but instead are tested for impairment at least annually. An impairment loss is recognized to the extent that the carrying amount exceeds the asset’s fair value. Regarding goodwill, this determination is made at the reporting unit level and consists of two steps. First, the Company determines the fair value of the reporting unit and compares it to its carrying amount. Second, if the carrying amount of the reporting unit exceeds its fair value, an impairment loss is recognized for any excess of the carrying amount of the unit’s goodwill over the implied fair value of that goodwill. The implied fair value of goodwill is determined by allocating the fair value of the reporting units in a manner similar to a purchase price allocation. The residual fair value after this allocation is the implied fair value of the reporting unit’s goodwill. The Company has seven reporting units where goodwill is reported - Alabama, Bravo Health Insurance Company, Florida, Pennsylvania, Tennessee, Texas-Bravo and Texas-HealthSpring. Goodwill valuations have been determined using an income approach based on the present value of expected future cash flows of each reporting unit. In assessing the recoverability of goodwill, the Company considers historical results, current operating trends and results, and makes estimates and assumptions about premiums, medical cost trends, margins and discount rates based on the Company’s budgets, business plans, economic projections, anticipated future cash flows and regulatory data. Each of these factors contains inherent uncertainties and management exercises substantial judgment and discretion in evaluating and applying these factors.
Medical claims liability represents the Company’s liability for services that have been performed by providers for its members that have not been settled as of any given balance sheet date. The liability consists of medical claims reported to the plans as well as an actuarially determined estimate of claims that have been incurred but not yet reported to the plans, or IBNR. In addition, the medical claims liability includes liabilities for prescription drug benefits and for amounts owed to providers under risk-sharing and quality management arrangements.
Medical expenses consist of claim payments, capitation payments, risk sharing payments and pharmacy costs, net of rebates, as well as estimates of future payments of claims provided for services rendered prior to the end of the reporting period. Capitation payments represent monthly contractual fees disbursed to physicians and other providers who are responsible for providing medical care to members. Risk-sharing payments represent amounts paid under risk sharing arrangements with providers; including independent physician associations (see Note 11). Pharmacy costs represent payments for members’ prescription drug benefits, net of rebates from drug manufacturers. Rebates are recognized when the rebates are earned according to the contractual arrangements with the respective vendors.
All derivatives are recognized on the balance sheet at their fair value. For all hedging relationships the Company formally documents the hedging relationship and its risk management objective and strategy for undertaking the hedge, the hedging instrument, the hedged item, the nature of the risk being hedged, how the hedging instrument’s effectiveness in offsetting the hedged risk will be assessed prospectively and retrospectively, and a description of the method of measuring ineffectiveness. To date, the two derivatives entered into by the Company qualify for and were designated as cash flow hedges. Changes in the fair value of a derivative that is highly effective, and that is designated and qualifies as a cash flow hedge to the extent that the hedge is effective, are recorded in other comprehensive income (loss) until earnings are affected by the variability of cash flows of the hedged transaction (e.g., until periodic settlements of a variable asset or liability are recorded in earnings). Any hedge ineffectiveness (which represents the amount by which the changes in the fair value of the derivatives differ from changes in the fair value of the hedged instrument) is recorded in current-period earnings. Also, on a quarterly basis, the Company measures hedge effectiveness by completing a regression analysis comparing the present value of the cumulative change in the expected future interest to be received on the variable leg of the Company’s swap against the present value of the cumulative change in the expected future interest payments on the Company’s variable rate debt.
Health plan premiums are due monthly and are recognized as revenue during the period in which the Company is obligated to provide services to the members.
As a result of the variability of factors, including plan risk scores, that determine such estimations, the actual amount of CMS’s retroactive risk premium settlement adjustments could be materially more or less than the Company’s estimates. The Company’s risk adjustment payments are subject to review and audit by CMS, which can potentially take several years to resolve completely. Any adjustment to premium revenue and the related medical expense for risk-sharing arrangements with providers as a result of such review and audit would be recorded when estimable. There can be no assurance that any retroactive adjustment to previously recorded revenue or expenses will not have a material effect on future results of operations.
Effective January 1, 2010, the Company adopted the FASB’s updated guidance related to fair value measurements and disclosures, which requires a reporting entity to disclose separately the amounts of significant transfers in and out of Level 1 and Level 2 fair value measurements and to describe the reasons for the transfers. In addition, in the reconciliation for fair value measurements using significant unobservable inputs, or Level 3, a reporting entity should disclose separately information about purchases, sales, issuances and settlements. The updated guidance also requires that an entity should provide fair value measurement disclosures for each class of assets and liabilities and disclosures about the valuation techniques and inputs used to measure fair value for both recurring and non-recurring fair value measurements for Level 2 and Level 3 fair value measurements. The guidance is effective for interim or annual financial reporting periods beginning after December 15, 2009, except for the disclosures about purchases, sales, issuances and settlements in the roll forward activity in Level 3 fair value measurements, which are effective for fiscal years beginning after December 15, 2010 and for interim periods within those fiscal years. Therefore, the Company has not yet adopted the guidance with respect to the roll forward activity in Level 3 fair value measurements. The adoption of the updated guidance for Levels 1 and 2 fair value measurements did not have an impact on the Company’s consolidated results of operations or financial condition.
On November 30, 2010, the Company acquired all the of the outstanding stock of Bravo Health, an operator of Medicare Advantage coordinated care plans in Pennsylvania, the Mid-Atlantic region, and Texas, and a Medicare Part D stand-alone prescription drug plan in 43 states and the District of Columbia. The Company acquired Bravo Health for approximately $545.0 million in cash, subject to a post-closing positive or negative adjustment based on a calculation relating to, among other things, the statutory net worth of Bravo Health’s regulated subsidiaries as of the closing. Any such positive adjustment, which is expected to be paid by the Company in June 2011, will not exceed $10.0 million. The estimated fair value of contingent consideration resulting from such closing adjustment was $10.0 million at November 30, 2010 and December 31, 2010. As of November 30, 2010, Bravo Health had 105,455 Medicare Advantage members and 300,969 PDP members.
The Company’s acquisition of Bravo Health was funded by borrowings of approximately $480.0 million under a new credit facility and the use of cash on hand. The Company’s new credit facility is described in Note 13 - Debt.
The Company incurred approximately $11.4 million of transaction-related expenses relating to the acquisition of Bravo Health. Such expenses are included in selling, general and administrative (SG&A) expenses and interest expense in our consolidated statement of income for the year ended December 31, 2010.
Goodwill included in the Bravo Health acquisition consists of $195.2 million allocated to the Company’s Medicare Advantage operating segment and $19.3 million allocated to its Part D operating segment.
A breakdown of the identifiable intangible assets, valuation method applied in arriving at fair value, their assigned values and expected lives is as follows (dollars in thousands):
-The multi-period excess earnings method estimates an intangible asset’s value based on the present value of the future net cash flows attributable to it. The value attributed to these intangibles was based on projected net cash inflows from existing membership.
-The cost approach method estimates an intangible asset’s value based on the estimated cost to acquire such intangible asset on a stand-alone basis.
-The relief from royalty method is an earnings approach which assesses the royalty savings the entity realizes as a result of owning the asset and not having to pay a third party a license fee for its use.
The unaudited pro forma information includes the results of operations for Bravo Health for the periods prior to the acquisition, with adjustments to give effect to pro forma events that are directly attributable to the acquisition and have a continuing impact, but excludes the impact of pro forma events that are directly attributable to the acquisition and are one-time occurrences. The pro forma information includes adjustments for interest expense on long-term debt and reduced investment income related to the cash used to fund the acquisition, additional depreciation and amortization associated with the purchase, reduced SG&A expense and interest expense for direct and incremental transaction costs, and the related income tax effects. The unaudited pro forma information does not give effect to the potential impact of current financial conditions, regulatory matters or any anticipated synergies, operating efficiencies or cost savings that may be associated with the acquisition. The unaudited pro forma financial information is presented for informational purposes only and may not be indicative of the results of operations had Bravo Health been owned by the Company for the full years ended December 31, 2010 and 2009, nor is it necessarily indicative of future results of operations. The following summary of unaudited pro forma financial information presents revenues, net income and per share data of the Company, as if the acquisition of Bravo Health had occurred at the beginning of the periods presented.
Effective October 1, 2008, the Company acquired a Medicare Advantage contract from Valley Baptist Health Plans (“Valley Plans”), operating in the Texas Rio Grande Valley counties of Hidalgo, Willacy, and Cameron, for approximately $7.2 million in cash. Valley Plans had approximately 2,700 members as of the acquisition date. Additional cash consideration of $0.9 million and $0.6 million (net of the subsequent return of $0.2 million related to membership retroactivity) was paid to the seller in 2009 and 2010, respectively, based upon membership levels retained. As part of the transaction, the Company entered into a provider contract with Valley Baptist Health System. The contract, with an initial term of five years, includes two hospitals and 12 out-patient facilities. The Company accounted for this acquisition as an asset acquisition and therefore 100% of the purchase price was allocated to the identified assets acquired as follows:
Medicare premium receivables at December 31, 2010 and 2009 include $52.2 million and $44.1 million, respectively, for receivables from CMS related to the accrual of retroactive risk adjustment payments. The Company expects to collect such amounts outstanding at December 31, 2010 in the second half of 2011. Accounts receivable relating to unpaid health plan enrollee premiums are recorded during the period the Company is obligated to provide services to enrollees and do not bear interest. The Company does not have any off-balance sheet credit exposure related to its health plan enrollees.
Investment securities, which consist primarily of debt securities, have been categorized as either available for sale or held to maturity. Held to maturity securities are those securities that the Company does not intend to sell, nor expects to be required to sell, prior to maturity. The Company holds no trading securities. At December 31, 2010, investment securities are classified as non-current assets based on the Company’s intention to reinvest such assets upon sale or maturity and to not use such assets in current operations. At December 31, 2009, the Company classified its investment securities based upon maturity dates.
There were no available for sale securities classified as current assets as of December 31, 2010. Available for sale securities classified as current assets at December 31, 2009 were as follows (in thousands):
Available for sale securities classified as non-current assets were as follows (in thousands):
Held to maturity securities classified as non-current assets at December 31, 2009 were as follows (in thousands):
Maturities of investments were as follows at December 31, 2010 (in thousands):
All issuers of securities the Company owned in an unrealized loss as of December 31, 2010 remain current on all contractual payments. The unrealized losses on investments were caused by an increase in investment yields as a result of a widening of credit spreads. The contractual terms of these investments do not permit the issuer to settle the securities at a price less than the amortized cost of the investment. The Company determined that it did not intend to sell these investments and that it was not more-likely-than-not to be required to sell these investments prior to their recovery, thus these investments are not considered other-than-temporarily impaired.
Depreciation expense on property and equipment for the year ended December 31, 2010, 2009, and 2008 was $13.2 million, $12.4 million and $9.4 million, respectively. Capitalized costs related to the internal development of software of $12.8 million and $6.6 million are reported in computer hardware and software and construction in progress as of December 31, 2010 and 2009, respectively. The unamortized balance of capitalized costs related to the internal development of software was $7.8 million and $3.0 million as of December 31, 2010 and 2009, respectively.
Changes to goodwill during 2010 and 2009 are as follows (in thousands):
The Company recorded $34.7 million of additional purchase price in connection with the release of 2.67 million shares of common stock to the former stockholders of Leon Medical Centers Health Plans (LMC Health Plans) (acquired by the Company in October 2007). Such additional purchase price was allocated to goodwill in the fourth quarter of 2009.
A breakdown of identifiable intangible assets, their assigned values, and accumulated amortizations at December 31, 2010 and 2009 is as follows (in thousands):
Amortization expense expected to be recognized during fiscal years subsequent to December 31, 2010 is as follows (in thousands):
On June 30, 2009, a stock repurchase program authorized by the Company’s Board of Directors to buy back up to $50.0 million of the Company’s common stock expired in accordance with its terms. Over the life of the repurchase program, the Company repurchased approximately 2.8 million shares of its common stock for approximately $47.3 million, or at an average cost of $16.65 per share.
In May 2010, the Company’s Board of Directors authorized a stock repurchase program to repurchase up to $100.0 million of the Company’s common stock through June 30, 2011. The program authorizes purchases of common stock from time to time in either the open market or through private transactions, in accordance with SEC and other applicable legal requirements. The timing, prices, and sizes of purchases depends upon prevailing stock prices, general economic and market conditions, and other factors. Funds for the repurchase of shares have, and are expected to, come primarily from unrestricted cash on hand and unrestricted cash generated from operations. The repurchase program does not obligate the Company to acquire any particular amount of common stock and the repurchase program may be suspended at any time at the Company’s discretion. As of December 31, 2010, the Company had repurchased approximately 838,000 shares of its common stock under the program in open market transactions for approximately $14.3 million, or at an average cost of $17.10 per share, and had approximately $85.7 million in remaining repurchase authority under the program.
Comprehensive income consists of two components: net income and other comprehensive income (loss). Other comprehensive income (loss) refers to revenues, expenses, gains, and losses that are recorded as an element of stockholders’ equity but are excluded from net income.
In November 2009, the Company released contingent consideration of 2.67 million shares of HealthSpring common stock, which was held in escrow since the acquisition in October 2007, to the former stockholders of LMC Health Plans. The released shares are included in the computation of basic and diluted earnings per share for the fourth quarter of 2009 and the year ended December 31, 2010 and as issued and outstanding on the Company’s consolidated balance sheets at December 31, 2010 and 2009.
The Company has stock options outstanding under its 2006 Equity Incentive Plan and its 2005 Stock Option Plan.
Options outstanding under the Amended Plan as of December 31, 2010 vest and become exercisable based on time, generally over a four-year period, and expire ten years from their grant dates. Nonqualified options to purchase an aggregate of 3,439,012 shares of Company common stock were outstanding under the Amended Plan as of December 31, 2010. Upon exercise, options are settled with authorized but unissued Company stock, including shares held in treasury.
The expected volatility used in 2010 is based on the actual volatility rates over a 10-year historic period for the Company (since its initial public equity offering in February 2006) and a peer group (for the historic period prior to February 2006). In 2009, the expected volatility used was based on the Company’s actual volatility rates. For all periods prior to 2009, the Company estimated a blended rate for volatility in a manner generally similar to the method applied in 2010. Additionally, because of the Company’s limited history of employee exercise patterns, the expected term assumption is based on industry peer information. The risk-free interest rate was based on a traded zero-coupon U.S. Treasury bond with a term substantially equal to the option’s expected term. The Company recognized a deferred income tax benefit of approximately $3.2 million, $3.6 million, and $3.4 million, for the years ended December 31, 2010, 2009, and 2008, respectively, related to the share-based compensation expense. The actual tax expense realized from stock options exercised during 2010, 2009, and 2008 was $874,000, $18,000 and, $199,000, respectively. There was no capitalized stock-based compensation expense in 2010, 2009, or 2008.
An analysis of stock option activity for the year ended December 31, 2010 under the Amended Plan is as follows:
During the year ended December 31, 2010, the Company granted 427,851 shares of restricted stock to employees pursuant to the Amended Plan. The restrictions relating to the restricted stock awards made in 2010 generally lapse over a four-year period.
The fair value of shares vested during the years ended December 31, 2010, 2009, and 2008 was $3.0 million, $1.1 million, and $1.2 million, respectively. Total compensation expense related to nonvested restricted stock awards not yet recognized was $7.7 million at December 31, 2010. The Company expects to recognize this compensation expense over a weighted average period of approximately 2.7 years. There are no other contractual terms covering restricted stock awards under the Amended Plan once the vesting restrictions have lapsed.
During the year ended December 31, 2010, 35,043 restricted shares were purchased by certain executives pursuant to the Management Stock Purchase Program (the “MSPP”). The restrictions on shares purchased under the MSPP generally lapse on the second anniversary of the issue date. At December 31, 2010, 421,672 shares were available for issuance under the MSPP.
The following table presents the calculation of the Company’s net income per common share available to common stockholders - basic and diluted, for the years ended December 31, 2010, 2009, and 2008 (dollars in thousands, except share data):
For the years ended December 31, 2010, 2009, and 2008, GulfQuest, L.P. earned management and other fees from RPO of approximately $21.3 million, $20.3 million, and $18.9 million, respectively. These amounts are reflected in management and other fees in the accompanying consolidated statements of income.
The Company incurred medical expense to RPO of approximately $148.3 million, $140.2 million, and $126.6 million for the years ended December 31, 2010, 2009, and 2008, respectively, related to medical services provided to its members by RPO. The 50%/50% risk sharing with respect to the common membership pool of RPO and the Company resulted in the Company accruing for amounts to RPO of approximately $2.1 million, $15,000, and $2.9 million for the years ended December 31, 2010, 2009, and 2008, respectively. GulfQuest, L.P.’s 25% share of RPO’s profits were approximately $16.5 million, $11.6 million, and $12.9 million for those same respective periods. These amounts are reflected as components of medical expense in the accompanying consolidated statements of income. Amounts payable to the Company’s subsidiaries from RPO in connection with these various relationships were $705,000 and $293,000 as of December 31, 2010 and 2009, respectively.
Herbert A. Fritch, the Company’s Chairman of the Board of Directors and Chief Executive Officer, owns a 36.7% membership interest in Predators Holdings, LLC (“Predators Holdings”), the owner of the Nashville Predators National Hockey League team. Mr. Fritch is a member of the executive committee of Predators Holdings. In December 2007, Mr. Fritch loaned Predators Holdings $2.0 million and, in January 2009, collateralized a letter of credit in the amount of $3.4 million in favor of Predators Holdings. A subsidiary of Predators Holdings manages the Bridgestone Arena in Nashville, Tennessee where the hockey team plays its home games. The Company is a party to a suite license agreement with another subsidiary of Predators Holdings pursuant to which the Company leases a suite for Predators games and other functions. In 2010 and 2009, the Company paid $144,000 and $134,000 respectively, under the license agreement for the use of the suite (including 16 tickets, but not food and beverage concessions, for each Predators’ home game).
Under the Leon Medical Services Agreement, LMC, either directly or through an affiliate of LMC or third party designees, manages certain advertising and other promotional activities with respect to LMC, in its capacity as a provider of medical services to LMC Health Plans’ members, and LMC Health Plans’ clinic model Medicare plan product offering in the operating areas that are the subject of the Leon Medical Services Agreement. The Leon Medical Services Agreement requires LMC Health Plans to reimburse LMC (or its affiliate or third party designees(s) through which it conducts such advertising and promotional activities) for costs and expenses incurred with respect to such advertising and promotional activities up to a contractual maximum amount with respect to any twelve calendar month period during the term of the agreement. LMC Health Plans’ aggregate reimbursements to Leon Advertising and Public Relations, Inc. for the years ended December 31, 2010, 2009, and 2008 totaled approximately $5.1 million, $3.4 million, and $3.2 million, respectively. The Company had accrued $401,000 and $351,000 for amounts due to Leon Advertising and Public Relations, Inc. under the Leon Medical Services Agreement at December 31, 2010 and 2009, respectively.
Long-term debt at December 31, 2010 and 2009 consists of the following (in thousands):
$175.0 million revolving credit facility maturing in February 2014 (the “Revolving Credit Facility”, $100.0 million of which was drawn at the closing); and
Borrowings under the Restated Credit Agreement accrue interest on the basis of either a base rate or LIBOR plus, in each case, an applicable margin depending on the Company’s total debt to adjusted EBITDA leverage ratio (initially 450 basis points for LIBOR borrowings under New Term Loan B and 375 basis points for LIBOR borrowings under the other Credit Facilities). With respect to New Term Loan B indebtedness, the Restated Credit Agreement includes a minimum LIBOR of 1.5%. The Company also is required to pay a commitment fee of 0.500% per annum, which may be reduced to 0.375% per annum if the Company’s total debt to adjusted EBITDA leverage ratio is 0.75 to 1.0 or less, on the daily unused portions of the Revolving Credit Facility. The effective interest rate on borrowings under the credit facilities was 4.8% as of December 31, 2010. The Revolving Credit Facility matures, the commitments thereunder terminate, and all amounts then outstanding thereunder are payable on February 11, 2014. The $175 million revolving credit facility, which is available for working capital and general corporate purposes including capital expenditures and permitted acquisitions, was drawn in the amount of $100.0 million as of December 31, 2010.
Under the Restated Credit Agreement, Existing Term Loan A and New Term Loan A are payable in quarterly principal installments. Prior to June 30, 2013, each quarterly principal installment payable in respect of each of Existing Term Loan A and New Term Loan A will be in an amount equal to 2.5% of the aggregate initial principal amount of Existing Term Loan A or New Term Loan A, as the case may be, and for principal installments payable on June 30, 2013 and thereafter, that percentage increases to 3.75%. The entire outstanding principal balance of each of Existing Term Loan A and New Term Loan A is due and payable in full at maturity on February 11, 2015.
Loans under the Restated Credit Agreement are secured by a first priority lien on substantially all assets of the Company and its non-regulated insurance subsidiaries, including a pledge by the Company and its non-regulated insurance subsidiaries of all of the equity interests in each of their domestic subsidiaries (including regulated insurance subsidiaries).
In connection with entering into the Prior Credit Agreement, the Company incurred financing costs of approximately $7.3 million, which were capitalized in February 2010. In connection with entering into the Restated Credit Agreement, the Company incurred financing costs of approximately $19.5 million, which were capitalized in November 2010. These capitalized cost amounts have been accounted for as deferred financing fees and are being amortized over the term of the Restated Credit Agreement using the interest method. The unamortized balance of such costs at December 31, 2010 totaled $24.8 million and is included in other assets on the accompanying consolidated balance sheet.
The Company’s medical claims liabilities at December 31, 2010 and 2009 consist of the following (in thousands):
The Company develops its estimate for IBNR by using standard actuarial developmental methodologies, including the completion factor method. This method estimates liabilities for claims based upon the historical lag between the month when services are rendered and the month claims are paid and takes into consideration factors such as expected medical cost inflation, seasonality patterns, product mix, and membership changes. The completion factor is a measure of how complete the claims paid to date are relative to the estimate of the total claims for services rendered for a given reporting period. Although the completion factors are generally reliable for older service periods, they are more volatile, and hence less reliable, for more recent periods given that the typical billing lag for services can range from a week to as much as 90 days from the date of service. As a result, for the most recent two to four months, the estimate for incurred claims is developed from a trend factor analysis based on per member per month claims trends experienced in the preceding months. At December 31, 2010 and 2009, the Company determined that no premium deficiency liabilities were required.
The following table provides a reconciliation of changes in the medical claims liability for the Company for the years ended December 31, 2010, 2009, and 2008 (in thousands):
Negative amounts reported for incurred related to prior periods result from fee-for-service medical claims estimates being ultimately settled for amounts less than originally anticipated (a favorable development).
Income tax expense consists of the following for the periods presented (in thousands):
A reconciliation of the U.S. federal statutory rate (35%) to the effective tax rate is as follows for the periods presented (in thousands):
The Company, including VIEs which are not consolidated for federal or state tax purposes, currently benefits from federal and state net operating loss carryforwards. The Company’s consolidated federal net operating loss carryforwards available to reduce future tax income are approximately $13.9 million and $5.2 million at December 31, 2010 and 2009, respectively. These net operating loss carryforwards, if not used to offset future taxable income, will expire from 2010 through 2030. State net operating loss carryforwards at December 31, 2010 and 2009 are approximately $46.8 million and $13,000, respectively. These net operating loss carryforwards, if not used to offset future taxable income, will expire from 2013 through 2030. In addition, the Company has alternative minimum tax credits which do not have an expiration date.
The Company’s utilization of these various tax attributes, at both the federal and state level, may be limited under rules relating to the ownership changes. This limitation is incorporated in the above table by the valuation allowance recorded against a portion of the deferred tax assets. The Company also recognized goodwill resulting from the recapitalization transaction that is reflected in the accompanying consolidated balance sheets. A portion of this goodwill is deductible for federal and state income tax purposes. None of the goodwill associated with the Bravo acquisition is deductible for tax purposes.
In many cases the Company’s uncertain tax positions are related to tax years that remain subject to examination by the relevant taxing authorities. The Company files U.S. federal income tax returns as well as income tax returns in various state jurisdictions. The Company may be subject to examination by the Internal Revenue Service (“IRS”) for calendar years 2007 through 2010. Additionally, any net operating losses that were generated in prior years and utilized in these years may also be subject to examination by the IRS. Generally, for state tax purposes, the Company’s 2006 through 2010 tax years remain open for examination by the tax authorities under a four year statute of limitations. At the date of this report the Company has been scheduled for income tax audits in certain state jurisdictions.
All derivatives were recognized on the balance sheet at their fair value. To the extent that the cash flow hedges were effective, changes in their fair value were recorded in other comprehensive income (loss) until earnings are affected by the variability of cash flows of the hedged transaction (e.g. until periodic settlements of a variable asset or liability are recorded in earnings). Any hedge ineffectiveness (which represents the amount by which the changes in the fair value of the derivatives differ from changes in the fair value of the hedged instrument) was recorded in current-period earnings. As a result of terminating the interest rate swap agreements, the Company settled the swap obligations with the counterparties for approximately $2.0 million and reclassified such amount from other comprehensive income to interest expense during the first quarter of 2010.
The Company had no derivative financial instruments outstanding at December 31, 2010. A summary of the aggregate notional amounts, balance sheet location and estimated fair values of derivative financial instruments at December 31, 2009 was as follows (in thousands):
The cost of the Company’s defined contribution plans during the years ended December 31, 2010, 2009, and 2008 was $3.6 million, $3.0 million, and $2.4 million, respectively. Employees are 100% vested in their contributions and vest fully in employer contributions after the first two years of service.
As of January 1, 2010, the Company revised its methodology for allocating SG&A expenses within its prescription drug operations to its MA-PD and PDP segments, which resulted in allocating a greater share of such expenses to its PDP segment. As a result of these revisions, the segment EBITDA amounts for the 2009 and 2008 periods include reclassification adjustments between segments such that the periods presented are comparable.
The Company uses segment EBITDA as an analytical indicator for purposes of assessing segment performance, as is common in the healthcare industry. Segment EBITDA should not be considered as a measure of financial performance under generally accepted accounting principles and segment EBITDA, as presented, may not be comparable to other companies.
The Company’s regulated insurance subsidiaries are required to maintain satisfactory minimum net worth requirements established by their respective state departments of insurance. At December 31, 2010, the statutory minimum net worth requirements and actual statutory net worth were as follows (in thousands):
Each of these subsidiaries was in compliance with applicable statutory requirements as of December 31, 2010. Notwithstanding the foregoing, the state departments of insurance can require the Company’s regulated insurance subsidiaries to maintain minimum levels of statutory capital in excess of amounts required under the applicable state law if they determine that maintaining additional statutory capital is in the best interest of the Company’s members. Effective December 31, 2010, the Company merged its Texas HMO and Accident and Health subsidiaries.
The Company’s primary lines of business, operating Medicare health maintenance organizations (including prescription drug benefits) and a stand-alone prescription drug plan, are significantly impacted by healthcare cost trends.
Financial instruments that potentially subject the Company to concentrations of credit risk consist primarily of investment securities, derivatives and receivables generated in the ordinary course of business. Investment securities are managed by professional investment managers within guidelines established by the Company that, as a matter of policy, limit the amounts that may be invested in any one issuer. The Company seeks to manage any credit risk associated with derivatives through the use of counterparty diversification and monitoring of counterparty financial condition. Receivables include premium receivables from CMS for estimated retroactive risk adjustment payments, premium receivables from individual and commercial customers, rebate receivables from pharmaceutical manufacturers, receivables related to prepayment of claims on behalf of members under the Medicare program and receivables owed to the Company from providers under risk-sharing arrangements and management services arrangements. The Company had no significant concentrations of credit risk at December 31, 2010.
When quoted prices in active markets for identical debt securities are available, the Company uses these quoted market prices to determine the fair value of debt securities and classifies these assets as Level I. In other cases where a quoted market price for identical debt securities in an active market is either not available or not observable, the Company obtains the fair value from a third party vendor that bases the fair value on quoted market prices of identical or similar securities or uses pricing models, such as matrix pricing, to determine fair value. These debt securities would then be classified as Level II. In the event quoted market prices were not available, the Company would determine fair value using broker quotes or an internal analysis of each investment’s financial statements and cash flow projections. In these instances, financial assets would be classified based upon the lowest level of input that is significant to the valuation. Thus, financial assets might be classified in Level III even though there could be some significant inputs that may be readily available.
There were no transfers to or from Levels 1 and II during the year ended December 31, 2010. The following tables summarize fair value measurements by level at December 31, 2010 and 2009 for assets and liabilities measured at fair value on a recurring basis: