On March 12, 2007, we announced that we had entered into an Agreement and Plan of Merger, dated as of March 11, 2007 (the “Merger Agreement”), with UnitedHealth Group Incorporated (UnitedHealth Group) and Sapphire Acquisition, Inc. (Merger Sub), an indirect wholly-owned subsidiary of UnitedHealth Group. The Merger Agreement provides that, upon the terms and subject to the conditions set forth in the Merger Agreement, Merger Sub will merge with and into Sierra, with Sierra continuing as the surviving company.
Our highlights for the year ended 2007 compared to 2006 include:
Total operating revenues increased by 11.1%. This increase was primarily driven by an 11.6% increase in medical premiums due to a 32.5% increase in premiums for our stand alone Medicare Part D prescription drug (PDP) programs, an increase in our commercial membership and premium rate increases. Also contributing to the increase in operating revenues was a 9.4% increase in professional fees primarily due to an increase in visits to our clinical subsidiaries.
Medical expenses, as a percentage of medical premiums and professional fees, or medical care ratio, increased to 81.6% in 2007 from 77.3% in 2006. The increase in our medical care ratio is primarily related to a 2007 pre-tax loss of $67.9 million related to our new enhanced PDP product that was recorded during the period, which significantly increased medical expenses. The medical ratio on this product was 159.9%. See Medical Expenses below for more details.
We had operating income of $148.7 million in 2007 compared to $217.4 million in 2006. This decrease is related to a $67.9 million operating loss recorded during 2007 related to our new enhanced PDP product. See Medical Expenses below for more details. This decrease was partially offset by an increase in operating income primarily driven by growth in our core membership lines of business.
Cash flows from operating activities decreased to $45.8 million from $190.4 million during 2006. This decrease is mostly due to a $67.9 million operating loss in our Enhanced Plan and a $22.6 million decrease in medical claims payable in 2007 compared to an $87.0 million increase in 2006. The change in the medical claims payable is mostly due to the settlement of provider disputes, the timing of claims payments, and claims activity related to our PDP. In 2006, we reserved amounts for a state to plan reconciliation related to our PDP and had a pharmacy claims run on December 31, 2006. Both of these amounts were settled in 2007. See Medical Expenses below for more details on our Enhanced Plan.
Medical Premiums. The increase in medical premiums for 2007 reflects a 4.4% increase in commercial member months (the number of months individuals are enrolled in a plan). This increase is attributed to in-case growth, movement from self-insured plans to our commercial products and new accounts and was partially offset by 11,000 commercial member terminations effective January 1, 2007 from three large employer groups. Commercial
The increase in medical premiums for 2007 includes $101.2 million from our new stand-alone enhanced PDP product (Enhanced Plan) that was effective January 1, 2007. This was partially offset by a $37.2 million decrease in our existing stand-alone basic PDP plan (Basic Plan). We recognize medical premiums from our PDP plans as earned over the contract period.
In 2008, we will continue to offer our Basic Plan to 30 states and the District of Columbia. In 2008, we will only be a PDP sponsor for auto-enrolled CMS subsidized beneficiaries in Arizona. We will no longer be a PDP sponsor for auto-enrolled Medicare and Medicaid beneficiaries in California, Colorado, Idaho, Nevada, Oregon, Utah and Washington as we did not meet the CMS benchmark in those states for 2008. This resulted in a significant decrease in membership on January 1, 2008. At January 1, 2008, we had 54,000 members enrolled in our Basic Plan.
CMS shares in a portion of the risk of pharmacy costs related to the basic coverage in our Basic Plan and our Enhanced Plan as well as our Medicare Advantage PDP. We recognize a risk sharing receivable or payable based on the year-to-date activity and a corresponding increase or decrease to medical premiums. The risk sharing receivable or payable is accumulated for each contract and recorded in prepaid expenses and other current assets or accrued and other current liabilities depending on the net contract balance at the end of the reporting period. See Note 2, "Summary of Significant Accounting Policies", in the Notes to Consolidated Financial Statements.
Effective January 2004, CMS adopted a new risk adjustment payment methodology for Medicare beneficiaries enrolled in managed care programs, including the Social HMO, which was administratively extended by CMS through 2007. For Social HMO members, the new methodology includes a frailty adjuster that uses measures of functional impairment to predict expenditures. CMS has transitioned to the new payment methodology on a graduated basis from 2004 through 2007 and we completely transitioned to the new methodology effective
Early in 2005, CMS replaced its legacy Group Health Plan system. The transition to the new system had led to some incorrect transactions and inconsistencies in the payments and data we received from CMS. We received overpayments, of over $30 million, from CMS in excess of our current best estimate of Medicare premiums in 2005. We have made CMS aware of the overpayments and they are in the process of researching the various issues. We expect a portion of these funds to be settled with CMS over the course of the next several quarters. Additionally, while we continue to have some membership discrepancies with CMS in 2007, the 2006 membership discrepancies previously disclosed have largely been resolved with CMS and we believe that the appropriate revenue and expenses for these members have been recognized.
The DHCFP awarded a contract to Health Plan of Nevada, Inc. (HPN) as one of two Medicaid managed care contractors in the state of Nevada. The new contract is effective November 1, 2006 through June 30, 2009. The new contract allows the DHCFP, at its sole option, to extend the term of the contract for up to two additional years. When the new contract became effective on November 1, 2006, existing Medicaid members were given the option to select either of the two Medicaid managed care contractors. It appears that the majority of members that made an active selection selected our plan and our share of the plan membership was initially close to 60%. The DHCFP tries to maintain a 55/45 market share band between the two contractors. Since our current membership is slightly above 55% of the plan membership, the other contractor will continue to receive the majority of new members that do not make an active selection. Over time, this is designed to keep the membership within a 55/45 market share band between the two contractors.
Investment and Other Revenue. The decrease in investment and other revenue primarily resulted from a decrease in revenue related to our administrative services subsidiary. Our investment income has remained flat; however, several of our trust deed mortgage notes are in default and in various stages of foreclosure. While the trust deed mortgage notes are secured by real estate assets, the current deterioration of the real estate market has caused the value of the underlying assets of several of the trust deed mortgage notes to significantly decrease. We also have joint ventures that have been impacted by the deterioration of the real estate market. We have evaluated each trust deed mortgage note and joint venture to determine if impairment exists. Based on this evaluation, we recorded $24.0 million in impairment charges during 2007 in general and administrative expenses. See Note 4, "Cash and Investments", in the Notes to Consolidated Financial Statements.
Medical Expenses. Our medical care ratio increased 430 basis points to 81.6%. The increase in our medical care ratio is due primarily to losses related to our Enhanced Plan, higher average bed days during 2007 for our Medicare HMO members, and the termination of our Hospital Corporation of America (HCA) contract on December 31, 2006.
In 2007, we began to offer the Enhanced Plan, which provides brand name and generic prescription drug benefits through the coverage gap or "donut hole". We engaged independent actuarial consultants in developing the Enhanced Plan. The premium structure for the Enhanced Plan was based on a projected level of utilization per member; however, our utilization per member was significantly higher than projected. We incurred a pre-tax operating loss of $67.9 million and a medical loss ratio of 159.9% during 2007 on this product. We did not submit a bid to CMS for an Enhanced Plan in 2008 and, therefore, will not be offering this plan for 2008.
The number of days in claims payable, which is the medical claims payable balance divided by the average medical expense per day, for 2007 was 48 compared to 63 for 2006. Pharmacy claims activity related to the PDP accounted for 8 days of this decrease due to the timing of the year end pharmacy claims run and amounts reserved under the state to plan reconciliation at December 31, 2006 that were settled during 2007. The remaining decrease was related to the settlement of certain provider disputes and the timing of claim payments.
We contract with hospitals, physicians and other independent providers of health care under capitated or discounted fee-for-service arrangements, including hospital per diems, to provide medical care services to members. We also have an extensive pharmacy network to provide pharmaceuticals to our members. Capitated providers are at risk for
a portion of the cost of medical care services provided to our members in the relevant geographic areas; however, we are ultimately responsible for the provision of services to our members should the capitated provider be unable to provide the contracted services. We incurred capitation expenses with non-affiliated providers of $132.6 million and $134.3 million, or 8.7% and 10.4%, of our total medical expenses for 2007 and 2006, respectively. Also included in medical expenses are the operating expenses of our medical provider subsidiaries and certain claims-related administrative expenses, which accounted for 25.9% and 28.4% of our total medical expenses for 2007 and 2006, respectively.
The Las Vegas area has thirteen hospitals. Our contract with our 2006 primary Las Vegas area contracted hospital organization, which includes three hospitals − Sunrise Hospital and Medical Center, Mountain View Hospital and Southern Hills Hospital and Medical Center − owned by HCA, expired on December 31, 2006. We have contracts in place through the end of 2008 with the remaining hospitals in southern Nevada, with the exception of one hospital system whose contract ends on June 30, 2008. We are currently in negotiations to extend their contract. These contracts are based on a fixed per diem rate structure and in some circumstances are higher than the previous HCA contract rates. While our efforts to move the majority of our HCA hospital days to other contracted hospitals have been successful, there are emergency and other situations that have required us to use the HCA hospitals in 2007. In 2007, we have negotiated a discount to billed charges with HCA for our commercial members based on certain prompt pay terms; however, these charges are still substantially higher than our current commercial rates with our contracted hospitals. We receive a significant discount to billed charges for services rendered to Medicare and Medicaid members at an HCA hospital because we pay charges at the established Medicare and Medicaid rates.
General and Administrative Expenses. G&A expenses increased primarily due to premium taxes, brokers’ fees, costs associated with our merger with UnitedHealth Group, costs related to our new enhanced PDP product and impairment charges related to our investments in trust deed mortgage notes and joint ventures. These increases were partially offset by a decrease in share-based compensation expense and management bonuses. As a percentage of medical premiums, G&A expenses were 13.0% and 12.7%, for 2007 and 2006, respectively.
The increase in medical premiums for 2006 includes $197.1 million from our stand-alone PDP described previously, which was effective January 1, 2006. We recognize medical premiums from the PDP as earned over the contract period. The increase in medical premiums for 2006 also reflects the annual Medicare increase described below and a 3.5% increase in HMO Medicare member months. The growth in Medicare member months contributes significantly to the increase in medical premiums as the Medicare per member premium rates are more than three
times the average commercial premium rate. CMS contracted with us to participate in the new voluntary PDP for our Medicare Advantage (MA) plans as well as a stand-alone program for 2006. We were also selected to participate in a local and regional Medicare Advantage PPO plan. During 2006, Sierra Health and Life Insurance Company, Inc. (SHL) offered the stand-alone PDP, marketed under the brand name SierraRx, in eight regions covering Arizona, California, Colorado, Idaho, Nevada, New Mexico, Oregon, Texas, Utah and Washington. SHL was also selected as a PDP sponsor in the same states for auto-enrolled CMS subsidized beneficiaries. SierraRx covers a wide variety of preferred generic and brand name prescription drugs that are distributed through most major retail pharmacy chains and a large number of independent pharmacies. At December 31, 2006, we had 184,900
beneficiaries enrolled in the PDP, the majority of which were auto-enrolled beneficiaries.
The number of days in claims payable, which is the medical claims payable balance divided by the average medical expense per day, for 2006, was 63 compared to 49 for 2005. Pharmacy claims activity related to the PDP accounted for 11 days of this increase due to the timing of a year end claims run and amounts reserved under the state to plan reconciliation. The remaining increase was related to an increase in claims payable for provider disputes and timing of claims payments.
Our medical claims payable liability requires us to make significant estimates. Any changes to the estimates would be reflected in the year the adjustments are made. Included in medical expenses is favorable development on prior years’ estimates of $15.9 million and $13.3 million for the years ended December 31, 2006 and 2005, respectively. The favorable development is a result of claims being settled for amounts less than originally estimated. We also
General and Administrative Expenses. G&A expenses increased primarily due to PDP related expenses, higher employee compensation related expenses, premium taxes, and brokers’ fees. As a percentage of medical premiums, G&A expenses were 12.7% for 2006, compared to 13.4% for 2005.
Interest Expense. Debenture holders converted $63.0 million of our senior convertible debentures during 2005. This conversion resulted in a decrease in interest expense in 2006 compared to 2005. This decrease was partially offset by using our credit facility to repurchase shares. At December 31, 2006, we had $75 million outstanding on our credit facility.
Our primary sources of cash are from premiums, professional fees, and income received on investments. Cash is used primarily for claim and benefit payments and operating expenses. We manage our cash, investments and capital structure so we are able to meet the short- and long-term obligations of our business while maintaining financial flexibility and liquidity. We forecast, analyze and monitor our cash flows to enable prudent investment management and financing within the confines of our investment policies.
Cash flows from operating activities decreased to $45.8 million from $190.4 million during 2006. This decrease is mostly due to a $67.9 million operating loss in our Enhanced Plan and a $22.6 million decrease in medical claims payable in 2007 compared to an $87.0 million increase in 2006. The change in the medical claims payable is mostly due to the settlement of provider disputes, the timing of claims payments, and claims activity related to our PDP. In 2006, we reserved amounts for a state to plan reconciliation related to our PDP and had a pharmacy claims run on December 31, 2006. Both of these amounts were settled in 2007. See Medical Expenses above for more details on our Enhanced Plan.
of our common stock before March 15, 2023 if (i) the market price of our common stock for at least 20 trading days
in a period of 30 consecutive trading days ending on the last trading day of the preceding fiscal quarter exceeds 120% of the conversion price per share of our common stock; (ii) the debentures are called for redemption; (iii) there is an event of default with respect to the debentures; or (iv) specified corporate transactions have occurred. Beginning December 2003 and for each subsequent period, the market price of our common stock has exceeded 120% of the conversion price for at least 20 trading days in a period of 30 consecutive trading days. The conversion rate is subject to certain adjustments. This conversion rate represents a conversion price of $9.145 per share. Holders of the debentures may require us to repurchase all or a portion of their debentures on March 15 in 2008, 2013 and 2018 or upon certain corporate events including a change in control. In either case, we may choose to pay the purchase price of such debentures in cash or common stock or a combination of cash and common stock. Notice was sent to debenture holders (“holders”) in January 2008 informing them of our intent to redeem the debentures for cash on March 20, 2008. Due to the impending redemption, the debentures have been classified as a current liability in the Consolidated Balance Sheet at December 31, 2007.
During 2005, we received offers and entered into five separate and privately negotiated transactions with holders pursuant to which the holders converted an aggregate of $63.0 million of debentures they owned into approximately 6.9 million shares of our common stock in accordance with the indenture governing the debentures. During 2006, a holder converted $500,000 in debentures for approximately 54,000 shares of common stock and we entered into a privately negotiated transaction with a holder pursuant to which the holder converted $8.0 million in debentures for approximately 875,000 shares of common stock in accordance with the indenture governing the debentures. During 2007, we entered into a privately negotiated transaction with a holder pursuant to which the holder converted $21.7 million in debentures for approximately 2.4 million shares of common stock in accordance with the indenture governing the debentures. As a result of these transactions, we expensed prepaid interest of $601,000, $176,000 and $1.5 million in 2007, 2006 and 2005, respectively, and deferred financing costs of $176,000, $91,000 and $1.2 million in 2007, 2006 and 2005, respectively.
On January 24, 2008, Sierra notified Wells Fargo Bank, N.A., as trustee under the Indenture dated as of March 3,
Our HMO and insurance subsidiaries are required by state regulatory agencies to maintain certain deposits and must also meet certain net worth and reserve requirements. The HMO and insurance subsidiaries had restricted assets on deposit in various states totaling $16.8 million at December 31, 2007. The HMO and insurance subsidiaries must also meet requirements to maintain minimum stockholders’ equity, on a statutory basis, as well as minimum risk based capital requirements, which are determined annually. We believe we are in material compliance with our regulatory requirements.
Our long-term debt consists of our 2.25% Senior Convertible Debentures Due 2023. We occupy space and lease equipment under leases that are accounted for as capital leases, where the property and equipment and related lease obligations are recorded on our balance sheet.
This liability is for transition services related to our sale of CII that we are required to provide through December 31, 2009.
As discussed in Note 9, "Employee and Director Benefit Plans", in the Notes to Consolidated Financial Statements, we have long-term liabilities for employee benefit plans, including a defined contribution pension and 401(k) plan, supplemental retirement plan and supplemental executive retirement plan. The payments related to the plans are not included above since they are dependent upon when the employee retires or leaves the Company, and whether the employee elects lump-sum or annuity payments.
While we are unable to predict what legislative or regulatory changes may occur or the impact of any particular change, our operations and financial results could be negatively affected by any legislative or regulatory requirements. For example, any proposals to eliminate or reduce the Employee Retirement Income Security Act (ERISA), which regulates insured and self-insured health care coverage plans offered by employers, pre-emption of state laws that would increase potential managed care litigation exposure, affect underwriting practices, limit rate increases, require new or additional benefits or affect contracting arrangements (including proposals to require HMOs and PPOs to accept any health care provider willing to abide by an HMO's or PPO's contract terms or commission arrangements) may have a material adverse effect on our business. The continued consideration and enactment of “anti-managed care” laws and regulations by federal and state bodies may make it more difficult for us to manage medical costs and may adversely affect financial results. In addition to changes in existing laws and regulations, we are subject to audits, investigations and enforcement actions. These include, but are not limited to, possible government actions relating to ERISA, the Federal Employees Health Benefit Plan, federal and state fraud and abuse laws and laws relating to utilization management and the delivery and payment of health care. In addition, our Medicare business is subject to Medicare regulations promulgated by CMS. Violation of government laws and regulations may result in an assessment of damages, civil or criminal fines or penalties, or other sanctions, including exclusion from participation in government programs. In addition, disclosure of any adverse investigation or audit results or sanctions could negatively affect our reputation in various markets and make it more difficult for us to sell our products and services and retain existing business.
In addition to the items described above, we urge you to review carefully the section “Forward-Looking Statements” in Part 1, Item 1 and “Risk Factors” in Part 1, Item 1A of this Annual Report on Form 10-K for a more complete discussion of the risks associated with an investment in our securities.
In September 2006, the FASB issued Statement of Financial Accounting Standards No. 157, “Fair Value Measurements” (SFAS 157). SFAS 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements. SFAS 157 applies only to other accounting pronouncements that require or permit fair value measurements. SFAS 157 is effective for fiscal years beginning after November 15, 2007. We do not believe the adoption of SFAS 157 will have a material impact on our consolidated financial position, results of operations or cash flows.
In December 2007, the FASB issued Statement of Financial Accounting Standards No.160, “Noncontrolling Interests in Consolidated Financial Statements - An Amendment of ARB No. 51” (SFAS 160). SFAS 160 requires that accounting and reporting for minority interests be recharacterized as noncontrolling interests and classified as a component of equity. We do not believe the adoption of SFAS 160 will have a material impact on our consolidated financial position, results of operations or cash flows.
Medical Claims Payable. Our medical claims payable balance includes claims in process, a provision for the estimate of incurred but not reported (IBNR) claims and a provision for disputed claims obligations including provider disputes. Our most significant accounting estimate is for our reserves for IBNR claims. We make this estimate primarily using standard actuarial methodologies based upon historical data. These standard actuarial methodologies recognize, among other factors, contractual requirements, historical utilization trends, the interval
Management believes, based on information presently available, that the recorded liability for medical claims payable, which at December 31, 2007 represented 44.4% of our total consolidated liabilities or $200.3 million, is reasonable and adequate to cover the related future health care claim payments. However, a difference between the recorded liability and actual developed claim payments could have a material impact on our financial results. For example, a 1% increase in medical claims payable as of December 31, 2007 would reduce reported net income for the year ended 2007 by $1.3 million or 1.4%, and diluted earnings per share would be reduced by $0.02.
The table below provides historical information regarding the accrual and payment of our medical claims payable. Components of the total incurred claims for each year include amounts accrued for current year estimated claims expense as well as adjustments to prior year estimated accruals. The impact of any “changes in prior periods’ estimates” may be offset as we establish the estimate for the current year. Our accounting practice is to consistently recognize the actuarial best estimate of our ultimate liability for our claims within a reasonable level of confidence required by actuarial standards. Thus, only when the release of a prior year reserve is not offset with the same level
of conservatism in estimating the current year reserve will the redundancy create a net reduction in current period medical expenses. The evaluation of medical claims payable at December 31, 2007 is comparable to prior years and we have applied our methodology in a consistent manner in determining our best estimate for medical claims payable at each reporting date.
Amounts incurred related to prior years vary from previously estimated liabilities as the claims are ultimately settled. Liabilities at any period-end are continually reviewed and re-estimated as information regarding actual claims payments, or run-out, becomes known. This information is compared to the originally established liability. Favorable development related to prior years, which is shown as a negative amount in the “changes in prior periods’ estimates”, results from claims being settled for amounts less than originally estimated.
In the fourth quarter of 2003, we recorded a charge of $15.6 million, gross and net of tax, to write-down the investment in Cal Indemnity to its estimated net sales proceeds of approximately $73 million. We used estimates and assumptions to project Cal Indemnity’s future operating results, the costs to perform transition services, the funds to be received for transition services, the expected value of certain assets, the development of loss and ALAE reserves, and the sales transaction costs.
The actuarial projections for the second and third quarters of 2004 had indicated only a small amount of loss development. In the fourth quarter of 2004, we engaged a new independent actuary to perform an analysis of the loss and ALAE reserves. The analysis was used to help us determine if a valuation allowance should be established on the note receivable. We were required to engage a new actuary to avoid a potential conflict of interest with our former actuary, who was still engaged by Cal Indemnity, and the resulting impact to internal controls. Our new actuary used standard casualty insurance projection methods including paid and incurred development methods and paid and incurred Bornhuetter-Ferguson methods. The development methods utilize historical patterns of paid and incurred development over time to estimate future development. The Bornhuetter-Ferguson methods determine the expected unreported and expected unpaid losses by estimating the expected loss ratio and subtracting the actual reported incurred and paid losses. The actuary then selected a projected ultimate cost using the four methods as a guide as well as considering industry trends and other factors.
At December 31, 2007, we re-evaluated the $15.0 million valuation allowance on the $62.0 million note receivable and considered the actuarial analyses at December 31, 2007. Based upon the analyses performed, it was determined no change to the valuation allowance was warranted at December 31, 2007.
As discussed in Note 4 to the consolidated financial statements, the financial statements include other investments and available-for-sale investments valued at $253,700,000 (33% of total assets) and $369,441,000 (46% of total assets) as of December 31, 2007 and 2006, respectively, whose fair values have been estimated by management in the absence of readily determinable fair values. Management's estimates are based on market data, information provided by pricing services, and independent appraisals.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Company's internal control over financial reporting as of December 31, 2007, based on the criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 17, 2008 expressed an unqualified opinion on the Company's internal control over financial reporting.
In 2005, the Company had two reportable segments based on the products and services offered: managed care and corporate operations, and military health services operations. The managed care and corporate operations segment includes managed health care services provided through our HMO, managed indemnity plans, third-party administrative services programs for employer-funded health benefit plans, self-insured workers' compensation plans, multi-specialty medical groups, other ancillary services and corporate operations. The military health services operations ("SMHS") segment administered a managed care federal contract for the Department of Defense's (“DoD”) TRICARE program in Region 1. Health care services under the Company's TRICARE contract for Region 1 ended on August 31, 2004. On September 1, 2004, the Company entered a phase-out period at substantially reduced revenues. During 2005, the Company reached a negotiated settlement with the DoD for certain outstanding change orders and bid price adjustments related to option period six and the phase-out of the Company's military health care operations. In 2007 and 2006, the Company believes that SMHS no longer meets the definition of an operating segment as described in Statement of Financial Accounting Standards No. 131, "Disclosures about Segments of an Enterprise and Related Information". The Company believes the only remaining reportable segment in 2007 and 2006 is the managed care and corporate operations segment.
Reclassifications. Military contract expense in the consolidated financial statements for the year ended December 31, 2006 has been reclassified to conform to the current year presentation.
Principles of Consolidation. All significant intercompany transactions and balances have been eliminated in consolidation. Sierra's consolidated subsidiaries include: Health Plan of Nevada, Inc. (“HPN”) which is a licensed HMO; Sierra Health and Life Insurance Company, Inc. (“SHL”), a health and life insurance company; Southwest Medical Associates, Inc. (“SMA”), a multi-specialty medical provider group; SMHS, a company that provided and administered managed care services to certain TRICARE eligible beneficiaries; CII Financial, Inc. ("CII"); administrative services companies; a home health care agency; a full service hospice agency; a home medical products subsidiary; and a company that provides and manages mental health and substance abuse services.
Medical Premiums. Commercial membership contracts are generally established on an annual basis subject to cancellation by the employer group or Sierra upon 60 days written notice. Premiums, including premiums from both commercial and governmental programs, are due monthly and are recognized as revenue during the period in which members are entitled to receive services and are net of estimated retroactive adjustments of members and groups. Commercial member enrollment is represented principally by employer groups or individuals. HPN offers a prepaid health care program to Medicare and Medicaid recipients and SHL offers a prepaid health care and pharmacy program to Medicare recipients. Revenues associated with Medicare recipients were approximately $879.7 million, $751.3 million and $505.1 million in 2007, 2006 and 2005, respectively. Revenues associated with Medicaid recipients were approximately $104.9 million, $108.9 million and $98.0 million in 2007, 2006 and 2005, respectively. Premiums collected in advance of the period that coverage for services is provided are recorded as unearned premium revenue and can include payments under prepaid Medicare contracts with the Centers for Medicare and Medicaid Services (“CMS”) and prepaid HPN and SHL commercial premiums.
Texas, Utah and Washington. The Company was also selected as a PDP sponsor in the same states for auto-enrolled CMS subsidized beneficiaries. The Basic Plan covers a wide variety of preferred generic and brand name prescription drugs that are distributed through most major retail pharmacy chains and a large number of independent pharmacies.
In 2007, the Company expanded its Basic Plan offering to 30 states and the District of Columbia. The Company remains eligible as a PDP sponsor for its 2006 auto-enrolled CMS subsidized beneficiaries in California and Nevada, and for its 2006 and new 2007 auto-enrolled beneficiaries in Arizona, Colorado, Idaho, Oregon, Utah and Washington. The Company was no longer a PDP sponsor for auto-enrolled CMS subsidized beneficiaries in New Mexico and Texas.
In 2007, the Company, for the first time, offered an enhanced PDP plan (“Enhanced Plan”) in the same 30 states and the District of Columbia. The Enhanced Plan provided brand name and generic prescription drug benefits through the coverage gap. The premium structure for the Enhanced Plan was based on a projected level of utilization per member. The Company engaged independent actuarial consultant, who used their national database, in developing the projected utilization for the Enhanced Plan; however, the actual utilization was significantly higher than the projections. The Company incurred a pre-tax operating loss of $67.9 million during 2007 on this product. At December 31, 2007, the Company had approximately 43,600 Enhanced Plan members. The Company did not submit a bid to CMS for an Enhanced Plan in 2008 and therefore will not be offering this plan for 2008.
In 2008, the Company will continue to offer the Basic Plan in 30 states and the District of Columbia, but will be a PDP sponsor for auto-enrolled CMS subsidized beneficiaries only in Arizona. The Company will no longer be a PDP sponsor for auto-enrolled CMS subsidized beneficiaries in California, Colorado, Idaho, Nevada, Oregon, Utah and Washington as it did not meet the CMS benchmark in those states for 2008.
recognized as incurred and are calculated using the specific identification method. Other revenues include administrative services fees and certain ancillary product revenues. Such revenues are recognized in the period in which the service is performed or the period that coverage for services is provided.
Trust deed mortgage notes and joint ventures are stated at the lower of amortized cost or fair value and categorized as other investments. All other investments are classified as current assets if expected maturity is within one year of the balance sheet date. Otherwise, they are classified as long-term investments, and are included in other assets. The Company reviews each trust deed mortgage note and joint venture quarterly for impairment. If a trust deed mortgage note or joint venture is determined to be impaired, it is written down to its fair value. During 2007, the Company wrote down certain trust deed mortgage notes and joint ventures that resulted in an impairment charge of $24.0 million. The Company believes that no further adjustments are required to its recorded amounts of investments in trust deed mortgage notes and joint ventures at December 31, 2007.
Restricted Cash and Investments. Certain subsidiaries are required by state regulatory agencies to maintain deposits and must also meet net worth and reserve requirements. The Company believes its subsidiaries are in material
Goodwill. The goodwill balance at December 31, 2007 and 2006 was $14.8 million, all of which is part of the managed care and corporate operations segment. During 2007, 2006 and 2005, the Company’s assessment of goodwill resulted in no impairment of goodwill.
Treasury Stock. Shares purchased and placed in treasury are valued at cost. Subsequent sales of treasury stock at amounts in excess of their cost are credited to additional paid-in capital. Sale of treasury stock at amounts below their cost are charged to additional paid-in capital to the extent it includes gains from previous sales and the remainder to retained earnings. Sales of treasury shares in 2007, 2006 and 2005, at amounts below their cost of $4.3 million, $14.1 million and $10.8 million, respectively, were charged to retained earnings, as the Company did not previously have gains in additional paid-in capital. Almost all issuance of treasury shares in 2007, 2006 and 2005 were in connection with the exercise of stock options.
written down to their fair value. At December 31, 2007 and 2006, the Company’s had $33.6 million, net of allowance, and $62.3 million in investments in trust deed mortgage notes, respectively. This approximates the fair value of the Company’s investments in trust deed mortgage notes and is its maximum exposure to them at December 31, 2007.
In February 2007, the FASB issued Statement of Financial Accounting Standards No. 159, "The Fair Value Option for Financial Assets and Financial Liabilities - Including an Amendment of FASB Statement No. 115" ("SFAS 159"). SFAS 159 would create a fair value option of accounting for qualifying financial assets and liabilities under which an irrevocable election could be made at inception to measure such assets and liabilities initially and subsequently at fair value, with all changes in fair value reported in earnings. SFAS 159 is effective as of the beginning of the first fiscal year beginning after November 15, 2007. The Company does not believe the adoption of SFAS 159 will have a material impact on its consolidated financial position, results of operations, or cash flows.
In December 2007, the FASB issued Statement of Financial Accounting Standards No.141 (Revised 2007), “Business Combinations” (SFAS 141R) which replaces SFAS No. 141, “Business Combinations”. SFAS 141R establishes principles and requirements for how an acquirer recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, any noncontrolling interest in the acquiree and the goodwill acquired. The statement also establishes disclosure requirements that will enable users to evaluate the nature and financial effects of the business combination. SFAS 141R is effective for the Company's fiscal year 2009 and must be applied prospectively to all new acquisitions closing on or after January 1, 2009. Early adoption of this standard is not permitted. The Company does not believe the adoption of SFAS 141R will have a material impact on its consolidated financial position, results of operations or cash flows.
On March 12, 2007, Sierra announced that it had entered into an Agreement and Plan of Merger, dated as of March 11, 2007 (the “Merger Agreement”), with UnitedHealth Group Incorporated (UnitedHealth Group) and Sapphire Acquisition, Inc. (Merger Sub), an indirect wholly-owned subsidiary of UnitedHealth Group. The Merger Agreement provides that, upon the terms and subject to the conditions set forth in the Merger Agreement, Merger Sub will merge with and into Sierra, with Sierra continuing as the surviving company.
On February 25, 2008, pursuant to the Merger Agreement, Merger Sub merged with and into Sierra, with Sierra continuing after the merger as a wholly owned subsidiary of UnitedHealth Group. Pursuant to the Merger Agreement, each issued and outstanding share of Sierra common stock (other than shares owned by UnitedHealth Group or Merger Sub, whose shares were cancelled) has been converted into the right to receive $43.50 in cash, on the terms specified in the Merger Agreement.
Trust deed mortgage notes and joint ventures are stated at the lower of amortized cost or fair value and categorized as other investments. These investments are classified as current assets if expected maturity is within one year of the balance sheet date. Otherwise, they are classified as long-term investments. The trust deed mortgage notes are secured by real estate assets; however, the current deterioration of the real estate market has caused the value of the underlying assets of several of the trust deed mortgage notes to significantly decrease. Several of the Company’s trust deed mortgage notes are in default and in various stages of foreclosure. The Company has evaluated each trust deed mortgage note to determine if impairment exists. Based on this evaluation, the Company recorded a $13.8 million impairment charge, which resulted in a valuation allowance of $14.0 million at December 31, 2007 on $35.6 million of trust deed mortgage notes determined to be impaired. Also, based on this evaluation, the Company recorded a $1.8 million impairment charge, which resulted in a valuation allowance of $1.8 million at December 31, 2007 for interest receivables related to the impaired trust deed mortgage notes. The impairment charges related to our trust deed mortgage notes are included in general and administrative expenses on the Consolidated Statement of Income. The Company believes that no further adjustments are required to its recorded amounts of investments in trust deed mortgage notes at December 31, 2007.
The Company has evaluated its investments in joint ventures and determined that its joint venture in a high rise condominium located near the Las Vegas Strip and its joint venture in residential land located in southern California has been impaired. The Company measured impairment on these joint ventures using discounted cashflows. During the fourth quarter of 2007, the Company recorded an $8.4 million impairment charge on these investments that was included in general and administrative expenses on the Consolidated Statement of Income.
The following table summarizes the Company's other investments, net of allowance, at December 31, 2007 and 2006:
2007, 2006 and 2005 were $2.3 million, $1.5 million and $1.3 million, respectively. Gross realized losses on investments, for 2007, 2006 and 2005 were $563,000, $835,000 and $242,000, respectively.
The following table summarizes the Company's available-for-sale investments at December 31, 2007:
The following table shows the fair value and unrealized losses, aggregated by investment category and length of time, that individual securities have been in a continuous unrealized loss position at December 31, 2007:
Expected maturities may differ from contractual maturities because certain borrowers have the right to call or prepay obligations.
Depreciation expense including capital leases in 2007, 2006 and 2005 was $15.3 million, $16.6 million and $15.0 million, respectively.
The following reconciles the difference between the reported and statutory provision for income taxes for the years ended December 31:
The tax effects of significant items comprising the net deferred tax assets of the Company are as follows at December 31:
Current income taxes receivable were $7.0 million at December 31, 2007 and are included in prepaid expenses and other current assets. The Company did not have an income tax receivable at December 31, 2006. Current income taxes payable were $18.9 million at December 31, 2006 and were included in accrued and other current liabilities.
The Company adopted the provisions of FASB Interpretation No. 48, "Accounting for Uncertainty in Income Taxes", on January 1, 2007 ("FIN 48"). The effect of adopting FIN 48 in the first quarter of 2007 resulted in an increase to the net liability for unrecognized tax benefits of $4.3 million, which was accounted for as a reduction in retained earnings. The total amount of gross unrecognized tax benefits as of the date of adoption was $19.2 million, including $1.9 million of interest and $1.5 million of penalties.
The total amount of unrecognized tax benefits that, if recognized, would affect the effective tax rate as of December 31, 2007 was $11.4 million. We believe that our liability for unrecognized tax benefits will decrease in the next twelve months by $4.0 to $5.0 million as a result of audit settlements and the expiration of statutes of limitations.
We currently file income tax returns in the U.S. federal jurisdiction and various state jurisdictions. Tax years 1996 to 2007 remain subject to examination for U.S. federal income tax and tax years 2002 to 2004 remain subject to examination by major state tax jurisdictions.
Sierra Debentures - In March 2003, the Company issued $115.0 million aggregate principal amount of its 2.25% Senior Convertible Debentures Due 2023. The debentures are not guaranteed by any of Sierra’s subsidiaries. The
The credit facility was secured by guarantees by certain of the Company’s subsidiaries and a first priority perfected security interest in (i) all of the capital stock of each of the Company’s unregulated, material domestic subsidiaries (direct or indirect) as well as all of the capital stock of certain regulated, material domestic subsidiaries; and (ii) all other present and future assets and properties of the Company and those of its subsidiaries that guarantee the credit agreement obligations (including, without limitation, accounts receivable, inventory, certain real property, equipment, contracts, trademarks, copyrights, patents, license rights and general intangibles) subject, in each case, to the exclusion of the capital stock of CII and certain other exclusions.
Scheduled maturities of the Company's long-term debt and future minimum payments under capital leases, together
The following table summarizes the share-based compensation expense included in the Consolidated Statements of Income for all share-based compensation plans that were recorded in accordance with Statement of Financial Accounting Standards No. 123 (revised 2004), "Share-Based Payment":
The following table represents the effect on net income and earnings per share if the Company had applied the fair value based method and recognition provisions of SFAS 123 to stock-based compensation for the year ended December 31, 2005.
The fair value of stock options granted was estimated at the date of grant using the Black-Scholes option-pricing model with the following assumptions:
The exercise price of options equals the market price of the Company's common stock on the date of grant. Stock options generally vest at a rate of 20% - 100% per year and expire from five to ten years from the date of grant.
The Company's Purchase Plan allows employees to purchase newly issued shares of common stock through payroll deductions at 85% of the fair market value of such shares on the lower of the first trading day of the plan period or the last trading day of the plan period as defined in the Purchase Plan. During 2006, 158,000 and 49,000 shares were purchased at prices of $30.67 and $34.43 per share, respectively. During 2007, 49,000 and 56,000 shares were purchased at prices of $30.63 and $30.46 per share, respectively. At December 31, 2007, the Company had 665,000 shares reserved for purchase under the Purchase Plan of which 40,000 shares were purchased by employees at $35.36 per share in January 2008.
The fair value shares purchased under the Purchase Plan were estimated at the date of grant using the Black-Scholes option-pricing model with the following assumptions:
The following table reflects the activity of the nonvested stock options for the year ended December 31, 2007:
The total fair value of vested stock options during 2007 was $3.0 million.
The Company issued 250,000 performance-based Units in 2004 to certain members of its management. The first third of the Units vested in 2004 with the remainder vesting in January 2005. The value of the transaction was based on the number of Units issued and the Company's common stock price on the date the performance criteria were met. The stock price on the date the first performance criteria was met was $20.65. For the Units vesting in 2005, the price used to value the Units was $26.69. Total expense associated with the Units was $100,000 for 2005.
The Company issued 156,000 performance-based Units in 2005. The first 10% of these Units vested in the second quarter of 2005 with the remainder vesting in the fourth quarter of 2005. The value of the transaction was based on the number of Units issued and the Company's common stock price on the date the performance criteria were met. The stock price on the date the first performance criteria was met was $35.73. The stock price on the date the second performance criteria was met was $38.41. Total expense recognized during 2005 for the Units was $6.2 million.
In August 2006, the Company issued 210,000 Units to certain members of its management. The Units vest according to a variety of vesting schedules, or earlier based on the occurrence of certain events. The majority of Units have a three year holding period from the date of grant. The fair value of the transaction was based on the number of Units issued, the Company stock price on the date of issuance, which was $43.60, and an estimated forfeiture rate. A discount was applied to the Units with a holding period as a result of the lack of marketability between the vesting dates and settlement dates. The fair value of Units granted with a holding period includes a discount that was estimated at the date of grant using the Black-Scholes option-pricing model with the following weighted average assumptions: expected volatility of 32.3%, risk-free interest rate of 4.8% and dividend rate of 0%. Total expense associated with the Units was $927,000 and $5.2 million for 2007 and 2006, respectively which approximates the fair value of vested Units during the year.
In January 2007, the Company issued 2,000 non-performance based Units to each of the five non-employee Directors. The first 50% of these Units vest in the first quarter of 2008 with the remainder vesting on the fourth anniversary of the grant date or earlier based on the occurrence of certain events. The fair value of the transaction was based on the number of Units issued and the Company's common stock price on the date of grant, which was $35.35. Total expense associated with the Units during 2007 was $192,000 which represents the fair value of vested Units during the year.
The following table reflects the activity of the restricted stock unit plans for the year ended December 31, 2007:
Defined Contribution Plan - The Company has a defined contribution pension and 401(k) plan (the “Plan”) for its employees. The Plan covers all employees who meet certain age and length of service requirements. The Company matches 50%-100% of an employee’s elective deferral up to a maximum of 6% of a participant’s annual compensation, subject to IRS limits. The Plan does not require additional Company contributions. Expense under the Plan totaled $7.2 million, $6.9 million and $4.9 million for the years ended December 31, 2007, 2006 and 2005, respectively.
Supplemental Retirement Plans - The Company has Supplemental Retirement Plans (the “SRPs”) for certain officers, directors and highly compensated employees. The SRPs are non-qualified deferred compensation plans through which participants may elect to postpone the receipt and taxation of a portion of their salary and bonuses received from the Company. As contracted with the Company, the participants or their designated beneficiaries may begin to receive benefits under the SRPs upon a participant’s death, disability, retirement, termination of employment or certain other circumstances including financial hardship. The Company had a liability of $23.9 million and $21.6 million for the SRPs at December 31, 2007 and 2006, respectively. While the SRPs are unfunded plans, the Company is informally funding the plans through life insurance contracts on certain Company employees. The life insurance contracts had cash surrender values of $21.7 million and $20.5 million at December 31, 2007 and 2006, respectively.
At December 31, 2007, expected future benefit payments related to the Company’s defined benefit plans were as follows:
Share Repurchase Program - From January 1, 2007 through December 31, 2007, the Company purchased 585,000 shares of its common stock in the open market for $21.1 million at an average cost per share of $36.04. Since the repurchase program began in early 2003 and through December 31, 2007, the Company purchased, in the open market or through negotiated transactions, 29.2 million shares, adjusted for the two-for-one stock split effective December 31, 2005, for $651.9 million at an average cost per share of $22.29. On January 25, 2007, the Company's Board of Directors authorized an additional $50.0 million in share repurchases. At December 31, 2007, $53.1 million was still available under the Board of Directors' authorized plan. The repurchase program has no stated expiration date. Effective March 11, 2007, the Company halted its repurchase program as a result of the merger with UnitedHealth Group.
as a defendant in these lawsuits. A multi-district litigation panel has consolidated some of these cases in the United States District Court for the Southern District of Florida, Miami Division. In the lead case, known as Shane, the amended complaint alleges multiple violations under the Racketeer Influenced and Corrupt Organizations Act ("RICO"). The suit seeks injunctive, compensatory and equitable relief as well as restitution, costs, fees and interest payments. On April 7, 2003, the United States Supreme Court determined that certain claims against certain defendants should be arbitrated.
Aetna, Inc., CIGNA Corporation, the Prudential Insurance Company of America, Wellpoint Inc., Health Net Inc. and Humana Inc. entered into settlement agreements which have been approved by the district court. On January 31, 2006, the trial court granted summary judgment on all claims to defendant PacifiCare Health Systems, Inc. ("PacifiCare"), finding that plaintiffs had failed to provide documents or other evidence showing that PacifiCare agreed to participate in the alleged conspiracy. On June 19, 2006, the trial court granted summary judgment on all remaining claims against the two remaining defendants, UnitedHealth Group, Inc. and Coventry Health Care, Inc., because the plaintiffs had not submitted evidence that would allow a jury to reasonably find that either had been part of a conspiracy to underpay doctors or that either had aided or abetted alleged RICO violations. Plaintiffs appealed this decision; however, on June 13, 2007 the Eleventh Circuit Court of Appeals issued an opinion affirming the trial court’s decision. The Eleventh Circuit Court of Appeals' decision has been appealed. Plaintiffs in the Shane proceeding had stated their intention to introduce evidence at trial concerning Sierra and other parties not named as defendants in the litigation.
For all claims that are considered probable and for which the amount of loss can be reasonably estimated, the Company accrued amounts it believes to be appropriate, based on information presently available. With respect to certain pending actions, the Company maintains commercial insurance coverage with varying deductibles for which the Company maintains estimated reserves for its self-insured portion based upon its current assessment of such litigation. Due to recent unfavorable changes in the commercial insurance market, the Company has for certain risks, purchased coverage with higher deductibles and lower limits of coverage. In the opinion of management, based on information presently available, the amount or range of any potential loss for certain claims and litigation cannot be reasonably estimated or is not considered probable. However, the ultimate resolutions of these pending legal proceedings are not expected to have a material adverse effect on the Company's financial condition, operating results and cash flows.
On March 19, 2007, a purported class action complaint, styled Edward Sara, on behalf of himself and all others similarly situated v. Sierra Health Services, Inc., Anthony M. Marlon, Charles L. Ruthe, Thomas Y. Hartley, Anthony L. Watson, Michael E. Luce and Albert L. Greene, was filed in the Eighth Judicial District Court for the State of Nevada in and for the County of Clark. The complaint names the Company and each of its directors as defendants (collectively, the "defendants"), and was filed by a purported stockholder of the Company. The complaint alleges, among other things, that the defendants breached and/or aided the other defendants’ breaches of their fiduciary duties of loyalty, due care, independence, good faith and fair dealing in connection with the merger with UnitedHealth Group, the defendants breached their fiduciary duty to secure and obtain the best price reasonably available for the Company and its shareholders, and the defendants are engaging in self-dealing and unjust enrichment. The complaint sought, among other relief, (i) an injunction prohibiting the defendants from consummating the merger unless and until the Company adopts and implements a procedure or process to obtain the highest possible price for shareholders and (ii) the imposition of a constructive trust upon any benefits improperly received by the defendants as a result of the alleged wrongful conduct.
disclosures in connection with the merger. The settlement will be subject to certain conditions, including court approval following notice to members of the proposed settlement class. If finally approved by the court, the settlement will resolve all of the claims that were or could have been brought on behalf of the proposed settlement class in the action being settled, including all claims relating to the merger, fiduciary obligations in connection with the merger, negotiations in connection with the merger and any disclosure made in connection with the merger. In addition, in connection with the settlement, the parties have agreed that, subject to approval of the court, the Company will pay plaintiffs’ counsel attorneys’ fees and expenses in the amount of $485,000. The settlement did not affect the amount of merger consideration paid in the merger or any other provision of the merger agreement.
The Company has a minority interest in a health care facility in Las Vegas, which is accounted for under the equity method. The Company made an initial capital contribution of $1.1 million and has subsequently increased the carrying amount of its investment by $3.3 million to reflect its share of the undistributed income of the health care facility. The Company made capitated payments of $30.7 million, $32.8 million and $30.4 million to the health care facility for services performed in the ordinary course of business during 2007, 2006 and 2005, respectively. Activities related to the minority interest are included in the Managed Care and Corporate Operations segment.
The Company’s investments include equity participation in real estate joint ventures and trust deed mortgage notes primarily for acquisition and/or development of land by unrelated third-party entities. Licensed mortgage brokers are the source of proposals for such transactions and make proposals not only to the Company but to other investors as well. A committee of the Chief Financial Officer and other executives reviews and considers the terms based upon internally-developed guidelines and recommends whether or not to make the investments, based on its view of the merits of the project and developer. The Company generally attempts to invest slightly more than a majority in each loan as the committee determines appropriate. The mortgage notes are secured by deeds of trusts and generally by the personal guarantee of the borrower. Dr. Marlon, Mr. Bunker, Mr. Collins, Mr. Briggs and certain other senior executives, Directors and employees of the Company, along with other unrelated third-party investors, also invest their personal funds in some of the same trust deed mortgage notes and real estate joint ventures discussed previously. The terms of these investments are the same for all participants including the unrelated third-party investors. At December 31, 2007, the Company had approximately $46.6 million, net of allowance, invested in trust deed mortgage notes and real estate joint ventures. The Company’s investments in trust deed mortgage notes are with numerous independent borrowers and are secured by real estate in several states. The Company’s investments in real estate joint ventures consist of three independent projects and are secured by real estate in California, Nevada, and Utah. The Company did not make any investments in trust deed mortgage notes or real estate joint ventures during 2008.
In 2005, the Company had two reportable segments based on the products and services offered: managed care and corporate operations, and military health services operations. The managed care and corporate operations segment includes managed health care services provided through our HMO, managed indemnity plans, third-party administrative services programs for employer-funded health benefit plans, self-insured workers' compensation plans, multi-specialty medical groups, other ancillary services and corporate operations. The military health services operations ("SMHS") segment administered a managed care federal contract for the Department of Defense's TRICARE program in Region 1. Health care services under the Company's TRICARE contract for Region 1 ended on August 31, 2004. On September 1, 2004, the Company entered a phase-out period at substantially reduced revenues. During 2005, the Company reached a negotiated settlement with the DoD for certain outstanding change orders and bid price adjustments related to option period six and the phase-out of the Company's military health care operations. In 2007 and 2006, the Company believes that SMHS no longer met the definition of an operating segment as described in Statement of Financial Accounting Standards No. 131, "Disclosures about Segments of an Enterprise and Related
Through participation in Medicare, the Federal Employees Health Benefit Plan programs and TRICARE in 2005, the Company generated approximately 44%, 44% and 38% of its total consolidated revenues from agencies of the U.S. government for the years ended December 31, 2007, 2006 and 2005, respectively.