This Item 7 contains forward-looking statements as described in Part I. These forward-looking statements involve risks and uncertainties described in Part I, Item 1A, “Risk Factors,” of this Form 10-K. The organization of our Management’s Discussion and Analysis of Financial Condition and Results of Operations is as follows:
Cash flow from operations of $272.3 million, a decrease from the prior year primarily due to the run out of medical claims from the PFFS product.
Operating earnings as a percentage of revenues were 5.9%, compared to 3.6% in the prior year.
We operate health plans, insurance companies, managed care services companies and workers’ compensation services companies and generate our operating revenues from premiums and fees for a broad range of managed care and management service products. Managed care premiums for our commercial risk products, for which we assume full underwriting risk, can vary. For example, premiums for our PPO and POS products are typically lower than our HMO premiums due to medical underwriting and higher deductibles and co-payments that are typically required of the PPO and POS members. Managed care premium rates for our government programs, Medicare and state-sponsored managed Medicaid are largely established by governmental regulatory agencies. These government products are offered in select markets where we believe we can achieve profitable growth based upon favorable reimbursement levels, provider costs and regulatory climates.
We generate cash through operations. As a profitable company in an industry that is not capital equipment intensive, we have generally not needed to use external financing to fund operations. Our primary use of cash is to pay medical claims. Any excess cash has historically been used for acquisitions, to repay indebtedness and for repurchases of our common stock.
As of December 31, 2010, we maintained allowances for retroactive billing adjustments of approximately $25.8 million, compared with approximately $22.6 million at December 31, 2009. We also maintained allowances for doubtful accounts of approximately $7.1 million and $21.4 million as of December 31, 2010 and 2009, respectively. The decrease from the prior year is primarily a result of our non-renewal of the PFFS product, which generated $2.9 billion of revenue in 2009, and an improvement in our ongoing Medicare Part D collections. The calculation for these allowances is based on a percentage of the gross accounts receivable with the allowance percentage increasing for older receivables.
We receive premium payments from the Centers for Medicare and Medicaid Services (“CMS”) on a monthly basis for our Medicare membership to provide healthcare benefits to our Medicare members. Premiums are fixed (subject to retroactive risk adjustment) on an annual basis by contracts with CMS. Membership and category eligibility are periodically reconciled with CMS and can result in adjustments to revenue. CMS uses a risk adjustment model that incorporates the use of hierarchical condition category (“HCC”) codes to determine premium payments to health plans. We estimate risk adjustment revenues based on the individual member diagnosis data (risk scores) submitted to CMS. Changes in revenue from CMS resulting from the periodic changes in risk adjustments scores for our membership are recognized when the amounts become determinable and the collectibility is reasonably assured.
CMS periodically performs audits and may seek return of premium payments made to us if risk adjustment factors are not properly supported by underlying medical record data. We estimate and record reserves for CMS audits based on information available at the time the estimates are made. The judgments and uncertainties affecting the application of these policies include significant estimates related to the amount of HCC revenue subject to audit and anticipated error rates. Although the Company maintains reserves for its exposure to the risk adjustment data validation (“RADV”) audits, actual results could differ materially from those estimates.
We employ a team of actuaries that have developed, refined and used the same set of reserve models over the past several years. These reserve models do not calculate separate amounts for reported but not paid claims and incurred but not reported claims, but rather a single estimate of medical claims liabilities. These reserve models make use of both historical claim payment patterns as well as emerging medical cost trends to project our best estimate of claim liabilities. Within these models, historical data of paid claims is formatted into claim triangles which compare claim incurred dates to the claim payment dates. This information is analyzed to create “completion factors” that represent the average percentage of total incurred claims that have been paid through a given date after being incurred. Completion factors are applied to claims paid through the financial statement date to estimate the ultimate claim expense incurred for the current period. Actuarial estimates of claim liabilities are then determined by subtracting the actual paid claims from the estimate of the ultimate incurred claims.
Actuarial standards of practice generally require the actuarially developed medical claims estimates to cover obligations under an assumption of moderately adverse conditions. Adverse conditions are situations in which the actual claims are expected to be higher than the otherwise estimated value of such claims. In many situations, the claims paid amount experienced will be less than the estimate that satisfies the actuarial standards of practice. Medical claims liabilities are recorded at an amount we estimate to be appropriate. Adjustments of prior years’ estimates may result in additional medical costs or, as we experienced during the last several years, a reduction in medical costs in the period an adjustment was made. Our reserve models have historically developed favorably suggesting that the accrued liabilities calculated from the models were more than adequate to cover our ultimate liability for unpaid claims.
The reduction in total reported medical cost from 2009 to 2010 was driven primarily as a result of our non-renewal of the Medicare PFFS product effective January 1, 2010. Prior year development experienced in 2010 was more favorable compared to amounts experienced in 2009. The higher favorable development is primarily due to lower than expected medical cost increases in the Medicare Advantage Coordinated Care Plan (“Medicare Advantage CCP”) and PFFS products for 2009.
For the more recent incurred months, the percentage of claims paid relative to claims incurred in those months is generally low. As a result, the completion factor methodology is less reliable for such months. For that reason, incurred claims for recent months are not projected solely from historical completion and payment patterns. Instead, they are projected by estimating the claims expense for those months based upon recent claims expense levels and health care trend levels, or “trend factors.” As these months mature over time, the two estimates (completion factor and trend) are blended with completion factors being used exclusively for older months.
A regular element of our unpaid medical claim liability estimation process is the examination of actual results and, if appropriate, the modification of assumptions and inputs related to the process based upon past experience. Our reserve setting methodologies have taken these changes into consideration when determining the factors used in calculating our medical claims liabilities as of December 31, 2010 by choosing factors that reflect more recent experience.
We believe that the amount of medical liabilities is adequate to cover our ultimate liability for unpaid claims as of December 31, 2010. However, actual claim payments and other items may differ from established estimates.
the length of time and the extent to which the fair value has been less than the amortized cost basis;
The following table includes only our investments in an unrealized loss position at December 31, 2010. For these investments, the table shows the gross unrealized losses and fair value aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position (in thousands).
Our municipal bond investments remain at an investment grade status based on their own merits (excluding monoline insurers). Although we do not rely on bond insurers exclusively to maintain our high level of investment credit quality, $331.7 million of our $883.7 million total state and municipal bond holdings are insured through a monoline insurer. For our mortgaged-backed and asset-backed securities, our holdings remain at investment grade with an AAA rating. We participate in only the higher level investment tranches. For our asset-backed securities, we only participate in offerings that are over collateralized to further protect our principal investment.
Goodwill is subject to an annual assessment and periodic assessments if other indicators are present for impairment by applying a fair-value-based test. We performed a goodwill impairment analysis, at the reporting unit level, as of October 1, our annual impairment test date. However, each year we could be required to evaluate the recoverability of goodwill and other indefinite lived intangible assets prior to the required annual assessment if there is any indication of a potential impairment. Those indications may include experiencing disruptions to business, unexpected significant declines in operating results, regulatory actions (such as heath care reform) that may affect operating results, divestiture of a significant component of the business or a sustained decline in market capitalization.
As of October 1, 2010 our market capitalization was below our book value. We concluded that this did not affect the overall goodwill impairment analysis, as we believe our suppressed market capitalization to be primarily attributed to negative market conditions as a result of the recent economic recession and the enactment of health care reform. We will continue to monitor our market capitalization as a potential impairment indicator considering overall market conditions and managed care industry events. Any impairment charges that may result will be recorded in the period in which the impairment is identified.
We reconcile the aggregate fair value of our reporting units to our market capitalization, the difference of which is generally referred to as an implied control premium. We then collect data on historical control premiums that resulted from business combinations of entities of a similar size and/or within our industry and concluded that our implied control premium was reasonable. While we believe we have made reasonable estimates and assumptions to calculate the fair values of the reporting units and other intangible assets, it is possible a material change could occur. Under the income approach, we assumed certain growth rates, capital expenditures, discount rates and terminal growth rates in our calculations. If the assumptions used in our fair-value-based tests differ from actual results, the estimates underlying our goodwill impairment tests could be adversely affected.
We account for share-based compensation in accordance with the provisions of ASC Topic 718 “Compensation - Stock Compensation.” Under the fair value recognition provisions of ASC Topic 718, determining the appropriate fair value model and calculating the fair value of share-based payment awards require the input of subjective assumptions, including the expected life of the share-based payment awards and stock price volatility. We believe that a blend of the implied volatility of our tradeable options and the historical volatility of our share price is a better indicator of expected volatility and future stock price trends than historical volatility alone. Therefore, the expected volatility was based on a blend of market-based implied volatility and the historical volatility of our stock. The assumptions used in calculating the fair value of share-based payment awards represent our best estimates. In addition, we are required to estimate the expected forfeiture rate and recognize expense only for those shares expected to vest. If our actual forfeiture rate is materially different from our estimate, the stock-based compensation expense could be significantly different from what we have recorded in the current period. See Note H, Stock-Based Compensation, to the consolidated financial statements for additional information on stock-based compensation which is incorporated herein by reference.
See Note C, Acquisitions, to the consolidated financial statements for information and disclosures related to acquisitions which is incorporated herein by reference.
The following table presents our membership as of December 31, 2010 and 2009 (in thousands).
Total Health Plan membership increased 340,000 compared to December 31, 2009, primarily reflecting an increase in Commercial and Medicare Advantage CCP membership from our acquisitions of Preferred Health Systems, Inc. (“PHS”) in the first quarter of 2010 and MHP, Inc. (“MHP”) in the fourth quarter of 2010. The increase also included organic growth in the Commercial membership and increases in the Medicaid membership. Medicaid membership increased as we began enrolling Medicaid members in the Commonwealth of Pennsylvania and the state of Nebraska during 2010, as well as steady growth in other Medicaid markets due to higher unemployment. These increases were partially offset by organic Commercial ASO membership losses as a result of group terminations outpacing new sales.
The decrease in Medicare PFFS membership of 329,000 members is due to our decision not to renew our PFFS product for the 2010 plan year. Other National ASO membership decreased 105,000 members, primarily due to the attrition of membership associated with our loss of National Accounts business.
As discussed in Note D, Discontinued Operations, to the consolidated financial statements which is incorporated herein by reference, on July 31, 2009 the Company sold its Medicaid/Public entity business, First Health Services Corporation (“FHSC”), and therefore its operations were classified as “discontinued” on the Company’s consolidated statements of operations and excluded from the information below. Accordingly, the amounts and discussion below relate to only the Company’s results from continuing operations for all years presented.
Managed care premium revenue decreased from the prior year as a result of our exit from the PFFS product line. This exit accounted for a decline of $2.9 billion in revenue during the current year. Partially offsetting this decrease was an increase in revenue as a result of the acquisitions of PHS and MHP in 2010, an increase in revenue from Medicare Advantage CCP due to an increase in membership, and an increase in Medicare Part D revenue due to a slightly higher premium yield in 2010.
Cost of sales increased during the current year due to the growth of our pharmacy benefit management program in the Workers’ Compensation Division.
Selling, general and administrative expense decreased from the prior year primarily due to lower salaries and benefits costs as well as decreased broker commissions. The salaries and benefits costs decrease resulted from a reduction in the number of full-time employees associated with the non-renewal of the PFFS product and continued general headcount reductions. Additionally, salaries and benefits declined as a result of executive severance accruals that occurred during the prior year that did not occur in the current year. Broker commissions decreased primarily as a result of the non-renewal of the PFFS product. Although lower in absolute terms, selling, general and administrative expense as a percentage of operating revenues increased as a result of the large decrease in operating revenues in the current year associated with the non-renewal of the PFFS product which had a high premium rate and a low relative expense level.
The charge for provider class action results from the Court of Appeal, Third Circuit for the State of Louisiana decision to affirm the trial court’s decision to grant summary judgment against a wholly-owned subsidiary of Coventry in provider class action litigation in Louisiana state court. As of December 31, 2010 this amount was accrued in “accounts payable and other accrued liabilities” in the accompanying balance sheets. For additional information regarding this matter, refer to Note L, Commitments and Contingencies, to the consolidated financial statements which is incorporated herein by reference.
Other income, net was lower during the current year as the prior year included a gain on the repayment of outstanding debt.
Interest expense decreased due to the repayment of the Company’s revolving credit facility and repurchase of senior notes during 2009 as well as decreased interest rates on the revolving credit facility during the current year.
Health Plan and Medical Services Division revenue decreased for the year primarily due to our exit from the PFFS product line which resulted in a decline of $2.9 billion. Partially offsetting this decrease in revenue was an increase across each of our other risk products. The increase in Commercial Risk revenue was due to the acquisitions of PHS and MHP in 2010. There was an increase in the average realized premium per member per month for the Commercial Risk business due to renewal rate increases.
Specialized Managed Care Division revenue increased for the year primarily due to an increase in Medicare Part D revenue which resulted from the higher membership volumes in the early portion of 2010. Including the effect of the CMS risk sharing premium adjustments as well as ceded revenue, the premium per member per month was $82.86 in 2010 compared to $80.98 in 2009. Excluding the effect of CMS risk sharing premium adjustments and revenue ceded to external parties, Medicare Part D premium per member per month for 2010 increased to $87.96 compared to $84.40 in 2009, primarily due to pharmacy cost trends.
When reviewing the premium yield for Medicare Part D business, we believe that adjusting for the ceded revenue is useful for comparisons to competitors that may not have similar ceding arrangements. When reviewing the Medicare Part D business, adjusting for the risk sharing amounts is useful to understand the results of the Part D business because of our expectation that the risk sharing revenue will eventually be insignificant on a full year basis.
The increase in gross margin was primarily driven by improved MLR for the Medicare Part D product in 2010 compared to the prior year periods. The improvement in MLR was primarily attributed to improved performance in our mainstream products which make up the majority of our Part D business.
Workers’ Compensation gross margin decreased for the current year due to declines in our network and clinical program volumes, which are higher margin products, partially offset by increases attributable to the growth of our pharmacy benefit management program which operates at a lower margin.
Workers’ Compensation gross margin decreased over the prior year due to the decline in claims volume in our bill review business, which is a higher margin product, and growth in the pharmacy benefit management program which operates at a lower margin.
The demand for our products and services is subject to many economic fluctuations, risks and uncertainties that could materially affect the way we do business. For instance, due to the non-renewal of our PFFS product, we paid medical claims in 2010 without the benefit of premium collections for this product. As a result, this had a negative effect on cash flows in our regulated subsidiaries. Despite the effect, we have ample current liquidity as a result of planning for the non-renewal of the PFFS product. See Part I, Item 1A, “Risk Factors,” in this Form 10-K for more information. Management believes that the combination of our ability to generate cash flows from operations, cash and investments on hand, and the excess funds held in certain of our regulated subsidiaries will be sufficient to fund continuing operations, capital expenditures, debt interest costs, debt principal repayments, required payments resulting from judgments or settlements in the Louisiana provider class action litigation, and any other reasonably likely future cash requirements. In addition, our long-term investment portfolio is available for further liquidity needs including satisfaction of policy holder benefits.
Net cash from operating activities for the year ended December 31, 2010 was a result of net earnings generated by our normal operations during the period and non-cash adjustments to earnings including the class action charge. These cash inflows were partially offset by a decrease in medical claim liabilities associated with the non-renewal of the PFFS product. Since premium revenues are generally received in advance of the expected cash payment for the related medical costs, the result is strong cash inflows upon the implementation of a benefit program and cash outflows upon the termination. The cash outflows for PFFS for the year ended December 31, 2010 were approximately $338.5 million. Also partially offsetting the operating cash inflow for the period was a decrease in other payables primarily as a result of the timing of Federal and State income tax payments.
Capital expenditures in 2010 of approximately $63.3 million consisted primarily of computer hardware, software and related costs associated with the development and implementation of improved operational and communication systems. Projected capital expenditures in 2011 of approximately $65 to $75 million consist primarily of computer hardware, software and other equipment.
Our Board of Directors has approved a program to repurchase our outstanding common stock. Stock repurchases may be made from time to time at prevailing prices on the open market, by block purchase or in private transactions. As a part of this program, no shares were repurchased in 2010, 1.5 million shares were purchased in 2009 at an aggregate cost of $30.0 million and 7.3 million shares of our common stock were purchased in 2008 at an aggregate cost of $318.0 million. As of December 31, 2010, the total remaining common shares we are authorized to repurchase under this program is 5.2 million. Excluded from these share repurchase program amounts are shares purchased in exchange for employee payroll taxes on vesting of restricted stock awards as these purchases are not part of the program.
Our regulated HMO and insurance company subsidiaries are required by state regulatory agencies to maintain minimum surplus balances, thereby limiting the dividends the parent may receive from our regulated entities. During 2010, we received $319.4 million in dividends from our regulated subsidiaries and we made $11.5 million in capital contributions to them. We had $1.9 billion of regulated capital and surplus at December 31, 2010.
The National Association of Insurance Commissioners (“NAIC”) has proposed that states adopt risk-based capital (“RBC”) standards which are a method of measuring the minimum amount of capital appropriate for a managed care organization to support its overall business operations in consideration of its size and risk profile. The managed care organization’s RBC is calculated by applying factors to various assets, premiums and reserve items. The factor is higher for those items with greater underlying risk and lower for less risky items. The adequacy of a managed care organization’s actual capital can then be measured by a comparison to its RBC as determined by the formula. Our health plans are required to submit a RBC report to the NAIC and their domiciled state’s department of insurance with their annual filing.
The majority of states in which we operate health plans have adopted a RBC policy that recommends the health plans maintain statutory reserves at or above the “Company Action Level” which is currently equal to 200% of their RBC. Some states in which our regulated subsidiaries operate require deposits to be maintained with the respective states’ departments of insurance. The table below summarizes our statutory reserve information, as of December 31, 2010 and 2009 (in millions, except percentage data).
The State of Florida does not have a RBC requirement for its regulated HMOs. Accordingly, the statutory reserve information provided for our health plans domiciled in Florida is based on the actual statutory minimum capital required by the State of Florida.
Excluding funds held by entities subject to regulation and excluding our equity method investments, we had cash and investments of approximately $1.1 billion and $713.0 million at December 31, 2010 and 2009, respectively. The increase resulted from earnings from non-regulated businesses and dividends from our regulated subsidiaries. These were partially offset by cash paid for acquisitions and capital infusions into our subsidiaries.
As of December 31, 2010, we were contractually obligated to make the following payments during the next five years and thereafter (in thousands):
Interest payable on credit facilities has been estimated based on interest rates as of December 2010 and assumes no additional changes in the principal amount.
The full effect of any current or future legislation provisions adopted at the state or federal level cannot be accurately predicted at this time. See “Government Regulation” under Part I, Item 1, “Business” for additional discussion of government regulation that affects our businesses.
Health Plan and Medical Services Division - We expect our Commercial Risk membership will be flat to slightly down for 2011 as compared to approximately 1.6 million members in 2010. The forecasted Commercial group MLR is expected to be in the range of 80.5% to 81.5%, an increase from the 2010 MLR of 79.2% largely driven by compliance with new healthcare reform regulations. The forecasted Commercial Individual MLR is expected to be in the range of 75.0% to 77.0%, an increase from the 2010 MLR of 66.1%, largely driven by compliance with new healthcare reform regulations.
We have audited the accompanying consolidated balance sheets of Coventry Health Care, Inc. as of December 31, 2010 and 2009, and the related consolidated statements of operations, stockholders' equity, and cash flows for each of the three years in the period ended December 31, 2010. Our audits also included the financial statement schedule listed in the Index at Item 15(a)(2). These financial statements and schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Coventry Health Care, Inc. at December 31, 2010 and 2009, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2010, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule referred to above, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Coventry Health Care, Inc.’s internal control over financial reporting as of December 31, 2010, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 25, 2011 expressed an unqualified opinion thereon.
Since the Company began operations in 1987 with the acquisition of the American Service Companies entities, including Coventry Health and Life Insurance Company (“CH&L”), the Company has grown substantially through acquisitions. See Note C, Acquisitions, to the consolidated financial statements for information on the Company’s recent acquisitions.
Other Receivables - Other receivables include pharmacy rebate receivables of $310.7 million and $314.9 million at December 31, 2010 and 2009, respectively. Other receivables also include Medicare Part D program related risk share and subsidy receivables, Medicare risk adjuster receivables, Office of Personnel Management (“OPM”) receivables, interest receivables, and any other receivables that do not relate to premiums. The increase in other receivables during 2010 primarily resulted from an increase in the Medicare Part D related receivables.
Discontinued Operations - The Company accounts for discontinued operations in accordance with ASC 360-10 “Accounting for the Impairment or Disposal of Long-Lived Assets.” The Company determines whether the group of assets being disposed of comprises a component of the entity, which requires cash flows that can be clearly distinguished from the rest of the entity. The Company also determines whether the cash flows associated with the group of assets have been or will be eliminated from the ongoing operations of the Company as a result of the disposal transaction and whether the Company has no significant continuing involvement in the operations of the group of assets after disposal. If these determinations result in an affirmative response, the results of operations of the asset group being disposed of, as well as the gain or loss on disposal are aggregated for separate presentation apart from the continuing operating results of the Company in the Consolidated Statements of Operations. See Note D, Discontinued Operations, to the consolidated financial statements for additional disclosure related to discontinued operations.
The negative medical cost amounts noted as “prior year development” are favorable adjustments for claim estimates being settled for amounts less than originally anticipated. As noted above, these favorable developments from original estimates occur due to changes in medical utilization, mix of provider rates and other components of medical cost trends. Medical claim liabilities are generally paid within several months of the member receiving service from the provider. Accordingly, the 2010 prior year development relates almost entirely to claims incurred in calendar year 2009.
Comprehensive Income - Comprehensive income includes net earnings and unrealized net gains and losses on investment securities. Other comprehensive income is net of reclassification adjustments to adjust for items currently included in net earnings, such as realized gains and losses on investment securities. The deferred tax provision for unrealized holding gains arising from investment securities during the years ended December 31, 2010, 2009 and 2008 was $4.1 million, $25.3 million, and $3.0 million, respectively. The deferred tax provision for reclassification adjustments for gains included in net earnings on investment securities during the years ended December 31, 2010, 2009 and 2008 was $4.3 million, $4.5 million, and $1.6 million, respectively.
The Medicare Part D program gives beneficiaries access to prescription drug coverage. Coventry has been awarded contracts by CMS to offer various Medicare Part D plans on a nationwide basis, in accordance with guidelines put forth by the agency. Payments from CMS under these contracts include amounts for premiums, amounts for risk corridor adjustments, and amounts for reinsurance and low-income cost subsidies.
Subsidy amounts received for reinsurance and for cost sharing related to low-income individuals are recorded in medical liabilities and will offset medical costs when paid. The Company does not recognize premium revenue or claims expense for these subsidies as the Company does not incur any risk with this part of the program. The majority of these receivables and payables are related to low-income subsidy and reinsurance amounts either owed by or owed to CMS. A reconciliation of the final risk sharing, low-income subsidy and reinsurance subsidy amounts is performed following the end of each contract year.
The table below summarizes the CMS receivables and payables, for all contract years, at December 31, 2010 and 2009, respectively (in thousands).
Premiums for services to federal employee groups are subject to audit and review by the OPM on a periodic basis. Such audits are usually a number of years in arrears. The Company estimates and records reserves for audit and other contract adjustments for both its managed care contracts and experience rated plans based on appropriate guidelines and historical results. Adjustments are recorded as additional information regarding the audits and reviews becomes available. Any differences between actual results and estimates are recorded in the period the audits are finalized.
Earnings Per Share - Basic earnings per share are based on the weighted average number of common shares outstanding during the year. Diluted earnings per share assume the exercise of all options and the vesting of all restricted stock using the treasury stock method. Potential common stock equivalents to purchase 10.3 million, 12.2 million and 8.3 million shares for the years ended December 31, 2010, 2009 and 2008, respectively, were excluded from the computation of diluted earnings per share because the potential common stock equivalents were anti-dilutive.
The Specialized Managed Care Division includes the Company’s Medicare Part D, network rental and behavioral health benefits businesses. As discussed in Note D, Discontinued Operations, to the consolidated financial statements, prior to its sale on July 31, 2009 the Company’s Medicaid/Public entity, First Health Services Corporation (“FHSC”), provided products and services to State Medicaid agencies and other government funded programs. FHSC operations are excluded from the Company’s results of continuing operations.
The Workers’ Compensation Division is comprised of the Company’s workers’ compensation services businesses which provide fee-based, managed care services such as provider network access, bill review, care management services and pharmacy benefit management to underwriters and administrators of workers’ compensation insurance.
On October 1, 2010, the Company completed its acquisition of MHP, a diversified health plan with approximately 90,000 commercial risk members, 60,000 commercial self-funded members and 30,000 Medicare Advantage Coordinated Care Plan members throughout Missouri and northwest Arkansas. The Company acquired MHP to expand its footprint in the Missouri market.
On February 13, 2008, the Company completed its acquisition of MHNet, a behavioral health company based in Austin, Texas. On May 14, 2008, the Company completed its acquisition of a majority ownership interest in Group Dental Service, Inc. (“GDS”), a dental company based in Rockville, Maryland. As a result of the MHNet and GDS acquisitions the Company has recorded $110.6 million of goodwill as of December 31, 2010, none of which is expected to be deductible for tax purposes.
The changes in the carrying amount of goodwill for the years ended December 31, 2010 and 2009 were as follows (in thousands):
The Company completed its 2010 annual impairment test of goodwill in accordance with ASC Topic 350 and determined that there were no impairments. In performing its impairment analysis the Company identified its reporting units in accordance with the provisions of ASC Topic 350 and ASC Topic 280, “Segment Reporting.”
In accordance with ASC Topic 350, for the purpose of testing goodwill for impairment, acquired assets and assumed liabilities were assigned to a reporting unit as of the acquisition date if both of the following criteria were met: (1) the asset will be employed in or the liability relates to the operations of a reporting unit and (2) the asset or liability will be considered in determining the fair value of the reporting unit. Corporate assets or liabilities were also assigned to a reporting unit if both of these criteria were met.
As an overall test of the reasonableness of the estimated fair values of the reporting units, the Company compared the aggregate fair values of its reporting units to its market capitalization. The comparison confirmed that the determined fair values were representative of market views when applying a reasonable control premium. The Company determined that its implied control premium was reasonable based on a review of such premiums identified in recent acquisitions for entities of similar size and/or in similar industries.
The Company performed an impairment test of its unamortized other intangible asset (trade name) as of October 1, 2010, and determined that the asset was not impaired.
For the years ending December 31, 2011, 2012, 2013, 2014, and 2015, the Company’s estimated intangible amortization expense is $64.9 million, $64.6 million, $64.2 million, $63.7 million and $32.1 million, respectively. The weighted-average amortization period is approximately 10 years for other intangible assets.
The Company considers all of its investments as available-for-sale securities. For debt securities, if the Company intends to either sell or determine that it will more-likely-than-not be required to sell a debt security before recovery of the entire amortized cost basis or maturity of the debt security, the Company recognizes the entire impairment in earnings. If the Company does not intend to sell the debt security and the Company determines that it will not more-likely-than-not be required to sell the debt security but it does not expect to recover the entire amortized cost basis, the impairment is bifurcated into the amount attributed to the credit loss, which is recognized in earnings, and all other cases, which are recognized in other comprehensive income. Realized gains and losses on the sale of investments are determined on a specific identification basis. Certain prior year investment balances have been reclassified in the tables below to conform to the 2010 presentation requirements.
The amortized cost, gross unrealized gain or loss and estimated fair value of short-term and long-term investments by security type were as follows at December 31, 2010 and 2009 (in thousands):
The Company adopted the provisions of ASC 320-10-65-1 related to its fixed maturity securities as of April 1, 2009. The portion of the Company’s impairment charge recorded prior to 2009 that was not related to a belief that the entire amortized cost basis would not be recovered, credit deterioration of the specific security, or securities that the Company has made the decision to sell was insignificant. Accordingly, the Company did not record a cumulative effect transition adjustment upon adoption.
Gross investment gains of $15.5 million and gross investment losses of $4.5 million were realized on sales of investments for the year ended December 31, 2010. This compares to gross investment gains of $14.0 million and gross investment losses of $2.4 million realized on sales of investments for the year ended December 31, 2009, and gross investment gains of $7.6 million and gross investment losses of $37.0 million realized on sales and the other-than-temporary impairment of investments for the year ended December 31, 2008. The Company’s other-than-temporary impairment charge and its realized gains and losses are recorded in other income, net in the Company's consolidated statements of operations.
The following table shows the Company’s investments’ gross unrealized losses and fair value at December 31, 2010 and December 31, 2009, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position (in thousands).
The following table presents the fair value hierarchy for the Company’s financial assets measured at fair value on a recurring basis at December 31, 2010 and 2009 (in thousands):
Under the Stock Incentive Plan, the terms and conditions of option grants are established on an individual basis with the exercise price of the options being equal to not less than 100% of the fair value of the underlying stock at the date of grant. Options generally become exercisable after one year in either 33% or 25% increments per year and expire ten years from the date of grant.
The total intrinsic value of options exercised was $11.3 million, $1.5 million, and $10.4 million for the years ended December 31, 2010, 2009 and 2008, respectively. The tax benefit realized from stock option exercises was $4.1 million, $0.5 million and $3.7 million, for the years ended December 31, 2010, 2009 and 2008, respectively. As of December 31, 2010, there was $21.4 million of total unrecognized compensation cost (net of expected forfeitures) related to nonvested stock option grants which is expected to be recognized over a weighted average period of 1.8 years.
The Company recorded compensation expense related to restricted stock grants, including restricted stock granted in prior periods, of approximately $19.5 million, $16.5 million and $25.3 million for the years ended December 31, 2010, 2009 and 2008, respectively. The total unrecognized compensation cost (net of expected forfeitures) related to the restricted stock was $29.6 million at December 31, 2010, and is expected to be recognized over a weighted average period of 1.9 years. The weighted-average fair value of restricted stock granted was $21.45, $16.43 and $39.06 per share for the years ended December 31, 2010, 2009 and 2008, respectively. The total fair value of shares vested during the years ended December 31, 2010, 2009 and 2008 was $14.4 million, $8.5 million and $17.3 million, respectively.
The following table summarizes restricted stock award activity for the year ended December 31, 2010:
During the twelve months ended December 31, 2010, the Company granted performance share units (“PSUs”) to key employees pursuant to the Stock Incentive Plan. The PSUs represent hypothetical shares of the Company’s common stock. The holders of PSUs have no rights as shareholders with respect to the shares of the Company’s common stock to which the awards relate. The PSUs will vest based upon the achievement of certain performance goals and vest over various periods through 2011. All PSUs that vest will be paid out in cash based upon the price of the Company’s common stock and therefore are classified as a liability by the Company. The related liability on the Company’s books at December 31, 2010 was $23.1 million, of which $18.2 million was paid out in February 2011. The liability on the Company’s books at December 31, 2009 was $13.8 million. During the twelve months ended December 31, 2010 the Company paid $10.9 million for PSUs that vested December 31, 2009. The Company recorded compensation expense related to the PSUs of approximately $20.2 million and $13.8 million for the years ended December 31, 2010 and 2009, respectively.
The following table summarizes PSU activity for the twelve months ended December 31, 2010 (in thousands):
The effect of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities at December 31, 2010 and 2009 are presented below (in thousands):
(1) Includes $339.6 million and $207.1 million classified as current assets at December 31, 2010 and 2009, respectively, and $(159.1) million and $(198.0) million classified as noncurrent assets (liabilities) at December 31, 2010 and 2009, respectively.
At December 31, 2010, the Company had approximately $151 million of federal and $257 million of state tax net operating loss carryforwards. The Federal net operating losses were primarily acquired through various acquisitions and are subject to limitation under Internal Revenue Code Section 382. The net operating loss carryforwards can be used to reduce future taxable income and expire over varying periods through the year 2030. A valuation allowance of approximately $3.6 million and $3.1 million has been recorded as of December 31, 2010 and 2009, respectively, for certain net operating loss deferred tax assets as the Company believes it is not more-likely-than-not that these deferred tax assets will be realized before expiration of those net operating losses.
Penalties and tax-related interest expense are reported as a component of income tax expense. As of December 31, 2010 and 2009, the total amount of income tax-related accrued interest and penalties, net of related tax benefit, recognized in the statement of financial position was $9.2 million and $6.5 million, respectively.
The Company is regularly audited by federal, state and local tax authorities, and from time to time these audits result in proposed assessments. Tax years 2007-2009 remain open to examination by these tax jurisdictions. The Company believes appropriate provisions for all outstanding issues have been made for all jurisdictions and all open years.
The Company is the sponsor of a 401(k) Restoration and Deferred Compensation Plan (“RESTORE”). Under RESTORE, participants may defer up to 75% of their base salary and up to 100% of any bonus awarded. The Company makes matching contributions equal to 100% of the participant’s contribution on the first 3% of the participant’s compensation and 50% of the participant’s contribution on the second 3% of the participant’s compensation. Participants vest in the Company’s matching contributions ratably over two years. All costs of RESTORE are funded by the Company as they are incurred.
The cost, principally employer matching contributions, of RESTORE charged to operations for 2010, 2009 and 2008 was $0.4 million, $0.9 million and $0.2 million, respectively.
The Company was the sponsor of a deferred compensation plan that was designed to promote the retention of key senior management and to recognize their strategic importance to the Company. The fixed dollar and stock equivalent allocations charged to operations for this plan was $1.6 million and $1.1 million in 2009 and 2008, respectively. The liability for this plan was $1.4 million at December 31, 2009 and, during 2010, this plan was settled and paid out.
For information regarding the Company’s stock-based compensation, please refer to Note H, Stock-Based Compensation, to the consolidated financial statements.
The Company’s outstanding debt was as follows at December 31, 2010 and 2009 (in thousands):
During 2010, the Company made no principal repayments on its outstanding senior notes or revolving credit facility.
During 2009, the Company repaid $235 million on its revolving credit facility. The remaining outstanding balance of $380 million will be used to optimize the Company’s liquidity position and for other general corporate purposes.
During 2008, the Company repaid a principal total of $10 million of its outstanding 5.95% Senior Notes due March 15, 2017.
During 2008, the Company drew down $543.5 million from its Revolving Credit Facility and repaid $103.5 million of this amount. The remaining outstanding balance of $615.0 million was used to optimize the Company’s liquidity position during the current uncertain macroeconomic environment and for general corporate purposes. Also, from time to time throughout 2008 the Company drew down amounts as needed and repaid certain amounts on its Revolving Credit Facility for general corporate purposes.
The Company’s senior notes and credit facility contain certain covenants and restrictions regarding, among other things, additional debt, dividends or other restricted payments, transactions with affiliates, asset dispositions and consolidations or mergers. Additionally, the Company’s credit facility requires compliance with a leverage ratio of 3 to 1. The Company’s credit facility and certain of its senior notes also include, as an event of default, the entry of a judgment against the Company or a subsidiary in excess of a specified amount ($50 million in the case of the credit agreement and $20 million in the case of the applicable senior notes) if enforcement proceedings are commenced or if enforcement is not stayed for a period of 30 consecutive days. As described in Note L, Commitments and Contingencies, to the consolidated financial statements, the Company had filed an appeal with the State of Louisiana intermediate appellate court of the partial summary judgment against FHGC which was denied. FHGC has filed an application for a writ of appeal with the Louisiana Supreme Court with respect to the class decertification order and the partial summary judgment order. The decision to grant or deny the application for a writ of appeal is at the discretion of the Louisiana Supreme Court. The Louisiana Supreme Court has not yet issued a decision on either of these applications. On December 6, 2010, the Company entered into a Memorandum of Understanding setting forth settlement terms of a partial summary judgment. On February 2, 2011, FHGC, counsel for the class representatives and the class representatives executed a definitive settlement agreement which was acceptable to FHGC. As set forth in the settlement agreement, certain contingencies must be satisfied before the settlement becomes final. For additional information regarding this contingency, see Note L, Commitments and Contingencies, to the consolidated financial statements. As of December 31, 2010, the Company was in compliance with the applicable covenants and restrictions under its senior notes and credit facility.
The Company operates in leased facilities with original lease terms of up to thirteen years with options for renewal. Total rent expense was $32.4 million, $35.6 million and $40.8 million, for the years ended December 31, 2010, 2009 and 2008, respectively.
As a result of the Louisiana appellate court’s decision on July 1, 2010 to affirm the state trial court’s summary judgment order, the Company recorded a $278 million pre-tax charge to earnings and a corresponding accrued liability during the quarter ended June 30, 2010. This amount represents the $262 million judgment amount plus post judgment interest and is included in “accounts payable and other accrued liabilities” in the accompanying balance sheets. The Company has accrued for legal fees expected to be incurred related to this case as well as post judgment interest subsequent to the second quarter charge, which are included in “accounts payable and other accrued liabilities” in the accompanying balance sheets.
On December 6, 2010, FHGC entered into a Memorandum of Understanding with attorneys representing the four plaintiffs and the class setting forth the settlement terms of the $262 million partial summary judgment entered in the class action lawsuit. The Memorandum of Understanding provides that subject to the execution of a settlement agreement acceptable to FHGC and final non-appealable approval of such settlement by the Louisiana state court, FHGC will pay $150.5 million to satisfy in full the amount of the partial summary judgment and to resolve and settle all claims of the class, including claims for pre and post judgment interest, attorneys fees and costs. In addition, Coventry will assign to the class certain rights it has to the proceeds of FHGC’s insurance policies relating to the claims asserted by the class. Pursuant to the Memorandum of Understanding, the parties have also agreed to request that the appropriate courts stay all related proceedings and consideration of any pending appellate writ applications, and to stay the effect of any outstanding judgments until the settlement agreement is prepared, executed and receives final court approval.
On February 2, 2011, FHGC, counsel for the class representatives and the class representatives executed a definitive settlement agreement which was acceptable to FHGC. The settlement agreement contains the same terms and conditions as was set forth in the Memorandum of Understanding. As noted above and as set forth in the settlement agreement, certain contingencies (preliminary court approval; resolutions of objections filed by class members challenging the fairness of the settlement; class members excluded from the settlement not exceeding a materiality threshold; and, final court approval) must be satisfied before the settlement becomes final. Given these various contingencies which must be satisfied before the settlement becomes final, no changes have been made to the previously recorded amounts.
In a related matter, FHGC has filed another lawsuit in Louisiana federal district court against 85 Louisiana providers seeking a declaratory judgment that its contracts are valid and enforceable, that its contracts are not subject to the Louisiana’s Any Willing Provider Act because its contracts pertain to payment for services rendered to injured workers, and FHGC is exempt from the notice provision of the Any Willing Provider Act because it has contracted directly with the providers. As a result of the Memorandum of Understanding and the settlement agreement executed in connection with the provider class action lawsuit in Louisiana referenced above, this lawsuit will be stayed and dismissed if the settlement agreement of the class action lawsuit becomes final.
The Company has capitation arrangements for certain ancillary heath care services, such as laboratory services and, in some cases, physician and radiology services. A small percentage of the Company’s membership is covered by global capitation arrangements. Under the typical arrangement, the provider receives a fixed percentage of premium to cover costs of all medical care or of the specified ancillary services provided to the capitated members. Under some capitated and professional capitation arrangements, physicians may also receive additional compensation from risk sharing and other incentive arrangements. Capitation arrangements limit the Company’s exposure to the risk of increasing medical costs, but expose the Company to risk as to the adequacy of the financial and medical care resources of the provider organization. The Company is ultimately responsible for the coverage of its members pursuant to the customer agreements. To the extent that a provider organization faces financial difficulties or otherwise is unable to perform its obligations under the capitation arrangements, the Company will be required to perform such obligations. Consequently, the Company may have to incur costs in excess of the amounts it would otherwise have to pay under the original global or ancillary capitation through our contracted network arrangements. Medical costs associated with capitation arrangements made up approximately 6.4%, 2.9% and 4.1% of the Company’s total medical costs for the years ended December 31, 2010, 2009 and 2008, respectively.
CMS periodically performs audits and may seek return of premium payments made to the company if risk adjustment factors are not properly supported by medical record data. We estimate and record reserves for CMS audits based on information available at the time the estimates are made. The judgments and uncertainties affecting the application of these policies include significant estimates related to the amount of HCC revenue subject to audit and anticipated error rates. Although the Company maintains reserves for its exposure to the risk adjustment data validation (“RADV”) audits, actual results could differ materially from those estimates. Accordingly, CMS audit results could have a material adverse effect on our financial position, results of operations, and cash flows.
The Company’s regulated HMO and insurance company subsidiaries are required by state regulatory agencies to maintain minimum surplus balances, thereby limiting the dividends the parent may receive from its regulated entities. During 2010, the Company received $319.4 million in dividends from its regulated subsidiaries and paid $11.5 million in capital contributions to these subsidiaries.
The State of Florida does not have a RBC requirement for its regulated HMOs. Accordingly, the statutory reserve information provided for the Company’s health plans domiciled in Florida is based on the actual statutory minimum capital required by the State of Florida.
The increase in capital and surplus for our regulated subsidiaries primarily resulted from net earnings, acquisition of PHS and MHP, and capital contributions made by the parent company, partially offset by dividends paid to the parent company.
Excluding funds held by entities subject to regulation and excluding our equity method investments, the Company had cash and investments of approximately $1.1 billion and $713.0 million at December 31, 2010 and 2009, respectively. The increase resulted from earnings from non-regulated businesses, and dividends from the Company’s regulated subsidiaries. These were partially offset by capital infusions into the Company’s subsidiaries.