: Properties As of December 31, 2002, we leased 83,000 square feet of space for our corporate office in Bethesda, Maryland, of which 28% is subleased. We also leased 850,000 aggregate square feet for office space, subsidiary operations and customer service centers for the various markets where our health plans operate, of which 8% is subleased. Our leases expire at various dates from 2003 through 2013. We also own a building in Richmond, Virginia with 45,000 square feet, which is used for administrative services related to our health plan in that state, of which 46% is subleased. We believe that our facilities are adequate for our operations.
Operating revenues $ 3,576,905 $ 3,147,245 $ 2,604,910 $ 2,162,372 $ 2,110,383
Cash and investments $ 1,119,120 $ 952,491 $ 752,450 $ 614,603 $ 614,583
Revenues We generate operating revenues from managed care premiums and management services. Our managed care premiums are derived from our commercial risk products and our government programs. Our commercial managed care premium revenues are comprised of premiums from our commercial HMO products and flexible provider products, including PPO and POS products for which we assume full underwriting risk. Premiums for such commercial PPO and POS products are typically lower than HMO premiums due to medical underwriting and higher deductibles and co-payments that are required of the PPO and POS members. Premium rates for Commercial HMO, POS and PPO products are reviewed by various state agencies based on rate filings. In response to this regulatory review, we may have to modify or revise our rate filings in order to obtain the required regulatory approvals. While these modifications have not been material in the past, no assurance can be given that future rate filings will be approved in the same fashion.
We provide comprehensive health benefits to members participating in government programs and receive premium payments from federal and state governments. Premium rates for the Medicaid and Medicare+Choice products are established by governmental regulatory agencies and may be reduced by regulatory action.
During the three years ended December 31, 2002, we experienced substantial growth in operating revenues in part due to membership increases from acquisitions. Additional membership growth was achieved through marketing efforts, geographic expansion and increased product offerings. One such product offering was the expansion of our PPO risk product to all of our health plans in 2000. Another new product offering was the introduction of our HealthAssurance Flex product in our Pennsylvania market in 2001, which was expanded to our Georgia and Iowa markets under the name Coventry Health Care Flex. We believe that our products can be adapted in order to meet customer’s cost reduction needs by offering a low benefit plan while still having a higher benefit plan as an option. We will offer a broad choice of products as market conditions require and to meet the needs of customers and brokers.
Expenses Our primary operating expenses consist of medical costs; selling, general and administrative expense; and depreciation and amortization expense. Our medical costs include medical claims paid under contractual relationships with a wide variety of providers and capitation payments. Medical costs also include an estimate of claims incurred but not reported (“IBNR”).
We currently enter into performance guarantees with employer groups where we pledge that we will meet certain standards. These standards vary widely and could involve customer service, member satisfaction, claims processing, claims accuracy, telephone on-hold time, etc. Under these performance guarantees, we could be at risk for not maintaining the standards held in the contracts. The risk level varies by agreement with penalties based on a variety of calculations including per member per month, percentage of premium, or percentage of administration fees. Risk levels are evaluated quarterly and when these performance standards are not met a liability is established.
Medical Claims Expense and Liabilities Medical claims liabilities consist of actual claims reported but not paid and estimates of health care services incurred but not reported. The estimated claims incurred but not reported are based on historical data, current enrollment, health service utilization statistics and other related information as described earlier in the section entitled “Expenses.” We also establish reserves, if required, for the probability that anticipated future health care costs and contract maintenance costs under the group of existing contracts will exceed anticipated future premiums and reinsurance recoveries on those contracts. These accruals are continually monitored and reviewed, and as settlements are made or accruals adjusted, differences are reflected in current operations. Changes in assumptions for medical costs caused by changes in actual experience could cause these estimates to change in the near term.
Within the reserve setting methodologies for inpatient and non-inpatient services, there are certain assumptions that are used. For inpatient services, authorized days are used for utilization factors, while cost trend assumptions are incorporated into per diem amounts. The per diem estimates reflect anticipated effects of changes in reimbursement structure and severity mix. For non-inpatient services, a composite trend assumption is applied which reflects anticipated changes in cost per service, provider contracts, utilization, and other factors.
Medical claims liabilities are recorded at an amount we estimate to be appropriately conservative. In 24 of the 25 most recent quarters, the reserve models have developed favorably. This suggests that the accrued liabilities calculated from the models were more than adequate to cover our ultimate liability for unpaid claims. We believe that this favorable development is a result of good communications between our health plans and our actuarial staff regarding medical utilization, provider contract changes and other components of medical cost trend.
The length of the time and the extent to which the market value has been less than cost.
Elimination or reduction in dividend payments, or scheduled interest and principal.
Temporary declines in value of investments classified as available-for-sale are netted with unrealized gains and reported as a net amount in a separate component of stockholders’ equity. A decline in fair value below amortized cost that is judged to be other-than-temporary is accounted for as a realized loss and the write down is included in earnings. Realized gains and losses on the sale of investments are determined on a specific identification basis.
Goodwill and Other Intangible Assets We account for goodwill and other intangible assets in accordance with SFAS No. 141 and SFAS No. 142. SFAS No. 141 requires all business combinations initiated after June 30, 2001 to be accounted for using the purchase method and states that acquired intangible assets should be separately recognized upon meeting certain criteria. Such intangible assets include, but are not limited to, trade and service marks, non-compete agreements, customer lists and licenses. SFAS No. 142 requires companies to cease amortization of goodwill. Rather, goodwill and other intangible assets that have indefinite lives will be subject to a periodic assessment for impairment by applying a fair-value-based test.
The second statement, SFAS No. 142 - “Goodwill and Other Intangible Assets,” requires companies to cease amortization of goodwill. Rather, goodwill and other intangible assets that have indefinite lives will be subject to a periodic assessment for impairment by applying a fair-value-based test. Impairment charges may result in future write-downs in the period in which the impairment took place. As required, we adopted SFAS No. 142 for the fiscal year beginning January 1, 2002, and, accordingly, goodwill was not amortized during 2002 nor did we incur an impairment charge related to goodwill.
The following table summarizes all business combinations and membership purchases for the three years ended December 31, 2002. The purchase price, in thousands, of each business combination includes the payment for net worth and transition costs.
Results of Operations The following table (in thousands, except percentages and membership data) is provided to facilitate a more meaningful discussion regarding the comparison of our operations for each of the three years in the period ended December 31, 2002.
Comparison of 2002 to 2001 Managed care premium revenue increased in 2002 over 2001 primarily from commercial rate increases that occurred throughout both years and from membership growth, both organically and through the previously discussed acquisitions. Commercial premium rates increased by an average of $20.75 over 2001 on a per member per month (“PMPM”) basis, to $183.80 PMPM.
Management services revenue increased in 2002 from 2001 as a result of the previously discussed acquisitions. In particular, the Health Partners, Blue Ridge, NewAlliance and Mid-America acquisitions accounted for approximately 113,800 new non-risk members.
Selling, general and administrative (“SG&A”) expense increased in 2002 primarily due to acquisitions, an increase in fees paid to brokers and incremental salary expense related to the expansion of our customer service organization. During 2002, we opened a new regional service center in Bismarck, North Dakota to perform customer service functions related to the Mid-America acquisition and to create additional capacity for future acquisitions. As a percentage of revenue, SG&A expense increased slightly by 0.2% to 12.2% for 2002.
Depreciation and amortization decreased compared to the prior year primarily due to the adoption of SFAS No. 142 in January 2002. In accordance with SFAS No. 142, we no longer amortize goodwill but rather test for impairment at least once a year. In 2001, we amortized $7.5 million in goodwill. We did not incur any impairment charges during 2002.
Senior notes interest and amortization expense was incurred in 2002 due to the issuance of our senior notes on February 1, 2002, as described below in “Liquidity and Capital Resources.”
Our provision for income taxes increased in 2002 due to an increase in operating earnings, offset by a decrease in our effective tax rate from 38.0% in 2001 to 35.5% in 2002. This decrease in the tax rate is the result of strategic tax planning and due to the elimination of goodwill amortization in 2002.
Management services revenue increased in 2001 from 2000 as a result of three significant acquisitions: WellPath in the fourth quarter of 2000, Health Partners in the first quarter of 2001 and Blue Ridge in the third quarter of 2001. These three acquisitions accounted for 94,000 new non-risk members.
Medical costs increased in 2001 compared to 2000 due to business growth and medical trend. Business growth was primarily in the Commercial and Medicaid segments. In the Commercial segment, the increase in membership was mostly due to acquisitions throughout the 2-year period. Medicaid growth was due to continuing underlying program growth. A significant portion of the Medicaid membership increase was related to a new lower cost mental health program that the Commonwealth of Pennsylvania implemented towards the end of 2001.
Depreciation and amortization decreased compared to the prior year primarily due to certain assets becoming fully depreciated.
Other income, net increased in 2001 from 2000 due to increased investment income as a result of an increase in our long-term investments compared to the prior year. We incurred no interest expense in 2001.
Liquidity and Capital Resources Consolidated Our total cash and investments, consisting of cash and cash equivalents and short-term and long-term investments, but excluding deposits of $17.9 million restricted under state regulations, increased $178.6 million to $1.1 billion at December 31, 2002 from $922.6 million at December 31, 2001.
Net cash used in investing activities increased for the year ended December 31, 2002 due to an increase in the amount of cash placed into short-term and long-term investments. In addition, for the year ended December 31, 2002 we made payments related to acquisitions, net of transaction costs and cash acquired, of approximately $40.9 million compared to cash acquired, net of transaction costs and cash payments, of approximately $28.7 million for the year ended December 31, 2001.
Net cash provided by operating activities for the year ended December 31, 2001 increased over 2000 due to an increase in net earnings, an increase in deferred revenue related primarily to the timing of Medicare premium payments and an increase in medical claims liabilities as a result of the timing of medical claim payments. Net cash used in investing activities increased for the year ended December 31, 2001 as a result of an increase in the amount of cash placed in short term and long term investments. Net cash used in financing activities during 2001 is primarily due to the repurchases of our common stock.
Our investment guidelines emphasize investment grade fixed income instruments in order to provide liquidity to meet future payment obligations and minimize the risk of principal. The fixed income portfolio includes government and corporate securities with an average quality rating of “AA+” and an average contractual maturity of 3.76 years, as of December 31, 2002. We believe that since our long-term investments are available-for-sale, the amount of such investments should be added to current assets when assessing our working capital and liquidity. On such basis, current assets plus long-term investments available-for-sale less current liabilities increased to $498.0 million at December 31, 2002 from $379.6 million at December 31, 2001.
Health Plans Our HMOs, our insurance company subsidiary, Coventry Health and Life Insurance Company (“CH&L”), and our captive subsidiary, CHC Risk Retention Group, Inc. (“CRRG”), are required by state regulatory agencies to maintain minimum surplus balances, thereby limiting the dividends the parent may receive from its HMOs, CH&L and CRRG. During 2002, the parent collected $36.7 million in dividends from our subsidiaries subject to such regulatory restrictions.
CH&L had surplus in excess of 250% of RBC of approximately $24.1 million and $3.4 million at December 31, 2002 and 2001, respectively. The total statutory reserve for CH&L, as a percentage of RBC, was 609% and 283% as of December 31, 2002 and 2001, respectively. The increase is primarily due to 2002 income.
Refer to Note I to our consolidated financial statement for disclosure related to our operating leases.
Projected capital investments in 2003 of approximately $13.7 million consist primarily of computer hardware, software and related equipment costs associated with the development and implementation of improved operational and communication systems.
The United States Department of Health and Human Services has issued rules, as mandated by the Health Insurance Portability and Accountability Act of 1996, which, among other things, impose security and privacy requirements with respect to individually identifiable patient data, including a member’s transactions with health care providers and payors, as well as requirements for the standardization of certain electronic transaction code sets and provider identifiers. The privacy standards were issued on December 28, 2000, and becomes mandatory on April 14, 2003. As of December 31, 2002, we had spent approximately $5.0 million on compliance matters during 2001 and 2002. We anticipate spending approximately $5.5 million in 2003, approximately $1.1 million of which we expect will be capitalized, related to our compliance with the electronic transaction code sets, provider identifier standards and security and patient information privacy standards.
The nature of our operations is such that cash receipts from premium revenues are typically received up to three months prior to the expected cash payment for related medical costs. The demand for our products and services are subject to many economical fluctuations, risks and uncertainties that could materially affect the way we do business. Please refer to the section entitled “Risk Factors” in this Form 10-K for more information. Management believes that our cash flows generated from operations, cash and investments and excess funds held in certain of our regulated subsidiaries will be sufficient to fund continuing operations, capital expenditures and debt interest costs at least through December 31, 2003.
Risk-Sensitive Financial Instruments and Position We have established policies and procedures to manage our exposure to changes in the fair value of our investments. These policies include an emphasis on credit quality, management of portfolio duration, maintaining or increasing investment income through high coupon rates and actively managing profile and security mix depending upon market conditions.
Share Repurchase Program On December 20, 1999, we announced a program to purchase up to 5% of our outstanding common stock. In August 2002, our Board of Directors approved the repurchase up to an additional 5% of our outstanding common stock. Stock repurchases may be made from time to time at prevailing prices in the open market, by block purchase or in private transactions. As a part of this program, we purchased 2.2 million shares of our common stock in 2002 at an aggregate cost of $65.5 million. The total remaining common shares we are authorized to repurchase under the program, including the new authorization, was approximately 2.5 million as of December 31, 2002.
We are a defendant in the provider track in the Managed Care Litigation filed in the United States District Court for the Southern District of Florida, Miami Division, MDL No. 1334, styled in re: Humana, Inc., Charles B. Shane, MD, et al. vs. Humana, Inc., et al. This action was filed by a group of physicians as a class action against us and twelve other companies in the managed care field. In its fourth amended complaint, the plaintiffs have alleged violations of RICO, conspiracy to violate RICO and aiding and abetting a scheme to violate RICO. In addition to these RICO claims, the complaint includes counts for breach of contract, violations of various state prompt payment laws and equitable claims for unjust enrichment and quantum meruit. We have filed a motion to dismiss each of these claims because they fail to state a cause of action or, in the alternative, to compel arbitration pursuant to the arbitration provisions which exist in our physician contracts. The trial court has certified various subclasses of physicians; however, we were not subject to the class certification order because the motion to certify was filed before we were joined as a defendant. The plaintiffs are currently pursuing class discovery against us and will then file their motion for class certification as to us. The defendants who were subject to the certification order have filed an appeal with the 11th Circuit Court of Appeals which has been granted. Although we can not predict the outcome, we believe that the claims asserted in this lawsuit are without merit and we intend to defend our position.
Legislation and Regulation Numerous proposals have been introduced in the United States Congress and various state legislatures relating to health care reform. Some proposals, if enacted, could among other things, restrict our ability to raise prices and to contract independently with employers and providers. Certain reform proposals favor the growth of managed health care, while others would adversely affect managed care. Although the provisions of any legislation adopted at the state or federal level can not be accurately predicted at this time, management believes that the ultimate outcome of currently proposed legislation would not have a material adverse effect on our results of operations in the short-term.
Pursuant to a Health Insurance Portability and Accountability Act of 1996 mandate, the Department of Health and Human Services released a final rule regarding standards for privacy of individually identifiable health information on December 20, 2000, effective April 14, 2003. We expect to institute all necessary modifications to systems and business processes by the compliance date.
The Department of Health and Human Services also released its final rule for electronic data standards on August 17, 2000, effective October 17, 2000. We expect to institute all necessary modifications to systems and business processes by the October 16, 2003 compliance date.
Inflation In recent years, health care cost inflation has exceeded the general inflation rate. To reduce the effect of health care cost inflation we have, where possible, increased premium rates and implemented cost control measures in our patient care management and provider contracting. We can not assure you that we will be able to increase future premium rates at a rate that equals or exceeds the health care cost inflation rate or that our other cost control measures will be effective.
2003 Outlook As a result of an improved sales force, a varied product offering, an improved underwriting process and superior customer service, we have increased our organic membership growth target to 5% for the year 2003.
We currently anticipate reducing selling, general and administrative expenses as a percentage of revenue to a rate not to exceed 11.6% in 2003, excluding the effect of any future acquisitions, through medical claims auto-adjudication, improved customer service, e-commerce initiatives and by slowing the increases in broker fees.
Management believes that the foregoing should result in progressive earnings improvements in 2003, although realization is dependent upon a variety of factors, some of which may be outside of our control.
A reduction in the number of members in our health plans could adversely affect our results of operations. Factors that could contribute to the loss of membership include:
We operate in a highly competitive environment that may affect our ability to attract new members and increase premium rates. We compete with other health plans for members. We believe the principal factors influencing the choice among health care options are:
We face competition from other managed care companies, hospitals, health care facilities and other health care providers that may have broader geographical coverage, more established reputations in our markets, greater market share, lower costs and greater financial and other resources.
We depend on the services of non-exclusive independent agents and brokers to market our products to employers, and we can not assure you that they will continue to market our products in the future.
We depend on the services of independent agents and brokers to market our managed care products and services, particularly to small employer group members. We do not have long term contracts with independent agents and brokers and they typically are not dedicated exclusively to us and frequently market the health care products of our competitors. We face intense competition for the services and allegiance of independent agents and brokers, and we can not assure you that agents and brokers will continue to market our products at reasonable costs.
Negative publicity regarding the managed health care industry generally or our company in particular could adversely affect our results of operations.
Over the last several years, the managed health care industry has been subject to negative publicity. Negative publicity regarding the managed health care industry generally or our company in particular may result in increased regulation and legislative review of industry practices, which may further increase our costs of doing business and adversely affect our results of operations by:
Negative publicity relating to our company or the managed care industry generally also may adversely affect our ability to attract and retain members.
The use of patient data by all of our businesses is regulated at the federal, state and local level. The Health Insurance Portability and Accountability Act of 1996, for example, imposed significant new requirements relating to maintaining the privacy of medical information. The government published regulations to implement these provisions in December 2000. Health plans must be in compliance by April 2003. The law is far-reaching and complex and proper interpretation and practice under the law continues to evolve. Consequently, our efforts to measure, monitor and adjust our business practices to comply with the law are ongoing. Because these regulations and other similar federal, state and local laws and regulations continue to evolve, we can not guarantee that the costs of compliance will not adversely affect our results of operations or cause us to change our operations significantly.
sales of substantial amounts of our common stock by our directors and executive officers or principal stockholders, or the perception that such sales could occur.
consolidate or merge with or into other companies or sell all or substantially all of our assets.
We may not be able to satisfy our obligations to holders of the senior notes upon a change of control.
Warburg Pincus, a private equity investment firm, currently beneficially owns 10,127,384 shares of our common stock, or approximately 17.2% of our outstanding shares of common stock as of December 31, 2002. As a result of its voting power, Warburg Pincus may be able to exert significant influence over matters submitted to a vote of stockholders, including the election of directors and approval of a change in control or business combination of our company. Warburg Pincus may purchase additional shares of our common stock, but has agreed, effective through May 2005, not to own more than 34.9% of our common stock on a fully diluted basis. When these limitations expire in May 2005, Warburg Pincus could acquire additional shares of our common stock.
In addition to its ownership position, pursuant to the terms of the Amended and Restated Securities Purchase Agreement between the Company and Warburg Pincus, Warburg Pincus designated two directors to serve on our board of directors. Pursuant to the agreement and our certificate of incorporation, Warburg Pincus had the right to designate at least two directors until such time as Warburg Pincus converted its shares of our Series A convertible preferred stock into shares of our common stock, which occurred on December 26, 2000. The agreement provides that as long as Warburg Pincus retains ownership of at least 50% of the shares of our common stock it beneficially owned at the time of its original investment in our predecessor in 1997, it will continue to have the right to designate at least one member on our board of directors. As of December 31, 2002, Warburg Pincus continued to beneficially own 100% of the shares represented by its original investment and, therefore, currently has the right to designate one member of our board of directors. Warburg Pincus also has certain rights under the agreement to require us to register all or part of the shares of our common stock owned by Warburg Pincus.
provide that directors may be removed without cause only by the affirmative vote of the holders of two-thirds of our outstanding shares;
There can be no assurance that the war on terrorism, the threat of future acts of terrorism or the related concerns of members or providers will not adversely affect our health care costs and our ability to predict and control such costs. Future acts of terrorism and bio-terrorism could adversely affect us through, among other things:
We have audited the accompanying consolidated balance sheet of Coventry Health Care, Inc. and subsidiaries as of December 31, 2002, and the related consolidated statements of operations, shareholders’ equity, and cash flows for the year then ended. Our audit also included the financial statement schedule listed in the Index at Item 15(a). These financial statements and schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audit. The financial statements and schedule of Coventry Health Care, Inc. and subsidiaries for the years ended December 31, 2001 and 2000 were audited by other auditors who have ceased operations and whose report dated February 1, 2002 expressed an unqualified opinion on those statements and schedule before the restatement disclosures described in Note C.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Coventry Health Care, Inc. and subsidiaries as of December 31, 2002, and the consolidated results of their operations and their cash flows for the year then ended in conformity with accounting principles generally accepted in the United States. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.
As discussed in Note C to the consolidated financial statements, effective January 1, 2002, Coventry Health Care, Inc., changed its method of accounting for goodwill and other intangible assets.
We have audited the accompanying consolidated balance sheets of Coventry Health Care, Inc. (a Delaware corporation) and subsidiaries as of December 31, 2001 and 2000, and the related consolidated statements of operations, stockholders’ equity and cash flows for each of the three years in the period ended December 31, 2001. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
Balance, December 31, 1999 $ $ (5,380) $ 480,792 $ (2,780) $ 7,157 $ 480,385
Investments - The Company accounts for investments in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 115 - “Accounting for Certain Investments in Debt and Equity Securities”, issued by the Financial Accounting Standards Board (“FASB”). The Company invests primarily in debt securities and classifies all its investments as available-for-sale. Investments are evaluated on at least a quarterly basis to determine if declines in value are other-than-temporary. In making that determination, all available evidence relating to the realizable value of a security is considered.
Temporary declines in value of investments classified as available-for-sale are netted with unrealized gains and reported as a net amount in a separate component of stockholders’ equity. A decline in fair value below amortized cost that is judged to be other-than-temporary is accounted for as if it was a realized loss and the write down is included in earnings. Realized gains and losses on the sale of investments are determined on a specific identification basis.
Business Combinations, Accounting for Goodwill and Other Intangibles - In June 2001, the FASB issued two standards related to business combinations. The first statement, SFAS No. 141 - “Business Combinations,” requires all business combinations initiated after June 30, 2001 to be accounted for using the purchase method and prohibits the pooling-of-interest method of accounting. SFAS No. 141 also states that acquired intangible assets should be separately recognized upon meeting certain criteria. Such intangible assets include, but are not limited to, trade and service marks, non-compete agreements, customer lists and licenses. The Company was not significantly affected by the implementation of this statement.
The second statement, SFAS No. 142 - “Goodwill and Other Intangible Assets,” requires companies to cease amortization of goodwill. Rather, goodwill and other intangible assets that have indefinite lives will be subject to a periodic assessment for impairment by applying a fair-value-based test. The Company uses three approaches to identifying the fair value of its goodwill and other intangible assets: the market approach, the market capitalization approach and the income approach. The market approach estimates a business’s fair value by analyzing the recent sales of similar companies. The market capitalization approach is based on market value of the Company’s total shares outstanding. The income approach is based on the present value of expected future cash flows. Impairment charges may result in the future write-downs in the period in which the impairment took place. As required, the Company adopted SFAS No. 142 for the fiscal year beginning January 1, 2002, and, accordingly, goodwill was not amortized during 2002 nor did the Company incur an impairment charge related to goodwill. See Note C to consolidated financial statements for disclosure related to intangible assets.
Revenue Recognition - Managed care premiums are recorded as revenue in the month in which members are entitled to service. Premiums are based on a per subscriber contract rate and the subscribers in the Company’s records at the time of billing. Premium billings are generally sent to employers in the month preceding the month of coverage. Premium billings may be subsequently adjusted to reflect changes in membership as a result of retroactive terminations, additions, or other changes. The Company also receives premium payments from the Centers for Medicare and Medicaid Services (“CMS”) on a monthly basis for its Medicare+Choice membership. Membership and category eligibility are periodically reconciled with CMS and could result in adjustments to revenue. Premiums collected in advance are recorded as deferred revenue. Employer contracts are typically on an annual basis, subject to cancellation by the employer group or by the Company upon 30 days notice.
Premiums for services to federal employee groups are subject to audit and review by the Office of Personnel Management (“OPM”) on a periodic basis. Such audits are usually a number of years in arrears. Any differences between actual results and estimates are recorded in the year the audits are finalized.
Income Taxes - The Company files a consolidated federal tax return for the Company and its subsidiaries. The Company accounts for income taxes in accordance with SFAS No. 109 - “Accounting for Income Taxes”. The deferred tax assets and/or liabilities are determined by multiplying the differences between the financial reporting and tax reporting bases for assets and liabilities by the enacted tax rates expected to be in effect when such differences are recovered or settled. The effect on deferred taxes of a change in tax rates is recognized in income in the period that includes the enactment date. See Note F to consolidated financial statements for disclosures related to income taxes.
Reclassifications - Certain 2001 and 2000 amounts have been reclassified to conform to the 2002 presentation.
The following table presents net earnings and earnings per share amounts restated to exclude goodwill amortization for the years ended December 31, 2002, 2001 and 2000 (in thousands, except per share data).
Depreciation expense for the years ended December 31, 2002, 2001 and 2000 was $15.8 million, $15.8 million and $16.9 million, respectively.
E. INVESTMENTS The Company considers all of its investments as available-for-sale securities and, accordingly, records unrealized gains and losses, except for those determined to be other than temporary impairments, as other comprehensive income in the stockholders’ equity section of its consolidated balance sheets.
State and municipal bonds $ 151,065 $ 2,065 $ (906) $ 152,224
The amortized cost and estimated fair value of short-term and long-term investments by contractual maturity were as follows at December 31, 2002 and December 31, 2001 (in thousands):
Proceeds from the sale and maturities of investments were $572.8 million, $435.6 million and $425.3 million for the years ended December 31, 2002, 2001 and 2000, respectively. Gross investment gains of $1.9 million and gross investment losses of $3.1 million were realized on these sales for the year ended December 31, 2002. This compares to gross investment gains of $4.7 million and gross investment losses of $2.2 million on these sales for the year ended December 31, 2001, and gross investment gains of $0.1 million and gross investment losses of $1.1 million on these sales for the year ended December 31, 2000.
F. INCOME TAXES The provision for income taxes consists of the following (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 market value of the underlying stock at the date of grant. Options generally become exercisable after one year in 20% to 25% increments per year and expire ten years from the date of grant. At December 31, 2002, the Stock Incentive Plan had outstanding options representing 3,800,523 shares of common stock.
Transactions with respect to stock options granted under the Stock Incentive Plan for the three years ended December 31, 2002 were as follows (shares in thousands):
The Company’s Employee Stock Purchase Plan, implemented in 1994, allows substantially all employees who meet length of service requirements to set aside a portion of their salary for the purchase of the Company’s common stock. At the end of each plan year, the Company issues the stock to participating employees at an issue price equal to 85% of the lower of the stock price at the end of the plan year or the average stock price, as defined. The Company has reserved 1.0 million shares of stock for this plan and has issued 10,997, 9,275 and 7,883 shares in 2002, 2001 and 2000, respectively.
Employee Retirement Plans As of December 31, 2002, the Company had two defined contribution retirement plans qualifying under the Internal Revenue Code Section 401(k), the Coventry Health Care, Inc. Retirement Savings Plan (the “Savings Plan”) and the Mid-America Health Partners Inc. 401 (k) and Investment Plan (the “MAH Plan”). All employees of Coventry Health Care, Inc. and employees of its subsidiaries can elect to participate in the Savings Plan. The Savings Plan assets are held by (1) Principal Life Insurance Company, as funding agent of the assets held under the terms of the Flexible Investment Annuity Contract with Coventry Health Care, Inc., (2) Delaware Charter Guarantee and Trust Company, as custodial trustee of the mutual funds and (3) Bankers Trust Company, as custodial trustee of the Savings Plan’s participant loans and the Coventry Health Care, Inc. Common Stock.
Several acquisitions have been completed since the adoption of the Savings Plan. Pursuant to specific terms of each acquisition’s respective merger agreement, the surviving entity (1) became an adopting employer of the Savings Plan, and/or (2) commenced participation in the Savings Plan following approval by the Company’s board of directors. Immediately upon participation in the Savings Plan, all participant account balances included in the assets of the former qualified retirement plan were rolled over into the Savings Plan and employees were permitted to commence participation in the Savings Plan except for participants of the former Mid-America Health Partners. All employees of the former Mid-America Health Partners were eligible to participate in the Savings Plan effective December 2, 2002; however their balance in the MAH Plan remained in the MAH Plan. The MAH Plan was terminated effective December 1, 2002 and the Plan assets will remain until the earlier of (i) termination of employment with Coventry or one of it’s affiliates; or (ii) receipt of the Internal Revenue Service determination letter approving the termination of the MAH Plan. No contributions were made to the MAH Plan after December 1, 2002. The MAH Plan assets are held by Fidelity Management Trust Company, as funding agent of the assets held under the terms of the Plan and Trust. All participants in the MAH Plan were 100% vested in employer matching contributions as of December 1, 2002. All costs of the MAH Plan are funded by the Company and participants as they are incurred.
The Senior Notes contain certain covenants, including covenants regarding incurring additional debt, limiting dividends or other restricted payments, and restricting transactions with affiliates, sales of assets and consolidations or mergers. The Company has complied with all covenants under the Senior Notes.
Less than 1 Year - 3 Years - 5 Years More than 5 Years
Leases The Company operates primarily in leased facilities with original lease terms of up to ten years with options for renewal. Through its acquisitions, the Company has office equipment leases with terms of approximately three years.
The majority of states in which the Company operates 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 (250% for CH&L). Although not all states have adopted the RBC policy, the total 200% of RBC for all of the Company’s HMO subsidiaries was $237.5 million at December 31, 2002. Combined statutory capital and surplus of the Company’s HMOs was $393.3 million at December 31, 2002 resulting in surplus in excess of 200% of RBC of $155.8 million, up from $72.1 million at December 31, 2001. These statutory reserves for the Company’s HMO subsidiaries, as a percentage of RBC, was 331% and 267% as of December 31, 2002 and 2001, respectively. The increase is due to income from 2002 and capital contributions made by the parent company to HMO subsidiaries in order to comply with newly adopted RBC policies or to prevent the impairment of the subsidiaries’ statutory net worth and offset by dividends paid to the parent company. Some states in which the Company’s HMOs operate require HMOs to maintain deposits with the respective states’ departments of insurance. These deposits totaled $13.9 million at December 31, 2002 and are included as part of cash and cash equivalents and investments.
For CH&L, 250% of risk-based capital was $16.8 million at December 31, 2002. Total adjusted statutory capital and surplus of CH&L was $40.9 million, resulting in surplus in excess of 250% of RBC of $24.1 million, up from $3.4 million at December 31, 2001. The total statutory reserve for CH&L, as a percentage of RBC, was 609% and 283% as of December 31, 2002 and 2001, respectively. The increase is primarily due to income from 2002. Statutory deposits for CH&L as of December 31, 2002 totaled approximately $3.9 million.
L. OTHER INCOME Other income for the years ended December 31, 2002, 2001 and 2000 includes investment income, net of fees, of approximately $40.9 million, $43.2 million and $41.2 million, respectively.
As a result of this settlement and the quantification of remaining medical obligations, the Company released $6.3 million of medical claims liabilities from its AHERF reserve, which was reflected as a gain in the fourth quarter and year-end 1999 results.
Subsequently, during the fourth quarter of 2000, the Company was notified that it would be receiving a distribution from the AHERF bankruptcy proceedings. In addition, the Company was in the final stages of renegotiating most of its AHERF related lease obligations. These events necessitated a re-estimation of the Company’s remaining lease liabilities. This re-estimation resulted in an additional release from the Company’s AHERF reserve of $4.3 million. This release and an estimation of the bankruptcy proceeds of $4.1 million was reflected as a gain in the 2000 results.
The balance of the AHERF reserve at December 31, 2002 was $2.8 million and represents the Company’s remaining obligations under the settlement (e.g. vacant office leases) and will be expended through August 2007.
N. 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 warrants and the vesting of all restricted stock using the treasury stock method.
O. SHARE REPURCHASE PROGRAM On December 20, 1999, the Company announced a program to purchase up to 5% of its outstanding common stock. In August 2002, the Company’s Board of Directors approved the repurchase of up to an additional 5% of the Company’s 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, the Company purchased 2.2 million shares of the Company’s common stock in 2002 at an aggregate cost of $65.5 million. The total remaining common shares the Company is authorized to repurchase under the program, including the new authorization, is approximately 2.5 million as of December 31, 2002.
R. SUBSEQUENT EVENT (UNAUDITED) On February 3, 2003, the Company completed its acquisition of PersonalCare Health Management, Inc. (“PersonalCare”), in Champaign, Illinois. The acquisition was accounted for using the purchase method of accounting, and, accordingly, the operating results of PersonalCare will be included in the Company’s consolidated financial statements. The purchase price for PersonalCare was allocated to the assets, including identifiable intangible assets and liabilities based on estimated fair values. PersonalCare had approximately 78,000 commercial members in the Central and Southern Illinois regions.