The table below provides selected consolidated financial data of WellPoint. The information has been derived from our consolidated financial statements for each of the years in the five year period ended December 31, 2006. You should read this selected consolidated financial data in conjunction with the audited consolidated financial statements and notes and Management’s Discussion and Analysis of Financial Condition and Results of Operations included in this Form 10-K.
VIII. Results of Operations-Year Ended December 31, 2005 Compared to the Year Ended December 31, 2004
We are the largest health benefits company in terms of commercial membership in the United States, serving over 34 million medical members as of December 31, 2006. We are an independent licensee of the Blue Cross and Blue Shield Association, or BCBSA, an association of independent health benefit plans. We serve our members as the Blue Cross licensee for California and as the Blue Cross and Blue Shield, or BCBS, licensee for: Colorado, Connecticut, Georgia, Indiana, Kentucky, Maine, Missouri (excluding 30 counties in the Kansas City area), Nevada, New Hampshire, New York (as BCBS in 10 New York City metropolitan and surrounding counties, and as Blue Cross or BCBS in selected upstate counties only), Ohio, Virginia (excluding the Northern Virginia suburbs of Washington, D.C.), and Wisconsin. We also serve customers throughout the country as UniCare. We are licensed to conduct insurance operations in all 50 states through our subsidiaries.
Operating revenue for the year ended December 31, 2006 was $56.1 billion, an increase of $12.2 billion, or 28%, over the year ended December 31, 2005. Operating revenue increases were primarily driven by the December 28, 2005 acquisition of WellChoice, Inc., or WellChoice, described in “Significant Transactions” below, as well as premium rate increases across all customer types, the addition of the New York state prescription drug contract and Medicare Part D Prescription Drug Plan, or Medicare Part D, enrollment.
Our Specialty segment is comprised of businesses providing specialty products and services such as group life and disability insurance benefits, pharmacy benefit management, or PBM, specialty pharmacy, dental, vision, behavioral health benefit services and long-term care insurance. We ceased underwriting workers compensation business effective December 31, 2005; however, we continue to provide network rental and medical management services to workers compensation carriers.
We have announced a new organizational structure designed to support our 2010 strategic plan. This new structure capitalizes on our unique local presence and emphasizes company-wide innovation and strong customer focus. As a result of this new organizational structure we are organized around two strategic business units: Commercial and Consumer Business, or CCB, and Specialty, Senior and State-Sponsored Business, or 4SB. In addition, our government services business includes the Federal Employees Program and National Government Services, Inc., which acts as a Medicare contractor in several regions across the nation. We expect to revise our reportable segments in the first quarter of 2007 in accordance with the new organizational structure, which reflects how our chief operating decision maker evaluates the performance of our business beginning January 1, 2007. See Note 19 to our audited consolidated financial statements as of and for the year ended December 31, 2006 included in this Form 10-K.
Our operating revenue consists of premiums, administrative fees and other revenue. Premium revenue comes from fully-insured contracts where we indemnify our policyholders against costs for covered health and life benefits. Administrative fees come from contracts where our customers are self-insured, or where the fee is based on either processing of transactions or a percent of network discount savings realized. Additionally, we earn administrative fee revenues from our Medicare processing business and from other health-related businesses including care management programs. Other revenue is principally generated from member co-payments and deductibles associated with the mail-order sale of drugs by our PBM companies.
Our cost of drugs consists of the amounts we pay to pharmaceutical companies for the drugs we sell via mail order through our PBM. This amount excludes the cost of drugs related to affiliated health customers recorded in benefit expense. Our cost of drugs can be influenced by the volume of prescriptions at our PBM, as well as cost changes, driven by prices set by pharmaceutical companies and mix of drugs sold.
Our results of operations depend in large part on our ability to accurately predict and effectively manage health care costs through effective contracting with providers of care to our members and our medical and care management programs. Several economic factors related to health care costs, such as regulatory mandates of coverage and direct-to-consumer advertising by providers and pharmaceutical companies, have a direct impact on the volume of care consumed by our members. The potential effect of escalating health care costs as well as any changes in our ability to negotiate competitive rates with our providers may impose further risks to our ability to profitably underwrite our business, and may have a material impact on our results of operations.
On July 11, 2005, we announced that an agreement was reached with representatives of more than 700,000 physicians nationwide involved in two multi-district class-action lawsuits against us and other health benefits companies. As part of the Multi-District Litigation Settlement Agreement, or the Agreement, we agreed to pay $135.0 million to physicians and to contribute $5.0 million to a not-for-profit foundation whose mission is to promote higher quality health care and to enhance the delivery of care to the disadvantaged and underserved. In addition, up to $58.0 million will be paid in legal fees. As a result of the Agreement, we incurred a pre-tax expense of $103.0 million during the year ended December 31, 2005, or $0.10 EPS, which represents the final settlement amount of the Agreement that was not previously accrued. Appeals of the settlement initially filed by certain physicians were resolved and final cash payments under the agreement totaling $209.5 million, including accrued interest, were made on October 5 and 6, 2006.
On June 9, 2005, we completed our acquisition of Lumenos, Inc., or Lumenos, for approximately $185.0 million in cash paid to the stockholders of Lumenos. Lumenos is recognized as a pioneer and market leader in consumer-driven health programs.
On November 30, 2004, Anthem, Inc. and WellPoint Health Networks Inc., or WHN, completed their merger. The merger with WHN helped us to create the nation’s leading health benefits company and the largest
Medical membership data for 2005 has been reclassified to conform to the current presentation. Our reclassifications for minimum premium amendments to fully-insured contracts resulted in an increase in self-funded membership and a corresponding decrease in fully-insured membership, with no impact on total medical membership.
Represents prescription volume for the years ended December 31, 2006 and 2005.
Large Group membership decreased 348,000, or 2%, primarily due to the loss of the state of Georgia PPO contract and the other Large Group account previously disclosed, partially offset by new sales.
State Sponsored membership decreased 53,000, or 3%, primarily due to the membership accounting change related to our Puerto Rico joint venture investment discussed above. Partially offsetting this 222,000 member decrease, we added 68,000 new members from the acquisition of QualChoice Select, Inc. and won new business from five awards in 2006 due to our comprehensive array of health management services we make available to the nation’s Medicaid recipients.
Self-funded medical membership increased 161,000, or 1%, primarily due to increases in our National Accounts and BlueCard businesses and shifts in the mix of business from fully-insured to self-funded, partially offset by the loss of the state of Georgia PPO contract and the other Large Group contract noted above, as well as the impact of the Puerto Rico joint venture membership accounting change. Fully-insured membership increased by 84,000 members, primarily due to the August 1, 2006 acquisition of QualChoice Select, Inc.
Vision membership increased 720,000, or 88%, due to the introduction of our Blue View Vision product and the associated conversion of 432,000 members of a competing plan in Virginia to this new product, as well as new sales in several markets.
The following discussion summarizes our aggregate cost of care trends for the full year 2006 for our Large Group and ISG fully-insured businesses only. In order to provide a more meaningful comparison to the current period due to the acquisition of WellChoice, cost of care information as discussed below is presented as if WellPoint and WellChoice were combined for all of 2005. Accordingly, cost of care reported previously for WellPoint is not comparable to the information presented below.
Our cost of care trends are calculated by comparing the year-over-year change in average per member per month claim costs for which we are responsible, which excludes member co-payments and deductibles. While our cost of care trend varies by geographic location, our aggregate cost of care was less than 8% for the full year 2006.
Costs for outpatient and inpatient services are the primary drivers of overall cost trends. Cost trend increases for outpatient services were primarily driven by higher per visit costs as more procedures are being performed during each visit to outpatient providers, particularly emergency room visits, as well as the impact of price increases included within certain provider contracts. However, we are seeing the positive impact of our expanding radiology management programs on our outpatient trends. These programs are designed to ensure appropriate use of radiology services by our members. Inpatient trends have been driven primarily by unit cost, a reflection of negotiated contract increases with hospitals. Utilization (admissions per 1,000 members) remains flat, while average length of hospital stay and hospital days per 1,000 members have both decreased slightly.
Pharmacy benefit cost trend increased primarily due to pharmacy unit cost (cost per prescription) trend. The unit cost trend in 2006 is reflecting a return to normal cost trends compared to 2005 when the unit cost trend was favorably impacted by merger synergies and improved pharmaceutical contracting following the merger with WHN, the non-renewal of pharmacy only business from a large state customer with historically high utilization and cost trends and the impact of lower utilization for the COX 2 Inhibitor therapeutic class of drugs. In addition, the increased use of specialty drugs, also known as biotech drugs, which generally have a higher cost and are being utilized more frequently, has increased the unit cost trend in 2006. These increases in unit costs were partially offset by increases in our generic usage rates and benefit plan design changes.
Net investment income increased $245.6 million, or 39%, to $878.7 million in 2006 primarily resulting from invested assets acquired with the acquisition of WellChoice, growth in invested assets from reinvestment of cash generated from operations and higher interest rates. This growth was partially offset by the use of cash for repurchases of our common stock.
Benefit expense increased $9.6 billion, or 29%, to $42.2 billion in 2006. On a comparable basis, benefit expense increased $4.5 billion, or 12%, primarily due to increased cost of care, which was driven by higher costs in outpatient and inpatient services, the addition of the New York State prescription drug contract and benefit expense for our Medicare Part D products.
On a comparable basis, our benefit expense ratio increased 20 basis points to 81.2% in 2006. This increase was primarily related to a change in business mix, primarily driven by the addition of the New York State prescription drug contract, growth in FEP and State Sponsored business, as well as the introduction of Medicare Part D. All of these products have a higher benefit expense ratio than the WellPoint average. These increases were partially offset by disciplined pricing and the non-recurrence of $35.0 million of benefit expense recorded in the second quarter of 2005 related to the multi-district litigation settlement agreement, or MDL settlement agreement, discussed in Significant Transactions within this MD&A.
On a comparable basis, our selling, general and administrative expense ratio decreased 80 basis points to 15.7% in 2006, primarily due to growth in premium income, continued expense control and further leveraging of general and administrative costs over a larger membership base. In addition, the 2005 selling, general and administrative expense ratio was negatively impacted by $68.0 million, or 10 basis points, related to the MDL settlement agreement.
Cost of drugs increased $13.2 million, or 5%, to $301.2 million in 2006. This increase is primarily attributable to increased mail-order prescription volume by our PBM companies, partially offset by higher utilization of generic prescription drugs.
Income tax expense increased $393.0 million, or 28%, to $1.8 billion in 2006, consistent with the increase in pre-tax income. The effective tax rate in 2006 and 2005 was 37.0% and 36.7%, respectively. The increase in the effective tax rate in 2006 was primarily related to increases in state taxes due to the addition of operations in New York following the acquisition of WellChoice.
Our Health Care segment’s summarized results of operations for the year ended December 31, 2006 and 2005 are as follows:
contract and Medicare Part D. These increases were partially offset by the impact of increased share-based compensation expense following the adoption of FAS 123R in 2006.
Our Specialty segment’s summarized results of operations for the year ended December 31, 2006 and 2005 are as follows:
Operating revenue increased $500.1 million, or 16%, to $3.6 billion in 2006. On a comparable basis, operating revenue increased $468.0 million, or 15%, primarily due to increased prescription volume by our PBM companies, including specialty pharmacy, driven by the addition of Medicare Part D, partially offset by the sale of our workers compensation business in Wisconsin in 2005.
Operating revenue from external customers increased $121.0 million, or 36%, to $454.6 million in 2006. On a comparable basis, operating revenue from external customers decreased $10.2 million, or 2%. On both a reported and comparable basis, the elimination of intersegment revenue increased $458.5 million, or 34%, in 2006, reflecting additional sales by our PBM companies of Medicare Part D and specialty pharmacy products to our Health Care segment.
Operating loss decreased $36.9 million, or 33%, to $75.0 million in 2006. On a comparable basis, operating loss decreased $50.8 million, or 40%, primarily due to lower expenses related to retention bonuses and other compensation costs associated with the merger between the former Anthem, Inc. and the former WellPoint Health Networks Inc.
The following table presents our medical membership by customer type, funding arrangement and geographical region as of December 31, 2005 and 2004. Also included below are key metrics from our Specialty segment, including prescription volume for our PBM companies and membership by product. The membership data presented is unaudited and in certain instances includes estimates of the number of members represented by each contract at the end of the period.
During the twelve months ended December 31, 2005, total medical membership increased approximately 6,128,000, or 22%, primarily due to our acquisition of WellChoice and organic growth in all customer types. Excluding the impact of the WellChoice acquisition: BlueCard membership increased 545,000, or 16%, representing membership growth in other Blue Cross and Blue Shield licensees with members who reside in or travel to our licensed areas; National Accounts membership increased 329,000, or 10%, primarily due to new sales, as well as in-group increases in membership and members acquired from the acquisition of Lumenos; Large Group membership increased 204,000, or 2% primarily due to our acquisition of Lumenos as well as new sales throughout the year; State Sponsored membership increased 148,000, or 9% due to new sales, primarily in the West region; and ISG membership increased 97,000, or 2%, primarily due to the introduction of new, more affordable product designs and an overall increase in consumer awareness of our wide variety of quality products and services as well as efforts to market products to the uninsured.
We discuss our 2005 and 2004 operations using “comparable basis” information, which is presented to provide a more meaningful 2004 comparison to 2005, due to the merger with WHN. Comparable basis information is not calculated in accordance with GAAP and is not intended to represent or be indicative of the results of WellPoint, Inc. had the merger been completed as of January 1, 2004. Comparable basis information for the year ended December 31, 2004 was calculated by adding the reclassified historical statements of income for the former WHN for the 11 months ended November 30, 2004 to the reported results of WellPoint, Inc. for the year ended December 31, 2004, which includes one month of the former WHN. Comparable basis information contains no intercompany eliminations or pro forma adjustments.
Premiums increased $22.0 billion, or 118%, to $40.7 billion in 2005. On a comparable basis, premium increased $2.6 billion, or 7%, primarily due to premium rate increases in our Large Group, ISG and Senior businesses and membership gains in our ISG, State Sponsored and Senior membership types. Partially offsetting the impact of premium rate increases was the conversion of some Large Group customers from fully-insured contracts to self-funded arrangements and the non-renewal of certain fully-insured accounts.
Other revenue principally includes amounts from mail-order drug sales by our PBM companies, which provides services to members of our Health Care segment and third party clients. Other revenue increased $300.8 million, or 138%, to $519.2 million in 2005. On a comparable basis, other revenue increased $30.0 million, or 6%, primarily due to additional mail-order prescription revenue and increased prices of prescription drugs sold by our PBM companies. Increased mail-order prescription volume resulted from both membership increases and additional utilization of our PBM’s mail-order pharmacy option.
Net investment income increased $321.4 million, or 103%, to $633.1 million in 2005 primarily resulting from invested assets acquired with the WHN merger (net of cash used in the merger) and from growth in invested assets from reinvestment of cash generated from operations.
A summary of our net realized (losses) gains on investments for the years ended December 31, 2005 and 2004 is as follows:
Benefit expense increased $17.3 billion, or 114%, to $32.6 billion in 2005. On a comparable basis, benefit expense increased $1.9 billion, or 6%, primarily due to increased cost of care, which was driven primarily by higher costs in outpatient and inpatient services. In addition, our benefit expense included $35.0 million in 2005 related to the MDL settlement agreement discussed in Significant Transactions within this MD&A. On a comparable basis, our benefit expense ratio decreased 60 basis points from 80.8% in 2004 to 80.2% in 2005. The decrease in our benefit expense ratio is driven by moderating cost of care trends coupled with disciplined underwriting practices.
Income tax expense increased $943.3 million, or 195%, to $1,426.5 million in 2005. Included in 2005 was $28.4 million in tax benefits associated with a refund claim recognizing the deductibility of capital losses on the sale of certain subsidiaries that occurred in prior years. Included in 2004 was $44.8 million in tax benefits associated with a change in Indiana laws governing the state’s high-risk health insurance pool.
Operating gain increased $321.2 million, or 305%, to $426.4 million. On a comparable basis, operating gain increased $89.2 million or 26%, primarily due to an increase in PBM, behavioral health and dental businesses.
Operating revenue from external customers increased $125.0 million, or 60%, to $333.6 million. On a comparable basis, operating revenue from external customers increased $17.7 million, or 6%. The elimination of intersegment revenue increased $618.7 million, or 85%. On a comparable basis, the elimination of intersegment revenue increased $236.7 million, or 21%, reflecting additional sales by our PBM companies to our Health Care segment.
The most judgmental accounting estimate in our consolidated financial statements is our liability for medical claims payable. At December 31, 2006, this liability was $5.3 billion and represented 19% of our total consolidated liabilities. We record this liability and the corresponding benefit expense for incurred but not paid claims including the estimated costs of processing such claims. Incurred but not paid claims include (1) an
Because the reserve methodology is based upon historical information, it must be adjusted for known or suspected operational and environmental changes. These adjustments are made by our actuaries based on their knowledge and their estimate of emerging impacts to benefit costs and payment speed. Circumstances to be considered in developing our best estimate of reserves include changes in utilization levels, unit costs, mix of business, benefit plan designs, provider reimbursement levels, processing system conversions and changes, claim inventory levels, claim processing patterns, claim submission patterns and operational changes resulting from business combinations. A comparison of prior period liabilities to re-estimated claim liabilities based on subsequent claims development is also considered in making the liability determination. In our comparison of prior year, the methods and assumptions are not changed as reserves are recalculated, rather the availability of additional paid claims information drives our changes in the re-estimate of the unpaid claim liability. To the extent appropriate, changes in such development are recorded as a change to current period benefit expense.
In addition to incurred but not paid claims, the liability for medical claims payable includes reserves for premium deficiencies, if appropriate. Premium deficiencies are recognized when it is probable that expected claims and administrative expenses will exceed future premiums on existing medical insurance contracts without consideration of investment income. Determination of premium deficiencies for longer duration life and disability contracts, which are reported with reserves for future policy benefits, includes consideration of investment income. For purposes of premium deficiencies, contracts are grouped in a manner consistent with our method of acquiring, servicing and measuring the profitability of such contracts.
While there are many factors that are used as a part of the estimation of our medical claims payable liability, the two key assumptions having the most significant impact on our incurred but not paid liability as of December 31, 2006 were the completion and trend factors. As discussed above, these two key assumptions can be influenced by other operational variables including system changes, provider submission patterns and business combinations.
Over the period from December 31, 2005 to December 31, 2006, completion factors have increased. With consideration of claim payments through December 31, 2006, the completion factors used to determine the incurred but not paid claim liability estimate for the December 31, 2005 valuation period have developed higher than those used at December 31, 2005, primarily because we are receiving claims information from our providers more timely as a result of increased electronic submissions. In addition, we are paying claims more quickly once they have been received. This resulted in approximately $113.6 million of redundancy in the December 31, 2005 estimate and is included in the statement of income for the year ended December 31, 2006. This continued increase has been taken into consideration when determining the completion factors used in establishing the December 31, 2006 incurred but not paid claim liability by choosing factors that reflect the more recent experience. The difference in completion factor assumptions, assuming moderately adverse experience, results in variability of 2%, or approximately $101.0 million, in the December 31, 2006 incurred but not paid claim liability, depending on the completion factors chosen. It is important to note that the completion factor methodology inherently assumes that historical completion rates will be reflective of the current period. However, it is possible that the actual completion rates for the current period will develop differently from historical patterns and therefore could fall outside the possible variations described herein.
Over the period from December 31, 2004 to December 31, 2005, completion factors increased. With consideration of claims payment through December 31, 2005, the completion factors used to determine the incurred but not paid claim liability estimate for the December 31, 2004 valuation period have developed higher than those used at December 31, 2004, primarily because we are receiving claims information from our providers more timely as a result of increased electronic submissions. This resulted in approximately $194.3 million of redundancy in the December 31, 2004 estimate and included in the statement of income for the year ended December 31, 2005. In 2003, results presented represent the former Anthem, Inc. on a stand alone basis. Due to the acquisition of WHN at the end of 2004, these periods are not on a comparable basis. Therefore, changes in assumptions from 2003 to 2004 are not meaningful in comparing these periods.
As summarized below, Note 10 to our audited consolidated financial statements for the year ended December 31, 2006 included in this Annual Report on Form 10-K provides historical information regarding the accrual and payment of our medical claims liability. Components of the total incurred claims for each year include amounts accrued for current year estimated claims expense as well as adjustments to prior year estimated accruals. In Note 10 to our audited consolidated financial statements, the line labeled “Net incurred medical claims: Prior years (redundancies)” accounts for those adjustments made to prior year estimates. The impact of any reduction of “Net incurred medical claims: Prior years (redundancies)” claims may be offset as we establish the estimate of “Net incurred medical claims: Current year”. Our reserving practice is to consistently recognize the actuarial best estimate of our ultimate liability for our claims. When we recognize a release of the redundancy, we disclose the amount that is not in the ordinary course of business, if material. We believe we have consistently applied our methodology in determining our best estimate for unpaid claims liability at each reporting date.
Amounts incurred related to prior years vary from previously estimated liabilities as the claims are ultimately settled. Liabilities at any period end are continually reviewed and re-estimated as information regarding actual claims payments, or runout, becomes known. This information is compared to the originally established year end liability. Negative amounts reported for incurred related to prior years result from claims being settled for amounts less than originally estimated. The prior year redundancy of $617.7 million shown above for the year ended December 31, 2006 represents an estimate based on paid claim activity from January 1, 2006 to December 31, 2006. Medical claim liabilities are usually described as having a “short tail”, which means that they are generally paid within several months of the member receiving service from the provider. Accordingly, the majority, or approximately 82%, of the $617.7 million redundancy relates to claims incurred in calendar year 2005, with the remaining 18% related to claims incurred in 2004 and prior.
The following table shows the variance between total net incurred medical claims as reported in the above table for each of 2005 and 2004 and the incurred claims for such years had it been determined retrospectively (computed as the difference between “net incurred medical claims-current year” for the year shown and “net incurred medical claims-prior years (redundancies)” for the immediately following year):
These small variances to total net incurred medical claims, adjusted for the impacts of WellChoice, Inc. and WHN, shows that our estimates of this liability have approximated the actual experience for the years depicted.
We account for income taxes in accordance with Statement of Financial Accounting Standards No. 109, Accounting for Income Taxes. This standard requires, among other things, the separate recognition of deferred tax assets and deferred tax liabilities. Such deferred tax assets and deferred tax liabilities represent the tax effect of temporary differences between financial reporting and tax reporting measured at tax rates enacted at the time the deferred tax asset or liability is recorded. A valuation allowance must be established for deferred tax assets if it is “more likely than not” that all or a portion may be unrealized. Our judgment is required in determining an appropriate valuation allowance.
During 2006 the valuation allowance increased by $0.5 million. This resulted from realized and unrealized capital losses of subsidiaries, which are not included in our consolidated tax return. During 2004 and 2003, the valuation allowance decreased by $33.8 million and $81.9 million, respectively. The 2004 and 2003 reductions resulted from utilizing alternative minimum tax, or AMT, credits and net operating losses on our federal income tax return for which we had a deferred tax asset with a corresponding valuation allowance. As deferred tax assets related to those deductions are available for use in the tax return, a valuation was no longer required and was reduced. The decrease in the valuation allowance in 2004 was partially offset by an additional $5.6 million related to Indiana state taxes, as discussed below.
temporary differences, net operating loss carryforwards and tax credits relating to our Indiana income tax filings. Following guidance in FAS 109, a valuation allowance of $5.6 million was established for the portion of the deferred tax asset, which we believe will likely not be utilized. There is no carryforward limitation on the tax credits and the net operating loss carryforwards do not begin to expire until 2018. We believe we will have sufficient taxable income in future years to offset these carryforwards; therefore, no additional valuation allowance was recorded.
In the ordinary course of business, we are regularly audited by federal and state authorities, and from time to time, these audits result in proposed assessments. We believe our tax positions comply with applicable tax law and intend to defend our positions vigorously through the IRS appeals process. We believe we have adequately provided for any reasonable foreseeable outcome related to these matters. Accordingly, although their ultimate resolution may require additional tax payments, we do not anticipate any material impact to earnings from these matters. As of December 31, 2006, the IRS was nearing completion of its examination of our 2003 tax year. The IRS will continue auditing our 2004 tax year and will initiate a review of the 2005 and 2006 tax years during 2007. In addition, the IRS has invited us to join the Compliance Assurance Program, or CAP, for 2007. The objective of CAP is to reduce taxpayer burden and uncertainty while assuring the IRS of the accuracy of tax returns prior to filing, thereby reducing or eliminating the need for post-filing examinations. Various tax examinations and proceedings also continue for certain subsidiaries for tax years prior to being included in our consolidated tax return.
On December 28, 2005, we purchased 100% of the outstanding common stock of WellChoice, Inc. In accordance with FAS 141, we allocated the purchase price to the fair value of assets acquired, including intangible assets, and liabilities assumed. This allocation process included the review of relevant information
For additional information, see Note 4 to our audited consolidated financial statements as of and for the year ended December 31, 2006 included in this Form 10-K.
WellPoint maintains various rabbi trusts to account for the assets and liabilities under certain deferred compensation plans. Under these plans, the participants can defer certain types of compensation and elect to receive a return on the deferred amounts based on the changes in fair value of various investment options, primarily a variety of mutual funds. Rabbi trust assets were previously classified as noncurrent available-for-sale investments. Effective January 1, 2006 and in connection with a restructuring of the plans, WellPoint changed its classification for the majority of such securities from available-for-sale to trading, which are reported in “Other invested assets, current” in the consolidated balance sheet. The change in the fair value of the trading portfolio rabbi trust assets during 2006 resulted in $35.6 million of realized gains, which, together with net investment income from trading portfolio rabbi trust assets of $8.6 million, is classified in general and administrative expense in the consolidated statement of income, consistent with the related increase in compensation expense.
of real estate, cash surrender value of corporate-owned life insurance policies and certain other investments. Due to their less liquid nature, these investments are classified as long-term.
During the year ended December 31, 2006, we sold $5.9 billion of fixed maturity and equity securities resulting in gross realized losses of $95.7 million. Subsequent to the acquisition of WellChoice, during 2006, we restructured our investment portfolios to align the merged portfolios with our overall investment guidelines. The majority of the sales of fixed maturity securities resulted in realized losses due to the prevailing interest rate environment. For equity securities, the 2006 sales to restructure the merged portfolios primarily resulted in realized gains. Similarly, subsequent to the merger with WHN, during 2005, we restructured our investment
A primary objective in the management of the fixed maturity and equity portfolios is to maximize total return relative to underlying liabilities and respective liquidity needs. In achieving this goal, assets may be sold to take advantage of market conditions or other investment opportunities as well as tax considerations. Sales will generally produce realized gains and losses.
We participate in securities lending programs whereby marketable securities in our investment portfolio are transferred to independent brokers or dealers based on, among other things, their creditworthiness in exchange for collateral initially equal to at least 102% of the value of the securities on loan and is thereafter maintained at a minimum of 100% of the market value of the securities loaned. The market value of the securities on loan to each borrower is monitored daily and the borrower is required to deliver additional collateral if the market value of the collateral falls below 100% of the market value of the securities on loan. The fair value of the collateral amounted to $904.7 million and $1,389.9 million, which represented 103% and 102% of the carrying value at December 31, 2006 and 2005, respectively. Under guidance provided in FAS 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, we recognize the collateral as an asset, which is reported as “securities lending collateral” on our balance sheet and we record a corresponding liability for the obligation to return the collateral to the borrower, which is reported as “securities lending payable”. The securities on loan are reported in the applicable investment category on the balance sheet.
We have evaluated the impact on the fixed maturity portfolio’s fair value considering an immediate 100 basis point change in interest rates. A 100 basis point increase in interest rates would result in an approximate $619.0 million decrease in fair value, whereas a 100 basis point decrease in interest rates would result in an approximate $583.0 million increase in fair value. An immediate 10% decrease in each equity investment’s value, arising from market movement, would result in a fair value decrease of $207.1 million. Alternatively, an immediate 10% increase in each equity investment’s value, attributable to the same factor, would result in a fair value increase of $207.1 million.
For additional information, see Part II, Item 7A, Quantitative and Qualitative Disclosures about Market Risk, of this Form 10-K, and Note 5 to our audited consolidated financial statements as of and for the year ended December 31, 2006 included in this Form 10-K.
The assumed long-term rate of return on assets is applied to a calculated value of plan assets, which recognizes changes in the fair value of plan assets in a systematic manner over three years, producing the expected return on plan assets that is included in the determination of pension expense. The difference between this expected return and the actual return on plan assets is deferred and amortized over the average remaining service of the workforce as a component of pension expense. The net deferral of past asset gains or losses affects the calculated value of plan assets and, ultimately, future pension expense.
In managing the plan assets, our objective is to be a responsible fiduciary while minimizing financial risk. Plan assets include a diversified mix of investment grade fixed maturity securities and equity securities across a range of sectors and levels of capitalization to maximize the long-term return for a prudent level of risk. In addition to producing a reasonable return, the investment strategy seeks to minimize the volatility in the Company’s expense and cash flow. As of our September 30, 2006 measurement date, we had approximately 67% of plan assets invested in equity securities, 27% in fixed maturity securities and 6% in other assets. No plan assets were invested in WellPoint common stock as of the measurement date.
For the year ended December 31, 2006, there were no contributions required under the Employee Retirement Income Securities Act of 1974, as amended, or ERISA; however we elected to make discretionary contributions totaling $108.6 million during the three months ended September 30, 2006. For the year ending December 31, 2007, we do not expect any required contributions under ERISA; however, we may elect to make discretionary contributions up to the maximum amount deductible for income tax purposes.
The Empire Blue Cross Blue Shield Cash Balance Pension Plan, or the Empire Plan, was merged into the Plan on December 31, 2006. Effective January 1, 2007, we curtailed the benefits under the Empire Plan. Most participants will no longer have pay credits added to their accounts, but will continue to earn interest on existing account balances. Participants will continue to earn years of service for vesting. Employees hired on or after January 1, 2007 will not be able to participate in the Plan. Certain participants will be “grandfathered” into the Plan based on age and years of service in the Empire Plan. Grandfathered participants will continue to receive pay credits under the Plan formula. There will be no curtailment gain or loss associated with the curtailment of benefits under the Empire Plan.
We provide most associates with certain life, medical, vision and dental benefits upon retirement. We use various actuarial assumptions including a discount rate and the expected trend in health care costs to estimate the costs and benefit obligations for our retiree benefits. We recognized a postretirement benefit liability of $554.4 million at December 31, 2006.
At our September 30, 2006 measurement date, the selected discount rate for all plans was 5.90% (compared to a weighted average discount rate of 5.29% for 2006 expense recognition). We developed this rate using a yield curve approach as described above.
For additional information regarding retirement benefits, see Note 17 to our audited consolidated financial statements as of and for the year ended December 31, 2006 included in this Form 10-K. See also New Accounting Pronouncements disclosure included in this Critical Accounting Policies and Estimates section of our MD&A for discussion of new accounting guidance related to retirement benefits.
In July 2006, FASB issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes-an interpretation of FASB Statement 109 (“FIN 48”). Among other things, FIN 48 creates a model to address uncertainty in tax positions and clarifies the accounting for income taxes by prescribing a minimum recognition threshold which all income tax positions must achieve before being recognized in the financial statements. In
During 2006, net cash flow provided by operating activities was $4,044.2 million, compared to $3,135.5 million in 2005, an increase of $908.7 million. This increase resulted from improved premium collections, and higher net income, including the impact of the acquisition of WellChoice, partially offset by higher tax payments.
Net cash flow used in investing activities was $457.3 million in 2006, compared to $5,151.6 million of cash used in 2005. The table below outlines the decrease in cash flow used in investing activities of $4,694.3 million between the two periods:
The increase in proceeds from the exercise of employee stock options reflects the significant increase in employees with vested options due to our merger with WHN. The increase in repurchases of common stock reflects the activity in our Board-approved common stock repurchase program. The decrease in repayments of long-term debt resulted primarily from the significant amount of repayments in 2004 as new long-term debt was issued to partially pay off outstanding long-term debt and fund the WHN merger. The decrease in proceeds from the issuance of common stock under Equity Security Units stock purchase contracts reflects the maturity of these instruments in 2004.
We maintained a strong financial condition and liquidity position, with consolidated cash, cash equivalents and investments, including long-term investments, of $20.8 billion at December 31, 2006. Since December 31, 2005, total cash, cash equivalents and investments, including long-term investments, increased by $476.2 million as cash generated from operations was used for the repurchase of our common stock.
During 2006, we received $2.3 billion of dividends from our subsidiaries. At December 31, 2006, we held at the parent company approximately $1.7 billion of cash, cash equivalents and investments, which is available for general corporate use, including investment in our businesses, acquisitions, share and debt repurchases and interest payments.
Our consolidated debt-to-total capital ratio (calculated as the sum of debt divided by the sum of debt plus shareholders’ equity) was 22.2% as of December 31, 2006 and 21.4% as of December 31, 2005, which increased only slightly considering our $4.6 billion of common stock repurchases during 2006.
As discussed in “Financial Condition” above, many of our subsidiaries are subject to various government regulations that restrict the timing and amount of dividends and other distributions that may be paid. Based upon these requirements, we are currently estimating approximately $2.7 billion of dividends to be paid to the parent company during 2007.
Our estimated contractual obligations and commitments as of December 31, 2006 are as follows:
In connection with the formation in 2000 of a joint venture providing Medicaid services in Puerto Rico, we agreed under certain circumstances to provide additional funding to the joint venture entity. Since the formation of the joint venture in 2000, we have not been required to make any payments under this guarantee. During December 2006, the joint venture was terminated and the guarantee was extinguished.
For additional information on these off-balance sheet arrangements, see Note 18 to our audited consolidated financial statements for the year ended December 31, 2006 included in this Form 10-K.
This document contains certain forward-looking information about WellPoint, Inc. (“WellPoint”) that is intended to be covered by the safe harbor for “forward-looking statements” provided by the Private Securities Litigation Reform Act of 1995. Forward-looking statements are statements that are not historical facts. Words such as “expect(s)”, “feel(s)”, “believe(s)”, “will”, “may”, “anticipate(s)” and similar expressions are intended to identify forward-looking statements. These statements include, but are not limited to, financial projections and estimates and their underlying assumptions; statements regarding plans, objectives and expectations with respect to future operations, products and services; and statements regarding future performance. Such statements are subject to certain risks and uncertainties, many of which are difficult to predict and generally beyond the control of WellPoint, that could cause actual results to differ materially from those expressed in, or implied or projected by, the forward-looking information and statements. These risks and uncertainties include: those discussed and identified in public filings with the U.S. Securities and Exchange Commission (“SEC”) made by WellPoint; trends in health care costs and utilization rates; our ability to secure sufficient premium rate increases; competitor pricing below market trends of increasing costs; increased government regulation of health benefits, managed care and pharmacy benefit management operations; risks and uncertainties regarding the Medicare Part D Prescription Drug benefits program, including potential uncollectability of receivables resulting from processing and/or verifying enrollment (including facilitated enrollment), inadequacy of underwriting assumptions, inability to receive and process information, uncollectability of premium from members, increased pharmaceutical costs, and the underlying seasonality of the business; significant acquisitions or divestitures by major competitors; introduction and utilization of new prescription drugs and technology; a downgrade in our financial strength ratings; litigation and investigations targeted at health benefits companies and our ability to resolve litigation and investigations within estimates; our ability to contract with providers consistent with past practice; other potential uses of cash in the future that present attractive alternatives to share repurchases; our ability to achieve expected synergies and operating efficiencies in the WellChoice, Inc. acquisition within the expected time frames or at all, and to successfully
integrate our operations; our ability to meet expectations regarding repurchases of shares of our common stock; future bio-terrorist activity or other potential public health epidemics; and general economic downturns. Readers are cautioned not to place undue reliance on these forward-looking statements that speak only as of the date hereof. WellPoint does not undertake any obligation to republish revised forward-looking statements to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events. Readers are also urged to carefully review and consider the various disclosures in WellPoint’s various SEC reports.
We have audited the accompanying consolidated balance sheets of WellPoint, Inc. (the “Company”) as of December 31, 2006 and 2005, and the related consolidated statements of income, shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2006. Our audits 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 and schedule based on our audits.
Investments: In accordance with FAS 115, Accounting for Certain Investments in Debt and Equity Securities, fixed maturity and equity securities are classified as “available-for-sale” or “trading” and are reported
WellPoint maintains various rabbi trusts to account for the assets and liabilities under certain deferred compensation plans. Under these plans, the participants can defer certain types of compensation and elect to receive a return on the deferred amounts based on the changes in fair value of various investment options, primarily a variety of mutual funds. Rabbi trust assets were previously classified as noncurrent available-for-sale investments. Effective January 1, 2006 and in connection with a restructuring of the plans, WellPoint changed its classification for the majority of such securities from available-for-sale to trading, which are reported in other invested assets, current in the consolidated balance sheet. The change in the fair value of the trading portfolio rabbi trust assets during 2006 resulted in $35.6 of realized gains, which, together with net investment income from trading portfolio rabbi trust assets of $8.6, is classified in general and administrative expense in the consolidated statement of income, consistent with the related increase in deferred compensation expense.
The Company uses the equity method of accounting for investments in companies in which its ownership interest enables the Company to influence the operating or financial decisions of the investee company. The Company’s proportionate share of equity in net income of these unconsolidated affiliates is reported with net investment income.
The Company participates in securities lending programs whereby marketable securities in its investment portfolio are transferred to independent brokers or dealers based on, among other things, their creditworthiness in exchange for collateral initially equal to at least 102 percent of the value of the securities on loan and is thereafter maintained at a minimum of 100 percent of the market value of the securities loaned. The market value of the securities on loan to each borrower is monitored daily and the borrower is required to deliver additional collateral if the market value of the collateral falls below 100 percent of the market value of the securities on loan. The fair value of the collateral amounted to $904.7 and $1,389.9, which represents 103 percent and 102 percent of the market value of the securities on loan at December 31, 2006 and 2005, respectively. In accordance with FAS 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, the Company recognizes the collateral as an asset, which is reported as “securities lending collateral” on its balance sheet and the Company records a corresponding liability for the obligation to return the collateral to the borrower, which is reported as “securities lending payable.” The securities on loan are reported in the applicable investment category on the balance sheet.
Derivative Financial Instruments: In accordance with FAS 133, Accounting for Derivative Instruments and Hedging Activities, all investments in derivatives are recorded at fair value. A derivative is typically defined as an instrument whose value is “derived” from an underlying instrument, index or rate, has a notional amount, requires little or no initial investment and can be net settled. The Company typically invests in the following types of derivative financial instruments: interest rate swaps, call options, embedded derivatives and warrants. Derivatives embedded within non-derivative instruments (such as options embedded in convertible fixed maturity securities) are bifurcated from the host instrument when the embedded derivative is not clearly and closely related to the host instrument.
Credit exposure associated with non-performance by the counterparties to derivative instruments is generally limited to the uncollateralized fair value of the asset related to instruments recognized in the consolidated balance sheets. The Company attempts to mitigate the risk of non-performance by selecting counterparties with high credit ratings and monitoring their creditworthiness and by diversifying derivatives among multiple counterparties.
The Company has exposure to economic losses due to interest rate risk arising from changes in the level or volatility of interest rates. The Company attempts to mitigate its exposure to interest rate risk through active portfolio management, which includes rebalancing its existing portfolios of assets and liabilities, as well as changing the characteristics of investments to be purchased or sold in the future. In addition, derivative financial instruments are used to modify the interest rate exposure of certain liabilities or forecasted transactions. These strategies include the use of interest rate swaps and forward contracts. These instruments are generally used to lock interest rates or to hedge (on an economic basis) interest rate risks associated with variable rate debt. The Company has used these types of instruments as designated hedges against specific liabilities.
The contractual or notional amounts for derivatives are used to calculate the exchange of contractual payments under the agreements and are not representative of the potential for gain or loss on these instruments. Interest rates and equity prices affect the fair value of derivatives. The fair values generally represent the estimated amounts that the Company would expect to receive or pay upon termination of the contracts at the reporting date. Dealer quotes are available for substantially all of the Company’s derivatives. For derivative instruments not actively traded, fair values are estimated using values obtained from independent pricing services, costs to settle or quoted market prices of comparable instruments.
Premium and Self-Funded Receivables: Premium and self-funded receivables include the uncollected amounts from insured and self-funded groups, and are reported net of an allowance for doubtful accounts of $120.8 and $96.0 at December 31, 2006 and 2005, respectively. The allowance for doubtful accounts is based on historical collection trends and management’s judgment regarding the ability to collect specific accounts.
Reserves for Future Policy Benefits: Reserves for future policy benefits include liabilities for life and long-term disability insurance policy benefits based upon interest, mortality and morbidity assumptions from published actuarial tables, modified based upon the Company’s experience. Future policy benefits also include liabilities for insurance policies for which some of the premiums received in earlier years are intended to pay anticipated benefits to be incurred in future years. Future policy benefits are continually monitored and reviewed, and when reserves are adjusted, differences are reflected in benefit expense.
Share-Based Compensation: The Company’s compensation philosophy provides for share-based compensation, including stock options and restricted stock awards, as well as an employee stock purchase plan. Stock options are granted for a fixed number of shares with an exercise price at least equal to the fair value of the shares at the date of the grant. Restricted stock awards are issued at the fair value of the stock on the grant date. The employee stock purchase plan allows for a purchase price per share which is 85% of the lower of the fair
value of a share of common stock on (i) the first trading day of the plan quarter, or (ii) the last trading day of the plan quarter. Through December 31, 2005, the Company historically accounted for share-based compensation using the intrinsic value method under Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (“APB 25”), and, accordingly, recognized no compensation expense related to stock options and employee stock purchases. For grants of restricted stock, other than those awarded under long-term incentive agreements, unearned compensation equivalent to the fair value of the shares at the date of grant was recorded as a separate component of shareholders’ equity and subsequently amortized to compensation expense over the award’s vesting period. The Company has historically reported pro forma results under the disclosure-only provisions of FAS 123, Accounting for Stock-Based Compensation (“FAS 123”), as amended by FAS 148, Accounting for Stock-Based Compensation-Transition and Disclosure.
The Company’s share-based employee compensation plans and assumptions are described in Note 12. The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of FAS 123 to share-based employee compensation:
On December 28, 2005, the Company completed its acquisition of WellChoice, Inc. (“WellChoice”). The acquisition was accounted for using the purchase method of accounting, and was deemed effective December 31, 2005 for accounting purposes. Accordingly, the operating results of WellChoice are included in WellPoint’s consolidated financial statements in periods following December 31, 2005.
Under the merger agreement, WellChoice stockholders received thirty-eight dollars and twenty-five cents ($38.25) in cash and 0.5191 of a share of WellPoint common stock for each share of WellChoice common stock outstanding. The value of the transaction is estimated to be approximately $6,463.9, including cash of $3,126.4, the issuance of 42.4 shares of common stock, valued at $3,180.8, 0.3 shares of WellChoice restricted stock and stock units converted to WellPoint stock, valued at $19.8, WellChoice stock options converted to WellPoint stock options, valued at $113.4, and $23.5 of transaction costs. The fair value of common stock issued was based on $74.97 per share, which represents the average closing price of the Company’s common stock for the five trading days ranging from two days before to two days after September 27, 2005, the date the merger was announced.
On June 9, 2005, the Company completed its acquisition of Lumenos, Inc. (“Lumenos”), a market leader in consumer-driven health programs. The total consideration for the acquisition was approximately $185.0 in cash paid to the stockholders of Lumenos. The acquisition was accounted for using the purchase method of accounting, and was deemed effective June 1, 2005 for accounting purposes. Accordingly, the results of operations for Lumenos are included in the Company’s consolidated financial statements for periods following June 1, 2005. In accordance with FAS 141, the purchase price was allocated to the fair value of Lumenos assets acquired and liabilities assumed, including identifiable intangible assets, and the excess of purchase price over the fair value of net assets acquired resulted in $119.3 of non-tax deductible goodwill, which was allocated to the Health Care segment. The pro forma effects of this acquisition were not material to the Company’s consolidated results of operations.
The unaudited pro forma information includes the results of operations for WHN for the periods prior to the merger, adjusted for interest expense on long-term debt and reduced investment income related to the cash and investment securities used to fund the acquisition, additional amortization and depreciation associated with the purchase and the related income tax effects. The unaudited pro forma financial information is presented for informational purposes only and may not be indicative of the results of operations had WHN been owned by WellPoint for the full year ended December 31, 2004, nor is it necessarily indicative of future results of operations.
The following summary of unaudited pro forma financial information presents revenues, net income and per share data of WellPoint for the year ended December 31, 2004 as if the WHN merger had occurred on January 1, 2004.
For a period of time after the date of a merger or acquisition, the initial fair values allocated to net assets acquired may be subject to change as these fair value estimates are refined. Changes in these fair value estimates are recorded as adjustments to goodwill. Subsequent to the purchase allocation period, additional changes to fair value of net assets acquired are recorded in current operations, except for certain adjustments related to income taxes and severance, which continue to be adjusted to goodwill.
As required by FAS 142, the Company completed its annual impairment tests of existing goodwill and other intangible assets with indefinite lives during the fourth quarters of 2006, 2005 and 2004. These tests involved the use of estimates related to the fair value of the reporting unit to which the goodwill and other intangible assets with indefinite lives are allocated. There were no impairment losses recorded during 2006, 2005 and 2004.
As of December 31, 2006, estimated amortization expense for each of the five years ending December 31, is as follows: 2007, $282.5; 2008, $265.2; 2009, $247.2; 2010, $226.7; and 2011, $209.6.
The Company’s fixed maturity investment portfolio is sensitive to interest rate fluctuations, which impact the fair value of individual securities. Accordingly, unrealized losses on fixed maturity securities reported above were generally caused by the effect of a rising interest rate environment on certain securities with stated interest rates currently below market rates. The Company has the ability and intent to hold these fixed maturity securities until their full cost can be recovered. Therefore, the Company does not believe the unrealized losses represent an other-than-temporary impairment as of December 31, 2006.
The amortized cost and fair value of fixed maturity securities at December 31, 2006, by contractual maturity, are shown below. Expected maturities may be less than contractual maturities because the issuers of the securities may have the right to prepay obligations without prepayment penalties.
portfolios primarily resulted in realized gains. Similarly, subsequent to the merger with WHN, during 2005, the Company restructured its investment portfolios to align the merged portfolios with the Company’s overall investment guidelines. The majority of the sales of fixed maturity securities resulted in realized losses due to the prevailing interest rate environment. For equity securities, the 2005 sales to restructure the merged portfolios primarily resulted in realized gains. During 2004, the majority of the sales of fixed maturity securities resulted in realized gains. Impairments recorded in 2006, 2005 and 2004 were primarily the result of the continued credit deterioration on specific issuers in the bond markets and certain equity securities’ fair value remaining below cost for an extended period of time.
The carrying value of fixed maturity investments that did not produce income during 2006 and 2005 was $6.9 and $4.7 at December 31, 2006 and 2005, respectively.
At December 31, 2006 and 2005, securities with carrying values of approximately $342.3 and $227.9, respectively, were deposited by the Company’s insurance subsidiaries under requirements of regulatory authorities.
During the year ended December 31, 2005, the Company entered into two fair value hedges with a total notional value of $660.0. The first hedge is a $360.0 notional amount interest rate swap agreement to exchange a fixed 6.800% rate for a LIBOR-based floating rate and expires on August 1, 2012. The second hedge is a $300.0 notional amount interest rate swap agreement to exchange a fixed 5.000% rate for LIBOR-based floating rate and expires December 15, 2014.
During the year ended December 31, 2005, the Company entered into forward starting pay fixed swaps with an aggregate notional amount of $875.0. The objective of these hedges was to eliminate the variability of cash flows in the interest payments on the debt securities to be issued to partially fund the cash portion of the WellChoice acquisition. These swaps were terminated in January 2006, and the Company paid a net $24.7, the net fair value at the time of termination. In addition, the Company recorded an unrealized loss of $16.0, net of tax, as accumulated other comprehensive income. Following the January 10, 2006 issuance of debt securities in connection with the WellChoice acquisition, the unamortized fair value of the forward starting pay fixed swaps included in accumulated other comprehensive income began amortizing into earnings, as an increase to interest expense, over the life of the hedged debt securities.
On January 10, 2006, the Company issued $700.0 of 5.000% notes due 2011; $1,100.0 of 5.250% notes due 2016; and $900.0 of 5.850% notes due 2036, under a shelf registration statement filed with the U.S. Securities and Exchange Commission on December 28, 2005. The proceeds from this debt issuance were used to repay the bridge loan of $1,700.0 (as further described below) and to repay approximately $1,000.0 of commercial paper, which were both obtained to partially fund the December 28, 2005 WellChoice acquisition.
WellPoint had cash requirements of approximately $3,138.0 for the WellChoice acquisition, including both the cash portion of the purchase price and estimated transaction costs. In anticipation of the acquisition, on December 28, 2005, WellPoint entered into a bridge loan agreement under which it could borrow up to $3,000.0. On December 28, 2005, WellPoint borrowed $1,700.0 under this bridge facility to partially fund the WellChoice acquisition. The interest rate on this bridge loan was based on either (i) the LIBOR rate plus a predetermined percentage rate based on the Company’s credit rating at the date of utilization, or (ii) a base rate as defined in the facility agreement. The weighted-average interest rate on the bridge loan at December 31, 2005 was 7.250%. The bridge loan was classified as long-term debt at December 31, 2005 in accordance with FAS 6, Classification of Short-Term Obligations Expected to Be Refinanced (“FAS 6”), as this short-term borrowing was replaced with a long-term borrowing on January 10, 2006.
On November 29, 2005, the Company entered into a senior credit facility (the “facility”) with certain lenders for general corporate purposes. The Company amended this facility in September 2006. The facility provides credit for up to $2,500.0 (reduced for any commercial paper issuances) and matures on September 30, 2011. The interest rate on this facility is based on either (i) the LIBOR rate plus a predetermined percentage rate based on the Company’s credit rating at the date of utilization, or (ii) a base rate as defined in the facility agreement. The Company’s ability to borrow under the facility is subject to compliance with certain covenants. Commitment fees for the facility were $2.4 in 2006 and there are no conditions that are probable of occurring under which the facility may be withdrawn. There were no amounts outstanding under the senior credit facility as of December 31, 2006 or during the year then ended. At December 31, 2006, the Company had $1,204.7 available under this facility.
Surplus notes are unsecured obligations of Anthem Insurance Companies, Inc. (“Anthem Insurance”), a wholly owned subsidiary, and are subordinate in right of payment to all of Anthem Insurance’s existing and future indebtedness. Any payment of interest or principal on the surplus notes may be made only with the prior approval of the Indiana Department of Insurance (“IDOI”), and only out of capital and surplus funds of Anthem Insurance that the IDOI determines to be available for the payment under Indiana insurance laws. During December 2004, WellPoint completed a tender offer to purchase Anthem Insurance surplus notes from the holders, and purchased $258.0 of 9.125% notes due 2010 and $174.9 of 9.000% notes due 2027. The Company recorded a loss of $146.1 which was recorded as loss on repurchase of debt securities in the statement of income for the year ended December 31, 2004.
Current and long-term investments, available-for-sale, at fair value: The carrying amount approximates fair value, based on quoted market prices, where available. For securities not actively traded, fair values were estimated using values obtained from independent pricing services or quoted market prices of comparable instruments.
Other invested assets, current: Other invested assets, current include securities held in rabbi trusts that are classified as trading. The carrying amount approximates fair value, based on quoted market prices, where available. For securities not actively traded, fair values were estimated using values obtained from independent pricing services or quoted market prices of comparable instruments.
The Company reinsures certain of its risks with other companies and assumes risk from other companies. The Company remains primarily liable to policyholders under ceded insurance contracts and is contingently liable for amounts recoverable from reinsurers in the event that such reinsurers do not meet their contractual obligations.
On December 28, 2005, as partial consideration in the WellChoice acquisition, the Company issued 0.5191 of a share of WellPoint common stock for each share of WellChoice common stock outstanding, resulting in
The Company’s 2001 Stock Incentive Plan, as amended and restated on January 1, 2003 (“2001 Stock Plan”) is an omnibus plan, which allowed for the grant of stock options, stock, restricted stock, phantom stock, stock appreciation rights and performance awards to eligible employees and non-employee directors. On March 15, 2006, the Board of Directors adopted the WellPoint 2006 Incentive Compensation Plan (the “2006 Incentive Plan”), which was approved by WellPoint’s shareholders on May 16, 2006. The 2006 Incentive Plan allows the flexibility to grant or award stock options, stock appreciation rights, restricted stock awards, restricted stock units, performance unit awards, performance share awards, cash-based awards and other share-based awards to eligible persons. Following approval of the 2006 Incentive Plan on May 16, 2006, no new awards have been or will be made under the 2001 Stock Plan, but the awards outstanding under the 2001 Stock Plan will remain in effect in accordance with their terms.
Stock options are granted for a fixed number of shares with an exercise price at least equal to the fair value of the shares at the grant date. The stock options granted in 2006 and 2005 generally vest over three years in equal semi-annual installments and have a term of ten years from the grant date. The stock options granted prior to 2005 generally vest in equal annual installments over three years and expire ten years from the grant date.
Certain option grants contain provisions whereby the employee continues to vest in the award subsequent to termination due to retirement. Prior to the adoption of FAS 123R, the Company’s expense attribution methodology did not consider such vesting provisions and the fair value of the awards was amortized over the stated vesting periods. Effective with the adoption of FAS 123R, the Company changed its attribution method for newly granted awards and now considers all vesting and other provisions, including retirement eligibility, in determining the requisite service period over which the fair value of the awards will be recognized.
Restricted stock awards are issued at the fair value of the stock on the grant date. The restrictions lapse in three equal annual installments. Prior to the adoption of FAS 123R, unearned compensation for grants of restricted stock equivalent to the fair value of the shares at the date of grant was recorded as a separate component of shareholders’ equity and subsequently amortized to compensation expense over the awards’ vesting period. In accordance with FAS 123R, shareholders’ equity is credited commensurate with the recognition of compensation expense. All unamortized unearned compensation at January 1, 2006 was reclassified to additional paid-in capital.
For the years ended December 31, 2006, 2005 and 2004, the Company recognized share-based compensation cost of $246.9, $81.2 and $10.0, respectively, as well as related tax benefits of $89.9, $28.5 and $3.6, respectively. As a result of the adoption of FAS 123R effective January 1, 2006, the Company’s income before income taxes and net income for the year ended December 31, 2006 were $158.2 and $97.9 lower, respectively, than if the Company had continued to account for the share-based compensation programs under APB 25. Accordingly, the reported basic and diluted earnings per share for the year ended December 31, 2006 were $0.16 and $0.15, respectively, lower than had the Company not adopted FAS 123R effective January 1, 2006.
A summary of the status of nonvested restricted stock activity for the year ended December 31, 2006 is as follows:
At the time of its initial public offering on November 2, 2001, the Company issued 4.6 Equity Security Units at 6.00%. Each Equity Security Unit contained a purchase contract under which the holder agreed to purchase, for twenty-five dollars, shares of the Company’s common stock on November 15, 2004. In November 2004, the Company received $230.0 for the issuance of approximately 10.6 shares of Anthem common stock pursuant to the purchase contract portion of the Equity Security Units. The number of shares purchased was determined based on the average trading price of the Company’s common stock at the time of settlement.
The net increase in the valuation allowance for 2006 and 2005 was $0.5 and $0.0, respectively. The increase resulted from realized and unrealized capital losses of subsidiaries not included in the Company’s consolidated tax return. The remaining valuation allowance is primarily attributable to the uncertainty of alternative minimum tax credits and net operating loss carryforwards. As deferred tax assets related to these types of deductions are recognized in the tax return, the valuation allowance is no longer required and is reduced.
During the third quarter of 2006, the Company decreased its state deferred tax liability by $43.0, resulting in a tax benefit, net of federal taxes, of $28.0, or $0.04 per basic and diluted shares, for the year ended December 31, 2006. This resulted from a lower effective tax rate due to changes in the Company’s state tax apportionment factors following the WellChoice acquisition.
As a result of legislation enacted in Indiana on March 16, 2004, the Company recorded deferred tax assets and liabilities, with a corresponding net tax benefit in the income statement of $44.8, or $0.15 per basic share and $0.14 per diluted share, for the year ended December 31, 2004. The legislation eliminated the creation of tax credits resulting from the payment of future assessments to the Indiana Comprehensive Health Insurance Association (“ICHIA”), Indiana’s high-risk health insurance pool. Under the new legislation, ICHIA tax credits are limited to any unused ICHIA assessment paid prior to December 31, 2004. A valuation allowance of $5.6 was established for the portion of the deferred tax asset, which the Company believes will likely not be utilized. There is no carryforward limitation on the tax credits and the net operating loss carryforwards do not begin to expire until 2018.
At December 31, 2006, the Company had unused federal tax net operating loss carryforwards of approximately $184.4 to offset future taxable income. The loss carryforwards expire in the years 2007 through 2024. During 2006, 2005 and 2004 federal income taxes paid totaled $1,553.3, $994.0 and $646.3, respectively.
A reconciliation of the components of accumulated other comprehensive income (loss) at December 31 is as follows:
The Company has certain lease agreements that contain contingent payment provisions. Under these provisions, the Company pays contingent amounts in addition to base rent, primarily based upon annual changes in the consumer price index. The schedule above contains estimated amounts for potential future increases in lease payments based on the contingent payment provisions.
Lease expense for 2006, 2005 and 2004 was $221.3, $149.3 and $62.8, respectively.
The WellPoint Cash Balance Pension Plan (the “Plan”), which name changed from the Anthem Cash Balance Pension Plan effective January 1, 2006, is a cash balance pension plan sponsored by Anthem Insurance.
Prior to December 31, 2006, WellPoint Holding Corp. sponsored the Empire Blue Cross Blue Shield Cash Balance Pension Plan (the “Empire Plan”) a cash balance defined benefit plan which covered eligible employees of WellChoice and certain of its subsidiaries prior to WellPoint’s acquisition of WellChoice. The Empire Plan was merged into the Plan on December 31, 2006. Effective January 1, 2007, the plan sponsor curtailed benefits under the Empire Plan. As a result, most participants’ accounts no longer accrue pay credits, but continue to earn interest. Employees hired on or after January 1, 2007 are not eligible to participate in the Plan. Certain participants were “grandfathered” into the Plan based on age and years of service in the former Empire Plan. Grandfathered participants continue to receive pay credits under the Plan formula. There will be no curtailment gain or loss associated with the curtailment of benefits under the Empire Plan.
The UGS Pension Plan is a defined benefit pension plan, which covers eligible employees (including certain employees covered by a collective bargaining agreement) of National Government Services, Inc., which name changed from AdminaStar Federal, Inc. effective November 17, 2006, who were formerly employed by United Government Services, LLC (“UGS”). Effective January 1, 2004, the plan sponsor curtailed benefits under the UGS Pension Plan, resulting in most non-bargained participants’ accounts no longer accruing pay credits but continuing to earn interest. Employees subject to collective bargaining, as well as certain non-bargained employees who were “grandfathered” based on age and years of service, continue to receive pay credits. Non-bargained employees of UGS hired after December 31, 2003 are not eligible to participate in the UGS Pension Plan.
In addition, the Company offers certain employees postretirement benefits including certain life, medical, vision and dental benefits upon retirement. There are several postretirement benefit plans, which differ in amounts of coverage, deductibles, retiree contributions, years of service and retirement age. The Company may fund certain benefit costs through discretionary contributions to a Voluntary Employees’ Beneficiary Association (“VEBA”) trust. Other costs are accrued, with the retiree paying a portion of the costs. Postretirement plan assets held in the VEBA trust consist primarily of bonds and equity securities.
The net amount recognized in the consolidated balance sheets is as follows:
The amounts included in accumulated other comprehensive income that have not been recognized as components of net period benefit costs are as follows:
The estimated net actuarial loss and prior service cost (credit) for the defined benefit pension plans that will be amortized from accumulated other comprehensive income into net periodic benefit costs over the next fiscal year are $1.2 and $(0.6), respectively. The estimated net loss and prior service cost (credit) for postretirement benefit plans that will be amortized from accumulated other comprehensive income into net periodic benefit costs over the next fiscal year are $4.8 and $(2.9), respectively.
As of December 31, 2006, certain pension plans of the Company had accumulated benefit obligations in excess of plan assets. For those same plans, the projected benefit obligation was also in excess of plan assets. Such plans had a combined projected benefit obligation, accumulated benefit obligation and fair value of plan assets of $103.4, $94.5 and $0.0, respectively.
The weighted average assumed health care cost trend rates to be used for next year to measure the expected cost of other benefits is 9.00% with a gradual decline to 5.0% by the year 2012. These estimated trend rates are subject to change in the future. The health care cost trend rate assumption has a significant effect on the amounts reported. For example, an increase in the assumed health care cost trend rate of one percentage point would increase the postretirement benefit obligation as of December 31, 2006 by $44.3 and would increase service and interest costs by $2.9. Conversely, a decrease in the assumed health care cost trend rate of one percentage point would decrease the postretirement benefit obligation by $38.1 as of December 31, 2006 and would decrease service and interest costs by $2.6.
Plan assets include a diversified mix of investment grade fixed maturity securities and equity securities across a range of sectors and levels of capitalization to maximize the long-term return for a prudent level of risk. As of the measurement date, the Company’s weighted-average targeted asset allocation and actual allocation by asset category are as follows:
In May 2000, a case titled California Medical Association vs. Blue Cross of California, et al. (the “CMA Litigation”), was filed in U.S. district court in San Francisco against Blue Cross of California (“BCC”), a subsidiary of WHN at the time, and now a Company subsidiary. The lawsuit alleges that BCC violated the Racketeer Influenced and Corrupt Organizations Act (“RICO”).
In August 2000, WHN was added as a defendant to Shane v. Humana, et al., a class-action lawsuit brought on behalf of health care providers nationwide alleging RICO violations (the “Shane Litigation”). Effective upon the November 30, 2004 merger with WHN, WHN became a wholly owned subsidiary of the Company. On September 26, 2002, Anthem was added as a defendant to the Shane Litigation.
In October 2000, the federal Judicial Panel on Multidistrict Litigation (“MDL”) issued an order consolidating the CMA Litigation, the Shane Litigation and various other pending managed care class-action lawsuits against the Company and other companies before District Court Judge Federico Moreno in the Southern District of Florida for purposes of pretrial proceedings. A mediator was appointed by Judge Moreno and the parties conducted court-ordered mediation. On December 9, 2004, Judge Moreno issued a new scheduling order extending the expert discovery deadline to February 7, 2005 and setting trial for September 6, 2005.
On July 11, 2005, the Company entered into a settlement agreement (the “Agreement”) with representatives of more than 700,000 (actual number) physicians nationwide to resolve the CMA Litigation, the Shane Litigation, the Thomas Litigation and certain other similar cases brought by physicians. Under the Agreement,
the Company agreed to make cash payments totaling up to $198.0, of which $135.0 is to be paid to physicians and $5.0 contributed to a not-for-profit foundation whose mission is to promote higher quality health care and to enhance the delivery of care to the disadvantaged members of the public. In addition, up to $58.0 will be paid in legal fees to be determined by the court. The Company also has agreed to implement and maintain a number of operational changes such as standardizing the definition of medical necessity in physician contracts, creating a formalized Physician Advisory Committee and modifying some of the Company’s claims payment and physician contracting provisions. The Agreement was subject to, and conditioned upon, review and approval by the U.S. District Court for the Southern District of Florida. The court preliminarily approved the settlement in an order filed July 15, 2005. The hearing for final approval was held on December 2, 2005 in Miami, Florida. The Court issued a final order approving the settlement on December 22, 2005, and issued an amended final order approving the settlement on January 4, 2006. As a result of the Agreement, the Company incurred a pre-tax expense of $103.0, or $0.10 per diluted share after tax, for the year ended December 31, 2005, which represents the final settlement amount of the Agreement that was not previously accrued. Appeals of the settlement initially filed by certain physicians have been resolved. Final cash payments under the Agreement totaling $209.5, including accrued interest, were made on October 5 and 6, 2006.
The WellChoice transaction was closed on December 28, 2005, after the settlement was reached with the plaintiffs in the CMA Litigation, the Shane Litigation and the Thomas Litigation. The former WellChoice company, which was merged with and into a wholly-owned subsidiary of WellPoint, continues to be a defendant in the Thomas Litigation, and is not affected by the settlement between the Company and plaintiffs. The Company believes that any liability that may result from this action is unlikely to have a material adverse effect on its financial position or results of operations.
Prior to WHN’s acquisition of the group benefit operations (“GBO”) of John Hancock Mutual Life Insurance Company (“John Hancock”), John Hancock entered into a number of reinsurance arrangements, including with respect to personal accident insurance and the occupational accident component of workers’ compensation insurance, a portion of which was originated through a pool managed by Unicover Managers, Inc. Under these arrangements, John Hancock assumed risks as a reinsurer and transferred certain of such risks to other companies. Similar reinsurance arrangements were entered into by John Hancock following WHN’s acquisition of the GBO of John Hancock. These various arrangements have become the subject of disputes, including a number of legal proceedings to which John Hancock is a party. The Company is currently in arbitration with John Hancock regarding these arrangements. The Company believes that the liability that may result from this matter is unlikely to have a material adverse effect on its consolidated financial condition or results of operations.
The Company entered into certain agreements with International Business Machines Corporation (“IBM”) to provide information technology infrastructure services. These services were previously performed in-house. The Company’s remaining commitment under these contracts at December 31, 2006 is approximately $935.6 over a six year period. The Company has the ability to terminate these agreements upon the occurrence of certain events, subject to certain early termination fees.
On July 15, 2004, the Company agreed to guarantee up to $37.0 of debt incurred by an unaffiliated entity to partially finance the purchase of a hospital. While the maximum amount of the guaranty may be reduced in periods after September 30, 2006 as determined by reference to the leverage ratio (as defined in the guaranty) of the unaffiliated entity, the maximum guaranty remained $37.0 at December 31, 2006. The guaranty also provides for full payment of all obligations under the guaranty to become immediately due and payable under specified circumstances. In connection with the guaranty, the unaffiliated entity agreed to reimburse the Company upon demand for any amounts paid by the Company under the guaranty. The obligations of the unaffiliated entity under the reimbursement agreement are secured by a second lien on certain real estate collateral. In addition, the parent company of the unaffiliated entity has provided a guaranty in favor of the Company guaranteeing the obligations of the unaffiliated entity under the reimbursement agreement.
In connection with an investment in July 2004 in a joint venture to develop and operate a well-being center in California, the Company may be required to make an additional capital contribution of up to $18.0 during the first three years that the well-being center is in operation if cash flows and room nights generated by the Company do not exceed specified targets. Construction of the well-being center was completed during December 2006.
Through December 31, 2006, the Company had three reportable segments: Health Care, Specialty, and Other.
The Health Care segment is an aggregation of various operating segments, principally differentiated only by geography. These Health Care operating segments have similar economic, product, distribution, customer and regulatory characteristics, and meet the aggregation criteria as defined under paragraph 17 of FAS 131, Disclosures about Segments of an Enterprise and Related Information (“FAS 131”). Operating segments comprising the Health Care segment provide a broad spectrum of network-based health plans and other health care-related products to large and small employers and individuals.
The Specialty segment is maintained as a separate segment providing various products, including pharmacy benefits management, specialty pharmacy, dental, vision, life and disability insurance and behavioral health benefit services.
In addition to intersegment sales and expense eliminations and corporate expenses not allocated to reportable segments, the Other segment includes results from the Company’s government health services and other businesses that do not meet the quantitative thresholds for an operating segment defined under FAS 131.
The Company announced a new organizational structure designed to facilitate the Company’s 2010 strategic plan. This new structure emphasizes unique local presence, company-wide innovation and strong customer focus. As a result of this new organizational structure the Company is organized around two strategic business units: Commercial and Consumer Business, and Specialty, Senior and State-Sponsored Business. In addition, our
The accounting policies of the segments are consistent with those described in the summary of significant accounting policies in Note 2 except that certain shared administrative expenses for each segment are recognized on a pro rata allocated basis, which in aggregate approximates the consolidated expense. Any difference between the allocated expenses and actual consolidated expense is included in other expenses not allocated to reportable segments. Intersegment sales and expenses are recorded at cost, and eliminated in the consolidated financial statements. The Company evaluates performance of the reportable segments based on operating gain or loss as defined above. The Company evaluates investment income, interest expense, amortization expense and income taxes, and asset and liability details on a consolidated basis as these items are managed in a corporate shared service environment and are not the responsibility of segment operating management.
The classification between managed care products and managed care services for the Health Care segment in the above table primarily distinguishes between the level of risk assumed. Managed care products represent insurance products where the Company bears the insurance risk, whereas managed care services represent product offerings where the Company provides claims adjudication and other administrative services to the customer, but the customer principally bears the insurance risk.
WellPoint’s insurance subsidiaries are domiciled in various jurisdictions. These subsidiaries prepare statutory financial statements in accordance with accounting practices prescribed or permitted by the respective jurisdictions’ insurance regulators. Prescribed statutory accounting practices are set forth in a variety of publications of the NAIC as well as state laws, regulations and general administrative rules.
WellPoint’s ability to pay dividends and other credit obligations is significantly dependent on receipt of dividends from its subsidiaries. The payment of dividends to WellPoint by its insurance subsidiaries without prior approval of the insurance departments of each subsidiary’s domiciliary jurisdiction is limited by formula. Dividends in excess of these amounts are subject to prior approval by the respective state insurance departments.
WellPoint’s insurance subsidiaries are subject to risk-based capital requirements. Risk-based capital is a method developed by the NAIC to determine the minimum amount of statutory capital appropriate for an insurance company to support its overall business operations in consideration of its size and risk profile. The formula for determining the amount of risk-based capital specifies various factors, weighted based on the perceived degree of risk, which are applied to certain financial balances and financial activity. Below minimum risk-based capital requirements are classified within certain levels, each of which requires specified corrective action. As of December 31, 2006 and 2005, all of WellPoint’s insurance subsidiaries exceeded the minimum risk-based capital requirements.
Statutory-basis capital and surplus for WellPoint’s insurance subsidiaries was $7,981.6 and $7,487.0 at December 31, 2006 and 2005, respectively. Statutory-basis net income of WellPoint’s insurance subsidiaries was $2,931.2, $2,385.1 and $1,545.9 for 2006, 2005 and 2004, respectively. Statutory-basis net income includes WellChoice and WHN statutory results for the full year ended December 31, 2006 and 2005 and WHN statutory results for the full year ended December 31, 2004.