The table below sets forth premium by insurance division for each of the three most recent fiscal years (excluding for all periods presented premium associated with our former Star HRG Division and Student Insurance Division, which we disposed of in July and December 2006, respectively):
The Company establishes liabilities for benefit claims that have been reported but not paid and claims that have been incurred but not reported under health and life insurance contracts. These claim liabilities are developed using actuarial principles and assumptions. See discussion below under the caption “Critical Accounting Policies and Estimates - Claims Liabilities” and Note 6 of Notes to Financial Statements.
In July 2006 and December 2006, in two separate transactions, we sold the assets comprising our former Star HRG Division and our former Student Insurance Division. In connection with these sales, we recorded an aggregate pre-tax gain in the amount of $201.7 million, of which $101.5 million was attributable to the Star HRG transaction and $100.2 million was attributable to the Student Insurance transaction.
See Note 2 of Notes to Financial Statements for additional information regarding the terms of the sales of the Star HRG Division and Student Insurance Division assets.
The Company formerly capitalized commissions and premium taxes associated with its SEA Division business (classified as “deferred acquisition costs” (“DAC”)) and amortized all of these costs over the period (and in proportion to the amount) that the associated unearned premium was earned. The Company utilized this accounting methodology in preparing its reported 2006 interim financial statements.
commissions. As of January 1, 2006, the change in accounting policy resulted in an increase in the Company’s capitalized DAC of $77.6 million, a related increase to its deferred tax liability by $27.1 million, and a net increase to shareholders’ equity of $50.5 million. The adoption of this new accounting policy had the effect of increasing reported underwriting, policy acquisition costs and insurance expenses (classified to its SEA Division) in 2006 by $15.5 million and, correspondingly, reducing after-tax net income by $10.1 million.
The table below sets forth certain summary information about our consolidated operating results for each of the three most recent fiscal years. For purposes of this presentation, we have reclassified and netted the operating revenues and expenses attributable to our former Star HRG Division and Student Insurance Division (which we disposed of in July and December 2006, respectively) to the line item “Income (loss) from Student Insurance operations and Star HRG Division (net of income tax)”:
In 2007, the Company reported consolidated revenues and income from continuing operations of $1.6 billion and $69.4 million, respectively, compared to revenues and income from continuing operations in 2006 of $2.147 billion and $216.6 million, respectively. Reflecting results from discontinued operations, the Company reported overall 2007 net income of $70.2 million compared to 2006 net income of $237.7 million.
The following comparative discussion of results of operations is by segment and division, including our disposed operations consisting of the Student Insurance Division and the Star HRG Division.
Set forth below is certain summary financial and operating data for the Company’s Self-Employed Agency Division for each of the three most recent fiscal years:
Expense Ratio. The Expense ratio is defined as Underwriting and acquisition expenses as a percentage of Earned premium revenue.
Benefits expense increased in 2007 compared to 2006 as reflected in the loss ratio of 57.4% versus 54.3%, respectively. The increase in the loss ratio reflects an ongoing gradual shift in product mix to the Company’s CareOne product suite and other PPO products which are designed to provide a higher proportion of premium dollars as benefits. The amount of benefit expenses reported each year is impacted by the estimate of claim liabilities. See discussion below in “Critical Accounting Policies” in the sections titled “Estimates of Claim Liabilities” and “Changes in SEA Claim Liability Estimates.”
Set forth below is certain summary financial and operating data for the Company’s Life Insurance Division for each of the three most recent fiscal years:
Loss Ratio. The loss ratio is defined as Benefits expense as a percentage of Earned premium revenue.
Investment income on equity. Includes investment income not otherwise allocated to the Insurance segment.
In 2007, total investment income on equity and realized gains on investments of $46.2 million were $9.2 million greater than the $37.0 million earned in 2006. The 2007 results reflected particularly favorable earnings on an international fund investment which is not anticipated to recur based on the most recent activity in that market and a reduction in the size of our commitment in that investment vehicle.
Variable stock-based compensation expense decreased substantially between 2007 and 2006. We maintain for the benefit of our independent agents various stock-based compensation plans, in connection with which we record non-cash variable stock-based compensation expense or benefit based on the performance of the fair value of the Company’s common stock. In 2007, we recognized a benefit of $482,000 compared to an expense of $16.6 million in 2006. These results primarily reflect a decrease in the fair value of our common stock from 2006 to 2007 and an increase in the fair value of our common stock from 2005 to 2006.
The Company’s Student Insurance Division (which offered tailored health insurance programs that generally provided single school year coverage to individual students at colleges and universities) reported operating income of $192,000 in 2007 compared to $12.2 million in 2006. Very little activity remains in the Student Insurance Division since the sale on December 1, 2006.
The Company’s Star HRG Division reported an operating income in 2007 in the amount of $199,000 compared to $2.3 million in 2006. Very little activity remains in the Star HRG Division since it was sold on July 11, 2006.
The Company reported income from discontinued operations in 2007 in the amount of $789,000, net of tax, compared to income from discontinued operations of $21.2 million, net of tax, in 2006. The income for the year ended December 31, 2006 consisted primarily of a tax benefit attributable to the release of certain tax reserves and valuation allowances on deferred tax assets related to capital loss carryovers and other capital items that are currently recoverable as a result of the sale of the Star HRG Division at a gain. A significant portion of the released tax allowances and reserves were originally established during 2003.
Unless the context indicates otherwise, the following comparative discussion of our 2006 and 2005 results of operations excludes the operations of the Company’s Student Insurance Division and Star HRG Division which were sold in July and December 2006, respectively.
Due to an increase in the prevailing yield on short-term securities, student loans and other investments, investment income increased to $98.9 million in 2006 compared to $91.0 million in 2005.
Underwriting costs, policy acquisition costs and insurance expenses remained virtually unchanged in the periods ($508.6 million in 2006 and $498.7 million in 2005). A decrease in administrative expenses in 2006 at the SEA Division was somewhat offset by additional amortization of capitalized acquisition costs in the amount of $15.5 million associated with a change in the Company’s method of accounting for a portion of deferred acquisition costs. See discussion above under the caption “2006 Change in Accounting Policy.” The Company maintains for the benefit of its independent agents various stock-based compensation plans, in connection with which we record non-cash variable stock-based compensation expense (benefit) in amounts that depend and fluctuate based upon the performance of the Company’s common stock. In 2006, the Company recognized a non-cash stock based compensation expense in the amount of $16.6 million, compared to non-cash stock based compensation expense of $7.2 million in 2005. The increase is principally due to greater change in share price during 2006 compared to 2005.
Operating Income. Operating income (exclusive of operating results at the Company’s Star HRG Division and Student Insurance Division) increased by 5% to $337.8 million in 2006 from $320.6 million in 2005. As discussed more fully below, the Company’s 2006 results from continuing operations benefited from realized gains of $201.7 million recorded upon the sales of the Star HRG and Student Insurance Divisions. These gains were offset by an increase in Merger costs of $39.0 million (from $9.0 million in 2005 to $48.0 million in 2006), a $35.1 million increase in interest expense (from $6.0 million in 2005 to $41.1 million in 2006) and a 24% decrease in operating income at the SEA Division (from $310.5 million in 2005 to $236.5 million in 2006).
which in 2006 represented approximately 14% of total SEA Division earned premium revenue) are expected to provide a higher proportion of the premium as benefits. In 2006, underwriting, policy acquisition costs and insurance expenses included additional amortization of capitalized policy acquisition costs in the amount of $15.5 million associated with a change in the Company’s method of accounting for a portion of deferred acquisition costs. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations - - 2006 Change in Accounting Policy” above.
The amount of benefit expenses reported each year is impacted by the estimate of claim liabilities. See discussion below in “Critical Accounting Policies” in the sections titled “Estimates of Claim Liabilities” and “Changes in SEA Claim Liability Estimates.”
In 2006, the Company’s Life Insurance Division generated annualized paid premium volume (i.e., the aggregate annualized life premium amount associated with new life insurance policies issued by the Company) in the amount of $20.0 million compared to $32.9 million in 2005. Annualized paid premium volume for 2006 was negatively impacted by service issues associated with an outside vendor that assists the Company in gathering key underwriting information and a delay in production due to the introduction of redesigned products that are expected to improve return on capital.
Other significant items affecting the 2006 results in the Other Key Factors segment included a $9.4 million increase in variable stock-based compensation and an increase in general corporate expenses for the period to $39.8 million compared to $11.0 million incurred in the comparable period in 2005. These additional overhead expenses were principally associated with the change of the Company’s corporate name, the Company’s corporate branding initiative and monitoring fees paid to the Private Equity Investors.
The Company’s Student Insurance Division (which offered tailored health insurance programs that generally provide single school year coverage to individual students at colleges and universities) reported operating income of $12.2 million in 2006 compared to operating losses of $(8.9) million in 2005. Results for 2006 at the Student Insurance Division reflected a significant improvement in loss experience on the Student Insurance book of business. The loss ratio on this business decreased to 70.9% in 2006, from 78.7% in 2005, which reflected the benefits of non-renewing certain underperforming schools for the 2005-2006 school year. For 2006, operating results also benefited from lower administrative expenses as a percentage of earned premium and from better utilization of network service agreements with healthcare providers. Earned premium revenue at the Student Insurance Division decreased to $233.3 million in 2006, from $282.5 million in 2005. The decrease in premium reflected, in part, the non-renewal in the 2005-2006 school year of certain accounts that had performed poorly in the 2004-2005 school year. In addition, premium in 2006 reflected eleven months of activity through the date of sale.
The Company reported income from discontinued operations in 2006 in the amount of $21.2 million, net of tax ($0.59 per diluted share), compared to income from discontinued operations of $531,000, net of tax ($0.01 per diluted share), in 2005. The income for the year ended December 31, 2006 consisted primarily of a tax benefit attributable to the release of certain tax reserves and valuation allowances on deferred tax assets related to capital loss carryovers and other capital items that are currently recoverable as a result of the sale of the Star HRG Division at a gain. A significant portion of the released tax allowances and reserves were originally established during 2003 primarily because management did not anticipate realizing before its expiration the tax benefits of the capital loss carryover from the 2003 sale of the Company’s former student finance subsidiary.
On a consolidated level, the Company’s primary sources of liquidity have been premium revenues from policies issued, investment income, fees and other income, proceeds from corporate borrowings and borrowings to fund student loans. The primary uses of cash have been payments for benefits, claims and commissions under those policies, operating expenses, cash dividends to shareholders, stock repurchases and the funding of student loans. During 2007, the Company generated on a consolidated basis net cash from operations in the amount of $78.8 million, compared to net cash from operations of $42.8 million in 2006 and $185.4 million in 2005.
At December 31, 2007 and 2006, the Company had an aggregate of $97.4 million and $119.0 million, respectively, of indebtedness outstanding under a secured student loan credit facility, which indebtedness is represented by Student Loan Asset-Backed Notes issued by a bankruptcy-remote special purpose entity (the “SPE”). See Note 9 of Notes to Financial Statements. At December 31, 2007 and 2006, indebtedness outstanding under the secured student loan credit facility was secured by alternative (i.e., non-federally guaranteed) student loans and accrued interest in the carrying amount of $98.7 million and $111.2 million, respectively, and by a pledge of cash, cash equivalents and other qualified investments in the amount of $6.5 million and $14.2 million, respectively. Prior to February 1, 2007, the SPE was authorized by the terms of the agreements governing the securitization to purchase from the Company additional student loans generated under the Company’s College First Alternative Loan program. Subsequent to February 1, 2007 the Company funded loans with cash on hand from HealthMarkets LLC.
HealthMarkets Inc. is a holding company, the principal asset of which is its investment in its wholly owned subsidiary, HealthMarkets LLC (collectively referred to as “holding company” in this section). HealthMarkets LLC’s principal assets are its investment in its separate operating subsidiaries, including its regulated insurance subsidiaries. The holding company’s ability to fund its cash requirements is largely dependent upon its ability to access cash, by means of dividends or other means from its subsidiaries. The laws governing the Company’s insurance subsidiaries restrict dividends paid by the Company’s domestic insurance subsidiaries in any year. Inability to access cash from its subsidiaries could have a material adverse effect upon the Company’s liquidity and capital resources.
In April 2006, the Company utilized proceeds from additional indebtedness in the amount of $600.0 million, consisting of $500.0 million under a term loan credit facility and $100.0 million of Floating Rate Junior Subordinated Notes to finance the Merger.
During 2007, the Company made contributions or investments in subsidiaries of $15.4 million substantially representing the acquisition of Fidelity Life Insurance Company for $13.4 million.
During 2006, the holding company expended significant amounts of cash for expenses related to the Merger totaling $120.9 million.
On April 5, 2006, the Company utilized $1.6 billion to repurchase 43,567,252 shares of its common stock in the Merger.
All indebtedness issued under the secured student loan credit facility represent obligations solely of the SPE and not of the Company or any other subsidiary and is secured by student loans, accrued investment income, cash, cash equivalents and qualified investments. The payments related to the future policy benefits and claim liabilities reflected in the table above have been projected utilizing assumptions based on the Company’s historical experience and anticipated future experience.
Through February 1, 2007, the Company has funded its College Fund Life Division student loan commitments with the proceeds of indebtedness issued by a bankruptcy-remote special purpose entity (the “SPE Notes”). The indenture governing the terms of the SPE Notes provided that the proceeds of such SPE Notes could be used to fund student loan commitments only until February 1, 2007, after which any monies then remaining on deposit in the acquisition fund created by the indenture not used to purchase additional student loans are required to be used to redeem the SPE Notes. After February 1, 2007, the Company will fund loans with cash on hand from HealthMarkets LLC. During 2006, principal payments on the Notes were made in the amount of $12.0 million from the proceeds from the repayment on the student loan receivables. See Note 9 of Notes to Financial Statements.
At each of December 31, 2007 and 2006, the Company had $14.3 million and $9.6 million, respectively, of letters of credit outstanding relating to its insurance operations.
The Company’s Investment Committee monitors the investment portfolio of the Company and its subsidiaries. The Investment Committee receives investment management services from external professionals and from the Company’s in-house investment management team. The internal investment management team monitors the performance of the external managers as well as directly managing approximately 68% of the investment portfolio.
Investments are reviewed quarterly (or more frequently if certain indicators arise) to determine if they have suffered an impairment of value that is considered other than temporary. Management’s review considers the following indicators of impairment: fair value significantly below cost; decline in fair value attributable to specific adverse conditions affecting a particular investment; decline in fair value attributable to specific conditions, such as conditions in an industry or in a geographic area; decline in fair value for an extended period of time; downgrades by rating agencies from investment grade to non-investment grade; financial condition deterioration of the issuer and situations where dividends have been reduced or eliminated or scheduled interest payments have not been made. Management monitors investments where two or more of the above indicators exist. The Company also identifies investments in economically challenged industries. If investments are determined to be other than temporarily impaired, a loss is recognized at the date of determination.
Fixed maturity securities represented 88.0% and 76.3% of the Company’s total investments at December 31, 2007 and 2006, respectively. Fixed maturity securities at December 31, 2007 consisted of the following:
A quality distribution for fixed maturity securities at December 31, 2007 is set forth below:
Set forth below is a summary of the Company’s gross unrealized losses in its portfolio of fixed maturity securities as of December 31, 2007:
At December 31, 2007, the Company had $23.0 million of unrealized losses in its fixed maturities portfolio. Of the $5.8 million in unrealized losses that have existed for less than twelve months, two securities have unrealized losses in excess of 10% of the security’s cost. The amount of unrealized loss with respect to those securities was $2.4 million at December 31, 2007. Of the $17.2 million in unrealized losses that have existed for twelve months or longer, nine securities had an unrealized loss in excess of 10% of the security’s cost. The amount of unrealized loss with respect to those securities was $6.8 million at December 31, 2007. Included with the nine securities that had unrealized losses in excess of 10% and classified as “Other” in the table above is the Company’s residual interest in Grapevine Finance LLC.
At December 31, 2007, Grapevine Finance LLC had an unrealized loss of $1.7 million, or 27.1% of cost. See Notes 3 and 11 of Notes to Financial Statements. The Company believes that the cash flows received from the security have not changed from those that were expected when the securitization was complete in 2006.
Company’s aggregate investment portfolio at December 31, 2007 and 2006, excluding investments in U.S. Government securities:
The Fidelity Institutional Money Market Fund is a diversified institutional money market fund that invests solely in high quality United States dollar denominated money market securities of domestic and foreign issuers.
For the majority of health insurance products in the Self-Employed Agency Division, the Company’s claim liabilities are estimated using the developmental method, which involves the use of completion factors for most incurral months, supplemented with additional estimation techniques, such as loss ratio estimates, in the most recent
incurral months. This method applies completion factors to claim payments in order to estimate the ultimate amount of the claim. These completion factors are derived from historical experience and are dependent on the incurred dates of the claim payments. The completion factors are selected so that they are equally likely to be redundant as deficient.
The Company establishes the claims liability using the original incurred date, with certain adjustments as described below. Under this incurred date methodology, claims liabilities for the cost of all medical services related to the accident or sickness are recorded at the earliest date of diagnosis or treatment, even though the medical services associated with such accident or sickness might not be rendered to the insured until a later financial reporting period. A break in service of more than six months will result in the establishment of a new incurred date for subsequent services. A new incurred date will be established if claims payments continue for more than thirty-six months without a six month break in service.
For example, if the loss ratio increased from 50% to 56% this would be an increase of “6.”
The SEA Division also makes various refinements to the claim liabilities as appropriate. These refinements estimate liabilities for circumstances, such as inventories of pending claims in excess of historical levels and disputed claims. When the level of pending claims appears to be in excess of normal levels, the Company typically establishes a liability for excess pending claims. The Company believes that such an excess pending claims liability is appropriate under such circumstances because of the operation of the developmental method used to calculate the principal claim liability, which method “develops” or “completes” paid claims to estimate the claim liability. When the pending claims inventory is higher than would ordinarily be expected, the level of paid claims is correspondingly lower than would ordinarily be expected. This lower level of paid claims, in turn, results in the developmental method yielding a smaller claim liability than would have been yielded with a normal level of paid claims, resulting in the need for an augmented claim liability.
Set forth below is a summary of claim liabilities by business unit at each of December 31, 2007, 2006 and 2005:
Reflects liability related to unpaid losses recoverable. The amount associated with Disposed Operations in 2007, 2006 and 2005 is $26.8 million, $61.3 million, and $2.7 million, respectively.
The developmental method used by the Company to estimate most of its claim liabilities produces a single estimate of reserves for both in course of settlement (ICOS) and incurred but not reported (IBNR) claims on an integrated basis. Since the IBNR portion of the claim liability represents claims that have not been reported to the Company, this portion of the liability is inherently more imprecise and difficult to estimate than other liabilities. A separate IBNR or ICOS reserve is estimated from the combined reserve by allocating a portion of the combined reserve based on historical payment patterns. Approximately 83-85% of the Company’s claim liabilities represent IBNR claims.
Set forth in the table below is the summary of the incurred but not reported claim liability by business unit at each of December 31, 2007, 2006 and 2005:
For the SEA Division, the favorable claims liability development experience in the prior year’s reserve for each of the years ended December 31, 2007, 2006 and 2005 is set forth in the table below by source:
As indicated in the table above, considerable favorable development ($35.5 million, $36.6 million and $74.3 million for year ended December 31, 2007, 2006 and 2005, respectively) is associated with the estimate of claim liabilities for the most recent incurral months and development of completion factors. The completion factors are derived from historical experience, and favorable or unfavorable development may result when current claim payment patterns differ from historical patterns. The completion factors are selected so that they are equally likely to be redundant as deficient. In estimating the ultimate level of claims for the most recent incurral months, the Company uses what it believes are prudent estimates that reflect the uncertainty involved in these incurral months. An extensive degree of judgment is used in this estimation process. Over time, the developmental method replaces anticipated experience with actual experience, resulting in an ongoing re-estimation of the claims liability. Since the greatest degree of estimation is used for more recent periods, the most recent prior year is subject to the greatest change. Recent actual experience has produced lower levels of claims payment experience than originally expected. The favorable development also reflects changes in the assumptions used to calculate the estimate of the claim liability. See discussion below regarding Changes in SEA Claim Liability Estimates.
Impact on Life Insurance Division. The varied claim liability development experience at the Life Insurance Division for each of the years presented is due to the development of a closed block of workers’ compensation business.
Impact on Disposed Operations. The products of the Company’s former Student Insurance and Star HRG Divisions consist principally of medical insurance. In general, medical insurance business, for which incurred dates are assigned based on date of service, has a “short tail,” which means that a favorable development or unfavorable development shown for prior years relates primarily to actual experience in the most recent prior year. During 2007, the development of the claim liabilities for the Disposed Operations showed a small favorable development of $43,000.
The favorable claim liability development experience at the Student Insurance Division in 2006 and 2005 was $478,000 and $5.2 million, respectively. This favorable development was due to claims in the current year developing more favorably than indicated by the loss trends used to determine the claim liability at December 31 of the preceding year.
The favorable claims liability development experience at Star HRG Division of $1.4 million in 2006 included the effects of claims in 2006 developing more favorably than indicated by the loss trends in 2005 used to determine the claim liability at December 31, 2005. The unfavorable claim liability development at the Star HRG Division in 2005 of $410,000 was within the normal statistical variation in the model used to develop the reserve. The actual development of prior years’ claims exceeded the expected development of the claim liability.
2007 Change in Claim Liability Estimates. During 2007, the Company made the following refinements to its claim liability estimate.
A reduction in the claim liability of $11.2 million recorded in the fourth quarter was attributable to an update of the completion factors used in the developmental method of estimating the unpaid claim liability to reflect more recent claims payment experience.
2006 Change in Claim Liability Estimates. During 2006, the Company made the following refinements to its claim liability estimate.
In the third quarter, the Company reduced the claim liability estimate by $11.2 million due to refinements of the estimate of the unpaid claim liability for the most recent incurral months. This update to the calculation distinguished between more mature products with reliable historical data and newer or lower volume products that had not established a reliable historical trend.
2005 Change in Claim Liability Estimates. During 2005, the Company made the following refinements to its claim liability estimate.
The Company incurs various costs in connection with the origination and initial issuance of its health insurance policies, including underwriting and policy issuance costs, costs associated with lead generation activities and distribution costs (i.e., sales commissions paid to agents). The Company defers those costs that vary with production. The Company generally defers commissions paid to agents and premium taxes with respect to the portion of health premium collected but not yet earned and the Company amortizes the deferred expense over the period as and when the premium is earned. Costs associated with generating sales leads with respect to the health business issued through the SEA Division are capitalized and amortized over the average life of a policy, which approximates a two-year period. Other underwriting and policy issuance costs (which the Company estimates are more fixed than variable) are expensed as incurred.
The cost of business acquired through acquisition of subsidiaries or blocks of business is determined based upon estimates of the future profits inherent in the business acquired. Such costs are capitalized and amortized over the estimated premium-paying period. Anticipated investment income is considered in determining whether a premium deficiency exists. The amortization period is adjusted when estimates of current or future gross profits to be realized from a group of products are revised.
We monitor and assesses the recoverability of deferred health and life policy acquisition costs on a quarterly basis.
The Company accounts for goodwill and other intangibles according to Financial Accounting Standards Board (“FASB”) FAS No. 142, Goodwill and Other Intangible Assets (“FAS 142”). FAS 142 requires that goodwill and other intangible assets with indefinite useful lives be tested for impairment at least annually or more frequently if certain indicators arise. An impairment loss would be recorded in the period such determination was made. FAS 142 also requires that intangible assets with estimable useful lives be amortized over their respective estimated useful lives to their estimated residual values and reviewed for impairment. The Company amortizes its intangible assets with estimable useful lives over a period ranging from one to twenty-five years. See Note 5 of Notes to Financial Statements.
The Company sponsors a series of stock accumulation plans (the “Agent Plans”) established for the benefit of the independent insurance agents and independent sales representatives associated with UGA - Association Field Services and Cornerstone America. The Company has established a liability for future unvested benefits under the Agent Plans and adjusts the liability based on the fair value of the Company’s Common Stock. The accounting treatment of the Company’s Agent Plans has resulted and will continue to result in unpredictable stock-based compensation charges, dependent upon fluctuations in the fair value of HealthMarkets Class A-2 common stock. These unpredictable fluctuations in stock based compensation charges may result in material non-cash fluctuations in the Company’s results of operations. See discussion above under the caption “Variable Stock-Based Compensation” and Note 14 of Notes to Financial Statements.
The Company has classified its investments in securities with fixed maturities as available for sale. Investments in equity securities and securities with fixed maturities have been recorded at fair value, and unrealized investment gains and losses are reflected in stockholders’ equity. Investment income is recorded when earned, and capital gains and losses are recognized when investments are sold. Investments are reviewed quarterly to determine if they have suffered an impairment of value that is considered other than temporary. If investments are determined to be other than temporarily impaired, a loss is recognized at the date of determination.
Testing for impairment of investments also requires significant management judgment. The identification of potentially impaired investments, the determination of their fair value and the assessment of whether any decline in value is other than temporary are the key judgment elements. The discovery of new information and the passage of time can significantly change these judgments. Revisions of impairment judgments are made when new information becomes known, and any resulting impairments are made at that time. The economic environment and volatility of securities markets increase the difficulty of determining fair value and assessing investment impairment. The same influences tend to increase the risk of potentially impaired assets.
On August 3, 2006, Grapevine Finance LLC (“Grapevine”) was incorporated in the State of Delaware as a wholly owned subsidiary of HealthMarkets, LLC. On August 16, 2006, the Company distributed and assigned to Grapevine the $150.8 million promissory note (“CIGNA Note”) and related Guaranty Agreement issued by Connecticut General Corporation in the Star HRG sale transaction (see Note 2 of Notes to Financial Statements). On August 16, 2006, Grapevine issued $72.4 million of its senior secured notes to an institutional purchaser collateralized by Grapevine’s assets including the CIGNA Note. The net proceeds from the senior secured notes were distributed to HealthMarkets, LLC.
The Company establishes a valuation allowance when management believes, based on the weight of the available evidence, that it is more likely than not that some portion of the deferred tax asset will not be realized. The Company considers future taxable income and ongoing prudent and feasible tax planning strategies in assessing the continued need for a recorded valuation allowance. Establishing or increasing the valuation allowance would result in a charge to income in the period such determination was made. In the event the Company were to determine that it would be able to realize its deferred tax assets in the future in excess of its net recorded amount, an adjustment to the deferred tax asset would increase income in the period such determination was made.
Student Insurance and the Star HRG Divisions generated capital gains in excess of the capital loss carryover. Accordingly, in 2006, the Company released the valuation allowance of $18.1 million thereby realizing the deferred tax benefits of the capital loss carryforwards.
The business of insurance is primarily regulated by the states and is also affected by a range of legislative developments at the state and federal levels. Recently-adopted legislation and regulations governing the use and security of individuals’ nonpublic personal data by financial institutions, including insurance companies, may have a significant impact on the Company’s business and future results of operations. See “Business - Regulatory and Legislative Matters.”
Dividends paid by domestic insurance companies out of earned surplus in any year are limited by the law of the state of domicile. See Item 5 - Market for Registrant’s Common Stock and Related Stockholder Matters and Note 13 of Notes to Financial Statements.
On March 19, 2008 the FASB issued FAS No. 161, Disclosures about Derivative Instruments and Hedging Activities, which amends FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities. The Statement requires companies with derivative instruments to disclose information that should enable financial statement users to understand how and why a company uses derivative instruments, how derivative instruments and related hedged items are accounted for under FAS No. 133, and how derivative instruments and related hedged items affect a company’s financial position, financial performance, and cash flows. The required disclosures include the fair value of derivative instruments and their gains or losses in tabular format, information about credit risk related contingent features in derivative agreements, counterparty credit risk, and a company’s strategies and objectives for using derivative instruments. The Statement expands the current disclosure framework in FAS No. 133. FAS No. 161 is effective prospectively for period beginning on or after November 15, 2008. The Company is currently evaluating the impact of this pronouncement on its financial position and results of operations.
In September 2006, the FASB issued Statement No. 157, Fair Value Measurement (FAS 157), which defines fair value as the price that would be received to sell an asset or that would be paid to transfer a liability in an orderly transaction between market participants at the measurement date. FAS 157 establishes a framework for measuring