We currently own and occupy our executive offices located at 9151 Boulevard 26, North Richland Hills, Texas 76180-5605 and 8825 Bud Jensen Drive, North Richland Hills, Texas 76180-5605 comprising in the aggregate approximately 281,000 and 30,000 square feet, respectively, of office and warehouse space. In addition, we lease office space at various locations.
Premiums on health insurance contracts are recognized as earned over the period of coverage on a pro rata basis. Premiums on traditional life insurance are recognized as revenue when due.
The Company’s expenses consist primarily of insurance claims expense and expenses associated with the underwriting and acquisition of insurance policies. Claims expenses consist primarily of payments to physicians, hospitals and other healthcare providers under health policies and include an estimated amount for incurred but not reported and unpaid claims. Underwriting, policy acquisition costs and insurance expenses consist of direct expenses incurred across all insurance lines in connection with issuance, maintenance and administration of in-force insurance policies, including amortization of deferred policy acquisition costs, commissions paid to agents, administrative expenses and premium taxes. The Company also incurs other direct expenses in connection with generating income derived by the Self-Employed Agency Division from ancillary services and membership
As part of the sale transactions, insurance subsidiaries of the Company entered into 100% coinsurance arrangements with each of the purchasers, pursuant to which (a) the purchasers agreed to assume liability for all future claims associated with the Star HRG and Student Insurance blocks of group accident and health insurance policies in force as of the respective closing dates and (b) the Company’s insurance subsidiaries transferred to the purchasers cash in an amount equal to the actuarial estimate of those future claims. While under the terms of the coinsurance agreements the Company’s insurance subsidiaries have ceded liability for all future claims made on the insurance policies in force at the closing date, the insurance subsidiaries remain primarily liable on those policies. Accordingly, for financial reporting purposes, at December 31, 2006 the Company has reflected and will continue to reflect the policy liabilities ceded to and assumed by the purchasers under the coinsurance agreements as “Policy liabilities” on its Consolidated Balance Sheet, with a corresponding amount recorded as a “Reinsurance receivable” on its Consolidated Balance Sheet. At December 31, 2006, the Company had recorded on its Consolidated Balance Sheet aggregate policy liabilities in the amount of $1.1 billion, of which $134.1 million was attributable to the Star HRG and Student Insurance policy liabilities ceded to and assumed by the purchasers under the coinsurance agreements. Correspondingly, at December 31, 2006, the Company had recorded a reinsurance receivable in the amount of $155.3 million, of which an aggregate of $132.8 million was attributable to the Star HRG and Student Insurance coinsurance agreements. In addition, for financial reporting purposes the Company will continue to report in future periods the residual results of operations of these businesses (anticipated to consist solely of residual wind-down expenses and any true-up, claw-back or earn-out items associated with the sales) in continuing operations and classified to the Company’s Disposed Operations business segment.
During 2006, the Company’s financial condition, cash flow and results from operations were impacted by the following key factors and developments:
The Company’s 2006 results from continuing operations reflected a 24% year-over-year decrease in operating income at its SEA Division. The SEA Division reported operating income in 2006 of $236.5 million, compared to operating income of $310.5 million in 2005. Results at the Company’s SEA Division in 2006 were negatively impacted by an increase in the health loss ratio (which increased to 54.3% in 2006 from 51.5% in 2005) and additional expense in the amount of $15.5 million associated with a change in accounting policy with respect to amortization of a portion of deferred acquisition costs. See the discussion below under the caption “2006 Change in Accounting Methodology.”.
During 2006, the Company incurred interest expense in the amount of $28.6 million associated with indebtedness incurred in connection with the Merger completed on April 5, 2006. In connection with the Merger, the Company borrowed $500.0 million under a term loan credit facility and issued $100.0 million of Floating Rate Junior Subordinated Notes. See Note I of Notes to Consolidated Financial Statements
Effective December 31, 2006, the Company changed its accounting policy with respect to the amortization of a portion of deferred acquisition costs associated with commissions paid to agents.
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.
The Company has elected to utilize the one time special transition provisions of SAB 108 and recorded an adjustment to retained earnings effective January 1, 2006 to reflect this change in accounting policy with respect to the capitalization and amortization of deferred acquisition costs associated with excess first and second year commissions. As of January 1, 2006, the change in accounting policy resulted in an increase in the Company’s capitalized deferred acquisition cost (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 the amount of $15.5 million and, correspondingly, reducing after-tax net income by $10.1 million. The Company has reflected the effects of this change in accounting policy for the 2006 interim periods in the “Quarterly Results” table in Management’s Discussion and Analysis of Financial Condition and Results of Operations.
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 operations (net of income tax)”:
See “Management’s Discussion and Analysis of Financial Condition and Results of Operations - 2006 Compared to 2005, Disposed Operations.”
Unless the context indicates otherwise, the following discussion comparative 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.
The Company experienced a 5% decrease in health premium revenue (to $1.364 billion in 2006 from $1.429 billion in 2005). This decrease was attributable to the decline in submitted annualized premium volume at the SEA Division in years prior to 2006. However, during 2006, annualized premium volume increased by 10% over annualized premium volume in 2005.
Life premiums and other considerations increased by 7%, to $65.7 million in 2006 from $61.6 million in 2005. This increase was attributable primarily to incremental sales of life products through relationships with two independent marketing companies and growth in renewal business from life products sold during 2004 and 2005.
Underwriting costs, policy acquisition costs and insurance expenses remained virtually unchanged in the periods ($492.0 million in 2006 and $491.5 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.”
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).
containment expenses resulting from the Company’s initiatives to control medical costs. Products in the CareOne product suite (sales of 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.
Results for the year ended December 31, 2006, also reflected a benefit in the amount of $47.1 million attributable to refinements of the Company’s estimate for its claim liability on its health insurance products. Of the $47.1 million of refinements to the estimated claim liability, $44.5 million is attributable to prior years.
An additional adjustment to the claim liability (approximately $25.1 million, of which $10.5 million was recorded in the third quarter and $14.6 million was recorded in the fourth quarter) was attributable to an update of the completion factors used in estimating the claim liability for the Accumulated Covered Expense (“ACE”) rider, an optional benefit rider available with certain scheduled/basic health insurance products that provides for catastrophic coverage for covered expenses under the contract that generally exceed $100,000 or, in certain cases, $75,000. This rider pays benefits at 100% after the stop loss amount is reached, up to the aggregate maximum amount of the contract for expenses covered by the rider. This adjustment to the claim liability reflects both actual historical data for the ACE rider and historical data derived from other products. Previously, the completion factors were calculated with more emphasis placed on historical data derived from other products, since there was insufficient data related to the ACE product rider to provide accurate and reliable completion factors. Had these refinements been made at December 31, 2005, the claim liability estimate would have been reduced by $19.1 million.
The loss ratio represents benefits, claims and settlement expenses related to accident insurance and reinsurance contracts stated as a percentage of earned premiums. The expense ratio represents underwriting, contract acquisition costs and expenses related to accident insurance and reinsurance contracts stated as a percentage of earned premiums.
The Other Insurance division consists of the operations of ZON Re USA LLC (an 82.5%-owned subsidiary), which underwrites, administers and issues accidental death, accidental death and dismemberment (AD&D), accident medical and accident disability insurance products, both on a primary and on a reinsurance basis. In 2006, ZON Re generated revenues and operating income of $35.3 million and $5.5 million, respectively, compared to revenues and operating income of $34.8 million and $4.7 million, respectively, in 2005.
The Other Key Factors segment reported operating income in 2006 of $90.5 million, compared to an operating loss of $(1.6) million in 2005.
The increase in operating income in the Other Key Factors segment in 2006 reflected the gains of approximately $201.7 million on the sales of substantially all of the assets comprising the Company’s Star HRG and Student Insurance operations completed in 2006. Results in 2006 also included Merger transaction costs in the amount of $48.0 million. The increase in interest expense on non-student loan debt in the 2006 period was due to the Merger-related indebtedness incurred in the second quarter of 2006. In connection with the Merger, the Company borrowed $500.0 million under a term loan credit facility and issued $100.0 million of Floating Rate Junior Subordinated Notes. See Note I of Consolidated Financial Statements.
On July 11, 2006 and December 1, 2006, the Company completed the sales of the assets formerly comprising its Star HRG and Student Insurance Divisions, respectively. See Note C of Notes to Consolidated Financial Statements.
Set forth below is certain summary financial and operating data for the Company’s former Star HRG Division (which designed, marketed and administered limited benefit health insurance plans for entry level, high turnover, and hourly employees) for each of the three most recent fiscal years:
The health loss ratio represents benefits, claims and settlement expenses related to health insurance policies stated as a percentage of earned health premiums. The health expense ratio represents underwriting expenses, policy acquisition costs and insurance expenses related to health insurance policies stated as a percentage of earned health premiums.
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
HealthMarkets reported revenues and income from continuing operations in 2005 of $2.121 billion and $203.0 million ($4.31 per diluted share), respectively, compared to 2004 revenues and income from continuing operations of $2.069 billion and $145.9 million ($3.07 per diluted share), respectively. Reflecting results from discontinued operations, the Company reported overall 2005 net income of $203.5 million ($4.32 per diluted share), compared to 2004 net income of $161.6 million ($3.40 per diluted share).
Revenues. HealthMarkets’ revenues increased to $1.684 billion in 2005 from $1.612 billion in 2004, an increase of $71.9 million, or 4%. The Company’s revenues were particularly impacted by the following factors:
The Company generated a 4% increase in health premium revenue (to $1.429 billion in 2005 from $1.370 billion in 2004), which increase was primarily attributable to the assumption of existing health policies acquired in October 2004 as part of the acquisition by the Company of substantially all of the assets of HealthMarket Inc.
Benefits, claims and settlement expenses increased nominally to $777.7 million in 2005 from $776.5 million in 2004.
The Company maintains for the benefit of its employees and independent agents various stock-based compensation plans, in connection with which it records 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 2005, the Company recognized a non-cash stock based compensation expense in the amount of $7.2 million, compared to non-cash stock based compensation expense of $14.3 million in 2004. The decrease is principally due to the smaller change in share price during 2005 (from $33.90 to $35.51)
compared to 2004 (from $13.28 to $33.90) and a decrease in the amount of unvested credits to 1,571,952 from 1,904,526.
Results at the SEA Division in both 2004 and 2005 reflected an aggregate benefit attributable to refinements of the Company’s estimate for its claim liability on its health insurance products. Results at the SEA Division in 2004 reflected a benefit associated with the reduction in the amount of $47.8 million of claim liabilities established in 2003 in response to a rapid pay down in 2003 of an excess pending claims inventory. In 2005, the Company recognized an aggregate benefit attributable to refinements of the Company’s estimate for its claim liability on its health insurance products in the amount of $40.9 million, of which $7.6 million was recorded in the first quarter of 2005 and $33.3 million was recorded in the third quarter of 2005.
The increase in operating margin in 2005 compared to 2004 was attributable primarily to the year-over-year increase in earned premium, lower loss ratio and a decrease in the effective commission rate (due to a decrease in the amount of first year premium relative to renewal premium, which carries a lower commission rate compared to commissions on first year premium). These factors favorably impacting operating margin in 2005 were offset by higher administrative expenses as a percentage of premium (which resulted from certain administrative costs associated with the previously announced multi-state market conduct review) and incremental administrative costs associated with the Company’s small group business acquired in November 2004.
In 2005, total SEA Division submitted annualized premium volume decreased by 16.3%, to $720.4 million in 2005 from $860.4 million in 2004. The decrease in submitted annualized premium volume can be attributed primarily to a reduction in the average number of writing agents per week in the field (from 2,329 in 2004 to 2,039 in 2005).
For the year ended December 31, 2005, 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 $32.9 million compared to $32.7 million in the corresponding 2004 period. Annualized paid premium volume for the fourth quarter of 2005 was negatively impacted by a slowdown in agent recruitment by the two independent marketing companies that distribute our products through networks of managing general agents (MGAs), who were waiting for the 2006 introduction of new life products.
The Company’s Other Key Factors segment reported operating losses of $(1.6) million in 2005, compared to operating income of $461,000 in 2004. The increase in operating losses in 2005 in the Other Key Factors segment was primarily attributable to a decrease in net realized gains associated with the Company’s investment portfolio
The Company’s Student Insurance Division (which until its disposition by the Company in December 2006 offered tailored health insurance programs that generally provide single school year coverage to individual students at colleges and universities) reported operating losses of $(8.9) million in 2005 compared to operating losses of $(49.5) million in 2004. Results for 2005 at the Student Insurance Division reflected a significant improvement in loss experience on the Student Insurance book of business. The loss ratio decreased to 78.7% in 2005, from 89.4% in 2004. For 2005, 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. Results in 2004 also reflected a second quarter impairment charge in the amount of $6.3 million, which was principally associated with the abandonment of computer hardware and software assets associated with a claims processing system. Earned premium revenue at the Student Insurance Division decreased to $282.5 million in 2005, from $297.0 million in 2004. 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.
The Company reported income from discontinued operations in 2005 the amount of $531,000, net of tax ($0.01 per diluted share) compared to income from discontinued operations of $15.7 million, net of tax ($0.33 per diluted share) in 2004.
The Company sponsors a series of stock accumulation plans established for the benefit of the independent insurance agents and independent sales representatives associated with its independent agent field forces, including UGA - Association Field Services and Cornerstone America. In connection with these plans, the Company has from time to time recorded and will continue to record non-cash variable stock-based compensation expense in amounts that depend and fluctuate based upon the fair value of the Company’s common stock. For financial reporting purposes, the Company reflects all non-cash variable stock based compensation associated with its agent stock plans in its “Other Key Factors” business segment. See Note Q of Notes to Consolidated Financial Statements.
The accounting treatment of the Company’s agent plans has resulted and will continue to result in unpredictable non-cash stock-based compensation charges, primarily dependent upon future fluctuations in the prevailing fair value of HealthMarkets common stock. These unpredictable fluctuations in stock based compensation charges may result in material non-cash fluctuations in the Company’s results of operations. Unvested benefits
under the agent plans vest in January of each year; accordingly, in periods of general appreciation in the price of HealthMarkets common stock, the Company’s cumulative liability, and corresponding charge to income, for unvested stock-based compensation is expected to be greater in each successive quarter during any given year.
Approximately $11.2 million of the benefit (recorded in the third quarter) was due to refinements of the estimate of the unpaid claim liability for the most recent incurral months. The calculation of the claim liability now distinguishes between more mature products with reliable historical data and newer or lower volume products that have not established a reliable historical trend. Had this refinement been made at December 31, 2005, the claim liability estimate would have been reduced by $14.8 million.
Results at the SEA Division in 2005 reflected an aggregate benefit in the amount of $40.9 million attributable to refinements of the Company’s estimate for its claim liability on its health insurance products. For financial reporting purposes, each of these refinements is considered to be a change in estimate, resulting from additional information and subsequent developments from prior periods. Accordingly, the financial impact of the refinements was accounted for in the respective periods that the refinements occurred.
not increased as rapidly as anticipated. This favorable claims experience has been reflected in the refinement of the anticipated loss ratios used in estimating the unpaid claim liability for the most recent incurral months. The remaining portion of the adjustment to the claim liability (approximately $12.3 million) was attributable to an update of the completion factors used in the developmental method of estimating the unpaid claim liability to reflect more current claims administration practices.
In addition, effective January 1, 2005, the Company’s SEA Division made certain refinements to its claim liability calculations related to the ACE rider, the effect of which decreased claim liabilities and correspondingly increased operating income in the amount of $7.6 million in the first quarter of 2005. Prior to January 1, 2005, the SEA Division utilized a technique that is commonly used to estimate claims liabilities with respect to developing blocks of business, until sufficient experience is obtained to allow more precise estimates. The Company believed that the technique produced appropriate reserve estimates in all prior periods. During the first quarter of 2005, the Company believed that there were sufficient claims paid on this benefit to produce a reserve estimate utilizing the completion factor technique. As a result, effective January 1, 2005, the SEA Division refined its technique used to estimate claim liabilities to utilize completion factors for older incurral dates. The technique continues to utilize anticipated loss ratios in the most recent incurral months. This completion factor technique utilized historical data derived from other products since there was insufficient data related to the ACE product rider to provide accurate and reliable completion factors.
The following table presents the information for each of the Company’s fiscal quarters in 2006 and 2005. This information is unaudited and has been prepared on the same basis as the audited Consolidated Financial Statements of the Company included herein and, in management’s opinion, reflects all adjustments necessary for a fair presentation of the information for the periods presented. The Company has elected to utilize the one time special transition provisions of SAB 108 and recorded an adjustment to retained earnings effective January 1, 2006 to reflect this change in accounting policy with respect to the capitalization and amortization of deferred acquisition costs associated with excess first and second year commissions. As of January 1, 2006, the change in accounting policy resulted in an increase in the Company’s capitalized deferred acquisition cost (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 the amount of $15.5 million and, correspondingly, reducing after-tax net income by $10.1 million. The Company has reflected the effects of this change in accounting policy for the 2006 interim periods in the “Quarterly Results” table below. The operating results for any quarter are not necessarily indicative of results for any future period.
In connection with the Merger, the Company borrowed $500.0 million under a term loan credit facility and issued $100.0 million of Floating Rate Junior Subordinated Notes. This indebtedness is more particularly described below:
The revolving credit facility will mature on April 5, 2011, and the term loan facility will mature on April 5, 2012. The term loan required nominal quarterly installments (not exceeding 0.25% of the aggregate principal amount at the date of issuance) until the maturity date, at which time the remaining principal amount is due. As a result of the $60.0 million prepayment, the Company is not obligated to make future nominal quarterly installments as previously required by the credit agreement. Borrowings under the credit agreement may be subject to certain mandatory prepayments. At HealthMarkets, LLC’s election, the interest rates per annum applicable to borrowings under the credit agreement are based on a fluctuating rate of interest measured by reference to either (a) LIBOR plus a borrowing margin, or (b) a base rate plus a borrowing margin. HealthMarkets, LLC will pay (a) fees on the unused loan commitments of the lenders, (b) letter of credit participation fees for all letters of credit issued, plus fronting fees for the letter of credit issuing bank, and (c) other customary fees in respect of the credit facility. Borrowings and other obligations under the credit agreement are secured by a pledge of HealthMarkets, LLC’s interest in substantially all of its subsidiaries, including the capital stock of MEGA, Mid-West and Chesapeake.
On April 5, 2006, HealthMarkets Capital Trust I and HealthMarkets Capital Trust II (two newly formed Delaware statutory business trusts) (collectively the “Trusts”) issued $100.0 million of floating rate trust preferred securities (the “Trust Securities”) and $3.1 million of floating rate common securities. The Trusts invested the proceeds from the sale of the Trust Securities, together with the proceeds from the issuance to HealthMarkets, LLC by the Trusts of the common securities, in $100.0 million principal amount of HealthMarkets, LLC’s Floating Rate Junior Subordinated Notes due June 15, 2036 (the “Notes”), of which $50.0 million principal amount accrue interest at a floating rate equal to three-month LIBOR plus 3.05% and $50.0 million principal amount accrue interest at a fixed rate of 8.367% through but excluding June 15, 2011
The Notes, which constitute the sole assets of the Trusts, are subordinate and junior in right of payment to all senior indebtedness (as defined in the Indentures) of HealthMarkets, LLC. The Company has fully and unconditionally guaranteed the payment by the Trusts of distributions and other amounts payable under the Trust Securities. The guarantee is subordinated to the same extent as the Notes. The Trusts are obligated to redeem the Trust Securities when the Notes are paid at maturity or upon any earlier prepayment of the Notes. Prior to June 15, 2011, the Notes may be redeemed only upon the occurrence of certain tax or regulatory events at 105.0% of the principal amount thereof in the first year reducing by 1.25% per year until it reaches 100.0%. On and after June 15, 2011 the Notes are redeemable, in whole or in part, at the option of the Company at 100.0% of the principal amount thereof.
On April 29, 2004, UICI Capital Trust I (a newly formed Delaware statutory business trust) (the “2004 Trust”) completed the private placement of $15.0 million aggregate issuance amount of floating rate trust preferred securities with an aggregate liquidation value of $15.0 million (the “2004 Trust Preferred Securities”). The 2004 Trust invested the $15.0 million proceeds from the sale of the 2004 Trust Preferred Securities, together with the proceeds from the issuance to the Company by the 2004 Trust of its floating rate common securities in the amount of $470,000 (the “Common Securities” and, collectively with the 2004 Trust Preferred Securities, the “2004 Trust Securities”), in an equivalent face amount of the Company’s Floating Rate Junior Subordinated Notes due 2034 (the “2004 Notes”). The 2004 Notes will mature on April 29, 2034, which date may be accelerated to a date not earlier than April 29, 2009. The 2004 Notes may be prepaid prior to April 29, 2009, at 107.5% of the principal amount thereof, upon the occurrence of certain events, and thereafter at 100.0% of the principal amount thereof. The 2004 Notes, which constitute the sole assets of the 2004 Trust, are subordinate and junior in right of payment to all senior indebtedness (as defined in the Indenture, dated April 29, 2004, governing the terms of the 2004 Notes) of the Company. The 2004 Notes accrue interest at a floating rate equal to three-month LIBOR plus 3.50%, payable quarterly on February 15, May 15, August 15, and November 15 of each year. At December 31, 2006, the 2004 Notes bore interest at an annual rate of 8.87%. The quarterly distributions on the 2004 Trust Securities are paid at the same interest rate paid on the 2004 Notes.
The SPE and the secured student loan facility were structured with an expectation that interest and recoveries of principal to be received with respect to the underlying student loans securing payment of the SPE Notes would be sufficient to pay principal of and interest on the SPE Notes when due, together with operating expenses of the SPE. This expectation was based upon analysis of cash flow projections, and assumptions regarding the timing of the financing of the underlying student loans to be held by the SPE, the future composition of and yield on the financed student loan portfolio, the rate of return on monies to be invested by the SPE in various funds and accounts established under the indenture governing the SPE Notes, and the occurrence of future events and conditions. There can be no assurance, however, that the student loans will be financed as anticipated, that interest and principal payments from the financed student loans will be received as anticipated, that the reinvestment rates assumed on the amounts in various funds and accounts will be realized, or other payments will be received in the amounts and at the times anticipated.
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.
Consists of dividends paid to the holding company by MEGA and Mid-West.
Includes borrowings from and/or repayments on loans from subsidiaries in the amount of $800,000, $358,000 and $3.9 million in 2006, 2005 and 2004, respectively, proceeds from subsidiaries related to agent stock plans in the amount of $20.4 million, $11.1 million and $19.7 million in 2006, 2005 and 2004, respectively, repayment on loans from non-affiliated companies of $3.9 million, and proceeds from the sale of Class A-1 common stock to officers and directors of $2.8 million in 2006.
Includes advances to subsidiaries in the amount of $150,000, $370,000 and $2.9 million in 2006, 2005, and 2004, respectively.
During 2006, the Company received a distribution from a special purpose subsidiary of the cash principal payment in the amount of $72.4 million on the $150.8 million promissory note received in July 2006 as consideration for sale of assets comprising the Company’s Star HRG unit.
On April 5, 2006, the Company received $985.0 million for the purchase of common stock by the group of private equity firms in connection with the merger.
In April 2004, the Company, through a newly formed Delaware statutory business trust, generated net proceeds of $14.6 million from the issuance in a private placement of $15.0 million aggregate issuance amount of floating rate trust preferred securities. See Note I of Notes to Consolidated Financial Statements.
During 2006, 2005 and 2004, the Company’s principal uses of cash and liquidity at the holding company were as follows:
In April 2005, HealthMarkets utilized approximately $7.0 million to repurchase 310,900 shares of its common stock pursuant to its share repurchase program. During 2004, HealthMarkets utilized approximately $16.3 million to repurchase 1,043,400 of its common stock pursuant to its share repurchase program. Such amounts are reflected as “Purchases of HealthMarkets common stock” in the table above.
In April 2004, the Company paid in full its outstanding 6% convertible subordinated notes in the aggregate amount of $15.0 million and accrued interest thereon to the date of prepayment. The notes had been issued by the Company in November 2003 in full payment of all contingent consideration payable in connection with HealthMarkets’ February 2002 acquisition of Star HRG.
Set forth below is a summary of the Company’s contractual obligations (on a consolidated basis) at December 31, 2006:
Through the Company’s former College Fund Life Division, the Company previously offered an interest-sensitive whole life insurance product issued with a child term rider, under which the Company committed to provide private student loans to help fund the named child’s higher education if certain restrictions and qualifications are satisfied. At December 31, 2006, the Company had outstanding commitments to fund student loans under the College Fund Life Division program for the years 2007 through 2025. Loans are limited to the cost of school or prescribed maximums. These loans are generally guaranteed as to principal and interest by a private guarantee agency and are also collateralized by either the related insurance policy or the co-signature of a parent or guardian. The total student loan funding commitments for each of the next five school years and thereafter, as well as the amount the Company expects to be required to fund based on historical utilization rates and policy lapse rates, are as follows as of December 31, 2006:
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 71% of the investment portfolio.
Corporate bonds included in the fixed maturity portfolio consist primarily of short term and medium term investment grade bonds. The Company’s investment policy with respect to concentration risk limits individual investment grade bonds to 3% of assets and non-investment grade bonds to 2% of assets. The policy also limits the investments in any one industry to 20% of assets. As of December 31, 2006, the largest concentration in any one investment grade corporate bond was $94.8 million, which represented 5.3% of total invested assets. This security was received as payment on the sale of the Student Division. To limit its credit risk, the Company has taken out $75.0 million of credit default insurance on this bond, reducing its default exposure to $19.8 million, or 1.1% of total invested assets. The largest concentration in any one non-investment grade corporate bond was $3.5 million, which represented less than 1% of total invested assets. The largest concentration to any one industry was less than 10%.
Included in the fixed maturity portfolio are mortgage-backed securities, including collateralized mortgage obligations, mortgage-backed pass-through certificates, and commercial mortgage-backed securities. To limit its credit risk, the Company invests in mortgage-backed securities that are rated investment grade by the public rating agencies. The Company’s mortgage-backed securities portfolio is a conservatively structured portfolio that is concentrated in the less volatile tranches, such as planned amortization classes and sequential classes. The Company seeks to minimize prepayment risk during periods of declining interest rates and minimize duration extension risk during periods of rising interest rates. The Company has less than 1% of its investment portfolio invested in the more volatile tranches.
During 2006, 2005 and 2004, the Company recorded impairment charges for certain fixed and equity securities in the amount of $2.4 million, $4.1 million and $3.6 million, respectively.
Set forth below is a summary of the Company’s gross unrealized losses in its portfolio of fixed maturity securities as of December 31, 2006:
At December 31, 2006, the Company had $26.9 million of unrealized losses in its fixed maturities portfolio. Of the $3.0 million in unrealized losses that have existed for less than twelve months, all but a single security have unrealized losses of less than 2% of cost. The single security (which consists of the Company’s residual interest in Grapevine Finance LLC and which has been classified as “Other” in the table above) had at December 31, 2006 an unrealized loss of $2.2 million, or 30.9% of cost. See Notes C and L of Notes to Consolidated 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 completed in 2006. Of the $23.9 million in unrealized losses that have existed for twelve months or longer, eight 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 $4.9 million at December 31, 2006. The Company continually monitors these investments and believes that, as of December 31, 2006, the unrealized loss in these investments is temporary.
Represents security received from the purchaser as consideration upon sale of the Company’s former Student Insurance Division on December 1, 2006. To reduce the Company’s credit risk, the Company has taken out $75.0 million of credit default insurance on this security, reducing the Company’s default exposure to $19.8 million. See Note C of Notes to Consolidated Financial Statements.
For the majority of health insurance products offered through the Self-Employed Agency Division, the Company establishes the claims liability using the original incurred date. Under the original 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.
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. For healthcare costs payable, the claim liability balances and the related benefit expenses are highly sensitive to changes in the assumptions used in the claims liability calculations. With respect to health claims, the items that have the greatest impact on the Company’s financial results are the medical cost trend, which is the rate of increase in healthcare costs, and the unpredictable variability in actual experience. Any adjustments to prior period claim liabilities are included in the benefit expense of the period in which adjustments are identified. Due to the considerable variability of healthcare costs and actual experience, adjustments to health claim liabilities usually occur each quarter and are sometimes significant.
The Company believes that its recorded claim liabilities are reasonable and adequate to satisfy its ultimate claims liability. Each of the Company’s major operating units has an actuarial staff that has primary responsibility for assessing the claim liabilities. The Company’s Corporate Risk Management staff has an oversight process in place to provide final review of the establishment of the claim liabilities. The Company uses its own experience as appropriate and relies on industry loss experience as necessary in areas where the Company’s data is limited. Our estimate of claim liabilities represents management’s best estimate of the Company’s liability as of December 31, 2006.
With respect to business at its Disposed Operations, the Company assigned incurred dates based on the date of service. This definition estimated the liability for all medical services received by the insured prior to the end of the applicable financial period. Appropriate adjustments were made in the completion factors to account for pending claim inventory changes and contractual continuation of coverage beyond the end of the financial period.
Reflects claims liabilities associated with the Company’s former Student Insurance Division and Star HRG Division. The claims liabilities remaining at December 31, 2006 represent the residual liability associated with a closed block short-term product previously offered by, and retained by the Company in the 2006 sale of, the Student Insurance Division.
Set forth in the table below is a summary of the claims liability development experience (favorable) unfavorable by business unit in the Company’s Insurance segment for each of the years ended December 31, 2006, 2005 and 2004:
Impact on SEA Division. As indicated in the table above, incurred losses developed at the SEA Division in amounts less than originally anticipated due to better-than-expected experience on the health business in the SEA Division in each of 2006, 2005 and 2004. For the SEA Division, the (favorable) unfavorable claims liability development experience in the prior year’s reserve for each of the years ended December 31, 2006, 2005 and 2004 is set forth in the table below by source:
As indicated in the table above, considerable redundancies in each year are associated with the estimate of claim liabilities for the most recent incurral months. The Company has limited data with respect to these most recent incurral months and, accordingly, estimates are based primarily on anticipated experience, taking into account the impact of the Company’s rate changes relative to expected medical trend. Since late 2003, the Company has severely reduced the level of rate increases on its underlying scheduled health insurance coverage in response to experience that has been more favorable than was assumed in the establishment of the premium rates. This favorable experience first appeared in incurred months in the latter half of 2002, which with hindsight proved to be much more favorable than prior experience would have suggested. At the end of 2003 and again at the end of 2004, there appeared to be evidence that loss ratios on these products were increasing again toward the anticipated levels, though hindsight eventually showed that much of this deterioration was the result of the redundancy that had developed in the completion factors, which were adjusted in the third quarter of 2005. Accordingly, the estimated claim liabilities assumed experience had deteriorated as medical trend rates exceeded actual rate increases. In hindsight, actual results were unusually favorable in each case. In the third quarter of 2005, claim liability estimates were adjusted to reflect this unusually favorable experience. Additional adjustments were made in the third quarter of 2006 to reflect this continuing favorable experience.
Impact on Other Insurance. Through our 82.5%-owned subsidiary, ZON Re USA LLC (“ZON Re”), we underwrite, administer and issue accidental death, accidental death and dismemberment (AD&D), accident medical and accident disability insurance products, both on a primary and on a reinsurance basis. The favorable claim liability experience of $2.5 million in 2006 is due to the release of reserves held at December 31, 2005 for catastrophic excess of loss contracts expiring during 2006. The unfavorable claim liability development experience at ZON Re in 2005 in the amount of $805,000 was due to certain large claims reported in 2005 associated with claims incurred in the prior year.
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.
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 is 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 unfavorable claims liability development experience in 2004 in the amount of $4.7 million reflects the effects of a delay in processing of prior-year claims and higher-than-expected claim experience associated with the business written for the 2003-2004 school year.
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 a two-year period, which approximates the average life of a policy. For financial reporting purposes, other underwriting and policy issuance costs (which the Company estimates are more fixed than variable) with respect to health policies issued through the Company’s SEA and Other Insurance division are expensed as incurred.
At December 31, 2006, the Company changed its accounting policy, effective January 1, 2006 with respect to the amortization of a portion of deferred acquisition costs associated with commissions paid to agents. Generally, the first year and second year commission rates on policies issued by the Company’s SEA Division are higher than renewal year commission rates. Commencing in 2006, the Company changed its accounting methodology with respect to the first year and second year excess commissions and now amortizes those excess commissions over a two year period (based on recent persistency studies showing that SEA policies have an average life of 2.09 years) rather than expensing the excess commissions in the period the commissions were paid. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations - 2006 Change in Accounting Policy.”
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 of the issuer deterioration 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 impaired, a loss is recognized at the date of determination.
The Company measures the fair value of its residual interest in Grapevine using a present value model incorporating the following two key economic assumptions: (1) the timing of the collections of interest on the CIGNA Note, payments of interest expense on the senior secured notes and payment of other administrative expenses and (2) an assumed discount rate equal to the 15 year swap rate.
losses. Accordingly, during 2006 the Company released the valuation allowance of $18.1 million established in 2003, thereby realizing the deferred tax benefits of the capital loss carryforwards generated in 2003.
In June 2006, the FASB issued FASB Interpretation No. 48 (FIN 48) Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109 Accounting for Income Taxes. FIN 48 prescribes a threshold for the financial statement recognition of tax benefits from tax positions taken or to be taken in an income tax return. For tax benefits to be recognized, a tax position must be more-likely-than-not to be sustained upon examination by taxing authorities. The amount of a tax benefit recognized is the largest amount of benefit that is greater than 50 percent likely of being realized upon ultimate settlement of the tax position. Required disclosures will include a tabular rollforward of the tax benefits that have not been recognized in the financial statements. The cumulative effect, if any, of adopting FIN 48 is to be recorded as an adjustment to retained earnings at the beginning of the period of adoption. FIN 48 is effective for the Company beginning January 1, 2007. The Company does not expect FIN 48 to have a material impact on its financial position or results of operations.
In February 2006, the Financial Accounting Standards Board (“FASB”) issued Statement 155 Accounting for Certain Hybrid Financial Instruments. Statement 155 amends FASB Statement 133 Accounting for Derivative Instruments and FASB Statement 140 Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities. Among other things, Statement 155 establishes a requirement to evaluate interests in securitized financial assets to identify interests that are freestanding derivatives or that are hybrid financial instruments that contain an embedded derivative requiring bifurcation. Statement 155 shall be effective for all financial instruments acquired, issued, or subject to a remeasurement (new basis) event occurring after the beginning of the fiscal year after September 15, 2006 (or fiscal year 2007 for the Company). The Company believes this statement will not have a material effect upon the financial condition or results of operations of the Company.
acquisition costs be expensed in full when the original contract is substantially changed by election or amendment of an existing contract feature or by replacement with a new contract. The Company expects to implement the SOP for contract changes beginning in the first quarter of 2007 with no material effects to the financial statements at implementation.
In May 2005, the Financial Accounting Standards Board (“FASB”) issued Statement 154 Accounting Changes and Error Corrections, which changes the requirements for the accounting and reporting of a change in accounting principle. Statement 154 applies to all voluntary changes in accounting principle as well as to changes required by an accounting pronouncement that does not include specific transition provisions. Statement 154 requires that changes in accounting principle be retrospectively applied. Under retrospective application, the new accounting principle is applied as of the beginning of the first period presented as if that principle had always been used. The cumulative effect of the change is reflected in the carrying value of assets and liabilities as of the first period presented and the offsetting adjustments would be recorded to opening retained earnings. Statement 154 replaces APB Opinion No. 20 and FASB Statement 3. Statement 154 is effective for the Company beginning in fiscal year 2006.
FASB Statement 123R (revised 2004), Share-Based Payment, became effective for the Company on January 1, 2006. Statement 123R requires all share-based payments to employees, including grants of employee stock options, to be recognized in the financial statements based on their fair values, a previously optional accounting method that the Company voluntarily adopted in 2003. The Company adopted Statement 123R using the modified prospective transition method, whereby compensation cost related to unvested awards as of the effective date are recognized as calculated for inclusion in the financial statements and pro forma disclosures under FASB Statement 123, and cost related to new awards are recognized in accordance with Statement 123R. For 2006, the impact of the transition to Statement 123R to the Company’s income from continuing operations net of income taxes was $27,000.
“anticipate,” “believe,” “estimate,” “expect,” “may,” “objective,” “plan,” “possible,” “potential,” “project,” “will” and similar expressions are intended to identify forward-looking statements. In addition to the assumptions and other factors referred to specifically in connection with such statements, factors that could impact the Company’s business and financial prospects include, but are not limited to, those discussed under the caption “Item 1A. Risk Factors” and those discussed from time to time in the Company’s various filings with the Securities and Exchange Commission or in other publicly disseminated written documents.