We are a diversified national managed healthcare company based in Bethesda, Maryland, operating health plans, insurance companies, network rental and workers’ compensation services companies. Through our Commercial Business, Individual Consumer & Government Business, and Specialty Business divisions, we provide a full range of risk and fee-based managed care products and services to a broad cross section of individuals, employer and government-funded groups, government agencies, and other insurance carriers and administrators.
Medicare Part D growth of 227,000 members from the prior year, an increase of 32%
GAAP cash flows from operations were $627.4 million, or 164% of net earnings
Operating earnings as a percentage of revenues were 5.2%, compared to 9.4% in the prior year
Net earnings were $381.9 million, a decline of 39% from 2007, net earnings
Our selling, general and administrative expenses consist primarily of salaries and related costs for personnel involved in the administration of services we offer. To a lesser extent, our selling, general and administration expenses include other administrative and facility costs needed to provide these administrative services as well as commissions paid to brokers and agents who assist in the sale of our products. We operate regional service centers that perform claims processing, premium billing and collection, enrollment and customer service functions. Our regional service centers enable us to take advantage of economies of scale, implement standardized management practices and capitalize on the benefits of our integrated information technology systems.
We generate cash through operations. As a profitable company in an industry that is not capital equipment intensive, we have generally not needed to use external financing to fund operations. While we have incurred debt (as described in Note J, Debt, to our consolidated financial statements in this Form 10-K), the proceeds have primarily been used to finance acquisitions. On October 3, 2008, the Company drew down $543.5 million from its Revolving Credit Facility and repaid $103.5 million of this amount on October 10, 2008. The remaining $440.0 million will be used to optimize the Company’s liquidity position during the current uncertain macroeconomic environment and for general corporate purposes. Our primary use of cash is to pay medical claims. Any excess cash has historically been used for acquisitions, to prepay indebtedness and for repurchases of our common stock.
We receive premium payments from the Centers for Medicare and Medicaid Services (“CMS”) on a monthly basis for our Medicare membership to provide healthcare benefits to our Medicare members. Premiums are fixed (subject to retroactive risk adjustment) on an annual basis by contracts with CMS. Membership and category eligibility are periodically reconciled with CMS and can result in adjustments to revenue. CMS uses a risk adjustment model to determine premium payments to health plans. This risk adjustment model apportions premiums paid to all health plans according to health severity based on diagnosis data provided to CMS. We estimate risk adjustment revenues based on the diagnosis data submitted to CMS. Changes in revenue from CMS resulting from the periodic changes in risk adjustments scores for our membership are recognized when the amounts become determinable and the collectibility is reasonably assured.
We contract with the United States Office of Personnel Management (“OPM”) and with various federal employee organizations to provide health insurance benefits under the Federal Employees Health Benefits Program (“FEHBP”). These contracts are subject to government regulatory oversight by the Office of the Inspector General (“OIG”) of OPM who perform periodic audits of these benefit program activities to ensure that contractors meet their contractual obligations with OPM. For our managed care contracts, the OIG conducts periodic audits to, among other things, verify that premiums established under its contracts are in compliance with community rating requirements under the FEHBP. The OPM may seek premium refunds or institute other sanctions against health plans that participate in the program. For our experience-rated plans, the OIG focuses on the appropriateness of contract charges, the effectiveness of claims processing, financial and cost accounting systems, and the adequacy of internal controls to ensure proper contract charges and benefits payments. The OIG may seek refunds of costs charged under these contracts or institute other sanctions against health plans. These audits are generally a number of years in arrears. We estimate and record reserves for audit and other contract adjustments based on appropriate guidelines. Any differences between actual results and estimates are recorded in the year the audits are finalized.
Lower than anticipated large claim liabilities of $28.4 million favorable development
Higher than expected inpatient hospital utilization of ($10.0) million unfavorable development
The increase in total reported medical cost from 2007 to 2008 was driven primarily by growth in the medical cost base of the Company. A secondary driver of the medical cost growth was the change in prior year development. Prior year development experienced in 2008 was less favorable compared to amounts experienced in 2007. The lower favorable development is primarily attributable to our PFFS line of business. PFFS experienced an unfavorable development due to lower than expected completion factors.
We believe that the amount of medical liabilities is adequate to cover our ultimate liability for unpaid claims as of December 31, 2008. However, actual claim payments and other items may differ from established estimates.
our intent and ability to retain our investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value;
We use prices from independent pricing services and, to a lesser extent, indicative (non-binding) quotes from independent brokers, to measure the fair value of our investment securities. We utilize multiple independent pricing services and brokers to obtain fair values; however, we generally obtain one price/quote for each individual security.
Any potential recovery of the fair value of these securities is not expected in the near term and therefore we no longer anticipate holding these securities for a period of time sufficient to allow for any anticipated recovery in fair value. These facts led us to conclude that these investment securities were other-than-temporarily impaired.
Goodwill and other intangible assets that have indefinite lives are subject to a periodic assessment for impairment by applying a fair-value-based test. We performed a goodwill impairment analysis, at the reporting unit level, as of October 1, our annual impairment test date. However, we could be required to evaluate the recoverability of goodwill and other indefinite lived intangible assets prior to the required annual assessment if there is any indication of a potential impairment. Those indications may include experiencing disruptions to business, unexpected significant declines in operating results, divestiture of a significant component of the business or a sustained decline in market capitalization.
In the case of a publicly traded company, the objective of the market capitalization approach is to determine whether the quoted market price is indicative of the fair value of its reporting units. In addressing the relationship of the determined fair value of our reporting units to our market capitalization, we considered factors outlined in SFAS No. 142, “Goodwill and Other Intangible Assets,” including:
While we considered the market capitalization decline in our evaluation of fair value of goodwill, we concluded that it did not impact the overall goodwill impairment analysis as we believe the decline to be primarily attributed to the negative market conditions as a result of the credit crisis, the economic recession and current pricing and/or medical trend issues within the managed care industry. We will continue to monitor our market capitalization as a potential impairment indicator considering overall market conditions and managed care industry events. Any impairment charges that may result will be recorded in the period in which the impairment is identified. We have not incurred an impairment charge related to goodwill.
In accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” we review intangible assets that are subject to amortization for recoverability whenever events or changes in circumstances indicate that its carrying amount may not be recoverable. An impairment loss shall be recognized if the carrying amount of an intangible asset is not recoverable and its carrying amount exceeds its fair value. Our intangible assets that are subject to amortization consist of our customer lists, licenses, and provider networks.
We account for share based compensation in accordance with the provisions of Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment” (“SFAS 123R”). Under the fair value recognition provisions of SFAS 123R, determining the appropriate fair value model and calculating the fair value of share-based payment awards require the input of subjective assumptions, including the expected life of the share-based payment awards and stock price volatility. We believe that a blend of the implied volatility of our tradeable options and the historical volatility of our share price is a better indicator of expected volatility and future stock price trends than historical volatility alone. Therefore, the expected volatility was based on a blend of market-based implied volatility and the historical volatility of our stock. The assumptions used in calculating the fair value of share-based payment awards represent our best estimates. In addition, we are required to estimate the expected forfeiture rate and recognize expense only for those shares expected to vest. If our actual forfeiture rate is materially different from our estimate, the stock-based compensation expense could be significantly different from what we have recorded in the current period. See Note G, Stock-Based Compensation, to the Consolidated Financial Statements in Item 8 for a further discussion on stock-based compensation.
The following table presents our membership as of December 31, 2008 and 2007 (in thousands).
(3)“Medicare Advantage” membership includes Medicare Advantage HMO, Medicare Advantage PPO and Medicare Advantage PFFS results.
Managed care premium revenue increased in both our Individual Consumer & Government and Commercial Divisions. The increase is a result of growth in existing products as well as from our acquisitions during 2007 of Vista Health Plans (“Vista”) and Mutual of Omaha (“Mutual”). The increase was partially offset by a decline in same store Commercial risk membership over the prior year.
Medical costs increased as a result of new business in both our Individual Consumer & Government and Commercial Divisions discussed above. Medical cost also increased due to increased Commercial and Medicare PFFS medical cost trend as well as unfavorable IBNR reserve development on our Medicare PFFS business. The Medicare Part D medical loss ratio increase was a result of the premium rate changes from the annual competitive bid filings for our Medicare part D products and growth in our low-income auto-assign population in 2008.
Depreciation and amortization expense primarily increased as a result of the expense associated with the identifiable intangible assets identified with our recent acquisitions.
Interest expense increased primarily as a result of the issuance of debt during the prior year and due to interest expense incurred on the net draw down of $440.0 million on the Revolving Credit Facility in October 2008. The increase was partially offset by the redemption during the first quarter of 2007 of our $170.5 million of outstanding 8.125% senior notes due February 15, 2012. Associated with this redemption, we recognized $9.1 million of interest expense in the prior year first quarter for both the premium paid on redemption as well as the write off of associated deferred financing costs.
The effective tax rate was essentially flat at 37.0%, as compared to 37.1% for the prior year.
Managed care premium revenue increased in both our Individual Consumer & Government and Commercial divisions. The growth was a result of our new PFFS product, growth in existing products as well as from the acquisitions; each of which is described above. Partially offsetting the increase was a decline in same store Commercial risk membership over the prior year period.
Medical costs increased almost exclusively as a result of new business in both our Individual Consumer & Government Division and Commercial Division discussed above. Medical costs as a percentage of premium revenue (“medical loss ratio”) increased 0.3% from the prior year as a result of slightly higher medical loss ratios, associated with acquired businesses and from our new Medicare PFFS business which has a slightly higher medical loss ratio than our overall business.
Our provision for income taxes increased due to an increase in earnings. The effective tax rate decreased to 37.1% compared to 37.5% for the same period in 2006 primarily as a result of a change in the proportion of our earnings in states with lower tax rates.
Commercial group risk premium revenue increased as a result of the acquisitions of Mutual and Vista in 2007. To a lesser extent the increase was a result of an increase in average realized premium yields per member per month in our commercial group risk business, resulting from renewal rate increases net of benefit buy downs on renewing groups and the mix of new group business net of terminated groups. This increase in premium revenue was partially offset by membership declines in our same store commercial group risk business. However, a portion of those members changed from our risk products to our non-risk products.
Gross margin decreased during the year as a result of the increase in the Commercial health plan medical loss ratio in 2008 and the decline in Commercial management services revenue discussed above. The decrease was partially offset by the gross margin derived from the acquisitions discussed above.
Individual Consumer & Government Division revenue increased as a result of membership growth from our Medicare Advantage business, as well as increased Medicare Part D and Individual membership, both organic and acquired.
When reviewing the premium yield for Medicare Advantage and Part D business, adjusting for the ceded revenue is useful for comparisons to competitors that may not have similar ceding arrangements. When reviewing the Medicare Part D business, adjusting for the risk share amounts is useful to understand the results of the Part D business because of our expectation that the risk sharing revenue will eventually be insignificant on a full year basis.
Specialty Division gross margin increased during the current year as a result of the revenue increases discussed above partially offset by an increase in medical costs attributable to MHNet and GDS and costs of sales associated with the revenue growth in workers’ compensation services.
The nature of a majority of our operations is such that cash receipts from premium revenues are typically received up to two months prior to the expected cash payment for related medical costs. Premium revenues are typically received at the beginning of the month in which they are earned, and the corresponding incurred medical expenses are paid in a future time period, typically 15 to 60 days after the date such medical services are rendered. The lag between premium receipts and claims payments creates positive cash flow and overall cash growth. As a result, we typically hold approximately one to two months of “float.” In addition, accumulated earnings provide further positive cash flow. In addition to ample current liquidity, our long-term investment portfolio is available for further liquidity needs including satisfaction of policy holder benefits.
Capital expenditures in 2008 of approximately $69.4 million consist primarily of computer hardware, software and related costs associated with the development and implementation of improved operational and communication systems. Projected capital expenditures in 2009 of approximately $65-$75 million consist primarily of computer hardware, software and other equipment.
On October 3, 2008, we drew down $543.5 million from our Revolving Credit Facility and repaid $103.5 million of this amount on October 10, 2008. The remaining $440.0 million will be used to optimize our liquidity position during the current uncertain macroeconomic environment and potentially for general corporate purposes. Also, a few times during 2008 we drew down and repaid certain amounts on our Revolving Credit Facility for general corporate purposes.
Our regulated HMO and insurance company subsidiaries are required by state regulatory agencies to maintain minimum surplus balances, thereby limiting the dividends the parent may receive from our regulated entities. During 2008, we received $332.1 million in dividends from our regulated subsidiaries and infused $225.2 million in capital contributions into our subsidiaries.
The majority of states in which we operate health plans have adopted RBC policy that recommends the health plans maintain statutory reserves at or above the ‘Company Action Level’ which is currently equal to 200% of their RBC. The State of Florida does not currently use RBC methodology in its regulation of HMOs. Some states, in which our regulated subsidiaries operate, require deposits to be maintained with the respective states’ departments of insurance. The table below summarizes our statutory reserve information, as of December 31, 2008 and 2007 (in millions, except percentage data).
As of December 31, 2008, we were contractually obligated to make the following payments within the next five years and thereafter (in thousands):
Refer to Note K, Commitments and Contingencies, to our consolidated financial statements for additional information related to our operating leases.
We expect our Health Plan Commercial Group Risk membership to decline 4% as of January 1, 2009, and 6% to 8% for the full year. We expect the corresponding medical loss ratio for Health Plan Commercial Group Risk to be between 82.5% and 83.0% for the year.
Regarding the use of cash, our first priority will be supporting the regulatory capital needs of our subsidiaries and maintaining liquidity. Our second priority will be a measured and balanced application of available cash to reduce our debt and to repurchase our shares consistent with our financial goals for the year.
Refer to Part I, Item 1A, “Risk Factors,” which is incorporated herein by reference.
We have audited the accompanying consolidated balance sheets of Coventry Health Care, Inc. and subsidiaries as of December 31, 2008 and 2007, and the related consolidated statements of operations, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2008. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Coventry Health Care, Inc. and subsidiaries at December 31, 2008 and 2007, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2008, in conformity with U.S. generally accepted accounting principles.
As discussed in Note H, Income Taxes, to the consolidated financial statements, Coventry Health Care, Inc. adopted FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes,” effective January 1, 2007.
Other Receivables - Other receivables include pharmacy rebate receivables, Medicare Part D program related receivables, risk share and subsidy receivables, Medicare risk adjuster receivables, Office of Personnel Management (“OPM”) receivables, receivables from providers and suppliers, interest receivables, and any other receivables that do not relate to premiums. The increase in other receivables during 2008 primarily resulted from an increase in the pharmacy rebate, Medicare Part D, and Medicare risk adjuster receivables due to growth in the Medicare risk business.
The following table shows the components of the change in medical liabilities for the years ended December 31, 2008, 2007 and 2006, respectively (in thousands):
The Medicare Part D program, gives beneficiaries access to prescription drug coverage. Coventry has been awarded contracts by CMS to offer various Medicare Part D plans on a nationwide basis, in accordance with guidelines put forth by the agency. Payments from CMS under these contracts include amounts for premiums, amounts for risk corridor adjustments and amounts for reinsurance and low-income cost subsidies.
The Company has quota share arrangements on certain individual and employer groups with two of its Medicare distribution partners covering portions of the Company’s Medicare Part D and Medicare Private Fee for Service businesses. As a result of the quota share sharing arrangements, for the years ended December 31, 2008, 2007 and 2006, the Company ceded premium revenue of $574.1 million, $250.2 million, and $65.8 million, respectively, and the associated medical costs to these partners. The ceded amounts are excluded from the Company’s results of operations. The Company is not relieved of its primary obligation to the policyholder under this ceding arrangement.
Other Income - Other income includes interest income, net of fees, of approximately $104.6 million, $138.7 million, and $101.5 million for the years ended December 31, 2008, 2007, and 2006 respectively. For the year ended December 31, 2008, other income included a charge of $36.2 million that consisted of $33.5 million for the other-than-temporary impairment of investment securities and $2.7 million in realized losses on the sale of securities.
In September 2006, the Financial Accounting Standards Board (FASB) issued SFAS No. 157, “Fair Value Measurements,” which defines fair value, establishes a framework for measuring fair value in accordance with generally accepted accounting principles and expands disclosures about fair value measurements. The company adopted the provisions of SFAS No. 157, as of January 1, 2008, for its financial instruments. The adoption of SFAS No. 157 did not have a material effect on the Company’s consolidated financial position or results of operations. The disclosures required by SFAS No. 157 are contained in Note F, Investments, to the consolidated financial statements for disclosures related to investments.
The Company has three reportable segments: Commercial, Individual Consumer & Government, and Specialty. Each of these segments, which the Company also refers to as “Divisions,” is separately managed and provides separate operating results that are evaluated by the Company’s chief operating decision maker. Beginning in 2008, in order to reflect a change in the management of its operations, the Company reclassified its network rental business operating results from its Commercial Division to its Specialty Division. The network rental business operating results for the corresponding 2007 and 2006 years have been reclassified to conform to the 2008 segment presentation.
The Individual Consumer & Government Division provides comprehensive health benefits to members participating in the Medicare Advantage HMO, Medicare Advantage PPO, Medicare Advantage Private-Fee-For-Service, Medicare Prescription Drug, and Medicaid programs and receives premium payments from federal and state governments. This Division also provides commercial fully-insured managed care services on an individual basis and offers products and services more specialized to the needs of state governments such as pharmacy benefit management, clinical management and fiscal intermediary services on a fee-for-service basis.
The Specialty Business Division currently provides workers’ compensation managed care services on a fee-based basis, including access to the Company’s provider network, pharmacy benefits management, field case management, telephonic case management, independent medical exam and bill review capabilities. This Division also includes the mental-behavioral health benefits of Mental Health Network Institutional Services, Inc. (“MHNet”) and the group dental services business of Group Dental Services (“GDS”). See Note C, Acquisitions, to the consolidated financial statements for additional information related to these acquisitions.
The table below summarizes the operating results of the Company’s reportable segments (in thousands) through the gross margin level, as gross margin is the measure of profitability used by the Company’s chief operating decision maker to assess segment performance and make decisions regarding the allocation of resources. A reconciliation of gross margin to operating earnings at a consolidated level is also provided. Additionally, the medical loss ratio (“MLR”) is presented for each applicable segment, as management believes that MLR is an important performance measure. The “other” column represents the elimination of premium and management service fees charged among segments. Total assets by reportable segment are not disclosed as these assets are not reported on a segment basis internally by the Company and therefore, are not reviewed separately by the Company’s chief operating decision maker.
The following table summarizes all business combinations and membership purchases for the years ended December 31, 2008 and 2007. The purchase price of each business combination includes the payment for net worth and estimated transition costs. The purchase price, inclusive of all retroactive balance sheet settlements to date and transaction cost adjustments, is presented below (in millions):
On February 13, 2008, the Company completed its acquisition of MHNet, a mental-behavioral health company based in Austin, Texas. On May 14, 2008, the Company completed its acquisition of a majority ownership interest in GDS, a dental company based in Rockville, Maryland. As a result of these acquisitions the Company recorded $112.4 million of goodwill, none of which is expected to be deductible for tax purposes.
The pro forma amounts represent historical operating results of the Company and the acquisitions and include the pro forma effect of the amortization of finite lived intangible assets arising from the purchase price allocation, interest expense related to financing the acquisitions and the associated income tax effects of the pro forma adjustments. The pro forma amounts assume that debt issuance and debt refinancing that occurred in 2007, which coincided with the acquisitions, would have occurred at the beginning of 2006. In addition, the pro forma amounts exclude $35.0 million in acquisition related costs that were incurred as a result of the acquisition. The pro forma amounts are presented for comparison purposes and are not necessarily indicative of the operating results that would have occurred if the acquisitions had been completed at the beginning of the periods presented, nor are they necessarily indicative of operating results in future periods.
In addition to the acquired businesses outlined above, effective February 1, 2007, the Company completed its purchase of approximately 26,500 members from FirstGuard, a wholly-owned subsidiary of Centene Corporation.
Goodwill and other intangible assets represent costs in excess of the fair value of the net tangible assets of subsidiaries or operations acquired through December 31, 2008. Goodwill is tested for impairment at the reporting unit level on at least an annual basis and more often if events and circumstances arise that could indicate that impairment exists. Intangible assets not subject to amortization are tested for impairment annually or more frequently if events or changes in circumstances indicate that the asset might be impaired. The Company has chosen October 1 as its impairment testing date for its goodwill and its intangible assets not subject to amortization. Intangible assets that are subject to amortization for recoverability are tested for impairment whenever events or changes in circumstances indicate that its carrying amount may not be recoverable.
The changes in the carrying amount of goodwill for the years ended December 31, 2008 and 2007 were as follows (in thousands):
The Company completed its 2008 impairment test of goodwill in accordance with SFAS No. 142, “Goodwill and Other Intangible Assets,” and determined that there was no impairment. In performing its impairment analysis the Company identified its reporting units in accordance with the provisions of SFAS No. 142 and SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information.”
In order to determine the fair value of its reporting units, the Company relied primarily on the income approach and secondarily on the market approach. The income approach is based on the present value of expected future cash flows. The income approach involves estimating the present value of our estimated future cash flows utilizing a risk adjusted discount rate. Under the income approach, the Company assumed certain growth rates, capital expenditures, discount rates and terminal growth rates in our calculations. The key assumptions used to determine the fair value of the Company’s reporting units included terminal values based upon long term growth rates and a discount rate based on the Company’s weighted average cost of capital adjusted for the risks associated with the operations. The market approach estimates a business’s fair value by utilizing market multiples. The approaches were reviewed together for consistency and commonality.
The Company has also considered whether any economic or other factors occurring subsequent to October 1, 2008 would more likely than not reduce the fair values of any of the reporting units below their respective carrying amounts. Given the magnitude of changes in certain market factors between October and December 2008, the Company performed certain sensitivity analyses of the fair values of the reporting units by considering higher discount rates, and the corresponding effect on future cash flows that would be expected to result from such higher costs of capital, and determined that no impairment had occurred for any of the Company’s reporting units.
During 2008, the Company determined that no impairment tests were required for its amortized other intangible assets as no events or changes in circumstance occurred that indicated that the carrying values associated with these assets may not be recoverable. The Company performed an impairment test of its unamortized other intangible assets as of October 1, 2008, and determined that the asset was not impaired.
Other intangible amortization expense for the years ended December 31, 2008, 2007 and 2006 was $65.6 million, $48.2 million and $35.4 million, respectively. The increase during the year ended December 31, 2008 in other intangible assets and the related amortization expense is a result of the other intangible assets obtained with the acquisitions of MHNet and GDS and from a full year of amortization in 2008 from the Company’s 2007 acquisitions. Estimated intangible amortization expense is $64.8 million for the year ending December 31, 2009, $64.6 million for the year ending December 31, 2010, $63.7 million for the year ending December 31, 2011, $63.3 million for the year ending December 31, 2012 and $62.9 million for the year ending December 31, 2013. The weighted-average amortization period is approximately 10 years for other intangible assets.
The amortized cost and estimated fair value of short-term and long-term investments by contractual maturity were as follows at December 31, 2008 and 2007 (in thousands):
The following table shows the Company’s investments’ gross unrealized losses and fair value, at December 31, 2008, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position (in thousands).
Any potential recovery of the fair value of these securities is not expected in the near term and therefore the Company no longer anticipates holding these securities for a period of time sufficient to allow for any anticipated recovery in fair value. These facts led the Company to conclude that these investment securities were other-than-temporary impaired.
Through its acquisition of First Health on January 28, 2005, the Company acquired eight separate investments (tranches) in a limited liability company that invests in equipment that is leased to third parties. The total investment as of December 31, 2008 was $49.5 million and is accounted for using the equity method. Coventry’s proportionate share of the partnership’s income was $5.4 million, $4.5 million and $6.7 million for the periods ended December 31, 2008, 2007 and 2006, respectively, and are included in other income. Coventry has between a 20% and 25% interest in the limited partners share of each individual tranche of the partnership (approximately 10% of the total partnership).
Through its acquisition of Vista on September 10, 2007, the Company acquired a 50% investment in Carefree Insurance Services (“Carefree”). Carefree performs marketing and sales of several Individual and Medicare products. As of December 31, 2008, the Company’s total investment was $4.1 million and is accounted for using the equity method.
SFAS No. 157 establishes a three-tier fair value hierarchy, which prioritizes the inputs used in measuring fair value. These tiers include: Level 1 - defined as observable inputs such as quoted prices in active markets; Level 2 - defined as inputs other than quoted prices in active markets that are either directly or indirectly observable; and Level 3 - defined as unobservable inputs in which little or no market data exists, therefore requiring an entity to develop its own assumptions.
The following table provides a summary of changes in the fair value of the Company’s Level 3 financial assets for the year ended December 31, 2008 (in thousands):
Under the Stock Incentive Plan, the terms and conditions of option grants are established on an individual basis with the exercise price of the options being equal to not less than 100% of the fair value of the underlying stock at the date of grant. Options generally become exercisable after one year in 25% increments per year and expire ten years from the date of grant. At December 31, 2008, the Stock Incentive Plan had outstanding options representing 11.6 million shares of common stock.
The Company continues to use the Black-Scholes-Merton option pricing model and amortizes compensation expense over the requisite service period of the grant. The methodology used in 2008 to derive the assumptions used in the valuation model is consistent with that used in prior years. The following average values and weighted-average assumptions were used for option grants.
The following table summarizes stock option activity for the year ended December 31, 2008:
At December 31, 2008, the Company had approximately $78 million of federal and $174 million of state tax net operating loss carryforwards. The Federal net operating losses were acquired through various acquisitions. The net operating loss carryforwards can be used to reduce future taxable income, and expire over varying periods through the year 2027.
No valuation allowance is needed for 2008 and 2007 deferred tax assets because the Company believes that the realization of the deferred tax assets, including net operating losses, is more likely than not due to the future reversals of existing taxable temporary differences, and expected future positive taxable income as a result of planned business and tax initiatives.
The Company’s current income taxes payable have been reduced by tax benefits resulting from equity based compensation transactions. These benefits were credited to shareholder’s equity and amounted to $385 thousand and $31.5 million for the years ended December 31, 2008 and 2007, respectively.
A reconciliation of the total amounts of unrecognized tax benefits at the beginning and end of 2008 and 2007 is as follows:
Penalties and tax-related interest expense are reported as a component of income tax expense. As of December 31, 2008 and 2007, the total amount of income tax-related accrued interest and penalties, net of related tax benefit, recognized in the statement of financial position was $9.6 million and $10.2 million, respectively. For the years ended December 31, 2008 and 2007, the total amount of income tax-related accrued interest and penalties, net of related tax benefit, recognized in the statement of operations was $2.4 million and $4.5 million, respectively.
As of December 31, 2008, the Company was the sponsor of a 401(k) Restoration and Deferred Compensation Plan (“RESTORE”). Under the RESTORE, participants may defer up to 75% of their base salary and up to 100% of any bonus awarded. The Company makes matching contributions equal to 100% of the participant’s contribution on the first 3% of the participant’s compensation and 50% of the participant’s contribution on the second 3% of the participant’s compensation. Participants vest in the Company’s matching contributions ratably over two years. All costs of the RESTORE are funded by the Company as they are incurred.
The cost, principally employer matching contributions, of the RESTORE charged to operations for 2008, 2007 and 2006 was $0.2 million, $1.8 million and $1.2 million, respectively.
As of December 31, 2008, the Company was the sponsor of a deferred compensation plan that is designed to promote the retention of key senior management and to recognize their strategic importance to the Company. During 2006, two similarly designed plans were settled and paid out. The fixed dollar and stock equivalent allocations charged to operations for these plans were $1.1 million, $2.9 million, and $5.0 million in 2008, 2007 and 2006, respectively, and the liability for these plans was $3.6 million and $4.2 million at December 31, 2008 and 2007, respectively.
On March 20, 2007, the Company completed the sale of $400 million aggregate principal amount of its 5.95% Senior Notes due March 15, 2017 (the “10-year Notes”) at the issue price of 99.63% per Note. The 10-year Notes are senior unsecured obligations of Coventry and rank equally with all of its other senior unsecured indebtedness. As of December 31, 2008, the fair value was $202.8 million.
During November and December 2008, the Company repurchased a total of $10.0 million of its outstanding 5.95% Senior Notes due March 15, 2017.
The Company’s senior notes dated January 28, 2005 and credit facilities require compliance with a leverage ratio. All of its senior notes and credit facility contain certain covenants and restrictions regarding additional debt, dividends or other restricted payments, transactions with affiliates, disposing of assets and in some cases provide for debt repayment upon consolidations or mergers. As of December 31, 2008, the Company was in compliance with the applicable covenants under the senior notes and credit facility.
As of December 31, 2008, the Company is contractually obligated to make the following minimum lease payments within the next five years and thereafter (in thousands):
In the normal course of business, the Company has been named as a defendant in various legal actions such as actions seeking payments for claims denied by the Company, medical malpractice actions, employment related claims and other various claims seeking monetary damages. The claims are in various stages of proceedings and some may ultimately be brought to trial. Incidents occurring through December 31, 2008 may result in the assertion of additional claims. The Company maintains general liability, professional liability and employment practices liability insurances in amounts that it believes are appropriate, with varying deductibles for which it maintains reserves. The professional liability and employment practices liability insurances are carried through its captive subsidiary. Although the results of pending litigation are always uncertain, the Company does not believe the results of such actions currently threatened or pending, including those described below, will individually or in the aggregate, have a material adverse effect on its consolidated financial position or results of operations.
The Company was a defendant in the provider track of the In Re: Managed Care Litigation filed in the United States District Court for the Southern District of Florida, Miami Division, Multi-District Litigation (“MDL”), No. 1334, in the action captioned, Charles B. Shane., et al., vs. Humana, Inc., et al. The trial court granted summary judgment in favor of the Company on all claims asserted in the litigation. The Eleventh Circuit Court of Appeals affirmed the trial court’s order granting summary judgment. The Shane lawsuit has triggered the filing of copycat class action complaints by other health care providers such as chiropractors, podiatrists, acupuncturists and other licensed health care, professionals. Each of these actions has been transferred to the MDL and has been designated as “tag-along” actions. There are three tag-along actions currently filed against the Company. The trial court had entered an order which stayed all proceedings in these tag-along actions. Recently, the trial court requested the parties in the tag-along actions to refile all motions pending at the time of the stay and to file any new motions. On July 14, 2008, the trial court entered an order in the Harrison vs. Coventry Health Care of Georgia, Inc. (“CHCGA”) tag along action which dismissed all of the plaintiffs’ claims except their breach of contract claim which the court ordered to arbitration. In addition, the court deferred to the arbitrator for decision, the Company’s affirmative defenses that the plaintiffs waived their right to arbitration and/or their claim is barred by the doctrines of collateral estoppel and res judicata. The Harrison tag along action is a purported class action on behalf of all physicians in Georgia who had written provider contracts with CHCGA. The plaintiffs allege that CHCGA breached their contracts by not paying statutory interest on claims not adjudicated in compliance with Georgia’s prompt pay statute. CHCGA denies the allegation. To date, the Harrison plaintiffs have not filed a demand for arbitration. In the two (2) other tag along actions, Blue Springs Internal Medicine, P.C. et al., vs. Coventry Health Care of Kansas, Inc. and James Mirabile, M.D. et.al., vs. Coventry Health Care of Kansas, Inc., the trial court referred each of the plaintiff’s motion to remand to a magistrate judge for a Report and Recommendation. On November 28, 2008, the magistrate judge issued his Report and Recommendation in the Mirabile action, which denied the plaintiff’s motion to remand. Mirabile has filed an objection to the magistrate’s Report and Recommendation. The district court in the Mirabile action, by order dated February 18, 2009, adopted the magistrate judge’s Report and Recommendation denying the plaintiff’s motion to remand the lawsuit back to state court. On December 8, 2008, the magistrate judge issued his Report and Recommendation in the Blue Springs action, which denied the plaintiff’s motion to remand. By order dated January 23, 2009, the district court adopted the magistrate judge’s Report and Recommendation in the Blue Springs action. Although the Company can not predict the outcome, it believes that the tag-along actions will not have a material adverse effect on its financial position or the results of operations. The Company also believes that the claims asserted in these lawsuits are without merit and intends to defend its position.
A small percentage of the Company’s membership is covered by global capitation arrangements. Under the typical arrangement, the provider receives a fixed percentage of premium to cover all the medical costs provided to the globally capitated members. Under some capitated arrangements, physicians may also receive additional compensation from risk sharing and other incentive arrangements. Global capitation arrangements limit the Company’s exposure to the risk of increasing medical costs, but expose the Company to risk as to the adequacy of the financial and medical care resources of the provider organization. In addition to global capitation arrangements, the Company has capitation arrangements for ancillary services, such as mental health care. The Company is ultimately responsible for the coverage of its members pursuant to the customer agreements. To the extent that the respective provider organization faces financial difficulties or otherwise is unable to perform its obligations under the capitation arrangements, the Company will be required to perform such obligations. Consequently, the Company may have to incur costs in excess of the amounts it would otherwise have to pay under the original global or ancillary capitation arrangements. Medical costs associated with capitation arrangements made up approximately 4.1%, 4.9%, and 6.1% of the Company’s total medical costs for the years ended December 31, 2008, 2007 and 2006, respectively.
The Company’s regulated HMO and insurance company subsidiaries are required by state regulatory agencies to maintain minimum surplus balances, thereby limiting the dividends the parent may receive from its regulated entities. During 2008, the Company received $332.1 million in dividends from its regulated subsidiaries and paid $225.2 million in capital contributions.
The majority of states in which the Company operates health plans have adopted a RBC policy that recommends the health plans maintain statutory reserves at or above the ”Company Action Level,” which is currently equal to 200% of their RBC. The State of Florida does not currently use RBC methodology in its regulation of HMOs. Some states, in which the Company’s regulated subsidiaries operate, require deposits to be maintained with the respective states’ departments of insurance. The table below summarizes the Company’s statutory reserve information as of December 31, 2008 and 2007 (in millions, except percentage data).
Allen F. Wise, Chief Executive Officer and Director of the Company, owns a majority interest in Health Risk Partners (“HRP”), an organization that has entered into a contract to perform consulting services for the Company. Two other Directors of the Company own minority interests in HRP. Specifically, HRP provides operational consulting, data processing, data reporting, and chart review / coding services, premium reconciliation, and hierarchical condition categories (“HCC”) revenue compliance related to the Company’s Medicare business. The contract began in 2008 and is expected to be less than $5.0 million for the year ended December 31, 2008. During 2008, the Company paid approximately $1.1 million to HRP for services rendered under the contract.