: Properties As of December 31, 2004, we leased approximately 60,000 square feet of space for our corporate office in Bethesda, Maryland. We also leased approximately 832,000 aggregate square feet for office space, subsidiary operations and customer service centers for the various markets where our health plans operate, of which 7% is subleased. Our leases expire at various dates from 2005 through 2013. We also own a building in Richmond, Virginia with approximately 45,000 square feet, which is used for administrative services related to our health plan in that state, of which 16% is subleased. We believe that our facilities are adequate for our operations.
: Selected Financial Data (in thousands, except per share and membership data)
Diluted weighted average shares outstanding (3) 90,589 90,765 91,865 101,812 98,635
Operations Statement Data include the results of operations of acquisitions since the date of acquisition. Balance Sheet Data reflect acquisitions as of December 31, of the year of acquisition. See the notes to consolidated financial statements for detail on our acquisitions.
Medical loss ratio excludes non-recurring charges and recoveries recorded in 2000.
On January 28, 2005, we acquired First Health which operates one of the largest national preferred provider organization networks. First Health is a major national provider of non-risk administrative and medical management services to commercial, governmental and third party payor customers. Since the acquisition was consummated in 2005, First Health’s financial position and operating results are not included in this discussion. We believe the combination of Coventry and First Health creates a leading health benefits company with the size, scale and product breadth to be a market leader with significant growth opportunities. First Health’s strengths and business mix are highly complementary to our existing business, enabling the following benefits, among others:
significantly expands our geographic presence, creating a national healthcare platform with substantial growth opportunities;
Selling, general and administrative expenses were 11.5% of operating revenue, a 50 basis point improvement over the prior year.
Operating margin of 9.4% improved 130 basis points over the prior year.
Cash flows from operations was $453.9 million, a 41% improvement over the prior year.
Total cash and investments was $1.7 billion, a 23% increase over the prior year.
We generate our operating revenues from premiums for a broad range of managed care and management service products. Premiums for our commercial risk products, for which we assume full underwriting risk, can vary. For example, premiums for our preferred provider organization (“PPO”) and point of service (“POS”) products are typically lower than our health maintenance organization (“HMO”) premiums due to medical underwriting and higher deductibles and co-payments that are typically required of the PPO and POS members. Premium rates for our government programs, Medicare and state-sponsored managed Medicaid, are established by governmental regulatory agencies. These government products are offered in selected markets where we believe we can achieve profitable growth based upon favorable reimbursement levels, provider costs and regulatory climates.
We generate cash through operations. As a profitable company in an industry that is not capital equipment intensive, we have not needed to use financing methods to fund operations. We have a low debt to capital ratio and while we did issue senior notes in 2002 (as described in Note H to our consolidated financial statements in this Form 10-K), the entire proceeds were used to repurchase a portion of our common stock and were not used to fund operations. Our primary use of cash is to pay medical claims. Any excess cash has historically been used for acquisitions and for repurchases of our common stock.
In late January 2005, in connection with the First Health merger, we incurred approximately $865 million of indebtedness in order to finance the acquisition of all of First Health’s outstanding common stock, refinance the existing indebtedness of First Health and pay related transaction fees and expenses. We do not anticipate that any of the proceeds of such indebtedness will be used to fund operations.
We also receive premium payments from the Centers for Medicare and Medicaid Services (“CMS”) on a monthly basis for our Medicare membership. Membership and category eligibility are periodically reconciled with CMS and could result in adjustments to revenue. Premiums collected in advance are recorded as deferred revenue.
We employ a team of actuaries that have developed, refined and used the same set of reserve models over the past several years. These reserve models do not calculate separate amounts for reported but not paid and incurred but not reported, but rather a single estimate of medical claims liabilities. These reserve models make use of both historical claim payment patterns as well as emerging medical cost trends to project our best estimate of claim liabilities. Within these models, historical data of paid claims is formatted into claim triangles which compare claim incurred dates to the claim payment dates. This information is analyzed to create “completion factors” that represent the average percentage of total incurred claims that have been paid through a given date after being incurred. Completion factors are applied to claims paid through the financial statement date to estimate the ultimate claim expense incurred for the current period. Actuarial estimates of claim liabilities are then determined by subtracting the actual paid claims from the estimate of the ultimate incurred claims.
Medical liabilities, beginning of period $ 597,190 $ 558,599 $ 522,854
The negative amounts noted as “prior year” medical costs are favorable adjustments for claim estimates being settled for amounts less than originally anticipated. As noted above, these favorable restatements from original estimates occur due to changes in medical utilization, mix of provider rates and other components of medical cost trends. Medical claim liabilities are generally paid within several months of the member receiving service from the provider. Accordingly, the 2004 prior year medical costs relate almost entirely to claims incurred in calendar year 2003.
We account for investments in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 115 - “Accounting for Certain Investments in Debt and Equity Securities.” We invest primarily in fixed income securities and classify all of our investments as available-for-sale. Investments are evaluated at least quarterly to determine if declines in value are other-than-temporary. In making that determination, we consider all available evidence relating to the realizable value of a security. This evidence includes, but is not limited to, the following:
The securities presented in this table do not meet the criteria for an other-than-temporarily impaired investment. These securities have an investment grade credit rating. The current unrealized loss is the result of interest rate increases and not unfavorable changes in the credit ratings associated with these securities. These investments are not in high risk industries or sectors and we intend to hold these investments for a period of time sufficient to allow for a recovery in market value.
Investments with original maturities in excess of three months and less than one year are classified as short-term investments and generally consist of corporate bonds, U.S. treasury notes and commercial paper. Long-term investments have original maturities in excess of one year and primarily consist of fixed income securities.
New Accounting Standards In December 2004, the Financial Accounting Standards Board (“FASB”) issued FASB Statement No. 123 (revised 2004), Share-Based Payment, which is a revision of SFAS No. 123 “Accounting for Stock-Based Compensation.” SFAS No. 123(R) supersedes Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees,” and amends SFAS No. 95, “Statement of Cash Flows.” Generally, the approach in SFAS No. 123(R) is similar to the approach described in SFAS No. 123. However, SFAS No. 123(R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values. Pro forma disclosure is no longer an alternative.
Under the modified-prospective method, compensation cost is recognized beginning with the effective date based on the requirements of SFAS No. 123(R) for all share-based payments granted after the effective date and based on the requirements of SFAS No. 123 for all awards granted to employees prior to the effective date of SFAS No. 123(R) that remain unvested on the effective date.
As permitted by SFAS No. 123, we currently account for share-based payments to employees using APB No. 25’s intrinsic value method and, as such, have recognized no compensation cost for employee stock options. Accordingly, the adoption of SFAS No. 123(R)’s fair value method will have an effect on our results of operations, although it will have no material effect on our overall financial position. The effect of adoption of SFAS No. 123(R) cannot be predicted at this time because it will depend on levels of share-based payments granted in the future. However, had we adopted SFAS No. 123(R) in prior periods using the Black-Scholes method of valuation, the effect of that standard would have approximated the effect of SFAS No. 123 as described in the disclosure of pro forma net income and earnings per share in Note A to our consolidated financial statements. SFAS No. 123(R) also requires the benefits of tax deductions in excess of recognized compensation cost to be reported as a financing cash flow, rather than as an operating cash flow as required under current literature. This requirement will reduce net operating cash flows and increase net financing cash flows in periods after adoption. While we cannot estimate what those amounts will be in the future (as it is dependent upon, among other things, when employees exercise stock options), the amount of operating cash flows that would have been recognized under SFAS No. 123 in 2004, 2003 and 2002 for such excess tax benefits were $15.8 million, $15.6 million, and $12.9 million, respectively.
The following table summarizes all business combinations and membership purchases for the three years ended December 31, 2004. The purchase price of each business combination includes the payment for net worth and estimated transition costs. The estimated transition costs may be adjusted as actual expenses are incurred, thereby affecting the final purchase price of the acquisition. In addition, most of our acquisition agreements contain a provision for a final retroactive balance sheet settlement which may result in adjustments to the purchase price. The purchase price shown for recent acquisitions, in thousands, is inclusive of all retroactive balance sheet settlements to date and transaction cost adjustments.
Membership The following table presents our membership as of December 31, 2004 and 2003 (in thousands) and the percentage change in membership between these dates.
Medicaid membership increased primarily as a result of the acquisition of OmniCare in the fourth quarter of 2004. The increase in non-risk membership was influenced by three large groups changing from a risk product to a non-risk product effective January 1, 2004, as well as from additional organic membership obtained in the Missouri market.
In January 2005, we lost a large commercial insured account to an administrative services only (“ASO”) bid and a large existing ASO account to another third party administrator. Because of the loss of this membership, organic growth was negative in January but currently is expected to be one to three percent for all of 2005.
Other income increased due to an increase in interest income as a result of higher interest rates and as a result of a larger investment portfolio in 2004. Additionally, 2003 other income included a gain from sale of our single derivative investment which partially offsets the current year increase.
Days in total medical claims liabilities decreased from the prior year due primarily to faster claim receipts and continually improved processing cycle times.
Medical costs have increased due to acquisitions, organic growth and medical trend. Our total medical costs as a percentage of managed care premiums for all products improved 2.1%. This favorable change was attributable mostly to our commercial business and is a result of the commercial premium rate increases mentioned above outpacing commercial medical trend. Reported commercial medical trends, net of benefit buy downs, have been below 10% for each of the last two years. Our Medicare business medical loss ratio improved as a result of an increase in premium yields discussed above and exiting three counties in the Kansas City market on January 1, 2003. Our Medicaid medical loss ratio increased as a result of changes in the geographical markets in which we operate, and an increase in membership in a capitated service. We exited the Delaware Medicaid market on July 1, 2002. Within our Pennsylvania market, membership in our capitated Medicaid behavioral health program has increased significantly during 2002 and 2003. This program has a high medical loss ratio, but is lower in risk to our Company. Our days in total medical claims liabilities have decreased 10.1 days from prior year due to faster claim receipts and processing cycle times as well as efforts to reduce claim inventories.
Selling, general and administrative expense increased primarily due to increased costs associated with acquisitions, an increase in broker commissions and an increase in salary expenses. Broker commissions, excluding acquisitions, have increased due to the growth in both organic membership and in premium yields. Salary expenses, excluding acquisitions, have increased due to annual salary increases, additional amortization expense related to restricted shares of common stock granted in 2003, additional management and sales incentive accruals and incremental salary expense related to our organic membership growth. As a percentage of revenue, selling, general and administrative expense decreased by 0.2%.
Senior notes interest and amortization expense has increased in 2003. Due to the issuance of the notes on February 1, 2002, the prior year period represented eleven months of interest compared to twelve months in 2003. Also contributing to the increase is a $0.5 million loss on the repurchase of a portion of our senior notes at a premium in the third quarter of 2003.
Our provision for income taxes increased primarily due to an increase in earnings before taxes. The effective tax rate increased to 36.4% in 2003 from 35.5% in 2002.
Our Board of Directors has approved a program to repurchase up to 10% of our outstanding common stock. Stock repurchases may be made from time to time at prevailing prices on the open market, by block purchase or in private transactions. As a part of this program, we purchased 3.3 million shares of our common stock in 2002 at an aggregate cost of $65.5 million, no shares in 2003 and 2.0 million shares during the first quarter of 2004 at an aggregate cost of $84.6 million. As of December 31, 2004, the total remaining common shares we are authorized to repurchase under the program is approximately 1.8 million. Excluded from these amounts are shares purchased in exchange for employee payroll taxes on vesting of restricted stock awards as these purchases are not part of the program.
On February 1, 2002 we issued $175.0 million in aggregate principal amount of 8.125% senior notes due 2012. The proceeds from the sale were used to purchase, from Principal Health Care, Inc., 7.1 million shares of our common stock and a warrant exercisable, at that time, for 3.1 million shares of our common stock. The aggregate purchase price for the shares of common stock and warrant was $176.1 million. Interest on our senior notes is payable on February 15 and August 15 each year. The 2002 notes mature on February 15, 2012.
In August 2003, we repurchased a portion of our senior notes with a face value of $4.5 million and a weighted average premium of 8.9%. We recorded a loss on the repurchase in accordance with SFAS No. 145 which requires gains and loses on extinguishments of debt to be classified as income or loss from continuing operations. The loss of $0.5 million was included as additional interest expense. The carrying value of our senior notes is equal to the face value and the fair value is based on the quoted market prices. As of December 31, 2004, the carrying value was $170.5 million and the fair value was $185.2 million.
Our senior notes contain certain covenants and restrictions regarding incurring additional debt, limiting dividends or other restricted payments, and restricting transactions with affiliates, sales of assets and consolidations or mergers. We have complied with all covenants under the senior notes.
During January 2005, we incurred approximately $865 million of additional indebtedness related to the acquisition of First Health. The additional indebtedness includes new senior, unsecured credit facilities consisting of a $300 million five-year term loan, all of which was drawn at closing, and a $150 million five-year revolving credit facility, of which $65 million was drawn at closing.
Loans under the new senior credit facilities bear interest at a margin or spread in excess of either (1) the one-, two-, three- or six-month rate for the Eurodollar deposits (the “Eurodollar Rate”) or (2) the greater of the federal funds rate plus 0.5% or the prime rate of the Administrative Agent (“ABR”), as selected by us. The margin or spread depends on the debt ratings assigned to the new credit facilities and our consolidated leverage ratio and varies from 0.75% to 2% for Eurodollar Rate loans and from 0% to 1.0% for ABR loans. Commitment fees will accrue and be payable quarterly in arrears at an initial rate of 0.375% per annum, and subsequently at a rate ranging from 0.25% to 0.5% depending on the debt ratings assigned to the new credit facilities and our consolidated leverage ratio, multiplied by the daily average undrawn portion of the revolving credit facility.
The indentures under which the new notes have been issued, among other things, restrict our ability and the ability of our restricted subsidiaries to: make investments; incur or guarantee additional indebtedness; pay dividends or make other distributions on capital stock or redeem or repurchase capital stock; create liens; incur dividend or other payment restrictions affecting subsidiaries; and merge or consolidate with other entities. From and after the date on which the notes receive investment grade ratings from two designated rating agencies, certain covenants related to the notes will terminate.
Excess capital and surplus above 300% of RBC $ 211.9 (a)
Senior notes $ 170,500 $ -- $ -- $ -- $ 170,500
We have typically paid 90% to 95% of medical claims within 6 months of the date incurred and approximately 99% of medical claims within 9 months of the date incurred. Accordingly, we believe medical claims liabilities are short-term in nature and therefore do not meet the listed criteria for classification as contractual obligations and have been excluded from the table above.
After giving effect to the new senior notes and new credit facilities in January 2005, we will be contractually obligated to make the following payments, in addition to the payments shown in the table above, within the next five years and thereafter (in thousands):
Interest payable on new credit facilities (a) 53,967 14,938 25,469 13,560 --
(a) subject to changes in the variable interest rates as discussed earlier.
We are a defendant in the provider track in the Managed Care Litigation filed in the United States District Court for the Southern District of Florida, Miami Division, Multi-District Litigation (“MDL”), styled In re: Managed Care Litigation, MDL No. 1334. This lawsuit was filed by a group of physicians as a class action against Coventry and twelve other companies in the managed care industry. The plaintiffs have alleged violations of the Racketeer Influenced and Corrupt Organizations Act (“RICO”), conspiracy to violate RICO and aiding and abetting a scheme to violate RICO. In addition to these federal law claims, the complaint includes state law claims for breach of contract, violations of various state prompt payment laws and equitable claims for unjust enrichment and quantum meruit. The trial court has dismissed several of the state law claims and ordered that all physicians who have an arbitration provision in their provider contracts must submit their direct RICO claims and all of their remaining state law claims to arbitration. As a consequence of this ruling, all the plaintiffs who have arbitration provisions voluntarily dismissed all of their claims that are subject to arbitration. The trial court however has ordered that the plaintiffs’ claims of conspiracy, conspiracy to violate RICO and aiding and abetting violations of RICO are not subject to arbitration. The defendants’ appeal to the 11th Circuit challenging the trial court’s arbitration decision was denied. The trial court has certified various subclasses of physicians; however, we are not subject to the class certification order because the motion to certify was filed before we were joined as a defendant. The plaintiffs have now filed a motion to certify various subclasses as to Coventry. We have filed our opposition to that motion which remains pending before the trial court. The defendants who were subject to the class certification order filed an appeal to the 11th Circuit Court of Appeals. The Court of Appeals has overturned the class certification order as to the plaintiffs’ state law claims but affirmed the certification with respect to the plaintiffs’ federal law claims. The U.S. Supreme Court has denied the defendants’ petition to review the 11th Circuit’s class certification decision. Two defendants have entered into settlement agreements with the plaintiffs. Both settlement agreements have been filed with the Court and have received final approval. This MDL 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. The court has entered an order which stays all proceedings in the tag-along actions until all pre-trial proceedings in the MDL action have been concluded. Although we can not predict the outcome, management believes that the MDL lawsuit and tag-along actions will not have a material adverse effect on its financial position or its results of operations. Management also believes that the claims asserted in these lawsuits are without merit, and we intend to defend our position.
Several companies in the insurance industry have received subpoenas for information from the New York Attorney General and the Connecticut Attorney General with respect to an industrywide investigation into certain insurance brokerage practices, including broker compensation arrangements, bid quoting practices and potential antitrust violations. As of the filing of this Annual Report on Form 10-K, Coventry has not been served with any such subpoenas.
Our health plans operate in highly competitive markets, but we believe that the pricing environment is rational in our existing markets, thus creating the opportunity for reasonable price increases. We will continue to obtain adequate premium increases and expect premium rates to continue to rise at a rate equal to or greater than medical trend in 2005. Management believes that existing markets have potential for premium growth for our commercial and governmental products.
The acquisition of First Health will provide significant growth opportunities. For 2005, we will pursue achievement of synergies, the alignment business operations, accountabilities, and people toward future success, and the establishment of a foundation for future growth in each of the businesses.
Our results of operations may be adversely affected if we are unable to accurately estimate and control future health care costs.
changes in the demographics of our members and medical trends affecting them;
In addition, medical liabilities in our financial statements include our estimated reserves for incurred but not reported and reported but not paid claims. The estimates for medical liabilities are made on an accrual basis. We believe that our reserves for medical liabilities are adequate, but we can not assure you of this. Any adjustments to our medical liabilities could adversely affect our results of operations.
We do not currently anticipate additional growth through acquisitions in 2005
We face competition from other managed care companies that may have broader geographical coverage, more established reputations in our markets, greater market share, larger contracting scale, lower costs and/or greater financial and other resources. We also may face increased rate competition from certain Blue Cross plan competitors that might be required by state regulation to reduce capital surpluses that may be deemed excessive.
Competition in the Federal Employees Benefit Plan and recent plan design changes in the Mail Handlers Benefit Plan may reduce membership and revenues.
First Health competes in a highly competitive environment against other major national managed care companies in its Corporate line of business to provide administrative, network access, and medical management services to large, multi-site, self-insured employers. Among these competitors are Aetna, United Healthcare and “Blue Card” (a joint venture of major Blue Cross plans), all of which have greater resources, brand identity and contracting scale compared to First Health or Coventry.
In some of our markets, there are large provider systems that have a major presence. Some of these large provider systems have operated their own health plans in the past or may choose to do so in the future. These provider systems could adversely affect our product offerings and results of operations if they refuse to contract with us, place us at a competitive disadvantage or use their market position to negotiate contracts that are less favorable to us. Provider agreements are subject to periodic renewal and renegotiations. We can not assure you that these large provider systems will continue to contract with us or that they will contract with us on terms that are favorable to us.
Negative publicity regarding the managed health care industry generally or our company in particular could adversely affect our results of operations or business.
A failure of our information technology systems could adversely affect our business.
The anticipated benefits of acquiring First Health may not be realized.
We may face substantial difficulties, costs and delays in integrating First Health. These factors may include:
diversion of management resources from the business of the combined company;
the retention of existing customers of each company, including, with respect to First Health, the Mail Handlers Benefit Plan (a nationally offered health plan for federal employees);
After the First Health acquisition, we may seek to combine certain operations and functions using common information and communication systems, operating procedures, financial controls and human resource practices, including training, professional development and benefit programs. We may be unsuccessful in implementing the integration of these systems and processes. For its fiscal year 2003, First Health’s revenues were approximately $891 million. While we believe that the companies share certain similar cultural characteristics and philosophies, the differences in size and scope of operations may affect our management processes.
We conduct business in a heavily regulated industry and changes in laws or regulations or violations of regulations could adversely affect our business and results of operations.
impose fines or other penalties as a result of market conduct reviews;
limit the ability of health plans to manage care and utilization due to “any willing provider” and direct access laws that restrict or prohibit product features that encourage members to seek services from contracted providers or through referral by a primary care provider;
In addition, plaintiffs continue to bring new types of legal claims against managed care companies. Recent court decisions and legislative activity increase our exposure to these types of claims. In some cases, plaintiffs may seek class action status and substantial economic, non-economic or punitive damages. The loss of even one of these claims, if it resulted in a significant damage award, could have an adverse effect on our financial condition or results of operations. In the event a plaintiff were to obtain a significant damage award it may make reasonable settlements of claims more difficult to obtain. We can not determine with any certainty what new theories of recovery may evolve or what their impact may be on the managed care industry in general or on us in particular.
The indentures for our senior notes and bank credit agreement impose restrictions on our business and operations. These restrictions limit our ability to, among other things:
Our ability to service our indebtedness will depend on our ability to generate cash in the future. Our ability to generate the cash necessary to service our indebtedness is subject to general economic, financial, competitive, legislative, regulatory and other factors that are beyond our control. We cannot assure you that our business will generate sufficient cash flow from operations or that future borrowings will be available in an amount sufficient to enable us to service our indebtedness or to fund other liquidity needs. In addition, we will be more vulnerable to economic downturns, adverse industry conditions and competitive pressures as a result of our significant indebtedness. We may need to refinance all or a portion of our indebtedness before maturity. We cannot assure you that we will be able to refinance any of our indebtedness or that we will be able to refinance our indebtedness on commercially reasonable terms.
We have a stockholder rights plan that may have the effect of discouraging unsolicited takeover proposals. The rights issued under the stockholder rights plan would cause substantial dilution to a person or group that attempts to acquire us on terms not approved in advance by our board of directors. In addition, provisions in our certificate of incorporation and bylaws and Delaware law may delay, discourage or prevent a merger, acquisition or change in control involving our company that our stockholders may consider favorable. These provisions could also discourage proxy contests and make it more difficult for stockholders to elect directors and take other corporate actions. Among other things, these provisions:
provide that any amendment or repeal of the provisions of our certificate of incorporation establishing our classified board of directors must be approved by the affirmative vote of the holders of three-fourths of our outstanding shares; and
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, 2004 and 2003, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2004, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.
We have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Coventry Health Care, Inc.’s internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations for the Treadway Commission and our report dated February 15, 2005 expressed an unqualified opinion thereon.
Balance, December 31, 2001 $ 1,002 $ (12,257) $ 540,730 $ 6,700 $ 152,904 $ 689,079
Non - cash item - Tax benefit of stock awards $ 21,449
A. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Coventry Health Care, Inc. (together with its subsidiaries, the “Company” or Coventry) is a managed health care company operating health plans under the names Altius Health Plans, Carelink Health Plans, Coventry Health Care, Coventry Health and Life, Group Health Plan, HealthAmerica, HealthAssurance, HealthCare USA, OmniCare, PersonalCare, SouthCare, Southern Health and WellPath. The Company provides a full range of managed care products and services including health maintenance organization (“HMO”), preferred provider organization (“PPO”) and point of service (“POS”) products. The Company also administers self-insured plans for large employer groups and rents its provider networks to various third parties.
Since the Company began operations in 1987 with the acquisition of the American Service Companies entities, including Coventry Health and Life Insurance Company (“CH&L”), the Company has grown substantially through acquisitions. The table below lists all of the Company’s acquisitions. See Note B to consolidated financial statements for additional information on the most recent acquisitions.
Significant Accounting Policies Principles of Consolidation - The consolidated financial statements include the accounts of the Company and its subsidiaries, all of which are 100% owned. All significant inter-company transactions have been eliminated.
Other Receivables - Other receivables include interest receivables, pharmacy rebate receivables, receivables from providers and suppliers and any other receivables that do not relate to premiums.
Business Combinations, Accounting for Goodwill and Other Intangibles - The Company accounts for business combinations, goodwill and other intangibles in accordance with SFAS No. 141 - “Business Combinations” and SFAS No. 142 - “Goodwill and Other Intangible Assets.” Acquired intangible assets are separately recognized upon meeting certain criteria. Such intangible assets include, but are not limited to, trade and service marks, non-compete agreements, customer lists and licenses. Goodwill and other intangible assets that have indefinite lives are subject to a periodic assessment for impairment by applying a fair-value-based test. The Company uses three approaches to identifying the fair value of its goodwill and other intangible assets: the market approach, the market capitalization approach and the income approach. The market approach estimates a business’s fair value by analyzing the recent sales of similar companies. The market capitalization approach is based on market value of the Company’s total shares outstanding. The income approach is based on the present value of expected future cash flows. As impairment charges occur, write-down charges will be recorded in the period in which the impairment took place. See Note C to consolidated financial statements for disclosure related to intangible assets.
The following table shows the components of the change in medical liabilities for the years ended December 31, 2004, 2003 and 2002, respectively:
Other Long-term Liabilities - Other long-term liabilities consist primarily of liabilities associated with the SERP and the deferred tax liability associated with the net unrealized gains on investments.
Revenue Recognition - Managed care premiums are recorded as revenue in the month in which members are entitled to service. Premiums are based on a per subscriber contract rate and the subscribers in the Company’s records at the time of billing. Premium billings are generally sent to employers in the month preceding the month of coverage. Premium billings may be subsequently adjusted to reflect changes in membership as a result of retroactive terminations, additions, or other changes. The Company also receives premium payments from the Centers for Medicare and Medicaid Services (“CMS”) on a monthly basis for its Medicare membership. Membership and category eligibility are periodically reconciled with CMS and such reconciliations could result in adjustments to revenue. Premiums collected in advance are recorded as deferred revenue. Employer contracts are typically on an annual basis, subject to cancellation by the employer group or by the Company upon 30 days notice.
Based on information received subsequent to premium billings being sent, historical trends, bad debt write-offs and the collectibility of specific accounts, the Company estimates, on a monthly basis, the amount of bad debt and future retroactivity and adjusts its revenue and reserves accordingly.
Stock-based Compensation - The Company accounts for stock-based compensation to employees under Accounting Principles Board (“APB”) No. 25 - “Accounting for Stock Issued to Employees,” and complies with the disclosure requirements for Statement of Financial Accounting Standards (“SFAS”) No. 123 - “Accounting for Stock-Based Compensation” and SFAS No. 148 - “Accounting for Stock-Based Compensation - Transition and Disclosure.” Had stock-based compensation cost been determined consistent with SFAS No. 123, the Company’s net earnings and earnings per share (“EPS”) would have been reduced to the following pro-forma amounts (in thousands, except per share data):
EPS, basic - as reported $ 3.83 $ 2.84 $ 1.64
EPS, diluted - as reported $ 3.72 $ 2.75 $ 1.58
In December 2004, the Financial Accounting Standards Board (“FASB”) issued FASB Statement No. 123 (revised 2004), Share-Based Payment, which is a revision of SFAS No. 123. SFAS No. 123(R) supersedes Accounting Principles Board (“APB”) Opinion No. 25, and amends SFAS No. 95, “Statement of Cash Flows.” Generally, the approach in SFAS No. 123(R) is similar to the approach described in SFAS No. 123. However, SFAS No. 123(R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values. Pro forma disclosure is no longer an alternative.
Under the modified-prospective method, compensation cost is recognized beginning on the adoption date based on the requirements of SFAS No. 123(R) for all share-based payments granted after the effective date and based on the requirements of SFAS No. 123 for all awards granted to employees prior to the effective date of SFAS No. 123(R) that remain unvested on the effective date.
As permitted by SFAS No. 123, the Company currently accounts for share-based payments to employees using APB No. 25’s intrinsic value method and, as such, has recognized no compensation cost for employee stock options. Accordingly, the adoption of SFAS No. 123(R)’s fair value method will have an effect on its results of operations, although it will have no material effect on its overall financial position. The effect of adoption of SFAS No. 123(R) cannot be predicted at this time because it will depend on levels of share-based payments granted in the future. However, had the Company adopted SFAS No. 123(R) in prior periods using the Black-Scholes method of valuation, the effect of that standard would have approximated the effect of SFAS No. 123 as described in the disclosure of pro forma net income and earnings per share above. SFAS No. 123(R) also requires the benefits of tax deductions in excess of recognized compensation cost to be reported as a financing cash flow, rather than as an operating cash flow as required under current literature. This requirement will reduce net operating cash flows and increase net financing cash flows in periods after adoption. While the Company cannot estimate what those amounts will be in the future (as it is dependent upon, among other things, when employees exercise stock options), the amounts of operating cash flows that would have been recognized under SFAS No. 123 in prior periods for such excess tax benefits were $15.8 million, $15.6 million, and $12.9 million in 2004, 2003 and 2002, respectively.
Contract Acquisition Costs - Costs related to the acquisition of customer contracts, such as commissions paid to outside brokers, are expensed as incurred.
Income Taxes - The Company files a consolidated federal tax return for the Company and its subsidiaries. The Company accounts for income taxes in accordance with SFAS No. 109 - “Accounting for Income Taxes.” The deferred tax assets and/or liabilities are determined by multiplying the differences between the financial reporting and tax reporting bases for assets and liabilities by the enacted tax rates expected to be in effect when such differences are recovered or settled. The effect on deferred taxes of a change in tax rates is recognized in income in the period that includes the enactment date. See Note F to consolidated financial statements for disclosures related to income taxes.
Earnings Per Share - Basic earnings per share are based on the weighted average number of common shares outstanding during the year. Diluted earnings per share assume the exercise of all options and warrants and the vesting of all restricted stock using the treasury stock method.
B. ACQUISITIONS During the three years ended December 31, 2004, the Company completed several business combinations and membership purchases. The Company’s business combinations are all accounted for using the purchase method of accounting and, accordingly, the operating results of each acquisition have been included in the Company’s consolidated financial statements since their effective date of acquisition. The purchase price for each business combination was allocated to the assets, including the identifiable intangible assets, and liabilities based on estimated fair values. The excess of the purchase price over the net identifiable assets acquired was allocated to goodwill. The purchase price of the Company’s membership purchases is allocated to identifiable intangible assets and is being amortized over a useful life of ten to twenty years.
As described in the Company’s segment disclosure, assets are not allocated to specific products, and, accordingly, goodwill can not be reported by segment. The Company has completed its impairment test of goodwill and has determined that there was no impairment of goodwill as of October 1, 2004, the Company’s annual impairment test date. The changes in the carrying amount of goodwill for the years ended December 31, 2004 and 2003 were as follows (in thousands):
Total amortized other intangible assets $ 49,247 $ 10,856 $ 38,391
Other intangible amortization expense for the years ended December 31, 2004, 2003 and 2002 was $2.7 million, $2.5 million and $3.1 million, respectively. Estimated intangible amortization expense is $2.6 million for the years ending December 31, 2005 through 2008 and $2.5 million for the year ending December 31, 2009. The weighted-average amortization period is 14 years for other intangible assets.
E. INVESTMENTS The Company considers all of its investments as available-for-sale securities and, accordingly, records unrealized gains and losses, except for those determined to be other-than-temporary impairments, as other comprehensive income in the stockholders’ equity section of its consolidated balance sheets.
State and municipal bonds $ 371,872 $ 11,721 $ (714) $ 382,879
Gross investment gains of $2.0 million and gross investment losses of $1.3 million were realized on sales of investments for the year ended December 31, 2004. This compares to gross investment gains of $2.2 million and gross investment losses of $1.5 million on these sales for the year ended December 31, 2003, and gross investment gains of $1.9 million and gross investment losses of $3.1 million on these sales for the year ended December 31, 2002.
The securities referenced in this table do not meet the criteria for an other-than-temporarily impaired investment. These securities have an investment grade credit rating. The current unrealized loss is the result of interest rate increases and not unfavorable changes the credit ratings associated with these securities. These investments are not in high risk industries or sectors and the Company intends to hold these investments for a period of time sufficient to allow for a recovery in market value.
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, 2004, the Stock Incentive Plan had outstanding options representing 6.6 million shares of common stock.
The weighted-average grant date fair values for options granted in 2004, 2003 and 2002 were $20.07, $10.69 and $10.44, respectively.
Several acquisitions have been completed since the adoption of the Savings Plan. Pursuant to specific terms of each acquisition’s respective merger agreement, the surviving entity (1) became an adopting employer of the Savings Plan, and/or (2) commenced participation in the Savings Plan following approval by the Company’s Board of Directors.
Immediately upon participation in the Savings Plan, all participant account balances included in the assets of the former qualified retirement plan were rolled over into the Savings Plan and employees were permitted to commence participation in the Savings Plan, except for participants of the former Mid-America Health Partners. All employees of the former Mid-America Health Partners were eligible to participate in the Savings Plan effective December 2, 2002; however their balance in the MAH Plan remained in the MAH Plan. The MAH Plan was terminated effective December 1, 2002 and the MAH Plan assets will remain until the earlier of (i) termination of employment with Coventry or one of its affiliates; or (ii) receipt of the Internal Revenue Service determination letter approving the termination of the MAH Plan. No contributions were made to the MAH Plan after December 1, 2002. The MAH Plan assets are held by Fidelity Management Trust Company, the funding agent of the assets held under the terms of the Plan and Trust. All participants in the MAH Plan were 100% vested in employer matching contributions as of December 1, 2002. All costs of the MAH Plan are funded by the Company and participants as they are incurred. All employees of Altius were eligible to participate in the Savings Plan effective January 1, 2004. The Altius SaveMore 401(k) Plan (the “Altius Plan”) was frozen effective December 31, 2003 and the Plan assets were merged with and into the Savings Plan on February 2, 2004. No contributions were made to the Altius Plan after December 31, 2003. The Altius Plan assets were held by Reliance Trust Company, the funding agent of the assets held under the terms of the Plan and Trust. All participants in the Altius Plan were 100% vested in employer matching contributions as of September 1, 2003. All costs of the Altius Plan were funded by the Company and participants as they were incurred.
As of December 31, 2004, the Company was the sponsor of a Supplemental Executive Retirement Plan (the “SERP”), currently known as the Coventry Health Care, Inc. Supplemental Executive Retirement Plan. Under the SERP, participants may defer up to 15% 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 SERP are funded by the Company as they are incurred.
H. SENIOR NOTES On February 1, 2002, the Company completed a transaction to sell $175.0 million original 8.125% senior notes due February 15, 2012 in a private placement. These senior notes were then registered with the Securities and Exchange Commission. The proceeds from the sale of senior notes were used to purchase, from Principal Health Care, Inc., 7.1 million shares of Coventry common stock and a warrant exercisable, at that time, for 3.1 million shares of Coventry common stock. The aggregate purchase price for the shares of common stock and the warrant was $176.1 million. Interest on the notes is payable on February 15 and August 15 each year.
The senior notes contain certain covenants and restrictions regarding incurring additional debt, limiting dividends or other restricted payments, and restricting transactions with affiliates, sales of assets and consolidations or mergers. The Company has complied with all covenants under the senior notes.
During the first quarter of 2005, the Company incurred additional indebtedness in order to finance the acquisition of First Health Group Corporation’s outstanding common stock, refinance the existing indebtedness of First Health and pay related transaction fees and expenses. See Note P to consolidated financial statements for disclosure related to subsequent events.
Total rent expense was $19.0 million, $17.4 million and $15.2 million, for the years ended December 31, 2004, 2003 and 2002, respectively.
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, 2004 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.
Coventry Health Care, Inc. is a defendant in the provider track in the Managed Care Litigation filed in the United States District Court for the Southern District of Florida, Miami Division, Multi-District Litigation (“MDL”), styled In re: Managed Care Litigation, MDL No. 1334. This lawsuit was filed by a group of physicians as a class action against Coventry and twelve other companies in the managed care industry. The plaintiffs have alleged violations of the Racketeer Influenced and Corrupt Organizations Act (“RICO”), conspiracy to violate RICO and aiding and abetting a scheme to violate RICO. In addition to these federal law claims, the complaint includes state law claims for breach of contract, violations of various state prompt payment laws and equitable claims for unjust enrichment and quantum meruit. The trial court has dismissed several of the state law claims and ordered that all physicians who have an arbitration provision in their provider contracts must submit their direct RICO claims and all of their remaining state law claims to arbitration. As a consequence of this ruling, all the plaintiffs who have arbitration provisions voluntarily dismissed all of their claims that are subject to arbitration. The trial court however has ordered that the plaintiffs’ claims of conspiracy, conspiracy to violate RICO and aiding and abetting violations of RICO are not subject to arbitration. The defendants’ appeal to the 11th Circuit challenging the trial court’s arbitration decision was denied. The trial court has certified various subclasses of physicians; however, Coventry is not subject to the class certification order because the motion to certify was filed before Coventry was joined as a defendant. The plaintiffs have now filed a motion to certify various subclasses as to Coventry. Coventry has filed its opposition to that motion which remains pending before the trial court. The defendants who were subject to the class certification order filed an appeal to the 11th Circuit Court of Appeals. The Court of Appeals has overturned the class certification order as to the plaintiffs’ state law claims but affirmed the certification with respect to the plaintiffs’ federal law claims. The U.S. Supreme Court has denied the defendants’ petition to review the 11th Circuit’s class certification decision. Two defendants have entered into settlement agreements with the plaintiffs. Both settlement agreements have been filed with the Court and have received final approval. This MDL 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. The court has entered an order which stays all proceedings in the tag-along actions until all pre-trial proceedings in the MDL action have been concluded. Although the Company can not predict the outcome, management believes that the MDL lawsuit and tag-along actions will not have a material adverse effect on its financial position or its results of operations. Management also believes that the claims asserted in these lawsuits are without merit, and the Company intends to defend its position.
The Company contracts with the Office of Personnel Management (“OPM”) to provide managed health care services under the Federal Employee Health Benefits Program (“FEHBP”). These contracts with the OPM and applicable government regulations establish premium rating arrangements for this program. The OPM conducts periodic audits of its contractors to, among other things, verify that the premiums established under its contracts are in compliance with the community rating and other requirements under FEHBP. The OPM may seek premium refunds or institute other sanctions against health plans that participate in the program.
K. STATUTORY INFORMATION The Company’s 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 2004, the Company received $173.6 million in dividends and $12.6 million for note repayments from its regulated subsidiaries.
Regulators will use the RBC results to determine if any regulatory actions are required. Regulatory actions that could take place, if any, range from filing a financial action plan explaining how the plan will increase its statutory net worth to the approved levels, to the health plan being placed under regulatory control
The increase in capital and surplus for the Company’s regulated subsidiaries is a result of income from 2004 offset by dividends paid to the parent company.
L. OTHER INCOME Other income for the years ended December 31, 2004, 2003 and 2002 includes investment income, net of fees, of approximately $44.1 million, $40.2 million and $40.9 million, respectively.
Loans under the new senior credit facilities bear interest at a margin or spread in excess of either (1) the one-, two-, three- or six-month rate for the Eurodollar deposits (the “Eurodollar Rate”) or (2) the greater of the federal funds rate plus 0.5% or the prime rate of the Administrative Agent (“ABR”), as selected by the Company. The margin or spread depends on the debt ratings assigned to the new credit facilities and the Company’s consolidated leverage ratio and varies from 0.75% to 2% for Eurodollar Rate loans and from 0% to 1% for ABR loans. Commitment fees will accrue and be payable quarterly in arrears at an initial rate of 0.375% per annum, and subsequently at a rate ranging from 0.25% to 0.5% depending on the debt ratings assigned to the new credit facilities and the Company’s consolidated leverage ratio, multiplied by the daily average undrawn portion of the revolving credit facility.
Coventry also closed the private placement of $250 million aggregate principal amount of 5 7/8% senior notes due 2012 and $250 million aggregate principal amount of 6 1/8% senior notes due 2015. These senior notes have since been registered with the Securities and Exchange Commission. The senior notes are general unsecured obligations of Coventry and rank equal in right of payment to all of Coventry’s existing and future senior debt, including its existing 8.125% senior notes due 2012 and its new credit facilities.
The Indentures under which the notes have been issued, among other things, restrict the Company’s ability and the ability of the Company’s restricted subsidiaries to: make investments; incur or guarantee additional indebtedness; pay dividends or make other distributions on capital stock or redeem or repurchase capital stock; create liens; incur dividend or other payment restrictions affecting subsidiaries; and merge or consolidate with other entities. From and after the date on which the notes receive investment grade ratings from two designated rating agencies, certain covenants related to the notes will terminate.
Coventry used the proceeds from the new credit facilities and senior notes, together with approximately $221 million of cash on hand, to fund the First Health acquisition, including the repayment of First Health’s outstanding bank debt and related transaction expenses.