The data for the years ended December 31, 2004, 2005 and 2006 have been restated to reflect the effects of the accounting errors discussed in the Explanatory Note on page 5 of this 2007 Form 10-K, as well as reclassifications that do not affect Net income for the years ended December 31, 2003, 2004, 2005 and 2006.
Pro forma net income per share is computed using the pro forma weighted average number of common shares outstanding, which gives effect to the automatic conversion of all outstanding common units of WellCare Holdings, LLC into shares of common stock of WellCare Health Plans, Inc. upon the closing of our initial public offering. For a discussion of the difference between pro forma net income per common share and net income attributable per common unit, see Note 15 to the consolidated financial statements of WellCare Health Plans, Inc.
As a result of the restatement and investigation, we were delayed in filing this 2007 Form 10-K. Due to the substantial lapse in time between December 31, 2007 and the date of filing of this 2007 Form 10-K, we were able to review substantially complete claims information that has become available due to the substantial lapse in time between December 31, 2007 and the date of filing of this 2007 Form 10-K. We have determined that the claims information that has become available provides additional evidence about conditions that existed with respect to medical benefits payable at the December 31, 2007 balance sheet date and has been considered in accordance with GAAP. Consequently, the amounts we recorded for medical benefits payable and medical benefits expense for the year ended December 31, 2007 are based on actual claims paid. The difference between our actual claims paid for this period and the amount that would have resulted from using our original actuarially determined estimate is approximately $92.9 million, or a decrease of 1.8% in the MBR. Thus, Medical benefits expense, medical benefits payable and the MBR for the year ended December 31, 2007 include the effect of using actual claims paid. Conversely, we anticipate that medical benefits expense and MBRs in 2008 will be unfavorably impacted because they will not have the off-setting benefit of the prior period development that otherwise would have been recorded in 2008 if we were filing timely.
Total stockholders’/members’ equity reflects limited liability company membership interests as of December 31, 2003 and reflects stockholders’ equity as of December 31, 2004, 2005, 2006 and 2007.
We first discuss below the restatement of our previously issued financial statements and the effect of such restatement on our audited consolidated financial statements for the fiscal year ended December 31, 2007, and then address our current operating environment and our business outlook.
As previously disclosed in our Current Report on Form 8-K filed July 21, 2008, upon consideration of certain issues identified in the Special Committee investigation and after discussions with management and our independent registered public accounting firm, the Audit Committee recommended to the Board, and the Board thereafter concluded, that our previously issued consolidated financial statements for the Restatement Period needed to be restated.
Our financial statements for the year ended December 31, 2007 included in this 2007 Form 10-K reflect applicable changes in accounting treatment that we adopted in response to the issues raised by the restatement.
We are engaged in resolution discussions as to matters under review with the USAO, the Civil Division, the OIG and the State of Florida. Based on the current status of matters and all information known to us to date, we have accrued a liability in the amount of $50.0 million in our financial statements for the year ended December 31, 2007 in connection with the ultimate resolution of these matters. However, we cannot provide any assurances regarding the likelihood, timing or terms and conditions of any potential negotiated resolution of pending investigations by the USAO, the Civil Division, the OIG or the State of Florida. For more information related to this accrual, see Notes 3 and 11 to the consolidated financial statements included in this 2007 Form 10-K.
As previously disclosed, our senior secured credit facility with Wachovia Bank, as Administrative Agent, and a syndicate of lenders, which has a term loan facility with an outstanding balance of approximately $152.8 million as of December 31, 2008, is currently in default and subject to acceleration by the lenders and, absent acceleration by the lenders, will become due and payable on May 13, 2009. Our senior secured credit facility also included a revolving credit facility that expired in May 2008. Taking into account, among other things, the increase in our unregulated cash balances as a result of our receipt of the $105.1 million in dividends described above, we currently expect that we will be able to repay in full the outstanding balance under the credit facility when it becomes due. However, we cannot provide any assurances that adverse developments will not arise that impede our ability to repay in full the outstanding balance under the credit facility when it becomes due. In particular, the timing and amount of any potential resolution of pending investigations by the USAO, the Civil Division, the OIG and the State of Florida are uncertain and could materially and adversely affect our ability to meet our near-term obligations, including repayment of the outstanding balance under the credit facility. Also, our ability to repay in full the outstanding balance under the credit facility could be materially and adversely affected if, among other things, Florida regulators were to require certain of our intercompany loan arrangements which total approximately $50 million to be terminated. In addition, there may be other potential adverse developments that could impede our ability to repay in full the outstanding balance under the credit facility.
Government funding continues to be a significant challenge to our business, particularly in light of the current economic conditions. Because the health care services we offer are through government-sponsored programs, our profitability is largely dependent on continued funding for government health care programs at or above current levels. Future Medicaid premium rate levels may be affected by continued government efforts to contain medical costs or state and federal budgetary constraints. Some of the states in which we operate have experienced fiscal challenges leading to significant budget deficits. Health care spending increases
We currently do not foresee large, one-time opportunities to expand our business, such as prior efforts like the launch of PDPs in 2006 and the privatization of Georgia Medicaid in 2006. We also intend to divert some resources to strengthening compliance and operating capabilities. These factors, when combined with the rationalization of our operations and the operational challenges we face, could cause us to not sustain the rapid growth we have achieved in the recent past.
We provide managed care services targeted exclusively to government-sponsored health care programs, focused on Medicaid and Medicare, including prescription drug plans and health plans for families, children, and the aged, blind and disabled. As of December 31, 2007, we served approximately 2,373,000 members. Most of our revenues are generated by premiums consisting of fixed monthly payments per member.
The consolidated balance sheets, statements of income, changes in stockholders’ and members’ equity and comprehensive income and cash flows include the accounts of the Company and all of its wholly owned subsidiaries. Intercompany accounts and transactions have been eliminated.
Medicaid was established to provide medical assistance to low income and disabled persons, and is state operated and implemented, although it is funded and regulated by both the state and federal governments. For a more detailed description of our Medicaid segment, please see “Item 1 - Business - Our Segments.” As of December 31, 2007, we had approximately 1,232,000 Medicaid members. The following table summarizes our Medicaid segment membership by line of business as of December 31, 2007, 2006, 2005 and 2004.
In our Medicare segment, we have just one customer, CMS, from which we receive 100% of our Medicare segment premium revenue.
For further detail about the CMS reimbursement methodology under the PDP program, see “Critical Accounting Policies” below.
In general, members are required to use our network, except in cases of emergencies, transition of care or when network providers are unavailable to meet a member’s medical needs, and generally must receive a referral from their primary care physician in order to receive health care from a specialist, such as an orthopedic surgeon or neurologist. Members do not pay any premiums, deductibles or co-payments for most of our Medicaid plans.
Most of our Medicare Advantage plans require members to pay a co-payment, which varies depending on the services and level of benefits provided. Typically, members of our CCPs are required to use our network of providers except in cases such as emergencies, transition of care or when specialty providers are unavailable to meet a member’s medical needs. CCP members may see an out-of-network specialist if they receive a referral from their PCP and may pay incremental cost-sharing. PFFS plans are open-access plans that allow members to be seen by any physician or facility that participates in the Medicare program, is willing to bill us for reimbursement and accepts our terms and conditions. Our pilot PPO plans offer members the option to seek any services outside of our contracted network but, in such case, they are subject to higher cost sharing. We also offer special needs plans to individuals who are dually eligible for Medicare and Medicaid, or D-SNPs, in most of our markets. D-SNPs are designed to provide specialized care and support for beneficiaries who are dually eligible for both Medicare and Medicaid. We believe that our D-SNPs are attractive to these beneficiaries due to the enhanced benefit offerings and clinical support programs.
Our largest expense is the cost of medical benefits that we provide, which is based primarily on our arrangements with health care providers and utilization of health care services by our members. Our profitability depends on our ability to predict and effectively manage medical benefits expense relative to the fixed premiums we receive. Our arrangements with providers primarily fall into two broad categories: capitation arrangements, where we pay the capitated providers a fixed fee per member, and fee-for-service and risk-sharing arrangements, where we assume all or part of the risk of the cost of the health care provided. Capitation payments represented 11% and 13% of our total medical benefits expense for the years ended December 31, 2007 and 2006, respectively. Other components of medical benefits expense are variable and require estimation and ongoing cost management.
Estimation of medical benefits payable is our most significant critical accounting estimate. See “Critical Accounting Policies” below.
Revenue recognition. Our Medicaid contracts with state governments are generally multi-year contracts subject to annual renewal provisions. Our Medicare Advantage and PDP contracts with CMS generally have terms of one year. We recognize premium revenues in the period in which we are obligated to provide services to our members. We estimate, on an ongoing basis, the amount of member billings that may not be fully collectible or that will be returned based on historical trends, anticipated or actual MBRs, and other factors. An allowance is established for the estimated amount that may not be collectible and a liability is established for premium expected to be returned. The allowance has not been significant to premium revenue. The payment we receive monthly from CMS for our PDP program generally represents our bid amount for providing prescription drug insurance coverage. We recognize premium revenue for providing this insurance coverage ratably over the term of our annual contract. Premiums collected in advance are deferred and reported as unearned premiums in the accompanying consolidated balance sheets and amounts that have not been received by the end of the period remain on the balance sheet classified as premium receivables.
The CMS risk-adjustment model pays more for Medicare members with predictably higher costs. Under this risk-adjustment methodology, diagnosis data from inpatient and ambulatory treatment settings are used to calculate the risk-adjusted premium payment to us. We collect claims and encounter data and submit the necessary diagnosis data to CMS within prescribed deadlines. We continually estimate risk-adjusted revenues based upon membership claim activity and the diagnosis data submitted to CMS, as well as the data which is ultimately accepted by CMS, and record such adjustments in our results of operations. However, due to the variability of the assumptions that we use in our estimates, our actual results may differ from the amounts that we have estimated. If our estimates are materially incorrect, it may have an adverse effect on our results of operations in future periods. Historically, we have not experienced significant differences between the amounts that we have recorded and the revenues that we actually received.
Estimating medical benefits expense and medical benefits payable. The cost of medical benefits is recognized in the period in which services are provided and includes an estimate of the cost of medical benefits that have been incurred but not yet reported. We contract with various health care providers for the provision of certain medical care services to our members and generally compensate those providers on a fee-for-service or capitated basis or pursuant to certain risk-sharing arrangements. Capitation represents fixed payments generally on a per-member-per-month, or PMPM, basis to participating physicians and other medical specialists as compensation for providing comprehensive health care services. Generally, by the terms of most of our capitation agreements, capitation payments we make to capitated providers alleviate any further obligation we have to pay the capitated provider for the actual medical expenses of the member. Participating physician capitation payments for the years ended December 31, 2007, 2006, 2005 and 2004, were 11%, 13%, 13% and 14% of total medical benefits expense, respectively.
Medical cost trends can be volatile and management is required to use considerable judgment in the selection of medical benefits expense trends and other actuarial model inputs. In developing the estimate, we apply different estimation methods depending on the month for which incurred claims are being estimated. For the more recent months, which constitute the majority of the amount of the medical benefits payable, we estimate claims incurred by applying observed trend factors to the PMPM costs for prior months, which costs have been estimated using completion factors, in order to estimate the PMPM costs for the most recent months. We validate our estimates of the most recent PMPM costs by comparing the most recent months’ utilization levels to the utilization levels in older months and actuarial techniques that incorporate a historical analysis of claim payments, including trends in cost of care provided and timeliness of submission and processing of claims.
Changes in medical benefits payable estimates are primarily the result of obtaining more complete claims information and medical expense trend data over time. Volatility in members’ needs for medical services, provider claims submissions and our payment processes result in identifiable patterns emerging several months after the causes of deviations from assumed trends occur. Since our estimates are based upon PMPM claims experience, changes cannot typically be explained by any single factor, but are the result of a number of interrelated variables, all influencing the resulting experienced medical cost trend. Differences in our financial statements between actual experience and estimates used to establish the liability, which we refer to as prior period developments, are recorded in the period when such differences become known, and have the effect of increasing or decreasing the reported medical benefits expense and resulting MBR in such periods.
As noted above, we historically have used an estimate of medical benefits expense and medical benefits payable because substantially complete claims data is typically not available at the required date to file timely our annual and interim reports. However, for the year ended December 31, 2007, we were able to review substantially complete claims information that has become available due to the substantial lapse in time between December 31, 2007 and the date of filing of this 2007 Form 10-K. We have determined that the claims information that has become available provides additional evidence about conditions that existed with respect to medical benefits payable at the December 31, 2007 balance sheet date and has been considered in accordance with GAAP. Consequently, the amounts we recorded for medical benefits payable and medical benefits expense for the year ended December 31, 2007 are based on actual claims paid. The difference between our actual claims paid for this period and the amount that would have resulted from using our original actuarially determined estimate is approximately $92.9 million, or a decrease of 1.8% in the MBR. Thus, medical benefits expense, medical benefits payable and the MBR for the year ended December 31, 2007 include the effect of using actual claims paid. Conversely, we anticipate that medical benefits expense and MBRs in 2008 will be unfavorably impacted because they will not have the off-setting benefit of the prior period development that otherwise would have been recorded in 2008 if we were filing timely.
The following table provides a reconciliation of the beginning and ending balance of medical benefits payable for the following periods (in thousands):
Medical benefits payable recorded at December 31, 2006, 2005 and 2004 developed favorably by approximately $100.2 million, $47.1 million and $26.4 million, respectively. These decreases in medical benefits payable in the amounts incurred related to prior years for 2007 related to 2006, 2006 related to 2005, and 2005 related to 2004, were primarily attributable to favorable development in our key assumptions consisting of trend factors and completion factors using an assumption of moderately adverse conditions.
Goodwill and intangible assets. We obtained goodwill and intangible assets as a result of the acquisitions of our subsidiaries. Goodwill represents the excess of the cost over the fair market value of net assets acquired. Intangible assets include provider networks, membership contracts, trademarks, non-compete agreements, state contracts, licenses and permits. Our intangible assets are amortized over their estimated useful lives ranging from one to 26 years.
We evaluate whether events or circumstances have occurred that may affect the estimated useful life or the recoverability of the remaining balance of goodwill and other identifiable intangible assets. We must make assumptions and estimates, such as the discount factor, in determining the estimated fair values. While we believe these assumptions and estimates are appropriate, other assumptions and estimates could be applied and might produce significantly different results. In August 2006, we were notified by the Indiana Office of Medicaid Policy and Planning that our Medicaid contract would not be renewed in 2007. As a result, we performed a review of our intangible assets associated with the Indiana market and deemed them to have no further economic value. Accordingly, the remaining amortization on the assets with a net value of $2.5 million that were purchased in 2004 was accelerated. Expense of $2.5 million is included in depreciation and amortization expense in our 2006 statement of income.
We review goodwill and intangible assets for impairment at least annually, or more frequently if events or changes in circumstances occur that may affect the estimated useful life or the recoverability of the remaining balance of goodwill or intangible assets. Events or changes in circumstances would include significant changes in membership, state funding, medical contracts and provider networks. We have selected the second quarter of each year, (the “Valuation” date) for our annual impairment test, which generally coincides with the finalization of state and federal contract negotiations and our initial budgeting process. Subsequent to the annual impairment testing date, we experienced several significant changes and the existence of certain uncertainties relating to pending federal and state governmental investigations. As a result of the investigation and the potential consequences, we re-tested the recoverability of goodwill in the fourth quarter of 2007, (the “Revaluation date”). As of the Valuation date and the Revaluation date, we have assessed the earnings forecast for our two reporting units and concluded that the fair value of the individual reporting units, based upon the expected present value of future cash flows and other qualitative factors, was in excess of net assets of each reporting unit. As of December 31, 2007, we believe that there is no impairment to the value of goodwill or intangible assets.
One of our primary management tools for measuring profitability is our MBR. Changes in the MBR from period to period result from, among other things, changes in Medicaid and Medicare funding, changes in the mix of Medicaid and Medicare membership, our ability to manage medical costs and changes in accounting estimates related to incurred but not reported claims. We use MBRs both to monitor our management of medical benefits expense and to make various business decisions, including what health care plans to offer, what geographic areas to enter or exit and the selection of health care providers. Although MBRs play an important role in our business strategy, we may be willing to enter into provider arrangements that might produce a less favorable MBR if those arrangements, such as capitation or risk-sharing, would likely lower our exposure to variability in medical costs.
Premium revenue. For the year ended December 31, 2007, total premium revenue increased $1,718.9 million, or 47.9%, to $5,304.9 million from $3,586.0 million for the same period in the prior year due to increases in premium revenue in both the Medicaid and Medicare segments, as discussed below. Total membership grew by 115,000 members, or 5.1%, from 2,258,000 at December 31, 2006 to 2,373,000 at December 31, 2007.
* We believe that Medicaid Medical Benefits Expense as adjusted for the year ended December 31, 2007, is a non-GAAP financial measure because it does not take into account the claims information that has become available as of the date of filing of this 2007 Form 10-K. The most directly comparable GAAP measure is Medicaid Medical Benefits Expense, which has been determined based on the substantially complete claims information that has subsequently become available as of the date of filing this 2007 Form 10-K. Consequently, the amounts we recorded in accordance with GAAP for Medicaid Medical Benefits Expense for the year ended December 31, 2007 are based on actual claims paid. The difference between Medicaid Medical Benefits Expense and Medicaid Medical Benefits Expense as adjusted, is approximately $39.5 million. Thus, our recorded amounts for Medicaid Medical Benefits Expense and MBR for the year ended December 31, 2007 both include the effect of using actual claims paid. Consequently, we believe that Medicaid Medical Benefits Expense as adjusted for the year ended December 31, 2007, which is based on our actuarially determined estimate, will better facilitate a year over year comparison of our Medicaid Medical Benefits Expense.
For the year ended December 31, 2007, medical benefits expense increased $725.2 million, or 53.7%, to $2,076.7 million from $1,351.5 million for the same period in the prior year due to the increases in medical benefits expense in both the Medicaid and Medicare segments, as discussed below. Our MBR was 79.5% for the year ended December 31, 2007 compared to 80.5% for the same period in the prior year.
Income tax expense. Income tax expense for the year ended December 31, 2007 was $161.7 million with an effective tax rate of 42.8% as compared to $79.8 million with an effective tax rate of 39.7% for the same period in the prior year. The increase in the effective tax rate is principally attributed to the non-deductible expense that was recorded in the amount of $50.0 million in connection with the ultimate resolution of the investigation related matters discussed in Notes 3 and 11 to the Consolidated Financial Statements. The ultimate terms and structure of any potential resolution of pending enforcement investigations is still unknown; therefore, we have assumed that the potential resolution amount will not be tax deductible.
Net income. For the year ended December 31, 2007, net income was $216.2 million compared to $121.2 million for the same period in the prior year, representing an increase of $95.0 million or 78.4%. Net income increased as a result of the favorable adjustment that was recorded to medical benefits expense to reflect the difference between the actual claims paid and the Company’s actuarially determined estimate which accounted for $53.1 million of the increase. This increase was off-set by the increase in non-deductible tax expense that was recorded in the amount of $50.0 million in connection with the potential resolution of the investigation related matters discussed in Note 11 to the Consolidated Financial Statements. The remaining $91.9 million increase is a result of significant premium growth as discussed above.
Premium revenue. For the year ended December 31, 2006, premium revenue increased $1,737.7 million, or 94.0%, to $3,586.0 million from $1,848.3 million for the same period in the prior year due to increases in premium revenue in both the Medicaid and
Medicare segments, as discussed below. Total membership grew by 1,403,000 members, or 164.1%, from 855,000 at December 31, 2005 to 2,258,000 at December 31, 2006.
Medical benefits expense. For the year ended December 31, 2006, medical benefits expense increased $1,401.9 million, or 93.1%, to $2,907.3 million from $1,505.4 million for the same period in the prior year due to the increases in medical benefits expense in both the Medicaid and Medicare segments, as discussed below. The MBR was 81.1% for the year ended December 31, 2006 compared to 81.4% for the same period in the prior year.
Selling, general and administrative expense. For the year ended December 31, 2006, selling, general and administrative expense increased $236.9 million, or 91.3%, to $496.4 million from $259.5 million for the same period in the prior year. Our selling, general and administrative expense to revenue ratio was 13.7% and 13.9% for the years ended December 31, 2006 and 2005, respectively. The increase in selling, general and administrative expense was primarily due to investments in information technology, investments in sales and marketing strategies and increased spending necessary to support and sustain our membership growth.
Interest expense. Interest expense was $14.1 million and $13.6 million for the years ended December 31, 2006 and 2005, respectively. The increase relates to higher borrowing costs due to the rising interest rate environment, partially off-set by the reduced amount of debt outstanding due to the settlement of the related party note.
Net income. For the year ended December 31, 2006, net income was $121.2 million compared to $47.4 million for the same period in the prior year, representing an increase of $73.8 million or 156.0%. The increase is due to increased revenues generated by our membership growth while maintaining a relatively consistent MBR.
Medicare. For the year ended December 31, 2005, Medicare segment premium revenue increased $169.7 million, or 50.7%, to $504.5 million from $334.8 million for the same period in the prior year. Growth in premium revenue within the Medicare segment was primarily due to increases in Medicare membership. Membership within the Medicare segment grew by 23,000 members, or 50%, from 46,000 members at December 31, 2004 to 69,000 members at December 31, 2005.
Investment income. For the year ended December 31, 2005, investment income increased $12.7 million, or 295.4%, to $17.0 million from $4.3 million for the same period in the prior year. The increase was primarily due to the increase in invested assets generated from our public offerings and additional cash generated by operations.
Medical benefits expense. For the year ended December 31, 2005, medical benefits expense increased $381.7 million, or 34.0%, to $1,505.4 million from $1,123.7 million for the same period in the prior year due to increases in medical benefits expense in both the Medicaid and Medicare segments, as discussed below. The MBR, which represents our medical benefits expense as a percentage of premium revenue, was 81.4% compared to 81.6% for the same period in the prior year.
Selling, general and administrative expense. For the year ended December 31, 2005, selling, general and administrative expense increased $88.2 million, or 51.5%, to $259.5 million from $171.3 million for the same period in the prior year. Our selling, general and administrative expense to revenue ratio was 13.9% and 12.4% for the years ended December 31, 2005 and 2004, respectively. The increase in selling, general and administrative expense was primarily due to investments in information technology, investments in sales and marketing strategies, and increased spending necessary to support and sustain our membership growth.
Our regulated subsidiaries’ primary uses of cash include payment of medical expenses, management fees to our non-regulated third-party administrator subsidiary (the “TPA”) and direct administrative costs which are not covered by the agreement with the TPA, such as selling expenses and legal costs. We refer collectively to the cash and investment balances maintained by our regulated subsidiaries as “regulated cash” and “regulated investments,” respectively.
As of September 30, 2008, our consolidated cash and cash equivalents were approximately $1,176.2 million. As of September 30, 2008, our consolidated investments were approximately $138.7 million. As of September 30, 2008, we had unregulated cash of approximately $86.7 million and unregulated investments of approximately $5.5 million. In addition, as of September 30, 2008, we had approximately $1,086.7 million in regulated cash and $133.2 million in regulated investments.
We are pursuing financing alternatives to raise additional unregulated cash. Some of these initiatives include, but are not limited to, seeking additional dividends from certain of our regulated subsidiaries to the extent that we are able to access available excess capital. For example, as discussed above, on December 31, 2008, three of our Florida regulated subsidiaries declared dividends to one of our non-regulated subsidiaries in the aggregate amount of $105.1 million, two of which were paid on December 31, 2008 and one of which was paid on January 2, 2009. We are currently considering other intercompany dividends to increase our unregulated cash balances. However, we cannot provide any assurances that any other applicable state regulatory authorities will approve, to the extent such approvals are required, the payment of dividends to our non-regulated subsidiaries by our regulated subsidiaries. In addition to dividends, our strategies include accessing the public and private debt and equity markets and potentially selling assets.
We believe we will be able to liquidate our auction rate securities without significant loss, and we currently believe these securities are not impaired, primarily due to government guarantees or municipal bond insurance; however, it could take until the final maturity of the underlying securities to realize our investments’ recorded value. The final maturity of the underlying securities could be as long as 33 years. The weighted-average life of the underlying securities for our auction rate securities portfolio is 22 years. We currently have the ability and intent to hold the remaining $61.4 million of auction rate securities until market stability is restored with respect to these securities.
Each of our HMO and insurance subsidiaries must maintain a minimum statutory net worth in an amount determined by statute or regulation and we may only invest in types of investments approved by the state. The minimum statutory net worth requirements differ by state and are generally based on a percentage of annualized premium revenue, a percentage of annualized health care costs, a percentage of certain liabilities, a statutory minimum, or risk-based capital (“RBC”), requirements. The RBC requirements are based on guidelines established by the National Association of Insurance Commissioners, or NAIC, and are administered by the states. As of December 31, 2007, our Connecticut, Georgia, Illinois, Indiana, Louisiana, Missouri, Ohio, and PFFS operations are subject to RBC requirements. The RBC requirements may be modified as each state legislature deems appropriate for that state. The RBC formula, based on asset risk, underwriting risk, credit risk, business risk and other factors, generates the authorized company action level, or CAL, which represents the amount of net worth believed to be required to support the regulated entity’s business.
At December 31, 2007 and 2006, all of our restricted assets consisted of cash and cash equivalents, money market accounts, certificates of deposits, and U.S. Government Securities. As of December 31, 2007, we believe our subsidiaries were in compliance with the minimum capital requirements with the exception of WellCare of Georgia, WellCare of Ohio, WellCare Health Insurance of Illinois, and Harmony Behavioral Health of Florida. We believe that we are in compliance with these minimum capital requirements as of the date of this report barring any change in regulatory requirements.
In 2007, investing activities consisted primarily of the investment of excess cash generated by operations totaling approximately $127.5 million in various short-term investment instruments, and an additional $39.3 million was invested in restricted investment accounts to satisfy the requirements of various state statutes. An additional $22.9 million was invested in capitalized assets.
In fiscal year 2004, excess cash totaling $41.7 million was invested in various short-term investment instruments. Our acquisition of Harmony in June 2004 required a net cash outlay of $36.5 million. To fulfill certain state requirements, $9.5 million was invested into restricted investment accounts. A total of $8.7 million was invested in property and equipment, principally at our corporate headquarters in Tampa.
In 2007, financing activities consisted of net proceeds from options exercised totaling $12.8 million, and the incremental tax benefit from options exercised of $23.1 million.
rate equal to the sum of a rate based upon the applicable six month LIBOR rate plus a rate equal to 2.50%. If we fail to pay any of our indebtedness when due, or if we breach any of the other covenants in the instruments governing our indebtedness, it may result in one or more events of default.
As part of the consideration for the acquisition of the WellCare group of companies, we issued a senior subordinated non-negotiable promissory note to related parties. The note payable to a related party was settled in full on September 15, 2006 in the amount of $24.0 million, resulting in a $1.0 million gain on the extinguishment of debt, which is included in other income, due to the settlement of identifiable expenses as defined in the agreements for the original purchase of the WellCare companies in August 2002. Interest on the principal amount accrued during the year at a rate of 5.25% per annum.
As of December 31, 2007, our credit ratings were as follows:
Our Board, various Board committees and our new senior management team are developing and implementing new processes and procedures to remediate, among other things, the material weaknesses that existed in our internal control over financial reporting as of December 31, 2007 as described in “Part II - Item 9A - Controls and Procedures.” We believe that these remedial measures that either have been implemented or are in the process of being implemented will remediate the material weaknesses we have identified as of December 31, 2007 and strengthen our internal control over financial reporting and disclosure controls and procedures.
Under the direction of the Audit Committee, management will continue to review and revise as warranted the overall design and operation of our internal control environment, as well as policies and procedures to improve the overall effectiveness of our internal control over financial reporting. As we continue to evaluate and work to improve our internal control over financial reporting, we may determine to take additional measures to address control deficiencies or determine to modify, or in appropriate circumstances not to complete, certain of the remedial measures described in “Part II - Item 9A - Controls and Procedures.”
We have incurred and expect to continue to incur significant additional costs in 2008 and 2009 as a result of the federal and state investigations and pending civil actions, including administrative expenses and costs necessary to remediate our internal controls, improve our corporate governance and address other issues that may be identified through the remediation process. In particular, as part of our remediation efforts and other ongoing compliance efforts, we have incurred and expect to continue to incur costs in 2008 and 2009 for reorganizing and expanding significantly our corporate compliance department, retaining outside compliance and other professional advisors to, among other things, assist us in designing and implementing certain compliance programs and related training, and making certain compliance-related technology investments. To the extent that we determine to take additional remediation or other compliance measures, we may incur additional costs in 2009.
In December 2007, the FASB issued FAS No. 141 (revised 2007), Business Combinations (“FAS 141R”). FAS 141R replaces current guidance in FAS 141 to better represent the economic value of a business combination transaction. FAS 141 establishes
principles and requirements for how an acquiring entity recognizes and measures all identifiable assets acquired, liabilities assumed, any non-controlling interest in the acquired entity and the goodwill acquired. The changes to be effected with FAS 141R from the current guidance include, but are not limited to treatment of certain specific items such as expensing transaction and restructuring costs and adjusting earnings in periods subsequent to the acquisition for changes in deferred tax asset valuation allowances and income tax uncertainties as well as changes in the fair value of acquired contingent liabilities. FAS 141R also includes a substantial number of new disclosure requirements that will enable users of financial statements to evaluate the nature and financial effect of business combination. FAS 141R must be applied prospectively to all new acquisitions closing on or after January 1, 2009. The impact of this pronouncement will depend on future acquisition activity of the Company, if any.