As of December 31, 2009, we leased approximately 89,000 square feet of space for our corporate office in Bethesda, Maryland. We also leased approximately 1,900,000 aggregate square feet for office space, subsidiary operations and customer service centers for the various markets where our health plans and other subsidiaries operate, of which approximately 4% is subleased. Our leases expire at various dates from 2010 through 2019. We also own nine buildings throughout the country with approximately 798,000 square feet, which is used for administrative services related to our subsidiaries’ operations, of which approximately 3% is subleased. We believe that our facilities are adequate for our operations.
The following discussion should be read in conjunction with the accompanying audited consolidated financial statements and notes thereto.
This Item 7 contains forward-looking statements as described in Part I. These forward-looking statements involved risks and uncertainties described in Part I., Item 1A, “Risk Factors.” The organization of our Management’s Discussion and Analysis of Financial Condition and Results of Operations is as follows:
We are a diversified national managed healthcare company based in Bethesda, Maryland, operating health plans, insurance companies, network rental and workers’ compensation services companies. Through our Health Plan and Medical Services Business, Specialized Managed Care Business, and Workers’ Compensation divisions, we provide a full range of risk and fee-based managed care products and services to a broad cross section of individuals, employer and government-funded groups, government agencies, and other insurance carriers and administrators.
Debt reduction of $303.5 million from the prior year resulting in a 30.1% debt to capital ratio at year-end
Operating earnings as a percentage of total revenue were 3.6%, compared to 5.0% in the prior year
Income from continuing operations was $315.3 million, a decline of 13% from 2008 income from continuing operations
Diluted EPS from continuing operations was $2.14, a decline of 11% from 2008 diluted EPS from continuing operations
We operate health plans, insurance companies, managed care services companies, and workers’ compensation services companies and generate our operating revenues from premiums and fees for a broad range of managed care and management service products. Managed care premiums for our commercial risk products, for which we assume full underwriting risk, can vary. For example, premiums for our PPO and POS products are typically lower than our HMO premiums due to medical underwriting and higher deductibles and co-payments that are typically required of the PPO and POS members. Managed care premium rates for our government programs, Medicare and state-sponsored managed Medicaid, are largely established by governmental regulatory agencies. These government products are offered in select markets where we believe we can achieve profitable growth based upon favorable reimbursement levels, provider costs and regulatory climates.
Revenue for our management services products (“non-risk”) is generally a fixed administrative fee, provided on a predetermined contractual basis or on a percentage-of-savings basis, for access to our health care provider networks and health care management services, for which we do not assume underwriting risk. The management services we provide typically include health care provider network management, clinical management, pharmacy benefit management (“PBM”), bill review, claims repricing, claims processing, utilization review and quality assurance.
We have capitation arrangements for certain ancillary heath care services such as laboratory services and in some cases physician and radiology services. A small percentage of our membership is covered by global capitation arrangements. Under the typical arrangement, the provider receives a fixed percentage of premium to cover costs of all medical care or of the specified ancillary services provided to the globally capitated members. Under some capitated arrangements, physicians may also receive additional compensation from risk sharing and other incentive arrangements. Global capitation arrangements limit our exposure to the risk of increasing medical costs, but expose us to risk as to the adequacy of the financial and medical care resources of the provider organization. We are ultimately responsible for the coverage of our members pursuant to the customer agreements. To the extent that the respective provider organization faces financial difficulties or otherwise is unable to perform its obligations under the capitation arrangements, we will be required to perform such obligations. Consequently, we may have to incur costs in doing so in excess of the amounts we would otherwise have to pay under the original global or ancillary capitation through our contracted network arrangements. Medical costs associated with capitation arrangements made up approximately 2.9% of the Company’s total medical costs for the year ended December 31, 2009.
We consider the accounting policies described below critical in preparing our consolidated financial statements. Critical accounting policies are ones that require difficult, subjective, or complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain. The judgments and uncertainties affecting the application of these policies include significant estimates and assumptions made by us using information available at the time the estimates are made. Actual results could differ materially from those estimates.
As of December 31, 2009, we maintained allowances for retroactive billing adjustments of approximately $22.6 million compared with approximately $35.0 million at December 31, 2008. We also maintained allowances for doubtful accounts of approximately $21.4 million and $11.0 million as of December 31, 2009 and 2008, respectively. The calculation for these allowances is based on a percentage of the gross accounts receivable with the allowance percentage increasing for older receivables.
The significant favorable / (unfavorable) factors driving the overall favorable prior year development for 2009 include:
Lower than anticipated large claim liabilities of $27.5 million favorable development
Lower than anticipated other specific case liabilities of $12.9 million favorable development
Higher than expected inpatient hospital utilization of $(3.6) million unfavorable development
The increase in total reported medical cost from 2008 to 2009 was driven primarily by growth in the medical cost base of the Company due to the growth in Part D and PFFS membership and partially due to medical cost inflation. Prior year development experienced in 2008 was less favorable compared to amounts experienced in 2007 and 2009. The lower favorable development is primarily attributable to our PFFS line of business. PFFS experienced unfavorable development in 2008 due to lower than expected completion factors.
For the more recent incurred months', the percentage of claims paid to claims incurred in those months is generally low. As a result, the completion factor methodology is less reliable for such months. For that reason, incurred claims for recent months are not projected solely from historical completion and payment patterns. Instead, they are projected by estimating the claims expense for those months based upon recent claims expense levels and health care trend levels, or “trend factors.” As these months mature over time, the two estimates (completion factor and trend) are blended with completion factors being used exclusively for older months.
A regular element of our unpaid medical claim liability estimation process is the examination of actual results and if appropriate, the modification of assumptions and inputs related to the process based upon past experience. Our reserve setting methodologies have taken these changes into consideration when determining the factors used in calculating our medical claims liabilities as of December 31, 2009 by choosing factors that reflect more recent experience.
We believe that the amount of medical liabilities is adequate to cover our ultimate liability for unpaid claims as of December 31, 2009. However, actual claim payments and other items may differ from established estimates.
We account for investments in accordance with ASC Topic 320 “Investments - Debt and Equity Securities.” We invest primarily in fixed income securities and classify all of our investments as available-for-sale. Investments are evaluated on an individual security basis 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:
adverse conditions specifically related to the security, an industry, or geographic area;
if we have decided to sell the security or it is more likely than not that we will be required to sell the security before recovery of its amortized cost.
Temporary declines in value of investments classified as available-for-sale are netted with unrealized gains and reported as a net amount in a separate component of stockholders’ equity, net of taxes. When we determine that a decline in fair value below amortized cost is judged to be other-than-temporary we are required to recognize the credit loss component as a charge in net earnings. Included in net earnings is the credit loss component of an other-than-temporary impairment charge. Realized gains and losses on the sale of investments are determined on a specific identification basis.
The following table includes only our investments in an unrealized loss position at December 31, 2009. For these investments, the table shows the gross unrealized losses and fair value aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position (in thousands).
Our municipal bond investments remain at an investment grade status based on their own merits (excluding monoline insurers). Although we do not rely on bond insurers exclusively to maintain our high level of investment credit quality, $432.4 million of our $899.6 million total state and municipal bond holdings are insured through a monoline insurer. For our mortgaged-backed and asset-backed securities, our holdings remain at investment grade with a AAA rating and AA+ rating, respectively. We participate in only the higher level investment tranches. For our asset-backed securities, we only participate in offerings that are over collateralized to further protect our principal investment.
Goodwill is subject to an annual assessment and periodically if other indicators are present for impairment by applying a fair-value-based test. We performed a goodwill impairment analysis, at the reporting unit level, as of October 1, our annual impairment test date. However, each year we could be required to evaluate the recoverability of goodwill and other indefinite lived intangible assets prior to the required annual assessment if there is any indication of a potential impairment. Those indications may include experiencing disruptions to business, unexpected significant declines in operating results, regulatory actions (such as heath care reform) that may impact operating results, divestiture of a significant component of the business or a sustained decline in market capitalization.
As of October 1, 2009 our market capitalization was below our book value which we considered in our evaluation of fair value of goodwill. We concluded that this did not affect the overall goodwill impairment analysis as we believe our suppressed market capitalization to be primarily attributed to negative market conditions as a result of the credit crisis, the economic recession, debate over health care reform and current pricing and/or medical trend issues within the managed care industry. We will continue to monitor our market capitalization as a potential impairment indicator considering overall market conditions and managed care industry events. Any impairment charges that may result will be recorded in the period in which the impairment is identified.
In accordance with ASC 350-30, “General Intangibles Other than Goodwill,” we test intangible assets not subject to amortization for impairment annually or more frequently if events or changes in circumstances indicate that the asset might be impaired. The impairment test consists of a comparison of the fair value of an intangible asset with its carrying amount. If the carrying amount of the intangible asset exceeds its fair value, an impairment loss shall be recognized in an amount equal to that excess. We have chosen October 1 as our annual impairment testing date. Our only intangible asset that is not subject to amortization consists of a trade name which we determined was not impaired based on the result of the October 1, 2009 analysis.
See Note E, Goodwill and Other Intangible Assets, to the consolidated financial statements for additional disclosure related to our goodwill and other intangible assets.
In accordance with ASC 360-10-35, we periodically review long-lived assets for recoverability whenever adverse events or changes in circumstances indicate the carrying value of the asset may not be recoverable. In assessing recoverability, we must make assumptions regarding estimated future cash flows and other factors to determine if an impairment loss may exist, and if so, estimate fair value. We also must estimate and make assumptions regarding the useful life we assign to our long-lived assets. If these estimates or their related assumptions change in the future, we may be required to record impairment losses or change the useful life, including accelerating depreciation for these assets.
Our other long-lived assets consist of property and equipment which are depreciated or amortized over their estimated useful life, and are subject to impairment reviews. In accordance with ASC 350-40, “Internal - Use Software,” the cost of internally developed software is capitalized and included in property and equipment. We capitalize costs incurred during the application development stage for the development of internal-use software. These costs primarily relate to payroll and payroll-related costs for employees along with costs incurred for external consultants who are directly associated with the internal-use software project. We have not incurred an impairment charge related to our long-lived assets. See Note F, Property and Equipment, to the consolidated financial statements for additional disclosure related to these assets.
We account for share based compensation in accordance with the provisions of ASC Topic 718 “Compensation - Stock Compensation.” Under the fair value recognition provisions of ASC Topic 718, determining the appropriate fair value model and calculating the fair value of share-based payment awards require the input of subjective assumptions, including the expected life of the share-based payment awards and stock price volatility. We believe that a blend of the implied volatility of our tradeable options and the historical volatility of our share price is a better indicator of expected volatility and future stock price trends than historical volatility alone. Therefore, the expected volatility was based on a blend of market-based implied volatility and the historical volatility of our stock. The assumptions used in calculating the fair value of share-based payment awards represent our best estimates. In addition, we are required to estimate the expected forfeiture rate and recognize expense only for those shares expected to vest. If our actual forfeiture rate is materially different from our estimate, the stock-based compensation expense could be significantly different from what we have recorded in the current period. See Note H, Stock-Based Compensation, to the Consolidated Financial Statements in Item 8 for a further discussion on stock-based compensation.
For this information, refer to Note A, Organization and Summary of Significant Accounting Policies, to the Notes to the Consolidated Financial Statements herein.
The following table presents our membership as of December 31, 2009 and 2008 (in thousands).
As discussed in Note D, Discontinued Operations, to the consolidated financial statements, on July 31, 2009 the Company sold its Medicaid/Public entity business First Health Services Corporation (“FHSC”) and therefore its operations are classified as “discontinued” on the Company’s consolidated statements of operations and excluded from the information below. Accordingly, the amounts and discussion below relate to only the Company’s results from continuing operations for all years presented.
Medical costs increased primarily as a result of the increase in Medicare membership, as discussed above. Total medical costs as a percentage of premium revenue, “medical loss ratio,” or “MLR” increased over the prior year as a result of a change in our mix of business primarily related to Medicare Advantage, Part D, and Commercial Risk.
Selling, general and administrative expense increased primarily due to the costs associated with the growth in the Medicare business including higher wage expense, an increase in broker commission costs and other member related costs due to the higher Medicare membership. Additionally there was higher wage expense related to annual incentive compensation accruals in the current year, while such types of incentive payments were not earned and accrued in 2008; new executive hires in the current year; and severance expense related to terminated employees in 2009. Selling, general and administrative expense as a percentage of revenue improved as a result of expenses being controlled at a rate lower than the increase in revenue.
Depreciation and amortization expense increased in 2009 primarily due to impairment charges to our customer list balances during 2009.
Managed care premium revenue increased as a result of growth in existing products, primarily Medicare Advantage and Medicare Part D, as well as from our acquisitions during 2007 of Vista Health Plans (“Vista”) and business from Mutual of Omaha (“Mutual”). The increase was partially offset by a decline in same store Commercial risk membership over the prior year.
The effective tax rate on continuing operations was essentially flat at 36.7%, as compared to 37.1% for the prior year.
As a result of the change in our executive leadership, we realigned our organizational structure during the first quarter of 2009. The new organizational structure brings enhanced focus to areas of growth opportunities. Accordingly, our reportable segments have changed to the following three reportable segments: Health Plan and Medical Services, Specialized Managed Care, and Workers’ Compensation. The Company’s segment results for the prior years presented have been reclassified to conform to the 2009 segment presentation, including the presentation of discontinued operations.
(1) Revenue per member per month excludes the effect of revenue ceded to external parties.
Health Plan and Medical Services revenue increased over the prior year primarily due to membership growth in the Medicare PFFS products, coupled with an increase in the average realized premium yield per member per month for the product. Deducting revenue ceded to third parties, the Medicare Advantage risk premium yield per member per month for the year increased to $798.16 in 2009 from $742.07 in 2008. The increase is a result of a smaller portion of our Medicare PFFS business in 2009 being ceded to external parties through quota share arrangements. When reviewing the premium yield for Medicare Advantage business, we believe that adjusting for the ceded revenue is useful for comparisons to competitors that may not have similar ceding arrangements. Additionally, the Medicare Advantage risk premium yields have increased as a result of higher risk scores.
Gross margin increased primarily due to the growth in the Medicare PFFS and Medicare Advantage businesses as well as the improved medical loss ratios for the Medicare PFFS product. The Medicare PFFS MLRs decreased over the prior year as the prior year included unfavorable IBNR reserve development. The increases in gross margin were partially offset by gross margin declines in Commercial Risk and Medicaid. The Commercial Risk decline in gross margin is a result of the decline in Commercial Risk membership discussed earlier. The decline in Medicaid gross margin was due to a higher medical loss ratio in 2009 as a result of higher medical cost trends and higher inpatient utilization without rate increases sufficient to cover these cost increases.
Revenue in the Workers’ Compensation Division increased in 2009 primarily due to the growth of our pharmacy benefit management program. The increase was partially offset by lower revenue in the division’s other business lines as a result of lower claim volume.
Net cash from investing activities for the year ended December 31, 2009 was an outflow primarily due to a large amount of investment purchases during the period. This outflow was partially offset by the proceeds received from the sales and maturities of investments and also from the proceeds received from the disposal of FHSC. Additionally, escrow payments totaling $10 million were received during the period from previous acquisitions.
The details of our debt repayment for 2009 are as follows:
Our Board of Directors has approved a program to repurchase 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, 1.5 million shares were purchased in 2009 at an aggregate cost of $30.0 million, 7.3 million shares of our common stock were purchased in 2008 at an aggregate cost of $318.0 million and 7.5 million shares of our common stock were purchased in 2007 at an aggregate cost of $429.0 million. As of December 31, 2009, the total remaining common shares we are authorized to repurchase under this program is 5.2 million.
The majority of states in which we operate health plans have adopted RBC policy that recommends the health plans maintain statutory reserves at or above the “Company Action Level” which is currently equal to 200% of their RBC. The State of Florida does not currently use RBC methodology in its regulation of HMOs. Some states, in which our regulated subsidiaries operate, require deposits to be maintained with the respective states’ departments of insurance. The table below summarizes our statutory reserve information, as of December 31, 2009 and 2008 (in millions, except percentage data).
We have typically paid 90% to 95% of medical claims within six months of the date incurred and approximately 99% of medical claims within nine 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. As of December 31, 2009, we had $129.1 million of unrecognized tax benefits. The above table excludes these amounts due to uncertainty of timing and amounts regarding future payments.
Regarding our effective tax rate, we expect it will range from 37% to 38% for the full year of 2010.
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, 2009 and 2008, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2009, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule referred to above, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.
Coventry Health Care, Inc. (together with its subsidiaries, the “Company” or “Coventry”) is a diversified national managed health care company based in Bethesda, Maryland operating health plans, insurance companies, network rental and workers’ compensation services companies. Through its Health Plan and Medical Services Business, Specialized Managed Care Business Division and Workers’ Compensation Business, the Company provides a full range of risk and fee-based managed care products and services to a broad cross section of individuals, employer and government-funded groups, government agencies, and other insurance carriers and administrators.
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. See Note C, Acquisitions, to these consolidated financial statements for information on the Company's recent acquisitions.
Significant Customers - The Company’s health plan business is diversified across a large customer base and there are no commercial groups that make up 10% or more of Coventry’s managed care premiums. The Company received 50.7%, 38.1%, and 33.1% of its managed care premiums for the years ended December 31, 2009, 2008 and 2007, respectively, from the federal Medicare program throughout its various markets. The Company also received 8.4%, 10.3%, and 10.7% of its managed care premiums for the years ended December 31, 2009, 2008 and 2007, respectively, from its state-sponsored Medicaid programs throughout its various markets. For the years ended December 31, 2009, 2008 and 2007, the State of Missouri accounted for almost half the Company’s Medicaid premiums. The Company received 10.5%, 9.2%, and 14.7% of its management services revenue from a single customer, Mail Handlers Benefit Plan, for the years ended December 31, 2009, 2008 and 2007, respectively.
Property and Equipment - Property, equipment and leasehold improvements are recorded at cost. In accordance with ASC 350-40, “Internal - Use Software,” the cost of internally developed software is capitalized and included in property and equipment. The Company capitalizes costs incurred during the application development stage for the development of internal-use software. These costs primarily relate to payroll and payroll-related costs for employees along with costs incurred for external consultants who are directly associated with the internal-use software project. Depreciation is computed using the straight-line method over the estimated lives of the related assets or, if shorter, over the terms of the respective leases.
Business Combinations, Accounting for Goodwill and Other Intangibles - The Company accounts for Business Combinations in accordance with ASC 805-10 and accounts for Intangibles - Goodwill and Other in accordance with ASC 350-10. 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’s annual impairment test date is October 1 of each fiscal year. For goodwill, the Company performs a two-step impairment test. In the first step, the Company compares the fair value of each reporting unit to its carrying value. The Company has five reporting units: Health Plans, Workers’ Compensation, MHNet, Medicare Part D, and Network Rental. The Company determines the fair value of its reporting units based on a weighting of income and market approaches. The market approach estimates the reporting unit’s fair value by utilizing market multiples of revenue or earnings for comparable companies. The income approach is based on the present value of estimated future cash flows. If the fair value of the reporting unit exceeds the carrying value of the net assets assigned to that unit, goodwill is not impaired and no further testing is performed. If the carrying value of the net assets assigned to the reporting unit exceeds the fair value of the reporting unit, then the Company must perform the second step of the impairment test in order to determine the implied fair value of the reporting unit’s goodwill. If the carrying value of a reporting unit’s goodwill exceeds its implied fair value, the Company records an impairment charge equal to the difference. Impairment charges are recorded in the period incurred. See Note E, Goodwill and Other Intangible Assets, to consolidated financial statements for disclosure related to these assets.
Medical Liabilities and Expense - Medical liabilities consist of actual claims reported but not paid and estimates of health care services incurred but not reported. The estimated claims incurred but not reported are based on historical data, current enrollment, health service utilization statistics and other related information. In determining medical liabilities, the Company employs standard actuarial reserve methods that are specific to each market’s membership, product characteristics, geographic territories and provider network. The Company also considers utilization frequency and unit costs of inpatient, outpatient, pharmacy and other medical expenses, as well as claim payment backlogs and the timing of provider reimbursements. The Company also establishes reserves, if required, for the probability that anticipated future health care costs and contract maintenance costs under the group of existing contracts will exceed anticipated future premiums and reinsurance recoveries on those contracts. These accruals are continually monitored and reviewed, and as settlements are made or accruals adjusted, differences are reflected in current operations. Changes in assumptions for medical costs caused by changes in actual experience could cause these estimates to change in the near term.
(3) Current year claim payments as a percentage of current year reported medical costs.
The Company also receives premium payments on a monthly basis from the state Medicaid programs with which the Company contracts for the Medicaid members for whom it provides health coverage. Membership and category eligibility are periodically reconciled with the state Medicaid programs 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.
The Company recognizes premium revenue for the Medicare Part D program ratably over the contract period for providing insurance coverage. Regarding the CMS risk corridor provision, an estimated risk sharing receivable or payable is recognized based on activity-to-date. Activity for CMS risk sharing is accumulated at the contract level and recorded within the consolidated balance sheet in other receivables or other accrued liabilities depending on the net contract balance at the end of the reporting period with corresponding adjustments to premium revenue. Costs for covered prescription drugs are expensed as incurred.
Management services revenue is generally a fixed administrative fee, provided on a predetermined contractual basis or on a percentage-of-savings basis, for access to the Company’s health care provider networks and health care management services, for which it does not assume underwriting risk. Percentage of savings revenue is determined using the difference between charges billed by contracted medical providers and the contracted reimbursement rates for the services billed and is recognized based on claims processed. The management services the Company provides typically include health care provider network management, clinical management, pharmacy benefit management, bill review, claims repricing, claims processing, utilization review and quality assurance.
The Company enters into performance guarantees with employer groups where it pledges to meet certain standards. These standards vary widely and could involve customer service, member satisfaction, claims processing, claims accuracy, telephone response time, etc. The Company also enters into financial guarantees which can take various forms including, among others, achieving an annual aggregate savings threshold, achieving a targeted level of savings per-member, per-month or achieving overall network penetration in defined demographic markets. For each guarantee, the Company estimates and records performance based revenue after considering the relevant contractual terms and the data available for the performance based revenue calculation. Pro-rata performance based revenue is recognized on an interim basis taking into account the ultimate rights and obligations of the parties upon termination of the contracts.
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 the vesting of all restricted stock using the treasury stock method. Potential common stock equivalents to purchase 12.2 million, 8.3 million, and 3.2 million shares for the years ended December 31, 2009, 2008 and 2007, respectively, were excluded from the computation of diluted earnings per share because the potential common stock equivalents were anti-dilutive.
Other Income, net - Other income, net includes interest income, net of fees, gains on the repayment of debt, realized gains and losses on sales of investments, and charges on the other-than-temporary impairment of investment securities.
In December 2007, the FASB issued ASC 805-10, “Business Combinations," which requires an acquirer to measure the identifiable assets acquired, the liabilities assumed and any noncontrolling interest in the acquiree at their fair values on the acquisition date, with goodwill being the excess value over the net identifiable assets acquired. ASC 805-10 was effective for financial statements issued for fiscal years beginning after December 15, 2008. Early adoption was prohibited. The Company implemented ASC 805-10 effective January 1, 2009. The potential impact of adopting ASC 805-10 on the Company’s future consolidated financial statements will depend on the magnitude and frequency of the Company’s future acquisitions.
The Health Plan and Medical Services Division is primarily comprised of the Company’s traditional health plan risk businesses and products and its Medicare Advantage Private Fee-for-Service (“PFFS”) product. In the second quarter of 2009, the Company’s management decided not to renew the PFFS product effective for the 2010 plan year. Additionally, through this Division the Company contracts with various federal employee organizations to provide health insurance benefits under the Federal Employees Health Benefits Program (“FEHBP”) and offers managed care and administrative products to businesses that self-insure the health care benefits of their employees. This Division also contains the Company’s dental services business.
The Workers’ Compensation Division is comprised of the Company’s workers’ compensation services businesses, which provides fee-based, managed care services such as access to our provider networks, pharmacy benefit management, and care management to underwriters and administrators of workers’ compensation insurance.
During the year ended December 31, 2008, the Company completed two business combinations. These business combinations were accounted for using the purchase method of accounting and therefore the operating results of each acquisition have been included in the Company’s consolidated financial statements since the date of their 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.
During 2007 the Company acquired Vista Health Plans (“Vista”), businesses from Mutual of Omaha, and Concentra. These acquisitions were individually insignificant but were significant when aggregated. As a result of these acquisitions, the Company recorded $952.8 million of goodwill, of which, $289.1 million is expected to be deductible for tax purposes. The following table lists the assigned value of the intangible assets as of the acquisition date (in millions) and the associated amortization period:
On July 31, 2009, the Company completed the sale of its fee-based Medicaid services subsidiary FHSC to Magellan Health Services, Inc. (“Magellan”) for $117.5 million in cash, which includes adjustments for changes in working capital. FHSC was a component of the Company’s business operations within its Specialized Managed Care operating segment. In accordance with ASC 205-20 “Discontinued Operations,” FHSC’s operations and disposal costs are presented as (loss) income from discontinued operations, net of tax in the Company’s consolidated statements of operations.
The Company considered the then pending sale of FHSC a potential indicator of impairment and in accordance with ASC Topic 350, “Intangibles - Goodwill and Other,” it was determined that the carrying value of the reporting unit was in excess of fair value. Accordingly, the Company performed an estimate of the probable impairment loss, determined that the goodwill allocated to the reporting unit was impaired, and recorded a gross impairment charge of $72.4 million during the year ended December 31, 2009.
As an overall test of the reasonableness of the estimated fair values of the reporting units, the Company compared the aggregate fair values of its reporting units to its market capitalization. The comparison confirmed that the determined fair values were representative of market views when applying a reasonable control premium. We determined that our control premium was reasonable based on a review of such premiums for entities of similar size and/or in similar industries.
Other intangible asset amortization expense for the years ended December 31, 2009, 2008 and 2007 was $71.0 million, $65.6 million, and $48.2 million, respectively.
Based on events and circumstances, primarily lower than expected customer retention levels, we recorded $5.5 million in impairment charges to our customer list balances in 2009. The impairment charges, which are included in the line item depreciation and amortization in the Company’s consolidated statements of operations, related to components of its Health Plan and Medical Services operating segment and its Specialized Managed Care operating segment, respectively. The fair values were based on present value calculations which are Level 3 in the fair value hierarchy.
The Company performed an impairment test of its unamortized other intangible asset (trade name) as of October 1, 2009, and determined that the asset was not impaired.
Estimated intangible amortization expense is $63.3 million for the year ending December 31, 2010, $62.4 million for the year ending December 31, 2011, $62.0 million for the year ending December 31, 2012 and $61.6 million for the year ending December 31, 2013 and $61.1 million for the year ending December 31, 2014. The weighted-average amortization period is approximately 10 years for other intangible assets.
Depreciation expense for the years ended December 31, 2009, 2008 and 2007 was $80.8 million, $84.6 million, and $94.4 million, respectively. Included in the depreciation expense for the years ended December 31, 2009, 2008 and 2007 was $25.4 million, $29.9 million, and $32.9 million, respectively, of amortization expense for developed software.
The Company adopted the provisions of ASC 320-10-65-1 related to its fixed maturity securities as of April 1, 2009. The portion of the Company’s impairment charge that was recorded prior to 2009 that was not related to a belief that the entire amortized cost basis would not be recovered, to credit deterioration of the specific security, or to securities that the Company has made the decision to sell, was insignificant. Accordingly, the Company did not record a cumulative effect transition adjustment upon adoption.
Through its acquisition of First Health on January 28, 2005, the Company acquired eight separate investments (tranches) in a limited liability company that invests in equipment that is leased to third parties. The total investment as of December 31, 2009 was $44.1 million and is accounted for using the equity method. The Company’s proportionate share of the partnership’s income was $0.9 million, $5.4 million, and $4.5 million for the years ended December 31, 2009, 2008 and 2007, respectively, and is included in other income in the Company’s statements of operations. The Company has between a 20% and 25% interest in the limited partners share of each individual tranche of the partnership (approximately 10% of the total partnership). During 2009, the Company determined that events and changes in circumstances occurred, indicating that the carrying value might not be fully recoverable. Accordingly, the investment was evaluated to determine fair value during the fourth quarter. As a result of this evaluation, the Company recorded an impairment charge of $2.5 million at December 31, 2009. The carrying value of this investment at December 31, 2009 approximates fair value.
Through its acquisition of Vista on September 10, 2007, the Company acquired a 50% investment in Carefree Insurance Services (“Carefree”). Carefree performs marketing and sales of several Individual and Medicare products. As of December 31, 2009, the Company’s total investment was $2.7 million and is accounted for using the equity method.
The following table shows the Company’s investments’ gross unrealized losses and fair value, at December 31, 2009 and December 31, 2008, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position (in thousands).
The unrealized losses presented in this table do not meet the criteria for an other-than-temporary impairment. The unrealized losses are the result of interest rate movements and significant increases in volatility and liquidity concerns in the securities and credit markets. The Company has not decided to sell and it is not more-likely-than not that the Company will be required to sell before a recovery of the amortized cost basis of these securities.
The Company’s Level 3 securities primarily consist of corporate financial holdings, and mortgage backed and asset-backed securities that were thinly traded due to market volatility and lack of liquidity. The Company determines the estimated fair value for its Level 3 securities using unobservable inputs that cannot be corroborated by observable market data including, but not limited to, broker quotes, default rates, benchmark yields, credit spreads and prepayment speeds.
The Company has one stock incentive plan, the Amended and Restated 2004 Stock Incentive Plan (the “Stock Incentive Plan”) under which shares of the Company’s common stock are authorized for issuance to key employees, consultants and directors in the form of stock options, restricted stock and other stock-based awards. Shares available for issuance under the Stock Incentive Plan were 6.8 million as of December 31, 2009.
The Company granted 3.5 million stock options during the twelve months ended December 31, 2009. The Company recorded compensation expense related to stock options of approximately $30.6 million, $35.3 million, and $36.1 million, for the years ended December 31, 2009, 2008 and 2007, respectively. The total intrinsic value of options exercised was $1.5 million, $10.4 million, and $77.9 million for the years ended December 31, 2009, 2008 and 2007, respectively. As of December 31, 2009, there was $35.5 million of total unrecognized compensation cost (net of expected forfeitures) related to nonvested stock option grants which is expected to be recognized over a weighted average period of 2.1 years.
The following table summarizes restricted stock award activity for the year ended December 31, 2009:
The Company recorded compensation expense related to the PSUs of approximately $13.8 million for the year ended December 31, 2009.
The effect of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities at December 31, 2009 and 2008 are presented below (in thousands):
At December 31, 2009, the Company had approximately $72 million of federal and $198 million of state tax net operating loss carryforwards. The Federal net operating losses were primarily acquired through various acquisitions and are subject to limitation under Internal Revenue Code Section 382. The net operating loss carryforwards can be used to reduce future taxable income, and expire over varying periods through the year 2029. A valuation allowance of approximately $3.0 million has been recorded for 2009 for certain net operating loss deferred tax assets because the Company believes it is not more likely than not that these deferred tax assets will be realized before expiration of those net operating losses.
The total amount of unrecognized tax benefits, as of December 31, 2009, 2008 and 2007, that if recognized would affect the effective tax rate was $40.4 million, $32.4 million, and $17.1 million, respectively. Further, the Company is unaware of any positions for which it is reasonably possible that the total amounts of unrecognized tax benefits will significantly increase or decrease within the next twelve months.
Penalties and tax-related interest expense are reported as a component of income tax expense. As of December 31, 2009, 2008, and 2007, the total amount of income tax-related accrued interest and penalties, net of related tax benefit, recognized in the statement of financial position was $6.5 million, $9.6 million, and $10.2 million, respectively. For the years ended December 31, 2009, 2008, and 2007, the total amount of income tax-related accrued interest and penalties, net of related tax benefit, recognized in the statement of operations was $2.8 million, $2.4 million, and $4.5 million, respectively.
Under the Savings Plan, participants may defer up to 75% of their eligible compensation, limited by the maximum compensation deferral amount permitted by applicable law. The Company makes matching contributions in the Company’s common stock equal to 100% of the participant’s contribution on the first 3% of the participant’s eligible compensation and equal to 50% of the participant’s contribution on the second 3% of the participant’s eligible compensation. Participants vest immediately in all safe harbor matching contributions. The Savings Plan permits all participants regardless of service to sell the employer match portion of the Coventry common stock in their accounts, during certain times of the year, and transfer the proceeds to other Coventry 401(k) funds of their choosing. All costs of the Savings Plan are funded by the Company and participants as they are incurred.
As a result of corporate acquisitions and transactions, the Company has acquired entities that have sponsored other qualified plans. All qualified plans sponsored by the acquired subsidiaries of the Company have either terminated or merged with and into the Savings Plan. The cost of the Savings Plan, including the acquired plans, for 2009, 2008 and 2007 was approximately $30.3 million, $31.5 million, and $21.6 million, respectively.
The Company is the sponsor of a deferred compensation plan that is designed to promote the retention of key senior management and to recognize their strategic importance to the Company. The fixed dollar and stock equivalent allocations charged to operations for these plans were $1.6 million, $1.1 million, and $2.9 million, in 2009, 2008 and 2007, respectively, and the liability for these plans was $1.4 million and $3.6 million at December 31, 2009 and 2008, respectively.
For information regarding the Company’s stock-based compensation, please refer to Note H, Stock-Based Compensation, to the notes to the consolidated financial statements.
6.30% Senior notes due 8/15/14, net of unamortized discount of $1,061 at December 31, 2009
Revolving Credit Facility due 7/11/12, 0.79% weighted average interest rate for the period ended December 31, 2009
During 2009 the Company repaid $235 million on its Revolving Credit Facility. The remaining outstanding balance of $380 million will be used to optimize the Company’s liquidity position and for other general corporate purposes.
The Company’s senior notes and credit facility contain certain covenants and restrictions regarding additional debt, dividends or other restricted payments, transactions with affiliates, asset dispositions, and consolidations or mergers. Additionally, the Company’s credit facility requires compliance with a leverage ratio of 3 to 1. As of December 31, 2009, the Company was in compliance with the applicable covenants and restrictions under its senior notes and credit facility.
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, 2009 may result in the assertion of additional claims. The Company maintains general liability, professional liability and employment practices liability insurances in amounts that it believes are appropriate, with varying deductibles for which it maintains reserves. The professional liability and employment practices liability insurances are carried through its captive subsidiary. Although the results of pending litigation are always uncertain, the Company does not believe the results of such actions currently threatened or pending, including those described below, will individually or in the aggregate, have a material adverse effect on its consolidated financial position or results of operations.
Four providers who have contracts with FHGC filed a state court class action lawsuit against FHGC and certain payors alleging that FHGC violated Louisiana’s Any Willing Provider Act (the “Act”), which requires a payor accessing a preferred provider network contract to give a one time notice 30 days before that payor uses the discounted rate in the preferred provider network contract to pay the provider for services rendered to a member insured under that payor’s health benefit plan. These provider plaintiffs allege that the Any Willing Provider Act applies to medical bills for treatment rendered to injured workers and that the Act requires point of service written notice in the form of a benefit identification card. If a payor is found to have violated the Act’s notice provision, the court may assess up to $2,000 in damages for each instance when the provider was not given proper notice that a discounted rate would be used to pay for the services rendered. In response to the state court class action, FHGC and certain payors filed a suit in federal court against the same four provider plaintiffs in the state court class action seeking a declaratory judgment that FHGC’s contracts are valid and enforceable, that its contracts are not subject to the Any Willing Provider Act since that Act does not apply to medical services rendered to injured workers and that FHGC is exempt from the notice requirements of the Act because it has contracted directly with each provider in its network. The federal district court ruled in favor of FHGC and declared that its contracts are not subject to the Any Willing Provider Act, that FHGC was exempt from the Act’s notice provision because it contracted directly with the providers, and that FHGC’s contracts were valid and enforceable, i.e., the four provider plaintiffs were required to accept the discounted rate in accordance with the terms of their written contracts with FHGC. Despite the federal court’s decision, the provider plaintiffs continued to pursue their state court class action against FHGC and filed a motion for partial summary judgment seeking damages of $2,000 for each provider visit where the provider was not given a benefit identification card at the time the service was performed. In response to the motion for partial summary judgment filed in the state court action, FHGC obtained an order from the federal court which enjoined, barred and prevented any of the four provider plaintiffs or their counsel from pursuing any claim against FHGC before any court or tribunal arising under Louisiana’s Any Willing Provider Act. Despite the issuance of this federal court injunction, the provider plaintiffs and their counsel pursued their motion for partial summary judgment in the state court action. Before the state court held a hearing on the motion for partial summary judgment, FHGC moved to decertify the class on the basis that the four named provider plaintiffs had been enjoined by the federal court from pursuing their claims against FHGC. The state court denied the motion to decertify the class but did enter an order permitting FHGC to file an immediate appeal of the state court’s denial of the motion. Even though FHGC had filed its appeal and there were no class representatives since all four named plaintiffs had been enjoined from pursuing their claims against FHGC, the state court held a hearing and granted the plaintiffs’ motion for partial summary judgment. The trial court granted the motion despite the fact that (1) the court lacked jurisdiction due to the appeal filed by FHGC challenging the denial of its motion to decertify the class; (2) there were no named class representatives because all four named plaintiffs had been enjoined from pursuing their claims against FHGC; (3) none of the providers in the class ever submitted a claim for payment to FHGC and therefore FHGC never made any discounted payments to any of the providers in the class in the absence of notice; (4) FHGC has contracted directly with every provider in the class and therefore, under the Act’s express language, FHGC was exempt from giving notice under the Act; and (5) the claims of the provider plaintiffs are time barred. The amount of the partial judgment was for $262 million. FHGC has taken an appeal from the entry of that judgment seeking to vacate its entry as invalid as a matter of law and has also taken an appeal from the lower court’s denial of FHGC’s motion to decertify the class. FHGC will file a motion with the federal court for sanctions against the provider plaintiffs and their counsel for violating the injunction issued by the federal district court which barred and enjoined them from pursuing their claims against FHGC in the state court action. The Company believes that FHGC will be successful in its efforts to overturn the partial summary judgment, has accrued an adequate reserve for its potential exposure, and that the actions will not have a material adverse effect on its financial position or the results of operations.
In a related matter, FHGC has filed another lawsuit in Louisiana federal district court against 85 Louisiana providers seeking a declaratory judgment that its contracts are valid and enforceable, that its contracts are not subject to the Louisiana’s Any Willing Provider Act because its contracts pertain to payment for services rendered to injured workers, and FHGC is exempt from the notice provision of the Any Willing Provider Act because it has contracted directly with the providers. This lawsuit is assigned to the same federal district court judge who issued the decision and injunction in the lawsuit filed by FHGC against the four provider plaintiffs in the state court action.
On October 13, 2009, two former employees and participants in the Coventry Health Care Retirement Savings Plan filed a putative ERISA class action lawsuit against the Company and several of its current and former officers, directors and employees in the U.S. District Court for the District of Maryland. Plaintiffs allege that defendants breached their fiduciary duties under ERISA by offering and maintaining Company stock in the Plan after it allegedly became imprudent to do so and by allegedly failing to provide complete and accurate information about the Company’s financial condition to plan participants in SEC filings and public statements. Three similar actions by different plaintiffs were later filed in the same court and were consolidated on December 9, 2009. A consolidated complaint has not yet been filed. The Company intends to vigorously defend against the allegations in the consolidated lawsuit, which is expected to be filed shortly. Although it cannot predict the outcome, the Company believes this lawsuit will not have a material adverse effect on its financial position or results of operations.
CMS periodically performs audits and may seek return of premium payments made to the company if risk adjustment factors are not properly supported by medical record data. We estimate and record reserves for CMS audits based on information available at the time the estimates are made. The judgments and uncertainties affecting the application of these policies include significant estimates related to the amount of HCC revenue subject to audit and anticipated error rates. Although we believe the Company maintains appropriate reserves for its exposure to the RADV audits, actual results could differ materially from those estimates. Accordingly, CMS audit results could have a material adverse effect on our financial position, results of operations, and cash flows.
Concentration of credit risk with respect to receivables is limited due to the large number of customers comprising the Company’s customer base and their breakdown among geographical locations. The Company believes the allowance for doubtful accounts adequately provides for estimated losses as of December 31, 2009. The Company has a risk of incurring losses if such allowances are not adequate.
The Company’s regulated HMO and insurance company subsidiaries are required by state regulatory agencies to maintain minimum surplus balances, thereby limiting the dividends the parent may receive from its regulated entities. During 2009, the Company received $121.0 million in dividends from its regulated subsidiaries and paid $293.8 million in capital contributions to these 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 majority of states in which the Company operates health plans have adopted a RBC policy that recommends the health plans maintain statutory reserves at or above the ”Company Action Level,” which is currently equal to 200% of their RBC. The State of Florida does not currently use RBC methodology in its regulation of HMOs. Some states, in which the Company’s regulated subsidiaries operate, require deposits to be maintained with the respective states’ departments of insurance. The table below summarizes the Company’s statutory reserve information as of December 31, 2009 and 2008 (in millions, except percentage data).
Allen F. Wise, Chief Executive Officer and Director of the Company, owns a majority interest in Health Risk Partners (“HRP”), an organization that has entered into a written contract with the Company to provide various services relating to the Company’s Medicare line of business. The contract was negotiated and entered into on an arms-length basis. Two other Directors of the Company own minority interests in HRP. Specifically, HRP provides operational consulting, data processing, data reporting, and chart review/coding services, premium reconciliation, and hierarchical condition categories (“HCC”) revenue compliance related to the Company’s Medicare business. For the years ended December 31, 2009 and 2008, the Company incurred expenses of approximately $12.2 million and $1.1 million, respectively, to HRP for services rendered under the contract. At December 31, 2009 and 2008, the Company had accrued amounts to HRP of approximately $4.6 million and $1.2 million. These amounts are recognized within accounts payable and other accrued liabilities in the Company’s consolidated balance sheets.
The Company has evaluated subsequent events through February 26, 2010, the date of issuance of the financial statements.