As discussed above, due to the delay in filing our 2007 Form 10-K, we were able to review substantially complete claims information that had become available due to the substantial lapse in time between December 31, 2007 and the date we filed our 2007 Form 10-K; therefore, the favorable development was reported in 2007 instead of 2008 as it otherwise would have been. Therefore, our recorded amounts for medical benefits expense and MBR for the year ended December 31, 2008 is approximately $92.9 million, or 1.4%, higher than it otherwise would have been if we had filed our 2007 Form 10-K on time.
The following discussion and analysis of our financial condition and results of operations should be read in conjunction with Part II, Item 6 - Selected Financial Data and our consolidated financial statements and related notes appearing elsewhere in this 2011 Form 10-K. The following discussion contains forward-looking statements that involve risks, uncertainties and assumptions that could cause our actual results to differ materially from management’s expectations. Factors that could cause such differences include those set forth under Part I, Item 1 - Business and Part I, Item 1A - Risk Factors, as well as Forward-Looking Statements discussed earlier in this 2011 Form 10-K.
We are a leading provider of managed care services to government-sponsored health care programs, serving approximately 2.6 million members nationwide. We operate exclusively within the Medicaid and Medicare programs, serving the full spectrum of eligibility groups, with a focus on lower-income beneficiaries. Our primary mission is to help our government customers deliver cost-effective health care solutions, while improving health care quality and access for these programs. We are committed to operating our business in a manner that serves our key constituents - members, providers, government clients, and associates - while delivering competitive returns for our investors.
Presented below are key developments and accomplishments relating to progress on our strategic business priorities that occurred during 2011 and impacted our financial condition and results of operations.
During the 2011 third quarter, we successfully completed an upgrade of our core operating systems. This new technology will enable further progress in our work to improve service and productivity, and positions us to comply with future regulatory changes such as the implementation of ICD-10. The upgrade will also support our health care quality and access initiatives.
In 2011, through continued organizational and process refinements, we achieved a 60 basis point reduction in our SG&A expense ratio, excluding investigation-related litigation and other costs (as defined in Results of Operations, Summary of Consolidated Financial Results, Selling general and administrative expense) . Administrative and medical cost initiatives remain an important discipline for us in light of the fiscal challenges of our state and federal customers. For 2012, we are anticipating a reduction in this ratio in the range of approximately 50 to 70 basis points.
In August 2011, we entered into a $300.0 million senior secured credit agreement (the “Credit Agreement”) that can be used for general corporate purposes. The Credit Agreement provides for a $150.0 million term loan facility as well as a $150.0 million revolving credit facility. Both the term loan and revolving credit facility expire in August 2016. Upon closing, we borrowed $150.0 million pursuant to the term loan facility and $146.3 million remained outstanding at December 31, 2011. This new credit agreement replaces our previous $65.0 million credit agreement, which was never drawn upon. Our new credit agreement provides liquidity in support of the significant growth opportunities available to us. In particular, additions to statutory capital may be needed for new markets, such as the new Kentucky Medicaid program, or markets experiencing significant growth. For further information regarding the new credit agreement, refer to New Credit Agreement under Liquidity and Capital Resources and in Part IV, Item 15(c)-Note 10-Debt.
We believe that the 2010 Acts will bring about significant changes to the American health care system. For further discussion of health care reform and its potential impact on our business, see Part I, Item 1 - Business - Health Care Reform. In addition, refer to the risks and uncertainties related to health care reform as discussed in Part I, Item 1A - Risk Factors - Future changes in health care law present challenges for our business that could have a material adverse effect on our results of operations and cash flows.
The states in which we operate continue to experience fiscal challenges which have led to budget cuts and reductions in Medicaid premiums in certain states or rate increases that are below medical costs trends. In particular, we continue to experience pressure on rates in Florida and Georgia, two states from which we derive a substantial portion of our revenue. Our rates increased approximately 2.5% - 3.0% in Georgia effective July 1, 2011. In Florida, changes that were effective September 1, 2011 had essentially no net impact on our overall rate. The ultimate premium rate is based on program type, demographic mix and geographic location.
Although premiums are generally contractually payable to us before or during the month in which we are obligated to provide services to our members, we have experienced delays in premium payments from certain states. In particular, the State of Georgia passed legislation in 2010 mandating that payment for Medicaid premiums in that state be made in the middle and at the end of the month in which services are provided. Previously, such payments were made at the beginning of each month. Additionally, the Georgia DCH has recently informed us that it is delaying the payment of certain premiums for as much as $300 million during the first quarter of 2012, and plans to restore these payments during the second quarter of 2012. Payments have already been delayed in January 2012 and February 2012 to date and if the delays continue through March 2012 as planned, our consolidated operating cash flow for the first quarter of 2012 will be materially impacted. However, at this time, the delays are considered to be a timing issue and we have adequate liquidity to manage the delays. We expect our programs in Georgia and elsewhere will continue to operate as they have historically. Given the budget shortfalls in many states with which we contract, additional payment delays may occur in the future.
In December 2011, the Georgia DCH amended its contracts for its Medicaid programs, to provide for two additional one year option terms, exercisable by Georgia DCH, which potentially extends the total contract term until June 30, 2014. Separately, Georgia DCH recently published a consultant’s report evaluating alternatives for its Medicaid program that includes a suggestion that the state should maintain the current program model, and also consider expanding it to include new populations, including the ABD population, that may number as many as 350,000 individuals.
In January 2012, Hawaii’s Department of Human Services selected us to serve the state’s QUEST Medicaid program, which covers beneficiaries of Hawaii’s TANF and CHIP, as well as other eligible beneficiaries across Hawaii. This is an expansion of Hawaii’s Medicaid program into managed care, where we currently serve approximately 24,000 ABD beneficiaries. We are one of five health plans selected to serve approximately QUEST 230,000 beneficiaries across the state. Beneficiaries of the QUEST program include low-income individuals, families and children who are not aged, blind or disabled. Services are expected to begin on or about July 1, 2012, and we will coordinate medical, behavioral and pharmacy services with a focus on improving health care access and the quality of care. With this new award, we become Hawaii’s only health plan to provide QUEST, QUEST Expanded Access and Medicare Advantage services across all six islands. We are unable to estimate our expected additional membership at this time.
Other states in which we have offered health plans for several years are expanding or reprocuring their Medicaid managed care programs, which may be very complementary to our existing operations and infrastructure, including Kansas, Missouri and Ohio. In addition, we anticipate the managed long-term care procurement by the Florida Medicaid program will occur in mid-2012.
Based on the outcome of our 2012 stand-alone PDP bids, our 2012 plans are below the benchmarks in five of the 34 CMS regions and within the de minimis range of the benchmark in 17 other CMS regions. Comparatively, in 2011, our plans were below the benchmarks in 20 regions and within the de minimis range in eight other regions. We have retained our auto-assigned members in those 17 regions in which we bid within the de minimis range; however, we will not be auto-assigned new members in those regions during 2012. Consequently, membership has declined to approximately 900,000 as of January 1, 2012, a decrease from 976,000 as of December 31, 2011. The Company anticipates PDP segment membership will decrease slightly during the remainder of 2012 due to normal attrition being offset by fewer new members as we will be auto-assigned newly eligible members in 2012 in only the five regions where we are below the benchmark. We believe our plans are well positioned relative to member utilization patterns, cost-sharing, and a focus on generic medications. Consequently, we believe our PDPs remain attractive to choosers, who comprise more than fifty percent of our current membership.
Our revenues and medical benefits expenses for fiscal years 2011 and 2010 were lower than in prior periods due to our exit on December 31, 2009 from our MA PFFS product and our exit from Medicaid programs in certain Florida counties during 2009. Premium revenue from our PFFS product represented approximately 41% of our MA reportable operating segment revenue and 17% of our consolidated premium revenue for the 2009 fiscal year.
Provider reimbursement levels are subject to change by the states and CMS. In addition, some hospital contracts are directly tied to state Medicaid fee schedules, resulting in reimbursement levels that may be adjusted up or down, generally on a prospective basis, based on adjustments made by the state to the fee schedule. We have experienced, and may continue to experience, such adjustments. Unless such adjustments are mitigated by corresponding changes in premiums, our profitability will be negatively impacted.
For a complete discussion of government investigations and litigation including the associated financial impact, please refer to our Selling, general and administrative expense discussion under Results of Operations below and Part IV, Item 15(a) - Note 11 - Commitments and Contingencies.
Reportable operating segments are defined as components of an enterprise for which discrete financial information is available and evaluated on a regular basis by the Company’s decision-makers to determine how resources should be allocated to an individual segment and to assess performance of those segments. Previously, we reported two operating segments, Medicaid and Medicare, which coincide with our two main business lines. During the first quarter of 2010, we reassessed our segment reporting practices and made revisions to reflect our current method of managing performance and determining resource allocation, which includes reviewing the results of our PDP operations separately from other Medicare products. Accordingly, we now have three reportable segments: Medicaid, MA and PDP. The PFFS product that we exited December 31, 2009 is reported within the MA segment. The prior periods have been revised to reflect this segment presentation.
We cover a wide spectrum of medical services through our MA plans including, in some cases, additional benefits not covered by original Medicare, such as vision, dental and hearing services. Through these enhanced benefits, the out-of-pocket expenses incurred by our members are reduced, which allows our members to better manage their health care costs.
Most of our MA plans require members to pay a co-payment, which varies depending on the services and level of benefits provided. Typically, members of our MA 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. MA CCP members may see out-of-network specialists if they receive referrals from their PCPs and may pay incremental cost-sharing. In most of our markets, we also offer special needs plans to individuals who are dually-eligible for Medicare and Medicaid. These plans, commonly called D-SNPs, are designed to provide specialized care and support for beneficiaries who are 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.
We offer stand-alone Medicare Part D coverage to Medicare-eligible beneficiaries through our PDP segment. The Medicare Part D prescription drug benefit is supported by risk sharing with the federal government through risk corridors designed to limit the losses and gains of the drug plans and by reinsurance for catastrophic drug costs. The government subsidy is based on the national weighted average monthly bid for this coverage, adjusted for risk-factor payments. Additional subsidies are provided for dually-eligible beneficiaries and specified low-income beneficiaries. The Medicare Part D program offers national in-network prescription drug coverage that is subject to limitations in certain circumstances.
Depending on medical coverage type, a beneficiary has various options for accessing drug coverage. Beneficiaries enrolled in original Medicare can either join a stand-alone PDP or forego Part D drug coverage. Beneficiaries enrolled in MA CCPs can join a plan with Part D coverage, select a separate Part D plan, or forego Part D coverage.
We use three measures to assess the performance of our reportable operating segments: premium revenue, MBR and gross margin. Our MBR measures the ratio of our medical benefits expense to premiums earned, after excluding Medicaid premium taxes. Our gross margin is defined as our premium revenue less our medical benefits expense.
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 arrangements with providers primarily fall into two broad categories: capitation arrangements, pursuant to which we pay the capitated providers a fixed fee per member and fee-for-service as well as risk-sharing arrangements, pursuant to which the provider assumes a portion of the risk of the cost of the health care provided. Capitation payments represented 11.0%, 12.0% and 11.0% of our total medical benefits expense for the years ended December 31, 2011, 2010 and 2009, respectively. Other components of medical benefits expense are variable and require estimation and ongoing cost management.
Estimation of medical benefits payable and medical benefits expense is our most significant critical accounting estimate. For further information regarding medical benefits expense, please refer below to Estimating Medical Benefits Expense and Medical Benefits Payable under Critical Accounting Estimates.
Our primary tools for measuring profitability are gross margin and MBR. Changes in gross margin and 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 IBNR claims. We use gross margin and MBRs both to monitor our management of medical benefits and medical benefits expense and to make various business decisions, including what health care plans to offer, what geographic areas to enter or exit and which health care providers to select. Although gross margin and MBRs play an important role in our business strategy, we may be willing to enter new geographical markets and/or enter into provider arrangements that might produce a less favorable gross margin and MBR if those arrangements, such as capitation or risk sharing, would likely lower our exposure to variability in medical costs or for other reasons.
In 2012, we expect membership growth in our Medicaid and MA segments, offset in part by reduced PDP segment membership. The growth expectation in Medicaid is driven by membership increases in Kentucky subsequent to our initial launch, the contract award for Hawaii’s QUEST Medicaid program in January that is effective July 1, 2012, as well as membership growth opportunities existing in states in which we currently operate. The growth expectation in MA is based on results of the annual election period, which resulted in an increase of approximately 10,000 members effective January 1, 2012, as well as our continued focus on dually-eligible beneficiaries. However, as a result of our 2012 PDP bids, our PDP membership declined to approximately 900,000 as of January 1, 2012. We anticipate PDP segment membership will decrease slightly during the remainder of 2012 due to normal attrition being offset by fewer new members as we will be auto-assigned newly eligible members in fewer regions.
As of December 31, 2010, we served approximately 2,224,000 members; a decrease of 97,000 members from the 2,321,000 members we served as of December 31, 2009. As previously discussed, our MA segment includes results from the PFFS product that we exited on December 31, 2009. The overall membership decrease was due primarily to our December 31, 2009 exit from our PFFS product, which accounted for 95,000 MA members as of December 31, 2009 as well as a decline in MA CCP membership. The decrease in MA CCP resulted from the 2009 CMS Medicare marketing sanction, which was lifted in November 2009. However, we were not eligible to receive auto-assignments of low-income subsidy, dually-eligible beneficiaries into our PDP plans for January 2010 enrollment. We received auto assignments of PDP members in subsequent months, although such assignments were below the level we typically experience in the month of January.
SG&A expense includes aggregate costs related to the resolution of the previously disclosed governmental and Company investigations and litigation, such as settlement accruals and related fair value accretion, legal fees and other similar costs; net of $25.8 million and $6.4 million of directors and officers liability insurance recoveries during December 31, 2010 and 2009, respectively, related to the putative class action complaints. Please refer to Part I, Item 3 - Legal Proceedings for a complete discussion of investigation-related litigation and other resolution costs. We believe it is appropriate to evaluate SG&A expense exclusive of these investigation-related litigation and other resolution costs because we do not consider them to be indicative of long-term business operations. A reconciliation of SG&A expense, including and excluding such costs, is presented below.
Excluding investigation-related litigation and other resolution costs, our SG&A expense increased approximately $41.0 million, or 7%, in 2011 compared to the same period in 2010. Our SG&A expense as a percentage of total revenue, excluding premium taxes (“SG&A ratio”), was 11.9% in the 2011 period compared to 16.6% for the same period in the prior year. After excluding the investigation-related litigation and other resolution costs, our SG&A ratio for 2011 was 11.1% compared to 11.7% for the same period in 2010. The improvement in our SG&A ratio, excluding investigation-related litigation and other resolution costs, represents solid progress toward our long-term goal of an adjusted SG&A ratio in the low 10% range, based on our current business and geographic mix. Business simplification projects, process management in our shared services functions, and continued evaluation of our organizational design continued to drive improvement in our administrative cost structure, partially offset by spending related to the launch of our Kentucky Medicaid program, increased costs associated with our Medicare annual election period strong sales performance, and costs incurred for other growth, regulatory and quality initiatives. An additional factor impacting the comparability of the periods was the impact of relatively low equity-based compensation expense resulting from a larger impact from forfeiture activity in 2010 compared to 2011.
Medicaid premium taxes incurred in the years ended December 31, 2011 and 2010 amounted to $76.2 million and $56.4 million, respectively. The increase in Medicaid premium taxes in 2011 was mainly due to the reinstatement of premium taxes by Georgia in July 2010. In October 2009, Georgia stopped assessing taxes on Medicaid premiums remitted to us, which resulted in an equal reduction to premium revenues and Medicaid premium taxes. However, effective July 1, 2010, Georgia began assessing premium taxes again on Medicaid premiums. Therefore, during the first half of 2010, we were not assessed, nor did we remit, any taxes on premiums in Georgia. We were assessed and remitted taxes on premiums in Hawaii, Missouri, New York and Ohio for both the 2011 and 2010 periods.
On December 15, 2011, we repurchased at 90% of face value all of the $112.5 million of subordinated notes issued in September 2011. The notes had an original a maturity date of December 31, 2016. We recorded a gain on the repurchase of subordinated notes in the amount of $10.8 million. For further information regarding the subordinated notes, refer to Part IV, Item 15(c)-Note 10-Debt.
Income tax expense for the year ended December 31, 2011 was $154.2 million compared to an income tax benefit of $19.4 million for the same period in 2010. Our effective income tax rate on pre-tax income was 36.9% for the year ended December 31, 2011 compared to 26.7% on a pre-tax loss for the same period in 2010. The comparability of the effective tax rates between 2011 and 2010 was impacted by changes related to estimated non-deductible amounts associated with investigation resolution payments, the favorable resolution of prior years’ state tax matters in 2011 and the incurrence of a pre-tax loss in 2010. Additionally, the effective tax rate for the 2010 period was impacted by limitations on the deductibility of certain administrative expenses associated with the resolution of investigation-related matters.
The following table reconciles our reportable segment results with our income (loss) before income taxes, as reported under GAAP.
Excluding Medicaid premium taxes, Medicaid premium revenue for the year ended December 31, 2011 increased 8% when compared to the same period in 2010. The increase in premium revenue was mainly due to rate increases in certain markets, the launch of the Kentucky Medicaid program on November 1, 2011 and additional premiums related to certain retrospective maternity claims that were impacted by a change that the DCH made to its methodology for determining and accepting qualifying maternity claims.
Medicaid medical benefits expense for the year ended December 31, 2011 decreased slightly when compared to the same period in 2010 due mainly to the impact of net favorable reserve development of prior period medical benefits payable and the impact of medical cost initiatives that we have implemented, partially offset by a change in member mix and the launch of the Kentucky Medicaid program in November 2011. The net favorable reserve development resulted primarily from unusually low utilization in 2010. Our Medicaid MBR improved by approximately 660 basis points in 2011 compared to 2010, and the decrease was also driven by the net favorable reserve development of prior period medical benefits payable, the impact of medical cost initiatives, rate increases in certain of our Medicaid markets and additional premiums recognized in connection with retrospective maternity claims in Georgia.
Medicaid medical benefits expense for the year ended December 31, 2010 increased $36.7 million to $2,847.3 million from $2,810.6 million from the same period in the prior year due mainly to the impact of prior period favorable reserve development experienced in 2009, increase in membership and a change in the demographic mix of our members. The decrease in Medicaid MBR for the year ended December 31, 2010 is mainly from premium increases during 2010 and the impact of medical cost initiatives that we have implemented, partially offset by the impact of the net favorable prior year reserve development recognized in 2009 that exceeds the impact of the net favorable prior year reserve development recognized in 2010.
For the Kentucky Medicaid program, membership for February 2012 is estimated to be 146,000, an increase from 116,000 as of the program launch on November 1, 2011, due to members’ opportunity to change plans. Based on the increase in estimated membership as well as changes in membership demographics, we currently anticipate that annual premium revenue from the Kentucky program in 2012 will be approximately $575 million to $600 million. Additionally, we were recently awarded a contract for Hawaii’s QUEST Medicaid program to serve TANF and CHIP members with an approximate effective date of July 1, 2012. We were one of five plans selected to serve approximately 230,000 beneficiaries across the state; however, we are unable to estimate our additional membership at this time.
Membership decreased by approximately 109,000 members to 116,000 as of December 31, 2010, from 225,000 as of December 31, 2009 primarily due to our exit from the PFFS plans in December 2009. Excluding premium revenue from our PFFS product, MA premium revenue for the year ended December 31, 2010 decreased $309.3 million to $1,332.6 million from $1,641.9 million for the same period in the prior year. The decrease in MA premium revenue and membership was primarily attributable due to our inability to enroll new MA CCP members during the 2009 CMS marketing sanction period. Correspondingly, MA gross margin, excluding the impact from our PFFS product in 2009, decreased by $81.5 million for the year ended December 31, 2010, to $245.1 million from $326.6 million compared to the same period in the prior year due to the decrease in premiums, partially offset by $33.1 million of prior period favorable reserve development in 2010 related to the PFFS product. The decrease in the 2010 MA MBR was primarily related to the withdrawal of PFFS plans, which operated at an MBR above the segment average, and the prior period favorable reserve development related to the PFFS product. Excluding the impact from our PFFS product in 2009, the MA segment MBR increased from 80.1% for the year ended December 31, 2009 to 81.6% for the year ended December 31, 2010. The overall increase in MBR was attributed to a change in the demographic mix of our members and increased utilization patterns.
For the MA segment, membership for January 2012 is estimated to be 145,000, an increase from 135,000 as of December 31, 2011. Currently, we expect MA segment membership to continue to grow during the remaining months of 2012, as we leverage our success in serving dually-eligible beneficiaries as well as the broader growth in the Medicare population.
PDP premium revenue increased 32% for the year ended December 31, 2011 when compared to the same period in 2010, resulting primarily from increased membership, partially offset by the impact of lower pricing consistent with our bid results. Membership increased by 27% in 2011, largely due to an increase in auto-assigned members resulting from our 2011 bids and the addition of one CMS region. The PDP MBR increased by 150 basis points in 2011 compared to 2010 due to our bid results, member mix and higher utilization. The segment gross margin increased by approximately 22%.
PDP premium revenue for the year ended December 31, 2010 decreased $49.7 million to $785.4 million from $835.1 million for the same period in the prior year. The lower premium revenue in 2010 is the result of lower membership in the first half of the year and a higher returned premium under the risk corridor provisions of the PDP product. The higher risk corridor returned premium is due to the lower claim expense in 2010.
Membership increased by approximately 21,000 members to 768,000 as of December 31, 2010 from 747,000 as of December 31, 2009, despite lower membership throughout the first half of the year. PDP membership at the beginning of 2010 was lower than the end of 2009 as we were unable to receive auto-assigned membership in January 2010 following the release of the 2009 CMS marketing sanction. Membership gradually increased throughout the year as we became eligible to receive auto assignments and engage in additional marketing activities.
PDP MBR improved for the year ended December 31, 2010 due to improved performance of the product as a result of our revised product benefit design and increased generic drug dispensing through the bid process. PDP gross margin for the year ended December 31, 2010 increased $67.5 million to $150.1 million from $82.6 million for the same period in the prior year. The improvement in gross margin was due mainly to better overall performance of the Part D product and improved MBR despite the decrease in premiums.
The table below presents our cash and investment positions, excluding restricted investments.
In August 2011, we entered into a $300.0 million senior secured credit agreement (the “Credit Agreement”) that can be used for general corporate purposes. The Credit Agreement provides for a $150.0 million term loan facility as well as a $150.0 million revolving credit facility. Upon closing, we borrowed $150.0 million pursuant to the term loan facility and incurred approximately $2.5 million of debt issuance costs that have been deferred and will be amortized over the life of the agreement. The Credit Agreement replaces the previous credit facility, which had never been drawn upon and which has now been terminated. We had at all times remained in compliance with all covenants associated with the former agreement.
Both the term loan and revolving credit facility are set to expire in August 2016. Subject to adjustment for prepayments, the term loan will amortize in quarterly installments of $1,875 for the first four quarters, $3,750 for the next eight quarters, $5,625 for the next four quarters and $7,500 for the next three quarters, with the remaining balance due upon maturity. As of December 31, 2011, our remaining term loan balance was $146.3 million, which is included in the current portion of long-term debt and long-term debt line items in our consolidated balance sheet.
The Credit Agreement also contains customary representations and warranties and events of default. The payment of outstanding principal under the Credit Agreement and accrued interest thereon may be accelerated and become immediately due and payable upon our default of payment or other performance obligations or our failure to comply with financial or other covenants in the Credit Agreement, subject to applicable notice requirements and cure periods as provided in the Credit Agreement.
As of the date of this filing, the revolving credit facility has not been drawn upon and we remain in compliance with all covenants.
On September 30, 2011, we issued tradable unsecured subordinated notes having an aggregate par value of $112.5 million, with a fixed coupon of 6% and a maturity date of December 31, 2016. These notes were issued in connection with the stipulation and settlement agreement, which was approved in May 2011, to resolve the putative class action complaints previously filed against us in 2007. On December 15, 2011 we repurchased all of the $112.5 million subordinated notes at 90% of face value. We recorded a gain on the repurchase of subordinated notes in the amount of $10.8 million. Interest of approximately $4.1 million was incurred on these notes in 2011, including amounts retroactive to May 2011, and was paid at the time of repurchase. For further information regarding the subordinated notes, refer to Note 10 - Debt.
As of December 31, 2011, we held municipal note investments with an auction reset feature (“auction rate securities”). These notes are issued by various state and local municipal entities for the purpose of financing student loans, public projects and other activities, which carry investment grade credit ratings. Liquidity for these auction rate securities is typically provided by an auction process which allows holders to sell their notes and resets the applicable interest rate at pre-determined intervals, usually every seven or 35 days. As of the date of this Form 10-K, auctions have failed for our auction rate securities and there is no assurance that auctions will succeed in the future. An auction failure means that the parties wishing to sell their securities could not be matched with an adequate volume of buyers. In the event that there is a failed auction the indenture governing the security requires the issuer to pay interest at a contractually defined rate that is generally above market rates for other types of similar instruments. The securities for which auctions have failed will continue to accrue interest at the contractual rate and be auctioned every seven or 35 days until the auction succeeds, the issuer calls the securities, or they mature. As a result, our ability to liquidate and fully recover the carrying value of our remaining auction rate securities in the near term may be limited or non-existent. In addition, while all of our auction rate securities currently carry investment grade ratings, if the issuers are unable to successfully close future auctions and their credit ratings deteriorate, we may in the future be required to record an impairment charge on these investments.
Although auctions continue to fail, we believe we will be able to liquidate these securities without significant loss. There are government guarantees or municipal bond insurance in place and we have the ability and the present intent to hold these securities until maturity or market stability is restored. Accordingly, we do not believe our auction rate securities are impaired and as a result, we have not recorded any impairment losses for our auction rate securities. 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 28 years. The weighted-average life of the underlying securities for our auction rate securities portfolio is 23 years. During 2011, auction rate securities of $11.2 million, in the aggregate, were called at par, at the option of the issuer.
In connection with the settlement agreement that we reached with the lead plaintiffs to resolve certain putative class action complaints, which was approved by the United States District Court for the Middle District of Florida in May 2011, we delivered to the escrow agent on behalf of the class, a $35.0 million non-negotiable, non-interest bearing, promissory note that was due and payable in full on July 31, 2011. This liability was previously accrued as part of amounts accrued related to the investigation resolution and this amount was paid in full on July 28, 2011. In March 2011, we paid $52.5 million and in September 2011, we issued $112.5 million of tradable unsecured subordinated notes in connection with the resolution of these class action complaints. Subsequently, in December 2011, we repurchased the subordinated notes as discussed in Issuance and Repurchase of Subordinated Notes above.
Each of our regulated subsidiaries generally must obtain approval from, or provide notice to, the state in which it is domiciled before entering into certain transactions such as declaring dividends in excess of certain thresholds, entering into other arrangements with related parties, and acquisitions or similar transactions involving an HMO or insurance company, or any change in control. For purposes of these laws, in general, control commonly is presumed to exist when a person, group of persons or entity, directly or indirectly, owns, controls or holds the power to vote 10% or more of the voting securities of another entity.
Each of our HMO and insurance subsidiaries must maintain a minimum amount of statutory capital determined by statute or regulation. The minimum statutory capital 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 RBC requirement or other financial ratios. The RBC requirements are based on guidelines established by the NAIC, and have been adopted by most states. As of December 31, 2011, our HMO operations in Connecticut, Georgia, Illinois, Indiana, Louisiana, Missouri, New Jersey, Ohio and Texas as well as three of our insurance company subsidiaries were 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 ACL, which represents the amount of capital required to support the regulated entity’s business. For states in which the RBC requirements have been adopted, the regulated entity typically must maintain a minimum of the greater of 200% of the required ACL or the minimum statutory net worth requirement calculated pursuant to pre-RBC guidelines. Our subsidiaries operating in Texas, Georgia and Ohio are required to maintain statutory capital at RBC levels equal to 225%, 250% and 300%, respectively, of the applicable ACL. Failure to maintain these requirements would trigger regulatory action by the state. At December 31, 2011, our HMO and insurance subsidiaries were in compliance with these minimum capital requirements. The combined statutory capital and surplus of our HMO and insurance subsidiaries was approximately $858.0 million and $695.0 million at December 31, 2011 and 2010, respectively, compared to the required surplus of approximately $310.0 million and $300.0 million at December 31, 2011 and 2010, respectively.
We generally receive premiums in advance of payments of claims for health care services; however, cash flows related to our operations can fluctuate significantly in a particular period depending on the timing of premiums receipts from our government partners or payments related to resolving government investigations and related litigation.
As discussed in Business and Financial Outlook/ Premium Rates and Payments, the Georgia DCH has recently informed us that it is delaying the payment of certain premiums for as much as $300 million during the first quarter of 2012, and plans to restore these payments during the second quarter of 2012. Payments have already been delayed in January 2012 and February 2012 to date and if the delays continue through March 2012 as planned, our consolidated operating cash flow for the first quarter of 2012 will be materially impacted. However, at this time, the delays are considered to be a timing issue and we have adequate liquidity to manage the delays. We expect our programs in Georgia and elsewhere will continue to operate as they have historically.
Based on the terms of the Preliminary Settlement reached with the Civil Division in June 2010 to settle pending civil inquiries related to qui tam complaints filed by relators against us, which includes interest. The Preliminary Settlement is subject to completion and approval of an executed written settlement agreement and other government approvals, as discussed in Part I, Item 3 - Legal Proceedings.
Amount includes a $10.5 million estimate related to the qui tam relators’ attorneys’ fees to be paid in addition to the Preliminary Settlement amount.
We recognize premium revenues in the period in which we are obligated to provide services to our members. Premiums are billed monthly for coverage in the following month and we are paid generally in the month in which we provide services. Any amounts that have been earned and have not been received are recorded in our consolidated balance sheets as premium receivables. Any amounts received by us in advance of the period of service are recorded as a liability, unearned premiums, in our consolidated balance sheets and are not recognized as revenue until the respective services have been provided. On a monthly basis, we bill members for any premiums for which they are responsible according to their respective plan. We estimate, on an ongoing basis, the amount of member billings that may not be fully collectible based on historical trends. An allowance is established for the estimated amount that may not be collectible and a liability is established for premium expected to be returned. Historically, the allowance for member premiums receivable has not been significant relative to premium revenue.
During the year ended December 31, 2011, Georgia DCH made retroactive premium adjustments for overpayments related to a reconciliation of duplicate member records and members belonging to a plan other than ours for periods dating back to the beginning of the program in 2006. In accordance with the policy stated above, we had previously identified and accrued an estimated liability for overpayments that we believed would be returned to Georgia DCH. In addition, Georgia DCH has notified us of expected retroactive premium adjustments for the understatement of historical capitation premium rates for the periods affected by duplicative enrollment. The net impact to premium revenue resulting from the adjustments was immaterial to our consolidated results of operations.
Our Florida Medicaid and Healthy Kids contracts and Illinois Medicaid contract require us to expend a minimum percentage of premiums on eligible medical expense. To the extent that we expend less than the minimum percentage of the premiums on eligible medical expense, we are required to refund all or some portion of the difference between the minimum and our actual allowable medical expense. We estimate the amounts due to the states as a return of premium each period based on the terms of our contracts with the applicable state agency, and such amounts are included in our consolidated results of operations as adjustments to premium revenues. Our liability to states under their respective minimum medical expense provisions was $12.3 million as of December 31, 2011 and $10.7 million as of December 31, 2010.
The data provided to CMS to determine the risk score is subject to audit by CMS even after the annual settlements occur. These audits may result in the refund of premiums to CMS previously received by us. While our experience to date has not resulted in a material refund, this refund could be significant in the future, which would reduce our premium revenue in the year that CMS determines repayment is required.
CMS has performed and continues to perform RADV audits of selected MA plans to validate the provider coding practices under the risk adjustment model used to calculate the premium paid for each MA member. Our Florida MA plan was selected by CMS for audit for the 2007 contract year and we anticipate that CMS will conduct additional audits of other plans and contract years on an ongoing basis. The CMS audit process selects a sample of 201 enrollees for medical record review from each contract selected. We have responded to CMS’s audit requests by retrieving and submitting all available medical records and provider attestations to substantiate CMS-sampled diagnosis codes. CMS will use this documentation to calculate a payment error rate for our Florida MA plan 2007 premiums. CMS has not indicated a schedule for processing or otherwise responding to our submissions.
Low-Income Premium Subsidy-For qualifying LIS members, CMS pays us for some or all of the LIS member’s monthly premium. The CMS payment is dependent upon a member’s income level which is determined by the Social Security Administration. Low-income premium is recognized over the contract period and reported as premium revenue.
The medical benefits payable estimate has been and continues to be our most significant estimate included in our financial statements. We historically have used and continue to use a consistent methodology for estimating our medical benefits expense and medical benefits payable. Our policy is to record management’s best estimate of medical benefits payable based on the experience and information available to us at the time. This estimate is determined utilizing standard actuarial methodologies based upon historical experience and key assumptions consisting of trend factors and completion factors using an assumption of moderately adverse conditions, which vary by business segment. These standard actuarial methodologies include using, among other factors, contractual requirements, historic utilization trends, the interval between the date services are rendered and the date claims are paid, denied claims activity, disputed claims activity, benefits changes, expected health care cost inflation, seasonality patterns, maturity of lines of business and changes in membership.
In developing our estimates, 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 fixed fee 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 prior 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 of which influence the resulting medical cost trend. Differences 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. Such differences can have a material impact on results of operations in the periods in which they are recognized.
Medical benefits payable recorded at December 31, 2010, 2009 and 2008 developed favorably by approximately $252.1 million, $116.3 million and $121.0 million in 2011, 2010 and 2009, respectively. A portion of the prior period development was attributable to the release of the provision for moderately adverse conditions, which is included as part of the assumptions. The release of the provision for moderately adverse conditions was substantially offset by the provision for moderately adverse conditions established for claims incurred in the current year. Accordingly, the change in the amount of the incurred claims related to prior years in the Medical benefits payable does not directly correspond to an increase in net income recognized during the period.
We obtained goodwill and other intangible assets as a result of the acquisitions of our subsidiaries. These assets are allocated to reporting segments for impairment testing purposes. Goodwill represents the excess of the cost over the fair market value of net assets acquired. Goodwill attributable to our Medicare reporting segment was determined to be fully impaired in 2008 and was completely written off. Accordingly, all of the remaining goodwill is attributable to our Medicaid reporting segment. Other intangible assets include provider networks, trademarks, state contracts, licenses and permits. Our other intangible assets are amortized over their estimated useful lives ranging from approximately one to 26 years.
We review goodwill and other intangible assets for potential 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 other intangible assets. Such events or changes in circumstances would include significant changes in membership, state funding, medical contracts and provider networks. We evaluate the potential impairment of goodwill and other intangible assets using both the income and market approach. In doing so, we must make assumptions and estimates, such as projected revenues and the discount factor, in estimating fair values. While we believe these assumptions and estimates are appropriate, other assumptions and estimates could be applied and might produce significantly different results. We use a two-step process to review goodwill for impairment. The first step is a screen for potential impairment, and the second step measures the amount of impairment, if any. An impairment loss is recognized for goodwill and intangible assets if the carrying value of such assets exceeds its fair value. We select the second quarter of each year for our annual goodwill potential impairment test, which generally coincides with the finalization of federal and state contract negotiations and our initial budgeting process, with the test completed during the third quarter of that year. As of our most recent testing date, we have determined that the estimated fair value of the Medicaid reporting segment exceeded its carrying value and as a result, there were no indications that would require additional impairment testing as of December 31, 2011.
Refer to Note 2, Summary of Significant Accounting Policies, included in the Notes to the Consolidated Financial Statements at Part IV, Item 15 of this 2011 Form 10k for information and disclosures related to new accounting standards which are incorporated herein by reference.