Our Health Plan Services reportable segment includes the operations of our commercial, Medicare (including the Medicare prescription drug benefit commonly referred to as “Part D”) and Medicaid health plans, the operations of our health and life insurance companies and our behavioral health and pharmaceutical services subsidiaries. We have approximately 3.6 million members, including Medicare Part D members, and 109,000 administrative services only (ASO) members in our Health Plan Services segment.
Our profitability depends in large part on our ability to, among other things, effectively price our health care products; manage health care costs, including pharmacy costs; contract with health care providers; attract and retain members; and manage our general and administrative (G&A) and selling expenses. In addition, factors such as regulation, competition and general economic conditions affect our operations and profitability. The potential effect of escalating health care costs, as well as any changes in our ability to negotiate competitive rates with our providers, may impose further risks to our ability to profitably underwrite our business, and may have a material impact on our business, financial condition or results of operations.
Health plan services premiums include HMO, POS and PPO premiums from employer groups and individuals and from Medicare recipients who have purchased supplemental benefit coverage (which premiums are based on a predetermined prepaid fee), Medicaid revenues based on multi-year contracts to provide care to Medicaid recipients, and revenue under Medicare risk contracts, including Medicare Part D, to provide care to enrolled Medicare recipients. Medicare revenue can also include amounts for risk factor adjustments. The amount of premiums we earn in a given year is driven by the rates we charge and enrollment levels. Administrative services fees and other income primarily includes revenue for administrative services such as claims processing, customer service, medical management, provider network access and other administrative services. Health plan services expense includes medical and related costs for health services provided to our members, including physician services, hospital and related professional services, outpatient care, and pharmacy benefit costs. These expenses are impacted by unit costs and utilization rates. Unit costs represent the health care cost per visit, and the utilization rates represent the volume of health care consumption by our members.
General and administrative expenses include those costs related to employees and benefits, consulting and professional fees, marketing, premium taxes and assessments and occupancy costs. Such costs are driven by membership levels, introduction of new products, system consolidations and compliance requirements for changing regulations. These expenses also include expenses associated with corporate shared services and other costs to reflect the fact that such expenses are incurred primarily to support the Health Plan Services segment. Selling expenses consist of external broker commission expenses and generally vary with premium volume.
Health Net’s financial performance in 2006 was strong. The Company’s diversified businesses all achieved improved profitability compared with 2005. This broad-based performance drove key measures higher as:
Health Net completed the Universal Care Acquisition on March 31, 2006. The information above includes the contribution from the businesses acquired from Universal Care.
We believe that our diverse products and services are well positioned to address the changing health care environment. During 2006, we maintained our diverse medical membership base by introducing Medicare Part D and other products. Our recent strategy of targeting the small group and mid-market has resulted in changing the mix of our membership: approximately 30% of our commercial enrollment, including ASO, is in the small group and individual segments at the end of 2006, up from 28% at the end of 2005. On January 1, 2007, we began offering Medicare Advantage Private-Fee-For Service plans, and we began marketing our Medicare Part D plans in all 50 states and the District of Columbia. We also increased the number of Part D plan choices that we offer seniors from two in 2006 to three in 2007, one of which provides beneficiaries with coverage of generic drug expenses through the coverage gap, or “donut hole.” In addition, we are continuing our strategy of targeting mid-market and small group segments. Our TRICARE membership is stable at 2.9 million beneficiaries, and we have expanded our relationship with the Department of Defense by providing behavioral health counseling services starting in 2006. In addition, we announced on February 12, 2007 that our behavioral health care business unit has been awarded a five-year contract to develop, administer and monitor the non-medical counseling program for military service members and their families known as Military Family Counseling Services (MFCS). The total contract is valued at approximately $250 million.
One of our key objectives in 2005 was to effectively manage our commercial health care costs and to ensure that pricing was consistent with improving health care cost trends in order to accomplish better MCRs and improve profit margins. Pretax profit margins improved during every quarter in 2005, and the pretax profit margin was 3.2% for the year ended December 31, 2005, compared to 0.6% for the year ended December 31, 2004.
The increase in commercial premium PMPM was 10.9% for the year ended December 31, 2005 compared to the same period in 2004.
In 2005, we made focused investments to prepare for the Medicare Part D drug benefit and to increase health plan marketing and advertising to generate more growth.
In addition, the transition to the new TRICARE contract for the North Region was completed during 2005, and pretax income from this business increased to $96.2 million for the year ended December 31, 2005 from $94.3 million for the year ended December 31, 2004.
Statutory capital is another key measure that improved substantially in 2005. Our objective in 2005 was to improve our risk-based capital (RBC) ratio to 350% as part of our ongoing effort to have our senior unsecured debt rating upgraded. As of December 31, 2005, our RBC ratio was approximately 375%.
Our total health plan membership increased by 9% to 3.7 million members at December 31, 2006 when compared to December 31, 2005. The increase was driven by the addition of 300,000 Medicare Part D members and 83,000 members from the Universal Care Acquisition. Consistent with our strategy of growing our small group and mid-market segments, our small group and individual enrollment increased by 33,000 members in 2006, or 5%, as compared to 2005. Membership in our large group declined by 45,000 members, or 3%, from 2005 to 2006. At December 31, 2006, approximately 30% of our commercial enrollment, including ASO, was in the small group and individual segments, up from 28% for the same period in 2005.
Membership in our commercial health plans decreased by 1% at December 31, 2006 compared to December 31, 2005. This decrease was primarily attributable to continued impact of premium pricing discipline and competition, particularly in the Northeast. The enrollment decline was primarily seen in our Northeast plans, which had a lapse rate of approximately 21%. This enrollment decline was partially offset by an increase in our small group and individual enrollment in California.
Membership in our Medicare Risk program, excluding members under Medicare Part D, increased by 25,000 members at December 31, 2006 compared to December 31, 2005, due to membership growth primarily in California from the addition of two new counties. Under Medicare Part D, which became effective on January 1, 2006, we added 300,000 members.
Membership in our commercial health plans decreased 10% at December 31, 2005 compared to December 31, 2004. This decrease was primarily attributable to the continued impact of premium pricing increases implemented in early 2004 to address higher health care costs and network provider issues. The enrollment decline was primarily seen in our California plan which had a net decline of 17,874 members in the large group market and a net decline of 85,867 members in the PPO/POS products for the small group and individual market reflecting a lapse rate of approximately 25%. Our New Jersey plan experienced a net decline of 45,571 members in the large group market and a net decline of 37,041 in the small group market. The Northeast health plans collectively had a lapse rate of approximately 23%.
Membership in our Medicare Risk and Medicaid programs remained relatively stable at December 31, 2005 compared to December 31, 2004.
Medicare Risk premiums increased by $730.3 million, or 46%, for the year ended December 31, 2006 as compared to the same period in 2005, primarily due to the premiums paid to us by CMS for the members participating in the new Medicare Part D prescription drug program effective January 1, 2006 and favorable Medicare risk factor adjustments in our Arizona, California, Connecticut, Oregon and New York plans totaling $92.0 million in the year ended December 31, 2006 (see “-Health Plan Services Costs” for detail regarding the
increase in capitation expense related to the Medicare rate adjustment). Of this amount, $51.9 million, $37.0 million and $3.1 million were for the 2006, 2005 and 2004 payment years, respectively.
Health Plan Services costs increased by $587.4 million, or 7%, for the year ended December 31, 2006 as compared to the same period in 2005, and decreased by $400.6 million, or 5%, for the year ended December 31, 2005 as compared to the same period in 2004 as shown in the following table:
Commercial health care costs decreased by $485.1 million, or 8%, for the year ended December 31, 2005 as compared to the same period in 2004. The decrease in commercial health care costs was primarily attributable to membership losses, primarily in California and New Jersey, and $143.5 million of costs recorded in 2004 associated with provider settlements relating to claims processing and payment issues. The increase in the commercial health care cost trend on a PMPM basis was 4% for the year ended December 31, 2005 over the same period in 2004 due to an increase in our pharmacy and physician costs, partially offset by moderating health care cost trends in our commercial market reflecting, in part, improvement in our hospital cost experience due to lower inpatient utilization.
The comparison of health care costs above were substantially impacted by the provider dispute costs related to the $169 million charge recorded in the fourth quarter of 2004 (of which $158 million was recorded in health care costs).
Health Plan Services MCR decreased to 84.3% for the year ended December 31, 2005 as compared to 88.4% for the same period in 2004. The decrease was primarily seen in our commercial business due to provider dispute settlements recorded in 2004. Excluding this, the favorable improvement in our MCR was primarily due to continued pricing discipline and moderating health care cost trends in our commercial market reflecting, in part, improvement in our hospital cost experience due to lower inpatient utilization resulting from enhanced medical management activities.
Administrative services fees and other income increased by $4.6 million, or by 9% for the year ended December 31, 2005 as compared to the same period in 2004. The increase was due to an increase in ASO membership of 36,000, primarily in our Northeast plans.
The selling costs ratio (selling costs as a percentage of Health Plan Services premiums) decreased to 2.3% for the year ended December 31, 2005 from 2.5% for the same period in 2004. The decrease was primarily due to a decline in our small group and individual membership which have lower commission cost structures.
In addition to the 2.9 million eligible beneficiaries that we service under the TRICARE contract for the North Region, we administer 14 contracts with the U.S. Department of Veterans Affairs to manage community based outpatient clinics in 10 states covering approximately 30,000 enrollees.
Year Ended December 31, 2005 Compared to Year Ended December 31,
The Government contracts ratio increased by 50 basis points for the year ended December 31, 2005 as compared to the same period in 2004 due to change in the business mix of the TRICARE contracts as we fully transitioned to the North Region contract in 2005.
We recorded litigation, severance and related benefit costs and asset impairments for the years ended December 31, 2006, 2005 and 2004 as detailed below:
During the three months ended December 31, 2006, we recorded a pretax charge of approximately $37.1 million in connection with two consolidated lawsuits, McCoy v. Health Net, Inc. et al., and Wachtel v. Health Net, Inc., et al (McCoy/Wachtel). See Notes 12 and 14 to our consolidated financial statements for additional information on this litigation matter. We intend to fund any payments required in connection with this matter with operating cash flows.
AmCareco litigation. On August 2, 2005 and November 4, 2005, a total of three separate judgments were entered against us in connection with a lawsuit arising from the 1999 sale of three of our health plan subsidiaries to Amcareco, Inc. The aggregate amount of the judgments was $108.7 million. During the three months ended June 30, 2005, we recorded a pretax charge of $15.9 million representing total estimated legal defense costs related to this litigation. As of December 31, 2006, no modifications have been made to the original estimated cost. We did not accrue any amount for the compensatory or punitive damages awards as of December 31, 2005, and we intend to vigorously appeal this judgment. See Notes 12 and 14 to the consolidated financial statements for additional information on this litigation.
We recorded a $1.7 million pretax charge for lease termination expenses associated with the exit of certain properties as part of the transition from our old TRICARE contracts to the TRICARE contract for the North Region.
See Note 14 to our consolidated financial statements for further information on severance and related benefit costs, asset impairments and lease termination costs.
We believe that cash flow from operating activities, existing working capital, lines of credit and cash reserves are adequate to allow us to fund existing obligations, introduce new products and services, and continue to develop health care-related businesses. We regularly evaluate cash requirements for current operations and commitments, and for capital acquisitions and other strategic transactions. We may elect to raise additional funds for these purposes, either through issuance of debt or equity, the sale of investment securities or otherwise, as appropriate.
During the fourth quarter of 2006, we recorded a pretax charge of approximately $37.1 million in connection with the McCoy/Wachtel litigation. We intend to fund any payments for litigation costs associated with these matters with cash flows from operations. During the third quarter of 2006, we paid $62 million as part of a physician class action lawsuit settlement. This settlement amount had been previously accrued for in 2005.
During 2006, we paid $74 million, including transaction costs, for the health plan businesses acquired in the Universal Care Acquisition. During 2006, 2005 and 2004, we sold certain subsidiaries. See Note 3 to the consolidated financial statements for additional information regarding subsidiaries sold. These divestitures, both collectively and in each of the years, did not have a material impact on our liquidity and capital resources.
Payment of $62 million for physician class action settlement as discussed in “-Litigation, Severance and Related Benefit Costs and Asset Impairments” above, and
Reduction in the net purchase of long-term investments of $262 million during 2006, partially offset by
Cash proceeds received of $79 million from the sale of certain non-real estate fixed assets in a sale/leaseback transaction with an independent third party in 2005.
Net cash used in investing activities increased for the year ended December 31, 2005 compared to the same period in 2004, due primarily to an increase in available funds not required for operations that were placed in long-term investments, offset by the proceeds received in June 2005 in connection with a sale-leaseback transaction. See Note 12 to the consolidated financial statements for additional information regarding the sale-leaseback transaction.
We used net free cash available to fund the share repurchases. The remaining authorization under our stock repurchase program as of December 31, 2006 was $200 million. As of December 31, 2006, we had repurchased an aggregate of 25,448,793 shares of our common stock under our stock repurchase program at an average price of $30.92 for aggregate consideration of approximately $787 million (which amount includes exercise proceeds and tax benefits the Company had received from the exercise of employee stock options).
In the second quarter of 2006, we began a series of transactions for the purpose of refinancing our 8.375% Senior Notes due 2011. The Senior Notes were issued pursuant to an indenture (the Senior Notes Indenture) dated as of April 12, 2001 between us and U.S. Bank Trust National Association, as Trustee (the Trustee).
the sum of the present values of the remaining scheduled payments on the Senior Notes to be redeemed consisting of principal and interest, exclusive of interest accrued to the date of redemption, at the rate in effect on the date of calculation of the redemption price, discounted to the date of redemption on a semiannual basis (assuming a 360-day year consisting of twelve 30-day months) at the applicable yield to maturity (as specified in the Senior Notes Indenture) plus 40 basis points plus, in each case, accrued interest to the date of redemption.
October 15 of each year. In connection with the redemption of the Senior Notes, we made a final interest payment, representing accrued interest on the Senior Notes from the last interest payment date to the date of the redemption.
We incurred a total of $70.1 million in costs associated with the refinancing of the Senior Notes, consisting of the $51.0 million redemption premium, the $8.0 million of professional fees and expenses and the $11.1 million of costs incurred in the termination and settlement of our Swap Contracts, which we recorded as a debt refinancing charge in our statement of operations for the year ended December 31, 2006. See Note 6 to our consolidated financial statements for additional information on the debt refinancing charge and Senior Note redemption.
We have a $700 million revolving credit facility under a five-year revolving credit agreement with Bank of America, N.A., as a lender, and as Administrative Agent, Swing Line Lender and L/C Issuer, and the other lenders party thereto. As of December 31, 2006, no amounts were outstanding under our revolving credit facility.
Borrowings under our revolving credit facility may be used for general corporate purposes, including acquisitions, and to service our working capital needs. We must repay all borrowings, if any, under the revolving credit facility by June 30, 2009, unless the maturity date under the revolving credit facility is extended. Interest on any amount outstanding under the revolving credit facility is payable monthly at a rate per annum of (a) London Interbank of America prime rate (LIBOR) plus a margin ranging from 50 to 112.5 basis points, depending on our debt rating by S&P, or (b) the higher of (1) the Bank of America prime rate and (2) the federal funds rate plus 0.5%, plus a margin of up to 12.5 basis points, depending on our debt rating by S&P. Following the redemption of our Senior Notes, Moody’s withdrew its public debt rating for the Company. We have also incurred and will continue to incur customary fees in connection with the revolving credit facility.
Our revolving credit facility contains customary representations and warranties and requires us to comply with certain covenants that impose restrictions on our operations, including financial covenants relating to a minimum borrower cash flow fixed charge coverage ratio (or, if our credit ratings meet specified criteria, a minimum consolidated fixed charge coverage ratio), a maximum consolidated leverage ratio and a minimum consolidated net worth, and a limitation on dividends and distributions. As of December 31, 2006, we were in compliance with all covenants under our revolving credit facility.
The revolving credit facility contains customary events of default subject to materiality and other qualifications and grace periods. The events of default include nonpayment of principal, interest, fees or other amounts under the applicable loan documents; failure to comply with specified covenants and agreements; any representation or warranty of ours in the applicable loan documents having been materially incorrect or misleading when made or deemed made; specified defaults by us or any of our subsidiaries under other indebtedness; specified bankruptcy and insolvency events; specified events involving the entry of judgments against us and/or our subsidiaries; non compliance by us or any of our subsidiaries under specified HMO or insurance regulations; specified events related to compliance with ERISA; actual or asserted invalidity of applicable loan documentation; and a change of control. Upon an event of a default under the revolving credit facility, the obligations under the revolving credit facility may be accelerated and the applicable interest rate increased.
of any outstanding letters of credit. As of December 31, 2006, we had an aggregate of $117.2 million in letters of credit issued pursuant to the revolving credit facility. In addition, we secured two letters of credit effective January 31, 2007 for a total amount of $3.5 million. As a result of the issuance of these letters of credit, the maximum amount available for borrowing under the revolving credit facility is $579.3 million as of January 31, 2007. No amounts have been drawn on any of these letters of credit.
The Bridge Loan Agreement contains representations and warranties, affirmative and negative covenants and events of default substantially similar to those contained in our revolving credit facility. Upon an event of default under the Bridge Loan Agreement, the obligations under the Bridge Loan Agreement may be accelerated and the applicable interest rate increased. As of December 31, 2006, we were in compliance with all covenants under the Bridge Loan Agreement.
On June 23, 2006, we borrowed $300 million under a term loan agreement with JP Morgan Chase Bank, N.A., as administrative agent and lender, Citicorp USA, Inc., as syndication agent and lender (Term Loan Agreement). As of December 31, 2006, $300 million was outstanding under the Term Loan Agreement. We may voluntarily prepay amounts outstanding under the Term Loan Agreement, in whole or in part, at any time without penalty or premium (subject to certain customary breakage costs). At our option, borrowings under the Term Loan Agreement generally may be designated and maintained as either base rate loans or eurodollar rate loans. Base rate loans generally bear interest at a rate per annum equal to the sum of (i) the higher of (a) the applicable prime commercial rate and (b) the Federal Funds Rate plus 0.5% and (ii) a margin that is fixed within a range of 0 basis points to 50 basis points, depending on our debt rating by S&P. Eurodollar rate loans generally bear interest at a rate per annum equal to the sum of (i) the applicable eurodollar interest rate (LIBOR) and (ii) a margin that is fixed within a range of 62.5 basis points to 150 basis points, depending on our debt rating by S&P. As of December 31, 2006, the applicable margin was 1.50% over LIBOR, and the interest rate on the term loan borrowings was 6.86%. This interest rate is effective until June 27, 2007, at which time the interest rate will be reset for the next period. Borrowings under the Term Loan Agreement have a final maturity date of June 23, 2011. On November 6, 2006, we amended the Term Loan Agreement to, among other things, allow for the repurchase of up to $500 million of our capital stock, subject to specified conditions contained in such agreements (including a maximum leverage ratio), without limitation as to the source of funds used to make the repurchases. See “-Recent Amendments” below.
The Term Loan Agreement contains representations and warranties, affirmative and negative covenants and events of default substantially similar to those contained in our revolving credit facility. Upon an event of a default under the Term Loan Agreement, the obligations under the Term Loan Agreement may be accelerated and the applicable interest rate increased. As of December 31, 2006, we were in compliance with all covenants under the Term Loan Agreement.
On November 6, 2006, we amended our revolving credit facility, Bridge Loan Agreement and Term Loan Agreement to allow for the repurchase of up to $500 million of our capital stock, subject to specified conditions contained in such agreements (including a maximum leverage ratio), without limitation as to the source of funds used to make the repurchases. Immediately prior to the November 6, 2006 amendments, the revolving credit facility, the Bridge Loan Agreement and the Term Loan Agreement would have allowed for repurchases of capital stock of up to $500 million only with proceeds from a financing transaction incurred specifically to fund stock repurchases, effectively limiting our share repurchases in any period of four consecutive quarters (in the absence of such a financing transaction) to no more than $75 million (plus proceeds received by us from the exercise of stock options held by employees, management or directors of the company and any tax benefit to us related to such exercise) less other restricted payments made in such period.
By law, regulation and governmental policy, our health plan and insurance subsidiaries, which we refer to as our regulated subsidiaries, are required to maintain minimum levels of statutory net worth. The minimum statutory net worth requirements differ by state and are generally based on balances established by statute, a percentage of annualized premium revenue, a percentage of annualized health care costs, or risk-based capital (RBC) requirements. The RBC requirements are based on guidelines established by the National Association of Insurance Commissioners. The RBC formula, which calculates asset risk, underwriting risk, credit risk, business
Our significant contractual obligations as of December 31, 2006 are summarized below for the years ending December 31:
Other purchase obligations include payments due under agreements for goods or services that are enforceable and legally binding on us and that specify all significant terms, including: fixed or minimum quantities to be purchased; fixed, minimum or variable price provisions; and the approximate timing of the transaction. We have included in the table above, obligations related to a three-year pharmacy benefit services agreement, a five-year agreement for a nurse advice line and other related services, a five-year agreement for a disease and condition management services and a four-year Medicare Part D pharmacy claims processing services agreement, and a three-year agreement for outsourcing services for our Prescription Drug Plan and Private Fee for Service products.
In order to secure judgment pending our appeal in the AmCareco litigation, we obtained surety bonds totaling $114.7 million, which are further secured by letters of credit in the amounts of $90.1 million issued in December 2005. See Notes 6 and 12 to the consolidated financial statements for additional information.
As of December 31, 2006, we had no off-balance sheet arrangements as defined under Regulation S-K 303(a)(4) and the instructions thereto.
Health plan services premiums include HMO, POS and PPO premiums from employer groups and individuals and from Medicare recipients who have purchased supplemental benefit coverage (for which premiums are based on a predetermined prepaid fee), Medicaid revenues based on multi-year contracts to provide care to Medicaid recipients, and revenue under Medicare risk contracts (including Part D) to provide care and services to enrolled Medicare recipients. Revenue is recognized in the month in which the related enrollees are entitled to health care services. Premiums collected in advance of the month in which enrollees are entitled to health care services are recorded as unearned premiums.
Reserves for claims and other settlements include reserves for claims (incurred but not reported claims (IBNR) and received but unprocessed claims), and other liabilities including capitation payable, shared risk settlements, provider disputes, provider incentives and other reserves. As of December 31, 2006, 72% of reserves for claims and other settlements were attributed to claims reserves. See Note 16 to our consolidated financial statements for a reconciliation of changes in the reserve for claims.
HN of California, our California HMO, generally contracts with various medical groups to provide professional care to certain of its members on a capitated, or fixed per member per month fee basis. Capitation contracts generally include a provision for stop-loss and non-capitated services for which we are liable. Professional capitated contracts also generally contain provisions for shared risk. We have risk-sharing arrangements with certain of our providers related to approximately 1,225,000 members, primarily in the California commercial market. Shared-risk arrangements provide for us to share with our providers the variance between actual costs and predetermined goals. Our health plans in Connecticut, New Jersey and New York market to small employer groups through a joint venture agreement with The Guardian. We have approximately 191,000 members under this agreement. In general, we share equally with The Guardian in the profits of the marketing agreement, subject to certain terms of the marketing agreement related to expenses. On February 27, 2007, we announced that we were purchasing the Guardian’s interest in our joint venture. See Item 1. Business-Recent and Other Developments and Other Company Information.
We perform our annual impairment test on our recorded goodwill and intangible assets not subject to amortization as of June 30 or more frequently if events or changes in circumstances indicate that we might not recover the carrying value of these assets for each of our reporting units. As a result of divestitures that occurred prior to and including 2004, Health Plans Services is our only reporting unit with goodwill as of December 31, 2006 and 2005. We test goodwill for impairment annually based on the estimated fair value of our Health Plan Services reporting unit. We test for impairment on a more frequent basis in cases where events and changes in circumstances would indicate that we might not recover the carrying value of goodwill. Our measurement of fair value is based on the income approach to fair value determination. The income approach is based on a discounted cash flow methodology. The discounted cash flow methodology is based upon converting expected cash flows to present value. Annual cash flows are estimated for each year of a defined multi-year period until the growth pattern becomes stable. The interim cash flows expected after the growth pattern becomes stable are calculated using an appropriate capitalization technique and then discounted. There are numerous assumptions and estimates underlying the determination of the estimated fair value of our reporting units, including certain assumptions and estimates related to future earnings and membership levels based on current and future plans and initiatives, long-term strategies and our annual planning and forecasting process as well as the weighted average cost of capital used in the discounting process. If these planned initiatives do not accomplish their targeted objectives, the assumptions and estimates underlying the goodwill impairment tests could be adversely affected and have a material effect upon our financial condition, results of operations or liquidity.
We file tax returns in many tax jurisdictions and, often, application of tax rules within the various jurisdictions is subject to differing interpretation. Despite our belief that our tax return positions are fully supportable, we believe that it is probable certain positions will be challenged by taxing authorities, and we may not prevail on the positions as filed. Accordingly, we maintain a reserve for the estimated amount of contingent tax challenges by taxing authorities upon examination, in accordance with SFAS No. 5, “Accounting for Contingencies.” The reserve is comprised of amounts for specific issues arising in periods subject to examination, and amounts are released from the reserve upon closure of such examinations or upon closure of the statute of limitations for assessment. The estimates of contingent tax costs comprising the reserve balance have been developed after careful analysis of the applicable statutory authority and court case precedent. As such, we believe that the reserve reflects the probable outcome of contingent tax challenges and that the probability of material assessments above the reserve balance is remote. The reserve is included in accounts payable and other liabilities in our consolidated balance sheets.
In 2006, the Financial Accounting Standards Board (FASB) issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes-an interpretation of FASB Statement 109” (FIN 48). This interpretation clarifies the accounting for uncertain taxes recognized in a company’s financial statements in accordance with SFAS No. 109, “Accounting for Income Taxes.” The interpretation requires us to analyze the amount at which each tax position meets a “more likely than not” standard for sustainability upon examination by taxing authorities. Only tax benefit amounts meeting or exceeding this standard will be reflected in tax provision expense and deferred tax asset balances. The interpretation also requires that any differences between the amounts of tax benefits reported on tax returns and tax benefits reported in the financial statements be recorded in a liability for unrecognized tax benefits. The liability for unrecognized tax benefits is reported separately from deferred tax assets and liabilities and classified as current or noncurrent based upon the expected period of payment. Additional disclosure in the footnotes to the audited financial statements will be required concerning the income tax liability for unrecognized tax benefits, any interest and penalties related to taxes that are included in the financial statements, and open statutes of limitations for examination by major tax jurisdictions. FIN 48 is effective for annual periods beginning after December 15, 2006 and any cumulative effect of adopting FIN 48 will be recorded as a change in accounting principle in the financial statements for the three months ended March 31, 2007. We anticipate the impact to be an immaterial reduction to the beginning balance of retained earnings.