We derived the selected consolidated financial data for 2005 and 2004 from our audited restated consolidated financial statements and notes thereto appearing in Item 8 of this Form 10-K. The consolidated statement of operations data for 2003 and 2002 and the consolidated balance sheet data as of the years ended 2004, 2003 and 2002 have been restated to conform to the restated consolidated financial statements included in this Form 10-K and are presented herein on an unaudited basis. We have presented these selected financial data on both a FAS 123R basis, which we adopted on January 1, 2006, and on an APB 25 basis, our historical accounting method for periods prior to January 1, 2006.
(1) UnitedHealth Group adopted FAS 123R on a modified retrospective basis on January 1, 2006. This method of adoption requires all prior periods to be restated by the amounts previously disclosed on a pro-forma basis under FAS 123.
(3) On January 1, 2006, the Company began serving as a plan sponsor offering Medicare Part D drug insurance coverage under a contract with CMS. Total revenues generated under this program were $5.7 billion for the
(4) The unaudited Consolidated Statements of Operations and Cash Flows data for 2003 and 2002, and the unaudited consolidated balance sheet data as of December 31, 2004, 2003 and 2002 have been revised to reflect adjustments related to the restatement described under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Note 3 of the Notes to Consolidated Financial Statements. Pre-tax adjustments related to 2003 and 2002 include non-cash stock-based compensation expense totaling $54 million and $62 million, respectively under FAS 123R, our current accounting method. The cumulative after tax impact of all restatement adjustments related to years prior to 2002 totaled $220 million under FAS 123R, our current accounting method, and has been reflected as an adjustment to retained earnings at December 31, 2001. The tables following the financial highlights presented under APB 25, our historical accounting method, reflect the detailed unaudited 2003 and 2002 Statements of Operations adjustments under APB 25 and FAS 123R.
Financial Highlights and Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read together with the accompanying Consolidated Financial Statements and Notes.
(1) UnitedHealth Group’s historical accounting policy for stock-based compensation followed the recognition and measurement principles of APB 25. Furthermore, UnitedHealth Group complied with the disclosure provisions of FAS 123.
(2) UnitedHealth Group acquired PacifiCare in December 2005 for total consideration of approximately $8.8 billion, Oxford in July 2004 for total consideration of approximately $5.0 billion and MAMSI in February 2004 for total consideration of approximately $2.7 billion. These acquisitions affect the comparability of 2006, 2005 and 2004 financial information to prior fiscal years. The results of operations and financial condition of PacifiCare, Oxford and MAMSI have been included in UnitedHealth Group’s Consolidated Financial Statements since the respective acquisition dates. See Note 5 of the Notes to Consolidated Financial Statements for a detailed discussion of these acquisitions.
(3) The unaudited Consolidated Statements of Operations and Cash Flows data for 2003 and 2002, and the unaudited Consolidated Balance Sheets data as of December 31, 2004, 2003 and 2002 have been revised to reflect adjustments related to the restatement described under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Note 3 of the Notes to Consolidated Financial Statements. Pre-tax adjustments related to 2003 and 2002 include non-cash stock-based compensation expense totaling $172 million and $144 million, respectively under APB 25, our historical accounting method. The cumulative after tax impact of all restatement adjustments related to years prior to 2002 totaled $507 million under APB 25, our historical accounting method, and has been reflected as an adjustment to retained earnings at December 31, 2001. The following tables reflect the detailed unaudited 2003 and 2002 Statement of Operations adjustments under APB 25 and FAS 123R.
(3) Represents adjustments made to restate our Consolidated Statement of Operations subsequent to the adoption of FAS 123R under the modified retrospective method of adoption and includes $54 million of additional stock-based compensation expense and $13 million of related deferred tax benefit.
(2) Reflects $156 million of stock-based compensation and $55 million of deferred tax benefit as recorded under the modified retrospective method of adoption of FAS 123R, net of the restatement adjustments under APB 25.
(3) Represents adjustments made to restate our Consolidated Statement of Operations subsequent to the adoption of FAS 123R under the modified retrospective method of adoption and includes $62 million of additional stock-based compensation expense and $18 million of related deferred tax benefit.
UnitedHealth Group is a diversified health and well-being company, serving approximately 70 million Americans. Our focus is on improving the American health care system by simplifying the administrative components of health care delivery; promoting evidence-based medicine as the standard for care; and providing relevant, actionable data that physicians, health care providers, consumers, employers and other participants in health care can use to make better, more informed decisions.
The following tables illustrate the effect of the restatement adjustments on our pro forma net earnings and pro forma net earnings per share if we had recorded compensation expense based on the estimated grant date fair value accounting method as defined by FAS 123 for all stock-based awards granted from 1995 to 2003. Refer to Note 3 for an illustration of the effect of the FAS 123R restatement adjustments relating to 2004 and 2005.
Diluted net earnings per common share of $2.97, an increase of 29% over 2005.
Earnings from operations of $7.0 billion, up $1.9 billion, or 37%, over 2005.
Operating margin of 9.8%, down from 10.9% in 2005, primarily due to changes in business mix related to the PacifiCare acquisition and the launch of the Medicare Part D program.
Cash flows from operations of $6.5 billion, up from $4.1 billion in 2005.
Consolidated revenues in 2006 of $71.5 billion increased by $25.1 billion, or 54%, over 2005. Excluding the impact of businesses acquired since the beginning of 2005, consolidated revenues increased by approximately 21% in 2006 principally driven by the successful launch of the Medicare Part D program on January 1, 2006, rate increases on premium-based and fee-based services and growth in individuals served across our business segments. Following is a discussion of 2006 consolidated revenue trends for each of our revenue components.
Premium Revenues Consolidated premium revenues totaled $65.7 billion in 2006, an increase of $23.6 billion, or 56%, over 2005. Excluding the impact of acquisitions, consolidated premium revenues increased by $8.8 billion, or 21%, over 2005. This increase was primarily driven by premium rate increases and the successful launch of the Medicare Part D program, partially offset by a slight decrease in the number of individuals served by our commercial risk-based products.
UnitedHealthcare premium revenues in 2006 totaled $33.5 billion, an increase of $7.6 billion, or 29%, over 2005. Excluding premium revenues from businesses acquired since the beginning of 2005, UnitedHealthcare premium revenues were essentially flat compared to 2005. This was primarily due to average net premium rate increases of approximately 8% or above on UnitedHealthcare’s renewing commercial risk-based products, offset by lower premium yields from new business due primarily to a larger portion of new customer sales generated from high-deductible lower-premium products (with correspondingly lower medical costs), and a 5% decrease in the number of individuals served by UnitedHealthcare’s commercial risk-based products due primarily to the Company’s internal pricing decisions in a competitive commercial risk-based pricing environment and the conversion of certain groups to fee-based products. Ovations premium revenues in 2006 totaled $24.4 billion, an increase of $15.2 billion, or 165%, over 2005. Excluding the impact of acquisitions, Ovations premium revenues increased by approximately $8.3 billion, or 92%, over 2005. The increase was driven primarily by the successful launch of the Medicare Part D program, which had premium revenues of $5.7 billion for 2006, and an increase in the number of individuals served by Medicare Advantage and Medicare supplement products, as well as rate increases on these products. Specialized Care Services premium revenues increased by approximately $1.0 billion over 2005. This was primarily due to the PacifiCare acquisition and strong growth in the number of individuals served by several Specialized Care Services businesses under premium-based arrangements. The remaining premium revenue increase resulted primarily from membership growth and premium revenue rate increases in AmeriChoice’s Medicaid programs, which contributed premium revenue increases of approximately $278 million, or 8%, over 2005 excluding the impact of acquisitions.
Service Revenues Service revenues in 2006 totaled $4.3 billion, an increase of $602 million, or 16%, over 2005. Excluding the impact of acquisitions, service revenues increased by approximately 12% over 2005. The increase in service revenues was driven primarily by aggregate growth of 8% in the number of individuals served by Uniprise and UnitedHealthcare under fee-based arrangements during 2006, as well as annual rate increases. In addition, Ingenix service revenues increased by approximately 23% due to new business growth in the health information and contract research businesses and from businesses acquired since the beginning of 2005.
Product Revenues Product revenues in 2006 totaled $737 million, an increase of $579 million over 2005. This was primarily due to pharmacy revenues at our PBM business, which was acquired in December 2005 with the purchase of PacifiCare.
Investment and Other Income Investment and other income during 2006 totaled $871 million, representing an increase of $366 million over 2005. Interest income increased by $372 million in 2006, principally due to the impact of increased levels of cash and fixed-income investments during the year, due in part to the acquisition of PacifiCare, as well as higher yields on fixed-income investments. Net capital gains on sales of investments were $4 million in 2006, compared with net capital gains of $10 million in 2005.
Medical costs for 2006 increased $19.6 billion, or 58%, to $53.3 billion, due to the impact of businesses acquired since the beginning of 2005, medical costs associated with the new Medicare Part D program and a medical cost trend of 7% to 8% on commercial risk-based business. Medical costs associated with the new Medicare Part D program for 2006 were $4.9 billion. Medical trend was due to both medical inflation and increases in health care consumption.
Health Care Services had revenues of $64.2 billion in 2006, representing an increase of $24.2 billion, or 60%, over 2005. Excluding the impact of acquisitions, Health Care Services revenues increased by approximately $8.9 billion, or 23%, over 2005. UnitedHealthcare revenues of $35.2 billion in 2006 increased by $8.0 billion, or 29%, over 2005. Excluding the impact of acquisitions, UnitedHealthcare revenues increased by approximately 1% over 2005 due to an increase in the number of individuals served with commercial fee-based products as well as average premium rate increases of approximately 8% or above on UnitedHealthcare’s renewing commercial risk-based products, offset by lower premium yields from a larger portion of new customer sales generated from high-deductible lower-premium products (with correspondingly lower medical costs) and a 5% decrease in the number of individuals served by UnitedHealthcare’s commercial risk-based products due primarily to the Company’s internal pricing decisions in a competitive commercial risk-based pricing environment and the conversion of certain groups to fee-based products. Ovations revenues of $25.3 billion in 2006 increased by approximately $15.9 billion, or 168% over 2005. Excluding the impact of acquisitions, Ovations revenues increased by $8.4 billion, or 91%, over 2005. The increase was driven primarily by the successful launch of the Medicare Part D program, which had premium revenues of $5.7 billion for 2006, and an increase in the number of individuals served by Medicare Advantage and Medicare supplement products, as well as rate increases on these products. The remaining increase in Health Care Services revenues is attributable to an 8% increase in AmeriChoice revenues, excluding the impact of acquisitions, driven primarily by membership growth and premium revenue rate increases on Medicaid products.
Health Care Services earnings from operations in 2006 were $5.1 billion, representing an increase of $1.5 billion, or 40%, over 2005. This increase was principally driven by acquisitions and increases in the number of individuals served by Ovations’ Medicare and Part D products and UnitedHealthcare’s fee-based products. The segment also benefited by productivity gains from technology deployment and other cost management initiatives, including cost savings associated with the PacifiCare acquisition integration. UnitedHealthcare’s commercial medical care ratio increased to 79.8% in 2006 from 78.6% in 2005, mainly due to the impact of the PacifiCare acquisition and changes in product, business and customer mix. Health Care Services’ operating margin for 2006 was 8.0%, a decrease from 9.2% in 2005. This decrease was driven mainly by the acquisition of PacifiCare and the new Medicare Part D program, which have lower operating margins than historic UnitedHealth Group businesses.
The number of individuals served by UnitedHealthcare’s commercial business as of December 31, 2006 increased by approximately 680,000, or 5%, over the prior year. Excluding the impact of acquisitions, commercial business individuals served increased by 185,000, or 1%, over the prior year. This included an increase of approximately 660,000 in the number of individuals served with commercial fee-based products, driven by new customer relationships and customers converting from risk-based products to fee-based products, offset by a decrease of approximately 475,000 in the number of individuals served with commercial risk-based products due primarily to the Company’s internal pricing decisions in a competitive commercial risk-based pricing environment and the conversion of certain groups to fee-based products.
Excluding acquisitions, the number of individuals served by Ovations’ Medicare Advantage products increased by 230,000, or 20%, from 2005 due primarily to new customer relationships. Excluding the impact of acquisitions, AmeriChoice’s Medicaid enrollment increased 65,000, or 5%, primarily due to new customer gains.
$4.0 billion increased by $1.2 billion, or 42%, over 2005. Excluding the impact of acquisitions, revenues increased by 22% over the prior periods. This increase was principally driven by an increase in the number of individuals served by several of its specialty benefit businesses and rate increases related to these businesses.
Ingenix offers database and data management services, software products, publications, consulting services, outsourced services and pharmaceutical development and consulting services on a national and international basis. Ingenix revenues for 2006 of $976 million increased by $169 million, or 21%, over 2005. This was driven primarily by new business growth in the health information and contract research businesses, as well as businesses acquired since the beginning of 2005.
Premium Revenues Consolidated premium revenues totaled $42.1 billion in 2005, an increase of $7.7 billion, or 22%, over 2004. Excluding the impact of acquisitions, consolidated premium revenues increased by approximately 11% over 2004. This increase was primarily driven by premium rate increases and a modest increase in the number of individuals served by our risk-based products.
served by Uniprise and UnitedHealthcare under fee-based arrangements during 2005, excluding the impact of acquisitions, as well as annual rate increases. In addition, Ingenix service revenues increased by 16% due to growth in the health information and contract research businesses as well as businesses acquired since the beginning of 2004.
Product Revenues Product revenues in 2005 totaled $158 million, an increase of $36 million over 2004. This was primarily due to pharmacy revenues at our PBM business, which was acquired in December 2005 with the purchase of PacifiCare, and increased revenues associated with the interim government-sponsored drug card program.
Investment and Other Income Investment and other income totaled $505 million, representing an increase of $92 million over 2004. Interest income increased by $126 million in 2005, principally due to the impact of increased levels of cash and fixed-income investments during the year due to the acquisitions of Oxford and MAMSI as well as higher yields on fixed-income investments. Net capital gains on sales of investments were $10 million in 2005, a decrease of $34 million from 2004.
The combination of pricing, benefit designs, consumer health care utilization and comprehensive care facilitation efforts is reflected in the medical care ratio. The consolidated medical care ratio decreased from 80.9% in 2004 to 80.0% in 2005. This medical care ratio decrease resulted primarily from changes in product, business and customer mix and an increase in favorable medical cost development related to prior periods.
For each period, our operating results include the effects of revisions in medical cost estimates related to all prior periods. Changes in medical cost estimates related to prior fiscal years, resulting from more complete claim information, that are identified in the current year are included in total medical costs reported for the current fiscal year. Medical costs for 2005 include approximately $400 million of favorable medical cost development related to prior fiscal years. Medical costs for 2004 include approximately $210 million of favorable medical cost development related to prior fiscal years. The increase in favorable medical cost development in 2005 was driven primarily by growth in the size of the medical cost base and related medical payables due to organic growth and businesses acquired since the beginning of 2004.
On an absolute dollar basis, 2005 medical costs totaled $33.7 billion, an increase of $5.8 billion, or 21%, over 2004. Excluding the impact of acquisitions, medical costs increased by approximately 9% driven primarily by a medical cost trend of 7% to 8% due to both inflation and an increase in health care consumption as well as organic growth.
On an absolute dollar basis, operating costs for 2005 totaled $7.1 billion, an increase of $1.1 billion, or 17%, over 2004. Excluding the impact of acquisitions, operating costs increased by approximately 11%. This increase was driven by an 8% increase in total individuals served by Health Care Services and Uniprise during 2005 (excluding the impact of acquisitions), growth in Specialized Care Services and Ingenix and general operating cost inflation, partially offset by productivity gains from technology deployment and other cost management initiatives.
Health Care Services earnings from operations in 2005 were $3.7 billion, representing an increase of $976 million, or 36%, over 2004. This increase primarily resulted from revenue growth and improved gross margins on UnitedHealthcare’s risk-based products, increases in the number of individuals served by UnitedHealthcare’s commercial fee-based products, and the acquisitions of Oxford and MAMSI during 2004. UnitedHealthcare’s commercial medical care ratio decreased to 78.6% in 2005 from 79.3% in 2004 mainly due to changes in product, business and customer mix. Health Care Services’ 2005 operating margin was 9.2%, an increase from 8.2% in 2004. This increase was driven mainly by the lower commercial medical care ratio as well as changes in business and customer mix.
(1) Excludes individuals served by Ovations’ Medicare supplement products provided to AARP members as well as Medicare institutional and Medicaid long-term care members.
Excluding the PacifiCare acquisition, the number of individuals served by Ovations’ Medicare Advantage products increased by 65,000, or 20%, over 2004 due primarily to new customer relationships. AmeriChoice’s Medicaid enrollment decreased by 10,000 from 2004 due primarily to the withdrawal of participation in one market during the third quarter of 2005 partially offset by new customer relationships since 2004.
Uniprise earnings from operations in 2005 were $740 million, representing an increase of $116 million, or 19%, over 2004. Operating margin for 2005 improved to 15.1% from 14.5% in 2004. Uniprise has expanded its
operating margin through operating cost efficiencies derived from process improvements, technology deployment and cost management initiatives that have reduced labor and occupancy costs in its transaction processing and customer service, billing and enrollment functions. Additionally, Uniprise’s infrastructure can be scaled efficiently, allowing its business to grow revenues at a proportionately higher rate than the associated growth in operating expenses.
Specialized Care Services revenues of $2.8 billion increased by $510 million, or 22%, over 2004. This increase was principally driven by an 11% increase in the number of individuals served by its specialty benefit businesses, excluding the impact of acquisitions, and rate increases related to these businesses as well as businesses acquired since the beginning of 2004.
Ingenix 2005 revenues of $807 million increased by $100 million, or 14%, over 2004. This was driven primarily by growth in the health information and contract research businesses as well as businesses acquired since the beginning of 2004.
Earnings from operations in 2005 were $135 million, up $34 million, or 34%, from 2004. Ingenix’s operating margin was 16.7% in 2005, up from 14.3% in 2004. The increase in earnings from operations and operating margin was primarily due to growth in the health information and contract research businesses, improving gross margins due to effective cost management and businesses acquired since the beginning of 2004.
Our non-regulated businesses also generate significant cash from operations for general corporate use. Cash flows generated by these entities, combined with the issuance of commercial paper, long-term debt and the availability of committed credit facilities, further strengthen our operating and financial flexibility. We generally use these cash flows to reinvest in our businesses in the form of capital expenditures, to expand the depth and breadth of our services through business acquisitions, and to repurchase shares of our common stock, depending
on market conditions. In August 2006, we announced that we would not purchase shares under our stock repurchase program until we had completed our restatement (which is reflected in this Form 10-K) and become current in our periodic SEC filings. As a result, we did not repurchase any shares through this publicly announced program for the quarter ended December 31, 2006.
Cash flows generated from operating activities, our primary source of liquidity, are principally from net earnings, prior to depreciation and amortization and other non-cash expenses. As a result, any future decline in our profitability may have a negative impact on our liquidity. The level of profitability of our risk-based insured business depends in large part on our ability to accurately predict and price for health care and operating cost increases. This risk is partially mitigated by the diversity of our other businesses, the geographic diversity of our risk-based business and our disciplined underwriting and pricing processes, which seek to match premium rate increases with estimated future health care costs. In 2006, a hypothetical unexpected 1% increase in commercial insured medical costs would have reduced net earnings by approximately $170 million.
Cash flows from operating activities were $6.5 billion in 2006, an increase over $4.1 billion in 2005. The increase in operating cash flows resulted primarily from an increase of $1.3 billion in net income prior to
depreciation, amortization and other noncash items as well as an increase of approximately $1.1 billion in cash flows generated from working capital changes. We generated operating cash flows from working capital changes of $1.6 billion in 2006 and $412 million in 2005. The year-over-year increase primarily resulted from the Company receiving twelve monthly Medicare premium payments during 2006 from CMS rather than the eleven monthly payments received in 2005, positively impacting the change in reported operating cash flows by $275 million, along with growth in medical payables during 2006 compared to 2005 primarily driven by overall growth of the insured business. Additionally, there was an increase in accrued taxes payable due largely to an increase in pre-tax earnings.
respectively. We believe the prudent use of debt optimizes our cost of capital and return on shareholders’ equity, while maintaining appropriate liquidity.
On December 20, 2005, the Company acquired PacifiCare. Under the terms of the agreement, PacifiCare shareholders received 1.1 shares of UnitedHealth Group common stock and $21.50 in cash for each share of PacifiCare common stock they owned. Total consideration issued for the transaction was approximately $8.8 billion, composed of approximately 99.2 million shares of UnitedHealth Group common stock (valued at approximately $5.3 billion based upon the average of UnitedHealth Group’s share closing price for two days before, the day of and two days after the acquisition announcement date of July 6, 2005), approximately $2.1 billion in cash, $960 million in cash paid to retire PacifiCare’s existing debt and UnitedHealth Group vested common stock options with an estimated fair value of approximately $420 million issued in exchange for PacifiCare’s outstanding vested common stock options.
On October 16, 2006, we executed a $7.5 billion 364-day revolving credit facility in order to ensure the Company’s immediate and continued access to additional liquidity, if necessary. The credit facility is available for working capital purposes as well as to pay or repay any outstanding borrowings of the Company. We have entered into amendments to this credit facility to provide us with additional time to deliver to the lenders this 10-K and our quarterly reports on Form 10-Q for the quarters ended June 30, 2006 and September 30, 2006 and our annual report on Form 10-K for the year ended December 31, 2006. As of December 31, 2006, we had no amounts outstanding under our $7.5 billion credit facility.
Our debt arrangements and credit facilities contain various covenants, the most restrictive of which require us to maintain a debt-to-total-capital ratio (calculated as the sum of commercial paper and long-term debt divided by the sum of commercial paper, long-term debt and shareholders’ equity) below 50%. After giving effect to the credit agreement amendments and waivers that we obtained from our lenders, we believe we are in compliance with the requirements of our debt covenants. On August 28, 2006 we received a purported notice of default from persons claiming to hold certain of our debt securities alleging a violation of our indenture governing our debt securities. This followed our announcement that we would delay filing our quarterly report on Form 10-Q for the quarter ended June 30, 2006. On or about November 2, 2006, we received a purported notice of acceleration from the holders who previously sent the notice of default that purports to declare an acceleration of our 5.8% Senior Unsecured Notes due March 15, 2036 as a result of our not filing our quarterly report on Form 10-Q for the quarter ended June 30, 2006. Our indenture requires us to provide to the trustee copies of the reports we are required to file with the SEC, such as our quarterly reports, within 15 days of filing such reports with the SEC. On October 25, 2006, we filed an action in the United States District Federal Court for the District of Minnesota seeking a declaratory judgment that we are not in default under the terms of the indenture. Immediately prior to the filing of this Form 10-K, we filed our quarterly reports on Form 10-Q for the quarters ended June 30, 2006 and September 30, 2006, as well as an amendment to our quarterly report on Form 10-Q for the quarter ended March 31, 2006. Should the Company ultimately be unsuccessful in this matter, the Company may be required to retire all or a portion of the $850 million of Senior Unsecured Notes due March 2036. We intend to prosecute the declaratory judgment action vigorously.
Our senior debt is rated “A” with a negative outlook by Standard & Poor’s (S&P), “A” with a negative watch by Fitch, and “A3” with a negative outlook by Moody’s. Our commercial paper is rated “A-1” with a negative outlook by S&P, “F-1” with a negative watch by Fitch, and “P-2” with a negative outlook by Moody’s. Moody’s downgraded our rating in October 2006 citing concerns about corporate governance following the release of the WilmerHale Report (See Note 3 of the Notes to Consolidated Financial Statements). We do not expect this Moody’s downgrade to significantly affect our borrowing capacity or costs. A significant downgrade in our debt or commercial paper ratings could adversely affect our borrowing capacity and costs. See “ - Cautionary Statements Relating to Our Historic Stock Option Practices - Credit Ratings” for additional information.
Under our Board of Directors’ authorization, we maintain a common stock repurchase program. Repurchases may be made from time to time at prevailing prices, subject to certain restrictions on volume, pricing and timing. There is no established expiration date for the program. During the year ended December 31, 2006, we repurchased 40.2 million shares at an average price of approximately $56 per share and an aggregate cost of approximately $2.2 billion. As of December 31, 2006, we had Board of Directors’ authorization to purchase up to an additional 136.7 million shares of our common stock. Our common stock repurchase program is discretionary as we are under no obligation to repurchase shares. We repurchase shares because we believe it is a prudent use of capital. The Company suspended purchases under its stock repurchase program in the third quarter of 2006 pending completion of our restatement (which is reflected in this Form 10-K) and becoming current in our periodic SEC filings. The Company intends to resume its stock repurchase program in 2007.
(1) Debt payments could be accelerated upon violation of debt covenants. We believe the likelihood of acceleration is remote.
(2) Calculated using stated rates from the debt agreements and related interest rate swap agreements and assuming amounts are outstanding through their contractual term. For variable-rate obligations, we used the rates in place as of December 31, 2006 to estimate all remaining contractual payments.
Due to the financial restatements previously discussed, the Company has determined that certain options exercised by nonexecutive officer employees in 2006 were discount options subject to Section 409A of the Internal Revenue Code. The Company notified the Internal Revenue Service (IRS) on February 28, 2007 that it would participate in the IRS’s resolution program which allows the Company to pay its employees’ additional tax costs under Section 409A. As such, the Company will take a charge, net of tax benefit, of approximately $55 million in the first quarter of 2007.
The underwriting gains or losses related to the AARP Medicare Supplement Insurance business are directly recorded as an increase or decrease to a rate stabilization fund (RSF). The primary components of the underwriting results are premium revenue, medical costs, investment income, administrative expenses, member services expenses, marketing expenses and premium taxes. Underwriting gains and losses are recorded as an increase or decrease to the RSF and accrue to the overall benefit of the AARP policyholders, unless cumulative net losses were to exceed the balance in the RSF. To the extent underwriting losses exceed the balance in the RSF, we would have to fund the deficit. Any deficit we fund could be recovered by underwriting gains in future periods of the contract. To date, we have not been required to fund any underwriting deficits. As further described in Note 13 to the Consolidated Financial Statements, the RSF balance is reported in Other Policy Liabilities in the accompanying Consolidated Balance Sheets. We believe the RSF balance at December 31, 2006 is currently sufficient to cover potential future underwriting and other risks associated with the contract.
Critical accounting policies are those policies that require management to make challenging, subjective or complex judgments, often because they must estimate the effects of matters that are inherently uncertain and may change in subsequent periods. Critical accounting policies involve judgments and uncertainties that are sufficiently sensitive to result in materially different results under different assumptions and conditions. We believe our critical accounting policies are those described below. For a detailed discussion of these and other accounting policies, see Note 2 of the Notes to Consolidated Financial Statements.
Each reporting period, we estimate our obligations for medical care services that have been rendered on behalf of insured consumers for which we have either not yet received or processed claims, and for liabilities for physician, hospital and other medical cost disputes. We develop estimates for medical costs incurred but not reported using an actuarial process that is consistently applied, centrally controlled and automated. The actuarial models consider factors such as time from date of service to claim receipt, claim backlogs, care provider contract rate changes, medical care consumption and other medical cost trends. Depending on the health care provider and type of service, the typical billing lag for services can range from two to 90 days from the date of service. Substantially all claims related to medical care services are known and settled within nine to twelve months from the date of service. We estimate liabilities for physician, hospital and other medical cost disputes based upon an analysis of potential outcomes, assuming a combination of litigation and settlement strategies.
(2) Reflects estimated potential changes in medical costs and medical costs payable caused by changes in medical costs PMPM trend data used in developing medical cost payable estimates for the most recent three months.
The analyses above include those outcomes that are considered reasonably likely based on the Company’s historical experience in estimating its liabilities for incurred but not reported benefit claims.
(b) Restated to include the impact of FAS 123R, which we adopted effective January 1, 2006, as well as impacts associated with the restatement described in Note 3 “Restatement of Consolidated Financial Statements.”
Communication Date. This methodology would select as the measurement date the date on which stock option grants were communicated to employees, assuming that the communication date is readily
Legal Execution Date. This methodology would select as the measurement date the date on which the Company has determined that the legal documentation approving a grant was likely executed, based on evaluation of all available information. For Section 16 Officers, this date is typically the date on which the Company has determined that the Written Action of the Compensation Committee was likely executed by a majority of the members of the Compensation Committee and, for all other employees, this date is typically the date on which the Company has determined that the CEO Certificate was likely executed by the former CEO of the Company.
Revenues are principally derived from health care insurance premiums. We recognize premium revenues in the period eligible individuals are entitled to receive health care services. Customers are typically billed monthly at a contracted rate per eligible person multiplied by the total number of people eligible to receive services, as recorded in our records. Employer groups generally provide us with changes to their eligible population one month in arrears. Each billing includes an adjustment for prior month changes in eligibility status that were not reflected in our previous billing. We estimate and adjust the current period’s revenues and accounts receivable accordingly. Our estimates are based on historical trends, premiums billed, the level of contract renewal activity and other relevant information. We revise estimates of revenue adjustments each period and record changes in the period they become known.
As of December 31, 2006, we had long-lived assets, including goodwill, other intangible assets, property, equipment and capitalized software, of $20.6 billion. We review our goodwill for impairment annually at the reporting unit level, and we review our remaining long-lived assets for impairment when events and changes in
circumstances indicate we might not recover their carrying value. To determine the fair value of our long-lived assets and assess their recoverability, we must make assumptions about a wide variety of internal and external factors including estimated future utility and estimated future cash flows, which in turn are based on estimates of future revenues, expenses and operating margins. If these estimates or their related assumptions change in the future, we may be required to record impairment charges for these assets that could materially affect our results of operations and shareholders’ equity in the period in which the impairment occurs.
On May 17, 2006, we received a subpoena from the U.S. Attorney for the Southern District of New York requesting documents from 1999 to the present relating to our stock option practices.
On June 6, 2006, we received a Civil Investigative Demand from the Minnesota Attorney General requesting documents from January 1, 1997 to the present concerning our executive compensation and stock option practices. After filing an action in Ramsey County Court, State of Minnesota, captioned UnitedHealth Group Incorporated vs. State of Minnesota, by Lori Swanson, Attorney General, we filed a Motion for Protective Order which was denied by the trial court. We are pursuing an appeal of the Order denying the Protective Order.
On June 6, 2006, a purported class action captioned Zilhaver v. UnitedHealth Group Incorporated, was filed against the Company and certain of our current and former officers and directors in the United State District Court for the District of Minnesota. This action alleges that the fiduciaries to the Company-sponsored 401(k) plan violated ERISA by allowing the plan to continue to hold Company stock. Defendants filed a motion to dismiss on February 6, 2007. We intend to vigorously defend against the action.
On August 28, 2006, we received a purported notice of default from persons claiming to hold certain of our debt securities alleging a violation of our indenture governing our debt securities. This follows our announcement that we would delay filing our quarterly report on Form 10-Q for the quarter ended June 30, 2006. On October 25, 2006, we filed an action in the United States District Court for the District of Minnesota, captioned UnitedHealth Group Incorporated v. Cede & Co. and the Bank of New York, seeking a declaratory judgment that we are not in default under the terms of the indenture. On or about November 2, 2006, we received a purported notice of acceleration from the holders who previously sent the notice of default that purports to declare an acceleration of our 5.80% Senior Unsecured Notes due March 15, 2036 as a result of our announcement that we would delay filing our quarterly report on Form 10-Q for the quarter ended June 30, 2006. Immediately prior to the filing of this Form 10-K, we filed our quarterly reports on Form 10-Q for the quarters ended June 30, 2006 and September 30, 2006, as well as an amendment to our quarterly report on Form 10-Q for the quarter ended March 31, 2006. Should the Company ultimately be unsuccessful in this matter, we may be required to retire all or a portion of the $850 million of Senior Unsecured Notes due March 2036. We intend to vigorously prosecute the declaratory judgment action.
breach of contract, unjust enrichment and prompt payment claims. During the course of the litigation, there have been co-defendant settlements. On January 31, 2006, the trial court dismissed all remaining claims against PacifiCare, and on June 19, 2006, the trial court dismissed all remaining claims against UnitedHealthcare brought by the lead plaintiff. The tag-along lawsuits remain outstanding. On July 27, 2006, the plaintiffs filed a notice of appeal to the Eleventh Circuit Court of Appeals challenging the dismissal of the claims against UnitedHealthcare. We intend to vigorously defend against the action.
Approximately $20.3 billion of our cash equivalents and investments at December 31, 2006 were debt securities. Assuming a hypothetical and immediate 1% increase or decrease in interest rates applicable to our fixed-income investment portfolio at December 31, 2006, the fair value of our fixed-income investments would decrease or increase by approximately $337 million. We manage our investment portfolio to limit our exposure to any one issuer or industry and largely limit our investments to U.S. Government and Agency securities, state and municipal securities, and corporate debt obligations that are investment grade.
an investment policy authorized by our Board of Directors. This policy limits the amounts that may be invested in any one issuer and generally limits our investments to U.S. Government and Agency securities, state and municipal securities and corporate debt obligations that are investment grade. Concentrations of credit risk with respect to accounts receivable are limited due to the large number of employer groups that constitute our customer base. As discussed more fully in Note 5 of the Notes to our Consolidated Financial Statements, we have an aggregate $2.0 billion reinsurance receivable resulting from the sale of our life and annuity business. We regularly evaluate the financial condition of the reinsurer and only record the reinsurance receivable to the extent that the amounts are deemed probable of recovery. As of December 31, 2006, there were no other significant concentrations of credit risk.
Matters relating to or arising out of our historic stock option practices, including regulatory inquiries, litigation matters, downgrades in our credit ratings, and potential additional cash and noncash charges could have a material adverse effect on the Company.
We and certain of our current and former directors and officers are defendants in a consolidated federal securities class action, an ERISA class action, and state and federal shareholder derivative actions relating to our historic stock option practices. We also have received several shareholder demands relating to our historic stock option practices. Our Board of Directors has designated an unaffiliated Special Litigation Committee, consisting of two former Minnesota Supreme Court Justices, to investigate the claims raised in the derivative actions and shareholder demands, and determine whether the claims should be pursued.
In addition, following our announcement that we would delay filing our Quarterly Report on Form 10-Q for the quarter ended June 30, 2006, we received a purported notice of default from persons claiming to hold certain of our debt securities alleging a violation of the indenture governing our debt securities. Subsequently, we filed an action in the U.S. District Court for the District of Minnesota, seeking a declaratory judgment that the Company is not in default under the terms of the indenture. The Company subsequently received a purported notice of acceleration from these holders who previously sent the notice of default that purports to declare an acceleration of the Company’s 5.80% Senior Unsecured Notes due March 15, 2036, of which an aggregate of $850 million principal amount is outstanding.
In connection with the departure of William W. McGuire, M.D., our former Chairman and Chief Executive Officer, we received an order from the U.S. District Court for the District of Minnesota in November 2006 granting a joint motion for temporary injunctive relief made by plaintiffs and Dr. McGuire. According to the order, Dr. McGuire is preliminarily enjoined from exercising any Company stock options without Court approval, and the Company and Dr. McGuire are preliminarily enjoined from taking any further action pursuant to or having any effect on Dr. McGuire’s employment agreement, as amended, and other related agreements, and while the preliminary injunction is in effect, no payments will be made to Dr. McGuire under these agreements, including any payments under Dr. McGuire’s Supplemental Employee Retirement Plan.
As a result of their concerns related to our historic stock option practices, Moody’s downgraded our A2 senior debt rating to A3 with a negative outlook in October 2006 and AM Best downgraded our financial strength ratings from A+ to A with a negative outlook in November 2006. Standard & Poor’s and FitchRatings confirmed their existing ratings and their negative outlook (Standard & Poor’s) and negative watch (FitchRatings) on the Company’s ratings. If our business results deteriorate significantly, or if there is an event, outcome or action as a result of the regulatory inquiries and document requests or the pending civil litigation, which is materially adverse to the Company, our credit ratings may be further downgraded. A significant downgrade in ratings may increase the cost of borrowing for the Company or limit the Company’s access to capital.
As described in the Explanatory Note immediately preceding Part I, Item 1, and in Note 3 “Restatement of Consolidated Financial Statements” of the Notes to Consolidated Financial Statements in this Form 10-K, the Company, after completing its internal review of the accounting treatment of all stock option grants and after consultation with the SEC’s Office of the Chief Accountant on certain interpretive accounting issues, recorded additional cash and noncash stock-based compensation expenses, and related tax effects, with regard to certain past stock option grants, and restated previously filed financial statements included in this Form 10-K. While we believe we have made appropriate judgments in determining the financial and tax impacts of our historic stock option practices, we cannot provide assurance that the SEC or the IRS will agree with the manner in which we have accounted for and reported, or not reported, the financial and tax impacts. If the SEC or the IRS disagrees with our financial or tax adjustments and such disagreement results in material changes to our historical financial statements, we may have to further restate our prior financial statements, amend prior filings with the SEC, or take other actions not currently contemplated.
Under our risk-based product arrangements, we assume the risk of both medical and administrative costs for our customers in return for monthly premiums. Premium revenues from risk-based products comprise approximately 90% of our total consolidated revenues. We generally use approximately 80% to 85% of our premium revenues to pay the costs of health care services delivered to these customers. The profitability of our risk-based products depends in large part on our ability to predict, price for, and effectively manage health care costs. Total health care costs are affected by the number of individual services rendered and the cost of each service. Our premium revenue is typically fixed in price for a 12-month period and is generally priced one to four months before the contract commences. We base the premiums we charge on our estimate of future health care costs over the fixed premium period; however, medical cost inflation, regulations and other factors may cause actual costs to exceed what was estimated and reflected in premiums. These factors may include increased use of services, increased cost of individual services, catastrophes, epidemics, the introduction of new or costly treatments and technology, new mandated benefits or other regulatory changes, insured population characteristics and seasonal changes in the level of health care use. As a measure of the impact of medical cost on our financial results, relatively small differences between predicted and actual medical costs as a percentage of premium revenues can result in significant changes in our financial results. For example, if medical costs increased by 1% without a proportional change in related revenues for UnitedHealthcare’s commercial insured products, our annual net earnings for 2006 would have been reduced by approximately $170 million. In addition, the financial results we report for any particular period include estimates of costs that have been incurred for which claims are still outstanding. If these
estimates prove too high or too low, the effect of the change in estimate will be included in future results. That change can be either positive or negative to our results.
Our businesses compete throughout the United States and face competition in all of the geographic markets in which they operate. For our Uniprise and Health Care Services segments, competitors include Aetna Inc., Cigna Corporation, Coventry Health Care, Inc., Humana Inc., Kaiser Permanente and WellPoint, Inc., numerous for-profit organizations and not-for-profit organizations operating under licenses from the Blue Cross and Blue Shield Association and enterprises that serve more limited geographic areas. Our Specialized Care Services and Ingenix segments also compete with a number of businesses. The addition of new competitors can occur relatively easily, and customers enjoy significant flexibility in moving between competitors. In particular markets, competitors may have capabilities or resources that give them a competitive advantage. Greater market share, established reputation, superior supplier or provider arrangements, existing business relationships, and other factors all can provide a competitive advantage to our businesses or to their competitors. In addition, significant merger and acquisition activity has occurred in the industries in which we operate, both as to our competitors and suppliers in these industries. Consolidation may make it more difficult for us to retain or increase customers, to improve the terms on which we do business with our suppliers, or to maintain or advance profitability.
The changes in Medicare as a result of the Medicare Modernization Act of 2003 (MMA) and the rules and regulations promulgated thereunder are complex and wide-ranging and continue to affect our businesses. We have taken advantage of new opportunities created by the MMA to partner with the federal government, including Medicare Part D prescription drug coverage, Medicare Advantage Regional PPOs, Private Fee for Service Plans and Special Needs Plans for chronically ill Medicare beneficiaries. We have invested considerable resources in creating new Medicare product offerings for these initiatives and in analyzing how to best address uncertainties and risks associated with these new programs and other changes arising from the MMA. Legislative or regulatory changes to these programs could have a significant impact on us. Additionally, our ability to successfully participate in the Medicare Part D program depends in part on coordination of information and information systems between us, CMS and state governments. The inability to receive correct information due to systems issues by the federal government, the applicable state government or us could adversely affect our business. Additionally, our participation in the Medicare Part D program is based upon certain assumptions regarding enrollment, utilization, pharmaceutical costs and other factors. In the event any of these assumptions are materially incorrect, either as a result of unforeseen changes to the Medicare Part D program or otherwise, our results could be materially affected. Any positive or negative developments for the Medicare Part D program as a whole are likely to have a significant impact on us as a result of the size of our enrollment in our Medicare Part D program.
Our business is regulated at the federal, state, local and international levels. The laws and rules governing our business and interpretations of those laws and rules are subject to frequent change. Broad latitude is given to the agencies administering those regulations. Existing or future laws and rules could force us to change how we do business, restrict revenue and enrollment growth, increase our health care and administrative costs and capital requirements, and increase our liability in federal and state courts for coverage determinations, contract interpretation and other actions. We must obtain and maintain regulatory approvals to market many of our products, to increase prices for certain regulated products and to complete certain acquisitions and dispositions, including integration of acquisitions. Delays in obtaining approvals or our failure to obtain or maintain these approvals could reduce our revenue or increase our costs.
State legislatures and Congress continue to focus on health care issues. Legislative and regulatory proposals at state and federal levels may affect certain aspects of our business, including contracting with physicians, hospitals and other health care professionals; physician reimbursement methods and payment rates; coverage determinations; mandated benefits and minimum medical expenditures; claim payments and processing; drug utilization and patient safety efforts; use and maintenance of individually identifiable health information; medical malpractice litigation; and government-sponsored programs. We cannot predict if any of these initiatives will ultimately become law, or, if enacted, what their terms or the regulations promulgated pursuant to such laws will be, but their enactment could increase our costs, expose us to expanded liability, require us to revise the ways in which we conduct business or put us at risk for loss of business.
Relationships with physicians, hospitals and other health care providers are important to our business.
Periodically, we become a party to the types of legal actions that can affect any business, such as employment and employment discrimination-related suits, employee benefit claims, breach of contract actions, tort claims, shareholder suits, and intellectual property-related litigation. In addition, because of the nature of our business, we are routinely made party to a variety of legal actions related to the design and management of our service offerings. These matters include, among others, claims related to health care benefits coverage, medical malpractice actions, contract disputes and claims related to disclosure of certain business practices. We are also party to certain class action lawsuits brought by provider groups. See “- Legal Matters” for a more detailed description of our pending litigation matters.
Our businesses providing PBM services face regulatory and other risks associated with the pharmacy benefits management industry that may differ from the risks of providing managed care and health insurance products.
Our ability to adequately price our products and services, to provide effective and efficient service to our customers, and to accurately report our financial results depends on the integrity of the data in our information systems. As a result of technology initiatives, changes in our system platforms and integration of new business acquisitions, we have been taking steps to consolidate the number of systems we operate and have upgraded and expanded our information systems capabilities. If the information we rely upon to run our businesses were found to be inaccurate or unreliable or if we fail to maintain our information systems and data integrity effectively, we could lose existing customers, have difficulty attracting new customers, have problems in determining medical cost estimates and establishing appropriate pricing, have disputes with customers, physicians and other health care providers, have regulatory problems, have increases in operating expenses or suffer other adverse consequences. In addition, failure to consolidate our systems successfully could result in higher than expected costs and diversion of management’s time and energy, which could materially impact our business, financial condition and operating results.
The use of individually identifiable data by our businesses is regulated at the international, federal and state levels. These laws and rules are changed frequently by legislation or administrative interpretation. Various state laws address the use and disclosure of individually identifiable health data. Most are derived from the privacy and security provisions in the federal Gramm-Leach-Bliley Act and the Health Insurance Portability and Accountability Act of 1996 (HIPAA). HIPAA also requires that we impose privacy and security requirements on our business associates (as this term is defined in the HIPAA regulations). Even though we provide for appropriate protections through our contracts with our business associates, we still have limited control over their actions and practices. Compliance with these proposals, requirements, and new regulations may result in cost increases due to necessary systems changes, the development of new administrative processes, and the effects of potential noncompliance by our business associates. They also may impose further restrictions on our use of patient identifiable data that is housed in one or more of our administrative databases.
These consolidated financial statements include certain amounts that are based on our best estimates and judgments. These estimates require us to apply complex assumptions and judgments, often because we must make estimates about the effects of matters that are inherently uncertain and will likely change in subsequent periods. The most significant estimates relate to medical costs, medical costs payable, historic stock option measurement dates, revenues, intangible asset valuations, asset impairments and contingent liabilities. We adjust these estimates each period, as more current information becomes available. The impact of any changes in estimates is included in the determination of earnings in the period in which the estimate is adjusted.
Service revenues consist primarily of fees derived from services performed for customers that self-insure the medical costs of their employees and their dependents. Under service fee contracts, we recognize revenue in the period the related services are performed based upon the fee charged to the customer. The customers retain the risk of financing medical benefits for their employees and their employees’ dependents, and we administer the payment of customer funds to physicians and other health care providers from customer-funded bank accounts. Because we neither have the obligation for funding the medical expenses, nor do we have responsibility for delivering the medical care, we do not recognize premium revenue and medical costs for these contracts in our consolidated financial statements.
pharmacy. In all retail pharmacy transactions, revenues recognized always exclude the member’s applicable co-payment. Product revenues are recognized upon sale or shipment. Service revenues are recognized when the prescription claim is adjudicated. The Company has entered into retail service contracts that separately obligate us to pay our network pharmacy providers for benefits provided to its customers, whether or not we are paid. We are also involved in establishing the prices charged by retail pharmacies, determining which drugs will be included in formulary listings and selecting which retail pharmacies will be included in the network offered to plan sponsors’ members. As a result, revenues are reported on a gross basis in accordance with Emerging Issues Task Force (EITF) Issue No. 99-19, “Reporting Gross Revenue as a Principal versus Net as an Agent.” Product revenues also include sales of Ingenix syndicated content products which are recognized as revenue upon shipment.
We administer certain aspects of AARP’s insurance program (See Note 13). Pursuant to our agreement, AARP assets are managed separately from our general investment portfolio and are used to pay costs associated with the AARP program. These assets are invested at our discretion, within investment guidelines approved by AARP. We do not guarantee any rates of return on these investments and, upon transfer of the AARP contract to another entity, we would transfer cash equal in amount to the fair value of these investments at the date of transfer to that entity. Because the purpose of these assets is to fund the medical costs payable, the rate stabilization fund (RSF) liabilities and other related liabilities associated with the AARP contract, assets under management are classified as current assets, consistent with the classification of these liabilities. Interest earnings and realized investment gains and losses on these assets accrue to the overall benefit of the AARP policyholders through the RSF. Accordingly, they are not included in our earnings.
We calculate depreciation and amortization using the straight-line method over the estimated useful lives of the assets. The useful lives for property, equipment and capitalized software are: from three to seven years for furniture, fixtures and equipment; from 35 to 40 years for buildings; the shorter of the useful life or remaining lease term for leasehold improvements; and from three to nine years for capitalized software. The weighted-average useful life of property, equipment and capitalized software at December 31, 2006 was approximately five years. The net book value of property and equipment was $966 million and $932 million as of December 31, 2006 and 2005, respectively. The net book value of capitalized software was $928 million and $715 million as of December 31, 2006 and 2005, respectively.
We review long-lived assets, including property, equipment, capitalized software and intangible assets, for events or changes in circumstances that would indicate we might not recover their carrying value. We consider many factors, including estimated future utility and cash flows associated with the assets, to make this decision. An impairment charge is recorded for the amount by which an asset’s carrying value exceeds its estimated fair value. We record assets held for sale at the lower of their carrying amount or fair value, less any costs for the final settlement.
Future policy benefits for life insurance and annuity contracts represent account balances that accrue to the benefit of the policyholders, excluding surrender charges, for universal life and investment annuity products. As a result of the October 2005 sale of the life and annuity business within our subsidiary Golden Rule Financial Corporation (Golden Rule) under an indemnity reinsurance arrangement described in Note 5, we have maintained a liability associated with the reinsured contracts, as we remain primarily liable to the policyholders, and have recorded a corresponding reinsurance receivable due from the purchaser on the Consolidated Balance Sheets. We evaluate the financial condition of the reinsurer and only record the reinsurance receivable to the extent of probable recovery.
We compute basic net earnings per common share by dividing net earnings by the weighted-average number of common shares outstanding during the period. We determine diluted net earnings per common share using the weighted-average number of common shares outstanding during the period, adjusted for potentially dilutive shares associated with the exercise of common stock options, stock-settled SARs and the conversion of convertible subordinated debentures.
recognized over the life of the agreements as an adjustment to interest expense in the Consolidated Statements of Operations. Our existing interest rate swap agreements convert a majority of our interest from a fixed to a variable rate and are accounted for under the short cut method as fair value hedges. Additional information on our existing interest rate swap agreements is included in Note 9.
In the normal course of business, we invest in various financial assets, incur various financial liabilities and enter into agreements involving derivative securities.
In September 2006, the SEC issued Staff Accounting Bulletin No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements” (SAB 108). SAB 108 provides interpretive guidance on how the effects of the carryover or reversal of prior year misstatements should be considered in quantifying a current year misstatement. Under SAB 108, registrants should quantify errors using both a balance sheet and income statement approach (“dual approach”) and evaluate whether either approach results in a misstatement that is material when all relevant quantitative and qualitative factors are considered. We adopted SAB 108 on December 31, 2006.
of net periodic benefit cost. FAS 158 also requires additional disclosures in the notes to the consolidated financial statements. We adopted FAS 158 on December 31, 2006. The adoption of this standard did not have a material impact on our Consolidated Financial Statements or results of operations.
In February 2007, the FASB issued FAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities - Including an amendment of FASB Statement No. 115” (FAS 159). FAS 159 permits an entity to elect fair value as the initial and subsequent measurement attribute for many financial assets and liabilities. Entities electing the fair value option would be required to recognize changes in fair value in earnings. Entities electing the fair value option are required to distinguish, on the face of the statement of financial position, the fair value of assets and liabilities for which the fair value option has been elected and similar assets and liabilities measured using another measurement attribute. FAS 159 is effective for our fiscal year 2008. The adjustment to reflect the difference between the fair value and the carrying amount would be accounted for as a cumulative-effect adjustment to retained earnings as of the date of initial adoption. We are currently evaluating the impact, if any, of FAS 159 on our Consolidated Financial Statements.
On April 4, 2006, the Company’s Board of Directors (the “Board”) created an independent committee comprised of three independent directors to review the Company’s option grant practices over the period from 1994 through 2005 (the “Independent Review Period”). The independent committee engaged the law firm of Wilmer Cutler Pickering Hale and Dorr LLP (“WilmerHale”) as counsel for its independent review, and WilmerHale retained independent accounting advisors.
After substantially completing its analysis of the accounting adjustments necessary to reflect the findings of the WilmerHale Report, on November 8, 2006, the Company filed with the SEC a Current Report on Form 8-K reporting management’s conclusion, which the Audit Committee of the Board had approved, that - due solely to the Company’s historic stock option practices - the Company’s financial statements for the fiscal years ended
After completing its internal review of the accounting treatment for all option grants, management has concluded, and the Audit Committee of the Board has approved the conclusion, that the Company used incorrect measurement dates and made other errors described below in accounting for stock option grants and, accordingly, that the Company’s previously issued financial statements should be restated.
As of January 1, 2006, the Company adopted FAS 123R, using the modified retrospective transition method. Under this method, all prior period financial statements are required to be restated to recognize compensation cost in the amounts historically disclosed in our consolidated financial statements under FAS 123. Prior to January 1, 2006, the Company accounted for share-based compensation granted under its stock option plans using the recognition and measurement provisions of APB 25. Under APB 25, a company was not required to recognize compensation expense for stock options issued to employees if the exercise price of the stock options was at least equal to the quoted market price of the Company’s common stock on the “measurement date.” APB 25 defined the measurement date as the first date on which both the number of shares that an individual employee was entitled to receive and the option or purchase price, if any, were known.
Section 16 Grants - Section 16 Grants, generally made to eight to twelve officers, required approval by the Compensation and Human Resources Committee of the Board (the “Compensation Committee”).
For the majority of Section 16 Grants, Compensation Committee approval was reflected in written actions. The WilmerHale Report concluded that the written actions were generally executed subsequent to the stated grant dates. (Under Minnesota corporate law, it is permissible to make a Written Action effective as of a date other than the date on which the last of the required signers affixes his or her signature, even if that effective date is before the last signature affixed.) Based on the available evidence, the Company has determined that the appropriate measurement date for each of these Section 16 Grants is the earlier of (a) the date on which a Form 4 (or other statement of changes in beneficial ownership) was filed with the SEC with respect to a particular officer’s grant or (b) the date on which the written action with respect to that grant was likely executed by a majority of the members of the Compensation Committee.
For option grants with stated grant dates in October 1999 that were made in connection with the entry of employment agreements for our former chief executive officer and our current chief executive officer (both of whom had been employed by the Company prior to that date), the Company has determined that the appropriate measurement date is the date on which the employment agreements were executed on behalf of the Company. With respect to stock option grants with a stated grant date in October 1999 that represented the number of additional stock options necessary to equal the minimum annual stock option grant provided for pursuant to each such employment agreement, the Company has determined that the appropriate measurement date is the last day of 1999, the calendar year in which the Company was contractually obligated to make the grants.
Broad-Based Grants - Between 1,500 and 4,000 middle and senior management employees periodically and customarily received options. As described in the WilmerHale Report, our former chief executive officer, acting pursuant to authority delegated to him by the Compensation Committee, chose the grant dates and overall amounts for Broad-Based Grants and ultimately reflected the Broad-Based Grants in CEO Certificates.
Based on all available evidence, the Company has determined that the appropriate measurement date for Broad-Based Grants was the later of the following two dates: (a) the date on which the evidence identified by the Company indicated that a communication to or from our former chief executive officer refers to a particular grant, or the grant was presented to the Compensation Committee or (b) the date on which the allocation of the options to individual employees and grant process associated with the Broad-Based Grant was substantially complete. Where information is not available to evidence either (a) or (b) above, the Company has determined the appropriate measurement date to be the date on which the Company determined, based upon all available evidence that the CEO Certificate for such grant was likely executed. Where option award amounts changed subsequent to the date the allocation process was substantially complete, the Company has determined that each award that was changed is a separate grant with its own measurement date and should not be considered indicative that the granting process was not complete.
New Hire and Promotion Grants - During the Independent Review Period, the Company granted stock options to approximately 2,500 employees in connection with their hire or promotion (“New Hire and Promotion Grants”).
date. In 2002, the Company changed to a practice of determining grant dates for new hires and promotions to be the date of the lowest closing price of the Company’s common stock between the start date of employment or date of promotion and the end of the quarter in which the employee started work or was promoted. The Company historically used these stated grant dates as the measurement dates for accounting purposes.
The Company has concluded that the measurement dates used with respect to nearly all of the New Hire and Promotion Grants during the Independent Review Period were not correct because the Company’s practice was to determine grant dates with the benefit of hindsight. The Company has determined that the appropriate measurement date for each New Hire and Promotion Grant was the date on which the Company set the terms of the award, or where the Company could not identify such date based on all available evidence, the last date of the fiscal quarter in which a particular New Hire or Promotion Grant was made.
1999 Grant of Supplemental Options. In the fourth quarter of 1999, following a decline in its stock price, the Company granted “supplemental” stock options to acquire 2.2 million shares of Company common stock (17.6 million shares on a split-adjusted basis) to a broad group of employees, including our former chief executive officer and other Section 16 officers. The supplemental options were granted in connection with the suspension of the vesting and exercisability of an equal number of options with exercise prices above $46.50 ($5.8125 on a split-adjusted basis) that had previously been granted to those employees (the “Suspended Options”). The supplemental options had a stated grant date of October 13, 1999 and an exercise price equal to $40.125 ($5.0156 on a split-adjusted basis).
2000 Reactivation of Suspended Options. In 2000, the Company reactivated the vesting and exercisability of the Suspended Options. The Company has determined that, under APB 25 and FAS 123, the reactivation of the vesting and exercisability of the Suspended Options was a new stock option grant that should have had a new measurement date, and the Company has determined that the appropriate measurement date is the date grantees were again permitted to exercise their previously vested awards.
Other Modifications of Option Terms. The Company has also determined that certain other actions were taken that resulted in the modification of option terms, as follows:
1999 Cancellation and Reissuance of Options. In the fourth quarter of 1999, the Company issued stock options to acquire an aggregate of 400,000 shares of Company common stock (3.2 million shares on a split-adjusted basis) to approximately 65 employees in exchange for the cancellation of an equal number of stock options that had previously been granted to those employees at various times earlier in 1999. The reissued stock options had a stated grant date of October 13, 1999 and an exercise price equal to $40.125 ($5.0156 on a split-adjusted basis), which was lower than the exercise price of the cancelled options. The Company has determined that, under APB 25, this constituted a “re-pricing”, resulting in variable accounting for each option until exercise, forfeiture or expiration. Additionally, the Company has concluded that, under FAS 123, this would also be viewed as a modification to the award and the incremental fair value in addition to the originally measured fair value should have been recognized over the remaining vesting period.
Additionally, on January 1, 2006, our Uniprise business segment began reporting premiums and expenses on a gross basis for a large account where we have employed third-party reinsurance. Historically, revenues and expenses associated with this account were reported net of amounts ceded to an unaffiliated reinsurer. While the reinsurance contract has been in place for a number of years, recent accounting interpretations suggest this reinsurance arrangement be presented on a gross versus net basis. Prior period amounts have been restated to conform to the 2006 presentation. The restatement has no effect on our net earnings or shareholders’ equity as previously reported.
The following table illustrates the effect of the restatement adjustments on our pro forma net earnings and pro forma net earnings per share if we had recorded compensation costs based on the estimated grant date fair value accounting method as defined by FAS 123 for 2005 and 2004.
(1) Includes $317 million of stock-based compensation and $89 million of deferred tax benefit associated with the restatement of our historical APB 25 Consolidated Statement of Operations as well as an adjustment to premium revenue of $1,113 million, medical costs of $1,016 million and operating costs of $97 million to reflect a reinsurance contract on a gross basis to conform to our current presentation. We have also reclassified certain service revenues and operating costs to product revenues and cost of products sold, respectively, primarily related to our pharmacy benefit management business acquired as part of the PacifiCare acquisition in December in 2005.
(2) Reflects $250 million of stock-based compensation and $90 million of deferred tax benefit as recorded under the modified retrospective method of adoption of FAS 123R that would have been recognized based on our original pro forma disclosure under FAS 123 prior to the restatement, net of the restatement adjustments under APB 25.
(3) Represents adjustments made to restate our Consolidated Statement of Operations subsequent to the adoption of FAS 123R under the modified retrospective method of adoption to correct the previously presented pro forma disclosures for the effects of the historical stock option practices and includes $56 million of additional stock-based compensation and $9 million of related deferred tax benefit.
(1) Includes $201 million of stock-based compensation and $56 million of deferred tax benefit associated with the restatement of our historical APB 25 Consolidated Statement of Operations as well as an adjustment to premium revenue of $1,016 million, medical costs of $926 million and operating costs of $90 million to reflect a reinsurance contract on a gross basis to conform to our current presentation. We have also reclassified certain service revenues and operating costs to product revenues and cost of products sold, respectively, primarily related to our pharmacy benefit management business acquired as part of the PacifiCare acquisition in December 2005.
(2) Reflects $203 million of stock-based compensation and $71 million of deferred tax benefit as recorded under the modified retrospective method of adoption of FAS 123R that would have been recognized based on our original pro forma disclosure under FAS 123 prior to the restatement, net of the restatement adjustments under APB 25.
(3) Represents adjustments made to restate our Consolidated Statement of Operations subsequent to the adoption of FAS 123R under the modified retrospective method of adoption to correct the previously presented pro forma disclosures for the effects of the historical stock option practices and includes $41 million of additional stock-based compensation and $10 million of related deferred tax benefit.
(2) Reflects adjustments to decrease non-current deferred tax liabilities by $212 million, increase additional paid-in capital by $1,036 million and decrease retained earnings by $824 million associated with the adoption of FAS 123R under the modified retrospective method as of December 31, 2005 that would have been recognized based on our original pro forma disclosure under FAS 123 prior to the restatement, net of the restatement adjustments under APB 25.
Catastrophic Reinsurance Subsidy - CMS pays the Company a cost reimbursement estimate monthly to fund the CMS obligation to pay approximately 80% of the costs incurred by individual members in excess of the individual annual out-of-pocket maximum of $3,600. A settlement is made based on actual cost experience subsequent to the end of the plan year.
Low-Income Member Cost Sharing Subsidy - For qualifying low-income members, CMS pays on the member’s behalf some or all of a member’s cost sharing amounts, such as deductibles and coinsurance. The cost sharing subsidy is funded by CMS through monthly payments to the Company. The Company administers and pays the subsidized portion of the claims on behalf of CMS, and a settlement payment is made between CMS and the Company based on actual claims experience, subsequent to the end of the plan year.
The Catastrophic Reinsurance Subsidy and the Low-Income Member Cost Sharing Subsidy represent cost reimbursements under the Medicare Part D program. The Company is fully reimbursed by CMS for costs incurred for these contract elements and, accordingly, there is no insurance risk to the Company. Amounts received for these subsidies are not reflected as premium revenues, but rather are accounted for as deposits, with the related liability recorded in Other Policy Liabilities in the Consolidated Balance Sheets. Related cash flows are presented as Customer Funds Administered within financing cash flows in the Consolidated Statements of Cash Flows.
Pharmacy benefit costs and administrative costs under the contract are expensed as incurred and are recognized in medical costs and operating costs, respectively, in the Consolidated Statements of Operations.
As a result of the Medicare Part D product benefit design, the Company incurs a disproportionate amount of pharmacy benefit costs early in the contract year. For example, the Company is responsible for approximately 67% of a Medicare Part D beneficiary’s drug costs up to $2,250, while the beneficiary is responsible for 100% of their drug costs from $2,250 up to $5,100 (at the Company’s discounted purchase price). Consequently, the Company incurs a disproportionate amount of benefit costs in the first half of the contract year as compared with
On September 19, 2005, our Health Care Services business segment acquired Neighborhood Health Partnership (NHP). NHP serves local employers primarily in South Florida. This acquisition strengthened our market position in this region and provided expanded distribution opportunities for our other UnitedHealth Group businesses. We paid approximately $185 million in cash in exchange for all of the outstanding equity of NHP. The results of operations and financial condition of NHP have been included in our Consolidated Financial Statements since the acquisition date. The pro forma effects of the NHP acquisition on our Consolidated Financial Statements were not material.
For the years ended December 31, 2006, 2005 and 2004, aggregate consideration paid or issued for smaller acquisitions accounted for under the purchase method was $276 million, $196 million and $158 million, respectively. These acquisitions were not material to our Consolidated Financial Statements.
As of December 31, 2006 and 2005, respectively, debt securities consisted of $3,310 million and $2,256 million in U.S. Government and Agency obligations, $4,203 million and $4,554 million in state and municipal obligations, and $2,437 million and $2,490 million in corporate obligations. At December 31, 2006, we held $833 million in debt securities with maturities of less than one year, $3,694 million in debt securities with maturities of one to five years, $2,733 million in debt securities with maturities of five to 10 years and $2,690 million in debt securities with maturities of more than ten years.
In accordance with FASB Staff Position FAS 115-1/124-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments,” the following table shows the gross unrealized losses and fair value of investments with unrealized losses that, in our judgment, are other-than-temporarily impaired. These investments are aggregated by investment type and length of time that individual securities have been in a continuous unrealized loss position (in millions)1:
(1) Debt securities classified as held-to-maturity investments have been excluded from this analysis. These investments are predominantly held in U.S. Government or Agency obligations and the contractual terms do not permit the issuer to settle the securities at a price less than the amortized cost of the investment. Additionally, the fair values of these investments approximate their amortized cost.
The unrealized losses on investments in U.S. Government and Agency obligations, state and municipal obligations and corporate obligations at December 31, 2006 were mainly caused by interest rate increases and not
by unfavorable changes in the credit ratings associated with these securities. We evaluate impairment at each reporting period for each of the securities where the fair value of the investment is less than its cost. The contractual cash flows of the U.S. Government and Agency obligations are either guaranteed by the U.S. Government or an agency of the U.S. Government. It is expected that the securities would not be settled at a price less than the cost of our investment. We evaluated the credit ratings of the state and municipal obligations and the corporate obligations, noting neither a significant deterioration since purchase nor other factors leading to other-than-temporary impairment.
We analyze relevant factors individually and in combination including the length of time and extent to which market value has been less than cost, the financial condition and near-term prospects of the issuer as well as specific events or circumstances that may influence the operations of the issuer, and our intent and ability to hold the investment for a sufficient time to recover our cost. We revise impairment judgments when new information becomes known or when we do not anticipate holding the investment until recovery. If any of our investments experience a decline in fair value that is determined to be other-than-temporary, based on analysis of relevant factors, we record a realized loss in our Consolidated Statements of Operations. We do not consider the unrealized losses on each of the investments described above to be other-than-temporarily impaired at December 31, 2006.
Included in the realized losses above are impairment charges of $4 million, $8 million and $8 million for 2006, 2005 and 2004, respectively.
Changes in the carrying amount of goodwill, by segment, during the years ended December 31, 2006 and 2005 (as restated), were as follows:
Medical costs and medical costs payable include estimates of our obligations for medical care services that have been rendered on behalf of insured consumers but for which we have either not yet received or processed claims, and for liabilities for physician, hospital and other medical cost disputes. We develop estimates for medical costs incurred but not reported using an actuarial process that is consistently applied, centrally controlled and automated. The actuarial models consider factors such as time from date of service to claim receipt, claim backlogs, care provider contract rate changes, medical care consumption and other medical cost trends. We estimate liabilities for physician, hospital and other medical cost disputes based upon an analysis of potential outcomes, assuming a combination of litigation and settlement strategies. Each period, we re-examine previously established medical costs payable estimates based on actual claim submissions and other changes in facts and circumstances. As the liability estimates recorded in prior periods become more exact, we adjust the amount of the estimates, and include the changes in estimates in medical costs in the period in which the change is identified. For example, in every reporting period our operating results include the effects of more completely developed medical costs payable estimates associated with previously reported periods.
(1) The carrying value of debt has been adjusted based upon the applicable interest rate swap fair values in accordance with the fair value hedge short-cut method of accounting described below.
As of December 31, 2006, our outstanding commercial paper had interest rates ranging from 5.3% to 5.5%.
Maturities of commercial paper and debt for the years ending December 31 are as follows: $1,483 million in 2007, $500 million in 2008, $1,350 million in 2009, $0 in 2010, $750 in 2011 and $3,373 million thereafter.
On October 16, 2006, we executed a $7.5 billion 364-day revolving credit facility in order to ensure the Company’s immediate and continued access to additional liquidity. The credit facility is available for working capital purposes as well as to pay or repay any outstanding borrowings of the Company. We have entered into amendments to our $7.5 billion credit facility to provide us with additional time to deliver to the lenders our quarterly reports on Form 10-Q for the quarters ended June 30, 2006 and September 30, 2006 and our annual report on Form 10-K for the year ended December 31, 2006. As of December 31, 2006, we had no amounts outstanding under our $7.5 billion credit facility.
In March 2006, we refinanced outstanding commercial paper by issuing $650 million of floating-rate notes due March 2009, $750 million of 5.3% fixed-rate notes due March 2011, $750 million of 5.4% fixed-rate notes due March 2016 and $850 million of 5.8% fixed-rate notes due March 2036. The floating-rate notes due March 2009 are benchmarked to the London Interbank Offered Rate (LIBOR) and had an interest rate of 5.5% at December 31, 2006.
In December 2005, we amended and restated our $1.0 billion five-year revolving credit facility supporting our commercial paper program. We increased the credit facility to $1.3 billion and extended the maturity date to December 2010. We have entered into amendments to our $1.3 billion credit facility to provide us with additional time to deliver to the lenders our quarterly reports on Form 10-Q for the quarters ended June 30, 2006 and September 30, 2006 and our annual report on Form 10-K for the year ended December 31, 2006, to obtain our lenders agreement and acknowledgement that the delivery of a notice of default or notice of acceleration under any indenture or credit agreement that is being contested by the Company in good faith does not cause a default or event of default under the credit agreement, and to obtain a waiver of any potential default that may arise as a result of our determination that our historical financial information should not be relied upon and as a result of our restatement of our historical financial statements. As of December 31, 2006, we had no amounts outstanding under our $1.3 billion credit facility.
In November and December 2005, we issued $2.6 billion of commercial paper primarily to finance the cash portion of the purchase price of the PacifiCare acquisition described above and to retire a portion of the PacifiCare debt at the closing of the acquisition, as well as to refinance current maturities of long-term debt.
In October 2005, we executed a $3.0 billion 364-day revolving credit facility to support a $3.0 billion increase in our commercial paper program in order to finance the cash portion of the PacifiCare acquisition. We terminated the 364-day revolving credit facility in March 2006.
Our debt arrangements and credit facilities contain various covenants, the most restrictive of which require us to maintain a debt-to-total-capital ratio (calculated as the sum of commercial paper and debt divided by the sum of commercial paper, debt and shareholders’ equity) below 50%. After giving effect to the credit agreement amendments and waivers that we obtained from our lenders, we believe we are in compliance with the requirements of all debt covenants. On August 28, 2006, we received a purported notice of default from persons claiming to hold certain of our debt securities alleging a violation of our indenture governing our debt securities. This followed our announcement that we would delay filing our quarterly report on Form 10-Q for the quarter ended June 30, 2006. On or about November 2, 2006, we received a purported notice of acceleration from the holders who previously sent the notice of default that purports to declare an acceleration of our 5.8% Senior Unsecured Notes due March 15, 2036. Our indenture requires us to provide to the trustee copies of the reports we are required to file with the SEC, such as our quarterly reports, within 15 days of filing such reports with the SEC. On October 25, 2006, we filed an action in the United States District Court for the District of Minnesota seeking a declaratory judgment that we are not in default under the terms of the indenture. Immediately prior to the filing of this Form 10-K, we filed our quarterly reports on Form 10-Q for the quarters ended June 30, 2006 and September 30, 2006, as well as an amendment to our quarterly report on Form 10-Q for the quarter ended March 31, 2006. Should the Company ultimately be unsuccessful in this matter, the Company may be required to retire all or a portion of the $850 million of Senior Unsecured Notes due March 2036. We intend to prosecute the declaratory judgment action vigorously.
PacifiCare had approximately $100 million par value of 3% convertible subordinated debentures (convertible notes) which were convertible into approximately 5.2 million shares of UnitedHealth Group’s common stock and $102 million of cash as of December 31, 2005. In December 2005, we initiated a consent solicitation to all of the holders of outstanding convertible notes pursuant to which we offered to compensate all holders who elected to convert their notes in accordance with existing terms and consent to an amendment to a covenant in the indenture governing the convertible notes. The compensation consisted of the present value of interest through October 18, 2007, the earliest redemption date, plus a pro rata share of $1 million. On January 31, 2006, approximately 91% of the convertible notes were tendered pursuant to the offer, for which we issued approximately 4.8 million shares of UnitedHealth Group common stock, valued at $282 million, and cash of $93 million.
The weighted-average fair value of stock options and SARs granted was $11 per share, $14 per share and $12 per share for 2006, 2005 and 2004, respectively. The aggregate fair value of stock options and SARs that vested during 2006, 2005 and 2004 was $371 million, $350 million and $322 million, respectively. As of December 31, 2006, the aggregate intrinsic value of outstanding stock options and SARs was $4.6 billion, with a weighted-average remaining contractual term of 6.0 years. The aggregate intrinsic value of exercisable stock options and SARs at that same date was $4.0 billion, with a weighted-average remaining contractual term of 4.8 years. The total intrinsic value of options and SARs exercised during 2006, 2005 and 2004 was $753 million, $847 million and $951 million, respectively.
Restricted stock awards generally vest ratably over two to four years. Compensation expense related to restricted stock awards is determined based upon the fair value of each award on the date of grant. Restricted stock award activity is summarized in the table below (shares in millions):
For 2006, 2005 and 2004, the income tax benefit realized from stock-based awards was $287 million, $311 million and $304 million, respectively.
In November and December 2006, 15 executives of the Company entered into options repricing agreements with the Company to ensure that there was no potential for financial gain from the incorrect dating of any option the executives had received in light of the conclusions of the WilmerHale Report, as well as to avoid potential additional surtax liability under Section 409A of the Internal Revenue Code (Section 409A). These repricings increased the exercise prices of certain awards to either the highest closing price of the stated grant year or to the closing price of the Company’s common stock on the accounting measurement date. There was no incremental fair value associated with these modifications.
As further discussed in Note 10, we maintain a common stock repurchase program. The objective of our share repurchase program is to optimize our capital structure, cost of capital and return to shareholders, as well as to offset the dilutive impact of shares issued for stock-based award exercises.
In addition, the Company maintains non-qualified, unfunded deferred compensation plans, which allow certain senior management and executives to defer portions of their salary or bonus and receive certain Company contributions on such deferrals, subject to plan limitations. The deferrals are recorded within Long-Term Investments with an equal offsetting amount in Other Long-Term Liabilities in the Consolidated Balance Sheets. The total deferrals are distributable based upon termination of employment or other periods as elected under the plans, and are $212 million and $179 million as of December 31, 2006 and 2005, respectively.
As discussed in Note 3, the Company has restated its previously filed financial statements to reflect additional stock-based compensation expense and related tax effects following an independent investigation of its historic stock option practices.
Consolidated income tax returns for fiscal years 2003 to 2005 are currently being examined by the Internal Revenue Service (IRS). Additionally, our 2006 tax year return is under advance review by the IRS under its Compliance Assurance Program (CAP). The Company and some of its subsidiaries also have ongoing audits with various state and local jurisdictions. We do not believe any adjustments that may result from these examinations will have a significant impact on our Consolidated Balance Sheets or Statements of Operations.
The underwriting gains or losses related to the AARP Medicare Supplement insurance business are directly recorded as an increase or decrease to a rate stabilization fund (RSF). The primary components of the underwriting results are premium revenue, medical costs, investment income, administrative expenses, member service expenses, marketing expenses and premium taxes. Underwriting gains and losses are recorded as an increase or decrease to the RSF and accrue to the overall benefit of the AARP policyholders, unless cumulative net losses were to exceed the balance in the RSF. To the extent underwriting losses exceed the balance in the RSF, we would have to fund the deficit. Any deficit we fund could be recovered by underwriting gains in future
periods of the contract. To date, we have not been required to fund any underwriting deficits. The RSF balance is reported in Other Policy Liabilities in the accompanying Consolidated Balance Sheets and changes in the RSF are reported in Medical Costs in the Consolidated Statements of Operations. We believe the RSF balance at December 31, 2006 is currently sufficient to cover potential future underwriting or other risks associated with the contract.
Pursuant to our agreement, AARP assets under management are managed separately from our general investment portfolio and are used to pay costs associated with the AARP program. These assets are invested at our discretion, within investment guidelines approved by AARP. We do not guarantee any rates of investment return on these investments and, upon transfer of the AARP contract to another entity, we would transfer cash equal in amount to the fair value of these investments at the date of transfer to that entity. Interest income and realized gains and losses related to assets under management are recorded as an increase to the AARP RSF and were $94 million, $90 million and $103 million in 2006, 2005 and 2004, respectively. Assets under management are reported at their fair market value, and unrealized gains and losses are included directly in the RSF associated with the AARP program. As of December 31, 2006 and 2005, the amortized cost, gross unrealized gains and losses, and fair value of cash, cash equivalents and investments associated with the AARP insurance program, included in Assets Under Management, were as follows (in millions):
including impairment analyses. As a result of these reviews, as is further discussed in Note 7, we did not identify any other-than-temporary impairments. Interest earnings and realized investment gains and losses on these assets accrue to the overall benefit of the AARP policyholders through the RSF and are, therefore, not included in our earnings.
Under a separate license agreement with AARP, we sell Medicare Prescription Drug benefit plans under the AARP brand name. We assume all operational and underwriting risks and losses for these plans.
Due to the financial restatements previously discussed, the Company has determined that certain options exercised by nonexecutive officer employees in 2006 were discount options subject to Section 409A of the Internal Revenue Code. The Company notified the Internal Revenue Service (IRS) on February 28, 2007 that it would participate in the IRS’s resolution program, which allows the Company to pay its employees’ additional tax costs under Section 409A. As such, the Company will take a charge, net of tax benefit, of approximately $55 million in the first quarter of 2007.
On May 17, 2006, we received a document request from the Internal Revenue Service seeking documents relating to stock option grants and other compensation for the persons who from 2003 to the present were the named executive officers in our annual proxy statements.
On June 6, 2006, we received a Civil Investigative Demand from the Minnesota Attorney General requesting documents from January 1, 1997 to the present concerning our executive compensation and stock option practices. After filing an action in Ramsey County Court, State of Minnesota, captioned UnitedHealth Group Incorporated vs. State of Minnesota, by Lori Swanson, Attorney General, we filed a Motion for Protective Order which was denied by the trial court. We are pursuing a stay of the Civil Investigative Demand as well as an appeal of the Order denying the Protective Order.
We have also received requests for documents from U.S. Congressional committees relating to our historical stock option practices and compensation of executives. With the exception of the Civil Investigative Demand from the Minnesota Attorney General, we have generally cooperated and will continue to cooperate with the regulatory authorities. At the conclusion of these regulatory inquiries, we could be subject to regulatory or criminal fines or penalties as well as other sanctions or other contingent liabilities, which could be material.
On March 29, 2006, the first of several shareholder derivative actions was filed against certain of our current and former officers and directors in the United States District Court for the District of Minnesota. The action has been consolidated with six other actions and is captioned In re UnitedHealth Group Incorporated Shareholder Derivative Litigation. The consolidated amended complaint is brought on behalf of the Company by several pension funds and other shareholders and names certain of our current and former directors and officers as defendants, as well as the Company as a nominal defendant. The consolidated amended complaint generally alleges that defendants breached their fiduciary duties to the Company, were unjustly enriched, and violated the securities laws in connection with our historic stock option practices. The consolidated amended complaint seeks unspecified money damages, injunctive relief and rescission of the options. On June 26, 2006, our Board of Directors created a Special Litigation Committee, consisting of two former Minnesota Supreme Court Justices, under Minnesota Statute 302A.241 with the power to investigate the claims raised in the derivative actions and a shareholder demand, and determine whether the Company’s rights and remedies should be pursued. Based on the existence of our Special Litigation Committee, defendants have moved to dismiss or in the alternative to stay the litigation pending resolution of the Special Litigation Committee process. A consolidated derivative action, reflecting a consolidation of two actions, is also pending in Hennepin County District Court, State of Minnesota. The consolidated complaint is captioned In re UnitedHealth Group Incorporated Derivative Litigation. The action was brought by two individual shareholders and names certain of our current and former officers and directors as defendants, as well as the Company as nominal defendant. On February 6, 2007, the State Court Judge entered an order staying the action pending resolution of the Special Litigation Committee process.
On June 6, 2006, a purported class action captioned Zilhaver v. UnitedHealth Group Incorporated, was filed against the Company and certain of our current and former officers and directors in the United State District Court for the District of Minnesota. This action alleges that the fiduciaries to the Company-sponsored 401(k) plan violated ERISA by allowing the plan to continue to hold company stock. Defendants filed a motion to dismiss on February 6, 2007. We intend to vigorously defend against the action.
In addition, other adjustments for non-operating cash charges may be required in connection with the resolution of stock option-related matters arising under litigation, and regulatory reviews by the SEC, IRS, U.S. Attorney, U.S. Congressional committees and Minnesota Attorney General, the amount and timing of which are uncertain, but which could be material.
Our accounting policies for business segment operations are the same as those described in the Summary of Significant Accounting Policies (See Note 2). Transactions between business segments principally consist of customer service and transaction processing services that Uniprise provides to Health Care Services, certain product offerings sold to Uniprise and Health Care Services customers by Specialized Care Services, and sales of medical benefits cost, quality and utilization data and predictive modeling to Health Care Services and Uniprise by Ingenix. These transactions are recorded at management’s estimate of fair value. All intersegment transactions are eliminated in consolidation. Assets and liabilities that are jointly used are assigned to each segment using estimates of pro-rata usage. Cash and investments are assigned such that each segment has at least minimum specified levels of regulatory capital or working capital for non-regulated businesses.
Substantially all of our operations are conducted in the United States. In accordance with accounting principles generally accepted in the United States, segments with similar economic characteristics may be combined. The financial results of UnitedHealthcare, Ovations and AmeriChoice have been combined in the Health Care Services segment column in the following tables because these businesses have similar economic characteristics and have similar products and services, types of customers, distribution methods and operational processes, and operate in a similar regulatory environment, typically within the same legal entity.
The following table presents segment financial information as of and for the years ended December 31, 2006, 2005 and 2004 (in millions):
(1) Total Assets and Net Assets exclude, where applicable, debt and accrued interest of $7,569 million, $7,161 million and $4,054 million, income tax-related assets of $561 million, $650 million and $361 million, and income tax-related liabilities of $1,218 million, $1,016 million and $676 million as of December 31, 2006, 2005 and 2004, respectively.
(1) Includes $78 million of stock-based compensation and $21 million of deferred tax benefit associated with the restatement of our historical APB 25 Consolidated Statement of Operations as well as an adjustment to premium revenue of $280 million, medical costs of $256 million and operating costs of $24 million to reflect a reinsurance contract on a gross basis. We have also reclassified certain service revenues and operating costs to product revenues and cost of products sold, respectively, primarily related to our pharmacy benefit management business acquired as part of the PacifiCare acquisition in December 2005 in order to conform to our current presentation.
(2) Reflects $67 million of stock-based compensation and $24 million of deferred tax benefit as recorded under the modified retrospective method of adoption of FAS 123R, net of the restatement adjustments under APB 25.
(3) Represents adjustments made to restate our Consolidated Statement of Operations subsequent to the adoption of FAS 123R under the modified retrospective method of adoption and includes $14 million of additional stock-based compensation and $2 million of related deferred tax benefit.
We have audited the accompanying consolidated balance sheets of UnitedHealth Group Incorporated and Subsidiaries (the “Company”) as of December 31, 2006 and 2005, and the related consolidated statements of operations, changes in shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2006. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of UnitedHealth Group Incorporated and Subsidiaries as of December 31, 2006 and 2005, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2006, in conformity with accounting principles generally accepted in the United States of America.
As discussed in Note 3, the accompanying 2005 and 2004 consolidated financial statements have been restated to reflect certain adjustments resulting from the Company’s historical stock option granting practices.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the Company’s internal control over financial reporting as of December 31, 2006, based on the criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 5, 2007 expressed an unqualified opinion on management’s assessment of the effectiveness of the Company’s internal control over financial reporting and an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting.