In a difficult state budgetary environment, we leveraged our partnerships with our states and negotiated a weighted average rate increase of 4.9% for each of the states’ budget years that began in 2004.
On July 2, 2004, the State of Texas released a Request for Proposal (RFP) to re-procure its current Medicaid managed care programs, as well as to expand the current programs. Although the State has said it will announce contract awards in early 2005 with implementation continuing into 2006, the announcement of the awards may not occur until after the conclusion of the Texas legislative session on May 30, 2005. The RFP includes all of the current Texas service areas and products in which we operate. Our response to the RFP included our current Texas service areas and products as well as expansion into new service areas and products. If we lost one or more contracts through the re-procurement process, our operating results could be materially and adversely affected.
Our results of operations depend on our ability to effectively manage expenses related to health benefits, as well as our ability to accurately predict costs incurred in recording the amounts in our consolidated financial statements. Expenses related to health benefits have two components: direct medical expenses and medically related administrative costs. Direct medical expenses include fees paid to hospitals, physicians and providers of ancillary medical services, such as pharmacy, laboratory, radiology, dental and vision. Medically related administrative costs include expenses related to services such as health promotion, quality assurance, case management, disease management and 24-hour on-call nurses. Direct medical expenses also include estimates of medical expenses incurred but not yet reported (IBNR). For the year ended December 31, 2004, approximately 95% of our direct medical payments related to fees paid on a fee-for-service basis to our PCPs, specialist physicians and other providers, including fees paid to third-party vendors for ancillary services. The balance related to fees paid on a capitation, or per member, basis. Primary care and specialist physicians not paid on a capitated basis are paid on a maximum allowable fee schedule set forth in the contracts with our providers. We reimburse hospitals on a negotiated per diem, case rate or an agreed upon percent of their standard charges. In Maryland, the state sets the amount reimbursed to hospitals.
In the current year, we experienced a reduction in the favorable prior year development of approximately $22.8 million related to 2003 and prior. In 2003, we experienced an increase in the favorable prior year development of $4.1 million related to 2002 and prior. The current year reduction was primarily the result of more precise claims estimates at December 31, 2003 due to a decrease in claims payment variability related to our maturing products and markets compared to the prior year. Actuarial claims estimates are based upon facts and circumstances at the time we record them. We believe that our claims experience has stabilized as the Company has grown, allowing us to more accurately estimate our medical expense liabilities at each period end. As we add new markets and products, the claims fluctuations may increase, but overall growth in the size of the Company mitigates this volatility on a consolidated basis.
Investment income decreased $1.3 million to $6.7 million for the year ended December 31, 2003. The decrease in investment income was primarily due to the continued decline in market interest rates and increased levels of tax-advantaged securities partially offset by an increase in overall cash and investments levels throughout the year. Cash and investments levels increased due to proceeds from our public offering and cash generated from operations.
SFAS No. 123(R) permits public companies to adopt its requirements using one of two methods:
2. A “modified retrospective” method which includes the requirements of the modified prospective method described above, but also permits entities to restate based on the amounts previously recognized under SFAS No. 123 for purposes of proforma disclosures either (a) all prior presented or (b) prior interim periods of the year of adoption.
Amortization expense for the years ended December 31, 2004, 2003 and 2002 was $3,504, $5,849 and $0, respectively, and the estimated aggregate amortization expense for the five succeeding years is as follows:
The fair value of each option grant is estimated on the date of grant using an option pricing model with the following assumptions: no dividend yield for all years, risk-free interest rate of 3.1%, 3.2% and 3.6%, expected life of 5.4, 6.7 and 4.0 years and volatility of 29.5%, 44.6% and 49.7%, for the years ended December 31, 2004, 2003 and 2002, respectively.