In March 2007, the District of Columbia released an RFP to provide managed care services to Medicaid and D.C. Alliance members in the District. Our subsidiary, AMERIGROUP Maryland, Inc., submitted a response to the RFP on July 24, 2007. We anticipate that the District will award the contracts to between two and four managed care organizations, based upon a best-value evaluation which includes premium rates, in mid-2008. We anticipate implementation following a contract award. If we are not awarded a contract through this process, we can make no assurance that our business, results of operations and financial condition would not be materially and adversely affected.
We continually monitor and adjust the medical claims payable and health benefits expense based on subsequent paid claims activity. If it is determined that our assumptions regarding medical cost trends and utilization are significantly different than actual results, our results of operations, financial position and liquidity could be impacted in future periods. Adjustments of prior year estimates may result in additional health benefits expense or a reduction of health benefits expense in the period an adjustment is made. Further, due to the considerable variability of health care costs, adjustments to medical claims payable occur each quarter and are sometimes significant as compared to the net income recorded in that quarter. Prior period development is recognized immediately upon the actuaries’ judgment that a portion of the prior period liability is no longer needed or that an additional liability should have been accrued.
For further information, please reference Note 6 to our audited consolidated financial statements as of and for the year ended December 31, 2007 included in this Form 10-K. See also the Recent Accounting Standards disclosure included in this Discussion of Critical Accounting Policies for information on the recently issued FASB Interpretation No. 48 Accounting for Uncertainty in Income Taxes (“FIN 48”). For calendar year companies, FIN 48 was effective January 1, 2007.
On July 13, 2006, the FASB issued FIN 48. FIN 48 clarifies the accounting for uncertainty in income taxes recognized in the financial statements in accordance with FASB Statement No. 109. This interpretation provides guidance on the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. For a tax benefit to be recognized, a tax position must be more likely than not to be sustained upon examination by applicable taxing authorities. The benefit recognized is the amount that has a greater than 50% likelihood of being realized upon final settlement of the tax position. We adopted the provisions of FIN 48 on January 1, 2007. As a result of the adoption of FIN 48, we recorded a $9.2 million increase to retained earnings as of January 1, 2007. As of the date of adoption, the total gross amount of unrecognized tax benefits was $0.3 million excluding interest. The gross amount of unrecognized tax benefits is $0.9 million (excluding interest) as of December 31, 2007. Of this total, $0.6 million (net of the federal benefit on state issues) represents the total amount of tax benefits that, if recognized, would impact the effective rate. For further information, please reference Note 6 to our audited consolidated financial statements as of and for the year ended December 31, 2007 included in this Form 10-K.
Net income for 2007 was $116.5 million, or $2.16 per diluted share, compared to $107.1 million, or $2.02 per diluted share in 2006. Net income for 2005 was $53.7 million or $1.02 per diluted share. Net income increased from 2006 to 2007 as a result of growth in total revenues (associated with geographic expansion, membership increases, premium rate increases and investment income increases) limiting the increase in HBR, and reducing SG&A as a percentage of revenues.
The proceeds of the Credit Agreement are available to (i) facilitate an appeal, payment or settlement of the judgment in the Qui Tam Litigation (as defined below), (ii) repay in full certain existing indebtedness, (iii) pay related transaction costs, fees, commissions and expenses, and (iv) provide for the ongoing working capital requirements and general corporate purposes, including permitted acquisitions. The borrowings under the Credit Agreement accrue interest at our option at a percentage, per annum, equal to the adjusted Eurodollar rate plus 2.0% or the base rate plus 1.0%. We are required to make payments of interest in arrears on each interest payment date (to be determined depending on interest period elections made by the Company) and at maturity of the loans, including final maturity thereof. The applicable interest rate was 7.0% at December 31, 2007.
Upon conversion of the Notes, we will pay cash up to the principal amount of the Notes converted. With respect to any conversion value in excess of the principal amount of the Notes converted, we have the option to settle the excess with cash, shares of our common stock, or a combination of cash and shares of our common stock based on a daily conversion value, as defined in the Indenture. If an “accounting event” (as defined in the Indenture) occurs, we have the option to elect to settle the converted notes exclusively in shares of our common stock. The initial conversion rate for the Notes will be 23.5114 shares of common stock per one thousand dollars of principal amount of Notes, which represents a 32.5 percent conversion premium based on the closing price of $32.10 per share of our common stock on March 22, 2007 and is equivalent to a conversion price of approximately $42.53 per share of common stock. The conversion rate is subject to adjustment in some events but will not be adjusted for accrued interest. In addition, if a “fundamental change” (as defined in the Indenture) occurs prior to the maturity date, we will in some cases increase the conversion rate for a holder of Notes that elects to convert its Notes in connection with such fundamental change.
The company was incorporated in 1994 and began operations of its wholly owned subsidiaries to develop, own and operate as managed healthcare companies.
Software is stated at cost less accumulated amortization in accordance with Statement of Position 98-1, Accounting for the Costs of Software Developed or Obtained for Internal Use. Software is amortized over its estimated useful life of three to ten years, using the straight-line method. Amortization expense on software was $9,543, $6,723 and $5,477 for the years ended December 31, 2007, 2006 and 2005, respectively.
For the year ended December 31, 2005, the Company accounted for stock based compensation plans under APB Opinion No. 25. Compensation cost related to stock options issued to employees was recorded only if the grant-date market price of the underlying stock exceeded the exercise price. The following table illustrates the effect on net income and earnings per share if the Company had applied fair value recognition.
In August 2007, the FASB proposed FASB Staff Position (“FSP”) APB 14-a, Accounting for Convertible Debt Instruments That May Be Settled in Cash upon Conversion (Including Partial Cash Settlement). The proposed FSP would require the proceeds from the issuance of such convertible debt instruments to be allocated between a liability component and an equity component. The resulting debt discount would be amortized over the period the convertible debt is expected to be outstanding as additional non-cash interest expense. The proposed change in accounting treatment would be effective for fiscal years beginning after December 15, 2008, and applied retrospectively to prior periods. If adopted, this FSP would change the accounting treatment for our $260,000 2.0% Convertible Senior Notes due May 15, 2012, which were issued effective March 28, 2007. If adopted in its current form, the impact of this new accounting treatment could be significant to our results of operations and result in an increase to non-cash interest expense beginning in fiscal year 2009 for financial statements covering past and future periods. We estimate earnings per diluted share could decrease by approximately $0.11 to $0.12 annually as a result of the adoption of this FSP. As the guidance is emerging and still under consideration regarding its effective date and scope, we can make no assurances that the actual impact upon adoption will not differ materially from our estimates.
At December 31, 2007, we served members who received healthcare benefits through contracts with the regulatory entities in the jurisdictions in which we operate. Four of our contracts individually accounted for 10% or more of our revenues for the year ended December 31, 2007, with the largest of these contracts representing approximately 27% of our revenues. Our state contracts have terms that are generally one- to two-years in length, some of which contain optional renewal periods at the discretion of the individual state. Some contracts also contain a termination clause with notification periods ranging from 30 to 180 days. At the termination of these contracts, re-negotiation of terms or the requirement to enter into a re-bidding or re-procurement process is required to execute a new contract.
Concurrent with the issuance of the Notes, we purchased convertible note hedges covering, subject to customary anti-dilution adjustments, 6,112,964 shares of our common stock. The convertible note hedges allow us to receive shares of our common stock and/or cash equal to the amounts of common stock and/or cash related to the excess conversion value that we would pay to the holders of the Notes upon conversion. These convertible note hedges will terminate at the earlier of the maturity dates of the Notes or the first day on which none of the Notes remain outstanding due to conversion or otherwise. The cost of the convertible note hedges aggregated approximately $52,700.
For the year December 31, 2005, the Company used a projected life for each award granted based on weighted-average historical experience of employees’ exercise behavior. The methods for determining the expected volatility and risk-free interest rate assumptions were the same as those used for the years ended December 31, 2007 and 2006.
In 2005, the Court allowed the State of Illinois and the United States of America to intervene and the plaintiffs were allowed to amend their complaint to add AMERIGROUP Corporation as a party. In the third amended complaint, the plaintiffs alleged that AMERIGROUP Corporation was liable as the alter-ego of AMERIGROUP Illinois, Inc. and that AMERIGROUP Corporation was liable for making false claims or causing false claims to be made.
As a result of the Qui Tam Litigation, it is possible that state or federal governments will subject us to greater regulatory scrutiny, investigation, action, or litigation. We have proactively been in contact with all of the insurance and Medicaid regulators in the states in which we operate as well as the Office of the Inspector General of the Department of Health and Human Services (“OIG”), with respect to the practices at issue in the Qui Tam Litigation. In connection with our discussions with the OIG, we entered into a tolling agreement with the OIG which preserves the rights that the OIG had as of October 30, 2006. Effective October 1, 2007, we entered into an indefinite extension of the tolling agreement which can be terminated by either party upon 90 days written notice. In some circumstances, state or federal governments may move to exclude a company from contracts as a result of a civil verdict under the False Claims Act. We are unable to predict at this time what, if any, further action any state or federal regulators may take. Exclusion is a discretionary step which we believe would not be commenced, if at all, until all appeals had been exhausted. Further, prior to any administrative action or exclusion taking effect, we believe we would have an opportunity to advocate our position. While the circumstances of this case do not appear to warrant such action, exclusion from doing business with the federal or any state governments could have a material adverse effect on our financial position, results of operations or liquidity.