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AMERIGROUP 10-K 2008
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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
 
     
þ
  ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
    For the fiscal year ended December 31, 2007
or
o
  TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
    For the transition period from          to          
 
Commission File Number 001-31574
 
     
Delaware   54-1739323
(State or Other Jurisdiction of Incorporation or Organization)   (I.R.S. Employer Identification No.)
4425 Corporation Lane, Virginia Beach, Virginia
(Address of principal executive offices)
  23462
(Zip Code)
 
Registrant’s telephone number, including area code:
(757) 490-6900
 
Securities registered pursuant to Section 12(b) of the Act:
 
     
Title of Each Class
 
Name of Each Exchange on Which Registered
 
Common Stock, $.01 par value
  New York Stock Exchange
 
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes þ     No o
 
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.  Yes o     No þ
 
Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes þ     No o
 
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this 10-K.  o
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
 
     
Large accelerated filer  þ
  Accelerated filer  o
Non-accelerated filer  o (Do not check if smaller reporting company)
  Smaller reporting company  o
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes o     No þ
 
As of June 30, 2007 the aggregate market value of the registrant’s common stock held by non-affiliates of the registrant was $1,242,453,439.
 
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.
 
     
Class
 
Outstanding at February 15, 2008
 
Common Stock, $.01 par value
  53,487,487
 
Documents Incorporated by Reference
 
     
Document
 
Parts Into Which Incorporated
 
Proxy Statement for the Annual Meeting of Stockholders
to be held May 8, 2008 (Proxy Statement)
  Part III
 


 

 
 
                 
        Page
 
 
    PART I.        
      Business     3  
      Risk Factors     21  
      Unresolved Staff Comments     34  
      Properties     34  
      Legal Proceedings     34  
      Submission of Matters to a Vote of Security Holders     36  
             
        PART II.        
      Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities     38  
      Selected Financial Data     41  
      Management’s Discussion and Analysis of Financial Condition and Results of Operations     42  
      Quantitative and Qualitative Disclosures About Market Risk     59  
      Financial Statements and Supplementary Data     61  
      Changes in and Disagreements with Accountants on Accounting and Financial Disclosure     97  
      Controls and Procedures     97  
      Other Information     98  
             
        PART III.        
      Directors, Executive Officers and Corporate Governance     100  
      Executive Compensation     100  
      Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters     100  
      Certain Relationships and Related Transactions, and Director Independence     100  
      Principal Accountant Fees and Services     101  
             
        PART IV.        
      Exhibits and Financial Statement Schedules     101  


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This Annual Report on Form 10-K, and other information we provide from time-to-time, contains certain “forward-looking” statements as that term is defined by Section 27A of the Securities Act of 1933, as amended (the “Securities Act”), and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). All statements regarding our expected future financial position, membership, results of operations or cash flows, our continued performance improvements, our ability to service our debt obligations and refinance our debt obligations, our ability to finance growth opportunities, our ability to respond to changes in government regulations and similar statements including, without limitation, those containing words such as “believes,” “anticipates,” “expects,” “may,” “will,” “should,” “estimates,” “intends,” “plans” and other similar expressions are forward-looking statements.
 
Forward-looking statements involve known and unknown risks and uncertainties that may cause our actual results in future periods to differ materially from those projected or contemplated in the forward-looking statements as a result of, but not limited to, the following factors:
 
  •  local, state and national economic conditions, including their effect on the rate increase process and timing of payments;
 
  •  the effect of government regulations and changes in regulations governing the healthcare industry;
 
  •  changes in Medicaid and Medicare payment levels and methodologies;
 
  •  liabilities and other claims asserted against us;
 
  •  our ability to attract and retain qualified personnel;
 
  •  our ability to maintain compliance with all minimum capital requirements;
 
  •  the availability and terms of capital to fund acquisitions and capital improvements;
 
  •  the competitive environment in which we operate;
 
  •  our ability to maintain and increase membership levels;
 
  •  demographic changes;
 
  •  increased use of services, increased cost of individual services, epidemics, the introduction of new or costly treatments and technology, new mandated benefits, insured population characteristics and seasonal changes in the level of healthcare use;
 
  •  our inability to operate new products and markets at expected levels, including, but not limited to, profitability, membership and targeted service standards;
 
  •  catastrophes, including acts of terrorism or severe weather; and
 
  •  the unfavorable resolution of pending litigation.
 
Investors should also refer to Item 1A entitled “Risk Factors” for a discussion of risk factors. Given these risks and uncertainties, we can give no assurances that any forward-looking statements will, in fact, transpire and, therefore, caution investors not to place undue reliance on them.


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PART I.
 
Item 1.   Business
 
 
We are a multi-state managed healthcare company focused on serving people who receive healthcare benefits through publicly sponsored programs, including Medicaid, State Children’s Health Insurance Program (“SCHIP”), FamilyCare, and Medicare Advantage. We believe that we are better qualified and positioned than many of our competitors to meet the unique needs of our members and government partners because of our focus, medical management programs and community-based education and outreach programs. We design our programs to address the particular needs of our members, for whom we facilitate access to healthcare benefits pursuant to agreements with the applicable regulatory authority. We combine medical, social and behavioral health services to help our members obtain quality healthcare in an efficient manner. Our success in establishing and maintaining strong relationships with our government partners, providers and members has enabled us to obtain new contracts and to establish and maintain a leading market position in many of the markets we serve.
 
We were incorporated in Delaware on December 9, 1994 as AMERICAID Community Care. Since 1994, we have expanded through developing products and markets, negotiating contracts with various state governments and through the acquisition of health plans. As of December 31, 2007, we provided an array of products to approximately 1,711,000 members in the District of Columbia, Florida, Georgia, Maryland, New Jersey, New York, Ohio, South Carolina, Tennessee, Texas and Virginia.
 
 
 
Based on U.S. Census Bureau data and estimates from the Congressional Budget Office, the United States is expected to have had a population of approximately 300 million and to have spent an estimated $2.3 trillion on healthcare in 2007. Approximately 97 million of that population was covered by state and federal funded healthcare programs, with approximately 42 million covered by the federally funded Medicare program and approximately 55 million covered by the joint federal and state funded Medicaid program. In 2007, estimated Medicare spending was $445 billion and estimated Medicaid spending was $340 billion. Approximately 57% of Medicaid funding comes from the federal government, with the remainder coming from state governments. More than 47 million Americans were uninsured in 2007, spending between $50 and $100 billion for healthcare.
 
By 2017, Medicaid spending is anticipated to be approximately $732 billion at the current rate of growth, with an expectation that spending under the current programs will approach $1 trillion by 2020. Medicaid continues to be one of the fastest-growing and largest components of states’ budgets. Medicaid spending currently represents more than 22%, on average, of a state’s budget and is growing at an average rate of 8% per year. Medicaid spending has surpassed other important state budget line items, including education, transportation and criminal justice. Forty-eight states have balanced budget requirements which means, by law, expenditures cannot exceed revenues. As Medicaid consumes more and more of the states’ limited dollars, states must either increase their tax revenues or reduce their total costs. The states are limited in their ability to increase their tax revenues pointing to cost reduction as the more attainable option. To reduce costs, states can either reduce funds allotted for Medicaid or spend less on other programs, such as education or transportation. As the need for these programs has not abated, state governments must find ways to control rising Medicaid costs. We believe that the most effective way to control rising Medicaid costs is through managed care.
 
 
Medicaid was established, as was Medicare, by the 1965 amendments to the Social Security Act of 1935. The amendments, known collectively as the Social Security Act of 1965, created a joint federal-state program. Medicaid policies for eligibility, services, rates and payment are complex, and vary considerably among states, and the state policies may change from time-to-time.


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States are also permitted by the federal government to seek waivers from certain requirements of the Social Security Act of 1965. In the past decade, partly due to advances in the commercial healthcare field, states have been increasingly interested in experimenting with pilot projects and statewide initiatives to control costs and expand coverage and have done so under waivers authorized by the Social Security Act of 1965 and with the approval of the federal government. The waivers most relevant to us are the Section 1915(b) freedom of choice waivers that enable:
 
  •  mandating Medicaid enrollment into managed care,
 
  •  utilizing a central broker for enrollment into plans,
 
  •  using cost savings to provide additional services, and
 
  •  limiting the number of providers for additional services.
 
Waivers are approved generally for three-year periods and can be renewed on an ongoing basis if the state applies. A 1915(b) waiver cannot negatively impact beneficiary access or quality of care and must be cost-effective. Managed care initiatives may be state-wide and required for all classes of Medicaid eligible recipients, or may be limited to service areas and classes of recipients. With the exception of South Carolina, all jurisdictions in which we operate have some sort of mandatory Medicaid program. However, under the waivers pursuant to which the mandatory programs have been implemented, there must be at least two managed care plans from which Medicaid eligible recipients may choose.
 
Many states operate under a Section 1115 demonstration rather than a 1915(b) waiver. This is a more expansive form of waiver that enables the state to have a Medicaid program that is broader than typically permitted under the Social Security Act of 1965. For example, Maryland’s 1115 waiver allows it to include more individuals in its managed care program than typically allowed under Medicaid.
 
In all the states in which we operate, we must enter into a contract with the state’s Medicaid regulator in order to be a Medicaid managed care organization. States generally use either a formal proposal process, reviewing many bidders, or award individual contracts to qualified applicants that apply for entry to the program. Although other states have done so in the past and may do so in the future, currently the District of Columbia, Florida, Georgia, Ohio, Tennessee and Texas are the only jurisdictions in which we operate that use competitive bidding processes.
 
 
Medicaid makes federal matching funds available to all states for the delivery of healthcare benefits to eligible individuals, principally those with incomes below specified levels who meet other state-specified requirements. Medicaid is structured to allow each state to establish its own eligibility standards, benefits package, payment rates and program administration under broad federal guidelines.
 
Most states determine threshold Medicaid eligibility by reference to other federal financial assistance programs, including Temporary Assistance to Needy Families (“TANF”) and Supplementary Security Income (“SSI”).
 
TANF provides assistance to low-income families with children and was adopted to replace the Aid to Families with Dependent Children program, more commonly known as welfare. Under the Personal Responsibility and Work Opportunity Reconciliation Act of 1996, Medicaid benefits were provided to recipients of TANF during the duration of their enrollment, with one additional year of coverage.
 
SSI is a federal income supplement program that provides assistance to aged, blind and disabled (“ABD”) individuals who have little or no income. However, states can broaden eligibility criteria. The ABD population is approximately 10% of the Medicaid population participating in managed care. For ease of reference, throughout this Form 10-K, we refer to those members who are aged, blind or disabled as ABD, as a number of states use ABD or SSI interchangeably.
 
SCHIP, developed in 1997, is a federal/state matching program that provides healthcare coverage to children not otherwise covered by Medicaid or other insurance programs. SCHIP enables a segment of the large uninsured population in the U.S. to receive healthcare benefits. States have the option of administering SCHIP as a Medicaid


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expansion program, or administratively through their Medicaid programs or as a freestanding program. Current enrollment in this non-entitlement program is approximately six million children and an estimated 500,000 adult parents nationwide.
 
FamilyCare programs have been established in several states including New Jersey, New York, and the District of Columbia. New Jersey FamilyCare, for example, is a voluntary federal and state-funded Medicaid expansion health insurance program created to help uninsured families, single adults and couples without dependent children obtain affordable healthcare coverage.
 
 
Medicare was also created by the Social Security Act of 1965 to provide health care coverage primarily to the Nation’s elderly population. Unlike the federal-state partnership of Medicaid, Medicare is solely a federal program. Under the Medicare Modernization Act of 2003 (“MMA”), the federal government expanded managed care for publicly sponsored programs by allowing Medicare Advantage plans to offer special needs plans. These plans focus on Medicare beneficiaries in three subgroups: those who are institutionalized in long-term care facilities; dual eligibles (those who are eligible for both Medicare and Medicaid benefits); and individuals with chronic conditions. The plans that are organized to provide services to these “special needs individuals” are called Special Needs Plans (“SNPs”). In keeping with our core strategy, we have focused on serving dual eligibles. We believe that the coordination of care offered by managing both the Medicare and Medicaid benefits will bring significant cost savings, while bringing increased accountability for patient care.
 
 
The federal government pays a share of the medical assistance expenditures under each state’s Medicaid program. That share, known as the Federal Medical Assistance Percentage (“FMAP”), is determined annually by a formula that compares the state’s average per capita income level with the national average per capita income level. Thus, states with higher per capita income levels are reimbursed a smaller share of their costs than states with lower per capita income levels.
 
The federal government also matches administrative costs, generally about 50%, although higher percentages are paid for certain activities and functions, such as development of automated claims processing systems. Federal payments have no set limits (other than for SCHIP programs), but rather are made on a matching basis. State governments pay the share of Medicaid and SCHIP costs not paid by the federal government. Some states require counties to pay part of the state’s share of Medicaid costs.
 
During the fiscal year 2007, the federal government estimated spending approximately $192 billion on Medicaid with a corresponding state match of approximately $145 billion, and an additional $5.7 billion in federal funds spent on SCHIP programs. Key factors driving Medicaid spending include:
 
  •  number of eligible individuals who enroll,
 
  •  price of medical and long-term care services,
 
  •  use of covered services,
 
  •  state decisions regarding optional services and optional eligibility groups, and
 
  •  effectiveness of programs to reduce costs of providing benefits, including managed care.
 
Federal law establishes general rules governing how states administer their Medicaid and SCHIP programs. Within those rules, states have considerable flexibility, including flexibility in how they set most provider prices and service utilization controls. Generally, state Medicaid budgets are developed and approved annually by the states’ governors and legislatures. Medicaid expenditures are monitored during the year against budgeted amounts.
 
Nationally, approximately 66% of Medicaid spending is directed toward hospital, physician and other acute care services, and the remaining approximately 34% is for nursing home and other long-term care. In general, inpatient and emergency room utilization tends to be higher within the Medicaid eligible population than among the


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general population because of the inability to afford access to a primary care physician (“PCP”), leading to the postponement of treatment until acute care is required.
 
The Centers for Medicare and Medicaid Services (“CMS”) reimburses the Company and other Medicare plans for care to their enrollees based on individual risk adjustment factors that estimate each member’s expected usage of healthcare services for the upcoming year. These factors are based on the beneficiary’s hospital and physician encounters during the previous year.
 
 
Historically, traditional Medicaid programs made payments directly to providers after delivery of care. Under this approach, recipients received care from disparate sources, as opposed to being cared for in a systematic way. As a result, care for routine needs was often accessed through emergency rooms or not at all.
 
The delivery of episodic healthcare under the traditional Medicaid program limited the ability of states to provide quality care, implement preventive measures and control healthcare costs. Over the past decade, in response to rising healthcare costs and in an effort to ensure quality healthcare, the federal government has expanded the ability of state Medicaid agencies to explore, and, in some cases, mandate the use of managed care for Medicaid beneficiaries. If Medicaid managed care is not mandatory, individuals entitled to Medicaid may choose either the traditional Medicaid program or a managed care plan, if available. According to information published by CMS, from 1996 to 2005, managed care enrollment among Medicaid beneficiaries increased to more than 65% of all enrollees. With the exception of South Carolina, all the markets in which we currently operate have some sort of state-mandated Medicaid managed care programs in place.
 
Currently, we believe that there are three emerging trends in Medicaid. First, certain states have major initiatives underway in our core business areas — reprocurement of the TANF populations currently in managed care, expansions of coverage, and moving existing populations into managed care for the first time.
 
Second, many states are moving to bring the ABD population into managed care. This population represents approximately 25% of all Medicaid beneficiaries and approximately 70% of all costs. The majority of the ABD population is not currently covered by managed care programs and this population represents significant potential for managed care growth as states continue to explore how best to provide health benefits to this population in the most cost effective manner.
 
Third, states are addressing Medicaid reform in an effort to provide healthcare benefits to those who are currently uninsured. As the states continue to explore solutions for this population, the managed care opportunity for growth appears to be significant.
 
 
Our healthcare operations are regulated by numerous, local, state and federal laws and regulations. Government regulation of the provision of healthcare products and services varies from jurisdiction to jurisdiction. Regulatory agencies generally have discretion to issue regulations and interpret and enforce these rules. Changes in applicable state and federal laws and corresponding rules may also occur periodically.
 
 
Our health plan subsidiaries in the District of Columbia, Florida, Georgia, Maryland, New Jersey, South Carolina, Tennessee, Texas, and Virginia are authorized to operate as Health Maintenance Organizations (“HMOs”) and in Ohio as a health insuring corporation (“HIC”) and in New York as a Prepaid Health Services Plan (“PHSP”). In each of the jurisdictions in which we operate, we are regulated by the relevant health, insurance and/or human services departments that oversee the activities of HMOs, HICs, and PHSPs providing or arranging to provide services to Medicaid enrollees.
 
The process for obtaining the authorization to operate as an HMO, HIC or PHSP is lengthy and complicated and requires demonstration to the regulators of the adequacy of the health plan’s organizational structure, financial resources, utilization review, quality assurance programs and complaint procedures. Each of our health plan


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subsidiaries must comply with minimum net worth requirements and other financial requirements, such as minimum capital, deposit and reserve requirements. Under state HMO, HIC and PHSP statutes and state insurance laws, our health plan subsidiaries are required to register and file periodic reports of financial and other information about operations, including inter-company transactions, by insurance companies or health maintenance organizations (in certain jurisdictions) domiciled within their jurisdiction which control or are controlled by other corporations or persons so as to constitute an insurance holding company system.
 
We are registered under such laws as an insurance holding company system in all of the jurisdictions in which we do business. Most states, including states in which our subsidiaries are domiciled, have laws and regulations that require regulatory approval of a change in control of an insurer or an insurer’s holding company. Where such laws and regulations apply to us and our subsidiaries, there can be no effective change in control of the Company unless the person seeking to acquire control has filed a statement with specified information with the insurance regulators and has obtained prior approval for the proposed change from such regulators. The usual measure for a presumptive change of control pursuant to these laws is, with some variation, the acquisition of 10% or more of the voting stock of an insurance company or its parent. In Florida, by agreement with the State, we are subject to a 5% threshold. These laws may discourage potential acquisition proposals and may delay, deter, or prevent a change in control of the Company, including through transactions, and in particular unsolicited transactions, that some or all of our stockholders might consider to be desirable.
 
In addition, such laws and regulations restrict the amount of dividends that may be paid by our subsidiaries to us. Such laws and regulations also require prior approval by the state regulators of certain material transactions with affiliates within the holding company system, including the sale, purchase, or other transfer of assets, loans, guarantees, agreements or investments, as well as certain material transactions with persons who are not affiliates within the holding company system if the transaction exceeds regulatory thresholds.
 
In addition, each health plan must meet numerous criteria to secure the approval of state regulatory authorities before implementing operational changes, including the development of new product offerings and, in some states, the expansion of service areas.
 
In addition to regulation as an insurance holding company system, our business operations must comply with the other state laws and regulations that apply to HMOs, HICs and PHSPs respectively in the states where we operate, and with laws, regulations and contractual provisions governing the respective state Medicaid managed care programs, which are discussed below.
 
 
In all the states in which we operate, we must enter into a contract with the state’s Medicaid regulator in order to be a Medicaid managed care organization. States generally use either a formal proposal process, reviewing many bidders, or award individual contracts to qualified applicants that apply for entry to the program.
 
The contractual relationship with the state is generally for a period of one to two years and renewable on an annual or biannual basis. The contracts with the states and regulatory provisions applicable to us generally set forth in great detail the requirements for operating in the Medicaid sector including provisions relating to:
 
  •  eligibility, enrollment and disenrollment processes,
 
  •  covered services,
 
  •  eligible providers,
 
  •  subcontractors,
 
  •  record-keeping and record retention,
 
  •  periodic financial and informational reporting,
 
  •  quality assurance,
 
  •  marketing,


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  •  financial standards,
 
  •  timeliness of claims’ payment,
 
  •  health education and wellness and prevention programs,
 
  •  safeguarding of member information,
 
  •  fraud and abuse detection and reporting,
 
  •  grievance procedures, and
 
  •  organization and administrative systems.
 
A health plan’s compliance with these requirements is subject to monitoring by state regulators. A health plan is subject to periodic comprehensive quality assurance evaluation by a third-party reviewing organization and generally by the insurance department of the jurisdiction that licenses the health plan. Most health plans must also submit quarterly and annual statutory financial statements and utilization reports, as well as many other reports in accordance with individual state requirements.
 
Our contracts with CMS are calendar year based and are renewed annually, and most recently were renewed as of January 1, 2008.
 
CMS requires that each Medicare Advantage plan meet the regulatory requirements set forth at 42 CFR 422 and the operational requirements described in the Medicare Managed Care (“MMC”) Manual. The MMC Manual provides the detailed requirements that apply to our Medicare line of business including provisions related to:
 
  •  enrollment and disenrollment,
 
  •  marketing,
 
  •  benefits and beneficiary protections,
 
  •  quality assessment,
 
  •  relationships with providers,
 
  •  payment from CMS,
 
  •  premiums and cost-sharing,
 
  •  our contract with CMS,
 
  •  the effect of a change of ownership during the contract period with CMS, and
 
  •  beneficiary grievances, organization determinations, and appeals.
 
CMS provides additional guidance on reporting in separate documents.
 
As a Medicare Advantage Prescription Drug Plan, we are also contractually obligated to meet the requirements outlined in 42 CFR 423 and the Prescription Drug Benefit (“PDB”) Manual. The PDB Manual provides the detailed requirements that apply only to the prescription drug benefits portion of our Medicare line of business. The PDB provides detailed requirements related to:
 
  •  benefits and beneficiary protections,
 
  •  Part D drugs and formulary requirements,
 
  •  marketing (included in the MMC Manual),
 
  •  enrollment and disenrollment guidance,
 
  •  quality improvement and medication therapy management,
 
  •  fraud, waste and abuse,


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  •  coordination of benefits, and
 
  •  Part D grievances, coverage determinations, and appeals.
 
CMS provides additional guidance on the Part D reporting requirements in separate documents.
 
In addition to the requirements outlined above, CMS requires that each Medicare Advantage plan conduct ongoing monitoring of its internal compliance with the requirements as well as oversight of any delegated vendors.
 
 
In accordance with the Health Insurance Portability and Accountability Act of 1996 (“HIPAA”), health plans are required to comply with all HIPAA regulations relating to standards for electronic transactions and code sets (“T&CS”), privacy of health information, security of healthcare information, national provider identifiers, and national employer identifiers.
 
AMERIGROUP implemented its privacy compliance program by April 14, 2003. AMERIGROUP received a two-year privacy accreditation from the Utilization Review Accreditation Commission on November 1, 2003 and has successfully been re-accredited through October 31, 2009. In accordance with CMS guidance regarding compliance with T&CS regulations, AMERIGROUP implemented a T&CS contingency plan in March 2003, and has since acted aggressively to complete implementation of the T&CS regulations, subject to compliance by its trading partners and the various state Medicaid programs. AMERIGROUP complies with the Department of Health and Human Services security regulations as of April 20, 2005 related to protected health information in electronic form and information systems.
 
Implementation of the National Provider Identifier (“NPI”) was originally required by May 27, 2007. During 2007, CMS, together with each state government, deferred the implementation deadline to various dates during 2008 ending on May 23, 2008. We anticipate that we will meet the requirements according to the timelines in each of the states in which we do business during 2008. We do not anticipate significant costs associated with compliance with the NPI.
 
 
Our operations are subject to various state and federal healthcare laws commonly referred to as “fraud and abuse” laws. Investigating and prosecuting healthcare fraud and abuse has become a top priority for state and federal law enforcement entities. The funding of such law enforcement efforts has increased in the past few years and these increases are expected to continue. The focus of these efforts has been directed at participants in public government healthcare programs such as Medicaid and Medicare. These regulations and contractual requirements applicable to participants in these programs are complex and changing.
 
Violations of certain fraud and abuse laws applicable to us may lead to civil monetary penalties, criminal fines and imprisonment, and/or exclusion from participation in Medicare, Medicaid and other federal healthcare programs and federally funded state health programs. These laws include the federal False Claims Act, which prohibits the knowing filing of a false claim or the knowing use of false statements to obtain payment from the federal government. When an entity is determined to have violated the False Claims Act, it must pay three times the actual damages sustained by the government, plus mandatory civil penalties of between $5,500 and $11,000 for each separate false claim. Suits filed under the False Claims Act, known as “qui tam” actions, can be brought by any individual on behalf of the government and such individuals (known as “relators” or, more commonly, as “whistleblowers”) may share in any amounts paid by the entity to the government in fines or settlement. In addition, certain states have enacted laws modeled after the federal False Claims Act. Qui tam actions have increased significantly in recent years, causing greater numbers of healthcare companies to have to defend a false claim action, pay fines or be excluded from the Medicare, Medicaid or other state or federal healthcare programs as a result of an investigation arising out of such action. In addition, the Deficit Reduction Action of 2005 (“DRA”) encourages states to enact state-versions of the False Claims Act that establish liability to the state for false and fraudulent Medicaid claims and that provide for, among other things, claims to be filed by qui tam relators. Although we are a defendant in the Qui Tam Litigation and recently settled the Batty case (described in Item 3


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entitled “Legal Proceedings”), we are currently unaware of any pending or filed but unsealed qui tam actions against us.
 
In recent years, we enhanced the regulatory compliance efforts of our operations, but ongoing vigorous law enforcement and the highly technical regulatory scheme mean that compliance efforts in this area will continue to require substantial resources.
 
 
Unlike many managed care organizations that attempt to serve multiple populations, we focus on serving people who receive healthcare benefits through publicly sponsored programs. We primarily serve Medicaid populations, and the Medicare dual eligible population through our Medicare Advantage product that began January 1, 2006. Beginning January 1, 2008, we expanded our Medicare membership by offering managed care services to additional Medicare enrollees. Our success in establishing and maintaining strong relationships with governments, providers and members has enabled us to obtain new contracts and to establish a strong market position in the markets we serve. We have been able to accomplish this by operating programs that address the various needs of these constituent groups.
 
 
We have been successful in bidding for contracts and implementing new products because of our ability to facilitate access to quality healthcare services in a cost-effective manner. Our education and outreach programs, our disease and medical management programs and our information systems benefit the individuals and communities we serve while providing the government with predictability of cost. Our education and outreach programs are designed to decrease the use of emergency care services as the primary access to healthcare through the provision of certain programs such as member health education seminars and system-wide, 24-hour on-call nurses. Our information systems are designed to measure and track our performance, enabling us to demonstrate the effectiveness of our programs to the government. While we promote ourselves directly in applying for new contracts or seeking to add new benefit plans, we believe that our ability to obtain additional contracts and expand our service areas within a state results primarily from our demonstration of prior success in facilitating access to quality care, while managing and reducing costs, and our customer-focused approach to working with government partners. We believe we will also benefit from this experience when bidding for and acquiring contracts in new state markets and in future Medicare Advantage applications.
 
 
Our providers include hospitals, physicians and ancillary medical programs that provide medical services to our members. In each of the communities where we operate, we have established extensive provider networks and have been successful in continuing to establish new provider relationships. We have accomplished this by working closely with physicians to help them operate efficiently by providing physician and patient educational programs, disease and medical management programs and other relevant information. In addition, as we increase our market penetration, we provide our physicians with a growing base of potential patients in the markets they serve. This network of providers and relationships assists us in implementing preventive care methods, managing costs and improving access to healthcare for members. We believe that our experience working and contracting with Medicaid providers will give us a competitive advantage in entering new markets. While we do not directly market to or through our providers, they are important in helping us attract new members and retain existing members.
 
 
In both enrolling new members and retaining existing members, we focus on understanding the unique needs of the Medicaid, SCHIP, FamilyCare and Medicare Advantage populations. We have developed a system that provides our members with appropriate access to care. We supplement this care with community-based education and outreach programs designed to improve the well-being of our members. These programs not only help our members control and manage their medical care, but also have been proven to decrease the incidence of emergency room care, which can be traumatic, or at a minimum, disruptive for the individual and expensive and inefficient for


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the healthcare system. We also help our members access prenatal care which improves outcomes for our members and is less costly than the potential consequences associated with inadequate prenatal care. As our presence in a market matures, these programs and other value-added services, help us build and maintain membership levels.
 
 
We focus on the members we serve and the communities in which they live. Many of our employees, including our marketing and outreach staff, are a part of the communities we serve. We are active in our members’ communities through education and outreach programs. We often provide programs in our members’ physician offices, churches and community centers. Upon entering a new market, we use these programs and advertising to create brand awareness and loyalty in the community.
 
We believe community focus and understanding are important to attracting and retaining members. To assist in establishing our community presence in a new market, we seek to establish relationships with prestigious medical centers, children’s hospitals, federally qualified health centers, community based organizations and advocacy groups to offer our products and programs.
 
 
Our principal competitors consist of the following:
 
  •  Traditional Fee-for-Service — Original unmanaged provider payment system whereby state governments pay providers directly for services provided to Medicaid and Medicare Advantage members.
 
  •  Primary Care Case Management Programs — Programs established by the states through contracts with PCPs to provide primary care services to the Medicaid recipient, as well as provide limited oversight over other services.
 
  •  Commercial HMOs — National and regional commercial managed care organizations that have Medicaid and Medicare members in addition to members in private commercial plans.
 
  •  Medicaid HMOs — Managed care organizations that focus solely on serving people who receive healthcare benefits through Medicaid.
 
  •  Medicare Coordinated Care Plans — Managed care organizations that focus on serving people who receive healthcare benefits through Medicare. These plans also may include Medicare Part D prescription coverage.
 
  •  Private Fee-For-Service Plans — These organizations provide the standard fee-for-service arrangements of Medicare, but are run by private plans and may or may not include a prescription drug plan.
 
  •  Medicare Prescription Drug Plans — These plans offer Medicare beneficiaries Part D prescription drug coverage only, while members of these plans continue to receive their medical benefits from either another Medicare plan or Medicare Fee-For-Service.
 
We will continue to face varying levels of competition as we expand in our existing service areas or enter new markets. Healthcare reform proposals may cause a number of commercial managed care organizations already in our service areas to decide to enter or exit the publicly sponsored healthcare market.
 
We compete with other managed care organizations to obtain state contracts, as well as to attract new members and to retain existing members. States generally use either a formal procurement process reviewing many bidders or award individual contracts to qualified applicants that apply for entry to the program. In order to be awarded a state contract, state governments consider many factors, which include providing quality care, satisfying financial requirements, demonstrating an ability to deliver services, and establishing networks and infrastructure. People who wish to enroll in a managed healthcare plan or to change healthcare plans typically choose a plan based on the service offered, ease of access to services, a specific provider being part of the network and the availability of supplemental benefits.
 
In addition to competing for members, we compete with other managed care organizations to enter into contracts with independent physicians, physician groups and other providers. We believe the factors that providers


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consider in deciding whether to contract with us include potential member volume, reimbursement rates, our medical management programs, timeliness of reimbursement and administrative service capabilities.
 
 
We offer a range of healthcare products through publicly sponsored programs within a care model that integrates physical and behavioral health. These products are also community-based and seek to address the social and economic issues faced by the populations we serve. Additionally, we seek to establish strategic relationships with prestigious medical centers, children’s hospitals and federally qualified health centers to assist in implementing our products and medical management programs within the communities we serve. The average premiums for our products vary significantly due to differences in the benefits offered and underlying medical conditions of the populations covered.
 
The following table sets forth the approximate number of our members who receive benefits under our products for the periods presented. Dual eligible members are counted in both the Medicare Advantage and Medicaid products when we receive two premiums for those members. Accordingly, membership counts represent an occurrence of payment under our contracts with our government partners.
 
                         
    December 31,  
Product
  2007     2006     2005  
 
TANF (Medicaid)(1)
    1,180,000       910,000       800,000  
SCHIP
    268,000       264,000       197,000  
ABD (Medicaid)(2)
    216,000       94,000       88,000  
FamilyCare (Medicaid)
    42,000       43,000       44,000  
Medicare Advantage (SNP)
    5,000       5,000        
                         
Total
    1,711,000       1,316,000       1,129,000  
                         
 
 
(1) Includes 129,000 members under an Administrative Services Only (“ASO”) contract in Tennessee in 2007.
 
(2) Includes 41,000 and 13,000 members under ASO contracts in Tennessee and Texas, respectively in 2007 and 14,000 and 10,000 members in Texas in 2006 and 2005, respectively.
 
As of December 31, 2007, 87% of our 1,711,000 members were enrolled in TANF, SCHIP and FamilyCare programs. The remaining 13% were enrolled in ABD and Medicare Advantage programs. Approximately 11% of our members receive benefits through ASO contracts.
 
 
We provide specific disease and medical management programs designed to meet the special healthcare needs of our members with chronic illnesses and medical conditions, to manage excessive costs and to improve the overall health of our members. We integrate our members’ behavioral health care with their physical health care utilizing our integrated medical management model. Members are systematically contacted and screened utilizing standardized processes through our early case finding program. Members are stratified based on their physical, behavioral, and social needs and grouped for care management. We offer a continuum of care management including disease management, pharmacy integration, centralized telephonic case management, case management at the health plans, and field-based case management for some of our higher-risk members. These programs focus on preventing acute occurrences associated with chronic conditions by identifying at-risk members, monitoring their conditions and proactively managing their care. These disease management programs also facilitate members in the self management of chronic disease and include asthma, chronic obstructive pulmonary disease, coronary artery disease, congestive heart failure, diabetes, depression, schizophrenia, and HIV/AIDS. These disease management programs attained National Committee for Quality Assurance (“NCQA”) accreditation in 2006. We have a standardized, centralized screening process for incoming pregnant members to detect potentially high risk conditions. High risk members are entered in our high risk prenatal case management program.


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We have a comprehensive quality management plan designed to improve access to cost-effective quality care. We have developed policies and procedures to ensure that the healthcare services arranged by our health plans meet the professional standards of care established by the industry and the medical community. These procedures include:
 
  •  Analysis of healthcare utilization data.  To avoid duplication of services or medications, in conjunction with the PCPs, healthcare utilization data is analyzed and, through comparative provider data and periodic meetings with physicians, we identify areas in which a physician’s utilization rate differs significantly from the rates of other physicians. On the basis of this analysis, we suggest opportunities for improvement and follow-up with the PCP to monitor utilization.
 
  •  Medical care satisfaction studies.  We evaluate the quality and appropriateness of care provided to our health plan members by reviewing healthcare utilization data and responses to member and physician questionnaires and grievances.
 
  •  Clinical care oversight.  Each of our health plans has a medical advisory committee comprised of physician representatives and chaired by the plan’s medical director. This committee reviews credentialing, approves clinical protocols and practice guidelines and evaluates new physician group candidates. Based on regular reviews, the medical directors who head these committees develop recommendations for improvements in the delivery of medical care.
 
  •  Quality improvement plan.  A quality improvement plan is implemented in each of our health plans and is governed by a quality management committee. The quality management committee is comprised of senior management at our health plans, who review and evaluate the quality of our health services and are responsible for the development of quality improvement plans spanning both clinical quality and customer service quality. These plans are developed from provider and membership feedback, satisfaction surveys and results of action plans. Our corporate quality improvement council oversees and meets regularly with our health plan quality management committees to help ensure that we have a coordinated, quality-focused approach relating to our members, providers and state governments.
 
 
We facilitate access to healthcare services for our members through mutually non-exclusive contracts with PCPs, specialists, hospitals and ancillary providers. Either prior to or concurrent with bidding for new contracts, we establish a provider network in each of our service areas. Our provider networks include approximately 82,424 physicians, including PCPs, specialists and ancillary providers, and approximately 638 hospitals across all of our markets in which we are currently providing managed care services.
 
The PCP is a critical component in care delivery, the management of costs and the attraction and retention of new members. PCPs include family and general practitioners, pediatricians, internal medicine physicians, obstetricians and gynecologists. These physicians provide preventive and routine healthcare services and are responsible for making referrals to specialists, hospitals and other providers. Healthcare services provided directly by PCPs include the treatment of illnesses not requiring referrals, periodic physician examinations, routine immunizations, well-child care and other preventive healthcare services.
 
Specialists provide medical care to members generally upon referral by the PCPs. However, we have identified specialists that are part of the ongoing care of our members, such as allergists, oncologists and surgeons, which our members may access directly without first obtaining a PCP referral. Our contracts with both the PCPs and specialists usually are for one- to two-year periods and automatically renew for successive one-year periods subject to termination by us for cause, if necessary, based on provider conduct or other appropriate reasons. The contracts generally can be canceled by either party without cause upon 90 to 120 days prior written notice.
 
Our contracts with hospitals are usually for one- to two-year periods and automatically renew for successive one-year periods. Generally, our hospital contracts may be terminated by either party without cause upon 90 to 120 days prior written notice. Pursuant to the contract, the hospital is paid for all pre-authorized medically necessary inpatient and outpatient services and all covered emergency and medical screening services provided to members. With the exception of emergency services, most inpatient hospital services require advance approval from the


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member’s PCP and our medical management department. We require hospitals in our network to participate in utilization review and quality assurance programs.
 
We have also contracted with other ancillary providers for physical therapy, mental health and chemical dependency care, home healthcare, vision care, diagnostic laboratory tests, x-ray examinations, ambulance services and durable medical equipment. Additionally, we have contracted with dental vendors that provide routine dental care in markets where routine dental care is a covered benefit and with a national pharmacy benefit manager that provides a local pharmacy network in our markets where pharmacy is a covered benefit.
 
In order to ensure the quality of our medical care providers, we credential and re-credential our providers using standards that are supported by the NCQA. Additionally, we provide feedback and evaluations on quality and medical management to them in order to improve the quality of care provided, increase their support of our programs and enhance our ability to attract and retain providers.
 
 
We review the fees paid to providers periodically and make adjustments as necessary. Generally, the contracts with providers do not allow for automatic annual increases in payments. Among the factors generally considered in adjustments are changes to state Medicaid or Medicare fee schedules, competitive environment, current market conditions, anticipated utilization patterns and projected medical expenses.
 
The following are the various provider payment methods in place as of December 31, 2007:
 
Fee-for-Service.  This is a reimbursement mechanism that pays providers based upon services performed. For the year ended December 31, 2007, approximately 98% of our expenses for direct health benefits were on a fee-for-service reimbursement basis, including fees paid to third-party vendors for ancillary services such as pharmacy, mental health, dental and vision benefits. The primary fee-for-service arrangements are maximum allowable fee schedule, per diem, case rates, percent of charges or any combination thereof. The following is a description of each of these mechanisms:
 
  •  Maximum Allowable Fee Schedule.  Providers are paid the lesser of billed charges or a specified fixed payment for a covered service. The maximum allowable fee schedule is developed using, among other indicators, the state fee-for-service Medicaid program fee schedule, Medicare fee schedules, medical costs trends and market conditions.
 
  •  Per Diem and Case Rates.  Hospital facility costs are typically reimbursed at negotiated per diem or case rates, which vary by level of care within the hospital setting. Lower rates are paid for lower intensity services, such as a low birth weight newborn baby who stays in the hospital a few days longer than the mother, compared to higher rates for a neonatal intensive care unit stay for a baby born with severe developmental disabilities.
 
  •  Percent of Charges.  We contract with providers to pay them an agreed-upon percent of their standard charges for covered services. This is typically done where hospitals are reimbursed under the state fee-for-service Medicaid program on a percent of charges basis.
 
Capitation.  Some of our PCPs and specialists are paid on a fixed-fee per member basis, also known as capitation. Our arrangements with ancillary providers for vision, dental, home health, laboratory, and durable medical equipment may also be capitated.
 
 
An important aspect of our comprehensive approach to healthcare delivery is our marketing and educational programs, which we administer system-wide for our providers and members. We often provide education through marketing and educational programs in churches and community centers. The programs we have developed are specifically designed to increase awareness of various diseases, conditions and methods of prevention in a manner that supports the providers, while meeting the unique needs of our members. For example, we conduct health promotion events in physicians’ offices. Direct provider marketing is supported by traditional marketing venues such as direct mail, telemarketing, television, radio and cooperative advertising with participating medical groups.


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We believe that we can also increase and retain membership through marketing and education initiatives. We have a dedicated staff that actively supports and educates prospective and existing members and community organizations. Through programs such as Safe Kids, Power Zone and Taking Care of Baby and Me®, a prenatal program for pregnant mothers and their babies, we promote a healthy lifestyle, safety and good nutrition to our members. In several markets, we provide value-added benefits as a means to attract and retain members. These benefits include free memberships to the local Boys and Girls Clubs and vouchers for over-the-counter medications.
 
We have developed specific strategies for building relationships with key community organizations, which help enhance community support for our products and improve service to our members. We regularly participate in local events and festivals and organize community health fairs to promote healthy lifestyle practices. Equally as important, our employees help support community groups by serving as board members and volunteers. In the aggregate, these activities serve to act not only as a referral channel, but also reinforce the AMERIGROUP brand and foster member loyalty.
 
We also have developed a strategy to bring education and services into the neighborhoods we serve with our Community Outreach Vehicles (“COVs”). The COVs are equipped to allow us to partner with various physicians, health educators and community/government organizations to bring health screenings and other resources into areas that would not typically have access to these services.
 
 
The ability to capture, process and allow local access to data and to translate it into meaningful information is essential to our ability to operate across a multi-state service area in a cost-effective manner. We primarily operate with two claims management applications, AMISYS and FACETS Extended EnterpriseTM administrative system (“FACETS”). We continue to convert our remaining AMISYS markets to our long-term solution, FACETS. This integrated approach helps to assure that consistent sources of claim, provider and member information are provided across all of our health plans. We use these common systems for billing, claims and encounter processing, utilization management, marketing and sales tracking, financial and management accounting, medical cost trending, reporting, planning and analysis. The platform also supports our internal member and provider service functions, including on-line access to member eligibility verification, PCP membership roster, authorization and claims status.
 
In November 2003, we signed a software licensing agreement with The Trizetto Group, Inc. for FACETS. During 2007, we continued to invest in the implementation and testing of FACETS with a staggered conversion to FACETS by health plan that began in 2005 and will continue through 2009. Additionally, all new health plans are implemented using FACETS. As of December 31, 2007, we are processing claims payments for our Georgia, New York, South Carolina, Tennessee and Texas health plans using FACETS which represents claims for approximately 63% of our current full-risk membership. We currently expect that FACETS will meet our software needs and will support our long-term growth strategies.
 
Our Health Plans
 
We currently have ten active health plan subsidiaries offering healthcare services in the District of Columbia, Florida, Georgia, Maryland, New Jersey, New York, Ohio, South Carolina, Tennessee, Texas, and Virginia. Additionally, on January 1, 2008 we began operations in our New Mexico health plan serving Medicare Advantage members.
 
All of our contracts, except those in the District of Columbia, Georgia, New Jersey and New York contain provisions for termination by us without cause generally upon written notice with a 30 to 180 day notification period. Our Maryland contract does not have a set term and can be terminated by us with 90 day written notice.


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As of December 31, 2007, we served members who received healthcare benefits through our contracts with the regulatory entities in the jurisdictions in which we operate. Four of our contracts, which are with the States of Florida, Georgia, Maryland and Texas, individually accounted for 10% or more of our premium revenue for the year ended December 31, 2007, with the largest of these contracts, Texas TANF, SCHIP and ABD, representing approximately 27% of our premium revenue. The following table sets forth the approximate number of our members we served in each state as of December 31, 2007, 2006 and 2005. Because we receive two premiums for members that are in both the Medicare Advantage and Medicaid products, these members have been counted twice in the states of Maryland and Texas where we offer Medicare Advantage plans.
 
                         
    December 31,  
Market
  2007     2006     2005  
 
Texas(1)
    460,000       406,000       399,000  
Tennessee(2)
    356,000              
Georgia
    211,000       227,000        
Florida
    206,000       202,000       219,000  
Maryland
    152,000       145,000       141,000  
New York
    112,000       126,000       138,000  
New Jersey
    98,000       102,000       109,000  
Ohio
    54,000       46,000       22,000  
District of Columbia
    38,000       40,000       41,000  
Virginia
    24,000       22,000       19,000  
South Carolina
                 
Illinois
                41,000  
                         
Total
    1,711,000       1,316,000       1,129,000  
                         
 
 
(1) Included in the Texas membership are approximately 13,000, 14,000, and 10,000 members under an ASO contract in 2007, 2006 and 2005, respectively.
 
(2) Included in the Tennessee membership are approximately 170,000 members under an ASO contract in 2007 commencing with the Memphis Managed Care Corporation (“MMCC”) acquisition effective November 1, 2007.
 
Each of our health plans provides managed care services through one or more of our products, as set forth below:
 
                                         
                            Medicare
 
Market
  TANF     SCHIP     ABD     FamilyCare     Advantage  
 
New Jersey
    ü       ü       ü       ü          
Maryland
    ü       ü       ü               ü  
District of Columbia
    ü       ü               ü          
Texas
    ü       ü       ü               ü  
Florida
    ü       ü       ü                  
New York
    ü       ü       ü       ü          
Virginia
    ü       ü       ü                  
Ohio
    ü       ü       ü                  
Georgia
    ü       ü                          
Tennessee
    ü               ü                  
South Carolina
    ü               ü                  


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Our Texas subsidiary, AMERIGROUP Texas, Inc., is licensed as an HMO and became operational in September 1996. Our current service areas include the cities of Austin, Corpus Christi, Dallas, Fort Worth, Houston and San Antonio and the surrounding counties. As of December 31, 2007, we had approximately 460,000 members in Texas. We believe that we have the largest Medicaid health plan membership of the three health plans in our Fort Worth market, the second largest Medicaid health plan membership of the three health plans in our Austin and Dallas markets, the second largest Medicaid health plan membership of the six health plans in our Houston market and the third largest Medicaid health plan membership of the three health plans in our Corpus Christi and San Antonio markets. Our joint TANF and SCHIP contract and ABD contract are effective through August 31, 2008, with the State’s option to renew for up to an additional eight years.
 
Effective January 1, 2006, AMERIGROUP Texas, Inc. began operations as a Medicare Advantage plan to offer Medicare benefits to dual eligibles that live in and around Houston, Texas. AMERIGROUP Texas, Inc. already served these members through the Texas Medicaid STAR+PLUS program and now offers these members Medicare Parts A & B benefits and the Part D drug benefit under this new contract that renews annually at the option of CMS. Effective January 1, 2008, AMERIGROUP Texas, Inc. expanded its Medicare Advantage offerings to the Houston contiguous counties and San Antonio service areas under a contract that renews annually at the option of CMS.
 
 
Our Tennessee subsidiary, AMERIGROUP Tennessee, Inc., is licensed as an HMO and became operational in April 2007. As of December 31, 2007, we had approximately 356,000 members in Tennessee including approximately 170,000 members under an ASO contract that began November 1, 2007 with the acquisition of MMCC. We cover approximately half of the risk membership in the Middle Tennessee region with the remaining half covered by one other health plan. Our risk contract with the State of Tennessee expires on June 30, 2008, with the State’s option to extend the contract on an annual basis through an executed contract amendment. We anticipate that the State will renew our contract effective July 1, 2008. Our ASO contract with the State of Tennessee expires on December 31, 2008. The State released the request for proposal for a full-risk contract in the West Tennessee region with an expected implementation date of November 2008. Additionally, effective January 1, 2008, AMERIGROUP Tennessee, Inc. began operating a Medicare Advantage plan for eligibles in Tennessee under a contract that renews annually at the option of CMS.
 
 
Our Georgia subsidiary, AMGP Georgia Managed Care Company, Inc., is licensed as an HMO and became operational in June 2006 in the Atlanta Region, and three additional regions in September 2006 in the North, East, and Southeast. As of December 31, 2007, we had approximately 211,000 members in Georgia. We believe we have the third largest Medicaid health plan membership of the three health plans in Georgia. Our TANF and SCHIP contract with the State of Georgia expires on June 30, 2008, with the State’s option to renew the contract for four additional one-year terms. We anticipate that the State will renew our contract effective July 1, 2008.
 
 
Our Florida subsidiary, AMERIGROUP Florida, Inc., is licensed as an HMO and became operational in January 2003. As of December 31, 2007, we had approximately 206,000 members in Florida. Our current service areas include the metropolitan areas of Miami/Fort Lauderdale, Orlando and Tampa that covers 17 counties in Florida. We believe that we have the second largest Medicaid health plan membership of the eleven health plans in our Miami/Ft. Lauderdale markets, the second largest Medicaid health plan membership of the five health plans in our Tampa market and the third largest Medicaid health plan membership of the four health plans in our Orlando market. The TANF Non-Reform contract expires on August 31, 2009 and the TANF Reform contract (Broward County) expires June 30, 2009. The TANF Reform contract is a contract under the State’s Medicaid Reform pilot program. The TANF contracts can be terminated by either party upon 30 days notice. Our Long-Term Care contract was renewed in September 2007 and expires August 31, 2008. However, either party can terminate the contract upon 60 days notice. Currently, we are in good standing with the Department of Elder Affairs, the agency with regulatory oversight of the Long-Term Care program, and have no reason to believe that the contract will not be


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renewed. Our SCHIP contract, executed in October 2006 extends through September 30, 2008. The Florida Healthy Kids Corporation, the agency with regulatory oversight of the SCHIP program, has entered into a reprocurement process for the contract period to begin October 1, 2008. Additionally, effective January 1, 2008, AMERIGROUP Florida, Inc. began operating a Medicare Advantage plan for eligibles in Florida under a contract that renews annually at the option of CMS.
 
 
Our District of Columbia subsidiary, AMERIGROUP Maryland, Inc., is licensed as an HMO in both Maryland and the District of Columbia and became operational in Maryland in June 1999. Our current service areas include 21 of the 24 counties in Maryland. As of December 31, 2007, we had approximately 152,000 members in Maryland. We believe that we have the largest Medicaid health plan membership of the seven health plans in our Maryland service areas. Our contract with the State of Maryland does not have a set term. We can terminate our contract with Maryland by notifying the State by October 1st of any given year for an effective termination date of January 1st of the following year. The State may waive this timeframe if the circumstances warrant, including but not limited to reduction in rates outside the normal rate setting process or an MCO exit from the program. Effective January 1, 2007, we began operations as a Medicare Advantage plan for eligibles in Maryland, which we expanded as of January 1, 2008 under a contract that renews annually at the option of CMS.
 
 
Our New York subsidiary, AMERIGROUP New York, LLC, formerly known as CarePlus, LLC, is licensed as a PHSP in New York. The State’s service areas include New York City, within the boroughs of Brooklyn, Manhattan, Queens and Staten Island, and Putnam County and became operational in January 2005. Effective March 1, 2007, we entered into amended TANF contracts with the State and City of New York expanding our service areas to the Bronx borough. The State TANF, ABD and FamilyCare contracts are for a term of three years (through September 30, 2008) with the State Department of Health’s option to extend for an additional two-year term. The City’s TANF contract with the City Department of Health has been extended through September 30, 2009. Our SCHIP contract with the State has been continued through the issuance of a five-year contract dated January 1, 2008. Our contract with the Department of Health under the Managed Long-Term Care Demonstration project was renewed for a three-year term through December 31, 2009. As of December 31, 2007, we had approximately 112,000 members in New York. We believe we have the seventh largest Medicaid health plan membership of the nineteen health plans in our New York service areas. Additionally, effective January 1, 2008, AMERIGROUP New York, LLC began operating a Medicare Advantage plan for eligibles in New York under a contract that renews annually at the option of CMS.
 
 
Our New Jersey subsidiary, AMERIGROUP New Jersey, Inc., is licensed as an HMO and became operational in February 1996. Our current service areas include 20 of the 21 counties in New Jersey. As of December 31, 2007, we had approximately 98,000 members in our New Jersey service areas. We believe that we have the third largest Medicaid health plan membership of the five health plans in our New Jersey service areas. Our contract with the State of New Jersey expires on June 30, 2008, with the State’s option to extend the contract on an annual basis through an executed contract amendment. We anticipate that the State will renew our contract effective July 1, 2008. Additionally, effective January 1, 2008, AMERIGROUP New Jersey, Inc. began operating a Medicare Advantage plan for eligibles in New Jersey under a contract that renews annually at the option of CMS.
 
 
Our Ohio subsidiary, AMERIGROUP Ohio, Inc., is licensed as a HIC and began operations in September 2005 in the Cincinnati service area. Through a reprocurement process in early 2006, we were successful in retaining our Cincinnati service area and expanding to the Dayton service area, thereby servicing a total of 16 counties in Ohio. Effective February 1, 2007, AMERIGROUP Ohio, Inc., began serving members in Medicaid’s ABD program in the Southwest Region of Ohio which includes eight counties near Cincinnati. As of December 31, 2007, we had approximately 54,000 members in Ohio. We believe we have the second largest Medicaid health plan membership


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of the four health plans in our Ohio service areas. Our contract with the State of Ohio expires on June 30, 2008. We anticipate the State will renew our contract effective July 1, 2008.
 
 
Our District of Columbia subsidiary, AMERIGROUP Maryland, Inc., is licensed as an HMO and became operational in the District of Columbia in August 1999. As of December 31, 2007, we had approximately 38,000 members in the District of Columbia. We believe that we have the second largest Medicaid health plan membership of the three health plans in our service areas in the District of Columbia. Our contract with the District of Columbia extends through April 30, 2008 which we anticipate will be extended to the implementation date of awards under the reprocurement process that the District of Columbia began in the first quarter of 2007. We anticipate notifications of awards will be provided in mid-2008 with a contract implementation date in mid-to-late 2008.
 
 
Our Virginia subsidiary, AMERIGROUP Virginia, Inc., is licensed as an HMO and began operations in September 2005 serving 11 counties in Northern Virginia. As of December 31, 2007, we had approximately 24,000 members in Virginia. We believe we have the second largest Medicaid health plan membership of the three health plans in our Northern Virginia service area. Our TANF, ABD, and SCHIP contracts with the Commonwealth of Virginia expire on June 30, 2008. We anticipate the State will renew our contract effective July 1, 2008.
 
 
Our South Carolina subsidiary, AMERIGROUP South Carolina, Inc., is licensed as an HMO and became operational in November 2007. Our contract with the State of South Carolina expires on March 31, 2008, with the State’s option to extend the contract on an annual basis through an executed contract amendment. A contract has been drafted and we anticipate that the State will renew our contract effective April 1, 2008.
 
 
Our former Illinois subsidiary, AMERIGROUP Illinois, Inc., allowed its contract with the Illinois Department of Healthcare and Family Services to terminate July 31, 2006. The termination of this contract did not have a material impact on the financial position, results of operations or liquidity of the Company.
 
 
As of December 31, 2007, we had approximately 4,200 employees. Our employees are not represented by a union. We believe our relationships with our employees are generally good.
 
 
We file annual, quarterly and current reports, proxy statements and all amendments to these reports and other information with the U.S. Securities and Exchange Commission (“SEC”). You may read and copy any materials we file with the SEC at the SEC’s Public Reference Room at 100 F Street, NE, Room 1580, Washington, DC 20549. You may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The SEC maintains an Internet site that contains reports, proxy and information statements, and other information regarding issuers that file electronically with the SEC and the address of that site is (http://www.sec.gov). We make available free of charge on or through our website at www.amerigroupcorp.com our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, all amendments to those reports as soon as reasonably practicable after such material is electronically filed with or furnished to the SEC, our Corporate Governance Principles, our Audit, Compensation and Nominating and Corporate Governance charters and our Code of Business Conduct and Ethics. Further, we will provide, without charge upon written request, a copy of our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and all amendments to those reports. Requests for copies should be addressed to Investor Relations, AMERIGROUP Corporation, 4425 Corporation Lane, Virginia Beach, VA 23462.


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In accordance with New York Stock Exchange (“NYSE”) Rules, on June 8, 2007, we filed the annual certification by our Chief Executive Officer certifying that he was unaware of any violation by us of the NYSE’s corporate governance listing standards at the time of the certification.


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Item 1A.   Risk Factors
 
RISK FACTORS
 
Risks related to being a regulated entity
 
 
Our business is extensively regulated by the states in which we operate and by the federal government. These laws and regulations are generally intended to benefit and protect providers and health plan members rather than the Company and its stockholders. Changes in existing laws and rules, the enactment of new laws and rules and changing interpretations of these laws and rules could, among other things:
 
  •  force us to change how we do business,
 
  •  restrict revenue and enrollment growth,
 
  •  increase our health benefits and administrative costs,
 
  •  impose additional capital requirements, and
 
  •  increase or change our claims liability.
 
 
We principally operate through our health plan subsidiaries. These subsidiaries are subject to regulations that limit the amount of dividends and distributions that can be paid to us without prior approval of, or notification to, state regulators. We also have administrative services agreements with our subsidiaries in which we agree to provide them with services and benefits (both tangible and intangible) in exchange for the payment of a fee. Some states limit the administrative fees which our subsidiaries may pay. For example, Ohio limits administrative fees paid to an affiliate to the cost of providing the services. If the regulators were to deny our subsidiaries’ requests to pay dividends to us or restrict or disallow the payment of the administrative fee or not allow us to recover the costs of providing the services under our administrative services agreement or require a significant change in the timing or manner in which we recover those costs, the funds available to our Company as a whole would be limited, which could harm our ability to implement our business strategy, expand our infrastructure, improve our information technology systems, make needed capital expenditures, service our debt and negatively impact our liquidity.
 
 
Our New Jersey and Maryland subsidiaries as well as our SCHIP product in Florida are subject to minimum medical expense levels as a percentage of premium revenue. Our Florida subsidiary is subject to minimum behavioral health expense levels as a percentage of behavioral health premium revenues. In New Jersey, Maryland and Florida, premium revenue recoupment may occur if these levels are not met. In addition, our Ohio subsidiary is subject to certain limits on administrative costs and our Virginia subsidiary is subject to a limit on profits. These regulatory requirements, changes in these requirements and additional requirements by our other regulators could limit our ability to increase or maintain our overall profits as a percentage of revenues, which could harm our operating results. We have been required, and may in the future be required, to make payments to the states as a result of not meeting these expense levels. Additionally, we could be required to file a corrective plan of action with the states and we could be subject to fines and additional corrective action measures if we did not comply with the corrective plan of action. Our failure to comply could also affect future rate determinations and membership enrollment levels. These limitations could negatively impact our revenues and operating results.
 
Our Texas health plan is required to pay an experience rebate to the State of Texas in the event profits exceed established levels. We file experience rebate calculation reports with the State for this purpose. These reports are subject to audits and if the audit results in unfavorable adjustments to our filed reports, our results of operations and liquidity could be negatively impacted.


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Our contracts with our government partners contain certain provisions regarding data submission, provider network maintenance, quality measures, continuity of care, call center performance and other requirements specific to state and program regulations. If we fail to comply with these requirements, we may be subject to fines, penalties and liquidated damages that could impact our profitability. Additionally, we could be required to file a corrective plan of action with the state and we could be subject to fines, penalties and liquidated damages and additional corrective action measures if we did not comply with the corrective plan of action. Our failure to comply could also affect future membership enrollment levels. These limitations could negatively impact our revenues and operating results.
 
In December 2006, our New Jersey subsidiary received a notice of deficiency for failure to meet provider network requirements in several New Jersey counties as required by our Medicaid contract with New Jersey. To date, we have not received notice of any final determination regarding our compliance with provider network requirements or possible fines and penalties. If we are unable to materially satisfy the provider network requirements, the State of New Jersey could impose fines and penalties that could have a material impact on our financial results.
 
 
We are subject to numerous local, state and federal laws and regulations. Violation of the laws or regulations governing our operations could result in the imposition of sanctions, the cancellation of our contracts to provide services, or in the extreme case, the suspension or revocation of our licenses. We can give no assurance that the terms of our contracts with the states or the manner in which we are directed to comply with our state contracts is in accordance with CMS regulations.
 
We cannot give any assurance that we will not be subject to material fines or other sanctions in the future. If we became subject to material fines or if other sanctions or other corrective actions were imposed upon us, our ability to continue to operate our business could be materially and adversely affected. From time-to-time we have been subject to sanctions as a result of violations of marketing regulations. Although we train our employees with respect to compliance with local, state and federal laws of each of the states in which we do business, no assurance can be given that violations will not occur.
 
We contract with various state governmental agencies to provide managed health care services. Pursuant to these contracts, we are subject to various reviews, audits and investigations to verify our compliance with the contracts and applicable laws and regulations. Any adverse review, audit or investigation could result in any of the following: refunds of premiums we have been paid pursuant to our contracts; imposition of fines, penalties and other sanctions; loss of our right to participate in various markets; or loss of one or more of our licenses.
 
We are, or may become subject to, various state and federal laws designed to address healthcare fraud and abuse, including false claims laws. State and federal laws prohibit the submission of false claims and other acts that are considered fraudulent or abusive. The submission of claims to a state or federal healthcare program for items and services that are determined to be “not provided as claimed” may lead to the imposition of civil monetary penalties, criminal fines and imprisonment, and/or exclusion from participation in state and federally funded healthcare programs, including the Medicare and Medicaid programs.
 
DRA requires all entities that receive $5.0 million or more in annual Medicaid funds to establish specific written policies for their employees, contractors, and agents regarding various false claims-related laws and whistleblower protections under such laws as well as provisions regarding their polices and procedures for detecting and preventing fraud, waste and abuse. These requirements are conditions of receiving all future payments under the Medicaid program. Entities were required to comply with the compliance related provisions of the DRA by January 1, 2007. The federal government provided limited guidance regarding acceptable measures of compliance in late December 2006. We believe that we have made appropriate efforts to meet the requirements of the compliance provisions of the DRA. However, if it is determined that we have not met the requirements


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appropriately, we could be subject to civil penalties and/or be barred from receiving future payments under the Medicaid programs in the states in which we operate thereby materially adversely affecting our business, results of operation and financial condition.
 
HIPAA broadened the scope of fraud and abuse laws applicable to healthcare companies. HIPAA created civil penalties for, among other things, billing for medically unnecessary goods or services. HIPAA establishes new enforcement mechanisms to combat fraud and abuse, including a whistle-blower program. Further, HIPAA imposes civil and criminal penalties for failure to comply with the privacy and security standards set forth in the regulation. No private cause of action under HIPAA has yet been created, and we do not know when or if such changes may be enacted.
 
The federal government has enacted, and state governments are enacting, other fraud and abuse laws as well. Our failure to comply with HIPAA or these other laws could result in criminal or civil penalties and exclusion from Medicaid or other governmental healthcare programs and could lead to the revocation of our licenses. These penalties or exclusions, were they to occur, would negatively impact our ability to operate our business.
 
The Sarbanes-Oxley Act of 2002 requires that we maintain effective internal control over financial reporting. In particular, we must perform system and process evaluation and testing of our internal control over financial reporting to allow management to report on, and our independent registered public accounting firm to attest to, our internal control over our financial reporting as required by Section 404 of the Sarbanes-Oxley Act of 2002. Our testing, or the subsequent testing by our independent registered public accounting firm, may reveal deficiencies in our internal control over financial reporting that are deemed to be material weaknesses. If we are not able to continue to comply with the requirements of Section 404 in a timely manner, or if we or our independent registered public accounting firm identifies deficiencies in our internal control over financial reporting that are deemed to be material weaknesses, the market price of our stock could decline and we could be subject to sanctions or investigations by the NYSE, the SEC or other regulatory authorities, which would require additional financial and management resources.
 
 
Numerous proposals relating to changes in healthcare law have been introduced, some of which have been passed by Congress and the states in which we operate or may operate in the future. These include Medicaid reform initiatives in Florida, as well as waivers requested by states for various elements of their programs. Changes in applicable laws and regulations are continually being considered and interpretations of existing laws and rules may also change from time-to-time. We are unable to predict what regulatory changes may occur or what effect any particular change may have on our business. Although some changes in government regulations, such as the removal of the requirements on the enrollment mix between commercial and public sector membership, have encouraged managed care participation in public sector programs, we are unable to predict whether new laws or proposals will continue to favor or hinder the growth of managed healthcare.
 
We cannot predict the outcome of these legislative or regulatory proposals, nor the effect which they might have on us. Legislation or regulations that require us to change our current manner of operation, provide additional benefits or change our contract arrangements could seriously harm our operations and financial results.
 
 
Most of our revenues come from state government Medicaid premiums. The base premium rate paid by each state differs, depending on a combination of various factors such as defined upper payment limits, a member’s health status, age, gender, county or region, benefit mix and member eligibility category. Future levels of Medicaid premium rates may be affected by continued government efforts to contain medical costs and may further be affected by state and federal budgetary constraints. Changes to Medicaid programs could reduce the number of persons enrolled or eligible, reduce the amount of reimbursement or payment levels, or increase our administrative or healthcare costs under such programs. States periodically consider reducing or reallocating the amount of money they spend for Medicaid. We believe that additional reductions in Medicaid payments could substantially reduce our profitability. Further, our contracts with the states are subject to cancellation by the state in the event of


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unavailability of state funds. In some jurisdictions, such cancellation may be immediate and in other jurisdictions a notice period is required.
 
State governments generally are experiencing tight budgetary conditions within their Medicaid programs. Budget problems in the states in which we operate could result in limited increases or even decreases in the premiums paid to us by the states. If any state in which we operate were to decrease premiums paid to us, or pay us less than the amount necessary to keep pace with our cost trends, it could have a material adverse effect on our profitability.
 
 
As of 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, which are with the States of Florida, Georgia, Maryland and Texas, individually accounted for 10% or more of our premium revenue for the year ended December 31, 2007, with the largest of these contracts, Texas, representing approximately 27% of our premium revenue. If any of our contracts were not renewed on favorable terms or were terminated for cause, our business would suffer. All of our material contracts have been extended until at least mid-2008. Termination or non-renewal of any single contract could materially impact our revenues and operating results.
 
Some of our contracts are subject to a re-bidding or re-application process. For example, our Texas markets are re-bid every six years (and were last re-bid in 2005), the District of Columbia market was re-bid in 2007 with award notification expected in 2008 and Florida SCHIP contracts are undergoing a re-bid for an October 2008 effective date. If we lost a contract through the re-bidding process, or if an increased number of competitors were awarded contracts in a specific market, our operating results could be materially and adversely affected.
 
 
In any program start-up, expansion, or re-bid, the state’s ability to manage the implementation as designed may be affected by factors beyond our control. These include political considerations, network development, contract appeals, membership assignment/allocation for members who do not self-select, and errors in the bidding process, as well as difficulties experienced by other private vendors involved in the implementation, such as enrollment brokers. Our business, particularly plans for expansion or increased membership levels, could be negatively impacted by these delays or changes.
 
 
States may only mandate Medicaid enrollment into managed care under federal waivers or demonstrations. Waivers and programs under demonstrations are approved for two-year periods and can be renewed on an ongoing basis if the state applies. We have no control over this renewal process. If a state does not renew its mandated program or the federal government denies the state’s application for renewal, our business would suffer as a result of a likely decrease in membership.
 
 
Premium payments to us are based upon eligibility lists produced by government enrollment data. From time-to-time, governments require us to reimburse them for premiums paid to us based on an eligibility list that a government later discovers contains individuals who are not in fact eligible for a government sponsored program or have been enrolled twice in the same program or are eligible for a different premium category or a different program. Alternatively, a government could fail to pay us for members for whom we are entitled to receive payment. Our results of operations would be adversely affected as a result of such reimbursement to the government if we had made related payments to providers and were unable to recoup such payments from the providers.


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Our operations are conducted through our wholly-owned subsidiaries, which include HMOs, one HIC and one PHSP. HMOs, HICs, and PHSPs are subject to state regulations that, among other things, require the maintenance of minimum levels of statutory capital and the maintenance of certain financial ratios (which are referred to as risk based capital requirements), as defined by each state. Certain states also require performance bonds or letters of credit from our subsidiaries. Additionally, state regulatory agencies may require, at their discretion, individual regulated entities to maintain statutory capital levels higher than the state regulations. If this were to occur or other requirements change for one of our subsidiaries, we may be required to make additional capital contributions to the affected subsidiary. Any additional capital contribution made to one of the affected subsidiaries could have a material adverse effect on our liquidity and our ability to grow.
 
Risks related to our business
 
 
In 2002, Cleveland A. Tyson (the “Relator”), a former employee of our former Illinois subsidiary, AMERIGROUP Illinois, Inc., filed a federal and state Qui Tam or whistleblower action against our former Illinois subsidiary. The complaint was captioned the United States of America and the State of Illinois, ex rel., Cleveland A. Tyson v. AMERIGROUP Illinois, Inc. (the “Qui Tam Litigation”). The complaint was filed in the U.S. District Court for the Northern District of Illinois, Eastern Division (the “Court”). It alleged that AMERIGROUP Illinois, Inc. submitted false claims under the Medicaid program by maintaining a scheme to discourage or avoid the enrollment into the health plan of pregnant women and other recipients with special needs.
 
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.
 
On November 22, 2006, the Court entered an initial judgment in the amount of $48.0 million and we subsequently filed motions for a new trial and remittur and for judgment as a matter of law and the plaintiffs filed motions to treble the civil judgment, impose the maximum fines and penalties and to assess attorney’s fees, costs and expenses against us. The trial began on October 4, 2006, and the case was submitted to the jury on October 27, 2006. On October 30, 2006, the jury returned a verdict against us and AMERIGROUP Illinois, Inc. in the amount of $48.0 million which under applicable law would be trebled to $144.0 million plus penalties, and attorney’s fees, costs and expenses. The jury also found that there were 18,130 false claims. The statutory penalties allowable under the False Claims Act range between $5,500 and $11,000 per false claim. The statutory penalties allowable under the Illinois Whistleblower Reward and Protection Act, 740 ILC 175/3, range between $5,000 and $10,000 per false claim.
 
On March 13, 2007, the Court entered a judgment against AMERIGROUP Illinois, Inc., and AMERIGROUP Corporation in the amount of approximately $334.0 million which includes the trebling of damages and false claim penalties. Under the Federal False Claims Act, the counsel for the Relator is entitled to collect their attorney’s fees, costs and expenses in the event the Relator’s claim is successful. On April 3, 2007, we delivered an irrevocable letter of credit in the amount of $351.3 million, which includes estimated interest on the judgment for one year, to the Clerk of Court for the U.S. District Court for the Northern District of Illinois, Eastern District to stay the enforcement of the judgment pending appeal. On May 11, 2007 we filed a notice of appeal with the United States Court of Appeals for the Seventh Circuit. On September 6, 2007, pursuant to a joint stipulation and order, we caused to be posted with the Court a surety bond in the amount of $8.4 million as the attorney’s fees, costs and expenses that Relator’s counsel would receive in the event the Plaintiffs prevail on the appeal. On September 17, 2007 we filed our memorandum of law in support of our appeal with the Court of Appeals. On December 17, 2007, the United States of America and the State of Illinois filed a joint brief, and the Relator filed a brief, in response to our memorandum of law. We have until February 29, 2008, to file our reply to these briefs with the Court of Appeals, which we


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intend to do. Following filing this brief, we expect the Court of Appeals to set a date for oral arguments prior to rendering a decision. While we do not control this timeline, it is possible the Court of Appeals could render a decision as early as summer 2008, but there is no assurance that the decision will not occur at an earlier or later date.
 
Although it is possible that the ultimate outcome of the Qui Tam Litigation judgment will not be favorable to us, the amount of loss, if any, is uncertain. Accordingly, we have not recorded any amounts in the Consolidated Financial Statements for unfavorable outcomes, if any, as a result of the Qui Tam Litigation judgment. There can be no assurances that the ultimate outcome of this matter will not have a material adverse effect on our financial position, results of operations or liquidity.
 
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.
 
It is also possible that plaintiffs in other states could bring similar litigation against us. While we believe that the practices at issue in the Qui Tam Litigation have not occurred outside of the operations of our former Illinois subsidiary, AMERIGROUP Illinois, Inc., a verdict in favor of a plaintiff in similar litigation in another state could have a material adverse effect on our financial position, results of operations or liquidity.
 
As participants in state and federal health care programs, we are subject to extensive fraud and abuse laws which may give rise to frequent lawsuits and claims against us, and the outcome of these lawsuits and claims may have a material adverse effect on our financial position, results of operations and liquidity.
 
Our operations are subject to various state and federal healthcare laws commonly referred to as “fraud and abuse” laws, including the federal False Claims Act. The federal False Claims Act prohibits any person from knowingly presenting, or causing to be presented for payment, a false or fraudulent claim for payment to the federal government. Suits filed under the False Claims Act, known as “qui tam” actions, can be brought by any individual (known as a “relator” or, more commonly, “whistleblower”) on behalf of the government. Qui tam actions have increased significantly in recent years, causing greater numbers of healthcare companies to have to defend a false claim action, pay fines or be excluded from the Medicare, Medicaid or other state or federal healthcare programs as a result of an investigation arising out of such action. In addition, the DRA encourages states to enact state-versions of the False Claims Act that establish liability to the state for false and fraudulent Medicaid claims and that provide for, among other things, claims to be filed by qui tam relators. Although we believe we are in substantial compliance with the health care laws applicable to our Company, we are currently a defendant in the Qui Tam Litigation and we can give no assurances that we will not be subject to additional False Claims Act suits in the future. Any violations of any of applicable fraud and abuse laws or any False Claims Act suit against us could have a material adverse effect on our financial position, results of operations and cash flows.
 
 
Most of our revenues are generated by premiums consisting of fixed monthly payments per member. These premiums are fixed by contract, and we are obligated during the contract period to facilitate access to healthcare


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services as established by the state governments. We have less control over costs related to the provision of healthcare than we do over our selling, general and administrative expenses. Historically, our reported expenses related to health benefits as a percentage of premium revenue have fluctuated. For example, our expenses related to health benefits were 83.1% of our premium revenue in 2007, and 81.1% of our premium revenue in 2006. If health benefits costs increase at a higher rate than premium increases, our earnings would be impacted negatively. In addition, if there is a significant delay in our receipt of premiums to offset previously incurred health benefits costs increases, our earnings could be negatively impacted.
 
Premiums are contractually payable to us before or during the month for services that we are obligated to provide to our members. Our cash flow would be negatively impacted if premium payments are not made according to contract terms.
 
 
Our profitability depends, to a significant degree, on our ability to predict and effectively manage medical costs. Changes in healthcare regulations and practices, level of use of healthcare services, hospital costs, pharmaceutical costs, major epidemics, new medical technologies and other external factors, including general economic conditions such as inflation levels or natural disasters, are beyond our control and could reduce our ability to predict and effectively control the costs of healthcare services. Although we attempt to manage medical costs through a variety of techniques, including various payment methods to primary care physicians and other providers, advance approval for hospital services and referral requirements, medical management and quality management programs, and our information systems and reinsurance arrangements, we may not be able to manage costs effectively in the future. In addition, new products or new markets, such as Tennessee, South Carolina and New Mexico, could pose new and unexpected challenges to effectively manage medical costs. It is possible that there could be an increase in the volume or value of appeals for claims previously denied and claims previously paid to non-network providers will be appealed and subsequently reprocessed at higher amounts. This would result in an adjustment to claims expense. If our costs for medical services increase, our profits could be reduced, or we may not remain profitable.
 
We maintain reinsurance to help protect us against severe or catastrophic medical claims, but we can provide no assurance that such reinsurance coverage will be adequate or available to us in the future or that the cost of such reinsurance will not limit our ability to obtain it.
 
 
Our medical expenses include estimates of claims that are yet to be received, or incurred but not reported (“IBNR”). We estimate our IBNR medical expenses based on a number of factors, including authorization data, prior claims experience, maturity of markets, complexity and mix of products and stability of provider networks. Adjustments, if necessary, are made to medical expenses in the period during which the actual claim costs are ultimately determined or when underlying assumptions or factors used to estimate IBNR change. In addition to using our internal resources, we utilize the services of independent actuaries who are contracted on a routine basis to calculate and review the adequacy of our medical liabilities. We cannot be sure that our current or future IBNR estimates are adequate or that any further adjustments to such IBNR estimates will not harm or benefit our results of operations. Further, our inability to accurately estimate IBNR may also affect our ability to take timely corrective actions, further exacerbating the extent of the harm on our results. Though we employ substantial efforts to estimate our IBNR at each reporting date, we can give no assurance that the ultimate results will not materially differ from our estimates resulting in a material increase or decrease in our health benefits expenses in the period such difference is determined. New products or new markets, such as Tennessee, South Carolina and New Mexico could pose new and unexpected challenges to effectively predict medical costs.
 
 
In underwriting new business opportunities we must estimate future medical expenses. We utilize a range of information and develop numerous assumptions. The information we use can often include, but is not limited to,


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historical cost data, population demographics, experience from other markets, trend assumptions and other general underwriting factors. The information we utilize may be inadequate or not applicable and our assumptions may be incorrect. If our underwriting estimates are incorrect our cost experience could be materially different than expected. If costs are higher than expected, our operating results could be adversely affected.
 
 
Historically, acquisitions including the acquisition of Medicaid contract rights and related assets of other health plans, both in our existing service areas and in new markets, have been a significant factor in our growth. Although we cannot predict our rate of growth as the result of acquisitions with complete accuracy, we believe that acquisitions similar in nature to those we have historically executed will continue to contribute to our growth strategy. Many of the other potential purchasers of these assets have greater financial resources than we have. In addition, many of the sellers are interested in either (1) selling, along with their Medicaid assets, other assets in which we do not have an interest; or (2) selling their companies, including their liabilities, as opposed to just the assets of the ongoing business. Therefore, we cannot be sure that we will be able to complete acquisitions on terms favorable to us or that we can obtain the necessary financing for these acquisitions.
 
We are currently evaluating potential acquisitions that would increase our membership, as well as acquisitions of complementary healthcare service businesses. These potential acquisitions are at various stages of consideration and discussion and we may enter into letters of intent or other agreements relating to these proposals at any time. However, we cannot predict when or whether we will actually acquire these businesses.
 
We are generally required to obtain regulatory approval from one or more state agencies when making acquisitions. In the case of an acquisition of a business located in a state in which we do not currently operate, we would be required to obtain the necessary licenses to operate in that state. In addition, although we may already operate in a state in which we acquire a new business, we would be required to obtain the necessary licenses to operate in that state. In addition, although we may already operate in a state in which we acquire new business, we would be required to obtain additional regulatory approval if, as a result of the acquisition, we will operate in an area of the state in which we did not operate previously. There can be no assurance that we would be able to comply with these regulatory requirements for an acquisition in a timely manner, or at all.
 
Our existing credit facility imposes certain restrictions on acquisitions. We may become subject to more limitations under any future credit facility. We may not be able to meet these restrictions.
 
In addition to the difficulties we may face in identifying and consummating acquisitions, we will also be required to integrate our acquisitions with our existing operations. This may include the integration of:
 
  •  additional employees who are not familiar with our operations,
 
  •  existing provider networks, which may operate on different terms than our existing networks,
 
  •  existing members, who may decide to switch to another healthcare provider, and
 
  •  disparate information and record keeping systems.
 
We may be unable to successfully identify, consummate and integrate future acquisitions, including integrating the acquired businesses on to our technology platform, or to implement our operations strategy in order to operate acquired businesses profitably. We also may be unable to obtain sufficient additional capital resources for future acquisitions. There can be no assurance that incurring expenses to acquire a business will result in the acquisition being consummated. These expenses could impact our selling, general and administrative expense ratio. If we are unable to effectively execute our acquisition strategy or integrate acquired businesses, our future growth will suffer and our results of operations could be harmed.
 
 
Start-up costs associated with a new business can be substantial. For example, in order to obtain a certificate of authority and obtain a state contract in most jurisdictions, we must first establish a provider network, have systems


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in place and demonstrate our ability to be able to process claims. If we were unsuccessful in obtaining the necessary license, winning the bid to provide service or attracting members in numbers sufficient to cover our costs, the new business would fail. We also could be obligated by the state to continue to provide services for some period of time without sufficient revenue to cover our ongoing costs or recover start-up costs. The costs associated with starting up the business could have a significant impact on our results of operations. In addition, if the new business does not operate at underwritten levels, our profitability could be harmed.
 
 
We have experienced rapid growth. In 1997, we had $64.9 million of premium revenue. In 2007, we had $3.9 billion in premium revenue. This increase represents a compounded annual growth rate of 50.5%.
 
Depending on acquisitions and other opportunities, we expect to continue to grow rapidly. Continued growth could place a significant strain on our management and on other resources. We anticipate that continued growth, if any, will require us to continue to recruit, hire, train and retain a substantial number of new and highly skilled medical, administrative, information technology, finance and other support personnel. Our ability to compete effectively depends upon our ability to implement and improve operational, financial and management information systems on a timely basis and to expand, train, motivate and manage our work force. If we continue to experience rapid growth, our personnel, systems, procedures and controls may be inadequate to support our operations, and our management may fail to anticipate adequately all demands that growth will place on our resources. In addition, due to the initial costs incurred upon the acquisition of new businesses, rapid growth could adversely affect our short-term profitability. Our inability to manage growth effectively or our inability to grow could have a negative impact on our business, operating results and financial condition.
 
 
We compete for members principally on the basis of size and quality of provider network, benefits provided and quality of service. We compete with numerous types of competitors, including other health plans and traditional state Medicaid programs that reimburse providers as care is provided. Some of the health plans with which we compete have substantially larger enrollments, greater financial and other resources and offer a broader scope of products than we do.
 
While many states mandate health plan enrollment for Medicaid eligible participants including all of those in which we do business except for South Carolina, the programs are voluntary in other states. Subject to limited exceptions by federally approved state applications, the federal government requires that there be a choice for Medicaid recipients among managed care programs. Voluntary programs and mandated competition will impact our ability to increase our market share.
 
In addition, in most states in which we operate we are not allowed to market directly to potential members, and therefore, we rely on creating name brand recognition through our community-based programs. Where we have only recently entered a market or compete with health plans much larger than we are, we may be at a competitive disadvantage unless and until our community-based programs and other promotional activities create brand awareness.
 
 
On March 26, 2007, we entered in to a Credit and Guaranty Agreement (the “Credit Agreement”) which provides, among other things, for commitments of up to $401.3 million consisting of (i) up to $351.3 million of financing under a senior secured synthetic letter of credit facility and (ii) up to $50.0 million of financing under a senior secured revolving credit facility. The Credit Agreement terminates on March 15, 2012. We initially borrowed $351.3 million under the senior secured synthetic letter of credit facility of the Credit Agreement. Shortly thereafter, we repaid $221.3 million of such borrowings with the proceeds from the issuance of the 2% Convertible Senior Notes. As a result, pursuant to the terms of the Credit Agreement, unless later amended by the parties, the


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commitments under the senior secured synthetic letter of credit facility were permanently reduced to $130.0 million and total commitments under the Credit Agreement were permanently reduced to $180.0 million.
 
The proceeds of the Credit Agreement are available to (i) facilitate an appeal, payment or settlement of the judgment in the Qui Tam Litigation, (ii) repay in full certain existing indebtedness, (iii) pay related transaction costs, fees, commissions and expenses, and (iv) provide for 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%. The applicable interest rate was 7.0% at December 31, 2007. 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 Credit Agreement includes customary covenants and events of default. If any event of default occurs and is continuing, the Credit Agreement may be terminated and all amounts owing there under may become immediately due and payable. The Credit Agreement also includes the following financial covenants: (i) maximum leverage ratios as of specified periods, (ii) a minimum interest coverage ratio and (iii) a minimum statutory net worth ratio. The Credit Agreement also imposes acquisition limitations that restrict our ability to make certain acquisitions above specified values. As a result of these restrictions and covenants, our financial and operating flexibility may be negatively impacted.
 
Borrowings under the Credit Agreement are secured by substantially all of our assets and the assets of our wholly-owned subsidiary, PHP Holdings, Inc., including the stock of each of our respective wholly-owned managed care subsidiaries, in each case, subject to carve-outs.
 
As of December 31, 2007, we had $129.0 million outstanding under the senior secured synthetic letter of credit facility of our Credit Agreement. These funds are held in restricted investments as partial collateral for an irrevocable letter of credit in the amount of $351.3 million, issued to the Clerk of Court for the U.S. District Court for the Northern District of Illinois, Eastern Division. The irrevocable letter of credit was provided to the court for the purpose of staying the enforcement of the judgment in the Qui Tam Litigation pending resolution of our appeal. As of December 31, 2007, we had no outstanding borrowings but have caused to be issued irrevocable letters of credit in the aggregate face amount of $35.6 million under the senior secured revolving credit facility of our Credit Agreement. We incurred offering expenses totaling $4.8 million in connection with the Credit Agreement which are included in other long-term assets in the accompanying Condensed Consolidated Financial Statements and are being amortized over the term of the Credit Agreement.
 
Events beyond our control, such as prevailing economic conditions and changes in the competitive environment, could impair our operating performance, which could affect our ability to comply with the terms of the Credit Agreement. Breaching any of the covenants or restrictions could result in the unavailability of the Credit Agreement or a default under the Credit Agreement. We can provide no assurance that our assets or cash flows will be sufficient to fully repay outstanding borrowings under the Credit Agreement or that we would be able to restructure such indebtedness on terms favorable to us. If we were unable to repay, refinance or restructure our indebtedness under the Credit Agreement, the lenders could proceed against the collateral expected to secure the indebtedness.
 
 
Our debt service obligation on the 2.0% Convertible Senior Notes is approximately $5.2 million per year in interest payments. Our debt service obligations on the Credit Agreement includes interest at the adjusted Eurodollar rate plus 2.0% or the base rate plus 1.0% and annual principal payments equal to 1.0% of the outstanding principal of the term loan. The applicable interest rate was 7.0% at December 31, 2007.
 
If we are unable to generate sufficient cash to meet these obligations and must instead use our existing cash or investments, we may have to reduce, curtail or terminate other activities of our business. Additionally, the Credit Agreement includes provisions that may limit our ability to incur additional indebtedness.


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We intend to fulfill our debt service obligations from cash generated by our operations, if any, and from our existing cash and investments. A substantial portion of our cash flows from operations will have to be dedicated to interest and principal payments and may not be available for operations, working capital, capital expenditures, expansion, acquisitions or general corporate or other purposes. Our capital structure may impair our ability to obtain additional financing in the future and may limit our flexibility in planning for, or reacting to, changes in our business and industry; and it may make us more vulnerable to downturns in our business, our industry or the economy in general.
 
Our operations may not generate sufficient cash to enable us to service our debt. If we fail to make a debt service obligation payments, we could be in default of both the Credit Agreement and the 2.0% Convertible Senior Notes.
 
 
U.S. generally accepted accounting principles (“GAAP”) and related implementation guidelines and interpretations can be highly complex and involve subjective judgments. Changes in these rules or their interpretation, the adoption of new pronouncements or the application of existing pronouncements to our business could significantly affect our results of operations.
 
For example, in August 2007, the Financial Accounting Standards Board (“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 $260.0 million 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. Further, we cannot predict the outcome of this process or any other changes in GAAP that may affect accounting for convertible debt securities. Any change in the accounting method for convertible debt securities could have an adverse impact on our results of operations.
 
 
As of February 20, 2008, $104.4 million of our total $202.7 million in short-term investments were comprised of municipal note investments with an auction reset feature (“auction rate securities”). These notes are issued by various state and local municipal entities for the purpose of financing student loans, public projects and other activities; they carry a AAA credit rating. Liquidity for these auction rate securities is typically provided by an auction process which allows holders to sell their notes and resets the applicable interest rate at pre-determined intervals, usually every 28 or 35 days. Recently, auctions for some of these auction rate securities have failed and there is no assurance that auctions on the remaining auction rate securities in our investment portfolio will continue to succeed. An auction failure means that the parties wishing to sell their securities could not be matched with an adequate volume of buyers. In the event that there is a failed auction the indenture governing the security requires the issuer to pay interest at a contractually defined rate that is generally above market rates for other types of similar short-term instruments. The securities for which auctions have failed will continue to accrue interest at the contractual rate and be auctioned every 28 or 35 days until the auction succeeds, the issuer calls the securities, or they mature. As a result, our ability to liquidate and fully recover the carrying value of our auction rate securities in the near term may be limited or not exist. All of these investments are currently classified as short-term investments but these developments may result in the classification of some or all of these securities as long-term investments in our consolidated financial statements in the future.


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If the issuers of these auction rate securities are unable to successfully close future auctions and their credit ratings deteriorate, we may in the future be required to record an impairment charge on these investments. We may be required to wait until market stability is restored for these instruments or until the final maturity of the underlying notes (up to 33 years) to realize our investments’ recorded value.
 
 
We contract with providers as a means to assure access to health care services for our members, to manage health care costs and utilization, and to better monitor the quality of care being delivered. In any particular market, providers could refuse to contract with us, demand higher payments, or take other actions which could result in higher health care costs, disruption to provider access for current members, or difficulty in meeting regulatory or accreditation requirements.
 
Our profitability depends, in large part, upon our ability to contract on favorable terms with hospitals, physicians and other healthcare providers. Our provider arrangements with our primary care physicians and specialists usually are for one- to two-year periods and automatically renew for successive one-year terms, subject to termination by us for cause based on provider conduct or other appropriate reasons. The contracts generally may be canceled by either party upon 90 to 120 days prior written notice. Our contracts with hospitals are usually for one- to two-year periods and automatically renew for successive one-year periods, subject to termination for cause due to provider misconduct or other appropriate reasons. Generally, our hospital contracts may be canceled by either party without cause on 90 to 150 days prior written notice. There can be no assurance that we will be able to continue to renew such contracts or enter into new contracts enabling us to service our members profitably. We will be required to establish acceptable provider networks prior to entering new markets. Although we have established long-term relationships with many of our providers, we may be unable to enter into agreements with providers in new markets on a timely basis or under favorable terms. If we are unable to retain our current provider contracts or enter into new provider contracts timely or on favorable terms, our profitability will be harmed. In some markets, certain providers, particularly hospitals, physician/hospital organizations and some specialists, may have significant market positions. If these providers refuse to contract with us or utilize their market position to negotiate favorable contracts to themselves, our profitability could be adversely affected.
 
Some providers that render services to our members are not contracted with our plans (non-network providers). In those cases, there is no pre-established understanding between the non-network provider and the plan about the amount of compensation that is due to the provider. In some states, with respect to certain services, the amount that the plan must pay to non-network providers of compensation is defined by law or regulation, but in certain instances it is either not defined or it is established by a standard that is not clearly translatable into dollar terms. In such instances non-network providers may believe they are underpaid for their services and may either litigate or arbitrate their dispute with the plan. The uncertainty of the amount to pay and the possibility of subsequent adjustment of the payment could adversely affect our financial position, results of operations or liquidity.
 
We are required to establish acceptable provider networks prior to entering new markets and to maintain such networks as a condition to continued operation in those markets. If we are unable to retain our current provider networks or establish provider networks in new markets in a timely manner or on favorable terms, our profitability could be harmed. Further if we are unable to retain our current provider networks, we may be subject to material fines, penalties or sanctions by our state partners.
 
 
In the past, the managed care industry has received negative publicity. This publicity has led to increased legislation, regulation, review of industry practices and private litigation in the commercial sector. These factors may adversely affect our ability to market our services, require us to change our services and increase the regulatory burdens under which we operate, further increasing the costs of doing business and adversely affecting our operating results.


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Our providers and employees involved in medical care decisions may be exposed to the risk of medical malpractice claims. Some states have passed or are considering legislation that permits managed care organizations to be held liable for negligent treatment decisions or benefits coverage determinations and or eliminate the requirement that certain providers carry a minimum amount of professional liability insurance. This kind of legislation has the effect of shifting the liability for medical decisions or adverse outcomes to the managed care organization. This could result in substantial damage awards against us and our providers that could exceed the limits of any applicable insurance coverage. Therefore, successful malpractice or tort claims asserted against us, our providers or our employees could adversely affect our financial condition and profitability.
 
In addition, we may be subject to other litigation that may adversely affect our business or results of operations. We maintain errors and omissions insurance and such other lines of coverage as we believe are reasonable in light of our experience to date. However, this insurance may not be sufficient or available at a reasonable cost to protect us from liabilities that might adversely affect our business or results of operations. Even if any claims brought against us were unsuccessful or without merit, we would still have to defend ourselves against such claims. Any such defenses may be time-consuming and costly, and may distract our management’s attention. As a result, we may incur significant expenses and may be unable to effectively operate our business.
 
 
We are currently involved in certain legal proceedings, including the Qui Tam Litigation, and, from time to time, we may be subject to additional legal claims. We may suffer an unfavorable outcome as a result of one or more claims, resulting in the depletion of capital to pay defense costs or the costs associated with any resolution of such matters. Depending on the costs of litigation and the amount and timing of any unfavorable resolution of claims against us, our financial position, results of operations or cash flows could be materially adversely affected.
 
In addition, we may be subject to securities class action litigation from time to time due to, among other things, the volatility of our stock price. When the market price of a stock has been volatile, regardless of whether such fluctuations are related to the operating performance of a particular company, holders of that stock have sometimes initiated securities class action litigation against such company. Any class action litigation against us could cause us to incur substantial costs, divert the time and attention of our management and other resources, or otherwise harm our business.
 
 
Historically, the number of persons eligible to receive Medicaid benefits has increased more rapidly during periods of rising unemployment, corresponding to less favorable general economic conditions. However, during such economic downturns, state budgets could decrease, causing states to attempt to cut healthcare programs, benefits and rates. If this were to happen while our membership was increasing, our results of operations could suffer. Conversely, the number of persons eligible to receive Medicaid benefits may grow more slowly or even decline if economic conditions improve, thereby causing our operating results to suffer. In either case, in the event that the Company experiences a change in product mix to less profitable product lines, our profitability could be negatively impacted.
 
 
Our operations are significantly dependent on effective information systems. The information gathered and processed by our information systems assists us in, among other things, monitoring utilization and other cost factors, processing provider claims and providing data to our regulators. Our providers also depend upon our information systems for membership verifications, claims status and other information.


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In November 2003, we signed a software licensing agreement with Trizetto Group Inc. for FACETS. During 2007, we continued to invest in the implementation and testing of FACETS with a staggered conversion to FACETS by health plan that began in 2005 and will continue through 2009. As of December 31, 2007, we are processing claims payments for our Georgia, New York, South Carolina, Tennessee and Texas health plans using FACETS. We estimate that our legacy claims payment system will have a useful life into 2010. We currently expect that FACETS will meet our software needs and will support our long-term growth strategies. However, if we cannot execute a successful system conversion for our remaining health plans, our operations could be disrupted, which would have a negative impact on our profitability and our ability to grow could be harmed.
 
Our information systems and applications require continual maintenance, upgrading and enhancement to meet our operational needs. Moreover, our acquisition activity requires frequent transitions to or from, and the integration of, various information systems. We are continually upgrading and expanding our information systems capabilities. If we experience difficulties with the transition to or from information systems or are unable to properly maintain or expand our information systems, we could suffer, among other things, from operational disruptions, loss of existing members and difficulty in attracting new members, regulatory problems and increases in administrative expenses.
 
 
Our profitability depends, to a significant degree, on our ability to predict and effectively manage medical costs. If an act or acts of terrorism or a natural disaster (such as a major hurricane) or a medical epidemic were to occur in markets in which we operate, our business could suffer. The results of terrorist acts or natural disasters could lead to higher than expected medical costs, network and information technology disruptions, and other related factors beyond our control, which would cause our business to suffer. A widespread epidemic in a market could cause a breakdown in the medical care delivery system which could cause our business to suffer.
 
Item 1B.   Unresolved Staff Comments
 
None.
 
Item 2.   Properties
 
We do not own any real property. We lease office space in Virginia Beach, Virginia, where our primary headquarters, call, claims and data centers are located. We also lease real property in each of the health plan locations. We are obligated by various insurance and Medicaid regulatory authorities to have offices in the service areas where we provide managed care services.
 
Item 3.   Legal Proceedings
 
 
In 2002, Cleveland A. Tyson (the “Relator”), a former employee of our former Illinois subsidiary, AMERIGROUP Illinois, Inc., filed a federal and state Qui Tam or whistleblower action against our former Illinois subsidiary. The complaint was captioned the United States of America and the State of Illinois, ex rel., Cleveland A. Tyson v. AMERIGROUP Illinois, Inc. (the “Qui Tam Litigation”). The complaint was filed in the U.S. District Court for the Northern District of Illinois, Eastern Division (the “Court”). It alleged that AMERIGROUP Illinois, Inc. submitted false claims under the Medicaid program by maintaining a scheme to discourage or avoid the enrollment into the health plan of pregnant women and other recipients with special needs.
 
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.
 
On November 22, 2006, the Court entered an initial judgment in the amount of $48.0 million and we subsequently filed motions for a new trial and remittur and for judgment as a matter of law and the plaintiffs filed motions to treble the civil judgment, impose the maximum fines and penalties and to assess attorney’s fees, costs


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and expenses against us. The trial began on October 4, 2006, and the case was submitted to the jury on October 27, 2006. On October 30, 2006, the jury returned a verdict against us and AMERIGROUP Illinois, Inc. in the amount of $48.0 million which under applicable law would be trebled to $144.0 million plus penalties, and attorney’s fees, costs and expenses. The jury also found that there were 18,130 false claims. The statutory penalties allowable under the False Claims Act range between $5,500 and $11,000 per false claim. The statutory penalties allowable under the Illinois Whistleblower Reward and Protection Act, 740 ILC 175/3, range between $5,000 and $10,000 per false claim.
 
On March 13, 2007, the Court entered a judgment against AMERIGROUP Illinois, Inc., and AMERIGROUP Corporation in the amount of approximately $334.0 million which includes the trebling of damages and false claim penalties. Under the Federal False Claims Act, the counsel for the Relator is entitled to collect their attorney’s fees, costs and expenses in the event the Relator’s claim is successful. On April 3, 2007, we delivered an irrevocable letter of credit in the amount of $351.3 million, which includes estimated interest on the judgment for one year, to the Clerk of Court for the U.S. District Court for the Northern District of Illinois, Eastern District to stay the enforcement of the judgment pending appeal. On May 11, 2007 we filed a notice of appeal with the United States Court of Appeals for the Seventh Circuit. On September 6, 2007, pursuant to a joint stipulation and order, we caused to be posted with the Court a surety bond in the amount of $8.4 million as the attorney’s fees, costs and expenses that Relator’s counsel would receive in the event the Plaintiffs prevail on the appeal. On September 17, 2007 we filed our memorandum of law in support of our appeal with the Court of Appeals. On December 17, 2007, the United States of America and the State of Illinois filed a joint brief, and the Relator filed a brief, in response to our memorandum of law. We have until February 29, 2008, to file our reply to these briefs with the Court of Appeals, which we intend to do. Following filing this brief, we expect the Court of Appeals to set a date for oral arguments prior to rendering a decision. While we do not control this timeline, it is possible the Court of Appeals could render a decision as early as summer 2008, but there is no assurance that the decision will not occur at an earlier or later date.
 
Although it is possible that the ultimate outcome of the Qui Tam Litigation judgment will not be favorable to us, the amount of loss, if any, is uncertain. Accordingly, we have not recorded any amounts in the Condensed Consolidated Financial Statements for unfavorable outcomes, if any, as a result of the Qui Tam Litigation judgment. There can be no assurances that the ultimate outcome of this matter will not have a material adverse effect on our financial position, results of operations or liquidity.
 
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.
 
It is also possible that plaintiffs in other states could bring similar litigation against us. While we believe that the practices at issue in the Qui Tam Litigation have not occurred outside of the operations of our former Illinois subsidiary, AMERIGROUP Illinois, Inc., a verdict in favor of a plaintiff in similar litigation in another state could have a material adverse effect on our financial position, results of operations or liquidity.
 
 
In March 2005, Colleen Batty, a former employee of our former Illinois subsidiary, AMERIGROUP Illinois, Inc., filed a federal and state Qui Tam or whistleblower complaint under seal against us and our former Illinois


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subsidiary AMERIGROUP Illinois, Inc. in the District Court in the Northern District of Illinois. The action, which is styled United States of America ex. rel. Colleen Batty, State of Illinois ex. rel. Colleen Batty and Colleen Batty, individually v. AMERIGROUP Illinois, Inc. and AMERIGROUP Corporation, was unsealed in May 2007. Ms. Batty’s complaint alleged, among other things, that AMERIGROUP Illinois, Inc. submitted false claims under the Medicaid program by underpaying certain hospitals in connection with emergency services delivered in out-of-network settings. The federal government and the State of Illinois declined to intervene in the suit. Ms. Batty’s complaint also alleged wrongful discharge of her employment in violation of the False Claims Act and the Illinois Whistleblower and Protection Act. Ms. Batty’s complaint sought: (i) an unspecified amount of compensatory damages under the False Claims Act and Illinois Whistleblower and Protection Act, which damages, if any, would be trebled under applicable law; (ii) statutory penalties allowable under the False Claims Act which range between $5,500 and $11,000 per false claim and statutory penalties allowable under the Illinois Whistleblower Reward and Protection Act, which range between $5,000 and $10,000 per false claim; and (iii) reinstatement to her job, two years’ back pay and compensatory damages. On August 31, 2007 we filed a motion with the Court to dismiss Ms. Batty’s claims. On December 21, 2007, the Court entered an order (the “Order”) granting our motion to dismiss all claims brought by Ms. Batty. The Order dismissed with prejudice all of the federal and state Qui Tam claims asserted by Ms. Batty under the False Claims Act and the Illinois Whistleblower Reward and Protection Act. The Order also dismissed without prejudice the wrongful discharge claims asserted by Ms. Batty. On January 15, 2008, we reached a confidential final settlement of Ms. Batty’s wrongful discharge claims which did not have a material effect on our results of operations. On February 11, 2008, the Court entered an order dismissing the case with prejudice.
 
Item 4.   Submission of Matters to a Vote of Security Holders
 
None.
 
 
Our executive officers, their ages and positions as of February 15, 2008, are as follows:
 
             
Name
 
Age
 
Position
 
James G. Carlson
    55     President and Chief Executive Officer
James W. Truess
    42     Executive Vice President and Chief Financial Officer
Stanley F. Baldwin
    59     Executive Vice President, General Counsel and Secretary
Catherine S. Callahan
    50     Executive Vice President
Nancy L. Grden
    56     Executive Vice President and Chief Marketing Officer
William T. Keena
    48     Executive Vice President, Support Operations
John E. Littel
    43     Executive Vice President, External Relations
Mary T. McCluskey, M.D. 
    49     Executive Vice President and Chief Medical Officer
Margaret M. Roomsburg
    48     Senior Vice President and Chief Accounting Officer
Leon A. Root, Jr. 
    54     Executive Vice President and Chief Information Officer
Linda K. Whitley-Taylor
    44     Executive Vice President, Associate Services
Richard C. Zoretic
    49     Executive Vice President and Chief Operating Officer
 
James G. Carlson joined us in April of 2003 and serves as our President and Chief Executive Officer. From April 2003 to August 2007, Mr. Carlson was our President and Chief Operating Officer. He has served on our Board of Directors since July 2007. Prior to joining AMERIGROUP, Mr. Carlson was an Executive Vice President of UnitedHealth Group and President of its UnitedHealthcare business unit, which served more than 10 million members in HMO and PPO plans nationwide. Prior to joining us, Mr. Carlson co-founded Workscape, Inc. in 1999, a privately held provider of benefits and workforce management solutions, for which he also served as Chief Executive Officer and a Director.
 
James W. Truess joined us in July 2006 as Executive Vice President and Chief Financial Officer. Mr. Truess has more than 18 years in the managed care industry, including the last 10 years as a chief financial officer. Prior to


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joining AMERIGROUP, Mr. Truess served as Chief Financial Officer and Treasurer of Group Health Cooperative from 2000 to 2006. Mr. Truess is a CFA charterholder.
 
Stanley F. Baldwin joined us in 1997 and serves as our Executive Vice President, General Counsel and Secretary. Mr. Baldwin is licensed to practice law in Virginia, Tennessee and Texas. Prior to joining the Company, Mr. Baldwin served as a senior officer and general counsel of Epic Holdings, Inc., EQUICOR — Equitable HCA Corporation and CIGNA Healthplans, Inc.
 
Catherine S. Callahan joined us in 1999 and serves as Executive Vice President. From 1999 to January 2008, Ms. Callahan served as our Executive Vice President, Associate Services. Ms. Callahan has more than 25 years of experience in human resources and administration. Prior to joining AMERIGROUP, Ms. Callahan was the Executive Vice President and Chief Administrative Officer for FHC Health Systems, Inc., parent company of ValueOptions, Inc. In 2007, Ms. Callahan has announced her retirement, which will become effective in the second quarter of 2008.
 
Nancy L. Grden joined us in 2001 and serves as our Executive Vice President and Chief Marketing Officer. Ms. Grden was Founder and President of Avenir, LLC, providing consulting and interim executive services to new ventures, as well as Chief Executive Officer for Lifescape, LLC, a web-based behavioral health services company for employers and providers. Ms. Grden also served as Executive Vice President and Chief Marketing Officer for FHC Health Systems, parent company of ValueOptions, Inc. Previously, Ms. Grden was Executive Vice President, Marketing Services for NationsBank, before the firm became part of Bank of America.
 
William T. Keena joined us in April 2006 and serves as our Executive Vice President, Support Operations. Prior to joining AMERIGROUP, Mr. Keena was a consultant for Accenture from August 2005 to April 2006. Prior to that, Mr. Keena served as Senior Vice President for Concentra, Inc. from January 2004 to October 2004 and as Senior Vice President Health Plan Operations for Wellcare Healthplan, Inc. from 2002 to 2003.
 
John E. Littel joined us in 2001 and serves as our Executive Vice President, External Relations. Mr. Littel has worked in a variety of positions within state and federal governments, as well as for non-profit organizations and political campaigns. Mr. Littel served as the Deputy Secretary of Health and Human Resources for the Commonwealth of Virginia. On the federal level, he served as the director of intergovernmental affairs for The White House’s Office of National Drug Control Policy. Mr. Littel also held the position of Associate Dean and Associate Professor of Law and Government at Regent University. Mr. Littel is licensed to practice law in the State of Pennsylvania.
 
Mary T. McCluskey, M.D. joined us in September 2007 as Executive Vice President and Chief Medical Officer. Prior to joining AMERIGROUP, Dr. McCluskey served in a variety of senior medical positions with Aetna Inc. since 1999, most recently as Chief Medical Officer, Northeast Region. Her previous positions at Aetna included National Medical Director/Head of Clinical Cost Management and Senior Regional Medical Director, Southeast Region.
 
Margaret M. Roomsburg joined us in 1996 and has served as Controller since 1999. Effective February 1, 2007, Ms. Roomsburg was named Senior Vice President and Chief Accounting Officer. Ms. Roomsburg is a certified public accountant. Prior to joining AMERIGROUP, Ms. Roomsburg was the Director of Finance for Value Options, Inc.
 
Leon A. Root, Jr. joined us in May 2002 as a Senior Vice President and Chief Technology Officer and has served as our Executive Vice President and Chief Information Officer since June 2003. Prior to joining AMERIGROUP, Mr. Root served as Chief Information Officer at Medunite, Inc., a private e-commerce company founded by Aetna, Cigna, PacifiCare Health Systems and five other national managed care companies.
 
Linda K. Whitley-Taylor joined us in January 2008 and serves as our Executive Vice President, Associate Services. Prior to joining AMERIGROUP, Ms. Whitley-Taylor was Senior Vice President, Human Resources Operations with Genworth Financial, where she was employed for nineteen years.
 
Richard C. Zoretic joined us in September of 2003 and serves as our Executive Vice President and Chief Operating Officer. From November 2005 to August 2007, he served as Executive Vice President, Health Plan Operations; and from September 2003 to November 2005, Mr. Zoretic was our Chief Marketing Officer. Prior to joining AMERIGROUP, Mr. Zoretic served as Senior Vice President of Network Operations and Distributions at CIGNA Dental Health from February 2003 to August 2003. Previously, he served in a variety of leadership positions at UnitedHealthcare, including Regional Operating President of United’s Mid-Atlantic operations and Senior Vice President of Corporate Sales and Marketing.


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Item 5.   Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
 
Our common stock has been listed on the New York Stock Exchange (“NYSE”) under the symbol “AGP” since January 3, 2003. From November 6, 2001 until January 2, 2003, our common stock was quoted on the NASDAQ National Market under the symbol “AMGP.” Prior to November 6, 2001, there was no public market for our common stock.
 
On December 14, 2004, we announced a two-for-one split of our common stock. The stock split was in the form of a one hundred percent stock dividend of one share of common stock for every share of common stock issued and outstanding. The stock dividend was distributed on January 18, 2005, to our shareholders of record on December 31, 2004.
 
The following table sets forth the range of high and low sales prices for our common stock for the period indicated.
 
                 
    High     Low  
 
2006
               
First quarter
  $ 23.31     $ 18.84  
Second quarter
    32.69       20.30  
Third quarter
    33.07       27.40  
Fourth quarter
    37.15       27.87  
2007
               
First quarter
  $ 39.44     $ 29.63  
Second quarter
    32.95       23.35  
Third quarter
    35.38       23.40  
Fourth quarter
    38.39       32.85  
December 31, 2007 Closing Sales Price
  $ 36.45          
 
On February 15, 2008, the last reported sales price of our common stock was $37.36 per share as reported on the NYSE. As of February 15, 2008, we had 61 shareholders of record.
 
We have never declared or paid any cash dividends on our common stock. We currently anticipate that we will retain any future earnings for the development and operation of our business. Also, under the terms of our credit facility, we are limited in the amount of dividends that we may pay to our stockholders without the consent of our lenders. Accordingly, we do not anticipate declaring or paying any cash dividends in the foreseeable future.
 
In addition, our ability to pay dividends is dependent on cash dividends from our subsidiaries. State insurance and Medicaid regulations limit the ability of our subsidiaries to pay dividends to us.
 
In February 2008, our Board of Directors authorized and approved the 2008 Stock Repurchase Program, whereby we may repurchase up to one million shares of our common stock. Stock repurchases may be made from time to time in the open market or in privately negotiated transactions and will be funded from unrestricted cash. We intend to adopt written plans pursuant to Rule 10b5-1 of the Exchange Act to effect the repurchase of a portion of shares authorized. The number of shares repurchased and the timing of the repurchases will be based on the level of available cash, limitations imposed by our Credit Agreement and other factors, including market conditions, the terms of any applicable 10b5-1 plans, and self-imposed blackout periods. There can be no assurances as to the exact number or aggregate value of shares that will be repurchased. The repurchase program may be suspended or discontinued at any time or from time to time without prior notice.


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Performance Graph
 
The following line graph compares the cumulative total stockholder return on our common stock against the cumulative total return of the Standard & Poor’s Corporation Composite 500 Index (the “S&P 500”) and a peer group index for the period from December 31, 2002 to December 31, 2007. The graph assumes an initial investment of $100 in AMERIGROUP common stock and in each of the indices.
 
The Current Year Peers index consists of Centene Corp. (CNC), Coventry Health Care Inc. (CVH), Health Net Inc. (HNT), Humana Inc. (HUM), Magellan Health Services Inc. (MGLN), Molina Healthcare Inc. (MOH), Pacificare Health Systems (PHS), Sierra Health Services (SIE), Wellcare Health Plans Inc. (WCG), and Wellchoice Inc. (WC). Due to United Health Group, Inc.’s acquisition of PHS, PHS ceased trading on the NYSE as of December 21, 2005. Due to WellPoint Inc.’s acquisition of WC, WC ceased trading on the NYSE on December 28, 2005. Both of these peers have been removed from the peer index on the day the stock ceased trading. The Company is not included in the peer group index. In calculating the cumulative total stockholder return of the peer group index, the returns of each of the peer group companies have been weighted according to their relative stock market capitalizations.
 
(PERFORMANCE GRAPH)
 
                                                             
      Value of $100 Invested Over Past 5 Years
      12/31/02     12/31/03     12/31/04     12/31/05     12/31/06     12/31/07
AGP
    $ 100.00       $ 140.71       $ 249.62       $ 128.41       $ 236.82       $ 240.51  
                                                             
Peers
    $ 100.00       $ 175.79       $ 240.34       $ 366.32       $ 367.49       $ 419.53  
                                                             
S&P 500
    $ 100.00       $ 128.68       $ 142.69       $ 149.70       $ 173.34       $ 182.86  
                                                             


39


 

Unregistered Sales of Equity Securities and Use of Proceeds
 
                                 
                Total Number of
    Maximum Number
 
                Shares (or Units
    (or Approximate
 
                Purchased
    Dollar Value) of
 
    Total Number
    Average
    as Part of
    Shares (or Units)
 
    of Shares
    Price Paid
    Publicly
    that May Yet Be
 
    (or Units)
    per Share
    Announced
    Purchased Under the
 
Period(1)
  Purchased     (or Unit)     Plans or Programs     Plans or Programs  
 
October 1 — October 31, 2007
        $             n/a  
November 1 — November 30, 2007
    805       36.51             n/a  
December 1 — December 31, 2007
                            n/a  
                                 
Total
    805     $ 36.51              
                                 
 
 
(1) The 2005 Plan allows, upon approval by the plan administrator, stock option recipients to deliver shares of unrestricted Company common stock held by the participant as payment of the exercise price and applicable withholding taxes upon the exercise of stock options or vesting of restricted stock. During the three months ended December 31, 2007, certain employees elected to tender shares to the Company in payment of related withholding taxes upon vesting of restricted stock.


40


 

Item 6.   Selected Financial Data
 
The following selected consolidated financial data should be read in connection with the consolidated financial statements and related notes and Management’s Discussion and Analysis of Financial Condition and Results of Operations appearing elsewhere in this Form 10-K. Selected financial data as of and for each of the years in the five-year period ended December 31, 2007 are derived from our consolidated financial statements, which have been audited by KPMG LLP, independent registered public accounting firm. All share and per share amounts included in the following consolidated financial data have been retroactively adjusted to reflect the two-for-one stock split effective January 18, 2005.
 
                                         
    Years Ended December 31,  
    2007     2006     2005     2004     2003  
    (Dollars in thousands, except per share data)  
 
Income Statement Data:
                                       
Revenues:
                                       
Premium
  $ 3,872,210     $ 2,795,810     $ 2,311,599     $ 1,813,391     $ 1,615,508  
Investment income and other
    73,320       39,279       18,310       10,340       6,726  
                                         
Total revenues
    3,945,530       2,835,089       2,329,909       1,823,731       1,622,234  
                                         
Expenses:
                                       
Health benefits
    3,216,070       2,266,017       1,957,196       1,469,097       1,295,900  
Selling, general and administrative
    499,000       369,896       258,446       191,915       186,856  
Depreciation and amortization
    31,604       25,486       26,948       20,750       23,650  
Interest
    12,291       608       608       731       1,913  
                                         
Total expenses
    3,758,965       2,662,007       2,243,198       1,682,493       1,508,319  
                                         
Income before income taxes
    186,565       173,082       86,711       141,238       113,915  
Income tax expense
    70,115       65,976       33,060       55,224       46,591  
                                         
Net income
  $ 116,450     $ 107,106     $ 53,651     $ 86,014     $ 67,324  
                                         
Basic net income per share
  $ 2.21     $ 2.07     $ 1.05     $ 1.73     $ 1.56  
                                         
Weighted average number of shares outstanding
    52,595,503       51,863,999       51,213,589       49,721,945       43,245,408  
                                         
Diluted net income per share
  $ 2.16     $ 2.02     $ 1.02     $ 1.66     $ 1.48  
                                         
Weighted average number of common shares and dilutive potential common shares outstanding
    53,845,829       53,082,933       52,857,682       51,837,579       45,603,300  
                                         
 
                                         
    December 31,  
    2007     2006     2005     2004     2003  
    (Dollars in thousands)  
 
Balance Sheet Data:
                                       
Cash and cash equivalents and short and long-term investments
  $  1,067,294     $ 776,273     $ 587,106     $  612,059     $  535,103  
Total assets
    2,088,621       1,345,695       1,093,588       919,850       826,021  
Long-term debt, less current portion
    361,458                          
Total liabilities
    1,174,714       577,110       452,034       351,138       364,307  
Stockholders’ equity
    913,907       768,585       641,554       568,712       461,714  


41


 

Item 7.   Management’s Discussion and Analysis of Financial Condition and Results of Operations
 
 
We are a multi-state managed healthcare company focused on serving people who receive healthcare benefits through publicly sponsored programs, including Medicaid, SCHIP, FamilyCare and Medicare Advantage programs. We were founded in December 1994 with the objective of becoming the leading managed care organization in the U.S. focused on serving people who receive these types of benefits. We continue to believe that managed healthcare remains the only proven mechanism that significantly reduces medical costs, helps our government partners control their costs, and improves health outcomes for those receiving these types of benefits.
 
 
As of December 31, 2007, our membership has increased by 395,000 members or 30.0% to 1,711,000 members, which includes approximately 183,000 members for which ASO services are provided. The membership growth is due primarily to our entry into the Tennessee market in the Middle-Grand region in April 2007 and the Western region with our acquisition of MMCC effective November 1, 2007. Premium revenues increased approximately $1,076.4 million or 38.5%. This increase is due primarily to (1) commencement of operations in Middle Tennessee; (2) a full year impact of operations in Georgia which began serving members in June 2006 in Atlanta and in the remaining regions we serve in the fall of 2006; (3) expansion of services to ABD members in two new Texas markets, Austin and San Antonio beginning in 2007; and (4) the initiation of services to ABD members in Ohio in February 2007. The remaining growth in 2007 is a result of premium rate increases and yield increases resulting from changes in membership mix across many of our markets.
 
Investment income and other increased $34.1 million from $39.3 million for the year ended December 31, 2006 to $73.4 million for the year ended December 31, 2007 primarily as a result of higher interest rates and an increase in the average balance of invested assets over the prior year. The increase in the average invested balances was largely driven by the establishment of restricted assets held as collateral in 2007.
 
 
In September 2007, we received approval from CMS to offer both Medicare Advantage Special Needs Plans and Medicare Advantage health plans in the following states: Florida, Maryland, New Jersey, New Mexico, New York, Tennessee and Texas. We had previously offered Medicare Advantage Special Needs Plans in Maryland and Texas. We expanded our service areas in these two states and added Medicare Advantage health plans. We are serving members in all seven states beginning in January 2008.
 
In August 2007, we concluded the contracting process with the State of South Carolina to begin serving Medicaid enrollees under the new South Carolina Healthy Connections Choices Program. The program will be implemented by region, with the Midlands Region, or the Columbia area, designated as the first area of service. We began enrollment in December 2007.
 
On April 1, 2007, AMERIGROUP Tennessee, Inc. began offering healthcare coverage to Medicaid members in the State of Tennessee for the Middle-Grand region. As of December 31, 2007, AMERIGROUP Tennessee, Inc. served approximately 186,000 members in the Middle-Grand region. On November 1, 2007, we acquired the contract rights and substantially all of the assets of MMCC, including substantially all of the assets of Midsouth Health Solutions, Inc., a subsidiary of MMCC. As of December 31, 2007, AMERIGROUP Tennessee, Inc. served approximately 170,000 members under an ASO arrangement in the West Tennessee region as a result of this acquisition. We believe this acquisition will strengthen our ability to respond to the West Tennessee request for proposal (“RFP”) that was released in January 2008. The State of Tennessee intends to convert the contracts in that region from an ASO arrangement to a risk arrangement.
 
We are in the process of establishing a contract with the State of New Mexico to serve the long-term care segment of the Medicaid population. Depending upon the pace of implementation established by the State, we may begin operations in 2008.


42


 

We can make no assurance that these efforts will result in new business for us or if that new business will be favorable to our results of operations or financial condition.
 
As of December 31, 2007, approximately 39% of our current membership has resulted from eleven acquisitions. We periodically evaluate acquisition opportunities to determine if they align with our business strategy. We continue to believe acquisitions can be an important part of our long-term growth strategy.
 
 
On January 28, 2008 we submitted our response to a request for proposal for expanded markets and reprocurement of our existing markets for the Florida Healthy Kids program. We anticipate the state will award contracts in early-to-mid-2008 with an implementation date of fall of 2008.
 
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.
 
 
 
As described in Item 3 — Legal Proceedings of this Form 10-K, we have appealed the $334.0 million verdict against us in the Qui Tam Litigation to the United States Court of Appeals for the Seventh Circuit. On September 17, 2007, we filed our memorandum of law in support of our appeal with the Court of Appeals. On December 17, 2007, the United States of America and the State of Illinois filed a joint brief, and the Relator filed a brief, in response to our memorandum of law. We have until February 29, 2008 to file our reply to these briefs with the Court of Appeals, which we intend to do. Following filing this brief, we expect the Court of Appeals to set a date for oral arguments prior to rendering a decision. While we do not control this timeline it is possible the Court of Appeals could render a decision as early as summer 2008, but there is no assurance that the decision will not occur at an earlier or later date.
 
Although it is possible that the ultimate outcome of the Qui Tam Litigation judgment will not be favorable to us, the amount of loss, if any, is uncertain. Accordingly, we have not recorded any amounts in the Consolidated Financial Statements for unfavorable outcomes, if any, as a result of the Qui Tam Litigation judgment. There can be no assurances that the ultimate outcome of this matter will not have a material adverse effect on our financial position, results of operations or liquidity. For additional information on the Qui Tam Litigation, see “Item 3 — Legal Proceedings — Qui Tam.”
 
 
AMERIGROUP Texas, Inc. is required to pay an experience rebate to the State of Texas in the event profits exceed established levels. The experience rebate calculation reports that we filed for the state fiscal years (SFYs) 2000 through 2005 have been audited by a contracted auditing firm retained by the State. In their report, the auditor challenged the inclusion in the experience rebate calculation of certain expenses incurred by the Company in providing services to AMERIGROUP Texas, Inc. for services obtained from AMERIGROUP Corporation under an administrative services agreement. The audits of experience rebate calculation reports for SFYs 2006 and 2007 are in process.
 
In February 2008, we resolved all of the open audit issues with respect to the experience rebate calculation reports for SFYs 2005 and prior and those experience rebate reports are now final. With respect to the experience rebate calculation reports for SFYs 2006 and 2007, we also reached agreement on the nature and amount of the administrative expenses incurred by AMERIGROUP Texas, Inc., for services provided by AMERIGROUP Corporation under the administrative services agreement that can be included in the experience rebate calculation. The impact of this resolution has been fully recognized in our consolidated financial statements for the year ended


43


 

December 31, 2007 which resulted in an increase to selling, general and administrative expenses of approximately $7.4 million.
 
 
In the Fort Worth service area, AMERIGROUP Texas, Inc. had an exclusive risk-sharing arrangement with Cook Children’s Health Care Network (“CCHCN”) and Cook Children’s Physician Network (“CCPN”), which includes Cook Children’s Medical Center (“CCMC”) that was terminated as of August 31, 2005. Under the risk-sharing arrangement the parties have an obligation to perform annual reconciliations and settlements of the risk pool for each contract year. We have recorded a receivable in the accompanying Condensed Consolidated Financial Statements for the 2005 contract year, in the amount of $10.6 million, as of December 31, 2007. The contract with CCHCN prescribes reconciliation procedures which have been completed. CCHCN subsequently engaged external auditors to review all medical claims payments made for the 2005 contract year and has provided the preliminary results to us. We are currently in discussions with the parties regarding resolution of this matter. Although we continue to believe this to be a valid receivable, if we are unable to resolve this matter resulting in payment in full to us, our results of operations may be adversely affected, and we may incur significant costs in our efforts to reach a final resolution of this matter.
 
 
In December 2006, AMERIGROUP New Jersey, Inc., our New Jersey subsidiary, received a notice of deficiency for failure to meet provider network requirements in several New Jersey counties as required by our Medicaid contract with New Jersey. To date, we have not received notice of any final determination regarding our compliance with provider network requirements or possible fines and penalties. If we are unable to materially satisfy the provider network requirements, the State of New Jersey could impose fines and penalties that could have a material impact on our financial results.
 
 
A Florida Statute (the “Statute”) gives the Florida Agency for Health Care Administration (“AHCA”) the right to contract with entities to provide comprehensive behavioral healthcare services, including mental health and substance abuse services. The Statute further requires the contractor to use at least 80% of the capitation for the provision of behavioral healthcare services, with any shortfall in the 80% expenditure being refunded to the State. In April 2007, our Florida subsidiary AMERIGROUP Florida Inc., and AHCA resolved the disagreement regarding this matter for the 2004 and 2005 contract years and AMERIGROUP Florida, Inc. paid approximately $5.3 million to AHCA.
 
Discussion of Critical Accounting Policies
 
In the ordinary course of business, we make a number of estimates and assumptions relating to the reporting of results of operations and financial condition in the preparation of our consolidated financial statements in conformity with U.S. generally accepted accounting principles. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. Actual results could differ from those estimates and the differences could be significant. We believe that the following discussion addresses our critical accounting policies, which are those that are most important to the portrayal of our financial condition and results of operations and require management’s most difficult, subjective and complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain.
 
 
We generate revenues primarily from premiums and ASO fees we receive from the states in which we operate to arrange for health benefit services for our members. We receive premiums from CMS for our Medicare Advantage members. We recognize premium and ASO fee revenue during the period in which we are obligated to provide services to our members. A fixed amount per member per month is paid to us to arrange for healthcare benefit services for our members pursuant to our contracts in each of our markets. These premium payments are


44


 

based upon eligibility lists produced by our government partners. Errors in this eligibility determination on which we rely can result in positive and negative revenue adjustments to the extent this information is adjusted by the state. Adjustments to eligibility data received from our government partners result from retroactive application of enrollment or disenrollment of members or classification changes of members between rate categories that were not known by us in previous months due to timing of the receipt of data or errors in processing by our government partners. These changes while common are not generally large. Retroactive adjustments to revenue for corrections in eligibility data are recorded in the period in which the information becomes known. We estimate the amount of outstanding retroactivity each period and adjust premium revenue accordingly, if appropriate. Historically, the impact of these adjustments has represented less than 1% of annual revenue, which results in a negligible impact on annual earnings as changes in revenue are typically accompanied by corresponding changes in the related health benefits expense. We believe this historical experience represents what is reasonably likely to occur in future periods.
 
In all of the states in which we operate, except Tennessee and Virginia, we are eligible to receive supplemental payments to offset the health benefits expenses associated with the birth of a baby. Each state contract is specific as to what is required before payments are collectible. Upon delivery of a baby, each state is notified according to our contract. Revenue is recognized in the period that the delivery occurs and the related services are provided to our member based on our authorization system for these services. Changes in authorization and claims data used to estimate supplemental revenues can occur as a result of changes in eligibility noted above or corrections of errors in the underlying data. Adjustments to revenue for corrections to authorization and claims data are recorded in the period in which the corrections become known. Historically, the impact of these adjustments has represented less than 1% of annual revenue which results in a negligible impact on annual earnings as changes in revenue are typically accompanied by corresponding changes in the related health benefits expense. We believe this historical experience represents what is reasonably likely to occur in future periods.
 
Estimating health benefits expense and claims payable
 
The most judgmental accounting estimate in our consolidated financial statements is our liability for medical claims payable. At December 31, 2007, this liability was $541.2 million and represented 46% of our total consolidated liabilities. Included in this liability and the corresponding health benefits expenses for incurred but not reported (IBNR) claims are the estimated costs of processing such claims. Health benefits expenses have two main components: direct medical expenses and medically-related administrative costs. Direct medical expenses include amounts paid to hospitals, physicians and providers of ancillary services, such as laboratories and pharmacies. Medically-related administrative costs include items such as case and disease management, utilization review services, quality assurance and on-call nurses.
 
We have used a consistent methodology for estimating our medical expenses and medical claims payable since inception, and have refined our assumptions to take into account our maturing claims, product and market experience. Our reserving practice is to consistently recognize the actuarial best point estimate within a level of confidence required by actuarial standards. Actuarial standards of practice generally require a level of confidence such that the liabilities established for IBNR have a greater probability of being adequate versus being insufficient, or such that the liabilities established for IBNR are sufficient to cover obligations under an assumption of moderately adverse conditions. Adverse conditions are situations in which the actual claims are expected to be higher than the otherwise estimated value of such claims at the time of the estimate. Therefore, in many situations, the claim amounts ultimately settled will be less than the estimate that satisfies the actuarial standards of practice.
 
In developing our medical claims payable estimates, we apply different estimation methods depending on the month for which incurred claims are being estimated. For mature incurred months (generally the months prior to the most recent three months), we calculate completion factors using an analysis of claim adjudication patterns over the most recent 39-month period. A completion factor is an actuarial estimate, based upon historical experience, of the percentage of incurred claims during a given period that have been adjudicated as of the date of estimation. We apply the completion factors to actual claims adjudicated-to-date in order to estimate the expected amount of ultimate incurred claims for those months.


45


 

We do not believe that completion factors are fully credible for estimating claims incurred for the most recent two to three months which constitute the majority of the amount of the medical claims payable. Accordingly, we estimate health benefits expenses incurred by applying observed medical cost trend factors to the average per member per month (PMPM) medical costs incurred in a more complete time period. Medical cost trend factors are developed through a comprehensive analysis of claims incurred in prior months for which more complete claim data is available. The average PMPM is also adjusted for known changes in hospital authorization data, provider contracting changes, changes in benefit levels, age and gender mix of members, and seasonality. The incurred estimates resulting from the analysis of completion factors, medical cost trend factors and other known changes are weighted together using actuarial judgment.
 
Many aspects of the managed care business are not predictable with consistency. These aspects include the incidences of illness or disease state (such as cardiac heart failure cases, cases of upper respiratory illness, the length and severity of the flu season, diabetes, the number of full-term versus premature births and the number of neonatal intensive care babies). Therefore, we must rely upon our historical experience, as continually monitored, to reflect the ever-changing mix, needs and growth of our members in our assumptions. Among the factors considered by management are changes in the level of benefits provided to members, seasonal variations in utilization, identified industry trends and changes in provider reimbursement arrangements, including changes in the percentage of reimbursements made on a capitated, as opposed to a fee-for-service, basis. These considerations are aggregated in the medical cost trend. Other external factors such as government-mandated benefits or other regulatory changes, catastrophes and epidemics may impact medical cost trends. Other internal factors such as system conversions and claims processing interruptions may impact our ability to accurately predict estimates of historical completion factors or medical cost trends. Medical cost trends potentially are more volatile than other segments of the economy. Management is required to use considerable judgment in the selection of health benefits expense trends and other actuarial model inputs.
 
Completion factors are the most significant factors we use in developing our medical claims payable estimates for older periods, generally periods prior to the most recent three months. The following table illustrates the sensitivity of these factors and the estimated potential impact on our medical claims payable estimates for those periods as of December 31, 2007:
 
         
Completion Factor
  Increase (Decrease) in
 
Increase (Decrease) in Factor
  Medical Claims Payable(1)  
    (In millions)  
 
(0.50)%
  $ 34.0  
(0.25)%
  $ 17.0  
0.25%
  $ (17.0 )
0.50%
  $ (34.0 )
 
 
(1) Reflects estimated potential changes in health benefits expenses and medical claims payable caused by changes in completion factors used in developing medical claims payable estimates for older periods, generally periods prior to the most recent three months.
 
Medical cost PMPM trend factors are the most significant factors we use in estimating our medical claims payable for the most recent three months. The following table illustrates the sensitivity of these factors and the


46


 

estimated potential impact on our medical claims payable estimates for the most recent three months as of December 31, 2007:
 
         
Medical Cost PMPM Trend
  Increase (Decrease) in
 
Increase (Decrease) in Factor
  Medical Claims Payable(2)  
    (In millions)  
 
10.0%
  $ 31.5  
5.0%
  $ 15.7  
2.5%
  $ 7.9  
(2.5)%
  $ (7.9 )
(5.0)%
  $ (15.7 )
(10.0)%
  $ (31.5 )
 
 
(2) Reflects estimated potential changes in health benefits expenses and medical claims payable caused by changes in medical costs PMPM trend data used in developing medical claims 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 medical claims payable.
 
Changes in estimates of medical claims payable are primarily the result of obtaining more complete claims information that directly correlates with the claims and provider reimbursement trends. Volatility in members’ needs for medical services, provider claims submission and our payment processes results in identifiable patterns emerging several months after the causes of deviations from assumed trends occur. Since our estimates are based upon PMPM claims experience, changes cannot typically be explained by any single factor, but are the result of a number of interrelated variables, all influencing the resulting experienced medical cost trend. Deviations, whether positive or negative, between actual experience and estimates used to establish the liability are recorded in the period known.
 
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.


47


 

The following table presents the components of the change in medical claims payable for the three years ended December 31 (in thousands):
 
                         
    2007     2006     2005  
 
Medical claims payable as of January 1
  $ 385,204     $ 348,679     $ 241,253  
Medical claims payable assumed from businesses acquired during the year
                27,424  
Health benefits expenses incurred during the year:
                       
Related to current year
    3,284,302       2,328,863       1,982,880  
Related to prior years
    (68,232 )     (62,846 )     (25,684 )
                         
Total incurred
    3,216,070       2,266,017       1,957,196  
Health benefits payments during the year:
                       
Related to current year
    2,769,331       1,971,505       1,646,664  
Related to prior years
    290,770       257,987       230,530  
                         
Total payments
    3,060,101       2,229,492       1,877,194  
                         
Medical claims payable as of December 31
  $ 541,173     $ 385,204     $ 348,679  
                         
Current year medical claims paid as a percent of current year health benefits expenses incurred
    84.3 %     84.7 %     83.0 %
                         
Health benefits expenses incurred related to prior years as a percent of prior year medical claims payable as of December 31
    (17.7 )%     (18.0 )%     (10.7 )%
                         
Health benefits expenses incurred related to prior years as a percent of the prior year’s health benefits expenses related to current year
    (2.9 )%     (3.2 )%     (1.7 )%
                         
 
Health benefits expenses incurred during the year, related to prior years for the year ended December 31, 2007 of approximately $68.2 million were comparable to that in the prior year of approximately $62.8 million. As our medical claims payable estimate increases in amount due to increases in our membership base and inflationary increases in medical costs, the absolute dollar amount of subsequent changes to that estimate will increase even if the accuracy of our medical claims payable estimate remains consistent as a percentage of our original estimate.
 
Health benefits expenses incurred during the year, related to prior years for the year ended December 31, 2006 increased approximately $37.1 million from approximately $25.7 million for the year ended December 31, 2005 to approximately $62.8 million for the year ended December 31, 2006. This increase was primarily a result of medical claims payments which increased at a more modest rate than estimated at the end of 2005. Claims payments for dates of service occurring in the early portion of 2005 increased significantly, based on available claims payment information as of December 31, 2005. We estimated health benefits expenses would continue to increase significantly through the remainder of 2005. As claims for medical services delivered in the second half of 2005 were paid during 2006, it became apparent that the elevated cost trends we anticipated did not continue throughout 2005.
 
As noted above, actuarial standards of practice generally require that the liabilities established for IBNR are sufficient to cover obligations under an assumption of moderately adverse conditions. In many situations, the claims amounts ultimately settled will be less than the estimate that satisfies the actuarial standards of practice. When this occurs, health benefits expenses incurred during a year, related to prior years, may be reduced.
 
Establishing the liabilities for IBNR, associated with health benefits expenses incurred during a year, related to that current year, at a level sufficient to cover obligations under an assumption of moderately adverse conditions will cause incurred health benefits expenses for that current year to be higher than if IBNR was established without sufficiency for moderately adverse conditions.


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Also included in medical claims payable are estimates for provider settlements due to clarification of contract terms, out-of-network reimbursement and claims payment differences, as well as amounts due to contracted providers under risk-sharing arrangements.
 
 
In addition to incurred but not paid claims, the liability for medical claims payable includes reserves for premium deficiencies, if appropriate. Premium deficiencies are recognized when it is probable that expected claims and administrative expenses will exceed future premiums and investment income on existing medical insurance contracts. For purposes of premium deficiencies, contracts are grouped in a manner consistent with our method of acquiring, servicing and measuring the profitability of such contracts. We did not have any premium deficiency reserves at December 31, 2007.
 
 
We account for income taxes in accordance with the provisions of FASB Statement No. 109, Accounting for Income Taxes. On a quarterly basis, we estimate our required tax liability based on enacted tax rates, estimates of book to tax differences in income, and projections of income that will be earned in each taxing jurisdiction. Deferred tax assets and liabilities representing the tax effect of temporary differences between financial reporting net income and taxable income are measured at the tax rates enacted at the time the deferred tax asset or liability is recorded.
 
After tax returns for the applicable year are filed, the estimated tax liability is trued up to the actual liability per the filed federal and state tax returns. Historically, we have not experienced significant differences between our estimates of tax liability and our actual tax liability.
 
Similar to other companies, we sometimes face challenges from the tax authorities regarding the amount of taxes due. Positions taken on our tax returns are evaluated and benefits are recognized only if it is more likely than not that our position will be sustained on audit. Based on our evaluation of tax positions, we believe that we have appropriately accounted for potential tax exposures.
 
In addition, we are periodically audited by federal and state taxing authorities and these audits can result in proposed assessments. We believe that our tax positions comply with applicable tax law and, as such, will vigorously defend these positions on audit. We believe that we have adequately provided for any reasonable foreseeable outcome related to these matters. Although the ultimate resolution of these audits may require additional tax payments, we do not anticipate any material impact to earnings.
 
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.
 
 
The valuation of goodwill and intangible assets at acquisition requires assumptions regarding estimated discounted cash flows and market analyses. These assumptions contain uncertainties because they require management to use judgment in selecting the assumptions and applying the market analyses to the individual acquisitions. Additionally, impairment evaluations require management to use judgment to determine if impairment of goodwill and intangible assets is apparent. We have applied a consistent methodology in both the original valuation and subsequent impairment evaluations for all goodwill and intangible assets resulting from acquisitions occurring since the adoption FASB Statement No. 142 Goodwill and Other Intangible Assets. We do not anticipate any changes to that methodology, nor has any impairment loss resulted from our analyses. If the assumptions used to evaluate the value of goodwill and intangible assets change in the future, an impairment loss may be recorded and it could be material to our results of operations in the period in which the impairment loss occurs.


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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.
 
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 $260.0 million 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.
 
In December 2007, the FASB issued FASB Statement No. 141 (revised 2007), Business Combinations (“FASB Statement No. 141(R)”). FASB Statement No. 141(R) establishes principles and requirements for how an acquirer determines and recognizes in its financial statements the identifiable assets acquired, the liabilities assumed, any noncontrolling interest in the acquiree and the goodwill acquired. FASB Statement No. 141(R) also establishes disclosure requirements to enable the evaluation of the nature and financial effects of the business combination. FASB Statement No. 141(R) is effective for any transaction occurring in fiscal years beginning after December 15, 2008; therefore, it will have no impact on our current results of operations and financial condition; however, future acquisitions will be accounted for under this guidance.


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The following table sets forth selected operating ratios for the years ended December 31, 2007, 2006 and 2005. All ratios, with the exception of the health benefits ratio, are shown as a percentage of total revenues.
 
                         
    Years Ended December 31,  
    2007     2006     2005  
 
Premium revenue
    98.1 %     98.6 %     99.2 %
Investment income and other
    1.9       1.4       0.8  
                         
Total revenues
    100.0 %     100.0 %     100.0 %
                         
Health benefits(1)
    83.1 %     81.1 %     84.7 %
Selling, general and administrative expenses
    12.6 %     13.0 %     11.1 %
Income before income taxes
    4.7 %     6.1 %     3.7 %
Net income
    3.0 %     3.8 %     2.3 %
 
 
(1) The health benefits ratio is shown as a percentage of premium revenue because there is a direct relationship between the premium received and the health benefits provided.
 
Summarized comparative financial information for the years ending December 31, 2007, 2006 and 2005 are as follows ($ in millions, except per share data)
 
                                         
    December 31,     % Change  
    2007     2006     2005     2006-2007     2005-2006  
 
Revenues:
                                       
Premium
  $  3,872.2     $  2,795.8     $  2,311.6       38.5 %     20.9 %
Investment income and other
    73.4       39.3       18.3       86.8 %     114.8 %
                                         
Total revenues
    3,945.6       2,835.1       2,329.9       39.2 %     21.7 %
Expenses:
                                       
Health benefits
    3,216.1       2,266.0       1,957.2       41.9 %     15.8 %
Selling, general and administrative
    499.0       369.9       258.4       34.9 %     43.2 %
Depreciation and amortization
    31.6       25.5       26.9       23.9 %     (5.2 )%
Interest
    12.3       0.6       0.6       1950.0 %     0.0 %
                                         
Total expenses
    3,759.0       2,662.0       2,243.1       41.2 %     18.7 %
                                         
Income before income taxes
    186.6       173.1       86.8       7.8 %     99.4 %
Income tax expense
    70.1       66.0       33.1       6.2 %     99.4 %
                                         
Net income
  $ 116.5     $ 107.1     $ 53.7       8.8 %     99.4 %
                                         
Diluted net income per common share
  $ 2.16     $ 2.02     $ 1.02       6.9 %     98.0 %
                                         
 
 
Premium revenue for the year ended December 31, 2007 increased $1,076.4 million, or 38.5%. The increase was primarily due to entry into Tennessee, expansion regions in Georgia and ABD expansion in San Antonio and Austin, Texas and the Southwest Region of Ohio. Additionally, our existing products and markets contributed further to revenue growth from premium rate increases and yield increases resulting from changes in membership mix. Total membership increased 30.0% to 1,711,000 as of December 31, 2007 from 1,316,000 as of December 31, 2006.
 
Premium revenue for the year ended December 31, 2006 increased $484.2 million, or 20.9%. The increase was primarily due to entry into the Georgia market, commencement of operations as a Medicare Advantage plan in our Houston, Texas market and premium rate increases. Total membership increased 16.6% to 1,316,000 as of December 31, 2006 from 1,129,000 as of December 31, 2005.


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The following table sets forth the approximate number of our members in each state for the periods presented. Because we receive two premiums for members that are in both the Medicare Advantage and Medicaid products, these members have been counted twice in the states where we offer Medicare Advantage plans.
 
                         
    December 31,  
Market
  2007     2006     2005  
 
Texas(1)
    460,000       406,000       399,000  
Tennessee(2)
    356,000              
Georgia
    211,000       227,000        
Florida
    206,000       202,000       219,000  
Maryland
    152,000       145,000       141,000  
New York
    112,000       126,000       138,000  
New Jersey
    98,000       102,000       109,000  
Ohio
    54,000       46,000       22,000  
District of Columbia
    38,000       40,000       41,000  
Virginia
    24,000       22,000       19,000  
South Carolina
                 
Illinois
                41,000  
                         
Total
    1,711,000       1,316,000       1,129,000  
                         
 
 
(1) Included in the Texas membership are approximately 13,000, 14,000, and 10,000 members under an ASO contract in 2007, 2006 and 2005, respectively.
 
(2) Included in the Tennessee membership are approximately 170,000 members under an ASO contract in 2007 commencing with the MMCC acquisition effective November 1, 2007.
 
As of December 31, 2007, we served approximately 1,711,000 members, which reflects an increase of approximately 395,000 members compared to December 31, 2006. Our entry into the Tennessee market in April 2007 resulted in approximately 186,000 members at year end. In addition, the acquisition of MMCC on November 1, 2007, increased our Tennessee membership by approximately 170,000 members. The ABD expansion markets in Texas and Ohio, which began enrollment in February 2007, increased membership by approximately 30,000 members. Texas membership has further increased as the State of Texas eliminated the primary care case management program, which expanded participation in health plans such as ours. These increases were offset by the contraction of the New York market whose membership decreased by 14,000 resulting from more stringent guidelines for eligibility re-determination implemented by the state in 2006 and a reduction in the size of our New York sales force in response to limits imposed by the State on marketing programs. Additionally, Georgia membership decreased by 16,000 resulting primarily from a decline in the overall eligible population as well as changes in our marketing programs during the year.
 
Investment income and other increased $34.1 million or 86.8% during the year ended December 31, 2007 and $21.0 million or 114.8% during the year ended December 31, 2006. These increases in investment income and other are primarily due to higher interest rates and increases in the average balance of invested assets. Additionally, 2007 benefited from approximately $14.2 million in income earned on restricted assets held as collateral. These assets were established in March and April 2007 from proceeds from borrowings under our Credit Agreement and the issuance of 2.0% Convertible Senior Notes due May 15, 2012, discussed below.
 
 
Expenses relating to health benefits for the year ended December 31, 2007 increased $950.1 million, or 41.9%. The HBR for the year ended December 31, 2007 was 83.1% compared to 81.1% in 2006. Our 2007 results compared to 2006 reflect an increase in HBR primarily as a result of a higher proportion of our business in developing markets. These developing markets (which include Georgia, Tennessee, Ohio ABD, and Texas ABD as well as Maryland Medicare Advantage, all as of December 31, 2007) generally have a higher HBR than our mature markets due to the


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introduction of managed care into a previously unmanaged population and the associated start-up period required to identify and implement appropriate care management and disease management strategies for the population. These markets have generally performed at expected levels for the year ended December 31, 2007. Expenses relating to health benefits for the year ended December 31, 2006 increased $308.8 million, or 15.8%. The HBR of 81.1% for the year ended December 31, 2006 improved over that for the year ended December 31, 2005 of 84.7% as a result of premium rate increases that exceeded medical trend and commencement of Medicare Advantage operations in our Houston, Texas market.
 
 
SG&A increased $129.1 million for the year ended December 31, 2007 compared to 2006. Our SG&A ratio for the year ended December 31, 2007 was 12.6% compared to 13.0% in 2006. The decrease in SG&A ratio is primarily a result of leverage gained through increased revenue. The increase in SG&A expenses was primarily due to:
 
  •  a growth in salaries and benefits expenses due to a 19.6% increase in the number of employees;
 
  •  an increase in premium taxes from revenue growth in markets where the tax is levied; and
 
  •  an increase in experience rebate expense in Texas driven by two factors: an accrual of $7.4 million associated with the resolution of audit items on all open experience rebate reports for prior years; and the experience rebate expense associated with the favorable operational performance in the State.
 
SG&A increased $111.5 million for the year ended December 31, 2006 compared to 2005. Our SG&A ratio for the year ended December 31, 2006 was 13.0% compared to 11.1% in 2005. The increase in SG&A ratio was primarily due to:
 
  •  an increase in salaries and benefits as a result of a 30% increase in employees, stock compensation expense related to the adoption of FASB Statement No. 123(R) and earnings-based compensation not provided for in the preceding year;
 
  •  an increase in premium taxes as a result of our entry into the Georgia market, increased revenues in our Maryland and Ohio markets which bear premium tax and an increase in the premium tax rate in New Jersey;
 
  •  an increase in legal expenses related to the Qui Tam Litigation; and
 
  •  an increase in operational and technological initiatives and recruiting expenses to support the Company’s growth.
 
Premium taxes were $85.2 million, $47.1 million and $25.9 million for the years ended December 31, 2007, 2006 and 2005, respectively.
 
 
Depreciation and amortization expense was $31.6 million, $25.5 million and $26.9 million for the years ended December 31, 2007, 2006 and 2005, respectively. The increase from 2006 to 2007 is a result of greater depreciable assets, the write-off of debt issuance costs related to the termination of the Company’s previous $150.0 million credit agreement and an increase in amortization of debt issuance costs as a result of the new Credit Agreement entered into in March 2007.
 
 
Interest expense was $12.3 million for the year ended December 31, 2007 and $0.6 million in each of the years ended December 31, 2006 and 2005. The increase in interest expense is a result of borrowings under our Credit Agreement and the issuance of the 2.0% Convertible Senior Notes due May 15, 2012, discussed below.
 
 
Income tax expense for 2007 and 2006 was $70.1 million and $66.0 million, respectively, with an effective tax rate of 37.6% in 2007 and 38.1% in 2006. Income tax expense for 2005 was $33.1 million with an effective tax rate


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of 38.1%. The decrease in effective tax rate from 2007 to 2006 is primarily a result of the decrease in the blended state income tax rate. The effective tax rate remained unchanged between 2006 and 2005 as the increase in the blended state income tax rate was offset by increases in federal tax exempt interest income.
 
 
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.
 
Net income increased from 2005 to 2006 as a result of actuarially sound premium rate increases in excess of medical trend, favorable prior period development and commencement of operation as a Medicare Advantage plan in Texas.
 
 
We manage our cash, investments and capital structure so we are able to meet the short- and long-term obligations of our business while maintaining financial flexibility and liquidity. We forecast, analyze and monitor our cash flows to enable prudent investment management and financing within the confines of our financial strategy.
 
Our primary sources of liquidity are cash and cash equivalents, short- and long-term investments, cash flows from operations and borrowings under our Credit Agreement. As of December 31, 2007, we had cash and cash equivalents of $487.6 million, short and long-term investments of $579.7 million and restricted investments on deposit for licensure of $89.5 million. Cash, cash equivalents, and investments which are unrestricted and unregulated totaled $206.4 million at December 31, 2007.
 
We believe that existing cash and investment balances, internally generated funds and available funds under our Credit Agreement will be sufficient to support continuing operations, capital expenditures and our growth strategy for at least 12 months. Our debt-to-total capital ratio at December 31, 2007 was 29.9%. As a result of significant borrowings under the Credit Agreement and the related debt service and issuance of the 2.0% Convertible Senior Notes, our access to additional capital may be limited which could restrict our ability to acquire new businesses or enter new markets and could impact our ability to maintain statutory net worth requirements in the states in which we do business.
 
Our operations are conducted through our wholly-owned subsidiaries, which include HMOs, one HIC and one PHSP. HMOs, HICs and PHSPs are subject to state regulations that, among other things, require the maintenance of minimum levels of statutory capital, as defined by each state, and restrict the timing, payment and amount of dividends and other distributions that may be paid to their stockholders. Additionally, certain state regulatory agencies may require individual regulated entities to maintain statutory capital levels higher than the state regulations.
 
As of December 31, 2007, we believe our subsidiaries were in compliance with all minimum statutory capital requirements. We anticipate the parent company will be required to fund minimum net worth shortfalls during 2008 using unregulated cash, cash equivalents and investments. We believe as a result that we will continue to be in compliance with these requirements at least through the end of 2008.
 
The National Association of Insurance Commissioners (“NAIC”) has defined risk-based capital (“RBC”) standards for HMOs and other entities bearing risk for healthcare coverage that are designed to identify weakly capitalized companies by comparing each company’s adjusted surplus to its required surplus (“RBC ratio”). The RBC ratio is designed to reflect the risk profile of HMOs. Within certain ratio ranges, regulators have increasing authority to take action as the RBC ratio decreases. There are four levels of regulatory action, ranging from requiring insurers to submit a comprehensive plan to the state insurance commissioner to requiring the state insurance commissioner to place the insurer under regulatory control. At December 31, 2007, the RBC ratio of each of the Company’s health plans was at or above the level that would require regulatory action. Although not all states


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had adopted these rules at December 31, 2007, at that date, each of the Company’s active health plans had a surplus that exceeded either the applicable state net worth requirements or, where adopted, the levels that would require regulatory action under the NAIC’s RBC rules.
 
 
Cash from operations was $350.7 million for the year ended December 31, 2007 compared to $235.7 million for the year ended December 31, 2006. The increase in cash from operations is primarily due to an increase in net income prior to depreciation, amortization and other noncash items of $28.2 million as well as an increase of approximately $81.1 million in cash flows generated from working capital changes. We generated operating cash flows from working capital changes of $187.4 million in 2007 and $106.3 million in 2006. The year-over-year increase primarily resulted from an increase in claims payable of $156.0 million driven by growth of the business, offset by an increase in premium receivables and a decline in the growth of accounts payable, accrued expenses and other current liabilities between the years.
 
Cash used in investing activities was $431.5 million for the year ended December 31, 2007 compared to cash used in investing activities of $342.2 million for the year ended December 31, 2006. This increase in cash used in investing activities results primarily from net purchases of restricted investments held as collateral of $351.3 million to fund the irrevocable letter of credit required to stay the execution of the judgment in the Qui Tam Litigation and net purchases of hedge and warrant instruments of $27.0 million offset by lower net investment purchases of $295.2 million. We currently anticipate total capital expenditures for 2008 of approximately $45.0 million to $50.0 million related to technological infrastructure development and the expansion of our medical management system.
 
Our investment policies are designed to provide liquidity, preserve capital and maximize total return on invested assets. As of December 31, 2007, our investment portfolio consisted primarily of fixed-income securities. The weighted average maturity is less than twelve months. We utilize investment vehicles such as money market funds, commercial paper, certificates of deposit, municipal bonds, debt securities of government sponsored entities, corporate securities, corporate bonds, auction rate securities and U.S. Treasury instruments. The states in which we operate prescribe the types of instruments in which our subsidiaries may invest their cash. The weighted average taxable equivalent yield on consolidated investments as of December 31, 2007 was approximately 5.02%.
 
As of December 31, 2007, $104.6 million of our $199.9 million in short-term investments were comprised of municipal notes investments with an auction reset feature (“auction rate securities”). These notes are issued by various state and local municipal entities for the purpose of financing student loans, public projects and other activities; they carry a AAA credit rating. Subsequent to December 31, 2007 all of the $104.6 million of auction rate securities that we held at the balance sheet date were either sold or had their interest rate reset through a successful auction. As of February 20, 2008, $104.4 million of our investments were comprised of auction rate securities. Liquidity for these auction rate securities is typically provided by an auction process which allows holders to sell their notes and resets the applicable interest rate at pre-determined intervals, usually every 28 or 35 days. As of February 20, 2008, auctions had failed for $39.2 million of our auction rate securities and there is no assurance that auctions on the remaining auction rate securities in our investment portfolio will continue to succeed. An auction failure means that the parties wishing to sell their securities could not be matched with an adequate volume of buyers. In the event that there is a failed auction the indenture governing the security requires the issuer to pay interest at a contractually defined rate that is generally above market rates for other types of similar short-term instruments. The securities for which auctions have failed will continue to accrue interest at the contractual rate and be auctioned every 28 or 35 days until the auction succeeds, the issuer calls the securities, or they mature. As a result, our ability to liquidate and fully recover the carrying value of our remaining auction rate securities in the near term may be limited or not exist. These developments may result in the classification of some or all of these securities as long-term investments in our consolidated financial statements for the first quarter of 2008 or in other future periods. In addition, while all of our auction rate securities are currently rated AAA, if the issuers are unable to successfully close future auctions and their credit ratings deteriorate, we may in the future be required to record an impairment charge on these investments.


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We believe we will be able to liquidate our auction rate securities without significant loss, and we currently believe these securities are not impaired, primarily due to government guarantees or municipal bond insurance; however, it could take until the final maturity of the underlying securities to realize our investments’ recorded value. The final maturity of the underlying securities could be as long as 33 years. The weighted-average life of the underlying securities for our auction rate securities portfolio is 25.3 years. We currently have the ability and intent to hold the remaining $104.6 million of auction rate securities, until market stability is restored with respect to these securities. We believe that, even allowing for the reclassification of these securities to long-term and the possible requirement to hold all such securities for an indefinite period of time, our remaining cash and cash equivalents and short-term investments will be sufficient to support continuing operations, capital expenditures and our growth strategies.
 
Cash provided by financing activities was $391.7 million and $11.1 million for the years ended December 31, 2007 and 2006, respectively. The increase in cash provided by financing activities was primarily related to proceeds received from the issuance of $260.0 million in aggregate principal amount of 2.0% Convertible Senior Notes and borrowings under the Credit Agreement of $351.3 million net of repayments of outstanding amounts under the Credit Agreement of $222.3 million and payment of debt issuance costs of $11.7 million.
 
Financing Activities
 
 
On March 26, 2007, we entered in to a Credit Agreement which provides, among other things, for commitments of up to $401.3 million consisting of (i) up to $351.3 million of financing under a senior secured synthetic letter of credit facility and (ii) up to $50.0 million of financing under a senior secured revolving credit facility. The Credit Agreement terminates on March 15, 2012. We initially borrowed $351.3 million under the senior secured synthetic letter of credit facility of the Credit Agreement. Shortly thereafter, we repaid $221.3 million of such borrowings with the proceeds from the issuance of the 2% Convertible Senior Notes. As a result, pursuant to the terms of the Credit Agreement, unless later amended by the parties, the commitments under the senior secured synthetic letter of credit facility were permanently reduced to $130.0 million and total commitments under the Credit Agreement were permanently reduced to $180.0 million.
 
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.
 
The Credit Agreement includes customary covenants and events of default. If any event of default occurs and is continuing, the Credit Agreement may be terminated and all amounts owing there under may become immediately due and payable. The Credit Agreement also includes the following financial covenants: (i) maximum leverage ratios as of specified periods, (ii) a minimum interest coverage ratio and (iii) a minimum statutory net worth ratio.
 
Borrowings under the Credit Agreement are secured by substantially all of our assets and the assets of our wholly-owned subsidiary, PHP Holdings, Inc., including a pledge of the stock of each of our respective wholly-owned managed care subsidiaries, in each case, subject to carve-outs.
 
As of December 31, 2007, we had $129.0 million outstanding under the senior secured synthetic letter of credit facility of our Credit Agreement. These funds are held in restricted investments as partial collateral for an irrevocable letter of credit in the amount of $351.3 million, issued to the Clerk of Court for the U.S. District Court for the Northern District of Illinois, Eastern Division. The irrevocable letter of credit was provided to the court for the purpose of staying the enforcement of the judgment in the Qui Tam Litigation pending resolution of our appeal. As of December 31, 2007, we had no outstanding borrowings but have caused to be issued irrevocable letters of credit in the aggregate face amount of $35.6 million under the senior secured revolving credit facility of our Credit


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Agreement. We incurred offering expenses totaling $4.8 million in connection with the Credit Agreement which are included in other long-term assets in the Condensed Consolidated Financial Statements and are being amortized over the term of the Credit Agreement.
 
 
Effective March 28, 2007, we issued an aggregate of $260.0 million in principal amount of 2.0% Convertible Senior Notes due May 15, 2012 (the “Notes’’). In May 2007, we filed an automatic shelf registration statement on Form S-3 with the SEC covering the resale of the Notes and common stock issuable upon conversion of the Notes. The total proceeds from the offering of the Notes, after deducting underwriting fees and estimated offering expenses, were approximately $253.1 million. We incurred offering expenses totaling $6.9 million in connection with the offering of the Notes which are included in other long-term assets in the accompanying Consolidated Financial Statements and are being amortized over the term of the Notes. As of December 31, 2007, approximately $221.3 million of these proceeds plus $1.0 million funded by the Company, are held as restricted investments as the balance of the collateral required for the irrevocable letter of credit which totals $351.3 million, as discussed above. The remainder of the proceeds of the Notes were used in connection with the purchase of convertible note hedges and sold warrants that were established concurrent with the issuance of the Notes as discussed below.
 
The Notes are governed by an Indenture dated as of March 28, 2007 (the “Indenture”). The Notes are senior unsecured obligations of the Company and will rank equally with all of our existing and future senior debt and senior to all of our subordinated debt. The Notes will be effectively subordinated to all existing and future liabilities of our subsidiaries and to any existing and future secured indebtedness, including the obligations under our Credit Agreement.
 
The Notes bear interest at a rate of 2.0% per year, payable semiannually in arrears in cash on May 15 and November 15 of each year, beginning on May 15, 2007. The Notes mature on May 15, 2012, unless earlier repurchased or converted. Holders may convert their Notes at their option on any day prior to the close of business on the scheduled trading day immediately preceding March 15, 2012, only under the following circumstances: (1) during the five business-day period after any five consecutive trading-day period (the measurement period) in which the price per Note for each day of that measurement period was less than 98 percent of the product of the last reported sale price of our common stock and the conversion rate on each such day; (2) during any calendar quarter after the calendar quarter ending June 30, 2007, if the last reported sale price of our common stock for 20 or more trading days in a period of 30 consecutive trading days ending on the last trading day of our immediately preceding calendar quarter exceeds 130 percent of the applicable conversion price in effect on the last trading day of the immediately preceding calendar quarter; or (3) upon the occurrence of specified corporate events. The Notes will be convertible, regardless of the foregoing circumstances, at any time on or after March 15, 2012 through the third scheduled trading day immediately preceding the maturity date of the Notes, May 15, 2012.
 
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.
 
Subject to certain exceptions, if we undergo a “designated event” (as defined in the Indenture) holders of the Notes will have the option to require us to repurchase all or any portion of their Notes. The designated event repurchase price will be 100% of the principal amount of the Notes to be purchased plus any accrued and unpaid


57


 

interest (including special interest, if any) up to but excluding the designated event repurchase date. We will pay cash for all Notes so repurchased. We may not redeem the Notes prior to maturity.
 
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 $52.7 million.
 
The convertible note hedges are expected to reduce the potential dilution upon conversion of the Notes in the event that the market value per share of our common stock, as measured under the convertible note hedges, at the time of exercise is greater than the strike price of the convertible note hedges, which corresponds to the initial conversion price of the Notes and is subject to certain customary adjustments. If, however, the market value per share of our common stock exceeds the strike price of the warrants (discussed below) when such warrants are exercised, we will be required to issue common stock. Both the convertible note hedges and warrants provide for net-share settlement at the time of any exercise for the amount that the market value of our common stock exceeds the applicable strike price.
 
Also concurrent with the issuance of the Notes, we sold warrants to acquire 6,112,964 shares of our common stock at an exercise price of $53.77 per share. If the average price of our common stock during a defined period ending on or about the settlement date exceeds the exercise price of the warrants, the warrants will be settled, at our option, in cash or shares of our common stock. Proceeds received from the issuance of the warrants totaled approximately $25.7 million.
 
The convertible note hedges and sold warrants are separate transactions which will not affect holders’ rights under the Notes.
 
 
On May 23, 2005, our shelf registration statement was declared effective with the SEC covering the issuance of up to $400.0 million of securities including common stock, preferred stock and debt securities. No securities have been issued under the shelf registration. Under this shelf registration, we may publicly offer such registered securities from time-to-time at prices and terms to be determined at the time of the offering.
 
 
The following table summarizes our material contractual obligations, including both on- and off-balance sheet arrangements, and our commitments at December 31, 2007 (in thousands):
 
                                                         
Contractual Obligations
  Total     2008     2009     2010     2011     2012     Thereafter  
 
Long-term obligations
  $ 441,594     $ 38,104     $ 13,681     $ 13,589     $ 13,497     $ 362,723     $  
Operating lease obligations
    95,018       14,482       13,760       12,846       12,045       11,404       30,481  
Capital lease obligations
    376       376                                
                                                         
Total obligations
  $  536,988     $  52,962     $  27,441     $  26,435     $  25,542     $  374,127     $  30,481  
                                                         
 
Operating Lease Obligations.  Our operating lease obligations are primarily for payments under non-cancelable office space leases.
 
Capital Lease Obligations.  Our capital lease obligations are primarily related to leased furniture, fixtures and equipment. The terms of these leases are normally between three and five years.


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Long-term Obligations.  Long-term obligations include amounts payable under our Credit Agreement which terminates March 12, 2012 and our 2.0% Convertible Senior Notes which mature May 15, 2012.
 
 
We have no investments, loans or any other known contractual arrangements with special-purpose entities, variable interest entities or financial partnerships. During the year ended December 31 2007, the Company obtained three letters of credit through our Credit Agreement. A letter of credit for $351.3 million was obtained in March 2007 for the benefit of the clerk of the United States District Court for the Northern District of Illinois on behalf of the Company and AMERIGROUP Illinois, Inc. to stay the enforcement of a judgment in Qui Tam Litigation in the United States District Court for the Northern District of Illinois pending the resolution of the appeal to the United States Court of Appeals for the Seventh Court. See Part I, Item 3, Legal Proceedings. A letter of credit for $18.2 million was obtained in connection with the November 1, 2007 MMCC acquisition to secure the contingent payment under the purchase agreement. Lastly, a letter of credit for the benefit of the State of Georgia Department of Community Health for $17.4 million was obtained in compliance with requirements of the Georgia Medicaid contract.
 
Commitments
 
As of December 31, 2007, the Company has no commitments.
 
 
Although the general rate of inflation has remained relatively stable and healthcare cost inflation has stabilized in recent years, the national healthcare cost inflation rate still significantly exceeds the general inflation rate. We use various strategies to reduce the negative effects of healthcare cost inflation. Specifically, our health plans try to control medical and hospital costs through contracts with independent providers of healthcare services. Through these contracted care providers, our health plans emphasize preventive healthcare and appropriate use of specialty and hospital services.
 
 
As of December 31, 2007, we had short-term investments of $199.9 million, long-term investments of $379.7 million and investments on deposit for licensure of $89.5 million. These investments consist of debt securities with maturities between three months and thirty-three years. These investments are subject to interest rate risk and will decrease in value if market rates increase. Credit risk is managed by investing in highly-rated securities which include U.S. Treasury securities, debt securities of government sponsored entities, municipal bonds, commercial paper, auction rate securities, corporate securities, corporate bonds and money market funds. Our investment policies are subject to revision based upon market conditions and our cash flow and tax strategies, among other factors. We have the ability to hold these investments to maturity, and as a result, we would not expect the value of these investments to decline significantly as a result of a sudden change in market interest rates. As of December 31, 2007, a hypothetical 1% change in interest rates would result in an approximate $6.7 million change in our annual investment income or $0.08 change in diluted earnings per share.
 
We also have interest rate risk from changing interest rates related to our outstanding debt under the Credit Agreement. As of December 31, 2007, we had $129.0 million of Eurodollar-based floating rate debt outstanding under the Credit Agreement. A hypothetical 1% increase in interest rates would increase our annual interest expense by $1.3 million or $0.01 per diluted share net of the related income tax effect.


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The Board of Directors and Stockholders
AMERIGROUP Corporation:
 
We have audited the accompanying consolidated balance sheets of AMERIGROUP Corporation and subsidiaries as of December 31, 2007 and 2006, and the related consolidated income statements and consolidated statements of stockholders’ equity and cash flows for each of the years in the three-year period ended December 31, 2007. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
 
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
 
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of AMERIGROUP Corporation and subsidiaries as of December 31, 2007 and 2006, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2007, in conformity with U.S. generally accepted accounting principles.
 
As discussed in Note 2 to the consolidated financial statements, effective January 1, 2006, AMERIGROUP Corporation adopted the provisions of Statement of Financial Accounting Standards No. 123(R), Share-Based Payments. Also as discussed in Note 2 to the consolidated financial statements, effective January 1, 2007, AMERIGROUP Corporation adopted the provisions of Financial Accounting Standards Board Interpretation No. 48, Accounting for Uncertainty in Income Taxes.
 
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), AMERIGROUP Corporation’s internal control over financial reporting as of December 31, 2007, based on criteria established in Internal Control — Integrated Framework, issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated February 22, 2008 expressed an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting.
 
/s/  KPMG LLP
Norfolk, VA
February 22, 2008


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Item 8.   Financial Statements and Supplementary Data
 
 
CONSOLIDATED BALANCE SHEETS
(Dollars in thousands, except per share data)
 
                 
    December 31,  
    2007     2006  
 
ASSETS
Current assets:
               
Cash and cash equivalents
  $    487,614     $    176,718  
Short-term investments
    199,947       167,703  
Restricted investments held as collateral
    351,318        
Premium receivables
    82,940       63,594  
Deferred income taxes
    23,475       21,550  
Provider and other receivables
    43,913       44,098  
Prepaid expenses and other current assets
    39,001       27,446  
                 
Total current assets
    1,228,208       501,109  
Long-term investments
    379,733       431,852  
Investments on deposit for licensure
    89,485       68,511  
Property, equipment and software, net
    97,933       81,604  
Deferred income taxes
    12,075        
Other long-term assets
    18,178       7,279  
Goodwill and other intangible assets, net of accumulated amortization of $29,986 and $27,707 at December 31, 2007 and 2006, respectively
    263,009       255,340  
                 
    $    2,088,621     $    1,345,695  
                 
 
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
               
Claims payable
  $    541,173     $    385,204  
Accounts payable
    6,775       6,285  
Unearned revenue
    55,937       26,116  
Accrued payroll and related liabilities
    47,965       39,951  
Accrued expenses and other current liabilities
    119,223       104,571  
Current portion of long-term debt
    27,567        
Current portion of capital lease obligations
    368       795  
                 
Total current liabilities
    799,008       562,922  
Long-term convertible debt
    260,000        
Long-term debt less current portion
    101,458        
Capital lease obligations less current portion
          415  
Deferred income taxes
          7,637  
Other long-term liabilities
    14,248       6,136  
                 
Total liabilities
    1,174,714       577,110  
                 
Commitments and contingencies (note 11)
               
Stockholders’equity:
               
Common stock, $0.01 par value. Authorized 100,000,000 shares; issued and outstanding 53,129,928 and 52,272,824 at December 31, 2007 and 2006, respectively
    532       523  
Additional paid-in capital
    412,065       391,566  
Retained earnings
    502,182       376,547  
                 
      914,779       768,636  
                 
Less treasury stock at cost (25,713 and 1,728 shares at December 31, 2007 and December 31, 2006, respectively)
    (872 )     (51 )
                 
Total stockholders’ equity
    913,907       768,585  
                 
Total liabilities and stockholders’equity
  $    2,088,621     $    1,345,695  
                 
 
See accompanying notes to consolidated financial statements.


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AMERIGROUP CORPORATION AND SUBSIDIARIES
 
CONSOLIDATED INCOME STATEMENTS
 
                         
    Year Ended December 31,  
    2007     2006     2005  
    (Dollars in thousands, except for per share data)  
 
Revenues:
                       
Premium
  $ 3,872,210     $ 2,795,810     $ 2,311,599  
Investment income and other
    73,320       39,279       18,310  
                         
Total revenues
    3,945,530       2,835,089       2,329,909  
                         
Expenses:
                       
Health benefits
    3,216,070       2,266,017       1,957,196  
Selling, general and administrative
    499,000       369,896       258,446  
Depreciation and amortization
    31,604       25,486       26,948  
Interest
    12,291       608       608  
                         
Total expenses
    3,758,965       2,662,007       2,243,198  
                         
Income before income taxes
    186,565       173,082       86,711  
Income tax expense
    70,115       65,976       33,060  
                         
Net income
  $ 116,450     $ 107,106     $ 53,651  
                         
Net income per share:
                       
Basic net income per share
  $ 2.21     $ 2.07     $ 1.05  
                         
Weighted average number of common shares outstanding
    52,595,503       51,863,999       51,213,589  
                         
Diluted net income per share
  $ 2.16     $ 2.02     $ 1.02  
                         
Weighted average number of common shares and dilutive potential common shares outstanding
    53,845,829       53,082,933       52,857,682  
                         
 
See accompanying notes to consolidated financial statements.


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AMERIGROUP CORPORATION AND SUBSIDIARIES
 
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
 
                                                         
                Additional
                      Total
 
    Common Stock     Paid-in
    Retained
    Treasury Stock     Stockholders’
 
    Shares     Amount     Capital     Earnings     Shares     Amount     Equity  
    (Dollars in thousands)  
 
Balances at January 1, 2005
    50,529,724     $  505     $  352,417     $  215,790           $     $  568,712  
Common stock issued upon exercise of stock options and purchases under the employee stock purchase plan
    1,037,616       11       10,756                         10,767  
Tax benefit from exercise of stock options
                8,571                         8,571  
Other
                      (147 )                 (147 )
Net income
                      53,651                   53,651  
                                                         
Balances at December 31, 2005
    51,567,340       516       371,744       269,294                   641,554  
Common stock issued upon exercise of stock options, vesting of restricted stock grants, and purchases under the employee stock purchase plan
    707,212       7       8,734                         8,741  
Compensation expense related to share-based payments
                8,477                         8,477  
Tax benefit from exercise of stock options
                2,611                         2,611  
Treasury stock redeemed for payment of stock option exercise
    (1,728 )                       1,728       (51 )     (51 )
Other
                      147                   147  
Net income
                      107,106                   107,106  
                                                         
Balances at December 31, 2006
    52,272,824       523       391,566       376,547       1,728       (51 )     768,585  
Common stock issued upon exercise of stock options, vesting of restricted stock grants, and purchases under the employee stock purchase plan
    881,089       9       11,653                         11,662  
Compensation expense related to share-based payments
                11,879                         11,879  
Tax benefit from exercise of stock options
                4,664                         4,664  
Treasury stock redeemed for payment of employee taxes
    (23,985 )                       23,985       (821 )     (821 )
Purchase of convertible note hedge instruments
                (52,702 )                       (52,702 )
Deferred tax asset related to purchase of convertible note hedge instruments
                19,343                         19,343  
Sale of warrant instruments
                25,662                         25,662  
Cumulative effect of adoption of Financial Accounting Standards Board Interpretation No. 48
                                                       
Accounting for Uncertainty in Income Taxes
                      9,185                   9,185  
Net income
                      116,450                   116,450  
                                                         
Balances at December 31, 2007
    53,129,928     $ 532     $ 412,065     $ 502,182       25,713     $  (872 )   $ 913,907  
                                                         
 
See accompanying notes to consolidated financial statements.


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AMERIGROUP CORPORATION AND SUBSIDIARIES
 
CONSOLIDATED STATEMENTS OF CASH FLOWS
 
                         
    Years Ended December 31,  
    2007     2006     2005  
    (Dollars in thousands)  
 
Cash flows from operating activities:
                       
Net income
  $ 116,450     $ 107,106     $ 53,651  
Adjustments to reconcile net income to net cash provided by operating activities:
                       
Depreciation and amortization
    31,604       25,486       26,948  
Loss (gain) on disposal or abandonment of property, equipment and software
    67       725       (61 )
Deferred tax benefit
    (2,204 )     (12,214 )     (1,247 )
Compensation expense related to share-based payments
    11,879       8,477        
Tax benefit related to exercise of stock options
                8,571  
Changes in assets and liabilities increasing (decreasing) cash flows from operations:
                       
Premium receivables
    (19,346 )     12,548       (26,234 )
Prepaid expenses, provider and other receivables and other current assets
    (18,499 )     (21,683 )     (15,919 )
Other assets
    (2,577 )     (647 )     (1,074 )
Claims payable
    155,969       36,525       80,002  
Accounts payable, accrued expenses and other current liabilities
    39,464       57,144       13,828  
Unearned revenue
    29,821       21,764       (24,600 )
Other long-term liabilities
    8,112       420       (760 )
                         
Net cash provided by operating activities
    350,740       235,651       113,105  
                         
Cash flows from investing activities:
                       
Purchase of restricted investments held as collateral
    (402,812 )            
Release of restricted investments held as collateral
    51,494              
Purchase of convertible note hedge instruments
    (52,702 )            
Proceeds from sale of warrant instruments
    25,662              
Proceeds from sale of available-for-sale securities
    1,618,765       1,576,108       1,120,383  
Purchase of available-for-sale securities
    (1,602,250 )     (1,602,946 )     (1,027,478 )
Proceeds from redemption of held-to-maturity securities
    524,458       383,466       214,333  
Purchase of held-to-maturity securities
    (521,098 )     (641,099 )     (237,393 )
Purchase of contract rights and related assets
    (11,733 )            
Purchase of property and equipment and software
    (40,334 )     (41,102 )     (25,819 )
Proceeds from redemption of investments on deposit for licensure
    63,339       50,006       46,064  
Purchase of investments on deposit for licensure
    (84,313 )     (61,860 )     (56,329 )
Purchase price adjustment paid
          (4,766 )      
Stock acquisition, net of cash acquired
                (107,645 )
                         
Net cash used in investing activities
    (431,524 )     (342,193 )     (73,884 )
                         
Cash flows from financing activities:
                       
Proceeds from issuance of convertible notes
    260,000              
Borrowings under credit facility
    351,318              
Repayment of borrowings under credit facility
    (222,293 )            
Payment of debt issuance costs
    (11,732 )           (1,626 )
Net (decrease) increase in bank overdrafts
    (1,097 )     1,397        
Payment of capital lease obligations
    (842 )     (1,607 )     (3,323 )
Proceeds from exercise of stock options and employee stock purchases
    11,662       8,690       10,767  
Tax benefit related to exercise of stock options
    4,664       2,611        
                         
Net cash provided by financing activities
    391,680       11,091       5,818  
                         
Net increase (decrease) in cash and cash equivalents
    310,896       (95,451 )     45,039  
Cash and cash equivalents at beginning of year
    176,718       272,169       227,130  
                         
Cash and cash equivalents at end of year
  $ 487,614     $ 176,718     $ 272,169  
                         
Non-cash disclosures:
                       
Common stock redeemed for payment of employee taxes
  $ (821 )   $ (51 )   $  
                         
Cumulative effect of adoption of Financial Accounting Standards Board
                       
Interpretation No. 48,
                       
Accounting for Uncertainty in Income Taxes
  $ 9,185     $     $  
                         
Deferred tax asset related to purchase of convertible note hedge instruments
  $ 19,343     $     $  
                         
Supplemental disclosures of cash flow information:
                       
Cash paid for interest
  $ 10,073     $ 576     $ 621  
                         
Cash paid for income taxes
  $ 77,931     $ 65,917     $ 27,494  
                         
 
See accompanying notes to consolidated financial statements.


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AMERIGROUP CORPORATION AND SUBSIDIARIES
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2007, 2006 and 2005
(Dollars in thousands, except for per share data)
 
 
  (a)   Corporate Organization
 
AMERIGROUP Corporation (the “Company”), a Delaware corporation, is a multi-state managed healthcare company focused on serving people who receive healthcare benefits through publicly sponsored programs, including Medicaid, State Children’s Health Insurance Program (“SCHIP”), FamilyCare and Medicare Advantage.
 
The company was incorporated in 1994 and began operations of its wholly owned subsidiaries to develop, own and operate as managed healthcare companies.
 
  (b)   Principles of Consolidation
 
The consolidated financial statements include the financial statements of AMERIGROUP Corporation and its wholly-owned subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation.
 
(2)  Summary of Significant Accounting Policies and Practices
 
  (a)   Cash Equivalents
 
We consider all highly liquid investments with original maturities of three months or less to be cash equivalents. We had cash equivalents of $436,280 and $142,291 at December 31, 2007 and 2006, respectively, which consist of commercial paper, money market funds, U.S. Treasury Securities, debt securities of government sponsored entities and municipal bonds.
 
  (b)   Short and Long-Term Investments and Investments on Deposit for Licensure
 
Short and long-term investments and investments on deposit for licensure at December 31, 2007 and 2006 consist of certificates of deposit, commercial paper, money market funds, U.S. Treasury securities, corporate securities, corporate bonds, debt securities of government sponsored entities, municipal bonds and auction rate securities. We consider all investments with original maturities greater than three months but less than or equal to twelve months to be short-term investments. We classify our debt securities in one of three categories: trading, available-for-sale or held-to-maturity. Trading securities are bought and held principally for the purpose of selling them in the near term. Held-to-maturity securities are those securities in which we have the ability and intent to hold the security until maturity. All other securities not included in trading or held-to-maturity are classified as available-for-sale. At December 31, 2007 and 2006, our auction rate securities are classified as available-for-sale. All other securities are classified as held-to-maturity.
 
Available-for-sale securities are recorded at fair value. Changes in fair value are reported in other comprehensive income until realized through the sale or maturity of the security. As of December 31, 2007 and 2006, the Company had no unrealized gains or losses related to available-for-sale securities.
 
Included in short-term investments are auction rate securities totaling $104,575 and $121,090 at December 31, 2007 and 2006, respectively. Auction rate securities are comprised of municipal note investments with an auction reset feature. These notes are issued by various state and local municipal entities for the purpose of financing student loans, public projects and other activities; they carry a AAA credit rating. Liquidity for these auction rate securities is typically provided by an auction process which allows holders to sell their notes and resets the applicable interest rate at pre-determined intervals, usually every 28 or 35 days. An auction failure may occur if parties wishing to sell their securities cannot be matched with an adequate volume of buyers. In the event that there is a failed auction the indenture governing the security requires the issuer to pay interest at a contractually defined rate that is generally above market rates for other types of similar short-term instruments.


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AMERIGROUP CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
Held-to-maturity securities are recorded at amortized cost, adjusted for the amortization or accretion of premiums or discounts. A decline in the market value of any held-to-maturity security below cost that is deemed other than temporary results in a reduction in carrying amount to fair value. The impairment is charged to earnings and a new cost basis for the security is established. Premiums and discounts are amortized or accreted over the life of the related held-to-maturity security as an adjustment to yield using the effective-interest method. Dividend and interest income is recognized when earned.
 
  (c)  Property and Equipment
 
Property and equipment are stated at cost less accumulated depreciation and amortization. Depreciation and amortization expense on property and equipment is calculated on the straight-line method over the estimated useful lives of the assets. Property and equipment held under capital leases and leasehold improvements are amortized on the straight-line method over the shorter of the lease term or estimated useful life of the asset. Depreciation and amortization expense on property and equipment was $16,372, $13,714 and $12,978 for the years ended December 31, 2007, 2006 and 2005, respectively. The estimated useful lives are as follows:
 
         
Leasehold improvements
    3-15 years  
Furniture and fixtures
    7 years  
Equipment
    3-5 years  
 
  (d)  Software
 
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.
 
  (e)  Goodwill and Other Intangibles
 
Goodwill represents the excess of cost over fair value of businesses acquired. In accordance with Financial Accounting Standards Board (“FASB”) Statement No. 142, Goodwill and Other Intangible Assets (“FASB Statement No. 142”), goodwill and intangible assets acquired in a purchase business combination and determined to have an indefinite useful life are not amortized, but instead tested for impairment at least annually. FASB Statement No. 142 also requires that intangible assets with estimable useful lives be amortized over their respective estimated useful lives to their estimated residual values, and reviewed for impairment in accordance with FASB Statement No. 144, Accounting for Impairment or Disposal of Long-Lived Assets.
 
  (f)  Other Assets
 
Other assets include cash on deposit for payment of claims under administrative services only arrangements, deposits, debt issuance costs and cash surrender value of life insurance policies.
 
  (g)  Income Taxes
 
We account for income taxes in accordance with the provisions of the FASB Statement No. 109, Accounting for Income Taxes. On a quarterly basis, we estimate our required tax liability based on enacted tax rates, estimates of book to tax differences in income, and projections of income that will be earned in each taxing jurisdiction. Deferred tax assets and liabilities representing the tax effect of temporary differences between financial reporting net income and taxable income are measured at the tax rates enacted at the time the deferred tax asset or liability is recorded.
 
After tax returns for the applicable year are filed, the estimated tax liability is trued up to the actual liability per the filed federal and state tax returns. Historically, we have not experienced significant differences between our estimates of tax liability and our actual tax liability.


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AMERIGROUP CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
Similar to other companies, we sometimes face challenges from the tax authorities regarding the amount of taxes due. Positions taken on our tax returns are evaluated and benefits are recognized only if it is more likely than not that our position will be sustained on audit. Based on our evaluation of tax positions, we believe that we have appropriately accrued for potential tax exposures.
 
In addition, we are periodically audited by federal and state taxing authorities and these audits can result in proposed assessments. We believe that our tax positions comply with applicable tax law and, as such, will vigorously defend these positions on audit. We believe that we have adequately provided for any reasonable foreseeable outcome related to these matters. Although the ultimate resolution of these audits may require additional tax payments, we do not anticipate any material impact to earnings.
 
  (h)  Premium Taxes
 
Taxes based on premium revenues are currently paid by our plans in the States of Texas, New Jersey, Maryland (beginning April 1, 2005), New York, Ohio, Georgia and Tennessee. Premium tax expense totaled $85,218, $47,100 and $25,903 in 2007, 2006 and 2005, respectively, and is included in selling, general and administrative expenses. As of December 31, 2007, premium taxes range from 2% to 6% of revenues or are calculated on a per member per month basis.
 
  (i)  Stock-Based Compensation
 
On December 16, 2004, the FASB issued FASB Statement No. 123 (revised 2004), Shared-Based Payment (“FASB Statement No. 123(R)”), which is a revision of FASB Statement No. 123. FASB Statement No. 123(R) supersedes Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, (APB Opinion No. 25), FASB Statement No. 148, Accounting for Stock-Based Compensation and amends FASB Statement No. 95, Statement of Cash Flows. FASB Statement No. 123(R) established the accounting for transactions in which an entity pays for employee services in share-based payment transactions. FASB Statement No. 123(R) requires companies to measure the cost of employee services received in exchange for an award of equity instruments based on the grant date fair value of the award. The fair value of employee share options and similar instruments is estimated using option-pricing models adjusted for the unique characteristics of those instruments. That cost is recognized over the period during which an employee is required to provide service in exchange for the award. The Company adopted FASB Statement No. 123(R) effective January 1, 2006, using the modified-prospective transition method. Under this method, compensation cost was recognized for awards granted and for awards modified, repurchased, or cancelled in the period after adoption. Compensation cost has also been recognized for the unvested portion of awards granted prior to adoption. Prior year financial statements were not restated.


67


 

 
AMERIGROUP CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
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.
 
         
    2005  
 
Net income:
       
Reported net income
  $  53,651  
Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects
    16,563  
         
Pro forma net income
  $ 37,088  
         
Basic net income per share:
       
Reported basic net income per share
  $ 1.05  
Pro forma basic net income per share
  $ 0.72  
Diluted net income per share:
       
Reported diluted net income per share
  $ 1.02  
Pro forma diluted net income per share
  $ 0.70  
 
On August 10, 2005, the Compensation Committee approved the immediate and full acceleration of vesting of approximately 909,000 “out-of-the-money” stock options awarded on February 9, 2005 to employees, including its executive officers, under the Company’s annual bonus program pursuant to its 2003 Equity Incentive Plan (the “Grant”). No other option grants were affected. Each stock option issued as a part of the Grant has an exercise price which is greater than the closing price per share on the date of the Compensation Committee’s action. The purpose of the acceleration was to enable the Company to avoid recognizing compensation expense associated with these options in future periods in its consolidated income statements, as a result of FASB Statement No. 123(R). The pre-tax charge avoided totals approximately $8,900 which would have been recognized over the years 2006 and 2007. This amount has been reflected in the proforma disclosures of the 2005 consolidated year-end financial statements. Because the options that were accelerated had a per share exercise price in excess of the market value of a share of the Company’s common stock on the date of acceleration, the Compensation Committee determined that the expense savings outweighs the objective of incentive compensation and retention.
 
  (j)  Premium Revenue
 
We record premium revenue based on membership and premium information from each government partner. Premiums are due monthly and are recognized as revenue during the period in which we are obligated to provide services to members. In all of our states except Tennessee and Virginia, we are eligible to receive supplemental payments for newborns and/or obstetric deliveries. Each state contract is specific as to what is required before payments are generated. Upon delivery of a newborn, each state is notified according to our contract. Revenue is recognized in the period that the delivery occurs and the related services are provided to our member. Additionally, in some states we receive supplemental payments for certain services such as high cost drugs and early childhood prevention screenings. Any amounts that have been earned and have not been received from the state by the end of the period are recorded on our balance sheet as premium receivables.
 
  (k)  Experience Rebate Payable
 
Experience rebate payable, included in accrued expenses and other current liabilities, consists of estimates of amounts due under contracts with the State of Texas. These amounts are computed based on a percentage of the contract profits as defined in the contract with the state. The profitability computation includes premium revenue earned from the state less actual medical and administrative costs incurred and paid and less estimated unpaid claims payable for the applicable membership. The unpaid claims payable estimates are based on historical


68


 

 
AMERIGROUP CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
payment patterns using actuarial techniques. A final settlement is generally made 334 days after the contract period ends using paid claims data and is subject to audit by the State any time thereafter. Any adjustment made to the experience rebate payable as a result of final settlement is included in current operations.
 
  (l)  Claims Payable
 
Accrued medical expenses for claims associated with the provision of services to our members (including hospital inpatient and outpatient services, physician services, pharmacy and other ancillary services) include amounts billed and not paid and an estimate of costs incurred for unbilled services provided. These estimates are principally based on historical payment patterns while taking into consideration variability in those patterns using actuarial techniques. In addition, claims processing costs are accrued based on an estimate of the costs necessary to process unpaid claims. Claims payable are reviewed and adjusted periodically and, as adjustments are made, differences are included in current operations.
 
The following table presents the components of the change in medical claims payable for the years ended December 31 (in thousands):
 
                         
    2007     2006     2005  
 
Medical claims payable as of January 1
  $ 385,204     $ 348,679     $ 241,253  
Medical claims payable assumed from businesses acquired during the year
                27,424  
Health benefits expenses incurred during the year:
                       
Related to current year
    3,284,302       2,328,863       1,982,880  
Related to prior years
    (68,232 )     (62,846 )     (25,684 )
                         
Total incurred
    3,216,070       2,266,017       1,957,196  
Health benefits payments during the year:
                       
Related to current year
    2,769,331       1,971,505       1,646,664  
Related to prior years
    290,770       257,987       230,530  
                         
Total payments
    3,060,101       2,229,492       1,877,194  
                         
Medical claims payable as of December 31
  $ 541,173     $ 385,204     $ 348,679  
                         
Current year medical claims paid as a percent of current year health benefits expenses incurred
    84.3 %     84.7 %     83.0 %