Coventry Health Care 10-K 2008
Documents found in this filing:
SECURITIES AND EXCHANGE COMMISSION
Washington, D. C. 20549
xANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the Fiscal Year Ended December 31, 2007
oTRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
COMMISSION FILE NUMBER 1-16477
COVENTRY HEALTH CARE, INC.
(Exact name of registrant as specified in its charter)
6705 Rockledge Drive, Suite 900, Bethesda, Maryland 20817
(Address of principal executive offices) (Zip Code)
Registrants telephone number, including area code: (301)581-0600
Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act:
Common Stock, $.01 par value
Common Stock purchase rights
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes x 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 x
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 x 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 registrants knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of accelerated filer and large accelerated filer in Rule 12b-2 of the Exchange Act (check one). Large accelerated filer x Accelerated filer o Non-accelerated filer 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 x
The aggregate market value of the registrants voting Common Stock held by non-affiliates of the registrant as of June 30, 2007 (computed by reference to the closing sales price of such stock on the NYSE® stock market on such date) was $8,925,733,975.
As of January 31, 2008, there were 154,706,723 shares of the registrants voting Common Stock outstanding.
DOCUMENTS INCORPORATED BY REFERENCE
Parts of the registrants Proxy Statement for its 2008 Annual Meeting of Shareholders to be filed with the Commission pursuant to Regulation 14A subsequent to the filing of this Form 10-K Report are incorporated by reference in Items 10 through 14 of Part III hereof.
COVENTRY HEALTH CARE, INC.
TABLE OF CONTENTS
Cautionary Statement Regarding Forward-Looking Statements
This Form 10-K contains forward-looking statements which are subject to risks and uncertainties in accordance with the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Forward-looking statements typically include assumptions, estimates or descriptions of our future plans, strategies and expectations, and are generally identifiable by the use of the words anticipate, will, believe, estimate, expect, intend, seek, or other similar expressions. Examples of these include discussions regarding our operating and growth strategy, projections of revenue, income or loss and future operations. Unless this Form 10-K indicates otherwise or the context otherwise requires, the terms we, our, our Company, the Company or us as used in this Form 10-K refer to Coventry Health Care, Inc. and its subsidiaries as of December 31, 2007.
These forward-looking statements may be affected by a number of factors, including, but not limited to, the Risk Factors contained in Item 1A, Risk Factors in this Form 10-K. Actual operations and results may differ materially from those expressed in this Form 10-K. Among the factors that may materially affect our business are increases in medical costs, difficulties in increasing premiums due to competitive pressures, unanticipated revenue shortfalls in recently acquired companies, price restrictions under Medicaid and Medicare, problems in integrating or realizing efficiencies in acquired companies, issues related to product marketing and imposition of regulatory restrictions, costs, or penalties. Other factors that may materially affect the Companys business include issues related to the inability in obtaining or maintaining favorable contracts with health care providers, credit risks on global capitation arrangements, financing costs and contingencies, the ability to increase membership and litigation risk.
Item 1: Business
We are a diversified national managed healthcare company based in Bethesda, Maryland, operating health plans, insurance companies, network rental and workers compensation services companies. Through our Commercial Business, Individual Consumer & Government Business, and Specialty Business divisions, we provide a full range of risk and fee-based managed care products and services to a broad cross section of individuals, employer and government-funded groups, government agencies, and other insurance carriers and administrators.
Coventry was incorporated under the laws of the State of Delaware on December 17, 1997 and is the successor to Coventry Corporation, which was incorporated on November 21, 1986. Our Annual Report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to these reports, and recent press releases can be found, within one week of being filed with or furnished to the Securities and Exchange Commission (SEC), free of charge, on the Internet at www.coventryhealth.com.
The Commercial Business Division provides products to a cross section of employer groups of all sizes including health maintenance organization (HMO), preferred provider organizations (PPO), and point of service (POS) products. We offer these products on an underwritten or risk basis where we receive a monthly premium in exchange for assuming underwriting risks including all medical and administrative costs. We also offer commercial management services products on a self-funded basis where we perform administrative services only (ASO) for a fee and the customer assumes the risk for medical costs. Within these products, we also offer consumer-directed benefit options including health reimbursement accounts (HRA) and health savings accounts (HSA). Additionally, the Commercial Business Division provides network rental services and other managed care products through a national PPO network to national, regional and local third party administrators (TPA) and insurance carriers.
The Individual Consumer & Government Division provides comprehensive health benefits to members participating in the Medicare Advantage HMO, Medicare Advantage PPO, Medicare Advantage Private-Fee-For-Service, Medicare Prescription Drug, and Medicaid programs and receives premium payments from federal and state governments. The Medicare Advantage and Medicaid products offered through our health plans are risk products. This division also provides fully-insured managed care services on an individual basis and also offers products and services more specialized to the needs of state governments such as pharmacy benefit management, clinical management and fiscal intermediary services on a fee-for-service basis.
The Specialty Business Division provides workers compensation managed care services on a fee-based basis, with products including access to our provider network, pharmacy benefits management, field case management, telephonic case management, independent medical exam and bill review capabilities.
We operate local health plans that serve 22 markets, primarily in the Mid-Atlantic, Midwest and Southeast United States. Our health plans are operated under the names Altius Health Plans, Carelink Health Plans, Coventry Health Care, Coventry Health and Life, Group Health Plan, HealthAmerica, HealthAssurance, HealthCare USA, OmniCare, PersonalCare, Southern Health, Vista and WellPath. Our health plans generally are located in small to mid-sized metropolitan areas. For a complete list of subsidiaries, refer to Exhibit 21 included with this Annual Report on Form 10-K.
Our health plans offer a broad range of managed care products that fall into both the Commercial Business Division and the Individual Consumer & Government Business Division. Our health plan Commercial products include traditional HMO, PPO, and POS risk products, as well as self-funded products. In selected markets, our health plans participate in Medicaid and Medicare Advantage programs. The Medicare Advantage and Medicaid products offered through our health plans are risk products.
Commercial Business Division
Commercial Risk Products
Our health plans offer employer groups a full range of commercial risk products, designed to meet the needs and objectives of a wide range of employers and members, as well as to comply with the regulatory requirements in the markets where they operate. Our health plans had 1.6 million commercial risk members as of December 31, 2007 that accounted for $4.8 billion of revenue in 2007.
Our health plan products vary with respect to product features, the level of benefits provided, the costs to be paid by employers and members, including deductibles and co-payments, and our members access to providers without referral or preauthorization requirements.
Health Maintenance Organizations
Our health plan HMO products provide comprehensive health care benefits to members, including ambulatory and inpatient physician services, hospitalization, pharmacy, mental health, ancillary diagnostic and therapeutic services. In general, a fixed monthly premium covers all HMO services although some benefit plans require co-payments or deductibles in addition to the basic premium. A primary care physician assumes overall responsibility for the care of a member, including preventive and routine medical care and referrals to specialists and consulting physicians. While an HMO members choice of providers is limited to those within the health plans HMO network, the HMO member is typically entitled to coverage of a broader range of health care services than is covered by typical reimbursement or indemnity policies. Furthermore, many of our HMO products have added features to more easily allow direct access to providers.
Preferred Provider Organizations and Point of Service
Our health plan risk-based PPO and POS products also provide comprehensive managed health care benefits to members, but allow members to choose their health care providers at the time medical services are required. Members may also use providers that do not participate in our health plan managed care networks. If a member chooses a non-participating provider, deductibles, co-payments and other out-of-pocket costs to the member generally are higher than if the member chooses a participating provider. Our health plans also offer high deductible products in conjunction with our consumer directed products. Premiums for our PPO and POS products typically are lower than HMO premiums due to the increased out-of-pocket costs borne by the members.
We offer stop-loss insurance to enable us to serve as an integrated, single source for the managed care needs of our self-insured clients. Stop-loss policies are written through our wholly-owned insurance subsidiaries and can be written for specific and/or aggregate stop-loss insurance.
Commercial Management Services Products
Our health plans offer management services and access to their provider networks to employers that self-insure their employee health benefits. The management services provided under these ASO arrangements typically include medical claims administration, pharmacy benefits management, utilization management and quality assurance. Other features commonly provided to fully insured customers (such as value-added wellness benefits) are most commonly also extended to ASO customers. Under the ASO arrangements, our health plans receive a fixed fee for these management services and access to their provider networks and they assume no underwriting risk. As of December 31, 2007, the health plans had approximately 750,000 non-risk health plan members.
We also offer our managed care and administrative products to businesses with locations in several states that self-insure the health care benefits of their employees (National Accounts). A variety of stand-alone managed care services, as well as a portfolio of integrated health plan products, are generally offered to national, multi-site companies with 500 employees or more as well as to mid-size companies in regional and local markets.
In addition, we provide services to plans in the Federal Employee Health Benefits Program (FEHB Program) which is the largest employer-sponsored group health program in the United States. In the FEHB Program, federal employees have the opportunity to choose a health benefits carrier from a number of offered plans each year. We serve as the plan administrator to the Mail Handlers Benefit Plan (MHBP), our largest client. The MHBP offers health care benefits under the FEHB Program to federal employees and annuitants nationwide. We provide a full range of managed care and administrative services to MHBP and provide various managed care or administrative services to certain other FEHB Program Plans.
Commercial management services accounted for $484.2 million of revenue for the year ended December 31, 2007.
Medical Claims Administration Services
We provide comprehensive claims administration to group health clients who purchase our managed care services. We provide clients with an integrated package of health care benefits administration, including:
Pharmacy Benefits Management
We offer a comprehensive pharmacy benefit management program through the use of a third-party administrator, including:
The single source combination of pharmacy benefits management and medical management is critical to managing and assessing the total medical cost. Pharmacy data sources are linked with other data sources to internally identify at-risk members for our disease management programs.
We provide clinical programs including utilization review, case management and disease management through an internal staff consisting primarily of allied health professionals, registered nurses and physicians. This staff is supplemented by a nationwide network of consulting physicians with a full range of specialties. The in-house physician staff is a resource for the development of programs, as well as clinical policies and guidelines. The staff includes experienced, board-certified physicians in such specialties as internal medicine, psychology, psychiatry and family practice. The staff is crucial to the development and maintenance of evidence-based medical necessity guidelines and network quality assessment efforts.
Our approach to clinical management is patient-centered, which means that we provide the level of support required to manage outcomes at an individual level. Our program focuses on proper management of illnesses and chronic conditions through early identification, intervention and education. Because we own and operate the program, we are able to aggregate data to identify at-risk members at an early stage and to monitor individual claims data to identify high-risk patients. We connect these patients with network providers and set appointments to facilitate compliance. We then work with the patients and their providers to identify and implement cost effective treatment alternatives. In all cases, the decision to proceed with these alternatives is made by the patient and the physician.
We offer our national PPO network and other managed care products to national, regional and local TPAs and insurance carriers. This business primarily operates on a business-to-business basis, focusing on delivering managed care and administrative solutions that increase client efficiency and improve their product offerings. Network services are supplemented with a variety of product offerings, including clinical management programs.
Individual Consumer & Governmental Business Division
As of December 31, 2007, our health plans operated six Medicare Advantage coordinated care plans in eight states. The Centers for Medicare & Medicaid Services (CMS) pays a county-specific fixed premium per member per month (PMPM) under our health plan Medicare contracts. Our health plans also receive a monthly premium from most of their Medicare members and/or their employer. However, beginning in 2006, each Medicare market in which the health plan segment operates had at least one benefit plan for which members do not pay a premium.
Commencing January 1, 2007, the Company began offering Medicare Advantage Private Fee for Service (PFFS) plans in 43 states under the name Advantra Freedom. These plans are offered under contracts with CMS and provide enrollees with all benefits they receive under original Medicare as well as additional benefits such as preventive care, eyeglasses/hearing aid coverage and pharmacy benefits. Enrollees are not limited to network providers and may utilize any provider willing to accept the plans terms and conditions. Providers generally receive the same reimbursement as under original Medicare. Our PFFS products are underwritten by our company insurance subsidiaries.
Our Medicare Advantage line of business covered 283,000 members as of December 31, 2007 and accounted for $2.2 billion of revenue in 2007.
Medicare Part D
The Medicare Part D program, which provides eligible beneficiaries access to prescription drug coverage, took effect January 1, 2006. As part of the Medicare Part D program, eligible Medicare recipients are able to select a prescription drug plan through Medicare Part D. Medicare Part D replaced the transitional prescription drug discount program and replaced Medicaid prescription drug coverage for dual-eligible beneficiaries. The Medicare Part D prescription drug benefit is largely subsidized by the federal government and is additionally supported by risk-sharing with the federal government through risk corridors designed to limit the profits or losses of the drug plans and through reinsurance for catastrophic drug costs. The government subsidy is based on the national weighted average monthly bid, by Medicare region, by participating plans for this coverage, adjusted for member demographics and risk factor payments. The beneficiary will be responsible for the difference between the government subsidy and his or her benefit plans bid, together with the amount of his or her benefit plans supplemental premium. Additional subsidies are provided for dual-eligible beneficiaries and specified low-income beneficiaries.
Our Medicare Part D business accounted for $700.8 million of revenue in 2007 and had 704,000 members as of December 31, 2007. The Medicare Part D plans are marketed under the brand names of Advantra Rx, First Health Premier and First Health Select. For 2007, these plans include options with first dollar coverage (no deductible) and options for generic coverage within the doughnut hole or the coverage gap in which no insurance coverage under the standard Part D program is available. These products are underwritten by Coventry Health and Life Insurance Company, First Health Life and Health Insurance Company and Cambridge Life Insurance Company. We have established partnerships with Medicare Supplement insurance carriers and brokerage channels nationwide to sell Medicare Part D prescription drug products to Medicare beneficiaries. Medicare eligibles can also purchase our Medicare Part D products via the internet.
Certain of our health plans offer health care coverage to Medicaid recipients in nine states which, as of December 31, 2007, covered 480,000 members and accounted for $928.3 million of revenue in 2007. These health plans enter into a Medicaid Management Care contract with each of these individual states. Under a Medicaid contract, the participating state pays a monthly premium per member based on the age, sex, eligibility category and in some states, county or region of the Medicaid member enrolled. In some states, these premiums are adjusted according to the health risk associated with the individual member. The majority of the Medicaid members are in the Florida, Michigan, Missouri and Pennsylvania markets, representing 87.6% of the total Medicaid membership.
Our health plans offer long-term major medical and high-deductible products to individual consumers. The products are purchased by the consumer with no federal or state government funding of the premium. There is no employer group to provide conditions of the contract or contribute to the premium. The distribution of these Coventry products is primarily through broker networks; however the consumer can access information and an application directly from us. Our health plans had 93,000 risk members as of December 31, 2007 and accounted for $104.7 million of revenue in 2007.
Our Medicaid/Public entity, (Public Sector), provides integrated automation, administration, payment and health care management services to state and local governments related to their pharmacy and health benefits programs. Our Public Sector offers pharmacy benefit management, health care management and fiscal agent services.
Our Public Sector pharmacy benefit management (PBM) program manages pharmacy benefit plans for Medicaid programs, state senior drug programs and state-funded specialty programs. This PBM program is one of the largest of its kind in the country and provides a full range of services.
Our Public Sector Health Care Management program provides quality of care evaluation, utilization review and long-term care review services to Medicaid programs, state mental health agencies and other public sector health care programs desiring to improve quality of care, contain costs, ensure appropriate care and measure outcomes.
Our Public Sector Fiscal Agent program administers state Medicaid benefit plans and other state-funded health care programs by providing clients with fiscal agent operations and systems maintenance and enhancement. Our Public Sector customers include state Medicaid agencies, state departments of human services and departments of health serving Medicaid populations and other public assistance health benefit programs. Typically, fiscal agent systems are modified to meet a specific states program policy and administration requirements so that services are offered for all claim types.
Specialty Business Division
The Specialty Business Division offers Workers Compensation managed care, network access, bill review, and other administrative services to insurance carriers, TPAs, state funds, and employers. We are not an underwriter of workers compensation insurance; instead we provide fee-based services to such underwriters and administrators of workers compensation insurance. In general, workers compensation carriers and self-funded entities have experienced significant challenges in recent years due to increases in medical costs. As a result, there is a demand by payors for products that target high cost and/or high volume services. We believe we have one of the most comprehensive suites of products including the largest and most cost effective workers compensation PPO network and bill review system providing national coverage to address customer needs. We operate our own workers compensation pharmacy benefit manager which when provided in coordination with our bill review and care management capabilities provides an attractive suite of services assisting our customers in managing their escalating workers compensation medical claims costs. Our clinical services include field case management, telephonic case management, utilization review, early intervention, and other services designed to manage the medical cost associated with a compensable workers compensation injury. Our business process outsourcing provides customers with work flow and medical records value-added solutions. In addition, we have developed other products to help our clients contain costs such as a subset point-of-entry network (smaller network of providers that are accessed for initial treatment by injured workers) and a Medicare set-aside program (when a payor determines that they want to settle a workers compensation claim, a Medicare set-aside program must be submitted to CMS, under certain conditions, to ensure that Medicares rights as the secondary payor are protected).
Workers Compensation Products
Our workers compensation Bill Review system offers national and multi-regional workers compensation clients a system to integrate and manage their workers compensation medical data. This means that clients can implement their workers compensation managed care strategies on a national basis, allowing them to capture data from multiple sources, analyze the information and use it to implement advanced managed care strategies.
Bill Review provides our clients with an accurate and consistent application of state fee schedule pricing, including applicable rules, regulations and clinical guidelines. State fee schedules, which represent the maximum reimbursement for medical services provided to the injured worker, differ by state (and change as state laws and regulations are passed and /or amended). The system features full integration with our provider network and provides a seamless process for determining claim payment rates. As part of the bill adjudication process, we subject bills to a sophisticated, proprietary process to detect duplicate bills and correct billing irregularities and inappropriate billing practices. We maintain and support virtually all aspects of the system. Therefore, clients gain efficiencies when using our integrated services by decreasing the staff previously required to support bill processing systems. We have the capability to program and implement client-specific enhancements, which provide truly customized bill review systems for our clients.
The system supports a number of electronic data interchanges from front-end systems, including claim systems and bill entry systems. The system also supports electronic data interchange output to populate back-end systems such as payment systems, claims systems, explanation of review production, state reporting and data warehousing.
In addition, our bill review system has a comprehensive reporting database that produces a standard set of client savings and management reports. Clients who lease the Bill Review system have online access to their data and are able to create reports at their desktops.
First Report of Injury
Early medical management intervention is important to achieving optimal outcomes in workers compensation cases. Prompt notification and initiation of medical management helps ensure that injured persons receive appropriate treatment that expedites their recovery and return to work.
Our First Report of Injury system is a quick and easy-to-use service that greatly simplifies the reporting process for workplace injuries, as well as non-occupational disability, property and general liability claims. The First Report of Injury service promotes immediate intervention after such occurrences. The system can transmit a first report to a designated representative within hours of notification. In addition to expediting reporting, the system can serve as a gateway to medical management services and channeling work place injury patients to our provider network.
Care Management Services
Our Care Management Services segment seeks to promote appropriate healthcare access and utilization by performing services designed to monitor cases and facilitate the return to work of injured or ill employees who have been out of work, receiving healthcare, or both, for an extended period of time due to a work-related or auto incident or disability. Care Management Services includes field case management, telephonic case management, independent medical examinations, utilization review and management, and peer reviews.
Field Case Management
We provide field case management services for workers compensation and auto injury cases through case managers working on a one-on-one basis with injured employees and their healthcare professional, employers, and insurance company adjusters.
Our field case managers, located in 49 states and the District of Columbia, focus on coordinating case activities to enable injured or ill workers to recover and return to work as quickly and safely as possible through medical management and vocational rehabilitation services. The medical management services we offer include reviewing diagnoses, prognoses, and treatment plans, coordinating the efforts of healthcare professionals, employers, and insurance company adjusters, and encouraging compliance and active participation on the part of the injured or ill worker to increase the effectiveness of the medical care provided. Our vocational rehabilitation services include job analysis, work capacity assessments, labor market assessments, job placement assistance, and return-to-work coordination.
Telephonic Case Management
Our telephonic case management services consist of telephonic management of workers compensation and auto injury claims, as well as of short-term disability, long-term disability, and employee absences covered under the Family and Medical Leave Act. Although similar to field case management in that telephonic case managers coordinate the efforts of individuals involved in a medical claim, telephonic case management is typically performed for claims of shorter duration. Most telephonic case management activities are completed within 30 to 90 days. Telephonic case management is an important component of early intervention that enables us to identify promptly those cases that require field case management or independent medical exams.
Independent Medical Examinations
We provide our customers with access to healthcare professionals who perform independent medical examinations to evaluate the medical condition and treatment plan of patients. We provide independent medical examination services primarily for the occupational healthcare, disability, and auto industries. Through our extensive network of independent medical professionals, our customers can receive independent medical reviews for injured claimants nationwide. Our technology enables customers to make on-line referrals and check on the current status of their cases.
Utilization Management, Pre-certification, Concurrent and Peer Review
Customers use our pre-certification and concurrent review services to ensure that a physician or registered nurse reviews, and pre-certifies if appropriate, specified medical procedures for medical necessity and appropriateness. Our pre-certification and concurrent review determinations are only recommendations to the customer; it is the customers claims adjuster who makes the actual decision to approve or deny a request for medical services. After we pre-certify a treatment plan, we follow up with the claimant to evaluate compliance and, as appropriate, discuss alternative treatment plans if the claimant does not respond to the initial treatment plan. Our peer services consist of the review of medical files by a physician, therapist, chiropractor, or other healthcare provider to determine if the care provided by other healthcare professionals appears to be necessary and appropriate.
Pharmacy Benefit Management
The workers compensation environment presents special challenges for pharmacy benefit management. Among these challenges are the need for coverage within hours after an injury has occurred, claimant freedom-of-choice in provider selection and rules, regulations and reimbursements that can widely differ from state-to-state.
Insurance carriers, third party administrators and employers contract with our First Script pharmacy benefit management program to overcome these challenges. First Script provides a retail network of over 58,000 pharmacies that can be accessed by workers compensation claimants immediately after an injury has occurred. First Script continues to provide service to these claimants throughout the life of their workers compensation claim, including through an integrated home delivery program.
In addition to providing network access to workers compensation claimants, First Script also offers a full suite of drug utilization review tools and reports to assist its clients in controlling their pharmacy costs. These tools go beyond basic formulary management and include predictive indicators of claim severity and direction. The application of these cost control tools must be balanced with the need for claimants to receive their drugs in a convenient and timely manner. Claimants who follow their doctors prescription orders are more likely to recover quicker and return to worker earlier. Both of these outcomes further contribute to lowering the clients overall workers compensation claim costs.
The geographic markets in which our health plans operate are described as follows:
Our provider network is the core of our health and workers compensation businesses, providing the foundation for our products and services. We contract with hospitals, physicians and other health care providers that provide health care services at pre-negotiated rates to members and customers of various payors, including employee groups, workers compensation payors, insurance carriers, TPAs, HMOs, self-insured employers, union trusts and government employee plans. Provider networks offer a means of managing health care costs by reducing the per-unit price of medical services accessed through the network while providing an increased number of patients to providers.
Our provider network optimizes client savings through a combination of increased penetration to a broad network and discounted unit costs savings. The majority of the facility contracts feature fixed rate structures that ensure cost effectiveness while incentivizing providers to control utilization. The fixed rate structures include per diems based on the intensity of care and/or Diagnostic Related Group based pricing for inpatient care. Hospital outpatient charges are typically controlled by fixed fee schedules. For facilities or procedures not covered by fixed pricing arrangements, charge master controls are generally negotiated.
Our health plans maintain provider networks in the local markets in which they operate. All of our health plans currently offer an open panel delivery system where individual physicians or physician groups contract with the health plans to provide services to members but also maintain independent practices in which they provide services to individuals who are not members of our health plans.
Most of our health plan contracted primary care and specialist physicians are compensated under a discounted fee-for-service arrangement. The majority of our health plans contract with hospitals to provide for inpatient per diem or per case hospital rates. Outpatient services are contracted on a discounted fee-for-service or a per case basis. Our health plans pay ancillary providers on a fixed fee schedule or a capitation basis. Prescription drug benefits are provided through a formulary and drug prices are negotiated at discounted rates through a national network of pharmacies.
Our health plans have capitation arrangements for certain ancillary health care services, such as mental health care, laboratory services and, in some cases, physician services. Under some capitated arrangements, physicians may also receive additional compensation from risk sharing and other incentive arrangements. Capitation arrangements limit our health plans exposure to the risk of increasing medical costs, but expose them to risk as to the adequacy of the financial and medical care resources of the provider organization. Our health plans are ultimately responsible for the coverage of their members pursuant to the customer agreements. To the extent that the respective provider organization faces financial difficulties or otherwise is unable to perform its obligations under the capitation arrangements, our health plans will be required to perform such obligations. Consequently, our health plans may have to incur costs in excess of the amounts they would otherwise have to pay under the original capitation arrangements. Medical costs associated with capitation arrangements made up approximately 4.9%, 6.1% and 6.5% of our total medical costs for the years ended December 31, 2007, 2006 and 2005, respectively. Membership associated with global capitation arrangements was approximately 110,000, 110,000 and 116,000 as of December 31, 2007, 2006 and 2005, respectively. Based on our knowledge and experience, we do not consider the financial risk associated with our existing capitation arrangements to be material.
We have established systems to monitor the availability, appropriateness and effectiveness of the patient care that our network providers provide to our members. We collect utilization data that is used to analyze over-utilization or under-utilization of services and to assist in arranging for appropriate care for our members and improving patient outcomes in a cost efficient manner. Our corporate medical department monitors the medical management policies of our subsidiaries and assists in implementing disease management programs, quality assurance programs and other medical management tools. In addition, we have internal quality assurance review committees made up of practicing physicians and staff members whose responsibilities include periodic review of medical records, development and implementation of standards of care based on current medical literature and the collection of data relating to results of treatment.
We have developed a comprehensive disease management program that identifies those members having certain chronic diseases, such as asthma and diabetes. Our case managers proactively work with members and their physicians to facilitate appropriate treatment, to help to ensure compliance with recommended therapies and to educate members on lifestyle modifications to manage the disease. We believe that our disease management program promotes the delivery of efficient care and helps to improve the quality of health care delivered.
Our medical directors supervise medical managers who review and approve, for coverage in accordance with the health benefit plan, requests by physicians to perform certain diagnostic and therapeutic procedures, using nationally recognized clinical guidelines developed based on nationwide benchmarks that maximize efficiency in health care delivery and InterQual, a nationally recognized evidence-based set of criteria developed through peer review medical literature. Medical managers also continually review the status of hospitalized patients and compare their medical progress with established clinical criteria, make hospital rounds to review patients medical progress and perform quality assurance and utilization functions.
Medical directors also monitor the utilization of diagnostic services and encourage the use of outpatient surgery and testing where appropriate. Data showing each physicians utilization profile for diagnostic tests, specialty referrals and hospitalization are collected and presented to physicians. The medical directors monitor these results in an attempt to ensure the use of cost-effective, medically appropriate services.
We focus on the satisfaction of our members. We monitor appointment availability, member-waiting times, provider environments and overall member satisfaction. We continually conduct membership surveys of existing employer groups concerning the quality of services furnished and suggestions for improvement.
We believe that integrated and reliable information technology systems are critical to our success. We have implemented advanced information systems to improve our operating efficiency, support medical management, underwriting and quality assurance decisions and effectively service our customers, members and providers. Each of our health plans operates on a single financial reporting system along with a common, fully integrated application which encompasses all aspects of our commercial, government and non-risk business, including enrollment, provider referrals, premium billing and claims processing.
We have dedicated in-house teams providing infrastructure and application support services to our members. Our data warehouse collects information from all of our health plans and uses it in medical management to support our underwriting, product pricing, quality assurance, rates, marketing and contracting functions. We have dedicated in-house teams that convert acquired companies to our information systems as soon as possible following the closing of the acquisition.
In 2007, approximately 71.7% of our claim transactions were received from providers in a Health Insurance Portability and Accountability Act of 1996 (HIPAA) compliant electronic data interface format. In 2007, our claims system auto adjudicated 81.7% of all claims.
We market our products and services to individuals, employer groups, national (multi-site) direct accounts, self-insured employers, government employees, multi-employer trusts with greater than 500 employees and through group health insurance carriers and TPAs. When marketing on a business-to-business basis directly to insurance carriers and TPAs, our customers have primary responsibility for offering our services to their underlying clients. We also market to both FEHB health plan sponsors and directly to federal employees as a means of increasing membership in the MHBP. Marketing is provided through our own direct sales staff and a network of non-exclusive, independent brokers and focused on developing new business as well as retaining existing business.
In addition to our commercial HMO, PPO, and POS products, both on a fully insured and self-funded basis, our local health plans also continue to expand the number of lower cost product options. These options include Coventry FlexChoice, a family of consumer-driven products, whereby the employee bears a substantially greater proportion of health care costs.
Where our large group segments may have benefit products provided to employees from multiple carriers, our small and medium size employers are most commonly offered our services on an exclusive basis. In the case of insurance carriers, we typically enter into a master service agreement under which we agree to provide our cost management services to health care plans maintained by the carriers customers. Our services are offered not only to new insurance policyholders, but also to existing policyholders at the time group health benefits are renewed.
Medicaid products are marketed to Medicaid recipients by state Medicaid authorities and through educational and community outreach programs.
Medicare Advantage products, which include both medical and pharmacy benefits, are commonly promoted through mass media and direct mail to both individuals and retirees of employer groups that provide benefits to retirees. Networks of independent brokers are also used in the marketing of Medicare products. Our Medicare Part D product is marketed through our existing channels as well as through joint marketing arrangements with Medicare Supplement Health Insurers, TPAs and related broker distribution entities. Additionally, we have established partnerships with Medicare Supplement Health Insurers and brokerage channels nationwide to provide Medicare Advantage products to Medicare beneficiaries.
We sell our Public Sector business, including government PBM, health care management and fiscal agent lines, through an internal sales team to state and local governments across the United States. While most contracts are ultimately awarded via request-for-proposals and a competitive bid process, pre-selling efforts are critical in targeting opportunities that best match our capabilities and service offerings. Through this pre-selling effort, we are also able to identify the particular needs of prospective clients and provide assistance in public and program policy development.
Workers compensation services are marketed to insurance carriers and TPAs, who in turn take responsibility for marketing our services to their prospects and clients. We also market directly to state funds, municipalities, self-insured payors and other distribution channels.
Our customer, the Mail Handlers Benefit Plan, represented 14.7%, 19.3% and 22.1% of our management services revenue for the years ended December 31, 2007, 2006 and 2005, respectively.
Our health plan commercial business is diversified across a large customer base and there are no commercial groups that make up 10% or more of our managed care premiums. We received 33.1%, 21.6%, and 11.8% of our managed care premiums for the years ended December 31, 2007, 2006 and 2005, respectively, from the federal Medicare programs throughout our various health plan markets and from national Part D and Medicare Private-Fee-For-Service products. We also received 10.7%, 11.1%, and 13.2% of our managed care premiums for the years ended December 31, 2007, 2006 and 2005, respectively, from our state-sponsored Medicaid programs throughout our various health plan markets. In 2007, the State of Missouri accounted for almost half of our health plan Medicaid premiums.
The managed care industry is highly competitive; both nationally and in the individual markets we serve. Generally, in each market, we compete against local health plans and nationally focused health insurers and managed care plans. We compete for employer groups and members primarily on the basis of the price of the benefit plans offered, locations of the health care providers, reputation for quality care and service, financial stability, comprehensiveness of coverage, diversity of product offerings and access to care. We also compete with other managed care organizations and indemnity insurance carriers in obtaining and retaining favorable contracts for health care services and supplies.
We compete in a highly fragmented market with national, regional and local firms specializing in utilization review and PPO cost management services and with major insurance carriers and TPAs that have implemented their own internal cost management services. In addition, other managed care programs, such as HMOs and group health insurers, compete for the enrollment of benefit plan participants. We are subject to intense competition in each market segment in which we operate. We distinguish ourselves on the basis of the quality and cost-effectiveness of our programs, our proprietary computer-based integrated information systems, our emphasis on commitment to service with a high degree of physician involvement, our national provider network including its penetration into secondary and tertiary markets and our role as an integrated provider of PBM services.
The Medicaid/Public lines of business have varying competitive factors that affect entry into the market as a new competitor. Fiscal agent services are provided to state Medicaid programs by only a few major competitors. The market for pharmacy services to states that have elected to outsource pharmacy benefit management services is served by a select group of major national competitors. The market for healthcare management services is more fragmented with no distinguishable market leader. In addition to national competitors including our Public Sector business, regional peer review organizations/quality improvement organizations also hold contracts in their individual states or local market.
Workers compensation competition includes regional and national managed care companies and other service providers with an emphasis on PPO, clinical programs or bill review. We differentiate ourselves based on our national PPO coverage and the ability to provide an integrated product, coupled with technology that reduces administrative cost. We compete with a multitude of PPOs, technology companies that provide bill review services, clinical case management companies, pharmacy benefit managers, and rehabilitation companies for the business of these insurers. While experience differs with various clients, obtaining a workers compensation insurer as a new client typically requires extended discussions and a significant investment of time. Given these characteristics of the competitive landscape, client relationships are critical to the success of our workers compensation products.
Required financial information related to our business segments is set forth in Note O of our consolidated financial statements.
Our Board of Directors has adopted a Code of Business Conduct and Ethics applicable to the members of our Board of Directors and our officers, including our Chief Executive Officer, Chief Financial Officer, Corporate Controller and our employees. In addition, the Board of Directors has adopted Corporate Governance Guidelines and committee charters for our Audit Committee, Compensation Committee and Nominating/Corporate Governance Committee. Our Code of Business Conduct and Ethics, Corporate Governance Guidelines and current committee charters can be accessed on our website at www.coventryhealth.com or may be requested by writing to the following address: Coventry Health Care, Inc., Attn: Corporate Secretary, 6705 Rockledge Drive, Suite 900, Bethesda, Maryland, 20817. Any amendments to our Code of Business Conduct and Ethics are posted to and can be accessed on our website.
As a managed health care company, we are subject to extensive government regulation of our products and services. The laws and regulations affecting our industry generally give state and federal regulatory authorities broad discretion in their exercise of supervisory, regulatory and administrative powers. These laws and regulations are intended primarily for the benefit of the members of the health plans. Managed care laws and regulations vary significantly from jurisdiction to jurisdiction and changes are frequently considered and implemented.
The states served by our health plans provide the principal legal and regulatory framework for the commercial risk products offered by our insurance companies and HMO subsidiaries. One of our insurance company subsidiaries, Coventry Health and Life Insurance Company (CH&L), offers managed care products, primarily PPO and POS products, in conjunction with our HMO subsidiaries in states where HMOs are not permitted to offer these types of health care benefits. CH&L does not currently offer traditional health indemnity insurance. In addition, one of our subsidiaries, First Health Life & Health Insurance Company, offers a small group PPO product in certain states.
Our regulated subsidiaries are required by state law to file periodic reports and to meet certain minimum capital and deposit and/or reserve requirements and may be restricted from paying dividends to the parent or making other distributions or payments under certain circumstances. They also are required to provide their members with certain mandated benefits. Our HMO subsidiaries are required to have quality assurance and educational programs for their professionals and enrollees. Certain states laws further require that representatives of the HMOs members have a voice in policy making. Most states impose requirements regarding the prompt payment of claims and several states permit any willing provider to join our network. Compliance with any willing provider laws could increase our costs of assembling and administering provider networks.
We also are subject to the insurance holding company regulations in the states in which our regulated subsidiaries operate. These laws and associated regulations generally require registration with the state department of insurance and the filing of reports describing capital structure, ownership, financial condition, certain inter-company transactions and business operations. Most state insurance holding company laws and regulations require prior regulatory approval or, in some states, prior notice, of acquisitions or similar transactions involving regulated companies, and of certain transactions between regulated companies and their parents. In connection with obtaining regulatory approvals of acquisitions, we may be required to agree to maintain capital of regulated subsidiaries at specified levels, to guarantee the solvency of such subsidiaries or to other conditions. Generally, our regulated subsidiaries are limited in their ability to pay dividends to their parent due to the requirements of state regulatory agencies that the subsidiaries maintain certain minimum capital balances.
Our workers compensation business is also subject to state governmental regulation. Historically, governmental strategies to contain medical costs in the workers compensation field have been limited to legislation on a state-by-state basis. Many states have adopted guidelines for utilization management and have implemented fee schedules that list maximum reimbursement levels for health care procedures. In certain states that have not authorized the use of a fee schedule, we adjust bills to the usual and customary levels authorized by the payor.
Most states now impose risk-based or other net worth-based capital requirements on our regulated entities. These requirements assess the capital adequacy of the regulated subsidiary based upon the investment asset risks, insurance risks, interest rate risks and other risks associated with the subsidiarys business. If a subsidiarys capital level falls below certain required capital levels, it may be required to submit a capital corrective plan to regulatory authorities, and at certain levels may be subjected to regulatory orders, including regulatory control through rehabilitation or liquidation proceedings. See Part II, Item 7, Managements Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources for more information.
Privacy, Security and other HIPAA Requirements
The use, disclosure and secure handling of individually identifiable health information by our business is regulated at the federal level, including the privacy provisions of the Gramm-Leach-Bliley Act and privacy and security regulations pursuant to HIPAA. Further, our privacy and security practices are subject to various state laws and regulations. These state and federal requirements change frequently as a result of legislation, regulations and judicial or administrative interpretation. Varying requirements and enforcement approaches in the different states may adversely affect our ability to standardize our products and services across state lines. Further, state and local authorities are increasingly focused on the importance of protecting individuals from identity theft, with a significant number of states enacting laws requiring businesses to notify individuals of security breaches involving personal information. The U.S. Congress also is considering similar or additional measures.
HIPAA includes administrative requirements directed at simplifying electronic data interchange through standardizing transactions and establishing uniform health care provider, payer and employer identifiers. HIPAA also imposes obligations for health insurance issuers and health benefit plan sponsors. HIPAA requires guaranteed health care coverage for small employers having 2 to 50 employees and for individuals who meet certain eligibility requirements. HIPAA also requires guaranteed renewability of health coverage for most employers and individuals and contains nondiscrimination requirements. HIPAA limits exclusions based on pre-existing conditions for individuals covered under group policies to the extent the individuals had prior creditable coverage.
Failure to comply with any of the statutory and regulatory HIPAA requirements, state privacy and security requirements and other similar federal requirements could subject us to significant penalties.
The provision of services to certain employee health benefit plans is subject to the Employee Retirement Income Security Act of 1974 (ERISA). ERISA regulates certain aspects of the relationships between us and employers who maintain employee benefit plans subject to ERISA. Some of our administrative services and other activities may also be subject to regulation under ERISA. For instance, the U.S. Department of Labor regulations under ERISA (insured and self-insured) regulate the time allowed for health and disability plans to respond to claims and appeals, establish requirements for plan responses to appeals and expand required disclosures to participants and beneficiaries. In addition, some states require licensure or registration of companies providing third party claims administration services for benefit plans. We provide a variety of products and services to employee benefit plans that are covered by ERISA.
Some of our subsidiaries contract with CMS to provide services to Medicare beneficiaries pursuant to the Medicare program. Some of our health plans also contract with states to provide health benefits to Medicaid recipients. As a result, we are subject to extensive federal and state regulations. CMS may audit any subsidiary operating under a Medicare contract to determine the plans compliance with federal regulations and contractual obligations.
CMS and the appropriate state regulatory agency have the right to audit any health plan operating under a Medicaid managed care contract to determine the plans compliance with state and federal law. In some instances, states engage peer review organizations to perform quality assurance and utilization review oversight of Medicaid managed care plans. Our health plans are required to abide by the peer review organizations standards.
CMS rules require Medicaid managed care plans to have beneficiary protections and protect the rights of participants in the Medicaid program. Specifically, states must assure continuous access to care for beneficiaries with ongoing health care needs who transfer from one health plan to another. States and plans must identify enrollees with special health care needs and assess the quality and appropriateness of their care. These requirements have not had a material adverse effect on our business.
The federal anti-kickback statute imposes criminal and civil penalties for paying or receiving remuneration (which is deemed to include a kickback, bribe or rebate) in connection with any federal health care program, including the Medicare, Medicaid and FEHB Programs. The law and related regulations have been interpreted to prohibit the payment, solicitation, offering or receipt of any form of remuneration in return for the referral of federal health care program patients or any item or service that is reimbursed, in whole or in part, by any federal health care program. Similar anti-kickback provisions have been adopted by many states, which apply regardless of the source of reimbursement.
With respect to the federal anti-kickback statute, there exists a statutory exception and two safe harbors addressing certain risk-sharing arrangements. A safe harbor is a regulation that describes relationships and activities that are deemed not to violate the federal anti-kickback statute. However, failure to satisfy each criterion of an applicable safe harbor does not mean that the arrangement constitutes a violation of the law; rather the arrangement must be analyzed on the basis of its specific facts and circumstances. We believe that our risk agreements satisfy the requirements of these safe harbors. In addition, the Office of the Inspector General has adopted other safe harbor regulations that relate to managed care arrangements. We believe that the incentives offered by our subsidiaries to Medicare and Medicaid beneficiaries and the discounts our plans receive from contracting health care providers satisfy the requirements of these safe harbor regulations. We believe that our arrangements do not violate the federal or similar state anti-kickback laws.
CMS has promulgated regulations that prohibit health plans with Medicare contracts from including any direct or indirect payment to physicians or other providers as an inducement to reduce or limit medically necessary services to a Medicare beneficiary. These regulations impose disclosure and other requirements relating to physician incentive plans such as bonuses or withholds that could result in a physician being at substantial financial risk as defined in Medicare regulations. Our ability to maintain compliance with such regulations depends, in part, on our receipt of timely and accurate information from our providers. Although we believe we are in compliance with all such Medicare regulations, we are subject to future audit and review.
The federal False Claims Act prohibits knowingly submitting false claims to the federal government. Private individuals known as relators or whistleblowers may bring actions on the governments behalf under the False Claims Act and share in any settlement or judgment. Violations of the federal False Claims Act may result in treble damages and civil penalties of up to $11,000 for each false claim. In some cases, whistleblowers, the federal government and some courts have taken the position that providers who allegedly have violated other statutes such as the federal anti-kickback statute have thereby submitted false claims under the False Claims Act. Under the Deficit Reduction Act of 2006 (DEFRA), every entity that receives at least $5 million annually in Medicaid payments must establish, by January 1, 2007, written policies for all employees, contractors or agents, providing detailed information about false claims, false statements and whistleblower protections under certain federal laws, including the federal False Claims Act, and similar state laws. The Company has established written policies that it believes comply with this provision of DEFRA.
A number of states, including states in which we operate, have adopted their own false claims provisions as well as their own whistleblower provisions whereby a private party may file a civil lawsuit in state court. DEFRA creates an incentive for states to enact false claims laws that are comparable to the federal False Claims Act. From time to time, companies in the healthcare industry, including ours, may be subject to actions under the False Claims Act or similar state laws.
Our subsidiaries contract with the Office of Personnel Management (OPM) to provide managed health care services under the FEHB Program in their service area. These contracts with the OPM and applicable government regulations establish premium rating arrangements for this program. The OPM conducts periodic audits of its contractors to, among other things, verify that the premiums established under its contracts are in compliance with the community rating and other requirements under FEHB Program. The OPM may seek premium refunds or institute other sanctions against health plans that participate in the program if the health plan is found to be non-compliant with the program requirements.
Numerous proposals have been introduced in the U.S. Congress and various state legislatures relating to managed health care reform. The provisions of legislation that may be adopted at the state level can not be accurately and completely predicted at this time, and we therefore can not predict the effect of proposed legislation on our operations. On the federal level, it is possible that some form of managed health care reform may be enacted. At this time, it is unclear as to when any legislation might be enacted or the content of any new legislation, and we can not predict the effect on our operations of proposed legislation or any other legislation that may be adopted.
In the normal course of business, we have been named as a defendant in various legal actions such as actions seeking payments for claims for medical services denied by the Company, medical malpractice actions, employment related claims and other various claims seeking monetary damages. The claims are in various stages of proceedings and some may ultimately be brought to trial. Incidents occurring through December 31, 2007 may result in the assertion of additional claims. We maintain general liability, professional liability and employment practices liability insurances in amounts that we believe are appropriate, with varying deductibles for which we maintain reserves. The professional liability and employment practices liability insurances are carried through our captive subsidiary.
At January 31, 2007, we employed approximately 15,000 persons, none of whom are covered by a collective bargaining agreement.
We began operations in 1987 with the acquisition of the American Service Companies entities, including Coventry Health and Life Insurance Company. We have grown substantially through acquisitions. The table below summarizes all of our significant acquisitions through December 31, 2007. See Note B to the consolidated financial statements for additional information on the most recent acquisitions.
We have the following federally registered service marks:
*Federal service marks and their federal registrations acquired from Concentra Operating Corporation on April 2, 2007. The recordation of the assignment of these marks was completed as of January 7, 2008.
We have pending applications for federal registration of the following service mark: HealthCare USA and Vista Platinum Plan.
We also have the right in perpetuity to use the HealthCare USA mark in Missouri, Illinois, Kansas and Florida.
The following table sets forth information with respect to our executive officers as of January 1, 2008:
Dale B. Wolf was elected Chief Executive Officer of our Company effective January 2005. Prior to that he served as Executive Vice President, Chief Financial Officer and Treasurer of our Company from December 1996 to December 2004. He is a director and a member of the audit and compensation committees of HealthExtras, Inc., a provider of pharmacy benefit management services and supplemental benefits. Mr. Wolf is a Fellow of the Society of Actuaries.
Thomas P. McDonough was elected President of our Company effective January 2005. Prior to that he served as Executive Vice President and Chief Operating Officer of our Company from April 1998 to December 2004.
Shawn M. Guertin was elected Executive Vice President and Chief Financial Officer of our Company effective January 2005, and Treasurer effective March 2005. Prior to that he served as Senior Vice President of our Company from February 2003 to December 2004. From January 1998 to February 2003, he was Vice President of Finance of our Company. Mr. Guertin is a Fellow of the Society of Actuaries and a Member of the American Academy of Actuaries.
Francis S. Soistman, Jr. was elected Executive Vice President of our Company, effective January 2005. Mr. Soistman is in charge of the Individual Consumer and Government Business Division and, previously, was in charge of Health Plan Operations. Prior to that he served as Senior Vice President of our Company from April 1998 to December 2004. He was named President and Chief Executive Officer of HealthAmerica Pennsylvania, Inc. and HealthAssurance Pennsylvania, Inc., our Pennsylvania subsidiaries, in May 1998 and July 2001, respectively, and served to January 2005.
Thomas C. Zielinski was elected Executive Vice President of our Company, effective November 2007. He is also General Counsel of our Company and has served in that capacity since August 2001. He served as Senior Vice President of our Company from August 2001 to November 2007. Prior to that time, Mr. Zielinski worked for 19 years in various capacities for the law firm of Cozen and OConnor, P.C., including as a senior member, shareholder and Chair of the firms Commercial Litigation Department.
Vishu Jhaveri, M.D. was elected Executive Vice President and Chief Medical Officer of our Company in May 2007. Dr. Jhaveri joined our Company as Chief Medical Officer in March 2007. From April 2006 to March 2007, he worked as an independent healthcare consultant and served on the advisory Board of InterComponentWare AG, a German IT firm specializing in electronic health records. From April 2004 to April 2006, he was the Corporate Medical Director and Chief Operating Officer of FutureHealth Corporation, a provider of health and productivity management solutions and a wholly owned subsidiary of Nationwide Insurance Companies. From August 1999 to March 2004, Dr. Jhaveri was the Chief Medical Officer and Vice President of Healthcare Operations of Keystone Health Plan Central, a health maintenance organization.
E. Harry Skip Creasey was elected Senior Vice President, National Network Management of our Company in March 2005. From February 2003 to the time he joined our company, Mr. Creasey served as Chairman and Chief Executive Officer of Kelson Physician Partners, Inc., a provider of pediatric management services. From August 2001 to February 2003, he was the President of InterPlan Group, a health care network company. From February 2000 to July 2001, he was the Chief Executive Officer of AviaHealth, Inc., a health care internet content provider.
Patrisha L. Davis was elected Senior Vice President of our Company, effective June 2007. From November 2000 to date, she has been the Chief Human Resources Officer of our Company. She was a Vice President of our Company from March 2005 to June 2007. Ms. Davis has been a Human Resources executive with our Company since April 1998.
David A. Finkel was elected Senior Vice President of our Company in August 2005. Mr. Finkel is in charge of our Customer Service Operations. From January 2003 to August 2005 he was Vice President, Group Administration for our Company. From June 2001 to December 2002, he was Senior Vice President, e-Business & Sales Support, for CIGNA HealthCare, a health and related benefits company.
Maria Fitzpatrick was elected Senior Vice President of our Company in May 2007. She is our Chief Information Officer in charge of our Companys information technology operations and has served in that capacity since joining our Company in November 2006. From February 2004 to October 2006, she was Vice President and Chief Information Officer of Mercury General Corp., a multiple line insurance organization offering automobile and homeowners insurance products. From February 2000 to April 2003, Ms. Fitzpatrick was Senior Vice President and Chief Information Officer of PacifiCare Health Systems, a diversified health and well-being company acquired by UnitedHealth Group in 2005.
James E. McGarry was elected Senior Vice President of our Company in July 1998. Mr. McGarry is currently in charge of our workers compensation line of business and has served in that capacity since November 2006. From August 2001 to October 2006, he served as head of our integration team for mergers and acquisitions. From July 1998 to July 2001, he was in charge of our Customer Service Operations.
John J. Ruhlmann was elected Senior Vice President of our Company in November 2006. Prior to that he was Vice President of our Company from November 1999 to November 2006. He has served as our Corporate Controller since November 1999.
Item 1A: Risk Factors
The risks described below are not the only ones that we face. Additional risks not presently known to us or that we currently deem immaterial may also impair our business operations.
Our business, financial condition or results of operations could be materially adversely affected by any of these risks. Further, the trading price of our common stock could decline due to any of these risks, and you may lose all or part of your investment.
Most of the premium revenue we receive is based upon rates set months before we deliver services. As a result, our results of operations largely depend on our ability to accurately estimate and control future health care costs. We base the premiums we charge, at least in part, on our estimate of expected health care costs over the applicable premium period. Factors that may cause health care costs to exceed our estimates include:
In addition, medical liabilities in our financial statements include our estimated reserves for incurred but not reported and reported but not paid claims. The estimates for medical liabilities are made on an accrual basis. We believe that our reserves for medical liabilities are adequate, but we can not assure you of this. Any adjustments to our medical liabilities could adversely affect our results of operations.
Our results of operations depend on our ability to increase premiums to offset increases in our health care costs. Although we attempt to base the premiums we charge on our estimate of future health care costs, we may not be able to control the premiums we charge as a result of competition, government regulations and other factors. Our results of operations could be adversely affected if we are unable to set premium rates at appropriate levels or adjust premium rates in the event our health care costs increase.
Our business is heavily regulated by federal, state and local authorities. Legislation or other regulatory reform that increases the regulatory requirements imposed on us or that changes the way we currently do business may in the future adversely affect our business and results of operations. Legislative or regulatory changes that could significantly harm us and our subsidiaries include changes that:
We also may be subject to governmental investigations or inquiries from time to time. For example in 2004, several companies in the insurance industry have received subpoenas for information from the New York Attorney General and the Connecticut Attorney General with respect to an industry-wide investigation into certain insurance brokerage practices, including broker compensation arrangements, bid quoting practices and potential antitrust violations. Insurance regulators in several states, including states in which our subsidiaries are domiciled, have sent letters of inquiry concerning similar matters to the companies subject to their jurisdiction, including our subsidiaries. We have furnished the information requested and have received no further inquiry or comment from the insurance regulatory authorities. The existence of such investigations in our industry could negatively affect the market value of all companies in our industry including our stock price. Any similar governmental investigations of Coventry could have a material adverse effect on our financial condition, results of operations or business or result in significant liabilities to the Company, as well as adverse publicity.
In addition, we are required to obtain and maintain various regulatory approvals to market many of our products. Delays in obtaining or failure to obtain or maintain these approvals could adversely impact our results of operations. Federal, state and local authorities frequently consider changes to laws and regulations that could adversely affect our business. We can not predict the changes that government authorities will approve in the future or assure you that those changes will not have an adverse effect on our business or results of operations.
The federal government and many states from time to time consider altering the level of funding for government healthcare programs, including Medicare and Medicaid. The Deficit Reduction Act of 2006, signed into law on February 8, 2006, included Medicaid cuts of approximately $4.8 billion over 5 years. In addition, proposed regulatory changes would, if implemented, further reduce federal Medicaid funding. We cannot predict future Medicare or Medicaid funding levels or ensure that changes to Medicare or Medicaid funding will not have an adverse effect on our business or results of operations.
A reduction in the number of members in our health plans could adversely affect our results of operations. Factors that could contribute to the loss of membership include:
Part of our growth strategy is to grow through the acquisition of additional health plans and other managed care businesses. Historically, we have significantly increased our revenues through a number of acquisitions. We can not assure you that we will be able to continue to locate suitable acquisition candidates, successfully integrate the businesses we acquire and realize anticipated operational improvements and cost savings. The businesses we acquire also may not achieve our anticipated levels of profitability. Our future growth rate will be adversely affected if we are not able to successfully complete acquisitions.
We operate in a highly competitive environment that may affect our ability to attract new members and increase premium rates. We compete with other health plans for members. We believe the principal factors influencing the choice among health care options are:
We compete with other managed care companies that may have broader geographical coverage, more established reputations in our markets, greater market share, larger contracting scale, lower costs and/or greater financial and other resources. We also may face increased rate competition from certain Blue Cross plan competitors that might be required by state regulation to reduce capital surpluses that may be deemed excessive.
Competition in the multi-site, national account business may limit our ability to grow revenues which could adversely affect our results of operations.
We compete in a highly competitive environment against other major national managed care companies in our national account business to provide administrative, network access, and medical management services to large, multi-site, self-insured employers. Among these competitors are Aetna, United Healthcare and Blue Card (a joint venture of major Blue Cross plans), all of which have greater resources, brand identity and provider contracting scale compared to us.
We depend on the services of independent agents and brokers to market our managed care products and services, particularly to small employer group members. We do not have long term contracts with independent agents and brokers, who typically are not dedicated exclusively to us and frequently market the health care products of our competitors. We face intense competition for the services and allegiance of independent agents and brokers, and we can not assure you that agents and brokers will continue to market our products in a fair and consistent manner.
Our future results largely depend on our ability to enter into cost-effective agreements with hospitals, physicians and other health care providers. The terms of those provider contracts will have a material effect on our medical costs and our ability to control these costs. In addition, our ability to contract successfully with a sufficiently large number of providers in a particular geographic market will impact the relative attractiveness of our managed care products in those markets, and our ability to contract at competitive rates with our PPO and workers compensation related providers will affect the attractiveness and profitability of our products in the national account, network rental and workers compensation businesses.
In some of our markets, there are large provider systems that have a major presence. Some of these large provider systems have operated their own health plans in the past or may choose to do so in the future. These provider systems could adversely affect our product offerings and results of operations if they refuse to contract with us, place us at a competitive disadvantage or use their market position to negotiate contracts that are less favorable to us. Provider agreements are subject to periodic renewal and renegotiations. We can not assure you that these large provider systems will continue to contract with us or that they will contract with us on terms that are favorable to us.
Over the last several years, the managed health care industry has been subject to negative publicity. Negative publicity regarding the managed health care industry generally, or our Company in particular, may result in increased regulation and legislative review of industry practices, further increase our costs of doing business and adversely affect our results of operations by:
Negative publicity relating to our company or the managed care industry generally also may adversely affect our ability to attract and retain members.
We depend on our information technology systems for timely and accurate information. Failure to maintain effective and efficient information technology systems or disruptions in our information technology systems could cause disruptions in our business operations, loss of existing customers, difficulty in attracting new customers, disputes with customers and providers, regulatory problems, increases in administrative expenses and other adverse consequences.
We face periodic reviews, audits and investigations under our contracts with federal and state government agencies, and these audits could have adverse findings that may negatively affect our business.
We contract with various federal and state governmental agencies to provide managed health care services. Pursuant to these contracts, we are subject to various governmental 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:
Due to the nature of our business, we are subject to a variety of legal actions relating to our business operations including claims relating to:
In addition, plaintiffs continue to bring new types of legal claims against managed care companies. Recent court decisions and legislative activity increase our exposure to these types of claims. In some cases, plaintiffs may seek class action status and substantial economic, non-economic or punitive damages. The loss of even one of these claims, if it resulted in a significant damage award, could have an adverse effect on our financial condition or results of operations. In the event a plaintiff was to obtain a significant damage award it may make reasonable settlements of claims more difficult to obtain. We can not determine with any certainty what new theories of recovery may evolve or what their impact may be on the managed care industry in general or on us in particular.
We have, and expect to maintain, liability insurance coverage for some of the potential legal liabilities we may incur. Currently, professional liability and employment practices liability insurance is covered through our captive subsidiary. Potential liabilities that we incur may not, however, be covered by insurance, our insurers may dispute coverage or may be unable to meet their obligations or the amount of our insurance coverage may be inadequate. We can not assure you that we will be able to obtain insurance coverage in the future, or that insurance will continue to be available on a cost effective basis, if at all.
From time to time, the price and trading volume of our common stock, as well as the stock of other companies in the health care industry, may experience periods of significant volatility. Company-specific issues and developments generally in the health care industry (including the regulatory environment) and the capital markets may cause this volatility. Our stock price and trading volume may fluctuate in response to a number of events and factors, including:
The indentures for our senior notes and bank credit agreement impose restrictions on our business and operations. These restrictions limit our ability to, among other things:
Our ability to service our indebtedness will depend on our ability to generate cash in the future. Our ability to generate the cash necessary to service our indebtedness is subject to general economic, financial, competitive, legislative, regulatory and other factors that are beyond our control. We can not assure you that our business will generate sufficient cash flow from operations or that future borrowings will be available in an amount sufficient to enable us to service our indebtedness or to fund other liquidity needs. In addition, we will be more vulnerable to economic downturns, adverse industry conditions and competitive pressures as a result of our significant indebtedness. We may need to refinance all or a portion of our indebtedness before maturity. We can not assure you that we will be able to refinance any of our indebtedness or that we will be able to refinance our indebtedness on commercially reasonable terms.
A substantial amount of our cash flow is generated by our regulated subsidiaries.
Our regulated subsidiaries conduct a substantial amount of our consolidated operations. Consequently, our cash flow and our ability to pay our debt and fund future acquisitions depends, in part, on the amount of cash that the parent company receives from our regulated subsidiaries. Our subsidiaries ability to make any payments to the parent company will depend on their earnings, business and tax considerations, legal and regulatory restrictions and economic conditions. Our regulated subsidiaries are subject to HMO and insurance regulations that require them to meet or exceed various capital standards and may restrict their ability to pay dividends or make cash transfers to the parent company. If our regulated subsidiaries are restricted from paying the parent company dividends or otherwise making cash transfers to the parent company, it could have a material adverse effect on the parent companys cash flow. For additional information regarding our regulated subsidiaries statutory capital requirements, see Part II, Item 7 Managements Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources - Statutory Capital Requirements.
Our certificate of incorporation and bylaws and Delaware law could delay, discourage or prevent a change in control of our Company that our stockholders may consider favorable.
Provisions in our certificate of incorporation and bylaws and Delaware law may delay, discourage or prevent a merger, acquisition or change in control involving our company that our stockholders may consider favorable. These provisions could also discourage proxy contests and make it more difficult for stockholders to elect directors and take other corporate actions. Among other things, these provisions:
These provisions of our certificate of incorporation and bylaws and Delaware law may discourage transactions that otherwise could provide for the payment of a premium over prevailing market prices for our common stock and also could limit the price that investors are willing to pay in the future for shares of our common stock.
Changes in general economic conditions could adversely affect our business and results of operations.
Changes in economic conditions could adversely affect our business and results of operations. The state of the economy could adversely affect our employer group renewal prospects and our ability to collect or increase premiums. The state of the economy could also adversely affect the states budgets, which could result in the states attempting to reduce payments to Medicaid plans in those states in which we offer Medicaid plans, and increase taxes and assessments on our activities. Although we could attempt to mitigate or cover our exposure from such increased costs through, among other things, increases in premiums, there can be no assurance that we will be able to mitigate or cover all of such costs resulting from any budget cuts in states in which we operate. Although we have attempted to diversify our product offerings to address the changing needs of our membership, the effects of economic conditions could cause our existing membership to seek health coverage alternatives that we do not offer or could result in significant membership loss, lower average premium yields or decreased margins on continuing membership.
Our efforts to capitalize on Medicare business opportunities could prove to be unsuccessful.
Medicare programs represent a significant portion of our business, accounting for approximately 33.1% of our managed care premium revenue in 2007. In connection with the passage of the Medicare Prescription Drug, Improvement and Modernization Act of 2003 (the Drug Act) and the Drug Acts implementing regulations adopted in 2005, we have significantly expanded our Medicare health plans and restructured our Medicare program management team and operations to enhance our ability to pursue business opportunities presented by the Drug Act and the Medicare program generally.
Particular risks associated with our providing Medicare Part D prescription drug benefits under the Drug Act include potential uncollectability of receivables, inadequacy of underwriting assumptions, inability to receive and process information and increased pharmaceutical costs (as well as the underlying seasonality of this business).
In 2007, we expanded our Medicare programs. Specifically, we introduced PFFS Medicare Advantage plans, expanded our Medicare Part D prescription drug benefits plans to all states, and enhanced our HMO/PPO product offerings. All of these growth activities required substantial administrative and operational capabilities. If we are unable to maintain the administrative and operational capabilities to address the additional needs of our growing Medicare programs, it could have a material adverse effect on our Medicare business and operating results.
In addition, if the cost or complexity of the recent Medicare changes exceed our expectations or prevent effective program implementation, if the government alters or reduces funding of Medicare programs, if we fail to design and maintain programs that are attractive to Medicare participants or if we are not successful in winning contract renewals or new contracts under the Drug Acts competitive bidding process, our current Medicare business and our ability to expand our Medicare operations could be materially and adversely affected, and we may not be able to realize any return on our investments in Medicare initiatives.
Item 1B: Unresolved Staff Comments
Item 2: Properties
As of December 31, 2007, we leased approximately 89,000 square feet of space for our corporate office in Bethesda, Maryland. We also leased approximately 2,430,000 aggregate square feet for office space, subsidiary operations and customer service centers for the various markets where our health plans and other subsidiaries operate, of which approximately 7% is subleased. Our leases expire at various dates from 2008 through 2018. We also own nine buildings throughout the country with approximately 798,000 square feet, which is used for administrative services related to our subsidiaries operations, of which approximately 6% is subleased. We believe that our facilities are adequate for our operations.
Item 3: Legal Proceedings
See Legal Proceedings in Note J, Commitments and Contingencies which is incorporated herein by reference.
Item 4: Submission of Matters to a Vote of Security Holders
No matters were submitted to a vote of security holders during the fourth quarter of the fiscal year 2007.
Item 5: Market for the Registrants Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.
Our common stock is traded on the New York Stock Exchange (NYSE) stock market under the ticker symbol CVH. The following table sets forth the quarterly range of the high and low sales prices of the common stock on the NYSE stock markets during the calendar period indicated. Such quotations represent inter-dealer prices without retail markup, markdown or commission and may not necessarily represent actual transactions:
On January 31, 2008, we had approximately 761 stockholders of record, not including beneficial owners of shares held in nominee name. On January 31, 2008, our closing price was $56.58.
We have not paid any cash dividends on our common stock and expect for the foreseeable future to retain all of our earnings to finance the development of our business. Our ability to pay dividends is limited by certain covenants and restrictions contained in our debt obligations and by insurance regulations applicable to our subsidiaries. Subject to the terms of such insurance regulations and debt covenants, any future decision as to the payment of dividends will be at the discretion of our Board of Directors and will depend on our earnings, financial position, capital requirements and other relevant factors. See Part II, Item 7, Managements Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources.
In February 2007, our Board of Directors approved an increase to the share repurchase program in an amount equal to 5% of our outstanding common stock, thus increasing our repurchase authorization by 7.9 million shares. Under the share repurchase program, the Company purchased 7.5 million shares of the Companys common stock during 2007, at an aggregate cost of $429.0 million, 4.6 million shares during 2006, at an aggregate cost of $256.1 million and no shares were purchased in 2005. The total remaining common shares the Company is authorized to repurchase under this program is 6.5 million as of December 31, 2007.
The following table shows our purchases of our common stock during the quarter ended December 31, 2007 (in thousands, except per share information).
Item 6: Selected Financial Data
Item 7: Managements Discussion and Analysis of Financial Condition and Results of Operations
The following discussion should be read in conjunction with the accompanying audited consolidated financial statements and notes thereto. The organization of our Managements Discussion and Analysis of Financial Condition and Results of Operations is as follows.
We are a diversified national managed healthcare company based in Bethesda, Maryland, operating health plans, insurance companies, network rental and workers compensation services companies. Through our Commercial Business, Individual Consumer & Government Business, and Specialty Business divisions, we provide a full range of risk and fee-based managed care products and services to a broad cross section of individuals, employer and government-funded groups, government agencies, and other insurance carriers and administrators.
We operate health plans, insurance companies, managed care services companies, and workers compensation services companies and generate our operating revenues from premiums for a broad range of managed care and management service products. Managed care premiums for our commercial risk products, for which we assume full underwriting risk, can vary. For example, premiums for our PPO and POS products are typically lower than our HMO premiums due to medical underwriting and higher deductibles and co-payments that are typically required of the PPO and POS members. Managed care premium rates for our government programs, Medicare and state-sponsored managed Medicaid, are largely established by governmental regulatory agencies. These government products are offered in selected markets where we believe we can achieve profitable growth based upon favorable reimbursement levels, provider costs and regulatory climates.
Revenue for our management services products (non-risk) is generally a fixed administrative fee, provided on a predetermined contractual basis or on a percentage-of-savings basis, for access to our health care provider networks and health care management services, for which we do not assume underwriting risk. The management services we provide typically include health care provider network management, clinical management, pharmacy benefit management (PBM), bill review, claims repricing, fiscal agent services (generally for state entitlement programs), claims processing, utilization review and quality assurance.
We incur medical costs related to our products for which we assume underwriting risk. Our medical costs include medical claims paid under contractual relationships with a wide variety of providers and capitation arrangements. Medical costs also include an estimate of claims incurred but not reported.
We maintain provider networks that furnish health care services through contractual arrangements with physicians, hospitals and other health care providers. Prescription drug benefits are provided through a formulary comprised of an extensive list of drugs. Drug prices are negotiated at discounted rates through a national network of pharmacies. Drug costs for our risk products are included in medical costs.
We have capitation arrangements for certain ancillary heath care services, such as mental health care, and a small percentage of our membership is covered by global capitation arrangements. Under the typical arrangement, the provider receives a fixed percentage of premium to cover costs of all medical care or of the specified ancillary services provided to the globally capitated members. Under some capitated arrangements, physicians may also receive additional compensation from risk sharing and other incentive arrangements. Global capitation arrangements limit our exposure to the risk of increasing medical costs, but expose us to risk as to the adequacy of the financial and medical care resources of the provider organization. We are ultimately responsible for the coverage of our members pursuant to the customer agreements. To the extent that the respective provider organization faces financial difficulties or otherwise is unable to perform its obligations under the capitation arrangements, we will be required to perform such obligations. Consequently, we may have to incur costs in doing so in excess of the amounts we would otherwise have to pay under the original global or ancillary capitation through our contracted network arrangements. Medical costs associated with capitation arrangements made up approximately 4.9% of the Companys total medical costs for the year ended December 31, 2007.
We have established systems to monitor the availability, appropriateness and effectiveness of the patient care we provide. We collect utilization data in each of our markets that we use to analyze over-utilization or under-utilization of services and assist our health plans in arranging for appropriate care for their members and improving patient outcomes in a cost efficient manner. Medical directors also monitor the utilization of diagnostic services and encourage the use of outpatient surgery and testing where appropriate. Each health plan collects data showing each physicians utilization profile for diagnostic tests, specialty referrals and hospitalization and presents such data to the health plans physicians. The medical directors monitor these results in an effort to ensure the use of medically, cost-effective appropriate services.
We incur cost of sales expense for prescription drugs provided by our workers compensation pharmacy benefit manager and for the independent medical examinations performed by physicians on injured workers. Both businesses were acquired with the acquisition of the workers compensation managed care services business from Concentra, Inc. (Concentra). These costs are associated with fee-based products.
Our selling, general and administrative expenses consist primarily of salaries and related costs for personnel involved in the administration of services we offer. To a lesser extent, our selling, general and administration expenses include other administrative and facility costs needed to provide these administrative services as well as commissions paid to brokers and agents who assist in the sale of our products. We operate regional service centers that perform claims processing, premium billing and collection, enrollment and customer service functions. Our regional service centers enable us to take advantage of economies of scale, implement standardized management practices and capitalize on the benefits of our integrated information technology systems.
We generate cash through operations. As a profitable company in an industry that is not capital equipment intensive, we have not needed to use financing methods to fund operations. While we have incurred debt (as described in Note I to our consolidated financial statements in this Form 10-K), the proceeds have been used to finance acquisitions and were not used to fund operations. Our primary use of cash is to pay medical claims. Any excess cash has historically been used for acquisitions, to prepay indebtedness and for repurchases of our common stock.
We consider the accounting policies described below critical in preparing our consolidated financial statements. Critical accounting policies are ones that require difficult, subjective, or complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain. The judgments and uncertainties affecting the application of these policies include significant estimates and assumptions made by us using information available at the time the estimates are made. Actual results could differ materially from those estimates.
Managed care premiums are recorded as revenue in the month in which members are entitled to service. Premiums are based on both a per subscriber contract rate and the number of subscribers in our records at the time of billing. Premium billings are generally sent to employers in the month preceding the month of coverage. Premium billings may be subsequently adjusted to reflect changes in membership as a result of retroactive terminations, additions, or other changes. Due to early timing of the premium billing, we are able to identify in the current month the retroactive adjustments for two subsequent months billings. Current period revenues are adjusted to reflect these retroactive adjustments.
Based on information received subsequent to generating premium billings, historical trends, bad debt write-offs and the collectibility of specific accounts, we estimate, on a monthly basis, the amount of bad debt and future membership retroactivity and adjust our revenue and allowances accordingly.
As of December 31, 2007, we maintained allowances for retroactive billing adjustments of approximately $29.7 million compared with approximately $20.1 million at December 31, 2006. We also maintained allowances for doubtful accounts of approximately $3.4 million and $1.9 million as of December 31, 2007 and 2006, respectively. The calculation for these allowances is based on a percentage of the gross accounts receivable with the allowance percentage increasing for the older receivables.
We also receive premium payments from the Centers for Medicare and Medicaid Services (CMS) on a monthly basis for our Medicare membership. Membership and category eligibility are periodically reconciled with CMS and can result in adjustments to revenue. Premiums collected in advance are recorded as deferred revenue.
We contract with the United States Office of Personnel Management (OPM) and with various federal employee organizations to provide health insurance benefits under the Federal Employees Health Benefits Program. These contracts are subject to government regulatory oversight by the Office of the Inspector General (OIG) of OPM who perform periodic audits of these benefit program activities to ensure that contractors meet their contractual obligations with OPM. For our managed care contracts, the OIG conducts periodic audits to, among other things, verify that premiums established under its contracts are in compliance with community rating requirements under the FEHB Program. The OPM may seek premium refunds or institute other sanctions against health plans that participate in the program. For our experience-rated plans, the OIG focuses on the appropriateness of contract charges, the effectiveness of claims processing, financial and cost accounting systems, and the adequacy of internal controls to ensure proper contract charges and benefits payments. The OIG may seek refunds of costs charged under these contracts or institute other sanctions against health plans. These audits are generally a number of years in arrears. We estimate and record reserves for audit and other contract adjustments based on appropriate guidelines. Any differences between actual results and estimates are recorded in the year the audits are finalized.
We enter into performance guarantees with employer groups where we pledge that we will meet certain standards. These standards vary widely and could involve customer service, member satisfaction, claims processing, claims accuracy, telephone response time, etc. We also enter into financial guarantees which can take various forms including, among others, achieving an annual aggregate savings threshold, achieving a targeted level of savings per-member per-month or achieving overall network penetration in defined demographic markets. For each guarantee, we estimate and record performance based revenue after considering the relevant contractual terms and the data available for the performance based revenue calculation. Pro-rata performance based revenue is recognized on an interim basis pursuant to the rights and obligations of each party upon termination of the contracts.
Medical Claims Expense and Liabilities
Medical liabilities consist of actual claims reported but not paid and estimates of health care services incurred but not reported. Medical liabilities estimates are developed using actuarial principles and assumptions that consider, among other things, historical claims payment patterns, provider reimbursement changes, historical utilization trends, current levels of authorized inpatient days, other medical cost inflation factors, membership levels, benefit design changes, seasonality, demographic mix change and other relevant factors.
We employ a team of actuaries that have developed, refined and used the same set of reserve models over the past several years. These reserve models do not calculate separate amounts for reported but not paid and incurred but not reported, but rather a single estimate of medical claims liabilities. These reserve models make use of both historical claim payment patterns as well as emerging medical cost trends to project our best estimate of claim liabilities. Within these models, historical data of paid claims is formatted into claim triangles which compare claim incurred dates to the claim payment dates. This information is analyzed to create completion factors that represent the average percentage of total incurred claims that have been paid through a given date after being incurred. Completion factors are applied to claims paid through the financial statement date to estimate the ultimate claim expense incurred for the current period. Actuarial estimates of claim liabilities are then determined by subtracting the actual paid claims from the estimate of the ultimate incurred claims.
Actuarial standards of practice generally require the actuarially developed medical claims estimates 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. In many situations, the claims paid amount experienced will be less than the estimate that satisfies the actuarial standards of practice. Medical claims liabilities are recorded at an amount we estimate to be appropriate. Adjustments of prior years estimates may result in additional medical costs or, as we have experienced during the last several years, a reduction in medical costs in the period an adjustment was made. Our reserve models have historically developed favorably suggesting that the accrued liabilities calculated from the models were more than adequate to cover our ultimate liability for unpaid claims. We believe that this favorable development is a result of good communications between our health plans and our actuarial staff regarding medical utilization, mix of provider rates and other components of medical cost trend.
The following table presents the components of the change in medical claims liabilities for the years ended December 31, 2007, 2006 and 2005, respectively (in thousands).
The negative medical cost amounts noted as prior year developments are favorable adjustments for claim estimates being settled for amounts less than originally anticipated. As noted above, these favorable restatements from original estimates occur due to changes in medical utilization, mix of provider rates and other components of medical cost trends. Medical claim liabilities are generally paid within several months of the member receiving service from the provider. Accordingly, the 2007 prior year developments relate almost entirely to claims incurred in calendar year 2006 and the increase in prior year medical cost was driven primarily by growth in the medical cost base of our Company.
The Medicare Part D related subsidy liabilities identified in the table above represent subsidy amounts received from CMS for reinsurance and for cost sharing related to low income individuals. These subsidies are recorded in medical liabilities and we do not recognize premium revenue or claims expense for these subsidies.
For the more recent incurred months, the percentage of claims paid to claims incurred in those months is generally low. As a result, the completion factor methodology is less reliable for such months. For that reason, incurred claims for recent months are not projected solely from historical completion and payment patterns. Instead, they are projected by estimating the claims expense for those months based upon recent claims expense levels and health care trend levels, or trend factors. As these months mature over time, the two estimates (completion factor and trend) are blended with completion factors being used exclusively for older months.
Within the reserve setting methodologies for inpatient and non-inpatient services, we use certain assumptions. For inpatient services, authorized days are used for utilization factors, while cost trend assumptions are incorporated into per diem amounts. The per diem estimates reflect anticipated effects of changes in reimbursement structure and severity mix. For non-inpatient services, a composite trend assumption is applied which reflects anticipated changes in cost per service, provider contracts, utilization and other factors.
Changes in the completion factors, trend factors and utilization factors can have a significant effect on the claim liability. The following example (in thousands, except percentages) provides the estimated effect to our December 31, 2007 unpaid claims liability assuming hypothetical changes in the completion, trend, and inpatient day factors. While we believe the selection of factors and ranges provided are reasonable, certain factors and actual results may differ.
We also establish reserves, if required, for the probability that anticipated future health care costs and contract maintenance costs under our existing provider contracts will exceed anticipated future premiums and reinsurance recoveries on those contracts.
As noted in the table above, presenting the components of the change in medical claims liabilities, we had $135.1 million in favorable prior year developments. The significant factors driving the favorable developments include:
A regular element of our unpaid medical claim liability estimation process is the examination of actual results and, if appropriate, the modification of assumptions and inputs related to the process based upon past experience. Our reserve setting methodologies have taken these changes into consideration when determining the factors used in calculating our medical claims liabilities as of December 31, 2007 by choosing factors that reflect more recent experience.
We believe that the amount of medical liabilities is adequate to cover our ultimate liability for unpaid claims as of December 31, 2007. However, actual claim payments and other items may differ from established estimates.
We account for investments in accordance with Statement of Financial Accounting Standards (SFAS) No. 115 - Accounting for Certain Investments in Debt and Equity Securities. We invest primarily in fixed income securities and classify all of our investments as available-for-sale. Investments are evaluated on an individual security basis at least quarterly to determine if declines in value are other-than-temporary. In making that determination, we consider all available evidence relating to the realizable value of a security. This evidence includes, but is not limited to, the following:
Temporary declines in value of investments classified as available-for-sale are netted with unrealized gains and reported as a net amount in a separate component of stockholders equity. A decline in fair value below amortized cost that is judged to be otherthantemporary is accounted for as a realized loss and the write down is included in earnings. Realized gains and losses on the sale of investments are determined on a specific identification basis.
The following table includes only our investments in an unrealized loss position at December 31, 2007. For those investments, the table shows the gross unrealized losses and fair value aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position (in thousands).
The securities presented in this table do not meet the criteria for an other-than-temporarily impaired investment. The unrealized loss is almost exclusively the result of interest rate movements. We intend to hold these investments for a period of time sufficient to allow for a recovery in market value, which may be maturity.
Additionally, due primarily to long standing conservative investment guidelines, we have a de minimis sub prime investment and auction rate security exposure. With our municipal bond investments, they remain at an investment grade status based on their own merits. Although we do not rely on bond insurers exclusively to maintain our high level of investment credit quality, $523.0 million of our $880.1 million state and municipal bond holdings are insured. For our mortgaged-backed and asset-backed securities, our holdings remain at investment grade with a AAA rating. We participate in only the higher level investment tranches. For our asset-backed securities, we only participate in offerings that are over collateralized to further protect our principal investment.
Goodwill and other intangible assets that have indefinite lives are subject to a periodic assessment for impairment by applying a fair-value-based test. For our impairment analysis we relied primarily on the income approach and secondarily on the market approach. The income approach is based on the present value of expected future cash flows. The income approach involves estimating the present value of our estimated future cash flows, and discounting these cash flows at a given rate of return. The market approach estimates a businesss fair value by analyzing the recent sales of similar companies. The approaches were reviewed together for consistency and commonality.
Under the income approach, we assumed certain growth rates, capital expenditures, discount rates and terminal growth rates in our calculations. If the assumptions used in our fair-value-based tests differ from actual results, the estimates underlying our goodwill impairment tests could be adversely affected. Any impairment charges that may result will be recorded in the period in which the impairment is identified. We have not incurred an impairment charge related to goodwill or indefinite lived intangibles. See Note C to the consolidated financial statements for additional disclosure related to intangible assets.
Our remaining long-lived assets consist of property and equipment and other finite-lived intangible assets. These assets are depreciated or amortized over their estimated useful life, and are subject to impairment reviews. In accordance with Statement of Position (SOP) 98-1, Accounting for the Costs of Computer Software Developed or Obtained for Internal Use, the cost of internally developed software is capitalized and included in property and equipment. We capitalize costs incurred during the application development stage for the development of internal-use software. These costs primarily relate to payroll and payroll-related costs for employees along with costs incurred for external consultants who are directly associated with the internal-use software project. We periodically review long-lived assets whenever adverse events or changes in circumstances indicate the carrying value of the asset may not be recoverable. In assessing recoverability, we must make assumptions regarding estimated future cash flows and other factors to determine if an impairment loss may exist, and, if so, estimate fair value. We also must estimate and make assumptions regarding the useful life we assign to our long-lived assets. If these estimates or their related assumptions change in the future, we may be required to record impairment losses or change the useful life, including accelerating depreciation for these assets.
Stock-Based Compensation Expense
We account for share based compensation in accordance with the provisions of Statement of Financial Accounting Standards No. 123 (revised 2004), Shared-Based Payment (SFAS 123R). Under the fair value recognition provisions of SFAS 123R, determining the appropriate fair value model and calculating the fair value of share-based payment awards require the input of subjective assumptions, including the expected life of the share-based payment awards and stock price volatility. We believe that a blend of the implied volatility of our tradeable options and the historical volatility of our share price is a better indicator of expected volatility and future stock price trends than historical volatility alone. Therefore, the expected volatility in 2006 and 2007 was based on a blend of market-based implied volatility and the historical volatility of our stock. The assumptions used in calculating the fair value of share-based payment awards represent our best estimates. In addition, we are required to estimate the expected forfeiture rate and recognize expense only for those shares expected to vest. If our actual forfeiture rate is materially different from our estimate, the stock-based compensation expense could be significantly different from what we have recorded in the current period. See Note F to the Consolidated Financial Statements in Item 8 for a further discussion on stock-based compensation.
In July 2006, the Financial Accounting Standards Board (FASB) issued Interpretation No. 48 (FIN 48), Accounting for Uncertainty in Income Taxes--an Interpretation of FASB Statement No. 109, which clarifies the accounting for uncertainty in income taxes recognized in the financial statements in accordance with SFAS No. 109. FIN 48 prescribes a more likely than not threshold for 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. The Company adopted FIN 48 effective January 1, 2007. The change in net assets, because of applying this pronouncement, is considered a change in accounting principle with the cumulative effect of the change required to be treated as an adjustment to the opening balance of retained earnings. The cumulative effect of implementing FIN 48 was an increase of $3.4 million to the beginning balance of retained earnings.
In May 2007, the Financial Accounting Standards Board (FASB) issued FASB Staff Position (FSP) FIN 48-1 Definition of Settlement in FASB Interpretation No. 48 (FSP FIN 48-1). FSP FIN 48-1 provides guidance on how to determine whether a tax position is effectively settled for the purpose of recognizing previously unrecognized tax benefits. FSP FIN 48-1 is effective retroactively to January 1, 2007. The implementation of this standard did not have a material effect on our consolidated financial position or results of operations.
In September 2006, the Financial Accounting Standards Board (FASB) issued SFAS No. 157, Fair Value Measurements, which defines fair value, establishes a framework for measuring fair value in accordance with generally accepted accounting principles and expands disclosures about fair value measurements. SFAS No. 157 is effective for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. We do not expect the adoption of SFAS No. 157 to have a material effect on our consolidated financial statements.
In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities. SFAS No. 159 permits companies to choose to measure many financial instruments and certain other items at fair value. SFAS No. 159 is effective for financial statements issued for fiscal years beginning after November 15, 2007. We do not expect the adoption of SFAS No. 159 to have a material effect on our consolidated financial statements.
In December 2007, the FASB issued SFAS No. 141 (R), Business Combinations. SFAS No. 141 (R) requires an acquirer to measure the identifiable assets acquired, the liabilities assumed and any noncontrolling interest in the acquiree at their fair values on the acquisition date, with goodwill being the excess value over the net identifiable assets acquired. SFAS No. 141 (R) is effective for financial statements issued for fiscal years beginning after December 15, 2008. Early adoption is prohibited. We have not yet determined the effect on our consolidated financial statements, if any, upon adoption of SFAS No. 141 (R).
During the three years ended December 31, 2007, we completed five business combinations and one membership purchase. These business combinations are all accounted for using the purchase method of accounting and, accordingly, the operating results of each acquisition have been included in our consolidated financial statements since their effective date of acquisition. The purchase price for each business combination was allocated to the assets, including the identifiable intangible assets, and liabilities based on estimated fair values. The excess of the purchase price over the net identifiable assets acquired was allocated to goodwill. The purchase price of our membership purchases is allocated to identifiable intangible assets and is being amortized over a useful life of ten to fifteen years.
The following table summarizes all business combinations and membership purchases for the three years ended December 31, 2007. The purchase price of each business combination includes the payment for net worth and estimated transition costs. The purchase price, inclusive of all retroactive balance sheet settlements to date and transition cost adjustments, is presented below (millions):
First Health is a full service national health benefits services company that serves the group health, workers compensation and state public program markets. Provider Synergies manages preferred drug lists and negotiates rebates on behalf of state government and commercial clients. The businesses acquired from Concentra include a preferred provider organization, provider bill review, pharmacy benefit management, field case management, telephonic case management and independent medical exam businesses. The businesses acquired from Mutual include Mutuals commercial employer group health business in Nebraska and Iowa, as well as its national Federal Employees Health Benefits administration business, representing approximately 233,000 members in total. Vista is a Florida-based diversified health plan serving approximately 294,000 members consisting of 150,000 commercial employer group members, 32,000 individual members, 28,000 Medicare Advantage HMO members and 84,000 state program members. Approximately 85% of the membership is in the south Florida market with the remainder in north central Florida and the states panhandle. In addition to the acquired businesses discussed above, we completed a purchase of approximately 26,500 members from FirstGuard Health Plan Missouri, Inc., a wholly-owned subsidiary of Centene Corporation. For additional information regarding our acquisitions, please refer to Note B to our consolidated financial statements.
The following table presents our membership as of December 31, 2007 and 2006 (in thousands).
Commercial group risk membership increased 123,000 over the prior year end due primarily to the members acquired through the acquisition of Vista and of certain group health businesses from Mutual of Omaha, which together added 168,000 members. Health plan ASO membership increased 129,000 due to acquisitions, which added 99,000 members, and due to new sales and certain groups changing from a risk product to a non-risk product. Other ASO membership declined due to losses in our National Accounts business which was partially offset by FEHBP members obtained through the group health business acquired from Mutual of Omaha.
Individual Consumer & Government membership increased 397,000 from the prior year end, primarily due to our new Medicare Private-Fee-for-Service (PFFS) product. Commencing January 1, 2007, we offered Medicare PFFS plans to individuals in 43 states under the name Advantra Freedom. The increase in membership related to PFFS was 166,000. Membership also increased from the prior year due to the members acquired through the acquisition of Vista and FirstGuard which together added 170,000 members. Additionally, we had organic growth in our Individual, Medicare Advantage HMO and PPO and our Part D businesses.
The following table is provided to facilitate a more meaningful discussion regarding the comparison of our operations for each of the three years in the period ended December 31, 2007 (in thousands, except earnings per share and percentage data).
Comparison of 2007 to 2006
Managed care premium revenue increased in both our Individual Consumer & Government and Commercial divisions. The growth is a result of our new Medicare PFFS product, growth in existing products as well as from the acquisitions; each of which is described above. Partially offsetting the increase was a decline in same store Commercial risk membership over the prior year period.
Management services revenue increased compared to the prior year as a result of the acquisition of Concentra and Mutual described above. This increase was partially offset by membership losses in our Commercial Divisions National Accounts business.
Medical costs increased almost exclusively as a result of new business in both our Individual Consumer & Government Division and Commercial Division discussed above. Medical costs as a percentage of premium revenue (medical loss ratio) increased 0.3% from the prior year as a result of slightly higher medical loss ratios, associated with acquired businesses and from our new Medicare PFFS business which has a slightly higher medical loss ratio than our overall business.
Selling, general and administrative expense increased primarily due to operating costs associated with our recent acquisitions of Concentra, Mutual and Vista, as well as costs related to our new Medicare PFFS business in 2007. The increase in total selling, general and administrative expense was also attributable to increased salary and benefit expense as we position ourselves for future growth initiatives and as we incur normal annual compensation increases.
Depreciation and amortization increased as a result of the expense associated with the fixed assets and identifiable intangible assets acquired with the recent acquisitions, as well as a result of an increase in property and equipment over the past twelve months.
Interest expense increased primarily as a result of the issuance of debt during the current year, details of which are discussed below in our discussion of liquidity. The increase is also a result of the redemption during the first quarter of 2007 of our $170.5 million of outstanding 8.125% senior notes due February 15, 2012. We redeemed the notes at a redemption price equal to 104.1% of the principal amount plus interest accrued on the redemption date. As a result of the redemption, we recognized $6.9 million of interest expense for the premium paid on redemption and wrote off $2.2 million of deferred financing costs related to the senior notes.
Other income increased primarily as a result of a larger investment portfolio and higher interest rates.
Our provision for income taxes increased due to an increase in earnings. The effective tax rate decreased to 37.1% compared to 37.5% for the same period in 2006 primarily as a result of a change in the proportion of our earnings in states with lower tax rates.
Comparison of 2006 to 2005
Managed care premium revenue increased as a result of business related to our Medicare Part D products, which was new in 2006, and as a result of rate increases that occurred throughout all markets. Medicare Part D business accounted for $669.9 million of managed care premium revenue in 2006.
Commercial premium yields (premium per member per month) increased as a result of rate increases that occurred throughout all markets. The reported commercial premium yield increase of 5.3% is lower than the rate increases on renewing business due to a mix change in the types of plans being purchased as new business (such as a change to lower benefit plans); the types of plans being selected by renewing members when they have a choice among multiple options (such as a change to higher deductible, lower premium plans); and the termination of certain large groups which had high costs and high premium yields. Medicare Advantage premium yields increased as a result of the rate increases from the annual competitive bid filings. Medicaid premium yields increased as a result of rate increases effective January 1 and July 1, 2006 in Missouri, our largest Medicaid market.
Management services revenue decreased partially as a result of declines in membership in the National Accounts and Federal Employees Health Benefit Plan businesses. Additionally, the implementation of Medicare Part D resulted in a decline of Medicaid/Public pharmacy administration fee based revenue during 2006 compared to 2005, although this decline was more than offset by the increased revenue from our new Medicare Part D business discussed above in the managed care premium revenue section. These decreases were also partially offset by reporting a full year of First Health results in 2006. First Health was acquired on January 28, 2005 and therefore only results from January 28, 2005 through December 31, 2005 are included in our 2005 results of operations.
Medical costs increased as a result of new business related to our Medicare Part D products and as a result of medical trend. Medicare Part D medical costs totaled $565.9 million. Excluding Medicare Part D business, medical costs from our health plans as a percentage of premium revenue declined 0.6% in 2006 compared with 2005. The decline is primarily a result of premium increases and better than expected cost trends. The better than expected cost trends were primarily attributed to lower inpatient and outpatient utilization and the uncertainties at the prior year-end regarding our Louisiana operations and the effects from Hurricane Katrina. Days in total medical claims liabilities decreased slightly from the prior year due primarily to faster claim receipts and continually improved processing cycle times.
Selling, general and administrative expense increased primarily as a result of costs related to the new Medicare Part D business in 2006, reporting a full year of the First Health results in 2006, recognizing stock option expense related to the adoption of SFAS 123(R) and increased salary expenses due to annual compensation increases. However, these increases are partially offset by synergies gained subsequent to the acquisition of First Health. Selling, general and administrative expenses as a percentage of revenue have improved as a result of these achieved synergies, continuing revenue growth and success in controlling overall administrative costs.
Depreciation and amortization increased as a result of reporting a full year of First Health results in 2006 and as a result of an increase in property and equipment during 2005 and 2006, primarily computer equipment and software related to our First Health business.
Interest expense was higher in 2005 as a result of the refinancing of our credit facilities during the second quarter of 2005. As a result of the refinancing, we wrote off $5.4 million of deferred financing costs in the second quarter of 2005 related to the original credit facilities associated with the First Health acquisition. Additionally, our debt has declined during 2005 and 2006 and, as a result, interest expense related to the indebtedness has also declined.
Other income increased as a result of a larger investment portfolio and a rise in interest rates during 2005 and 2006.
Our provision for income taxes increased almost exclusively due to an increase in earnings. Our effective tax rate remained relatively flat at 37.5% in 2006 compared to 37.3% in 2005.
In an effort to further integrate the First Health business acquired in January of 2005, we realigned in 2007 into new operating units, which are based on the product sold and the customer type. Our new organizational structure, effective January 1, 2007, capitalizes on existing synergies and brings enhanced focus on areas of growth opportunities. As a result of the new organizational structure, our reportable segments changed. Each of our three new segments is managed separately and separate operating results are available that are evaluated by the chief operating decision maker. The Commercial Business Division is comprised of all of our commercial employer-focused businesses including the traditional health plan group risk and ASO products as well as the National Accounts, FEHBP, and Network Rental businesses. The Individual Consumer & Government Division contains the individual consumer products and all Medicare and Medicaid products. The Specialty Division includes our workers compensation services businesses.
Operating Revenues (in thousands)
Gross Margin (in thousands)
Revenue and Medical Cost Statistics
Comparison of 2007 to 2006
Commercial group risk premium revenue increased from 2006 as a result of the acquisitions of Mutual and Vista, which accounted for $196.7 million in revenue. The increase was also a result of an increase in average premium yields per member per month in our commercial group risk business. Commercial premium yields increased as a result of rate increases that occurred throughout all markets. This increase was partially offset by membership declines in our same store commercial group risk business. However, a portion of those members changed from our risk products to our non-risk products. Commercial management services revenue declined in 2007 due to membership losses in our national accounts non-risk business, partially offset by an increase in our commercial health plan ASO membership.
The gross margin decreased as a result of the decline in commercial management services revenue discussed above and the increase in the Health Plan Commercial medical loss ratio in 2007 compared to 2006. The year-to-year increase in the medical loss ratio is a result of the inclusion of the acquired Mutual of Omaha and Vista businesses in 2007, as well as the low medical loss ratio experienced by our Louisiana health plan in 2006, which was driven by the unique circumstances that existed in the Louisiana market at that time, the effects due to Hurricane Katrina.
Individual Consumer & Government Division
Individual Consumer & Government revenue increased from 2006 as a result of membership from our new Medicare PFFS business, as well as the increased Part D, Medicaid and Individual membership, both organic and acquired. Part D revenue includes adjustments attributable to the estimation of CMS risk sharing payments.
Medicare Advantage risk premium yields per member per month decreased as a result of the addition of our new Medicare Private-Fee-For-Service business, which has a lower premium yield than our existing Medicare Advantage business, since our individually distributed PFFS products generally did not include a pharmacy benefit in 2007. This average premium yield decrease was partially offset by the rate increases from the annual competitive bid filings for our Medicare Advantage products, as well as from increases in risk factor adjustment scores for certain of our Medicare products. Part D premium yields have declined in 2007 compared to 2006 primarily due to the lower CMS risk sharing accruals as well as the annual competitive bid filings for our Part D products. This change is a result of the improved profitability of the Part D program, which is discussed below. Medicaid premium yields increased as a result of rate increases in Missouri, our largest Medicaid market, effective July 1, 2006 and July 1, 2007.
The increase in gross margin was driven by the increased business discussed above and was partially offset by the increased medical costs associated with this increased business. Part D medical costs as a percentage of premium revenue have decreased over the prior year quarter as a result of favorable pharmacy cost trend due to re-negotiated pharmaceutical contracts resulting from higher enrollment and as a result of members moving to generic drugs. Medicaid medical costs as a percentage of premium revenue increased over the prior year as a result of an increase in large claims incurred in our Missouri market.
Specialty revenue and operating expenses increased primarily as a result of the acquisition of Concentra during the second quarter of 2007.
Liquidity and Capital Resources
The nature of a majority of our operations is such that cash receipts from premium revenues are typically received up to two months prior to the expected cash payment for related medical costs. Premium revenues are typically received at the beginning of the month in which they are earned, and the corresponding incurred medical expenses are paid in a future time period, typically 15 to 60 days after the date such medical services are rendered. The lag between premium receipts and claims payments creates positive cash flow and overall cash growth. As a result, we typically hold approximately two months of float. In addition, accumulated earnings provide further positive cash flow. In addition to ample current liquidity, our long-term investment portfolio is available for further liquidity needs.
Our investment guidelines require our fixed income securities to be investment grade in order to provide liquidity to meet future payment obligations and minimize the risk to the principal. Our fixed income portfolio includes government and corporate securities with an average quality rating of AA+ and an average contractual duration of 3.6 years as of December 31, 2007. Typically, the amount and duration of our short-term assets are more than sufficient to pay for our short-term liabilities and we do not anticipate that sales of our long-term investment portfolio will be necessary to fund our claims liabilities.
Our cash and investments, consisting of cash, cash equivalents, short-term investments, and long-term investments, but excluding deposits of $64.4 million restricted under state regulations, increased $57.5 million to $2.8 billion at December 31, 2007 from $2.7 billion at December 31, 2006.
The demand for our products and services is subject to many economic fluctuations, risks and uncertainties that could materially affect the way we do business. See Part I, Item 1A, Risk Factors, in this Form 10-K for more information. Management believes that the combination of our ability to generate cash flows from operations, cash and investments on hand and the excess funds held in certain of our regulated subsidiaries will be sufficient to fund continuing operations, capital expenditures, debt interest costs, debt principal repayments and any other reasonably likely future cash requirements.
Net cash from operating activities is primarily driven by net earnings and by an increase in medical liabilities of approximately $194.8 million related to the new Medicare PFFS business. The nature of Medicare PFFS is such that premium revenues are generally received up to two months prior to the cash payment for the related medical costs. Accordingly, this results in strong cash inflows upon the implementation of a new benefit program. These inflows are partially offset by the $363.7 million payment to CMS, which was expected, related to the 2006 Medicare Part D contract year which was the primary driver for the decrease in medical claims liabilities, and other accrued liabilities. The decrease in cash flows from other receivables was primarily a result of an increase in pharmacy rebate receivables related to the Medicare Part D business and the CMS payment previously mentioned. Additionally, accounts payable and other accrued liabilities decreased primarily due to a decrease in income taxes payable, attributable largely to tax payments for the year exceeding the tax provision, offset by other normal operating activities.
Capital expenditures in 2007 of approximately $61.3 million consist primarily of computer hardware, software and related costs associated with the development and implementation of improved operational and communication systems. Projected capital expenditures in 2008 of approximately $65-$75 million consist primarily of computer hardware, software and other equipment.
During 2007, we made acquisitions for a total cost of approximately $1.2 billion, net of cash acquired, which was paid in cash, including $34.2 million paid into an escrow account pending final settlement.
Proceeds from the issuance of debt include approximately $789.1 million of new Senior Notes, net of any discounts and payments made for debt issuance costs. These proceeds also include an amended and restated credit agreement providing for an $850 million credit facility, of which $365.0 million was drawn in 2007. In addition to cash on hand, the proceeds were partially used to retire both the $170.5 million of 2002 Senior Notes and our $90 million term loan, which included a $10 million scheduled repayment, and to fund the previously mentioned acquisitions. The details of these transactions are as follows:
Our senior notes dated January 28, 2005 and credit facilities require compliance with a leverage ratio. All of our senior notes and credit facility contain certain covenants and restrictions regarding additional debt, dividends or other restricted payments, transactions with affiliates, disposing of assets and in some cases provide for debt repayment upon consolidations or mergers. As of December 31, 2007, we were in compliance with applicable covenants under the senior notes and credit facility.
Our Board of Directors has approved a program to repurchase our outstanding common stock. Stock repurchases may be made from time to time at prevailing prices on the open market, by block purchase or in private transactions. In February 2007, our Board of Directors approved an increase to the share repurchase program of 7.9 million shares. As a part of this program, no shares were purchased in 2005, 4.6 million shares of our common stock were purchased in 2006 at an aggregate cost of $256.1 million and 7.5 million shares of our common stock were purchased in 2007 at an aggregate cost of $429.0 million. As of December 31, 2007, the total remaining common shares we are authorized to repurchase under this program is 6.5 million.
Our regulated HMO and insurance company subsidiaries are required by state regulatory agencies to maintain minimum surplus balances, thereby limiting the dividends the parent may receive from our regulated entities. During 2007, we received $421.6 million in dividends from our regulated subsidiaries and paid $71.9 million in capital contributions.
The National Association of Insurance Commissioners (NAIC) has proposed that states adopt risk-based capital (RBC) standards that, if adopted, would generally require higher minimum capitalization requirements for HMOs and other risk-bearing health care entities. RBC is a method of measuring the minimum amount of capital appropriate for a managed care organization to support its overall business operations in consideration of its size and risk profile. The managed care organizations RBC is calculated by applying factors to various assets, premiums and reserve items. The factor is higher for those items with greater underlying risk and lower for less risky items. The adequacy of a managed care organizations actual capital can then be measured by a comparison to its RBC as determined by the formula. Our health plans are required to submit an RBC report to the NAIC and their domiciled states department of insurance with their annual filing.
Regulators will use the RBC results to determine if any regulatory actions are required. Regulatory actions that could take place, if any, range from filing a financial action plan explaining how the plan will increase its statutory net worth to the approved levels, to the health plan being placed under regulatory control.
The majority of states in which we operate health plans have adopted RBC policy that recommends the health plans maintain statutory reserves at or above the Company Action Level which is currently equal to 200% of their RBC. The State of Florida does not currently use RBC methodology in its regulation of HMOs. Some states, in which our regulated subsidiaries operate, require deposits to be maintained with the respective states departments of insurance. The table below summarizes our statutory reserve information, as of December 31, 2007 and 2006 (in millions, except percentage data).
The increase in capital and surplus for our regulated subsidiaries is a result of net earnings as well as the inclusion of the Vista and Mutual of Omaha acquisitions. This was partially offset by dividends paid to the parent company.
We believe that all subsidiaries which incur medical claims maintain more than adequate liquidity and capital resources to meet these short-term obligations as a matter of both Company policy and applicable department of insurance regulations.
Excluding funds held by entities subject to regulation and excluding our equity method investments, we had cash and investments of approximately $436.2 million and $563.1 million at December 31, 2007 and December 31, 2006, respectively. The decrease was primarily due to payments made for the Concentra, Mutual of Omaha and Vista acquisitions and payments for share repurchases. These payments were partially offset by the proceeds from the sale of our Senior Notes, dividends received from our regulated subsidiaries, and additional borrowings on our credit facility.
As of December 31, 2007, we were contractually obligated to make the following payments within the next five years and thereafter (in thousands):
Refer to Note J to our consolidated financial statements for disclosure related to our operating leases.
We have typically paid 90% to 95% of medical claims within six months of the date incurred and approximately 99% of medical claims within nine months of the date incurred. Accordingly, we believe medical claims liabilities are short-term in nature and therefore do not meet the listed criteria for classification as contractual obligations and have been excluded from the table above. As of December 31, 2007, we had $83.5 million of unrecognized tax benefits. The above table excludes these amounts due to uncertainty of timing and amounts regarding future payments. See note G to the consolidated financials statements for additional information.
See Legal Proceedings in Note J, Commitments and Contingencies which is incorporated herein by reference.
As a managed health care company, we are subject to extensive government regulation of our products and services. The laws and regulations affecting our industry generally give state and federal regulatory authorities broad discretion in their exercise of supervisory, regulatory and administrative powers. These laws and regulations are intended primarily for the benefit of the members of the health plans. Managed care laws and regulations vary significantly from jurisdiction to jurisdiction and changes are frequently considered and implemented. Likewise, interpretations of these laws and regulations are also subject to change.
Although the provisions of any future legislation adopted at the state or federal level can not be accurately predicted at this time, management believes that the ultimate outcome of currently proposed legislation should not have a material adverse effect on the results of our operations in the short-term. Nevertheless, it is possible that future legislation or regulation could have a significant effect on our operations.
In recent years, health care cost inflation has exceeded the general inflation rate. To reduce the effect of health care cost inflation on our business operations, in which we assume underwriting risk, we have, where possible, increased premium rates and implemented cost control measures in our patient care management and provider contracting. We can not be certain that we will be able to increase future premium rates at a rate that equals or exceeds the health care cost inflation rate or that our other cost control measures will be effective.
Given the results of sales activity through February, 2008, we expect to add 100,000 net Medicare Advantage members during 2008 from both individual and group sales.
We expect to add at least 125,000 net Part D members from our 2007 year end results. A majority of these new members will be in Low Income Subsidy products. As a result of this growth and the overall programs wider risk sharing corridor in 2008, our Part D business is expected to have a steeper medical loss ratio (MLR) slope, resulting in a greater seasonal effect on the progression of quarterly earnings per share. More specifically, in the fourth quarter of 2007, we reported a Part D MLR of 58%. For the first quarter of 2008, we are expecting a loss ratio of 104% (vs. a 95% and 98% MLR in the first quarter of 2007 and 2006, respectively). Despite the better than previously expected membership growth and quarterly MLR progression referred to above, our expectations of the full year Part D MLR have not changed.
We expect to grow our commercial risk membership 1% to 2% for the full year. As with the first quarter of 2007, we expect that our commercial risk membership will decrease in the first quarter of 2008. However, based on our strong underlying small group results, and the large group pipeline, we expect membership to grow in each of the remaining quarters. Regarding the MLR for our same store commercial group business, we expect it to remain relatively flat in 2008 at approximately 78%, with the expected 2008 reported commercial group MLR, including the annualization impact of 2007 acquisitions, to be in the mid to high 78%s.
We expect individual membership to grow to 150,000 members by the end of 2008. This would essentially double our non-Vista organic membership from our 2007 results.
We expect investment income to decrease in 2008 due to lower market interest rates.
Regarding use of cash, we remain committed to share repurchase as well as evaluating acquisition opportunities. We closed on an acquisition of a small behavioral health company during February 2008. This acquisition will have an immaterial effect on our consolidated revenue and results for the year. We expect to gain the benefits of in-sourcing our behavioral health business in all of our markets over the next several years.
We are also pursuing a range of solutions for both group life and dental products, and expect to move forward in these areas in 2008 as well. Any effect of these initiatives on revenue or earnings for 2008 is expected to be immaterial.
See Part I, Item 1A, Risk Factors, which is incorporated herein by reference.
Item 7A: Quantitative and Qualitative Disclosures About Market Risk
Under an investment policy approved by our Board of Directors, we invest primarily in marketable U.S. government and agency, state, municipal, mortgage-backed and asset-backed securities and corporate debt obligations that are investment grade. Our Investment Policy and Guidelines generally do not permit the purchase of equity-type investments or fixed income securities that are below investment grade. Our investment guidelines include a permitted exception to allow for such investments if those investments are obtained through a business combination and if, in our best interest, such investments were not disposed within 90 days after acquisition. As described in the notes to the financial statements, we acquired investments in an equipment leasing limited liability company through our acquisition of First Health and in an insurance agency through our acquisition of Vista. We have classified all of our investments as available-for-sale. We are exposed to certain market risks including interest rate risk and credit risk.
We have established policies and procedures to manage our exposure to changes in the fair value of our investments. Our policies include an emphasis on credit quality and the management of our portfolios duration and mix of securities. We believe our investment portfolio is diversified and currently expect no material loss to result from the failure to perform by the issuers of the debt securities we hold. The mortgage-backed securities are insured by several associations, including Government National Mortgage Administration, Federal National Mortgage Administration and the Federal Home Loan Mortgage Corporation.
We invest primarily in fixed income securities and classify all our investments as available-for-sale. Investments are evaluated on an individual security basis at least quarterly to determine if declines in value are other-than-temporary. In making that determination, we consider all available evidence relating to the realizable value of a security. This evidence includes, but is not limited to, the following:
Temporary declines in value of investments classified as available-for-sale are netted with unrealized gains and reported as a net amount in a separate component of stockholders equity. A decline in fair value below amortized cost that is judged to be otherthantemporary is accounted for as a realized loss and the write down is included in earnings. Realized gains and losses on the sale of investments are determined on a specific identification basis. The current unrealized loss is almost exclusively the result of interest rate movements. We intend to hold these investments for a period of time sufficient to allow for a recovery in market value, which may be maturity. See Note E to our consolidated financial statements in this Form 10-K for more information concerning other-than-temporary impaired investments.
Our investments at December 31, 2007 mature according to their contractual terms, as follows, in thousands (actual maturities may differ because of call or prepayment rights):
Our projections of hypothetical net gains in fair value of our market rate sensitive instruments, should potential changes in market rates occur, are presented below. The projection is based on a model, which incorporates effective duration, convexity and price to forecast hypothetical instantaneous changes in interest rates of positive and negative 100, 200 and 300 basis points. The model only takes into account the fixed income securities in the portfolio and excludes all cash. While we believe that the potential market rate change is reasonably possible, actual results may differ.
Item 8: Financial Statements and Supplementary Data
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders of Coventry Health Care, Inc.
We have audited the accompanying consolidated balance sheets of Coventry Health Care, Inc. and subsidiaries as of December 31, 2007 and 2006, and the related consolidated statements of operations, stockholders equity, and cash flows for each of the three years in the period ended December 31, 2007. These financial statements are the responsibility of the Companys management. Our responsibility is to express an opinion on these 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 financial statements referred to above present fairly, in all material respects, the consolidated financial position of Coventry Health Care, Inc. and subsidiaries at December 31, 2007 and 2006, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2007, in conformity with U.S. generally accepted accounting principles.
As discussed in Note F to the consolidated financial statements, on January 1, 2006, Coventry Health Care, Inc. changed the method of accounting for stock-based compensation in accordance with guidance provided in Statement of Financial Accounting Standards No. 123(R), Share-Based Payment. As discussed in Note G to the consolidated financial statements, Coventry Health Care, Inc. adopted FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes, effective January 1, 2007.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Coventry Health Care, Inc.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 and our report dated February 28, 2008 expressed an unqualified opinion thereon.
/s/ Ernst & Young, LLP
February 28, 2008
Coventry Health Care, Inc. and Subsidiaries
Consolidated Balance Sheets
See accompanying notes to the consolidated financial statements.
Coventry Health Care, Inc. and Subsidiaries
Consolidated Statements of Operations
(in thousands, except per share data)
See accompanying notes to the consolidated financial statements.
Coventry Health Care, Inc. and Subsidiaries
Consolidated Statements of Stockholders Equity
Years Ended December 31, 2007, 2006 and 2005
(in thousands, except shares which are in millions)