Item
1. Financial
Statements
Condensed
Consolidated Balance Sheets
(in
thousands, except per share data)
(Unaudited)
|
|
September
30,
2007
|
|
|
December
31, 2006
|
|
Assets
|
|
|
|
|
|
|
Current
assets:
|
|
|
|
|
|
|
|
Cash
and cash equivalents
|
|
$
|
53,160
|
|
|
$
|
58,918
|
|
|
Investments
|
|
|
284,420
|
|
|
|
323,846
|
|
|
Accounts
receivable (less allowance for doubtful accounts:
|
|
|
|
|
|
|
|
|
|
|
2007-$7,400;2006-$5,518)
|
|
|
30,366
|
|
|
|
21,308
|
|
|
Current
portion of deferred tax asset
|
|
|
33,584
|
|
|
|
29,861
|
|
|
Prepaid
expenses and other current assets
|
|
|
129,475
|
|
|
|
110,020
|
|
Total
current assets
|
|
|
531,005
|
|
|
|
543,953
|
|
|
|
|
|
|
|
|
|
|
Property
and equipment, net
|
|
|
64,197
|
|
|
|
71,893
|
|
Restricted
cash and investments
|
|
|
17,274
|
|
|
|
19,428
|
|
Goodwill
|
|
|
14,782
|
|
|
|
14,782
|
|
Deferred
tax asset (less current portion)
|
|
|
28,762
|
|
|
|
18,656
|
|
Note
receivable (less valuation allowance: 2007 and 2006 -
$15,000)
|
|
|
47,000
|
|
|
|
47,000
|
|
Other
assets
|
|
|
92,006
|
|
|
|
93,700
|
|
Total
assets
|
|
$
|
795,026
|
|
|
$
|
809,412
|
|
|
|
|
|
|
|
|
|
|
Liabilities
and stockholders' equity
|
|
|
|
|
|
|
|
|
Current
liabilities:
|
|
|
|
|
|
|
|
|
|
Accrued
and other current liabilities
|
|
$
|
85,389
|
|
|
$
|
99,314
|
|
|
Trade
accounts payable
|
|
|
2,082
|
|
|
|
1,552
|
|
|
Accrued
payroll and taxes
|
|
|
29,351
|
|
|
|
25,925
|
|
|
Medical
claims payable
|
|
|
191,122
|
|
|
|
222,895
|
|
|
Premium
deficiency reserve
|
|
|
22,081
|
|
|
|
1,076
|
|
|
Unearned
premium revenue
|
|
|
52,207
|
|
|
|
52,075
|
|
|
Current
portion of long-term debt
|
|
|
153
|
|
|
|
116
|
|
Total
current liabilities
|
|
|
382,385
|
|
|
|
402,953
|
|
|
|
|
|
|
|
|
|
|
Long-term
debt (less current portion)
|
|
|
20,535
|
|
|
|
118,734
|
|
Other
liabilities
|
|
|
91,062
|
|
|
|
71,007
|
|
Total
liabilities
|
|
|
493,982
|
|
|
|
592,694
|
|
|
|
|
|
|
|
|
|
|
Commitments
and contingencies
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Stockholders'
equity:
|
|
|
|
|
|
|
|
|
|
Preferred
stock, $.01 par value, 1,000 shares authorized;
|
|
|
|
|
|
|
|
|
|
none
issued or outstanding
|
|
|
¾
|
|
|
|
¾
|
|
|
Common
stock, $.005 par value, 120,000 shares authorized; 2007 –
73,582;
|
|
|
|
|
|
|
|
|
|
2006
– 70,835 shares issued; 2007 – 56,180; 2006 – 53,824 shares
outstanding
|
|
|
368
|
|
|
|
354
|
|
|
Treasury
stock at cost: 2007 – 17,402; 2006 – 17,011 common stock
shares
|
|
|
(614,976
|
)
|
|
|
(600,539
|
)
|
|
Additional
paid-in capital
|
|
|
469,645
|
|
|
|
436,643
|
|
|
Accumulated
other comprehensive loss
|
|
|
(7,408
|
)
|
|
|
(8,635
|
)
|
|
Retained
earnings
|
|
|
453,415
|
|
|
|
388,895
|
|
Total
stockholders' equity
|
|
|
301,044
|
|
|
|
216,718
|
|
Total
liabilities and stockholders' equity
|
|
$
|
795,026
|
|
|
$
|
809,412
|
|
See
accompanying Notes to Condensed Consolidated Financial
Statements
Sierra
Health Services, Inc. And Subsidiaries
(In
thousands, except per share data)
(Unaudited)
|
|
Three
Months Ended
September
30,
|
|
|
Nine
Months Ended
September
30,
|
|
|
|
2007
|
|
|
2006
|
|
|
2007
|
|
|
2006
|
|
Operating
revenues:
|
|
|
|
|
|
|
|
|
|
|
|
|
Medical
premiums
|
|
$
|
445,680
|
|
|
$
|
405,618
|
|
|
$
|
1,371,000
|
|
|
$
|
1,220,726
|
|
Professional
fees
|
|
|
13,483
|
|
|
|
13,300
|
|
|
|
42,519
|
|
|
|
39,097
|
|
Investment
and other revenues
|
|
|
9,761
|
|
|
|
11,079
|
|
|
|
32,089
|
|
|
|
32,860
|
|
Total
|
|
|
468,924
|
|
|
|
429,997
|
|
|
|
1,445,608
|
|
|
|
1,292,683
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Operating
expenses:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Medical
expenses
|
|
|
375,075
|
|
|
|
323,694
|
|
|
|
1,172,597
|
|
|
|
981,758
|
|
General
and administrative expenses
|
|
|
42,264
|
|
|
|
51,291
|
|
|
|
160,984
|
|
|
|
153,052
|
|
Total
|
|
|
417,339
|
|
|
|
374,985
|
|
|
|
1,333,581
|
|
|
|
1,134,810
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Operating
income
|
|
|
51,585
|
|
|
|
55,012
|
|
|
|
112,027
|
|
|
|
157,873
|
|
Interest
expense
|
|
|
(584
|
)
|
|
|
(1,015
|
)
|
|
|
(3,576
|
)
|
|
|
(2,793
|
)
|
Other
income (expense), net
|
|
|
279
|
|
|
|
14
|
|
|
|
1,773
|
|
|
|
(10
|
)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Income
before income taxes
|
|
|
51,280
|
|
|
|
54,011
|
|
|
|
110,224
|
|
|
|
155,070
|
|
Provision
for income taxes
|
|
|
(16,654
|
)
|
|
|
(19,082
|
)
|
|
|
(37,477
|
)
|
|
|
(53,936
|
)
|
Net
income
|
|
$
|
34,626
|
|
|
$
|
34,929
|
|
|
$
|
72,747
|
|
|
$
|
101,134
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net
income per common share
|
|
$
|
0.62
|
|
|
$
|
0.62
|
|
|
$
|
1.30
|
|
|
$
|
1.78
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net
income per common share assuming dilution
|
|
$
|
0.59
|
|
|
$
|
0.56
|
|
|
$
|
1.24
|
|
|
$
|
1.61
|
|
See
accompanying Notes to Condensed Consolidated Financial
Statements
Sierra
Health Services, Inc. And Subsidiaries
(In
thousands)
(Unaudited)
|
|
Common
Stock
|
|
In
Treasury
|
|
Additional
Paid-in
|
|
Accumulated
Other
Comprehensive
|
|
Retained
|
|
Total
Stock-
holders'
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Shares
|
|
Amount
|
|
Shares
|
|
Amount
|
|
Capital
|
|
Loss
|
|
Earnings
|
|
Equity
|
Balance,
January 1, 2006
|
69,136
|
$
|
346
|
|
11,006
|
$
|
(377,190)
|
$
|
400,287
|
$
|
(1,750)
|
$
|
262,559
|
$
|
284,252
|
Common
stock issued in connection with stock plans
|
624
|
|
3
|
|
(562)
|
|
19,095
|
|
8,534
|
|
¾
|
|
(13,569)
|
|
14,063
|
Share-based
compensation expense
|
¾
|
|
¾
|
|
(1)
|
|
23
|
|
5,782
|
|
¾
|
|
5
|
|
5,810
|
Common
stock issued in connection with conversion of debentures
|
929
|
|
5
|
|
¾
|
|
¾
|
|
8,495
|
|
¾
|
|
¾
|
|
8,500
|
Excess
tax benefits from share-based payment arrangements
|
¾
|
|
¾
|
|
¾
|
|
¾
|
|
11,445
|
|
¾
|
|
¾
|
|
11,445
|
Repurchase
of common stock shares
|
¾
|
|
¾
|
|
3,136
|
|
(127,780)
|
|
¾
|
|
¾
|
|
¾
|
|
(127,780)
|
Comprehensive
income:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net
income
|
¾
|
|
¾
|
|
¾
|
|
¾
|
|
¾
|
|
¾
|
|
101,134
|
|
101,134
|
|
Other
comprehensive income:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net
unrealized holding loss on
available-for-sale
investments ($746 pretax)
|
¾
|
|
¾
|
|
¾
|
|
¾
|
|
¾
|
|
(485)
|
|
¾
|
|
(485)
|
Total
comprehensive income
|
¾
|
|
¾
|
|
¾
|
|
¾
|
|
¾
|
|
(485)
|
|
101,134
|
|
100,649
|
Balance,
September 30, 2006
|
70,689
|
$
|
354
|
|
13,579
|
$
|
(485,852)
|
$
|
434,543
|
$
|
(2,235)
|
$
|
350,129
|
$
|
296,939
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Balance,
January 1, 2007
|
70,835
|
$
|
354
|
|
17,011
|
$
|
(600,539)
|
$
|
436,643
|
$
|
(8,635)
|
$
|
388,895
|
$
|
216,718
|
Common
stock activity in connection with stock plans
|
204
|
|
1
|
|
(194)
|
|
5,444
|
|
2,833
|
|
¾
|
|
(4,158)
|
|
4,120
|
Share-based
compensation expense
|
¾
|
|
¾
|
|
¾
|
|
1,200
|
|
2,493
|
|
¾
|
|
198
|
|
3,891
|
Common
stock issued in connection with conversion of debentures
|
2,543
|
|
13
|
|
¾
|
|
¾
|
|
23,243
|
|
¾
|
|
¾
|
|
23,256
|
Excess
tax benefits from share-based payment arrangements
|
¾
|
|
¾
|
|
¾
|
|
¾
|
|
4,433
|
|
¾
|
|
¾
|
|
4,433
|
Repurchase
of common stock shares
|
¾
|
|
¾
|
|
585
|
|
(21,081)
|
|
¾
|
|
¾
|
|
¾
|
|
(21,081)
|
Cumulative
effect from adoption of
FIN
48
|
¾
|
|
¾
|
|
¾
|
|
¾
|
|
¾
|
|
¾
|
|
(4,267)
|
|
(4,267)
|
Comprehensive
income:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net
income
|
¾
|
|
¾
|
|
¾
|
|
¾
|
|
¾
|
|
¾
|
|
72,747
|
|
72,747
|
|
Other
comprehensive income:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net
unrealized holding gain on available-for-sale investments
($823 pretax)
|
¾
|
|
¾
|
|
¾
|
|
¾
|
|
¾
|
|
535
|
|
¾
|
|
535
|
|
Unfunded
portion of defined benefit pension plan ($1,064 pretax)
|
¾
|
|
¾
|
|
¾
|
|
¾
|
|
¾
|
|
692
|
|
¾
|
|
692
|
Total
comprehensive income
|
¾
|
|
¾
|
|
¾
|
|
¾
|
|
¾
|
|
1,227
|
|
72,747
|
|
73,974
|
Balance,
September 30, 2007
|
73,582
|
$
|
368
|
|
17,402
|
$
|
(614,976)
|
$
|
469,645
|
$
|
(7,408)
|
$
|
453,415
|
$
|
301,044
|
See
accompanying Notes to Condensed Consolidated Financial
Statements
Sierra
Health Services, Inc. And Subsidiaries
(In
thousands)
(Unaudited)
|
|
Nine
Months Ended September 30,
|
|
|
|
2007
|
|
|
2006
|
|
Cash
flows from operating activities:
|
|
|
|
|
|
|
Net
income
|
|
$
|
72,747
|
|
|
$
|
101,134
|
|
Adjustments
to reconcile net income to net cash
|
|
|
|
|
|
|
|
|
provided
by operating activities:
|
|
|
|
|
|
|
|
|
Depreciation
|
|
|
11,615
|
|
|
|
12,327
|
|
Share-based
compensation expense
|
|
|
3,891
|
|
|
|
5,810
|
|
Excess
tax benefits from share-based payment arrangements
|
|
|
(4,433
|
)
|
|
|
(11,445
|
)
|
Provision
for doubtful accounts
|
|
|
5,222
|
|
|
|
1,796
|
|
Other
adjustments
|
|
|
(1,083
|
)
|
|
|
213
|
|
Change
in operating assets and liabilities:
|
|
|
|
|
|
|
|
|
Deferred
tax asset
|
|
|
(14,105
|
)
|
|
|
(2,986
|
)
|
Other
current assets
|
|
|
(26,810
|
)
|
|
|
(53,303
|
)
|
Other
assets
|
|
|
(3,172
|
)
|
|
|
(4,270
|
)
|
Accrued
payroll and taxes
|
|
|
3,426
|
|
|
|
6,747
|
|
Medical
claims payable
|
|
|
(31,773
|
)
|
|
|
21,396
|
|
Other
current liabilities
|
|
|
(1,980
|
)
|
|
|
14,121
|
|
Unearned
premium revenue
|
|
|
132
|
|
|
|
3,499
|
|
Premium
deficiency reserve
|
|
|
21,005
|
|
|
|
¾
|
|
Other
liabilities
|
|
|
16,479
|
|
|
|
(1,136
|
)
|
Net
cash provided by operating activities
|
|
|
51,161
|
|
|
|
93,903
|
|
|
|
|
|
|
|
|
|
|
Cash
flows from investing activities:
|
|
|
|
|
|
|
|
|
Capital
expenditures, net of dispositions
|
|
|
(2,967
|
)
|
|
|
(13,183
|
)
|
Purchase
of investments, net of proceeds
|
|
|
34,832
|
|
|
|
11,500
|
|
Net
cash provided by (used for) investing activities
|
|
|
31,865
|
|
|
|
(1,683
|
)
|
|
|
|
|
|
|
|
|
|
Cash
flows from financing activities:
|
|
|
|
|
|
|
|
|
Payments
on debt and capital leases
|
|
|
(78,494
|
)
|
|
|
(82
|
)
|
Purchase
of treasury stock
|
|
|
(21,081
|
)
|
|
|
(127,780
|
)
|
Excess
tax benefits from share-based payment arrangements
|
|
|
4,433
|
|
|
|
11,445
|
|
Proceeds
from exercise of stock in connection with stock plans
|
|
|
6,358
|
|
|
|
14,063
|
|
Net
cash used for financing activities
|
|
|
(88,784
|
)
|
|
|
(102,354
|
)
|
|
|
|
|
|
|
|
|
|
Net
decrease in cash and cash equivalents
|
|
|
(5,758
|
)
|
|
|
(10,134
|
)
|
Cash
and cash equivalents at beginning of period
|
|
|
58,918
|
|
|
|
88,059
|
|
Cash
and cash equivalents at end of period
|
|
$
|
53,160
|
|
|
$
|
77,925
|
|
|
|
|
|
|
|
|
|
|
Supplemental
condensed consolidated statement of cash flows
information:
|
|
|
|
|
|
|
|
|
Cash
paid during the period for interest
|
|
$
|
3,828
|
|
|
$
|
2,672
|
|
Net
cash paid during the period for income taxes
|
|
|
57,615
|
|
|
|
37,398
|
|
Non-cash
investing and financing activities:
|
|
|
|
|
|
|
|
|
Senior
convertible debentures converted into Sierra common stock
|
|
|
23,256
|
|
|
|
8,500
|
|
Asset
received in consideration for payment of a loan
|
|
|
6,815
|
|
|
|
¾
|
|
Additions
to capital leases
|
|
|
212
|
|
|
|
¾
|
|
Cashless
exercise of restricted stock units
|
|
|
2,237
|
|
|
|
¾
|
|
Investments
purchased but not settled (received but not yet purchased)
|
|
|
9,222
|
|
|
|
(539
|
)
|
See
accompanying Notes to Condensed Consolidated Financial
Statements
Sierra
Health Services, Inc.
Notes
to Condensed Consolidated Financial
Statements
(Unaudited)
The
accompanying unaudited condensed consolidated financial statements include
the
consolidated accounts of Sierra Health Services, Inc. ("Sierra", a holding
company, together with its subsidiaries, collectively referred to herein as
the
"Company"). All material intercompany balances and transactions have been
eliminated. These statements and the Company's annual audited consolidated
financial statements have been prepared in conformity with accounting principles
generally accepted in the United States of America; however, these statements
do
not contain all of the information and disclosures that would be required in
a
complete set of audited financial statements. They should, therefore, be read
in
conjunction with the Company's annual audited consolidated financial statements
and related notes thereto for the year ended December 31, 2006. In the opinion
of management, the accompanying unaudited condensed consolidated financial
statements reflect all material adjustments, consisting only of normal recurring
adjustments, necessary for a fair presentation of the financial results for
the
interim periods presented.
The
preparation of financial statements in conformity with accounting principles
generally accepted in the United States of America requires management to make
estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities at the date
of
the financial statements and the reported amounts of revenues and expenses
during the reporting period. Such estimates and assumptions could change in
the
future as more information becomes available, which could impact the amounts
reported and disclosed herein. Actual results may differ materially from
estimates.
Certain
amounts in the condensed consolidated financial statements for the three and
nine months ended September 30, 2006 have been reclassified to conform to the
current year presentation. Such reclassifications have no effect on net income
as previously reported.
2. Pending
Business Combination
On
March
11, 2007, the Company entered into an Agreement and Plan of Merger (the "Merger
Agreement"), with UnitedHealth Group Incorporated, a Minnesota corporation
("UnitedHealth Group"), and Sapphire Acquisition, Inc., a Nevada corporation
and
an indirect wholly-owned subsidiary of UnitedHealth Group ("Merger
Sub"). The Merger Agreement provides that, upon the terms and subject
to the conditions set forth in the Merger Agreement, Merger Sub will merge
with
and into the Company (the "Merger"), with Sierra continuing as the surviving
company. At the effective time of the Merger, each issued and
outstanding share of the Company's common stock (other than shares owned by
UnitedHealth Group or Merger Sub, whose shares will be cancelled), will be
converted into the right to receive $43.50 in cash, on the terms specified
in
the Merger Agreement. Completion of the Merger is subject to various conditions,
including, among others, (i) approval of the holders of a majority of the
outstanding shares of the Company's common stock, (ii) expiration or termination
of the applicable Hart-Scott-Rodino Act ("HSR") waiting period, (iii) absence
of
any order, injunction or other judgment or decree prohibiting the consummation
of the Merger, (iv) receipt of required governmental consents and approvals
without negative regulatory action, and (v) subject to certain exceptions,
the
accuracy of the representations and warranties of the Company and UnitedHealth
Group, as applicable, and compliance by the Company and UnitedHealth Group
with
their respective obligations under the Merger Agreement. The Merger
Agreement contains certain termination rights for both the Company and
UnitedHealth Group, and further provides that, upon termination of the Merger
Agreement under specified circumstances, the Company may be required to pay
UnitedHealth Group a termination fee of $85.0 million and in other
circumstances, UnitedHealth Group may be required to pay Sierra a termination
fee of $25.0 million.
On
May
16, 2007, the Company and UnitedHealth Group received a request for additional
information from the Antitrust Division of the U.S. Department of Justice
("DOJ") regarding the proposed merger between the two companies. The
information request, also known as a "second request," was issued under
notification requirements of the HSR. The effect of the second
request is to extend the waiting period imposed by the HSR until 30 days
after
the
Company and UnitedHealth Group have substantially complied with the request
for
additional information, unless the period is extended voluntarily by the parties
or terminated sooner by the DOJ.
On
June
27, 2007, the Company’s stockholders approved the Merger
Agreement. On August 27, 2007, the Company received an order granting
approval of the merger from the Commissioner of Nevada's Division of Insurance.
On September 6, 2007, the Company received notice that the California Department
of Insurance granted approval of the merger.
3. Medicare
Part D Prescription Drug Program ("PDP")
The
Company contracted with the Centers for Medicare and Medicaid Services ("CMS")
to offer a basic stand-alone PDP ("Basic Plan") to eligible Medicare
beneficiaries effective January 1, 2006. The Company offered the
Basic Plan in eight regions covering Arizona, California, Colorado, Idaho,
Nevada, New Mexico, Oregon, Texas, Utah and Washington. The Company was also
selected as a PDP sponsor in the same states for auto-enrolled CMS subsidized
beneficiaries.
In
2007,
the Company expanded its Basic Plan offering to 30 states and the District
of
Columbia. The Company remains eligible as a PDP sponsor for its 2006
auto-enrolled CMS subsidized beneficiaries in California and Nevada, and for
its
2006 and new 2007 auto-enrolled beneficiaries in Arizona, Colorado, Idaho,
Oregon, Utah and Washington. The Company is no longer a PDP sponsor for
auto-enrolled beneficiaries in New Mexico and Texas. For 2007, the
Company, for the first time, offers an enhanced benefit plan ("Enhanced Plan")
in the same 30 states and the District of Columbia. The Enhanced Plan
provides brand name and generic prescription drug benefits through the coverage
gap. See Note 4 for further discussion of the premium deficiency
reserve associated with the Enhanced Plan.
In
2008,
the Company will continue to offer the Basic Plan in 30 states and the District
of Columbia, but will be a PDP sponsor for auto-enrolled beneficiaries only
in
Arizona. The Company will no longer be a PDP sponsor for auto-enrolled
beneficiaries in California, Colorado, Idaho, Nevada, Oregon, Utah and
Washington as it did not meet the CMS benchmark in those states for 2008. The
Company did not submit a bid to CMS for an Enhanced Plan offering for 2008
and
therefore will not be offering this plan in 2008.
The
Company recognizes premium revenue as earned over the contract period; however,
pharmacy and administrative costs are required to be recognized as incurred
with
no allocation or annualized estimation of the impact of deductibles, the
coverage gap or "donut hole," prior to it being reached by the member, or
reinsurance. This method of recognizing revenues and expenses results
in a disproportionate amount of expense in the first part of each contract
year
when the plan is responsible for a larger portion of the drug cost.
CMS
shares in the risk of certain pharmacy costs related to the basic benefits
covered in both of the Company’s stand-alone plans and its Medicare Advantage
PDP. The Company recognizes a risk sharing receivable or payable
based on the year-to-date activity. The risk sharing receivable or
payable is accumulated for each contract and recorded in the Condensed
Consolidated Balance Sheet in prepaid expenses and other current assets or
accrued and other current liabilities depending on the net contract balance
at
the end of the reporting period. The Company had a $19.9
million and an $11.8 million risk sharing payable balance related to its
Medicare Advantage PDP at September 30, 2007 and December 31, 2006,
respectively, which is included in accrued and other current liabilities in
the
Condensed Consolidated Balance Sheet.
Payments
from CMS for reinsurance and for cost sharing related to low income individuals
("Subsidies") are recorded as a payable when received. This payable is reduced
when reinsurance is utilized and Subsidies are provided by the
Company. This activity is accumulated and when the net balance for
each contract is negative, it is reclassed to a receivable. The
payable or receivable is recorded in the Condensed Consolidated Balance Sheet
in
prepaid
expenses and other current assets or accrued and other current liabilities
depending on the net contract balance at the end of the reporting period. The
Company had a $42.2 million and a $63.4 million receivable balance at September
30, 2007 and December 31, 2006, respectively, for reinsurance and Subsidies
related to our stand-alone PDP, which is included in prepaid and other current
assets in the Condensed Consolidated Balance Sheet. A reconciliation
of the final risk sharing, Subsidies, and reinsurance amounts is usually
performed in the third quarter following the plan year. The Company
has received the reconciliation for the 2006 plan year and received the final
payment in the fourth quarter of 2007.
4. Premium
Deficiency Reserves
In
2007,
the Company offered its Basic Plan and, for the first time, it offered an
Enhanced Plan. The Company engaged independent actuarial consultants
in developing the Enhanced Plan. The premium structure for the
Enhanced Plan was based on a projected level of utilization per
member. The Company's experience so far in 2007 indicates it has
experienced significantly increased costs from what the actuarial projections
anticipated. Based on the data available to date, the estimated 2007
pharmacy and administrative maintenance costs will exceed the estimated 2007
premiums.
For
purposes of analyzing premium deficiencies, the Company follows the guidance
provided by the Financial Accounting Standards Board ("FASB") in Statement
of
Financial Accounting Standards No. 60 "Accounting and Recording by Insurance
Enterprises" ("SFAS 60"), which requires contracts to be grouped in a manner
consistent with its method of acquiring, servicing, and measuring the
profitability of such contracts. Based on the guidance provided in
SFAS 60, the Company concluded that it should evaluate the Enhanced Plan and
the
Basic Plan separately when determining if a premium deficiency
exists. SFAS 60 also requires a premium deficiency be recognized if
the sum of expected claim costs and claim adjustment expenses, expected
dividends to policyholders, unamortized acquisition costs, and administrative
maintenance costs exceeds related unearned premiums. The Company does
not consider anticipated investment income in determining if a premium
deficiency exists. During the first half of 2007, the Company recorded a $55.3
million pre-tax loss related to the Enhanced Plan, which resulted in a premium
deficiency reserve of $39.3 million at June 30, 2007. This
represented the Company's estimate of the full year 2007 losses for the Enhanced
Plan based on the data available at that time. Based on the data
which is currently available, the Company now believes that the entire year
2007
losses for the Enhanced Plan will be $58.9 million. The Company has
recorded an additional $3.6 million in premium deficiency reserves during the
quarter ended September 30, 2007. The change in estimate was
due to higher than projected utilization during the third quarter of 2007 and
lower than projected risk share from CMS resulting in an $9.4 million increase
in projected medical losses, which was partially offset by a $5.8 million
decrease in projected general and administrative expenses, due to better than
expected collections of the members’ portion of the premiums. At
September 30, 2007, the remaining premium deficiency reserve balance for the
Enhanced Plan was $22.1 million.
5. Investments
Of
the
cash and cash equivalents and current investments that total $337.6 million
in
the accompanying Condensed Consolidated Balance Sheet at September 30, 2007,
$307.4 million is limited for use only by the Company's regulated
subsidiaries. Such amounts are available for transfer to Sierra from
the regulated subsidiaries only to the extent that they can be remitted in
accordance with terms of existing management agreements and by dividends, which
customarily must be approved by regulating state insurance
departments. The remainder is available to Sierra on an unrestricted
basis.
Investments
consist primarily of U.S. Government and its agencies' securities, municipal
bonds, corporate bonds, securities, trust deed mortgage notes, limited
partnerships, and real estate joint ventures. At September 30, 2007,
approximately 70% of the Company's investment portfolio is invested in U.S.
Government and its agencies' securities and municipal bonds. All
non-restricted investments that are designated as available-for-sale are
classified
as
current assets and stated at fair value. Fair value is estimated
primarily from published market values at the balance sheet
date. These investments are available for use in the current
operations regardless of contractual maturity dates. Restricted
investments are classified as non-current assets. The Company calculates
realized gains and losses using the specific identification method and includes
them in investment and other revenues. Unrealized holding gains and
losses on available-for-sale investments are included as a separate component
of
stockholders' equity, net of income tax effects, until realized. The
Company does not have any held-to-maturity investments. The Company does not
believe any of its available-for-sale or restricted investments are other than
temporarily impaired at September 30, 2007.
The
Company classifies investments in trust deed mortgage notes, limited
partnerships, and real estate joint ventures as other
investments. These investments are classified as current assets if
expected maturity is within one year of the balance sheet
date. Otherwise, they are classified as long-term investments and
included in other assets in the Condensed Consolidated Balance Sheet. The
Company believes that no adjustments are required to its recorded amounts of
investments in trust deed mortgage notes, limited partnerships or real estate
joint ventures at September 30, 2007.
6. Long-Term
Debt
Sierra
Debentures
- In March 2003, the Company issued $115.0 million aggregate
principal amount of its 2¼% senior convertible debentures due March 15,
2023. The debentures are not guaranteed by any of Sierra's
subsidiaries. The debentures pay interest, which is due semi-annually
on March 15 and September 15 of each year. Each $1,000 principal
amount of debentures is convertible, at the option of the holders, into 109.3494
shares of the Company's common stock before March 15, 2023 if: (i) the market
price of the Company's common stock for at least 20 trading days in a period
of
30 consecutive trading days ending on the last trading day of the preceding
fiscal quarter exceeds 120% of the conversion price per share of the Company's
common stock; (ii) the debentures are called for redemption; (iii) there is
an
event of default with respect to the debentures; or (iv) specified corporate
transactions have occurred. Beginning December 2003, and for each
subsequent period, the market price of the Company's common stock exceeded
120%
of the conversion price for at least 20 trading days in a period of 30
consecutive trading days. The conversion rate is subject to certain
adjustments. This conversion rate represents a conversion price of $9.145 per
share. Holders of the debentures may require the Company to
repurchase all or a portion of their debentures on March 15 in 2008, 2013 and
2018, or upon certain corporate events, including a change in
control. In either case, the Company may choose to pay the purchase
price of such debentures in cash or common stock or a combination of cash and
common stock. The Company can redeem the debentures for cash
beginning March 20, 2008.
During
the first quarter of 2006, a debenture holder ("holder") converted $500,000
in
debentures for approximately 54,000 shares of common stock. During
the third quarter of 2006, the Company entered into a privately negotiated
transaction with a holder pursuant to which the holder converted $8.0 million
in
debentures for approximately 875,000 shares of common stock in accordance with
the indenture governing the debentures. During the first quarter of 2007, the
Company entered into one privately negotiated transaction with a holder pursuant
to which the holder converted an aggregate of $21.7 million in debentures for
approximately 2.4 million shares of common stock in accordance with the
indenture governing the debentures. In addition, two other holders also
converted $1.5 million in debentures for approximately 168,000 shares of common
stock. At September 30, 2007, the Company had outstanding $20.2
million in aggregate principal amount of its 2¼% senior convertible debentures
due March 15, 2023.
Revolving
Credit Facility -
On March 3, 2003, the Company entered into a revolving
credit facility. Effective June 26, 2006, the current facility was
amended to extend the maturity from December 31, 2009 to June 26, 2011, increase
the availability from $140.0 million to $250.0 million and reduce
the drawn and undrawn fees. The current
incremental
borrowing rate is LIBOR plus 0.60%. The facility is available for
general corporate purposes and at September 30, 2007, the Company had no
outstanding balance on this facility.
The
credit facility remains secured by guarantees by certain of the Company's
subsidiaries and a first priority perfected security interest in (i) all of
the
capital stock of each of the Company's unregulated, material domestic
subsidiaries (direct or indirect) as well as all of the capital stock of certain
regulated, material domestic subsidiaries; and (ii) all other present and future
assets and properties of the Company and those of its subsidiaries that
guarantee the credit agreement obligations (including, without limitation,
accounts receivable, inventory, certain real property,
equipment,
contracts, trademarks, copyrights, patents, license rights and general
intangibles) subject, in each case, to the exclusion of the capital stock of
CII
Financial, Inc. ("CII") and certain other exclusions.
The
revolving credit facility's covenants limit the Company's ability to dispose
of
assets, incur indebtedness, incur other liens, make investments, loans or
advances, make acquisitions, engage in mergers or consolidations, make capital
expenditures and otherwise restrict certain corporate activities. The
Company's ability to pay dividends, repurchase its common stock and prepay
other
debt is unlimited provided that the Company can still exceed a certain required
leverage ratio after such transaction or any borrowing incurred as a result
of
such transaction. In addition, the Company is required to comply with
specified financial ratios as set forth in the credit agreement. The
Company believes it is in compliance with all covenants of the credit agreement
at September 30, 2007 and 2006.
7. Employee
and Director Benefit Plans
Share-based
Compensation
- The Company's employee stock plan and non-employee director
stock plan provide common share-based awards to employees and to non-employee
directors. The plans provide for the granting of restricted stock units,
options, and other share-based awards. At September 30, 2007, the
employee plan and the non-employee director plan permit the granting of share
options and shares of up to 4.0 million and 221,000 shares, respectively, of
common stock. A committee appointed by the Board of Directors grants awards.
Awards become exercisable at such times and in such installments as set by
the
committee.
The
following table summarizes the share-based compensation expense included in
the
Condensed Consolidated Statements of Income for all share-based compensation
plans that were recorded in accordance with Statement of Financial Accounting
Standards No. 123 (revised 2004), "Share-Based Payment":
|
|
Three
Months Ended September 30,
|
|
|
Nine
Months Ended September 30,
|
|
|
|
2007
|
|
|
2006
|
|
|
2007
|
|
|
2006
|
|
|
|
(In
thousands)
|
|
Medical
expenses
|
|
$
|
224
|
|
|
$
|
250
|
|
|
$
|
801
|
|
|
$
|
671
|
|
General
and administrative
expenses
|
|
|
673
|
|
|
|
2,518
|
|
|
|
3,090
|
|
|
|
5,139
|
|
Share-based
compensation expense before income taxes
|
|
|
897
|
|
|
|
2,768
|
|
|
|
3,891
|
|
|
|
5,810
|
|
Income
tax benefit
|
|
|
(314
|
)
|
|
|
(969
|
)
|
|
|
(1,362
|
)
|
|
|
(2,034
|
)
|
Net
share-based compensation expense
|
|
$
|
583
|
|
|
$
|
1,799
|
|
|
$
|
2,529
|
|
|
$
|
3,776
|
|
For
the
nine months ended September 30, 2007 and 2006, net cash proceeds realized from
stock option exercises and purchases under the Company's Employee Stock Purchase
Plan ("Purchase Plan") were $6.4 million and $14.1 million, respectively, and
the actual tax benefit realized from stock option exercises and purchases under
the Purchase Plan was $5.1 million and $11.6 million, respectively.
Employee
Stock Purchase Plan and Stock Options
The
Company's Purchase Plan allows employees to purchase newly issued shares of
common stock through payroll
deductions
at 85% of the fair market value of such shares on the lower of the first trading
day of the plan period or the last trading day of the plan period as defined
in
the Purchase Plan. During 2007, 49,000 and 56,000 shares were
purchased at prices of $30.63 and $30.46 per share, respectively. During 2006,
158,000 and 49,000 shares were purchased at prices of $30.67 and $34.43 per
share, respectively. At September 30, 2007, the Company had 665,000
shares reserved for purchase under the Purchase Plan. There were no
stock option grants during the periods ended September 30, 2007 or
2006.
The
following table reflects the activity of the stock option plans for the nine
months ended September 30, 2007:
|
|
|
|
|
|
|
|
Weighted
|
|
|
|
|
|
|
Number
|
|
|
Weighted
|
|
|
Average
|
|
|
Aggregate
|
|
|
|
Of
|
|
|
Average
|
|
|
Contractual
Life
|
|
|
Intrinsic
|
|
|
|
Shares
|
|
|
Exercise
Price
|
|
|
Remaining
|
|
|
Value
|
|
|
|
(In
thousands)
|
|
|
(per
share)
|
|
|
(In
years)
|
|
|
(In
thousands)
|
|
Outstanding,
January 1, 2007
|
|
|
1,775
|
|
|
$
|
12.94
|
|
|
|
|
|
|
|
Granted
|
|
|
¾
|
|
|
|
¾
|
|
|
|
|
|
|
|
Exercised
|
|
|
(322
|
)
|
|
|
9.79
|
|
|
|
|
|
|
|
Cancelled
|
|
|
(26
|
)
|
|
|
17.94
|
|
|
|
|
|
|
|
Outstanding,
September 30, 2007
|
|
|
1,427
|
|
|
$
|
13.56
|
|
|
|
4.83
|
|
|
$
|
40,845
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Exercisable
at September 30, 2007
|
|
|
891
|
|
|
$
|
10.52
|
|
|
|
4.72
|
|
|
$
|
28,211
|
|
The
aggregate intrinsic value in the table above represents the total pretax
intrinsic value (the difference between the market price of the Company's stock
on September 30, 2007 and the exercise price, times the number of shares) that
would have been received by the option holders had all option holders exercised
their options on September 30, 2007. This amount changes based on the market
value of the Company's stock and the number of shares exercisable or
outstanding. The total intrinsic value of options exercised during the three
months ended September 30, 2007 and 2006 was $1.1 million and $3.4 million,
respectively. The total intrinsic value of options exercised during the nine
months ended September 30, 2007 and 2006 was $9.9 million and $32.1 million,
respectively.
The
following table reflects the activity of the nonvested stock options for the
nine months ended September 30, 2007:
|
|
Number
|
|
|
Weighted-Average
|
|
|
|
Of
|
|
|
Grant
Date
|
|
|
|
Shares
|
|
|
Fair
Value
|
|
|
|
(In
thousands)
|
|
|
(per
share)
|
|
Nonvested
shares, January 1, 2007
(1)
|
|
|
803
|
|
|
$
|
7.34
|
|
Granted
|
|
|
¾
|
|
|
|
¾
|
|
Vested
|
|
|
(405
|
)
|
|
|
6.42
|
|
Canceled
|
|
|
(12
|
)
|
|
|
6.17
|
|
Nonvested
shares, September 30, 2007
(1)
|
|
|
386
|
|
|
$
|
8.35
|
|
|
(1)
|
Excludes
164,000 and 150,000 shares at January 1, 2007 and September 30, 2007,
respectively, which vested in 2005, but are not exercisable until
2008.
|
As
of
September 30, 2007, the Company expects to recognize future total compensation
cost of $1.6 million related to nonvested stock options over a weighted-average
period of nine months.
Restricted
Stock Units
In
January 2007, the Company issued 2,000 units of restricted stock ("Units")
to
each of the five non-employee Directors. In January 2006, the Company
issued 4,000 Units to each of the six non-employee Directors. Each
Unit represents a nontransferable right to receive one share of the Company's
common stock and there is no cost to the recipient to exercise the Units. The
Units vest according to a variety of vesting schedules or earlier based on
the
occurrence of certain events, including a change of control in the
Company. The fair value of the transactions was based on the number
of Units issued and the Company's stock price on the date of issuance, which
was
$35.35 and $38.49 in 2007 and 2006, respectively. Total expense
associated with the Units was $99,000 and $48,000 for the three months ended
September 30, 2007 and 2006, respectively. Total expense associated with the
Units was $284,000 and $287,000 for the nine months ended September 30, 2007
and
2006, respectively.
In
August
2006, the Company issued 210,000 Units to certain members of its
management. The Units vest according to a variety of vesting
schedules, or earlier based on the occurrence of certain events, including
a
change of control in the Company. The majority of Units have a three
year holding period from the date of grant. The fair value of the transaction
was based on the number of Units issued, the Company's stock price on the date
of issuance, which was $43.60, and an estimated forfeiture
rate. A discount was applied to the Units with a holding period
as a result of the lack of marketability between the vesting dates and
settlement dates. The discount was estimated at the date of grant
using the Black-Scholes option-pricing model with the following weighted average
assumptions: expected volatility of 32.3%, risk-free interest rate of 4.8%
and
dividend rate of 0%. Total expense associated with the Units was $193,000 and
$730,000 for the three and nine months ended September 30, 2007, which
approximates the fair value of vested Units during the year. Total
expense associated with the Units was $1.7 million for the three and nine months
ended September 30, 2006.
The
Company allows employees to surrender vested Units ("Cashless Exercise") to
pay
for payroll withholdings. During 2007, the Company had employees
Cashless Exercise 11,000 Units to pay for $2.2 million in payroll
withholdings.
The
following table reflects the activity of the restricted stock unit plans for
the
nine months ended September 30, 2007:
|
|
Number
|
|
|
Aggregate
|
|
|
Of
|
|
|
Intrinsic
|
|
|
Shares
|
|
|
Value
|
|
|
(In
thousands)
|
Outstanding,
January 1, 2007
(1)(2)
|
|
|
104
|
|
|
|
Granted
|
|
|
10
|
|
|
|
Vested
|
|
|
(23
|
)
|
|
|
Canceled
|
|
|
(1
|
)
|
|
|
Outstanding,
September 30, 2007
(1)(3)
|
|
|
90
|
|
$
|
3,797
|
(1)
|
The
Units have no exercise price.
|
(2)
|
Does
not include 540,000 Units that have vested but have not
settled. These Units are included in outstanding
shares.
|
(3)
|
Does
not include 296,000 Units that have vested but have not settled.
These
Units are included in outstanding
shares.
|
As
of
September 30, 2007, the Company expects to recognize future total compensation
cost of $2.7 million related to nonvested Units over a weighted-average period
of 1.4 years.
Supplemental
Executive Retirement Plan ("SERP")
The
Company has a non-qualified defined benefit retirement plan covering certain
key
employees. The Company is informally funding the benefits through the
purchase of life insurance policies. Certain participant benefits are based
on,
among other things, the employee's average earnings of the three highest years
over the five-year period prior to retirement or termination, and length of
service. Other participant benefits are defined by the plan and based
on length of service. Any benefits attributable to service prior to
the adoption of the plan are amortized over the estimated remaining service
period for those employees participating in the plan. During the
quarter, four SERP participants retired and started to receive benefits under
the plan.
For
the
nine months ended September 30, 2007 and 2006, the Company contributed $680,000
and $548,000, respectively to fund benefit payments. The Company’s non- current
SERP balance was $31.1 million and $30.7 million at September 30, 2007 and
December 31, 2006, respectively, which is included in other liabilities in
the
Condensed Consolidated Balance Sheet.
|
|
Three
Months Ended September 30,
|
|
|
Nine
Months Ended September 30,
|
|
|
|
2007
|
|
|
2006
|
|
|
2007
|
|
|
2006
|
|
|
|
(In
thousands)
|
|
Components
of net periodic benefit cost:
|
|
|
|
|
|
|
|
|
|
|
|
|
Service
cost
|
|
$
|
139
|
|
|
$
|
126
|
|
|
$
|
417
|
|
|
$
|
378
|
|
Interest
cost
|
|
|
426
|
|
|
|
399
|
|
|
|
1,278
|
|
|
|
1,197
|
|
Amortization
of prior service credits
|
|
|
303
|
|
|
|
302
|
|
|
|
908
|
|
|
|
908
|
|
Recognized
actuarial loss
|
|
|
52
|
|
|
|
32
|
|
|
|
157
|
|
|
|
96
|
|
Net
periodic benefit cost
|
|
$
|
920
|
|
|
$
|
859
|
|
|
$
|
2,760
|
|
|
$
|
2,579
|
|
8. Share
Repurchases
From
January 1, 2007 through September 30, 2007, the Company purchased 585,000 shares
of its common stock in the open market for $21.1 million at an average cost
per
share of $36.04. Since the repurchase program began in early 2003 and through
September 30, 2007, the Company purchased, in the open market or through
negotiated transactions, 29.2 million shares, adjusted for the two for one
stock
split effective December 30, 2005, for $651.9 million at an average cost per
share of $22.29. On January 25, 2007, the Company's Board of
Directors authorized an additional $50.0 million in share
repurchases. At September 30, 2007, $53.1 million was still available
under the Board of Directors' authorized plan. The repurchase program
has no stated expiration date. The Company's revolving credit
facility, as amended, currently allows for unlimited stock repurchases based
on
meeting a certain covenant ratio; however, effective March 11, 2007, the Company
has halted its repurchase program pending the UnitedHealth Group
merger.
9. Earnings
Per Share
The
following table provides a reconciliation of basic and diluted income per
share:
|
|
Three
Months Ended September 30,
|
|
|
Nine Months
Ended September 30,
|
|
|
|
2007
|
|
|
2006
|
|
|
2007
|
|
|
2006
|
|
|
|
(In
thousands, except per share data)
|
|
Basic
income per share:
|
|
|
|
|
|
|
|
|
|
|
|
|
Net
income
|
|
$
|
34,626
|
|
|
$
|
34,929
|
|
|
$
|
72,747
|
|
|
$
|
101,134
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Weighted
average common shares outstanding
|
|
|
56,162
|
|
|
|
56,332
|
|
|
|
55,865
|
|
|
|
56,706
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net
income per common share
|
|
$
|
0.62
|
|
|
$
|
0.62
|
|
|
$
|
1.30
|
|
|
$
|
1.78
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Diluted
income per share:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net
income
|
|
$
|
34,626
|
|
|
$
|
34,929
|
|
|
$
|
72,747
|
|
|
$
|
101,134
|
|
Interest
expense on Sierra debentures, net of tax
|
|
|
74
|
|
|
|
185
|
|
|
|
242
|
|
|
|
562
|
|
Income
for purposes of computing diluted net income per share
|
|
$
|
34,700
|
|
|
$
|
35,114
|
|
|
$
|
72,989
|
|
|
$
|
101,696
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Weighted
average common shares outstanding
|
|
|
56,162
|
|
|
|
56,332
|
|
|
|
55,865
|
|
|
|
56,706
|
|
Dilutive
options and restricted shares outstanding
|
|
|
665
|
|
|
|
807
|
|
|
|
701
|
|
|
|
943
|
|
Dilutive
impact of conversion of Sierra debentures
|
|
|
2,214
|
|
|
|
5,517
|
|
|
|
2,414
|
|
|
|
5,598
|
|
Weighted
average common shares outstanding assuming dilution
|
|
|
59,041
|
|
|
|
62,656
|
|
|
|
58,980
|
|
|
|
63,247
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net
income per common share assuming dilution
|
|
$
|
0.59
|
|
|
$
|
0.56
|
|
|
$
|
1.24
|
|
|
$
|
1.61
|
|
10. Comprehensive
Income
The
following table presents comprehensive income for the periods
indicated:
|
|
Three
Months Ended September 30,
|
|
|
Nine
Months Ended September 30,
|
|
|
|
2007
|
|
|
2006
|
|
|
2007
|
|
|
2006
|
|
|
|
(In
thousands)
|
|
Net
income
|
|
$
|
34,626
|
|
|
$
|
34,929
|
|
|
$
|
72,747
|
|
|
$
|
101,134
|
|
Change
in net unrealized holding loss on available-for-sale
investments
|
|
|
1,892
|
|
|
|
1,640
|
|
|
|
535
|
|
|
|
(485
|
)
|
Change
in unfunded portion of defined benefit pension plan
|
|
|
230
|
|
|
|
¾
|
|
|
|
692
|
|
|
|
¾
|
|
Comprehensive
income
|
|
$
|
36,748
|
|
|
$
|
36,569
|
|
|
$
|
73,974
|
|
|
$
|
100,649
|
|
11.
Income
Taxes
In
June
2006, the FASB issued FASB Interpretation No. 48, "Accounting for Uncertainty
in
Income Taxes - an Interpretation of FASB Statement No. 109" ("FIN 48"). FIN
48
clarifies the accounting for uncertainty in income taxes recognized in an
enterprise's financial statements in accordance with Statement of Financial
Accounting Standards No. 109, "Accounting for Income Taxes". FIN 48 prescribes
a
recognition threshold and measurement attribute for the financial statement
recognition and measurement of a tax position taken or expected to be taken
in a
tax return. FIN 48 also provides guidance on derecognition, classification,
interest and penalties, accounting in interim periods, disclosure, and
transition.
The
Company adopted FIN 48 as of January 1, 2007. The cumulative effect
of adopting FIN 48 has resulted in an increase to our liability for uncertain
tax positions of $4.3 million. This increase was accounted for as an
adjustment
to
the
beginning balance of retained earnings on the balance
sheet. Including the cumulative effect increase, at the beginning of
2007, the Company had approximately $19.2 million of total gross unrecognized
tax benefits.
The
total
amount of unrecognized tax benefits that, if recognized, would favorably affect
the effective income tax rate in future periods was $12.6 million as of
adoption. Interest and penalties related to income tax matters
are classified as a component of income tax expense and totaled $200,000
tax benefit and $300,000 tax expense for the three and nine
months ended September 30, 2007.
The
Company and its subsidiaries are subject to U.S. federal income tax as well
as
income tax of multiple state jurisdictions. Tax years 1996 to 2007
remain subject to examination for U.S. federal income tax and tax years 2002
to
2004 remain subject to examination by major state tax
jurisdictions.
During the
next 12 months, the Company expects a decrease of $1.8
million in gross unrecognized tax benefits associated
with a request for change in accounting method.
12.
Recently
Issued Accounting Standards
In
September 2006, the FASB issued Statement of Financial Accounting Standards
No.
157, "Fair Value Measurements" ("SFAS 157"). SFAS 157 defines fair value,
establishes a framework for measuring fair value in generally accepted
accounting principles, and expands disclosures about fair value measurements.
SFAS 157 applies only to other accounting pronouncements that require or permit
fair value measurements. SFAS 157 is effective for fiscal years
beginning after November 15, 2007.
The
Company does not believe the
adoption
of
SFAS
157
will
have
a
material impact
on
its
consolidated financial position
,
results
of operations
,
or cash flows
.
In February
2007, the FASB issued Statement of Financial Accounting Standards No. 159,
"The Fair Value Option for Financial Assets and Financial Liabilities -
Including an Amendment of FASB Statement No. 115" ("SFAS 159"). SFAS 159
would create a fair value option of accounting for qualifying financial assets
and liabilities under which an irrevocable election could be made at inception
to measure such assets and liabilities initially and subsequently at fair value,
with all changes in fair value reported in earnings. SFAS 159 is
effective as of the beginning of the first fiscal year beginning after November
15, 2007. The Company is currently evaluating the impact that the adoption
of SFAS 159 will have on its consolidated financial position, results of
operations and cash flows.
In
previous years, the Company had two reportable segments based on the products
and services offered: managed care and corporate operations, and military health
services operations. The managed care and corporate operations segment includes
managed health care services provided through our HMO, managed indemnity plans,
third-party administrative services programs for employer-funded health benefit
plans, self-insured workers' compensation plans, multi-specialty medical groups,
other ancillary services and corporate operations. The military
health services operations ("SMHS") segment administered a managed care federal
contract for the Department of Defense's TRICARE program in Region
1. Prior to 2006, SMHS commenced a phase-out of operations and has
had minimal activity during 2006 and 2007. The Company believes that
SMHS no longer meets the definition of an operating segment as described in
Statement of Financial Accounting Standards No. 131, "Disclosures about
Segments of an Enterprise and Related Information". The Company
believes the only remaining reportable segment is the managed care and corporate
operations segment. This segment's required financial information is
represented in the accompanying unaudited condensed consolidated financial
statements.
The
Company generated approximately 43% of its total consolidated revenues from
agencies of the U.S. government for both the three month periods ended September
30, 2007 and 2006, through participation in Medicare and the Federal Employees
Health Benefit Plan programs. The Company generated approximately 45%
of its total consolidated revenues from agencies of the U.S. government for
both
the nine month periods ended September 30, 2007 and 2006.
14.
Commitments
and
Contingencies
Litigation
and Legal Matters.
Although the Company
has
not been sued, Sierra was identified in discovery submissions in pending class
action litigation against major managed care companies as having allegedly
participated in an unlawful conspiracy to improperly deny, diminish or delay
payments to physicians. In Re: Managed Care Litigation, MDL No. 1334
(S.D.Fl.).
Beginning
in 1999, a series of class action lawsuits were filed against many major firms
in the health benefits business alleging an unlawful conspiracy to deny,
diminish or delay payments to physicians. The Company has not been named as
a
defendant in these lawsuits. A multi-district litigation panel has consolidated
some of these cases in the United States District Court for the Southern
District of Florida, Miami Division. In the lead case, known as
Shane
,
the amended complaint alleges multiple violations under the Racketeer Influenced
and Corrupt Organizations Act ("RICO"). The suit seeks injunctive, compensatory
and equitable relief as well as restitution, costs, fees and interest payments.
On April 7, 2003, the United States Supreme Court determined that certain claims
against certain defendants should be arbitrated.
Subsequent
lower court rulings have further resolved which of the plaintiffs' claims are
subject to arbitration. In 2004, the Court of Appeals for the Eleventh Circuit
upheld a district court ruling certifying a plaintiff class in the
Shane
case. In February 2005, the district court determined to
bifurcate the case, holding a trial phase limited to liability issues, and
a
second, if necessary, regarding damages.
Aetna,
Inc., CIGNA Corporation, the Prudential Insurance Company of America, Wellpoint
Inc., Health Net Inc. and Humana Inc. entered into settlement agreements which
have been approved by the district court. On January 31, 2006, the
trial court granted summary judgment on all claims to defendant PacifiCare
Health Systems, Inc. ("PacifiCare"), finding that plaintiffs had failed to
provide documents or other evidence showing that PacifiCare agreed to
participate in the alleged conspiracy. On June 19, 2006, the
trial court granted summary judgment on all remaining claims against the two
remaining defendants, UnitedHealth Group, Inc. and Coventry Health Care, Inc.,
because the plaintiffs had not submitted evidence that would allow a jury to
reasonably find that either had been part of a conspiracy to underpay doctors
or
that either had aided or abetted alleged RICO violations. Plaintiffs appealed
this decision; however, on June 13, 2007 the Eleventh Circuit Court of Appeals
issued an opinion affirming the trial court’s decision. Plaintiffs in
the
Shane
proceeding had stated their intention to introduce evidence
at trial concerning Sierra and other parties not named as defendants in the
litigation.
The
Company is subject to other various claims and litigation in the ordinary course
of business. Such litigation includes, but is not limited to, claims
of medical malpractice, claims for coverage or payment for medical services
rendered to HMO and other members, and claims by providers for payment for
medical services rendered to HMO and other members. Some litigation
may also include claims for punitive or other damages that are not covered
by
insurance. These actions are in various stages of litigation and some
may ultimately be brought to trial.
For
all
claims that are considered probable and for which the amount of loss can be
reasonably estimated, the Company accrued amounts it believes to be appropriate,
based on information presently available. With respect to certain
pending actions, the Company maintains commercial insurance coverage with
varying deductibles for which the Company maintains estimated reserves for
its
self-insured portion based upon its current assessment of such
litigation. Due to recent unfavorable changes in the commercial
insurance market, the Company has for certain risks, purchased coverage with
higher deductibles and lower limits of coverage. In the opinion of
management,
based
on
information presently available, the amount or range of any potential loss
for
certain claims and litigation
cannot
be
reasonably estimated or is not considered probable. However, the
ultimate resolutions of these pending legal proceedings are not expected to
have
a material adverse effect on the Company's financial condition, operating
results and cash flows.
On
March
19, 2007, a purported class action complaint, styled Edward Sara, on behalf
of
himself and all others similarly situated v. Sierra Health Services, Inc.,
Anthony M. Marlon, Charles L. Ruthe, Thomas Y. Hartley, Anthony L. Watson,
Michael E. Luce and Albert L. Greene, was filed in the Eighth Judicial District
Court for the State of Nevada in and for the County of Clark. The
complaint names the Company and each of its directors as defendants
(collectively, the "defendants"), and was filed by a purported stockholder
of
the Company. The complaint alleges, among other things, that the
defendants breached and/or aided the other defendants’ breaches of their
fiduciary duties of loyalty, due care, independence, good faith and fair dealing
in connection with the merger contemplated with UnitedHealth Group, the
defendants breached their fiduciary duty to secure and obtain the best price
reasonably available for the Company and its shareholders, and the defendants
are engaging in self-dealing and unjust enrichment. The complaint
seeks, among other relief, (i) an injunction prohibiting the defendants from
consummating the merger unless and until the Company adopts and implements
a
procedure or process to obtain the highest possible price for shareholders
and
(ii) the imposition of a constructive trust upon any benefits improperly
received by the defendants as a result of the alleged wrongful
conduct.
On
June 4, 2007, the Company and the defendants reached an agreement in
principle to settle the lawsuit. As part of the settlement, the
defendants deny all allegations of wrongdoing, and the Company agreed to make
certain additional disclosures in connection with the merger. The
settlement will be subject to certain conditions, including court approval
following notice to members of the proposed settlement class and consummation
of
the merger. If finally approved by the court, the settlement will resolve all
of
the claims that were or could have been brought on behalf of the proposed
settlement class in the action being settled, including all claims relating
to
the merger, fiduciary obligations in connection with the merger, negotiations
in
connection with the merger and any disclosure made in connection with the
merger. In addition, in connection with the settlement, the parties have agreed
that, subject to approval of the court, the Company will pay plaintiffs’ counsel
attorneys’ fees and expenses in the amount of $485,000. The merger may be
consummated prior to final court approval of the settlement. The settlement
will
not affect the amount of merger consideration to be paid in the merger or any
other provision of the merger agreement.
Condition
And Results Of
Operations
Item
2.
The
following discussion and analysis provides information that management believes
is relevant for an assessment and understanding of our consolidated financial
condition and results of operations. The discussion should be read in
conjunction with our audited consolidated financial statements and accompanying
notes for the year ended December 31, 2006, and "Management's Discussion and
Analysis of Financial Condition and Results of Operations," included in our
2006
Annual Report on Form 10-K filed with the Securities and Exchange Commission
on
February 27, 2007 and accompanying notes for the three and nine month periods
ended September 30, 2007 and 2006, included in this Form 10-Q. The information
contained below is subject to risk factors. We urge the reader to review
carefully the sections "Forward-Looking Statements" in Part I, Item 1 and "Risk
Factors" in Part I, Item 1A of our 2006 Annual Report on Form 10-K as well
as
"Risk Factors" in Part II, Item 1A of this Form 10-Q for a more complete
discussion of the risks associated with an investment in our
securities.
This
report on Form 10-Q contains "forward-looking statements" within the meaning
of
Section 27A of the Securities Act of 1933 and Section 21E of the Securities
Exchange Act of 1934, both as amended. The forward-looking statements
regarding our business and results of operations should be considered by our
stockholders or any reader of our business or financial information along with
the risk factors discussed in our 2006 Annual Report on Form
10-K. All statements, other than statements of historical fact, are
forward-looking statements for purposes of federal and state securities laws.
The cautionary statements are made pursuant to the "safe harbor" provisions
of
the Private Securities Litigation Reform Act of 1995, as amended, and identify
important factors that could cause our actual results to differ materially
from
those expressed in any projected, estimated or forward-looking statements
relating to us. These forward-looking statements are generally
identified by their use of terms and phrases such as "anticipate," "believe,"
"continue," "could," "estimate," "expect,"
"hope," "intend," "may," "plan," "predict," "project," "seeks,"
"will," and other similar terms and phrases, including all references to
assumptions.
Although
we believe that the expectations reflected in any of our forward-looking
statements are reasonable, actual results could differ materially from those
projected or assumed in any of our forward-looking statements. Readers are
cautioned not to place undue reliance on these forward-looking statements that
speak only as of the date hereof. We undertake no obligation to publish revised
forward-looking statements to reflect events or circumstances after the date
hereof or to reflect the occurrence of unanticipated events.
Summary
of Consolidated Results – Three Months Ended September 30, 2007 and
2006
|
|
Three
Months Ended
September
30,
|
|
|
Percent
Of Revenue
Three
Months Ended
September
30,
|
|
|
Increase
(Decrease)
|
|
2007
|
|
|
|
|
|
|
|
|
|
|
|
2007
vs. 2006
|
|
|
|
(In
thousands, except percentages, per share and
membership)
|
|
Operating
revenues:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Medical
premiums
|
|
$
|
445,680
|
|
|
$
|
405,618
|
|
|
|
95.0
|
%
|
|
|
94.3
|
%
|
|
$
|
40,062
|
|
|
|
9.9
|
%
|
Professional
fees
|
|
|
13,483
|
|
|
|
13,300
|
|
|
|
2.9
|
|
|
|
3.1
|
|
|
|
183
|
|
|
|
1.4
|
|
Investment
and other revenues
|
|
|
9,761
|
|
|
|
11,079
|
|
|
|
2.1
|
|
|
|
2.6
|
|
|
|
(1,318
|
)
|
|
|
(11.9
|
)
|
Total
|
|
|
468,924
|
|
|
|
429,997
|
|
|
|
100.0
|
|
|
|
100.0
|
|
|
|
38,927
|
|
|
|
9.1
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Operating
expenses:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Medical
expenses
|
|
|
375,075
|
|
|
|
323,694
|
|
|
|
80.0
|
|
|
|
75.3
|
|
|
|
51,381
|
|
|
|
15.9
|
|
Medical
care ratio
|
|
|
81.7
|
%
|
|
|
77.3
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
4.4
|
|
General
and administrative expenses
|
|
|
42,264
|
|
|
|
51,291
|
|
|
|
9.0
|
|
|
|
11.9
|
|
|
|
(9,027
|
)
|
|
|
(17.6
|
)
|
Total
|
|
|
417,339
|
|
|
|
374,985
|
|
|
|
89.0
|
|
|
|
87.2
|
|
|
|
42,354
|
|
|
|
11.3
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Operating
income
|
|
|
51,585
|
|
|
|
55,012
|
|
|
|
11.0
|
|
|
|
12.8
|
|
|
|
(3,427
|
)
|
|
|
(6.2
|
)
|
Interest
expense
|
|
|
(584
|
)
|
|
|
(1,015
|
)
|
|
|
(0.1
|
)
|
|
|
(0.2
|
)
|
|
|
431
|
|
|
|
(42.5
|
)
|
Other
income (expense), net
|
|
|
279
|
|
|
|
14
|
|
|
|
¾
|
|
|
|
¾
|
|
|
|
265
|
|
|
|
1892.9
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Income
before income taxes
|
|
|
51,280
|
|
|
|
54,011
|
|
|
|
10.9
|
|
|
|
12.6
|
|
|
|
(2,731
|
)
|
|
|
(5.1
|
)
|
Provision
for income taxes
|
|
|
(16,654
|
)
|
|
|
(19,082
|
)
|
|
|
(3.5
|
)
|
|
|
(4.5
|
)
|
|
|
2,428
|
|
|
|
(12.7
|
)
|
Tax
rate
|
|
|
32.5
|
%
|
|
|
35.3
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
(2.8
|
)
|
Net
income
|
|
$
|
34,626
|
|
|
$
|
34,929
|
|
|
|
7.4
|
%
|
|
|
8.1
|
%
|
|
$
|
(303
|
)
|
|
|
(0.9
|
)%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net
income per common share assuming dilution
|
|
$
|
0.59
|
|
|
$
|
0.56
|
|
|
|
|
|
|
|
|
|
|
$
|
0.03
|
|
|
|
5.4
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Membership
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
HMO:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Commercial
|
|
|
282,400
|
|
|
|
273,600
|
|
|
|
|
|
|
|
|
|
|
|
8,800
|
|
|
|
3.2
|
%
|
Medicare
|
|
|
56,600
|
|
|
|
57,000
|
|
|
|
|
|
|
|
|
|
|
|
(400
|
)
|
|
|
(0.7
|
)
|
Medicaid
|
|
|
57,500
|
|
|
|
57,000
|
|
|
|
|
|
|
|
|
|
|
|
500
|
|
|
|
0.9
|
|
Subtotal
HMO
|
|
|
396,500
|
|
|
|
387,600
|
|
|
|
|
|
|
|
|
|
|
|
8,900
|
|
|
|
2.3
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Commercial
PPO and HSA
|
|
|
37,900
|
|
|
|
31,300
|
|
|
|
|
|
|
|
|
|
|
|
6,600
|
|
|
|
21.1
|
|
Medicare
PPO and PFFS
|
|
|
3,500
|
|
|
|
1,700
|
|
|
|
|
|
|
|
|
|
|
|
1,800
|
|
|
|
105.9
|
|
Medicare
Part D-Basic
|
|
|
152,400
|
|
|
|
183,300
|
|
|
|
|
|
|
|
|
|
|
|
(30,900
|
)
|
|
|
(16.9
|
)
|
Medicare
Part D-Enhanced
|
|
|
45,500
|
|
|
|
¾
|
|
|
|
|
|
|
|
|
|
|
|
45,500
|
|
|
|
100.0
|
|
Medicare
supplement
|
|
|
12,500
|
|
|
|
13,700
|
|
|
|
|
|
|
|
|
|
|
|
(1,200
|
)
|
|
|
(8.8
|
)
|
Administrative
services
|
|
|
228,500
|
|
|
|
221,100
|
|
|
|
|
|
|
|
|
|
|
|
7,400
|
|
|
|
3.3
|
|
Total
membership
|
|
|
876,800
|
|
|
|
838,700
|
|
|
|
|
|
|
|
|
|
|
|
38,100
|
|
|
|
4.5
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Member
months
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Commercial
|
|
|
950,700
|
|
|
|
903,600
|
|
|
|
|
|
|
|
|
|
|
|
47,100
|
|
|
|
5.2
|
%
|
Medicare
HMO
|
|
|
170,000
|
|
|
|
171,000
|
|
|
|
|
|
|
|
|
|
|
|
(1,000
|
)
|
|
|
(0.6
|
)
|
Medicaid
|
|
|
171,800
|
|
|
|
171,600
|
|
|
|
|
|
|
|
|
|
|
|
200
|
|
|
|
0.1
|
|
The
table
above should be reviewed in association with the discussion that
follows.
Summary
of Consolidated Results – Nine Months Ended September 30, 2007 and
2006
|
Nine
Months Ended
September
30,
|
|
|
Percent
Of Revenue
Nine
Months Ended
September
30,
|
|
|
Increase
(Decrease)
|
|
|
2007
|
|
|
|
|
|
|
|
|
|
|
|
2007
vs. 2006
|
|
(In
thousands, except percentages, per share and
membership)
|
|
Operating
revenues:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Medical
premiums
|
|
$
|
1,371,000
|
|
|
$
|
1,220,726
|
|
|
|
94.8
|
%
|
|
|
94.4
|
%
|
|
$
|
150,274
|
|
|
|
12.3
|
%
|
Professional
fees
|
|
|
42,519
|
|
|
|
39,097
|
|
|
|
3.0
|
|
|
|
3.0
|
|
|
|
3,422
|
|
|
|
8.8
|
|
Investment
and other revenues
|
|
|
32,089
|
|
|
|
32,860
|
|
|
|
2.2
|
|
|
|
2.6
|
|
|
|
(771
|
)
|
|
|
(2.3
|
)
|
Total
|
|
|
1,445,608
|
|
|
|
1,292,683
|
|
|
|
100.0
|
|
|
|
100.0
|
|
|
|
152,925
|
|
|
|
11.8
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Operating
expenses:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Medical
expenses
|
|
|
1,172,597
|
|
|
|
981,758
|
|
|
|
81.1
|
|
|
|
76.0
|
|
|
|
190,839
|
|
|
|
19.4
|
|
Medical
care ratio
|
|
|
83.0
|
%
|
|
|
77.9
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
5.1
|
|
General
and administrative expenses
|
|
|
160,984
|
|
|
|
153,052
|
|
|
|
11.2
|
|
|
|
11.8
|
|
|
|
7,932
|
|
|
|
5.2
|
|
Total
|
|
|
1,333,581
|
|
|
|
1,134,810
|
|
|
|
92.3
|
|
|
|
87.8
|
|
|
|
198,771
|
|
|
|
17.5
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Operating
income
|
|
|
112,027
|
|
|
|
157,873
|
|
|
|
7.7
|
|
|
|
12.2
|
|
|
|
(45,846
|
)
|
|
|
(29.0
|
)
|
Interest
expense
|
|
|
(3,576
|
)
|
|
|
(2,793
|
)
|
|
|
(0.2
|
)
|
|
|
(0.2
|
)
|
|
|
(783
|
)
|
|
|
28.0
|
|
Other
income (expense), net
|
|
|
1,773
|
|
|
|
(10
|
)
|
|
|
0.1
|
|
|
|
¾
|
|
|
|
1,783
|
|
|
|
(17,830.0
|
)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Income
before income taxes
|
|
|
110,224
|
|
|
|
155,070
|
|
|
|
7.6
|
|
|
|
12.0
|
|
|
|
(44,846
|
)
|
|
|
(28.9
|
)
|
Provision
for income taxes
|
|
|
(37,477
|
)
|
|
|
(53,936
|
)
|
|
|
(2.6
|
)
|
|
|
(4.2
|
)
|
|
|
16,459
|
|
|
|
(30.5
|
)
|
Tax
rate
|
|
|
34.0
|
%
|
|
|
34.8
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
(0.8
|
)
|
Net
income
|
|
$
|
72,747
|
|
|
$
|
101,134
|
|
|
|
5.0
|
%
|
|
|
7.8
|
%
|
|
$
|
(28,387
|
)
|
|
|
(28.1
|
)%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net
income per common share assuming dilution
|
|
$
|
1.24
|
|
|
$
|
1.61
|
|
|
|
|
|
|
|
|
|
|
$
|
(0.37
|
)
|
|
|
(23.0
|
)%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Member
months
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Commercial
|
|
|
2,809,400
|
|
|
|
2,644,000
|
|
|
|
|
|
|
|
|
|
|
|
165,400
|
|
|
|
6.3
|
%
|
Medicare
HMO
|
|
|
510,200
|
|
|
|
509,700
|
|
|
|
|
|
|
|
|
|
|
|
500
|
|
|
|
0.1
|
|
Medicaid
|
|
|
527,300
|
|
|
|
507,600
|
|
|
|
|
|
|
|
|
|
|
|
19,700
|
|
|
|
3.9
|
|
The
table
above should be reviewed in association with the discussion that
follows.
Overview
We
are a
managed health care organization that provides and administers the delivery
of
comprehensive health care programs with an emphasis on quality care and cost
management. Our strategy has been to develop and offer a portfolio of
managed health care products to government agencies, employer groups, and
individuals. We derive revenues primarily from our health maintenance
organization (HMO) and managed indemnity plans. To a lesser extent, we also
derive revenues from professional fees (consisting primarily of fees for
providing health care services to non-members, co-payment fees received from
members and ancillary products), and investment and other revenue (including
fees for workers' compensation third party administration, utilization
management services and ancillary products).
Our
principal expenses consist of medical expenses and general and administrative
expenses. Medical expenses represent capitation fees and other
fee-for-service payments, including hospital per diems, paid to independently
contracted physicians, hospitals and other health care providers to cover
members, pharmacy costs, as well as the aggregate expenses to operate and manage
our wholly-owned multi-specialty medical group and other provider
subsidiaries. As a provider of health care management services, we
seek to positively affect quality of care and expenses by contracting with
physicians, hospitals and other health care providers at negotiated price
levels, by adopting quality assurance programs, monitoring and coordinating
utilization of physician and hospital services and providing incentives to
use
cost-effective providers. General and administrative expenses generally
represent operational costs other than those directly associated with the
delivery of health care services.
Pending
Business Combination
On
March
11, 2007, we entered into an Agreement and Plan of Merger (the Merger
Agreement), with UnitedHealth Group Incorporated, a Minnesota corporation
(UnitedHealth Group), and Sapphire Acquisition, Inc., a Nevada corporation
and
an indirect wholly-owned subsidiary of UnitedHealth Group (Merger
Sub). The Merger Agreement provides that, upon the terms and subject
to the conditions set forth in the Merger Agreement, we will merge with the
Merger Sub (the Merger), and we will continue as the surviving
company. At the effective time of the Merger, each issued and
outstanding share of our common stock (other than shares owned by UnitedHealth
Group or Merger Sub, whose shares will be cancelled), will be converted into
the
right to receive $43.50 in cash, on the terms specified in the Merger Agreement.
Completion of the Merger is subject to various conditions, including, among
others, (i) approval of the holders of a majority of the outstanding shares
of our common stock, (ii) expiration or termination of the applicable
Hart-Scott-Rodino Act (HSR) waiting period, (iii) absence of any order,
injunction or other judgment or decree prohibiting the consummation of the
Merger, (iv) receipt of required governmental consents and approvals without
negative regulatory action, and (v) subject to certain exceptions, the accuracy
of the representations and warranties of us and UnitedHealth Group, as
applicable, and compliance by us and UnitedHealth Group with their respective
obligations under the Merger Agreement. The Merger Agreement contains
certain termination rights for both us and UnitedHealth Group, and further
provides that, upon termination of the Merger Agreement under specified
circumstances, we may be required to pay UnitedHealth Group a termination fee
of
$85.0 million and in other circumstances, UnitedHealth Group may be required
to
pay us a termination fee of $25.0 million.
On
May
16, 2007, we and UnitedHealth Group received a request for additional
information from the Antitrust Division of the U.S. Department of Justice (DOJ)
regarding the proposed merger between the two companies. The
information request, also known as a "second request," was issued under
notification requirements of the HSR. The effect of the second
request is to extend the waiting period imposed by the HSR until 30 days after
we and UnitedHealth Group have substantially complied with the request for
additional information, unless the period is extended voluntarily by the parties
or terminated sooner by the DOJ.
On
June
27, 2007, our stockholders approved the Merger Agreement. On August
27, 2007, we received an order granting approval of the merger from the
Commissioner of Nevada's Division of Insurance. On September 6, 2007, we
received notice that the California Department of Insurance granted approval
of
the merger.
Executive
Summary
Our
highlights for the nine months ended September 30, 2007 compared to the nine
months ended September 30, 2006 include:
·
|
Total
operating revenues increased by 11.8%. This improvement was
primarily driven by a 12.3% increase in medical premiums due to a
38.0%
increase in premiums for our stand alone Medicare Part D prescription
drug
(PDP) programs, an increase in our commercial membership and premium
rate
increases. Also contributing to the improvement in operating
revenues was an 8.8% increase in professional fees due to an increase
in
visits to our clinical
subsidiaries.
|
·
|
HMO
membership increased 2.3% as a result of new accounts and in-case
growth
on commercial membership and growth in Medicaid member
months. This increase is net of the 11,000 commercial member
terminations effective January 1, 2007, from three large employer
groups
that had been anticipated.
|
·
|
Medical
expenses, as a percentage of medical premiums and professional fees,
or
medical care ratio, increased to 83.0% in 2007 from 77.9% in
2006. The increase in our medical care ratio is primarily
related to the estimated full year 2007 pre-tax loss of $58.9 million
related to our new enhanced PDP product that was recorded during
the
period, which significantly increased medical expenses. See
Medical Expenses below for
|
·
|
General
and administrative (G&A) expenses as a percentage of medical premiums
decreased to 11.7% in 2007 from 12.5% in 2006. G&A expenses
increased 5.2% primarily due to costs associated with our pending
merger
with UnitedHealth Group, increases in premium taxes and brokers'
fees, and
G&A costs related to our new enhanced PDP
product.
|
·
|
We
had operating income of $112.0 million in 2007 compared to $157.9
million
in 2006. This decrease is related to the $58.9 million
operating loss recorded during 2007 related to our new enhanced PDP
product. See Medical Expenses below for more details. This
decrease was partially offset by an increase in operating income
primarily
driven by medical premium revenue growth from new members and premium
rate
increases.
|
·
|
Cash
flows from operating activities decreased to $51.2 million from $93.9
million during 2006. This decrease is mostly due to the timing
of tax payments and a $19.3 million decrease in operating cash flows
from
our PDP plans during 2007 compared to 2006, which was primarily related
to
the timing of PDP payments during the year and operating losses related
to
our new enhanced PDP product. See Medical Expenses below for
more details.
|
Results
Of Operations For The Three Months Ended September 30, 2007 Compared To The
Three Months Ended September 30, 2006
Medical
Premiums.
The increase in medical premiums for 2007 reflects a
5.2% increase in commercial member months (the number of months individuals
are
enrolled in a plan). This increase is attributed to in-case growth,
movement from self-insured plans to our commercial products and other new
accounts, which was partially offset by 11,000 commercial member terminations
effective January 1, 2007 from three large employer
groups. Commercial premium rates for renewing commercial groups
increased approximately 8.9% while the overall recorded per member per month
revenue increase, including new and continuing business, was approximately
3.7%,
net of changes in benefits.
The
increase in medical premiums for 2007 includes $19.2 million from our new
stand-alone enhanced PDP product (Enhanced Plan) that was effective January
1,
2007. This was partially offset by a $6.4 million decrease in our
stand-alone basic PDP plan (Basic Plan). We recognize medical
premiums from our PDP plans as earned over the contract period.
In
2007,
we expanded our offering of our Basic Plan to 30 states and the District of
Columbia. We engaged a national marketing partner for our Basic Plan
and we are using our established broker network in Nevada and
Utah. Additionally, our Basic Plan remained eligible as a PDP sponsor
for our 2006 auto-enrolled Medicare and Medicaid beneficiaries in California
and
Nevada, and for our 2006 and new 2007 auto-enrolled beneficiaries in Arizona,
Colorado, Idaho, Oregon, Utah and Washington. Our Basic Plan is no longer a
PDP
sponsor for auto-enrolled beneficiaries in New Mexico and Texas. At
September 30, 2007, we had 152,400 beneficiaries enrolled in our Basic Plan,
the
majority of which were auto-enrolled beneficiaries. In 2007,
for the first time, we offered an Enhanced Plan, which provides brand name
and
generic prescription drug benefits through the coverage gap or "donut hole",
in
30 states and the District of Columbia. Based on the data available
to date, we now anticipate that estimated 2007 pharmacy and administrative
maintenance costs will exceed estimated 2007 premiums by $58.9
million. See Medical Expenses below for more details. At
September 30, 2007, we had 45,500 members enrolled in our Enhanced
Plan. We do expect some new members to enroll in the Enhanced Plan
during the fourth quarter as newly eligible Medicare beneficiaries can still
enroll; however, existing Medicare beneficiaries cannot change stand-alone
PDP
plans during the year unless unusual circumstances exist.
In
2008,
we will continue to offer our Basic Plan to 30 states and the District of
Columbia. In 2008, we will be a PDP sponsor for auto-enrolled
Medicare and Medicaid beneficiaries in Arizona. We will no longer be a
PDP
sponsor
for auto-enrolled Medicare and Medicaid beneficiaries in California, Colorado,
Idaho, Nevada, Oregon, Utah and Washington as we did not meet the Centers for
Medicare and Medicaid Services ("CMS") benchmark in those states for 2008.
As of
September 30, 2007, auto-enrolled Medicare and Medicaid beneficiaries in these
states accounted for approximately 57% of our total stand alone PDP membership.
Based on our prior years' experience, we expect to retain a small percentage
of
this population through voluntary enrollment. We did not submit a bid
to CMS for an Enhanced Plan in 2008 and therefore will not be offering this
plan
for 2008.
CMS
shares in a portion of the risk of pharmacy costs related to the basic coverage
in our Basic Plan and our Enhanced Plan as well as our Medicare Advantage
PDP. We recognize a risk sharing receivable or payable based
on
the
year-to-date activity and a corresponding increase or decrease to medical
premiums. The risk sharing receivable or payable is
accumulated for each contract and recorded in prepaid expenses and other current
assets or accrued and other current liabilities depending on the net contract
balance at the end of the reporting period. See Note 3, "Medicare
Part D Prescription Drug Program", in the Notes to Condensed Consolidated
Financial Statements.
In
2007,
we continue to offer local and regional Medicare Advantage PPO (MAPPO) plans
and
for the first time, we are offering a Medicare Advantage Private Fee-For-Service
(MAPFFS) plan. This plan is available in 28 states and the District of Columbia.
The MAPFFS plan does not include Medicare Part D prescription drug coverage
but
does provide hospital and physician coverage. Members pay a monthly premium,
co-payments and coinsurance, with reasonable out-of-pocket maximum amounts.
Members also have unlimited network access. At September 30, 2007, we had 2,100
and 400 members enrolled in our regional and local MAPPO plans, respectively.
At
September 30, 2007, we had 1,000 members enrolled in our MAPFFS
plan. In 2008, we will continue to offer our local and regional
MAPPO plans as well as our MAPFFS plan.
Effective
January 2004, CMS adopted a new risk adjustment payment methodology for Medicare
beneficiaries enrolled in managed care programs, including the Social HMO,
which
has been administratively extended by CMS through 2007. For Social
HMO members, the new methodology includes a frailty adjuster that uses measures
of functional impairment to predict expenditures. CMS has
transitioned to the new payment methodology on a graduated basis from 2004
through 2007 and we will be completely transitioned to the new methodology
effective
January
1, 2008. In 2006, we were paid 50% based on the previous payment
methodology and 50% based on the new methodology. For 2007, we are
paid 25% based on the previous payment methodology and 75% based on the new
methodology. We received a higher than expected mid-year adjustment
from CMS to the risk factor used to calculate a portion of our
payment. This adjustment was retroactive to January 1,
2007. We expect our 2007 net Medicare per-member-per-month yield to
be slightly higher than 2006.
For
2008,
we will be fully transitioned to a risk payment methodology; however, we have
been notified by CMS that there will continue to be a frailty factor component
to our payment through 2010. The frailty factor will be a component
of the risk score calculation for former Social HMO plans by using 75%, 50%
and
25% of the current frailty factor for plan years 2008, 2009 and 2010,
respectively. Even with the additional frailty factor component, we
believe that a full transition to a risk payment methodology will likely cause
our per member payment in 2008 to be less than our per member payment in
2007.
Early
in
2005, CMS replaced its legacy Group Health Plan system. The
transition to the new system had led to some incorrect transactions and
inconsistencies in the payments and data we received from CMS. We
received overpayments, of over $30 million, from CMS in excess of our current
best estimate of Medicare premiums in 2005. We have made CMS aware of the
overpayments and they are in the process of researching the various
issues. We expect a portion of these funds to be settled with CMS
over the course of the next several quarters. Additionally, while we continue
to
have some membership discrepancies with CMS in 2007, the 2006 membership
discrepancies previously disclosed have largely been resolved with CMS and
we
believe that the appropriate revenue and expenses for these members have been
recognized.
We
contract with the Division of Healthcare Financing and Policy of the state
of
Nevada (DHCFP) to provide health care coverage to certain Medicaid eligible
individuals. To enroll in our Medicaid program, an individual must be
eligible for the Temporary Assistance for Needy Families or the Children's
Health Assurance Program categories of the state's Medicaid program. At
September 30, 2007, we had approximately 41,300 members enrolled in this
program. We also contract with the DHCFP to provide health care
coverage to the Nevada Check Up program, which covers certain uninsured children
who do not qualify for Medicaid. At September 30, 2007, we had
approximately 16,200 members enrolled in this program. We receive a monthly
fee
for each Medicaid and Nevada Check Up member enrolled by the state's Managed
Care Division and we also receive a per case fee for each Medicaid and Nevada
Check Up eligible newborn delivery. In the first quarter we received a 1.0%
rate
increase retroactive to January 1, 2007 and do not expect to receive any further
rate increases for 2007.
The
DHCFP
awarded a contract to Health Plan of Nevada, Inc. (HPN) as one of two Medicaid
managed care contractors in the state of Nevada. The new contract is
effective November 1, 2006 through June 30, 2009. The new contract allows
the DHCFP, at its sole option, to extend the term of the contract for up to
two
additional years. When the new contract became effective on November 1,
2006, existing Medicaid members were given the option to select either of the
two Medicaid managed care contractors. It appears that the majority of
members that made an active selection selected our plan and our share of the
plan membership was initially close to 60%. The DHCFP tries to maintain a
55/45 market share band between the two contractors. Since our current
membership is slightly above 55% of the plan membership, the other contractor
will continue to receive the majority of new members that do not make an active
selection. Over time, this is designed to keep the membership within a
55/45 market share band between the two contractors.
Continued
medical premium revenue growth is principally dependent upon continued
enrollment in our products and upon competitive and regulatory
factors.
Professional
Fees.
The increase in professional fees primarily resulted from
increased visits to our clinical subsidiaries.
Investment
and Other Revenue.
The decrease in investment and
other revenue primarily resulted from a decrease in revenue related to our
administrative services subsidiary and a decrease in yields on our
investments. The decrease in yields is due to a declining exposure to
investments in trust deed mortgage notes. While they have provided
higher yields than our other investments, we have tried to reduce our exposure
due to the continued deterioration of the real estate market. See
Note 5, "Investments", in the Notes to Condensed Consolidated Financial
Statements.
Medical
Expenses.
Our medical care ratio increased 440 basis
points to 81.7%. The increase in our medical care ratio is due
primarily to an increase in the premium deficiency related to our Enhanced
Plan,
higher average bed days during 2007 for our Medicare HMO members, and the
termination of our HCA Inc. (HCA) contract on December 31, 2006.
In
2007,
we began to offer the Enhanced Plan, which provides brand name and generic
prescription drug benefits through the coverage gap or "donut
hole". We engaged independent actuarial consultants in developing the
Enhanced Plan. The premium structure for the Enhanced Plan was based
on a projected level of utilization per member. Our experience so far
in 2007 indicates that we have experienced significantly increased costs from
what the actuarial projections anticipated. During the first half of
2007, we recorded a $55.3 million pre-tax loss related to our Enhanced Plan,
which resulted in a premium deficiency reserve of $39.3 million at June 30,
2007. This represented our estimate of the full year 2007 losses for
the Enhanced Plan based on the data available at that time. Based on
the most current data available to date, we now believe that the entire year
2007 losses for the Enhanced Plan will be $58.9 million. We recorded
an additional $3.6 million in premium deficiency reserves during the
quarter. The change in estimate was due to higher than
projected utilization during the third quarter of 2007 and lower than projected
risk share from CMS resulting in an $9.4 million increase in projected medical
losses, which was partially offset by a $5.8 million decrease in our projected
G&A expenses, due to better than expected
collections
of the members’ portion of the premiums. At September 30, 2007, our
premium deficiency reserve balance for our Enhanced Plan was $22.1 million.
See
Note 4, "Premium Deficiency Reserves", in the Notes to Condensed Consolidated
Financial Statements for further discussion of our Enhanced Plan.
The
number of days in claims payable, which is the medical claims payable balance
divided by the average medical expense per day, for 2007 was 47 compared to
45
for 2006. The increase was related to an increase in claims payable
for provider disputes and the timing of claims payments.
We
contract with hospitals, physicians and other independent providers of health
care under capitated or discounted fee-for-service arrangements, including
hospital per diems, to provide medical care services to members. We
also have an extensive pharmacy network to provide pharmaceuticals to our
members. Capitated providers are at risk for
a
portion
of the cost of medical care services provided to our members in the relevant
geographic areas; however, we are ultimately responsible for the provision
of
services to our members should the capitated provider be unable to provide
the
contracted services. We incurred capitation expenses with
non-affiliated providers of $32.7 million and $34.1 million, or 8.7% and 10.5%,
of our total medical expenses for 2007 and 2006, respectively. Also included
in
medical expenses are the operating expenses of our medical provider subsidiaries
and certain claims-related administrative expenses, which accounted for 26.5%
and 28.2% of our total medical expenses for 2007 and 2006,
respectively.
The
Las
Vegas area has thirteen hospitals. Our contract with our 2006 primary
Las Vegas area contracted hospital organization, which includes three hospitals
− Sunrise Hospital and Medical Center, Mountain View Hospital and Southern Hills
Hospital and Medical Center − owned by HCA, expired on December 31,
2006. We have contracts in place through at least the middle of 2008
with the remaining hospitals in southern Nevada. These contracts are
based on a fixed per diem rate structure and in some circumstances are higher
than the previous HCA contract rates. While our efforts to move the majority
of
our HCA hospital days to other contracted hospitals have been successful, there
are emergency and other situations that have required us to use the HCA
hospitals in 2007. In 2007, we have negotiated a discount to billed
charges with HCA for our commercial members based on certain prompt pay terms;
however, these charges are still substantially higher than our current
commercial rates with our contracted hospitals. We receive a significant
discount to billed charges for services rendered to Medicare and Medicaid
members at an HCA hospital because we pay charges at the established Medicare
and Medicaid rates.
General
and Administrative Expenses.
G&A expenses
decreased primarily due to a decrease in our premium deficiency reserve recorded
in G&A related to our new enhanced PDP product, a decrease in expenses
related to salaries and bonuses, and a decrease in share-based compensation
expense. These decreases were partially offset by an increase in
premium taxes, brokers’ fees and costs associated with our pending merger with
UnitedHealth Group. The decrease in the premium deficiency reserve
recorded in G&A was related to better than expected collections for the
members’ portion of premiums. As a percentage of medical premiums,
G&A expenses were 9.5% and 12.6% for 2007 and 2006,
respectively.
Interest
Expense.
Interest expense decreased due to a decrease in long-term
debt. At September 30, 2007, we had no balance outstanding on our
credit facility.
Provision
for Income Taxes.
Our effective tax rate is lower than the
statutory tax rate primarily due to tax-preferred investment income and the
recognition of tax benefits associated with a change in accounting
method for a subsidiary, Health Plan of Nevada, Inc., which was
approved by the Internal Revenue Service in the third quarter of
2007. See Note 11, "Income Taxes", in the Notes to Condensed
Consolidated Financial Statements for further discussion of our income
taxes.
Our
effective tax rate is based on actual or expected income, statutory tax rates
and tax planning opportunities available to us. We use significant
estimates and judgments in determining our effective tax rate. We are
occasionally audited by federal, state or local jurisdictions regarding
compliance with federal, state and local tax
laws
and
the recognition of income and deductibility of expenses. Tax
assessments may not arise until several years after tax returns are
filed. While there is an element of uncertainty in predicting the
outcome of tax audits, we believe that the recorded tax assets and liabilities
are appropriately stated based on our analyses of probable outcomes, including
interest and other potential adjustments. Our tax assets and
liabilities are adjusted based on the most current facts and circumstances,
including the progress of audits, case law, emerging legislation and
interpretations; any adjustments are included in the effective tax rate in
the
current period.
Results
Of Operations For The Nine Months Ended September 30, 2007 Compared To The
Nine
Months Ended September 30, 2006
Medical
Premiums.
The increase in medical premiums for 2007 reflects a
6.3% increase in commercial member months. This increase is
attributed to in-case growth, movement from self-insured plans to our commercial
products and other new accounts, which was partially offset by 11,000 commercial
member terminations effective January 1, 2007 from three large employer
groups. The increase in medical premiums for 2007 also includes a
3.9% increase in Medicaid member months and a 0.1% increase in Medicare HMO
member months as well as $83.5 million in medical premiums related to our
Enhanced Plan that was effective January 1, 2007. This was partially
offset by a $24.6 million decrease in medical premiums related to our Basic
Plan.
Commercial
premium rates for renewing commercial groups increased approximately 6.1% while
the overall recorded per member per month revenue increase, including new and
continuing business, was approximately 3.8%, net of changes in
benefits.
Professional
Fees.
The increase in professional fees primarily resulted from
increased visits to our clinical subsidiaries.
Investment
and Other Revenue.
The decrease in investment and
other revenue primarily resulted from a decrease in revenue related to our
administrative services subsidiary. See Note 5, "Investments", in the
Notes to Condensed Consolidated Financial Statements.
Medical
Expenses.
Our medical care ratio increased to 83.0%
from 77.9%. The increase is mainly due to estimated losses for the
full year of 2007 from our Enhanced Plan recorded in the year and the
termination of our HCA contract on December 31, 2006.
We
incurred capitation expenses with non-affiliated providers of $99.8 million
and
$99.9 million, or 8.5% and 10.2% of our total medical expenses for 2007 and
2006, respectively. Also included in medical expenses are the operating expenses
of our medical provider subsidiaries and certain claims-related administrative
expenses, which accounted for 25.3% and 26.0% of our total medical expenses
for
2007 and 2006, respectively.
General
and Administrative Expenses.
G&A expenses
increased primarily due to costs associated with our pending merger with
UnitedHealth Group, premium taxes, brokers' fees and our new Enhanced
Plan. As a percentage of medical premiums, G&A expenses were
11.7% for 2007, compared to 12.5% for 2006.
Interest
Expense.
Interest Expense increased due to prepaid interest and
other costs associated with debenture holders converting $23.3 million of our
senior convertible debentures during 2007 and an increase in the average balance
of our credit facility during 2007 compared to 2006, which resulted from a
significant repurchase of shares in the fourth quarter of 2006. At September
30,
2007, we had nothing outstanding on our credit facility.
Provision
for Income Taxes.
Our effective tax rate is lower than the
statutory tax rate primarily due to tax-preferred investment income and the
recognition of previously unrecognized tax benefits associated with a
change in accounting method for a subsidiary, Health Plan of
Nevada, Inc., which was approved by the Internal
Revenue
Service
in the third quarter of 2007. See Note 11, "Income Taxes", in the
Notes to Condensed Consolidated Financial Statements for further discussion
of
our income taxes.
Liquidity
And Capital Resources
A
summary
of our major sources and uses of cash is reflected in the table
below.
|
|
Nine
Months Ended September 30,
|
|
|
|
2007
|
|
|
2006
|
|
|
|
(In
thousands)
|
|
Sources
of cash:
|
|
|
|
|
|
|
Cash
provided by operating activities
|
|
$
|
51,161
|
|
|
$
|
93,903
|
|
Purchase
of investments, net of proceeds
|
|
|
34,832
|
|
|
|
11,500
|
|
Exercise
of stock in connection with stock plans
|
|
|
6,358
|
|
|
|
14,063
|
|
Other
|
|
|
4,433
|
|
|
|
11,445
|
|
Total
cash sources
|
|
|
96,784
|
|
|
|
130,911
|
|
|
|
|
|
|
|
|
|
|
Uses
of cash:
|
|
|
|
|
|
|
|
|
Purchase
of treasury stock
|
|
|
(21,081
|
)
|
|
|
(127,780
|
)
|
Payment
on debt and capital leases
|
|
|
(78,494
|
)
|
|
|
(82
|
)
|
Other
|
|
|
(2,967
|
)
|
|
|
(13,183
|
)
|
Total
cash uses
|
|
|
(102,542
|
)
|
|
|
(141,045
|
)
|
Net
decrease in cash
|
|
$
|
(5,758
|
)
|
|
$
|
(10,134
|
)
|
Our
primary sources of cash are from premiums, professional fees, and income
received on investments. Cash is used primarily for claim and benefit payments
and operating expenses. We manage our cash, investments and capital structure
so
we are able to meet the short- and long-term obligations of our business while
maintaining financial flexibility and liquidity. We forecast, analyze and
monitor our cash flows to enable investment management and financing within
the
confines of our investment policies.
Cash
flows from operating activities decreased to $51.2 million from $93.9 million
during 2006. This decrease is mostly due to the timing of tax
payments and a $19.3 million decrease in operating cash flows from our PDP
plans
during 2007 compared to 2006, which was primarily related to the timing of
PDP
activity during the year and operating losses related to our new enhanced PDP
product. See Medical Expenses above for more details. We continue to
have negative cash flow related to our Basic Plan due to the timing of
reimbursement from CMS for our reimbursable low-income subsidy and
reinsurance. These costs should be fully reimbursed after CMS
performs its year-end reconciliation, which is expected to be in the third
quarter following the plan year. We have received the reconciliation
for the 2006 plan year and expect to receive final payment in the fourth quarter
of 2007. We received an interim payment from CMS of $36.5 million,
which represented our projected cash shortfall through June 30, 2007; however,
we expect a total funding deficit of approximately $50-$70 million for
2007. While we are receiving our full payments from CMS related to
our Enhanced Plan, we expect to incur losses of $58.9 million during the year
on
this product. We believe that our operating cash flows and available
cash reserves will be sufficient to cover any negative cash flows related to
our
Basic Plan and Enhanced Plan. See Note 4, "Premium Deficiency
Reserves", in the Notes to Condensed Consolidated Financial Statements for
further discussion of our Enhanced Plan. We have received the reconciliation
for
the 2006 plan year and received final payment in the fourth quarter
2007.
Net
cash
used for investing activities during 2007 included capital expenditures
associated with the continued implementation of new computer systems, leasehold
improvements on facilities, furniture and equipment and other capital purchases
to support our growth. The net cash change in investments for the
period was a decrease in investments due to the timing of purchasing and selling
investments.
Sierra
Debentures
In
March
2003, we issued $115.0 million aggregate principal amount of 2¼% senior
convertible debentures due March 15, 2023. The debentures pay
interest, which is due semi-annually on March 15 and September 15 of each
year. Each $1,000 principal amount of debentures is convertible, at
the option of the holders, into 109.3494 shares of our common stock before
March
15, 2023 if (i) the market price of our common stock for at least 20 trading
days in a period of 30 consecutive trading days ending on the last trading
day
of the preceding fiscal quarter exceeds 120% of the conversion price per share
of our common stock; (ii) the debentures are called for redemption; (iii) there
is an event of default with respect to the debentures; or (iv) specified
corporate transactions have occurred. Beginning December 2003 and for
each subsequent period, the market price of our common stock has exceeded 120%
of the conversion price for at least 20 trading days in a period of 30
consecutive trading days. The conversion rate is subject to certain
adjustments. This conversion rate represents a conversion price of
$9.145 per share. Holders of the debentures may require us to repurchase all
or
a portion of their debentures on March 15 in 2008, 2013 and 2018 or upon certain
corporate events including a change in control. In either case, we
may choose to pay the purchase price of such debentures in cash or common stock
or a combination of cash and common stock. We can redeem the
debentures for cash beginning March 20, 2008.
During
the first quarter of 2006, a debenture holder (holder) converted $500,000 in
debentures for approximately 54,000 shares of common stock. During
the third quarter of 2006, we entered into a privately negotiated transaction
with a holder pursuant to which the holder converted $8.0 million in debentures
for approximately 875,000 shares of common stock in accordance with the
indenture governing the debentures. During the first quarter of 2007, we entered
into one privately negotiated transaction with a holder pursuant to which the
holder converted an aggregate of $21.7 million in debentures for approximately
2.4 million shares of common stock in accordance with the indenture governing
the debentures. In addition, two other holders also converted $1.5 million
in
debentures for approximately 168,000 shares of common stock. At
September 30, 2007, we had outstanding $20.2 million in aggregate principal
amount of our 2¼% senior convertible debentures due March 15, 2023.
Revolving
Credit Facility
On
March
3, 2003, we entered into a revolving credit facility. Effective June 26, 2006,
this facility was amended to extend the expiration from December 31, 2009 to
June 26, 2011, increase the availability from $140.0 million to $250.0
million and reduce the drawn and undrawn fees. The current incremental
borrowing rate is LIBOR plus 0.60%. The facility is available for
general corporate purposes and at September 30, 2007, we had nothing outstanding
on this facility.
The
credit facility is secured by guarantees by certain of our subsidiaries and
a
first priority security interest in: (i) all of the capital stock of each of
our
unregulated, material domestic subsidiaries (direct or indirect) as well as
all
of the capital stock of certain regulated, material domestic subsidiaries;
and
(ii) all other present and future assets and properties of ours and those of
our
subsidiaries that guarantee our credit agreement obligations (including, without
limitation, accounts receivable, inventory, certain real property, equipment,
contracts, trademarks, copyrights, patents, license rights and general
intangibles) subject, in each case, to the exclusion of the capital stock of
CII
Financial, Inc. and certain other exclusions.
The
revolving credit facility's covenants limit our ability and the ability of
our
subsidiaries to dispose of assets, incur indebtedness, incur other liens, make
investments, loans or advances, make acquisitions, engage in mergers or
consolidations, make capital expenditures and otherwise restrict certain
corporate activities. Our ability to pay dividends, repurchase our
common stock and prepay other debt is unlimited provided that we can still
exceed a certain required leverage ratio after such transaction or any borrowing
incurred as a result of such transaction. In
addition,
we are required to comply with specified financial ratios as set forth in the
credit agreement. We believe that we are in compliance with all
covenants of the credit agreement at September 30, 2007 and
2006.
Sierra
Share Repurchase Program
From
January 1, 2007 through September 30, 2007, we purchased 585,000 shares of
our
common stock in the open market for $21.1 million at an average cost per share
of $36.04. Since the repurchase program began in early 2003 and through
September 30, 2007, we purchased, in the open market or through negotiated
transactions, 29.2 million shares, adjusted for the two for one stock split
effective December 30, 2005, for $651.9 million at an average cost per share
of
$22.29. On January 25, 2007, our Board of Directors authorized an
additional $50.0 million in share repurchases. At September 30, 2007,
$53.1 million was still available under the Board of Directors' authorized
plan. The repurchase programs have no stated expiration
date. Our revolving credit facility, as amended, currently allows for
unlimited stock repurchases based on meeting a certain covenant ratio; however,
on March 11, 2007 we halted our repurchase program pending the UnitedHealth
Group merger.
Statutory
Capital and Deposit Requirements
Our
HMO
and insurance subsidiaries are required by state regulatory agencies to maintain
certain deposits and must also meet certain net worth and reserve
requirements. The HMO and insurance subsidiaries had restricted
assets on deposit in various states totaling $16.5 million at September 30,
2007. The HMO and insurance subsidiaries must also meet requirements to maintain
minimum stockholders' equity, on a statutory basis, as well as minimum
risk-based capital requirements, which are determined annually. We
surrendered our HMO license in Texas during the year and are no longer required
to maintain a deposit. We believe we are in material compliance with
our regulatory requirements.
Of
the
$53.2 million in cash and cash equivalents held at September 30, 2007, $48.9
million was designated for use only by the regulated
subsidiaries. Amounts are available for transfer to the parent
company from the HMO and insurance subsidiaries only to the extent that they
can
be remitted in accordance with the terms of existing management agreements
and
by dividends. The parent company will not receive dividends from its regulated
subsidiaries if such dividend payment would cause a violation of statutory
net
worth and reserve requirements.
Obligations
and Commitments
We
believe that funds from future operating cash flows, cash and cash equivalents
and investments and funds available under our credit agreement will be
sufficient for future operations and commitments and for capital acquisitions
and other strategic transactions within the limits of the Merger
Agreement.
For
additional information regarding our estimated contractual obligations and
commitments at December 31, 2006, see "Contractual Obligations, Commitments
and
Off-Balance Sheet Arrangements" included in the "Liquidity and Capital
Resources" section of our 2006 Annual Report on Form 10-K filed with the
Securities and Exchange Commission on February 27, 2007.
Recently
Issued Accounting Standards
In
June
2006, the FASB issued FASB Interpretation No. 48, "Accounting for Uncertainty
in
Income Taxes - an Interpretation of FASB Statement No. 109" (FIN
48). FIN 48 clarifies the accounting for uncertainty in income taxes
recognized in an enterprise's financial statements in accordance with Statement
of Financial Accounting Standards No. 109, "Accounting for Income Taxes"
.
FIN 48 prescribes a recognition threshold and measurement attribute
for the
financial statement recognition and measurement of a tax position taken or
expected to be taken in a tax return. FIN 48 also provides guidance on
derecognition, classification, interest and penalties, accounting in interim
periods, disclosure, and transition. On January 1, 2007, we adopted
FIN 48. A
pplying
the
provisions of FIN
48
to all
tax positions resulted in a cumulative effect adjustment to beginning retained
earnings in the amount of $4.3 million. For more information on the
adoption of FIN 48, see Note 11, "Income Taxes", in the Notes to Condensed
Consolidated Financial Statements.
In
September 2006, the FASB issued Statement of Financial Accounting Standards
No.
157, "Fair Value Measurements" (SFAS 157). SFAS 157 defines fair value,
establishes a framework for measuring fair value in generally accepted
accounting principles, and expands disclosures about fair value measurements.
SFAS 157 applies only to other accounting pronouncements that require or permit
fair value measurements. SFAS 157 is effective for fiscal years
beginning after November 15, 2007.
We
do not believe the
adoption
of
SFAS
157
will
have
a
material impact
on
our
consolidated financial position
,
results of operations
,
or cash flows
.
In February
2007, the FASB issued Statement of Financial Accounting Standards No. 159,
"The Fair Value Option for Financial Assets and Financial Liabilities -
Including an Amendment of FASB Statement No. 115" (SFAS 159). SFAS 159
would create a fair value option of accounting for qualifying financial assets
and liabilities under which an irrevocable election could be made at inception
to measure such assets and liabilities initially and subsequently at fair value,
with all changes in fair value reported in earnings. SFAS 159 is
effective as of the beginning of the first fiscal year beginning after November
15, 2007. We are currently evaluating the impact that the adoption of SFAS
159 will have on our consolidated financial position, results of operations
or
cash flows.
Ratings
Financial
strength ratings are the opinion of the rating agencies and the significance
of
individual ratings varies from agency to agency. Companies with
higher ratings generally, in the opinion of the rating agency, have the
strongest capacity for repayment of debt or payment of claims, while companies
at the bottom end of the range have the weakest capacity. Rating
agencies continually review the financial performance and condition of insurers.
The current financial strength ratings of Sierra's HMO and health and life
insurance subsidiaries and senior convertible debentures are as
follows:
|
|
A.M.
Best Company, Inc.
(1)
|
|
Fitch
Ratings
(2)
|
|
|
Rating
|
|
Ranking
|
|
Rating
|
|
Ranking
|
|
Financial
strength rating:
|
|
|
|
|
|
|
|
|
|
HMO
and health and life insurance subsidiaries
|
|
B++
Good
|
|
5th
of 16
|
|
A-
Strong
|
|
7th
of 23
|
|
|
|
|
|
|
|
|
|
|
|
Issuer
credit ratings:
|
|
|
|
|
|
|
|
|
|
HMO
and health and life insurance subsidiaries
|
|
bbb+
Adequate
|
|
8th
of 22
|
|
n/a
|
|
n/a
|
|
|
|
|
|
|
|
|
|
|
|
Parent
company
|
|
bb+
Speculative
|
|
11th
of 22
|
|
BBB
Good
|
|
9th
of 23
|
|
|
|
|
|
|
|
|
|
|
|
Senior
convertible debentures
|
|
bb+
Speculative
|
|
11th
of 22
|
|
BBB-
Investment Grade
|
|
10th
of 23
|
|
|
|
|
Standard
& Poor's Corp.
(3)
|
|
|
Rating
|
|
Ranking
|
|
|
|
|
|
|
|
Counterparty
credit rating
|
|
BB+
Speculative
|
|
11th
of 22
|
|
|
|
|
|
|
|
Senior
convertible debentures
|
|
BB+
Speculative
|
|
11th
of 22
|
|
(1)
Under
review with positive implications. (2) Rating watch positive. (3)
Credit watch with positive implications.
The
financial strength ratings reflect the opinion of each rating agency on our
operating performance and ability to meet obligations to policyholders, and
are
not evaluations directed toward the protection of investors in our common stock
or senior convertible debentures.
Inflation
Health
care costs continue to rise at a rate faster than the Consumer Price
Index. We use various strategies to mitigate the negative effects of
health care cost inflation, including setting commercial premiums based on
our
anticipated health care costs, risk-sharing arrangements with our various health
care providers and other health care cost containment measures including member
co-payments. There can be no assurance, however, that in the future,
our ability to manage medical costs will not be negatively impacted by items
such as technological advances, competitive pressures, applicable regulations,
change in provider contracts, increases in pharmacy and other medical costs,
utilization changes and catastrophic items, which could, in turn, result in
medical cost increases equaling or exceeding premium increases.
Critical
Accounting Policies and Estimates
We
prepared our condensed consolidated financial statements in conformity with
accounting principles generally accepted in the United States of
America. In preparing these condensed consolidated financial
statements, we are required to make judgments, assumptions and estimates, which
we believe are reasonable and prudent based on the available facts and
circumstances. These judgments, assumptions and estimates affect
certain of our revenues and expenses and their related balance sheet accounts
and disclosure of our contingent assets and liabilities. We base our
assumptions and estimates primarily on historical experience and trends and
factor in known and projected trends. On an on-going basis, we
re-evaluate our selection of assumptions and the method of calculating our
estimates. Actual results, however, may materially differ from our
calculated estimates and this difference would be reported in our current
operations. Our critical accounting policies and estimates have been
reviewed by the Audit Committee of our Board of Directors.
For
a
more detailed description of all our critical accounting policies and estimates,
see Part II, Item 7 of our 2006 Annual Report on Form 10-K. As of
September 30, 2007, our critical accounting policies have not changed from
those
described in our 2006 Annual Report on Form 10-K. For a more
extensive discussion of our accounting policies, see Note 2, "Summary of
Significant Accounting Policies", in the Notes to the Consolidated Financial
Statements in our 2006 Annual Report on Form 10-K.
At
September 30, 2007, we had unrealized holding losses on available for sale
investments of $1.4 million, net of tax, compared to unrealized holding losses
of $1.9 million, net of tax, at December 31, 2006. We believe that
changes in market interest rates, resulting in unrealized holding gains or
losses, should not have a material impact on future earnings or cash flows,
as
it is unlikely that we would need or choose to substantially liquidate our
investment portfolio.
At
September 30, 2007, we had outstanding $20.2 million in aggregate principal
amount of our 2¼% senior convertible debentures due March 15,
2023. The debentures are fixed rate, and therefore, the interest
expense on the debentures will not be impacted by future interest rate
fluctuations. The borrowing rate on our revolving credit facility is
currently LIBOR plus 0.60%. At September 30, 2007, we had nothing
drawn on this facility.
At
September 30, 2007, we had $67.3 million invested in trust deed mortgage notes
and real estate joint ventures. Trust deed mortgage notes and real estate joint
ventures are classified and accounted for as other investments. Our
investments in trust deed mortgage notes are with numerous independent borrowers
and are secured by real estate in several states. All of our trust deed mortgage
notes require interest only payments with a balloon payment of the principal
at
maturity. Loan to value ratios for these investments are typically based on
appraisals or other market data obtained at the time of loan origination and
may
not reflect subsequent changes in value estimates. As a result, there
may be less security than anticipated at the time the loan was originally made.
If the values of the underlying assets decrease and default occurs, we may
not
recover the full amount of the loan or any interest due. Our
investments in real estate joint ventures consist of three independent projects
and are secured by real estate in California, Nevada, and Utah. We
evaluate our investments in trust deed mortgage notes and real estate joint
ventures for recoverability on a quarterly basis, or more frequently if
impairment indicators exist. Based on our most current assessment, we believe
that no adjustments are required to the September 30, 2007 carrying value of
our
investments in trust deed mortgage notes and real estate joint
ventures. However, if the real estate market continues to
deteriorate, impairment adjustments may be required in future
periods.
Evaluation
of Disclosure Controls and Procedures
The
Company's management, with the participation of the Company's Chief Executive
Officer and Chief Financial Officer, evaluated the effectiveness of the
Company's disclosure controls and procedures at the end of the period covered
by
this report. Based on that evaluation, the Chief Executive Officer
and Chief Financial Officer concluded that the Company's disclosure controls
and
procedures as of the end of the period covered by this report were designed
and
were functioning effectively to provide reasonable assurance that the
information required to be disclosed by the Company in reports filed under
the
Securities Exchange Act of 1934 is recorded, processed, summarized and reported
within the time periods specified in the SEC's rules and forms. The
Company believes that a system of controls, no matter how well designed and
operated, cannot provide absolute assurance that the objectives of the controls
are met, and no evaluation of controls can provide absolute assurance that
all
control issues and instances of fraud, if any, within a company have been
detected. Management is required to apply its judgment in evaluating
the cost-benefit relationship of such controls and procedures.
Change
in Internal Control over Financial Reporting
No
change
in the Company's internal control over financial reporting occurred during
the
Company's most recent fiscal quarter that has materially affected, or is
reasonably likely to materially affect, the Company's internal control over
financial reporting.