Centene Corporation is an American health care provider. Centene primarily acts as a provider of Medicaid and Medicar services and works in these areas with the governments of the relevant states and the United States government. The company serves over 8.6 million Medicaid members and over 400,000 Medicare beneficiaries in the United States.
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Form 10-K
(Mark One)
For the fiscal year ended December 31, 2005
or
For the transition period from to
Commission file number: 000-33395
Centene Corporation
(Exact name of registrant as specified in its charter)
Registrant’s telephone number, including area code: (314) 725-4477
Securities registered pursuant to Section 12(b) of the Act:
Securities registered pursuant to Section 12(g) of the Act:
None
(Title of Each Class)
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes x No ¨
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes ¨ No x
Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filed, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in rule 12b-2 of the Exchange Act.
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes ¨ No x
The aggregate market value of the voting and non-voting common equity held by non-affiliates of the registrant, based upon the last reported sale price of the common stock on the New York Stock Exchange on June 30, 2005, was $1,393,980,683.
As of December 31, 2005 the registrant had 42,988,230 shares of common stock outstanding.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Proxy Statement for the registrant’s 2006 annual meeting of stockholders are incorporated by reference in Part II, Item 5 and Part III, Items 10, 11, 12, 13 and 14.
TABLE OF CONTENTS
Item 1.
Business
Item 1A.
Risk Factors
Item 1B.
Unresolved Staff Comments
Item 2.
Properties
Item 3.
Legal Proceedings
Item 4.
Submission of Matters to a Vote of Security Holders
Item 5.
Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
Item 6.
Selected Financial Data
Item 7.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 7A.
Quantitative and Qualitative Disclosures About Market Risk
Item 8.
Financial Statements and Supplementary Data
Item 9.
Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
Item 9A.
Controls and Procedures
Item 9B.
Other Information
Item 10.
Directors and Executive Officers of the Registrant
Item 11.
Executive Compensation
Item 12.
Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
Item 13.
Certain Relationships and Related Transactions
Item 14.
Principal Accountant Fees and Services
Item 15.
Exhibits and Financial Statement Schedules
Signatures
Certifications
“BUCKEYE COMMUNITY HEALTH PLAN,” “CENTENE,” “FIRSTGUARD HEALTH PLAN,” “MANAGED HEALTH SERVICES,” “NURSEWISE,” “START SMART FOR YOUR BABY” and “UNIVERSITY HEALTH PLANS” are our registered service marks. This filing also contains trademarks, service marks and trade names of other companies.
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PART I
Item 1. Business
OVERVIEW
We are a multi-line healthcare enterprise that provides Medicaid and Medicaid-related programs to organizations and individuals through government subsidized programs, including Medicaid, Supplemental Security Income (SSI) and the State Children’s Health Insurance Program (SCHIP). In addition, we provide specialty services including behavioral health, disease management, nurse triage and treatment compliance to our own and other healthcare organizations. Effective January 2006, we acquired US Script, Inc., a privately held pharmacy benefits manager (PBM). This acquisition has added pharmacy benefits management to our specialty product line. We have health plans in Indiana, Kansas, Missouri, New Jersey, Ohio, Texas and Wisconsin. Our health plan in Georgia will begin membership operations in 2006. We also provide specialty services in each of the states in which we have health plans as well as free-standing programs in Arizona.
We believe our local approach to managing our subsidiaries, including provider and member services, enables us to provide accessible, high quality, culturally-sensitive healthcare services to our communities. Our disease management, educational and other initiatives are designed to help members best utilize the healthcare system to ensure they receive appropriate, medically necessary services and effective management of routine, severe and chronic health problems resulting in better health outcomes. We combine our decentralized local approach for care with a centralized infrastructure of support functions such as finance, information systems and claims processing.
We were organized in Wisconsin in 1993 and reincorporated in Delaware in 2001. We initially were formed to serve as a holding company for a Medicaid managed care line of business that has been operating in Wisconsin since 1984. Our corporate office is located at 7711 Carondelet Avenue, Suite 800, St. Louis, Missouri 63105, and our telephone number is (314) 725-4477.
We maintain a website with the address www.centene.com. We are not including the information contained on our website as part of, or incorporating it by reference into, this filing. We make available, free of charge through our website, our Section 16 filings, annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K, and any amendments to these reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act as soon as reasonably practicable after we electronically file such material with, or furnish such material to, the SEC.
INDUSTRY
Established in 1965, Medicaid is the largest publicly funded program in the United States, providing health insurance to low-income families and individuals with disabilities. Authorized by Title XIX of the Social Security Act, Medicaid is an entitlement program funded jointly by the federal and state governments and administered by the states. The majority of funding is provided at the federal level. Each state establishes its own eligibility standards, benefit packages, payment rates and program administration within federal standards. As a result, there are 56 Medicaid programs—one for each U.S. state, each U.S. territory and the District of Columbia. The National Association of State Budget Officers (NASBO) estimates the total Medicaid market was approximately $310 billion in 2004 and the federal Centers for Medicare and Medicaid Services, or CMS, estimate the market will grow to over $400 billion by fiscal year 2007. Medicaid spending increased by 7.5% in fiscal 2005 according to the most recent survey by the Kaiser Commission on Medicaid and the Uninsured. States appropriated an increase of 5.5% for Medicaid in fiscal 2006 budgets. The NASBO reports Medicaid expenditures are approximately 22% of all state spending. Medicaid eligibility is based on a combination of income and asset requirements subject to federal guidelines, often determined by an income level relative to the
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federal poverty level. The number of persons covered by Medicaid increased from 23 million in 1989 to approximately 45 million in 2005. Historically, children have represented the largest eligibility group.
SSI beneficiaries receive the majority of their healthcare needs through Medicaid. SSI beneficiaries are people with chronic physical disabilities or behavioral health impairments. State Medicaid expenditures related to the SSI population represents the largest component of all Medicaid-related expenses.
The Balanced Budget Act of 1997 created SCHIP to help states expand coverage primarily to children whose household income level does not allow them to qualify for Medicaid. SCHIP is the single largest expansion of health insurance coverage for children since the enactment of Medicaid and some states include the parents of these children in their SCHIP programs. Costs related to the largest eligibility group, children, are primarily composed of pediatrics and family care. These costs tend to be more predictable than other healthcare issues which predominantly affect the adult population.
While Medicaid programs have directed funds to many individuals who cannot afford or otherwise maintain health insurance coverage, they did not initially address the inefficient and costly manner in which the Medicaid population tends to access healthcare. Medicaid recipients in non-managed care programs typically have not sought preventive care or routine treatment for chronic conditions, such as asthma and diabetes. Rather, they have sought healthcare in hospital emergency rooms, which tends to be more expensive. As a result, many states have found that the costs of providing Medicaid benefits have increased while the medical outcomes for the recipients remained unsatisfactory.
Since the early 1980s, increasing healthcare costs, combined with significant growth in the number of Medicaid recipients, have led many states to establish Medicaid managed care initiatives. Continued pressure on states’ Medicaid budgets should cause public policy to recognize the value of managed care as a means of delivering quality health care and effectively controlling costs. A growing number of states, including each of the seven states in which we operate health plans, have mandated that their Medicaid recipients enroll in managed care plans. Currently, 42 states have mandated managed care for some or all of their Medicaid recipients and other states are considering moving to a mandated managed care approach. As a result, a significant market opportunity exists for managed care organizations with operations and programs focused on the distinct socio-economic, cultural and healthcare needs of the Medicaid, SSI and SCHIP populations. We believe our approach and strategy enable us to be a growing participant in this market.
OUR APPROACH
Our multi-line managed care approach is based on the following key attributes:
Medicaid Expertise. Over the last 21 years, we have developed a specialized Medicaid expertise that has helped us establish and maintain strong relationships with our constituent communities of members, providers and state governments. We have implemented programs developed to achieve savings for state governments and improve medical outcomes for members by reducing inappropriate emergency room use, inpatient days and high cost interventions, as well as by managing care of chronic illnesses. We do this primarily by supplying nurse case managers who support our provider network in implementing disease management programs and by supplying incentives for our provider network to provide preventive care on a regular basis. We recruit and train staff and providers who are attentive to
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the needs of our members and who are experienced in working with culturally diverse, low-income Medicaid populations. Our experience in working with state regulators helps us to implement and deliver our programs and services efficiently and offers us opportunities to provide input regarding Medicaid industry practices and policies in the states in which we operate.
OUR STRATEGY
Our objective is to become the leading multi-line Medicaid and Medicaid-related healthcare enterprise. We intend to achieve this objective by implementing the following key components of our strategy:
Diversify Our Business Lines. We seek to broaden our business lines into areas that complement our business to enable us to grow our revenue and income stream. In January 2006, we acquired US Script,
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Inc., a PBM. In 2005 we acquired AirLogix, Inc., a disease management provider. In 2003 we acquired Cenpatico, a behavioral health services company, and purchased assets of ScriptAssist, a treatment compliance company. In addition to the services provided through these acquisitions and NurseWise, our 24-hour telephone triage service, we are considering other lines of business that would complement our core business. We believe we have opportunities to offer these services to other healthcare organizations, states and other commercial entities.
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MEDICAID MANAGED CARE
Health Plans
We have regulated subsidiaries offering healthcare services in each state we serve. We have never been denied a contract renewal from a state in which we do business. The table below provides summary data for the state markets we currently serve.
Local Health Plan Name
First Year of Operations
Counties Served at December 31, 2005
Membership at December 31, 2005
States
Our ability to establish and maintain a leadership position in the markets we serve results primarily from our demonstrated success in providing quality care while reducing and managing costs, and from our customer-focused approach to working with state governments. Among the benefits we are able to provide to the states with which we contract are:
• significant cost savings compared to fee-for-service
• timely payment of provider claims
• data-driven approaches to balance cost and verify eligibility
• cost saving outreach and specialty programs
• establishment of realistic and meaningful expectations for quality deliverables
• responsible collection and dissemination of encounter data
• managed care expertise in government subsidized programs
• timely and accurate reporting
• improved medical outcomes
Member Programs and Services
We recognize the importance of member-focused delivery of quality managed care services. Our locally based staff assist members in accessing care, coordinating referrals to related health and social services and addressing member concerns and questions. While covered healthcare benefits vary from state to state, our health plans generally provide the following services:
• primary and specialty physician care
• 24-hour nurse advice line
• inpatient and outpatient hospital care
• transportation assistance
• emergency and urgent care
• vision care
• prenatal care
• dental care
• laboratory and x-ray services
• immunizations
• home health and durable medical equipment
• prescriptions and limited over-the-counter drugs
• behavioral health and substance abuse services
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We also provide the following education and outreach programs to inform and assist members in accessing quality, appropriate healthcare services in an efficient manner:
Providers
For each of our service areas, we establish a provider network consisting of primary and specialty care physicians, hospitals and ancillary providers. As of December 31, 2005, our health plans contracted with the following number of physicians and hospitals:
Indiana
Kansas
Missouri
New Jersey
Ohio
Texas
Wisconsin
The primary care physician is a critical component in care delivery, management of costs and the attraction and retention of new members. Primary care physicians include family and general practitioners, pediatricians, internal medicine physicians and OB/GYNs. Specialty care physicians provide medical care to members generally upon referral by the primary care physicians.
We work with physicians to help them operate efficiently by providing financial and utilization information, physician and patient educational programs and disease and medical management programs. In addition, we are governed by state prompt payment policies. Our programs are also designed to help the physicians coordinate care outside of their offices.
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We believe our collaborative approach with physicians gives us a competitive advantage in entering new markets. Our physicians serve on local committees that assist us in implementing preventive care programs, managing costs and improving the overall quality of care delivered to our members. The following are among the services we provide to support physicians:
Our contracted physicians also benefit from several of the services offered to our members, including the CONNECTIONS, EPSDT case management and disease management programs. For example, the CONNECTIONS staff facilitate doctor/patient relationships by connecting members with physicians, the EPSDT programs encourage routine checkups for children with their physicians and the disease management programs assist physicians in managing their patients with chronic disease.
We provide access to healthcare services for our members primarily through contracts with our providers. Our contracts with primary and specialty care physicians and hospitals usually are for one to two-year periods and renew automatically for successive one-year terms, but generally are subject to termination by either party upon 90 to 120 days prior written notice. In the absence of a contract, we typically pay providers at state Medicaid reimbursement levels. We pay physicians under a capitated or fee-for-service arrangement.
Where appropriate, our health plans utilize Cenpatico to provide behavioral health services. We also contract with third-party providers on a negotiated fee arrangement for physical therapy, home healthcare, vision care, diagnostic laboratory tests, x-ray examinations, ambulance services and durable medical equipment. Additionally, we contract with dental vendors in markets where routine dental care is a covered benefit. In our health plans, where prescription and limited over-the-counter drugs are a covered benefit, we have fee-for-service arrangements with national pharmacy vendors that provide a pharmacy network. Beginning in 2006, we intend to move our pharmacy network to US Script, the PBM we acquired in January 2006.
Quality Management
Our medical management programs focus on improving quality of care in areas that have the greatest impact on our members. We employ strategies, including disease management and complex case management, that are
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fine-tuned for implementation in our individual markets by a system of physician committees chaired by local physician leaders. This process promotes physician participation and support, both critical factors in the success of any clinical quality improvement program.
We have implemented specialized information systems to support our medical quality management activities. Information is drawn from our data warehouse, clinical databases and our membership and claims processing system, as sources to identify opportunities to improve care and to track the outcomes of the interventions implemented to achieve those improvements. Some examples of these intervention programs include:
We provide reporting on a regular basis using our data warehouse. State and Health Employer Data and Information Set, or HEDIS, reporting constitutes the core of the information base that drives our clinical quality performance efforts. This reporting is monitored by Plan Quality Improvement Committees and our corporate medical management team.
In order to ensure the quality of our provider networks, we verify the credentials and background of our providers using standards that are supported by the National Committee for Quality Assurance.
Management Information Systems
The ability to access data and translate it into meaningful information is essential to operating across a multi-state service area in a cost-effective manner. Our centralized information systems which are located in St. Louis, Missouri, support our core processing functions under a set of integrated databases and are designed to be both replicable and scalable to accommodate internal growth and growth from acquisitions. We have the ability to leverage the platform we have developed for our existing states for configuration into new states or health plan acquisitions.
Our integrated approach helps to assure that consistent sources of claim and member information are provided across all of our health plans. Our membership and claims processing system is capable of expanding to support additional members in an efficient manner as needed.
We have a disaster recovery and business resumption plan developed and implemented in conjunction with a third party. This plan allows us complete access to the business resumption centers and hot-site facilities provided by the plan.
SPECIALTY SERVICES
Our Specialty Services segment is a key component of our healthcare enterprise and complements our core Medicaid Managed Care business. The specialty services diversify our revenue stream, provide higher quality health outcomes to our membership and others, and effectively control costs. Our specialty services are provided primarily through the following interrelated businesses:
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CORPORATE COMPLIANCE
Our Corporate Ethics and Compliance Program was first established in 1998 and provides methods by which we further enhance operations, safeguard against fraud and abuse, improve access to quality care and helps assure that our values are reflected in everything we do.
The two primary standards by which corporate compliance programs in the healthcare industry are measured are the 1991 Federal Organizational Sentencing Guidelines and the “Compliance Program Guidance” series issued by the Office of the Inspector General, or OIG, of the Department of Health and Human Services.
Our program contains each of the seven elements suggested by the Sentencing Guidelines and the OIG guidance. These key components are:
Our internal Corporate Compliance website, accessible by all employees, contains our Business Ethics and Conduct Policy; our Mission, Values and Philosophies and Compliance Programs; a company-wide policy and
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procedure database and our toll-free hotline to allow employees or other persons to report suspected incidents of fraud, abuse or other violations. The audit committee and the board of directors review a full compliance report, including an incident log, on a quarterly basis.
COMPETITION
In our business, our principal competitors for state contracts, members and providers consist of the following types of organizations:
We will continue to face varying levels of competition as we expand in our existing service areas or enter new markets as federal regulations require at least two competitors in each service area. Healthcare reform proposals may cause a number of commercial managed care organizations already in our service areas to decide to enter or exit the Medicaid market. The licensing requirements and bidding and contracting procedures in some states, in the absence of specific healthcare experience, however, present barriers to entry into the Medicaid managed healthcare industry.
We compete with other managed care organizations and specialty companies for state contracts. In order to grant a contract, state governments consider many factors. These factors include quality of care, financial requirements, an ability to deliver services and establish provider networks and infrastructure.
We also compete to enroll new members and retain existing members. People who wish to enroll in a managed healthcare plan or to change healthcare plans typically choose a plan based on the quality of care and services offered, ease of access to services, a specific provider being part of the network and the availability of supplemental benefits. In certain markets, where recipients select a physician instead of a health plan, we are able to grow our membership by adding new physicians to our provider base.
We also compete with other managed care organizations to enter into contracts with physicians, physician groups and other providers. We believe the factors that providers consider in deciding whether to contract with us include existing and potential member volume, reimbursement rates, medical management programs, speed of reimbursement and administrative service capabilities.
FINANCIAL INFORMATION
All of our revenue is derived from operations within the United States and its territories. Our managed care subsidiaries in Indiana, Kansas, Texas and Wisconsin have revenues from their respective state governments that each exceeded 10% of our consolidated total revenues in 2005. Other financial information about our segments is found in Note 17 of our Notes to Consolidated Financial Statements included elsewhere in this Form 10-K.
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REGULATION
Our healthcare and specialty operations are regulated at both state and federal levels. Government regulation of the provision of healthcare products and services is a changing area of law that varies from jurisdiction to jurisdiction. Regulatory agencies generally have discretion to issue regulations and interpret and enforce laws and rules. Changes in applicable laws and rules also may occur periodically.
Our regulated subsidiaries are licensed to operate as health maintenance organizations and/or insurance companies in their respective states. In each of the jurisdictions in which we operate, we are regulated by the relevant health, insurance and/or human services departments that oversee the activities of managed care organizations providing or arranging to provide services to Medicaid enrollees.
The process for obtaining authorization to operate as a managed care organization is lengthy and involved and requires demonstration to the regulators of the adequacy of the health plan’s organizational structure, financial resources, utilization review, quality assurance programs, complaint procedures, provider network adequacy and procedures for covering emergency medical conditions. Under both state managed care organization statutes and state insurance laws, our health plan subsidiaries must comply with minimum statutory capital requirements and other financial requirements, such as deposit and reserve requirements. Insurance regulations may also require prior state approval of acquisitions of other managed care organizations’ businesses and the payment of dividends, as well as notice for loans or the transfer of funds. Our subsidiaries are also subject to periodic reporting requirements. In addition, each health plan must meet criteria to secure the approval of state regulatory authorities before implementing operational changes, including the development of new product offerings and, in some states, the expansion of service areas.
States have adopted a number of new regulations that may affect our business and results of operations. These regulations in certain states include:
State Contracts
In order to be a Medicaid Managed Care organization in each of the states in which we operate, we must operate under a contract with the state’s Medicaid agency. States generally use either a formal proposal process, reviewing a number of bidders, or award individual contracts to qualified applicants that apply for entry to the program. We receive monthly payments based on specified capitation rates determined on an actuarial basis. These rates differ by membership category and by state depending on the specific benefits and policies adopted by each state.
During 2005, we entered into a contract with the Arizona Department of Health Services / Division of Behavioral Health Services to provide behavioral healthcare services through our subsidiary, Cenpatico. The contract commenced July 1, 2005 and has an initial termination date of June 30, 2008. The contract may be extended for up to two additional years. The contract may be terminated by the state for non-performance or mutual agreement of the parties.
During 2005, we entered into a contract with the Georgia Department of Community Health to provide healthcare benefits and services through our subsidiary, Peach State Health Plan. The contract commenced on July 1, 2005 with membership operations to commence in 2006. The contract has an initial scheduled termination date of June 30, 2006, with six one-year renewal options. The contract may be terminated by the State for event of default or significant changes in circumstances.
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During 2004, we entered into a contract with the Indiana Office of Medicaid Policy and Planning and Office of the Children’s Health Insurance Program to provide Indiana Medicaid and Indiana Children’s Health Insurance Program services through our subsidiary, Coordinated Care Corporation Indiana, Inc. The contract commenced January 1, 2005 and has a scheduled termination date of December 31, 2006. This contract may be terminated by the State without cause upon sixty days prior written notice. We have held a contract with the State of Indiana since 1993.
With the acquisition of FirstGuard, we have a contract with the State of Kansas, Department of Social and Rehabilitation Services to provide Medicaid and SCHIP services. The contract commenced on July 1, 2001 and has been renewed through June 30, 2006. The contract may be terminated by the State for event of default or significant change in circumstances. FirstGuard has held a contract with the State of Kansas since 1999.
We have entered into a contract with the State of Kansas, Director of Health Policy and Finance to provide behavioral healthcare services through our subsidiary, Cenpatico. The contract commenced January 1, 2005 and has a scheduled termination date of December 31, 2006. The contract may be terminated by the state for cause, without cause upon thirty days prior written notice or for lack of federal funding. Cenpatico has held a contract with the State of Kansas since 2005.
Additionally, with the acquisition of FirstGuard, we have a contract with the State of Missouri, Office of Administration, Division of Purchasing and Materials Management to provide Medicaid and SCHIP services. The contract commenced on January 1, 2004 and has been renewed through June 30, 2006. The contract may be terminated by the State for event of default or significant change in circumstances. FirstGuard has held a contract with the State of Missouri since 1997.
We have a contract with the State of New Jersey Department of Human Services to provide Medicaid and SCHIP services through our subsidiary, University Health Plans (UHP). The contract commenced on July 1, 2002 and has been renewed through June 30, 2006. The agreement is renewable annually for successive twelve-month periods. The contract may be terminated by the State for event of default or significant change in circumstances. UHP has held a contract with the State of New Jersey since 1994.
We have entered into a contract with the Ohio Department of Job and Family Services to provide Medicaid services through our subsidiary, Buckeye Community Health Plan. The contract commenced July 1, 2004 and has been renewed through June 30, 2006. The agreement is renewable annually for successive twelve-month periods. The contract may be terminated by the State for event of default. We have held a contract with the State of Ohio since January 2004.
We presently are party to several contracts with the Texas Health and Human Services Commission (HHSC) to provide Medicaid and SCHIP managed care services in our Texas markets through our Superior HealthPlan, Inc. subsidiary. In December 2005, we entered into a Medicaid/CHIP HMO managed care contract between HHSC and Superior. The operational start date, the date membership operations commence under the contract, is September 1, 2006 and the contract has a scheduled termination date of August 31, 2008. The agreement is renewable for an additional period or periods not to exceed a total term of eight years. Our current Texas Medicaid and SCHIP contracts commenced September 1, 2004 and have been renewed through August 31, 2006. The contracts generally may be terminated upon any event of default or in the event state or federal funding for Medicaid programs is no longer available. We have held a contract with the State of Texas since 1999.
We have entered into an Exclusive Provider Organization (EPO) contract with the Texas Health and Human Services Commission to provide SCHIP managed care services in Texas through our Bankers Reserve subsidiary, d/b/a Superior HealthPlan Network. The contract commenced on September 1, 2004 and is scheduled to end on August 31, 2007. Upon mutual consent the agreement is renewable for a period or periods, but the contract term may not exceed six years. The contract generally may be terminated upon any event of default or in the event state or federal funding for Medicaid programs is no longer available.
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We have entered into a contract with the Wisconsin Department of Health and Family Services to provide Medicaid and SCHIP services. The contract commenced February 1, 2006 and has a scheduled termination date of December 31, 2007. This contract is renewable for an additional one-year term. The contract can be terminated if a change in state or federal laws, rules or regulations materially affects either party’s rights or responsibilities under the contract. We have held a contract with the State of Wisconsin since 1984.
We have also entered into an agreement with Network Health Plan of Wisconsin, Inc. pursuant to which Network Health Plan subcontracts to us its Medicaid and SCHIP services under its contract with the State of Wisconsin. The agreement commenced January 1, 2001 and has a scheduled termination of December 31, 2011. The agreement renews automatically for successive five-year terms and can be terminated by either party upon two-years notice prior to the end of the then current term. The agreement may also be terminated if a change in state or federal laws, rules or regulations materially affects either party’s rights or responsibilities under the contract, or if Network Health Plan’s contract with the State of Wisconsin is terminated.
Our contracts with the states and regulatory provisions applicable to us generally set forth in great detail the requirements for operating in the Medicaid sector, including provisions relating to:
• eligibility, enrollment and disenrollment processes;
• health education and wellness and prevention programs;
• covered services;
• timeliness of claims payment;
• eligible providers;
• financial standards;
• subcontractors;
• safeguarding of member information;
• record-keeping and record retention;
• fraud and abuse detection and reporting;
• periodic financial and informational reporting;
• grievance procedures; and
• quality assurance;
• organization and administrative systems.
A health plan’s compliance with these requirements is subject to monitoring by state regulators and by CMS. A health plan is also subject to periodic comprehensive quality assurance evaluations by a third-party reviewing organization and generally by the insurance department of the jurisdiction that licenses the health plan. A health plan must also submit reports to various regulatory agencies, including quarterly and annual statutory financial statements and utilization reports.
HIPAA
In 1996, Congress enacted the Health Insurance Portability and Accountability Act of 1996, or HIPAA. The Act is designed to improve the portability and continuity of health insurance coverage and simplify the administration of health insurance claims. Among the main requirements of HIPAA are standards for the processing of health insurance claims and related transactions.
The regulation’s requirements apply to transactions conducted using “electronic media.” Since “electronic media” is defined broadly to include “transmissions that are physically moved from one location to another using magnetic tape, disk or compact disk media,” many communications are considered to be electronically transmitted. Under the HIPAA regulations, health plans are required to have the capacity to accept and send all covered transactions in a standardized electronic format. Penalties can be imposed for failure to comply with these requirements.
HIPAA regulations also protect the privacy of medical records and other personal health information maintained and used by healthcare providers, health plans and healthcare clearinghouses. We have implemented processes, policies and procedures to comply with the HIPAA privacy regulations, including educating and training for employees. In addition, the corporate privacy officer and health plan privacy officials serve as
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resources to employees to address any questions or concerns they may have. Among numerous other requirements, the privacy regulations:
The preemption provisions of HIPAA provide that the federal standards will not preempt state laws that are more stringent than the related federal requirements. In addition, the Secretary of HHS may grant exceptions allowing state laws to prevail if one or more of a number of conditions are met, including but not limited to the following:
In 2003, HHS published final regulations relating to the security of electronic individually identifiable health information. Compliance was required by April 2005. These rules require healthcare providers, health plans and healthcare clearinghouses to implement administrative, physical and technical safeguards to ensure the privacy and confidentiality of such information when it is electronically stored, maintained or transmitted through such devices as user authentication mechanisms and system activity audits. In addition, numerous states have adopted personal data security laws that provide for, among other things, private rights of action for breaches of data security and mandatory notification to persons whose identifiable information is obtained without authorization.
Patients’ Rights Legislation
The United States Senate and House of Representatives passed different versions of patients’ rights legislation in June and August 2001, respectively. Both versions included provisions that specifically apply protections to participants in federal healthcare programs, including Medicaid beneficiaries. Although no such federal legislation has been enacted, patients’ rights legislation is frequently proposed in Congress. If enacted, this type of legislation could expand our potential exposure to lawsuits and increase our regulatory compliance costs. Depending on the final form of any patients’ rights legislation, such legislation could, among other things, expose us to liability for economic and punitive damages for making determinations that deny benefits or delay beneficiaries’ receipt of benefits as a result of our medical necessity or other coverage determinations. We cannot predict when or whether patients’ rights legislation will be enacted into law or, if enacted, what final form such legislation might take.
Other Fraud and Abuse Laws
Investigating and prosecuting healthcare fraud and abuse became a top priority for law enforcement entities in the last decade. The focus of these efforts has been directed at participants in public government healthcare programs such as Medicaid. The laws and regulations relating to Medicaid fraud and abuse and the contractual requirements applicable to health plans participating in these programs are complex and changing and may require substantial resources.
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EMPLOYEES
As of December 31, 2005, we had approximately 1,800 employees. Our employees are not represented by a union. We believe our relationships with our employees are good.
EXECUTIVE OFFICERS
The following table sets forth information regarding our executive officers, including their ages at January 31, 2006:
Name
Position
Michael F. Neidorff
Chairman and Chief Executive Officer
Joseph P. Drozda, Jr., M.D.
Executive Vice President, Chief Medical Officer
James D. Donovan, Jr.
Senior Vice President, Health Plans
Marie J. Glancy
Senior Vice President, Operational Services and Regulatory Affairs
Carol E. Goldman
Senior Vice President, Chief Administration Officer
Cary D. Hobbs
Senior Vice President, Strategy and Business Implementation
William N. Scheffel
Senior Vice President, Specialty Companies
Lisa M. Wilson
Senior Vice President, Investor Relations
Karey L. Witty
Senior Vice President, Chief Financial Officer, Secretary and Treasurer
Michael F. Neidorff has served as our Chairman of our board of directors and Chief Executive Officer since May 2004. From May 1996 to May 2004 Mr. Neidorff served as President, Chief Executive Officer and as a member of our board of directors. From May 1996 to November 2001, Mr. Neidorff also served as our Treasurer. From 1995 to 1996, Mr. Neidorff served as a Regional Vice President of Coventry Corporation, a publicly traded managed care organization, and as the President and Chief Executive Officer of one of its subsidiaries, Group Health Plan, Inc. From 1985 to 1995, Mr. Neidorff served as the President and Chief Executive Officer of Physicians Health Plan of Greater St. Louis, a subsidiary of United Healthcare Corp., a publicly traded managed care organization now known as UnitedHealth Group Incorporated.
Joseph P. Drozda, Jr., M.D. has served as our Executive Vice President, Chief Medical Officer since May 2005. Dr. Drozda served as our Executive Vice President, Operations from September 2003 through May 2005. Dr. Drozda served as our Senior Vice President, Medical Affairs from November 2000 through August 2003 and as our part-time Medical Director from January 2000 through October 2000. From June 1999 to October 2000, Dr. Drozda was self-employed as a consultant to managed care organizations, physician groups, hospital networks and employer groups on a variety of managed care delivery and financing issues.
James D. Donovan, Jr., MPH has served as our Senior Vice President, Health Plans since May 2005 and as our Senior Vice President, New Products and New Markets from September 2004 through May 2005. From September 1995 to March 2004, Mr. Donovan served as Chief Executive Officer of Amerigroup Texas, Inc., a subsidiary of Amerigroup Corporation. From 1973 to August 1995, Mr. Donovan served in a variety of roles for Kaiser Permanente Medical Care Program, a not-for-profit managed care organization.
Marie J. Glancy has served as our Senior Vice President, Operational Services and Regulatory Affairs since February 2006. Ms. Glancy served as our Senior Vice President, Government Relations from January 2005 to February 2006 and as our Vice President, Government Relations from July 2003 to January 2005. From 1996 to July 2003, Ms. Glancy served as a public policy executive for Deere and Company.
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Carol E. Goldman has served as Senior Vice President, Chief Administration Officer since July 2002. From September 2001 to July 2002, Ms. Goldman served as our Plan Director of Human Resources. From 1998 to August 2001, Ms. Goldman was Human Resources Manager at Mallinckrodt Inc., a medical device and pharmaceutical company.
Cary D. Hobbs has served as our Senior Vice President, Strategy and Business Implementation since January 2004. She served as our Vice President of Strategy and Business Implementation from September 2002 to January 2004 and as our Director of Business Implementation from 1997 to August 2002.
William N. Scheffel has served as our Senior Vice President, Specialty Companies since May 2005 and as our Senior Vice President and Controller from December 2003 to May 2005. From July 2002 to October 2003, Mr. Scheffel was a partner with Ernst & Young LLP. From 1975 to July 2002, Mr. Scheffel was with Arthur Andersen LLP. Mr. Scheffel is a Certified Public Accountant.
Lisa M. Wilson has served as our Senior Vice President, Investor Relations since January 2005 and as our Vice President, Investor Relations from March 2004 to January 2005. Ms. Wilson previously worked as a consultant for us since our initial public offering in 2001. From 1995 to March 2004, Ms. Wilson served as the founder and President of In-Site Communications, an investor relations firm in New York, New York.
Karey L. Witty has served as our Senior Vice President and Chief Financial Officer since August 2000, as our Secretary since February 2000 and as our Treasurer since November 2001. From March 1999 to August 2000, Mr. Witty served as our Vice President of Health Plan Accounting. From 1996 to March 1999, Mr. Witty was Controller of Heritage Health Systems, Inc., a healthcare company in Nashville, Tennessee. Mr. Witty is a Certified Public Accountant.
Information concerning our executive officers’ compliance with Section 16(a) of the Securities Exchange Act will appear in our Proxy Statement for our 2006 annual meeting of stockholders under “Section 16(a) Beneficial Ownership Reporting Compliance.” These portions of our Proxy Statement are incorporated herein by reference. Information concerning our audit committee financial expert and identification of our audit committee will appear in our Proxy Statement for our 2006 annual meeting of stockholders under “Information about Corporate Governance.” Information concerning our code of ethics will appear in our Proxy Statement for our 2006 annual meeting of stockholders under “Code of Business Conduct and Ethics.”
Item 1A. Risk Factors
FACTORS THAT MAY AFFECT FUTURE RESULTS AND THE
TRADING PRICE OF OUR COMMON STOCK
You should carefully consider the risks described below before making an investment decision. The trading price of our common stock could decline due to any of these risks, in which case you could lose all or part of your investment. You should also refer to the other information in this filing, including our consolidated financial statements and related notes. The risks and uncertainties described below are those that we currently believe may materially affect our Company. Additional risks and uncertainties that we are unaware of or that we currently deem immaterial also may become important factors that affect our Company.
Risks Related to Being a Regulated Entity
Reduction in Medicaid, SCHIP and SSI Funding Could Substantially Reduce Our Profitability.
Most of our revenues come from Medicaid, SCHIP and SSI premiums. The base premium rate paid by each state differs, depending on a combination of factors such as defined upper payment limits, a member’s health status, age, gender, county or region, benefit mix and member eligibility categories. Future levels of Medicaid,
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SCHIP and SSI funding and premium rates may be affected by continued government efforts to contain medical costs and may further be affected by state and federal budgetary constraints. For example, in August 2004, the Centers for Medicare & Medicaid Services, or CMS, proposed a rule that would have required states to estimate improper payments made under their Medicaid and SCHIP programs, report such overpayments to Congress, and, if necessary, take actions to reduce erroneous payments. In October 2005, CMS announced an interim rule under which a CMS contractor will randomly select states for review once every three years to estimate each state’s rate of erroneous payments, the federal share of which the states will be required to return to CMS.
In February 2005, the Bush administration called for changes in Medicaid that would cut payments for prescription drugs and give states new power to reduce or reconfigure benefits. The Bush administration has also proposed to reduce total federal funding for the Medicaid program, by $10 billion over the next five years and both the House of Representatives and the Senate have approved budget bills containing Medicaid reductions. Some states, including Texas, have been authorized to implement special measures to accommodate the arrival of large numbers of beneficiaries from Gulf Coast areas evacuated as a result of hurricanes Katrina and Rita, but it is unknown whether these measures will be sufficient to cover the additional Medicaid costs incurred by these states. The newly effective Medicare prescription drug benefit is interrupting prescription drug coverage for many Medicaid beneficiaries, prompting several states to pay for prescription drugs on an emergency basis without any assurance of receiving reimbursement from Medicaid.
Changes to Medicaid, SCHIP and SSI programs could reduce the number of persons enrolled or eligible, reduce the amount of reimbursement or payment levels, or increase our administrative or healthcare costs under those programs. States periodically consider reducing or reallocating the amount of money they spend for Medicaid, SCHIP and SSI. In recent years, the majority of states have implemented measures to restrict Medicaid, SCHIP and SSI costs and eligibility. We believe that reductions in Medicaid, SCHIP and SSI payments could substantially reduce our profitability. Further, our contracts with the states are subject to cancellation by the state after a short notice period in the event of unavailability of state funds.
If Our Medicaid and SCHIP Contracts are Terminated or are Not Renewed, Our Business Will Suffer.
We provide managed care programs and selected services to individuals receiving benefits under federal assistance programs, including Medicaid, SSI and SCHIP. We provide those healthcare services under contracts with regulatory entities in the areas in which we operate. The contracts expire on various dates between June 30, 2006 and August 31, 2008. Our contracts may be terminated if we fail to perform up to the standards set by state regulatory agencies. In addition, the Indiana contract under which we operate can be terminated by the State without cause. Our contracts are generally intended to run for one or two years and may be extended for one or two additional years if the state or its contractor elects to do so. When our contracts expire, they may be opened for bidding by competing healthcare providers. There is no guarantee that our contracts will be renewed or extended. If any of our contracts are terminated, not renewed, or renewed on less favorable terms, our business will suffer, and our operating results may be materially affected.
Changes in Government Regulations Designed to Protect the Financial Interests of Providers and Members Rather than Our Stockholders Could Force Us to Change How We Operate and Could Harm Our Business.
Our business is extensively regulated by the states in which we operate and by the federal government. The applicable laws and regulations are subject to frequent change and generally are intended to benefit and protect the financial interests of health plan providers and members rather than stockholders. Changes in existing laws and rules, the enactment of new laws and rules or changing interpretations of these laws and rules could, among other things:
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For example, Congress has considered various forms of patient protection legislation commonly known as the Patients’ Bill of Rights and such legislation is frequently proposed in Congress. We cannot predict the impact of this legislation, if adopted, on our business.
Regulations May Decrease the Profitability of Our Health Plans.
Our Texas plan is required to pay a rebate to the State in the event profits exceed established levels. Similarly, our New Jersey plan is required to pay a rebate to the State in the event its health benefits ratio is less than 80%. These regulatory requirements, changes in these requirements or the adoption of similar requirements by our other regulators may limit our ability to increase our overall profits as a percentage of revenues. The states of Indiana, New Jersey and Texas have implemented prompt-payment laws and are enforcing penalty provisions for failure to pay claims in a timely manner. Failure to meet these requirements can result in financial fines and penalties. In addition, states may attempt to reduce their contract premium rates if regulators perceive our health benefits ratio as too low. Any of these regulatory actions could harm our operating results.
In recent years, CMS has reduced the rates at which states are permitted to reimburse non-state government-owned or operated hospitals for inpatient and outpatient hospital services, with the upper payment limit decreasing to 100% of Medicare payments for comparable services. Any further reductions in this limit could decrease the profitability of our health plans.
Failure to Comply With Government Regulations Could Subject Us to Civil and Criminal Penalties.
Federal and state governments have enacted fraud and abuse laws and other laws to protect patients’ privacy and access to healthcare. Violation of these and other laws or regulations governing our operations or the operations of our providers could result in the imposition of civil or criminal penalties, the cancellation of our contracts to provide services, the suspension or revocation of our licenses or our exclusion from participating in the Medicaid, SSI and SCHIP programs. If we were to become subject to these penalties or exclusions as the result of our actions or omissions or our inability to monitor the compliance of our providers, it would negatively affect our ability to operate our business. For example, failure to pay our providers promptly could result in the imposition of fines and other penalties. In some states, we may be subject to regulation by more than one governmental authority, which may impose overlapping or inconsistent regulations.
The Health Insurance Portability and Accountability Act of 1996, or HIPAA, broadened the scope of fraud and abuse laws applicable to healthcare companies. HIPAA created civil penalties for, among other things, billing for medically unnecessary goods or services. HIPAA established new enforcement mechanisms to combat fraud and abuse. Further, HIPAA imposes civil and, in some instances, criminal penalties for failure to comply with specific standards relating to the privacy, security and electronic transmission of most individually identifiable health information. It is possible that Congress may enact additional legislation in the future to increase penalties and to create a private right of action under HIPAA, which could entitle patients to seek monetary damages for violations of the privacy rules.
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We May Incur Significant Increased Costs as a Result of Compliance With New Government Regulations and Our Management Will Be Required to Devote Time to Compliance.
The issuance of future judicial or regulatory guidance regarding the interpretation of regulations, the states’ ability to promulgate stricter rules and continuing uncertainty regarding many aspects of the regulations’ implementation may make compliance with this regulatory landscape difficult. For example, our existing programs and systems may not enable us to comply in all respects with recent security regulations. In order to comply with new regulatory requirements, we were required to employ additional or different programs and systems. Further, compliance with new regulations could require additional changes to many of the procedures we currently use to conduct our business, which may lead to additional costs that we have not yet identified. We do not know whether, or the extent to which, we will be able to recover from the states our costs of complying with these new regulations. The new regulations and the related compliance costs could have a material adverse effect on our business.
In addition, the Sarbanes-Oxley Act, as well as rules subsequently implemented by the SEC and the New York Stock Exchange, or the NYSE, have imposed various requirements on public companies, including requiring changes in corporate governance practices. Our management and other personnel will continue to devote time to these new compliance initiatives. Moreover, these rules and regulations will increase our legal and financial compliance costs and will make some activities more time-consuming and costly.
The Sarbanes-Oxley Act requires, among other things, that we maintain effective internal control over financial reporting. In particular, we must perform system and process evaluation and testing of our internal controls over financial reporting to allow management to report on the effectiveness of our internal controls over our financial reporting as required by Section 404 of the Sarbanes-Oxley Act. Our testing, or the subsequent testing by our independent registered public accounting firm, may reveal deficiencies in our internal controls over financial reporting that are deemed to be material weaknesses. Our compliance with Section 404 requires that we incur substantial accounting expense and expend significant management efforts. Moreover, if we are not able to comply with the requirements of Section 404, or if we or our independent registered public accounting firm identifies deficiencies in our internal control over financial reporting that are deemed to be material weaknesses, the market price of our stock could decline and we could be subject to sanctions or investigations by the NYSE, SEC or other regulatory authorities, which would require additional financial and management resources.
Changes in Healthcare Law and Benefits May Reduce Our Profitability.
Numerous proposals relating to changes in healthcare law have been introduced, some of which have been passed by Congress and the states in which we operate or may operate in the future. Changes in applicable laws and regulations are continually being considered, and interpretations of existing laws and rules may also change from time to time. We are unable to predict what regulatory changes may occur or what effect any particular change may have on our business. For example, these changes could reduce the number of persons enrolled or eligible for Medicaid, reduce the reimbursement or payment levels for medical services or reduce benefits included in Medicaid coverage. More generally, we are unable to predict whether new laws or proposals will favor or hinder the growth of managed healthcare. Legislation or regulations that require us to change our current manner of operation, benefits provided or our contract arrangements may seriously harm our operations and financial results.
If a State Fails to Renew a Required Federal Waiver for Mandated Medicaid Enrollment into Managed Care or Such Application is Denied, Our Membership in That State Will Likely Decrease.
States may administer Medicaid managed care programs pursuant to demonstration programs or required waivers of federal Medicaid standards. Waivers and demonstration programs are generally approved for two-year periods and can be renewed on an ongoing basis if the state applies. We have no control over this renewal
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process. If a state does not renew such a waiver or demonstration program or the Federal government denies a state’s application for renewal, membership in our health plan in the state could decrease and our business could suffer.
Changes in Federal Funding Mechanisms May Reduce Our Profitability.
The Bush Administration has proposed a major long-term change in the way Medicaid and SCHIP are funded. The proposal, if adopted, would allow states to elect to receive, instead of federal matching funds, combined Medicaid-SCHIP “allotments” for acute and long-term healthcare for low-income, uninsured persons. Participating states would be given flexibility in designing their own health insurance programs, subject to federally-mandated minimum coverage requirements. It is uncertain whether this proposal will be enacted. Accordingly, it is unknown whether or how many states might elect to participate or how their participation may affect the net amount of funding available for Medicaid and SCHIP programs. If such a proposal is adopted and decreases the number of persons enrolled in Medicaid or SCHIP in the states in which we operate or reduces the volume of healthcare services provided, our growth, operations and financial performance could be adversely affected.
In April 2004, the Bush Administration adopted a new policy that seeks to reduce states’ use of intergovernmental transfers for the states’ share of Medicaid program funding. By restricting the use of intergovernmental transfers as part of states’ Medicaid contributions, this policy, if continued, may restrict some states’ funding for Medicaid, which could adversely affect our growth, operations and financial performance.
In February 2005, the Bush Administration called for changes in Medicaid that would cut payments for prescription drugs and give states new power to reduce or reconfigure benefits. The Administration has also proposed to reduce total federal funding for the Medicaid program by $10 billion over the next five years, and both the House and the Senate have approved budget bills containing Medicaid reductions. Some states, including Texas, have been authorized to implement special measures to accommodate the arrival of large numbers of beneficiaries from Gulf Coast areas evacuated as a result of hurricanes Katrina and Rita, but it is unknown whether these measures will be sufficient to cover the additional Medicaid costs incurred by these states. Any reduction or reconfiguration of state funding could adversely affect our growth, operations and financial performance.
Recent legislative changes in the Medicare program may also affect our business. For example, the Medicare Prescription Drug, Improvement and Modernization Act of 2003, revised cost-sharing requirements for some beneficiaries and requires states to reimburse the federal Medicare program for costs of prescription drug coverage provided to beneficiaries who are enrolled simultaneously in both the Medicaid and Medicare programs. These changes may reduce the availability of funding for some states’ Medicaid programs, which could adversely affect our growth, operations and financial performance. The new Medicare prescription drug benefit is interrupting the distribution of prescription drugs to many beneficiaries simultaneously enrolled in both Medicaid and Medicare, prompting several states to pay for prescription drugs on an unbudgeted, emergency basis without any assurance of receiving reimbursement from the federal Medicaid program. These expenses may cause some states to divert funds originally intended for other Medicaid services.
If State Regulatory Agencies Require a Statutory Capital Level Higher than the State Regulations, We May be Required to Make Additional Capital Contributions.
Our operations are conducted through our wholly owned subsidiaries, which include HMOs and managed care organizations, or MCOs. HMOs and MCOs are subject to state regulations that, among other things, require the maintenance of minimum levels of statutory capital, as defined by each state. Additionally, state regulatory agencies may require, at their discretion, individual HMOs to maintain statutory capital levels higher than the state regulations. If this were to occur to one of our subsidiaries, we may be required to make additional capital contributions to the affected subsidiary. Any additional capital contribution made to one of the affected subsidiaries could have a material adverse effect on our liquidity and our ability to grow.
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If We Are Unable to Participate in SCHIP Programs, Our Growth Rate May be Limited.
SCHIP is a federal initiative designed to provide coverage for low-income children not otherwise covered by Medicaid or other insurance programs. The programs vary significantly from state to state. Participation in SCHIP programs is an important part of our growth strategy. If states do not allow us to participate or if we fail to win bids to participate, our growth strategy may be materially and adversely affected.
If State Regulators Do Not Approve Payments of Dividends and Distributions by Our Subsidiaries to Us, We May Not Have Sufficient Funds to Implement Our Business Strategy.
We principally operate through our health plan subsidiaries. If funds normally available to us become limited in the future, we may need to rely on dividends and distributions from our subsidiaries to fund our operations. These subsidiaries are subject to regulations that limit the amount of dividends and distributions that can be paid to us without prior approval of, or notification to, state regulators. If these regulators were to deny our subsidiaries’ request to pay dividends to us, the funds available to our Company as a whole would be limited, which could harm our ability to implement our business strategy.
Risks Related to Our Business
Ineffectiveness of State-operated Systems and Subcontractors Could Adversely Affect Our Business
Our health plans rely on other state-operated systems or sub-contractors to qualify, solicit, educate and assign eligible clients into the health plans. The effectiveness of these state operations and sub-contractors can have a material effect on a health plan’s enrollment in a particular month or over an extended period. When a state implements new programs to determine eligibility, new processes to assign or enroll eligible clients into health plans, or chooses new contractors, there is an increased potential for an unanticipated impact on the overall number of members assigned into the health plans.
Failure to Accurately Predict Our Medical Expenses Could Negatively Affect Our Reported Results.
Our medical expenses include estimates of incurred but not reported (IBNR) medical expenses. We estimate our IBNR medical expenses monthly based on a number of factors. Adjustments, if necessary, are made to medical expenses in the period during which the actual claim costs are ultimately determined or when criteria used to estimate IBNR change. We cannot be sure that our IBNR estimates are adequate or that adjustments to those estimates will not harm our results of operations. From time to time in the past, our actual results have varied from our estimates, particularly in times of significant changes in the number of our members. Our failure to estimate IBNR accurately may also affect our ability to take timely corrective actions, further harming our results.
Receipt of Inadequate Premiums Would Negatively Affect Our Revenues and Profitability.
Nearly all of our revenues are generated by premiums consisting of fixed monthly payments per member. These premiums are fixed by contract, and we are obligated during the contract periods to provide healthcare services as established by the state governments. We use a large portion of our revenues to pay the costs of healthcare services delivered to our members. If premiums do not increase when expenses related to medical services rise, our earnings will be affected negatively. In addition, our actual medical services costs may exceed our estimates, which would cause our health benefits ratio, or our expenses related to medical services as a percentage of premium revenue, to increase and our profits to decline. In addition, it is possible for a state to increase the rates payable to the hospitals without granting a corresponding increase in premiums to us. If this were to occur in one or more of the states in which we operate, our profitability would be harmed.
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Failure to Effectively Manage Our Medical Costs or Related Administrative Costs Would Reduce Our Profitability.
Our profitability depends, to a significant degree, on our ability to predict and effectively manage expenses related to health benefits. We have less control over the costs related to medical services than we do over our general and administrative expenses. Because of the narrow margins of our health plan business, relatively small changes in our health benefits ratio can create significant changes in our financial results. Changes in healthcare regulations and practices, the level of use of healthcare services, hospital costs, pharmaceutical costs, major epidemics, new medical technologies and other external factors, including general economic conditions such as inflation levels, are beyond our control and could reduce our ability to predict and effectively control the costs of providing health benefits. We may not be able to manage costs effectively in the future. If our costs related to health benefits increase, our profits could be reduced or we may not remain profitable.
Difficulties in Executing Our Acquisition Strategy Could Adversely Affect Our Business.
Historically, the acquisition of Medicaid businesses, contract rights and related assets of other health plans both in our existing service areas and in new markets has accounted for a significant amount of our growth. Many of the other potential purchasers of Medicaid assets have greater financial resources than we have. In addition, many of the sellers are interested either in (a) selling, along with their Medicaid assets, other assets in which we do not have an interest or (b) selling their companies, including their liabilities, as opposed to the assets of their ongoing businesses.
We generally are required to obtain regulatory approval from one or more state agencies when making acquisitions. In the case of an acquisition of a business located in a state in which we do not currently operate, we would be required to obtain the necessary licenses to operate in that state. In addition, even if we already operate in a state in which we acquire a new business, we would be required to obtain additional regulatory approval if the acquisition would result in our operating in an area of the state in which we did not operate previously, and we could be required to renegotiate provider contracts of the acquired business. We cannot assure you that we would be able to comply with these regulatory requirements for an acquisition in a timely manner, or at all. In deciding whether to approve a proposed acquisition, state regulators may consider a number of factors outside our control, including giving preference to competing offers made by locally owned entities or by not-for-profit entities.
In addition to the difficulties we may face in identifying and consummating acquisitions, we will also be required to integrate and consolidate any acquired business or assets with our existing operations. This may include the integration of:
Accordingly, we may be unable to identify, consummate and integrate future acquisitions successfully or operate acquired businesses profitably. We also may be unable to obtain sufficient additional capital resources for future acquisitions. If we are unable to effectively execute our acquisition strategy, our future growth will suffer and our results of operations could be harmed.
If Competing Managed Care Programs are Unwilling to Purchase Specialty Services From Us, We May Not be Able to Successfully Implement Our Strategy of Diversifying Our Business Lines.
We are seeking to diversify our business lines into areas that complement our Medicaid business in order to grow our revenue stream and balance our dependence on Medicaid risk reimbursement. In 2005, for example, we
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acquired Airlogix, Inc., a disease management company. In order to diversify our business, we must succeed in selling the services of our specialty subsidiaries not only to our managed care plans, but to programs operated by third-parties. Some of these third-party programs may compete with us in some markets, and they therefore may be unwilling to purchase specialty services from us. In any event, the offering of these services will require marketing activities that differ significantly from the manner in which we seek to increase revenues from our Medicaid programs. Our inability to market specialty services to other programs may impair our ability to execute our business strategy.
Failure to Achieve Timely Profitability in Any Business Would Negatively Affect Our Results of Operations.
Start-up costs associated with a new business can be substantial. For example, in order to obtain a certificate of authority in most jurisdictions, we must first establish a provider network, have systems in place and demonstrate our ability to obtain a state contract and process claims. If we were unsuccessful in obtaining the necessary license, winning the bid to provide service or attracting members in numbers sufficient to cover our costs, any new business of ours would fail. We also could be obligated by the state to continue to provide services for some period of time without sufficient revenue to cover our ongoing costs or recover start-up costs. The expenses associated with starting up a new business could have a significant impact on our results of operations if we are unable to achieve profitable operations in a timely fashion.
We Derive a Majority of Our Premium Revenues From Operations in a Small Number of States, and Our Operating Results Would be Materially Affected by a Decrease in Premium Revenues or Profitability in Any One of Those States.
Operations in Arizona, Indiana, Kansas, Missouri, New Jersey, Ohio, Texas and Wisconsin have accounted for most of our premium revenues to date. If we were unable to continue to operate in each of those states or if our current operations in any portion of one of those states were significantly curtailed, our revenues could decrease materially. Our reliance on operations in a limited number of states could cause our revenue and profitability to change suddenly and unexpectedly depending on legislative actions, economic conditions and similar factors in those states. Our inability to continue to operate in any of the states in which we operate would harm our business.
Competition May Limit Our Ability to Increase Penetration of the Markets That We Serve.
We compete for members principally on the basis of size and quality of provider network, benefits provided and quality of service. We compete with numerous types of competitors, including other health plans and traditional state Medicaid programs that reimburse providers as care is provided. Subject to limited exceptions by federally approved state applications, the federal government requires that there be choices for Medicaid recipients among managed care programs. Voluntary programs and mandated competition may limit our ability to increase our market share.
Some of the health plans with which we compete have greater financial and other resources and offer a broader scope of products than we do. In addition, significant merger and acquisition activity has occurred in the managed care industry, as well as in industries that act as suppliers to us, such as the hospital, physician, pharmaceutical, medical device and health information systems businesses. To the extent that competition intensifies in any market that we serve, our ability to retain or increase members and providers, or maintain or increase our revenue growth, pricing flexibility and control over medical cost trends may be adversely affected.
In addition, in order to increase our membership in the markets we currently serve, we believe that we must continue to develop and implement community-specific products, alliances with key providers and localized outreach and educational programs. If we are unable to develop and implement these initiatives, or if our competitors are more successful than we are in doing so, we may not be able to further penetrate our existing markets.
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If We are Unable to Maintain Relationships With Our Provider Networks, Our Profitability May be Harmed.
Our profitability depends, in large part, upon our ability to contract favorably with hospitals, physicians and other healthcare providers. Our provider arrangements with our primary care physicians, specialists and hospitals generally may be cancelled by either party without cause upon 90 to 120 days prior written notice. We cannot assure you that we will be able to continue to renew our existing contracts or enter into new contracts enabling us to service our members profitably.
From time to time providers assert or threaten to assert claims seeking to terminate noncancelable agreements due to alleged actions or inactions by us. Even if these allegations represent attempts to avoid or renegotiate contractual terms that have become economically disadvantageous to the providers, it is possible that in the future a provider may pursue such a claim successfully. In addition, we are aware that other managed care organizations have been subject to class action suits by physicians with respect to claim payment procedures, and we may be subject to similar claims. Regardless of whether any claims brought against us are successful or have merit, they will still be time-consuming and costly and could distract our management’s attention. As a result, we may incur significant expenses and may be unable to operate our business effectively.
We will be required to establish acceptable provider networks prior to entering new markets. We may be unable to enter into agreements with providers in new markets on a timely basis or under favorable terms. If we are unable to retain our current provider contracts or enter into new provider contracts timely or on favorable terms, our profitability will be harmed.
Changes in Stock Option Accounting Rules May Have a Significant Adverse Affect on Our Operating Results.
We have a history of using broad based employee stock option programs to hire, incentivize and retain our workforce in a competitive marketplace. Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation,” allows companies the choice of either using a fair value method of accounting for options that would result in expense recognition for all options granted, or using an intrinsic value method, as prescribed by Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” or APB 25, with a pro forma disclosure of the impact on net income (loss) of using the fair value option expense recognition method. We have previously elected to apply APB 25, and, accordingly, we generally have not recognized any expense with respect to employee stock options as long as such options are granted at exercise prices equal to the fair value of our common stock on the date of grant.
In December 2004, the Financial Accounting Standards Board issued Statement of Financial Accounting Standard No. 123 (revised 2004) “Share Based Payment” (SFAS123R) which would require all companies to measure compensation cost for all share-based payments, including employee stock options, at fair value. In April 2005 the SEC delayed the implementation until the first annual period beginning after June 15, 2005. We are required to and will adopt SFAS 123R on January 1, 2006. The effect of expensing stock options in accordance with the original SFAS 123 is presented in Note 2 of our Notes to Consolidated Financial Statements included elsewhere in this Form 10-K.
We May be Unable to Attract and Retain Key Personnel.
We are highly dependent on our ability to attract and retain qualified personnel to operate and expand our business. If we lose one or more members of our senior management team, including our chief executive officer, Michael F. Neidorff, who has been instrumental in developing our business strategy and forging our business relationships, our business and operating results could be harmed. Our ability to replace any departed members of our senior management or other key employees may be difficult and may take an extended period of time because of the limited number of individuals in the Medicaid Managed Care and Specialty Services industry with the breadth of skills and experience required to operate and successfully expand a business such as ours. Competition to hire from this limited pool is intense, and we may be unable to hire, train, retain or motivate these personnel.
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Negative Publicity Regarding the Managed Care Industry May Harm Our Business and Operating Results.
The managed care industry has received negative publicity. This publicity has led to increased legislation, regulation, review of industry practices and private litigation in the commercial sector. These factors may adversely affect our ability to market our services, require us to change our services, and increase the regulatory burdens under which we operate. Any of these factors may increase the costs of doing business and adversely affect our operating results.
Claims Relating to Medical Malpractice Could Cause Us to Incur Significant Expenses.
Our providers and employees involved in medical care decisions may be subject to medical malpractice claims. In addition, some states, including Texas, have adopted legislation that permits managed care organizations to be held liable for negligent treatment decisions or benefits coverage determinations. Claims of this nature, if successful, could result in substantial damage awards against us and our providers that could exceed the limits of any applicable insurance coverage. Therefore, successful malpractice or tort claims asserted against us, our providers or our employees could adversely affect our financial condition and profitability. Even if any claims brought against us are unsuccessful or without merit, they would still be time-consuming and costly and could distract our management’s attention. As a result, we may incur significant expenses and may be unable to operate our business effectively.
Loss of Providers Due to Increased Insurance Costs Could Adversely Affect Our Business.
Our providers routinely purchase insurance to help protect themselves against medical malpractice claims. In recent years, the costs of maintaining commercially reasonable levels of such insurance have increased dramatically, and these costs are expected to increase to even greater levels in the future. As a result of the level of these costs, providers may decide to leave the practice of medicine or to limit their practice to certain areas, which may not address the needs of Medicaid participants. We rely on retaining a sufficient number of providers in order to maintain a certain level of service. If a significant number of our providers exit our provider networks or the practice of medicine generally, we may be unable to replace them in a timely manner, if at all, and our business could be adversely affected.
Growth in the Number of Medicaid-Eligible Persons During Economic Downturns Could Cause Our Operating Results and Stock Prices to Suffer if State and Federal Budgets Decrease or Do Not Increase.
Less favorable economic conditions may cause our membership to increase as more people become eligible to receive Medicaid benefits. During such economic downturns, however, state and federal budgets could decrease, causing states to attempt to cut healthcare programs, benefits and rates. We cannot predict the impact of changes in the United States economic environment or other economic or political events, including acts of terrorism or related military action, on federal or state funding of healthcare programs or on the size of the population eligible for the programs we operate. If federal funding decreases or remains unchanged while our membership increases, our results of operations will suffer.
Growth in the Number of Medicaid-Eligible Persons May be Countercyclical, Which Could Cause Our Operating Results to Suffer When General Economic Conditions are Improving.
Historically, the number of persons eligible to receive Medicaid benefits has increased more rapidly during periods of rising unemployment, corresponding to less favorable general economic conditions. Conversely, this number may grow more slowly or even decline if economic conditions improve. Therefore, improvements in general economic conditions may cause our membership levels to decrease, thereby causing our operating results to suffer, which could lead to decreases in our stock price during periods in which stock prices in general are increasing.
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We Intend to Expand Our Medicaid Managed Care Business Primarily into Markets Where Medicaid Recipients are Required to Enroll in Managed Care Plans.
We expect to continue to focus our business in states in which Medicaid enrollment in managed care is mandatory. Currently, the majority of states require health plan enrollment for Medicaid eligible participants in all or a portion of their counties. The programs are voluntary in other states. Because we concentrate on markets with mandatory enrollment, we expect the geographic expansion of our Medicaid Managed Care segment to be limited to those states.
If We are Unable to Integrate and Manage Our Information Systems Effectively, Our Operations Could be Disrupted.
Our operations depend significantly on effective information systems. The information gathered and processed by our information systems assists us in, among other things, monitoring utilization and other cost factors, processing provider claims, and providing data to our regulators. Our providers also depend upon our information systems for membership verifications, claims status and other information.
Our information systems and applications require continual maintenance, upgrading and enhancement to meet our operational needs and regulatory requirements. Moreover, our acquisition activity requires frequent transitions to or from, and the integration of, various information systems. We regularly upgrade and expand our information systems’ capabilities. If we experience difficulties with the transition to or from information systems or are unable to properly maintain or expand our information systems, we could suffer, among other things, from operational disruptions, loss of existing members and difficulty in attracting new members, regulatory problems and increases in administrative expenses. In addition, our ability to integrate and manage our information systems may be impaired as the result of events outside our control, including acts of nature, such as earthquakes or fires, or acts of terrorists.
We Rely on the Accuracy of Eligibility Lists Provided by State Governments. Inaccuracies in Those Lists Would Negatively Affect Our Results of Operations.
Premium payments to us are based upon eligibility lists produced by state governments. From time-to-time, states require us to reimburse them for premiums paid to us based on an eligibility list that a state later discovers contains individuals who are not in fact eligible for a government sponsored program or are eligible for a different premium category or a different program. Alternatively, a state could fail to pay us for members for whom we are entitled to payment. Our results of operations would be adversely affected as a result of such reimbursement to the state if we had made related payments to providers and were unable to recoup such payments from the providers.
We May Not be Able to Obtain or Maintain Adequate Insurance.
We maintain liability insurance, subject to limits and deductibles, for claims that could result from providing or failing to provide managed care and related services. These claims could be substantial. We believe that our present insurance coverage and reserves are adequate to cover currently estimated exposures. We cannot assure you that we will be able to obtain adequate insurance coverage in the future at acceptable costs or that we will not incur significant liabilities in excess of policy limits.
Item 1B. Unresolved Staff Comments
None.
Item 2. Properties
Our corporate office headquarters building is located in St. Louis, Missouri. The real estate we own surrounding this building is adequate to accommodate office expansion needs to support future company growth.
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We operate claims processing facilities in Missouri and Montana. We lease space in each of the states where our health plans and specialty companies operate. We are required by various insurance and regulatory authorities to have offices in the service areas where we provide benefits. We believe our current facilities are adequate to meet our operational needs for the foreseeable future.
Item 3. Legal Proceedings
We routinely are subjected to legal proceedings in the normal course of business. While the ultimate resolution of such matters is uncertain, we do not expect the results of these matters to have a material effect on our financial position or results of operations.
Item 4. Submission of Matters to a Vote of Security Holders
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PART II
Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
Market for Common Stock; Dividends
Our common stock has been traded and quoted on the New York Stock Exchange under the symbol “CNC” since October 16, 2003. All share and per share information presented below has been adjusted for a two-for-one stock split effected in the form of a 100% stock dividend paid December 17, 2004 to stockholders of record on November 24, 2004.
First Quarter
Second Quarter
Third Quarter
Fourth Quarter
As of December 31, 2005 there were 51 holders of record of our common stock.
We have never declared any cash dividends on our capital stock and currently anticipate that we will retain any future earnings for the development, operation and expansion of our business.
Issuer Purchases of Equity Securities
In November 2005, our board of directors adopted a stock repurchase program authorizing us to repurchase up to 4,000,000 shares of common stock from time to time on the open market or through privately negotiated transactions. The repurchase program extends through October 31, 2007, but we reserve the right to suspend or discontinue the program at any time. During the year ended December 31, 2005, we did not repurchase any shares through this program. We have established a trading plan with a registered broker to repurchase shares under certain market conditions.
Securities Authorized for Issuance Under Equity Compensation Plans
Information concerning our equity compensation plans will appear in our Proxy Statement for our 2006 annual meeting of stockholders under “Equity Compensation Plan Information.” This portion of our Proxy Statement is incorporated herein by reference.
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Item 6. Selected Financial Data
The following selected consolidated financial data should be read in connection with the consolidated financial statements and related notes and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” appearing elsewhere in this filing. The data for the years ended December 31, 2005, 2004 and 2003 and as of December 31, 2005 and 2004 are derived from consolidated financial statements included elsewhere in this filing. The data for the years ended December 31, 2002 and 2001 and as of December 31, 2003, 2002 and 2001 are derived from audited consolidated financial statements not included in this filing.
Statement of Earnings Data:
Revenues:
Premium
Service
Total revenues
Expenses:
Medical costs
Cost of services
General and administrative expenses
Total operating expenses
Earnings from operations
Other income (expense):
Investment and other income
Interest expense
Earnings before income taxes
Income tax expense
Minority interest
Net earnings
Accretion of redeemable preferred stock
Net earnings attributable to common stockholders
Net earnings per common share:
Basic
Diluted
Weighted average number of common shares outstanding:
Balance Sheet Data:
Cash and cash equivalents
Investments
Total assets
Medical claims liabilities
Debt
Total stockholders’ equity
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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following discussion of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and the related notes included elsewhere in this filing. The discussion contains forward-looking statements that involve known and unknown risks and uncertainties, including those set forth under Item 1A. Risk Factors of this Form 10-K.
We are a multi-line healthcare enterprise operating in two segments. Our Medicaid Managed Care segment provides Medicaid and Medicaid-related programs to organizations and individuals through government subsidized programs, including Medicaid, Supplemental Security Income (SSI) and the State Children’s Health Insurance Program (SCHIP). Our Specialty Services segment operates through contracts with our health plans, as well as other healthcare organizations, state programs and other commercial organizations. These specialty services include behavioral health, disease management, nurse triage and treatment compliance. Effective January 2006, our specialty services also include pharmacy benefits management through our acquisition of US Script, Inc.
Our 2005 financial highlights include:
Over the last 2 years we have experienced strong growth in our Medicaid Managed Care segment including membership growth of 78%. Highlights of our growth include the following acquisitions or new contracts:
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We have also experienced growth in our Specialty Services segment highlighted by the following acquisitions or new contracts:
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RESULTS OF OPERATIONS AND KEY METRICS
Summarized comparative financial data for 2005, 2004 and 2003 are as follows ($ in millions):
Premium revenue
Service revenue
Investment and other income, net
Diluted earnings per common share
Revenues and Revenue Recognition
We generate revenues in our Medicaid Managed Care segment primarily from premiums we receive from the states in which we operate health plans. We receive a fixed premium per member per month pursuant to our state contracts. We generally receive premium payments during the month we provide services and recognize premium revenue during the period in which we are obligated to provide services to our members. Some contracts allow for additional premium related to certain supplemental services provided such as maternity deliveries. Revenues are recorded based on membership and eligibility data provided by the states, which may be adjusted by the states for updates to this data. These adjustments are immaterial in relation to total revenue recorded and are reflected in the period known.
We generate revenues in our Specialty Services segment under contracts with states and local government entities, our health plans and third-party customers. Revenues are recognized when the services are provided or as ratably earned over the covered period of services. For performance-based contracts, we do not recognize revenue subject to refund until data is sufficient to measure performance. Such amounts are recorded as unearned revenue.
Premium and service revenues collected in advance are recorded as unearned revenue. Premium and service revenues due to us are recorded as premium and related receivables and are recorded net of an allowance based on historical trends and our management’s judgment on the collectibility of these accounts. As we generally receive payments during the month in which services are provided, the allowance is typically not significant in comparison to total revenues and does not have a material impact on the presentation of our financial condition or results of operations.
We have increased our total revenue each year primarily through 1) membership growth in the Medicaid Managed Care segment, 2) premium rate increases, and 3) growth in our Specialty Services segment.
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1. Membership growth
From December 31, 2003 to December 31, 2005, we increased our membership by 78.1%. The following table sets forth our membership by state in our Medicaid Managed Care segment:
Total
The following table sets forth our membership by line of business in our Medicaid Managed Care segment:
Medicaid
SCHIP
SSI
In 2005, we increased our membership in Ohio through our acquisition of the Medicaid-related assets of SummaCare, Inc. Our membership increased in Indiana, New Jersey and Wisconsin from additions to our provider networks, expansion into SSI in Wisconsin, increases in counties served and growth in the overall number of Medicaid beneficiaries. In Kansas, we increased our membership by eliminating a ceiling on our membership total with the State. Our membership decreased in Missouri and Texas because of more stringent eligibility requirements for the Medicaid and SCHIP programs.
In 2004, we entered the Kansas and Missouri markets through our acquisition of FirstGuard and the Ohio market with our acquisition of the Medicaid-related assets of FHP. We increased our Texas membership by approximately 87,500 members from the EPO contract award effective September 1, 2004. Our membership increased in Indiana and Wisconsin from additions to our provider network, increases in counties served and growth in the overall number of Medicaid beneficiaries.
2. Premium rate increases
In 2005, we received premium rate increases ranging from 0.6% to 8.7%, or 3.2% on a composite basis across our markets. In 2004, we received premium rate increases ranging from 2.3% to 5.3%, or 4.4% on a composite basis across our markets.
3. Specialty Services segment growth
In 2005, we began performing under our behavioral health contracts with the States of Arizona and Kansas. At December 31, 2005, our behavioral health company, Cenpatico, provided behavioral health services to 94,700 members in Arizona, 38,800 members in Kansas and 702,100 members through contracts with our health plans compared to 584,500 members through contracts with our health plans at December 31, 2004. Additionally, in July 2005 we began offering disease management services through our acquisition of AirLogix.
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Operating Expenses
Medical Costs
Our medical costs include payments to physicians, hospitals, and other providers for healthcare and specialty services claims. Medical costs also include estimates of medical expenses incurred but not yet reported, or IBNR, and estimates of the cost to process unpaid claims. Monthly, we estimate our IBNR based on a number of factors, including inpatient hospital utilization data and prior claims experience. As part of this review, we also consider the costs to process medical claims and estimates of amounts to cover uncertainties related to fluctuations in physician billing patterns, membership, products and inpatient hospital trends. These estimates are adjusted as more information becomes available. We utilize the services of independent actuaries who are contracted to review our estimates quarterly. While we believe that our process for estimating IBNR is actuarially sound, we cannot assure you that healthcare claim costs will not materially differ from our estimates.
Our results of operations depend on our ability to manage expenses related to health benefits and to accurately predict costs incurred. Our HBR represents medical costs as a percentage of premium revenues and reflects the direct relationship between the premium received and the medical services provided. The table below depicts our HBR for our external membership by member category:
Medicaid and SCHIP
Specialty Services
Our Medicaid and SCHIP HBR increased in 2005 due to our settlement of a lawsuit with Aurora Health Care, Inc., which increased our ratio by 0.3%; and expansion into new markets previously unmanaged by us; which increased our ratio by 1.2%. For example, we experienced higher cost trends in Indiana where we added membership in 2005 as the state expanded their Medicaid managed care program to include all Medicaid and SCHIP enrollees. Our Specialty Services ratio includes the behavioral health contracts in Arizona and Kansas and reflects the State of Arizona’s minimum HBR requirements.
Our Medicaid and SCHIP HBR decreased in 2004 from 2003 due primarily to initiatives to reduce inappropriate emergency room usage and to establish preferred drug lists.
Cost of Services
Our cost of services expenses include all direct costs to support the local functions responsible for generation of our services revenues. These expenses primarily consist of the salaries and wages of the physicians, clinicians, therapists and teachers who provide the services and expenses related to facilities and equipment used to provide services.
General and Administrative Expenses
Our general and administrative (G&A) expenses primarily reflect wages and benefits and other administrative costs related to health plans, specialty companies and our centralized functions that support all of our business units. Our major centralized functions are finance, information systems and claims processing. Premium taxes are classified as G&A expenses. G&A expenses increased in 2005 primarily due to expenses for additional facilities and staff to support our growth, especially in Arizona, Georgia, Kansas and Missouri.
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Our G&A expense ratio represents general and administrative expenses as a percentage of total revenues and reflects the relationship between revenues earned and the costs necessary to earn those revenues. The following table sets forth the general and administrative expense ratios by business segment and in total:
Medicaid Managed Care
The decrease in the Medicaid Managed Care G&A expense ratio in 2005 reflects the overall leveraging of our expenses over higher revenues and lower compensation costs related to our performance bonus plans. These factors were partially offset by implementation costs in Georgia of $6.2 million, higher spending on information systems process improvements and increased charitable contributions. Premium taxes totaled $9.8 million in 2005, increasing the ratio by 0.5%.
The increase in the Medicaid Managed Care G&A expense ratio in 2004 reflects the impact of premium taxes enacted in September 2003 in Texas and July 2004 in New Jersey. These taxes totaled $5.5 million in 2004 and $1.4 million in 2003 and had the effect of increasing our G&A expense ratio by 0.5% in 2004 and 0.2% in 2003. Additionally, the 2004 results include 1) start-up costs associated with the Texas EPO contract, our claims processing facility in Montana and FirstGuard, 2) severance costs related to job eliminations, and 3) higher compensation costs related to our performance bonus plans.
The Specialty Services G&A ratio varies depending on the nature of the services provided and will have a higher general and administrative expense ratio than the Medicaid Managed Care segment. The 2005 results reflect the operations of our behavioral health company in Arizona, including $1.5 million in implementation costs, and $0.2 million in Georgia implementation costs. The 2004 results were affected by expenses associated with transitioning certain activities within Specialty Services, including closing costs of our clinic facilities in Texas and California as Cenpatico fully transitioned to a third-party service model for behavioral health services, due diligence costs related to a potential transaction we decided not to pursue, and costs related to investing in new business opportunities.
Other Income (Expense)
Other income (expense) consists principally of investment income from our cash and investments and interest expense on our debt. Investment and other income increased $4.2 million in 2005 as a result of higher average investment balances and an increase in market interest rates. Interest expense increased $3.3 million from increased borrowings under our credit facility and mortgages.
Income Tax Expense
Our effective tax rate in 2005 was 35.2%, compared to 37.0% in 2004. The decrease was primarily due to a lower state income tax expense resulting from the resolution of state income tax examinations and the recognition of deferred tax benefits related to a change in law during the third quarter of 2005. This change was recorded in our operating results in the period known.
Earnings Per Share and Shares Outstanding
Our earnings per share calculations in 2005 reflect higher basic weighted average shares outstanding resulting from the shares issued upon exercise of stock awards and the shares issued for the acquisition of assets from SummaCare, Inc. Our earnings per share calculations in 2004 reflect an increase in the weighted average shares primarily resulting from 6,900,000 common shares sold in August 2003.
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LIQUIDITY AND CAPITAL RESOURCES
We finance our activities primarily through operating cash flows and borrowings under our revolving credit facility. Our operating activities provided cash of $74.0 million in 2005, $99.4 million in 2004 and $56.0 million in 2003. Cash flow from operations in 2005 reflects an increase in premium and related receivables and a $4.5 million increase in medical claims liabilities. The increase in receivables resulted primarily from the timing of delivery receivable collections. The increase in medical claims liabilities, lower than in prior years, reflects the $9.5 million payment made to Aurora Health Care, Inc. to settle a lawsuit, information systems improvements to reduce our claims processing cycle time and the effect of our behavioral health contract in Arizona. During 2004, the increase in operating cash flow was due primarily to continued profitability, increases in membership and increases in medical claims liabilities.
Our investing activities used cash of $56.4 million in 2005, $122.5 million in 2004 and $140.7 million in 2003. During 2005, our investing activities primarily consisted of the acquisitions of AirLogix and certain Medicaid-related assets of SummaCare, Inc. Approximately $34.1 million was paid, net of cash acquired, for AirLogix. Of the total purchase price of approximately $30.4 million paid to SummaCare, $21.4 million was paid in cash and the remaining $9.0 million was paid through the issuance of our common stock. During 2004, our investing activities primarily consisted of the acquisition of FirstGuard. In 2003, the largest component of investing activities related to increases in our investment portfolio as a result of our stock offering. Our investment policies are designed to provide liquidity, preserve capital and maximize total return on invested assets within our investment guidelines. Net cash provided by and used in investing activities will fluctuate from year to year due to the timing of investment purchases, sales and maturities. As of December 31, 2005, our investment portfolio consisted primarily of fixed-income securities with an average duration of 1.6 years. Cash is invested in investment vehicles such as municipal bonds, corporate bonds, insurance contracts, commercial paper and instruments of the U.S. Treasury. The states in which we operate prescribe the types of instruments in which our regulated subsidiaries may invest their cash.
We spent $26.9 million, $14.7 million and $6.6 million in 2005, 2004 and 2003, respectively, on capital assets consisting primarily of new software, software and hardware upgrades, and furniture, equipment and leasehold improvements related to office and market expansions. We anticipate spending $43 million on additional capital expenditures in 2006 primarily related to market expansions and system upgrades, and approximately $20 million for the acquisition of additional property related to our redevelopment agreement discussed below.
Effective December 30, 2005, we executed an agreement with the City of Clayton, Missouri, a suburb of St. Louis, for the redevelopment of certain properties surrounding our corporate offices. Our primary purpose for the agreement is to accommodate office expansion needs for future company growth. The total scope of the project includes building two new office towers and street-level retail space. We plan to occupy a portion of those towers. The total expected cost of the project is approximately $190 million. It is not our intent to serve as developer of the project; we expect a commercial real estate developer to fund the majority of the project cost.
During 2005, we acquired $5.0 million of property under capital leases. This property consists primarily of the land and building related to our new claims processing facility in Montana. During 2004, we purchased the property adjacent to our corporate headquarters in St. Louis, Missouri for an aggregate purchase price of $10.3 million. This property is being used for the expansion of our corporate offices. We financed a portion of the purchase price through a $5.5 million non-recourse mortgage loan arrangement. In July 2003, we purchased the building in which our corporate headquarters is located for an aggregate purchase price of $12.6 million. We financed a portion of the purchase price through an $8.0 million non-recourse mortgage loan arrangement. The mortgage agreements bear interest at the prevailing prime rate less .75%. At December 31, 2005, our mortgages bore interest at 6.5%.
Our financing activities provided cash of $45.7 million in 2005, $42.8 million in 2004 and $89.4 million in 2003. During 2005 and 2004, our financing activities primarily related to proceeds from borrowings under our
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credit facility. These borrowings were used primarily for our investing activities in conjunction with the acquisition of new business. During 2003, our financing cash flows primarily consisted of the proceeds from the issuance of common stock through our public offering completed in August 2003.
At December 31, 2005, we had working capital, defined as current assets less current liabilities, of $58.0 million as compared to $22.1 million at December 31, 2004. Our working capital is sometimes negative due to our efforts to increase investment returns through purchases of investments that have maturities of greater than one year and, therefore, are classified as long-term. Our investment policies are designed to provide liquidity and preserve capital. We manage our short-term and long-term investments to ensure that a sufficient portion is held in investments that are highly liquid and can be sold to fund short-term capital requirements as needed.
Cash, cash equivalents and short-term investments were $204.1 million at December 31, 2005 and $178.4 million at December 31, 2004. Long-term investments were $146.2 million at December 31, 2005 and $139.0 million at December 31, 2004, including restricted deposits of $22.6 million and $22.2 million, respectively. At December 31, 2005, cash and investments held by our unregulated entities totaled $27.7 million while cash and investments held by our regulated entities totaled $322.6 million.
On September 9, 2005, we executed an amendment to our Revolving Credit Agreement dated September 14, 2004, with several lending institutions, for which LaSalle Bank National Association serves as administrative agent and co-lead arranger. The amendment increased the total amount available under the credit agreement to $200 million from $100 million, including a sub-facility for letters of credit in an aggregate amount up to $50 million. In addition, the lending institutions released our prior grant of a security interest in the outstanding common stock and membership interests of each of our subsidiaries. The credit agreement is now an unsecured facility. Borrowings under the agreement bear interest based upon LIBOR rates, the Federal Funds Rate or the Prime Rate. Under our current capital structure, borrowings under the agreement bear interest at LIBOR plus 1.25%. This rate may change under differing capital structures over the life of the agreement. The agreement contains non-financial and financial covenants, including requirements of minimum fixed charge coverage ratios, maximum debt-to-EBITDA ratios and minimum tangible net worth. The agreement will expire on September 9, 2010 or on an earlier date in the instance of a default as defined in the agreement. As of February 23, 2006, we had $109.0 million in borrowings outstanding under the agreement and $15.0 million in letters of credit outstanding, leaving an availability of $76.0 million. As of December 31, 2005, we were in compliance with all covenants.
We have filed a shelf registration statement on Form S-3 with the Securities and Exchange Commission, or the SEC, covering the issuance of up to $300 million of securities including common stock and debt securities. No securities have been issued under the shelf registration. We may publicly offer securities from time-to-time at prices and terms to be determined at the time of the offering.
Based on our operating plan, we expect that our available cash, cash equivalents and investments, cash from our operations and cash available under our credit facility will be sufficient to finance our operations and capital expenditures for at least 12 months from the date of this filing.
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Our principal contractual obligations at December 31, 2005 consisted of medical claims liabilities, debt, operating leases and purchase obligations. Our debt consists of borrowings from our credit facility, mortgages and capital leases. The purchase obligations consist primarily of software purchase and maintenance contracts in addition to agreements pertaining to the expansion of our corporate headquarters. The contractual obligations over the next five years and beyond are as follows (in thousands):
3-5
Years
Operating leases
Purchase obligations
REGULATORY CAPITAL AND DIVIDEND RESTRICTIONS
As managed care organizations, certain of our subsidiaries are subject to state regulations that, among other things, require the maintenance of minimum levels of statutory capital, as defined by each state, and restrict the timing, payment and amount of dividends and other distributions that may be paid to us. Generally, the amount of dividend distributions that may be paid by a regulated subsidiary without prior approval by state regulatory authorities is limited based on the entity’s level of statutory net income and statutory capital and surplus. Our subsidiaries are required to maintain minimum capital requirements prescribed by various regulatory authorities in each of the states in which we operate.
As of December 31, 2005, our regulated subsidiaries had aggregate statutory capital and surplus of $183.5 million, compared with the required minimum aggregate statutory capital and surplus requirements of $87.7 million.
The National Association of Insurance Commissioners has adopted rules which set minimum risk-based capital requirements for insurance companies, managed care organizations and other entities bearing risk for healthcare coverage. As of December 31, 2005, our Georgia, Indiana, New Jersey, Ohio, Texas and Wisconsin health plans were in compliance with risk-based capital requirements enacted in these states. If adopted by Kansas or Missouri, risk-based capital requirements may increase the minimum capital required for these subsidiaries. We continue to monitor the requirements in Kansas and Missouri and do not expect that they will have a material impact on our results of operations, financial position or cash flows. Acquisitions in new states or new markets in existing states may require additional capital funding for our regulated subsidiaries.
RECENT ACCOUNTING PRONOUNCEMENTS
In December 2004 FASB issued Statement of Financial Accounting Standards No. 123 (revised 2004), “Share Based Payment,” (SFAS 123R). SFAS 123R focuses primarily on accounting for transactions in which an entity obtains employee services in share-based payment transactions. SFAS 123R requires public entities to measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award. The grant-date fair value of employee share options and similar instruments will be estimated using option-pricing models adjusted for the unique characteristics of those instruments. That cost will be recognized over the period during which an employee is required to provide service in exchange for the award. We will adopt SFAS 123R on January 1, 2006 using the modified-prospective method, and expect the 2006 effect to decrease diluted earnings per share by approximately $0.15.
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CRITICAL ACCOUNTING POLICIES
Our significant accounting policies are more fully described in Note 2 to our consolidated financial statements included elsewhere herein. Our accounting policies regarding medical claims liabilities and intangible assets are particularly important to the portrayal of our financial position and results of operations and require the application of significant judgment by our management. As a result, they are subject to an inherent degree of uncertainty.
Medical Claims Liabilities
Our medical claims liabilities include claims reported but not yet paid (inventory), estimates for claims incurred but not reported, or IBNR, and estimates for the costs necessary to process unpaid claims. We, together with our independent actuaries, estimate medical claims liabilities using actuarial methods that are commonly used by health insurance actuaries and meet Actuarial Standards of Practice. These actuarial methods consider factors such as historical data for payment patterns, cost trends, product mix, seasonality, utilization of healthcare services and other relevant factors. These estimates are continually reviewed each period and adjustments based on actual claim submissions and additional facts and circumstances are reflected in the period known.
Our management uses its judgment to determine the assumptions to be used in the calculation of the required estimates. In developing our estimate for IBNR, we apply various estimation methods depending on the claim type and the period for which claims are being estimated. For more recent periods, incurred non-inpatient claims are estimated based on historical per member per month claims experience adjusted for known factors. Incurred hospital claims are estimated based on authorized days and historical per diem claim experience adjusted for known factors. For older periods, we utilize an estimated completion factor based on our historical experience to develop IBNR estimates. The completion factor is an actuarial estimate of the percentage of claims incurred during a given period that have been adjudicated as of the reporting period to the estimate of the total ultimate incurred costs. These approaches are consistently applied to each period presented.
The completion factor, claims per member per month and per diem cost trend factors are the most significant factors affecting the IBNR estimate. The following table illustrates the sensitivity of these factors and the estimated potential impact on our operating results caused by changes in these factors based on December 31, 2005 data:
(Decrease)
Increase
in Factors
While we believe our estimates are appropriate, it is possible future events could require us to make significant adjustments for revisions to these estimates. For example, a 1% increase or decrease in our estimated medical claims liabilities would have affected net earnings by $1.1 million for the year ended December 31, 2005. The estimates are based on our historical experience, terms of existing contracts, our observance of trends in the industry, information provided by our customers and information available from other outside sources, as appropriate.
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The change in medical claims liabilities is summarized as follows (in thousands):
Balance, January 1
Acquisitions
Incurred related to:
Current year
Prior years
Total incurred
Paid related to:
Total paid
Balance, December 31
Claims inventory, December 31
Days in claims payable (a)
Acquisitions in 2004 include reserves acquired in connection with our acquisition of FirstGuard. Acquisitions in 2003 include reserves acquired in connection with our acquisition of UHP.
Medical claims are usually paid within a few months of the member receiving service from the physician or other healthcare provider. As a result, these liabilities generally are described as having a “short-tail,” which causes less than 5% of our medical claims liabilities as of the end of any given year to be outstanding the following year. Management expects that substantially all the development of the estimate of medical claims liabilities as of December 31, 2005 will be known by the end of 2006.
Actuarial Standards of Practice generally require that medical claims liabilities estimates be adequate to cover obligations under moderately adverse conditions. Moderately adverse conditions are situations in which the actual claims are expected to be higher than the otherwise estimated value of such claims at the time of estimate. In many situations, the claims amounts ultimately settled will be less than the estimate that satisfies the Actuarial Standards of Practice.
Changes in estimates of incurred claims for prior years were attributable to favorable development, including changes in medical utilization and cost trends. These changes in medical utilization and cost trends can be attributable to our “margin protection” programs and changes in our member demographics. For all of our membership, we routinely implement new or modified policies that we refer to as our “margin protection” programs that assist with the control of medical utilization and cost trends such as emergency room policies. While we try to predict the savings from these programs, actual savings have proven to be better than anticipated, which has contributed to the favorable development of our medical claims liabilities.
Intangible Assets
We have made several acquisitions since 2003 that have resulted in our recording of intangible assets. These intangible assets primarily consist of purchased contract rights, provider contracts, non-compete agreements and
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goodwill. At December 31, 2005 we have $157.3 million of goodwill and $17.4 million of other intangible assets. Purchased contract rights are amortized using the straight-line method over periods ranging from 5 to 15 years. Provider contracts are amortized using the straight-line method over periods ranging from 5 to 10 years. Non-compete agreements are amortized using the straight-line method over 5 years, the period of the agreement.
Our management evaluates whether events or circumstances have occurred that may affect the estimated useful life or the recoverability of the remaining balance of goodwill and other identifiable intangible assets. If the events or circumstances indicate that the remaining balance of the intangible asset or goodwill may be permanently impaired, the potential impairment will be measured based upon the difference between the carrying amount of the intangible asset or goodwill and the fair value of such asset determined using the estimated future discounted cash flows generated from the use and ultimate disposition of the respective acquired entity. Our management must make assumptions and estimates, such as the discount factor, future utility and other internal and external factors, in determining the estimated fair values. While we believe these assumptions and estimates are appropriate, other assumptions and estimates could be applied and might produce significantly different results.
Goodwill is reviewed every year during the fourth quarter for impairment. In addition, we will perform an impairment analysis of other intangible assets based on other factors. These factors would include significant changes in membership, state funding, medical contracts and provider networks and contracts. We did not recognize any impairment losses during the three years ended December 31, 2005.
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FORWARD-LOOKING STATEMENTS
This filing contains forward-looking statements that relate to future events or our future financial performance. We have attempted to identify these statements by terminology including “believe,” “anticipate,” “plan,” “expect,” “estimate,” “intend,” “seek,” “goal,” “may,” “will,” “should,” “can,” “continue” or the negative of these terms or other comparable terminology. These statements include statements about our market opportunity, our growth strategy, competition, expected activities and future acquisitions, investments and the adequacy of our available cash resources. These statements may be found in Item 1. “Business” and Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” Readers are cautioned that matters subject to forward-looking statements involve known and unknown risks and uncertainties, including economic, regulatory, competitive and other factors that may cause our or our industry’s actual results, levels of activity, performance or achievements to be materially different from any future results, levels of activity, performance or achievements expressed or implied by these forward-looking statements. These statements are not guarantees of future performance and are subject to risks, uncertainties and assumptions.
Actual results may differ from projections or estimates due to a variety of important factors, including the factors set forth in Item 1A. “Risk Factors.” Our results of operations and projections of future earnings depend in large part on accurately predicting and effectively managing health benefits and other operating expenses. A variety of factors, including competition, changes in healthcare practices, changes in federal or state laws and regulations or their interpretations, inflation, provider contract changes, new technologies, government-imposed surcharges, taxes or assessments, reduction in provider payments by governmental payers, major epidemics, disasters and numerous other factors affecting the delivery and cost of healthcare, such as major healthcare providers’ inability to maintain their operations, may in the future affect our ability to control our medical costs and other operating expenses. Governmental action or business conditions could result in premium revenues not increasing to offset any increase in medical costs and other operating expenses. Once set, premiums are generally fixed for one-year periods and, accordingly, unanticipated costs during such periods cannot be recovered through higher premiums. The expiration, cancellation or suspension of our Medicaid managed care contracts by the state governments would also negatively affect us. Due to these factors and risks, we cannot give assurances with respect to our future premium levels or our ability to control our future medical costs.
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Item 7A. Quantitative and Qualitative Disclosures About Market Risk
INVESTMENTS
As of December 31, 2005, we had short-term investments of $56.7 million and long-term investments of $146.2 million, including restricted deposits of $22.6 million. The short-term investments consist of highly liquid securities with maturities between three and 12 months. The long-term investments consist of municipal, corporate and U.S. Agency bonds, life insurance contracts and U.S. Treasury investments and have maturities greater than one year. Restricted deposits consist of investments required by various state statutes to be deposited or pledged to state agencies. Due to the nature of the states’ requirements, these investments are classified as long-term regardless of the contractual maturity date. Our investments are subject to interest rate risk and will decrease in value if market rates increase. Assuming a hypothetical and immediate 1% increase in market interest rates at December 31, 2005, the fair value of our fixed income investments would decrease by approximately $3.1 million. Declines in interest rates over time will reduce our investment income.
INFLATION
Although the general rate of inflation has remained relatively stable and healthcare cost inflation has stabilized in recent years, the national healthcare cost inflation rate still exceeds the general inflation rate. We use various strategies to mitigate the negative effects of healthcare cost inflation. Specifically, our health plans try to control medical and hospital costs through our margin protection program and contracts with independent providers of healthcare services. Through these contracted care providers, our health plans emphasize preventive healthcare and appropriate use of specialty and hospital services.
While we currently believe our strategies to mitigate healthcare cost inflation will continue to be successful, competitive pressures, new healthcare and pharmaceutical product introductions, demands from healthcare providers and customers, applicable regulations or other factors may affect our ability to control the impact of healthcare cost increases.
COMPLIANCE COSTS
Federal and state regulations governing standards for electronic transactions, data security and confidentiality of patient information have been issued in recent years. Due to the uncertainty surrounding the regulatory requirements, we cannot be sure that the systems and programs that we have implemented will comply adequately with the regulations that are ultimately adopted. Implementation of additional systems and programs may be required. Further, compliance with these regulations would require changes to many of the procedures we currently use to conduct our business, which may lead to additional costs that we have not yet identified. We do not know whether, or the extent to which, we will be able to recover our costs of complying with these new regulations from the states.
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Item 8. Financial Statements and Supplementary Data
Our consolidated financial statements and related notes required by this item are set forth on the pages indicated in Item 15.
QUARTERLY SELECTED FINANCIAL INFORMATION
(In thousands, except share data and membership data)
(Unaudited)
Per share data:
Basic earnings per common share
Period end membership
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
Item 9A. Controls and Procedures
Evaluation of Disclosure Controls and Procedures - Our management, with the participation of our chief executive officer and chief financial officer, evaluated the effectiveness of our disclosure controls and procedures as of December 31, 2005. The term “disclosure controls and procedures,” as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act, means controls and other procedures of a company that are designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is accumulated and communicated to the company’s management, including its principal executive and principal financial officers, as appropriate to allow timely decisions regarding required disclosure. Management recognizes
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that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving their objectives and management necessarily applies its judgment in evaluating the cost-benefit relationship of possible controls and procedures. Based on the evaluation of our disclosure controls and procedures as of December 31, 2005, our chief executive officer and chief financial officer concluded that, as of such date, our disclosure controls and procedures were effective at the reasonable assurance level.
Management’s Report on Internal Control Over Financial Reporting - Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rules 13a-15(f) and 15d-15(f). Under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on our evaluation under the framework in Internal Control—Integrated Framework, our management concluded that our internal control over financial reporting was effective as of December 31, 2005. Our management’s assessment of the effectiveness of our internal control over financial reporting as of December 31, 2005 has been audited by KPMG LLP, an independent registered public accounting firm, as stated in their report which is included herein.
Management has excluded AirLogix, Inc. from its assessment of internal control over financial reporting as of December 31, 2005 because AirLogix was acquired by the Company in a purchase business combination effective July 22, 2005. AirLogix is a wholly owned subsidiary whose total assets and total revenues represent 6.6% and 0.5%, respectively, of the related consolidated financial statement amounts as of and for the year ended December 31, 2005.
Changes in Internal Control Over Financial Reporting - No change in our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) occurred during the quarter ended December 31, 2005 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
The Board of Directors and Stockholders
Centene Corporation:
We have audited management’s assessment, included in the accompanying Management’s Report on Internal Control over Financial Reporting, that Centene Corporation (the Company) maintained effective internal control over financial reporting as of December 31, 2005, based on the criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, management’s assessment that Centene Corporation maintained effective internal control over financial reporting as of December 31, 2005, is fairly stated, in all material respects, based on the criteria established in Internal Control—Integrated Frameworkissued by COSO. Also, in our opinion, Centene Corporation maintained, in all material respects, effective internal control over financial reporting as of December 31, 2005, based on the criteria established in Internal Control—Integrated Framework issued by COSO.
Centene Corporation acquired AirLogix, Inc. during 2005, and management excluded from its assessment of the effectiveness of Centene Corporation’s internal control over financial reporting as of December 31, 2005, AirLogix, Inc.’s internal control over financial reporting associated with total assets of $44.0 million and total revenues of $8.2 million included in the consolidated financial statements of Centene Corporation and subsidiaries as of and for the year ended December 31, 2005. Our audit of internal control over financial reporting of Centene Corporation also excluded an evaluation of the internal control over financial reporting of AirLogix, Inc.
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We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheet of Centene Corporation and subsidiaries as of December 31, 2005, and the related consolidated statements of earnings, stockholders’ equity, and cash flows for the year ended December 31, 2005, and our report dated February 23, 2006, expressed an unqualified opinion on those consolidated financial statements.
/s/ KPMG LLP
St. Louis, Missouri
February 23, 2006
Item 9B. Other Information
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PART III
Item 10. Directors and Executive Officers of the Registrant
(a) Directors of the Registrant
Information concerning our directors will appear in our Proxy Statement for our 2006 annual meeting of stockholders under “Election of Directors.” This portion of the Proxy Statement is incorporated herein by reference.
(b) Executive Officers of the Registrant
Pursuant to General Instruction G(3) to Form 10-K and Instruction 3 to Item 401(b) of Regulation S-K, information regarding our executive officers is provided in Item 1 of Part I of this Annual Report on Form 10-K under the caption “Executive Officers.”
Item 11. Executive Compensation
Information concerning executive compensation will appear in our Proxy Statement for our 2006 annual meeting of stockholders under “Information About Executive Compensation.” This portion of the Proxy Statement is incorporated herein by reference. The sections entitled “Compensation Committee Report” and “Stock Performance Graph” in our 2006 proxy statement are not incorporated herein by reference.
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
Information concerning the security ownership of certain beneficial owners and management and our equity compensation plans will appear in our Proxy Statement for our 2006 annual meeting of stockholders under “Information About Stock Ownership” and “Equity Compensation Plan Information.” These portions of the Proxy Statement are incorporated herein by reference.
Item 13. Certain Relationships and Related Transactions
Information concerning certain relationships and related transactions will appear in our Proxy Statement for our 2006 annual meeting of stockholders under “Related Party Transactions.” This portion of our Proxy Statement is incorporated herein by reference.
Item 14. Principal Accountant Fees and Services
Information concerning principal accountant fees and services will appear in our Proxy Statement for our 2006 annual meeting of stockholders under “Independent Auditor Fees.” This portion of our Proxy Statement is incorporated herein by reference.
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PART IV
Item 15. Exhibits and Financial Statement Schedules
(a) The following documents are filed as part of this report:
1. Consolidated Financial Statements
Reports of Independent Registered Public Accounting Firms
Consolidated Balance Sheets as of December 31, 2005 and 2004
Consolidated Statements of Earnings for the Years Ended December 31, 2005, 2004 and 2003
Consolidated Statements of Stockholders’ Equity for the Years Ended December 31, 2005, 2004 and 2003
Consolidated Statements of Cash Flows for the Years Ended December 31, 2005, 2004 and 2003
Notes to Consolidated Financial Statements
2. Financial Statement Schedules
3. Exhibits
The exhibits listed in the accompanying Exhibit Index are filed or incorporated by reference as part of this filing.
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REPORTS OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRMS
The Board of Directors and Shareholders
Centene Corporation.:
We have audited the accompanying consolidated balance sheet of Centene Corporation and subsidiaries as of December 31, 2005 and the related consolidated statements of earnings, stockholders’ equity, and cash flows for the year ended December 31, 2005. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Centene Corporation and subsidiaries as of December 31, 2005 and the results of their operations and their cash flows for the year ended December 31, 2005, in conformity with U.S. generally accepted accounting principles.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of internal control over financial reporting of Centene Corporation as of December 31, 2005, based on the criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated February 23, 2006 expressed an unqualified opinion on management’s assessment of, and the effective operation of, internal control over financial reporting.
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To the Board of Directors and Stockholders of Centene Corporation:
In our opinion, the accompanying consolidated balance sheet as of December 31, 2004 and the related consolidated statements of earnings, stockholders’ equity and cash flows present fairly, in all material respects, the financial position of Centene Corporation and its subsidiaries at December 31, 2004, and the results of their operations and their cash flows for each of the two years in the period ended December 31, 2004, in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit of financial statements includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
/s/ PricewaterhouseCoopers LLP
February 24, 2005
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CENTENE CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(In thousands, except share data)
ASSETS
Current assets:
Premium and related receivables, net of allowances of $343 and $462, respectively
Short-term investments, at fair value (amortized cost $56,863 and $94,442, respectively)
Other current assets
Total current assets
Long-term investments, at fair value (amortized cost $126,039 and $117,177, respectively)
Restricted deposits, at fair value (amortized cost $22,821 and $22,295, respectively)
Property, software and equipment, net
Goodwill
Other intangible assets, net
Other assets
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable and accrued expenses
Unearned revenue
Current portion of long-term debt and notes payable
Total current liabilities
Long-term debt
Other liabilities
Total liabilities
Stockholders’ equity:
Common stock, $.001 par value; authorized 100,000,000 shares; issued and outstanding 42,988,230 and 41,316,122 shares, respectively
Additional paid-in capital
Accumulated other comprehensive income:
Unrealized loss on investments, net of tax
Retained earnings
Total liabilities and stockholders’ equity
See notes to consolidated financial statements.
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CONSOLIDATED STATEMENTS OF EARNINGS
Earnings per share:
Weighted average number of shares outstanding:
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CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
$.001 ParValue
Shares
UnrealizedGain
(Loss) onInvestments
Balance, December 31, 2002
Change in unrealized investment gains, net of $(186) tax
Comprehensive earnings
Common stock issued for stock options and employee stock purchase plan
Proceeds from stock offering
Stock compensation expense
Tax benefits related to stock options
Cash paid for fractional share impact of stock split
Balance, December 31, 2003
Change in unrealized investment gains, net of $(703) tax
Balance, December 31, 2004
Change in unrealized investment losses, net of $(801) tax
Common stock issued for acquisitions
Balance, December 31, 2005
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CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
Cash flows from operating activities:
Adjustments to reconcile net earnings to net cash provided by operating activities—
Depreciation and amortization
Loss (gain) on sale of investments
Loss on disposal of property and equipment
Deferred income taxes
Changes in assets and liabilities—
Premium and related receivables
Other operating activities
Net cash provided by operating activities
Cash flows from investing activities:
Purchase of property, software and equipment
Purchase of investments
Sales and maturities of investments
Acquisitions, net of cash acquired
Net cash used in investing activities
Cash flows from financing activities:
Proceeds from issuance of common stock
Proceeds from exercise of stock options
Proceeds from borrowings
Reduction of long-term debt and notes payable
Other financing activities
Net cash provided by financing activities
Net increase in cash and cash equivalents
Cash and cash equivalents, beginning of period
Cash and cash equivalents, end of period
Interest paid
Income taxes paid
Supplemental schedule of non-cash investing and financing activities:
Property acquired under capital leases
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands, except share data)
1. Organization and Operations
Centene Corporation (Centene or the Company) provides multi-line healthcare programs and related services to individuals receiving benefits under government subsidized programs including Medicaid, Supplemental Security Income (SSI), and the State Children’s Health Insurance Program (SCHIP). Centene’s Medicaid Managed Care segment operates under its own state licenses in Indiana, Kansas, Missouri, New Jersey, Ohio, Texas and Wisconsin, and contracts with other managed care organizations to provide risk and non-risk management services. Centene’s Specialty Services segment contracts with Centene owned companies, as well as other healthcare organizations and states, to provide specialty services including behavioral health, disease management, nurse triage, pharmacy benefits management and treatment compliance.
In November 2004, the Company declared a two-for-one stock split effected in the form of a 100% stock dividend, payable December 17, 2004 to shareholders of record on November 24, 2004. In May 2004, the Company’s stockholders approved an increase in the authorized shares of common stock to 100,000,000 shares. In May 2003, the Company declared a three-for-two stock split effected in the form of a 50% stock dividend, payable July 11, 2003 to shareholders of record on June 20, 2003. All share and stockholders’ equity amounts have been restated to reflect these stock splits and the increase in authorized shares.
2. Summary of Significant Accounting Policies
Principles of Consolidation
The accompanying consolidated financial statements include the accounts of Centene Corporation and all majority owned subsidiaries. All material intercompany balances and transactions have been eliminated.
Estimates
The preparation of financial statements in conformity with generally accepted accounting principles 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. Actual results could differ from those estimates.
Cash and Cash Equivalents
Investments with original maturities of three months or less are considered to be cash equivalents. Cash equivalents consist of commercial paper, money market funds, repurchase agreements and bank savings accounts.
Short-term investments include securities with maturities between three months and one year. Long-term investments include securities with maturities greater than one year.
Short-term and long-term investments are classified as available for sale and are carried at fair value based on quoted market prices. Unrealized gains and losses on investments available for sale are excluded from earnings and reported as a separate component of stockholders’ equity, net of income tax effects. Premiums and discounts are amortized or accreted over the life of the related security using the effective interest method. The Company monitors the difference between the cost and fair value of investments. Investments that experience a
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decline in value that is judged to be other than temporary are written down to fair value and a realized loss is recorded in investment and other income. To calculate realized gains and losses on the sale of investments, the Company uses the specific amortized cost of each investment sold. Realized gains and losses are recorded in investment and other income.
Restricted Deposits
Restricted deposits consist of investments required by various state statutes to be deposited or pledged to state agencies. These investments are classified as long-term, regardless of the contractual maturity date, due to the nature of the states’ requirements. The Company is required to annually adjust the amount of the deposit pledged to certain states.
Property, Software and Equipment
Property, software and equipment is stated at cost less accumulated depreciation. Capitalized software includes certain costs incurred in the development of internal-use software, including external direct costs of materials and services and payroll costs of employees devoted to specific software development. Depreciation is calculated principally by the straight-line method over estimated useful lives ranging from 40 years for buildings, three to five years for software and computer equipment and five to seven years for furniture and equipment. Leasehold improvements are depreciated using the straight-line method over the shorter of the expected useful life or the remaining term of the lease ranging between one and ten years.
Intangible assets represent assets acquired in purchase transactions and consist of non-compete agreements, purchased contract rights, provider contracts and goodwill. Purchased contract rights are amortized using the straight-line method over periods ranging from 5 to 15 years. Provider contracts are amortized using the straight-line method over periods ranging from 5 to 10 years. Non-compete agreements are amortized using the straight line method over 5 years, the period of the agreement.
Goodwill is reviewed annually during the fourth quarter for impairment. In addition, the Company performs an impairment analysis of other intangible assets based on the occurrence of other factors. Such factors include, but are not limited to, significant changes in membership, state funding, medical contracts and provider networks and contracts. An impairment loss is recognized if the carrying value of intangible assets exceeds the implied fair value. The Company did not recognize any impairment losses for the periods presented.
Medical services costs include claims paid, claims reported but not yet paid (inventory), estimates for claims incurred but not yet received (IBNR) and estimates for the costs necessary to process unpaid claims.
The estimates of medical claims liabilities are developed using standard actuarial methods based upon historical data for payment patterns, cost trends, product mix, seasonality, utilization of healthcare services and other relevant factors including product changes. These estimates are continually reviewed and adjustments, if necessary, are reflected in the period known. Management did not change actuarial methods during the years presented. Management believes the amount of medical claims payable is reasonable and adequate to cover the Company’s liability for unpaid claims as of December 31, 2005; however, actual claim payments may differ from established estimates.
Revenue Recognition
The majority of the Company’s Medicaid Managed Care premium revenue is received monthly based on fixed rates per member as determined by state contracts. Some contracts allow for additional premium related to
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certain supplemental services provided such as maternity deliveries. Revenue is recognized as earned over the covered period of services. Revenues are recorded based on membership and eligibility data provided by the states, which may be adjusted by the states for updates to this membership and eligibility data. These adjustments are immaterial in relation to total revenue recorded and are reflected in the period known. Premiums collected in advance are recorded as unearned revenue.
The Specialty Services segment generates revenue under contracts with state and local government entities, our health plans and third-party customers. Revenues for services are recognized when the services are provided or as ratably earned over the covered period of services. For performance-based contracts, the Company does not recognize revenue subject to refund until data is sufficient to measure performance. Such amounts are recorded as unearned revenue.
Revenues due to the Company are recorded as premium and related receivables and recorded net of an allowance for uncollectible accounts based on historical trends and management’s judgment on the collectibility of these accounts. Activity in the allowance for uncollectible accounts for the years ended December 31 is summarized below:
Allowances, beginning of year
Amounts charged to expense
Write-offs of uncollectible receivables
Allowances, end of year
Significant Customers
Centene receives the majority of its revenues under contracts or subcontracts with state Medicaid managed care programs. The contracts, which expire on various dates between June 30, 2006 and August 31, 2008 are expected to be renewed. Contracts with the states of Indiana, Kansas, Texas and Wisconsin each accounted for 18%, 12%, 22% and 23%, respectively, of the Company’s revenues for the year ended December 31, 2005.
Reinsurance
Centene has purchased reinsurance from third parties to cover eligible healthcare services. The current reinsurance program covers 90% of inpatient healthcare expenses in excess of annual deductibles of $300 per member, up to a lifetime maximum of $2,000. Centene’s Medicaid Managed Care subsidiaries are responsible for inpatient charges in excess of an average daily per diem.
Reinsurance recoveries were $4,014, $3,730, and $5,345, in 2005, 2004, and 2003, respectively. Reinsurance expenses were approximately $4,105, $6,724, and $6,185 in 2005, 2004, and 2003, respectively. Reinsurance recoveries, net of expenses, are included in medical costs.
Other income (expense) consists principally of investment income and interest expense. Investment income is derived from the Company’s cash, cash equivalents, restricted deposits and investments.
Interest expense relates to borrowings under our credit facility, mortgage interest, interest on capital leases and credit facility fees.
Income Taxes
Deferred tax assets and liabilities are recorded for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases.
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Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date of the tax rate change.
Valuation allowances are provided when it is considered more likely than not that deferred tax assets will not be realized. In determining if a deductible temporary difference or net operating loss can be realized, the Company considers future reversals of existing taxable temporary differences, future taxable income, taxable income in prior carryback periods and tax planning strategies.
Stock Based Compensation
The Company accounts for stock based compensation plans under APB Opinion No. 25 “Accounting for Stock Issued to Employees.” Compensation cost related to stock options issued to employees is calculated on the date of grant only if the current market price of the underlying stock exceeds the exercise price. Compensation expense for stock options and restricted stock unit awards is recognized on a straight-line basis over the vesting period, generally five years for stock options and five to ten years for restricted stock unit awards. The following table illustrates the effect on net earnings and earnings per share if a fair value based method applied to all awards.
Stock-based employee compensation expense included in net earnings, net of related tax effects
Stock-based employee compensation expense determined under fair value based method, net of related tax effects
Pro forma net earnings
Basic earnings per common share:
As reported
Pro forma
Diluted earnings per common share:
In October 2005 the Compensation Committee approved the immediate and full acceleration of vesting of 260,000 “out-of-the-money” stock options to certain employees. These employees did not include any of the Company’s executive officers or other employees at Vice President level or above. Each stock option issued as a part of these grants has an exercise price greater than the closing price per share on the date of the Compensation Committee’s action. The purpose of the acceleration is to enable the Company to avoid recognizing compensation expense associated with these options in future periods in our consolidated statements of earnings, as a result of SFAS 123R. The pre-tax charge to be avoided totals approximately $3.0 million which would have been recognized over the years 2006, 2007, 2008 and 2009. This amount is reflected in the pro forma disclosures included above. The options that have been accelerated have an exercise price in excess of the current market value of our common stock, and, accordingly, the Compensation Committee determined that the expense savings outweighs the objective of incentive compensation and retention.
Additional information regarding the stock option plans is included in Note 12.
Reclassifications
Certain amounts in the consolidated financial statements have been reclassified to conform to the 2005 presentation. These reclassifications have no effect on net earnings or stockholders’ equity as previously reported.
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Recent Accounting Pronouncements
In December 2004, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 123 (revised 2004), “Share Based Payment,” (SFAS 123R). SFAS 123R establishes the accounting for transactions in which an entity obtains employee services in share-based payment transactions. SFAS 123R requires public companies to measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award. The grant-date fair value of employee share options and similar instruments will be estimated using option-pricing models adjusted for the unique characteristics of those instruments. That cost will be recognized over the period during which an employee is required to provide service in exchange for the award. The Company will adopt SFAS 123R effective January 1, 2006, using the modified-prospective method, and expects the 2006 effect to decrease diluted earnings per share by approximately $0.15.
3. Acquisitions
AirLogix
Effective July 22, 2005, the Company acquired AirLogix, Inc., a disease management provider. The Company paid approximately $36,200 in cash and related transaction costs. If certain performance criteria are achieved, additional consideration of up to $5,000 may be paid. The results of operations for AirLogix are included in the consolidated financial statements since July 22, 2005.
The preliminary purchase price allocation resulted in estimated identified intangible assets of $5,000 and associated deferred tax liabilities of $1,900, and goodwill of approximately $30,100. The identifiable intangible assets have an estimated useful life of five years. The acquired goodwill is not deductible for income tax purposes. Pro forma disclosures related to the acquisition have been excluded as immaterial.
SummaCare
Effective May 1, 2005, the Company acquired certain Medicaid-related assets from SummaCare, Inc. for a purchase price of approximately $30,400. The purchase price and related transaction costs consisted of approximately $21,400 in cash and 318,735 shares of common stock valued at approximately $9,000. The cost to acquire the Medicaid-related assets has been preliminarily allocated to the assets acquired and liabilities assumed according to estimated fair values. The results of operations for SummaCare are included in the consolidated financial statements since May 1, 2005.
The preliminary purchase price allocation resulted in identified intangible assets of $550, representing purchased contract rights and provider contracts and goodwill of approximately $29,900. The identified intangible assets are being amortized over periods ranging from 5 to 10 years. The acquired goodwill is deductible for income tax purposes. Pro forma disclosures related to the acquisition have been excluded as immaterial.
FirstGuard
The Company purchased FirstGuard, Inc. and FirstGuard Health Plan, Inc. from Swope Community Enterprises (Swope) effective December 1, 2004. Centene paid $96,020 in cash and related transaction costs. The results of operations for FirstGuard are included in the consolidated financial statements since December 1, 2004.
The purchase price and costs associated with the acquisition exceeded the estimated fair value of the net tangible assets acquired by approximately $91,920. The Company has allocated the excess purchase price over the fair value of the net tangible assets acquired to identifiable intangible assets of $7,800, representing purchased contract rights and associated deferred tax liabilities of $2,977, and goodwill of approximately
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$87,097. The purchased contract rights have an estimated useful life ranging from 10 to 15 years. The acquired goodwill is not deductible for income tax purposes. The final estimate of the fair value of the tangible assets/(liabilities) as of the acquisition date is as follows:
Cash, cash equivalents and investments
Premium and related receivables and other current assets
Property, software and equipment
Due to seller
Net tangible assets acquired
The following unaudited pro forma information presents the results of operations of Centene and subsidiaries as if the FirstGuard acquisition described above had occurred at the beginning of each period presented. These pro forma results may not necessarily reflect the actual results of operations that would have been achieved, nor are they necessarily indicative of future results of operations.
Revenue
Family Health Plan
Effective January 1, 2004, the Company commenced operations in Ohio through the acquisition from Family Health Plan, Inc. of certain Medicaid-related assets for a purchase price of approximately $6,864. The cost to acquire the Medicaid-related assets has been allocated to the assets acquired and liabilities assumed according to estimated fair values.
The purchase price allocation resulted in identified intangible assets of $1,800, representing purchased contract rights, provider network contracts and a non-compete agreement. The intangibles are being amortized over periods ranging from five to ten years. In addition, goodwill approximated $5,064 which is deductible for tax purposes.
HMO Blue Texas
Effective August 1, 2003, the Company acquired certain Medicaid-related contract rights of HMO Blue Texas in the San Antonio, Texas market for $1,045. The purchase price was allocated to acquired contracts, which are being amortized on a straight-line basis over a period of five years, the expected period of benefit.
Cenpatico Behavioral Health
During 2003, the Company acquired a 100% ownership interest in Group Practice Affiliates, LLC, a behavioral healthcare services company (63.7% in March 2003 and 36.3% in August 2003). In September 2004, the Company renamed the subsidiary Cenpatico Behavioral Health, LLC (Cenpatico). The consolidated financial statements include the results of operations of Cenpatico since March 1, 2003. The Company paid $1,800 and assumed net liabilities of approximately $1,939 for its purchase of Cenpatico. The cost to acquire the ownership interest has been allocated to the assets acquired and liabilities assumed according to estimated fair values. The allocation has resulted in goodwill of $3,315. The goodwill is not deductible for tax purposes.
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ScriptAssist
In March 2003, the Company purchased contract and name rights of ScriptAssist, LLC (ScriptAssist), a treatment compliance company. The purchase price of $563 was allocated to acquired contracts, which are being amortized on a straight-line basis over a period of five years, the expected period of benefit.
University Health Plans
On December 1, 2002, the Company purchased 80% of the outstanding capital stock of University Health Plans, Inc. (UHP) in New Jersey. In October 2003, the Company exercised its option to purchase the remaining 20% of the outstanding capital stock. Centene paid a total purchase price of $13,258. The results of operations for UHP are included in the consolidated financial statements since December 1, 2002.
4. Short-term and Long-term Investments and Restricted Deposits
Short-term and long-term investments and restricted deposits available for sale by investment type at December 31, 2005 consist of the following:
U.S. Treasury securities and obligations of U.S. government corporations and agencies
Corporate securities
State and municipal securities
Life insurance contracts
Short-term and long-term investments and restricted deposits available for sale by investment type at December 31, 2004 consist of the following:
Asset backed securities
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The Company monitors investments for other than temporary impairment. Certain investments have experienced a decline in market value due to changes in market interest rates. Based on the credit quality of the investments and our ability to hold these investments to recovery (which may be maturity), no other than temporary impairment has been recorded. Investments in a gross unrealized loss position at December 31, 2005 are as follows:
Corporate
Government
Municipal
Investments in a gross unrealized loss position at December 31, 2004 are as follows:
The contractual maturities of short-term and long-term investments and restricted deposits as of December 31, 2005, are as follows:
One year or less
One year through five years
Five years through ten years
The contractual maturities of short-term and long-term investments and restricted deposits as of December 31, 2004, are as follows:
Actual maturities may differ from contractual maturities due to call or prepayment options. Asset backed securities are included in the one year through five years category, and life insurance contracts are included in the five years through ten years category.
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The Company recorded realized gains and losses on the sale of investments for the years ended December 31 as follows:
Gross realized gains
Gross realized losses
Net realized (losses) gains
Various state statutes require the Company’s managed care subsidiaries to deposit or pledge minimum amounts of investments to state agencies. Securities with a fair market value of $22,555 and $22,187 were deposited or pledged to state agencies by Centene’s managed care subsidiaries at December 31, 2005 and 2004, respectively. These investments are classified as long-term restricted deposits in the consolidated financial statements due to the nature of the states’ requirements.
5. Property, Software and Equipment
Property, software and equipment consist of the following as of December 31:
Building
Computer software
Land
Computer hardware
Furniture and office equipment
Leasehold improvements
Less accumulated depreciation
Depreciation expense for the years ended December 31, 2005, 2004 and 2003 was $8,134, $5,149 and $3,469, respectively.
6. Intangible Assets
Goodwill balances and the changes therein are as follows:
Balance as of December 31, 2003
Deferred tax asset recognition
Balance as of December 31, 2004
Balance as of December 31, 2005
Goodwill reductions in 2005 and 2004 were related to the recognition of acquired net operating loss carryforward benefits.
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Other intangible assets at December 31 consist of the following:
Purchased contract rights
Provider contracts
Non-compete agreements
Estimated identifiable intangibles
Other intangible assets
Less accumulated amortization:
Total accumulated amortization
Amortization expense was $2,416, $1,481 and $986 for the years ended December 31, 2005, 2004 and 2003, respectively. The estimated amortization expense for 2006, 2007, 2008, 2009 and 2010, assuming no further acquisitions, is approximately $2,800, $2,800, $2,500, $2,200 and $1,700, respectively.
7. Income Taxes
The consolidated income tax expense consists of the following for the years ended December 31:
Current provision:
Federal
State and local
Total current provision
Deferred provision
Total provision for income taxes
The reconciliation of the tax provision at the U.S. Federal Statutory Rate to the provision for income taxes is as follows:
Tax provision at the U.S. federal statutory rate
State income taxes, net of federal income tax benefit
Other, net
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The tax effects of temporary differences which give rise to deferred tax assets and liabilities are presented below for the years ended December 31:
Deferred tax assets:
Unearned premium and other deferred revenue
Unrealized loss on investments
Federal net operating loss carry forward
State net operating loss carry forward
Stock compensation
Other
Total gross deferred tax assets
Deferred tax liabilities:
Intangible assets
Prepaid assets
Total gross deferred tax liabilities
Valuation allowance
Net deferred tax assets
The Company’s deferred tax assets include federal and state net operating losses (NOLs), the majority of which were acquired in business combinations. Accordingly, the total and annual deduction for those NOLs is limited by tax law. The federal NOLs expire between the years 2011 and 2024 and the state NOLs expire between the years 2006 and 2026. Valuation allowances are recorded for those NOLs the Company believes are more-likely-than-not to expire unused. During 2005 and 2004, the Company recorded valuation allowance reductions of $5,340 and $1,745, respectively and recorded additional valuation allowances of $2,048 and $255, respectively. The 2005 and 2004 tax provision included $790 and $273 of the valuation allowance reductions. The remainder was recorded as a reduction of goodwill and other intangible assets. The net deferred tax assets and liabilities are reflected on the consolidated balance sheets in other current assets and other liabilities.
8. Medical Claims Liabilities
The change in medical claims liabilities is summarized as follows:
Changes in estimates of incurred claims for prior years were attributable to favorable development, including changes in medical utilization and cost trends.
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The Company had reinsurance recoverables related to medical claims liabilities of $261 and $953 at December 31, 2005 and 2004, respectively, included in premium and related receivables.
9. Debt
Debt consists of the following at December 31:
Revolving line of credit
Mortgage notes payable
Capital leases
Total debt
Less current maturities
In September 2005, the Company executed an amendment to the five-year Revolving Credit Agreement dated September 14, 2004 with various financial institutions, for which LaSalle Bank National Association serves as administrative agent and co-lead arranger. The amendment increased the total amount available under the credit agreement to $200,000 from $100,000, including a sub-facility for letters of credit in an aggregate amount up to $50,000. In addition, under the amendment the lending institutions released the Company’s prior grant of a security interest in the outstanding common stock and membership interests of each of the Company’s subsidiaries. The credit agreement is now an unsecured facility. Borrowings under the agreement bear interest based upon LIBOR rates, the Federal Funds Rate or the Prime Rate. There is a commitment fee on the unused portion of the agreement that ranges from 0.225% to 0.35% depending on the total debt-to-EBITDA ratio. The agreement contains non-financial and financial covenants, including requirements of minimum fixed charge coverage ratios, maximum debt-to-EBITDA ratios and minimum tangible net worth. The agreement will expire in September 2010 or on an earlier date in the instance of a default as defined in the agreement. At December 31, 2005, the outstanding borrowings totaled $75,000 bearing interest at a weighted average composite of 5.7% and outstanding letters of credit totaled $15,000.
Mortgage notes payable consists of two mortgages collateralized by the Company’s headquarters property. The mortgages bear interest at the prevailing prime rate less .75%. (6.5% at December 31, 2005). The respective properties had a net book value of $21,858 at December 31, 2005. The mortgages include a financial covenant requiring a minimum rolling twelve-month debt service coverage ratio. As of December 31, 2005, the Company was in compliance with this covenant.
Capital leases consist of office equipment and building facilities with a weighted average composite interest rate of 5.4%.
Aggregate maturities for the Company’s debt are as follows:
2006
2007
2008
2009
2010
Thereafter
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10. Stockholders’ Equity
In August 2003, the Company issued 6,900,000 shares of common stock at $12.50 per share. Centene received net proceeds of $81,313 from this offering.
The Company has 10,000,000 authorized shares of preferred stock at $.001 par value. At December 31, 2005, there were no preferred shares outstanding.
In November 2005, the Company’s board of directors adopted a stock repurchase program authorizing the Company to repurchase up to 4,000,000 shares of common stock from time to time on the open market or through privately negotiated transactions. The repurchase program extends through October 31, 2007 but the Company reserves the right to suspend or discontinue the program at anytime. During the year ended December 31, 2005, the Company did not repurchase any shares through this program.
11. Statutory Capital Requirements and Dividend Restrictions
Various state laws require Centene’s regulated subsidiaries to maintain minimum capital levels specified by each state and restrict the amount of dividends that may be paid without prior regulatory approval. At December 31, 2005 and 2004, Centene’s subsidiaries had aggregate statutory capital and surplus of $183,500 and $123,600, respectively, compared with the required minimum aggregate statutory capital and surplus of $87,700 and $65,100, respectively. The Company received dividends from its managed care subsidiaries of $7,000, $0 and $6,000 during the years ended December 31, 2005, 2004 and 2003, respectively.
12. Stock Incentive Plans
The Company’s stock incentive plans allow for the granting of restricted stock awards and options to purchase common stock for key employees and other contributors to Centene. Both incentive options and nonqualified stock options can be awarded under the plans. Further, no option will be exercisable for longer than ten years after the date of grant. The Plans have 790,769 shares available for future awards. Options granted generally vest over a three or five-year period beginning on the first anniversary of the date of grant and annually thereafter.
Option activity for the years ended December 31 is summarized below:
Options outstanding, beginning of year
Granted
Exercised
Canceled
Options outstanding, end of year
Weighted average remaining life
Weighted average fair value of options granted
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The following table summarizes information about options outstanding as of December 31, 2005:
Options Outstanding
Range of Exercise Prices
Weighted Average
Remaining
Contractual Life
Options
Exercisable
$0.00 - $2.49
$2.50 - $4.99
$5.00 - $9.99
$10.00 - $14.99
$15.00 - $19.99
$20.00 - $24.99
$25.00 - $29.99
$30.00 - $34.99
The fair value of each option grant is estimated on the date of the grant using an option pricing model with the following assumptions: no dividend yield; expected volatility of 47%, 57% and 53%; risk-free interest rate of 4.3%, 3.7% and 3.1% and expected lives of 6.4, 6.0 and 6.0 for the years ended December 31, 2005, 2004 and 2003, respectively.
In 2005 the Company granted 12,905 shares of restricted stock with a grant date fair market value per share of $29.05 with full vesting in 2006 and 140,750 shares of restricted stock units with a weighted average market value per share of $29.15. Restricted stock units granted generally vest over a three or five-year period beginning on the first anniversary of the date of grant and annually thereafter.
In 2004 the Company granted 1,000,000 restricted stock units with a grant date fair market value per share of $24.60. These restricted stock units will vest as follows: 600,000 in 2009 and 80,000 each in 2010 to 2014.
During 2002, Centene implemented an employee stock purchase plan. The Company has reserved 900,000 shares of common stock and issued 45,497 shares, 20,676 shares, and 18,428 shares in 2005, 2004 and 2003, respectively, related to the employee stock purchase plan.
13. Retirement Plan
Centene has a defined contribution plan which covers substantially all employees who work at least 1,000 hours in a twelve consecutive month period and are at least twenty-one years of age. Under the plan, eligible employees may contribute a percentage of their base salary, subject to certain limitations. Centene may elect to match a portion of the employee’s contribution. Company expense related to matching contributions to the plan were $1,124, $822 and $581 during the years ended December 31, 2005, 2004 and 2003, respectively.
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14. Commitments
Centene and its subsidiaries lease office facilities and various equipment under non-cancelable operating leases which may contain escalation provisions. The rental expense related to these leases is recorded on a straight-line basis over the lease term, including rent holidays. Rent expense was $7,623, $5,482 and $3,144 for the years ended December 31, 2005, 2004 and 2003, respectively. Annual non-cancelable minimum lease payments over the next five years and thereafter are as follows:
15. Contingencies
The Company is routinely subject to legal proceedings in the normal course of business. While the ultimate resolution of such matters are uncertain, the Company does not expect the results of these matters to have a material effect on its financial position or results of operations.
16. Earnings Per Share
The following table sets forth the calculation of basic and diluted net earnings per share for the years ended December 31:
Shares used in computing per share amounts:
Weighted average number of common shares outstanding
Common stock equivalents (as determined by applying the treasury stock method)
Weighted average number of common shares and potential dilutive common shares outstanding
The calculation of diluted earnings per common share for 2005, 2004 and 2003 excludes the impact of 328,250, 0 and 1,317,820 shares, respectively, related to stock options, unvested restricted stock and restricted stock units which are anti-dilutive.
17. Segment Information
With the acquisition of Cenpatico and the purchase of ScriptAssist assets on March 1, 2003, Centene began operating in two segments: Medicaid Managed Care and Specialty Services. The Medicaid Managed Care segment consists of Centene’s health plans including all of the functions needed to operate them. The Specialty Services segment consists of Centene’s specialty companies including behavioral health, disease management, nurse triage and treatment compliance functions.
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Factors used in determining the reportable business segments include the nature of operating activities, existence of separate senior management teams and the type of information presented to the Company’s chief operating decision maker to evaluate all results of operations.
Segment information as of and for the year ended December 31, 2005, follows:
Revenue from external customers
Revenue from internal customers
Total revenue
Depreciation expense
Capital expenditures
Segment information as of and for the year ended December 31, 2004, follows:
Segment information as of and for the year ended December 31, 2003, follows:
The Company evaluates performance and allocates resources based on earnings before income taxes. The accounting policies are the same as those described in the “Summary of Significant Accounting Policies” included in Note 2.
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18. Comprehensive Earnings
Differences between net earnings and total comprehensive earnings resulted from changes in unrealized losses on investments available for sale, as follows:
Reclassification adjustment, net of tax
Change in unrealized losses on investments available for sale,net of tax
Total comprehensive earnings
19. Subsequent Events
US Script
In January 2006, the Company acquired US Script, Inc., a pharmacy benefits manager. The purchase price of approximately $40,000 plus transaction costs will be allocated to the assets acquired and liabilities assumed according to estimated fair values. In accordance with the terms of the agreement, the Company may pay up to an additional $10,000 if US Script, Inc. achieves certain earnings targets over a five-year period.
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EXHIBIT INDEX
EXHIBIT
NUMBER
DESCRIPTION
3.1
3.1a
3.1b
3.2
4.1
4.2
10.1
10.2
10.2a
10.3
10.3a
10.4
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10.4a
10.5
10.6
10.7
10.8
10.9
10.10
10.10a
10.10b
10.11
10.12
10.12a
10.13
10.14
10.15
10.16
10.17
10.18
10.19
10.20
10.21
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10.22
10.22a
10.22b
10.23
10.24
10.25
10.26
10.27
10.28
10.29
12.1
77
23a
31.1
31.2
32.1
32.2
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SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, as of February 24, 2006.
CENTENE CORPORATION
By:
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons, on behalf of the registrant and in the capacities as indicated, as of February 24, 2006.
Signature
Title
/s/ MICHAEL F. NEIDORFF
Chairman and Chief Executive Officer (principal executive officer)
/s/ KAREY L. WITTY
Senior Vice President, Chief Financial Officer, Secretary and Treasurer (principal financial and accounting officer)
/s/ STEVE BARTLETT
Steve Bartlett
Director
/s/ ROBERT K. DITMORE
Robert K. Ditmore
/s/ JOHN R. ROBERTS
John R. Roberts
/s/ DAVID L. STEWARD
David L. Steward
/s/ TOMMY G. THOMPSON
Tommy G. Thompson
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