Form 10-Q
Table of Contents

 
 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the Quarterly Period Ended September 30, 2009
Commission File Number: 001-32739
HealthSpring, Inc.
(Exact Name of Registrant as Specified in Its Charter)
     
Delaware   20-1821898
(State or Other Jurisdiction of Incorporation or Organization)   (I.R.S. Employer Identification No.)
     
9009 Carothers Parkway    
Suite 501    
Franklin, Tennessee   37067
(Address of Principal Executive Offices)   (Zip Code)
(615) 291-7000
(Registrant’s Telephone Number, Including Area Code)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes þ No o
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes o No o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
             
Large Accelerated Filer þ   Accelerated Filer o   Non-Accelerated Filer o   Smaller Reporting Company o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No þ
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.
     
    Outstanding at October 27, 2009
Common Stock, Par Value $0.01 Per Share   57,583,405 Shares
 
 

 

 


 

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 Exhibit 10.1
 Exhibit 31.1
 Exhibit 31.2
 Exhibit 32.1
 Exhibit 32.2

 

 


Table of Contents

Part I — FINANCIAL INFORMATION
 
Item 1:   Financial Statements
HEALTHSPRING, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands, except share data)
(unaudited)
                 
    September 30,     December 31,  
    2009     2008  
 
Assets
               
Current assets:
               
Cash and cash equivalents
  $ 389,766     $ 282,240  
Accounts receivable, net
    71,546       74,398  
Investment securities available for sale
    6,066       3,259  
Investment securities held to maturity
    16,040       24,750  
Funds due for the benefit of members
    4,085       40,212  
Deferred income taxes
    3,458       4,198  
Prepaid expenses and other
    8,794       6,560  
 
           
Total current assets
    499,755       435,617  
Investment securities available for sale
    18,480       30,463  
Investment securities held to maturity
    41,924       20,086  
Property and equipment, net
    29,177       26,842  
Goodwill
    589,760       590,016  
Intangible assets, net
    207,739       221,227  
Restricted investments
    16,260       11,648  
Risk corridor receivable from CMS
    8,967        
Other
    7,176       8,878  
 
           
Total assets
  $ 1,419,238     $ 1,344,777  
 
           
 
Liabilities and Stockholders’ Equity
               
Current liabilities:
               
Medical claims liability
  $ 200,372     $ 190,144  
Accounts payable, accrued expenses and other current liabilities
    28,305       35,050  
Risk corridor payable to CMS
    3,089       1,419  
Current portion of long-term debt
    35,729       32,277  
 
           
Total current liabilities
    267,495       258,890  
Deferred income taxes
    80,433       89,615  
Long-term debt, less current portion
    208,425       235,736  
Other long-term liabilities
    9,027       9,658  
 
           
Total liabilities
    565,380       593,899  
 
           
Stockholders’ equity:
               
Common stock, $0.01 par value, 180,000,000 shares authorized, 58,113,246 shares issued and 54,916,737 outstanding at September 30, 2009, 57,811,927 shares issued and 54,619,488 outstanding at December 31, 2008
    581       578  
Additional paid in capital
    511,933       504,367  
Retained earnings
    389,986       295,170  
Accumulated other comprehensive loss, net of tax
    (1,288 )     (1,955 )
Treasury stock, at cost, 3,196,509 shares at September 30, 2009 and 3,192,439 shares at December 31, 2008
    (47,354 )     (47,282 )
 
           
Total stockholders’ equity
    853,858       750,878  
 
           
Total liabilities and stockholders’ equity
  $ 1,419,238     $ 1,344,777  
 
           
See accompanying notes to condensed consolidated financial statements.

 

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Table of Contents

HEALTHSPRING, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(in thousands, except share data)
(unaudited)
                                 
    Three Months Ended     Nine Months Ended  
    September 30,     September 30,  
    2009     2008     2009     2008  
Revenue:
                               
Premium revenue
  $ 649,795     $ 515,892     $ 1,955,842     $ 1,611,450  
Management and other fees
    9,108       8,207       29,065       24,056  
Investment income
    877       3,800       3,532       11,975  
 
                       
Total revenue
    659,780       527,899       1,988,439       1,647,481  
 
                       
Operating expenses:
                               
Medical expense
    519,478       411,703       1,607,481       1,292,042  
Selling, general and administrative
    65,851       58,634       200,408       177,512  
Depreciation and amortization
    7,782       7,047       22,948       21,280  
Interest expense
    3,762       4,520       12,014       14,513  
 
                       
Total operating expenses
    596,873       481,904       1,842,851       1,505,347  
 
                       
Income before income taxes
    62,907       45,995       145,588       142,134  
Income tax expense
    (20,593 )     (16,635 )     (50,772 )     (51,494 )
 
                       
Net income
  $ 42,314     $ 29,360     $ 94,816     $ 90,640  
 
                       
Net income per common share:
                               
Basic
  $ 0.78     $ 0.53     $ 1.74     $ 1.61  
 
                       
Diluted
  $ 0.77     $ 0.53     $ 1.73     $ 1.61  
 
                       
Weighted average common shares outstanding:
                               
Basic
    54,518,162       55,693,943       54,502,081       56,137,029  
 
                       
Diluted
    54,700,390       55,811,236       54,653,367       56,243,533  
 
                       
See accompanying notes to condensed consolidated financial statements.

 

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HEALTHSPRING, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(unaudited)
                 
    Nine Months Ended  
    September 30,  
    2009     2008  
Cash flows from operating activities:
               
Net income
  $ 94,816     $ 90,640  
Adjustments to reconcile net income to net cash provided by operating activities:
               
Depreciation and amortization
    22,948       21,280  
Stock-based compensation
    7,513       6,722  
Amortization of deferred financing cost
    1,785       1,840  
Equity in earnings of unconsolidated affiliate
    (281 )     (357 )
Deferred tax (benefit) expense
    (8,794 )     680  
Increase (decrease) in cash due to:
               
Accounts receivable
    3,446       3,997  
Prepaid expenses and other current assets
    (2,231 )     (1,284 )
Medical claims liability
    10,228       29,570  
Accounts payable, accrued expenses, and other current liabilities
    (6,766 )     9,029  
Risk corridor payable to/receivable from CMS
    (7,298 )     (8,794 )
Other
    94       (772 )
 
           
Net cash provided by operating activities
    115,460       152,551  
 
           
 
               
Cash flows from investing activities:
               
Purchases of property and equipment
    (11,519 )     (8,386 )
Purchases of investment securities
    (39,766 )     (41,181 )
Maturities of investment securities
    36,107       51,296  
Deposit made for acquisition
          (7,200 )
Additional consideration paid on acquisition
    (910 )      
Proceeds received on disposition
    297        
Purchases of restricted investments
    (16,015 )     (6,410 )
Maturities of restricted investments
    11,403       5,857  
Distributions from affiliates
    196       309  
 
           
Net cash (used in) investing activities
    (20,207 )     (5,715 )
 
           
 
               
Cash flows from financing activities:
               
Funds received for the benefit of the members
    494,591       378,950  
Funds withdrawn for the benefit of members
    (458,465 )     (374,557 )
Payments on long-term debt
    (23,859 )     (20,994 )
Proceeds from stock options exercised
    6       1,210  
Purchase of treasury stock
          (28,347 )
 
           
Net cash provided by (used in) financing activities
    12,273       (43,738 )
 
           
Net increase in cash and cash equivalents
    107,526       103,098  
Cash and cash equivalents at beginning of period
    282,240       324,090  
 
           
Cash and cash equivalents at end of period
  $ 389,766     $ 427,188  
 
           
 
               
Supplemental disclosures:
               
Cash paid for interest
  $ 10,454     $ 12,803  
Cash paid for taxes
  $ 62,992     $ 48,017  
See accompanying notes to condensed consolidated financial statements

 

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HEALTHSPRING, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)
(1) Organization and Basis of Presentation
HealthSpring, Inc., a Delaware corporation (the “Company”), was organized in October 2004 and began operations in March 2005 in connection with a recapitalization transaction accounted for as a purchase. The Company is one of the country’s largest coordinated care plans whose primary focus is on Medicare, the federal government sponsored health insurance program for United States citizens aged 65 and older, qualifying disabled persons, and persons suffering from end-stage renal disease. Through its health maintenance organization (“HMO”) and regulated insurance subsidiaries, the Company operates Medicare Advantage health plans in the states of Alabama, Florida, Illinois, Mississippi, Tennessee, and Texas and offers Medicare Part D prescription drug plans on a national basis. The Company also provides management services to health plans and physician partnerships.
The accompanying condensed consolidated financial statements are unaudited and should be read in conjunction with the consolidated financial statements and notes thereto of HealthSpring, Inc. as of and for the year ended December 31, 2008, included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2008 as filed with the Securities and Exchange Commission (the “SEC”) on February 25, 2009 (the “2008 Form 10-K”).
The accompanying unaudited condensed consolidated financial statements reflect the Company’s financial position as of September 30, 2009, the Company’s results of operations for the three and nine months ended September 30, 2009 and 2008 and cash flows for the nine months ended September 30, 2009 and 2008. Certain 2008 amounts have been reclassified to conform to the 2009 presentation.
The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). Accordingly, certain information and footnote disclosures normally included in complete financial statements prepared in accordance with GAAP have been condensed or omitted pursuant to the rules and regulations applicable to interim financial statements. In the opinion of management, the accompanying unaudited condensed consolidated financial statements reflect all adjustments (including normally recurring accruals) necessary to present fairly the Company’s financial position at September 30, 2009, its results of operations for the three and nine months ended September 30, 2009 and 2008, and its cash flows for the nine months ended September 30, 2009 and 2008.
The results of operations for the 2009 interim period are not necessarily indicative of the operating results that may be expected for the year ending December 31, 2009. Subsequent events have been evaluated through October 29, 2009, the date of the issuance of the Company’s condensed consolidated financial statements.
The preparation of the condensed consolidated financial statements requires management of the Company to make a number of estimates and assumptions relating to the reported amount of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenue and expenses during the period. The most significant item subject to estimates and assumptions is the actuarial calculation for obligations related to medical claims. Other significant items subject to estimates and assumptions include the Company’s estimated risk adjustment payments receivable from The Centers for Medicare & Medicaid Services (“CMS”), the valuation of goodwill and intangible assets, the useful life of definite-lived assets, the valuation of debt securities carried at fair value, and certain amounts recorded related to the Part D program. Actual results could differ significantly from those estimates. As future events and their effects cannot be determined with precision, actual results could differ significantly from these estimates. Changes in estimates resulting from continuing changes in the economic environment will be reflected in the financial statements in future periods.
The Company’s HMO and regulated insurance subsidiaries are restricted from making distributions without appropriate regulatory notifications and approvals or to the extent such distributions would put them out of compliance with statutory net worth requirements or requirements under the Company’s credit facilities. At September 30, 2009, $413.3 million of the Company’s $488.5 million of cash, cash equivalents, investment securities, and restricted investments were held by the Company’s HMO and regulated insurance subsidiaries and subject to these dividend restrictions.

 

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HEALTHSPRING, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)
(2) Recently Adopted Accounting Pronouncements
In September 2006, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standard (“SFAS”) No. 157, “Fair Value Measurements,” as codified in the FASB’s Accounting Standards Codification (“ASC”) topic 820 (“ASC 820”). ASC 820 establishes a common definition for fair value to be applied to GAAP requiring use of fair value, establishes a framework for measuring fair value, and expands disclosure about such fair value measurements. ASC 820 is effective for financial assets and financial liabilities for fiscal years beginning after November 15, 2007. FSP 157-2 “Partial Deferral of the Effective Date of Statement 157,” as codified in FASB ASC subtopic 820-10, deferred the effective date of ASC 820 for all nonfinancial assets and nonfinancial liabilities to fiscal years beginning after November 15, 2008. The implementation of ASC 820 for financial assets and financial liabilities, effective January 1, 2008, did not have a material impact on the Company’s financial statements and results of operations. The adoption ASC 820 for nonfinancial assets and nonfinancial liabilities, effective January 1, 2009, did not have a material impact on the Company’s financial statements.
In December 2007, the FASB issued SFAS No. 141 (Revised 2007), “Business Combinations,” as codified in FASB ASC topic 805 (“ASC 805”). ASC 805 significantly changes the accounting for business combinations. Under ASC 805, an acquiring entity is required to recognize all the assets acquired and liabilities assumed in a transaction at the acquisition-date fair value with limited exceptions. ASC 805 also includes a substantial number of new disclosure requirements. ASC 805 applies prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008, which is the year beginning January 1, 2009 for the Company. The adoption of this ASC did not have a material effect on the Company’s financial statements. The provisions of ASC 805 will impact the Company if it is party to a business combination that is consummated after January 1, 2009.
In December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements — an amendment of ARB No. 51,” as codified in FASB ASC topic 810 (“ASC 810”). ASC 810 improves the relevance, comparability, and transparency of the financial information that a reporting entity provides in its consolidated financial statements by establishing accounting and reporting standards that require all entities to report noncontrolling (minority) interests in subsidiaries as equity in the consolidated financial statements. Additionally, ASC 810 requires that entities provide sufficient disclosures that clearly identify and distinguish between the interests of the parent and the interests of the noncontrolling owners. ASC 810 affects those entities that have an outstanding noncontrolling interest in one or more subsidiaries or that deconsolidate a subsidiary. ASC 810 is effective for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2008. The Company adopted ASC 810 effective January 1, 2009. The adoption of this ASC did not impact the Company’s financial statements.
In March 2008, the FASB issued SFAS No. 161, “Disclosures about Derivative Instruments and Hedging Activities,” as codified in FASB ASC topic 815 (“ASC 815”). ASC 815 requires enhanced disclosures about an entity’s derivative and hedging activities and was effective for the Company as of the first quarter of fiscal 2009. The adoption of this ASC as of January 1, 2009 required additional disclosures related to renewal or extension assumptions, but did not have a material impact on the Company’s financial statements.
In April 2008, the FASB issued FSP No. FAS 142-3, “Determination of the Useful Life of Intangible Assets,” as codified in FASB ASC subtopic 350-30 (“ASC 350-30”), which amends the list of factors an entity should consider in developing renewal or extension assumptions used in determining the useful life of recognized intangible assets under SFAS No. 142, “Goodwill and Other Intangible Assets,” as codified in FASB ASC topic 350. The new guidance applies to (1) intangible assets that are acquired individually or with a group of other assets and (2) intangible assets acquired in both business combinations and asset acquisitions. Under ASC 350-30, companies estimating the useful life of a recognized intangible asset must consider their historical experience in renewing or extending similar arrangements or, in the absence of historical experience, must consider assumptions that market participants would use about renewal or extension. For the Company, ASC 350-30 requires certain additional disclosures beginning January 1, 2009 and application to useful life estimates prospectively for intangible assets acquired after December 31, 2008. The adoption of this ASC did not have a material impact on the Company’s financial statements.
In April 2009, the FASB issued FSP FAS No. 107-1 and APB 28-1, “Interim Disclosures about Fair Value of Financial Instruments,” as codified in FASB ASC section 825-10-65 (“ASC 825-10-65”), ASC 825-10-65 requires disclosures about fair value of financial instruments for interim reporting periods as well as in annual financial statements. The adoption of ASC 825-10-65 as of the quarter ending June 30, 2009 required additional disclosures, but did not have a material impact on the Company’s financial statements.

 

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HEALTHSPRING, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)
In April 2009, the FASB issued FSP No. 157-4, “Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly,” as codified in FASB ASC section 820-10-65 (“ASC 820-10-65”). ASC 820-10-65 provides additional guidance to highlight and expand on the factors that should be considered in estimating fair value when there has been a significant decrease in market activity for a financial asset. ASC 820-10-65 also requires new disclosures relating to fair value measurement inputs and valuation techniques (including changes in inputs and valuation techniques). The adoption of ASC 820-10-65 as of the quarter ending June 30, 2009 did not impact the Company’s financial statements.
In April 2009, the FASB issued FSP No. FAS 115-2 and FAS 124-2, “Recognition and Presentation of Other-Than-Temporary Impairments,” as codified in FASB ASC section 320-10-65 (“ASC 320-10-65”). ASC 320-10-65 amends current other-than-temporary impairment guidance in GAAP for debt securities to make the guidance more operational and to improve the presentation and disclosure of other-than-temporary impairments on debt and equity securities in the financial statements. ASC 320-10-65 does not amend existing recognition and measurement guidance related to other-than-temporary impairments of equity securities. ASC 320-10-65 applies to fixed maturity securities only and requires separate display of losses related to credit deterioration and losses related to other market factors. The adoption of ASC 320-10-65 as of June 30, 2009 did not impact the Company’s financial statements.
In May 2009, the FASB issued SFAS No. 165, “Subsequent Events,” as codified in FASB ASC section 855-10-05 (“ASC 855-10-05”). ASC 855-10-05 establishes general standards for accounting for and disclosure of events that occur after the balance sheet date but before financial statements are issued or are available to be issued (“subsequent events”). More specifically, ASC 855-10-05 sets forth the period after the balance sheet date during which management of a reporting entity should evaluate events or transactions that may occur for potential recognition in the financial statements, identifies the circumstances under which an entity should recognize events or transactions occurring after the balance sheet date in its financial statements and the disclosures that should be made about events or transactions that occur after the balance sheet date. See Note 1, “Organization and Basis of Presentation” for the related disclosures. The adoption of ASC 855-10-05 in the second quarter of 2009 did not impact the Company’s financial statements.
In June 2009, the FASB issued SFAS No. 168, “The FASB Accounting Standards Codification and the Hierarchy of Generally Accepted Accounting Principles, a replacement of FASB Statement No. 162,” and establishes only two levels of U.S. GAAP, authoritative and nonauthoritative. The FASB Accounting Standards Codification (the “Codification”) became the source of authoritative, nongovernmental GAAP, except for rules and interpretive releases of the SEC, which are sources of authoritative GAAP for SEC registrants. All other non-grandfathered, non-SEC accounting literature not included in the Codification became nonauthoritative. This standard is effective for financial statements for interim or annual reporting periods ending after September 15, 2009. The Company began to use the new guidelines and numbering system prescribed by the Codification when referring to GAAP in the quarter ended September 30, 2009. As the Codification was not intended to change or alter existing GAAP, it did not have an impact on the Company’s financial statements.

 

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HEALTHSPRING, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)
(3) Accounts Receivable
Accounts receivable at September 30, 2009 and December 31, 2008 consisted of the following (in thousands):
                 
    September 30,     December 31,  
    2009     2008  
Medicare premium receivables
  $ 27,299     $ 31,535  
Rebates
    33,524       25,603  
Due from providers
    11,976       17,409  
Other
    3,011       1,871  
 
           
 
  $ 75,810     $ 76,418  
Allowance for doubtful accounts
    (4,264 )     (2,020 )
 
           
Total
  $ 71,546     $ 74,398  
 
           
Medicare premium receivables at September 30, 2009 include $24.3 million for receivables from CMS related to the accrual of retroactive risk adjustment payments for the Final CMS Settlement (as defined below) for the 2009 plan year which will not be paid until the second half of 2010.
The Company’s Medicare premium revenue is subject to adjustment based on the health risk of its members. This process for adjusting premiums is referred to as the CMS risk adjustment payment methodology. Under the risk adjustment payment methodology, coordinated care plans must capture, collect, and report diagnosis code information to CMS. After reviewing the respective submissions, CMS establishes the payments to Medicare plans generally at the beginning of the calendar year, and then adjusts premiums on two separate occasions on a retroactive basis.
The first retroactive risk premium adjustment for a given fiscal year generally occurs during the third quarter of such fiscal year. This initial settlement (the “Initial CMS Settlement”) represents the updating of risk scores for the current year based on updated diagnoses from the prior year. CMS then issues a final retroactive risk premium adjustment settlement for that fiscal year in the following year (the “Final CMS Settlement”).
All such estimated amounts are periodically updated as additional diagnosis code information is reported to CMS and are adjusted to actual amounts when the ultimate settlements are known to the Company.
During the first half of 2009, the company updated its estimated Final CMS Settlement payment amounts for 2008 as a result of additional diagnosis code information and ultimately upon receiving notification in July 2009 from CMS of Final CMS Settlements for 2008. The change in estimate related to the 2008 plan year resulted in an additional $-0- and $6.5 million of premium revenue for the three and nine months ended September 30, 2009. The impact of the change in estimate during 2009 relating to the 2008 plan year on net income, after the expense for risk sharing with providers and income tax expense, for the nine months ended September 30, 2009, was $2.1 million. Similarly, the impact of the change in estimate related to the 2007 plan year resulted in an additional $29.3 million of premium revenue for the nine months ended September 30, 2008. The resulting impact of such changes on net income, after the expense for risk sharing with providers and income tax expense, for the nine months ended September 30, 2008, was $13.4 million.
Rebates for drug costs represent estimated rebates owed to the Company from prescription drug companies. The Company has entered into contracts with certain drug manufacturers which provide for rebates to the Company based on the utilization of specific prescription drugs by the Company’s members. Due from providers primarily includes management fees receivable as well as amounts owed to the Company for the refund of certain medical expenses paid by the Company under risk sharing agreements. Accounts receivable relating to unpaid health plan enrollee premiums are recorded during the period the Company is obligated to provide services to enrollees and do not bear interest. The Company does not have any off-balance sheet credit exposure related to its health plan enrollees.

 

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HEALTHSPRING, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)
(4) Investment Securities
There were no investment securities classified as trading as of September 30, 2009 or December 31, 2008. Investment securities available for sale classified as current assets were as follows (in thousands):
                                                                 
    September 30, 2009     December 31, 2008  
            Gross     Gross                     Gross     Gross        
            Unrealized     Unrealized                     Unrealized     Unrealized        
    Amortized     Holding     Holding     Estimated     Amortized     Holding     Holding     Estimated  
    Cost     Gains     Losses     Fair Value     Cost     Gains     Losses     Fair Value  
 
                                                               
Municipal bonds
  $ 5,962       104             6,066     $ 3,195       64             3,259  
 
                                               
Investment securities available for sale classified as non-current assets were as follows (in thousands):
                                                                 
    September 30, 2009     December 31, 2008  
            Gross     Gross                     Gross     Gross        
            Unrealized     Unrealized                     Unrealized     Unrealized        
    Amortized     Holding     Holding     Estimated     Amortized     Holding     Holding     Estimated  
    Cost     Gains     Losses     Fair Value     Cost     Gains     Losses     Fair Value  
 
                                                               
Municipal bonds
  $ 18,172       308             18,480     $ 24,874       262       (206 )     24,930  
Corporate debt securities
                            5,533                   5,533  
 
                                               
 
 
  $ 18,172       308             18,480     $ 30,407       262       (206 )     30,463  
 
                                               
Investment securities held to maturity classified as current assets were as follows (in thousands):
                                                                 
    September 30, 2009     December 31, 2008  
            Gross     Gross                     Gross     Gross        
            Unrealized     Unrealized                     Unrealized     Unrealized        
    Amortized     Holding     Holding     Estimated     Amortized     Holding     Holding     Estimated  
    Cost     Gains     Losses     Fair Value     Cost     Gains     Losses     Fair Value  
 
                                                               
U.S. Treasury securities
  $ 1,815       2             1,817     $ 3,649       22             3,671  
Municipal bonds
    2,024       21             2,045       1,738       7             1,745  
Government agencies
    5,111       21             5,132       10,761       134             10,895  
Corporate debt securities
    7,090       71             7,161       8,602       15       (26 )     8,591  
 
                                               
 
 
  $ 16,040       115             16,155     $ 24,750       178       (26 )     24,902  
 
                                               
Investment securities held to maturity classified as non-current assets were as follows (in thousands):
                                                                 
    September 30, 2009     December 31, 2008  
            Gross     Gross                     Gross     Gross        
            Unrealized     Unrealized                     Unrealized     Unrealized        
    Amortized     Holding     Holding     Estimated     Amortized     Holding     Holding     Estimated  
    Cost     Gains     Losses     Fair Value     Cost     Gains     Losses     Fair Value  
 
                                                               
Municipal bonds
  $ 22,988       454       (48 )     23,394     $ 7,500       97       (71 )     7,526  
Government agencies
    4,628       35             4,663       3,081       243             3,324  
Corporate debt securities
    14,308       350             14,658       9,505       85       (70 )     9,520  
 
                                               
 
 
  $ 41,924       839       (48 )     42,715     $ 20,086       425       (141 )     20,370  
 
                                               
There were no realized gains or losses on maturities of investment securities for the three and nine months ended September 30, 2009 and 2008.

 

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HEALTHSPRING, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)
Maturities of investments were as follows at September 30, 2009 (in thousands):
                                 
    Available for sale     Held to maturity  
    Amortized     Estimated     Amortized     Estimated  
    Cost     Fair Value     Cost     Fair Value  
 
                               
Due within one year
  $ 5,962       6,066     $ 16,040       16,155  
Due after one year through five years
    8,327       8,599       36,761       37,350  
Due after five years through ten years
    1,475       1,505       5,163       5,365  
Due after ten years
    8,370       8,376              
 
                       
 
                               
 
  $ 24,134       24,546     $ 57,964       58,870  
 
                       
Gross unrealized losses on investment securities and the fair value of the related securities, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at September 30, 2009, were as follows (in thousands):
                                                 
    Less Than     More Than        
    12 Months     12 Months     Total  
    Unrealized     Fair     Unrealized     Fair     Unrealized     Fair  
    Losses     Value     Losses     Value     Losses     Value  
 
                                               
Municipal bonds
  $ 20       2,921       28       803       48       3,724  
 
                                   
The Company reviews fixed maturities and equity securities with a decline in fair value from cost for impairment based on criteria that include duration and severity of decline; financial viability and outlook of the issuer; and changes in the regulatory, economic and market environment of the issuer’s industry or geographic region.
Gross unrealized losses on investment securities and the fair value of the related securities, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at December 31, 2008, were as follows (in thousands):
                                                 
    Less Than     More Than        
    12 Months     12 Months     Total  
    Unrealized     Fair     Unrealized     Fair     Unrealized     Fair  
    Losses     Value     Losses     Value     Losses     Value  
 
Municipal bonds
  $ 277       5,894                   277       5,894  
Corporate debt securities
    95       10,959       1       299       96       11,258  
 
                                   
 
                                               
Total
  $ 372       16,853       1       299       373       17,152  
 
                                   
Municipal Bonds and Government Agencies: The unrealized losses on investments in municipal bonds were caused by an increase in investment yields as a result of a widening of credit spreads. The contractual terms of these investments do not permit the issuer to settle the securities at a price less than the amortized cost of the investment. For periods prior to April 1, 2009, the Company determined that it had the ability and intent to hold these investments until maturity, thus these investments are not considered other-than-temporarily impaired. For periods beginning on or after April 1, 2009, the Company determined that it did not intend to sell these investments and that it was not more-likely-than-not to be required to sell these investments prior to their recovery, thus these investments are not considered other-than-temporarily impaired.

 

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HEALTHSPRING, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)
Corporate Debt Securities: The unrealized losses on corporate debt securities were caused by an increase in investment yields as a result of a widening of credit spreads. The contractual terms of the bonds do not allow the issuer to settle the securities at a price less than the face value of the bonds. For periods prior to April 1, 2009, the Company determined that it had the ability and intent to hold these investments until maturity, thus these investments are not considered other-than-temporarily impaired. For periods beginning on or after April 1, 2009, the Company determined that it did not intend to sell these investments and that it was not more-likely-than-not to be required to sell these investments prior to their recovery, thus these investments are not considered other-than-temporarily impaired.
(5) Fair Value Measurements
The Company’s 2009 third quarter condensed consolidated balance sheet includes the following financial instruments: cash and cash equivalents, accounts receivable, investment securities, restricted investments, accounts payable, medical claims liabilities, interest rate swap agreements, funds due (held) from CMS for the benefit of members, and long-term debt. The carrying amounts of accounts receivable, funds due (held) from CMS for the benefit of members, accounts payable, and medical claims liabilities approximate their fair value because of the relatively short period of time between the origination of these instruments and their expected realization. The fair value of the Company’s long-term debt (including the current portion) was $225.8 million at September 30, 2009 and consisted solely of non-tradable bank debt.
Cash and cash equivalents consist of such items as certificates of deposit, commercial paper, and money market funds. The original cost of these assets approximates fair value due to their short-term maturity. The fair value of the Company’s interest rate swap agreements are derived from a discounted cash flow analysis based on the terms of the contract and the interest rate curve. In addition, the Company incorporates credit valuation adjustments to appropriately reflect both its own non-performance or credit risk and the counterparties’ non-performance or credit risk in the fair value measurements. Credit risk under these swap arrangements is believed to be remote as the counterparties to the Company’s interest rate swap agreements are major financial institutions and the Company does not anticipate non-performance by the counterparties. The Company has designated its interest rate swaps as cash flow hedges which are recorded in the Company’s consolidated balance sheet at fair value. The fair value of the Company’s interest rate swaps at September 30, 2009 reflected a liability of approximately $2.5 million and is included in other long term liabilities in the accompanying consolidated balance sheet. The fair values of available for sale securities is determined by pricing models developed using market data provided by a third party vendor.
The following are the levels of the hierarchy as defined by SFAS No. 157, as codified in FASB ASC topic 820, and a brief description of the type of valuation information (“inputs”) that qualifies a financial asset for each level:
     
Level Input   Input Definition
Level I  
Inputs are unadjusted quoted prices for identical assets or liabilities in active markets at the measurement date.
   
 
Level II  
Inputs other than quoted prices included in Level I that are observable for the asset or liability through corroboration with market data at the measurement date.
   
 
Level III  
Unobservable inputs that reflect management’s best estimate of what market participants would use in pricing the asset or liability at the measurement date.
When quoted prices in active markets for identical assets are available, the Company uses these quoted market prices to determine the fair value of financial assets and classifies these assets as Level I. In other cases where a quoted market price for identical assets in an active market is either not available or not observable, the Company obtains the fair value from a third party vendor that uses pricing models, such as matrix pricing, to determine fair value. These financial assets would then be classified as Level II. In the event quoted market prices were not available, the Company would determine fair value using broker quotes or an internal analysis of each investment’s financial statements and cash flow projections. In these instances, financial assets would be classified based upon the lowest level of input that is significant to the valuation. Thus, financial assets might be classified in Level III even though there could be some significant inputs that may be readily available.

 

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HEALTHSPRING, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)
The following table summarizes fair value measurements by level at September 30, 2009 for assets and liabilities measured at fair value on a recurring basis (in thousands):
                                 
    Level I     Level II     Level III     Total  
Assets
                               
Cash and cash equivalents
  $ 389,766     $     $     $ 389,766  
 
                       
Investment securities, available for sale:
                               
municipal bonds
  $     $ 24,546     $     $ 24,546  
 
                       
Liabilities
                               
Derivative — interest rate swaps
  $     $ 2,530     $     $ 2,530  
 
                       
(6) Medical Liabilities
The Company’s medical liabilities at September 30, 2009 and December 31, 2008 consisted of the following (in thousands):
                 
    September 30,     December 31,  
    2009     2008  
Medicare medical liabilities
  $ 146,270     $ 126,762  
Pharmacy liabilities
    54,102       63,382  
 
           
Total
  $ 200,372     $ 190,144  
 
           
(7) Medicare Part D
Total Part D related net assets (excluding medical claims payable) of $38,793 at December 31, 2008 all relate to the 2008 CMS plan year. The Company’s Part D related assets and liabilities (excluding medical claims payable) at September 30, 2009 were as follows (in thousands):
                         
    Related to the     Related to the        
    2008 plan year     2009 plan year     Total  
Current assets (liabilities):
                       
Funds due (held) for the benefit of members
  $ 38,972     $ (34,887 )   $ 4,085  
 
                 
Risk corridor payable to CMS
  $ (3,089 )   $     $ (3,089 )
 
                 
 
                       
Non-current assets:
                       
Risk corridor receivable from CMS
  $     $ 8,967     $ 8,967  
 
                 
Balances associated with risk corridor amounts are expected to be settled in the second half of the year following the year to which they relate. In October 2009, the Company received notification from CMS that net settlement amounts due to the Company from CMS totaled $36.6 million. Current year Part D amounts are routinely updated in subsequent periods as a result of retroactivity.
(8) Derivatives
In October 2008, the Company entered into two interest rate swap agreements relating to the floating interest rate component of the term loan agreement under its $400.0 million, five year credit facility (collectively, the “Credit Agreement”). The total notional amount covered by the agreements is $100.0 million of the currently $244.2 million outstanding under the term loan agreement. Under the swap agreements, the Company is required to pay a fixed interest rate of 2.96% and is entitled to receive LIBOR every month until October 31, 2010. The actual interest rate payable under the Credit Agreement in each case contains an applicable margin, which is not affected by the swap agreements. The interest rate swap agreements are classified as cash flow hedges, as defined by SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities,” as codified in FASB ASC topic 815. See Note 5 for a discussion of fair value accounting related to the swap agreements.

 

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HEALTHSPRING, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)
The Company entered into the two interest rate swap derivatives to convert floating-rate debt to fixed-rate debt. The Company’s interest rate swap agreements involve agreements to pay a fixed rate and receive a floating rate, at specified intervals, calculated on an agreed-upon notional amount. The Company’s objective in entering into these financial instruments is to mitigate its exposure to significant unplanned fluctuations in earnings caused by volatility in interest rates. The Company does not use any of these instruments for trading or speculative purposes.
Derivative instruments used by the Company involve, to varying degrees, elements of credit risk, in the event a counterparty should default, and market risk, as the instruments are subject to interest rate fluctuations.
All derivatives are recognized on the balance sheet at their fair value. To date, the two derivatives entered into by the Company qualify for and are designated as cash flow hedges. To the extent that the cash flow hedges are effective, changes in their fair value are recorded in other comprehensive income (loss) until earnings are affected by the variability of cash flows of the hedged transaction (e.g. until periodic settlements of a variable asset or liability are recorded in earnings). Any hedge ineffectiveness (which represents the amount by which the changes in the fair value of the derivatives differ from changes in the fair value of the hedged instrument) is recorded in current-period earnings. Also, on a quarterly basis, the Company measures hedge effectiveness by completing a regression analysis comparing the present value of the cumulative change in the expected future interest to be received on the variable leg of its swap against the present value of the cumulative change in the expected future interest payments on its variable rate debt.
A summary of the aggregate notional amounts, balance sheet location and estimated fair values of derivative financial instruments at September 30, 2009 is as follows (in thousands):
                                 
    Notional             Estimated Fair Value  
Hedging instruments   Amount     Balance Sheet Location   Asset     (Liability)  
 
                               
Interest rate swaps
  $ 100,000     Other noncurrent liabilities           (2,530 )
 
                         
A summary of the effect of cash flow hedges on the Company’s financial statements is as follows (in thousands):
                                         
    Effective Portion     Ineffective Portion   
                    Hedge Gain        
            Income Statement     (Loss)        
    Pretax Hedge     Location of Gain     Reclassified        
    Gain (Loss)     (Loss) Reclassified     from     Income        
    Recognized in     from Accumulated     Accumulated     Statement        
    Other     Other     Other     Location of     Hedge Gain  
    Comprehensive     Comprehensive     Comprehensive     Gain (Loss)     (Loss)  
Type of Cash Flow Hedge   Income     Income     Income     Recognized     Recognized  
For the three months ended September 30, 2009:
                                       
Interest rate swaps
  $ 137     Interest Expense   $     None   $  
 
                                 
 
                                       
For the nine months ended September 30, 2009:
                                       
Interest rate swaps
  $ 725     Interest Expense   $     None   $  
 
                                 
(9) Stock-Based Compensation
Stock Options
The Company granted options to purchase 150,000 and 590,528 shares of common stock pursuant to the 2006 Equity Incentive Plan during the three and nine months ended September 30, 2009, respectively. Options for the purchase of 4,103,132 shares of common stock were outstanding under this plan at September 30, 2009. The outstanding options vest and become exercisable based on time, generally over a four-year period, and expire ten years from their grant dates. Upon exercise, options are settled with authorized but unissued Company common stock or treasury shares.

 

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HEALTHSPRING, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)
The fair value for all options granted during the three and nine months ended September 30, 2009 and 2008 was determined on the date of grant and was estimated using the Black-Scholes option-pricing model with the following assumptions:
                                 
    Three Months Ended     Nine Months Ended  
    September 30,     September 30,  
    2009     2008     2009     2008  
Expected dividend yield
    0.0 %     0.0 %     0.0 %     0.0 %
Expected volatility
    58.0 %     39.5 %     43.6-58.0 %     36.2-39.5 %
Expected term
  5 years     5 years     5 years     5 years  
Risk-free interest rates
    2.84 %     3.23 %     1.88-2.84 %     2.93-3.23 %
The weighted average fair values of stock options granted during the nine months ended September 30, 2009 and 2008 were $6.32 and $7.28, respectively. The cash proceeds to the Company from stock options exercised during the three and nine months ended September 30, 2009 were immaterial.
Total compensation expense related to unvested options not yet recognized was $11.2 million at September 30, 2009. The Company expects to recognize this compensation expense over a weighted average period of 2.2 years.
Restricted Stock
During the three and nine months ended September 30, 2009, the Company granted 12,500 and 185,075 shares, respectively, of restricted stock to employees pursuant to the 2006 Equity Incentive Plan, the restrictions of which generally lapse over a four-year period. Additionally, in the first quarter of 2009, 67,809 shares were purchased by certain executives pursuant to the Management Stock Purchase Program (the “MSPP”). The restrictions on shares purchased under the MSPP generally lapse on the second anniversary of the grant date.
During the three and nine months ended September 30, 2009, the Company awarded -0- and 60,516 shares, respectively, of restricted stock to non-employee directors pursuant to the 2006 Equity Incentive Plan, all of which were outstanding at September 30, 2009. The restrictions relating to the restricted stock awarded in the current period lapse one year from the grant date. In the event a director resigns or is removed prior to the lapsing of the restriction, or if the director fails to attend 75% of the board and applicable committee meetings during the one-year period, shares would be forfeited unless resignation or failure to attend is caused by death or disability.
Total compensation expense related to unvested restricted stock awards not yet recognized, including awards made in previous periods, was $3.8 million at September 30, 2009. The Company expects to recognize this compensation expense over a weighted average period of approximately 2.7 years. Unvested restricted stock at September 30, 2009 totaled 417,438 shares.
Stock-based Compensation
Stock-based compensation is included in selling, general and administrative expense. Stock-based compensation for the three and nine months ended September 30, 2009 and 2008 consisted of the following (in thousands):
                         
                    Total  
    Compensation Expense Related To:     Compensation  
    Restricted Stock     Stock Options     Expense  
Three months ended September 30, 2009
  $ 426     $ 1,929     $ 2,355  
 
                 
 
Three months ended September 30, 2008
    391       1,844       2,235  
 
                 
 
Nine months ended September 30, 2009
    1,441       6,072       7,513  
 
                 
 
Nine months ended September 30, 2008
    1,096       5,626       6,722  
 
                 

 

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HEALTHSPRING, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)
(10) Net Income Per Common Share
The following table presents the calculation of the Company’s net income per common share — basic and diluted (in thousands, except share data):
                                 
    Three Months Ended     Nine Months Ended  
    September 30,     September 30,  
    2009     2008     2009     2008  
Numerator:
                               
Net income
  $ 42,314     $ 29,360     $ 94,816     $ 90,640  
 
                       
Denominator:
                               
Weighted average common shares outstanding — basic
    54,518,162       55,693,943       54,502,081       56,137,029  
Dilutive effect of stock options
    77,250       94,599       75,857       91,838  
Dilutive effect of unvested restricted shares
    104,978       22,694       75,429       14,666  
 
                       
Weighted average common shares outstanding — diluted
    54,700,390       55,811,236       54,653,367       56,243,533  
 
                       
 
                               
Net income per common share:
                               
Basic
  $ 0.78     $ 0.53     $ 1.74     $ 1.61  
 
                       
Diluted
  $ 0.77     $ 0.53     $ 1.73     $ 1.61  
 
                       
Diluted earnings per share (“EPS”) reflects the potential dilution that could occur from outstanding equity plan awards, including unexercised stock options and unvested restricted shares. The dilutive effect is computed using the treasury stock method, which assumes all share-based awards are exercised and the hypothetical proceeds from exercise are used by the Company to purchase common stock at the average market price during the period. The incremental shares (difference between shares assumed to be issued versus purchased), to the extent they would have been dilutive, are included in the denominator of the diluted EPS calculation. Options with respect to 4.2 million shares and 3.7 million shares were antidilutive and therefore excluded from the computation of diluted earnings per share for the three and nine months ended September 30, 2009 and 2008, respectively. Approximately 2.7 million shares of common stock held in escrow are excluded from the computation of basic and diluted earnings per share until such time that all conditions for their release from escrow have been satisfied. See Note 15 — Subsequent Event, for further discussion of escrowed shares.
In June 2007, the Company’s Board of Directors authorized a stock repurchase program to buy back up to $50.0 million of the Company’s common stock over the subsequent 12 months. In May 2008, the Company’s Board of Directors extended this program to June 30, 2009. On June 30, 2009 the repurchase program expired in accordance with its terms. Over the life of the repurchase program, the Company repurchased approximately 2.8 million shares of its common stock for approximately $47.3 million, at an average cost of $16.65 per share.

 

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HEALTHSPRING, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)
(11) Intangible Assets
A breakdown of the identifiable intangible assets and their assigned value and accumulated amortization at September 30, 2009 is as follows (in thousands):
                         
    Gross Carrying     Accumulated        
    Amount     Amortization     Net  
Trade name
  $ 24,497     $     $ 24,497  
Noncompete agreements
    800       733       67  
Provider network
    137,098       19,642       117,456  
Medicare member network
    93,620       29,016       64,604  
Management contract right
    1,555       440       1,115  
 
                 
 
  $ 257,570     $ 49,831     $ 207,739  
 
                 
Amortization expense on identifiable intangible assets for the three months ended September 30, 2009 and 2008 was approximately $4.5 million and $4.7 million, respectively. Amortization expense on identifiable intangible assets for the nine months ended September 30, 2009 and 2008 was approximately $13.8 million and $14.5 million, respectively.
(12) Comprehensive Income
The following table presents details supporting the determination of comprehensive income for the three and nine months ended September 30, 2009 and 2008 (in thousands):
                                 
    Three Months Ended     Nine Months Ended  
    September 30,     September 30,  
    2009     2008     2009     2008  
 
       
Net income
  $ 42,314     $ 29,360     $ 94,816     $ 90,640  
Net unrealized gain on available for sale investment securities, net of tax
    51       4       189       109  
Net gain on interest rate swaps, net of tax
    84             478        
 
                       
Comprehensive income, net of tax
  $ 42,449     $ 29,364     $ 95,483     $ 90,749  
 
                       
(13) Segment Information
The Company reports its business in four segments: Medicare Advantage, stand-alone Prescription Drug Plan, Commercial, and Corporate. Medicare Advantage (“MA-PD”) consists of Medicare-eligible beneficiaries receiving healthcare benefits, including prescription drugs, through a coordinated care plan qualifying under Part C and Part D of the Medicare Program. Stand-alone Prescription Drug Plan (“PDP”) consists of Medicare-eligible beneficiaries receiving prescription drug benefits on a stand-alone basis in accordance with Medicare Part D. Commercial consists of the Company’s commercial health plan business. The Commercial segment was insignificant as of September 30, 2009 and 2008. The Corporate segment consists primarily of corporate expenses not allocated to the other reportable segments. The Company identifies its segments in accordance with the aggregation provisions of SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information,” as codified in FASB ASC topic 280 which aggregates products with similar economic characteristics. These characteristics include the nature of customer groups as well as pricing and benefits. These segment groupings are also consistent with information used by the Company’s chief executive officer in making operating decisions.
The accounting policies of each segment are the same and are described in Note 1 to the 2008 Form 10-K. The results of each segment are measured and evaluated by earnings before interest expense, depreciation and amortization expense, and income taxes (“EBITDA”). The Company does not allocate certain corporate overhead amounts (classified as selling, general and administrative expenses) or interest expense to the segments. The Company evaluates interest expense, income taxes, and asset and liability details on a consolidated basis as these items are managed in a corporate shared service environment and are not the responsibility of segment operating management.

 

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HEALTHSPRING, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)
Revenue includes premium revenue, management and other fee income, and investment income.
Asset and equity details by reportable segment have not been disclosed, as the Company does not internally report such information.
Financial data by reportable segment for the three and nine months ended September 30 is as follows (in thousands):
                                         
    MA-PD     PDP     Commercial     Corporate     Total  
Three months ended September 30, 2009
                                       
Revenue
  $ 589,966     $ 69,044     $ 754     $ 16     $ 659,780  
EBITDA
    71,983       10,644       (269 )     (7,907 )     74,451  
Depreciation and amortization expense
    6,330       20             1,432       7,782  
 
                                       
Three months ended September 30, 2008
                                       
Revenue
  $ 466,916     $ 59,917     $ 960     $ 106     $ 527,899  
EBITDA
    57,477       6,429       670       (7,014 )     57,562  
Depreciation and amortization expense
    6,060       2             985       7,047  
 
                                       
Nine months ended September 30, 2009
                                       
Revenue
  $ 1,736,970     $ 249,158     $ 2,269     $ 42     $ 1,988,439  
EBITDA
    183,866       18,557       (277 )     (21,596 )     180,550  
Depreciation and amortization expense
    19,052       60             3,836       22,948  
 
                                       
Nine months ended September 30, 2008
                                       
Revenue
  $ 1,430,899     $ 211,923     $ 4,346     $ 313     $ 1,647,481  
EBITDA
    190,758       7,974       66       (20,871 )     177,927  
Depreciation and amortization expense
    18,261       5             3,014       21,280  
As of January 1, 2009, the Company revised its methodology for allocating the selling, general, and administrative expenses, but only within its prescription drug operations, which resulted in its allocating a greater share of such expenses to its MA-PD segment. As such, the MA-PD and PDP segment EBITDA amounts for the 2008 period include reclassification adjustments between segments such that the periods presented are comparable.
A reconciliation of reportable segment EBITDA to net income included in the consolidated statements of income for the three and nine months ended September 30 is as follows (in thousands):
                                 
    Three Months Ended     Nine Months Ended  
    September 30,     September 30,  
    2009     2008     2009     2008  
EBITDA
  $ 74,451     $ 57,562     $ 180,550     $ 177,927  
Income tax expense
    (20,593 )     (16,635 )     (50,772 )     (51,494 )
Interest expense
    (3,762 )     (4,520 )     (12,014 )     (14,513 )
Depreciation and amortization
    (7,782 )     (7,047 )     (22,948 )     (21,280 )
 
                       
Net Income
  $ 42,314     $ 29,360     $ 94,816     $ 90,640  
 
                       
The Company uses segment EBITDA as an analytical indicator for purposes of assessing segment performance, as is common in the healthcare industry. Segment EBITDA should not be considered as a measure of financial performance under generally accepted accounting principles and segment EBITDA, as presented, may not be comparable to other companies.

 

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HEALTHSPRING, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)
(14) Related Parties
Renaissance Physician Organization (“RPO”) is a Texas non-profit corporation the members of which are GulfQuest L.P., one of the Company’s wholly-owned HMO management subsidiaries, and 14 affiliated independent physician associations, comprised of over 1,000 physicians providing medical services primarily in and around counties surrounding and including the Houston, Texas metropolitan area. Texas HealthSpring, LLC, the Company’s Texas HMO, has contracted with RPO to provide professional medical and covered medical services and procedures to its members. Pursuant to that agreement, RPO shares risk relating to the provision of such services, both upside and downside, with the Company on a 50%/50% allocation. Another agreement the Company has with RPO delegates responsibility to GulfQuest L.P. for medical management, claims processing, provider relations, credentialing, finance, and reporting services for RPO’s Medicare and commercial members. Pursuant to that agreement, GulfQuest L.P. receives a management fee, calculated as a percentage of Medicare premiums, plus a dollar amount per member per month for RPO’s commercial members. In addition, RPO pays GulfQuest, L.P. 25% of the profits from RPO’s operations.
FASB Interpretation No. 46 (Revised December 2003), “Consolidation of Variable Interest Entities — an interpretation of ARB No. 51,” as codified in FASB ASC topic 810 (“ASC 810”) requires an entity to consolidate a variable interest entity (“VIE”) if that entity holds a variable interest that will absorb a majority of the VIE’s expected losses, receive a majority of the VIE’s expected residual returns, or both. The entity required to consolidate a VIE is known as the primary beneficiary. The Company has evaluated its interests in RPO and concluded that it is not the primary beneficiary of RPO, and as such is not required to consolidate RPO. The Company does not carry any investment in RPO on its balance sheet but does record management and other fees as well as medical expenses (under the contractual provisions discussed above) in its results from operations. Under ASC 810, VIEs are reassessed for consolidation when reconsideration events occur. Reconsideration events include changes to the VIEs’ governing documents that reallocate the expected losses/returns of the VIE between the primary beneficiary and other variable interest holders or sales and purchases of variable interests in the VIE.
(15) Subsequent Event
In October 2007, the Company acquired LMC Health Plans for $355.0 million in cash and 2,666,667 shares of the Company’s common stock, which share consideration was deposited in escrow and would be released to the former stockholders of LMC Health Plans if Leon Medical Centers, Inc. completed the construction of two additional medical centers in accordance with the timetable set forth in the stock purchase agreement. As of September 30, 2009, the contingent consideration represented by the 2,666,667 shares placed in escrow were not included in the purchase price and were excluded from outstanding and issued shares on the Company’s consolidated balance sheet.
In late October 2009, the second new medical center was completed, thereby satisfying the contingency for the release of the escrowed shares. As such, these shares will be included in the computation of basic and diluted earnings per share in the fourth quarter of 2009 and as issued and outstanding on the Company’s balance sheet as of the end of October 2009. The Company will also record additional purchase price in the fourth quarter of 2009 associated with the release of such shares.

 

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Item 2: Management’s Discussion and Analysis of Financial Condition and Results of Operations
You should read the following discussion and analysis in conjunction with our condensed consolidated financial statements and related notes included elsewhere in this report and our audited consolidated financial statements and the notes thereto for the year ended December 31, 2008, appearing in our Annual Report on Form 10-K that was filed with the Securities and Exchange Commission (“SEC”) on February 25, 2009 (the “2008 Form 10-K”). Statements contained in this Quarterly Report on Form 10-Q that are not historical fact are forward-looking statements that the company intends to be covered by the safe harbor provisions for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995. Statements that are predictive in nature, that depend on or refer to future events or conditions, or that include words such as “anticipates,” “believes,” “could,” “estimates,” “expects,” “intends,” “may,” “plans,” “potential,” “predicts,” “projects,” “should,” “will,” “would,” and similar expressions are forward-looking statements.
The company cautions that forward-looking statements involve known and unknown risks, uncertainties, and other factors that may cause our actual results, performance, or achievements to be materially different from any future results, performance, or achievements expressed or implied by the forward-looking statements. Forward-looking statements reflect our current views with respect to future events and are based on assumptions and subject to risks and uncertainties. Given these uncertainties, you should not place undue reliance on these forward-looking statements.
In evaluating any forward-looking statement, you should specifically consider the information set forth under the captions “Special Note Regarding Forward-Looking Statements” and “Item 1A. Risk Factors” in the 2008 Form 10-K and the information set forth under “Cautionary Statement Regarding Forward-Looking Statements” in our earnings and other press releases, as well as other cautionary statements contained in our 2009 periodic filings and elsewhere in this report, including the matters discussed in “Critical Accounting Policies and Estimates” and “Item 1A. Risk Factors.” We undertake no obligation beyond that required by law to update publicly any forward-looking statements for any reason, even if new information becomes available or other events occur in the future. You should read this report and the documents that we reference in this report and have filed as exhibits to this report completely and with the understanding that our actual future results may be materially different from what we expect.
Overview
General
HealthSpring, Inc. (the “company” or “HealthSpring”) is one of the country’s largest coordinated care plans whose primary focus is Medicare, the federal government-sponsored health insurance program for U.S. citizens aged 65 and older, qualifying disabled persons, and persons suffering from end-stage renal disease.
We operate Medicare Advantage plans in Alabama, Florida, Illinois, Mississippi, Tennessee, and Texas and offer Medicare Part D prescription drug plans on a national basis. We sometimes refer to our Medicare Advantage plans, including plans providing prescription drug benefits, or “MA-PD,” collectively as “Medicare Advantage” plans and our stand-alone prescription drug plan as our “PDP.” For purposes of additional analysis, the company provides membership and certain financial information, including premium revenue and medical expense, for our Medicare Advantage (including MA-PD) and PDP plans.
Medicare premiums, including premiums paid to our PDP, account for substantially all of our revenue. As a consequence, our profitability is dependent on government funding levels for Medicare programs. The President and both houses of Congress are currently engaged in active debate concerning the reformation of the structure and funding for the U.S. healthcare system, including the Medicare program. Although the bills currently being considered have not become law, various proposals contain items that, if adopted as law, we expect would have a material adverse impact on Medicare Advantage plans, generally, and our plans, specifically. Such proposals include, without limitation, provisions reducing Medicare funding, provisions requiring “competitive bidding” against a reduced plan benefit design, legally-imposed minimum medical loss ratios, premium excise taxes, and further limitations on Medicare Advantage marketing and enrollment periods. Given the inherent uncertainty in the legislative process, we are not currently able to predict what provisions will become law, if any, or the potential impact on the profitability or viability of any of our Medicare Advantage plans, or the potential impact of legislative changes on our Medicare Advantage plan members and their benefits.
We disclose our results by reportable segment in accordance with Statement of Financial Accounting Standard (“SFAS”) No. 131, “Disclosures about Segments of an Enterprise and Related Information,” as codified in the Financial Accounting Standards Board’s Accounting Standards Codification (“FASB ASC”) topic 280. We report our business in four segments: Medicare Advantage; PDP; Commercial; and Corporate. The following discussion of our results of operations includes a discussion of revenue and certain expenses by reportable segment. See “—Segment Information” below for additional information related thereto.

 

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In late October 2009, Leon Medical Centers (“LMC”) completed the second new medical center in Miami-Dade County, Florida, thereby satisfying the contingency for the release of 2,666,667 shares (the “Leon Shares”) of company common stock to the former shareholders of Leon Medical Centers Health Plans, Inc., which was acquired by the company in October 2007. The Leon Shares were placed in escrow at the time of the acquisition pending completion of the two new centers by LMC, which brings the total number of LMC medical centers under exclusive arrangements with the company to seven. The Leon Shares will be included in the computation of basic and diluted earnings per share in the fourth quarter of 2009 and as issued and outstanding on the company’s balance sheet at year end 2009. The company will also record additional purchase price in the fourth quarter of 2009 associated with the release of such shares.
Results of Operations
The consolidated results of operations include the accounts of HealthSpring and its subsidiaries. The following tables set forth the consolidated statements of income data expressed in dollars (in thousands) and as a percentage of total revenue for each period indicated:
                                 
    Three Months Ended September 30,  
    2009     2008  
Revenue:
                               
Premium revenue
  $ 649,795       98.5 %   $ 515,892       97.7 %
Management and other fees
    9,108       1.4       8,207       1.6  
Investment income
    877       0.1       3,800       0.7  
 
                       
Total revenue
    659,780       100.0       527,899       100.0  
 
                       
Operating expenses:
                               
Medical expense
    519,478       78.7       411,703       78.0  
Selling, general and administrative
    65,851       10.0       58,634       11.1  
Depreciation and amortization
    7,782       1.2       7,047       1.3  
Interest expense
    3,762       0.6       4,520       0.9  
 
                       
Total operating expenses
    596,873       90.5       481,904       91.3  
 
                       
Income before income taxes
    62,907       9.5       45,995       8.7  
Income tax expense
    (20,593 )     (3.1 )     (16,635 )     (3.1 )
 
                       
Net income
  $ 42,314       6.4 %   $ 29,360       5.6 %
 
                       
                                 
    Nine Months Ended September 30,  
    2009     2008  
Revenue:
                               
Premium revenue
  $ 1,955,842       98.3 %   $ 1,611,450       97.8 %
Management and other fees
    29,065       1.5       24,056       1.5  
Investment income
    3,532       0.2       11,975       0.7  
 
                       
Total revenue
    1,988,439       100.0       1,647,481       100.0  
 
                       
Operating expenses:
                               
Medical expense
    1,607,481       80.8       1,292,042       78.4  
Selling, general and administrative
    200,408       10.1       177,512       10.8  
Depreciation and amortization
    22,948       1.2       21,280       1.3  
Interest expense
    12,014       0.6       14,513       0.9  
 
                       
Total operating expenses
    1,842,851       92.7       1,505,347       91.4  
 
                       
Income before income taxes
    145,588       7.3       142,134       8.6  
Income tax expense
    (50,772 )     (2.5 )     (51,494 )     (3.1 )
 
                       
Net income
  $ 94,816       4.8 %   $ 90,640       5.5 %
 
                       

 

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Membership
Our primary source of revenue is monthly premium payments we receive based on membership enrolled in Medicare. The following table summarizes our membership as of the dates specified:
                         
    September 30,     December 31,     September 30,  
    2009     2008     2008  
Medicare Advantage Membership
                       
Alabama
    31,007       29,022       28,651  
Florida
    31,513       27,568       27,204  
Illinois
    11,077       9,245       9,005  
Mississippi
    4,473       2,425       2,183  
Tennessee
    57,240       49,933       49,366  
Texas
    51,325       43,889       39,896  
 
                 
Total
    186,635       162,082       156,305  
 
                 
 
                       
Medicare PDP Membership
    303,975       282,429       272,469  
 
                 
 
                       
Commercial
    735       895       921  
 
                 
Medicare Advantage. Our Medicare Advantage membership increased by 19.4% to 186,635 members at September 30, 2009, as compared to 156,305 members at September 30, 2008, with membership gains in all our health plans. Our Medicare Advantage net membership gain of 30,330 since September 30, 2008 reflects both focused sales and marketing efforts through the annual open enrollment and election periods and better retention rates resulting from, we believe, the relative attractiveness of our various plans’ benefits. We currently anticipate small but incremental membership growth throughout the remainder of 2009 in our Medicare Advantage membership through the offering of products to beneficiaries whose enrollment is not restricted by lock-in rules, including age-ins, dual-eligibles, and beneficiaries eligible for one of our special needs plans (“SNPs”).
PDP. PDP membership increased by 11.6% to 303,975 members at September 30, 2009 as compared to 272,469 at September 30, 2008, primarily as a result of the auto-assignment of members at the beginning of the year, despite reducing the CMS regions in which we receive auto-assignments from 31 in 2008 to 24 in 2009. We do not actively market our PDPs and have relied on CMS auto-assignments of dual-eligible beneficiaries for membership. We have continued to receive assignments or otherwise enroll dual-eligible beneficiaries in our PDP plans during lock-in and expect incremental growth for the balance of the year. The company’s membership in its stand-alone PDP as of November 1, 2009 was approximately 309,500.
According to a release by The Centers for Medicare & Medicaid Services (“CMS”), we are again below the relevant benchmarks in 24 of the 34 CMS PDP regions for 2010, although the regions have changed. Based upon recent data released by CMS, the company now estimates that it will have approximately 380,000 — 390,000 members in these 24 regions as of January 1, 2010.
Risk Adjustment Payments
The company’s Medicare premium revenue is subject to adjustment based on the health risk of its members. This process for adjusting premiums is referred to as the CMS risk adjustment payment methodology. Under the risk adjustment payment methodology, coordinated care plans must capture, collect, and report diagnosis code information to CMS. After reviewing the respective submissions, CMS establishes the payments to Medicare plans generally at the beginning of the calendar year, and then adjusts premiums on two separate occasions on a retroactive basis.
The first retroactive risk premium adjustment for a given fiscal year generally occurs during the third quarter of such fiscal year. This initial settlement (the “Initial CMS Settlement”) represents the updating of risk scores for the current year based on updated diagnoses from the prior year. CMS then issues a final retroactive risk premium adjustment settlement for that fiscal year in the following year (the “Final CMS Settlement”).
During the first half of 2009, the company updated its estimated Final CMS Settlement payment amounts for 2008 as a result of additional diagnosis code information and ultimately upon receiving notification from CMS in July 2009 of Final CMS Settlement amounts for 2008. The change in estimate related to the 2008 plan year resulted in an additional $-0- and $6.5 million of premium revenue for the three and nine months ended September 30, 2009, respectively. The impact to net income of the change in estimate during 2009 relating to the 2008 plan year, after the expense for risk sharing with providers and income tax expense, for the three and nine months ended September 30, 2009, was $-0- million and $2.1 million, respectively. Similarly, the change in estimate related to the 2007 plan year resulted in an additional $-0- million and $29.3 million of premium revenue for the three and nine months ended September 30, 2008, respectively. The resulting impact of such changes on net income, after the expense for risk sharing with providers and income tax expense, for the three and nine months ended September 30, 2008, was $-0- million and $13.4 million, respectively.

 

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Total Final CMS Settlement for the 2008 plan year was $31.8 million and represented 1.8% of total Medicare Advantage premiums, as adjusted for risk payments, for the 2008 plan year. Total Final CMS Settlement for the 2007 plan year was $57.9 million and represented 4.4% of total Medicare Advantage premiums, as adjusted for risk payments, received for the 2007 plan year.
Reconciliation of 2008 Part D Activity with CMS
In October 2009, the company received notification from CMS that the company’s receivable from CMS for all Part D activity for the 2008 plan year totaled $36.6 million. The company anticipates settling such amounts from 2008 with CMS in the fourth quarter of 2009. There was no material impact on the company’s financial condition and results of operations as of and for the three and nine months ended September 30, 2009 as a result of adjusting our estimates to final settlement amounts.
Comparison of the Three-Month Period Ended September 30, 2009 to the Three-Month Period Ended September 30, 2008
Revenue
Total revenue was $659.8 million in the three-month period ended September 30, 2009 as compared with $527.9 million for the same period in 2008, representing an increase of $131.9 million, or 25.0%. The components of revenue were as follows:
Premium Revenue: Total premium revenue for the three months ended September 30, 2009 was $649.8 million as compared with $515.9 million in the same period in 2008, representing an increase of $133.9 million, or 26.0%. The components of premium revenue and the primary reasons for changes were as follows:
Medicare Advantage: Medicare Advantage (including MA-PD) premiums were $580.0 million for the three months ended September 30, 2009 as compared to $455.8 million in the third quarter of 2008, representing an increase of $124.2 million, or 27.3%. The increase in Medicare Advantage premiums in 2009 is attributable to increases in membership and in per member per month, or “PMPM,” premium rates in all of our plans. Additionally, the 2009 third quarter included $6.4 million of premium revenue for changes in estimates for current-year retroactive risk settlements related to the first half of 2009. PMPM premiums for the 2009 third quarter averaged $1,043.09, which reflects an increase of 6.7% as compared to the 2008 third quarter. The PMPM premium increase in the current quarter is the result of rate increases in CMS-calculated base rates as well as rate increases related to risk scores.
PDP: PDP premiums (after risk corridor adjustments) were $69.0 million in the three months ended September 30, 2009 compared to $59.1 million in the same period of 2008, an increase of $9.9 million, or 16.8%. The increase in premiums for the 2009 third quarter is primarily the result of increases in membership and PDP PMPM premium rates. Our average PMPM premiums (after risk corridor adjustments) increased 4.7% to $76.34 in the 2009 third quarter, as compared to $72.92 during the 2008 third quarter.
Fee Revenue. Fee revenue was $9.1 million in the third quarter of 2009 compared to $8.2 million for the third quarter of 2008, an increase of $0.9 million. The increase in the current period is attributable to increased management fees as a result of new independent physician associations (“IPAs”) under contract since the 2008 third quarter and higher membership in managed IPAs compared to the same period last year.
Investment Income. Investment income was $0.9 million for the third quarter of 2009 as compared to $3.8 million for the comparable period of 2008, reflecting a decrease of $2.9 million, or 76.9%. The decrease is primarily attributable to a decrease in the average yield on invested and cash balances.

 

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Medical Expense
Medicare Advantage. Medicare Advantage (including MA-PD) medical expense for the three months ended September 30, 2009 increased $101.1 million, or 28.0%, to $462.2 million from $361.1 million for the comparable period of 2008, which is primarily attributable to membership increases in the 2009 period as compared to the 2008 period and increases in PMPM medical expense. For the three months ended September 30, 2009, the Medicare Advantage medical loss ratio, or “MLR,” was 79.7% versus 79.2% for the same period of 2008. The impact from risk adjustment payments relating to current year periods was favorable by 0.7% on the 2009 third quarter. Higher outpatient expenses and increases in physician expenses in Alabama, Tennessee, and Texas health plans resulted in deterioration in the current period MLR. In addition, degradation in the results for the drug benefit component of our MA-PD plans during the current period contributed to the deterioration in the MLR. The deterioration in the current period was partially offset by improvements in inpatient admissions across all markets and continued strong performance in the Florida plan.
Our Medicare Advantage medical expense calculated on a PMPM basis was $831.18 for the three months ended September 30, 2009, compared with $774.36 for the comparable 2008 quarter.
PDP. PDP medical expense for the three months ended September 30, 2009 increased $6.0 million to $56.3 million, compared to $50.3 million in the same period last year. PDP MLR for the 2009 third quarter was 81.5%, compared to 85.1% in the 2008 third quarter. The decrease in PDP MLR for the current quarter was primarily attributable to higher PDP PMPM revenue.
Selling, General, and Administrative Expense
Selling, general, and administrative expense, or “SG&A,” for the three months ended September 30, 2009 was $65.9 million as compared with $58.6 million for the same prior year period, an increase of $7.3 million, or 12.3%. As a percentage of revenue, SG&A expense decreased approximately 110 basis points for the three months ended September 30, 2009 compared to the prior year third quarter. The decrease in SG&A as a percentage of revenue in the current quarter was primarily the result of improved operating leverage, with increases in revenue exceeding increased administrative costs. The $7.3 million increase in the 2009 third quarter as compared to the same period of the prior year is the result of personnel cost increases, primarily related to growth in headcount associated with the management of membership increases.
Depreciation and Amortization Expense
Depreciation and amortization expense was $7.8 million in the three months ended September 30, 2009 as compared with $7.1 million in the same period of 2008, representing an increase of $0.7 million. The increase in the current quarter was the result of incremental amortization expense associated with intangible assets recorded as part of the acquisition in October 2008 by our Texas plan of certain Medicare Advantage contracts from Valley Baptist Health Plans operating in the Rio Grande Valley and incremental depreciation on property and equipment additions made in 2008 and 2009.
Interest Expense
Interest expense was $3.8 million in the 2009 third quarter compared with $4.5 million in the 2008 third quarter. The decrease in the current quarter was the result of lower effective interest rates and lower average principal balances outstanding. The weighted average interest rate incurred on our borrowings during the three month periods ended September 30, 2009 and 2008 was 5.9% and 6.3%, respectively (4.7% and 5.3%, respectively, exclusive of amortization of deferred financing costs).
Income Tax Expense
For the three months ended September 30, 2009, income tax expense was $20.6 million, reflecting an effective tax rate of 32.7% for the 2009 third quarter versus $16.6 million, reflecting a tax rate of 36.2% for the same period of 2008. This lower tax rate principally resulted from a favorable tax impact related to business combination accounting for the Florida health plan acquisition as well as the finalization of the calendar year 2008 tax returns. The Company currently expects the effective income tax rate for the full year will approximate 35.2% after consideration of these items reported in the third quarter.

 

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Comparison of the Nine-Month Period Ended September 30, 2009 to the Nine-Month Period Ended September 30, 2008
Revenue
Total revenue was $1,988.4 million in the nine-month period ended September 30, 2009 as compared with $1,647.5 million for the same period in 2008, representing an increase of $340.9 million, or 20.7%. The components of revenue were as follows:
Premium Revenue: Total premium revenue for the nine months ended September 30, 2009 was $1,955.8 million as compared with $1,611.5 million in the same period in 2008, representing an increase of $344.3 million, or 21.4%. The components of premium revenue and the primary reasons for changes were as follows:
Medicare Advantage: Medicare Advantage (including MA-PD) premiums were $1,704.6 million for the nine months ended September 30, 2009 as compared to $1,398.0 million in the same period of 2008, representing an increase of $306.6 million, or 21.9%. The increase in Medicare Advantage premiums in 2009 is primarily attributable to increases in membership and in PMPM premium rates in substantially all of our plans. PMPM premiums for the current nine month period averaged $1,050.99, which reflects an increase of 6.2% as compared to the 2008 comparable period, as adjusted to exclude retroactive risk adjustments associated with prior years. The PMPM premium increase in the current period is the result of rate increases in CMS-calculated base rates as well as rate increases related to risk scores.
PDP: PDP premiums (after risk corridor adjustments) were $248.9 million in the nine months ended September 30, 2009 compared to $209.1 million in the same period of 2008, an increase of $39.8 million, or 19.1%. The increase in premiums for the current nine month period is primarily the result of increases in membership and PDP PMPM premium rates. Our average PMPM premiums (after risk corridor adjustments) increased 7.0% to $94.65 in the current nine month period, as compared to $88.43 during the same 2008 period.
Fee Revenue. Fee revenue was $29.1 million in the current nine month period of 2009 compared to $24.1 million for the same period of 2008, an increase of $5.0 million. The increase in the current period is attributable to increased management fees as a result of new IPAs under contract since the same period in 2008 and higher membership in managed IPAs compared to the same period last year.
Investment Income. Investment income was $3.5 million for the first nine month period of 2009 as compared to $12.0 million for the comparable period of 2008, reflecting a decrease of $8.5 million, or 70.5%. The decrease is primarily attributable to a decrease in the average yield on invested and cash balances.
Medical Expense
Medicare Advantage. Medicare Advantage (including MA-PD) medical expense for the nine months ended September 30, 2009 increased $287.9 million, or 26.3%, to $1,380.5 million from $1,092.6 million for the comparable period of 2008, which is primarily attributable to membership increases in the 2009 period as compared to the 2008 period and increases in PMPM medical expense. For the nine months ended September 30, 2009, the Medicare Advantage MLR, was 81.1% as compared to 79.2% for the same period of 2008, as adjusted to exclude favorable final CMS settlement adjustments associated with prior years. (See “—Risk Adjustment Payments” above.) The deterioration in the MLR for the current period was primarily attributable to increased inpatient procedure costs in our Tennessee health plan and increases in physician and outpatient expenses in our Alabama, Tennessee, and Texas health plans. The deterioration was partially offset by improvements in our Florida plan’s MLR attributable primarily to hospital recontracting efforts.
Our Medicare Advantage medical expense calculated on a PMPM basis was $852.39 for the nine months ended September 30, 2009, compared with $783.99 for the comparable 2008 period, as adjusted to exclude favorable retroactive risk adjustments associated with prior years.
PDP. PDP medical expense for the nine months ended September 30, 2009 increased $29.4 million to $224.5 million, compared to $195.1 million in the same period last year. PDP MLR for the 2009 nine month period was 90.2%, compared to 93.3% in the same period in 2008. The decrease in PDP MLR for the current period was primarily attributable to higher PDP revenue and higher utilization of generic prescription drugs.

 

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Selling, General, and Administrative Expense
SG&A for the nine months ended September 30, 2009 was $200.4 million as compared with $177.5 million for the same prior year period, an increase of $22.9 million, or 12.9%. As a percentage of revenue, SG&A expense decreased approximately 70 basis points for the nine months ended September 30, 2009 compared to the prior year same period, primarily as a result of improved operating leverage. The $22.9 million increase in the 2009 period as compared to the same period of the prior year is the result of personnel cost increases, primarily related to growth in headcount and increases in commissions associated with the anticipated growth in membership in the current period.
Consistent with historical trends, the company expects the majority of its sales and marketing expenses to be incurred in the first and fourth quarters of each year in connection with the annual Medicare enrollment cycle.
Depreciation and Amortization Expense
Depreciation and amortization expense was $22.9 million in the nine months ended September 30, 2009 as compared with $21.3 million in the same period of 2008, representing an increase of $1.6 million, or 7.8%. The increase in the current period was the result of incremental amortization expense associated with the acquisition in October 2008 of certain Medicare Advantage contracts from Valley Baptist Health Plans operating in the Rio Grande Valley and incremental depreciation on property and equipment additions.
Interest Expense
Interest expense was $12.0 million in the 2009 nine month period, compared with $14.5 million in the 2008 same period. The decrease in the current period was the result of lower effective interest rates and lower average principal balances outstanding. The weighted average interest rate incurred on our borrowings during the nine month periods ended September 30, 2009 and 2008 was 6.1% and 6.6%, respectively (4.9% and 5.6%, respectively, exclusive of amortization of deferred financing costs).
Income Tax Expense
For the nine months ended September 30, 2009, income tax expense was $50.8 million, reflecting an effective tax rate of 34.9%, versus $51.5 million, reflecting an effective tax rate of 36.2%, for the same period of 2008. This lower tax rate resulted from a favorable tax impact related to business combination accounting for the Florida health plan acquisition as well as the finalization of the calendar year 2008 tax returns. The Company currently expects the effective income tax rate for the full year will approximate 35.2% after consideration of these items reported in the third quarter.
Segment Information
We report our business in four segments: Medicare Advantage, stand-alone Prescription Drug Plan, Commercial, and Corporate. Medicare Advantage (“MA-PD”) consists of Medicare-eligible beneficiaries receiving healthcare benefits, including prescription drugs, through a coordinated care plan qualifying under Part C and Part D of the Medicare Program. Stand-alone Prescription Drug Plan (“PDP”) consists of Medicare-eligible beneficiaries receiving prescription drug benefits on a stand-alone basis in accordance with Medicare Part D. Commercial consists of our commercial health plan business. The Commercial segment was insignificant as of September 30, 2009 and 2008. The Corporate segment consists primarily of corporate expenses not allocated to the other reportable segments. These segment groupings are also consistent with information used by our chief executive officer in making operating decisions.
The results of each segment are measured and evaluated by earnings before interest expense, depreciation and amortization expense, and income taxes (“EBITDA”). We do not allocate certain corporate overhead amounts (classified as SG&A expense) or interest expense to our segments. We evaluate interest expense, income taxes, and asset and liability details on a consolidated basis as these items are managed in a corporate shared service environment and are not the responsibility of segment operating management.
Revenue includes premium revenue, management and other fee income, and investment income.

 

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Financial data by reportable segment for the three and nine months ended September 30 is as follows (in thousands):
                                         
    MA-PD     PDP     Commercial     Corporate     Total  
Three months ended September 30, 2009
                                       
Revenue
  $ 589,966     $ 69,044     $ 754     $ 16     $ 659,780  
EBITDA
    71,983       10,644       (269 )     (7,907 )     74,451  
Depreciation and amortization expense
    6,330       20             1,432       7,782  
 
                                       
Three months ended September 30, 2008
                                       
Revenue
  $ 466,916     $ 59,917     $ 960     $ 106     $ 527,899  
EBITDA
    57,477       6,429       670       (7,014 )     57,562  
Depreciation and amortization expense
    6,060       2             985       7,047  
 
                                       
Nine months ended September 30, 2009
                                       
Revenue
  $ 1,736,970     $ 249,158     $ 2,269     $ 42     $ 1,988,439  
EBITDA
    183,866       18,557       (277 )     (21,596 )     180,550  
Depreciation and amortization expense
    19,052       60             3,836       22,948  
 
                                       
Nine months ended September 30, 2008
                                       
Revenue
  $ 1,430,899     $ 211,923     $ 4,346     $ 313     $ 1,647,481  
EBITDA
    190,758       7,974       66       (20,871 )     177,927  
Depreciation and amortization expense
    18,261       5             3,014       21,280  
As of January 1, 2009, the company revised its methodology for allocating the selling SG&A expense, but only within its prescription drug operations, which resulted in allocating a greater share of such expenses to the company’s MA-PD segment. As such, the MA-PD and PDP segments’ EBITDA amounts for the 2008 period include reclassification adjustments between segments such that the periods presented are comparable.
A reconciliation of reportable segment EBITDA to net income included in the consolidated statements of income for the three and nine months ended September 30 is as follows (in thousands):
                                 
    Three Months Ended     Nine Months Ended  
    September 30,     September 30,  
    2009     2008     2009     2008  
EBITDA
  $ 74,451     $ 57,562     $ 180,550     $ 177,927  
Income tax expense
    (20,593 )     (16,635 )     (50,772 )     (51,494 )
Interest expense
    (3,762 )     (4,520 )     (12,014 )     (14,513 )
Depreciation and amortization
    (7,782 )     (7,047 )     (22,948 )     (21,280 )
 
                       
Net Income
  $ 42,314     $ 29,360     $ 94,816     $ 90,640  
 
                       
We use segment EBITDA as an analytical indicator for purposes of assessing segment performance, as is common in the healthcare industry. Segment EBITDA should not be considered as a measure of financial performance under generally accepted accounting principles and segment EBITDA, as presented, may not be comparable to other companies.
Liquidity and Capital Resources
We finance our operations primarily through internally generated funds. All of our outstanding funded indebtedness was incurred in connection with the acquisition of the LMC Health Plans in October 2007. See “—Indebtedness” below.
We generate cash primarily from premium revenue and our primary use of cash is the payment of medical and SG&A expenses and principal and interest on indebtedness. We anticipate that our current level of cash on hand, internally generated cash flows, and borrowings available under our revolving credit facility will be sufficient to fund our working capital needs, our debt service, and anticipated capital expenditures over at least the next twelve months.

 

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The reported changes in cash and cash equivalents for the nine month period ended September 30, 2009, compared to the comparable period of 2008, were as follows (in thousands):
                 
    Nine Months Ended  
    September 30,  
    2009     2008  
Net cash provided by operating activities
  $ 115,460     $ 152,551  
Net cash (used in) investing activities
    (20,207 )     (5,715 )
Net cash provided by (used in) financing activities
    12,273       (43,738 )
 
           
Net increase in cash and cash equivalents
  $ 107,526     $ 103,098  
 
           
Cash Flows from Operating Activities
Our primary sources of liquidity are cash flows provided by our operations and available cash on hand. To date, we have not borrowed under our $100.0 million revolving credit facility. We generated cash from operating activities of $115.5 million during the nine months ended September 30, 2009, compared to generating cash of $152.6 million during the nine months ended September 30, 2008. Cash flows from operations for the 2009 period was favorably impacted by the receipt of approximately $31.8 million of prior year Final CMS Settlements compared to similar net amounts received in the 2008 period of $57.9 million. Additionally, current period cash flows from operations were negatively impacted by the timing of incentive compensation and income tax payments in 2009.
Cash Flows from Investing and Financing Activities
For the nine months ended September 30, 2009, the primary investing activities consisted of expenditures of $55.8 million to purchase investment securities, the receipt of $47.5 million in proceeds from the maturity of investment securities and $11.5 million in property and equipment additions. The investing activity in the prior year period consisted primarily of $47.6 million used to purchase investments, $57.2 million in proceeds from the maturity of investment securities, $8.4 million in property and equipment additions, and the expenditure of $7.2 million for the Valley Plan acquisition. During the nine months ended September 30, 2009, the company’s financing activities consisted primarily of $36.1 million of funds received in excess of funds withdrawn from CMS for the benefit of members, and $23.9 million for the repayment of long-term debt. The financing activity in the prior year period consisted primarily of $4.4 million of funds received in excess of funds withdrawn from CMS for the benefit of members, $28.3 million used for the purchase of treasury stock and $21.0 million for the repayment of long-term debt. Funds due (held) for the benefit of members from CMS are recorded on our balance sheet at September 30, 2009 and at December 31, 2008. We anticipate settling approximately $36.6 million of such Part D related amounts (including risk corridor settlements) relating to 2008 with CMS during the fourth quarter of 2009 as part of the final settlement of Part D payments for the 2008 plan year.
Cash and Cash Equivalents
At September 30, 2009, the company’s cash and cash equivalents were $389.8 million, $75.3 million of which was held at unregulated subsidiaries. Approximately $34.9 million of the cash balance relates to amounts held by the company for the benefit of its Part D members. We expect CMS to settle this amount, related to the 2009 plan year, during the second half of 2010.
Substantially all of the company’s sources of liquidity are in the form of cash and cash equivalents ($389.8 million at September 30, 2009), the majority of which ($314.5 million at September 30, 2009) is held by the company’s regulated insurance subsidiaries, which amounts are required by law and by our credit agreement to be invested in low-risk, short-term, highly-liquid investments (such as government securities, money market funds, deposit accounts, and overnight repurchase agreements). The company also invests in securities ($98.8 million at September 30, 2009), primarily corporate and government debt securities, that it generally intends, and has the ability, to hold to maturity. Because the company is not relying on these debt instruments for liquidity, short term fluctuations in market pricing generally do not affect the company’s ability to meet its liquidity needs. To date, the company has not experienced any material issuer defaults on its debt investments.

 

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Statutory Capital Requirements
Our HMO and regulated insurance subsidiaries are required to maintain satisfactory minimum net worth requirements established by their respective state departments of insurance. At September 30, 2009, our Texas (200% of authorized control level was $29.4 million; actual $67.6 million), Tennessee (minimum $17.5 million; actual $93.3 million), Florida (minimum $9.8 million; actual $22.9 million) and Alabama (minimum $1.1 million; actual $41.6 million) HMO subsidiaries as well as our life and health insurance subsidiary (minimum $1.4 million; actual $18.8 million) were in compliance with statutory minimum net worth requirements. Notwithstanding the foregoing, the state departments of insurance can require our HMO and regulated insurance subsidiaries to maintain minimum levels of statutory capital in excess of amounts required under the applicable state law if they determine that maintaining additional statutory capital is in the best interest of our members. In addition, as a condition to its approval of the LMC Health Plans acquisition, the Florida Office of Insurance Regulation has required the Florida plan to maintain 115% of the statutory surplus otherwise required by Florida law until September 2010.
The HMOs and regulated insurance subsidiaries are restricted from making distributions without appropriate regulatory notifications and approvals or to the extent such distributions would put them out of compliance with statutory net worth requirements. During the nine months ended September 30, 2009, our Alabama and Texas HMO subsidiaries distributed $14.0 million and $15.0 million in cash, respectively, to the parent company.
Effective July 31, 2009, we novated our PDP members and transferred the related assets and liabilities of the PDP business from the company’s Tennessee insurance subsidiary to our life and health insurance subsidiary. We obtained approvals for the transaction from CMS, the Tennessee Department of Commerce and Insurance, and the Texas Department of Insurance. In connection with the novation, we were required to infuse $2.5 million of capital into our life and health subsidiary in the second quarter and agree to other financial measures relating to such subsidiary’s net worth and capital in order to comply with various state regulatory requirements. As a result of the novation and corresponding asset transfer, our Tennessee HMO’s statutory capital requirements will no longer be impacted by the PDP business segment’s operating results and financial position.
Indebtedness
Long-term debt at September 30, 2009 and December 31, 2008 consisted of the following (in thousands):
                 
    September 30,     December 31,  
    2009     2008  
Senior secured term loan
  $ 244,154     $ 268,013  
Less: current portion of long-term debt
    (35,729 )     (32,277 )
 
           
Long-term debt less current portion
  $ 208,425     $ 235,736  
 
           
In connection with funding the acquisition of LMC Health Plans, on October 1, 2007, we entered into agreements with respect to a $400.0 million, five-year credit facility (collectively, the “Credit Agreement”) which, subject to the terms and conditions set forth therein, provides for $300.0 million in term loans and a $100.0 million revolving credit facility. The $100.0 million revolving credit facility, which is available for working capital and general corporate purposes including capital expenditures and permitted acquisitions, is undrawn as of the date of this report. Due to Credit Agreement covenants restricting the company’s leverage, available borrowings under the revolving credit facility at September 30, 2009 were limited to $63.0 million.
Off-Balance Sheet Arrangements
At September 30, 2009, we did not have any off-balance sheet arrangement requiring disclosure.
Commitments and Contingencies
We did not experience any material changes to contractual obligations outside the ordinary course of business during the nine months ended September 30, 2009.

 

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Critical Accounting Policies and Estimates
The preparation of our consolidated financial statements requires our management to make a number of estimates and assumptions relating to the reported amount of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the period. We base our estimates on historical experience and on various other assumptions that we believe are reasonable under the circumstances. Changes in estimates are recorded if and when better information becomes available. As future events and their effects cannot be determined with precision, actual results could differ significantly from these estimates. Changes in estimates resulting from continuing changes in the economic environment will be reflected in the financial statements in future periods.
We believe that the accounting policies discussed below are those that are most important to the presentation of our financial condition and results of operations and that require our management’s most difficult, subjective, and complex judgments. For a more complete discussion of these and other critical accounting policies and estimates of the company, see our 2008 Form 10-K.
Medical Expense and Medical Claims Liability
Medical expense is recognized in the period in which services are provided and includes an estimate of the cost of medical expense that has been incurred but not yet reported, or IBNR. Medical expense includes claim payments, capitation payments, risk sharing payments and pharmacy costs, net of rebates, as well as estimates of future payments of claims incurred, net of reinsurance. Capitation payments represent monthly contractual fees disbursed to physicians and other providers who are responsible for providing medical care to members. Pharmacy costs represent payments for members’ prescription drug benefits, net of rebates from drug manufacturers. Rebates are recognized when earned, according to the contractual arrangements with the respective vendors. Premiums we pay to reinsurers are reported as medical expense and related reinsurance recoveries are reported as deductions from medical expense.
Medical claims liability includes medical claims reported to the plans but not yet paid as well as an actuarially determined estimate of claims that have been incurred but not yet reported.
The IBNR component of total medical claims liability is based on our historical claims data, current enrollment, health service utilization statistics, and other related information. Estimating IBNR is complex and involves a significant amount of judgment. Accordingly, it represents our most critical accounting estimate. The development of the IBNR includes the use of standard actuarial developmental methodologies, including completion factors and claims trends, which take into account the potential for adverse claims developments, and considers favorable and unfavorable prior period developments. Actual claims payments will differ, however, from our estimates. A worsening or improvement of our claims trend or changes in completion factors from those that we assumed in estimating medical claims liabilities at September 30, 2009 would cause these estimates to change in the near term and such a change could be material.
As discussed above, actual claim payments will differ from our estimates. The period between incurrence of the expense and payment is, as with most health insurance companies, relatively short, however, with over 90% of claims typically paid within 60 days of the month in which the claim is incurred. Although there is a risk of material variances in the amounts of estimated and actual claims, the variance is known quickly. Accordingly, we expect that substantially all of the estimated medical claims payable as of the end of any fiscal period (whether a quarter or year end) will be known and paid during the next fiscal period.
Our policy is to record the best estimate of medical expense IBNR. Using actuarial models, we calculate a minimum amount and maximum amount of the IBNR component. To most accurately determine the best estimate, our actuaries determine the point estimate within their minimum and maximum range by similar medical expense categories within lines of business. The medical expense categories we use are: in-patient facility, outpatient facility, all professional expense, and pharmacy. The lines of business are Medicare and commercial.
We apply different estimation methods depending on the month of service for which incurred claims are being estimated. For the more recent months, which account for the majority of the amount of IBNR, we estimate our claims incurred by applying the observed trend factors to the trailing twelve-month PMPM costs. For prior months, costs have been estimated using completion factors. In order to estimate the PMPMs for the most recent months, we validate our estimates of the most recent months’ utilization levels to the utilization levels in older months using actuarial techniques that incorporate a historical analysis of claim payments, including trends in cost of care provided, and timeliness of submission and processing of claims.

 

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Actuarial standards of practice generally require the actuarially developed medical claims liability estimates to be sufficient, taking into account an assumption of moderately adverse conditions. As such, we previously recognized in our medical claims liability a separate provision for adverse claims development, which was intended to account for moderately adverse conditions in claims payment patterns, historical trends, and environmental factors. In periods prior to the fourth quarter of 2008, we believed that a separate provision for adverse claims development was appropriate to cover additional unknown adverse claims not anticipated by the standard assumptions used to produce the IBNR estimates that were incurred prior to, but paid after, a period end. When determining our estimate of IBNR at December 31, 2008, however, we determined that a separate provision for adverse claims development was no longer necessary, primarily as a result of the growth and stabilizing trends experienced in our Medicare business, continued favorable development of prior period IBNR estimates, and the declining significance of our commercial line of business.
The following table illustrates the sensitivity of the completion and claims trend factors and the impact on our operating results caused by changes in these factors that management believes are reasonably likely based on our historical experience and September 30, 2009 data (dollars in thousands):
                         
Completion Factor (a)   Claims Trend Factor (b)
    Increase           Increase
    (Decrease)           (Decrease)
Increase   in Medical   Increase   in Medical
(Decrease)   Claims   (Decrease)   Claims
in Factor   Liability   in Factor   Liability
   3%   $ (4,886 )         (3)%     $ (2,598 )
2     (3,294 )     (2)       (1,730 )
1     (1,666 )     (1)       (864 )
(1)     1,705       1       862  
 
     
(a)   Impact due to change in completion factor for the most recent three months. Completion factors indicate how complete claims paid to date are in relation to estimates for a given reporting period. Accordingly, an increase in completion factor results in a decrease in the remaining estimated liability for medical claims.
 
(b)   Impact due to change in annualized medical cost trends used to estimate PMPM costs for the most recent three months.
Each month, we re-examine the previously established medical claims liability estimates based on actual claim submissions and other relevant changes in facts and circumstances. As the liability estimates recorded in prior periods become more exact, we increase or decrease the amount of the estimates, and include the changes in medical expenses in the period in which the change is identified. In every reporting period, our operating results include the effects of more completely developed medical claims liability estimates associated with prior periods.
In establishing medical claims liability, we also consider premium deficiency situations and evaluate the necessity for additional related liabilities. There were no required premium deficiency accruals at September 30, 2009 or December 31, 2008.
Premium Revenue Recognition
We generate revenues primarily from premiums we receive from CMS to provide healthcare benefits to our members. We receive premium payments on a PMPM basis from CMS to provide healthcare benefits to our Medicare members, which premiums are fixed (subject to retroactive risk adjustment) on an annual basis by contracts with CMS. Although the amount we receive from CMS for each member is fixed, the amount varies among Medicare plans according to, among other things, plan benefits, demographics, geographic location, age, gender, and the relative risk score of the membership.
We generally receive premiums on a monthly basis in advance of providing services. Premiums collected in advance are deferred and reported as deferred revenue. We recognize premium revenue during the period in which we are obligated to provide services to our members. Any amounts that have not been received are recorded on the balance sheet as accounts receivable.

 

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Our Medicare premium revenue is subject to periodic adjustment under what is referred to as CMS’s risk adjustment payment methodology based on the health risk of our members. Risk adjustment uses health status indicators to correlate the payments to the health acuity of the member, and consequently establishes incentives for plans to enroll and treat less healthy Medicare beneficiaries. Under the risk adjustment payment methodology, coordinated care plans must capture, collect, and report diagnosis code information to CMS. After reviewing the respective submissions, CMS establishes the payments to Medicare plans generally at the beginning of the calendar year, and then adjusts premium levels on two separate occasions on a retroactive basis. The first retroactive risk premium adjustment for a given fiscal year generally occurs during the third quarter of such fiscal year. This initial settlement (the “Initial CMS Settlement”) represents the updating of risk scores for the current year based on the prior year’s dates of service. CMS then issues a final retroactive risk premium adjustment settlement for that fiscal year in the following year (the “Final CMS Settlement”). We estimate and record on a monthly basis both the Initial CMS Settlement and the Final CMS Settlement.
We develop our estimates for risk premium adjustment settlement utilizing historical experience and predictive actuarial models as sufficient member risk score data becomes available over the course of each CMS plan year. Our actuarial models are populated with available risk score data on our members. Risk premium adjustments are based on member risk score data from the previous year. Risk score data for members who entered our plans during the current plan year, however, is not available for use in our models; therefore, we make assumptions regarding the risk scores of this subset of our member population.
All such estimated amounts are periodically updated as additional diagnosis code information is reported to CMS and adjusted to actual amounts when the ultimate adjustment settlements are either received from CMS or the company receives notification from CMS of such settlement amounts. We have refined our process of estimating risk settlements by increasing the frequency of risk data submissions to CMS which results in a more timely and complete data set used to populate our actuarial models.
As a result of the variability of factors, including plan risk scores, that determine such estimations, the actual amount of CMS’s retroactive risk premium settlement adjustments could be materially more or less than our estimates. Consequently, our estimate of our plans’ risk scores for any period and our accrual of settlement premiums related thereto, may result in favorable or unfavorable adjustments to our Medicare premium revenue and, accordingly, our profitability. There can be no assurances that any such differences will not have a material effect on any future quarterly or annual results of operations.
The following table illustrates the sensitivity of the Final CMS Settlements and the impact on premium revenue caused by differences between actual and estimated settlement amounts that management believes are reasonably likely, based on our historical experience and premium revenue for the nine months ending September 30, 2009 (dollars in thousands):
             
      Increase  
  Increase   (Decrease)  
  (Decrease)   In Settlement  
  in Estimate   Receivable  
     1.5%   $ 25,107    
  1.0     16,738    
  0.5     8,369    
  (0.5)     (8,369 )  

 

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Goodwill and Indefinite-Life Intangible Assets
Goodwill represents the excess of cost over fair value of assets of businesses acquired. Goodwill and intangible assets acquired in a purchase business combination and determined to have an indefinite useful life are not amortized, but instead are tested for impairment at least annually. An impairment loss is recognized to the extent that the carrying amount exceeds the asset’s fair value. This determination is made at the reporting unit level and consists of two steps. First, the company determines the fair value of the reporting unit and compares it to its carrying amount. Second, if the carrying amount of the reporting unit exceeds its fair value, an impairment loss is recognized for any excess of the carrying amount of the unit’s goodwill over the implied fair value of that goodwill. The implied fair value of goodwill is determined by allocating the fair value of the reporting units in a manner similar to a purchase price allocation, in accordance with SFAS No. 141 (Revised 2007), “Business Combinations,” as codified in FASB ASC 805. The residual fair value after this allocation is the implied fair value of the reporting unit’s goodwill. Goodwill currently exists at four of our reporting units — Alabama, Florida, Tennessee and Texas.
Goodwill valuations have been determined using an income approach based on the present value of future cash flows of each reporting unit. In assessing the recoverability of goodwill, we consider historical results, current operating trends and results, and we make estimates and assumptions about premiums, medical cost trends, margins and discount rates based on our budgets, business plans, economic projections, anticipated future cash flows and regulatory data. Each of these factors contains inherent uncertainties and management exercises substantial judgment and discretion in evaluating and applying these factors.
Although we believe we have sufficient current and historical information available to us to test for impairment, it is possible that actual cash flows could differ from the estimated cash flows used in our impairment tests. We could also be required to evaluate the recoverability of goodwill prior to the annual assessment if we experience various triggering events, including significant declines in margins or sustained and significant market capitalization declines. These types of events and the resulting analyses could result in goodwill impairment charges in the future. Impairment charges, although non-cash in nature, could adversely affect our financial results in the periods of such charges. In addition, impairment charges may limit our ability to obtain financing in the future.
Recently Issued Accounting Pronouncements
In June 2009, the FASB issued SFAS No. 167, “Amendments to FASB Interpretation No. 46(R),” as codified in the FASB ASC subtopic 810-10 (“ASC 810-10”). SFAS No. 167 amends FASB Interpretation No. 46(R), “Variable Interest Entities,” as codified in the FASB ASC section 810-10-10 (“ASC 810-10-10”) for determining whether an entity is a variable interest entity (“VIE”) and requires an enterprise to perform an analysis to determine whether the enterprise’s variable interest or interests give it a controlling financial interest in a VIE. Under ASC 810-10, an enterprise has a controlling financial interest when it has a) the power to direct the activities of a VIE that most significantly impact the entity’s economic performance and b) the obligation to absorb losses of the entity or the right to receive benefits from the entity that could potentially be significant to the VIE. ASC 810-10 also requires an enterprise to assess whether it has an implicit financial responsibility to ensure that a VIE operates as designed when determining whether it has power to direct the activities of the VIE that most significantly impact the entity’s economic performance. ASC 810-10 also requires ongoing assessments of whether an enterprise is the primary beneficiary of a VIE, requires enhanced disclosures and eliminates the scope exclusion for qualifying special-purpose entities. ASC 810-10 will be effective as of January 1, 2010. We are currently evaluating the impact that ASC 810-10 will have on our financial statements.
On August 28, 2009, the FASB issued Accounting Standard Update (ASU) 2009-05, an update to ASC 820, “Fair Value Measurement and Disclosures: Measuring Liabilities at Fair Value.” The ASU provides clarification on measuring liabilities at fair value when a quoted price in an active market is not available. The guidance is effective for the first reporting period beginning after issuance. We are currently evaluating the impact that ASU 2009-05 will have on our financial statements.
Item 3: Quantitative and Qualitative Disclosures About Market Risk
No material changes have occurred in our exposure to interest rate risk since the information previously reported under the caption “Item 7A. Quantitative and Qualitative Disclosures About Market Risk” in our 2008 Form 10-K, other than an increase in our cash and cash equivalents in the ordinary course of business, the sensitivity of which to changes in interest rates we would not consider material to our business.

 

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As of September 30, 2009, the company had approximately $6.7 million of investments that are collateralized by mortgages, no material amounts of which are collateralized by subprime mortgages.
Item 4: Controls and Procedures
Our senior management carried out the evaluation required by Rule 13a-15 under the Exchange Act, under the supervision and with the participation of our Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”), of the effectiveness of our disclosure controls and procedures as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act (“Disclosure Controls”). Based on the evaluation, our senior management, including our CEO and CFO, concluded that, as of September 30, 2009, our Disclosure Controls were effective.
There has been no change in our internal control over financial reporting identified in connection with the evaluation that occurred during the quarter ended September 30, 2009 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
Our management, including our CEO and CFO, does not expect that our Disclosure Controls and internal controls will prevent all errors and all fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, with the company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty and that breakdowns can occur because of simple error and mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of controls.
The design of any system of controls also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions; over time, a control may become inadequate because of changes in conditions or the degree of compliance with the policies or procedures may deteriorate. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and may not be detected.

 

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PART II — OTHER INFORMATION
Item 1. Legal Proceedings.
We are not currently involved in any pending legal proceeding that we believe is material to our financial condition or results of operations. We are, however, involved from time to time in routine legal matters and other claims incidental to our business, including employment-related claims, claims relating to our health plans’ contractual relationships with providers and members, and claims relating to marketing practices of sales agents and agencies that are employed by, or independent contractors to, our health plans.
Item 1A. Risk Factors.
In addition to the other information set forth in this report, you should consider carefully the risks and uncertainties previously reported and described under the caption “Part I — Item 1A. Risk Factors” in the 2008 Form 10-K, the occurrence of any of which could materially and adversely affect our business, prospects, financial condition, or operating results. The risks previously reported and described in our 2008 Form 10-K are not the only risks facing our business. Additional risks and uncertainties not currently known to us or that we currently consider to be immaterial also could materially and adversely affect our business, prospects, financial condition, or operating results.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.
Issuer Purchases of Equity Securities
                                 
                    Total Number of        
                    Shares Purchased as     Maximum Number of  
                    Part of Publicly     Shares that May Yet  
    Total Number of     Average Price Paid per     Announced Plans or     Be Purchased Under  
Period   Shares Purchased     Share (1)($)     Programs     the Plans or Programs  
07/01/09 — 07/31/09
                       
08/01/09 — 08/31/09
                       
09/01/09 — 09/30/09
    1,534       13.97              
 
                       
Total
    1,534       13.97              
 
                       
     
(1)   Shares purchased are attributable to the withholding of shares by the company to satisfy the payment of tax obligations related to the vesting of shares of restricted stock.
Item 3. Defaults Upon Senior Securities.
Inapplicable.
Item 4. Submission of Matters to a Vote of Security Holders.
Inapplicable.
Item 5. Other Information.
On October 29, 2009, the company, through its subsidiaries, entered into an amendment (the “Amendment”) to HealthSpring’s management services agreement with Argus Health Systems, Inc. (“Argus”), the company’s contracted pharmacy benefits manager. Pursuant to the management services agreement, Argus disburses amounts payable for members in HealthSpring’s Medicare plans with prescription drug coverage and provides certain other administrative services to HealthSpring, primarily with respect to its Medicare Part D prescription drug benefit plans. The material provisions of the Amendment (i) reduced the initial term to expire on December 31, 2010, (ii) implemented a revised fee schedule, and (iii) modified certain performance standards.
Item 6. Exhibits.
See Exhibit Index following signature page.

 

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SIGNATURE
Pursuant to the requirements 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.
         
 
  HEALTHSPRING, INC.
 
       
Date: October 29, 2009
  By:   /s/ Karey L. Witty
 
       
 
      Karey L. Witty
 
      Executive Vice President and
 
      Chief Financial Officer
(Principal Financial and Accounting Officer)

 

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EXHIBIT INDEX
         
  10.1    
First Amendment to Amended and Restated Management Services Agreement, dated as of April 2, 2009, between Argus Health Systems, Inc. and HealthSpring of Tennessee, Inc., Texas HealthSpring, LLC, HealthSpring Life & Health Insurance Company, Inc., HealthSpring of Florida, Inc., and HealthSpring of Alabama, Inc.
       
 
  31.1    
Certifications of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
       
 
  31.2    
Certifications of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
       
 
  32.1    
Certification of the Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
       
 
  32.2    
Certification of the Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

 

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