10-K period ending 12/31/06



UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

FORM 10-K

x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the Fiscal Year Ended December 31, 2006

OR

o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the Transition Period From _____________ to _____________

_________________________________________________

Commission File Number 001-32209

WellCare Health Plans, Inc.
(Exact Name of Registrant as Specified in Its Charter)

 
Delaware
 
47-0937650
 
 
(State or Other Jurisdiction of Incorporation Organization)
 
(I.R.S. Employer Identification No.)
 
         
 
8725 Henderson Road, Renaissance One
Tampa, Florida
 
 
33634
 
 
(Address of Principal Executive Offices)
 
(Zip Code)
 

 
(813) 290-6200
 
 
Registrant’s telephone number, including area code
 

Securities registered pursuant to Section 12(b) of the Exchange Act:

 
Common Stock, par value $0.01 per share
 
New York Stock Exchange
 
 
(Title of Class)
 
(Name of Each Exchange on which Registered)
 

Securities registered pursuant to Section 12(g) of the Exchange Act:
NONE

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes x No

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 of Section 15(d) of the Act. Yes o No x

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No o

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. Large Accelerated Filer x Accelerated Filer o Non-Accelerated Filer o 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes o No x

The aggregate market value of Common Stock held by nonaffiliates of the registrant (33,422,044 shares) on June 30, 2006 was $1,639,351,258 (based on the closing price of $49.05 per share on June 30, 2006 as reported on the New York Stock Exchange). For purposes of this computation, all officers, directors and 10% beneficial owners of the registrant are deemed to be affiliates. Such determination should not be deemed to be an admission that such officers, directors or 10% beneficial owners are, in fact, affiliates of the registrant.

As of February 14, 2007 there were outstanding 40,944,434 shares of the registrant's Common Stock, par value $0.01 per share.

Documents Incorporated by Reference

Portions of the registrant's definitive Proxy Statement for the 2007 Annual Meeting of Stockholders are incorporated by reference into Part III of this Form 10-K.



 


TABLE OF CONTENTS

   
Page
PART 1
   
PART II
   
PART III
   
PART IV
   
 


PART I

Item 1. Business

Overview

We provide managed care services exclusively to government-sponsored healthcare programs, focusing on Medicaid and Medicare. We offer a variety of Medicare and Medicaid plans, including health plans for families, children, the aged, blind and disabled and prescription drug plans, as of December 31, 2006 serving over 2,258,000 members nationwide.

Medicaid was established under the U.S. Social Security Act of 1965 to provide medical assistance to low income and disabled persons. It is state operated and implemented, although it is funded by both the state and federal governments. Our Medicaid plans include plans for individuals who are dually eligible for both Medicare and Medicaid, and recipients of the Temporary Assistance to Needy Families (“TANF”) programs, Supplemental Security Income (“SSI”) programs, State Children’s Health Insurance (“S-CHIP”) programs, and the Family Health Plus (“FHP”) programs. The TANF program generally provides assistance to low-income families with children and the SSI program generally provides assistance to low-income aged, blind or disabled individuals. Families who exceed the income thresholds for Medicaid may be able to qualify for the state S-CHIP and FHP programs.

Medicare is a federal program that provides eligible persons age 65 and over and some disabled persons a variety of hospital, medical insurance and prescription drug benefits. Medicare is administered and funded by the federal Centers for Medicare & Medicaid Services (“CMS”). Our Medicare plans include stand-alone prescription drug plans (“PDP”) and Medicare Advantage (“MA”) plans which include both Medicare coordinated care (“MCC”) plans and Medicare private fee-for-service (“PFFS”) plans. Medicare Advantage is Medicare’s managed care alternative to original Medicare fee-for-service which individuals enroll into directly through CMS. MCC plans are plans that are administered through a health maintenance organization (“HMO”) and generally require members to seek health care services from a network of health care providers. PFFS plans are open-access plans that allow members to be seen by any physician or facility that participates in the Medicare program.

We believe that our experience in managing healthcare for this broad range of beneficiaries better positions us to capitalize on growth opportunities across all of these programs. In addition, unlike many other managed care organizations that attempt to serve the general population through commercial health plans, we focus exclusively on serving individuals in government programs. We believe that this focus allows us to better serve our members and providers and to more efficiently manage our operations. We have centralized core functions, such as claims processing and medical management, combined with localized marketing and strong provider relationships. We believe that this approach will allow us to continue effectively growing our business, both through organic growth and through acquisitions.

Through our licensed subsidiaries, as of December 31, 2006, we operated our Medicaid plans in Florida, New York, Connecticut, Illinois, Indiana, Missouri, Georgia and Ohio and our MCC plans in Florida, New York, Connecticut, Illinois, Louisiana and Georgia. We also operate stand-alone Medicare PDP plans in all 50 states and the District of Columbia. On January 1, 2007, we ceased offering Medicaid plans in Indiana, but began offering PFFS plans to Medicare beneficiaries in 793 counties in 39 states and Washington, D.C.

We were formed in May 2002 when we acquired our Florida, New York and Connecticut health plans. From inception to July 2004, we operated through a holding company that was a Delaware limited liability company. In July 2004, immediately prior to the closing of our initial public offering, that company was merged into a Delaware corporation and we changed our name to WellCare Health Plans, Inc. Our principal executive offices are located at 8725 Henderson Road, Renaissance One, Tampa, Florida 33634, and our telephone number is (813) 290-6200. Our website is www.wellcare.com. Information contained on our website is not incorporated by reference into this report and such information should not be considered to be part of this report. We make available our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and any amendments to those reports on our website, free of charge, to individuals interested in acquiring such reports. The reports can be accessed at our website as soon as reasonably practicable after they are electronically filed with the Securities and Exchange Commission, or SEC. References to “WellCare,” “we,” “our” and “us” refer to WellCare Health Plans, Inc. together in each case with our subsidiaries and any predecessor entities unless the context suggests otherwise.



Our Health and Prescription Drug Plans

As of December 31, 2006, we had aggregate membership of approximately 2,258,000 Medicaid and Medicare members. The following tables summarize our membership by segment and line of business as of December 31, 2006 and 2005.

   
December 31,
2006
 
December 31,
2005
 
Medicaid
         
TANF
   
1,069,000
   
621,000
 
S-CHIP
   
95,000
   
82,000
 
SSI
   
51,000
   
58,000
 
FHP
   
30,000
   
25,000
 
     
1,245,000
   
786,000
 
               
Medicare
             
MA
   
90,000
   
69,000
 
PDP
   
923,000
   
-
 
     
1,013,000
   
69,000
 
               
Total
   
2,258,000
   
855,000
 

Our Medicaid and Medicare contracts with government agencies generally have terms of one to three years. We receive premiums from state and federal agencies for the members that are assigned to or have selected us to provide healthcare services under each program. The amount of premiums we receive for each member is fixed, although it varies according to the specific government program and also may vary according to demographics, including the member’s geographic location, age and gender, and according to health status. Further, the premiums we receive under each of our government benefit plans are generally determined at the beginning of the contract period. These premiums may be subsequently adjusted, up or down, generally at the commencement of each new contract period, although states also generally have the ability to adjust the rates during the term of the contract. As a result of these periodic premium rate adjustments, even when membership remains constant, we cannot predict with certainty what our future revenues will be under each of our government contracts.

Medicaid. The Medicaid programs and services we offer to our members vary by state and county and are designed to address the unique needs of our members within the various communities we serve. Although our Medicaid contracts determine to a large extent the type and scope of healthcare services that we arrange for our members, we also customize our benefits in ways that we believe make our products more attractive. Our Medicaid plans provide our members with access to a broad spectrum of medical benefits from all facets of primary care and preventative programs to full hospitalization and tertiary care.

Members are required to use our network, except in cases of emergencies, transition of care or when network providers are unavailable to meet a member’s medical needs, and generally must receive a referral from their primary care physician in order to receive healthcare from a specialist, such as an orthopedic surgeon or neurologist. Members do not pay any premiums, deductibles or co-payments for many of our plans.

Medicare. Through our MCC plans and our PFFS plans, we also cover a wide spectrum of medical services. We provide an enhanced level of services relative to original Medicare fee-for-service coverage, ranging from reduced out-of-pocket expenses to prescription drug coverage. Through these enhanced benefits, the out-of-pocket expenses incurred by our members are reduced, which allows them to better plan their healthcare costs.

Most of our MCC plans and PFFS plans require members to pay a co-payment for services provided, and the amount of the co-payment varies by benefit. None of our plans require a deductible for services. Members of our MCC plans are required to use our network of providers except in limited cases such as emergencies, transition of care or when specialty providers are unavailable to meet a member’s medical needs, and generally must receive a referral from their primary care physician in order to receive healthcare from a specialist. PFFS plans are open-access plans that allow members to be seen by any physician or facility that participates in the Medicare program. Also, compared to our Medicaid plans, we have more flexibility in designing benefits packages for our Medicare plans, and we can charge members a premium for benefits that the original Medicare fee-for-service plan does not offer. We also offer “special needs” plans in each of our markets. Special needs plans are designed to provide specialized care and support for Medicare beneficiaries, including those who are dually eligible for both Medicare and Medicaid, with frailties, or serious chronic conditions. We believe that our special needs plans are attractive to this population due to the enhanced benefit offerings.

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The Medicare Part D benefit, which provides prescription drug benefits, is available to Medicare Advantage enrollees as well as original Medicare fee-for-service enrollees. MCC plans are required to offer a Part D drug benefit, whereas PFFS plans have the option of providing a Part D benefit but are not required to do so. Most of our PFFS products offer a Part D benefit. MCC plans and PFFS plans that include a Part D drug benefit are also known as MA-PD plans. Original Medicare fee-for-service beneficiaries and PFFS enrollees are able to purchase a stand-alone prescription drug plan, called a PDP plan, from a list of CMS-approved PDP plans, such as ours.

Florida

We are the largest operator of Medicaid managed care plans in Florida. We began providing Medicaid services in Florida in 1994, and now operate the two largest Medicaid managed care plans in the state under the names Staywell and HealthEase, which operate in 15 counties and 30 counties, respectively. We also participate in Florida’s S-CHIP program, known as Healthy Kids. We began providing MCC services in Florida in 2000 and now operate our MCC plan in 22 counties under the WellCare name. During 2006, our overall membership in Florida decreased from approximately 545,000 members to approximately 525,000 members.

Our Medicaid contracts with the State of Florida for our Staywell and HealthEase plans expire on August 31, 2009. Our Staywell and HealthEase plans are also parties to Medicaid Reform contracts for Brevard and Duvall Counties which expire on August 31, 2009. Our Healthy Kids contract with the State of Florida expires on October 1, 2007. Our Florida MCC contract with CMS expires on December 31, 2007.

New York

Our New York plan began operations in 1985. We currently offer Medicaid plans in 12 counties in the State of New York. We also offer Child Health Plus, Family Health Plus and Medicaid Advantage plans for dual-eligibles. We operate MCC plans in 14 counties in New York. We provide both our Medicaid and MCC plans under the WellCare name. During 2006, our overall New York membership grew from approximately 95,000 members to approximately 117,000 members.

Our Medicaid and Family Health Plus contract with the State of New York expires on September 30, 2008 and our Medicaid and Family Health Plus contract with the City of New York expires on September 30, 2007. The Medicaid Advantage contracts with Albany County and the City of New York expire on December 31, 2007. Our New York MCC contract with CMS expires on December 31, 2007. We also have a Child Health Plus contract with the State of New York that expires on June 30, 2007.

Connecticut

In Connecticut, we operate our Medicaid managed care plans under the name PreferredOne and our MCC plans under the WellCare name. Our Connecticut plan began operations in 1995. We currently offer Medicaid plans in each of Connecticut’s eight counties and MCC plans in three Connecticut counties. During 2006, our total Connecticut membership grew from approximately 37,000 members to approximately 39,000 members. Our Medicaid contracts with the State of Connecticut expire on June 30, 2007 and our Connecticut Medicare contract with CMS expires on December 31, 2007.

Illinois

Our Illinois subsidiary, which we acquired in June 2004, operates under the name Harmony Health Plan of Illinois. Harmony began operations in Illinois in 1996. We also began offering MCC plans in two counties in May 2005. During 2006, our total membership in Illinois grew from approximately 92,000 members to approximately 98,000 members. Our Medicaid contract with the State of Illinois expires on July 31, 2009 and our Illinois MCC contract with CMS expires on December 31, 2007.

Indiana

Harmony also operated a Medicaid managed care plan in Indiana under the name Harmony Health Plan of Indiana through December 31, 2006. Harmony began operations in Indiana in February 2001. During 2006, Harmony’s membership in Indiana decreased from approximately 85,000 members to approximately 70,000 members.

On August 4, 2006, we were notified by the Indiana Office of Medicaid Policy and Planning that we were not selected for a new contract to provide managed care benefits to Indiana Medicaid recipients in 2007. Our contract with the State of Indiana expired on December 31, 2006.

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Missouri

Harmony also operates a Medicaid managed care plan in Missouri under the name Harmony Health Plan of Missouri. Harmony began operations in Missouri in July 2006. At December 31, 2006, our total Missouri membership was approximately 4,000 members. Our Medicaid contract with the State of Missouri expires on June 30, 2007.

Louisiana

We began operations as a MCC plan in Louisiana in September 2004. Our Louisiana plan operates under the WellCare name in 10 Louisiana parishes. During 2006, MCC membership in Louisiana grew from approximately 1,000 members to approximately 3,000 members. Our Louisiana MCC contract with CMS expires on December 31, 2007.

Georgia

We began operations as a MCC plan in two Georgia counties in March 2005 and as a Medicaid managed care plan in Georgia in July 2006. We provide both our MCC and Medicaid plans under the WellCare name. During 2006, our Georgia membership grew from less than 300 members to approximately 477,000 as the State transitioned to Medicaid managed care on a region-by-region basis throughout the year. Our Georgia MCC contract with CMS expires on December 31, 2007 and our Medicaid contract with the Georgia Department of Community Health expires on June 30, 2007.

Ohio

We began providing Medicaid services as a Medicaid managed care plan in the State of Ohio’s Covered Family and Children program in December 2006. We were also awarded an Aged, Blind, and Disabled contract by the Ohio Department of Job and Family Services in October of 2006, which will transition membership to our plan in 2007. We will provide both of the plans under the WellCare name. As of February 1, 2007, our total Ohio membership was approximately 26,000 members. Our Ohio Medicaid contracts expire on June 30, 2007.

PDP

We began operations as a Medicare prescription drug plan in January 2006 under the WellCare name. We currently offer PDP plans nationwide in each of the 34 CMS regions, serving approximately 923,000 members as of December 31, 2006. As of February 1, 2007, our total PDP membership was approximately 967,000 members. Our PDP Medicare contract with CMS expires on December 31, 2007.

PFFS

We began operations as a PFFS plan in January 2007. We operate our PFFS plans through three life and health insurance subsidiaries under the WellCare name. We currently offer PFFS plans nationwide in 739 counties in 39 states and Washington, D.C. As of February 1, 2007, our PFFS membership was approximately 18,000 members. Our PFFS contracts with CMS expire on December 31, 2007.

Our Growth Strategy

Our objective is to be the leading provider of managed care services for government-sponsored healthcare programs. To achieve this objective, we intend to expand our Medicaid business within our existing markets, leverage our established Medicaid business to continue to develop Medicare plans and enter new Medicaid and Medicare markets through internal growth, expansion of our current service territory, new product initiatives and selective acquisitions. For example, during 2006, we successfully launched our PDP and Georgia, Ohio and Missouri Medicaid plans.

Provider Networks

We have longstanding, established relationships with many of our network providers in the markets we currently serve. We arrange for the provision of healthcare services to our members through mutually non-exclusive contracts with independent primary care physicians, specialists, ancillary medical agencies and professionals and hospitals. We seek to enter into mutually beneficial arrangements with our providers which help them to develop their practices. We strive to provide quality service and to be a supportive partner in developing and maintaining strong relationships with our providers. In addition, our approach to contracting has allowed us to build strong provider networks, which we believe provides our members with access to physicians to whom they may not otherwise have access.

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The primary care physicians in our network play an integral role in managing the healthcare of our members. The relationship between the primary care physician, or PCP, and a member is critical for the member to make the most effective use of managed care. Our PCPs are encouraged to discuss care options with new members during their first visit, and answer questions they may have about managed care, as well as to assist them in understanding the role of the PCP. PCPs include family and general practitioners, pediatricians, internal medicine physicians and OB/GYNs. Specialty care physicians provide medical care to members generally upon referral by the primary care physicians. As of December 31, 2006, our network included approximately 50,000 physicians, approximately 600 hospitals, and approximately 15,000 other ancillary providers and skilled nursing facilities.

We have contracted with ancillary providers and professionals for physical therapy, mental health and chemical dependency care, home healthcare, vision care, diagnostic laboratory tests, x-ray examinations, ambulance services and durable medical equipment. Additionally, we have contracted with a national pharmacy benefit manager that provides a local pharmacy network in each of our markets where pharmacy is a covered benefit as well as where we offer PDP plans. As of December 31, 2006, we had approximately 60,000 contracted pharmacies in this network. We also offer, through two of our subsidiaries which use in-house resources, comprehensive management of mental health and substance abuse services.

We also consult with members of our provider network to obtain their assistance in designing benefit packages, and we enter into relationships using a range of contract types, including capitated and fee-for-service arrangements. See “Provider Payment Methods” below. We believe that our focus on strong provider relationships has helped us to make our health plans more attractive and increase our membership.

In order to help ensure the quality of our providers, we credential and re-credential our providers using standards that are required by CMS and the states in which we operate. We also continuously upgrade and review our networks to help ensure adequacy of coverage and compliance of individual providers with our network and operational standards, and we replace and add providers as appropriate.

Our contracts with hospitals, independent primary care physicians and specialists are typically for one- to two-year periods and automatically renew for successive one-year terms. The contracts generally can be cancelled by either party upon a specified prior written notice period, which is typically 60 or 90 days, subject to various conditions. With respect to our hospital contracts, the hospital is paid for all medically necessary inpatient and outpatient services, including emergency services, diagnostic services and therapeutic care provided to members. With the exception of admissions from the emergency room, all inpatient hospital services require precertification from our utilization review staff. All contracted hospitals are required to participate in our utilization review and quality improvement programs.

Provider Payment Methods

We utilize three primary methods of payment with our network providers: a fixed fee per member, which is commonly referred to as capitation, fee-for-service and risk-sharing arrangements, the latter of which we utilize in our Medicare business. In addition, in order to encourage our PCPs to be proactive in the treatment of our members, we pay a fee-for-service rate in excess of the capitation rate to our PCPs who provide specified preventative health services, such as childhood immunizations, lead screening and well-child check-ups. In New York, PCPs to whom we pay a capitation also receive an additional payment, or bill-above, for supplying us with timely encounter data regarding the nature of members’ Medicaid visits. We use this data to improve the level of preventative healthcare available under our plans, such as vaccinations, immunizations and health screenings for newborn children. This data also helps us to monitor the amount and level of medical treatment and improve our compliance with regulatory reporting requirements to ensure our contracted providers are providing appropriate medical care. We periodically review our payment methods as necessary. Factors we generally consider in adjusting payment methods include changes to state Medicaid fee schedules, the competitive environment, current market conditions, anticipated utilization patterns and projected medical benefits expense.

Medicaid

Capitation. We pay most of our PCPs on a capitation basis. Under this arrangement, the PCP is at risk for all costs related to the services rendered by such physician, with the exception of those preventative health services that are paid in addition to the capitation and subject, in some cases, to stop-loss arrangements. In some instances, certain specialty physicians are also paid on a capitated basis. For the year ended December 31, 2006, approximately 16% of our Medicaid payments to physicians were on a capitated basis.

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Fee-for-Service. We pay our other providers, including most specialists, based upon the service performed, which is referred to as fee-for-service. For the year ended December 31, 2006, approximately 84% of our Medicaid payments to providers were on a fee-for-service basis. The primary fee-for-service arrangements are payments based on a percentage of the Medicaid fee schedule and per diem and case rates. These arrangements may also be combined.

A significant percentage of our fee-for-service contracts with providers allow for automatic adjustments in payments based upon changes in government reimbursement rates.

Medicare

Risk-sharing Arrangements. Within our capitation and fee-for-service arrangements, which accounted for 8% and 92%, respectively, of our Medicare payments to providers for the year ended December 31, 2006, a small number of Medicare providers operate under specialized capitated risk arrangements in order to more efficiently align our interests. Under these arrangements, we establish a risk fund for each provider based on a percentage of premium paid, which is evaluated on an individual or group basis, subject to monitoring and analysis by our actuaries. Based on this analysis, we estimate the amount, if any, due to the provider and establish a liability and pay the applicable provider on a periodic basis, to the extent that the balance exceeds claim payments.

Out-of-Network Providers

When our members receive services for which we are responsible from a provider outside our network, such as in the case of emergency room services from non-contracted hospitals, we generally attempt to negotiate a rate with that provider. In some cases, we may be obligated to pay the full rate billed by the provider. In the case of a Medicare patient who is admitted to a non-contracted hospital, we are obligated to pay only the amount that that hospital would have received from CMS under original Medicare fee-for-service.

Sales and Marketing Programs

Our internal sales force consists of approximately 750 associates. Our sales associates focus their efforts on individuals and communities, rather than on employer groups. We believe that our targeted sales and marketing efforts are primarily responsible for our rapid membership growth in several of our markets.

We have developed our sales and marketing programs on a localized basis with a focus on the communities in which our members reside. We often conduct our sales programs in churches, community centers and in coordination with government agencies. We regularly participate in local events and festivals and organize community health fairs to promote our products and the benefits of preventative care. We also utilize traditional marketing methods such as direct mail, telemarketing, mass media and cooperative advertising with participating medical groups to generate leads. Consistent with our community-focused approach, we employ a culturally diverse sales staff, with more than 18 languages represented, including Spanish, Russian and Chinese. This allows us to target specific demographic markets, including markets requiring specific language skills and knowledge.

In addition, we have fee-for-service relationships with third-party brokers and agents to help us promote our Medicare plans in some markets.

Our PDP marketing efforts are largely focused on individuals who are lower income seniors, including those who are dually eligible for both Medicare and Medicaid. Although we rely on auto-assignment for PDP growth, we also market our PDP products through other traditional methods, such as direct mail and print advertising initiatives.

Our PFFS marketing efforts are focused on traditional direct mail, outbound telemarketing and print advertising initiatives in conjunction with the use of a network of independently licensed insurance agents.

Our marketing and sales activities are heavily regulated by CMS and the states. For example, our sales and marketing materials must be approved in advance by the applicable regulatory authority and our sales activities are limited to such activities as conveying information regarding the benefits of preventative care, describing the operations of managed care plans and providing information about eligibility requirements. The activities of third-party brokers and agents are also heavily regulated by CMS and the states. See “Regulation” for a further description of restrictions on marketing and sales activities.

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Quality Improvement

We continually strive to improve the quality of care delivered by our network providers to our members. We believe that it is important to continuously improve the delivery of quality care and measure the results of our quality improvement efforts in order to continue to grow our managed care business.

Our Quality Improvement Program provides the basis for our quality and utilization management functions and outlines specific, ongoing processes and services designed to improve the delivery of quality healthcare services to our members, as well as to ensure compliance with regulatory and accreditation standards. Our Quality Improvement Committees include senior executives, management and other key company associates as members. The Quality Improvement Committees also have a number of subcommittees that are charged with monitoring certain aspects of care and service, such as healthcare utilization, pharmacy services and provider credentialing/recredentialing. Several of our subcommittees include physicians as members.

Elements of our Quality Improvement Program include the following: evaluation of the effects of particular preventative measures; member satisfaction surveys; grievance and appeals processes for members and providers; orientation visits to, and site audits of, select providers; provider credentialing and recredentialing; ongoing member education programs; ongoing provider education programs; health plan accreditation; and medical record audits.

As part of our Quality Improvement Program, we have implemented changes to our reimbursement methods to reward those providers who encourage preventative care, such as well-child check-ups and prenatal care. In addition, we have specialized systems to support our quality improvement activities. We gather information from our systems to identify opportunities to improve care and to track the outcomes of the services provided to achieve those improvements. Some examples of our intervention programs include: a prenatal case management program to help women with high-risk pregnancies deliver full-term, healthy infants; a program to reduce the number of inappropriate emergency room visits; a disease management program to decrease the need for emergency room visits and hospitalizations for asthma, congestive heart failure and diabetes patients; and a wound management program to redirect specialized care to the home setting, resulting in improved patient outcomes and reduced cost of care.

We believe that these efforts have improved the quality of care delivered by our network of providers to our members, while reducing our medical costs. As a result of our Quality Improvement Program, in 2004 we received a three-year accreditation from the Accreditation Association for Ambulatory Health Care, or AAAHC, in the State of Florida and our New York health plan was awarded Quality Health Plan status by the State of New York in 2006.

Corporate Compliance

Due to the increasingly complex legal and ethical questions facing all participants in the healthcare industry, we have unified our corporate ethics and compliance policies by implementing a comprehensive corporate ethics and compliance program, called the Trust Program. The Trust Program covers all aspects of our company and is designed to assist us with conducting our business in accordance with applicable federal and state laws and high standards of business ethics. The Trust Program applies to members of our board of directors, our executive team, our associates, and in some cases, our business partners and our independent contractors. We intend to disclose any future amendments to or waivers from the Trust Program, if any, made with respect to our directors and executive officers on our Internet site.

We maintain and update training and monitoring programs to educate our directors, executives, and associates and independent contractors on the legal and regulatory requirements of their respective duties and positions and to detect possible violations. To help ensure compliance with the Trust Program, we also undergo regular, periodic compliance audits by internal and external auditors and compliance staff who have expertise in federal and state healthcare laws and regulations.

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Competition

We compete with other managed care providers such as Centene Corporation, Coventry Health Care, Inc., Amerigroup Corp., Humana, Inc., WellPoint, Inc. and UnitedHealth Group, Inc. for government healthcare program contracts, renewals of those government contracts, members and providers.  Many of our competitors are large companies that have greater financial, technological and marketing resources than we do. Our Medicaid plans collectively have approximately 31%, 5%, 12%, 53%, 1% and 36% market share based on membership in Florida, New York, Connecticut, Illinois, Missouri and Georgia, respectively. Currently, our Medicaid market share in Ohio and our Medicare Advantage market share in Louisiana, Connecticut, Illinois, New York and Georgia is minimal. Our MCC plan in Florida has an approximate 10% market share based on membership, competing with approximately 20 other managed care plans. In addition, we have approximately 5% market share of the overall PDP market and we are one of only nine nationwide PDP plans.

States and the federal government generally use either a competitive bidding process or award individual contracts to any applicant that can demonstrate that it meets the government’s requirements. To select a winning bid or award a contract, state governments and the federal government consider many factors, including the plan’s provider network, quality and utilization management processes, responsiveness to member complaints and grievances, timeliness of claims payment and financial resources. We will continue to face varying levels of competition as we expand in our existing service areas or enter new markets. However, the licensing requirements and bidding and contracting procedures in some states present barriers to entry into the Medicaid and Medicare managed care markets.

In the Medicaid managed care market, our principal competitors for state contracts, members and providers include the following types of organizations:

·  
Primary Care Case Management Programs. Programs established by the states through contracts with primary care providers to provide to the Medicaid recipient primary care services, on a non-capitated, non-risk basis, as well as to provide limited oversight over other services.

·  
Commercial HMOs. National and regional commercial managed care organizations that have Medicaid members in addition to members in private commercial plans.

·  
Medicaid HMOs. Managed care organizations that focus solely on providing healthcare services to Medicaid recipients, typically on a capitated, full-risk basis. Many of these competitors operate in a single or small number of geographic locations. There are a few multi-state Medicaid-only organizations that tend to be larger in size and therefore able to leverage their infrastructure over a larger membership base.

In the Medicare market, our primary competitors for contracts, members and providers are national and regional managed care organizations and insurance companies that serve Medicare recipients and provider-sponsored organizations. In addition, beginning in 2006, a new regional Medicare Preferred Provider Organization, or Medicare PPO, program was implemented pursuant to the Medicare Prescription Drug, Improvement and Modernization Act of 2003 (“MMA”). These regional Medicare PPO plans also compete with Medicare plans, including the plans we offer.

Regulation

Our healthcare operations are highly regulated by both state and federal government agencies. Regulation of managed care products and healthcare services is an evolving area of law that varies from jurisdiction to jurisdiction. Regulatory agencies generally have discretion to issue regulations and interpret and enforce laws and rules. Changes in applicable laws and rules occur frequently.

In order to operate a health plan, we must apply for and obtain a certificate of authority or license from each state in which we intend to operate. Our health plans were licensed to operate as health maintenance organizations in Florida, New York, Connecticut, Illinois, Indiana, Georgia, Ohio, Louisiana and Missouri as of December 31, 2006.

In order to operate a PDP, the MMA generally requires PDP sponsors to be licensed under state law as a risk-bearing entity eligible to offer health insurance or health benefits coverage in each state in which the sponsor wishes to offer a PDP. However, CMS has implemented two waiver processes to allow PDP sponsors to begin operations prior to obtaining state licensure or certification in all states in which they do business, even if the state already has in place a licensing process for PDP sponsors. For plan years 2006 and 2007, PDP sponsors may seek a “single state waiver” in such states by submitting to CMS a waiver application. Prior to submitting the application to CMS, the PDP sponsor must have submitted a PDP licensure application to each such state. Once granted, this waiver permits the PDP to operate even without having obtained a license from the state. A “regional plan waiver” also is available to PDP sponsors that have obtained licensure as a risk-bearing entity in at least one state in a PDP region, and this waiver allows the PDP sponsor to operate throughout that particular PDP region pending the granting of a license by the other states in the region, if such states have a licensing process for PDP sponsors. The entity through which we operate our PDP plans currently is licensed as a domestic insurance company in the State of Florida and as a foreign insurer in 22 states plus the District of Columbia. In the remaining states, the PDP entity is currently operating under one of the previously mentioned CMS waivers, but is applying for authority to conduct business as a foreign insurer.

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As HMOs and insurance companies, we are regulated by both the state insurance departments and in some cases in respect of the HMOs, another state agency with responsibility for oversight of health maintenance organizations. Generally, the licensing requirements are the same for us as they are for commercial and managed healthcare organizations. We generally must demonstrate to the state, among other things, that:

·  
we have an adequate provider network;

·  
our quality and utilization management processes comply with state requirements;

·  
we have procedures in place for responding to member and provider complaints and grievances;

·  
our systems are capable of processing providers’ claims in a timely fashion and for collecting and analyzing the information needed to manage our business; and

·  
we have the financial resources necessary to pay our anticipated medical care expenses and the infrastructure needed to account for our costs.

·  
we will comply with certain guidelines and regulatory limitations relating to our sales and marketing activities.

Each of our health plans is required to report quarterly on its performance to the appropriate regulatory agency in the state in which it is licensed. Each plan also undergoes periodic examinations and reviews by the applicable state. The plans generally must obtain approval from the state before declaring dividends in excess of certain thresholds and prior to entering into certain transactions between the plan and a related party. Each plan must maintain a net worth in an amount determined by statute or regulation and we may only invest in types of investments approved by the state. In addition, any change in control of a health plan must also be approved by the state in which the plan is domiciled. For purposes of these laws, in general, control is presumed to exist when a person, group of persons or entity, directly or indirectly, owns, controls or holds the power to vote 10% or more of the voting securities of another entity.

In addition, our Medicaid and S-CHIP activities are regulated by each state’s department of health services or equivalent agency, and our Medicare activities are regulated by CMS. These agencies typically require demonstration of the same capabilities mentioned above and perform periodic audits of performance, usually annually.

State enforcement authorities, including state attorneys general and Medicaid fraud control units, have become increasingly active in recent years in their review and scrutiny of various sectors of the health care industry, including health insurers and managed care organizations. We routinely respond to requests for information from these entities and, more generally, we endeavor to cooperate fully with all government agencies that regulate our business.

Medicaid

Medicaid was established under the U.S. Social Security Act of 1965 to provide medical assistance to low income and disabled persons. It is state-operated and implemented, although it is funded by both the state and federal governments. Our contracts with the state Medicaid programs place additional requirements on us. Within broad guidelines established by the federal government, each state:

·  
establishes its own eligibility standards;

·  
determines the type, amount, duration and scope of services;

·  
sets the rate of payment for services; and

·  
administers its own program.

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Some states, such as those in which we operate, award Medicaid managed care contracts to applicants that can demonstrate that they meet the state’s requirements. Other states engage in a competitive bidding process for all or certain programs. We must demonstrate to the satisfaction of the state Medicaid program that we are able to meet the state’s operational and financial requirements. These requirements are in addition to those required for a license and are targeted to the specific needs of the Medicaid population. For example:

·  
we must measure provider access and availability in terms of the time needed for a member to reach the doctor’s office using public transportation;

·  
our quality improvement programs must emphasize member education and outreach and include measures designed to promote utilization of preventative services;

·  
we must have linkages with schools, city or county health departments, and other community-based providers of healthcare, in order to demonstrate our ability to coordinate all of the sources from which our members may receive care;

·  
we must have the capability to meet the needs of disabled members and others with “special needs”;

·  
our providers and member service representatives must be able to communicate with members who do not speak English or who are hearing impaired; and

·  
our member handbook, newsletters and other communications must be written at the prescribed reading level and must be available in languages other than English.

In addition, we must demonstrate that we have the systems required to process enrollment information, to report on care and services provided and to process claims for payment in a timely fashion. We must also have adequate financial resources needed to protect the state, our providers and our members against the risk of our insolvency.

Once awarded, our Medicaid government contracts generally have terms of one to three years, with renewal options at the discretion of the states. In addition to the operating requirements listed above, state contract requirements and regulatory provisions applicable to us generally set forth detailed provisions relating to subcontractors, marketing, safeguarding of member information, fraud and abuse reporting and grievance procedures.

Our health plans are subject to periodic financial and informational reporting and comprehensive quality assurance evaluations. We regularly submit periodic utilization reports, operations reports and other information to the appropriate Medicaid program regulatory agencies.

Medicare

Medicare is a federal program that provides eligible persons age 65 and over and some disabled persons a variety of hospital, medical insurance and prescription drug benefits. Medicare beneficiaries have the option to enroll in a Medicare Advantage plan, such as a MCC plan or PFFS plan, in areas where such a plan is offered. Under Medicare Advantage, managed care organizations contract with CMS to provide Medicare benefits comparable to original Medicare fee-for-service in exchange for a fixed monthly payment per member that varies based on the county in which a member resides, the demographics of the member and the member’s health condition.

The MMA made numerous changes to the Medicare program, including expanding the Medicare program to include a prescription drug benefit. Beginning in 2006, Medicare beneficiaries had the option of selecting a prescription drug benefit from a Medicare Advantage plan or from a PDP plan. The drug benefit, available to beneficiaries for a monthly premium, is subject to certain cost sharing depending upon the specific benefit design of the selected plan. Under the standard drug coverage for 2007, Medicare beneficiaries will have drug benefits as follows:

·  
an initial annual deductible of $265;

·  
cost sharing of 25% for the beneficiary and 75% for the Part D plan on the next $2,135 of prescription drug costs up to an initial limit of $2,400;

·  
no insurance coverage for annual drug costs of the beneficiary between $2,400 and $5,451 (sometimes referred to as the “donut hole”); and

·  
once the beneficiary has spent $3,850 in out-of-pocket drug costs in a year, the beneficiary pays the greater of 5% of the drug costs or $2 for generic drugs and $5 for brand name drugs.

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Plans are not required to mirror these limits; instead, drug plans are required to provide coverage that is at least actuarially equivalent to the standard drug coverage delineated in the MMA. The standard drug coverage will be adjusted on an annual basis and plans will submit new bids annually. The MMA provides subsidies and the reduction or elimination of cost sharing for certain low-income beneficiaries, including dual-eligible individuals who receive benefits under both Medicare and Medicaid. The Medicare Part D benefit, which provides prescription drug benefits, is available to Medicare Advantage enrollees as well as original Medicare fee-for-service enrollees. MCC plans are required to offer a Part D drug benefit, whereas PFFS plans have the option of providing a Part D benefit, but are not required to do so. Most of our PFFS products offer a Part D benefit. MCC plans and PFFS plans that include a Part D drug benefit are also known as MA-PD plans. Original Medicare fee-for-service beneficiaries and PFFS enrollees are able to purchase a stand-alone prescription drug plan, called a PDP plan, from a list of CMS-approved PDP plans, such as ours.

Beginning in 2006, the MMA also expanded the Medicare Advantage program to include new regional PPO plans which provide out-of-network benefits in addition to in-network benefits. The Secretary of Health and Human Services, or HHS, created 26 regions for the new regional PPO program.

The MMA also revised payment methodologies for Medicare Advantage organizations, including creating a new competitive bidding process which began in 2006. This process was established to set the payment to the Medicare Advantage plans and to establish the beneficiary premium and benefits. The bidding process does not limit the number of plans that may participate in the Medicare Advantage program. Along with other providers of Part D prescription drug benefits, which include PDP and MA-PD plans, we bid on the Part D benefits in June of each year. Based on the bids submitted, CMS established a national benchmark. In 2006, CMS paid the Part D plans a percentage of the benchmark on a per-member-per-month basis with the remaining portion of the premium being paid by the Medicare member. Members whose income fell below 150% of the federal poverty level qualified for the federal low income subsidy, through which the federal government helped pay the member’s Part D premium and certain other cost sharing expenses.

The MMA shifted coverage responsibility for prescription drug benefits for those individuals dually eligible for both Medicaid and Medicare. Prior to 2006, the drug coverage responsibility for the dual-eligible population was left to the state Medicaid programs. Beginning on January 1, 2006, dual-eligibles began receiving their drug coverage from the Medicare program and not the Medicaid program. Under the current program, dual-eligibles who do not select a MA-PD plan or a PDP plan for their prescription drug coverage are auto-assigned into a stand-alone PDP plan, such as ours.

S-CHIP Programs

The State Children’s Health Insurance Program, or S-CHIP, is a federal and state matching program designed to help states expand health insurance to children whose families earn too much to qualify for traditional Medicaid, yet not enough to afford private health insurance. States have the option of administering S-CHIP through their existing Medicaid programs, creating separate programs or combining both strategies. The S-CHIP programs in Florida, New York, Connecticut, Illinois, Georgia and Missouri are administered by the same agency that administers the state’s Medicaid program. Currently, all 50 states, the District of Columbia and all U.S. territories have approved S-CHIP plans, and many states continue to submit plan amendments to further expand coverage under S-CHIP. The S-CHIP program must be reauthorized by Congress this year.

HIPAA and State Privacy Laws

In 1996, Congress enacted the Health Insurance Portability and Accountability Act of 1996, known as HIPAA, and thereafter, the Secretary of Health and Human Services issued regulations implementing HIPAA. HIPAA is intended to improve the portability and continuity of health insurance coverage and simplify the administration of health insurance claims and related transactions. All health plans, including ours, are subject to HIPAA. HIPAA generally requires health plans to:

 
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·  
protect the privacy and security of patient health information through the implementation of appropriate administrative, technical and physical safeguards; and

·  
establish the capability to receive and transmit electronically certain administrative healthcare transactions, such as claims payments, in a standardized format.

We are also subject to applicable state laws that are not preempted by HIPAA, including those that provide for greater privacy of individuals’ health information than mandated by the federal law.

Fraud and Abuse Laws

Federal and state governments have made a priority of investigating and prosecuting healthcare fraud and abuse, and have increased their activities in this area in recent years. For example, New York State recently created an Office of Medicaid Inspector General, which is tasked primarily with addressing fraud and abuse, and New York also agreed to meet specific fraud and abuse recovery targets as a condition for enhanced federal Medicaid funding. Fraud and abuse prohibitions encompass a wide range of operating activities, including kickbacks or other inducements for referral of members or for the coverage of products (such as prescription drugs) by a health plan, billing for unnecessary medical services, improper marketing and violation of patient privacy rights. Companies involved in public healthcare programs such as Medicaid and Medicare are often the subject of fraud and abuse investigations. The regulations and contractual requirements applicable to participants in these public-sector programs are complex and subject to change. For example, the relatively new Medicare Part D benefit is likely to lead to increased scrutiny by enforcement officials of managed care providers operating PDP plans and MA-PD plans. Although we believe that we have structured our compliance program with care in an effort to meet all statutory and regulatory requirements, we expect to invest significant resources to maintain our compliance efforts in light of ongoing vigorous law enforcement actions and the burdens imposed by a highly technical regulatory scheme.

Required Statutory Capital

By law, regulation and government policy, our HMO and insurance subsidiaries, which we refer to as our regulated subsidiaries, are required to maintain minimum levels of statutory net worth. The minimum statutory net worth requirements differ by state and are generally based on a percentage of annualized premium revenue, a percentage of annualized healthcare costs or risk-based capital, or RBC, requirements. The RBC requirements are based on guidelines established by the National Association of Insurance Commissioners, or NAIC, and are administered by the states. As of December 31, 2006, our Connecticut, Georgia, Illinois, Indiana, Louisiana, Missouri and Ohio operations were subject to RBC requirements. Additionally, our insurance subsidiaries that offer PFFS products also are subject to the RBC requirements. The RBC requirements may be modified as each state legislature deems appropriate for that state. The RBC formula, based on asset risk, underwriting risk, credit risk, business risk and other factors, generates the authorized control level, or ACL, which represents the amount of net worth believed to be required to support the regulated entity’s business. For states in which the RBC requirements have been adopted, the regulated entity typically must maintain a minimum of the greater of the required ACL or the minimum statutory net worth requirement calculated pursuant to pre-RBC guidelines. In addition to the foregoing requirements, our regulated subsidiaries are subject to restrictions on their ability to make dividend payments, loans and other transfers of cash.

The statutory framework for our regulated subsidiaries’ statutory net worth requirements may change over time. For instance, RBC requirements may be adopted by more of the states in which we operate. These subsidiaries are also subject to their state regulators’ overall oversight powers. For example, New York enacted regulations in 2005 that increase the reserve requirement by 150% over an eight-year period. In addition, regulators could require our subsidiaries to maintain minimum levels of statutory net worth in excess of the amount required under the applicable state laws if the regulators determine that maintaining such additional statutory net worth is in the best interest of our members. Moreover, as we expand our plan offerings in new states or pursue new business opportunities, such as the PFFS programs, we may be required to make additional statutory capital contributions.

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Marketing

Our Medicaid marketing efforts are highly regulated by the states in which we operate, each of which imposes different requirements and restrictions on Medicaid marketing. In general, the states in which we operate can impose a variety of sanctions for marketing violations, or for alleged violations, including fines, a suspension of marketing and/or a suspension of new enrollment.

Likewise, the marketing activities of Medicare managed care plans are strictly regulated by CMS. CMS must approve all marketing materials before they can be used unless a plan uses standard marketing materials that have already been approved by CMS. Federal law precludes states from imposing additional marketing restrictions on Medicare managed care plans.

Technology

A foundation of our approach to managed care is the accurate and timely capture, processing and analysis of critical data. Focusing on data is essential to operating our business in a cost effective manner. Data processing and data-driven decision making are key components of both administrative efficiency and medical cost management. We have successfully developed a system that enables our management team to better assess and control medical costs. Our system gathers information from our centralized computer-based information system, which operates Perot Systems’ Peradigm 3.0 software, an enterprise software solution designed to be scalable to accommodate both internal growth and growth from acquisitions. Its integrated database architecture helps to assure that consistent sources of claim and member information are provided across all of our health plans. We use our information system for premium billing, claims processing, utilization management, reporting, medical cost trending, planning and analysis. The system also supports member and provider service functions, including enrollment, member eligibility verification, primary care and specialist physician roster access, claims status inquiries, and referrals and authorizations.

In 2005, we implemented our disaster recovery plan and business continuity of operations plans addressing manual downtime and automated recovery procedures for our claims production application. We have a hot-site and business recovery site agreement with SunGard Recovery Services LP to provide for the restoration of our general support systems at the remote processing center. We will perform our annual disaster recovery testing for all critical lines of business in 2007.

Customers

We currently provide Medicaid plans under 17 separate contracts including five contracts in New York, five contracts in Florida, two contracts in each of Connecticut and Ohio, and one contract in each of Georgia, Illinois and Missouri. Our 2006 premium revenues from our Florida and Georgia contracts together accounted for approximately 46% of our total premium revenues. Similarly, we offer Medicare plans under separate contracts with CMS for each of the states in and programs under which we offer such plans. Our 2006 Medicare premium revenues from all of our CMS contracts, on an aggregate basis, represented 43% of our total 2006 premium revenues. Other than Florida and Georgia, we did not receive in excess of 10% of our total 2006 premium revenues under any state or CMS contract when taken individually.

Executive Officers of the Company

The following are our executive officers and their ages:

Todd S. Farha (age 38) has served as our President and Chief Executive Officer and as a member of our board of directors since May 2002. Mr. Farha was also named the Chairman of our Board in October 2006. From January 2000 to June 2001, Mr. Farha served as Chief Executive Officer of Best Doctors, Inc., a provider of information and referral services for patients suffering from critical illnesses. In addition, from 1999 to 2004, Mr. Farha served as President and Chief Executive Officer of a company he founded, Medical Technology Management LLC, a provider of shared medical equipment and services for physicians and hospitals. From August 1995 to November 1998, Mr. Farha served as Chief Executive Officer of Oxford Specialty Management, a subsidiary of Oxford Health Plans, Inc., a health care company focusing on the management of acute clinical conditions in six specialty areas. In 1995, Mr. Farha served in the Office of the Chief Executive Officer of Oxford Health Plans. Prior to that, from 1990 to 1993, he held various positions with Physician Corporation of America, a Florida-based health plan focused on Medicaid recipients. Mr. Farha received a bachelors degree in economics from Trinity University and a masters of business administration from Harvard Business School. Mr. Farha is a cousin of Mr. Hourani, one of our directors.

Paul L. Behrens (age 45) has served as our Senior Vice President and Chief Financial Officer since September 2003. Prior to that date, Mr. Behrens was a partner in the healthcare practice of Ernst & Young LLP, which he joined in 1983. Mr. Behrens received his undergraduate degree from Dana College. Mr. Behrens is a certified public accountant.

Thaddeus Bereday (age 41) has served as our Senior Vice President and General Counsel since November 2002. From 2001 to 2002, Mr. Bereday was a partner at Brobeck, Phleger & Harrison, LLP, and from 2000 to 2001, he was a partner at Morgan, Lewis & Bockius, LLP. From 1998 to 1999, Mr. Bereday served as Vice President and General Counsel of SmarTalk TeleServices, Inc., a publicly-traded telecommunications company, and as its President and Acting General Counsel from 1999 to 2000, after the company filed for Chapter 11 bankruptcy protection. Mr. Bereday received his undergraduate degree from Brown University and a juris doctor from Case Western Reserve University School of Law.

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Anil Kottoor (age 41) has served as our Senior Vice President and Chief Information Officer since January 2007. Prior to joining us, Mr. Kottoor served as Vice President and Chief Application Development Officer for WellPoint, Inc. from June 2003 to November 2006. From June 2002 through January 2003, Mr. Kottoor served as Head of Project Services for Aetna, Inc. and from September 1997 to May 2002 as Vice President of IT Application Development for Oxford Health Plans, Inc. He received his bachelors degree from Concordia College in New York and earned his masters of business administration from Pace University.

Adam Miller (age 41) has been the Chief Operating Officer of our Medicare Prescription Drug Plan business since January 2006. From July 2001 to November 2005, Mr Miller ran UnitedHealth Group’s Arizona Medicaid and Medicare Special Needs program. Mr. Miller also worked for General Electric in the Medical Systems business in a series of strategy, business development and operational roles from May 1997 to June 2001. Prior to this, Mr. Miller was with the Boston Consulting Group from 1993 to 1997. Mr. Miller is a graduate of Harvard Business School and the Wharton School of Business at The University of Pennsylvania.

Imtiaz (“MT”) Sattaur (age 44) has served as the President of our Florida business since April 2004 and as Senior Vice President, National Medicare Programs from January 2004 to April 2004. From October 2002 to December 2003, Mr. Sattaur served as President and Chief Executive Officer of Amerigroup Florida, Inc., a Medicaid health care company. From April 1999 to September 2002, Mr. Sattaur served as Vice President and Chief Operating Officer of Affinity Health Plan in New York. Mr. Sattaur received his undergraduate degree from Florida International University.

Employees

As of December 31, 2006, we had approximately 3,000 full-time associates. Our associates are not represented by any collective bargaining agreement, and we have never experienced a work stoppage. We believe we have good relations with our associates.



FORWARD-LOOKING STATEMENTS

Statements contained in this Annual Report on Form 10-K which are not historical fact may be forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934 (the “Exchange Act”). We intend such statements to be covered by the safe harbor provisions for forward-looking statements contained in Section 21E of the Exchange Act. Such statements which may address, among other things, market acceptance of our products and services, expansion into new targeted markets, product development, our ability to finance growth opportunities, our ability to respond to change in governance regulations, sales and marketing strategies, projected capital expenditures, liquidity and availability of additional funding sources may be found in the sections of this report entitled “Business,” “Risk Factors,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and elsewhere in this report generally. In some cases, you can identify forward-looking statements by terminology such as “may,” “will,” “should,” “expects,” “plans,” “anticipates,” “believes,” “estimates,” “predicts,” “potential,” “continues” or the negative of such terms or other comparable terminology. You are cautioned that matters subject to forward-looking statements involve risks and uncertainties, including economic, regulatory, competitive and other factors that may affect our business. 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.

Our actual results may differ materially from those indicated by forward-looking statements as a result of various important factors including the expiration, cancellation or suspension of our state and federal contracts. In addition, our results of operations and projections of future earnings depend in large part on accurately predicting and effectively managing health benefits and other operating expenses. A variety of factors, including competition, changes in healthcare practices, changes in federal or state laws and regulations or their interpretations, inflation, provider contract changes, changes in or terminations of our contracts with government agencies, new technologies, government-imposed surcharges, taxes or assessments, reduction in provider payments by governmental payors, major epidemics, disasters and numerous other factors affecting the delivery and cost of healthcare, such as major healthcare providers’ inability to maintain their operations, may in the future affect our ability to control our medical costs and other operating expenses. Governmental action or business conditions could result in premium revenues not increasing to offset any increase in medical costs and other operating expenses. Once set, premiums are generally fixed for one-year periods and, accordingly, unanticipated costs during such periods cannot be recovered through higher premiums. Furthermore, if we are unable to accurately estimate incurred but not reported medical costs, our profitability may be affected. Due to these factors and risks, we cannot provide any assurance regarding our future premium levels or our ability to control our future medical costs.

From time to time, legislative and regulatory proposals are made at the federal and state government levels related to the healthcare system, including but not limited to limitations on managed care organizations, including benefit mandates, and reform of the Medicaid and Medicare programs. Such legislative and regulatory action could have the effect of reducing the premiums paid to us by governmental programs, increasing our medical or administrative costs or requiring us to materially alter the manner in which we operate. We are unable to predict the specific content of any future legislation, action or regulation that may be enacted or when any such future legislation or regulation will be adopted. Therefore, we cannot predict accurately the effect of such future legislation, action or regulation on our business.



Item 1A. Risk Factors

You should carefully consider the following factors, together with all the other information included in this report, in evaluating our company and our business. If any of the following risks actually occur, our business, financial condition and results of operations could be materially and adversely affected, and the value of our stock could decline. The risks and uncertainties described below are those that we currently believe may materially affect our company. Additional risks and uncertainties not presently known to us or that we currently deem immaterial also may impair our business operations.

Risks Related to Our Business

If our government contracts are not renewed or are terminated, our business could be substantially impaired.

We provide our Medicaid, Medicare, S-CHIP and other services through a limited number of contracts with state, federal or local government agencies. These contracts generally have terms of one to three years and are subject to non-renewal by the applicable agency. All of our government contracts are terminable for cause if we breach a material provision of the contract or violate relevant laws or regulations. In addition, our right to add new members may be suspended by a government agency if it finds deficiencies in our provider network or operations or for other reasons.

Our contracts with the states are generally subject to cancellation or a potential freeze on enrollment by the state in the event of the unavailability of adequate funding. In some jurisdictions, a cancellation or enrollment freeze may be immediate and in other jurisdictions a notice period is required. Some of our contracts are also subject to termination or are eligible for renewal through annual competitive bids.

If we are unable to renew, or to successfully rebid or compete for any of our government contracts, or if any of our contracts are terminated, our business could be substantially impaired. If any of those circumstances were to occur, we would likely pursue one or more alternatives, including seeking to enter into contracts in other geographic markets, seeking to enter into contracts for other services in our existing markets or seeking to acquire other businesses with existing government contracts. If we were unable to do so, we could be forced to cease conducting business. In any such event, our revenues would decrease materially. For example, in August 2006, we were notified by the Indiana Office of Medicaid Policy and Planning that we were not selected for a new contract to provide managed care benefits to Indiana Medicaid recipients beginning in 2007. Our Indiana membership and revenue represent 3.1% and 3.5% of total membership and revenue for the year ended December 31, 2006, respectively. We may face increased competition as other plans attempt to enter our markets through the contracting process.

Because our premiums, which generate most of our revenues, are fixed by contract, we are unable to increase our premiums during the contract term if our corresponding medical benefits expense exceeds our estimates.

Most of our revenues are generated by premiums consisting of fixed monthly payments per member. These payments are fixed by contract, and we are obligated during the contract period, which is generally one to three years, to provide or arrange for the provision of healthcare services as established by state and federal governments. We have less control over costs related to the provision of healthcare services than we do over our selling, general and administrative expense. Historically, our medical benefits expense as a percentage of premium revenue has fluctuated. For example, our medical benefits expense was 80.9% in 2004, 81.2% in 2005, and 81.1% for the year ended December 31, 2006. If our medical benefits expense exceeds our estimates, we will be unable to adjust the premiums we receive under our current contracts, and our profits may decline.

If we are unable to estimate and manage medical benefits expense effectively, our profitability likely will be reduced or we could cease to be profitable.

Our profitability depends, to a significant degree, on our ability to predict and effectively manage our costs related to the provision of healthcare services. Relatively small changes in the ratio of our expenses related to healthcare services to the premiums we receive, or medical benefits ratio, can create significant changes in our financial results. Factors that may cause medical benefits expense to exceed our estimates include:

·  
an increase in the cost of healthcare services and supplies, including pharmaceuticals, whether as a result of inflation or otherwise;

·  
higher than expected utilization of healthcare services;

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·  
periodic renegotiation of hospital, physician and other provider contracts;

·  
the occurrence of catastrophes, major epidemics, terrorism or bio-terrorism;

·  
changes in the demographics of our members and medical trends affecting them; and

·  
new mandated benefits or other changes in healthcare laws, regulations and/or practices.

Because of the relatively high average age of the Medicare population, medical benefits expense for our Medicare plans, including our PDP plans, may be particularly difficult to control.

Although we have been able to manage our medical benefits expense through a variety of techniques, including various payment methods to primary care physicians and other providers, advance approval for hospital services and referral requirements, medical management and quality management programs, upgraded information systems, and reinsurance arrangements, we may not be able to continue to manage these expenses effectively in the future. If our medical benefits expense increases, our profits could be reduced or we may not remain profitable. For example, a hypothetical 1% increase in our medical benefits ratio would have reduced our earnings before income taxes for the years ended December 31, 2005 and 2006 by $18.6 million and $36.2 million, respectively.

We maintain reinsurance to protect us against certain severe or catastrophic medical claims, but we cannot assure you that such reinsurance coverage currently is or will be adequate or available to us in the future or that the cost of such reinsurance will not limit our ability to obtain it.

Reductions in funding for government healthcare programs could substantially reduce our profitability.

All of the healthcare services we offer are through government-sponsored programs, such as Medicaid and Medicare. As a result, our profitability is dependent, in large part, on continued funding for government healthcare programs at or above current levels. For example, the premium rates paid by each state to health plans like ours differ depending on a combination of factors such as upper payment limits established by the state and federal governments, a member’s health status, age, gender, county or region, benefit mix and member eligibility categories. Future Medicaid premium rate levels may be affected by continued government efforts to contain medical costs or state and federal budgetary constraints. In the recent past, some of the states in which we operate have experienced fiscal challenges leading to significant budget deficits. According to the National Association of State Budget Officers, Medicaid spending consumes more than a fifth of the average state’s budget, representing the largest expenditure in 2005. While healthcare spending increases appear to be more limited than they have been in recent years, states continue to look at Medicaid programs as opportunities for savings and some states may find it difficult to continue paying current rates to Medicaid health plans, or to continue covering all services or groups.

Changes in Medicaid funding, for example, may lead to reductions in the number of persons enrolled in or eligible for Medicaid, reductions in the amount of reimbursement or elimination of coverage for certain benefits such as pharmacy, behavioral health or other benefits. In some cases, changes in funding could be made retroactive in which case we may be required to return premiums already received or receive reduced future payments. In the recent past, all of the states in which we operate have implemented or considered legislation or regulations that would reduce reimbursement rates, payment levels, benefits covered or the number of persons eligible for Medicaid. New York, for example, has agreed to certain cost containment measures, including a temporary freeze on managed care premiums, as a condition for enhanced federal Medicaid funding. Similarly, recent proposed federal regulations would reduce federal payments to states for Medicaid by $3.8 billion over five years, and the President’s recently released proposed federal budget includes substantial additional cuts in federal spending on Medicaid. Many of these proposed cuts effectively would shift certain costs of the Medicaid program back to the states, which would in turn place increased pressure on states to reduce expenditures, control enrollment or limit benefits. Reductions in Medicaid payments could reduce our profitability if we are unable to reduce our expenses. New federal Medicaid citizenship requirements as well as changes in work participation rules for federal welfare program recipients could mean fewer Medicaid eligibles in the future. In addition, the S-CHIP program must be reauthorized by Congress this year, and we cannot be sure what, if any, changes will be made in the program, or how such changes might affect our businesses.

Similarly, reductions in payments under Medicare or the other programs under which we offer health and prescription drug plans could likewise reduce our profitability. Recent changes in Medicare pursuant to the MMA permit premium levels for certain plans to be established through competitive bidding, with Congress retaining the ability to limit increases in premium levels established through bidding from year to year. The federal government has also passed legislation that phases out Medicare Advantage budget neutrality payments through 2011, which impacts premium increases over that timeframe. Congress may consider other reductions to rates or other changes to the Medicare Part D program which could also reduce our revenues.

 
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We are subject to extensive government regulation, and any violation of the laws and regulations applicable to us could reduce our revenues and profitability and otherwise adversely affect our operating results.

Our business is extensively regulated by the federal government and the states in which we operate. The laws and regulations governing our operations are generally intended to benefit and protect health plan members and providers rather than stockholders. The government agencies administering these laws and regulations have broad latitude to enforce them. These laws and regulations, along with the terms of our government contracts, regulate how we do business, what services we offer, and how we interact with our members, providers and the public. We are subject, on an ongoing basis, to various governmental reviews, audits and investigations to verify our compliance with our contracts and applicable laws and regulations and such scrutiny is likely to increase, particularly for companies like ours that offer Medicare Part D plans. We are also subject to state laws regarding insurers and HMOs that are subsidiaries of insurance holding companies. Under such laws, certain dividends, distributions and other transactions between an insurance or HMO subsidiary and the holding company or its other subsidiaries require notification to, or the approval of, one or more state insurance or health departments. These laws also require prior regulatory approval for any direct or indirect change of control of an HMO or insurance subsidiary. For purposes of these laws, in most states control is presumed to exist when a person, group of persons or entity acquires the power to vote 10% or more of the voting securities of another entity although exemptions to this requirement are available in certain circumstances.

Violations of any of these laws, rules or regulations or an adverse review, audit or investigation could result in one or more of the following:

·  
forfeiture or recoupment of amounts we have been paid pursuant to our government contracts;

·  
imposition of significant civil or criminal penalties, fines or other sanctions on us and/or our key employees;

·  
loss or limitation of our right to participate in government-sponsored programs, including Medicaid and Medicare;

·  
damage to our reputation in various markets;

·  
increased difficulty in marketing our products and services;

·  
inability to obtain approval for future service or geographic expansion; and

·  
suspension or loss of one or more of our licenses to act as an insurer, health maintenance organization or third party administrator or to otherwise provide a service.

Because we receive payments from federal and state governmental agencies, we are subject to various laws, including the Federal False Claims Act (“FFCA”), which permit state and federal governments to institute suit against us for regulatory violations, particularly relating to billing fraud, kickbacks and other intentional wrongdoing. In some cases, these laws permit the government to seek treble damages, penalties and assessments. In addition, private citizens, acting as whistleblowers, can sue as if they were the government under a special provision of the FFCA. Any violations of any of these laws, rules or regulations or any adverse review, audit or investigation could reduce our revenues and profitability and otherwise adversely affect our operating results.

If state regulatory agencies require a higher statutory capital level for our existing operations or if we are subject to additional capital requirements as we pursue new business opportunities, we may be required to make additional capital contributions which would negatively impact our cash flows and liquidity.

Our operations are conducted through subsidiaries in various states. These subsidiaries are subject to state regulations that, among other things, require the maintenance of minimum levels of statutory capital, as defined by each state. One or more of these states may raise the statutory capital level from time to time, which could adversely impact our financial condition. For example, New York in 2005 adopted regulations that increase the reserve requirement by 150% over an eight-year period. Other states may elect to adopt risk-based capital requirements based on guidelines adopted by the National Association of Insurance Commissioners. As of December 31, 2006, our operations in Connecticut, Georgia, Illinois, Indiana, Louisiana, Missouri and Ohio, were subject to those requirements. Additionally, our insurance subsidiaries that offer PFFS products also are subject to RBC requirements. Our subsidiaries also may be required to maintain higher levels of statutory net worth due to the adoption of risk-based capital requirements by other states in which we operate. Our subsidiaries are also subject to their state regulators’ general oversight powers. Regardless of whether they adopt the risk-based capital requirements, these state regulators can require our subsidiaries to maintain minimum levels of statutory net worth in excess of amounts required under the applicable state laws if they determine that maintaining such additional statutory net worth is in the best interests of our members. The phased-in increase in reserve requirements to which our New York plan is subject will, over time, materially increase our reserve requirements in New York. In addition, as we continue to expand our plan offerings in new states or pursue new business opportunities, such as our strategy to offer PFFS plans, we may be required to make additional statutory capital contributions. In such a case, our liquidity and cash flows could be materially reduced, which could harm our ability to implement our business strategy, for example, by hindering our ability to make debt service payments on amounts drawn from our credit facilities.

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Our failure to estimate incurred but not reported medical benefits expense accurately will affect our reported financial results.

Our medical benefits expense includes estimates of medical claims incurred but not reported, or IBNR. We, together with our internal and consulting actuaries, estimate our medical cost liabilities using actuarial methods based on historical data adjusted for payment patterns, cost trends, product mix, seasonality, utilization of healthcare services and other relevant factors. Actual conditions, however, could differ from those assumed in the estimation process. We continually review and update our estimation methods and the resulting reserves and make adjustments, if necessary, to medical benefits expense when the criteria used to determine IBNR change and when actual claim costs are ultimately determined. Due to the uncertainties associated with the factors used in these assumptions, the actual amount of medical benefits expense that we incur may be materially more than the amount of IBNR originally estimated. If our estimates of IBNR are inadequate in the future, our reported results of operations could be negatively impacted. Further, our inability to estimate IBNR accurately may also affect our ability to take timely corrective actions, further exacerbating the extent of any adverse effect on our results.

We derive a large portion of our Medicaid revenues and profits from operations in Florida and Georgia and legislative or regulatory actions, economic conditions or other factors that adversely affect those operations could materially reduce our revenues and profits.

For the year ended December 31, 2006, our Florida and Georgia Medicaid health plans accounted for 33% and 26% of our total premium revenues, respectively. If we are unable to continue to operate in Florida and Georgia, or if our current operations in any portion of Florida or Georgia are significantly curtailed, our revenues will decrease materially. Our reliance on our Medicaid operations in Florida and Georgia could cause our revenues and profitability to change suddenly and unexpectedly, depending on legislative or regulatory actions, economic conditions and similar factors. For example, in July 2006, Florida implemented a Medicaid reform pilot program in two counties which could cause us to face increased competition from new providers, including provider-sponsored networks, which could reduce our revenues and harm our overall operating results. Further, the legislation that implemented this Medicaid reform contemplates that the program will be expanded to additional counties, including three additional counties in 2007, with the goal of full statewide implementation by June 30, 2011. In Georgia, there has been resistance among providers to the implementation of the new Medicaid managed care program. In response, Georgia has requested that we increase our outreach and communication programs, which could increase our administrative expense of operating in the state. Further, if the Medicaid managed care program in Georgia fails to achieve acceptance among providers, the Georgia legislature could modify the program or repeal it which could have a negative affect on our Georgia results of operations.

We derive a substantial portion of our Medicare revenues from our PDP operations, and legislative or regulatory actions, economic conditions or other factors that adversely affect those operations could materially reduce our revenues and profits.

Because PDP plans are relatively new to Medicare and to the health insurance market generally, we do not know whether we will be able to sustain our PDP operation’s profitability over the long-term, and our failure to do so could have an adverse effect on our results of operations. Factors that could effect our PDP operations include:

·  
Legislative: The current Congress is expected to make changes to the Medicare program this year, which may include changes to the Part D benefit. We cannot predict what these changes might include or what effect they might have on our revenues or plans for growth.

·  
Regulatory and administration: Medicare Part D is a new program and CMS may alter the program in a manner that could be detrimental to us. In addition, historically CMS has experienced challenges in the administration of the program which has affected our ability to accurately determine our membership and revenues from our PDP plans.

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·  
Utilization of benefits: We are making actuarial assumptions about the utilization of benefits in our PDP plans. Because this continues to be a new program both for the Federal government and for us, there is limited historical basis for these assumptions, and we cannot assure you that these assumptions will prove to be correct or that premiums will be sufficient to cover the benefits provided.

·  
Competition: We have encountered competition from other PDP plans, some of which may have significantly greater resources and brand recognition than we do and new PDP plans are entering the business. We have entered into a marketing arrangement with Walgreens which is non-exclusive and Walgreens may enter into marketing arrangements with our competitors. We cannot predict whether we will be able to continue to effectively compete in this new market.

·  
Membership: Medicare beneficiaries who are dual-eligibles generally are able to disenroll and choose another PDP plan at any time, and certain Medicare beneficiaries also have a limited ability to disenroll from the plan they initially select and choose a different PDP plan. Medicare beneficiaries who are not dually eligible will be able to change PDP plans during the annual open enrollment period. We may not be able to retain the auto-assigned members or those members who affirmatively choose our PDP plans, and we may not be able to attract new PDP members.

Our limited operating history as a stand-alone entity makes evaluating our business and future prospects difficult.

We were formed in May 2002 to acquire the WellCare group of companies. Until the closing of that acquisition in July 2002, the companies that comprise our Florida operations had operated as a closely-held business, and our New York and Connecticut businesses had operated as subsidiaries of a public company, the majority stockholders of which were the owners of the Florida operations. Almost all of the senior members of our current management, including Todd S. Farha, our Chairman, President and Chief Executive Officer, have worked for us for less than five years. Our limited operating history under current management may not be adequate to enable you to fully assess our future prospects.

We may not be able to sustain our high rates of historic growth.

From December 31, 2001 to December 31, 2006, our membership grew at an average annual rate of 51.4%. An important aspect of our strategy is continued growth in existing and new markets. We may not be able to sustain our high historical growth rates, which would impair our ability to implement this strategy. For example, we already have a large share of the Florida Medicaid managed care market which is highly penetrated. We also have 5% of the Medicare PDP market share, and do not expect significant future growth in this market. These factors may limit our ability to continue to increase our membership in Florida and Medicare PDP, which are our largest markets. If we are unable to continue to increase our membership in the markets in which we currently operate, we may not be able to successfully implement our growth strategy.

We may be unsuccessful in implementing our growth strategy if we are unable to make or finance other acquisitions on favorable terms or integrate the businesses we acquire into our existing operations.

Acquisitions of contract rights and other health plans are an important element of our growth strategy. We may be unable to identify and complete appropriate acquisitions rapidly enough, if at all, to meet our or our investors’ expectations for future growth. For example, many of the other potential purchasers of contract rights and plans have greater financial resources than we have. The market price of Medicaid plans has generally increased recently, which may increase the amount we are required to pay to complete acquisitions. In addition, we are generally required to obtain regulatory approval from one or more state or federal agencies when making acquisitions, which may require a public hearing. This is the case regardless of whether we already operate a plan in the state in which the business to be acquired is located. We may be unable to comply with these regulatory requirements for an acquisition in a timely manner, or at all. Moreover, some sellers may insist on selling assets that we do not want, such as commercial lines of business, or transferring their liabilities to us as part of the sale of their companies or assets. Even if we identify suitable acquisition targets, we may be unable to complete acquisitions or obtain the necessary financing for these acquisitions on terms favorable to us, or at all.

Further, to the extent we complete acquisitions, we may be unable to realize the anticipated benefits from acquisitions because of operational factors or difficulties in integrating the acquisitions with our existing businesses. This may include the integration of:

·  
additional employees, whom we refer to as associates, who are not familiar with our operations;

·  
new provider networks, which may operate on terms different from our existing networks;

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·  
additional members, who may decide to transfer to other healthcare providers or health plans;

·  
disparate information, claims processing and record keeping systems;

·  
integration efforts may divert attention of our management team away from our core business; and

·  
accounting policies, including those which require a high degree of judgment or complex estimation processes, such as estimates of medical claims incurred but not reported, accounting for goodwill, intangible assets, stock-based compensation and income tax matters.

We may be unable to expand into some geographic areas without incurring significant additional costs.

We are likely to incur additional costs if we enter states or counties where we do not currently operate. Our rate of expansion into other geographic areas may also be inhibited by:

·  
the time and costs associated with obtaining the necessary license to operate in the new area or the expansion of our licensed service area, if necessary;

·  
our inability to develop a network of physicians, hospitals and other healthcare providers that meets our requirements and those of government regulators;

·  
competition, which increases the costs of recruiting members;

·  
the cost of providing healthcare services in those areas; and

·  
demographics and population density.

Accordingly, we may be unsuccessful in entering other metropolitan areas, counties or states, which may impede our growth.

Ineffective management of our growth may adversely affect our results of operations, financial condition and business.

Depending on acquisitions and other opportunities, we expect to continue to increase our membership and to expand into other markets. We had total revenue of approximately $1.9 billion and $3.8 billion in 2005 and 2006, respectively. Continued rapid growth could place a significant strain on our management and on other resources. Our ability to manage our growth may depend on our ability to retain and strengthen our management team and attract, train and retain skilled associates, and our ability to implement and improve operational, financial and management information systems on a timely basis. If we are unable to manage our growth effectively, our financial condition and results of operations could be materially and adversely affected. In addition, due to the initial substantial costs related to potential acquisitions, rapid growth could adversely affect our short-term profitability and liquidity.

Several changes to the Medicare program resulting from the MMA legislation that became effective in 2006 could reduce our profitability and increase competition for our existing and prospective members.

On December 8, 2003, President Bush signed the MMA. This legislation, which is complex and wide-ranging, made significant changes to the Medicare program. There are numerous provisions in the legislation that affect our Medicare business. We believe that many of these changes have, and will continue to benefit the managed care sector. However, the new bidding process for determining rates, expanded benefits and shifts in certain coverage responsibilities pursuant to the MMA has increased competition and created some uncertainties, including the following:

·  
Plans now offer various products, including regional preferred provider organizations, or PPOs, pursuant to the MMA. Medicare PPOs allow their members more flexibility to select physicians than the MCC plans, such as HMOs, which often require members to coordinate their care through a primary care physician. The Secretary of Health and Human Services created 26 regions for the regional Medicare PPO program. Regional Medicare PPO plans compete with MCC plans and PFFS plans, such as ours.

·  
In order to participate in the Medicare Advantage regional PPO program, a plan must meet certain requirements, including having an adequate provider network throughout the region. The MMA provides some incentives for certain hospitals to join the network. Although we currently do not participate in any Medicare Advantage regional PPO programs, if in the future we decide to participate in the programs, we cannot assure you that we will be able to contract with a sufficient number of providers throughout our regions to satisfy the network adequacy requirements under the MMA that would enable us to participate in the regional product.

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·  
The payments for the local and regional Medicare Advantage plans are based on a competitive bidding process that may decrease the amount of premiums paid to us or cause us to increase the benefits we offer.

·  
Organizations that offer MCC plans of the type we offer are required to offer prescription drug benefits in at least one plan in every area they serve. In addition, most Medicare Advantage enrollees choosing to obtain prescription drug benefits are required to do so from their Medicare Advantage plan. Enrollees may prefer a stand-alone drug plan and may disenroll from the Medicare Advantage plan altogether in order to participate in a stand-alone drug plan. Accordingly, the new Medicare Part D prescription drug benefit could reduce our profitability and membership enrollment.

·  
In 2006, we began offering stand-alone PDP plans to Medicare beneficiaries who are not enrolled in one of our Medicare Advantage plans. In addition, Medicare began auto-assigning Medicare dual-eligibles to our stand-alone PDP plans, and as of 2007 we are eligible for auto-assignment in all 50 states. Because PDP plans are still relatively new to Medicare and to the health insurance market generally, we cannot guarantee future profits from this Medicare line of business.

·  
Some enrollees may have chosen our MCC plans in the past rather than an original Medicare fee-for-service plan because of the added drug benefit that we offer with our MCC plans. Following the implementation of the new prescription drug benefit, Medicare beneficiaries have the opportunity to obtain a drug benefit without joining a managed care plan which could affect our membership.

·  
Beginning in 2006, dual-eligibles began to receive their drug coverage from Medicare rather than from Medicaid. Because Medicaid is no longer directly responsible for most drug coverage for dual-eligibles, Medicaid payments to plans have been reduced. Accordingly, this change in Medicaid payments could have an adverse effect on our operating results. Further, dual-eligibles who are auto-enrolled into our PDP plans have the right to switch plans at any time. As a result, there can be no assurance that the dual-eligible beneficiaries who are automatically assigned to us will stay in our PDP plans.

We may be unsuccessful in implementing our growth strategy or continuing to participate in certain Medicare programs if we are unable to meet submission and approval deadlines imposed by CMS.

CMS has imposed rigorous deadlines for the filing and approval of applications. Meeting these deadlines is important to support our growth strategy. As a result, we must devote extensive resources to preparing and timely filing applications, and we cannot assure you that we will submit any applications by the deadlines imposed by CMS. If we are unable to submit these applications by the applicable deadlines, we may be unsuccessful in implementing our growth strategy, or in continuing the participation of one or more of our plans in the Medicare programs, which could materially adversely affect our revenues and profits.

Other changes in federal funding mechanisms also could reduce our profitability.

On February 8, 2006, the President signed the Deficit Reduction Act of 2005 (the “DRA”). According to the Congressional Budget Office, the provisions of this Act are expected to reduce federal Medicaid spending by $4.8 billion and Medicare spending by $6.4 billion over the next five years.

The Medicaid savings provisions that could impact health plans center on additional recipient cost-sharing and flexibility in the design of health benefits by states. Other savings will be achieved through changes in the setting of pharmaceutical prices in Medicaid fee-for-service programs and through restrictions on asset transfers by people seeking to receive Medicaid-funded long term care services. At the same time, the DRA includes an option for states to allow parents of disabled children whose incomes are up to 300% of the federal poverty guidelines to buy-in to Medicaid and allows for the creation of health opportunity accounts in up to ten states. Because we cannot anticipate if and how the states in which we operate will implement these changes, we cannot predict the impact these changes, if any, will have on our operating results.

The Medicare savings provisions of the DRA most likely affect health plans by providing for the phase-out, over a five-year period, of so-called “budget neutrality” payments made to Medicare Advantage plans. These changes are consistent with modifications previously planned by CMS and announced in 2005, therefore any adverse impact of these modifications already were anticipated in our operating plans. However, in December 2006, Congress reversed a scheduled 2007 decrease in fee-for-service physician fee schedules which we did not anticipate. The combination of the phase-out of the budget neutrality and the recent freeze on physician fee schedules will have a negative impact on our per-member-per-month revenue trend from our Medicare products. Should CMS implement these provisions in the future in a manner inconsistent with its previously announced plans, this could impact our growth strategy or the continuing participation of one or more of our plans in the Medicare Advantage program, which could materially affect our revenues and profits.

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In December 2006, Congress also passed, and the President signed, other measures impacting Medicaid, S-CHIP and Medicare, including a reduction in Medicaid provider taxes, including HMO provider taxes, which are used to generate federal revenue. This could have a negative impact on the ability of some states in which we hold Medicaid contracts to fund Medicaid managed care services.

Congress also acted to reallocate funding in the S-CHIP program to states facing shortfalls in overall funding for 2007. However, despite this federal action, Georgia continues to face a shortfall in its S-CHIP program in 2007. If Congress does not reallocate funds for 2007, Georgia may reduce eligibility or benefits for its S-CHIP program which would negatively impact our Georgia S-CHIP business. Several other states in which we operate will face similar shortfalls in the funding of their S-CHIP programs if Congress does not increase annual allotments in its 2008-2012 reauthorization.

Congressional leaders have indicated their intention to look carefully at many aspects of the Medicare program this year and to make further changes.  We cannot predict what these changes might include and what effect they might have on our existing business or our plans for growth.

We are required to comply with laws governing the transmission, security and privacy of health information, and we have not yet determined what our total compliance costs will be.

Regulations under the Health Insurance Portability and Accountability Act of 1996, or HIPAA, require us to comply with standards regarding the exchange of health information within our company and with third parties, such as healthcare providers, business associates, and our members. These regulations include standards for common healthcare transactions, such as claims information, plan eligibility, and payment information; unique identifiers for providers (commencing May 2007) and employers; security; privacy and enforcement. HIPAA also provides that to the extent that state laws impose privacy standards that are not contrary to HIPAA (which may include standards that are more stringent than HIPAA privacy regulations), a state seeks and receives an exception from the Department of Health and Human Services regarding certain state laws, or state laws concern certain specified areas, such state standards and laws will not be preempted.

The Department of Health and Human Services finalized the transaction standards on August 17, 2000. However, Congress delayed for one year the transaction standards’ original implementation deadline of October 16, 2002 for providers such as us that submitted a compliance plan by the original implementation deadline. In response to CMS guidance, we adopted a contingency plan in July 2003, pursuant to which we continue to process HIPAA standard transactions and also engage in legacy transactions as appropriate. The Department issued the privacy standards on December 28, 2000, and after certain delays, the privacy standards became effective on April 14, 2001, with a compliance date of April 14, 2003 for most covered payers and providers, including us. The security standards became effective on April 21, 2003, with a compliance date of April 20, 2005 for most covered entities, including us. Sanctions for failing to comply with the HIPAA health information provisions include criminal penalties and civil sanctions.

Given HIPAA’s complexity and the possibility that the regulations may change and may be subject to changing and perhaps conflicting interpretation, our ongoing ability to comply with any of the HIPAA requirements is uncertain. Furthermore, a state’s ability to promulgate stricter laws, and uncertainty regarding many aspects of such state requirements, make compliance with applicable health information laws more difficult. For these reasons, we are unable to calculate reliably what our total compliance costs will be.

Future changes in healthcare law may reduce our profitability or liquidity.

Healthcare laws and regulations, and their interpretations, are subject to frequent change. Changes in existing laws or regulations, or their interpretations, or the enactment of new laws or the issuance of new regulations could reduce our profitability, among other things, by:

·  
imposing additional license, registration and/or capital requirements;

·  
increasing our administrative and other costs;
 
 
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·  
requiring us to undergo a corporate restructuring;

·  
increasing mandated benefits;

·  
limiting our ability to engage in intra-company transactions with our affiliates and subsidiaries;

·  
requiring us to restructure our relationships with providers; or

·  
requiring us to implement additional or different programs and systems.

Changes in state law, regulations and rules also may adversely affect our profitability. Requirements relating to managed care consumer protection standards, including increased plan information disclosure, limits to premium increases, expedited appeals and grievance procedures, third party review of certain medical decisions, health plan liability, access to specialists, clean claim payment timing, physician collective bargaining rights and confidentiality of medical records either have been enacted or continue to be under discussion. Future healthcare legislation or regulation may require us to change the way we operate our business, which may be costly. Further, although we believe we have exercised care in structuring our operations to attempt to comply in all material respects with the laws and regulations applicable to us, government officials charged with responsibility for enforcing such laws and/or regulations have in the past asserted and may in the future assert that we or transactions in which we are involved are in violation of these laws, or courts may ultimately interpret such laws in a manner inconsistent with our interpretation. Therefore, it is possible that future legislation and regulation and the interpretation of laws and regulations could have a material adverse effect on our ability to operate under the Medicaid, Medicare and S-CHIP programs and to continue to serve our members and attract new members.

State regulatory restrictions on our marketing activities may constrain our membership growth and our ability to increase our revenues.

Although we enroll some of our new members through automatic enrollment programs and voluntary member enrollment, we rely on our marketing and sales efforts for a significant portion of our membership growth. All of the states in which we currently operate permit marketing but impose strict requirements and limitations as to the types of marketing activities that are permitted. In Florida and New York, other Medicaid plans have been prohibited from engaging in marketing activities for a period of time after being found to have violated the state’s requirements. While no such action is currently pending or threatened against us, from time to time we have been cited, and in some cases fined, for alleged marketing violations. In circumstances where our marketing efforts are prohibited or curtailed, our ability to increase or sustain membership will be significantly harmed, which will adversely affect our revenue.

If we are unable to maintain satisfactory relationships with our providers, our profitability could decline and we may be precluded from operating in some markets.

Our profitability depends, in large part, upon our ability to enter into cost-effective contracts with hospitals, physicians and other healthcare providers in appropriate numbers in our geographic markets and at convenient locations for our members. In any particular market, however, providers could refuse to contract, demand higher payments or take other actions that could result in higher medical benefits expense. In some markets, certain providers, particularly hospitals, physician/hospital organizations or multi-specialty physician groups, may have significant market positions. If such a provider or any of our other providers refused to contract with us, use their market position to negotiate contracts that might not be cost-effective or otherwise place us at a competitive disadvantage, those activities could adversely affect our operating results in that market area. Also, in some rural areas, it is difficult to maintain a provider network sufficient to meet regulatory requirements. In the long term, our ability to contract successfully with a sufficiently large number of providers in a particular geographic market will affect the relative attractiveness of our managed care products in that market. If we are unsuccessful in negotiating satisfactory contracts with our network providers, it could preclude us from renewing our Medicaid or Medicare contracts in those markets or from entering into new markets. Also, in situations where we have a gap in our provider network, regulators require us to allow members to obtain care from out-of-network providers at no additional cost, which could adversely affect our ability to manage expenses.

Our provider contracts with network primary care physicians and specialists generally have terms of one year, with automatic renewal for successive one-year terms. We may terminate these contracts for cause, based on provider conduct or other appropriate reasons, subject to laws giving providers due process rights. The contracts generally may be cancelled by either party without cause upon 60 or 90 days prior written notice. Our contracts with hospitals generally have terms of one to two years, with automatic renewal for successive one-year terms. We may terminate these contracts for cause, based on provider misconduct or other appropriate reasons. Our hospital contracts generally may be cancelled by either party without cause upon 120 days prior written notice. We may be unable to continue to renew such contracts or enter into new contracts enabling us to serve our members profitably. Also, in some states, such as New York, automatic renewal provisions may not be enforceable unless the parties comply with certain notice provisions prior to the renewal date. We will be required to establish acceptable provider networks prior to entering new markets. Although we have established long-term relationships with many of our network providers, we may be unable to maintain those relationships or enter into agreements with providers in new markets on a timely basis or under favorable terms. If we are unable to retain our current provider contracts or enter into new provider contracts timely or on favorable terms, our profitability could decline.

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If a state fails to renew or alter the terms of its federal waiver application for mandated Medicaid enrollment into managed care or such application is denied, our membership in that state will likely decrease.

A significant percentage of our Medicaid plan enrollment results from mandatory Medicaid enrollment in managed care plans. States may only mandate Medicaid enrollment into managed care through CMS-approved plan amendments or under federal waivers or demonstrations. Waivers and programs under demonstrations are generally approved for two- to five-year periods and can be renewed on an ongoing basis if the state applies and the waiver request is approved or renewed by CMS. We have no control over this renewal process. If a state in which we operate does not renew its mandated program, alters the terms of its waiver in a way that limits mandated Medicaid enrollment into managed care, or the federal government denies the state’s application for renewal, our business would suffer as a result of a likely decrease in membership.

We rely on the accuracy of eligibility lists provided by the government to collect premiums, and any inaccuracies in those lists cause such governments to recoup premium payments from us, which could reduce our revenues and profitability.

Premium payments that we receive are based upon eligibility lists produced by the government. From time to time, governments require us to reimburse them for premiums that we received that were based on an eligibility list that such government later discovers contains individuals who were not eligible for any government-sponsored program or are eligible for a different premium category or a different program. We determine potential liabilities and reserve for such situations. However, we are uncertain what the final impact to us could be in certain situations.

In addition to recoupment of premiums previously paid, we also face the risk that a government could fail to pay us for members for whom we are entitled to payment. Our profitability would be reduced as a result of the government’s failure to pay us for related payments to providers we made and we were unable to recoup such payments from the providers. We have established a reserve in anticipation of recoupment by the government of previously paid premiums, but ultimately our reserve may not be sufficient to cover the amount, if any, of recoupments. If the amount of any recoupments exceeds our reserves, our revenues and profits may be materially harmed.

The inability or failure to properly maintain effective and secure management information systems and applications, successfully update or expand processing capability or develop new capabilities to meet our business needs could result in operational disruptions and other adverse consequences.

Our business depends on effective and secure information systems, applications and operations. The information gathered and processed by our management information systems assists us in, among other things, marketing and sales tracking, underwriting, billing, claims processing, medical management, medical care cost and utilization trending, financial and management accounting, reporting, planning and analysis and e-commerce. These systems also support our customer services functions, provider and member administrative functions and support tracking and extensive analysis of medical expenses and outcome data. These systems remain subject to unexpected interruptions resulting from occurrences such as hardware failures or increased demand. There can be no assurance that such interruptions will not occur in the future, and any such interruptions could adversely affect our business and results of operations. Moreover, operating and other issues can lead to data problems that affect the performance of important functions, including, but not limited to, claims payment and customer service.

There can also be no assurance that our process of improving existing systems, developing new systems to support our operations and improving service levels will not be delayed or that system issues will not arise in the future. Our information systems and applications require continual maintenance, upgrading and enhancement to meet our operational needs. If we are unable to maintain or expand our systems, we could suffer from, among other things, operational disruptions, such as the inability to pay claims or to make claims payments on a timely basis, loss of members, difficulty in attracting new members, regulatory problems and increases in administrative expenses.

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We have contracted with various business process outsourcing vendors to provide significant portions of our operational support including, but not limited to, certain enrollment, billing, call center, benefit administration and claims processing functions.  This dependence makes our operations vulnerable to such third parties’ failure to perform adequately under our contracts with them.  Significant failure to perform under the terms of our contracts by these third parties could negatively affect our results of operations.

Additionally, events outside our control, including acts of nature, such as hurricanes, earthquakes or fires, or terrorism, could significantly impair our information systems and applications. To ensure continued operations in the event that our primary data center operations are rendered inoperable, in 2005, we implemented our disaster recovery plan and business continuity of operations plans addressing manual downtime and automated recovery procedures for our claims production application. We have a hot-site and business recovery site agreement with SunGard Recovery Services LP to provide for the restoration of our general support systems at the remote processing center. We will perform our annual disaster recovery testing for all critical lines of business in 2007.

Our business requires the secure transmission of confidential information over public networks. Advances in computer capabilities, new discoveries in the field of cryptography or other events or developments could result in compromises or breaches of our security systems and client data stored in our information systems. Anyone who circumvents our security measures could misappropriate our confidential information or cause interruptions in services or operations. The Internet is a public network, and data is sent over this network from many sources. In the past, computer viruses or software programs that disable or impair computers have been distributed and have rapidly spread over the Internet. Computer viruses could be introduced into our systems, or those of our providers or regulators, which could disrupt our operations, or make our systems inaccessible to our providers or regulators. We may be required to expend significant capital and other resources to protect against the threat of security breaches or to alleviate problems caused by breaches. Because of the confidential health information we store and transmit, security breaches could expose us to a risk of regulatory action, litigation, possible liability and loss. Our security measures may be inadequate to prevent security breaches, and our business operations would be adversely affected by cancellation of contracts and loss of members if they are not prevented.

We may not have adequate intellectual property rights in our brand names for our health plans, and we may be unable to adequately enforce such rights.

Our success depends, in part, upon our ability to market our health plans under our brand names, including “WellCare,” “HealthEase,” “Staywell” and “Harmony.” While we hold federal trademark registrations for the “WellCare” trademark, we have not taken enforcement action to prevent infringement of our federal trademark and have not secured registrations of all of our other marks. Other businesses may have prior rights in the brand names that we market under or in similar names, which could limit or prevent our ability to use these marks, or to prevent others from using similar marks. If we are unable to prevent others from using our brand names, or if others prohibit us from using them, our revenues could be adversely affected. Even if we are able to protect our intellectual property rights in such brands, we could incur significant costs in doing so.

We encounter significant competition that may limit our ability to increase or maintain membership in the markets we serve, which may harm our growth and our operating results.

We operate in a highly competitive environment and in an industry that is currently subject to significant changes due to business consolidations, new strategic alliances and aggressive marketing practices by other managed care organizations. We compete for members principally on the basis of size, location and quality of provider network, benefits provided, quality of service and reputation. A number of these competitive elements are partially dependent upon and can be positively affected by financial resources available to a health plan. Many other organizations with which we compete have substantially greater financial and other resources than we do. In addition, changes resulting from the MMA, or state Medicaid reform or other initiatives, may bring additional competitors into our market area. As a result, we may be unable to increase or maintain our membership.

We have debt obligations that could restrict our operations.

We have outstanding indebtedness at December 31, 2006, including approximately $155.6 million in borrowings under our senior secured credit facilities, which expire in May 2009. We have available borrowing capacity under our senior secured revolving credit facility of approximately $125.0 million, which expires in May 2008. We may also incur additional indebtedness in the future. Our substantial indebtedness could have adverse consequences, including:

●  
increasing our vulnerability to adverse economic, regulatory and industry conditions, and placing us at a disadvantage compared to our competitors that are less leveraged;

●  
limiting our ability to compete and our flexibility in planning for, or reacting to, changes in our business and the industry in which we operate;

27

 
●  
limiting our ability to borrow additional funds for working capital, capital expenditures, acquisitions and general corporate or other purposes; and

●  
exposing us to greater interest rate risk since the interest rate on borrowings under our senior credit facilities is variable.

Our debt service obligations will require us to use a portion of our operating cash flow to pay interest and principal on indebtedness instead of for other corporate purposes, including funding future expansion of our business and ongoing capital expenditures which could impede our growth. If our operating cash flow and capital resources are insufficient to service our debt obligations, we may be forced to sell assets, seek additional equity or debt capital or restructure our debt which could harm our long-term business prospects.

Restrictions and covenants in our credit facilities and instruments governing our additional indebtedness may limit our ability to make certain acquisitions and declare dividends.

The documents governing our senior secured credit facilities contain various restrictions and covenants, including prescribed fixed charge coverage and leverage ratios and limitations on capital expenditures and acquisitions, that restrict our financial and operating flexibility, including our ability to make certain acquisitions and declare dividends without lender approval.

Our failure to comply with covenants in our debt instruments could result in our indebtedness being immediately due and payable and the loss of our assets.

Our credit facilities are secured by a pledge of stock of our operating subsidiaries, as well as a pledge of substantially all of the assets of our non-regulated entities. If we fail to pay any of our indebtedness when due, or if we breach any of the other covenants in the instruments governing our indebtedness, it may result in one or more events of default, including cross-defaults among multiple portions of our indebtedness. These events of default could permit our creditors to declare all amounts owing to be immediately due and payable. If we were unable to repay indebtedness owed to our secured creditors, they could proceed against the collateral securing that indebtedness.

We may not be able to retain our executive officers, and the loss of any one or more of these officers, including, in particular, our Chairman, President and Chief Executive Officer, and their managed care expertise would adversely affect our business.

Our operations are highly dependent on the efforts of our Chairman, President and Chief Executive Officer and our other senior executives, each of whom has been instrumental in developing our business strategy and forging our business relationships. Although some of our executives have entered into employment agreements with us, these agreements may not provide sufficient incentives for those executives to continue their employment with us. While we believe that we could find replacements, the loss of the leadership, knowledge and experience of Mr. Farha and our other executive officers could adversely affect our business. Replacing one or more of our executive officers might be difficult or take an extended period of time because a limited number of individuals in the managed care industry have the breadth and depth of skills and experience necessary to operate and expand successfully a business such as ours. We do not currently maintain key-man life insurance on any of our executive officers other than our Chairman, President and Chief Executive Officer, and such insurance may not be sufficient to cover the costs of recruiting and hiring a replacement Chief Executive Officer or the loss of his services. Our success is also dependent on our ability to hire and retain qualified management, technical and medical personnel. We may be unsuccessful in recruiting and retaining such personnel, which could adversely affect our operations.

28

 
Claims relating to medical malpractice and other litigation could cause us to incur significant expenses.

Our providers involved in medical care decisions may be exposed to the risk of medical malpractice claims. An increasing percentage of these providers do not have malpractice insurance. Due to increased costs or inability to secure malpractice insurance, the percentage of physicians who do not have malpractice insurance may increase, particularly in Florida, our largest market. Although our network providers are independent contractors, claimants sometimes allege that a managed care organization such as us should be held responsible for alleged provider malpractice, particularly where the provider does not have malpractice insurance, and some courts have permitted that theory of liability. In addition, managed care organizations may be sued directly for alleged negligence, such as in connection with the credentialing of network providers or for alleged improper denials or delay of care. In addition, Congress and several states have considered or are considering legislation that would expressly permit managed care organizations to be held liable for negligent treatment decisions or benefits coverage determinations. Any legislature or judicial efforts in this area could increase our exposure to medical malpractice claims, which could harm our operating results and financial condition.

From time to time, we are party to various other litigation matters, some of which seek monetary damages. We cannot predict with certainty the eventual outcome of any pending litigation or potential future litigation, and we might incur substantial expense in defending these or future lawsuits or indemnifying third parties with respect to the results of such litigation.

We maintain errors and omissions policies as well as other insurance coverage and, in some cases, indemnification rights that we believe are adequate based on industry standards. However, potential liabilities may not be covered by insurance or indemnity, our insurers or indemnifying parties may dispute coverage or may be unable to meet their obligations, or the amount of our insurance or indemnification coverage may be inadequate. We cannot assure you that we will be able to obtain insurance coverage in the future, or that insurance will continue to be available on a cost-effective basis, if at all. Moreover, even if claims brought against us are unsuccessful or without merit, we would have to defend ourselves against such claims. The defense of any such actions may be time-consuming and costly and may distract our management’s attention. As a result, we may incur significant expenses and may be unable to effectively operate our business.

Growth in the number of Medicaid eligibles may be counter-cyclical to general economic conditions, which could adversely affect our operating results in an improving economic environment.

The number of persons eligible to receive Medicaid benefits may grow more slowly or even decline if economic conditions continue to improve. Therefore, improvements in general economic conditions may cause our membership levels to decrease, thereby causing our operating results to suffer, which could lead to decreases in our stock price during periods in which stock prices in general are increasing.

Negative publicity may harm our business and operating results.

The managed care industry is frequently subject to negative publicity. In the past, our company has received negative publicity. This publicity may lead to increased legislation, regulation, review of industry practices and litigation. These factors may adversely affect our ability to market our services, require us to change our services and increase the regulatory or legal burdens under which we operate, further increasing the costs of doing business and adversely affecting our operating results.

If state regulators do not approve payments of dividends and distributions by our affiliates to us, our liquidity could be materially impaired.

We operate our business principally through our health plan subsidiaries, which generally are subject to laws and regulations that limit either the amount of dividends and distributions that they can pay to us or the amount of fees that may be paid to affiliates of our health plan subsidiaries without prior approval of, or notification of, state regulators. The discretion of the state regulators, if any, in approving or disapproving a dividend is not clearly defined. Health plans that declare non-extraordinary dividends must usually provide notice to the regulators in advance of the intended distribution date of a non-extraordinary dividend. If the regulators were to deny or significantly restrict our subsidiaries’ requests to pay dividends to us or to pay fees to the affiliates of our health plan subsidiaries, the funds available to our company as a whole would be limited, which could harm our ability to implement our business strategy. For example, we could be hindered in our ability to make debt service payments on amounts drawn from our credit facilities. None of our health plan subsidiaries paid any dividends during 2004, 2005 or 2006. However, the aggregate amounts our Florida health plan subsidiaries could have paid us at December 31, 2004, 2005 and 2006 without approval of the regulatory authorities were $7.2 million, $59.0 million and $37.2 million, respectively, assuming no dividends had been paid during the respective periods. No dividends were available to be paid from our New York and Connecticut health plan subsidiaries during those periods. Moreover, the recently adopted increase in reserve requirements in New York may further hinder the ability of our New York managed care plan to pay dividends.

If our regulators were to deny or significantly further restrict our subsidiaries’ ability to pay dividends to us or to pay management fees to our affiliates, the funds available to us as a whole would be limited, which could harm our ability to implement our business strategy. For example, we could be hindered in our ability to make debt service payments on amounts drawn from our credit facility.

29

 
Risks Related to Our Common Stock

Future sales, or the availability for sale, of our common stock may cause our stock price to decline.

Sales of substantial amounts of our common stock in the public market, or the perception that such sales could occur, could adversely affect the market price of our common stock and could materially impair our future ability to raise capital through offerings of our common stock.

As of December 31, 2006, we had outstanding options to purchase 2,906,360 shares of our common stock, of which 956,790 were exercisable, at a weighted-average exercise price of $30.64 per share. From time to time, we may issue additional options to associates, non-employee directors and consultants pursuant to our equity incentive plans.

The provisions in our charter documents and under Delaware law, could discourage a takeover that stockholders may consider favorable and make it more difficult for a stockholder to elect directors of its choosing.

The provisions of our certificate of incorporation, bylaws and provisions of applicable Delaware law may discourage, delay or prevent a merger or other change in control that a stockholder may consider favorable. These provisions could also discourage proxy contests, make it more difficult for stockholders to elect directors of their choosing and cause us to take other corporate actions that stockholders may consider unfavorable.

Item 1B. Unresolved Staff Comments

None.

Item 2. Properties

Our principal administrative, sales and marketing facilities are located at our headquarters in Tampa, Florida. We currently occupy approximately 377,000 square feet of office space in the Tampa facility under a lease whose term is scheduled to expire in various phases from 2011 through 2016. We also lease office space for our health plans in Florida, New York, Illinois, Connecticut, Georgia, Ohio and Louisiana. We believe these facilities are suitable and provide the appropriate level of capacity for our current operations.

Item 3. Legal Proceedings

We are involved in legal actions in the normal course of business, some of which seek monetary damages, including claims for punitive damages, which are not covered by insurance. We currently believe that none of these actions, when finally concluded and determined, will, in our opinion, have a material adverse effect on our financial position, results of operations or cash flows.

We believe that we have obtained adequate insurance or, where appropriate, have established adequate reserves in connection with these legal proceedings.

Item 4. Submission of Matters to a Vote of Security Holders

None.



PART II

Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
 
Market for Common Stock

Our common stock is listed on the New York Stock Exchange under the symbol “WCG.” The following table sets forth the high and low closing sales prices of our common stock, as reported on the New York Stock Exchange, for each of the periods listed.

       
High
 
Low
 
 2006  
 
         
First Quarter ended March 31, 2006
       
$
45.44
 
$
37.27
 
Second Quarter ended June 30, 2006
       
$
50.05
 
$
39.41
 
Third Quarter ended September 30, 2006
       
$
60.00
 
$
49.06
 
Fourth Quarter ended December 31, 2006
       
$
70.72
 
$
56.00
 
                     
 2005    
 
             
First Quarter ended March 31, 2005
       
$
37.95
 
$
27.80
 
Second Quarter ended June 30, 2005
       
$
36.25
 
$
28.31
 
Third Quarter ended September 30, 2005
       
$
43.36
 
$
35.53
 
Fourth Quarter ended December 31, 2005
       
$
42.74
 
$
30.23
 
                     

The last reported sale price of our common stock on the New York Stock Exchange on February 14, 2007 was $78.03. As of February 14, 2007, we had approximately 45 holders of record of our common stock.

Performance Graph

The following graph compares the cumulative total stockholder return on our common stock for the period from July 1, 2004, the date shares of our common stock began trading on the New York Stock Exchange, to December 31, 2006 with the cumulative total return on the stocks included in the Standard & Poor’s 500 Stock Index and a Peer Group Index over the same period. The graph assumes an investment of $100 made in our common stock and each index on July 1, 2004. We did not pay any dividends during the period reflected in the graph. Note that our common stock price performance shown below should not be viewed as being indicative of future performance.

The Custom Composite Index consists of the following companies: Aetna Inc., Amerigroup Corporation, Centene Corporation, Coventry Health Care, Inc., HealthNet, Inc., Humana, Inc., Pacificare Health Systems, Inc. (ending during the fourth quarter of 2005), Sierra Health Services, Inc., United HealthGroup, Inc. and WellPoint, Inc. (formerly known as WellPoint Health Networks Inc.).
 

 

  
7/1/04
12/31/04
12/31/05
12/31/06
WellCare Health Plans, Inc.
$100
$191
$240
$405
S&P 500 Index
$100
$108
$114
$132
Custom Composite Index
$100
$140
$201
$186
 
 
31

 
Dividends

We have never paid cash dividends on our common stock. We currently intend to retain any future earnings to fund the development and growth of our business, and we do not anticipate paying any cash dividends in the future.

Our ability to pay dividends is dependent on our receipt of cash dividends from our subsidiaries. Laws of the states in which we operate or may operate, as well as requirements of the government-sponsored health programs in which we participate, limit the ability of our subsidiaries to pay dividends to us. In addition, the terms of our credit facility limit our ability to pay dividends. Any future determination to pay dividends will be at the discretion of our board of directors and will depend upon, among other factors, our results of operations, financial condition, capital requirements and contractual restrictions.

Securities Authorized for Issuance Under Equity Compensation Plans

The following table includes the specified information as of December 31, 2006 for all of our equity compensation plans which have been approved by our shareholders and all of our equity compensation plans which have not been approved by our shareholders.

Securities Authorized for Issuance Under Equity Compensation Plans
Plan Category
Number of securities to be issued upon exercise of outstanding options, warrants and rights
Weighted-average exercise price of outstanding options, warrants andrights ($)
Number of securities remaining available for future issuance under equity compensation plans (excluding securities reflected in
column (a))
 
(a)
(b)
(c)
Equity compensation plans approved by security holders(1)
2,169,213
 
38.24
 
2,678,052
 
Equity compensation plans not approved by security holders(2) 
737,147
 
8.28
 
__
 
Total
2,906,360
30.64
2,678,052
 
(1)  
The WellCare Health Plans, Inc. 2004 Equity Incentive Plan (the “2004 Equity Plan”) was approved by our shareholders in June 2004 and the WellCare Health Plans, Inc. 2005 Employee Stock Purchase Plan (the “ESPP”) was approved by our shareholders in June 2005. As of December 31, 2006, there were 2,297,438 shares reserved for future issuance under the 2004 Equity Plan and 380,614 shares reserved for future issuance under the ESPP. The total number of shares of common stock subject to the granting of awards under our 2004 Equity Plan may be increased on January 1 of each year, commencing on January 1, 2005 and ending on January 1, 2013, in an amount equal to the lesser of 3% of the number of shares of common stock outstanding on each such date, 1,200,000 shares, or such lesser amount determined by our board of directors. The total number of shares of common stock subject to the granting of awards under our 2004 Equity Plan was increased by 1,182,840 shares effective January 1, 2006. In addition to options, shares may be issued in restricted stock awards, performance awards and other stock-based awards under the 2004 Equity Plan.

32

 
(2)  
Equity compensation plans not approved by our shareholders include the WellCare Holdings, LLC 2002 Employee Option Plan (the “2002 Plan”) and an aggregate of seven stock option agreements (the “Non-Plan Grants”) entered into with individuals prior to our initial public offering. The 2002 Plan was adopted by our board of directors in September 2002 and is administered by our compensation committee. Under the 2002 Plan, certain employees were granted non-qualified stock options to purchase shares of our common stock at an exercise price per share equal to the fair market value of our stock on the date of grant as determined by our board. Generally, option awards granted under the 2002 Plan vest as to 25% of the shares subject to the award on the first anniversary of the date of grant, and as to 2.083% upon the end of each full calendar month thereafter, and expire on the tenth anniversary of the date of grant. Subject to certain exemptions and conditions, if a grantee ceases to be an employee of ours for any reason other than death, all of the grantee’s options that were exercisable on the date of termination of employment will remain exercisable for 60 days after the date of such termination. In the case of death, all of the grantee’s options that were exercisable on the date of death will remain exercisable for a period of 180 days from such date. Unvested options will terminate upon a change in control. Options issued under the 2002 Plan may not be sold, pledged, assigned, transferred or otherwise disposed of other than pursuant to applicable laws of descent and distribution or for estate planning purposes if approved by the board. The board generally has the power and authority to amend or terminate the 2002 Plan at any time without approval from our stockholders; however, no amendment may, in any material respect, adversely impair the rights of any grantee without the grantee’s written consent. No option awards have been granted under the 2002 Plan since June 2004 and no options remain available for future issuance under this plan. The terms of the Non-Plan Grants are materially similar to the terms of options granted under the 2002 Plan. Six of the Non-Plan Grants, exercisable for an aggregate of 23,780 shares of common stock, were issued to individuals other than our directors or executive officers. The weighted-average exercise price of those six outstanding option grants is $4.72 per share. The vesting schedule of those six Non-Plan Grants is as follows: (a) three options, exercisable for an aggregate of 18,494 shares, vested as to 25% after one year, and as to 2.083% upon the end of each full calendar month thereafter, (b) one option, exercisable for an aggregate of 4,066 shares, vested in full on the grant date, and (c) two options, exercisable for an aggregate of 1,220 shares, vest as to 4.167% upon the end of each full calendar month following the grant date. In November 2004, our board of directors determined to fully accelerate the vesting of four out of the five option grants listed in both subsections (a) and (c) above. The remaining Non-Plan Grant was issued to one of our directors, Christian Michalik. On December 31, 2003, Mr. Michalik was granted options to purchase 40,657 shares at a per share exercise price of $6.47. These options expire on December 31, 2013, vested as to 25% of the shares subject thereto on June 30, 2004, and vest as to 2.083% upon the end of each full calendar month thereafter.
 
Initial Public Offering

In connection with our initial public offering of our common stock, the SEC declared our Registration Statement on Form S-1 (No. 333-112829), filed under the Securities Act of 1933, effective on June 30, 2004.

Upon the completion of our initial public offering, we invested the net proceeds from the offering in short-term, interest-bearing, investment-grade securities. As of December 31, 2006, we have used approximately $48.1 million of our offering proceeds in the original amount of $157.5 million. Of the proceeds used, $24.0 million was used to pay-off the related party note described below in “Seller Note,” and the remaining $24.1 million was used to fund other expansion opportunities, including the required statutory capital for our new markets.

Item 6. Selected Financial Data

The following table sets forth our summary financial data. This information should be read in conjunction with our financial statements and the related notes and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included elsewhere in this filing. WellCare, as it existed prior to the July 31, 2002 acquisition of the WellCare group of companies, is referred to as “Predecessor.” WellCare, as it existed on and after July 31, 2002, is referred to as “Successor.” The data for the years ended December 31, 2004, 2005, and 2006, and as of December 31, 2005 and 2006 is derived from consolidated financial statements included elsewhere in this filing. The data for the five-month period ended December 31, 2002, seven-month period ended July 31, 2002 and the year ended December 31, 2003, and as of December 31, 2002, 2003 and 2004 is derived from audited financial statements not included in this filing.



   
Predecessor
 
Successor
 
   
Seven-Month Period Ended July 31,
2002
 
Five-Month Period Ended December 31, 2002
 
 
Year Ended December 31, 2003
 
 
Year Ended December 31, 2004
 
 
Year Ended December 31, 2005
 
 
Year Ended December 31, 2006
 
   
(in thousands, except per unit/share data)
 
Consolidated and Combined Statements of Income:
                         
Revenues:
                         
Premium:
                         
Medicaid
 
$
329,164
 
$
267,911
 
$
740,078
 
$
1,055,000
 
$
1,357,995
 
$
1,927,616
 
Medicare
   
170,073
   
120,814
   
288,330
   
334,760
   
504,502
   
1,785,429
 
Other(1)
   
17,976
   
9,928
   
14,444
   
1,136
   
   
 
Total premium
   
517,213
   
398,653
   
1,042,852
   
1,390,896
   
1,862,497
   
3,713,045
 
Investment and other income
   
2,819
   
3,152
   
3,130
   
4,307
   
17,042
   
49,881
 
Total revenues
   
520,032
   
401,805
   
1,045,982
   
1,395,203
   
1,879,539
   
3,762,926
 
Expenses:
                                     
Medical benefits:
                                     
Medicaid
   
274,672
   
222,007
   
609,233
   
851,153
   
1,099,901
   
1,556,466
 
Medicare
   
145,768
   
107,384
   
238,933
   
275,348
   
412,208
   
1,455,697
 
Other(1)
   
14,484
   
12,372
   
12,887
   
(941
)
 
   
 
Total medical benefits
   
434,924
   
341,763
   
861,053
   
1,125,560
   
1,512,109
   
3,012,163
 
Selling, general and administrative
   
54,492
   
45,384
   
126,106
   
171,257
   
259,491
   
492,808
 
Depreciation and amortization
   
1,239
   
3,734
   
8,159
   
7,715
   
9,204
   
17,170
 
Interest
   
1,446
   
1,462
   
10,172
   
10,165
   
13,562
   
14,087
 
Total expenses
   
492,101
   
392,343
   
1,005,490
   
1,314,697
   
1,794,366
   
3,536,228
 
Income before income taxes
   
27,931
   
9,462
   
40,492
   
80,506
   
85,173
   
226,698
 
Income tax expense(2)
   
   
4,805
   
16,955
   
31,256
   
33,245
   
87,511
 
Net income
 
$
27,931
 
$
4,657
 
$
23,537
 
$
49,250
 
$
51,928
 
$
139,187
 
Net income per share:
                                     
Net income per share - basic
                   
$
1.70
 
$
1.38
 
$
3.54
 
Net income per share - diluted
                   
$
1.56
 
$
1.32
 
$
3.43
 
Net income attributable per common unit:
                                     
Net income attributable per unit - basic
       
$
0.09
 
$
0.66
                   
Net income attributable per unit - diluted
       
$
0.08
 
$
0.60
                   
Pro forma net income per common share:(3)
                                     
Basic
             
$
0.82
                   
Diluted
             
$
0.73
                   
Pro forma common shares outstanding:(3)
                                     
Basic
               
21,466,300
                   
Diluted
               
23,937,664
                   

 
   
As of December 31,
 
   
2002
 
2003
 
2004
 
2005
 
2006
 
Operating Statistics:
                     
Medical benefits ratio - consolidated(4)
   
84.8
%
 
82.6
%
 
80.9
%
 
81.2
%
 
81.1
%
Medical benefits ratio - Medicaid(4)
   
83.2
%
 
82.3
%
 
80.7
%
 
81.0
%
 
80.7
%
Medical benefits ratio - Medicare(4)
   
87.0
%
 
82.9
%
 
82.3
%
 
81.7
%
 
81.5
%
Medical benefit ratio - other(4)
   
96.2
%
 
89.2
%
 
(82.8
%)
 
   
 
Selling, general and administrative expense ratio(5)
   
10.8
%
 
12.1
%
 
12.3
%
 
13.8
%
 
13.1
%
Members - consolidated
   
470,000
   
555,000
   
747,000
   
855,000
   
2,258,000
 
Members - Medicaid
   
420,000
   
512,000
   
701,000
   
786,000
   
1,245,000
 
Members - Medicare
   
42,000
   
42,000
   
46,000
   
69,000
   
1,013,000
 
Members - commercial
   
8,000
   
1,000
   
   
   
 
 
 
   
As of December 31,
 
   
2002
 
2003
 
2004
 
2005
 
2006
 
Balance Sheet Data:
                     
Cash and cash equivalents
 
$
146,784
 
$
237,321
 
$
397,627
 
$
421,766
 
$
964,542
 
Total assets
   
409,504
   
497,107
   
799,036
   
887,489
   
1,663,965
 
Long-term debt (including current maturities)
   
156,295
   
135,755
   
184,200
   
182,600
   
155,621
 
Total liabilities
   
334,587
   
397,530
   
490,405
   
517,365
   
1,100,910
 
Total stockholders’/members’ equity(6)
   
74,917
   
99,577
   
308,631
   
370,124
   
563,055
 

(1)  
Other premium revenue and other medical benefits relates to our commercial business, which was no longer operated beginning May 2004.

(2)  
Income tax expense was not recorded by the Predecessor because its tax structure included entities that had elected subchapter S status under the Internal Revenue Code, the income of which was taxed at the stockholder level, as well as entities that were subject to tax, but did not generate tax liabilities or benefits due to operating losses. Pro forma tax expense for the seven months ended July 31, 2002 at an estimated tax rate of 42% (our effective tax rate as the Successor in 2003) is $11,731.

(3)  
Pro forma net income per share is computed using the pro forma weighted average number of common shares outstanding, which gives effect to the automatic conversion of all outstanding common units of WellCare Holdings, LLC into shares of common stock of WellCare Health Plans, Inc. upon the closing of our initial public offering. For a discussion of the difference between pro forma net income per common share and net income attributable per common unit, see Note 13 to the consolidated financial statements of WellCare Health Plans, Inc.

34

 
(4)  
Medical benefits ratio represents medical benefits expense as a percentage of premium revenue.

(5)  
Selling, general and administrative expense ratio represents selling, general and administrative expense as a percentage of total revenue and excludes depreciation and amortization expense for purposes of determining the ratio.

(6)  
Total stockholders’/members’ equity reflects limited liability company membership interests during 2002 and 2003 and reflects stockholders’ equity for Successor as of December 31, 2004, 2005 and 2006.

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion and analysis of our financial condition and results of operations should be read in conjunction with “Selected Financial Data” beginning on Page 33 and our combined and consolidated financial statements and related notes appearing elsewhere in this report. The following discussion contains forward-looking statements that involve risks, uncertainties and assumptions that could cause our actual results to differ materially from management’s expectations. Factors that could cause such differences include those set forth under “Risk Factors,” “Forward-Looking Statements,” “Business” and elsewhere in this report.



Overview

We provide managed care services exclusively to government-sponsored healthcare programs, focusing on Medicare and Medicaid. We offer a variety of Medicare and Medicaid plans, including health plans for families, children, the aged, blind and disabled and prescription drug plans, as of December 31, 2006 serving over 2,258,000 members nationwide.

Medicaid was established under the U.S. Social Security Act of 1965 to provide medical assistance to low income and disabled persons. It is state operated and implemented, although it is funded by both the state and federal governments. Our Medicaid plans include plans for individuals who are dually eligible for both Medicare and Medicaid, and recipients of the Temporary Assistance to Needy Families (“TANF”) programs, Supplemental Security Income (“SSI”) programs, State Children’s Health Insurance (“S-CHIP”) programs, and the Family Health Plus (“FHP”) programs. The TANF program generally provides assistance to low-income families with children and the SSI program generally provides assistance to low-income aged, blind or disabled individuals. Families who exceed the income thresholds for Medicaid may be able to qualify for the state S-CHIP and FHP programs.

Medicare is a federal program that provides eligible persons age 65 and over and some disabled persons a variety of hospital, medical insurance and prescription drug benefits. Medicare is administered and funded by the federal Centers for Medicare & Medicaid Services (“CMS”). Our Medicare plans include stand-alone prescription drug plans (“PDP”) and Medicare Advantage plans which include both Medicare coordinated care (“MCC”) plans and Medicare private fee-for-service (“PFFS”) plans. Medicare Advantage is Medicare’s managed care alternative to original Medicare fee-for-service which individuals enroll into directly through CMS. MCC plans are plans that are administered through a health maintenance organization (“HMO”) and generally require members to seek health care services from a network of health care providers. PFFS plans are open-access plans that allow members to be seen by any physician or facility that participates in the Medicare program.

We believe that our experience in managing healthcare for this broad range of beneficiaries better positions us to capitalize on growth opportunities across all of these programs. In addition, unlike many other managed care organizations that attempt to serve the general population through commercial health plans, we focus exclusively on serving individuals in government programs. We believe that this focus allows us to better serve our members and providers and to more efficiently manage our operations. We have centralized core functions, such as claims processing and medical management, combined with localized marketing and strong provider relationships. We believe that this approach will allow us to continue effectively growing our business, both through organic growth and through acquisitions.

Through our licensed subsidiaries, as of December 31, 2006, we operated our Medicaid plans in Florida, New York, Connecticut, Illinois, Indiana, Missouri, Georgia and Ohio and our MCC plans in Florida, New York, Connecticut, Illinois, Louisiana and Georgia. We also operate stand-alone Medicare PDP plans in all 50 states and the District of Columbia. On January 1, 2007, we ceased offering Medicaid plans in Indiana, but began offering PFFS plans to Medicare beneficiaries in 793 counties in 39 states and Washington, D.C.
 
The following tables summarize our membership by segment and line of business as of December 31, 2006 and 2005.

 
December 31,
2006
 
December 31,
2005
Medicaid
     
TANF
1,069,000
 
621,000
S-CHIP
95,000
 
82,000
SSI
51,000
 
58,000
FHP
30,000
 
25,000
 
1,245,000
 
786,000
       
Medicare
     
MA
90,000
 
69,000
PDP
923,000
 
-
 
1,013,000
 
69,000
       
Total
2,258,000
 
855,000

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On August 4, 2006, we were notified by the Indiana Office of Medicaid Policy and Planning (“OMPP”) that we were not selected for a new contract to provide managed care benefits to Indiana Medicaid recipients in 2007. Our contract with the state expired on December 31, 2006. As a result, the associated Indiana market intangible assets were deemed to have no further economic value. Accordingly, the remaining amortization on the assets with a net value of $2,500 that were purchased in 2004 was accelerated. Expense of $2,500 is included in depreciation and amortization expense in the 2006 annual statement of income. Our Indiana membership and revenue represent 3.1% and 3.5% of total membership and annual revenue as of December 31, 2006, respectively. Management does not believe that the loss of this contract will have a material impact on our future operations.

We enter into contracts with government agencies that administer health benefits programs. These contracts generally are subject to renewal every one to three years. We receive premiums from state and federal agencies for the members that are assigned to or have selected us to provide healthcare services under each benefit program. The amount of premiums we receive for each member is fixed, although it varies according to demographics, including the government program, and the member’s geographic location, age and gender, and the premiums are subject to periodic adjustments.

Our largest expense is the cost of medical benefits that we provide, which is based primarily on our arrangements with healthcare providers. Our profitability depends on our ability to predict and effectively manage medical benefits expense relative to the fixed premiums we receive. Our arrangements with providers fall into two broad categories: capitation arrangements, where we pay the capitated providers a fixed fee per member, and fee-for-service and risk-sharing arrangements, where we assume all or part of the risk of the cost of the healthcare provided. Generally, capitation payments represent 20% or less of our total medical benefits expense. Other components of medical benefits expense are variable and require estimation and ongoing cost management.

Estimation of medical benefits expense is our most significant critical accounting estimate. See “—Critical Accounting Policies.”

We use a variety of techniques to manage our medical benefits expense, including payment methods to providers, referral requirements, quality and disease management programs, reinsurance and member co-payments and premiums for some of our Medicare plans. National healthcare costs have been increasing at a higher rate than the general inflation rate, however, and relatively small changes in our medical benefits expense relative to premiums that we receive can create significant changes in our financial results. Changes in healthcare laws, regulations and practices, levels of use of healthcare services, competitive pressures, hospital costs, major epidemics, terrorism or bio-terrorism, new medical technologies and other external factors could reduce our ability to manage our medical benefits expense effectively.

One of our primary tools for measuring profitability is our medical benefits ratio, the ratio of our medical benefits expense to the premiums we receive. Changes in the medical benefits ratio from period to period result from, among other things, changes in Medicaid and Medicare funding, changes in the mix of Medicaid and Medicare membership, our ability to manage medical costs and changes in accounting estimates related to incurred but not reported claims. We use medical benefits ratios both to monitor our management of medical benefits expense and to make various business decisions, including what healthcare plans to offer, what geographic areas to enter or exit and the selection of healthcare providers. Although medical benefits ratios play an important role in our business strategy, we may be willing to enter into provider arrangements that might produce a less favorable medical benefits ratio if those arrangements, such as capitation or risk-sharing, would likely lower our exposure to variability in medical costs.
 
Basis of Presentation

The consolidated results of operations include the accounts of WellCare Health Plans, Inc. and all of its subsidiaries. Significant inter-company accounts and transactions have been eliminated.

Segments

We have two reportable business segments: Medicaid and Medicare.

Medicaid

Medicaid, a state administered program, was enacted in 1965 to make federal matching funds available to all states for the delivery of healthcare benefits to eligible individuals, principally those with incomes below specified levels who meet other state specified requirements. Medicaid is structured to allow each state to establish its own eligibility standards, benefits package, payment rates and program administration under broad federal guidelines. Most states determine threshold Medicaid eligibility by reference to other federal financial assistance programs including the TANF and SSI programs.

37

 
The TANF program provides assistance to low-income families with children and was adopted to replace the Aid to Families with Dependent Children program. SSI is a federal program that provides assistance to low-income aged, blind or disabled individuals. However, states can broaden eligibility criteria.

S-CHIP, developed in 1997, is a federal/state matching program that provides healthcare coverage to children in low income families not otherwise covered by Medicaid or other insurance programs. It must be reauthorized by Congress this year. S-CHIP enables a segment of the large uninsured population in the United States to receive healthcare benefits. States have the option of administering S-CHIP through their Medicaid programs.

FHP is a New York State program that provides health insurance for certain adults and their families between the ages of 19 and 64 who do not have health insurance on their own, but have income too high to qualify for Medicaid.

Medicare

Medicare is a federal program that provides eligible persons age 65 and over and some disabled persons a variety of hospital, medical insurance and prescription drug benefits. Most individuals eligible for Medicare are entitled to receive inpatient hospital care without the payment of any premium, but are required to pay a premium to the federal government, which is adjusted annually, to be eligible for physician care and other services.

Under the MA program, managed care plans can contract with CMS to provide health insurance coverage in exchange for a fixed monthly payment per member based on the geographic area in which the member resides. The fixed monthly payment per member is subject to periodic adjustments determined by CMS based upon a number of factors, including retroactive changes in members’ status such as Medicaid eligibility, and risk measures based on demographic factors such as age, gender, county of residence and health status. The weighting of the risk measures in the determination of the amount of the periodic adjustments to the fixed monthly payments was phased in over time, and first became fully implemented in 2007. Individuals who elect to participate in the MA program are relieved of the obligation to pay some or all of the deductible or coinsurance amounts required under the original Medicare fee-for-service program, but, in the case of MCC plans, are generally required to use services provided by the MA plan’s network providers, and may be required to pay a premium to the federal Medicare program unless the MA plan chooses to pay the premium as part of its benefit package.

As part of the Medicare reform legislation known as the Medicare Prescription Drug, Improvement and Modernization Act of 2003, or MMA, beginning in January 2006, Medicare recipients were provided the opportunity to select a prescription drug plan through Medicare Part D, largely funded by the federal government. The Medicare Part D benefit is available to Medicare managed care enrollees as well as Medicare fee-for-service enrollees. MCC plans are required to offer a plan that includes Part D drug benefits, called a MA-PD plan, in every region in which they operate.

The Medicare Part D benefit, which provides prescription drug benefits, is available to Medicare Advantage enrollees as well as original Medicare fee-for-service enrollees. MCC plans are required to offer a Part D drug benefit, whereas PFFS plans have the option of providing a Part D benefit, but are not required to do so. Most of our PFFS products offer a Part D benefit. MCC plans and PFFS plans that include a Part D drug benefit are also known as MA-PD plans. Original Medicare fee-for-service beneficiaries and PFFS enrollees are able to purchase a stand-alone prescription drug plan, called a PDP plan, from a list of CMS-approved PDP plans, such as ours.

We have experienced and continue to expect seasonality and fluctuations in our PDP earnings on a quarterly basis resulting from the design of our benefits and the interaction of various product features, such as deductibles, co-payments, the coverage gap, catastrophic coverage, risk corridors and reinsurance arrangements, all of which will impact our PDP earnings. Our PDP medical costs will be higher in the first half of the year than in the second half of the year. As a result, our net income margins to be lower in the first half of the year and to increase in the second half of the year.
 
We purchased a one-year, nonrenewable, aggregate reinsurance policy for calendar year 2006 to mitigate the risks associated with our new PDP product by complementing the risk corridor protection and catastrophic coverage provided by CMS under the Medicare Part D program. The terms of this aggregate reinsurance policy resulted in higher recoveries in periods of higher medical benefits ratios and lower or no recoveries in periods of lower medical benefits ratios. The recoveries and net reinsurance impact under this aggregate reinsurance policy were cumulative over the one-year term of the policy. The medical benefits ratio of our PDP business in fiscal year 2006 resulted in a net reinsurance expense of $4.0 million which unfavorably impacted the year-to-date gross profit on our Medicare segment. The results of our PDP business in the fourth quarter of 2006 were favorably impacted by increased membership coupled with favorable medical utilization and cost trends, resulting in lower medical benefits ratios. As a result, the gross profit on our Medicare segment in the fourth quarter was favorably impacted by a refund of premium of $1.9 million based on our favorable experience for the three-month period ended December 31, 2006. Our 2006 net income was reduced by $2.4 million of net reinsurance expense. In light of the 2007 PDP bid results and our 2006 experience with the PDP product, we have not purchased a similar reinsurance arrangement in 2007.

38

 
Critical Accounting Policies

In the ordinary course of business, we make a number of estimates and assumptions relating to the reporting of our results of operations and financial condition in conformity with accounting principles generally accepted in the United States. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. Actual results could differ significantly from those estimates under different assumptions and conditions. We believe that the accounting policies discussed below are those that are most important to the portrayal of our financial condition and results and require management’s most difficult, subjective and complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain.
 
Revenue recognition. Our Medicaid contracts with state governments are generally multi-year contracts subject to annual renewal provisions. Our Medicare Advantage and PDP contracts with CMS generally have terms of one year. We generally receive premiums in advance of providing services, and recognize premium revenue during the period in which we are obligated to provide services to our members. Premiums are billed monthly for coverage in the following month and are recognized as revenue in the month for which insurance coverage is provided. We estimate, on an ongoing basis, the amount of member billings that may not be fully collectible based on historical trends and other factors. An allowance is established for the estimated amount that may not be collectible. This allowance has not been significant to premium revenue. The payment we receive monthly from CMS for our PDP program generally represents our bid amount for providing prescription drug insurance coverage. We recognize premium revenue for providing this insurance coverage ratably over the term of our annual contract. However, our CMS payment is subject to (i) risk corridor adjustments and (ii) subsidies in order for us and CMS to share the risk associated with financing the ultimate costs of the Part D benefit. The amount of revenue payable to a plan by CMS is subject to adjustment, positive or negative, based upon the application of risk corridors that compare a plan’s revenues targeted in their bids (“target amount’) to actual prescription drug costs. Variances exceeding certain thresholds may result in CMS making additional payments to us or require us to refund to CMS a portion of the premiums we received. Actual prescription drug costs subject to risk sharing with CMS are limited to the costs that are, or would have been, incurred under the CMS “defined standard” benefit plan (“allowable risk corridor costs”). We estimate and recognize an adjustment to premium revenues related to the risk corridor payment adjustment based upon pharmacy claims experience to date as if the annual contract were to terminate at the end of each reporting period. Accordingly, this estimate provides no consideration to future pharmacy claims experience. Premiums collected in advance are deferred and reported as unearned premiums in the accompanying Consolidated Balance Sheets, any amounts that have not been received by the end of the period remain on the balance sheet classified as premium receivables.

Premium payments that we receive are based upon eligibility lists produced by the government. From time to time, states require us to reimburse them for premiums that we received from the states based on an eligibility list that a state later discovers contains individuals who were not eligible for any government-sponsored program or are eligible for a different premium category or a different program. We record adjustments to revenues based on member retroactivity. These adjustments reflect changes in the number of and eligibility status of enrollees subsequent to when revenue was billed. We estimate the amount of outstanding retroactivity each period and adjust premium revenue accordingly, if appropriate. The estimates of retroactivity adjustments are based on historical trends, premiums billed, the volume of member and contract renewal activity and other information. Our government contracts establish monthly rates per member, but may have additional amounts due to us based on items such as age, working status or specific health issues of the member. For example, CMS has implemented a risk adjustment model which apportions premiums paid to all Medicare plans according to the health status of each beneficiary enrolled.

The CMS risk adjustment model pays more for Medicare members with predictably higher costs. Under this risk adjustment methodology, diagnosis data from inpatient and ambulatory treatment settings are used to calculate the risk adjusted premium payment to us. We collect, capture and submit the necessary diagnosis data to CMS within prescribed deadlines. We estimate risk adjustment revenues based upon the diagnosis data submitted to CMS and ultimately accepted by CMS.
 
39

 
CMS transitioned to the risk adjustment model while the old demographic model was being phased out. The demographic model based the monthly premiums paid to Medicare plans on factors such as age, gender and disability status. The monthly premium amount for each member was separately determined under both the risk adjustment and demographic model, and these separate payment amounts were blended according to a transition schedule. 2007 is the first year in which risk adjusted payment for health plans is fully phased in. The PDP payment methodology is based 100% on the risk adjustment model which began in 2006. As a result of this process and the phasing in of the risk adjustment model, our CMS monthly premium payments per member may change materially, either favorably or unfavorably.

Estimating medical benefits expense and medical benefits payable. The cost of medical benefits is recognized in the period in which services are provided and includes an estimate of the cost of medical benefits that have been incurred but not yet reported. We contract with various healthcare providers for the provision of certain medical care services to our members and generally compensate those providers on a fee-for-service or capitated basis or pursuant to certain risk-sharing arrangements. Capitation represents fixed payments generally on a per-member-per-month, or PMPM, basis to participating physicians and other medical specialists as compensation for providing comprehensive healthcare services. By the terms of our capitation agreements, capitation payments we make to capitated providers alleviate any further obligation we have to pay the capitated provider for the actual medical expenses of the member. Participating physician capitation payments for the years ended December 31, 2006, 2005 and 2004 were 12.3%, 12.8% and 13.8%, respectively, of total medical benefits expense.

Medical benefits expense has two main components: direct medical expenses and medically-related administrative costs. Direct medical expenses include amounts paid to hospitals, physicians and providers of ancillary services, such as laboratory and pharmacy. Medically-related administrative costs include items such as case and disease management, utilization review services, quality assurance and on-call nurses.

Medical benefits payable represents amounts for claims fully adjudicated awaiting payment disbursement and estimates for incurred, but not yet reported claims.

The following table provides a reconciliation of the total medical benefits payable balances as of December 31, 2006 and 2005:

   
 
December 31, 2006
 
% of Total
 
 
December 31, 2005
 
% of Total
 
   
(in thousands)
 
Claims adjudicated, but not yet paid
 
$
43,066
   
9.2
%
$
12,428
   
5.1
%
IBNR
   
422,515
   
90.8
%
 
228,947
   
94.9
%
Total Medical benefits payable
 
$
465,581
       
$
241,375
       

We have used the same methodology for estimating our medical benefits expense and medical benefits payable since our acquisition of the WellCare group of companies in 2002. Our policy is to record management’s best estimate of medical benefits payable. Monthly, we estimate ultimate benefits payable based upon historical experience and other available information as well as assumptions about emerging trends, which vary by business segment. The process for preparing the estimate utilizes standard actuarial methodologies based on historical data. These standard actuarial methodologies include, among other factors, contractual requirements, historical utilization trends, the interval between the date services are rendered and the date claims are paid, denied claims activity, disputed claims activity, benefit changes, expected health care cost inflation, seasonality patterns and changes in membership. In developing the estimate, we apply different estimation methods depending on the month for which incurred claims are being estimated. For the more recent months, which constitute the majority of the amount of the medical benefits payable, we estimate our claims incurred by applying observed trend factors to the PMPM costs for prior months, which costs have been estimated using completion factors, in order to estimate the PMPM costs for the most recent months. We validate our estimates of the most recent PMPM costs by comparing the most recent months’ utilization levels to the utilization levels in older months, 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.

Also included in medical benefits payable are estimates for provider settlements due to clarification of contract terms, out-of-network reimbursement and claims payment differences, as well as amounts due to contracted providers under risk-sharing arrangements.

Many aspects of the managed care business are not predictable with consistency. These aspects include the incidences of illness or disease state (such as cardiac heart failure cases, cases of upper respiratory illness, the length and severity of the flu season, diabetes, the number of full-term versus premature births and the number of neonatal intensive care babies). Therefore, we must rely upon our historical experience, as continually monitored, to reflect the ever-changing mix, needs and growth of our members in our trend assumptions. Among the factors considered by management are changes in the level of benefits provided to members, seasonal variations in utilization, identified industry trends and changes in provider reimbursement arrangements, including changes in the percentage of reimbursements made on a capitated, as opposed to a fee-for-service, basis. These considerations are aggregated in the trend in medical benefits expense. Other external factors such as government-mandated benefits or other regulatory changes, catastrophes and epidemics may impact medical cost trends. Other internal factors such as system conversions and claims processing interruptions may impact our ability to accurately predict estimates of historical completion factors or medical cost trends. Medical cost trends potentially are more volatile than other segments of the economy. Management is required to use considerable judgment in the selection of medical benefits expense trends and other actuarial model inputs.

40

 
We record reserves for estimated referral claims related to healthcare providers under contract with us who are financially troubled or insolvent and who may not be able to honor their obligations for the costs of medical services provided by other providers. In these instances, we may be required to honor these obligations for legal or business reasons. Based on our current assessment of providers under contract with us, such losses have not been and are not expected to be significant.

Changes in estimates of medical benefits payable are primarily the result of obtaining more complete claims information that directly correlates with the claims and provider reimbursement trends. Volatility in members’ needs for medical services, provider claims submission and our payment processes results in identifiable patterns emerging several months after the causes of deviations from assumed trends occur. Since our estimates are based upon PMPM claims experience, changes cannot typically be explained by any single factor, but are the result of a number of interrelated variables, all influencing the resulting experienced medical cost trend. Deviations, whether positive or negative, between actual experience and estimates used to establish the liability are recorded in the period known.

The following table provides a reconciliation of the beginning and ending balance of medical benefits payable for the following periods:

   
Year Ended December 31, 2004
 
Year Ended December 31, 2005
 
Year Ended December 31, 2006
 
   
(in thousands)
 
Balances as of beginning of period
 
$
148,297
 
$
190,595
   
241,375
 
Opening medical benefits payable related to Harmony Acquisition
   
18,160
   
   
 
Medical benefits incurred related to:
                   
Current period
   
1,151,948
   
1,538,495
   
3,059,300
 
Prior periods
   
(26,388
)
 
(26,386
)
 
(47,137
)
Total
   
1,125,560
   
1,512,109
   
3,012,163
 
Medical benefits paid related to:
                   
Current period
   
(985,844
)
 
(1,331,914
)
 
(2,610,713
)
Prior periods
   
(115,578
)
 
(129,415
)
 
(177,244
)
Total
   
(1,101,422
)
 
(1,461,329
)
 
(2,787,957
)
Balances as of end of period
 
$
190,595
 
$
241,375
 
$
465,581
 

Medical benefits payable recorded at December 31, 2005 developed favorably by approximately $47.1 million. This favorable development was primarily due to realized medical benefits expense trends that were less than initially assumed trends. We initially assumed a medical benefits expense trend increase of 7.0% and an increase of 8.0% for the Medicaid and Medicare segments, respectively, at December 31, 2005 due to data available at the time of the estimate utilized in developing assumptions that suggested less favorable product benefit design and increased member utilization. Based upon payments made subsequent to December 31, 2005, for dates of service prior to December 31, 2005, the realized trends were an increase of 4.5% for the Medicaid segment and an increase of 4.6% for the Medicare segment.

Medical benefits payable recorded at December 31, 2004 developed favorably by approximately $26.4 million. This favorable development was primarily due to realized medical benefits expense trends that were less than initially assumed trends. We initially assumed a medical benefits expense trend increase of 6.4% and a decrease of 5.7% for the Medicaid and Medicare segments, respectively, at December 31, 2004 due to data available at the time of the estimate utilized in developing assumptions that suggested less favorable product benefit design and increased member utilization. Based upon payments made subsequent to December 31, 2004, for dates of service prior to December 31, 2004, the realized trends were an increase of 0.4% for the Medicaid segment and a decrease of 3.2% for the Medicare segment.

We believe that the amount of medical benefits payable as of December 31, 2006 is adequate to cover our ultimate liability for unpaid claims as of that date; however, actual payments may differ from established estimates. During the past five years, we have experienced favorable deviations from our estimated amounts in a range of 1.2% to 3.1% of total medical expenses, which would increase current year net income by approximately $36.1 million to $93.4 million if historical deviations remain consistent. However, if we were to experience unfavorable trends within the same range, current year net income would decrease by approximately $36.1 million to $93.4.

41

 
Goodwill and intangible assets. We obtained goodwill and intangible assets as a result of the acquisitions of our subsidiaries. Goodwill represents the excess of the cost over the fair market value of net assets acquired. Intangible assets include provider networks, membership contracts, trademark, noncompete agreements, state contracts, licenses and permits. Our intangible assets are amortized over their estimated useful lives ranging from one to 26 years.

We evaluate whether events or circumstances have occurred that may affect the estimated useful life or the recoverability of the remaining balance of goodwill and other identifiable intangible assets. We must make assumptions and estimates, such as the discount factor, in determining the estimated fair values. While we believe these assumptions and estimates are appropriate, other assumptions and estimates could be applied and might produce significantly different results. In August 2006, we were notified by the Indiana OMPP that our Medicaid contract would not be renewed in 2007. As a result, we performed a review of our intangible assets associated with the Indiana market and deemed them to have no further economic value. Accordingly, the remaining amortization on the assets with a net value of $2.5 million that were purchased in 2004 was accelerated. Expense of $2.5 million is included in depreciation and amortization expense in our 2006 statement of income.

We review goodwill and intangible assets for impairment at least annually, or more frequently if events or changes in circumstances occur that may affect the estimated useful life or the recoverability of the remaining balance of goodwill or intangible assets. Events or changes in circumstances would include significant changes in membership, state funding, medical contracts and provider networks. We have selected the third quarter for our annual impairment test, which generally coincides with the finalization of state and federal rate and benefit negotiations and our initial budgeting process. During the third quarter ended September 30, 2006, we assessed the earnings forecast for our two reporting units and concluded that the fair value of the individual reporting units, based upon the expected present value of future cash flows and other qualitative factors, was in excess of net assets of each reporting unit. As of December 31, 2006, we believe that there is no impairment to the value of goodwill or intangible assets.

The purchase of our Florida subsidiaries was partially financed through a contingent note payable to the former shareholders of those subsidiaries. The principal amount of this note, which was paid in full on September 15, 2006, was subject to adjustment for various contingencies. Adjustments to the note resulted in an increase in the purchase price and the amount of goodwill acquired of $41.6 million.

In June 2004, we acquired Harmony Health Systems, Inc., a provider of Medicaid managed care plans in Illinois and Indiana. The purchase price for the acquisition was approximately $50.3 million in cash, after deducting (i) pre-closing cash distributions made by Harmony to its equityholders and (ii) certain transaction expenses incurred by Harmony or its shareholders. In June 2005, we made a subsequent payment of $4.9 million as an adjustment in the purchase price to account for excess reserves for medical claims as of December 31, 2003. The payment was recorded as an addition to goodwill. Goodwill and other intangibles associated with the Harmony acquisition were $44.9 million.

We have acquired 100% of the stock of three life and health insurance companies during 2006 through which we operate our PFFS business. The purchase price allocated to intangible assets consisted of state insurance licenses in the amount of $4.3 million.

Results of Operations

The following table sets forth the consolidated statements of income data, expressed as a percentage of revenues for each period indicated. The historical results are not necessarily indicative of results to be expected for any future period.

   
Percentage of Revenues
 
   
Consolidated Year Ended December 31, 2004
 
Consolidated Year Ended December 31, 2005
 
Consolidated Year Ended December 31, 2006
 
Statement of Operations Data:
             
Revenues
             
Premium
   
99.7
%
 
99.1
%
 
98.7
%
Investment and other income
   
0.3
%
 
0.9
%
 
1.3
%
Total revenues
   
100.0
%
 
100.0
%
 
100.0
%
Expenses:
                   
Medical benefits
   
80.7
%
 
80.5
%
 
80.0
%
Selling, general and administrative
   
12.3
%
 
13.8
%
 
13.1
%
Depreciation and amortization
   
0.6
%
 
0.5
%
 
0.5
%
Interest
   
0.7
%
 
0.7
%
 
0.4
%
Total expenses
   
94.3
%
 
95.5
%
 
94.0
%
Income before income taxes
   
5.7
%
 
4.5
%
 
6.0
%
Income tax expense
   
2.2
%
 
1.8
%
 
2.3
%
Net income
   
3.5
%
 
2.7
%
 
3.7
%

42

 
One of our primary management tools for measuring profitability is our medical benefits ratio, the ratio of our medical benefits expense to the premiums we receive. Changes in the medical benefits ratio from period to period result from, among other things, changes in Medicaid and Medicare funding, changes in the mix of Medicaid and Medicare membership, our ability to manage medical costs and changes in accounting estimates related to incurred but not reported claims. We use medical benefits ratios both to monitor our management of medical benefits expense and to make various business decisions, including what healthcare plans to offer, what geographic areas to enter or exit and the selection of healthcare providers. Although medical benefits ratios play an important role in our business strategy, we may be willing to enter into provider arrangements that might produce a less favorable medical benefits ratio if those arrangements, such as capitation or risk-sharing, would likely lower our exposure to variability in medical costs.

Comparison of Year Ended December 31, 2006 to Year Ended December 31, 2005

Premium revenue. For the year ended December 31, 2006, premium revenue increased $1,850.5 million, or 99.4%, to $3,713.0 million from $1,862.5 million for the same period last year due to the addition of members, the mix of these members between our product lines and the demographic mix of our membership. The increase is primarily attributable to the addition of members from membership growth in both our Medicaid and Medicare segments. The Medicaid segment increase is primarily due to the Georgia launch and the Medicare segment increase is principally the new PDP product offering. Total membership grew by 1,403,000 members, or 164.1%, from 855,000 at December 31, 2005 to 2,258,000 at December 31, 2006.

Medicaid. Our Medicaid segment includes Medicaid programs and other state-sponsored healthcare programs. For the year ended December 31, 2006, Medicaid segment premium revenue increased $569.6 million, or 41.9%, to $1,927.6 million from $1,358.0 million for the same period last year. The increase in Medicaid segment revenue is due to growth in membership, principally in Georgia, coupled with increases in premium rates in certain markets. Aggregate membership in the Medicaid segment grew by 459,000 members, or 58.4%, from 786,000 members at December 31, 2005 to 1,245,000 at December 31, 2006 principally due to the addition of the Georgia market, off-set by small decreases in other markets.
 
   
Medicaid Revenues and Membership
 
   
For the Year Ended December 31,
 
   
2006
 
2005
 
Revenues
 
$
1,927.6
 
$
1,358.0
 
% of Total Premium Revenues
   
51.9
%
 
72.9
%
               
Membership
   
1,245,000
   
786,000
 
% of Total Membership
   
55.1
%
 
91.9
%
 
Medicare. For the year ended December 31, 2006, Medicare segment premium revenue increased $1,280.9 million, or 253.9%, to $1,785.4 million from $504.5 million for the same period last year. Growth in premium revenue within the Medicare segment was primarily the result of PDP membership growth of 923,000 members and premium increases associated with the demographic mix of our Medicare coordinated care plan membership. Membership within the Medicare segment grew by 944,000 members, or 1,368.1%, from 69,000 members at December 31, 2005 to 1,013,000 members at December 31, 2006, principally due to the new PDP product.

   
Medicare Revenues and Membership
 
   
For the Year Ended December 31,
 
   
2006
 
2005
 
Revenues
 
$
1,785.4
 
$
504.5
 
% of Total Premium Revenues
   
48.1
%
 
27.1
%
               
Membership
   
1,013,000
   
69,000
 
% of Total Membership
   
44.9
%
 
8.1
%
 
Investment and other income. For the year ended December 31, 2006, investment and other income increased $32.9 million, or 193.5%, to $49.9 million from $17.0 million for the same period last year. The increase was due to increased cash and investment positions held throughout 2006 primarily from the new PDP and Georgia businesses, as well as the higher interest rate environment. The higher average cash and investment balances accounted for approximately $14.4 million of the increase and the higher interest rate environment contributed approximately $18.5 million to the increase.

43

 

Medical benefits expense. For the year ended December 31, 2006, medical benefits expense increased $1,500.1 million, or 99.2%, to $3,012.2 million from $1,512.1 million for the same period last year. The increase in medical benefits expense was due to the addition of members primarily from our Georgia and PDP launch, the mix of these members between our product lines and the demographic mix of our membership. The medical benefits ratio, which represents our medical benefits expense as a percentage of premium revenue was 81.1% for the year ended December 31, 2006 compared to 81.2% for the same period last year.

Medicaid. For the year ended December 31, 2006, Medicaid medical benefits expense increased $456.6 million, or 41.5%, to $1,556.5 million from $1,099.9 million for the same period last year. The membership increase, principally in our Georgia market, accounted for $339.8 million of the increase. Increased healthcare costs and the demographic change in membership accounted for $116.8 million of the increase. For the year ended December 31, 2006, the Medicaid medical benefits ratio was 80.7% compared to 81.0% for the same period last year. This decline resulted from premium rate increases, changes in the healthcare utilization pattern of our members and the demographic mix of our members in our 2005 existing markets, partially off-set by the higher medical costs associated with our Georgia launch.

   
Medicaid Medical Benefits Expense
 
   
For the Year Ended December 31,
 
   
2006
 
2005
 
Medical Benefits
 
$
1,556.5
 
$
1,099.9
 
MBR
   
80.7
%
 
81.0
%

Medicare. For the year ended December 31, 2006, Medicare medical benefits expense increased $1,043.5 million, or 253.2%, to $1,455.7 million from $412.2 million for the same period last year. The increase was primarily due to the growth in membership, principally in PDP, which accounted for $959.6 million of the increase. Increased healthcare costs and the demographic change in membership accounted for $83.9 million of the increase. For the year ended December 31, 2006, the Medicare medical benefits ratio was 81.5% compared to 81.7% for the same period last year.

   
Medicare Medical Benefits Expense
 
   
For the Year Ended December 31,
 
   
2006
 
2005
 
Medical Benefits
 
$
1,455.7
 
$
412.2
 
MBR
   
81.5
%
 
81.7
%

Selling, general and administrative expense. For the year ended December 31, 2006, selling, general and administrative expense increased $233.3 million, or 89.9%, to $492.8 million from $259.5 million for the same period last year. Our selling, general and administrative expense to revenue ratio was 13.1% and 13.8% for the years ended December 31, 2006 and 2005, respectively. The increase in selling, general and administrative expense was primarily due to investments in information technology, investments in sales and marketing strategies and increased spending necessary to support and sustain our membership growth.

   
Selling, General and Administrative Expense
 
   
For the Year Ended December 31,
 
   
2006
 
2005
 
SG&A
 
$
492.8
 
$
259.5
 
SG&A expense to total revenue ratio
   
13.1
%
 
13.8
%

 
Interest expense. Interest expense was $14.1 million and $13.6 million for the years ended December 31, 2006 and 2005, respectively. The increase relates to the rising interest rate environment, off-set by the reduced amount of debt outstanding due to the settlement of the related party note.

44

 
Income tax expense. Income tax expense for the year ended December 31, 2006 was $87.5 million with an effective tax rate of 38.6% as compared to $33.2 million with an effective tax rate of 39.0% for the same period last year.

   
Income Tax Expense
 
   
For the Year Ended December 31,
 
   
2006
 
2005
 
Income tax expense
 
$
87.5
 
$
33.2
 
Effective tax rate
   
38.6
%
 
39.0
%

Net income. For the year ended December 31, 2006, net income was $139.2 million compared to $51.9 million for the same period last year, representing an increase of 168.2%. The increase is due to increased revenues generated by our membership growth while maintaining a relatively consistent medical benefits ratio.

   
Net Income
 
   
For the Year Ended December 31,
 
   
2006
 
2005
 
Net income
 
$
139.2
 
$
51.9
 
Net income per diluted share
 
$
3.43
 
$
1.32
 


Comparison of Year Ended December 31, 2005 to Year Ended December 31, 2004

Premium revenue. For the year ended December 31, 2005, premium revenue increased $471.6 million, or 34%, to $1,862.5 million from $1,390.9 million for the period ended December 31, 2004 due to the addition of members, the mix of these members between our product lines and the demographic mix of our membership. Additionally, premium rate increases on our products and the inclusion of Harmony for the entire year ended December 31, 2005, compared to seven months for the year ended December 31, 2004, contributed to the increase in premium revenues. Total membership grew by 108,000 members, or 14%, from 747,000 at December 31, 2004 to 855,000 at December 31, 2005.

Medicaid. Our Medicaid segment includes Medicaid programs and other state-sponsored healthcare programs. For the year ended December 31, 2005, Medicaid segment premium revenue increased $303.0 million, or 29%, to $1,358.0 million from $1,055.0 million for the period ended December 31, 2004. The increase was primarily due to growth in Medicaid membership, the inclusion of Harmony revenue for the entire year and increases in premium rates. Aggregate membership in the Medicaid segment grew by 85,000 members, or 12%, from 701,000 members at December 31, 2004 to 786,000 at December 31, 2005.

   
Medicaid Revenues and Membership
 
   
For the Year Ended December 31,
 
   
2005
 
2004
 
Revenues
 
$
1,358.0
 
$
1,055.0
 
% of Total Premium Revenues
   
72.9
%
 
75.9
%
               
Membership
   
786,000
   
701,000
 
% of Total Membership
   
91.9
%
 
93.8
%

Medicare. For the year ended December 31, 2005, Medicare segment premium revenue increased $169.7 million, or 51%, to $504.5 million from $334.8 million for the period ended December 31, 2004. Growth in premium revenue within the Medicare segment was primarily the result of membership increases. Membership within the Medicare segment grew by 23,000 members, or 50%, from 46,000 members at December 31, 2004 to 69,000 members at December 31, 2005.

   
Medicare Revenues and Membership
 
   
For the Year Ended December 31,
 
   
2005
 
2004
 
Revenues
 
$
504.5
 
$
334.8
 
% of Total Premium Revenues
   
27.1
%
 
24.1
%
               
Membership
   
69,000
   
46,000
 
% of Total Membership
   
8.1
%
 
6.2
%

Investment and other income. For the year ended December 31, 2005, investment and other income increased $12.7 million, or 295%, to $17.0 million from $4.3 million for the period ended December 31, 2004. The increase was due primarily to the investment of proceeds from our public offerings, additional cash generated by operations and a higher interest rate environment.

 
Medical benefits expense. For the year ended December 31, 2005, medical benefits expense increased $386.5 million, or 34%, to $1,512.1 million from $1,125.6 million for the period ended December 31, 2004. The increase in medical benefits expense was due to the addition of members, the mix of these members between our product lines and the demographic mix of our membership. The medical benefits ratio, which represents our medical benefits expense as a percentage of premium revenue was 81.2% for the year ended December 31, 2005 compared to 80.9% for the period ended December 31, 2004.

Medicaid. For the year ended December 31, 2005, Medicaid medical benefits expense increased $248.8 million, or 29%, to $1,100.0 million from $851.2 million for the period ended December 31, 2004. The membership increase accounted for $183.0 million of the increase. Increases in healthcare costs, the inclusion of Harmony for the entire year ended December 31, 2005 and demographic changes in membership accounted for the remaining $65.8 million of the increase. For the year ended December 31, 2005, the Medicaid medical benefits ratio was 81.0% compared to 80.7% for the period ended December 31, 2004.

   
Medicaid Medical Benefits Expense
 
   
For the Year Ended December 31,
 
   
2005
 
2004
 
Medical Benefits
 
$
1,100.0
 
$
851.2
 
MBR
   
81.0
%
 
80.7
%

Medicare. For the year ended December 31, 2005, Medicare medical benefits expense increased $136.9 million, or 50%, to $412.2 million from $275.3 million for the period ended December 31, 2004. The increase was primarily due to the growth in membership, which accounted for $115.2 million of the increase. Increased healthcare costs and the demographic change in membership accounted for $21.7 million of the increase. For the year ended December 31, 2005, the Medicare medical benefits ratio was 81.7% compared to 82.3% for the period ended December 31, 2004.

   
Medicare Medical Benefits Expense
 
   
For the Year Ended December 31,
 
   
2005
 
2004
 
Medical Benefits
 
$
412.2
 
$
275.3
 
MBR
   
81.7
%
 
82.3
%
 
Selling, general and administrative expense. For the year ended December 31, 2005, selling, general and administrative expense increased $88.2 million, or 51%, to $259.5 million from $171.3 million for the period ended December 31, 2004. Our selling, general and administrative expense to revenue ratio was 13.8% and 12.3% for the years ended December 31, 2005 and 2004, respectively. The increase in selling, general and administrative expense was primarily due to investments in information technology, investments in sales and marketing strategies and increased spending necessary to support and sustain our membership growth. Additionally, SG&A expense for the year ended December 31, 2005 increased due to costs incurred relating to our Georgia expansion and PDP implementation costs of approximately $0.38 per pro forma fully diluted share.

   
Selling, General and Administrative Expense
 
   
For the Year Ended December 31,
 
   
2005
 
2004
 
SG&A
 
$
259.5
 
$
171.3
 
SG&A expense to total revenue ratio
   
13.8
%
 
12.3
%

Interest expense. Interest expense was $13.6 million and $10.2 million for the years ended December 31, 2005 and 2004. The increase primarily relates to the additional amount of debt outstanding for the full year of 2005 and the rising interest rate environment.

Income tax expense. Income tax expense for the year ended December 31, 2005 was $33.2 million with an effective tax rate of 39.0% as compared to $31.3 million with an effective tax rate of 38.8% for the period ended December 31, 2004.

   
Income Tax Expense
 
   
For the Year Ended December 31,
 
   
2005
 
2004
 
Income tax expense
         
Income tax expense
 
$
33.2
 
$
31.3
 
Effective tax rate
   
39.0
%
 
38.8
%

46

 
Net income. For the year ended December 31, 2005, net income was $51.9 million compared to $49.3 million for the period ended December 31, 2004, representing an increase of 5%. The increase is due to increased revenues generated by our membership growth while maintaining a consistent medical benefits ratio.

   
Net Income
 
   
For the Year Ended December 31,
 
   
2005
 
2004
 
Net income
 
$
51.9
 
$
49.3
 
Net income per diluted share
 
$
1.32
 
$
1.56
 

Liquidity and Capital Resources

We manage our cash and investments in a manner that allows us to meet our short-term, long-term and regulatory requirements. We monitor and forecast our capital resources to ensure that we maintain the financial flexibility we need to take advantage of viable business opportunities. As of December 31, 2006 and 2005, cash and cash equivalents were $964.5 million and $421.8 million, respectively. We also had short-term investments with maturities of three to 12 months of $30.9 million and $84.0 million as of December 31, 2006 and 2005, respectively.

Our regulated subsidiaries are financed principally through internally generated funds. We generate cash mainly from premium revenue, and we generally receive premium revenue in advance of payment of claims for related healthcare services. Our primary use of cash is the payment of expenses related to medical benefits and administrative costs. Our investment policies are designed primarily to provide liquidity and preserve capital. The states in which we operate prescribe the types of instruments in which our regulated subsidiaries may invest their funds. As of December 31, 2006 and 2005, a significant portion of our cash was invested in certificates of deposit and a portfolio of highly liquid money market securities with a weighted average maturity of 133 days and 35 days, respectively. The average portfolio yield for the years ended December 31, 2006 and 2005 was approximately 4.2% and 2.6%, respectively.

Our non-regulated businesses also generate positive cash flows that are used for corporate purposes. As of December 31, 2006, free cash in our non-regulated businesses was $109.4 million. We generally invest cash generated from our non-regulated entities in certificates of deposit and municipal bonds. The factors that we consider in making these investment decisions include term to maturity, rate of return and municipal bonds ratings.

We expect our future funding for working capital needs, capital expenditures, long-term debt repayments and other financing activities will continue to be provided from these resources. From time to time, we may need to raise additional capital or draw on our revolving credit facility to fund planned geographic and product expansion or acquire healthcare businesses. As of December 31, 2006, we had not utilized our revolving credit facility. We believe that our cash resources and internally generated funds will be sufficient to support our operations, regulatory requirements and other infrastructure investments for the next 12 months.

Each of our existing and projected sources of cash are impacted by operational and financial risks that influence the overall amount of cash generated and the capital available to us. For a further discussion of risks that can impact our liquidity, see our Risk Factors beginning on Page 17.

Regulatory Capital and Restrictions on Dividends and Management Fees. We conduct our operations primarily through our HMO, insurance and other regulated subsidiaries. These subsidiaries are subject to state regulations that, among other things, may require the maintenance of minimum levels of statutory capital, as defined by each state. These regulations may restrict the amount, payment, and timing of the distribution of dividends that may be paid to our parent company from our HMO, insurance and other regulated subsidiaries. The regulators can also limit the ability of our companies to make inter-company transfers, such as the payment of management fees. The regulators can, in their sole discretion, require individual subsidiaries to maintain statutory capital levels higher than state mandated minimums.

The National Association of Insurance Commissioners has adopted rules which, to the extent they are implemented by the states in which we operate, set minimum capitalization requirements for our HMOs, insurance and other regulated entities. The requirements take the form of risk-based capital rules. Florida and New York have not yet adopted the risk-based capital standard as a net worth requirement. Our operations in Illinois, Georgia, Connecticut, Louisiana, Missouri, Ohio, and our PFFS operations are subject to the National Association of Insurance Commissioners’ guidance. Our subsidiaries are required to maintain minimum capital amounts as prescribed by the various states in which we operate. Our restricted assets consist of cash and cash equivalents that are deposited or pledged to state agencies in accordance with state rules and regulations. As of December 31, 2006 and 2005, all of our restricted assets consisted of cash and cash equivalents. As of December 31, 2006 and 2005, we believe all of our subsidiaries were in compliance with the minimum capital requirements. Barring any change in regulatory requirements, we expect that we will continue to be in compliance with these requirements at least through 2007. For example, New York enacted regulations in 2005 that increase reserve requirements by 150% over an eight-year period, which will over time, materially increase the capital requirements of our New York managed care plan.

47

 
Overview of Cash Flow Activities

For the years ended December 31, 2006, 2005 and 2004 our cash flows from operations are summarized as follows:

   
2006
 
2005
 
2004
 
Net cash provided by operations
   
512,654
 
$
81,447
 
$
48,762
 
Net cash used in investing activities
   
(91,852
)
 
(59,330
)
 
(96,466
)
Net cash provided by financing activities
   
121,974
   
2,022
   
208,010
 

Net cash provided by operations. The net cash inflow from operations for the years 2006, 2005 and 2004 was primarily due to increased revenues from increased membership, improved profitability and changes in the receivables and liabilities due to timing of cash receipts and payments. Because we generally receive premium revenue in advance of payment for the related medical care costs, our cash has historically increased during periods of enrollment growth.

Net cash used in investing activities. In 2006, investing activities consisted primarily of the investment of excess cash generated by operations totaling approximately $32.3 million in various short term investment instruments. An additional $35.5 million was invested in capitalized assets, which included expansion costs related to our Tampa facility and investments needed for our new product offerings. Additionally, $16.1 million was invested in restricted investment accounts to satisfy the requirements of various state statutes.

During 2005, investing activities consisted primarily of investment of excess cash generated by operations totaling approximately $18.6 million in various short term investment instruments. An additional $28.9 million was invested in capitalized assets, which included expansion costs related to our Tampa facility and investments in technology needed in anticipation of our entry into the Georgia market and PDP product offerings. Additionally, $5.8 million was invested in restricted investment accounts to satisfy the requirements of various state statutes, and $4.9 million was paid in final settlement of the Harmony acquisition.

In 2004, excess cash totaling $41.7 million was invested in various short term investment instruments. Our acquisition of Harmony in June 2004 required a net cash outlay of $36.5 million. To fulfill certain state requirements, $9.5 million was invested into restricted investment accounts. A total of $8.7 million was invested in property and equipment, principally at our corporate headquarters in Tampa.

Net cash provided by financing activities In 2006, financing activities consisted of proceeds from options exercised totaling $9.0 million, proceeds from our follow-on offering of $22.0 million, partially offset by payments on our credit agreement of $25.6 million.

Also included in financing activities are funds held for the benefit of others, which totaled approximately $113.6 million as of December 31, 2006. These funds are PDP member subsidies and represent pass-through payments from government partners and are not accounted for in our results of operations since they represent pass-through payments from our government partners to fund deductibles, co-payments and other member benefits for certain of our members.

In 2005, financing activities consisted of proceeds from options exercised totaling $3.9 million, partially offset by payments on our credit agreement of $1.6 million.

In 2004, cash from financing activities was primarily related to our public offerings which generated net proceeds of $157.5 million. Additionally we obtained $159.2 million from the proceeds of a debt issuance. These proceeds were partially offset by payments made on previous debt facilities totaling approximately $108.8 million.

48

 
Debt and Credit Facilities.

Credit Agreement

We and some or our subsidiaries are parties to a credit agreement, dated as of May 13, 2004, which was subsequently amended on September 1, 2005 and on September 28, 2006 (as amended, the “Credit Agreement”).

The credit facilities under the Credit Agreement consist of a senior secured term loan facility in the amount of approximately $155,600 and a revolving credit facility in the amount of $125,000, of which $10,000 is available for short-term borrowings on a swing-line basis. The term loan and credit facilities are secured by a pledge of stock of our operating subsidiaries, as well as a pledge of substantially all of the assets of our non-regulated entities. Interest is payable quarterly, currently at a rate equal to the sum of a rate based upon the applicable six month LIBOR rate plus a rate equal to 2.50%. The term loan matures in May 2009, and the revolving credit facility will expire in May 2008. We are a party to this agreement for the purpose of guaranteeing the indebtedness of our subsidiaries that are parties to the agreement. As of December 31, 2006, the revolving credit facility has not been utilized.

The Credit Agreement contains various restrictive covenants which limit, among other things, our ability to incur indebtedness and liens and to enter into business combination transactions. The Second Amendment to the Credit Agreement increased the amount of capital expenditures that we are permitted to incur on an annual basis. We believe that we are in compliance with all financial and non-financial covenants under the Credit Agreement as of December 31, 2006.

Seller Note

As part of the consideration for the acquisition of the WellCare group of companies, we issued a senior subordinated non-negotiable promissory note to related parties. The note payable to a related party was settled in full on September 15, 2006 in the amount of $24.0 million, resulting in a $1.0 million gain on the extinguishment of debt, which is included in other income, due to the settlement of indemnifiable expenses as defined in the agreements for the original purchase of the WellCare companies in August 2002. Interest on the principal amount accrued during the year at a rate of 5.25%.

Working Capital

In 2006, based on our earnings results, membership growth, business diversification, balance sheet and capital position, Moody’s raised its investment outlook from stable to positive and Standard & Poor’s raised our credit rating from B+ to BB-. As of December 31, 2006, our credit ratings were as follows:

Agency
Outlook
 
Credit Rating
Moody’s
Positive
 
Ba3
Standard & Poor’s
Positive
 
BB-

Consequently, if we seek to raise funds in capital markets transactions, our ability to do so will be limited to issuing additional non-investment grade debt or issuing equity and/or equity-linked instruments.

We expect to fund our working capital requirements and capital expenditures during the next several years from our existing cash balances, our cash flow from operations, public offerings or other possible future capital markets transactions. We have taken a number of steps to increase our internally generated cash flow, including reducing our health care expenses by, among other things, exiting from unprofitable markets and undertaking cost savings initiatives. From time to time, we may need to draw upon available funds under our revolving credit facility, which matures in May 2008, or issue additional debt or equity securities if our cash flow from operations is inadequate to support expansion activities. Based on the above, we believe that we will be able to adequately fund our current and long-term capital needs.

A failure to comply with any covenant in our credit facilities could make funds under our credit facilities unavailable. We also may be required to take additional actions to reduce our cash flow requirements, including the deferral of planned investments aimed at reducing our selling, general and administrative expenses. The deferral or cancellation of any investments could have a material adverse impact on our ability to meet our short-term business objectives. We regularly evaluate cash requirements for current operations and commitments, and for capital acquisitions and other strategic transactions. We may elect to raise additional funds for these purposes either through additional debt or equity, the sale of investment securities or otherwise as appropriate.
 
Off Balance Sheet Arrangements

At December 31, 2006, we did not have any off-balance sheet financing arrangements except for operating leases as described in the table below.

 
49

 
Commitments and Contingencies

The following table sets forth information regarding our contractual obligations.

   
Payments due to period
 
Contractual Obligations at
December 31, 2006
 
 
Total
 
Less Than
1 Year
 
1-3
Years
 
3-5
Years
 
More than
5 Years
 
   
(in thousands)
 
Long-term debt(1) (2)
 
$
168,255
 
$
1,886
 
$
166,369
 
$
 
$
 
Operating leases
   
73,094
   
11,906
   
24,603
   
20,278
   
16,307
 
Other liabilities
   
   
   
   
   
 
Purchase obligations
   
4,895
   
3,605
   
1,290
   
   
 
Total
 
$
246,244
 
$
17,397
 
$
192,262
 
$
20,278
 
$
16,307
 

(1)  
Long-term debt (including current maturities) at December 31, 2006 includes total short and long-term debt of $167,876 plus the unamortized portion of the discount on the term loan of $379.
(2)  
Long-term debt (including current maturities) at December 31, 2006 includes interest at an assumed (current) rate of 7.875%.

We are not an obligor under or guarantor of any indebtedness of any other party; however, we may have to pay referral claims of healthcare providers under contract with us who are not able to pay costs of medical services provided by other providers.

Recent Accounting Pronouncements

In December 2004, the FASB issued Statement No. 123(R) (“SFAS No. 123(R)”), “Share-Based Payment,” that requires compensation costs related to share-based payment transactions to be recognized in the financial statements. We are required to comply with SFAS No. 123(R) for the period ended December 31, 2006. In March 2005, the SEC issued Staff Accounting Bulletin No. 107, Share-Based Payment, which provides interpretive guidance related to the interaction between SFAS No. 123(R) and certain SEC rules and regulations, as well as provides the SEC staff’s views regarding the valuation of share-based payment arrangements. See Note 2 regarding the impact of these pronouncements on our financial statements.

In June 2006, the FASB issued FASB Interpretation (“FIN”) No. 48, Accounting for Uncertainty in Income Taxes — an interpretation of FASB Statement No. 109 (“FIN 48”). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in a company’s financial statements. FIN 48 requires companies to determine whether it is “more likely than not” that a tax position will be sustained upon examination by the appropriate taxing authorities before any part of the benefit can be recorded in the financial statements. It also provides guidance on the recognition, measurement and classification of income tax uncertainties, along with any related interest and penalties. Previously recorded income tax benefits that no longer meet this standard are required to be charged to earnings in the period that such determination is made. FIN 48 will also require significant additional disclosures. FIN 48 is effective for fiscal years beginning after December 15, 2006. We intend to adopt the new standard during the first quarter of 2007 as required. The effect of adoption of FIN 48 is not currently expected to be material.

In September 2006, the SEC issued SAB No. 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements (“SAB 108”). SAB 108 provides guidance on how prior year misstatements should be considered when quantifying misstatements in current year financial statements for purposes of assessing materiality. SAB 108 requires that registrants quantify errors using both a balance sheet and income statement approach and evaluate whether either approach results in quantifying a misstatement that, when relevant quantitative and qualitative factors are considered, is material. SAB 108 is effec